Common Cents Page 8

  Another serious problem we face today is that the feedback signals from the macroeconomy have become deliberately distorted. We hear various statistics announced every week in the media. The three main ones that capture our politicians’ attentions are Gross Domestic Product (GDP), the unemployment rate, and the Consumer Price Index (CPI). All three statistics have been manipulated in recent years with new formulas that bias the information they were designed to convey. For instance, core CPI inflation statistics, which determine wage and Social Security cost of living adjustments (COLAs), do not include food and energy price changes, even though these have a big impact on household spending patterns. Then, in 1983, housing price changes were removed from the index, further understating one of the largest costs facing families, especially in the last ten years. A widely subscribed alternate statistical service estimates that our current level of inflation as of early 2011 is closer to 10% than the reported CPI of 1%, and that our meaningful unemployment level is closer to 23% than the reported 9.4%. Our real GDP is -2% rather than the reported 3.4%.[31] The biases also indicate some conflicts of interest among those who determine these statistics. A lower reported CPI allows the government to pay out less in benefits and inflation-adjusted bonds because these payments are keyed off the CPI. We have already discussed how confidence has a real impact on the valuation of capital, so this strategy on the part of our political leaders to overstate the "good news" is not surprising. Ultimately, however, the data we use to formulate policy are misleading and have been corrupted by politics.

  Given the distortions in the statistics our policymakers use to measure macroeconomic performance (GDP, the unemployment rate, CPI), it is little wonder that their preferred solution to every problem is to maximize real GDP growth to make all these statistics look better. This is also where our current macroeconomic theories and tools gain the most traction with their proposed solutions. It's a little bit like the old saying that if you only have a hammer, every problem looks like a nail. Economic growth has become the solution for every problem. We can agree that growth is a good measure of material well-being and brings improvements in the quality of life. But, as we have demonstrated with our simple model of sustainable growth, the economy is a system of flows between consumption, saving, investment, and production over time. This system of flows is a distributional process. Sustainable economic growth is a function of how we distribute or allocate our resources across different activities over time. So while politicians and economists have been focusing on the production problem—how to produce more—ultimately, we must also face the distributional problem, for which we have few solid answers.

  Imagine we have a field of crops that we need to fertilize and water. If our irrigation system delivers all the water to only one half of the field and we spread all our fertilizer on the other half, or if we fertilize this month and water next month, is there any doubt our crop yield is likely to be dismal? It is essential that the water and fertilizer be efficiently and adequately distributed in proper proportions across the entire field. This is also true for the distribution of capital and labor in our economic production process. Distributional allocations across the entire economy over how much to produce must sync with the consumption demand for specific products between now and the future. We need to sprinkle our capital, labor, energy and others resources in the right proportions across the economy. You can imagine the difficulty of getting this right because the objective is dependent on getting hundreds of millions of people to do what is necessary, and to do so voluntarily. If we get the policies wrong, say, by encouraging everyone to speculate in trading houses, then the economy will list and capsize like a boat where all the passengers run to one side. In 2008/9 the world economy actually did capsize. Now it is struggling to right itself, but the problems that swamped it remain.

  2.7 Distributional Failures

  I like to make the argument that our most challenging economic problems are problems of maldistributions, or skewed distributions, of essential resources. In economics these are sometimes referred to as coordination failures, but I prefer distributional failures. At a recent social gathering among friends I noted an amusing anecdote to illustrate the issue. Several of us folically-challenged men were being teased as being “bald.” One friend came to my rescue, grabbing the shock of hair at the back of my head to claim, “Look, he has lots of hair.” I readily seconded him by explaining that I did not have a “balding” problem, I had sprouted lots of new hair in recent years – on my back, in my nose, out my ears – the real problem was that it was all in the wrong places. It was the maldistribution of hair! Mine is not a problem of baldness, but male pattern thinning (and that can be fixed). A bald man needs a miracle cure to promote new hair growth, but a man with pattern baldness merely needs a good transplant surgeon.

  The problem of market distribution is much the same and the cure must also be correctly tailored to the problem. For example, we know how to grow enough food and create enough wealth in this world, but we haven't really figured out how to distribute that food and wealth to the most needy, whether they are living in inner-city America or in some impoverished African nation. Clean water and medicine also present failures of distribution; education and investment in human capital also requires getting the goods to the people who will employ them.

  But distributional failures are more than a matter of delivery; the problem is more a matter of the neediest having the means to create the wealth necessary to pay for the good and its delivery. In macroeconomics, the problem we’ve discovered in business cycles is that demand is not distributed adequately across the population over time. This becomes reflected in levels of investment and production. Every week we can read new reports in the media on the growing gaps in wages, income, and wealth. The skewed distribution of the means of producing wealth (financial and human capital) is probably the most critical and intractable economic problem we face and one we need to solve. I contend that this is more than a social or political problem; it is a macroeconomic problem that will require appropriate economic policies. Our flow system of economic production and exchange is constrained by growing inequality. These distributional failures become even more challenging when we realize we are dealing with the world economy rather than just the U.S. national economy.

  2.8 Globalization: National vs. International Economy

  We have been treating the U.S. macroeconomy as if it was a closed system, where all inputs and outputs must balance over time. This is similar to looking at the earth as a closed system where we must recycle energy and resources in order to sustain life. (Of course, the earth ultimately receives all its energy from the sun, which the physicists say will burn out someday as the universe expands, but let's not go there.) The international global economy is a closed system. We don’t trade with Martians or get financed by aliens—all trade among earthlings is conducted in a closed system. However, each sovereign nation has a domestic economy that is not a closed system, but is part of an open, global international system of trade and capital exchange markets.

  Within the global system, each sovereign nation controls its own macroeconomic policies, which differ from nation to nation. Thus, the imbalances we have been discussing that can lead to market failures and economic crises can be complicated by imbalances among national economies and national policies. The best illustration is the contrast between China and the United States over the past two decades. China has been saving, producing, and exporting while the U.S. has been borrowing and spending on consumption. This behavior on a national scale leads to imbalances in consumption, saving, investing and production between the two countries that are often aggravated by policies. Without overcomplicating the problem, we should understand that one country cannot only sell while another one only buys. Imagine if you traded with your neighbor, selling things, but never buying anything in return. Soon you would have all his money and he would have all your goods. Then you lend him money to buy even more goods that you could make a
nd sell. But he'd never be able to pay you back. Imagine this type of exchange between countries and you will understand some of the irrationality of the international system. Sovereign nations that wish to increase their national wealth pursue policies that subsidize the export, or selling, sector. But every nation cannot be a net exporter, unless we're also selling to Martians and other non-earthlings.

  Currency exchange rates[32] can unduly complicate our intuitive model of the international economy, but a basic understanding of them is necessary. We have discussed how price signals, such as the price of money (the interest rate), affect our economic choices. The exchange rate between one nation's currency and another's affects all prices between these two nations uniformly. If the U.S. dollar's value relative to the euro falls by 50%, then all goods and services that Americans can buy from Europeans will be twice as expensive in dollar prices, while all the goods and services that Europeans buy from Americans will be halved in euro prices. This means U.S. exports will be much cheaper for Europeans and Europeans exports to the U.S. will be much more expensive. This will cause U.S. consumers to cut back on European goods and substitute U.S. goods, and also cause U.S. exporters to increase production to sell to Europeans. The net national effect will be to shift Americans to saving and producing more and to shift Europeans into buying and consuming more while saving and producing less. We can apply this logic to the imbalance between the U.S. and China noted above. Because of the imbalances between Chinese and U.S. consumption patterns, the Chinese currency should appreciate relative to the dollar, causing Americans to produce more for export and Chinese consumers to consume more American exports. Unfortunately, national governments often interfere with market rebalancing of exchange rates for political reasons. They may adopt economic policies that keep the national currency undervalued in order to promote export production. With exchange rates out of whack, trade imbalances grow.

  National economic policies diverge because of political demands from citizens and the need for politicians to meet those demands in order to win elections, or, in the case of non-democracies, to stay in power. Most populations consistently want a better, higher quality of life, which is measured by rising GDP. This also means they desire a more competitive claim on the world's resources such as food, energy, labor, and capital, which puts them in competition with other nations. Policies that seek to maximize wealth by attracting the necessary resources for production run into a problem because of the mobility of capital relative to labor. What this means is that one can send one's capital in an instant to any part of the world for investment. But a nation’s labor resources must rely on migration or immigration to relocate, so the ideal combination of capital and labor is difficult to engineer. We see the side effects of this in the dislocations caused by outsourcing and illegal immigration as capital flows to where labor is cheapest and surplus labor tries to migrate to nations with scarcer, higher paid, labor. While the reallocation of capital and labor helps to increase wealth in a closed world economy, the process entails high social and economic costs, such as those borne by workers who get displaced. This creates more demands from domestic groups for trade protection, as well as what we call "beggar thy neighbor" economic policies, to resist globalization. The term was originally devised to characterize policies of trying to cure domestic depression and unemployment by shifting effective demand away from imports onto domestically produced goods, either through tariffs, quotas on imports, or by competitive devaluation. This last strategy, to manipulate the currency either to attract more capital or increase exports by making them cheaper, offers a solution that is often worse than the disease because unstable currency values inhibit productive investment.

  For a stable world economy, which for all practical purposes is a closed economic system, we need national economies to be more self-sustaining over time. Properly managed through national economic policies, globalization’s benefits can far outweigh its costs. Producing/exporting countries will have to consume more, and consuming/importing countries will have to save, invest, and produce more. But national economic policies that are responding to the demands of competing populations are extremely difficult to coordinate. This political dilemma contributed to the international trade protectionism that exacerbated the Great Depression. It's not possible for all of us to be richer than our neighbors, but since wealth is the source of power and material freedom, the competitive desire to surpass our fellows will not soon disappear. (Nor, necessarily, should it.)

  2.9 Risk, Uncertainty, and Insurance

  Since we live in a world of constant change and the effects of change are unpredictable, we are always operating in an environment of risk and uncertainty. It is the nature of our world. One of my favorite quotes on uncertainty was given by Donald Rumsfeld in a speech in 2002, when he was Secretary of Defense:

  …as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.

  The wisdom of Secretary Rumsfeld's remarks on "unknown unknowns" have been underappreciated by the chattering classes ever since, who found amusement in his exposition (see "unks-unks.") But such uncertainties, whose unpredictability we cannot touch or grasp, operate in the recesses of our mind and have profound implications for our choices in life.

  I find risk and uncertainty to be the most fascinating topic in political economy. I also believe it is the most important concept—the key—to understanding our economic and political environment. As we are living organisms operating under the imperative to survive and reproduce, nature has made us most sensitive to risks to our survival, whether we are aware of this fact or not. We act on our survival instinct without thinking, just like any other sentient being. This means that the risks we perceive in our everyday environment will impact significantly on our behavior.

  The best demonstration for me of how the fear instinct dominates our innate behavior was when I went up the CN Tower in Toronto. At the top there was a large section of the flooring constructed with thick, see-through glass. Through the glass one could see straight down to the ground, more than one thousand feet down. It was fascinating to observe, but I found that I could not walk out over the glass floor. My rational mind knew there was no possibility the glass could break, but still, my survival instinct overpowered any rational thought. Try it some time. My bodily reaction confirms a wealth of behavioral studies that support the conclusion that our risk-taking choices are determined not by the question: “What will I gain?” but by the question: “What do I have to lose?”

  As our universe is uncertain, and our human nature is driven by loss aversion, the concepts of risk and uncertainty connect our individual selves with the broader universe, admittedly in a non-spiritual, material sense. If we can get a handle on how the uncertainties of our changing environment shape our perceptions of risk, we will have a powerful analytical tool that can help us understand human behavior and social science phenomena.

  Let us take, for example, the historical development of large scale business enterprise. Big business needs adequate capital to fund its investment projects, but early on there were few sources of capital that would willingly assume such risks at a price any one enterprise could afford to pay. The later development of joint-stock ownership allowed investors to spread their risks across different capital investments, thus reducing the returns investors would demand from a single enterprise, thereby lowering the cost of capital to that enterprise. The joint-stock company was first adopted by the East India Company in order to expand its international shipping trade in the 17th century, though there are cases of shared risk enterprises going back to Roman days. The modern public corporation added to the diversified risk model with a legal design that provides limited liability for the c
orporation's owners (i.e., stockholders). This limits the risks of new investment to the assets of the corporation, not to the assets of its owners. When you buy a share of IBM, the most you can lose is the value of that share—i.e., nobody who has a claim against IBM can go after your house or your car. This sharing of risk through capital markets reduces the cost of capital (because more investors are willing to provide the firm with more capital, the price of this capital goes down) and promotes risk-taking investment. The merchants of risk—those bankers and traders on Wall Street and other financial centers across the globe—have developed a wide variety of financial product innovations that include bonds, equities, and a mind-boggling array of financial derivatives. These markets promote risk-taking enterprise and allow anyone who wishes to share in successful enterprise to invest according to their risk preferences. If we think iPods and iPhones are great products, we can choose to invest in Apple and share in the wealth created.

  The importance of risk has become more apparent after our recent financial debacle, which most people now understand resulted from a colossal disregard for risk and the theory of risk management. The biggest impact was in the financial sector because the financial sector's raison d'être is risk management. "Systemic risk" and "too big to fail" have now become part of the popular vernacular; unfortunately, we learned the consequences after the fact.

  From an analytical point of view, risk and uncertainty are not exactly the same thing. Uncertainty is like not knowing which horse will win at the track, or even if the race will run or the weather will hold. Risk enters when we've placed a bet on a particular horse, a bet with real money that we may lose. Exposure to risk is not just borne by money or capital. It is also present, for instance, for the jockey who may fall off the horse and suffer serious injury. We place the bet and the jockey runs the race because we both hope to gain from a successful wager.[33]