Tag Archives: economics

Depression and Decline: American Irresponsibility is Ending the American Era with a Bang

9 Replies

Despite the assurances of US Treasury Secretary Timothy Geithner it is increasingly likely there will be no debt deal. The United States is going to default on its debt. I know it sounds crazy, but I believe it is going to happen. If it does, this is the black swan event no one imagined or was prepared to contemplate. Its impacts are going to be significant. Possibly immeasurable.

For history, August 2nd, 2011 could end up marking the end of the American Era. Sadly, it will not have been inevitable, it will have been entirely self-inflicted and it may now be irreversible. Even if an agreement is reached tomorrow I suspect the world will increasingly be unwilling to entrust the role of global financial system caretaker to the United States. The world has lost faith in America. And why not. Its Congress has demonstrated that it can no longer be trusted with the responsibility of global financial management. Indeed, even its closest allies have had their confidence shaken.

The economic and geopolitical ramifications of this outcome cannot be underestimated.

Economically, we may now be closer to a global depression than at anytime since 1930s. For all the talk of the financial crises being a near miss, this could potentially be much, much worse, simply because the consequences fall outside our predictive models.

What is clear is that America is trapped. In the short term spending less will devastate its population. Today more Americans (18.1%) than ever use food stamps. It takes American workers 40 weeks (and rising) to find a job, twice as long than in any previous recession. 1 in every 6 Americans use Medicaid. Any cuts to these services will have an immediate and harsh affect on the quality of life of a huge number of Americans.

Longer term, America cannot restart its economy. Already the top 5% of Americans by income account for 37% of all consumer outlays. This is unsurprising given the top 5% of Americans account for 34.7% of all income. This is similar to 1929 when the top 5% accounted for the top third of all personal income. This is precisely the type of economic structure that Kenneth Galbraith argues in The Great Crash, 1929, transformed the great crash into the great depression. Rather than being able to rely on a broad consumer base to power economic growth, the United States then (as now) was dependent on a high level of investment and luxury consumer spending driven by a small elite. The crash caused that elite to seize up, leaving the American economy paralyzed.

In other words, the Bush Tax cuts may have killed the US economically, and possibly geopolitical. By killing the surpluses they have broken the US treasury. By radically curtailing wealth redistribution they have fatally eroded the capacity of the US domestic economy to power new growth. Combine this with two wars that have sapped trillions of taxpayer dollars, and it is hard not to see a United States more ill prepared than at any time in its history to deal with an economic crisis. The only question that may remain is how much of the rest of the world it drags down with it.

Of course economic decline could become a leading indicator for political decline.

When I arrived to grad school in 1998 to study international relations the field had spent much of the previous decade grappling with the issue of American decline. Books like The Rise and Fall of Great Powers and Lester Thurow’s Head to Head seemed to suggest that economically and militarily, the United States was in, at the very least, relative decline as a the world’s leading power.

But then the successes of the US economy – coupled with the turn around in the size of the US government’s debt –  meant that as a peer, China felt a long way off while Brazil and India seemed more distant still. Europe was too old, disorganized and unambitious to matter. Russia, was fading quickly from the scene. Suddenly decline theory was, itself in decline.

But today the writings of Kennedy feel even more urgent. America, with or without a raised debt ceiling, cannot afford its empire, or the means to protect it. It may be able to find allies to help shoulder the burden – today the central challenge of 21st century geopolitics is the integration of India into the Western Alliance, something that proceeds apace. But if it defaults (and maybe even if it does not) it’s capacity to raise money at a reasonable rate should a major conflict arise, may be compromised. War, for America, is going to get more expensive because investors may be more nervous.

I want to clearly state that I don’t write any of this with any glee. Leftish non-americans who relish a world without the US hegemony should look at the what the period after Britain’s decline, or any period of hegemonic decline. They generally aren’t pretty. Indeed, they are often unstable, violent and nasty. Not something any country should wish for, especially smaller countries (such as my own – Canada). Moreover, while there is no immediate peer that could take America’s place, it isn’t clear that the most likely candidate – China – is one that most people would feel more comfortable with. Be careful what you wish for.

I hope that I’m wrong. I hope a deal will be reached. And that if it is, or if it isn’t, the impact on the markets will be minimal or non-existent. Or maybe, I just need to have more confidence in what I have often tell others: do not to underestimate America. As Sir Winston Churchill famously noted: “Americans can always be counted on to do the right thing…after they have exhausted all other possibilities.” And maybe they’ll have enough time to boot.

But I genuinely fear that in the haze of summer this crisis, as much as it has spurred some scary headlines, remains a sleeper. That we are confronting the mother of all black swans, and that a period of financial turmoil that will make the last two years look like a merry ride, could be upon us. Worse, that that financial turmoil will lead to other, great military and/or political turmoil.

These are scary times.

I can honestly say I never written a blog post that I hope I’m more wrong about.

Update: The Atlantic has a great article worth reading about the origins of the deficit published later this morning that includes a reference this fantastic graph from a few months ago.

The Great Crash vs. Emergence (re-mixed)

15 Replies

So it is with impeccable timing that about 3 weeks ago I started listening to John Kenneth Galbraith’s “The Great Crash: 1929.” (Indeed, I wish I had similar impeccable timing when planning my RRSP, 401k and stock purchases). Obviously the events of the last week, and more precisely the events of yesterday make this essential reading for everyone.

By quirk of luck (due to a recommendation by Mark Surman) I have also been reading Emergence: The Connected Lives of Ants, Brains, Cities, and Software by Steven Johnson. Emergence is about “the way complex systems and patterns arise out of a multiplicity of relatively simple interactions.” Possibly the most easily understood exmaple of emergence is seeing how ants or termites can create complex societies based on a few simple rules.

Interestingly, although Galbraith and Johnson almost certainly never met, and their books were written over 50 years apart, they are fundamentally writing about the same thing.

John Kenneth Galbraith’s The Great Crash is about an emergent system – the speculatory stock market bubble that lead to the 1929 crash. Indeed what makes reading these books simultaneously so interesting is observing how Galbraith describe an emergent system without the language and frameworks available to Johnson 50 years later. Consequently, Galbraith’s book is hints at a larger system even as he struggles to describe how the decisions of hundreds of thousands of individuals could be simultaniously coorindated but not directed. He intuits a distributed system, but simple can’t describe it as accurately as Johnson.

A great example of this struggle is visible when Galbraith’s describes his frustration with others efforts to pin the 1929 crash on a given, or set of, individuals. I’m willing to bet that, sadly, we are about to embark on a similar misadventure: I wager the next congress is going to launch a series of hearings to determine “who” caused our current financial crises. This, as Galbraith pointed out about “The Great Crash”, will be nothing short than a colossal waste of time and energy, one that will distract us from the real challenge. This is not to say illegal activities did not occurr somewhere on wallstreet (or K street) both in recent years and in the years leading up to 1929. I’m certain they did. Nor should they go unpunsished. They should. It is just that then, as well as today, they almost certainly did not cause this crisis. As Galbraith puts it:

“This notion that great misadventures are the work of great and devious adventurers, and that the latter can and must be found if we are to be safe, is a popular one of our time. Since the search for the architect of the Wall Street debacle, we have had a hue and cry for the man who let the Russians into Western Europe, the man who lost China, and the man who thwarted MacArthur in Korea. While this may be a harmless avocation, it does not suggest an especially good view of historical processes. No one was reponsible for the great Wall Street crash. No one engineered the speculation that preceded it. Both were the product of the free choice and decisions of thousands of individuals. The latter were not lead to the slaughter. There were impelled to it by the seminal lunacy which has always seized people who are seized in turn with the notion that they can become very rich. There were many Wall Streeters who helped foster this insanity, and some of them will appear among the heroes of these pages. There was none who caused it.”

There was no one who caused it. Remember that. Galbraith wants to pin it on something large and decentralized but can’t put his finger on what it is. Consider this line “No one engineered the speculation that preceded it. Both were the product of the free choice and decisions of thousands of individuals. The latter were not lead to the slaughter. There were impelled to it by the seminal lunacy which has always seized people who are seized in turn with the notion that they can become very rich.” Throughout his book Galbraith keeps talking about a “collective lunacy” but cannot account for it. As he concedes, the desire to become rich is ever present, something in 1929 triggered a larger hysteria. Some emergent property made it vogue.

This is what we need to understand. In 1929 – as well as today – a group of people lived and worked in a system that had powerful incentives that encouraged them to engage in risky practices (in 1929 it was investing in stock on margin, today it was lending people money who simply could not afford it). Finding the people will achieve little compared to understanding the basic set of rules that created these incentives – removing the people will do little. Managing the incentives will do everything. A big part of this may involve new regulations, but probably more importantly it requires recognizing that whole new business models are required as these shape incentives far more than regulations. No business wants to go through this type of crises again. A business model that insulates them against it will be the one to copy. This is why Umair Haque’s post is so important.

Encouragingly and contrary to popular beleif, Galbraith doesn’t believe that the crash of 1929 caused the Great Depression. Depressingly he sites other problems that lead to the larger crisis – problems some of us might see as familiar:

  • A dramatic and uneven distribution of income (we got that)
  • Poor corporate structures (we got that one too)
  • Poor banking structure (check)
  • A uneven state of the foreign balance (check again, although in reverse)
  • Opaque economic intelligence (not so sure about this one).

Yikes, so we are batting 3, maybe 4 out of 5.

My biggest fear and suspicion is that this bailout, if it occurs. Will probaby not “rescue” the system. It will simply give us breathing room to adapt the system. Certainly that would have been the case in 1929, and history very much looks like an emergent system, beyond the control of a top down state, has once again taken over.

Sicko – I laughed, I cried, but I didn't think

8 Replies

I saw Sicko on Sunday night. No doubt, Michael Moore makes a fun movie. Clearly the US health insurance system is broken. It is, in all honesty, an embarrassment – a fact Moore ruthlessly exploits to great effect. That said, I nonetheless left the theater vaguely unsatisfied. I think it is because there is virtually no analysis of why the US healthcare system is broken, beyond of course the old stand by of “corporations are evil.”

As the film repeatedly demonstrates, health insurance firms often behave appallingly. But it isn’t because they are staffed entirely by evil people. This is a structural problem. For some reason, these firms are incented to literally turn their clients into their enemies (which is never a sound business strategy).

The best explanation I’ve seen comes from 5 pages in The Undercover Economist (an excellent book) where the author – Tim Harford – talks about the problems created in markets where there are asymmetries in knowledge. It is so good, I’ve reprinted (in an edited and very condensed form) the relevant bits:

“Economists have known for a while that when one participant in a transaction has inside information, markets may not work. It makes intuitive sense. But it wasn’t until an economist named George Akerlof published a revolutionary paper in 1970 that economists realized quite how profound the problem might be.

Using the used car market as an example, Akerlof showed that even if the market is highly competitive, it simply cannot work if sellers know the quality of their cars and buyers do not. For example, let’s say that half the used cars on sale are “peaches,” and half are “lemons.” The peaches are worth more to prospective buyers than to sellers – otherwise the buyers wouldn’t be buyers – say, $5,000 to prospective buyers and $4000 to sellers. The lemons are worthless pieces of junk. Sellers know if the car they’re selling is a lemon or peach. Buyers have to guess.

A buyer who doesn’t mind taking a fair gamble might think that anything between $2000 and $2500 would be a reasonable price for a car that has a 50/50 chance of being a peach. The seller of course don’t have to gamble: they know for certain whether their car is a peach or lemon. The problem is that sellers with lemons would snatch up a $2500 offer while sellers with peaches would find it insulting. Wander around offering $2500 for a car and you’ll discover that only lemons are for sale at that price. Of course, if you offered $4001 you would also see the peaches on the market – but the lemons won’t go away, and $4001 is not an attractive price for a car that only has a 50% chance of running properly.

This isn’t just about a trivial problem around the fringes of the market. In this scenario there is no market. Sellers won’t sell a peach for less than $4000, but buyers won’t offer that much for a car that has a 50% chance of being a lemon. With buyers only offering $2500 the sellers won’t sell their peaches, so in the end the only cars that get traded are worthless lemons, which get passed around for next nothing. Less extreme assumptions about the problem lead to less extreme breakdowns of the market, but the conclusions are similar.

Now let’s look at health insurance in this lens:

Let’s say that people who are likely prone to sickness are “lemons”; people who are likely to stay healthy are “peaches.” If, I suspect myself to be a lemon, I’d be advised to buy all the medical insurance I can. If, on the other hand, you feel fine and all your ancestors lived to be a hundred, then you may only buy medical insurance if it is cheap. After all, you hardly expect to need it.

Thanks to Akerlof’s proof that markets whose players have asymmetrical information are doomed, we can see how the insurance market may disappear. You, whose body is a succulent peach, will not find a typical insurance package a good deal; while I, whose body is a bitter lemon, will embrace a typical insurance package with open arms. The result is that the insurance company only sells insurance to people who are confident they will use it. As a result, the insurer loses clients who are unlikely to make claims and acquires the clients who are likely to make costly claims. As a result the insurer has to cut back on benefits and raise premiums. People of middling health now find the insurance is too expensive and cancel it, eliminating even more marginal “peaches” from the insurance pool and forcing insurance coming to raise premiums even higher to stay in business. More and more people cancel their policies, and in the end only the most sickly of the lemons will buy insurance at a price that will be nearly impossible to afford.”

Admittedly, this hardly covers all the problems facing the US healthcare system, but it does give an assessment of why the market for health insurance creates firms who behave so poorly (and yes, criminally). It is, in my mind, the best explanation for why a single insurer system (like what we have here in Canada) can work more effectively. However, this a single insurer system also creates problematic incentives, but more on that later in the week… (is anyone left reading a post this long?)