Thursday, October 30, 2008

Short Course on Capitalist Economics vs. Socialism

When I hear the word “Socialist” connected to anything important my blood begins to boil. If it doesn’t for you, I invite you to read my article here. You may not agree with what I say. Or you may thank me later.

This Presidential election is truly important among all presidential elections, as some commentators have said. Joe Biden may be a good old-line Democrat, but Barack Obama is something quite different. You, me, and the rest of the electorate don’t know exactly how different, in my opinion, because Obama’s fa├žade has been so carefully crafted and maintained.

Your vote, if you cast one, is important. Between these presidential candidates we’re making a more profound choice than usual, and we all have to live with the results.

The Republican campaign has trumpeted that Obama’s ideas, positions and associations seem like socialism. It hasn’t had much effect. The surprise to me has been how little effect it’s had. A key problem with this election is that many people, and possibly you, don’t know the fundamentals of why socialism is bad. Many people don’t seem to have the visceral reaction to it they used to. If one doesn’t know why capitalism and free markets are good for a society, it follows that one can’t fully appreciate how socialism is bad for it.

I’m taking on the task of attempting to explain why free markets are important. I apologize in advance for this article being longer than your typical op-ed piece.

Should we Pursue our Enlightened Self-Interest?

In economics, people acting in their “enlightened self-interest” is an important concept. It revolves around being a good citizen in the American Constitutional sense while pursuing economic goals in one’s own self-interest. A market-oriented economics professor can prove to you with numbers that everyone in a society benefits as people do this. And they benefit to a greater degree than under any other economic system.

But aren’t the rich taking from the poor? No, a capitalist economy is not a zero-sum game. Wealth is *created*. It may be intuitively nice to compare haves and have-nots and think “if only those poorer people could have some of what those richer people have”. The non-intuitive truth is that wealth taken from haves and given to have-nots will result in less wealth for everybody. Any rosy outcome will be temporary, followed by less wealth for everybody at some lag. Economics can show clearly why this is true and how it works.

The fact that a capitalist economy is not a zero-sum game is extremely important. To understand why, consider the opposite assertion for a moment. If a capitalist economy *is* a zero-sum game and there’s only a finite amount of wealth in an economy, than for poor people to have any more some will need to be removed from rich people, or the people in the middle. If there’s a finite amount of wealth in an economy, for rich people to get richer someone else has to get poorer. If there’s a finite amount of wealth in an economy, the equality of the outcome (meaning the wealth people have at a given moment) is skewed to become more important than the equality of opportunity – that is, the possibility that people may have more wealth in the future. Many policies, and virtually all of these are well-intentioned, are built on the fallacious assumption that the economy is a zero-sum game.

Where’s That Altruism as We Create Wealth?

In fact, wealth creation is a fundamental purpose of a society, if not of civilization in general. The elemental catch with the notion of “redistributing the wealth” is the incentives, or disincentives, created in that environment. The “richies” have less incentive to work and produce as the wealth is taken away, and the “poories” have less incentive to get out and work as wealth is given to them. Years ago we debated how welfare mothers would get *trapped* into not working at all, because if they did, they lost too much in the way of benefits. There are some ways to reduce the harm done; for those ideas I refer you to Milton Friedman.

Some on the Socialist side talk about the altruism involved in redistributing from rich to the poor. The catch is that most people don’t act all that altruistic most of the time. So the Socialists help things along with “enforced altruism”. In the end a society is pretty much left with just force to accomplish the wealth transfers.

Some economists looking the Microeconomics side of things say there’s really no human altruism at all; it’s just that the incentives people are operating under aren’t properly recognized. The altruism argument can continue – but the bottom line is that capitalism is aligned with human nature to a much greater degree than is Socialism. And it’s hugely more aligned with human nature than Socialism’s more extreme variant, Communism. That’s an essential reason why the capitalist system creates more wealth than the others.

An economically-minded walk through anthropology and history would show the same outlines. Which societies traded? Which societies developed technologies, arts, sciences, and advanced culturally in general? And what freedoms did at least some strata of those societies enjoy? Consider how the merchant classes “got away” from the aristocratic classes in the European Renaissance. They pretty much took economic power through a sort of generations-long accident.

Looking the other way, consider what happens when modern technology is used to control people and restrict freedoms. This can be done very effectively today, but when it is the wealth scenario isn’t pretty. For examples see North Korea, Russia, Venezuela, and some African countries. An old joke about the Soviet Russian economy is “We pretend to work, and they pretend to pay us.” The evolution of markets, or perhaps better called the market anarchy, after the Soviet Union fell is a separate study.

Politics was once known as “Political Economy” and for good reason. One of the government’s top responsibilities is to promote a good economy for the prosperity of its citizens. So we can say that good politics is, or should be, good economics.

For another view of wealth creation consider that American poor people are far richer than many people throughout history, and richer than most poor people throughout the rest of the world today. Why is that? Wealth creation. But that wealth isn’t ordained to continue forever. The “golden goose” of the free market economy must be cared for. For still another view consider Cuba, where poor people are far poorer. And most of the people are poor. In Cuba the disincentives to wealth creation are considerable, and in large part people are outright prevented from wealth-producing activities.

How is Wealth Created?

If someone has some money, they can do two interesting things with it. They can invest it or spend it on consumption. The uninteresting thing they can do with it is to hide it under the proverbial mattress.

If our person invests a dollar it becomes capital for investment. And that’s the main purpose of capital in a capitalist system. Capital is assembled, investments are made, and innovations result. The innovations and efficiency improvements that result from investments are the key to the creation of wealth.

I should note here that for many people the word capitalism is associated with greedy capitalist fat cats sitting in guilded mansions and hording money from the little guys. A capitalist may consume conspicuously. But to dwell on that is to miss the fundamental point. A capitalist invests capital in the hopes of creating wealth and therefore profitable returns or she won’t be a capitalist (with any capital) for long.

The key property that makes the whole process work is that the new wealth benefits not just the original capitalist but the entire society and economy. That is what the “supply-sider” economists are talking about. For a grossly simple example, companies made money inventing, improving, manufacturing and selling televisions. Everybody has benefited from televisions.

If our person spends a dollar economists can study where that dollar goes. As the dollar goes through various companies’ and people’s hands economists can calculate the rate of travel. They call it the velocity of money. Banks amplify the available money in the system through lending. Economists study banks and the effects their lending has on the money supply. The multiplier effects of the different paths that money can take through an economic system are studied.

If our person chooses to hide money under the mattress that has an economic effect too. It’s easy to see how the velocity of that money is slowed down. Also no new wealth is created, no consumption is enjoyed, and our person can sleep soundly on the mattress until she realizes that inflation has in time eroded the value of her money.

The institutional fear in the present credit crisis has caused banks and other players to do the corporate equivalent of hiding money under their mattresses. And we are observing the contractions in economic activity resulting from those choices. We’re also watching governments scramble to restore confidence so money and economies start moving again.

I’ve really just hinted at huge subject areas within the study of wealth creation. I can only urge you to study the subject, at least a little. Also I invite you to capture your own good ideas and try to make them real. You could create some wealth.

Capitalism provides the incentives and means to create wealth. This is as true for the guy with the idea at his kitchen table it is for the big company investing billions annually in R&D (Research and Development). If either of them or any other company comes up with a product people want, business expands and more people are hired to supply the product. Wealth is created and the virtuous cycle continues.

Capitalism and free markets know no boundaries of race, ethnicity, gender, sexual orientation, language, physical ability or any other human classification you can think of. It works like math and it works for everybody. The boundaries and impediments perceived by people are real, but they are not inherent properties of Capitalism. Therefore their remedies do not lie in tinkering with, or rather distorting, markets.

What’s a Free Market and How are Markets Distorted?

Capitalism is built on free markets. So to truly understand the Capitalism and Socialism discussion, one must understand the basics of a market, and free markets. I’m going to attempt a rudimentary discussion of markets with only text. But it’s better with pictures, or actually with graphs containing supply and demand curves. In college we used an edition of the Paul Samuelson economics book. He’s author of a monumental series of economics textbooks. Weighty tomes to be sure, but to me the “dismal science” of economics gets exciting when it’s applied. Have a look at a Samuelson economics text or any like it for loads of graphs like the ones I discuss here.

First, imagine a garden variety X-Y graph, with a downward-sloping left-to-right demand curve and an upward-sloping left-to-right supply curve. Your X-axis across the bottom is quantity, from zero up to “a lot”. Your Y-axis up the left side is price, from zero up to “a-lot”.

Why are the curves this way? If something is expensive people don’t want to buy very much of it. Quantity is low. If something is cheap, people will take a lot of that! Oh yeah! If something is free people will take it all. Self-interest is certainly visible there, but maybe not all that enlightened. On the other hand if something is very cheap suppliers can’t find a way to supply much of it. So the quantity supplied would be low at that price. But if the price is very high suppliers will be happy to supply it all day! Quantity is high.

In economics, the point where the two curves cross is what the free market will bear. And that’s the most efficient quantity of the product to be supplied and consumed. It’s also the most efficient price. In economics you’d learn all about what happens to quantities supplied and demanded when distortions are inflicted on a market.

During the spike in crude oil and gasoline prices, many commentators, including those who should have known better, said "demand has fallen". That was usually incorrect. When prices rose, the “quantity demanded” fell.

To understand the difference, return to our typical downward-sloping demand curve.
Again, the price rose and people bought less gasoline. Had demand fallen? No, because the demand curve has not moved. Had the price fallen back to where it started people would have bought just as much gas as before. The market was just at a different point on the demand curve then, where the price was higher and the quantity demanded was less.

A few weeks later, people had developed workarounds for the high gas prices. The demand curve had indeed moved, and therefore demand had really fallen. And now the markets are working on discovering new prices given that people have actually changed their preferences and behavior at a given price of gasoline.

So if you were to say "the quantity demanded fell" rather than "demand fell" earlier on that would have been economically correct, if not quite as short and clean a phrase. Why does this matter? Economists need to understand this stuff accurately to make good recommendations. Traders need to understand things accurately to have a chance at making profitable trades. I took you through it all so you’d have a feel for how markets are viewed.

What about a market distortion? Gasoline during the “oil shock” of the 1970s was a classic example. The price went up high, but in that instance the government decided to fix it. Price controls were mandated. The result was that people could buy the gas at the mandated price – if they could find it. Hence the infamous gas lines. Given where the supply curve then was, supplier’s decisions amounted to “well if we can only get that price, then we can only supply that much of it.” They weren’t trying to punish anybody, they were just interested in staying in business.

I’ll leave to you the reader the challenge of researching how to draw this type of market distortion on the graph. A hint is that you’ll see a disturbing gap between the quantity the buyers want and the suppliers supply at the given price. These shortages are painful and inefficient.

This time around with the gas price spike, the government had kind of learned its lesson and decided to forebear on capping the price of gasoline, to its credit. See, we lived through it and prices are coming down. A windfall profits tax on oil and gas producers would have been a whole different type of market distortion.

Market Distortion is a very timely subject as it applies to the credit crisis, sub-prime mortgage debacle and the housing price bubble and bust. For the best and most detailed account of this I refer you to the Thursday October 30 front page article in Investor’s Business Daily (IBD) entitled Why The Mortgage Crisis Happened.

Price Discovery and Where to Look for the Invisible Hand

As we look at markets we come the next key concept in economics, known as the “Invisible Hand”. This was introduced early on by Adam Smith, a very well-known economist in history. The Invisible Hand is just referring to people changing their behavior to react to the realities in the markets in which they participate. Why did a person or company decide to do this or that? The Invisible Hand guided them to do it.

The Invisible Hand guides people in making the most efficient decisions in their “enlightened self-interest” through the mechanism of free markets. The sum total result is the most efficient allocation of resources in the subject economy. That’s another way of saying the most wealth and the highest level of enjoyment, or total utility, for the people in the economy.

When a market is distorted, the player’s decisions in the market are distorted. Politicians sometimes seem to ask “Well can’t we just distort things a little bit? Can’t we just take a little tax or nudge things this way or that?” Sure we can. It’s done all the time. But every time it’s done the outcome is less than optimal, the player’s decisions around price and quantity are changed and the total wealth and “utility” enjoyed by the society are reduced. Don’t just take my word for it, let a market-minded economist prove it to you with numbers.

Free markets, the Invisible Hand, and people’s pursuit of their own Enlightened Self Interest depend on “price discovery”. How can you know what to do with something if you don’t know its price? Ask a person who has just sold a $10,000 piece of art at their garage sale for $10 and learned of their error about price discovery.

Price discovery is an essential outcome of trading and speculation. When the price is discovered it’s usually visible to all. In the recent credit crunch you’ve heard about Credit Default Swaps (CDS). These can be loosely described as insurance policies written against defaults on portfolios of loans. But they’re not traded on an exchange for all to see. They are privately traded “over the counter”. So it emerged in the crisis that the prices of these CDSs were not discoverable or visible. And since their total value was gigantic and owned by companies worldwide, fear set in on a massive scale and a lot of behavior was distorted, to go along with the markets.

Dynamic Analysis and International Trade

A mistake often made by our friends in government is that of static analysis. It’s essentially the assumption that a tax or some other distortion can be introduced into a market and no player will change their behavior. That is, customers will buy and suppliers will supply the same quantities as before. And everyone will stay just where they are, doing the same thing, and all be happy (well, I’m getting a little snide here.)

The governing entity is shocked to learn that the quantities change, markets are sometimes abandoned, industries die, or companies move to different states or offshore entirely. And the government’s revenue gain or intended outcome is quite different than projected in the analysis.

So dynamic analysis rather than static analysis would have been a better way to go. But sadly, governments at all levels get to learn this lesson over and over. Dynamic analysis is harder to do, but not impossible for good economists.

This brings us to international trade. Free trade versus protectionism is also an important subject of contention in this presidential election. The various devices of protectionism are all simply market distortions. And as such they reduce the overall efficiency and wealth creation of the participating countries. A discussion of international trade and countries’ “comparative advantage” is a bit out of scope here. I’ll just offer the by-now-unsurprising comment that you can ask your local free-market economist, who can prove to you with numbers that free trade really is better for overall wealth creation.

The only positive thing to be said for protections is that a grossly uneven trading relationship will have strains. That is, a completely free-trade country trading with a highly protectionist one will suffer some costs. Consider our trading relationship with China versus our trading relationship with Canada as examples. The take-away is that protections sometimes need to be ratcheted down with a partner, rather than unilaterally abandoned, for optimal results.

For more on these subjects I refer you to the Tuesday, October 28th editorial in Investor’s Business Daily (IBD) entitled Defining Problems With Socialism For The Post-Cold War Generation.

Please consider these points as you listen to what the candidates say, however inarticulately or intentionally distorted. I hope you’ve enjoyed at least a line or two in here. Thanks for reading.