Missing the Margin

by Don Boudreaux on May 22, 2020

in Economics, Myths and Fallacies, Seen and Unseen

Another unmistakable clue that the folks at American Compass work with a faulty understanding of the economy is this passage in the opening paragraph of Wells King’s May 20th essay, “Coin-Flip Capitalism: A Primer”:

But the buying and selling of companies, the mergers and divestments, the hedging and leveraging, are not themselves valuable activity. They invent, create, build, and provide nothing. Their claim to value is purely derivative – by improving the allocation of capital and configuration of assets, they are supposed to make everyone operating in the real economy more productive.

By asserting that the financial-market activities identified above “are not themselves valuable activity” – that these activities “invent, create, build, and provide nothing” – and that their value “is purely derivative,” King reveals a pointless fetish for the physical. (Overlook here the apparent contraction between the claim that financial-market activities are “not themselves valuable activity” and the claim that the value of these activities “is purely derivative.” This contradiction is evidence of the confusion of King’s thought.)

By calling the value of financial-market activity “derivative,” King clearly suggests that these activities are less important than are the activities from which they derive whatever value they have. But this suggestion is wrongheaded.

Because modern manufacturing, modern construction, and modern farming could not occur without modern financing, modern financial-market activities are every bit as essential today to the physical production of goods as are the welders, assembly-line workers, riveters, carpenters, and farm hands who manually help to produce goods. To assume that the latter activities are somehow more ‘essential’ to production than are financial-market activities makes no more sense than to assume that the tires of an automobile, because they are the only part of the car to touch the road, are more essential to that vehicle’s mobility than are the engine, the fuel tank, the transmission, and even the brakes.

Just as a car would not be able to move as its driver wishes it to move were it stripped of any of these and other of its key parts, the modern-day physical production of goods would not occur without modern financing. Nor would this production occur without modern marketing, management, accounting, insurance, communications, transportation, wholesaling, and retailing – all of which are services the value of which is no less or more “derivative” than is the value of financing or of welding or of hammering or of snapping-components-together.

Put differently, the value of financing is no more “derivative” of physical production than is the value of physical production “derivative” of financing. All derive their economic value from the contributions they make to the value of final outputs, which itself is determined by consumer expenditures. To single out physical production generally, or manufacturing specifically, as being somehow more fundamental, more crucial, is to reveal profound economic misunderstanding.

…..

Economists who read King’s essay immediately see that he completely misses the importance of marginal analysis – that is, a recognition of the deep importance of the fact that decisions are made at the margin. It’s true that economists did not fully grasp the importance of the margin until the early 1870s with the “marginal revolution,” as it is appropriately called. But the concept has been around now for nearly 150 years; it ought to be understood by everyone who today writes about economics.

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Open Letter to Wells King

by Don Boudreaux on May 22, 2020

in Financial Markets, Hubris and humility

Mr. King:

I just read your essay, “Coin-Flip Capitalism: A Primer.” You claim to show that hedge funds and private-equity operations perform poorly relative to your benchmarks. That might be. If so, you’ve done a good service for investors by exposing poor options for using their funds.

But I can’t help but wonder why investors themselves haven’t by now figured out what you claim to show. They are, after all, investing their own money. Because people personally gain from their wise investments and personally suffer from their unwise ones, each person has strong incentives to invest wisely.

You, however, obviously believe that people who invest in hedge funds and in private-equity operations nevertheless consistently invest unwisely. And you offer a list of problems that allegedly are thereby created by the unwise decisions fostered by today’s financial markets – problems suffered not only by these stubbornly stupid investors but also by society at large.

On your list, for example, is this asserted problem: “Floods of capital intent on ‘disruption’ can dismantle established industries while failing to build sustainable businesses in their stead.”

Well, yes, such unprofitable investment can indeed happen. And it surely does so sometimes. But the relevant question is: How often? You offer no answer to this question, although your inclusion of this problem on your list suggests that you believe it to be chronic. (It’s amazing, by the way, that investors who keep losing money somehow always have more lying around to be eagerly invested in additional losing projects.)

If you’re correct about the chronic failure of these investments, the question then becomes: What to do about it? Because you work for American Compass – whose founder, Oren Cass, endorses industrial policy – you likely believe that entrusting more investment decisions to politicians and bureaucrats would result in a better allocation of capital. But industrial policy has its own problems, chief among them being politicians’ and bureaucrats’ inability to know how to allocate capital wisely.

Fortunately for society, however, you exist. Your apparently superior knowledge of financial markets and investment options means that you can earn a personal fortune while simultaneously improving the economy’s allocation of capital. Put your money where your mouth is, quit American Compass, and set up shop as a private investor.

If your assessment of the current state of financial markets is correct, you’ve discovered a vast opportunity for personal profit. Investors, having learned from you how they’ve been throwing their money away, will entrust their funds to you. You’ll then be able to direct these funds in ways that earn high returns for your clients, earn handsome fees for yourself, and are a more productive allocation of capital for society.

If you know what you claim to know, there’s no reason for you not to do as I here propose. Yet if you don’t do as I here propose, then we have strong evidence that you yourself really aren’t confident in the assertions that you present so confidently to the public – in which case we are all well-advised to significantly discount the policy advice offered by you and your colleagues.

Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030

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… is from page 5 of the 1999 Liberty Fund edition of James M. Buchanan’s and Gordon Tullock’s seminal 1962 book, The Calculus of Consent:

Economic theory does not explain the organization of private choices sufficiently to enable the professional economist to predict the precise composition of the national product, the exchange ratio between any two goods or services, or the price of any one good in terms of money. Such predictions would require omniscience, not science, because we must deal with individuals as actors, not as atoms. The sciences of human choice must be modest in their aims.

DBx: Yes. The brilliant economist no more than the merely competent one studies human exchange and the different institutions to which this exchange gives rise and how, in turn, these institutions affect exchange. The brilliant economist no more than the merely competent one develops a good sense of which questions to ask and what fallacies to guard against.

And the brilliant economist no less than the merely competent one is completely without access to knowledge of individuals’ preferences and to knowledge of the detailed facts on the ground – knowledge that, if possessed by an omniscient creature, would allow that creature to make specific economic predictions of the sort that naive people think scientific economists should be able to make.

Knowledge – detailed knowledge – of these inconceivably large number of ever-changing details is necessary for specific predictions of changes in relative prices, changes in the pattern of output, changes in GDP, changes in the ‘distribution’ of income, changes in almost any of the phenomena that, to repeat, naive pundits and people, along with poor economists, suppose economists ought to (be able to) predict.

People who propose the use of industrial policy to improve the economy package their proposals as the fruits of science. But this packaging is wholly misleading. In reality, as Buchanan and Tullock understood, for industrial policy to work as advertised, what is required isn’t science but omniscience.

And so unless you really believe that politicians, bureaucrats, professors, pundits, and thinktank scholars are, or can become, omniscient, you should reject industrial policy without hesitation or qualification.

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… is from this superb column by the Wall Street Journal’s Holman Jenkins:

Those who talk of governments “following the science,” “acting on the science,” most of whom could not give a coherent account of the science of anything, are like dogs who yap because the other dogs are yapping.

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Here’s a letter to a regular correspondent of mine who “sees plenty of common sense in Oren Cass’ writings”:

Mr. Dye:

I’m familiar with the concept of externalities. And I agree that looming somewhere in the bowels of Oren Cass’s hostility to financial-market activities is an aching suspicion that these activities give rise to negative externalities – that is, to undesirable effects on third parties that are unaccounted for by persons whose actions create those effects.

Any such ache, however, is psychosomatic. It’s unjustified by reality.

Investors who buy other firms spend their own money and money entrusted to them voluntarily. When their merged firms succeed, these investors profit; when these firms fail, they lose. Likewise, owners who sell their assets gain when their decisions are wise and lose when they aren’t. This prospect of gain and threat of loss ‘internalizes’ on those who make financial-market decisions the benefits and costs of these decisions. And this internalization is at work in financial markets no less than it is at work in what Cass & Co. confusingly call “the real economy,” by which they mean manufacturing and other activities that directly produce tangible outputs. (All parts of the market economy are real; they all really do positively contribute to the production of goods and services that enhance our living standards.)

In short, American Compass’s hostility to financial markets reflects nothing so advanced as a well-worked out and tested theory of externalities. The externality that Cass & Co. seem to have in mind – or, rather, have in their guts – is based on the superstition that value is created only by the actual, physical production of tangible goods, and that all other activities are merely “derivative.” Strong evidence that Cass embraces this absurd superstition is found in the e-mail that he sent out yesterday.

Of course it’s true that taxes and regulations themselves often create externalities that enable individuals to profit at the public’s larger expense. Subsidies that would be part of Cass’s industrial policy are a classic example of a negative externality created by government: some producers free-riding on resources seized from other people. But there’s no reason to suppose that such distortions are more numerous or worse in financial markets than in the so-called “real economy.” And it certainly makes no sense to ask the very people who impose these harmful interventions – politicians – to address the problem with additional interventions rather than simply to remove the offending ones.

Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030

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One giant writes about the important work of another: Here’s John Tierney on Robert Higgs’s work on how and why government grows in response to crises – crises real as well as imagined and always hyped. A slice:

Higgs sees government, as usual, vastly expanding during the crisis, and he’s sure that it will not shrink back to its former scale once the crisis is over. It never does, as he famously documented in his 1987 book, Crisis and Leviathan: Critical Episodes in the Growth of American Government, and in later works exploring this “ratchet effect.”

By surveying the effect of wars, financial panics, and other crises over the course of a century, Higgs showed that most government growth occurs in sporadic bursts during emergencies, when politicians enact “temporary” programs and regulations that never get fully abolished. New Deal bureaucracies and subsidies persisted long after the Great Depression, for example, and the U.S. military didn’t revert to its prewar size after either of the world wars.

Besides charting the growth of government, Higgs identified the fundamental psychological cause. He recognized the political significance of the negativity effect, also called the negativity bias—the universal tendency of negative events and emotions to affect us more strongly than positive ones.

In our recent book on this bias, The Power of Bad, social psychologist Roy Baumeister and I drew on Higgs’s work to argue that the greatest problem in politics is what we call the Crisis Crisis—the never-ending series of crises, real or imagined, that are hyped by the media and lead to cures too often worse than the disease. It’s a perpetual problem because it’s so deeply rooted in human psychology, as Higgs explained in a 2005 essay, “The Political Economy of Fear.”

“To tell people not to be afraid is to give them advice that they cannot take,” Higgs wrote. “Our evolved physiological makeup disposes us to fear all sorts of actual and potential threats, even those that exist only in our imagination. The people who have the effrontery to rule us, who call themselves our government, understand this basic fact of human nature. They exploit it, and they cultivate it.” Rulers instinctively heed Machiavelli’s advice: “It is much safer to be feared than loved”—a sixteenth-century formulation of the negativity effect.

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George Will writes eloquently and powerfully in opposition to the tyrannical process of plea bargaining as it now plays out in the United States. A slice:

Plea bargaining is, [Clark] Neily argues “pervasive and coercive” partly because of today’s “trial penalty” — the difference between the sentences offered to those who plead guilty and the much more severe sentences typically imposed after a trial. This penalty discourages exercising a constitutional right. A defendant in a computer hacking case, Neily says, committed suicide during plea bargaining in which prosecutors said he could avoid a trial conviction and sentence of up to 35 years by pleading guilty and accepting a six-month sentence.

My intrepid Mercatus Center colleague Veronique de Rugy takes sharp aim at a deserving target. A slice:

No doubt, the superrich do lead different lives than we do. However, most of their wealth is tied up in productive activities. A vast majority of it is invested in companies. It is used to fund research and development that will create better goods and services for consumers; that wealth is the capital that smaller-scale innovators and producers borrow from banks to grow their enterprises. And it employs workers. The Zuckerbergs’ wealth, for instance, contributes directly to the employment of 45,000 people worldwide.

Deflation or inflation? Richard Rahn ponders.

Jeffrey Tucker asks if the lockdowns saved lives.

Perhaps protectionists are victims of a commonplace psychological quirk.

Eric Boehm rightly tears into the lethal protectionist idiocy hawked by Sen. Josh Hawley. A slice:

Just as importantly, Hawley’s wrong on the economics. Withdrawing from the WTO would leave America cut off from the lower tariff rates that member nations grant to one another, effectively raising barriers to American exports and harming American manufacturing and farming. The global trade that’s possible because of America’s membership in the WTO boosts the U.S. economy by $2.1 trillion every year, according to an estimate from the Peterson Institute for International Economics, a trade-focused think tank.

I’m honored and very happy to have been interviewed for this podcast by Keri DiNarda of The Fund for American Studies. The topic is globalization and health.

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… is from pages 42-43 of the May 9th, 2020, draft of the forthcoming monograph from Deirdre McCloskey and Alberto Mingardi, The Illiberal and Anti-Entrepreneurial State of Mariana Mazzucato:

Profits have the latent function (as the sociologists put it) of sending out memos concerning whether resources are being used badly or well. Governments regularly don’t get the memos, or refuse to read them, because the politics has other messages in mind, chiefly the preservation of the status quo and the enrichment of the politically powerful.

DBx: Profits and losses in markets are, like the prices that result in them, vital  both as signals of which resource uses work better than others, and as incentives for resource owners to find ever-more-useful combinations of resources.

When profits and losses are set by markets, the criteria for which uses are ever-more-useful are determined ultimately by consumers spending their own money. To the extent that government interferes in markets – for example, with tariffs and subsidies – government distorts and sometimes even mutes these market signals and incentives.

I repeat here – because the objection is central yet routinely ignored – the ought-to-be astonishing observation that advocates of industrial policy, grand or petit, offer no explanation of how the government officials whom they wish to entrust with power to override market signals will get the information these officials need to cause the economy to perform over time better than do competitive markets.

Advocates of protectionism and industrial policy never tire of pointing out – as if it’s breaking news – that real-world markets seldom work as perfectly as do the model-markets in economics textbooks. Impressed by their discovery of a reality known and repeatedly trumpeted since before the time of Adam Smith, these advocates of intervention believe themselves to make a case for tariffs and subsidies simply by pointing to this reality. If these proponents of protectionism and industrial policy would apply this same logic to, say, transportation, they would begin by announcing breathlessly – as if to an audience unaware of the fact – that automobiles sometimes crash and kill. (“And notice that the automobile companies don’t put this gruesome fact front and center in their advertisements!”) These interventionists would then therefore conclude that government should coercively obstruct people’s particular automobile-riding choices whenever government officials divine that particular rides will kill or maim.

…..

It should be the case – but it will never be the case – that those who propose protectionism and industrial policy as means of strengthening the home economy should be ignored until they offer some plausible, substantive explanation of how (always imperfect) government officials will get the information necessary to out-perform (always-imperfect) markets. Merely asserting that government officials ‘will take a longer-run view’ or ‘will support the industries of tomorrow’ sounds lovely to gullible ears. Who, after all, opposes the taking of a longer-run view? Who objects to supporting the industries of tomorrow? The substantive and key question is how will government officials get the information necessary to achieve the happy outcomes promised by these glorious phrases. Proponents of protectionism and industrial policy never as much as ask, never mind answer, this question.

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Here’s another open letter to Oren Cass:

Mr. Oren Cass
American Compass

Oren:

In your mass e-mail this morning announcing American Compass’s project that you tellingly name “Coin-Flip Capitalism,” you write:

The buying and selling of companies, the mergers and divestments, the hedging and leveraging, are not themselves valuable activity. They invent, create, build, and provide nothing. Their claim to value is purely derivative—by improving the allocation of capital and configuration of assets, they are supposed to make everyone operating in the real economy more productive.

With respect, this paragraph is a nest of nonsense.

Your most fundamental error is one that was exposed and debunked in the seminal 1965 article “Mergers and the Market for Corporate Control.” In this article, the late Henry Manne explained how mergers and other methods by which ownership rights over corporate assets are transferred are a principal means both of encouraging owners and managers to use corporate assets efficiently and to facilitate the transfer of poorly managed assets to owners who will ensure that these assets are managed better.

With no active market in assets, assets remain wherever they happen to be and used however they happen to be used, regardless of how productive or unproductive these uses are. And so for you to dismiss as “purely derivative” the market activities that transfer assets into hands that use those assets most productively reveals an oversight of a fundamental and beneficial function of capital markets.

Dismissing, as you do, the importance of such financial-market activities on the grounds that their “value is purely derivative” makes no more sense than dismissing as “purely derivative” the value of driving medical-supply delivery trucks to hospitals. Because diagnostic equipment, syringes, antibiotics, and other medical supplies become productive only when in the hands of people who use them to their best effect, all activities undertaken to get these supplies into the hands of physicians and nurses are productive no less than are the activities of the physicians and nurses who then manually use these supplies.

Do you believe that the driving of these delivery trucks is wasteful because its value is “purely derivative”? If not, you should rethink your indictment of the financial-market activities that you hold in such low esteem.

I know, I know: I’m just one of those neo-liberal market fundamentalists addicted to simplistic absolutisms. Perhaps. And so if I am mistaken in what I write above, then you have found for yourself a goldmine. With so many people being paid goo-gobs of money to perform activities that you have perceptively identified as valueless, you can make yourself incredibly rich while simultaneously improving the economy’s productivity.

Simply set up a firm that doesn’t use capital markets. If you’re correct, your firm – free of all the waste weighing down your competitors – will be extraordinarily profitable. Alternatively, hire yourself out as a consultant, advising existing firms on how to avoid all the waste that you believe clogs existing economic arrangements. Itching to get a leg up on her rivals, some perceptive corporate CEO will surely pay you big bucks for your unique insights on how her firm can increase its profits merely by refusing to participate in all the activities that you have identified as wasteful.

Sincerely,
Don

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Here’s a letter that I sent last week to the Washington Post:

Editor:

Robert Samuelson is correct: the national debt is out of control (May 11). But he’s incorrect to suggest that this problem can be addressed with equal effectiveness by both tax increases and spending cuts.

In their meticulously researched 2019 book, Austerity: When It Works and When It Doesn’t, Harvard economist Alberto Alesina, along with Carlo Favero and Francesco Giavazzi, report that cutting spending is far more effective at reducing debt burdens than is raising taxes. As put by the blurb offered by the publisher, Princeton University Press: “Looking at thousands of fiscal measures adopted by sixteen advanced economies since the late 1970s, Austerity assesses the relative effectiveness of tax increases and spending cuts at reducing debt. It shows that spending cuts have much smaller costs in terms of output losses than tax increases.”

Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030

…..

I’m pleased to share the news that Austerity is the winner of the Manhattan Institute’s 2020 Hayek Book Prize. Congratulations to the authors for this well-deserved prize that acknowledges the high quality and deep importance of the research that they report in this superb book.

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