Nobel Prize in Economics Breaks New Ground

Popular Economics Weekly

STOCKHOLM (AP) — The 2019 Nobel Prize in Economic Sciences has been awarded Monday to Abhijit Banerjee, Esther Duflo and Michael Kremer “for their experimental approach to alleviating global poverty.”

It was ground-breaking for several reasons. Firstly, the Nobel committee is recognizing that the field of economics is finally becoming more science than social science by championing empirical field research, rather than purely academic research that was conducted mostly in ivory towers with mathematical formulas.

For instance, Prof George Akerlof, one of three that won the 2001 Nobel Prize, was the first of several so-called behavioral economists to win for his research on how individuals actually make financial decisions. He proved that humans don’t always act rationally in their best interests without institutional safeguards, such as Lemon Laws that prevent faulty used car sellers from putting new car dealers out of business.

Though the proof was done with mathematical formulas, it began the ongoing divorce from what was originally called Political Economics. What else to call it when one major branch of microeconomics was under the assumption that investors and wage earners actually acted in their own best interests in a level playing field without government oversight, yet never was validated with actual results?

The lines had been drawn between conservatives that advocated Adam Smith’s pronouncement that free, mostly unregulated markets with low taxation would remain healthy of their own accord and were the best way to maximize prosperity for all; with the Keynesian, New Deal economics of progressives that wanted governments to discipline capital markets for their excesses.

These opposing viewpoints on how human beings made financial decisions were based more on political choices than actual scientific research on financial behavior until research in other fields, such as psychology were brought into economics.

Hence this new approach is called ‘experimental’, because it prioritized actual field work using scientific methods to improve the lives of the poorest in developing countries. What did they discover?

“The Laureates’ research findings,” said the Nobel Prize announcement, “– and those of the researchers following in their footsteps – have dramatically improved our ability to fight poverty in practice. As a direct result of one of their studies, more than five million Indian children have benefitted from effective programmes of remedial tutoring in schools. Another example is the heavy subsidies for preventive healthcare that have been introduced in many countries,” (that made preventative healthcare accessible to the poor).

It looks like this is becoming a worldwide movement to alleviate poverty and income inequality in developed countries as well, such as the U.S. of A. that has been lagging other developed (and underdeveloped) countries in improving the lives of our poorest citizens—thanks in large part to Big Business’s proclivity to maximize profits over every other corporate goal.

One example of this trend: JP Morgan Chase CEO Jamie Dimond announced in August a Statement on the Purpose of a Corporation by the Business Roundtable, a group of almost 200 large businesses, in which they “share a fundamental commitment to all of our Stakeholders”.
“While each of our individual companies serves its own corporate purpose,” said Dimond, “we share a fundamental commitment to all of our stakeholders. We commit to:

• · Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.
• · Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.
• · Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.
• · Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
• · Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.

It remains to be seen if corporate behavior--that is in large part responsible for the record income inequality we see with the globalization of market forces--actually changes. But this award shines a light on what can happen when the Economic Sciences begin to follow the rules of scientific discovery, rather than the Political Economic verities of old.

Harlan Green © 2019

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Corporate Austerity Not the Answer in 2012

Popular Economics Weekly

Why so much gloom and tentativeness about U.S. economic growth when all the indicators are looking up for 2012? For instance, the Conference Board’s Index of Leading Economic Indicators again showed positive growth ahead. It rose 0.4 percent with 7 of its 10 indicators positive.

And the Q4 ‘advance’ estimate of GDP growth was 2.8 percent, almost double Q3. Equipment and software, which includes autos and exports, was the largest component. It would be even higher if corporation would use more of their cash hoard for job creation, rather than speculative investments and excessive executive compensation.

Graph: Econoday

Could it be because of the euro’s problems? “This somewhat positive outlook for a strengthening domestic economy would seem to be at odds with a global economy that is losing some steam,” said Ken Goldstein, a Conference Board economist. “Looking ahead, the big question remains whether cooling conditions elsewhere will limit domestic growth or, conversely, growth in the U.S. will lend some economic support to the rest of the globe.”

But JP Morgan’s President Jamie Dimon said even the damage from a default of Greek debt would be “negligible”, in a CNBC interview at the Davos, Switzerland economic summit. So what’s the problem? The austerity (meaning deficit) hawks have their hands around the throats of European commerce. Why? In the mistaken belief that more stimulus spending will increase debt without actually causing more growth.

But Professor Robert Shiller, co-author of Animal Spirits with Nobelist George Akerlof, calls it debt delusion. When the private sector, including households, becomes over indebted, they begin to save more and spend less. But if governments do it at the same time, it causes a downward spiral towards deflation and recession or depression. This comes from the belief of fiscal conservatives that public borrowing takes money away from private users.

That, however, isn’t the case, because the private sector has plenty of funds, but is hoarding them (some $2 trillion in cash to date), rather than creating more jobs. So if governments are also hoarding their monies—in the form of trade or currency surpluses, as is happening in most of Europe today, then the bottom falls out of the economy. I.e., if no one is buying and everyone is saving, then no business gets done. This should be self-evident, because such a truth has been known since the Great Depression and New Deal that established our modern safety net, and ultimately put so many people back to work.

What underlies that truth is that Great Depressions and Great Recessions only happen when there is a wrenching transformation of whole economies. It was transformation of a mostly rural economy to manufacturing in the 1920s that brought on the Great Depression, and now it is wholesale migration of manufacturing jobs overseas and transformation to the Information Age, when little needs to be manufactured in the U.S.

Rutgers Econ Professor James Livingston has explained this transformation best in recent papers and articles. The great wealth shift away from wage earners-consumers to corporate profits began during the Great Depression, according to Livingston: “The underlying cause of that economic disaster (the Great Depression of 1929-33, 1937-38) was a fundamental shift of income shares away from wages/consumption to corporate profits that produced a tidal wave of surplus capital that could not be profitably invested in goods production—and, in fact, was not invested in good production…and that, on the other hand, produced the tidal wave of surplus capital which produced the stock market bubble of the late-1920s.”

And in a recent New York Times Op-ed, It’s Consumer Spending, Stupid, Livingston expands on the reasons for our current prolonged malaise:

“As an economic historian who has been studying American capitalism for 35 years, I’m going to let you in on the best-kept secret of the last century: private investment — that is, using business profits to increase productivity and output — doesn’t actually drive economic growth. Consumer debt and government spending do. Private investment isn’t even necessary to promote growth.”

This, to put it mildly, explodes that rationale used by Wall Street and corporations to justify not passing on more of their profits to consumers—80 percent of which are wage and salary earners. The reasoning being that it is their profits that drive growth.

Professor Livingston says, “Economists will tell you that private business investment causes growth because it pays for the new plant or equipment that creates jobs, improves labor productivity and increases workers’ incomes. As a result, you’ll hear politicians insisting that more incentives for private investors — lower taxes on corporate profits — will lead to faster and better-balanced growth.”

Not so, says Livingston, “But history shows that this is wrong. Between 1900 and 2000, real gross domestic product per capita (the output of goods and services per person) grew more than 600 percent. Meanwhile, net business investment declined 70 percent as a share of G.D.P. What’s more, in 1900 almost all investment came from the private sector — from companies, not from government — whereas in 2000, most investment was either from government spending (out of tax revenues) or “residential investment,” which means consumer spending on housing, rather than business expenditure on plants, equipment and labor.

“In other words, over the course of the last century, net business investment atrophied while G.D.P. per capita increased spectacularly. And the source of that growth? Increased consumer spending, coupled with and amplified by government outlays.”

Much has been written already about the record profits of both financial and non-financial corporations that have drained consumption, and that is the main reason why average real household incomes have actually declined over the past 30 years. In fact, corporate profits today are highest in history as a percentage of GDP.

Graph: Trading Economics

And this could be actually endangering economic growth by causing rampant market speculation, rather than productive investments, say many pundits, including Professor Livingston: “So corporate profits do not drive economic growth — they’re just restless sums of surplus capital, ready to flood speculative markets at home and abroad. In the 1920s, they inflated the stock market bubble, and then caused the Great Crash. Since the Reagan revolution, these superfluous profits have fed corporate mergers and takeovers, driven the dot-com craze, financed the “shadow banking” system of hedge funds and securitized investment vehicles, fueled monetary meltdowns in every hemisphere and inflated the housing bubble.”

How to cure the record income inequality that has resulted from so much power going to Wall Street and the corporations? Let us return to the income tax brackets that brought on so much prosperity to the middle class during the 1960s and 1970s. What were they?

The maximum bracket has fluctuated from 91 percent for those earning more than $400,000 in 1960, to the current low of 35 percent for those earning more than $379,150 today. And this has coincided with the astronomical increase in both household and government debt.

So it should be a no-brainer, if we want to see American growth restored to historical levels. Higher taxes have meant more growth, because public revenues are invested in growth-inducing infrastructure, better public safety, and upward mobility inducing education, for starters. Whereas lower taxes mean higher debts, with less growth and more speculative risk-taking to show for it. Why history is so easily forgotten may be a question only psychologists can answer.

Harlan Green © 2012

Goldman’s Defense--Innocent Fraud?

Financial FAQs

The U.S. Senate has finally begun debate on financial reform, but only after eye-opening testimony at Senator Carl Levin’s Permanent Subcommittee on Investigations by Goldman Sachs’ executives, who claimed that hedging their bets on subprime mortgages was perfectly legal, while not believing that telling clients what they thought of the securities or derivatives sold to them was relevant.

Why their belief that they were innocent of any fraud? This is when economic theory gets mixed up with ideological belief systems. Economist John Kenneth Galbraith labeled it “The Economics of Innocent Fraud” in his book of that title (2004, Houghton Mifflin, Boston). “Most progenitors of innocent fraud…are not deliberately in its service. They are unaware of how their views are shaped, how they are had. No clear legal question is involved. Response comes not from violations of law but from personal and social belief. There is no serious sense of guilt; more likely, there is self-approval.”

The inherent conflict in Goldman’s case was that of the classic inside trader, who believed that free, unregulated market forces should determine investor behavior. We now know that unregulated ‘free markets’ are a vehicle for manipulation by insiders. Goldman had inside information that their buyers didn’t—i.e., that there was a great likelihood the underlying subprime mortgages might have very high default rates. And as ‘market-makers’, their function as a pure trader was to find buyers for sellers and vice versa, without evaluating the underlying worth of the assets being traded.

Of course there were other conflicts of interest. Goldman was both an unregulated securities’ trader and an investment bank regulated by the Federal Reserve, which gave them a source of very cheap funds (i.e., because tax payer guaranteed). Until the Depression era Glass-Steagall Act was repealed in 2000, commercial banks regulated by the Fed could not also be securities’ traders. The reason was that stock, bond, and derivatives’ trading was a very risky business where caveat emptor prevailed—‘buyer beware’, in other words.

This was precisely why Senate members used the Las Vegas casino analogy at the Goldman hearings. Bets were being placed on which direction the subprime market would go, without the bettors having any ‘skin’ in the game—i.e., no equity or ownership interest in the underlying securities—just like placing a horse racing bet. It was gambling, in a word, but Las Vegas gamblers knew they were gambling as Nevada’s Senator John Ensign said at the hearings, whereas Wall Street investors did not at the time.

And, more importantly, because derivatives’ trading was unregulated, no one knew how much was bet for or against subprime mortgages at the time. It was being transacted through a shadow-banking system specifically set up to escape regulation. Whereas horse race bettors know exactly what the odds are, because regulations require the odds to be publicly posted.

The result was that traders’ profited, but those pension funds and foreign banks that had no real knowledge of the risks inherent in such trades did not. That is why this ‘last bastion of free enterprise’, as some traders call it has to become more transparent. Financial markets are now as interconnected as our environment. What happens in one part of the financial environment can affect other parts not directly involved.

The environmental analogy is apt here. Financial markets have become an internationally connected financial ecosystem subject to ‘pollution’ with toxic securities, just as our environment has become polluted with toxic chemicals. The world has become ‘flat’ and interconnected, said columnist and author Thomas Friedman, precisely because information is now transmitted at light speeds in our new digital world.

The Darwinian world’s survival of the fittest analogy was true 100 years ago when Capitalism was an infant struggling to survive in a post-feudal age world where ownership was still in the hands of the few—whether monarchs or military dictators. But once the Industrial Revolution prevailed over the feudal age, laws regulating private property rights and controlling predatory behavior became necessary.

In fact, markets only function well when there is transparency. Otherwise assets become mispriced, bubbles formed, and greater losses ensue. Nobelist George Akerlof knew this best when he did ground-breaking research on how asset markets really function. He studied the Lemon used-car market, of all things, which before it became regulated meant buyers had no knowledge whether a new or used car was a lemon—had some undetectable defect, in other words. And because buyers therefore discounted the price of those unguaranteed cars, it drove sellers with vehicles of better quality out of the market.

And that is why state vehicle Lemon Laws now require some guarantee or warranty of quality for each vehicle for sale. Professor Akerlof’s seemingly innocuous research, along with that of Joseph Stiglitz and Michael Spence won them the 2001 Nobel Prize in the Economic Sciences “for their analysis of markets with asymmetric information”, and proved that insider trading will always harm markets, if not regulated.

Professor Akerlof, also the co-author with behavioral economist Robert Shiller of “Animal Spirits”, has been very vocal about the need for regulations and laws to keep up with financial innovations. One of his favorite sayings first appeared in a New York Times editorial.

“If you let your toddler out of her playpen, you need to watch her more carefully. This wisdom is known by every American parent but has been systematically ignored in economic deregulation…Now is the time to remember the lessons of the playpen: increased scope for action must be accompanied by increased regulatory oversight.”

JK Galbraith’s innocent fraud is the reason ideology may trump economic reality. Those AAA ratings on subprime mortgage securities were an illusion, fostered by Goldman’s traders that generated tremendous profits. There is a ‘snake oil’ element in all financial markets that free market ideologues are loath to admit. “…those employed or self-employed who tell of the future financial performance of an industry or firm, given the unpredictable but controlling influence of the larger economy, do not know and normally don’t know they do not know.” Those predictions “are thought to reflect economic and financial expertise. And there is no easy denial of an expert’s foresight.”

Harlan Green © 2010

Why Financial Reform?

Financial FAQs

It is becoming clearer that economic self-interest under the guise of trickle-down economics no longer rules in the debate over financial market regulation. There must be regulations that protect the self from itself, and the predatory behavior of others. The SEC’s charge that Goldman Sachs committed fraud in marketing Collateralized Debt Obligation insurance on the worst of subprime mortgage pools is the opening salvo in a campaign to make the players who almost drove financial markets over the cliff responsible for their deeds.

“The SEC suit again Goldman, if proven true, will confirm to people their suspicions about the total selfishness of these financial institutions,” said Wall Street historian Steve Fraser, as quoted in the New York Times. “This is way beyond recklessness. This is way beyond incompetence. This is cynical, selfish exploiting.”

Even President Bill Clinton said recently on ABC’s “This Week” that had he known the damage that unregulated derivatives could wreak on an unsophisticated public as well as sophisticated investors, he would never have backed the 1999 legislation that deregulated them. “I have said many times since then, I made a mistake.”

And even economists are beginning to see the light. A Cambridge, U.K. conference sponsored by currency trader George Soros is looking for other systems that might take us away from economic self-interest. Britain’s chief regulator said, "We need a fundamental challenge to recent conventional wisdom…a dominant conventional wisdom that markets were always rational and self-equilibrating."

Some of the difficulty in pinning down responsibility has been misconceptions about a capitalist economy, said 2001 Nobelist George Akerlof. There is always an element of ‘snake oil’ in all financial markets, which tend to be overlooked even by regulators. What is overlooked is their agenda, such as the ratings’ agencies underestimation of risk, or regulators’ inability to spot a Bernie Madoff. Regulators such as the SEC were either too overworked, or too unsophisticated in not looking under the covers of many offerings. And rating agencies were paid by the companies issuing the securities, hence tended to soften their risk analysis so that even some subprime-based securities were rated AAA.

Secondly, no one seemed to even understand the consequences. A string of unprecedented financial innovations created institutions that “don’t take into account the kind of communities we want to build”, said economist Robert Shiller in a recent New York Times Op-ed. Yet as leaders of their respective institutions it was certainly their job to foresee any downside consequences. There were certainly precedents, such as the creation of extreme asset bubbles in Japan. In fact, the Federal Reserve had worried about Japanese-style deflation in the early 2000s, the result of Japan’s own busted real estate and stock bubbles.

On the contrary, the biggest players only saw the upside. Greenspan in fact trumpeted the advantages of exotic (and unregulated) derivatives that spread the risk more widely, that he thought lessened the dangers of default. Yet Greenspan of all people should have foreseen the crash.

I remember well that he encouraged risky mortgages by recommending adjustable rate mortgages as preferable to fixed rates because their interest rates were lower, even though he admitted at hearings he only borrowed at fixed rates! A housing bubble was most unlikely, he said, because home owners couldn’t buy and sell their homes like stocks. Their transaction costs were higher, the housing market was less liquid—and moving costs were considerable.

This was when the Fed had been holding down short-term interest rates in 2003-4 almost as low as today in a bid to fight Japanese-style deflationary fears, and boost a recovery that hadn’t yet added one net job from the end of the 2001 recession. Because inflation was so low then—below 1 percent—the cost of money was in fact less than zero, which made it advantageous to mortgage with little or no down payment.

Why could some of the “smartest guys in the room” so miscall the worst downturn since the Great Depression? Greenspan for one, a disciple of Ayn Rand, believed that free markets embodied the highest moral order (his words). What made it moral? Greenspan, as Ayn Rand, et. al., believed that free market forces were the most efficient and impartial allocator of resources. So when crises did occur, they functioned as a market clearing device, and any attempt to mitigate their effects only prolonged the adjustment to new circumstances. Such crises embodied the forces of ‘creative destruction’ and shouldn’t be tampered with, in other words.

This is why many conservative economists who decried the stimulus spending said “let the banks fail”, so that bad debt can be wiped out. Creative destruction—the replacement of failing businesses with more vibrant ones—happened in nature, so why shouldn’t it be allowed to happen in the urban jungle?

The problem was that Greenspan’s ideology was outdated, and had become group think. The invisible hand of Adam Smith was no longer sufficient to control market forces that had become complex beyond understanding. Bubbles were caused by ignorance of fundamentals, including fundamental market forces that could go easily out of control when greater risk taking was encouraged, with no limits on borrowing.

Household incomes had been steadily shrinking in real (after inflation) terms since the 1970s, except for a short while in the 1990s, so the housing bubble and easy credit encouraged many households to spend borrowed money to keep up their standard of living, a standard that was now beyond their means.

A sustainable economic system in today’s world has to take more than individual self-interest into account, since more than the individual is affected. Financial markets are today intimately linked, so that markets may collapse world-wide if leaders are not held accountable for their risk-taking. Alan Greenspan made a choice of individual gain without regard for its consequences when he chose to ignore the housing bubble. But the captains of industry-and government-have to be held accountable for the welfare of all those affected by their actions as well.

Harlan Green © 2010