Homework for Austrians and Chicago Schoolers

There is some good news. I’ve seen figures that say that the property market in China is stabilizing. Prices are still going down, but lots of people are snapping up cheap deals in real estate, and so the volume of real estate sales is actually going up.

I think the huge savings is going to be very helpful for China to recover, since if you have lots of money in the sidelines, the markets don’t collapse when there is a massive price drop. You see a super-cheap house or super-cheap stock. The buyer has cash. The seller has cash. The buyer and seller both shake hands. The buyer gets a really good deal. The seller takes a loss but has cash. This is the way that markets are *supposed* to work.

The problem right now in the United States, is that this won’t happen if the buyer and seller both have large debts. You don’t have buyers with ready cash, and what cash they have, they want to keep. The sellers are also broke so they can’t sell and realize a loss.

An exercise for Austrian economists is to look at market microstructure. Austrians have developed a rather rigorous framework for going from the individual actions of buyers and sellers into social good. The basic idea is simple which is that the buyer and seller will only undertake exchanges that improve each others well-being, and therefore a system based on market exchanges will naturally deal to an improvement in social well-being.

What I think Austrians should do is to look at situations where this breaks down.  If you have a situation in which “bad things are happening” then it must mean that this rigourous logic has broken down somewhere, and the nice thing about rigourous logic is that when it breaks, you can list the places where it is broken.

So you have situations in which:

1) invididual exchanges benefit the people making them but don’t result in social benefit, perhaps because there is a third party that is not part of the transaction that is being harmed.  A very good example of this is the whole subprime mortgage issuance system.  You have a mortgage broker that makes money from commission when a deal is signed, and a borrower that gets a lot of immediate cash.

2) individual exchanges which *would* benefit the people making them don’t happen.  This can be because neither has the cash.

One thing that comes out of this is that corporate structures are very important.  Many economic transactions include merely a buyer and a seller, but most economic transactions involve agents and the buyer and seller may be abstract entities.  Also, it’s important to look at this carefully because I think it is obvious now that some of the things that were suggested to align the interests of the “principal” and the “agent” did no such thing.  Stock options and bonus system for example.  The problem with stock options and the bonus system is that you make a ton of money when the company makes a ton of money, but you lose the same amount if the company loses a small amount of money or $1 trillion dollars.  So the logical thing to do is to assume huge amounts of borrowing and risk so that when the company makes money, it gets magnified, but if the company loses a ton of money and threatens to destroy the world financial system, you just get fired.

In any case, I think thinking in terms of market failure at the level of individuals is another way of looking at the problem, and it’s something that I think Austrians and Chicago Schoolers can do usefully if they want to keep the evil socialist, big government, serfdom promoting Keynesians from totally dominating the economic conversation.

It is good for a ship to sink inefficiently

Observer: Inefficient DOES NOT mean less systemic risk, says Chinese banks of the 90s.

It does, and the experience of Chinese banks in the 1990’s illustrates nicely my point.

Lehman Brothers was only about to be insolvent for about a week before it stopped operating. Chinese state banks were able to continue to operate for about a decade even though they were insolvent, and that was because they were highly “inefficient.”

The reason for this is that Lehman had about 3% of their assets in cash or near-cash equivalent. Chinese banks in the mid-1990’s had about 50% of their assets in cash or near-cash equivalents. What this meant was that the second Lehman went insolvent, it was game over, whereas Chinese banks in the 1990’s could continue to operate even though they had huge amounts of debt, because they had large holdings of cash.

The same is illustrated by the commercial banks in the US. Investment banks were leveraged 30:1. Commercial banks are leveraged 10:1 and have a cash line from the government. What this means is that investment banks had days to deal with insolvency, US commercial banks have months, and Chinese banks in the 1990’s had years.

Where the US ran into trouble is having cash reserves and not using leverage is seen as inefficiency, which it is. If you have cash reserves and you don’t use leverage, you are big and slow. But if you hit an iceberg, then you *want* to be big and slow, because the bigger and slower you are, the more time it takes for the ship to sink and the more time you have to do something. If you have five years to fix a problem, you can do all sorts of things that you can’t do if you have five days or even five hours.

Comments on economic education

http://organizationsandmarkets.com/2007/11/14/a-plea-for-economic-education/

One thing that often surprises people is the degree to which people working in Wall Street investment banks tend to not be “economic conservatives.” Investment banks are huge bureaucracies, and the people in them are generally not allergic to working in large bureaucracies. Also people who work on the raw edge of markets everyday see some of the limitations of said markets. Lots of Rubin Democrats in the banks.

People like George Soros and Warren Buffet have warned against market fundamentalism, and I don’t recall anyone out of a major Wall Street investment bank that has recently called for unfettered capitalism. (Hedge funds are different.)

One of the funny ironies involves sitting at a trading desk at the center of global capitalism, and going through a maddening socialist central-planning bureaucracy trying to get a phone installed.

A brief history of recent US finance

http://www.rgemonitor.com/content/view/226049/86/

50 Cent: Really? Explain how US banks were able to offer fixed rate mortgages before the 1980s without a liquid market for derivatives.

Simple. Between 1933 and 1980, the Federal Reserve set interest rates. Under regulation Q, all retail savings rates in the United States were set at 5.25% and checking account interest was set at zero. Once retail savings were fixed, then the government through FHA set the lending rates at below market rates, making it easy for people to finance home purchases.

It was a massive successful system that worked for about 50 years, but ended up being unsustainable. One thing that killed it was the inflation of the 1970’s. Once you had inflation, people were no longer willing to save at 5.25% when inflation was at 10%, and people invented clever things like money market accounts and certificate of deposits to circumvent Regulation Q. Another thing the fact that the government couldn’t increase interest rates meant that it didn’t have a way of controlling the inflation of the 1970’s. Also, the US government could pretty easily set interest rates and do whatever it wanted domestically in 1933 to 1965 when US markets were the only game in town. In 1948, if you didn’t like the lousy interest that the US government was setting for you, you pretty much were stuck since there was no where else in the world you could move your money to. This stopped being true in the 1960’s which was one reason the system broke done. Another was Vietnam and the Great Society. Have a major war and not increasing taxes means that the wealth has got to come from somewhere………..

So finally in 1980. the US government gave up, deregulated interest rates. This quickly lead to a huge set of banks making stupid loans creating an early savings and loan crisis in the US. It also very quickly lead to the formation of a derivatives market in the mid-1980’s. By the early-1990’s, there was a demand for people who could calculate the value of those derivatives, which led to lots of physics Ph.D.’s being hired on Wall Street.

The Chinese financial system looks in some ways like the US financial system of 1965, but there are lots of pressures for floating interest and currency rates. It’s not that floating interest or currency rates are morally better or worse, it’s that like the US in the late-1970’s, China is finding that it *must* to certain things in order to avoid chaos. What I find fascinating about the history of US finance from 1970 to 1990 is that pretty much *none* of it was planned.

The other thing is that among the financial innovations that people found scary in the late 1970’s were money market funds and certificate of deposits. Money market funds turn out to be a great thing since it means that you can basically have a checking account that pays interest, which is a hellishly difficult thing to create.

Also, one curious thing is that the US retail derivatives market is not nearly as well developed as the Asian or European markets. In the US, you can’t go into a bank, and buy a complex structured note, and there are dozens of legal, cultural,. and regulatory reasons why not. In the UK, you can.

Systems of social control – How Chomsky is right — and wrong

In George Orwell’s 1984, Winston Smith asks O’Brien whether the things that Smith has read in the secret banned book are true. O’Brien’s reply is “As description, yes. The programme it sets forth is nonsense.”

I keep thinking about this in relation the writings of Noam Chomsky

http://www.thirdworldtraveler.com/Chomsky/Noam_Chomsky.html

who I think is a wonderfully lucid and accurate description on how the power elites in developed nations keep their control by corporate control of the media. My big difference with Chomsky, is that he assumes that there is a better system out there, and I’m skeptical. Part of the reason I’m skeptical is that I’ve been in academia. Presumably the academics that write about systems of social control want to model society in the image of academia, and in any case they have the power to model academia after their vision of a perfect society. However, my first hand experience is that the world of academia has a rigid caste system and is exploitive in a way that is unheard of in the “corrupt world of business and politics.” Let’s be brutally honest about this, academia is a world of lords (tenured faculty) and serfs (adjuncts and graduate students). The one nice thing about the academia is that academics don’t run society, and there are enough social limits to keep the dysfunctions of academia inside of academia, where they are harmless. In cases where academics have free rein to run a society, the results have invariably been disastrous. The one clear modern example where you had academics running a society was the Khmer Rouge.

Let me give you an obvious example of how the power elite in the United States maintains control over society, and why it isn’t such a bad thing. I want to invite you to a speech by Chomsky. Except that you can’t go because you have to work. Why do you have to work? Just quit your job, and join the revolution. Well, because you have this mortgage and you have car payments, and you just bought this big giant big screen HDTV and you want to catch the latest episode of Lost. Well why don’t you get rid of these things, become a hermit, quit your job, and join the revolution. Well, I just saw this commercial that makes me want to buy this bigger HDTV and I don’t want my neighbors to think that I am a “loser” for having a small HDTV or a small house. Why do you think you are a loser if you aren’t a business success and have a small television? Well, there is this commercial that I saw while I was watching Lost….. And….

So who ends up joining the demonstration. It’s people who don’t care about money and status, and these people generally have no money and connections and so are harmless. The US doesn’t have political prisoners, because anyone that wants to change the system in a way that is unacceptable to the power elite either by bought out or ignored. I’m a good example of this. I say good things about the power elite, because the power elite dumps enough money in front of me to keep me happy and controlled. If the checks stop coming, I become unhappy and uncontrolled, and seeing that I have some useful talents, the people that run the United States don’t want to see me uncontrolled. And this is true for most of the people living in the United States.

So what the hell is wrong with the system????

Personally I don’t think that there is much wrong with the system (and that’s largely because of those semi-monthly paychecks that I get from it that allow me to satisfy the urges that the system makes me thing that I have). Basically what is happening is that the rich and powerful are bribing the less rich and less powerful with wealth and goodies so that the rich and powerful can keep their wealth and goodies.

Chomsky does have a problem because he has a model of economics in which the wealth that the developed world has has to come from exploitation of the third world. That HDTV? Where did it come from? Chomsky would argue that it came from a slave labor factory in China. But that is not what is happening.

The Chinese government is bright enough to know that they just can’t stay in power through tanks and torture. There aren’t enough soldiers and police to keep control, and then you run into the problem of keeping control of the soldiers and police. So the Chinese government has copied the American government and is trying to stay in power by bribing the masses. People work in Chinese sweatshops because *they* want their goodies, *they* want to be seen as a success, and *they* want a bigger house and motorbike than their neighbors. And as long as the checks keep coming, people are too exhausted to demonstrate. If you look in situations where people *are* demonstrating in China, it’s largely because of economic issues. Their checks aren’t big enough. So people make noise, and when they get a fat enough check, they stop making noise. The system isn’t quite as developed in China, so the government has to sometimes resort to jailing dissidents, but what the government is trying to push for is a system like that American system in which the dissidents are harmless and jailing them causes more problems than ignoring them.  The ideal system would be one in which anyone who wants to destroy the system, gets to join the party.  *wink*

For this system to continue to work both the US and Chinese economic and political elites need to generate enough wealth to keep their populations satisfied, and they need to be open enough so that people (like me) that could be threat to the basic stability of the system, get bought out. That’s not a bad thing, and it’s a heck of a lot better than what the academics have come up with…….

Let be close by pointing out the fatal flaw that academics have that I think causes them create such hellish systems. Academics think that they are smarter than everyone else. The people who get a paycheck, buy a high-definition TV, and then relax to watch Lost, they are stupid sheep in the eyes of academics. They should be reading about Chomsky or joining the revolution. The trouble with this attitude is that it means that academics ignore the ideas and perspectives of non-academics, and so when they get into a position of power, they know what is right, everyone else is wrong, and this causes hell to happen…..

So now that I’ve told you all of this, are you going to go out and revolt…… I don’t think so. I think you are just going to go into the refrigerator, pull out a cold beverage and watch TV….. which is exactly what the power elites wants you to do…..

China and the socialist calculation debate

http://organizationsandmarkets.com/2007/09/04/what-does-austrian-economics-predict/ 

One big prediction…..

If the essential problem with socialist systems is calcuation, then a government owned system in which the institutions have been set up so that these calculations can be performed in a real market (and not an Oskar Lange pseudo-market) will work.

That’s the system currently in place in China, and Chinese economic reform can be seen in the context of creating a real market to resolve the socialist calculation problem in the context of public ownership. A lot of this works because there aren’t vertical command and control systems, which means that actual decisions are taking place at a lower level.

Also there is a fundamental tension between prediction and human freedom. If something is predictable than that means that you don’t have the freedom to change it, whereas if you to have the freedom to change something that renders it less predictable.

Comments on biography on von Mises

http://organizationsandmarkets.com/2007/09/04/new-mises-biography/

Great link, and I learned a bit more about why I find myself so attracted to von Mises and his ideas. The social situation of a Chinese-American circa 2007 is very similar to the social situation of an Austrian Jews circa 1880, and like von Mises, my family background is that of “fallen aristocracy.” Being “fallen aristocracy” puts you under a huge amount of psychological pressure, because you are surrounded by bits and pieces of past glory in the middle of the meagre present.

The conflicted and complex feelings that liberal Austrians had with the Habsburg monarchy and the irony of supporters of liberalism supporting an at times repressive monarchy parallels the very complex feelings that I have toward the Chinese Communist Party.

At times it is extremely painful for me to read about the history of Austria in the late 19th century because I know what happened in the 20th century. This is especially the case, because I doubt that anyone living in Austria would could have imagined how bad things would have gotten over the next 100 years, and that knowledge is frightening when you look around the United States in 2007, and realize that the fact things look nice and stable right now, doesn’t mean that it can’t all fall apart in horrific ways.

One reason I like Austrian economics over mainstrean economics is that in Austrian economics, people matter. In mainstream economics, there is no room for human will and human choice. We are all “robots” (and the word robot is related to the forms of serfdom described in the early parts of the book). My hope is that future people will look at what I did and note that I did what I could to keep the United States and indeed the entire world from going down the path that Austria did.

The one thing that I disagree with is with the title of the book, von Mises was not the last knight of liberalism.

—–

The one other thing that I thought the book brought out in the conflict between von Mises and the Randians is how basic assumptions about how the world works influences human behavior. If one believes as von Mises and Hayek does that the knowledge of the invididual is limited, then one is going to be very nice and polite toward people who you disagree with since they might will be right, and even if they aren’t, the have access to part of the truth that you need.

If one believes that one is in possession of the truth, then there is no reason to be civil toward people who you disagree with.

One other point is that I once made the statement that I learned a huge amount about Chinese nationalism by studying Hungarian nationalism, and the biography about von Mises touches on some of the things that I found. For example, there was a very strong debate over what it meant to be “Hungarian” and one of the ideas that lost was the idea of “Hungaranius” which was an inclusive notion of Hungarianness based on Latin. One curious parallel was the vital role of Latin in the Hungarian identity in the 19th century and the important role of Latin in my own life and in the development of the idea of “Confucianism.”

Now I had no idea that there would be such deep parallels between the struggles and the debates about “What it means to be Hungarian?” versus the struggles and debates about “What it means to be Chinese?”  or ‘What does it mean to be American?”  I just randomly picked up a few books in an used book shop a few years ago, and one was about the last years of the Habsburgs.

Why I am an Austrian

The history of Austrian economics in the United States was that because Austrian economists were “anti-New Deal” they formed an political marriage with the “old Right” in the United States.The reason I find Austrian economics interesting is because a lot of the analysis of Austrian economics fits nicely with Confucian social analysis. This creates a synthesis that is very different than what Murray Rothbard has come up with.

In particular, the three things that I find useful about Austrian economics is that conventional neo-classical economics assumes a pre-existing institutional structure, which may not exist in the case of a developing country like China. Neo-classical models can come up with a good theory that calculate equilibrium values if you do something with interest rates, but what happens if you don’t have a banking system or if you have an industral infrastructure that reacts in a non-conventional way to interest rates. The problems that China presents involve creating institutions, and neo-classical economics says nothing about the types of institutions you should create and how to create them.

By contrast, Austrian economics begins at the very core with “human desire”. You look at the individual and how he or she behaves, and then you zoom out and look at how collections of individuals behave. With this view, you can try to figure out what institutions need to be created and how to create them.  The big success of the Austrians was to figure out what the essential problem with central planning is, which is that central planning simply cannot handle all of the economic calculations necessary to run a national economy, and those calculations have to be done through some sort of market mechanism.

The second thing that then that I find useful about Austrian economics is that Austrian economics thinks about the process of wealth creation, whereas neo-classical economics really doesn’t have anything useful that I can see about the process of wealth creation. Neo-classical economics mainly concerns itself with how to efficiently redistribution wealth that is already existing, but it doesn’t have a theory about how to actually create wealth. Neither do Austrians, but they are thinking about the topic.

The final thing that I find useful about Austrian economics is that it concerns itself with imperfect information. What do you do if you don’t know what is going on? This is particularly important in Chinese economic reform because the process of Chinese economic reform has been a process of learning.

Within the framework, I’ve come up with different conclusions and views than von Mises and Rothbard. In particular, von Mises’s notion that private managers in large private corporations act differently than private managers in large socialist state corporations is in my empirical experience, wrong. This also fits with the experience in China. In the early-1980’s China was able to have huge bursts in agricultural production by making farmers individual entrepreneurs. These policies also worked very well with small companies, but in large companies, these policies failed miserably

One thing that I noticed is that I’m more concerned with institutions than the typical Austrian, and I  think figured out why.  It turns out that my thinking was very similar to the “Texas institutionists” which was odd because even though I live in Texas, I wasn’t aware of them.  So I was thinking about what we were seeing that caused us to see the world in the same way, and it hit me that it was because of the oil industry.  I worked in a major oil company for a number of years, and the bureaucracy and the culture within a private oil company is the same as within a state-owned oil company is the same as frankly within a large bureaucratic institution like the Communist Party of China.  The reason that big business gets along well with the Communist Party of China is that the people and the culture within them are pretty much the same.  The only difference is at the top where there is a need not to go bankrupt in private corporations which is not present in state enterprises.

So I while I agree with von Mises and Hayek’s ideas on the central nature of economic calculation, and I agree about the importance of entreprenurship in small companies, I just don’t think that their description of the difference between large state companies and large private companies is correct.

Notes on “Institutions, Financial Development, and Corporate Investment: Evidence from An Implied Return on Capital in China”

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=965631

This is another one of a long line of papers purporting to show that state-owned enterprises are more inefficient than other forms and therefore the Chinese financial system is vastly misallocating capital.

Like other such papers, it has a number of methodological flaws:

1) It doesn’t correct for the differences between state-owned enterprises and non-state owned firms.  The big one is that money losing SOE’s are responsible for a great deal of social welfare spending.  If you remove those social obligations from SOE’s, it might make the firm more efficient, but someone else needs to pick up the tab.

2) The other problem is that China has a huge number of tiny SOE’s which don’t make that much money in contrast to a small number of huge SOE’s which do.  The result of this is that if you do a factors analysis, you pick up the huge number of tiny SOE’s which are losing money, but I suspect that if you weight things by industry size, you’ll find that the bulk of bank loans are no longer going to these small SOE’s.

3) Finally, something that is consistent in these studies is that “mixed” or “collective” enterprises do as well as “private” ones.  This makes no sense if you believe that the cause of inefficiency is state ownership, but it makes perfect sense if you assume that there is some “cherry picking” going on.  Basically, any SOE which isn’t hopeless is going to find investors, and not be an SOE.

One thing that I’d like to do at some point is to dig into the NBS data, and write a paper on this.  The trouble is that I’m already booked to write three papers, and part of the reason I’ve limited myself to three papers this year is so that I don’t try to write ten.

This has some relationship to my affinity to Austrian economics.  Austrians look at numbers with a lot of skepticism and focus on the idea that we don’t really know that much about economics.  This sort of skepticism about quantitative data, I find refreshing among economics.  In the literature trying to analyze quantitative performance of Chinese firms, I’ve rarely found that the author goes in and questions the numbers and the meaning of the numbers.

Why quantitative finance is important for a quantitative theory of Austrian economics

The reason that derivative markets and quantitative finance is important in developing a quantitative theory of Austrian economics is that you end up with observable quantities, which allow for hypothesis testing.