Wednesday, October 29, 2008

What went wrong? Bandits everywhere 

Let�s first consider the basic function of capitalism. Its success lies in efficiently allocating capital toward profit, the difference between costs and returns. When the system works, market prices provide the information and the incentives to invest where legal returns are greatest.

But this is perhaps not capitalism�s greatest asset. In addition to being an engine of prosperity, only free markets spontaneously and peacefully organize the daily, voluntary interactions of millions of primarily self-interested individuals.

Socialism works poorly because it is unable to efficiently coordinate and allocate resources. Hence, it never generates wealth for the masses�but socialist elites enjoy privilege and plenty. Their greed rigs the game to their advantage. Likewise, America�s investment bankers have rented and bribed politicians to rig the game to socialize risks and privatize profits. Fannie and Freddie�s failures and rich rewards to former managers, $100 million to one, are prime examples.

Our current problems flow largely from Wall Street bankers� financial innovations. They discovered ways to profit by misallocating capital, and in the process they decoupled risk from their returns. Under legislation for which they lobbied, they were rewarded for pumping evermore capital into overvalued housing.

...When politicians allocate capital, we can�t expect efficiency, but corruption by special interests is certain. Investment banks benefited from this political arrangement.
John Baden last week, who continues this morning:
In response to my recent column, �What Went Wrong,� several people emailed me this question: What�s next? The answer is easy; America will attempt to emulate Europe�s welfare state. Our perceived crisis is inimical to sound policy and provides a good seedbed for political opportunism.

...Those who created the American experiment recognized the problem of constraining two kinds of bandits: the stationary and the mobile. Mobile bandits include highwaymen, pirates, common thieves, and muggers. These are conceptually easy to constrain; enlist honest police.

Stationary bandits are more difficult, and were a focus of America�s founders. Their challenge was to create a constitution to generate and maintain laws that foster progress�while constraining those making the laws. How might those in power be kept from rigging the game to the advantage of themselves and their most politically powerful constituents?

Over the long run this may be impossible in a large democracy comprised of numerous factions, interest groups, and ethnic and racial identities. No such nation has successfully dealt with this challenge. It is easier in a small, relatively homogenous country, not one like ours.

The current worldwide financial crisis gives license to our stationary bandits to advantage themselves and powerful constituents. Franklin Raines, White House Budget Director under Clinton, became CEO of Fannie Mae and received $90 million in salary and bonuses. Of course Fannie Mae had made large and strategic concessions and donations to politicians. That�s how politics works.

America�s automakers, protected for years by tariffs from foreign competitors, are but one of numerous corporate examples of powerful firms, and unions, shaping the rules and seeking to loot taxpayers. Such pleading is bound to increase; the political tide is with those who see and seize opportunities for advantage, always, of course, in the �public interest.� The results are ominous and the causes clear.
The concept of mobile and stationary bandits is at the heart of a book I use in teaching comparative economic systems, Mancur Olson's Power and Prosperity. Olson's uses 'roving' rather than 'mobile', but the concept is identical. Or, as Jack Hirshleifer put it, there are always two ways to get something for yourself: You can produce it, or try to take it from others. "The way of production and exchange enlarges the social total of wealth. The way of predation and conflict merely redistributes that total (less whatever is dissipated in the struggle." (p. 2)

Those dissipation costs are important however. To take only one example, the death tax takes in very little revenue, but there is a large deadweight cost from investing in wealth transferring mechanism and away from capital formation. A 1993 paper by Richard Wagner at George Mason put that cost then at about $640 billion over eight years. It's likely much more than that now.

Baden's hope for smaller, more homogeneous economies has seldom found an example either. Europe -- whose values are still epitomized in the French Revolution's motto of Liberty, Fraternity, Equality (thanks to Dennis Prager last night for encapsulating the difference between the American and French Revolutions so succinctly) -- has no examples. You might choose the island economies of Hong Kong and Singapore, but neither turn out to be bastions of political freedom even as they uphold economic freedoms.

I see much of the political debate this fall in that last paragraph from Baden.

(h/t for Baden: Arnold Kling.)

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