November 30, 2008
The Future of Conservatism--Posner
The defeat of the Republican Party in the November election is widely thought to signal the decline of conservatism in the United States. But it is important to distinguish between the Republican Party and conservatism rather than to equate them. In a two-party system, political parties are opportunistic coalitions and hence lack ideological homogeneity, especially in a culturally heterogeneous nation, such as the United States. Apart from the many Republicans and Democrats who vote for a party out of habit or nostalgia or family tradition or attachment to a particular issue or a personal liking or loathing for the other people who vote for the party, there are ideological voters. In the Republican Party these fall into three main groups: believers in (1) free markets, low taxes, and small government; (2) believers in tough criminal laws and a strong foreign policy; and (3) social (mainly religious) conservatives, who are hostile to abortion, gay marriage, pornography, and gun control. Groups (2) and (3) converge on hostility to illegal immigrants. Groups (1) and (2) are in some tension because a national security state requires big government and therefore high taxes. Group (1) is in tension with (3) because (1) is libertarian and (3) is regulatory.
All three groups have been hurt by recent events, and all three are moving apart because of the hits on the others. The financial crisis has hit economic libertarians in the solar plexus, because the crisis is largely a consequence of innate weaknesses in free markets and of excessive deregulation of banking and finance, rather than of government interference in the market. Believers in a strong foreign policy have been hurt by the protracted and seemingly purposeless war in Iraq (the main effects of which seem to have been discord between the United States and its allies, increased recruitment of Islamic terrorists, and the strengthening of Iran and of the Taliban in Afghanistan and of al Qaeda in Pakistan) and the Bush Administration’s lack of success in dealing with Iran, North Korea, Afghanistan, Pakistan, and the Arab-Israeli conflict. And social conservatives have been hurt by the stridency of some of their most prominent advocates, who all too often give the appearance of being mean-spirited, out-of-touch, know-nothing deniers of science (e.g., evolution, climate change).
The efficiency gap between the competing presidential campaigns created the appearance of a competence gap between the parties. As the campaigns progressed, a surprising number of conservatives switched their support to Obama. Thoughtful conservatives, already disturbed by the accumulation of blunders of the current Administration (the Iraq WMD, Katrina, the Justice Department scandals), culminating in its uncertain response to the financial crisis, were appalled at the iconic status that Joe the Plumber attained in the Republican campaign, the wild rumors spread by the conservative bloggers and talk-radio hosts, and the intellectual vacuity of many Republican candidates and advocates. The Republican Party seemed to have descended to anti-intellectualism--to deriding highly educated people who speak in complete sentences as "elitists," as compared to the down-to-the-earth ignorance of Joe and his ilk--which sorts badly with the strong intellectual tradition of conservatism. It is a self-defeating strategy of conservatives to argue that "all" intellectuals are liberal and therefore conservatives should think with their guts rather than their brains.
For myself, I would be happy to see conservatism exit from the political scene--provided it takes liberalism with it. I would like to see us enter a post-ideological era in which policies are based on pragmatic considerations rather than on conformity to a set of preconceptions rooted in a rapidly vanishing past. We have accumulated a substantial history of liberal and conservative failures. The liberal failures include underestimating the cost of egalitarianism and of social engineering by judges (the Warren Court, Roe v. Wade, the near abolition of capital punishment), and the benefits of discipline, of punishment, of enforcing principles of personal responsibility, and of military force. The conservative failures include overestimating the efficiency of unregulated markets, the efficacy of military force, and the beneficent effects of religiosity. Liberals are wrong to promote unions (described by one wag, albeit with some exaggeration, as the parasites that kill their hosts) and conservatives to promote abstinence as a substitute for condoms in preventing teenage pregnancy.
Now I know that it isn't really possible to think without preconceptions. As Bayesian decision theory teaches, a rational decision maker starts with a prior probability of some uncertain event (that a credit crunch will turn into a major depression, for example), but adjusts that probability as new evidence comes to his attention--which means that his prior belief, his preconception, may, depending on the strength and direction of the evidence, affect his ultimate decision, which will be based on his posterior probability that the event will occur. Nor do I mean to deny the value of theory, in particular economic theory, in guiding policy. But there is a difference between rational preconceptions, based on theory and experience, and rigid emotional preconceptions, such as dogmatic libertarianism or egalitarianism or ungrounded hopeful beliefs such as that everybody in the world is yearning for and ready for democracy, that tell one more about the thinker's personality than about the quality of his thought and that may be impervious to reconsideration in the light of new evidence. We should be skeptical of world views rooted in emotion that insulate people against inquiry into the foundations of their beliefs. Concretely, there is a range of perfectly respectable economic theorizing, at one end (the interventionist) typified by Paul Samuelson and at the other end (the libertarian) by Milton Friedman, but it would be a mistake to commit to one or the other end since neither can be proved to be correct. The libertarian end of the range failed to grasp the danger of deregulation of financial markets and underestimated the risk and depth of the current economic crisis--an economic shock that appears to be severe enough to trigger a genuine depression.
But the point I particularly want to stress is that the recent failures of conservatism are not a vindication of liberalism. Both can fail, and as long as the failures are recognized, the United States can do fine.
Posted by Richard Posner at 02:41 PM | Comments (49) | TrackBack (0)
The Future of Free Market Conservatism- Becker
I agree with Posner that the future of free market policies in the United States has been damaged by the financial crisis, and by the continuing rise in unemployment and slowdown of the American (and world) economy. The degree of damage, however, will be determined by the length and severity of this recession. If the recession does not develop into a deep and prolonged depression, there will not be a sizable retreat from the market policies that have been in effect.
The big victory of Senator Obama and the Democratic Party was not a referendum on free market policies. Rather it reflected the continuing unpopularity of the Iraq war and of the Bush administration, and months of growing concern about foreclosures, rising unemployment, and the weak economy. American voters seem to want greater regulation of the financial sector, not an abandonment of policies that generally have supported the private sector and competition. This is reflected in the economists Obama has appointed to top positions in his administration. These economists, such as Larry Summers and Paul Volker, have generally recognized the importance of competition as a way to regulate market behavior.
Nevertheless, in light of the severity of the financial crisis, greater regulation of financial institutions is merited. The challenge is to find regulations that would significantly reduce the probability of future financial crises without discouraging the valuable contributions commercial banks, investment banks, and other financial institutions make to risk management and the financing of home ownership and business investments.
Several changes do seem likely to be beneficial. Greater capital requirements (relative to assets) for all financial institutions, including investment banks and hedge funds, would help banks better weather runs on their assets. Greater transparency in the information financial institutions provide about their assets would also be useful, although modern assets are often so complicated that transparency will not always be easy to achieve. Fully privatizing Fannie Mae and Freddie Mac would help reduce the flow of mortgages to unqualified homeowners. Incomes of many fund managers and private equity leaders rose enormously, but it is difficult to prevent that from happening again without introducing controls over their salaries, stock options, and bonuses. The greatest challenge is to find ways to reduce the type of private risk-taking in which the taxpayer bails out failure, although greater capital requirements would help.
Posner advocates a pragmatic approach to the evaluation of public policies. Up to a point that approach is fine if it just means a careful consideration of all the available evidence relevant to proposed policies, including knowledge built up from the successes and failures of past policies and actions. But facts themselves are silent without being guided by an analytical framework or theory, so pragmatism is not sufficient to provide important insights into the desirability of various public policies. Conservatism, liberalism, and various combinations of these positions provide different frameworks to interpret the facts.
Posner agrees that a theoretical framework is crucial for interpreting evidence because knowledge about how particular policies worked in the past or might work in the future is seriously incomplete. This knowledge has to be supplemented with predictions about how particular policies would affect the operation of the economy, especially over aspects of the economy where evidence about behavior is very incomplete. These predictions can only come from a theory about behavior and markets that sheds light on the behavior that is not directly observed.
To take a concrete example, the consequences of imposing minimum capital requirements relative to assets on all financial institutions, including hedge funds and private equity companies, depends not only on how such a requirement would affect the operation of the financial system, but also how it would affect investments, employment, and other aspects of the real economy. To understand these consequences requires a theory of the effectiveness of competition in this sector, and an analysis of whether the present financial crisis would have been much milder if capital requirements had already been in place.
The general point I am making is that an economic theory of how markets operate is necessary to evaluate any significant new regulations and other government policies for financial markets (and more generally, for other markets as well, such as the subject of our blog two weeks ago on whether a bailout of the auto industry is justified). Some retreat from free market conservatism is to be expected an s a result of the crisis, but it would be a serious mistake if the analysis of financial and other markets that becomes dominant in Washington gives insufficient weight to the enormous contributions of business competition in raising human welfare.
Posted by becker at 02:30 PM | Comments (19) | TrackBack (0)
November 25, 2008
Notice
We did not post this past Sunday. We will post next on Sunday, November 30.
Posted by Richard Posner at 04:21 PM | Comments (9) | TrackBack (0)
November 16, 2008
Bail Out the Big Three Auto Producers? Not a Good Idea-Becker
The big three American auto producers General Motors, Ford, and Chrysler, are in terrible financial shape. They have asked the government for a bailout, and the Democratic leadership in Congress is eager to give them one. The United Auto Workers union was a strong supporter of President-elect Obama and of Democratic candidates.
These companies have lost tens of billions of dollars during the past few years, and they will shortly run out of cash. GM's shares have lost almost all their value, and Ford has not done much better. Cerberus Capital, a private equity company, owns Chrysler, and it has lost most of what it invested in the company. For this reason Cerberus is trying get out of the automobile manufacturing business. All three companies were heavily into producing trucks and SUV's when the sharp run up in gas prices induced consumers to shift away from these gas-guzzlers and toward smaller and more fuel-efficient cars. Moreover, what money GM had been making came mainly not from car production but from its automobile credit business, (GMAC). This company would borrow from banks to lend to consumers who needed help in financing their GM car purchases. The financial crisis has dried up the money available to auto financing companies, and hence eliminated the major source of their profits.
If GM is not bailed out, the company claims it will be forced into bankruptcy within a few months, and Ford's situation is only slightly better. GM is blitzing Congress, President Bush, and President -elect Obama with pleas for a bailout, followed by a warning that bankruptcy will also hurt auto suppliers throughout the nation that depend on GM's business. GM is also claiming that bankruptcy will put major financial pressure on the Pension Benefit Guaranty Corp, the federal agency that insures benefits to retirees in the auto industry as well as to million of other workers.
Nevertheless, I believe bankruptcy is better than a bailout for American consumers and taxpayers. The main problem with American auto companies is that during the good times of the 1970s, 1980s and 1990s, they made overly generous settlements with the United Auto workers (UAW) on wages, pensions, and health benefits. Only a couple of years ago, GM was paying $5 billion per year in health benefits to retirees and current employees because their plans had wide health coverage with minimal co-payments and deductibility on health claims by present and retired employees. In those days, the UAW was one of the most powerful unions in the US, and it bargained aggressively with the auto manufacturers, carrying out strikes when its demands were not met. When the American auto industry began to face tough competition from Japanese and German carmakers, they were saddled with excessive pay to their workers, and vastly excessive pensions and health benefits to their current and retired workers.
It is not that cars cannot be produced profitably with American workers: the American plants of Toyota and other Japanese companies, and of German auto manufacturers, have been profitable for many years. The foreign companies have achieved this mainly by setting up their factories in Southern and border states where they could avoid the UAW, and thereby introduce efficient methods of production. Their workers have been paid well but not excessively, and these companies have kept their pension and health obligations under control while still maintaining good morale among their employees. In recent years GM and the other American manufacturers have chipped away at their generous fringe benefits, but their health and retirement benefits still considerably exceed those received by American auto workers employed by foreign companies. As a result of lower costs, better management, and less hindrance from work rules imposed by the UAW, about 1/3 of all cars produced in the US now come from foreign owned plants.
Bankruptcy would help GM and Ford become more competitive by abrogating significant parts of their labor contracts with the UAW. One of the greatest needs would be sizable reduction in their health costs through sharp increases in the deductibility and co-payments, and a reduced coverage of medical procedures. Bankruptcy should also help bring the wage rates of GM and Ford in line with those of foreign producers in the US. Some of their pension liabilities may be shifted onto the Pension Benefit Guarantee Corp, but even that would be preferable to an overall bailout.
A good analogy is what happened to United Airlines. By entering bankruptcy it was able to reduce its inflated cost structure by breaking contracts it had with the pilots union and other employee unions. It exited bankruptcy a slimmer and more efficient airline. Whether it is able to compete effectively in the long run is still not certain, but it is in much better shape to compete than before it entered bankruptcy.
Bankruptcy may also force out the current management of GM and Ford. I do not know for certain whether they have competent management- GM surely did not have top management for much of its recent history. I do believe, however, that when a coach of a team loses a few games, he might legitimately explain that by injuries, bad luck, or even bad officiating. These excuses become lame when he consistently loses many games, and the correct and common practice is then to fire the coach. The same considerations apply to top management. When a company consistently does badly while some of its competitors (like Toyota) are doing well, its time to fire the management team, and see if another team can do better.
Is GM "too big" to fail? I do not believe the company is too big to go into a reorganization-which is what bankruptcy would involve. Such reorganization would abrogate its untenable labor contracts, and give it a chance to survive in long run. A bailout, by contrast, would simply postpone the needed reforms in these labor contracts, the business model of GM, and its management.
Posted by becker at 08:34 PM | Comments (94) | TrackBack (0)
Bail Out the Detroit Auto Manufacturers? Posner's Comment
Becker has laid out the case for refusing to bail out GM, Ford, and Chrysler. It is a powerful case, and if the drop in auto sales that is driving these companies toward insolvency had occurred two years ago, there would be in my view no case, other than a political one, for a bailout. But in the current financial crisis, I believe a bailout is warranted, provided that the shareholders and managers of the companies are not allowed to profit from it.
There are two types of corporate bankruptcy: liquidation and reorganization (Chapter 7 and Chapter 11 of the Bankruptcy Code, respectively). In a liquidation the bankrupt company closes down, lays off all its workers, and sells all its assets. That probably would not be the efficient solution to the problems of the Detroit automakers. They are still producing millions of motor vehicles per year, and if they suddenly ceased production entirely there would be a big shortage even though demand is way down. To put this another way, although at present the companies are probably losing money on virtually every vehicle they sell, at a lower level of production the price at which they sold their vehicles would exceed marginal cost.
The alternative to liquidation--reorganization--can work well in normal times, as in the United Air Lines bankruptcy that Becker mentions. The reorganized business is able to borrow money because its post-bankruptcy borrowings ("debtor in possession" loans, as they are called) are given priority over its pre-bankruptcy debts, which are usually written down in bankruptcy, reducing the reorganized firm's debt costs and thereby enabling it to recover solvency. The debts that get written down can include health and pension benefits, which in the case of the auto companies continue to be a big drag on profitability.
The major problems with allowing the automakers to be forced into bankruptcy within the next few months are three, all arising from the depression that the nation appears to be rapidly sinking into. The first problem is that the companies might have to liquidate, because they might be unable to attract the substantial post-bankruptcy loans that they would need to enable them to remain in business. The credit crunch--less politely the near insolvency of much of the banking industry--has made that industry unable or unwilling to make risky loans, and loans to the auto companies after they declared bankruptcy would be risky.
Second, not only the size of the automakers, but peculiarities of the industry, would cause bankruptcy to greatly exacerbate the nation's already dire economic condition. In the very short term, the automakers would probably stop paying their suppliers, which would precipitate a number of the latter--already in perilous straits because of the plunge in the number of motor vehicles being produced--into bankruptcy. Many of the suppliers would probably liquidate, generating many layoffs. At the other end of the supply-distribution chain, consumers would be reluctant to buy cars or other motor vehicles manufactured by a bankrupt company because they would worry that the manufacturer's warranties would be unenforceable. So more dealerships would close, producing more bankruptcies, liquidations, and layoffs. With the demand for the vehicles made by the Detroit automakers further depressed and the supply-distribution chain in disarray, the liquidation of those companies would begin to loom as a real and imminent possibility. Liquidation of the automakers would produce an enormous number of layoffs up and down the chain of supply and distribution. Such prospects reinforce the unlikelihood that a reorganized industry could survive on debtor in possession loans.
The likely psychological impact of a bankruptcy of the U.S.-owned auto industry should not be underestimated. Already consumers, rendered fearful by repeated misinformation from government officials concerning the gravity of the economic situation (including their reluctance to acknowledge that the nation was even in a “recession,” long after it was obvious to the man in the street that we were in something worse), are reducing their buying, precipitating big layoffs in the retail industry, which in turn reduce buying power, which in turn spurs more layoffs. This vicious cycle would be accelerated by the laying off of hundreds of thousands of workers in the automobile industry, including employees of suppliers and dealers as well as of the manufacturers.
The U.S.-owned auto industry may be doomed; it may simply be unable to compete with foreign manufacturers (including foreign manufacturers that have factories in the U.S.); or a reorganization in bankruptcy may be the industry's eventual salvation. But the automakers should be kept out of the bankruptcy court until the depression bottoms out and the economy begins to grow again. (Recall that the government bailed out the airlines after 9/11, allowing United Air Lines to have an orderly bankruptcy reorganization beginning the following year and ending in 2006.) Any bailout, however, should come with strict conditions, to minimize the inevitable moral hazard effects of government bailouts of sick companies. The government should insist on being compensated by receipt of preferred stock in the companies, on the companies' ceasing to pay dividends, and on caps on executive compensation, including severance pay.
A possible alternative would be for the government to refuse to bail out the industry but agree to provide the necessary debtor in possession loans to keep the auto companies from liquidating after they declare bankruptcy. But this would be a kind of bailout, and probably would not be sufficient to avert the shock effects that I have described.
Posted by Richard Posner at 06:59 PM | Comments (64) | TrackBack (0)
November 09, 2008
Do Depressions Have a Silver Lining? Posner
The costs of a depression in lost output, reduced incomes, and anxiety almost certainly exceed the benefits, and can have disastrous long-run consequences--had it not been for the Great Depression, it is unlikely that Hitler would have become chancellor of Germany. But that is not to deny that there can be some benefits, as our current depression illustrates. (The use of the word "recession" to describe any contraction less severe than the Great Depression is a triumph of euphemism over clarity.)
A depression is an essential backup to efforts to moderate the business cycle. The housing bubble could not expand indefinitely; leverage could not keep growing indefinitely. The government was doing nothing to prick the bubble or to limit leverage. The longer the world economy went without a depression, the worse the collapse would be when it finally, inevitably, came. The saving grace of catastrophes is averting worse catastrophes: imagine if, instead of attacking the United States with commandeered airliners, al Qaeda had waited a few years and attacked with suitcase nuclear bombs. We would not have been on guard, as we are now because of the 9/11 attacks.
A depression increases the efficiency with which both labor and capital inputs are used by business, because it creates an occasion for reducing slack.One might think that a firm that has slack in good times will have as much incentive to reduce it as it would in bad times; slack (failing to maximize profits) is an opportunity cost, which in economics has the same motivational effect as an out-of-pocket expense. But firms are organizations, and organizations experience agency costs, which are more difficult to control in good times than in bad. If a firm's profits are growing, it is easier for the firm's executives to skim some of the profits, pocketing them in the form of excessive compensation or perquisites, than when the firm is shrinking. In the former case, stockholders will be doing well, so the pressure they exert through the board of directors to minimize the extraction of rents by executives and other employees will be less intense than when the firm is at risk of collapse. When the depression ends, the firm will have lower average costs, though they will drift upwards as the firm re-grows.
Government is rife with agency costs as well. The depression will induce states, cities, and the federal government, all of which will be experiencing sharply reduced tax revenues, to provide public services more efficiently. It will accelerate the very desirable trend toward privatization of government services such as toll roads and airports.
By increasing unemployment, a depression increases the demand for education by reducing the opportunity cost of it (forgone income is the largest cost of higher education); and education produces positive externalities. It might seem that the depression would also reduce the income gains from being educated; but those gains accrue over a lifetime and so are little affected by a depression during a person's school years.
A depression is a learning experience. The banking industry has certainly learned a great deal from the current financial crisis about the risks of leverage and the downside of complex financial instruments intended to diversify risk more effectively than by traditional means such as retaining highly safe liquid reserves to buffer any unexpected decline in the bank's loan revenues.
The current depression has depressed commodity prices. Of particular importance has been its dramatic effect on the price of oil, which has fallen by about 40 percent in the last six months. The price spike of last spring seems to have been due primarily to a shortage of supply; the industry could not expand production fast enough to keep pace with surging demand, particularly in China and India. The fall in price seems to have been due primarily to a worldwide reduction in demand for oil caused by the global depression. The combination of low prices with low demand is optimal from the standpoint of U.S. (and probably world) welfare. The low demand reduces the amount of carbon emissions, thus alleviating (though only to a slight extent) the problem of global warming. The fall in the price of oil has reduced the wealth of the oil-producing nations—a goal that should be central to U.S. foreign policy because of the hostility to us (Russia, Iran, Venezuela), or the political instability (Iraq, Nigeria, Algeria), of so many major oil-producing nations.
By undermining faith in free markets, the depression opens the door to more government intervention in the economy and eventually to higher taxes (though probably not until the economy improves). These are not necessarily bad things. Obviously neither the optimal amount of government intervention nor the optimal level of taxation is zero. There are compelling arguments for greater government intervention to deal with the threat of global warming, to improve transportation and other infrastructure, to reduce traffic congestion, and to protect biodiversity. Though in principle the money needed for such programs could be obtained from cutting wasteful government programs, that is politically infeasible. So taxes will have to rise. Federal taxes as a percentage of Gross Domestic Product are no higher today than they were in the 1940s, 1950s, and 1960s—periods of healthy economic growth. The marginal income tax rate reached 94 percent in 1945 and did not decline to 70 percent until 1964 (it is 35 percent today). A modest increase in marginal rates from their present low level would increase tax revenues substantially, probably with little offset due to the distortions that any tax increase is bound to produce.
Taxes should not be increased during a depression, but as we come out of it they can be raised modestly to finance infrastructure investments and other investments in public goods, such as reducing carbon emissions.
The anxiety, reduced consumption, and reduced incomes during a depression are real costs and very heavy ones, but on the other hand the excessive borrowing that precipitated the depression enabled, for a period of years, higher consumption than the nation could actually afford. Thus the current drop in consumption is in part an offset to the abnormal level of consumption earlier. Indeed, since people loaded up with cars, fancy dresses, etc., while times were good (illusorily good because the nation was living beyond its means), the current reduction in the purchase of durables, while hard on sellers, may not be a great hardship to consumers. (Nevertheless, people quickly get habituated to a high level of consumption, and a decline from that level is very painful.)
A related point is that the experience of a depression will induce greater thrift, increasing the formation of investment capital after the depression abates.
Finally, the depression will stimulate fresh thinking by the economics profession. The profession's embarrassing failure to foresee the depression, and the failure of the Federal Reserve Board, of deposit insurance, and of other regulatory institutions and requirements to avert the near collapse of the banking industry, will stimulate fresh thinking about and research in macroeconomics and financial economics; and the regulatory responses initiated by the Bush Administration and those that will be undertaken by the Obama Administration will generate valuable data about the effects of economic regulation. Economists will learn from the bad policies adopted in response to the depression (and some are bound to be bad) as well as from the good ones.
Posted by Richard Posner at 08:13 PM | Comments (63) | TrackBack (1)
Depressions Cause a lot More Pain than Benefits-Becker
Some older theories of business cycles-usually associated with the "Austrian" school of economics- claimed that recessions and depressions were useful in helping to remove the poison from an economy that builds up during good times. For example, weaker companies are the first to go when the demand for an industry's product falls during recessions. Employees who are allowed a lot of slack during good times are forced to work harder during recessions in order to keep their jobs.
Positive effects such as these may be somewhat important during very mild downturns, but they are overwhelmed during major recessions and depressions by the negative effects. I define a "major" recession as having an extended period of unemployment rates at 9 percent or more, coupled with declining GDP. It looks like the US and the world economies may be headed for such a recession for the next year or so.
Economists have underplayed the cost to individuals of mild to severe recessions in part because they have neglected the cost of the "fear" generated by bad economic times. In his1932 inaugural address in the midst of the Great Depression Franklin Delano Roosevelt reassured he American public that the "Only Thing We Have to Fear Is Fear Itself". In fact they had a lot more to fear, but Roosevelt recognized the great importance of fear during depressions. In the present crisis too, consumers and workers have multiple fears due to various kinds of uncertainty. Homeowners fear that they may lose their homes after having used most of their savings as down payments on their homes. The employed fear that they will be laid off, while the unemployed fear that its duration will be quite long, and that they eventually will only get jobs that are much inferior to the ones they had. To be sure, some of the unemployed in many countries will receive unemployment compensation, but many unemployed American do not qualify for this benefit. Moreover, unemployed workers in this country usually receive much less than their earnings while employed, and after a while they run out of benefits, although benefits get extended during recessions.
The fear about losing one's job interacts with fears about being unable to make payments on homes, cars, and other consumer durables. Unemployed persons start missing payments on their homes or cars. If this goes on for several months, they may have their cars repossessed, and their homes put into foreclosure, usually at a time when home prices are down a lot, so that can at best regain only a fraction of the equity they put into their homes.
In addition, the burden of a major recession is not shared uniformly. It usually falls disproportionately on unskilled workers, the young, and those in shaky financial positions, which tend to be persons with lower educations and incomes. For example, the unemployment rate of high school dropouts is traditionally several times that of college graduates, so when the average unemployment rate goes from 6 to 9 percent, that of college graduates may rise to about 4 percent, while that of dropouts will increase to over 20 percent. This recession may be a bit different since the financial sector is being hit so hard. Individuals and families already in shaky circumstances get hit especially hard by major recessions.
It is relatively easy to measure what happens to the unemployment rate during recessions and its differential incidence among different groups, or the number of persons who drop out of the labor force because they despair of finding a job. One can also measure relatively accurately the effects on profits, wages, the path of GDP and personal incomes, and other important variables. It is far harder to measure precisely the effects of serious recessions on individual welfare and happiness. Surveys of reported happiness find that workers who become unemployed are less happy than they were, and persons whose incomes have fallen reported a decline in their happiness, at least initially. Divorce rates and even suicide rates also tend to rise during major recessions, as does crime, discrimination against minorities and immigrants, and pressure toward greater protectionism.
Relative to these major costs, the alleged benefits of a recession to the United States seem quite small, and some of them could also be costs on balance. For example, how many infrastructure projects can be undertaken when states are already running deficits, and face even larger ones in the coming months? The federal government will have a huge deficit during the next year, perhaps a trillion dollars, because of the $700 billion bailout, the stimulus package, and the expected sharp declines in tax revenues.
A serious recession will certainly lead to increased regulation of business and labor markets. Some greater regulation of financial markets would certainly be desirable, as I have argued in prior posts, but some of the likely new regulations will be harmful, such as greater protectionism, wage-type controls over income of top executives, higher taxes on capital gains, and others.
The decline in oil prices by over 50 percent to $60 or less a barrel will certainly help American consumers and companies since the US imports about 2/3 of the oil it uses. It is also helpful to American interests to have less revenue flowing to Venezuela, Russia, and some of the Middle Eastern countries. On the other hand, the US is a major exporter of grains and beef, and the decline in their prices will cause considerable problems for farmers. On balance, I believe the decline in commodity prices is a plus for the US, but not a huge one, especially if oil prices begin to rise sharply after the world recession is over.
A serious recession will further erode the pay and bonuses of top executives at financial and other companies, which many will be happy to see. Managers of mutual and hedge funds and investment banks may have been making much more money than is justified by their productivity, but surely the misery inflicted on the lesser skilled workers, low income families, poor homeowners, and other economically weaker groups is not worth any benefits from a sharp fall in the incomes of those at the top.
So my bottom line in discussing the question whether depressions have a silver lining is that any such lining is very thin and small compared to the major costs to households, workers, and small businessmen.
Posted by becker at 05:42 PM | Comments (18) | TrackBack (1)
November 02, 2008
“Does the Free Market Corrode Moral Character?”-Becker
The title of this discussion is taken from a question put by the John Templeton
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If the question had been put to me, I would have first discussed whether corrupt and dishonest businessmen make greater profits than honest and morally admirable businessmen. Honest businessman would be more successful than corrupt ones when they compete against each other in a free market, as long as consumers can punish dishonest businessmen by not giving them repeat business, (when repeat business is necessary to succeed). Dishonest businessmen may make greater profits in the short run, but honest businessmen make higher profits in the longer run because cheaters cannot attract back customers who they cheated.
Two conditions must be operative for this process to be effective:1) customers must be able to detect when they are being cheated or misled, and 2) customers must be frequent enough buyers, so that repeat business is an important determinant of profitability. Both these conditions often prevail, but one or the other may be absent under certain circumstances. For example, repeat business is not so important in vacation areas where tourists seldom come back. Then morally corrupt and dishonest businessmen may do relatively well, although tourists do get recommendations from friends who have been there before, or from the hotels where they stay. Another example deals with certain durable consumer goods since consumers only infrequently purchase expensive goods like a car or home. Although repeat business is less important in these markets, consumers will put more time and research into considering decisions that require large expenditures. In addition, word of mouth information about the reputations of different sellers can hurt the dishonest sellers.
Even when repeat business is important, consumers would not be able to punish corrupt businessmen if they cannot readily determine whether or not they have been cheated or badly misled. For example, consumers who buy defective used cars that break down only after a year or so of driving may blame the breakdowns on their own actions rather than on the quality of the cars that were sold to them.
Adam Smith claimed that businessmen were, on the whole, more trustworthy than diplomats. His argument was based on the importance of repeated interactions. Essentially, Smith argued that repeat business was usually more important to businessmen than to diplomats. Smith argued that diplomats frequently broke treaties since treaties are made infrequently. As a result, the gain from breaking treaties often exceeds the gain from living up to the obligations imposed by the treaties.
Another, much more famous, result of Adam Smith shows that under certain conditions, businessmen in competitive industries would promote the general welfare, even though they were only trying to increase their profits. These conditions include that businessmen are prevented from colluding-Smith correctly argued that businessmen try to collude in order to exercise monopoly power- and Smith assumed consumers could punish dishonest businessmen.
Many critics judge the performance of free markets relative to alternatives the way a judge might make her decision about the winner of a beauty contest between two contestants. She chose the second contestant after seeing the warts on the first one. Prominent and not so prominent businessmen in market economies have been involved in various scandals where they have provided misleading information, lie, sell shoddy and dangerous products, and the like. When such scandals arise, there is a clamor for greater regulation in the sectors where the scandals occurred, and sometimes even for government takeovers of these enterprises. This presumes that regulators and government officials act with sufficient knowledge about the industries involved, and with great wisdom and morality. Unfortunately, often that is not the case.
Aside from the not infrequent cases of outright bribery of regulators and legislators, many other more subtle ways exist to bias, even corrupt, officials when their decisions replace the forces of market competition. Regulators often get "captured" by the companies they regulate, so that regulations are developed to keep out competition rather than promote greater honest competition (this capture theory was given an economic interpretation by our late friend, colleague, and Nobel-prize winning economist, George Stigler). One of the more notorious examples is the former Civil Aeronautics Board that was supposed to regulate competition among airlines, but had trouble giving approval to new airlines to compete against the established airlines.
Legislators sometimes bail out companies in financial distress, or restrict competition from abroad in order to raise the profitability of domestic companies-in effect they become tools of these companies at the expense of taxpayers and consumers. Why should American automakers get subsidies from the government during this present crisis, and in the past, when they have repeatedly made bad production, marketing, and labor contract decisions during the past 30 years? A free market in the automobile industry with less government involvement would have given American consumers faster and easier access to the cheaper and better cars made by Japanese, German, and now Korean companies.
I might add in concluding that I have spent my whole career in academia, and I have witnessed many examples of morally corrupt behavior by professors. So it is far from obvious to me that businessmen have worse morality than professors, although I may be making the same mistake in this inference as the judge did in the beauty contest I referred to earlier who had seen up close only some of the contestants.
Posted by becker at 06:51 PM | Comments (31) | TrackBack (0)
Does the Free Market Corrode Moral Character? Posner's Comment
The essays commissioned by the John Templeton Foundation and available at www.templeton.org/market/ offer a variety of answers to the question whether free markets corrode moral character. Becker's posting offers an interestingly different answer, and I shall offer a different answer as well.
Different cultures and, within cultures, different occupations both select for different character traits and shape character traits. Let me start with culture. One can distinguish between a culture built on notions of honor, military prowess, and status within a hierarchy often based on birth, on the one hand, and a commercial culture on the other. English history is a case study of the transition from the first to the second, the second having been realized in the United States earlier and more fully than in the mother country. The two types of culture select for and inculcate quite different character traits--reckless physical courage, a fierce concern with personal honor, identification with a group (family, dynasty, or nation), and hierarchic control in the former; cooperativeness, empathy, tact, politeness, intelligence, individualism, self-interest, prudence, and deferral of satisfactions (i.e., a low discount rate) in the latter. Aggressiveness and a willingness to deceive are constants, although deception is more skillfully deployed in a commercial society.
Politicians possess and cultivate the traits associated with whatever culture they operate in. Honor-based societies attract charismatic leaders, often warriors; democratic societies model their politics on the economic market. As Schumpeter explained in his unfortunately rather neglected economic theory of democracy (sometimes called "competitive democracy"), democratic politicians, constituting the members of a governing class much like the business community in the economic domain, compete for the support of "consumers" (= voters) who "pay" (vote) for the competitor whose product (a package of policies, values, and leadership traits) they prefer.
People in a commercial society are probably more self-interested than people in an honor-based society, because the latter are more likely to identify with leaders or causes than to behave as separate individuals with individual tastes and goals. Although commercial society selects for and encourages traits that we are apt to think "good," such as cooperativeness, intelligence, and empathy, in fact these qualities are morally neutral. Intelligent and cooperative businessmen, whose empathetic qualities enable them to manipulate consumers' emotions and intellectual limits, will be prone to collude with their competitors and defraud their consumers, as well as to ignore pollution and other externalities that economic activity produces. That is why even libertarians, with the exception of anarcho-capitalist extremists, believe that antitrust and antifraud laws are necessary controls over commercial activity.
Even without such laws, it is true, not all markets would be riven by collusion and fraud. Collusion invites free riding, since a seller can increase its profits by slightly undercutting the cartel price; and the reputation concerns stressed by Becker will often deter fraud. But without any regulation, cartel agreements would be legally enforceable, which would discourage free riding, though they would be eroded by new entry--but often the new entrants, attracted by supracompetitive prices, would be less efficient than the incumbent firms. Reputation concerns will not deter deceptive advertising concerning traits shared by all products in the market in question. A cigarette advertiser who advertises that his cigarettes are "safer" than competitors' cigarettes is reminding consumers that smoking is in fact unsafe. The cigarette companies (also the automobile manufacturers) tried for decades to conceal the dangers inherent in their products, since trumpeting those dangers would have reduced demand.
Businessmen also have an incentive to manipulate the regulatory process, seek tax loopholes, and the like. Although we tend to blame politicians and bureaucrats for bad policies, often they are merely brokering interest-group deals. In a democratic society, it is legitimate (in fact inevitable) for policy to yield to the demands of interest groups. We should not blame politicians who are honest agents of politically powerful forces. Politicians who do not yield to those forces are ineffectual.
Of course politicians lie a great deal, but so does anyone who depends on the goodwill of others. Max Weber in a famous essay on politics as a vocation distinguished between private and public morality. Anyone in a public position--and this includes business and academic leaders as well as politicians--cannot indulge a taste for candor or altruism and expect to be successful at his job. It is the same reason why good business leaders drive hard bargains with their suppliers, play off subordinates against one another, lay off workers by the thousands, receive huge compensation packages, and often relocate plants overseas when foreign wages and taxes are lower.
The difference between public and private morality shows that even honesty is a morally neutral quality. Often the regulations imposed on business are mindless and crippling and to survive a businessman must violate them; in doing so he promotes both his own welfare and that of society as a whole.
History teaches that a commercial society is bound to be more prosperous and peaceful than an honor-based traditional society. The commercial culture creates incentives and constraints that, provided that economic activity is effectively regulated, (an important qualification) maximizes the values that are important to most people. This doesn't mean that people in a commercial society are "better" than people in other types of society. The human race is genetically uniform, and our "moral" genes are not much different from the corresponding genes in chimpanzees. The success of commercial societies just illustrates that different institutional structures produce different human behavior.
Posted by Richard Posner at 05:12 PM | Comments (11) | TrackBack (0)
October 26, 2008
The Controversy over the Milton Friedman Institute--Posner
Milton Friedman was one of the twentieth century's most distinguished economists, and one of the century's three economists (the other two being John Maynard Keynes and Friedrich Hayek) who had the greatest political influence--and he was the only American in the group. Friedman spent most of his career at the University of Chicago, so it is natural that the University should name a major new component of the University, devoted to economic research, after him. The Institute is essentially a joint venture of the University's economics department, graduate school of business, and law school. The use of his name will help the University raise the funds required for the new Institute.
The decision, announced five months ago, has generated controversy on the University campus, sharpened by the current economic crisis that is thought in some circles to have damaged Friedman's legacy (it has certainly damaged Alan Greenspan's legacy). Some 170 faculty members have signed a petition circulated by a Committee for Open Research on Economy and Society--which opposes the decision naming the new institute after Friedman--asking that a meeting of the University Senate (which consists of some University administrators and all faculty members who have been on the faculty for more than a year) be convened to discuss the decision. The stated ground of opposition is that naming the Institute after Friedman would constitute the University's endorsement of his political views and would bias the research conducted by the Institute in favor of the free-market ideology that Friedman promoted so strongly. But the opposition is also and probably primarily powered by distaste for Friedman's political and policy views and for his willingness to provide economic advice to the Chilean dictator Augusto Pinochet. Friedman's association with policies that are either liberal or politically neutral, such as the volunteer army, the earned income tax credit (the negative income tax), the legalization of the laws against marijuana and other mind-altering drugs, and even affirmative action, is overlooked.
I don't think anyone would quarrel with the idea of an institute devoted to the support of academic research on economic issues, even though many of the issues that economists examine have political implications. The name is the focus of the controversy. Friedman was an advocate of politically controversial policies with which a number of University faculty do not want the University to be associated. When buildings, classrooms, institutes, schools, etc. in universities are named after someone, it is usually a donor. Especially when an institute, which is likely to be a special-purpose organization, is named after a public figure, it is natural to associate the mission of the organization with the name of that figure: the Hoover Institution of Stanford University was named after Herbert Hoover and is indeed conservative, though it is noteworthy that the Institution's conservative reputation has not extended to Stanford University as a whole, and no more would one expect the University of Chicago to be branded as conservative merely because it contains an institute named after a conservative economist. The University of Chicago is not a conservative institution, though it is not as monolithically liberal as its peer institutions.
The purpose of naming the new institute after Friedman was presumably to encourage fund-raising; one economics professor at the University has been quoted as saying that Friedman's name would "resonate with the donors." So a further worry is that most of the donors will be conservatives who support Friedman's political views (that is to say, his conservative political views, as many of his views were not conservative), and that the new Institute will perhaps unconsciously bias hiring and promotion in favor of economists who support those views. The Institute might (again, whether consciously or unconsciously), it is feared, conceive its mission as being to promote the ideas of the "Chicago School of Economics," of which Friedman was perhaps the leading (though not the founding), and certainly the most influential, member.
But that is unlikely. Economics is a highly competitive academic field, and piety toward distinguished predecessors is not the path to academic success. It is odd that the opponents of the Friedman naming should think that economists, of all people, would subordinate career motives to loyalty to Friedman's memory or the "Chicago School" (especially young economists for whom Friedman is just a name). If the religion professor who is leading the movement against the naming is right that "Friedman's over"--that the current economic crisis has consigned Friedman, along with Greenspan, to the dustbin of economic history--he should have no fear that the new Institute will be biased in favor of Friedman's views. If a physics institute were named after Albert Einstein, would the institute's researchers reject quantum theory?
It might seem that the controversy could be easily resolved by simply changing the name of the Institute. But that would be costly to the University in several respects. First, it would doubtless offend many donors, and probably leave the Institute in worse financial shape than had it not been named after Friedman in the first place. Second, it would weaken the University administration and encourage the encroachment by faculty on administration prerogatives. There is a whiff of the 1960s in the effort by faculty (joined by a number of students) to move the University of Chicago leftward. Even if the original naming of the Institute after Friedman was a mistake, there is now too much at stake for the University administration to back down.
Posted by Richard Posner at 10:55 AM | Comments (33) | TrackBack (0)
