UNDERSTANDING FREE MARKET MYTHS, II

Does "homo economicus" exist?

The idea that market players are the dominant actors that drive and shape society, and should be left alone to pursue their ends because their activities lead to better societal outcomes, has it's roots in the 18th century. But the idea persists to this day. There are many reasons for this. All too often people will believe something simply because it's convenient, or because it's what they were told growing up. Worse, they may not know any better.

This is one of the reasons why I wrote The Myth of the Free Market: The Role of the State in a Capitalist Economy. In my book I take a look at the idea that market players should be left to pursue their own ends. Specifically, I review the arguments made by one of the economic icons of market capitalism, Milton Friedman. What follows below are some of the issues that I discuss in my book, and some of the concepts we will be discussing in class this week (I've listed page numbers where the topic can be found in my book throughout the text below).
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Did Milton Friedman "Get it Wrong"?
In my book I begin my discussion of market capitalism by taking a look at the arguments made by economist Milton Friedman. I make it very clear that I think he not only got some very basic assumptions wrong, but that his approach to economics has caused some real damage to our society because of how his arguments have encouraged many people to believe that people in the pursuit of profit become rational and virtuous in a market setting.

To understand how Nobel Laureate Milton Friedman got it wrong I start by looking at what Adam Smith, the patron saint of modern capitalism, said about markets and trade in 1776. Adam Smith made it clear that a level playing field, or what he called the "laws of justice" should not be undermined. Custom, tradition, privilege, market conspiracies, favorable legislation, and affronts to human dignity (e.g. the violation of individual rights) all work to undermine the market's playing field by shifting resources to those that don't necessarily work for their reward (15-17, 26).

The interesting thing is that Adam Smith wasn't the only one who saw how the laws of justice could be violated in 1776. James Madison and the Founding Fathers spoke about the need to reign in merchants and other "factions" because the "most common and durable source of factions has been the various and unequal distribution of property" (17-19).

These considerations, according to the Founding Fathers, inflamed "passions" in post-revolutionary America to such a degree that they threatened to tear apart the new union. Worse, according to Madison, is how "the latent causes of factions are thus sown in the nature of man." Simply put, we're not necessarily good people, especially in a trading environment. Madison understood this and wrote: "If men were angels, no government would be necessary."

Guess what? We're not angels. So we can't trust one another, even in a market setting.

This is why we ditched the Articles of Confederation, which gave market players at the time free rein, and created a Constitution that gave the federal government broad authority in the market (see especially Art. I, Section 8). The fact that we can't trust one another in a market setting (see this) is why we create laws and regulations. Human nature demands it.

Friedman's Unicorn View of Human Nature
All of this is something Milton Friedman passed over, or simply got wrong, when he discussed the power of "the market" to transform the passions of merchants. More specifically, Friedman placed so much faith in people doing the right thing in a market setting that he virtually ignored what the Founding Fathers, and Adam Smith, said about the human condition.

The Founding Fathers, in particular, had seen in real time what a weak central government could produce, and did not want to re-visit the Articles of Confederation. Like it or not, they believed merchants can't always be trusted in a market setting. For his part, Adam Smith believed that merchants, left to their own devices, would work against the interests of the consumer, and would use the state to secure their positions if necessary. If  Adam Smith, James Madison, and the Founding Fathers understood this, why not Friedman?

Part of Milton Friedman's problem can be traced to his position on freedom, and how he assumes liberty is kind of like air ... it's just there for everyone. This is why he suggests an "umpire model" for society. Let the state call balls and strikes in the market, and leave it at that.

What Friedman ignored is how umpires call games differently (ideological extremism can get in the way). He also ignored how strike zones can be changed (deregulation & favorable legislation). Worse, he ignored how some people never get to the plate (women and people of color). Finally, he ignored how umpires can get dirt thrown in their faces (yes, market players can and will collude with government regulators and members of Congress ... as Wall Street in 2008, and a trail of bailouts illustrate).

The Moral Justification of Capitalism
All of this can undermine our level playing field. It can also destroy the moral justification of capitalism. We need to remember that the moral justification of capitalism, which is the cornerstone of our market economy, rests on one simple principle: If you work hard you will get ahead.

Personal responsibility and a strong set of moral obligation for middle America has grown out of this simple principle.

Once you undermine the conditions that make the moral justification of capitalism work we're all in trouble. Stagnating incomes, record bankruptcies, and homeowners walking away from their mortgages, among others, are not good signs today.

Still, in spite of crashing our market in 2008, market players on Wall Street continue to invoke what Adam Smith referred to as our system of "natural liberty" to pursue their own selfish ends. Ironically, while they channel the spirit of Adam Smith to justify their efforts in the market, their activities not only undermine the laws of justice (by influencing how reward and resources are distributed) but violate what Adam Smith called "the order of nature and reason" (which leads to market imbalances and societal disconnect; 37-45).

Because of his belief that market players will do the right thing in a market setting was so strong Milton Friedman grafted his assumptions on to his policy analysis, and his policy prescriptions. This is where he got it wrong, big time.

Men aren't angels. Men pursuing profits and wealth aren't much better. To believe otherwise is to embrace Unicorn theories of the human condition.

Embracing the Unicorn
Milton Friedman didn't simply get the human condition wrong. He embraced the Unicorn.



Specifically, he went beyond promoting an umpire model of markets (i.e. we can be trusted in a market setting while we're pursuing profits) by deliberately distorting the debate, and the facts. While there are many things that Milton Friedman missed when it came to understanding human nature, below is a partial list of what Milton Friedman got wrong, ignored, or misrepresented in his work(s) (which I discuss in chapter 2 of my book).

FALSE DICHOTOMY: Throughout his writings Friedman consistently warns about the collectivist tendencies he saw in western democracies. Seeing socialist ghosts in every corner, Friedman constantly warned about creeping socialism, and how market capitalism was threatened by a state that promoted civil liberties and civil rights.

What Friedman ignored is that markets aren't an either/or proposition. A state can't embrace either complete freedom for all, or be on the march to socialism. This is a false dichotomy (10). Saying you either do it my way or we're going down a socialist rat hole does not represent what happens in the real world, and is not sound analysis (especially for jump starting a debate).

IGNORES ECONOMIC GROWTH: For all of Milton Friedman's dire warnings about America, and the west, going to hell in a hand basket because of the creeping socialism, Friedman missed one important fact: Post-war America and the west experienced the greatest, and widest, degree of economic growth and prosperity in human history (5-13). We avoided the threat of major market collapse, or economic depression too.

Warning about the dire effects of an evolving "collectivist" regime when growth and stability are high and widespread is simple fear-mongering. Global confidence in the sturdiness of the world's financial center, New York, evolved for one simple reason: Transparency was at the heart of sensible regulations, which were tethered to a viable system of justice (something to think about today).

PLAYING POLITICAL GAMES: One of Milton Friedman's key assets (and problems) is that he understood he could ride on the back of the field of economics, which maintains an elevated - but undeserved - position in the political world, and in the social sciences. This position was a powerful tool politically. Milton Friedman understood this and deliberately sought to discredit his opponent's arguments by:

(1) Conflating government regulations and the push for civil liberty protections with socialism and collectivism (his influence is so great that those in the Tea Party movement today still don't seem to understand the difference between these categories),

(2) Marginalizing the efforts and duties of government as wasteful, when we all know that state functions are distinct from those performed by the market,

(3) Derisively dismissing other, competing, disciplines as "speculative philosophical discourse" that are less rigorous than economics (which studies homo economicus), and

(4) Denigrating his opponents arguments by making references to the "bubbly emotionalism" of their position(s).

To be sure, all intellectual battles require that you distort, marginalize, dismiss, and deride the efforts of your opponents if you can't defeat them on the merits. But think about it. How many professional economists saw the market collapse coming in 2008? (I'll try and link a short list here later.) How many understand it's roots today? (And, no, it's not Fannie Mae's fault, or the fault of all those people who took out loans they couldn't afford, or the fault of government spending alone ...)

Milton Friedman understood the political climate of the day, and took advantage of it to irresponsibly push a world view that does not adequately capture the human condition (see esp. the intro to Ch. 4).

DOWNPLAYS DEMANDS OF MODERN WORLD: If you create an automobile we know that we need the DMV, the CHP, the DOT, and ... the list goes on. Or do you trust other motorists to do the right thing? Do you trust the states to build and maintain highways?

Similarly, do you trust Wall Street to do the right thing now that the overly dramatic fears of the economic crisis of 2008 have passed (for now)? Do you really trust that British Petroleum will make things whole in the Gulf of Mexico? Do you care if your medical doctor is certified? Complex industrial societies require rules and regulations. As Hernan de Soto would argue, unlocking the mystery of capital demands it.

Milton Friedman, however, seemed to believe that creating a complex and interdependent society across a continent is it's own achievement. It's not. You might want the government off of your back, but I can assure you that you want the government on your neighbor's back.

DOWNPLAYS HISTORIC ROLE OF THE STATE: Manifest Destiny ... Land grant colleges ... Our Indian land policy (someone had to kick them off for you to invest in it) ... Land acquisition policies (war/purchase) ... Market subsidies ... Mass market purchases (starting with the Civil War) ... Infrastructures (Erie Canal, RR, etc.) ... The creation of America's middle-class (yeoman farmer, blue collar workforce, and the social wage earner) ... Education policies ... Tariff policies ... Civil Rights legislation ... All of these developments make it clear that the state has had a dominant role in creating the conditions for freedom and liberty to prosper, and for wealth to grow in America (30-35, plus Ch. 6). There are no invisible hands here.

IGNORES WHAT MAKES MORAL JUSTIFICATION OF CAPITALISM TICK: Work hard and get ahead? Not if you were a woman, black, or even white male without land (initially). The state has worked hard to open and guarantee opportunities for those who were once relegated to second class status in America. Access wasn't provided by enlightened market players. There was too much money to be made keeping the field tilted in their favor. It was fought for and taken by those who were excluded from the liberties and freedoms granted by the Constitution.

Later, when child labor laws, family wage laws, and Jim Crow/Civil Rights's laws were required, the state once again stepped in. Industry, for the most part, fought the state every step of the way. Markets didn't magically open up opportunities for everyone in America. It was democracy in action. It was people making demands on the state, and then having the state act. Political movements and the state made the moral justification of capitalism work in America, not market players.

There's more, but this is enough (for now).

- Mark

NOTE: I presented an earlier version of this for another class five months ago.

WHAT MILTON FRIEDMAN GOT WRONG ... EXAM POST

Does homo economicus exist? The notion that market actors are the dominant players who drive and shape society towards efficiency and stability - and should be left alone to pursue their ends for doing so - has it's roots in the 18th century, and persists to this day. In my view, whether you believe in homo economicus isn't as important as whether you can explain WHY you believe it.

All to often people believe something simply because: (1) it's convenient, (2) it's what they were told growing up, or (3) they don't know any better. This is one of the reasons why I wrote The Myth of the Free Market: The Role of the State in a Capitalist Economy. I wanted to help shed light on the misguided belief that market players should be deferred to because they're virtuous in a market setting.

To help my students prepare for exams in my International Commerce class I address the issue of what Milton Friedman got wrong, and cover several concepts they need to be familiar with for their exams. Below are some of the issues I've covered (I've listed page numbers where the topic can be found in my book throughout the text below).

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HOW DID MILTON FRIEDMAN "GET IT WRONG"?
To understand how Nobel Laureate Milton Friedman got it wrong I start by looking at what Adam Smith, the patron saint of modern capitalism, said about markets and trade in 1776. Adam Smith made it clear that a level playing field - or what he called the "laws of justice" - should not be undermined. Custom, tradition, privilege, market conspiracies, favorable legislation, and affronts to human dignity all work to undermine the market's playing field by shifting resources to those that don't necessarily work for their reward (15-17, 26).

The interesting thing is that Adam Smith wasn't the only one who saw how the laws of justice could could be violated in 1776. James Madison and the Founding Fathers spoke about the need to reign in merchants and other factions because the "most common and durable source of factions has been the various and unequal distribution of property" (17-19).

These considerations, according to the Founding Fathers, inflamed "passions" in post-revolutionary America and threatened to tear apart the new union. Worse, according to Madison, is how "the latent causes of factions are thus sown in the nature of man." Simply put, we're not necessarily good people, especially in a trading environment. Madison wrote: "If men were angels, no government would be necessary." Guess what? We're not angels. And unicorns don't exist either.

We can't trust one another, even in a market setting. This is why we have a Constitution (see especially Art. I, Section 8). This is why we create laws and regulations.

FRIEDMAN'S UNICORN VIEW OF CAPITALISM
All of this is something Milton Friedman passed over, or got wrong, when he discussed the power of "the market" to transform the passions of merchants. More specifically, Friedman placed so much faith in people doing the right thing in a market setting that he virtually ignored what the Founding Fathers, and Adam Smith, said about the human condition. The Founding Fathers, in particular, had seen in real time what a weak central government would produce, and did not want to re-visit the Articles of Confederation.

Like it or not, they all believed merchants can't always be trusted in a market setting. Indeed, Adam Smith believed that merchants, left to their own devices, would work against the interests of the consumer, and would use the state to secure their positions if necessary. If  Adam Smith, James Madison, and the Founding Fathers understood this, why not Friedman?

I think I know why ...

Making Milton Friedman's position on freedom even more bizarre is how he assumes liberty is like air, it's just there for everyone. This is why he suggests an "umpire model" for society. Let the state call balls and strikes in markets, and that's it.

However, Friedman ignored how umpires can be changed (to market friendly umpires). He ignored how strike zones can be changed (deregulation & favorable legislation). He ignored how, for a long time, some people never got to the plate (women and people of color). Finally, he ignored how umpires can get dirt thrown in their faces (yes, market players can and will collude with government regulators and members of Congress ... as Wall Street in 2008, and what's happening in the Gulf of Mexico now, illustrate).

THE MORAL JUSTIFICATION OF CAPITALISM
All of this can undermine our level playing field and, worse, can destroy the moral justification of capitalism. We need to remember that the moral justification of capitalism, which is the cornerstone of our market economy, rests on one simple principle: If you work hard you will get ahead.

Personal responsibility and a strong set of moral obligation has grown out of this simple principle.

Once you undermine the conditions that make the moral justification of capitalism work we're all in trouble. Personal debt levels, record bankruptcies, and homeowners walking away from their mortgages, among others, are not good signs today.

Still, today market players continue to invoke what Adam Smith referred to as our system of "natural liberty" to pursue their own selfish ends. Ironically, while they channel the spirit of Adam Smith to justify their efforts in the market, their activities in the modern era both undermine the laws of justice (i.e. our level playing field which helps determine how reward and resources are distributed) and violate what Adam Smith called "the order of nature and reason" (which leads to market imbalances and societal disconnect; 37-45).

Because his belief that market players will do the right thing in a market setting was so strong Milton Friedman irresponsibly grafted his biases on to his policy analysis, and his policy prescriptions. This is where he got it wrong. Men aren't angels. Men pursuing profits and wealth can become even worse.

To believe otherwise is to embrace the unicorn.

DOUBLING DOWN ON THE UNICORN
Milton Friedman didn't simply get the human condition wrong. He doubled down on the Unicorn.

Specifically, he went beyond promoting his umpire model of markets (we can all be trusted in a market setting while we're pursuing profits) to deliberately distorting the debate, and the facts. While there are many things that Milton Friedman missed when it came to understanding human nature, below is a partial list of what Milton Friedman got wrong, ignored, or misrepresented in his work(s) (which I discuss in chapter 2 of my book).

FALSE DICHOTOMY
Throughout his writings Friedman consistently warns about the collectivist tendencies he saw in western democracies. Seeing socialist ghosts in every corner, Friedman constantly warned about creeping socialism, and how market capitalism (at least his Unicorn vision of markets) was being threatened. What Friedman ignored is that markets aren't an either/or proposition. This is a false dichotomy (10). Saying you either do it my way or we're going down a socialist rat hole does not represent what happens in the real world, and is not sound analysis (especially for jump starting a debate).

IGNORES ECONOMIC GROWTH
For all of Milton Friedman's dire warnings about America - and the west - going to hell in a hand basket because of the creeping socialism he saw threatening our world, Friedman missed one important fact: Post-war America and the west experienced the greatest, and widest, degree of economic growth and prosperity in human history (5-13). We avoided the threat of major market collapse, or economic depression too.

Warning about the dire effects of an evolving "collectivist" regime when growth and stability are high and widespread is simple fear-mongering. Global confidence in the sturdiness of the world's financial center, New York, evolved for one simple reason: Transparency was tethered to sensible regulations (something to think about today).

PLAYING POLITICAL GAMES
Milton Friedman understood he could ride on the back of the field of economics, which maintains in an elevated - but undeserved - position in the political world, and in the social sciences of academia. This position was a powerful tool politically. Milton Friedman understood this and deliberately sought to discredit his opponent's arguments by:

(1) Conflating government regulations and the push for civil liberty protections with socialism and collectivism (his influence is so great that Tea Baggers today still don't know the difference between the categories).
(2) Marginalizing the efforts and duties of government as wasteful, when we all know that state functions are distinct from those of the market.
(3) Dismissing other, competing, disciplines as "speculative philosophical discourse" that are less rigorous than economics (which studies homo economicus).
(4) Denigrating his opponents arguments by making references to the "bubbly emotionalism" of their position(s).

To be sure, all intellectual battles require that you distort, marginalize, dismiss, and deride the efforts of your opponents if you can't defeat them on the merits (I know, I know ... the Unicorns). But think about it. How many professional economists saw the market collapse coming in 2008? (I'll link a short list here later.) How many understand it's roots today? (And, no, it's not Fannie Mae's fault, or the fault of all those people who took out loans they couldn't afford, or the fault of government spending alone ...) Milton Friedman understood the political climate of the day, and took advantage of it to irresponsibly push his world view (see esp. the intro to Ch. 4).

DOWNPLAYS DEMANDS OF MODERN WORLD
If you create an automobile we now know that we need the DMV, the CHP, the DOT, and ... the list goes on. Do you really trust Wall Street to do the right thing now that the crisis has passed (for now)? Do you trust British Petroleum will make things whole in the Gulf of Mexico? Do you care if your medical doctor is certified? Complex industrial societies require rules and regulations. Commerce over long distances requires it. Milton Friedman seemed to believe that creating a complex and interdependent society across a continent is it's own achievement. It's not. You might want the government off of your back, but I can assure that you want him on your neighbor's.

DOWNPLAYS HISTORIC ROLE OF THE STATE
Whether it's Manifest Destiny, land grant colleges, our Indian land policy (someone had to kick them off for you to invest in it), land acquisition policies (war/purchase), market subsidies, mass market purchases (starting with the Civil War), infrastructures (Erie Canal, RR, etc.), the creation of America's middle-class (yeoman farmer, blue collar workforce, and the social wage earner), education policies, tariff policies, civil rights, etc. it's clear that the state has had the dominant role in creating the conditions for wealth creation in America (30-35, plus Ch. 6). There are no invisible hands here.

IGNORES WHAT MAKES THE MORAL JUSTIFICATION OF CAPITALISM TICK
Work hard and get ahead? Not if you were a woman, black, or even white male without land (initially). The state has worked hard to open and guarantee opportunities for those who were once relegated to second class status in America. Access wasn't provided by enlightened market players. There was too much money to be made keeping the field tilted in their favor.

Later, when child labor laws, family wage laws, and Jim Crow/Civil Rights laws were required, the state once again stepped in. Industry, for the most part, fought the state every step of the way. The market didn't open opportunities magically. It was democracy in action. It was people making demands on the state, and then having the state act. This is politics, which means the state. The state made the moral justification of capitalism work in America, not market players.

There's more, but this is more than enough (for now). Next exam post: From War & Mercantilism to Classical Liberalism.

- Mark

GREENSPAN WINS DYNAMITE PRIZE IN ECONOMICS

The on-line journal Real-World Economics Review Blog recently had a contest to see who their readers believed was the economist most responsible for blowing up the world economy.

Here are the top three vote getters for the Dynamite Prize in Economics, with a brief professional "bio" explaining their rank.

Alan Greenspan: As the former chair of the Federal Reserve (1987-2006), Alan Greenspan won because of how his fairytopian market views helped ruin our nation's economy. His economic dream world ran so deep that he believed markets didn't need regulation because they're so efficient that even corruption and stupidity are eventually weeded out. People, after all, can be expected to do the right thing when money and profits are staring them in the face. He was so convinced about his Ayn Rand drenched ideology that he consistently lowered interest rates, and expanded the money supply, foolishly believing that people who get money nearly for free will act rationally.

For believing that people are angels in a market setting, Greenspan's award is well deserved.

Milton Friedman: Encouraged by the brilliance of his own writings (he was a good writer), Friedman managed to convince himself that the Federal Reserve was to blame for the Great Depression. Friedman pushed his delusions about markets - and evil government - to such a degree that he wrote the policy paper that led the U.S. out of the draft and into an all volunteer military. To get the results he needed - which focused on market efficiency rather than national security - he deliberately ignored the research methods he was asked by Congress to use in the policy paper. Because of Milton Friedman we now have: (1) a Federal Reserve that believes it's so important that it can stonewall congress, and; (2) a military that allows U.S. presidents to ignore the will of the people (a draft to fight reckless wars would get our attention), and increasingly depends on private mercenary companies, like Blackwater.

After considering how his academic career influenced public policy, Friedman probably should have received a Life Time Achievement Award.

Larry Summers: Former Harvard economist Larry Summers was at the center of the good 'ol boy wolf pack that went after Brooksley Born. Who's Brooksley Born? In her post as director of the Commodity Futures Trading Commission (CFTC), Born warned Washington that if we did nothing to rein in derivative trading that we were looking at a market collapse ... in 1997! Summers - along with Robert Rubin (Treasury), Alan Greenspan (the Fed), and Arthur Levitt (SEC) - thought it was better to bury Born politically. Kudos.

Proving that his Born Stupidity was not a one time fluke, in 1999 Summers also gave intellectual weight to the idea of dispensing with the Glass-Steagall Act (1933). The Glass-Steagall Act separated commercial banks, investment banks, and insurance companies after it was discovered that the financial sector had worked collectively to speculate and defraud customers before 1929. For reasons not yet explained, Summers believed that ignoring history and bringing banks, brokers, and insurance companies together again was a good idea.

Don't feel bad for Larry Summers if you think he should have won this time around. He can still prevail. For my money, as a member of President Obama's "don't-push-Wall-Street-too-hard" economic team, Summers has a very good chance of winning the Dynamite Prize in Economics in the future.

While I would have liked to see Arthur Laffer, the economic genius behind supply-side economics, as one of the nominees, there's no doubt that the top vote getters deserve their place in Dynamite lore.

- Mark

WHAT WENT WRONG ...

I wasn't going to post for a few more days but this article (by way of nakedcapitalism.com) caught my attention. It was written by Steven Keen, at Business Spectator, who was asked to contribute to a German journal. The discussion topic? The failure of the vast majority of mathematics-economic models to anticipate the Global Financial Crisis.

In a few words Keen argues that economists have created so many myopic models that they and our increasingly sycophantic media don't understand how our economic world really works. Keen looks specifically at two "modelling" areas that have led economists off track: (1) a continued belief in Milton Friedman's monetary theories, which don't adequately account for credit and debt creation, and (2) a disturbing belief that economies tend toward disequilibrium.

How did these two beliefs impact our (mis)understanding of the world before last year's meltdown? Keen responds:

Because neoclassical economists treated any economic variable generated by a market economy as being in equilibrium, they fantasised that stock and house prices were in equilibrium when clearly they were in a bubble, and they ignored rising levels of private debt in the belief that whatever level of debt applied was an equilibrium one – and therefore justified by market fundamentals.

In a few words what we have is market arrogance coupled with ideological blinders working to create - as I have described elsewhere - a fairytopian world of perfect competition and fluid decisions that somehow work themselves out ... as if some mythical and magical invisible hand make things work in harmony all the time.

What a bunch of crap.

I wrote about this in my book when I described how markets really work, whether through favorable legislation or money policies that benefit specific groups. Specifically, I pointed to economists like Hyman Minsky (who saw debt as both good and bad, and tried to make sure that we understood the difference too) and John Maynard Keynes (who saw disequilibrium). Both understood and saw the flaws Keens writes about. Still, modern economists try to explain away favorable legislation, or downplay disequilibrium, as aberrations because they don't fit the model.

This is why I especially like what commentator Raymond D'Hollander has to say about economists depending too much on mathematical models:

Mathematics is simply a tool to be used in engineering systems. Nothing more, nothing less. Every engineer knows that the world is not perfectly normal (in the statistical sense) so no engineer worth his salt would base his entire design on some untested mathematical formulas. Boeing or Airbus would never design an airplane in a computer, manufacture it from the computer-generated instructions, and then immediately load it up with 300 passengers on its maiden flight. On the other hand economists and the global financial sector appear to believe that this is a perfectly viable way of approaching the world's economy.

In my view, economists and market players believe in the models they create for two, self-serving, reasons.

First, models - especially in CDS, CDO, and other ABS markets - allow(ed) economists to believe that they are "scientific" and are in control of what they see. Second - and simply put - the models that have been created allow market players to get rich. They buy enough time to squeeze money and profits that don't really exist. The bailout funded counter party payouts (thank you Ben Bernanke and Tim Geithner) show this to be true. The money wasn't really there, unless you were always banking on a bailout.

Steven Keen does a good job of explaining what went wrong with the models and assumptions of economists (though some might find it somewhat technical). I encourage you to read it if you get the time. The comment section is especially good too.

- Mark

MILTON FRIEDMAN GOT THINGS WRONG TOO

Last week I had a post explaining "How We Got Here" and made reference to how economists and other academics dropped the ball when it came to holding policymakers to account. I ended by promising to post something that would show how Nobel prize economist Milton Friedman got things wrong too. Then I failed to post it. Ooops.

A day late, and a dollar short, here's the post I promised. What follows is an excerpt from my forthcoming book, The Myth of the Free Market: The Role of the State in a Capitalist Economy (click on the book's icon located on the left side of this blog).

In Free to Choose: A Personal Statement, Milton Friedman took care to review the causes of the Great Depression. With characteristic bravado he declared that “the independent Federal Reserve System was to blame for the mistaken monetary policy that converted a recession into a catastrophic depression.” He also claimed “[w]e now know that the depression was not produced by a failure of private enterprise, but rather by a failure of government.”

Speaking of failures, Friedman failed to say anything about the well documented market schemes, market myopia, speculative euphoria, and structural weaknesses in the overall economy at the time. Friedman’s greatest failure, however, was to falsely suggest – with his “We now know …” claim – that there’s scholarly consensus on the causes of the Great Depression. Nothing could be further from the truth.

Nobel Laureate Paul Samuelson, for example, argues there could be “dozens” of explanations for “cycle theories” that explain business slumps and economic depression. Looking at the claim that the Federal Reserve encouraged speculation early on John Kenneth Galbraith dismisses the argument as ‘formidable nonsense.’

Another Nobel Laureate, Kenneth Arrow, questioned Friedman’s focus on monetary policy, warning “the sole emphasis on incompetent monetary policy as the cause of the Great Depression is disputed by serious scholars.” He adds that “really bad turns in monetary policy did not come until the end of 1930” when the recession was already “severe.”

Friedman also ignores that before the creation of the Federal Reserve System capitalist history is rife with market failures on a grand scale, suggesting “instability” is “endemic in the free enterprise system.” Indeed, standard history texts of the American economy point to easy lending by industry (margin purchases, easy credit, shady loans, etc.), structural weaknesses in the banking industry, and slowdowns in the agriculture and housing markets, among other issues.

In sum, it’s clear the causes behind the Great Depression are far from decided, and the manias that lead to destructive herd mentalities in markets may be more common than we want to believe. More importantly, it tells us that Milton Friedman was prone to making broad statements that aren’t supported by the facts . . .

- Mark

HOW WE GOT HERE . . .

I think by now most of us realize that the market players involved in creating our financial mess had a stake in the game, and weren't about to blow the whistle on their financial Pot of Gold. We also understand that government agencies were being hacked and bullied into deregulation and lax oversight by a market mentality that had overtaken government bureaucracies. But have you ever wondered why so many experts in the field of economics didn't see the financial train wreck coming? Wonder no more.

The following is from University of Oregon economist Marc Thoma's blog, the Economist's View:

. . . it's becoming a lot easier to understand how financial economists missed the developing bubble and the effect it would have on the macroeconomy. We specialize mightily in academic economics, people will work on very narrow questions for their entire careers and become world class experts on that question, but they tend to forget what they learned in other areas over time, and they can't possibly keep up with developments outside their areas of specialization. So we rely and depend upon the expertise of others to inform us about areas in which we don't normally work.

One thing I've learned from the current episode is not to automatically trust that the most well-known economists in the field have done due diligence before speaking out on an issue, even when that issue is of great public importance, or even to trust that they've thought very hard about the problems they are speaking to. I used to think that, for the most part, the name brands in the field would live up to their reputations, that they would think hard about problems before speaking out in public, that they would provide clarity and insight, but they haven't.

In fact, in many cases they have undermined their reputations and confused the issues. People have been deferential in the past, myself included, and these people have been given authority in the public discourse - even when they are demonstrably wrong their arguments show up in the press as a "he said, she said" presentation. But, unfortunately for the economics profession and for the public generally, the so called best and brightest among us have not lived up to the responsibilities that come with the prominent positions that they hold.

I agree. The experts in academia - and not just economists - became deferential to the experts and politicos in the public square, expecting others to pick up the slack (the Fourth Estate's to blame as well, but that's another post). There are reasons why this happened. It begins with living in the "Dark Ages" of macroeconomics (read Thoma's blog), but deference is the key. My next post will address this point.

And it nails Milton Friedman to the wall.

- Mark

THE ROOTS OF MARKETS AND WEALTH

Those of you who have been following my program and reading this blog know that I sent out the manscript for my book, tentatively titled, The Roots of Markets & Wealth: The Indispensable Role of the State in Making Markets Work. I say "tentatively" because it looks like I'll be changing the title, at the request of the publisher. It turns out what I wrote fits right into this market meltdown mess. What I post below is a snippet from Chapter 1, "Milton Friedman Got it Wrong ... Politics is at the Heart of American Capitalism."

To set up the excerpt below, what I'm saying is that we are a nation that prides itself on the separation of powers concept. I've selected the passage below because the bailout proposal put forth by Secretary of Treasury Paulson eviscerates this principle. If you haven't been following the news, Secretary Paulson and the Bush administration have put together a $700 billion bailout that says the plan can't “be reviewed by any court of law or any administrative agency.”

We all know what happened the last time the Bush administration asked for a blank check (in war). I especially like the section below because it's clear bailouts and "trust us" weren't something Adam Smith & the Founding Fathers thought were good ideas ...

ADAM SMITH’S “LAWS OF JUSTICE” AND THE FEDERALIST PAPERS
As we will see in Chapter 2, market opportunities for everyone are difficult to achieve ... and are not something that “just happen.” Opportunities grow when government removes the stagnant blood of political privilege. Opportunities are created when we seek to eliminate stifling social practices that prohibit certain groups from participating. Opportunities multiply when policy-makers seek out and defeat market conspiracies. Opportunities grow when the state moves against favorable legislation that lowers competition. Finally, opportunities emerge when the quest for advantage and power in markets – which is very similar to the search for power and advantage in politics – is tamed by both constitutions and the law.

But these proactive approaches to government aren't always acknowledged. To avoid taking our opportunities “for granted” (see Milton Friedman) it is imperative that society accept that government oversight and regulations are necessary for markets to function smoothly. The reasons for this are simple, and two-fold.

First, if there was anything Adam Smith believed would undermine the market and the logic of the invisible hand, it was the unearned acquisition of resources (and he wasn’t talking about assistance to the poor here). We can understand this by looking at the state’s historic role in transferring funds, granting subsidies, and protecting specific industries. While prefacing his discussion on the importance of the “laws of justice” Adam Smith argued that deliberately shifting a “greater share” of resources to an industry “than would naturally go to it” would retard “the progress of society toward real wealth and greatness.” Specifically Smith wrote:

Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men.

But, as we know, there are undue subsidies, protected industries, and tax obligations that are not absorbed equally across society. There’s also the prospect that private players will not provide the goods and services they say they will. It’s one of the reasons Adam Smith believed that proprietors of private roads (who charge tolls) should be placed “under the management of commissioners or trustees.”

These are the dynamics Adam Smith worried about. He understood that the quest for advantage and power in politics has a parallel world in markets. To insure the laws of justice were not violated it was the duty of the state (i.e. “the sovereign”) to protect the “system of natural liberty.” This would occur only if the state made an effort “to protect every member of the society” – to the extent possible – “from the injustice or oppression of every other member” in it. Smith was arguing that, while it is good to believe in natural liberty, the state has to confirm the conditions that make it work. Put another way, when it comes to the harmony creating forces of the market, it is good to “trust, but verify.” This is where warnings and caveats on human nature from The Federalist Papers become important for us.

As many might recall, The Federalist Papers were a series of articles prepared by John Jay, Alexander Hamilton, and James Madison to try and convince the states to ratify the new Constitution (most understand that James Madison did most of the writing). They are also considered philosophical masterpieces. Among the many observations made, the articles warned about the dangers of allowing small groups, or factions, to run roughshod over a weak central government. The real danger for the new nation was that small powerful groups might be able to capture the levers of a corrupt or weak government, and then place their narrow interests above those of the nation. The subtext here is of equal voltage to the larger argument. Specifically The Federalist Papers warned a young nation of human frailties and about the dangers inherent in the individual quest for power.

In Federalist #10, for example, Madison bluntly tells us that, “If men were angels, no government would be necessary.” For our purposes this tells us that we would not need government if those pursuing wealth and profit were angels. But they are not. In spite of Milton Friedman’s optimism, there is little to indicate that markets are immune from the emotions and biases that dominate the human condition. Advantage seeking, jealousies, ego, poor judgment and the search for power get the best of us. This is why the concerns Adam Smith had with reference to the laws of justice and natural liberty are warranted. Simply stated, while the pursuit of wealth may drive people to work hard, the prospect of wealth and power also drive us to violate the laws of justice.

It is not a stretch to argue the individual search for power through commerce and wealth – like the search for power through government and authority – push people to conduct themselves in a manner that is not commensurate with the actions of angels. This is why both our political and economic world requires institutional checks and balances. This helps explain why Adam Smith believed that among the duties of the state, the need to “verify” that the laws of justice in markets were not violated was among them. These concerns were not lost on James Madison ...

- Mark

Note: At the end of the day, not only have the neo-conservatives and the Bush administration violated the laws of justice Adam Smith believed were so important but, with with the restrictions proposed by Paulson's bailout plan, the Bush administration is now advocating that we toss out the separation of power principles the Founding Father's put in place.

THE ROOTS OF MARKETS AND WEALTH

In A Short History of Financial Euphoria, John Kenneth Galbraith discusses the famous case of “Tulipomania” in Amsterdam at the beginning of the 17th century. What started as the granting of prestige to those who possessed novel tulip bulbs turned into wild speculation over successive price increases throughout 1636. Specifically, competition over tulips turned into mania, with single bulbs trading for new carriages and homes, or fetching as much as $25-50,000 each. Demand reached such heights that the Amsterdam Stock Exchange developed a futures market for the bulb.

This market, as well as the dreams of many speculators, would collapse under the weight of its own nonsense and spectacular avarice. As sellers demanded that their tulip contracts be enforced, they were disappointed when their petitions fell on the deaf ears of the courts. Because the market had little to do with the production of actual goods and services, the courts viewed Tulipomania as little more than a gambling operation.

As is the case throughout these histories, panic, default, and bankruptcy followed. Galbraith wrote “no one knows for what reason” the speculation and mania ended, but there’s little doubt common sense finally prevailed in a market spun out of control by deluded buyers and sellers.

Fast forward almost 340 years. We find the creation of another futures market, but this time in U.S. dollars. In The Vandal’s Crown: How Rebel Currency Traders Overthrew the World’s Central Banks, Gregory J. Millman tells the story of how a glut of U.S. dollars helped turn the world’s anchor currency into another commodity, just like corn and beef. Driven by the need to pay for the defense of the West, while solving social problems at home, by the mid-1960s the U.S. government had put too many dollars into circulation.

Because too much of anything drives down its value traders knew that the future price of the dollar would both fluctuate and drop, especially with the amount of deficits and debt the U.S. ran up every year. Like all good entrepreneurs traders wanted to get rich, but wanted to go beyond what traders in the Eurocurrency markets were doing. They wanted to trade in all areas touched by the future value of the dollar.

By 1970 they wanted to trade and speculate on the dollar like Chicago Mercantile dealers bought and sold pork bellies and cattle. To do this, they needed to convince the Nixon administration that speculating on the value of the dollar was a good thing. They would say nothing about what made trading on the dollar so profitable – the underlying irresponsibility of bloated budgets, growing debt, and price fixing.

For $5,000 Milton Friedman was goaded into writing a paper supporting the idea that a futures market supported by deficit dollars was a good idea. Friedman, too, would ignore the underlying irresponsibility of bloated budgets and growing debt. Friedman’s paper was sent to Nixon’s Treasury Secretary, George Schultz, who bought into the idea, stating “…if it’s good enough for Milton [Friedman], it’s good enough for me.”

The result has been an explosion in currency trading and “innovative” financial instruments whose value far outpaces the total worth of goods and services produced around the world. An entire industry of traders, analysts, and lawyers make their living off of what Peter F. Drucker called a “symbolic economy.” Ignored is how little the average person understands about this aspect of the market economy, and how bloated budgets and growing debt feed it.

Also left unaddressed – if not conveniently ignored – is how continued deficit spending and bloated budgets virtually insured the collapse of the dollar. These dynamics fly in the face of what Adam Smith had to say about the importance of knowledge, transparency, and information in capitalist markets. Given these two cases (and there are more), do we simply trust market players to do what’s right and not succumb to speculation and the herd mentality that overtook Holland’s tulip traders?

This is an honest question because if history has taught us anything it’s this: The further a generation gets from the great financial disasters of the past the more their confidence grows in the brilliant and innovative discoveries they’ve made in the markets of their day. Past experience and legitimate questions are “dismissed as the primitive refuge of those who do not have the insight to appreciate” what the new wonderkinds have fashioned ...

- Mark

THE ROOTS OF MARKETS & WEALTH

Below is an excerpt from the book I'm working on, The Roots of Markets & Wealth. The topic is the Milton Friedman fed (or led) myth that the Federal Reserve created the conditions for the Great Depression in 1929.

... In Free to Choose: A Personal Statement, Milton Friedman took care to review the causes of the Great Depression. With characteristic bravado he declared that “the independent Federal Reserve System was to blame for the mistaken monetary policy that converted a recession into a catastrophic depression.” He also claimed “[w]e now know that the depression was not produced by a failure of private enterprise, but rather by a failure of government.”

Speaking of failures, Friedman failed to say anything about the well documented market schemes, market myopia, speculative euphoria, and structural weaknesses in the overall economy. Perhaps Friedman’s greatest overstatement is falsely suggesting – with his “We now know …” claim – that there is some kind of scholarly unanimity behind the causes of the Great Depression. Nothing could be further from the truth.

Nobel Laureate Paul Samuelson, for example, argued that there could be “dozens” of explanations for “cycle theories” that explain business slumps and economic depression. Indeed, looking at the claim that the Federal Reserve encouraged speculation early on John Kenneth Galbraith researches and then dismisses the position as ‘formidable nonsense.’


Another Nobel Laureate, Kenneth Arrow, questioned Friedman’s focus on monetary policy, warning that “the sole emphasis on incompetent monetary policy as the cause of the Great Depression is disputed by serious scholars.” He adds that “really bad turns in monetary policy did not come until the end of 1930” when the recession was already “severe.”

Friedman also ignores that before the creation of the Federal Reserve System capitalist history is rife with market failures on a grand scale, suggesting “instability” is “endemic in the free enterprise system.” Indeed, standard history texts of the American economy point to easy lending by industry (margin purchases, easy credit, shady loans, etc.), structural weaknesses in the banking industry, and slowdowns in agriculture and housing markets, among other problems in the overall economy.

In sum, it is clear the causes behind the Great Depression are far from decided, and the manias that lead to destructive herd mentalities in markets may be more common than we want to believe. More importantly, it tells us that Milton Friedman was prone to making broad statements that aren’t supported by the facts ...

- Mark

MEANDERING IGNORANCE & THE DRAFT

During Dick Cheney's interview with ABC's Martha Raddatz on the war in Iraq last week Raddatz pointed out: "Two-thirds of Americans say it's not worth fighting, and they're looking at the value gained versus the cost in American lives, certainly, and Iraqi lives."

Ever so thoughtful, Dick Cheney responded: "So?"

While this is yet another example of what happens when arrogance and indifference merge in the minds of the painfully mediocre, it's Cheney's response to another Raddatz question that walks away with my Meandering Ignorance award.

RADDATZ: "What sacrifice have most Americans made?"

CHENEY: Well, I think they've been asked to support the effort and the enterprise. But it's not the kind of thing, for example, where you would have wanted to institute a draft. We've got an all-volunteer force; it's one of our great assets, one of our great national assets. I suppose you could have created a sense of sacrifice if you'd gone back to the draft, but that would have, in my opinion, done serious damage to the state of our military. We built a volunteer force because that was a decision we made 30 years ago, and it's been a very good -- a good decision.

Where do I start? How about with this: "We built a volunteer force because that was a decision we made 30 years ago ..." does not explain why we went to an all volunteer military. It's kind of like George Bush saying "I lied about the reasons for going into Iraq because I didn't tell the truth ..."

Cheney's response is truly as ignorant an answer as you can get when it comes to explaining the "sacrifices" America is making in a war that Cheney has compared to World War II. And, for the record, the reason we went to an all volunteer military is because the economist studying whether we should get rid of the draft willfully ignored Congress.

Specifically, Congress wanted to know how much more the country would have to pay in recruitment costs, public relations, higher wages, better benefits, privatization, etc. if we went to an all volunteer military. The economist went out of his way to use his own methods, and argued that people not working in the private sector because they were drafted into the military meant lost national income. His methods weren't questioned (and no one took the time to ask if he was injecting his own political views) so the Gates Commission adopted the proposal. We dropped the draft in 1973. The economist? Milton Friedman.

- Mark