Category: Economics

Economics Lesson: Is deflation bad?

Fortunately the key insights about inflation or deflation are fairly intuitive and easy to understand. Stable prices—i.e., zero inflation—is best, fully anticipated inflation (or deflation) is second best, and inflation/deflation surprises are bad. If you would like a bit more detail, read on.

Inflation refers to the rate at which the value of money (average prices usually measure by a consumer price index—CPI) changes over time. Zero inflation, constant purchasing power of a currency over time in its local market (e.g. the value of the US dollar in the US), is best because all of the other factors impacting the supply and demand for individual goods that potentially change their prices relative to other goods and services can be expressed in terms of a constant unit account, a constant measuring rod. This makes comparing prices stated in that unit of account, especially over time, much easier. Imagine if the length or weight of something had to be expressed in units of weights and measure that themselves were always changing. Economic resources are better allocated to the satisfaction of public demand when the relative scarcity of each good and service can be clearly discerned. Decisions about the allocation of resources (whether to build a new factory to produce a new product or more of an old one and/or to hire more workers, etc.) are necessarily forward looking. The entrepreneurs’ question is what will people pay for something next year and the year after and what will it cost to produce it and how does this compare with producing something else. This is more difficult to do when the forecast of prices need to mix in the changing value of the currency in which they are stated.

However, a decent second best is a rate of inflation (positive or negative) that is steady and predictable. The inflation target of 2 percent chosen by many central banks, if reliably achieved, provides an example. If the inflation rate is fully and correctly anticipated, whether positive or negative, all other relative prices, including interest rates and wage contracts, can and will take the anticipated rate into account when setting prices in contracts for the future (e.g., a wage contract). If borrowers and lenders are willing to contract for a loan for five years at 3% per year with zero inflation in the value of the money borrowed and repaid, they would both be willing to undertake the same loan at 5% if they both expected inflation of 2% per year over those five years. If that expectation were rather uncertain, a suitable risk premium would need to be added to the interest rate. If everyone expected with certainty a 2% deflation over the same period, the loan would carry a 1% nominal rate. In both of these examples, the so-called real rate of interest—the rate adjusted for inflation—would be 3%. Thus, modest deflation does no harm if everyone fully and correctly anticipates it.

As an aside for the more advanced students, Milton Friedman explained why a fully anticipated, mild deflation was actually good because it would reduce or eliminate the opportunity cost of holding money and thus encourage people to hold larger cash balances on average without any cost to themselves or society. The money we hold in our wallets or nightstands or in our checking accounts at the bank is like any other inventory of goods that shop keepers keep on their shelves. Without an adequate inventory of what they sell, they would occasionally run out and miss some potential sales. But it cost money to hold an inventory of something. The cost can be measured by the interest you could have earned investing the money you spent to acquire the inventory (called “opportunity cost” by economists), plus any storage costs. Deflation reduces the opportunity cost of holding money by generating a real return from holding it (it is worth more in the future).

Unanticipated inflation, however, is bad because contracts written in dollar terms (so called “nominal” terms) will turn out to have a different real value than was expected. Normally a voluntary contract benefits both parties to it; it is win win. But when the inflation outcome was not anticipated, it will produce unexpected winners and losers. Debtors benefit from unanticipated inflation and creditors lose. More to the point in our current, over indebted environment, a deflation that was not anticipated when the money was borrowed, will increase the real value of the money that must be repaid. Lenders will benefit from the unexpected windfall only if borrowers actually repay their loans. But the unexpected increase in the real value of the debt being repaid may result in a larger number of defaults. So central banks are trying to avoid deflation, or more accurately are trying to achieve their inflation targets (generally 2%) in order to avoid making the economy’s excessive indebtedness even worse.

The above discussion concerns the value of a currency in its own country. But given the very extensive commerce across borders and the fact that most countries use their own currencies, cross border payments require exchanging one currency for the other. If the exchange rates of all currencies were fixed and never changed, the above analysis would apply globally as well. However, the exchange rates of many currencies, such as the USD/Euro rate, vary continuously and sometimes very significantly. The USD/Euro rate has fallen (i.e., the dollar has appreciated) 30% in the last 12 months (on April 9, 2015). This represents an enormous and very disruptive shock to the value of US trade with Europe, increasing the cost of our exports and reducing the cost of imports from Europe by very large, unpredicted amounts. Following the collapse of the gold standard, which fixed the exchange rates of most currencies, in the early 1970s, a costly financial market of insurance against exchange rate movements has developed. The total daily value of FX related transactions (spot, forwards, swaps, options) are estimated at around 4 trillion US dollars. Yes, that is daily and yes, that is trillions. These added costs of international trade would be eliminated if all or most countries returned to credibly fixed exchange rates or better still one globally used currency. The enormous gains in the standard of living from this trade could be extended even further.

The world is now “blessed” with a variety of monetary policy regimes. All of them aim in one way or another to deliver stable value for their currency either domestically or relative to another currency. The major industrial countries generally target inflation domestically and allow the exchange rates of their currency to float against other currencies. Many smaller countries fix or target the exchange rate of their currency to the US dollar or the Euro or the IMF’s Special Drawing Rights (SDR) thus causing the domestic values of their currencies to reflect the inflation rates of the currency to which they are fixed.

Two major reforms would establish a global monetary system with stable money (zero inflation). The first would be to change the IMF’s international reserve asset, the SDR, from a currency whose value is determined by a basket of key currencies (the USD, Euro, UK pound, and Japanese Yen) and allocated on the basis of political decisions, to a currency whose value is determined by a basket of real goods that is issued on the basis of market demand in accordance with currency board rules. These reforms are explained in more detail in earlier articles such as https://wcoats.wordpress.com/2010/01/21/the-u-s-dollar-and-the-sdr-as-international-reserve-currencies/ and https://wcoats.wordpress.com/2013/07/31/a-hard-anchor-for-the-dollar/. The above reforms in the SDR would include an international agreement to replace the US dollar and Euro in international pricing and payments with the reformed SDR, which I call the Real SDR.  http://works.bepress.com/warren_coats/25/

The second reform would follow naturally given the greater stability of the Real SDR. Countries would fix the exchange rate of their national currencies to the Real SDR or replace them all together with the Real SDR (the equivalent of dollarization). If all or most countries did this, the world would enjoy the benefits described above of a global currency with a completely predictable and stable value relative to a “typical household consumption basket” across the globe. It is worth fighting for.

Economics Lesson: Income Inequality

French economist Thomas Piketty’s bestselling book on wealth inequality, “Capital in the Twenty-First Century,” has become the focus of a debate over increasing income inequality in the US and many other countries. I have not read the book, which apparently presents lots of interesting data, the use and interpretation of which is also being debated. A recent paper on Piketty worth reading is by a young PhD candidate at MIT: http://www.washingtonpost.com/blogs/wonkblog/wp/2015/03/19/meet-the-26-year-old-whos-taking-on-thomas-pikettys-ominous-warnings-about-inequality/

The issue that interests me in this note is the great divide in attitudes toward inequality and thus the policies proposed to address it. Some people think income inequality, or at least too much of it, is bad per se. Thus taxing the rich and redistributing the proceeds to middle and lower income families is the solution. For me, and many others, the issue is whether the wealthy (to simplify) earned their income fair and square (to be explained below) and is thus a just reward for their contributions to the economy providing an important incentive for their efforts. To the extent that they have not (monopoly power, government favors, etc.) the solution is to attack and remove the policies and impediments to competitive markets that made their exorbitant incomes possible.

If it is not desirable (fair) for some people to be wealthy when others are not, the collateral damage from income redistribution may be a price worth paying. This collateral damage is well known. If the wealthy cannot keep the income they get from their efforts and/or from their investments in innovative technology, miracle drugs, or the companies that produce what we want and provide our jobs, they will reduce their efforts and investments, thus reducing the income available to us all and available to redistribute. At the other end—recipient—of the redistribution, if the programs through which middle and lower income families receive such income are not well designed they will reduce incentives to work and or misallocate resources further reducing the income available to redistribute. The policy issues become how to design such programs and what is the optimal balance between the “good” effect of more equal income distribution and the bad effects of lower income.

In my book of moral principles, disapproval of the higher incomes of others per se is due to envy, and envy is not a virtue and should be resisted. There is some evidence that many people care both about their absolute income and their income relative to others. Such envy should be discouraged in my view. My standard of morality in this area is that people deserve what they fairly earn but this requires an understanding and agreement on what income is fair. Economists have a straightforward definition of “fair” income. Profits (revenue in excess of costs) earned without artificial government help (subsidies, regulations that keep out or discourage competitors, or state sanctioned monopolies) are fair because they are the (ultimately) competitive return on providing something people value. With competition, profits will be normal, what economists call a normal rate of return on investment.

Unless the government interferes, excessive profits (those above a normal rate of return) will ultimately be competed away as others enter the field to grab some of the high return. While the inventor and developer of a new technology or product may enjoy a quasi monopoly return initially, as long as there are no artificial impediments to competition, i.e. as long as the monopoly is contestable, returns will ultimately become normal. George Will provides some relevant and interesting cases drawn from a new book by John Tamny. “With the iPod, iPhone and iPad, unique products when introduced, Jobs’ Apple created monopolies. But instead of raising their prices, Apple has cut them because ‘profits attract imitators and innovators.’ Which is one reason why monopolies come and go.” “Since 2000, the price of a 50-inch plasma TV has fallen from $20,000 to $550.” “Henry Ford doubled his employees’ basic wage in 1914, supposedly to enable them to buy Fords. Actually, he did it because in 1913 annual worker turnover was 370 percent. He lowered labor costs by reducing turnover and the expense of constantly training new hires.” http://www.washingtonpost.com/opinions/how-income-inequality-benefits-everybody/2015/03/25/1122ee02-d255-11e4-a62f-ee745911a4ff_story.html

There are many examples of profits that are not normal or contestable, which by definition are unfair. Those on my side of this issue would look for the government favors or interferences that made them possible and seek to remove them. There is no doubt, for example, that US monetary and regulatory policies have made possible lopsided returns from one-sided risk taking by Wall Street (the moral hazard of tax payer bail outs when excessive bank risk taking goes wrong). These policies need to be reformed in order to make the economy fairer and more efficient. See my Letter from the Editorial Board in the next issue of the Cayman Financial Review.

A very large political/policy battlefield in America today is between those who wish to redistribute income to make it more equal and those who want to make income distribution more equal by reducing or removing the economic rents generated by excessive and inappropriate government regulations and subsidies. They are each motivated by dramatically different philosophies and conceptions of what is fair and what is good. We might call these positions “egalitarianism” and “capitalism.” The motivation of an egalitarian to redistribute income from the rich to the poor is dramatically different than the desire of virtually all American’s to provide what Ronald Reagan called an adequate social safety net for the truly disadvantaged and those who have fallen off the ladder. I am on the side of capitalism.

US Global Leadership – More on AIIB

Following the end of the second of two devastating World Wars within three decades, the world came together to establish international institutions and norms meant to prevent another world war and to promote the shared economic and political interests of all peace loving countries. The United States led this effort and has dominated the resulting global governance structure (the UN, IMF, World Bank, WTO to name a few of the best known). The one-country-one-vote structure of the UN has limited its effectiveness. The International Financial Institutions like the IMF, on the other hand, are governed on the basis of votes and financial contributions proportional to their economic importance. Their effectiveness and legitimacy depend, in part, on maintaining such relative voting strength as countries’ economies grow.

Resolving conflicts without world war has been a magnificent achievement. But the opening of the world to freer trade and finance with broadly agreed rules under which it is conducted are dramatically important achievements as well. Economic growth is not a zero sum game. Every country has benefited from global financial cooperation. Estimates (by Bradford DeLong and the World Bank) of Global World Product rose from $1.1 trillion dollars in 1900 to 4.1 trillion in 1950 but exploded there after reaching $41.1 trillion in 2010 (all in 1990 US dollars). According to the World Bank, global poverty has been cut in half in the last twenty years.

The dominant role of the US in International Financial Institutions reflects its economic size and military strength but equally the perception of the rest of the world that the liberal, free markets and trade model promoted by the US was indeed the right one for each country’s growth and prosperity. The world’s continued acceptance of the US’s leadership rests on the general belief that the US is an honest broker, fairly promoting rules that serve the general good rather than seeking special advantage for its own people and industries. The US cannot expect other countries to abide by such international norms of behavior if it is not willing to conform to them itself (i.e. subjugate its sovereignty to international agreements in these areas).

America’s record is not pure by any means. The increasing crony capitalist nature of our military industrial complex, about which we were so presciently warned by President Eisenhower, is hardly a model of competitive market capitalism. But the political structures established after WWII have generally worked well to coordinate national cross boarder activities peacefully and without wars. To cite one example, the International Telecommunications Union has developed rules and procedures for allocating radio spectrum, satellite orbits and technical telecommunications standards that have made possible efficient and interconnected global communications systems. You could not telephone anyone you want any where in the world from anywhere in the world (not to mention the Internet) without them.

The International Monetary Fund is another example of an international cooperative agreement, in this case for facilitating the financing of trade and capital movements (cross border investments). It has played an important role in removing economic restrictions on global trade and finance, though that role has been undermined to some extent and made more complex by the US abandonment of its obligations to redeem its currency for gold under the gold exchange standard imbedded in the IMF’s Articles of Agreement when President Nixon killed what was left of the gold standard.

Few countries want the leadership provided by the US replaced by China or anyone else, but as China and many other country’s economies and trade have grown relative to the US and especially to Europe, they rightly expect to have a larger role in organizations that act for the entire world. The US congress has very shortsightedly and foolishly refused to approve the adjustments in the governance of the IMF that would accomplish that. As a result it is undermining the foundation of the US’s leadership role. “Indeed, Treasury Secretary Jacob Lew made this point implicitly in testimony this week in which he also restated U.S. reservations about the AIIB: Our continued failure to approve the IMF quota and governance reforms is causing other countries, including some of our allies, to question our commitment to the IMF and other multilateral institutions that we worked to create and that advance important US and global economic and security interests.

…The IMF reforms will help convince emerging economies to remain anchored in the multilateral system that the United States helped design and continues to lead.” http://www.lobelog.com/washington-misses-bigger-picture-of-new-chinese-bank/#more-28547

While there are legitimate arguments over whether an Asian Infrastructure Investment Bank is a good thing or whether such funds would be better spent through the Asian Development Bank (China, which would lead the new AIIB, doesn’t have such a great record with the quality of its own infrastructure spending), the real issue is whether the world will remain united in the post WWII international order and presumably under US leadership of the International Financial Institutions it helped establish. The principles of inclusiveness and a level playing field that have always been the foundation of US promoted institutions clearly call for and would be promoted by supporting the expanded role of China in these institutions in keeping with its increasing involvement in the world economy. US opposition to the IMF governance reforms and its reaction against the AIIB appear duplicitous and are undermining the foundations of its leadership. “The decision by the UK, and subsequently, France, Germany, and Italy, to participate is therefore significant not only because they will be major shareholders, but also because the decision by traditional U.S. allies signals that Washington is increasingly isolated.” http://www.cfr.org/global-governance/bank-too-far/p36290

Everyone has a strong interest in having China join and work within the established liberal economic order rather than going its own way with a competing order. Recent US behavior hardly promotes that goal.

For my earlier comments on the AIIB see: https://wcoats.wordpress.com/2015/03/18/the-asian-infrastructure-investment-bank-aiib/

The Asian Infrastructure Investment Bank – AIIB

Last evening CCTV, the China Central Television company, contacted me about an interview about the AIIB at 8:15 am the next morning (i.e., this morning). I have appeared on their Biz Asia show several times in the past. I agreed to the interview and they arranged for a car to pick me up at 7:15am. Due to a mistake in scheduling the car, it did not arrive in time to get to the studio. Rather than go back to bed I am writing this note to share with you what I would have said.

Background

Frustrated with the slow pace of governance reform of the existing international financial institutions (IMF, World Bank, Asian Development Bank) in which China was under-represented in relation to its economic size, China began discussing the establishment of alternative institutions. The first was the New Development Bank of BRICS (Brazil, Russia, India, China, and South Africa) to be headquartered in Shanghai, China. The AIIB was launched with a signing ceremony in Beijing on October 24, 2014 that included, in addition to China, representatives from Bangladesh, Brunei, Cambodia, India, Kazakhstan, Kuwait, Laos, Malaysia, Mongolia, Myanmar, Nepal, Oman, Pakistan, the Philippines, Qatar, Singapore, Sri Lanka, Thailand, Uzbekistan, and Vietnam. It will focus on the development of infrastructure in developing countries in the Asian-Pacific region.

The United States, which has traditionally held the Presidency of the World Bank and on whose territory are housed the headquarters of both the World Bank and the International Monetary Fund, has been cool to these developments, which initially resulted in Australia, New Zealand, and European countries as well as the U.S. declining to join (as financiers). However, last week Britain’s Chancellor of the Exchequer, George Osborne, announced that the UK would join as a founding member and was quickly followed by Germany, France, and Italy. Australia and New Zealand are reconsidering their earlier lack of interest. If that weren’t embarrassing enough for the US, a US government official told the Financial Times, “We are wary about a trend toward constant accommodation of China, which is not the best way to engage a rising power.”

CCTV Interview

Early this morning I received the following email from CCTV.

“Hello Warren,

“This is Qingzhao from China24 program, CCTVNEWS. Thanks for joining our studio AIIB discussion. You will discuss with two more guests in Beijing studio. They are Mr Ding Yifan, senior fellow of the Institute of World Development under the Development Research Center of the State Council. And John Ross, Senior Fellow of Chongyang Institute for Financial Studies, Renmin University of China. He is also the former adviser of ex-London mayor Ken Livingstone.  Question 3 and Question 5 are for you, please take a look.

“Q1: The first question is for you, Mr Ding. So far, the number of countries that have joined or are in the process of joining as a founding member have surpassed 30…Talk to us about the tangible benefits to Europe and Asia as more nations from the EU want to join the AIIB.

“Q2: John, the UK, Germany, France and Italy ALL applying to join as founding members of the AIIB. What’s the attraction for western countries to join in?

“Q3: Warren, following now FOUR western European nations wanting to join the Asian Infrastructure Investment Bank…U.S. Treasury Secretary, Jack Lew is urging HIS country’s lawmakers to pass reforms of the International Monetary Fund. Will IMF reforms finally be pressured to pass and if so, impact on attractiveness of AIIB?

“Q4: Mr Ding, with more western countries applying to join the AIIB, some people have concerns that their participation will, to some extent, weaken China’s role in the system. What’s your take? What’s the possibility of some countries turning out to be a Trojan horse?

“Q5: Warren, Washington views the AIIB as a rival to the U.S. led World Bank and IMF, but China has said the AIIB will COMPLEMENT existing multilateral institutions. What’s your take on AIIB’s role?”

Had I made it to their studio I would have said the following:

Question 3: Secretary Lew has been trying to get the IMF reforms passed by the US Congress for several years. Ironically the US was very instrumental in pressuring European countries to reduce their representation on the IMF’s Executive Board in favor of increasing the representation of the BRICS and other emerging market countries, by bringing IMF member country quotas closer to those calculated on the bases of their economic size and share in world trade. Europe has long been over represented and the emerging market countries under-represented on this basis. The US voluntarily accepted a smaller quota than this formula would produce long ago (thus reducing its financial contribution as well as its vote) and the proposed new amendments would not further reduce the US quota share. Moreover, the proposed doubling of the IMF’s quota resources would not increase the US financial contribution. Rather it would convert the large loan from the US to the IMF made during the recent financial crises from a loan to a quota increase. Thus it is strange for the US now to hesitate to support these reforms. Given that the International Financial Institutions (World Trade Organization, IMF, and WB) that the US helped create are part of the new post World War II world order of global trade from which the US and other market economies have so benefited, this strange US behavior is extremely short sighted.

I would like to think that Congress would get around to approving these reforms independently from the threats posed by China’s new institutions. Virtually every other IMF member country has, but the US enjoys veto power by virtue of its large quota of 17.5% and the requirement that any amendments to the IMF Articles of Agreement must be adopted by members collectively with 85% of the quotas. The reality seems to be the other way around. China was pressured to create competing institutions because the US has failed so far to endorse governance reforms in the existing one.

Question 5: The AIIB is more of a rival to the Asian Development Bank than to the World Bank, and is no rival to the IMF, which does not make development loans, at all. China claims that the AIIB is a compliment rather than a rival to the other development banks. It will have the virtue of a clear and relatively narrow mandate; while the World Bank is all over the map. Voting membership by the UK, Germany, France, etc. should help ensure that its loans meet the standards set by the ADB and the WB. The US has maneuvered itself out of that possibility, not that Congress would ever approve the funds for it anyway. On the other hand, establishing a new institution will absorb a lot of time and other resources in developing its staff, procedures and facilities that would not have been necessary if China had contributed the same funds for the same purposes to the ADB. The traditional Japanese Presidency of the ADB, whose headquarters are in the Philippines, is likely to yield to new governance provisions in the future, giving China a shot at the Presidency, just as the American and European leadership of the WB and IMF are likely to yield in the future as well.

In short, this is all political and the US has played it poorly to say the least. In the past US leadership internationally, whether through the institutions it helped build or in other ways, has been welcomed and accepted because the US stood for principles others could embrace and promoted and applied them fairly. More recently, and I mean for the last decade or two, and certainly in the case of the IMF and AIIB, it is behaving more like the king on the mountain leading others to want to knock it off. This promotes neither the American nor the global community’s interests.

Economic Sanctions

Economic sanctions can be a political tool to punish and hopefully stop or deter bad behavior by another country, group, firm, or individual. However, sanctions are rarely effective, often hurting the wrong people. Robert Pape’s examination of past sanctions on countries found that only 4% were clearly effective. Their virtue is that they tangibly register disapproval of bad behavior without going to war. An important policy question is when to use them. In my opinion sanctions should be used very rarely against countries when there is a broad global consensus that the behavior of the country is significantly and unacceptably at variance with established international norms. This is both because they are rarely effective, in part because they often hurt the general public rather than the leaders responsible for the bad behavior, and because it should generally not be the business of our government to dictate how other governments behave unless that behavior is directly against us. What that means, for example, is that sanctions should not generally be used against countries whose human rights behavior we disapprove of.

Under what circumstances might the use of economic sanctions be justified and effective? The effectiveness of economic sanctions varies greatly with their nature and the circumstances in which they are applied. In what follows I very briefly illustrate the range of experience and possibilities.

Cuba

Clearly the sanctions of one country against another, such as outlawing trade in certain products or outlawing trade and financial transactions of any sort, are of very limited effectiveness as the sanctioned country can simply trade with others instead. Cuba illustrates this point. First imposed over 50 years ago by President John F. Kennedy and now enforced through six different statutes, the United States forbids most trade with Cuba by its citizens or companies. President Bill Clinton extended and stretched the reach of this embargo to apply to the foreign subsidiaries of American companies as well. The purpose of this embargo as stated in the Cuban Democracy Act of 1992 is to encourage the Cuban government to move toward “democratization and greater respect for human rights”.

Though the U.S. has put a lot of pressure on other countries to restrict their own trade with and travel to Cuba, it has been largely ignored. The U.S. pretty much stands alone. The cost of the embargo has fallen more on the U.S. than on Cuba. The U.S. Chamber of Commerce estimates the cost to the U.S. economy at $1.2 billion per year in lost sales and exports. More over it has not improved governance in Cuba nor led to regime change. In 2009, Daniel Griswold, director of the Cato Institute’s Center for Trade Policy Studies, criticized the embargo by stating:

“The embargo has been a failure by every measure. It has not changed the course or nature of the Cuban government. It has not liberated a single Cuban citizen. In fact, the embargo has made the Cuban people a bit more impoverished, without making them one bit more free. At the same time, it has deprived Americans of their freedom to travel and has cost US farmers and other producers billions of dollars of potential exports.” Former Secretary of State George P Schultz called the embargo “insane.”

Cuba is a mess not because of U.S. sanctions but because of the highly repressive Marxist regime in control for the last 52 years. The American embargo has given the Castro government an escape goat for its own failures—and the Castro government still rules. President Obama recently reestablished diplomatic relations with Cuba but the embargoes will remain until Congress amends or removes them. The President has been criticized for not getting enough in return for reestablishing relations and its link with Cuba’s freeing of American spy Alan P. Gross is certainly unfortunate, but the U.S.’s diplomatic recognition of a country should have nothing to do with whether we approve of its government and its approach to governing. The 50 plus year-old embargo has totally failed in its objectives as well, which were not justified in any event. It should finally be lifted and we, and our government, should continue to criticize the Cuban government’s oppressive and destructive policies.

Iran

Economic and financial sanctions against Iran have been more successful. Though the U.S. initially imposed limited sanctions following the Iranian revolution in 1979, international sanctions were imposed by the U.N. Security Council in 2006 and later by the EU in response to Iran’s refusal to suspend its uranium enrichment program. These sanctions banned supplying Iran with nuclear-related materials and technology, and froze the assets of key individuals and companies related to the program. In the following years these sanctions were expanded to include an arms embargo and broader freezes on assets held abroad and monitoring the activities of Iranian banks, and inspecting Iranian ships and aircraft.

These sanctions have reduced Iran’s export (largely oil) revenue and sharply restricted its imports of materials needed for its uranium enrichment program. The international arms embargo has negatively impacted Iran’s military capacity as it is now reliant on Russian and Chinese military assistance. The U.S./EU embargo on oil shipments was made more effective when the EU extended its embargo to ship insurance resulting in most supertankers refusing to load Iranian oil. Excluding Iran from international payments via SWIFT has significantly complicated such payments. The value of Iranian rial plunged by 80% and the standard of living is suffering.

While smuggling has allowed wide spread evasion of many restrictions, they significantly raise the cost of, and thus reduce the gains from, trade. In the list of unintended consequences, Fareed Zakaria argues that sanctions have strengthened the state relative to civil society because in Iran the market for imports is dominated by state enterprises and state-friendly enterprises, thus smuggling requires strong connections with the government.

While it is difficult to assess the impact of sanctions on public attitudes, they seem to be succeeding in increasing pressure on the government to reach an agreement with the U.S. and EU to reign in its uranium enrichment program. This qualified success reflects the broadly accepted purpose for the sanctions (thwarting Iran’s nuclear weapons potential), and hence broad (but not universal) enforcement of such sanctions.

Islamic State — Da’ish

Da’ish is not a recognized state but is so widely seen as an evil pariah that it constitutes an entity and cause for which sanctions should have their maximum impact. Moreover it is being resisted and attacked militarily as well. While direct U.S. military engagement would be counterproductive in the long run (it is their region and interest, not ours), logistical and weapons support to the government of Iraq and close coordination with Iraq’s neighbors has been and will be helpful. Blocking every possible source of income, payments, and weapons procurement by Da’ish will gradually degrade its ability to fight and to hold on to the territory it needs to fulfill its Islamic caliphate objective.

When virtually the whole world is behind sanctions, we have many tools and capability to make them effective. But even in this most obvious and potentially effective case, there are challenges. While strongly and rightly defending the right of anyone to offend the Prophet or anyone else we can hardly forbid public statements in support of Da’ish. The British “human rights group” CAGE, for example, is under attack for calling Jihadist John “a beautiful young man.” The group, led by former Guantanamo Bay inmate Moazzam Begg, is being attacked by both public and private groups in the UK for its jihadist sympathies. Similar issues exist in the U.S. Read more: http://www.dailymail.co.uk/news/article-2972757/Fury-charities-fund-ISIS-Jihadi-John-apologists.html and http://www.bbc.com/news/uk-31657333

But what about financial support to terrorist groups from their sympathizers? Striking the right balance between fighting terrorists and freedom of expression will require care. Who of my generation can forget the controversies raised in the 1970s and 80s over the financial contributions of Irish Americans and their charities to the Irish Republican Army (officially a terrorist group)?

Russia

In general, the modern world is blessed with many positive incentives for people and countries to behave well. The broadly embraced values of the Enlightenment, and classical liberalism’s respect for each individual and his and her rights has established a presumption against force and coercion and hence against war. It is far more profitable (for both sides) to buy what we want than to try to take it (trade vs war). But unfortunately this has not always been enough to deter bad behavior necessitating consideration of deterrents. Russia’s President Vladimir Putin, whose behavior I can only understand as that of a self enriching gangster who is happy to exploit the fears and paranoia of the average Russian to enhance his power and control, but who cares little for the future well being of his country, is grossly violating post Westphalian principals of sovereignty. Our interest in Ukraine is marginal and Putin’s is intense for reasons of Russian history and its emotional value for Russian support of its new autocrat. U.S. intervention of any sort in Ukraine would likely precipitate intensified interference by Russia. Where and when would the escalation on each side end? Would Russia’s bankruptcy end the fighting before reaching the nuclear level? We should not try to find out. Whether we should provide the pro west Ukraine government with defensive arms is a more difficult question, but would risk ill-advised escalation by Ukraine, a risk we should not take. This leaves us with economic sanctions as the most appropriate deterrent of Russia’s bad behavior.

Interestingly and frustratingly the vary interdependencies that develop with trade also create weapons that can be used by either side to promote a country’s aims. Da’ish is not in a position to deprive us of anything in retaliation to sanctions we impose on it. Even shutting down all exports of oil in the territories it controls or is likely to control would be barely noticed. On the other hand, Russian threats to shut off the flow of oil and gas to Europe and especially Germany, which receives 40% of its oil from Russia, must be taken very seriously. All of the natural gas consumed in Estonia, Finland, Latvia, Lithuania, and Macedonia comes from Russia as does over 50% in Bulgaria, Czech Republic, Greece, Hungary, Montenegro, Serbia, Slovenia, Turkey, and Ukraine. A Russian cut off of gas and to a lesser extent of oil would be devastating to Europe. On the other hand, the loss of that revenue would be devastating to Russia. This is the two-sided nature of trade. It introduces caution into measures to harm trading partners.

Russia’s recent deal to supply oil and gas to China will reduce its reliance on its European market and hopefully Europe will also take steps to reduce its reliance on Russia. However, the U.S. has moved slowly if at all to increase its capacity to ship gas and oil to Europe, which is currently heavily dependent on existing pipelines from Russia. Russia has spent billions of dollars in Europe through environmental groups and others to discourage the development of Europe’s oil shale potential and to encourage the reduction of its use of nuclear energy. http://www.thenewamerican.com/world-news/europe/item/18546-nato-head-russia-is-funding-anti-fracking-movement http://www.washingtontimes.com/news/2015/feb/2/richard-rahn-vladimir-putin-funding-opposition-to-/

Sanctions so far have been carefully (and wisely) targeted to a few specific individuals and companies. It is difficult to determine whether they are having any effect on Putin’s behavior. If they are increased, the risk of Russian retaliation will increase as well, the burden of which would fall on Europe, not the U.S. Russia has cut off the flow of its gas and oil to Europe before for relatively short periods but has resisted doing so for the last few years. Putin is now threatening it again: http://www.washingtonpost.com/world/europe/putin-threatens-to-cut-gas-to-ukraine-as-showdowns-shift-to-economy/2015/02/25/b0d709de-bcf6-11e4-9dfb-03366e719af8_story.html.

Putin’s behavior justifies increasing sanctions but they should remain well targeted. A total blockade of Russia, which would be extremely difficult for Europe, would lead to a collapse of the Russian economy with unpredictable political consequences. The collapse of the Soviet Union in 1991 following the end of the cold war in December 8, 1987, with the signing of the Intermediate Nuclear Forces (INF) Treaty launched the transition (for a while) to a more liberal regime. It was the most dramatic and totally peaceful regime change the world has ever seen, but it took 70 years of patience to achieve. In a letter to this week’s Economist former British Ambassador to Russia Sir Tony Brenton said: “The solution to the Russia problem is not to sanction and isolate, but to hug close and thus, eventually, subvert.” We have a strong interest in an orderly political transition in nuclear-armed Russia.

Israel

Ironically the opposite side of the page of the Washington Post story on Russia linked above reported on the very disturbing use of economic sanctions by Israel against the Palestinians living in the West Bank. Israel refused to turn on the promised water to a new upscale city (residences, shopping mall, theater complex, sports club, school, etc.) being built on a West Bank mountaintop. “Before granting water access to the planned city of Rawabi, Israel — which controls the area that the water pipe would run through — wants Palestinian Authority officials to return to an Israeli-Palestinian Joint Water Committee. The Palestinians abandoned the group in 2010 because they don’t want to approve water projects to Jewish settlements in the occupied West Bank, which are built on land that Palestinians want for a future state — and which still get plenty of water.” http://www.washingtonpost.com/world/middle_east/new-palestinian-city-has-condos-a-mall-and-a-sports-club–but-no-water/2015/02/24/d5a28dcc-b92e-11e4-a200-c008a01a6692_story.html

After driving Palestinians from their homes in the war of 1948 that established the Jewish state of Israel, the new state of Israel and the international community accepted boundaries between Israel and the rest of Palestine that were somewhat enlarged from the UN approved partition of Palestine into Israel and the West Bank and Gaza Strip. The right of the 700,000 displaced Palestinians to return to their homes remain one of the unresolved issues in the Israeli-Palestinian dispute. The Jewish settlements referred to above are in the West Bank and have been ruled illegal in a number of UN resolutions and U.S. State Department opinions. http://works.bepress.com/warren_coats/26/

On several occasions Israel has also withheld the import tariffs that it collects on behalf of the WBG government (the Palestinian Authority) in order to pressure the PA not to challenge the construction of additional illegal settlements in the West Bank. “To protest the Palestinian Authority’s move this year to join the International Criminal Court in The Hague, Israel has also withheld for three months the transfer of $381 million in custom duties Israel collects on Palestinians’ behalf.” http://www.washingtonpost.com/world/middle_east/israel-to-let-water-flow-to-west-bank-development-at-center-of-political-feud/2015/02/27/d1b598de-be84-11e4-bdfa-b8e8f594e6ee_story.html

These are examples of a country’s use of “sanctions” to achieve its own, not widely shared, political ends. In the New York Times Nicholas Kristof said: “The reason to oppose settlements is not just that they are bad for Israel and America, but also that this nibbling of Arab land is just plain wrong. It’s a land grab.” http://www.nytimes.com/2015/02/26/opinion/nicholas-kristof-the-human-stain.html?_r=0 The same can be said of Russia’s land grab in Ukraine.

Fortunately in the case of Israel, Prime Minister Netanyahu intervened on February 27 and approved turning on the water before traveling to the U.S., presumably worried about bad press from Israel’s behavior, something President Putin unfortunately but predictably doesn’t seem to care about.

Greece, Debt, and Parenting

If you are a parent, you may have experienced something like the following:

Son number 1 and his children live in a much nicer home than you did at his age. It is the biggest house he could qualify to buy and you put up the down payment to assist him in his purchase. He worked hard as an auto mechanic earning a decent income. His wage was increased modestly each year as his productivity gradually increased with experience, though barely keeping up with inflation. He and his wife were loving parents with three wonderful children and enjoyed their family time together spending what they earned on their children. However, they spent his income as he received it and borrowed the maximum possible to buy a nice second hand family van. When the car needed more than the normal repairs, he had no savings and borrowed the money from you. The occasional family illnesses were paid for by additional loans from you as well and rather than paying off their mortgage and other debts over time these debts grew larger. When his children reached college age they took jobs that did not require college educations as no money had been saved for college.

Son number 2 was also an auto mechanic but ran his own repair shop. His wife and two children lived in a more modest home with lower mortgage payments and they consumed his earnings carefully and modestly in order to save for emergencies, the children’s college fund, and his retirement, and to invest in equipment that would make his repair shop more productive. For a number of years they enjoyed a lower standard of living than did son number 1, but gradually paid down their mortgage without incurring additional debt. More importantly, his income rose more rapidly than did his brother’s because of his investments in tools and equipment. Within 24 years his income was twice his brothers as a result of its growing 3% per year faster.

With the bursting of the housing bubble in 2007 and having his hours of work reduced because of the slowing economy, son number 1 was forced to sell his house in a short sale arranged with the mortgage holder and you wrote off what he owned you. His family was forced to cut many of their expenditures because no one would lend them the money needed to continue living beyond their means. They were forced to cut their consumption even further in order to have some savings when the inevitable health and mechanical emergencies occurred because you decided that your earlier financial help had only perpetuated their shortsighted behavior and refused to lend him more. They complained about the fall in their standard of living as they were now forced to consume within their means. Your son number 1’s family was now poorer. Or more accurately, their standard of living matched reality and became sustainable. Their earlier, higher standard of living was an unsustainable illusion.

Needless to say, son number 2’s future was brighter. His family took advantage of the fall in housing prices by 2008 to buy a larger home, keeping their original one for its rental income. His two daughters went to and graduated from college. His higher standard of living was real and sustainable (i.e. he paid for his higher consumption fully out of his higher earnings).

If you rename son number 1 “Greece”, and son number 2 “Germany” you can begin to understand the difference between the situation of each economy and the difference between competitiveness (exports that match and pay for imports) and productivity (the level of wages and income). For a while Greece enjoyed an artificial and unsustainable standard of living. It needed to “adjust” to reality, i.e. to bring its expenditure in line with its income both internally (the government and each household better matching their incomes and expenditures) and externally (imports matched by –i.e., paid for by—exports) and thus to recognize that it is really poorer than it had pretended. This is what is meant by being competitive. To raise its standard of living it must become more productive by creating a more business friendly environment, reducing its blotted government bureaucracy, and liberalizing labor and product markets. For more details see my earlier articles on Greece: https://wcoats.wordpress.com/2010/05/30/greeces-debt-crisis-simplified/ and https://wcoats.wordpress.com/2012/02/26/saving-greece-austerity-andor-growth/

Comments on the All-Volunteer Military

My friend and former University of Chicago classmate sent the following comments on my All-Volunteer Force note. From 1989-93 Chris Jehn was the Assistant Secretary of Defense for Force Management and Personnel.

Warren–
I read with interest your recent essay on unintended consequences of ending conscription in the U.S. Having spent a large part of my career on issues surrounding implementation of the All-Volunteer Force. I was curious to learn what consequences you had in mind. I was disappointed to read, “the top 20-30 percent of income earners in the United States provide almost none of their sons and now daughters” to the military. Where did you hear this? It is a commonly held view of liberal critics of the military, but, like many persuasions of the left, it is not based on fact. (You could have looked it up. See Table 41 of the DoD population report at http://prhome.defense.gov/portals/52/Documents/POPREP/poprep2011/appendixb/b_41.html.) Using the only available data on the issue, census tract home of record for new enlisted recruits, DoD/CNA analysis shows that 18.5% of recruits in FY 2011 came from the top quintile of the income distribution. Adding new officers to the analysis (not possible since officers’ original home is not carried in their military records) would probably raise that percentage somewhat since virtually all new officers are college graduates. It is surprising to many to learn that the recruits each year are drawn more or less evenly from across income quintiles, but this has been true for 30 years now.

However, the overall percent of the population recruited each year is quite low, regardless of income class. (About 4,000,000 kids turn 18 each year and the military recruits somewhat over 200,000.) This leaves most families without any first-hand connection to the military and that is another lament of the left (and some on the right). I think this is usually mindless World War II envy. At the end of WW II, about 12 million men and women were in uniform, about 10% of the TOTAL population of the U.S. So that meant everyone knew many in the military. That’s not true today. To match that percent today would require a military of over 30 million (compared to today’s 2.5 million, including reserves). And this demographic phenomenon was ultimately the source of draft opposition in the 1960s (and has been in many European countries recently). When most draft-age men serve (as they did in the ’50s) conscription’s inequities are more tolerable. The increasingly large birth cohorts of the baby boom changed that.

But fundamentally, all the debate about the military’s “representativeness” is silly (whether it’s representativeness in terms of socioeconomic class, race, geography or anything else). The requirement for representativeness is based on a view that military service is a burden to be equitably distributed rather than a profession freely chosen and well compensated. In other words, it is antithetical to the notion of a force of professional volunteers.

Another liberal criticism of the AVF is that it has enabled military adventurism. There is no evidence for this assertion either, despite its face appeal. Interestingly, the only Gates Commission member I’ve discussed this with, Allen Wallis, thought this was a positive aspect–freeing the President to use the military without immediate political pushback. So, at least for Wallis, this consequence was not unintended. Of course, pushback from the draft objectors didn’t slow Johnson and Nixon down much, despite an eventual 50,000 deaths in Viet Nam, ten times the toll of Iraq and Afghanistan.

I must apologize for not inviting you to a CNA event in September when we discussed many of these questions at a symposium to honor Walter Oi. I think you would have found it interesting. We did a reprise at last month’s AEA meetings in Boston. Most agree Walter was the most important economist in the battle to end conscription. Among my remarks, I said the following about Walter:

“There are many heroes in this story [of the end of conscription]: the Gates Commission members, Mel Laird, Marine Corps Generals Wilson and Barrow, Army General Max Thurman, and many economists and other analysts. But among the analysts and economists, none was more important than Walter Oi.

It’s tempting to cite instead the economists on the Gates Commission, Milton Friedman, Allen Wallis, and Alan Greenspan. They were essential. But they were advocates, cheerleaders. Walter made the first empirical, data-based argument for voluntarism. And that case helped convince President Nixon and, later, other Gates Commission members. It’s possible that without Walter’s early work—which, as the Hogan-Warner paper notes, stood the test of time and subsequent analyses—conscription would have ended much later, if at all. There were, after all, other politically plausible proposals to ‘fix’ the draft and end the controversy surrounding it, not just a force of all volunteers.”

Some support for my argument is contained in a short note Stephen Herbits prepared for the CNA event (also attached). As part of the planning for the two events, I interviewed the two surviving members of the Gates Commission, Herbits and Alan Greenspan. That was fun and educational.

I should also note that an AVF’s budget costs are not clearly higher than those of a conscripted force of equal capability, due to the high turnover and training costs for draftees. The most careful analysis of this question was GAO’s in 1988. I cite it (as well as my article on conscription in Europe) in my piece on conscription in David Henderson’s encyclopedia (http://www.econlib.org/library/Enc/Conscription.html).

Finally, I think your memory of the 1960s may have failed you here. You and your colleagues may have had some skin in the game. The first lottery in 1968 included those under 26 who had held student deferments. You were probably too old, but I and other classmates were subject to conscription depending on our lottery number (based on our birth date, not our Selective Service number). I luckily drew a number in the 300s.

As for your concluding proposal, while your draft-related arguments don’t support it, it has merit on other purely budgetary grounds, as you note. I too think it’s unconscionable that “overseas contingencies” (to use the Pentagon’s euphemism) are funded through supplemental appropriations funded from borrowing and the general revenues. (And DoD has not “suffered” as a result. You can safely ignore the whining on the subject by Pentagon leaders and their allies in Congress and the press.) But your proposal will never go anywhere. If the Congress had wanted do things differently, they wouldn’t have been doing it like this for as long as I can remember.)

I hope you find much of this interesting, perhaps even educational. If you do nothing else, please look at the Warner-Hogan paper: “Walter Oi and His Contributions to the All-Volunteer Force: Theory, Evidence, Persuasion”, by John T. Warner and Paul F. Hogan, presented at the Contributions to Public Policy: A Session in Honor of Walter Oi, American Economic Association Annual Meetings, Boston, MA, January 3, 2015

–Chris

My Key stories of the world in 2014

Twenty fourteen was a busy year for the planet and in general a rather unhappy time. But believing as I do that when the pendulum swings too far in one direction (big brother) it swings back (personal freedom), I am such an optimist that I see some hopeful signs for 2015. These are the developments that I think are important (and/or felt like writing about).

Torture: A big plus this year was the eye-opening report of the United States Senate Select Committee on Intelligence Report on CIA Torture. It found that the CIA used torture (violating the Universal Declaration of Human Rights, the United Nations Declaration Against Torture, and the I, II, and IV Geneva Conventions of 1949 all of which were signed by the United States and are thus binding laws of the land) and that it was not effective in gathering actionable information that couldn’t have been obtained with traditional interrogation techniques. Admittedly Senator Diane Feinstein was angry about CIA illegal hacking of computers of the Committee staff who have the legal responsibility of CIA oversight and may have been settling some scores. But if you do not find these abuses of power frightening, you live in the wrong country. While the report might not have been fully balanced, its findings on the ineffectiveness of torture are consistent with the earlier findings. https://wcoats.wordpress.com/2010/02/26/torture-is-immoral-and-doesn’t-work/

Our common sense assumption that a prisoner being tortured will tell his captures whatever they want to hear in order to stop the pain was dramatically confirmed by the recent news that Nian Bin was released by the Chinese government after eight years in prison for murders he did not commit. He was originally tortured into admitting the alleged crimes. http://www.washingtonpost.com/world/asia_pacific/in-china-a-rare-criminal-case-in-which-evidence-made-a-difference/2014/12/29/23f86b80-796b-11e4-9721-80b3d95a28a9_story.html

Hopefully these disclosures will reign in these embarrassing and appalling abuses by the United States government.

Greece: Since joining the EU and adopting the Euro (still very popular in Greece as protection against the bad old inflation days), Greece has enjoyed and unfortunately recklessly indulged in a higher living standard (consumption) than it earned (produced) by borrowing from the rest of Europe at the low interest rates paid by Germany. This mispricing of the risk of lending to Greece by financial markets resulted in part from the failure of the European Central Bank (ECB) to rate Greece sovereign debt realistically (treating all sovereign debt of its members alike). It also reflected the moral hazard of the wide spread belief that the EU, ECB, and international financial institutions such as the IMF would bail out holders of such debt. But no one and no country can live beyond its means forever. What can’t go on forever, won’t. https://wcoats.wordpress.com/2010/05/30/greeces-debt-crisis-simplified/, https://wcoats.wordpress.com/2012/02/26/saving-greece-austerity-andor-growth/

The balance between what Greece (short hand for individuals, firms, and government domiciled in Greece) imports and (pays for with) exports can be restored by lowering the cost of Greek goods and services. This will increase its exports and decrease its imports. This can be achieved by lowering wages and other costs of production or increasing productivity. Lowering wages without an increase in productivity simply acknowledges the reality that Greeks are poorer than most other Europeans. Increasing productivity improves Greek competitiveness and thus exports while also increasing its real standard of living.

The loans provided to the Greek government by the troika (EU, ECB, and IMF) tied to (i.e. conditional on) reductions in the government’s borrowing needs (reducing government employees, increasing tax revenue, etc) and structural reforms to make the economy more productive, provided an alternative to its default and forced sudden cut in government spending that markets would have forced on it otherwise. There is debate about which approach would be best for Greece in the long term. Hopefully Greek voters will face and debate this choice honestly in the presidential elections in January: http://www.washingtonpost.com/world/europe/greek-impasse-forces-early-elections-and-fears-of-euro-crisis-return/2014/12/29/3be75924-8f4e-11e4-ba53-a477d66580ed_story.html The implications for the EU and the Euro are huge. https://wcoats.wordpress.com/2011/11/02/the-greek-referendum/

Cuba: President Obama has decided to diplomatically recognize Cuba after a half century long failed policy of sanctions. Not only have our economic sanctions failed to displace the Castro brothers and their pernicious regime (most other countries do not observe our sanctions and trade and invest with Cuba anyway), we have no business (or national self interest) in adopting and promoting a regime change as national policy, however much we might wish for it. Moreover it is very much in our national interest to have good information on and channels of communication with every country with a government no matter how chosen. The linked article by Marc Thiessen illustrates the arrogant and dangerous thinking of our neocons. If Thiessen supports something, I start out against it until convinced otherwise: http://www.washingtonpost.com/opinions/marc-thiessen-cuban-dissidents-blast-obamas-betrayal/2014/12/29/cc68ffcc-8f5b-11e4-ba53-a477d66580ed_story.html

Crony capitalism: President Eisenhower famously worried about the dangers of the military industrial complex as he sought to conduct a cold war with the USSR: https://wcoats.wordpress.com/2011/01/17/eisenhowers-farewell-address-50-years-later/. It is difficult for the government to objectively serve the public interest while dealing with or regulating industry. https://wcoats.wordpress.com/2014/12/18/free-markets-uber-alles/ The relationship that develops in such a situation often serves the interests of the regulated industry more than the general public. The result is what we call crony capitalism and it is the enemy of true capitalism as much as its variants– socialism and fascism. One of the particularly alarming examples of truly disgusting and damaging crony capitalist deals is described in the following article. It involves JPMorgan Chase CEO Jamie Dimon and Eric Holder’s Justice Department agreeing on what seems like a large fine, but is more accurately described as a bribe, to suppress evidence of criminal behavior on the part of Chase. http://www.rollingstone.com/politics/news/the-9-billion-witness-20141106.

Twenty fifteen will be a better year than was 2014 if public outrage at the use of torture, the abuse of the privacy of American’s, the bailing out of and favoritism toward Wall Street and the costly and counter productive deployment of American military around the world, result in rolling back these dangerous excesses. My fear is that nothing will be done and that there will be more the same. I hope that I am wrong.

FREE MARKETS UBER ALLES

World per capita income didn’t change much from the time of Christ to the founding of the United States ($444 to $650 in 1990 dollars), a period of 1,790 years. But in the following 320 years it jumped to $8,080. And about half of that jump came over the last 50 years. What explains this fairly recent explosion of well being? Many things, of course, but central to this explosion of wealth was trade. Only when people could specialize, which requires relying on others to produce part of what they need or want, i.e. to trade, was it possible to dramatically increase the productivity of individuals. The prospect of selling to others also carried the incentive to innovate and develop new technologies, etc.

Trading requires some level of trust in the person you are trading with and mutual acceptance of the rules of the game (contracts). This is relatively easy when you trade with your neighbors and fellow villagers face to face. But as trade extended over longer distances—as it expanded from personal to impersonal dealings— the development of trust became more challenging but no less essential. Product standardization, for example, allowed even greater efficiency and productivity but also facilitated the development of trust in the quality of what we are buying. Companies invested in building and preserving their reputations, which became associated with brand names. As trade expanded, the need for trust was satisfied in more innovative ways.

In today’s rapidly expanding Internet world, where virtually anything under the sun (virtual or real) can be traded via the impersonal Internet, the old brand name reputation approach to establishing trust continues to be useful. Thus we trust the level of quality of products marketed by Sears, or Nieman Marcus on their website to match what we find in their physical locations. However, “the customer review” is rapidly becoming an important source of trust, whether looking for a plumber, a restaurant, a hotel room, or buying a new car.

Government’s have long facilitated trade via providing security (Feudal Lords providing Sheriffs to hunt down highway robbers) and enforcement of contracts. At some point governments began to think that they could establish (or replace) trust more effectively than did competitive markets by imposing regulations to inform or protect consumers. Standard product information, for example, the contents and their nutritional values on the labels of food products, help consumers decide which product best meets their needs. Licensing practitioners of various professions—from cab drivers to physicians—became a widespread form of vetting minimum professional competence or standards. In many if not most professions the regulators tended to be captured by the industry they regulated resulting in protection of the practitioners from competition rather than protection of the customers from poorly trained service providers. Medical doctors fought, often successfully for a long time, competition from providers of alternative medical services (chiropractors, acupuncturists, Internet medical service providers, etc.). Licensed taxi companies obtained exclusive rights to serve specific areas and limit their number in order to boost fares in the name of consumer protection.

The medallions required to operate a taxi in New York City are a famous example of a government created monopoly. The following is from the website of the New York City Taxi and Limousine Commission announcing the auction of 89 medallions on May 2, 2008:

New York City Taxi and Limousine Commission (TLC) Commissioner/Chairman Matthew W. Daus has determined that the Minimum Upset (Bid) Price for each of the 43 available lots of two Minifleet (Corporate) Accessible Medallions that will be auctioned on May 2, 2008 will be $700,000. One Individual Accessible Medallion will likewise be available for bid on that date at a Minimum Upset Price, also set by the Chairman, of $189.000, as will two Individual Alternative-Fuel Medallions at a Minimum Upset Price of $300,000.

The Minimum Upset Price is the minimum amount that will be considered valid. The highest valid bids will be named apparent winners.

Such systems of licensing are meant to insure minimum quality of service (both of the car and of the driver). They are meant to establish trust on the part of customers that when a yellow car pulls up, he will not over charge or rape or rob you. These issues are explored in an interesting paper by Christopher Koopman, Matthew Mitchell, and Adam Thierer: “The Sharing Economy and Consumer Protection Regulation: The Case for Policy Change” Mercatus Center, George Mason University

Click to access Koopman-Sharing-Economy.pdf

“Under the traditional ‘public interest theory’ of regulation, regulation is sought to protect consumers from externalities, inadequate competition, price gouging, asymmetric information, unequal bargaining power, and a host of other perceived ‘market failures’.”

Unfortunately, as economists Mark Steckbeck and Peter J. Boettke observe, regulators often ignore ‘the dynamism of markets and the incentive mechanism driving entrepreneurs to discover ways to ameliorate problems associated with market exchange.’” page 6

“Writing in 1920, Arthur C. Pigou cautioned against contrasting ‘the imperfect adjustments of unfettered private enterprise with the best adjustment that economists in their studies can imagine.’ Instead, he noted that in the real world, policymakers may not implement policy as scholars think they ought to: For we cannot expect that any public authority will attain, or will even whole-heartedly seek, that ideal. Such authorities are liable alike to ignorance, to sectional pressure and to personal corrup¬tion by private interest. A loud-voiced part of their constituents, if organised for votes, may easily outweigh the whole.” Page 7

“Because rent-seeking is used to contrive exclusive privileges rather than to create value for customers, these efforts cost society forgone productive opportunities. To compound the problem, rent-seeking changes the way people allocate their talents. Rather than keeping a focus on devising new and innovative ways to create value, entrepreneurs turn their efforts toward devising new ways to acquire these regulatory privileges.” Page 10

So how has NYC’s medallion system worked? Ask a New Yorker. In 2006 there were only 12,799 licensed taxicabs in New York City, compared with 21,000 in 1931, when the city had about 1 million fewer inhabitants.

Koopman, et al, explore the implication of the choice (or mix) between market and government regulation for the area of what they call the “sharing economy.” The trading facilitated by Craigslist, Uber, and Airbnb has existed for centuries, but the use of the Internet by some clever entrepreneurs has transformed the business model.

Most of us in years past have taken advantage of a limousine driver between official jobs passing by slowly and offering a relatively cheap fare. Unauthorized drivers hang around airports and Theaters to pick up extra fares illegally. My favorite experiences were in the former Soviet Union in the first few years after its collapse. Most everyone wanted free markets but didn’t have a very clear idea how they were organized. We came to realize that virtually any car on the road was potentially an informal taxi. We could flag down almost any car and if we could communicate where we wanted to go and agree on a price, we had a ride. Uber has provided a high tech means of connecting such drivers with customers. “The company says it is not a transport or taxi service; it is a technology company whose product is not car rides but the phone application used to arrange them. Its UberX service relies on partnerships with thousands of independent contractors who use their own vehicles. Drivers find passengers using Uber’s phone app and then remit a percentage of the fare to the company.” uber-pressures-regulators-by-mobilizing-riders-and-hiring-vast-lobbying-network/2014/12/13/Washington Post

But what about trust? Those of you who have used Uber have probably experienced, as I have, an easier, faster, more polite, and cheaper ride. But how can we trust that the car will be safe and the driver competent and honest? The success of Uber and other web based services rests on their being able to satisfy these concerns. Will the dictates of market success do a better job than government regulation in satisfying these customer concerns?

“Reputation systems are arguably the unsung heroes of the social web. In some form or another, they are an integral part of most of today’s social web applications.” Chrysanthos Dellarocas, “Designing Reputation Systems for the Social Web,” in The Reputation Society: How Online Opinions Are Reshaping the Offline World, ed. Hassan Masum and Mark Tovey (Cambridge, MA: MIT Press, 2011), 3. To gain and keep the public’s trust, Uber has established internal standards for the private drivers and their cars that it signs up to connect with customers through Uber. The failure of any driver or car to live up to those standards (and they have several car types) hurts Uber’s reputation and thus its bottom line. It has a strong incentive to get it right. Uber also uses easy to provide customer reviews of each ride experience as do a growing number of web based trading serves.

But what about dishonest reviewers, perhaps working for a competitor (the world is a harsh and cynical place)? The presence of dishonest people lowers the standard of living in any society whatever its system of government or economy. Societies heavily dominated by honest people, are more prosperous. But some people will be dishonest and we need ways to deal with them and minimize their damage. Waze, the very popular GPS based car destination app, provides up to the minute information on traffic conditions on your route provided by users on the spot. It harnesses the desire of most people to be helpful. The information provided by users (their reviews, if you will) is rated for accuracy by other users (in the form of an easily delivered “thank you”). I have no doubt that services traded via the Internet will continue to explore better ways of establishing trust in the products and services traded there.

The recent alleged rape of a young woman in New Delhi, India by an Uber driver raises this issue in a dramatic way that the rape of a young woman in Fort Lauderdale two months earlier by a Yellow cab driver didn’t seem to. A foolish, careless comment by an Uber official about how he might use travel information on Uber’s customers, also raises questions about the safety and uses of such information. Are these problems better handled by regulation or by market competition?

The answer in my view is that the government should provide the foundation for trade provided by contract law and its enforcement, and minimal requirements that are generally applicable (a driver’s license and appropriate insurance). But the Uber’s of the world should be required by free competition to prove themselves and their service to the satisfaction of their potential customers rather than to regulators. If you want to know the standards of safety Uber has set for its self as it seeks customers, check its website, for example: http://blog.uber.com/driverscreening.

The Rule of Law

The rule of law is an essential foundation of modern market economies. It increases the prospect and expectation that our individual efforts will be rewarded on the basis of merit (i.e., the success with which we satisfy the public’s wants at prices the public is willing to pay) rather than on the basis of favoritism (i.e., who we know). It introduces an element of certainty (rules of the game) in an otherwise uncertain world upon which to build our entrepreneurial efforts. It is fundamental to our notion of fairness and a protector of our personal freedoms. It is a notion and practice that attracts wide admiration from ambitious and freedom-loving people around the world and to our great benefit brings many of them to our shores.

We have never enjoyed the rule of law fully or perfectly, but our belief in it and our relatively close adherence to it remains critical to our success and the world’s eroding respect. Departures from the rule of law in our dealings with each other at home or abroad, undermine the efficiency of our market economy and diminish our freedom, but more importantly undermine the respect of others and our moral authority, which is almost as important to our place in the world as our military strength. Thus any erosions of the rule of law should be exposed and resisted vigorously.

Two principles of the rule of law are that they must apply to everyone equally (ourselves as well as others) and that the rules can’t be changed retroactively.

Through the Foreign Account Tax Compliance Act (FATCA) and other tax and Anti Money Laundering measures the United States has been increasingly forcing its own laws on other countries and turning banks into policemen to the detriment of the banking system. According to The Economist magazine (6/28/14): “In a piece of extraterritoriality stunning even by Washington’s standards, the new law requires banks, funds and other financial institutions around the world to report assets held by American clients or face a ruinous 30% withholding tax. America is, in essence, using threats to outsource its financial policing. This is working: so far, more than 77,000 financial institutions have agreed to pass information to the IRS. The costs of complying with FATCA are likely to dwarf the extra revenue it raises” Many of the approximately 7 million Americans living abroad are finding it difficult to open bank accounts. “Many have been rejected by foreign providers of banking services, insurance and mortgages because, given the amount of paperwork needed to satisfy Uncle Sam, American clients are simply too much hassle. Foreign firms are less keen to hire Americans because of the extra tax complications. Not surprisingly, the number of Americans renouncing their citizenship has quadrupled since FATCA was hatched…. FATCA’s intrusiveness raises serious privacy issues…. The financial superpower looks ever more a regulatory bully, setting rules it ignores itself.” “America’s new law tax compliance heavy handed inequitable and hypocritical FATCAs-flaws?”

When contracts can’t be honored because a company is not earning enough money, bankruptcy laws provide for a well-defined process for transferring ownership from shareholders to creditors, which includes the priority of creditor claims against the inadequate assets of the failed company. Bank bondholders and other creditors price their credit in light of their place in the cue. It violates the principles of the rule of law to changes these priorities after the fact, but this is exactly what the Obama administration did when it put General Motors into bankruptcy by favoring the United Auto Workers pension fund: “A bedrock principle of bankruptcy law is that creditors with similar claims priority receive equal treatment. In the auto bankruptcies, however, the administration gave the unsecured claims of VEBA [union pension] much higher priority than those of other unsecured creditors, such as suppliers and unsecured bondholders.” “Obama’s UAW Bailout”

The government’s inconsistent and unpredictable treatment of distressed financial institutions in 2007-8, some were bailed out and some were allowed to fail, and the resulting uncertainty about future treatment, has surely contributed to the reluctance of banks to lend and of firms to invest thus slowing the pace of our economic recovery. “The Financial Crisis: Act II”

Sadly the examples of political hypocrisy with regard to the rules of the game are growing. Fortunately there are some signs of push back. The Supreme Court just unanimously overturned as illegal the President’s so called recess appointments of members to the National Labor Relations Board. “Supreme court strikes blow-Obama exceeded authority with recess appointments” The Speaker of the House of Representatives is suing “the Obama administration for its use of executive actions to change laws.” “Boehner confirms lawsuit against Obama executive actions”

The hypocrisy has been non-partisan. Though fully justified, the hypocrisy of the outcry over the IRS’s missing emails related to targeting conservative organizations was exposed fully in Sunday’s Washington Post. Government departments and agencies are required by law to maintain copies of official correspondence (all office emails included). This law has been regularly violated. Examples are “the Bush White House’s destruction of millions of e-mail messages [including those of John Yoo, the Department of Justice lawyer who justified torture] as well as the destruction of pre-investigative files by the Securities and Exchange Commission, including files pertaining to Bernie Madoff and Goldman Sachs.” How has this happened? “Congress has neither appropriated sufficient funds for agencies to implement electronic record-keeping nor added oversight and penalties to the Federal Records Act that would ensure compliance.” “The IRS isn’t the only agency with an e-mail-problem”

Hypocrisy is rendered impotent, hopefully, from exposure. Thus hopefully George Wills’ latest column on the Redskins will be widely read. “The government decided that redskins bothers you” It begins: “Amanda Blackhorse, a Navajo who successfully moved a federal agency to withdraw trademark protections from the Washington Redskins because it considers the team’s name derogatory, lives on a reservation where Navajos root for the Red Mesa High School Redskins.” And the hypocrisy gets worse from there.

For more examples see my “Big brother is getting bigger”