Tag: Monetary and financial system

19th November 2010

Harvard University academics prove once again that the government is a poor manager of our money

That governments are terrible spenders of our money is obvious to me (and I'm sure to you), but many economists remain in serious confusion about this basic issue throughout their lives, preferring to believe their mathematical models to thinking based on first principles. Now, mathematical models do work, but only if all relevant factors are taken into account – a feat impossible in any serious macro-economic model which therefore always fail to estimate the impacts of government failure.

As a result of their fascination with simplistic mathematical equations, Keynesian macro-economists, therefore, are sometimes shocked to discover that government is the worst manager of our money, thus nullifying the work of their entire career! True, such proofs are not easy. As the article from The Economist cited below notes, the fundamental problem in (empirical) economics is the difficulty of isolating individual factors. For instance, it is hard to detect precisely how much impact a particular policy has (in isolation of other effects that are also changing at the same time in the environment). As a result, Keynesian economists continue, for the most part, to live in a world of delusions wherein the government policy maker knows better (or more) than citizens, and can "stimulate" or "cool off" the economy at will, like a thermostat.

Unlike Keynesians, I prefer theoretical analysis of a standard far richer than macro-economic models can possibly admit. Both the consideration of first principles (namely, the need of a social contract to defend our freedoms which precludes giving unnecessary powers to governments) and personal experience (I have now worked for 28 years in the government and can claim to know the incentives of bureaucrats inside out!), confirm to me that the government should NEVER undertake tasks that can be better performed by citizens on their own.

Indeed, by taking up unnecessary tasks (such as non-emergency health care/university education/R&D/aged pension, etc.) the government creates moral hazard and perverse incentives, thus distorting cruical allocative decisions and leading to serious inefficiencies.

For instance, it is common in Australia for people to splurge their tax-sheltered superannuation savings close to their pensionable age by going on overseas holidays, and then returning from abroad with a begging bowl, asking the state for aged pension and other welfare! That's called having your cake and eating it too! A free lunch! The tax-payer in the West is taken for a ride at each step by the so-called "morally superior" bureaucrat who "plans" for our future and the "unethical" citizen. But why would a rational citizen not rip-off the idiot government? In fact, financial planners openly write about the many ways to cheat the system.

Anyway, now there is serious research (Far from the meddling crowd – Buttonwood) to confirm the existence of government failure in making investment decisions on our behalf. Government investment seriously crowds out private expenditure (which is more productive) and harms economic growth. The study "found that a 1% rise in government consumption as a share of GDP eventually reduced private-sector consumption by 1.9%. Temporary spending to pick up economic slack may be useful but the long-term benefits of austerity seem clear."

It is amazing that it takes Harvard University to prove this most basic of all points of political economy – that the government should restrict itself to the bare-bones of defence, police, and justice – and a few (very few) other things such as infrastructure and (if funds permit) a frugal equal opportunity regime.

The papers

“Canada’s Budget Triumph”, by David R Henderson, Mercatus Center, George Mason University

“Do Powerful Politicians Cause Corporate Downsizing?” by Lauren Cohen, Joshua Coval and Christopher Malloy, Harvard Business School

“The Impact of Government Spending on the Private Sector: Crowding-out versus Crowding-in Effects”, by Davide Furceri and Ricardo Sousa:

16th November 2010

American Harakiri

In 1997-98, while I was a doctoral student in USA, I was commissioned by a consultancy firm to study the US social security system. What I found was shocking – a pension system in shambles. Its trajectory after about 2015 was in serious trouble, with committed outflows strongly exceeding inflows.

George Bush, with his limited economic sense, cut taxes (without cutting expenses) at the same time when Alan Greenspan was lowering interest rates to ridiculous levels. The housing market went in over-drive. The GFC was the immediate consequence of these actions (more details in my blog post here). In 'resolving' the GFC, seriously bad Keynesian approaches were applied. QE2, or quantitative easing No.2, marks perhaps the final nail in the American coffin.

The current American situation is this:

1. Its dollar is spiralling downwards (15% devaluation in the last six months), held up largely by Chinese intransigence to revalue the yuan. Once China decides to dump the USD (not an easy decision for them, though), it will, given continuation of bad policy in USA, become a relatively worthless piece of paper. Its devaluation will definitely help US exports but its consumers are going to be badly pushed against the wall, being unable to buy cheap goods any more.

2. Its baby boomers are looking to a bleak future with their pensions likely to collapse. Retirees' savings will be going to be further crunched by the loss of value of the dollar and the mega-inflation that is almost certainly going to set in during the next few months (or years, if US is lucky) because of huge liquidity being injected into the US economy. Poverty and crime are likely to increase seriously in consequence.

3. American armed forces are badly stretched. Cheaper options to influence the world (such as those I have advocated here) through the spread of freedom and good governance have been rejected in favour of aggressive and badly managed approaches against terrorism.

There is no free lunch in life. That is the main lesson of economics. Bad policy ALWAYS leads to bad consequences, although in the short-term its impacts are masked by transferring the risks to the poor and elderly who hold savings in the bank. In the end, bad policy always comes back to haunt. India was done in by Nehruvian bad policies (most of which still continue).

American policy makers are now working at a furious pace to crash its economy. America is entering dangerous unchartered territory just as its baby boomers start to retire.

Worse, if India does manage to get its act together, many Indians in America (who supply a significant chunk of American brainpower in medicine, education, and IT) will return to India, hollowing out America's intellectual leadership and hurting its recovery even more.

Time is fast running out on America.

As you know, I thoroughly recommend Nassim Taleb's books (here). Well, here's an outstanding interview he gave recently on QE2. Please watch this video. It will tell you how America is committing Harakri. And why it is well advised to bite the bullet and let structural adjustments occur sooner than later.

Addendum. Watch this. Very pertinent.

28th September 2010

Is the world getting more uncertain, or less uncertain?

I've by now attended a few expert sessions where I hear that uncertainty is increasing in the modern world. For instance this report talks about an "increasingly uncertain global environment", and that "The complexity and uncertainty that the public sector faces is driving the need for governments to foster agility in its people, systems and outlook."

I agree that complexity is increasing, even as things look increasingly simper on the surface because of a more sophisticated way of using technology (a good example would be the I-Phone). Also, of course, things are getting more complicated – which is a subset of complexity (consider modern cars compared with earlier cars).

But I can't find evidence that uncertainty is increasing. On the contrary, I find uncertainty is decreasing.

Let's use the Rumsfeld framework to determine the extent of our knowledge (or ignorance):

1. known knowns: This is the situation of perfect information.

2. known unknowns: In this case we may know the distribution of something (say in the game of dice), but don't know precisely which outcome we will experience. So there is a level of known risk with well-defined probabilities.

3. unknown unknowns: This refers primarily to Black Swan events that hit us from the blue. We neither know their mean, nor distribution. We don't even know that they exist!

The question before us is: Are (2) and (3) increasing? Are uncertain events increasing? Are shocks and accidents increasing?

Consider this graph from my draft manuscript DOF.

As knowledge about the world has grown our ignorance has reduced.

To the hunter-gatherer, life was almost entirely uncertain. He did not know whether he'd find food on a given day, how far and in which direction he'd have to go to find food, whether he would return home safe, whether his wife would still be at home when he returned or have been picked up in a neighbouring tribal raid, whether his child would live or die of disease, snakebite, and so on. Life was a mystery. Survival was a herculean challenge. The savage knew virtually nothing. Almost everything was an unknown unknown.

In that sense certainty has dramatically increased. We get up at a fixed time. Immediately, hot water and food are available. We go to work in a bus (in my case) that might be five minutes late, but the thing still comes! We might see a traffic accident on the way once in a year but generally everyone reaches safely to work. Our families are generally safe, our children don't mosly die of disease. And so on.

We know almost exactly what we know and what we don't know. What we don't know we can find on google.

The area of the unknown unknown has shrunk to almost total insignificance. Black swan events that are largely man-made (e.g. GFC) can be readily explained by those who know, and will confound those who are ignorant about how markets work. The fact that some people don't understand freedom and free markets doesn't mean that the event was not predictable.

True, we do a lot many more things than we did in the past. Therefore the things that can change have increased. So there are more 'distributions' today – that were not even in existence in our hunter-gathering days – many of which are not fully known.

But despite that, on average, on all things that matter, life is FAR MORE certain than it was ever before.

ADDENDUM

Ways by which uncertainty is reduced in the modern world:

– Hedging of risks (typically foreign exchange risk).

– Diversification of one's portfolio

– Insurance and risk management

– Complete markets including for insurance (although insurance markets will never be complete)

– Predictable regulatory frameworks

– Systematic governance arrangements (both in the public and private sectors) including accounting and other practices.

– continuous improvement in health technology and science

As competition has increased (relatively to our hunter-gathering days? – not sure) people's jobs are not assured. But it is still assured that they will survive longer and healthier than hunter-gatherers or pre-modern men.

Even if a major glitch occurs (e.g. the Virgin Blue breakdown of computers yesterday), the net loss is relatively small, since individually, these things account for an increasingly smaller share of our income.

12th August 2010

The Keynesians will bury the West

I normally don't comment on Australian policy, particularly where it is somewhat related to my official work. But in areas where my official role is not directly involved, I am able to comment without violating Conduct Rules. And so this post deals with Australian policy. I would like to remind everyone that my views are purely my own and do not represent the official entity that I work for.

Remember that I have commented adversely against the bailouts and stimulus packages in the USA (here). The so-called "stimulus" package in Australia has proved the same point point closer to home: that Keynesians are the greatest enemies of the West, along with Rawlsian social "liberals" or social democrats.

With NOT THE SLIGHTEST CLUE about how governments actually work (never having worked in the 'trenches' perhaps, inside government), these economists rush in where angels fear to tread, borrowing money in the billions and then throwing it into the ditch.

I had read a lot of Stiglitz's work as a doctoral student and to an extent he talks sense, but I soon realised that he is among the economists best avoided. I am now very clear that Keynesians of all sorts are dangerous ignoramuses, with absolutely no clue about human incentives and capacities. If only they had the slightest idea of how governments actually work. But they also have an ego the size of the dung on top of the dung beetle: always confident about their reckless "plans" for the economy. Socialists at heart, they are not bothered about things like individual freedom and the limits of a government's role. The whole society is theirs to experiment with, it would appear, with taxpayers' money. If money doesn't exist, they'll print it.

The following article in The Age today is a breath of fresh air, putting out the key arguments against the reckless destruction of wealth and damage to incentives caused by Keynesians (and he has left out: the welfare socialists) to Australia.

Have a read: "ALP's knight is a thief in rusty armour" by Niall Ferguson

(I just visited Ferguson's website (here) and found a bunch of interesting articles such as "End of the Euro" – the end of which seems inevitable unless strong enforcement mechanisms are devised. The monetary union is turning out to be a cartel where penalties can't be enforced. Ferguson is an economic historian at Harvard – definitely worth reading more of his work.)

Key point from his article:

"Joseph Stiglitz … praised the government's debt splurge as "one of the best-designed Keynesian stimulus packages of any country"." "But is Stiglitz sure — I mean graduate-seminar sure, as opposed to Fairfax-press sure — that this was really due to the government's $52 billion cash splash?"

(Clearly Stiglitz is imagining things, of that one can have not the slightest doubt).

The "more plausible explanations for Australia's relative outperformance" include: "1. Lady Luck 2. The Howard government 3. The RBA 4. China 5. The mining industry".

Indeed, I have argued at length on internal forums on FTI that Australia's financial system, reformed after the Wallis Review of 1997 (during the Howard government) significantly reformed the financial system and created checks and balances. There remain a few gaps which I believe can be eliminated without significant additional regulation but by better focusing of attention by the regulators.

There does exist a significant further phase of financial reform (for India but equally applicable to Australia – see DOF) which will include dissolution of the central bank and splitting its function into the private sector or independent regulators – as appropriate. Once that happens, all major risks to the financial system will be eliminated.

The government must ONLY regulate. It must NOT directly manage the financial system. And (in relation to the 'stimulus') while infrastructure funding is valid, reckless burning of tax-payer funds is not.

ADDENDUM:

Must read this related article: http://www.nytimes.com/2010/08/12/opinion/12poole.html?_r=1