Sunday, June 27, 2010

Stimulus believers put economic machine ahead of people

Published in The Tennessean, Sunday, June 27, 2010

Stimulus believers put economic machine ahead of people

by Richard J Grant

An unfortunate effect from the teaching of mainstream (Keynesian) macroeconomics over the past 50 years has been to give the impression that the economy is some kind of machine that requires a government in the driver’s seat. This view has led to trouble precisely because the economy is not a machine.

Our conventional measure of economic activity is what we call the Gross Domestic Product, or GDP. It gives us a rough idea of the dollar value of transactions that have taken place. When GDP falls for about half a year, we call it a “recession.”

In the early stages of our most recent recession it was very common to hear people repeat the observation that “consumption makes up 70 percent of our economy.” This superficial observation would be harmless, but it led many to believe that we could make our economy “grow” again by encouraging people to consume more. That is, spend more, save less.

From the perspective of an individual, this is especially bad advice during a recession. When the times (and future income) become more uncertain, it is better to have more cash on hand. Each individual is better situated to determine his own cash and spending needs than is some policymaker peering at aggregated data.

Policymakers want to rev up the machine. But the machine doesn't exist. Individuals exist, and they want to adjust their plans to fit the realities around them. They tend to cut back on their least-important expenditures. Keynesian policymakers hate this. They dread the “paradox of saving,” which (they believe) brings slower growth.

This superficial perspective can lead even honest, non-statist people to believe that if individuals won't spend more, then the government must do it for them. That is the logic that led us from “stimulus checks” three years ago, to the subsequent series of “stimulus packages” and other incentives to spend.

“Stimulus” used to be a useful word until we put it in front of “package.” Now it has come to be associated with the redistribution of capital from higher-valued to lower-valued uses.

Some of that money might have been spent by individuals on things that they really wanted. Some of it might have been held as cash to carry a family through a time of hardship. Some of it might have been invested in a new business, or in a retirement fund.
Instead, we see signs along the highway bragging about how some of that money was spent for us.

Government “stimulus” spending is a net loser – and more is worse. But there are still economists who believe that the government must spend more. Nobel laureate, Paul Krugman began a recent article with the admonition, “Spend now, while the economy remains depressed; save later, once it has recovered. How hard is this to understand?”

Professor Krugman seems quite upset that some of us disagree with him. Not satisfied with urging stimulus upon politicians here in the U.S., he has taken on Germany. But the Germans have had enough of such advice. Although our own president has clearly bought into a Krugman-like policy, a recent news report began, “Chancellor Angela Merkel roundly rebuffed U.S. President Barack Obama’s call for Germans to aid the global recovery by spending more and relying less on exports.”

Krugman's theory conflates limits on government spending with “imposing suffering.” He refers to “deficit hawks” as “hypocrites.” But for all his concern with the people's plight, his attention is really directed toward the welfare of the machine. He recognizes that “we need to fix our long-run budget problems,” but adds, “not by refusing to help our economy in its hour of need.”

Unfortunately, this is not just a matter of semantics. Stimulus theory really does put the machine ahead of real people. That is why it fails. By rewarding failure and punishing prudence, the “stimulus” has left our economic machine sucking its own exhaust.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010

Sunday, June 20, 2010

Progressives don’t realize how much they don’t know

Published in The Tennessean, Sunday, June 20, 2010

Progressives don’t realize how much they don’t know

by Richard J. Grant

On ancient maps it was common to fill in unexplored or feared regions at the edges of the world with pictures of serpents or the warning, “Here be dragons.” Today it remains unwise to venture into such territory unprepared either to survive or to accept the consequences.

With greater knowledge and technology, we travel casually beyond the ancient frontiers. But we still fear dragons, the unknown.

We also attract trouble when we believe we know more than we really do. That is why we put limits on children. That is also why we put limits on governments.

Why do countries with high levels of government control tend also to be countries with high levels of poverty? Government officials cannot possibly possess the knowledge necessary to create and direct resources to their most important and productive uses. The socialists’ belief that it was possible to centrally plan prosperity is what Professor Friedrich Hayek labeled, “the fatal conceit.”

Government in America is growing, not because of its past successes, but because of progressives’ conceit. They do not know how much they do not know. That gives them the confidence of the child, raised on Disney films, who skips happily into the jungle to play with Bambi. They imagine that if we just let government write the script, then we will always have a happy ending.

When life doesn't follow that script, we often hear charges of “market failure.” But not often enough do we recognize the ubiquity of government failure.

“The Market” is often imagined as some kind of unified collective entity, as some sort of counterpart to government. But that is a misunderstanding. Markets are really just an activity: the exchanges of goods, services, and information between individuals. Even exchanges between companies are conducted by individuals on behalf of other individuals with whom they have agreed to associate.

It is in these exchanges and associations that real information and market knowledge are produced. By their actions in production and exchange, individuals reveal information about their preferences and true abilities. They also generate information about the availability of, and need for, various resources. This information is most useful when the transactions are least hampered by third parties, such as bandits and governments.

This is where governments can play a useful role. Productive exchanges will continue to occur only when the traders (and third parties) respect one another's rights to the property that they trade. Governments can help protect those property rights. When governments fail at this task, then governments fail.

Countries prosper when their governments help to define, extend, and protect property rights. Most of our social problems are due to a failure or inability to assign clarity to property rights. Who is liable for the consequences of one person’s actions? Who has a claim to our income and wealth? Who owns the seabed or has a right to the resources (whether fish or oil) in the Gulf of Mexico?

Clearer answers to these questions would help us now as we watch the damage to property from oil gushing into the Gulf from a botched drilling operation. Accidents happen, but they are less likely where property rights and rules of liability are clearest, and where infractions are detectable. Basic laws against theft, fraud, and aggression provide our first and most powerful line of defense. Modest, rational regulations can reduce the costs of enforcement of our property rights.

But current levels of regulation go way beyond reason. Intrusive regulation tends to blind us to external reality and to the likely consequences of our actions. How did BP perceive its need to make provision for potential liabilities from its operations in the Gulf? We might ask the same question about the de facto custodian of the territory in which the oil well was drilled, the US Government.

Did the custodian not require BP to purchase adequate insurance? High insurance premiums warn us of dragons.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010

Sunday, June 13, 2010

Derivatives serve a purpose, when used correctly

Published in The Tennessean, Sunday, June 13, 2010

Derivatives serve a purpose, when used correctly

by Richard J. Grant

Readers ask about derivatives. These include forward contracts, futures, options, and swaps. A derivative is a financial security whose value derives from the value of something else that we call the "underlying." The underlying might be a commodity price, an interest rate, a stock price, an exchange rate, or even another derivative.

Suppose you buy an ounce of gold for $1000. If the gold price then rises to $1100, you could sell it for a $100 profit, a gain of 10 percent. But if the price had fallen to $900, you would have lost 10 percent.

Now suppose that you have only $100 but can borrow $900 to buy the ounce of gold. If the price then rises to $1100, you would once again make a profit of $100. This time your capital gain is 100 percent. But a price fall to $900 would wipe out your initial capital. If it falls further, you lose more than 100 percent. By combining asset ownership with debt, you have created leverage. The net value of your capital is far more volatile than it would have been.

Futures: Rather than borrow, you could enter into an agreement today to buy an ounce of gold for $1000 six months from today. If you put down a $100 deposit, then you are in a risk situation similar to that of the loan example. This is known as a forward or futures contract.

Options: If you wanted to limit your downside risk, you could pay someone a premium, say $10, for the option to buy an ounce of gold for $1000 within the next six months. You would have the right but not the obligation to buy. If the gold price rises to $1100, then you could exercise your option (buy for $1000, sell for $1100) and get a profit of $90 ($100 minus $10). But if the gold price does not rise above $1000 during that time, then the option will expire worthless and you will have lost your $10.

Swaps: Swaps are agreements to exchange cash flows during a specified period of time. For example, if you are obligated to make payments according to a variable interest rate, but would prefer to make fixed interest payments, then you could contract with someone who is in the opposite situation to swap payment obligations (according to a formula).

In each of these examples, you could have been in the opposite situation: you could sell (go short) rather than buy (go long). This makes derivatives very useful tools for hedging our risks. They enable us to reduce the total effects of the natural risk in our lives by contracting with people who are better able to evaluate and bear those risks.

Most derivatives are not difficult to understand. But, as in any type of agreement or relationship, they can be made to be very complex. Even plain gold bullion has a complex multitude of influences on its value. Using debt (borrowing) or derivatives in your portfolio, adds leverage and increases the potential volatility of your portfolio's net value. You need to understand those effects and how to balance, monitor, and control them through time.

The demonization of derivatives in general is a sign of confusion, a fear born of ignorance. Derivatives cause harm only when misused. But that charge can also be leveled against the use of debt, cars, lawnmowers, and baseball bats. Mama taught us not to run with scissors; we can learn to use derivatives safely also.

Those who do not study derivatives should not use (or regulate) them. Most people don't. But many people get into debt carelessly; and in so doing, they put their homes and other assets at risk.

From a national perspective, government should not bail out those individuals or institutions that misuse debt and derivatives. Markets protect us by moving capital away from the imprudent. Bailouts reward and encourage recklessness.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010

Sunday, June 06, 2010

Government mired in crisis of size and scope

Published in The Tennessean, Sunday, June 6, 2010

Government mired in crisis of size and scope

by Richard J. Grant

If the General Welfare is our standard of reference, then we are now being shown that those people who are true-believers in Big Government are also the least competent in managing Big Government. Those who are out of touch with reality are most likely to be surprised by the consequences of their actions. They might not even see that those consequences were the result of their actions.

Those are perhaps the kindest words that one could say about the Obama administration. This is not a good time for the Obama presidency, which is now surrounded by the smoke of scandal, heavy handedness, incompetence, and strategic confusion. The American people are increasingly worried about the source of that smoke.

As governments grow in size and power beyond those very few functions for which they are both suited and justified, they become increasingly unmanageable, inefficient, and corrupt. In US history, the Anti-Federalists were particularly worried about the growth and centralization of governmental power. But even the Federalists would likely be dismayed by what has grown around their constitution.

As our governments have grown, particularly since World War I, people's expectations of government have also grown. This has changed not only our relationship with government and what it means to be a citizen, but also the types of leaders that we are likely to elect.

Voters must deal with more variables. Instead of choosing on the basis of a few traditional virtues, voters are faced with hundreds of policy trade-offs. Any one of those trade-offs could cause a particular voter to reject a candidate. The candidate least likely to lose such votes is the one who is little more than a blank screen upon which voters can project their own desires and illusions.

It would be unfair to expect any US president to be an expert in petroleum engineering (just in case an oil rig explodes), but the types of experts and cabinet officials with which the president surrounds himself will tell us much about his worldview, character, and fitness for the job. Much is revealed in a president’s response and moral consistency in a time of crisis.

The president is necessarily involved in the problem of the deep-sea oil well that is currently out of control (spewing oil into the Gulf of Mexico), because the federal government controls the territory in which the well is located and the resulting pollution is causing widespread harm to the private property and livelihoods of thousands of citizens. Few could envy him at this time.

What is telling about the president is that one of his first clear statements resulting from the issue was a call for higher taxes on the oil industry in order to pay for the development of “clean” energy research and development. One could almost hear him exclaiming, "Tax, baby, tax!” But what we really need to hear from him is why BP was drilling in such a difficult location when there are so many potentially oil-rich sites in safer, easier-to-access locations that are currently out of bounds.

It might also be interesting to hear the president explain why subsidies are supposedly necessary to the nuclear-power industry. What that industry really needs is the rationalization of its regulatory structure, which currently imposes huge costs, delays, and uncertainty on any company that dares to proceed with construction. Also, why is the government hampering the reprocessing of spent nuclear fuel? Is this not a more promising way to look at energy development than the current policy?

Our government can be too big and too heavy-handed. It is both. The true-believers in Big Government are currently making it worse, not better. The real current crisis in America is not environmental, not financial, and not medical.

The real crisis hinges on whether voters will continue to vote for true-believers in Big Government or for those who are more in touch with the real meaning of America.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010