Free Markets V – The Role of Capital and Investment

Accumulation of capital is the essential portion of a capitalist system. As societies become more advanced, the machinery and supplies needed to keep it running become more expensive, and soon exceed the average day-to-day cash flow of an individual. Few of us can afford to buy the buildings and machinery for, say, an auto assembly plant. So somehow there has to be a mechanism for accumulating enough surplus capital to invest in such expensive infrastructure.

To start or expand a small business an entrepreneur may be able to assemble the required capital from his or her own savings, and perhaps borrow some from a local bank.  But for larger business ventures, an entrepreneur needs to find other sources of capital, and the usual way to do this is to find investors who have extra capital available and are willing to put it into the new business venture in hopes of earning an attractive return.

So for a capitalist free market system like ours (almost) is, the availability of surplus capital, and of investors willing to risk their surplus capital on promising business ventures, is essential. One wants government policies that encourage people to accumulate capital, and to invest that accumulated capital in new business ventures.

The problem is that as soon as politicians see a pile of accumulated capital, whether in an individual’s bank account or in a corporation’s bank account, there is an irresistible urge to try to tax part of it away on the grounds that “the rich” ought to pay more.  If governments really were able to confiscate all the accumulated capital of “rich” individuals and corporations, the immediate result would be a crisis in business, which could no longer find investment capital to keep operating and expanding.

Similarly, one takes the risk of investing one’s surplus capital in companies hoping for a good rate of return.  If government sharply reduces that rate of return by heavily taxing dividends, it becomes much less attractive to take the risk of investing.

Now it is true that we have grown up a whole class of short-term investors who are in essence just gambling – traders who really have no real interest in investing, but who just gamble on day-to-day fluctuations in stock prices.  So there is some logic to taxing more heavily positions that are held only for a short time – that is in essence simply a gambling tax. 

But one wants to be careful about taxing too heavily either the accumulation of surplus capital or the returns from investments, popular though such taxes are with populist politicians and the general public.  The accumulation and (long-term) investment of surplus capital is what makes our system work as well as it does.

Of course, there is an argument for having government take all the accumulated capital and itself deciding whom to fund. (It is never stated this bluntly, but that is in essence what happens when government taxes heavily and then subsidizes businesses or industries with the taxed money. It is also what happens in Communist “central planning” economies).  So why would this not be as good, or even better?

The reason is twofold. (1) When an investor invests (and risks) his or her own money, they have the maximum incentive to be careful, to do due diligence, and to watch the investment carefully.   When a government bureaucrat does it, it isn’t his or her money, it’s just “play money” and isn’t watched nearly as carefully (if at all).  (2) Investors care about the business succeeding. Governments usually care about other things, like advancing ideological causes or favoring powerful supporters.  So in general, having the government make investment decisions has never been anywhere near as effective or as efficient as allowing individual investors to make investment decisions, as anyone can see who reads recent economic history.

Recommended: Fixing Congress

Representative Jim Cooper (D, Tennessee) has written an outstanding article on the Boston Review page, entitled Fixing Congress.  It is well worth reading.

Free Markets IV – Entrepreneurs vs Workers

There are essentially two kinds of people in a free market economy - entrepreneurs and workers. Both are needed, though there are generally more workers than entrepreneurs. People are free to be either, and to move between the roles if they want to.

Workers sell their labor and skills. They take relatively little risk (beyond the risk of unemployment), because they get paid their wages whether their employer does well or not. They invest little beyond their time, except perhaps for some investment in training or schooling to prepare them for the job.  They depend on someone else to provide the job for them, as well as any capital equipment (machinery, supplies, etc) needed for them to perform the job. And in general they can go home at night and forget about the business until the next day.

Entrepreneurs create jobs for themselves, and sometimes for others as well (employees).  They invest their own capital, and perhaps borrow capital as well, to start a business around an idea they think might be marketable.  This is essentially the same whether it is a poor tailor in India buying a used sewing machine and some cloth, or Intel investing a billion dollars in a new microcircuit plant.  Entrepreneurs (and their investors, if any) take all the risk, and that risk is considerable since only two-thirds of new small businesses survive at least two years, and just 44 percent survive at least four years, according to a study by the U.S. Small Business Association.  In return for taking that risk, they have the potential for large rewards. Entrepreneurs in general work hard, and worry a lot about meeting the payroll, and can’t just go home at night and forget the business. (Trust me, I know.  I have been both, and being an entrepreneur and business owner is a LOT harder!)

There is of course a middle ground, people who work on commission.  Someone else provides the job, and perhaps a minimal wage, but mostly they depend upon their own hard work and skill to earn commissions on their sales.  Real estate agents fit this model, as do many waiters, who may depend on tips for a substantial portion of their income.

Now a free market needs both workers and entrepreneurs, but it is the entrepreneurs who are most essential, as well as the scarcest. Without entrepreneurs there would be no jobs for non-entrepreneurs.  So one wants to be careful about penalizing successful entrepreneurs too much with confiscatory taxes. The job is already risky enough without limiting the potential upside. There has to be the promise of possible riches to encourage people to take the risks and invest the hard work and risk their savings on a new business.

(Note, by the way, that few corporate CEOs qualify as entrepreneurs; most are just overpaid employees. Sam Walton and Bill Gates, people who actually started and built their businesses, are examples of true entrepreneur CEOs who created whole industries and thousands of jobs. Most corporate CEOs are just employees who gamed their way into an overpaid position originally created by someone else.)

So in a free market economy, politicians need to restrain their natural populist ardor for ”taxing the rich” entrepreneurs, even though it plays well with the workers. In general, it is entrepreneurs who are providing the worker’s jobs in the first place, so one doesn’t want to discourage their risk taking.

Free Markets III – The Proper Role of Government in Free Markets

As mentioned in the last post, free markets don’t necessarily stay free of their own accord.  There are always incentives for producers to “game” the market to their advantage by distorting the price signals. The proper role of government in a free market economy is to police the market in ways which keep it as free as possible, with price signals as real as possible.

So, for example, enforcing antitrust laws is a proper role of government, to prevent producers from conspiring with one another to restrain competition and fix prices at an “unnaturally” high price point – eg. a price point that would not be competitively sustainable if there were real competitors.

Enforcing laws that require honest descriptions of goods and services for sale is a proper government function in a free market economy, and has been ever since ancient city-states had officials in the marketplace ensuring that the merchant’s scales were accurate. The FDA’s oversight of food products is a similar function wholly appropriate to government in a free market system.

Enforcing “antidumping” laws that prevent producers from selling goods at a loss to drive competitors out of business is also a proper role of government.

Government licensing laws are also a way to ensure that consumers are getting what they think they are getting.  For example, medical licenses are the way I know my doctor has really been trained in his field, and hasn’t just hung up a shingle without adequate training.

So governments do have a critical role to play in free market economies.  In fact, without them, free markets tend not to stay so free. But government’s proper role is to keep the market as free as possible, and the price signals as uncontaminated as possible. It is not, as is so often the case, the government’s role to contaminate the price signals for political or ideological purposes.

In that regard, governments ought properly to be very suspicious of unions, which are in effect labor “cartels” restricting competition for jobs in order to push the labor costs higher than the free market forces would have had them.  Now it is true that unions came into being to oppose producers who used their positions unfairly to depress wages, and to that extent they have been a good thing. But as the decades have passed they have morphed into labor cartels that push wages higher than they “ought” to be under normal market forces, and along the way have driven companies and industries out of business, leaving their workers unemployed.

Of course, union members vote, and unions have accumulated huge amounts of money to buy elections, so naturally they have evolved disproportionate influence on the political system (though one might justifiably argue that this just offsets the influence large corporations have on politics – a valid point).

However, since the world as a whole is essentially one big free market, unions that push wages disproportionately high (or require hiring more labor than is really needed) simply drive companies and their jobs elsewhere, where wages are more competitive.  Hence the steady flow of US jobs “outsourced” overseas.

The current government policy with regard to Boeing’s new aircraft plant in a “right to work” (eg: non-union) state (South Carolina) is a classic example of getting it wrong. Normal market forces are driving Boeing to build a new plant where it will not be as disrupted by union strikes, which have cost it money and lost it customers. The government opposes it (well, the National Labor Relations Board opposes it, and the administration isn’t interfering), yet if the NLRB prevails, it will simply drive other companies to build their first plants in non-union states, depriving even more union members of work.

Government policy in this regard then ought to be to keep the American economy, producers and labor both, as “free” and competitive as possible, so as to encourage US companies to stay in the US and foreign companies to move here, bringing jobs with them.   This is not a policy that recent administrations in either political party seem to have understood.

Free Markets II – Interference with Free Markets

As the previous post explained, free markets work as well as they do because of the price signals.  But there are two major ways that price signals can be interfered with and distorted, always to the detriment of the market.

Producers can distort the price signals (to their advantage) by various means. They can form cartels, in which all producers conspire together to hold the supply lower (and hence the price higher) than it would naturally be were free competition allowed.  The OPEC oil producers have tried to do this for years, but with only modest success because the temptation for individual members to cheat is high. The DeBeers Combine managed to inflate the price of diamonds for years this way, though eventually new fields in Russia that they could not control broke their hold on the market.

Producers can also indulge in predatory pricing wars, in which they sell a product at a loss (covered by profits in other areas) for a while, trying to drive their competitors out of the market, after which they can raise prices and hence profits because there is less (or no) competition left.

Governments can also interfere with the price signals, and often do for political or ideological reasons.  For example, they can offer producers subsidies (or grants, or tax breaks), making it profitable to allocate capital and labor to an area which would otherwise not be profitable. Corn ethanol is currently subsidized that way, primarily as a sop (vote getter) to farmers in the Midwest corn belt. Without the subsidies, corn ethanol is non-competitive as a fuel.  Similarly passenger train service is subsidized in the US, because it is inherently unprofitable (trains are very efficient at hauling bulk materials like grain or coal or tightly packed containers, and very inefficient at hauling passengers).

Government can also distort market price signals by restricting competition among producers. For example, tariffs (extra taxes on imported goods) make foreign producers less competitive, so that local producers can charge more and make a higher profit. Of course there is no free lunch – those higher profits come out of the pockets of the consumers, who are in effect being forced to subsidize the producers.

In general, all interference with market price signals, whether by producers or the government, makes the market less efficient. Nevertheless, governments in particular like to interfere to favor (politically powerful) constituents, or to advance ideological goals that are not themselves inherently supported by the market forces.  For example, many authoritarian governments around the world subsidize food and fuel as a way to try to keep their populations docile.  In general, the more they do this, the worse their domestic production of food and fuel becomes, and hence the more it costs them to continue to subsidize it.

The same rules apply to labor. Under normal free market circumstances, market forces determine labor wages.  Skills and/or experience in short supply with high demand can command higher wages than more common skills and experience. That encourages (rational) workers to acquire the skills and experience that are more in demand. If one is an expert in making buggy whips in a world that doesn’t need buggy whips, there is a natural incentive to learn another trade, one more in demand. 

Unions and minimum wage laws are both mechanisms that interfere with the free market price signals for labor, usually with results not helpful to the laborers. Unions drove American steel companies out of business in the middle of the last century, pricing the labor (and hence the finished steel) above what the world market would accept. And unions almost managed the same feat with American auto makers (though the auto maker management helped with some poor management decisions). And minimum wage laws have simply made some jobs go away, automated or shipped offshore, because some workers are simply not worth the minimum wage.  (A general rule: a worker has to make more profit for the company than they cost, or there is no point in hiring them. Despite what Congress thinks, companies don’t exist to make jobs for people – they exist to make a profit for their investors.)   

 

Free Markets I - Why Free Markets are Better

There are two primary economic models in the world today - free markets and centrally (government) planned economies, though of course neither exists in the real world in pure form.  Nonetheless, history has produced overwhelming evidence that the free market works better, indeed far better, than the centrally planned economy.  It’s not hard to understand why this should be so.

Markets are a means of allocating scarce capital and labor among competing desires.  If there were a real surplus of capital and labor, there would be no need for a market – everyone could have all they want of everything they might desire.  But in the real world, scarcity prevails.

Now the free market is a feedback system, with price as the feedback signal. When there is high demand for a good or service that is in short supply, the price (and the profit for producers) rises.  That encourages (a) more producers to enter the market and invest more capital and labor in creating more supply, and (b) encourages users to be more careful with the available supply. (If gas costs $8 a gallon, I’ll become more careful with my driving, combining trips where possible and perhaps forgoing an expensive driving vacation).

When there is a surplus of a good or service, the price (and hence the profit) will fall, encouraging producers to reinvest their capital and labor somewhere else, in some good or service that is currently in short supply relative to the demand.

Hence the free market works continuously and automatically to adjust the allocation of capital and labor toward goods or services in demand.  Of course it is not perfect. There are time lags and unexpected surges in demand and the like, but all in all it works pretty well, factoring in the daily price signals from tens of millions of customers each day as they decide what they need and how much they are willing to pay.

Now the centrally-planned economy tries to replace all those millions of daily price signals with the expertise of a few government bureaucrats.  In practice these are frequently political appointees with no special expertise in the economy, making decisions based on political priorities or ideological mythologies. But even if we were to find the world’s smartest economists for these positions, they simply can’t get all the day-to-day information that is provided by the price signals from tens of millions of customers.

So that, in a nutshell, is why the free market works better than a centrally-planned economy.  No central planning authority can possibly get as accurate and as timely information about day-to-day fluctuations in demand and supply as simple market price signals from tens of millions of consumers every day.

Health care debacle

By Ricardo Alonso-Zaldivar, Associated Press, May 11, 2011

WASHINGTON – President Barack Obama's main idea for getting quality health care at less cost was in jeopardy Wednesday after key medical providers called his administration's initial blueprint so complex it's unworkable.

Just over a month ago, top officials released long-awaited draft regulations for "accountable care organizations," networks of doctors and hospitals that would collaborate to keep Medicare patients healthier and share in the savings with taxpayers. Obama's health care overhaul law envisioned quickly setting up hundreds of such networks around the county to lead a bottom-up reform of America's bloated health care system.

But in an unusual rebuke, an umbrella group representing premier organizations such as the Mayo Clinic wrote the administration Wednesday saying that more than 90 percent of its members would not participate, because the rules as written are so onerous it would be nearly impossible for them to succeed.

 So why should we be surprised, when the rules were written by a bunch of Congressional lawyers, staffers, and agency bureaucrats, almost none of whom have the slightest experience in the real day-to-day health care field?

Recommended: Tiger Mom: Here's how to reshape U.S. education

Here is a great article by Amy Chua, the author of the controversial book Battle Hymn of the Tiger Mom. It is entitled Tiger Mom: Here's how to reshape U.S. education.  She points out that Asian countries are beginning to realize that their rote training isn't as effective as some things the US does, but nevertheless

The average American child spends 66% more time watching television than attending school. We have alarming rates of teenage substance abuse and the highest teenage pregnancy rate in the developed world. In the recent Program for International Student Assessment (PISA) tests, American high school students ranked 17th in reading, 23rd in science and 31st in math — with Asian nations taking top marks. This is a problem across the board. Even America's top math students rank poorly compared with top performers elsewhere.

Clearly we have been doing some things right in the past, and clearly we are doing some things wrong now.  It occurs to me that the public education system of the past was well suited to producing hard-working factory workers, but is ill suited to producing the highly innovative technical workers needed in today's world.

US Corporate Tax Rates

Continuing the thought from the last post, the Reuters site has an interesting chart comparing US Corporate tax rates to those of the rest of the developed world:

As one can see, the US Corporate tax rate is already higher then most developed countries. But of course many corporations don't pay anywhere near these tax rates, since the current tax code gives many of them all sorts of exemptions and credits -- which is another argument for reforming the tax code.

Nonetheless, major corporations these days are global in reach.  If we tax them significantly more than other nations, they will just export their factories -- and their jobs -- to nations with a lower tax burden. In the long run, if we want more jobs in this nation (certainly a key issue these days), we need to keep an attractive tax structure for corporations.

Taxes: Raise them or not?

Democrats seem to have finally come around, very reluctantly, to admitting that the federal budget needs to be cut, though they still are wildly unrealistic about how much it needs to be cut, and they still persist in the delusion that the fiscal problem can be solved without touching entitlements.

Republicans have taken a stand that taxes should not be raised, because, they argue, increasing taxes is the last thing one wants to do in an weak economy. This is a more difficult issue to understand. On the one hand, more federal revenues would certainly help the fiscal problem, though it is by no means certain that raising taxes would increase the revenue much -- it might just depress the economy more, and it will certainly encourage corporations and wealthy individuals to put more of their money in offshore investments or tax-free bonds.

On the other hand, raising taxes seems to me just an easy out for all those in Congress who can't seem to face cutting the federal budget.  In any case, one can't raise taxes enough to make much of a dent in the deficit, so tax increases (especially on the rich) are just pandering to the base, not solving the problem.

On balance, I think major (draconian) cuts in the federal budget are the essential step to solving the problem, painful as they will be.  The only real issue is how to make them so the pain is relatively even all around.  And I think rather than raising federal taxes, Congress needs to bite the bullet and FINALLY revise and simplify the tax code, so that it doesn't have thousands of special interest exemptions, and it doesn't take a lawyer to understand the 20,000+ pages of the federal tax code.

So after thinking about it, I guess I agree with the Republicans, who are indeed probably just pandering to their own base, but are nevertheless probably right to focus on spending cuts rather than tax increases.

The definition of chutzpah

I find it interesting that Osama Bin Laden's sons today are reported to be upset that he was buried at sea, and that he didn't get a trial. They complain that a man as important as he was should have been shown more dignity 

Funny, Bin Laden himself didn't seem to think it was important that any of his thousands of victims should be buried with dignity, or given a trial. It's a new level of Chutzpah.

Recommended: High Noon in Pakistan

It seems almost impossible that Osama Bin Laden could have lived for many years in an upscale neighborhood in a major Pakistani city, surrounded not only by retired military officers but within walking distance of Pakistan's premier army training center - their "West Point" equivalent - without anyone in the Pakistani government or military or ISI intelligence agency being aware of it.  The interesting question is whether this absurd situation is due to Pakistani complicity or simple incompetence.

Walter Russel Mead has an interesting assessment of this question, and of the ramifications of this whole issue, in his American Interest piece High Noon in Pakistan.  Pakistan is, of course, only a small chess piece in the whole "great game" between China and India and the US, but it is an important piece because of it's nuclear capabilities, and because it plays a key role in keeping Afghanistan and Iraq unstable and volatile, and keeping India occupied.

Satisfying as it was to finally get the 9/11 mastermind, far more important is how the administration handles, or mishandles, the subsequent relationship with Pakistan.

A fundamental social issue

Beneath the mindless political ideology, the childish Democrat vs Republican point-scoring, and the insincere promises that makes up Washington’s political theater these days there lurk some real, fundamental national and even cultural philosophical questions worth pondering.

One of these is the question of how much responsibility a culture owes to people who don’t take responsibility for themselves.  In a primitive tribal culture living with little or no surplus, the answer is clear.  The culture when possible takes care of those who can’t take care of themselves – children, orphans, the old and the sick.  Everyone else is expected to contribute to the pot, and if they don’t then they don’t eat.

Now in our culture we actually have two kinds of people; (1) those who through no fault of their own are unable to take care of their needs, and (2) those who, though their own life choices, have chosen paths that don’t give them enough to take care of their needs.  There is no question but that a culture like ours should support the first class – those who were perhaps born impaired, or through accident or illness not due to their own fault or habits have left them unable to help themselves.

But what about the second class of “poor”? Those who made conscious choices that put them into these circumstances? People who dropped out of school and now don’t have employable skills? People who are just lazy?  People who blew their minds or crippled their bodies with alcohol or drugs?  People who chose to overeat all their lives, or chose to be couch potatoes and now have expensive health problems?   People who chose to spend every penny they made, rather than save some of it for their old age? Do we who didn’t make such bad choices have an obligation to support those who did?

Years ago I was involved in an organization which gave self-help workshops.  Among those who came to the workshops were “hippy” types who lived in a commune. These people were forever arguing that there ought to be a sliding scale of fees for the workshops, and that those who lived in the commune and chose not to make much money ought to get a fee reduction (recovered, of course, by charging those of us with real 9 to 5 jobs more). This never seemed right to me.  These people were arguing for a free ride simply because they chose not to do the hard work of keeping a regular paying job.

Now the fundamental problem is this: if we don’t offer assistance to people who made bad choices they are going to suffer the natural consequences of their bad choices – consequences that are sometimes hard for us to watch (think homeless people and starving in the streets).  But if we do save them from the natural consequences of their own bad decisions we create a moral hazard – why should people be more prudent if the society will always save them from their bad decisions?

This is the fundamental dilemma that we ought to be thinking about as we create social policy in our nation.  Personally, I think the ultimate touchstone for such decisions is the long-term survival of the culture, civilization, or nation.  If our social policy doesn’t help us survive, than it is dysfunctional.  In that light, social policy which doesn’t encourage hard work and prudent decision-making, with real and painful consequences for poor life choices, is probably not in the long-term interests of our nation.

Edward Gibbon argued in his monumental Decline and Fall of the Roman Empire that it was the loss of such civic virtue among the Romans that led to the eventual dissolution of their mighty empire.  I think that argument might apply just as well to our current American empire, which was founded by hard-working people who looked out for themselves, but has evolved in recent decades toward what seems to me a much more permissive – not to say unrealistic -- approach toward bad life choices.