19^th Century Print Exhibition of Industrial Machinery

Economic Growth in the U.S.

This financial crisis became a crisis of the system, of social organization. The solution therefore involves issues of politics and culture.

Adam Smith published Wealth of Nations in 1776, the world’s first treatise on general economic growth. It described the emergent English economy, giving play to the “natural state of freedom,” guided by the Invisible Hand of the market. The three main principles of this economy were:

1) Self-interest and Competition in Free Markets

“As it is the power of exchanging that gives occasion to the division of labor, so the extent of this division must always be limited…by the extent of the market….It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard of their own interest.” ¹

Robert Heilbroner wrote, “The great message of the Wealth is…a positive and hopeful one. Left to itself the system will generate wealth; and this wealth will diffuse throughout society…” ²

2) Division of Labor

“The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgement…seem to have been the effect of the division of labour.” Smith then proceeds to his celebrated discussion of the pin factory where, “…ten persons…could make among them upwards of forty-eight thousand pins in a day…(whereas separately) they certainly could not each of them have made twenty…” ³

3) Security of Property

“The property which every man has in his own labour, as it is the original foundation of all other property, so it is the most sacred and inviolable.” ⁴

As disrupting to the existing order as the first two principles later turned out to be, Smith’s vision was essentially conserving. His ideal economy consisted of town and country existing in an interrelated system of mutual service, with agriculture primary. What happened after the publication of his book? Not much, at least from the standpoint of GDP statistics. Western Europe’s GDP/capita in the period 1776-1848 showed a minimal acceleration of economic growth from the previous years that included feudalism.

However, intruding upon Smith’s bucolic vision was a flux of social reality.

According to the natural course of things…the greater part of the capital of every growing society is, first, directed to agriculture, afterwards to manufacturers, and last of all to foreign commerce (our note: this is a risk-adverse portfolio)…it has, in all the modern states of Europe, been, in many respects, entirely inverted. The foreign commerce of some of their cities has introduced all their finer manufactures, or such as were fit for distant sale; and manufacturers and foreign commerce together, have given birth to the principal improvements in agriculture. The manners and customs which the nature of their original government introduced, and which remained after that government had greatly altered, necessarily forced them into this unnatural and retrograde order…. ⁵

By the 1850s, that flux had turned into a torrent. Technological progress created the steam engine and electric power, both means of energy capture. The English, later American and German economies, began their more than exponential ascents. The economic growth of the Victorian era further required these elements: 1) Smith’s free markets, international in scope 2) Technological progress that increased productivity 3) A large rural labor force, willing to migrate or emigrate to the growing industrial centers.

These elements are now largely present in East Asia, the first two introduced by the British in Hong Kong who made Smith’s laissez faire capitalism a guiding philosophy. Asian economies are further benefitting from industrial and information revolutions occurring at the same time, and government planning.⁶ Are Smith’s principles of economic growth appropriate to the U.S. in the 21^st century? They are.

I) Markets

Markets and Financial Reform

Markets mean freedom. Freedom essentially means you can do what you want. But unregulated human nature has a tendency to excess; causing manias, panics, and crashes in the financial markets; thus freedom requires law. The Great Recession has shown that the financial markets do not automatically lead to finely tuned rational outcomes, where capital is invested to its best uses. In chapter 12 of The General Theory, Keynes noted:

It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life…but with what the market will value it at, under the influence of mass psychology three months or a year hence (our note: they want to make money fast). ⁷

Derivatives are financial contracts that derive their values from something else, such as a bushel of wheat or a stock index. They can make or lose money fast if they are not used for hedging. At the end of 2008, the notional value of directly negotiated (OTC) derivatives was $592 trillion.⁸, or about 9.8X world GDP. They are usually defended as enabling non-financial institutions such as Boeing or Intel to better control their risks.

In June of 2008, according to a Peterson Institute article, 89% of all OTC derivative counterparties were other financial institutions.⁹ Thus a major activity of the financial industry is to create complicated paper ¹⁰ for other financial institutions, also very greatly increasing financial system leverage and risk. Because, taken as a whole, derivative positions net out or offset each other, that means that the financial industry is playing a non-productive zero sum game, where for example AIG’s losses on credit default swaps were Goldman Sachs’ gain (also speaking figuratively). In this process, the rest of the economy did not gain, and in fact lost when the whole financial system nearly blew up and real lending ceased.

Modern finance has become increasingly abstract since all financial assets, for instance equity and loans, can be theoretically decomposed into puts and calls, elemental derivatives.¹¹ To be useful to the rest of the economy, finance should finance business ideas and people in the real economy, not combine abstract objects into tradable abstract investments that tend to blow up. Paul Wilmott, an authority on quantitative finance, writes:

In the last decade the derivatives business has grown to a staggering size, such that the outstanding notional of all contracts is now many multiples of the underlying world economy. No longer are derivatives for helping people control and manage their financial risks from other businesses and industries, no, it seems that the people are toiling away in the fields to keep the derivatives market afloat! ¹²

Including derivatives, re-regulation of the financial markets is obviously required. The goals of such regulation should 1) Restore stability to finance, and thus to the economy. This requires a banking system that serves as a stable core for economic growth. 2) Modify a system that disproportionately rewards market trading over financing real businesses.

In this context, the complicated financial reforms before Congress, while doing no harm, are probably too complicated to do much good. A Council of Regulators, a newly vigilant Fed, Resolution Authority, and a Consumer Protection Agency are unlikely to avert future financial catastrophes because they rely too much upon administrative discretion, upon both the ability and willingness of future appointed regulators to act. Much better would be a few simple rules that apply to the banking system that would direct capital to the real economy and away from financing finance. The major activity of banks should be to lend soundly to the rest of the economy. These rules should keep banks from misdirecting capital and getting into problems in the first place. An overly complex financial system is fragile, unmanageable, can’t be regulated, and unfortunately subject to ecological collapse.

On 4/7/10, Alan Greenspan testified before the Financial Crisis Inquiry Commission. Among other things, he said that the only government regulations that work don’t require forecasts. That means that a rule-based regulatory system will be the most effective, such as the Volker rule, rather than a system of regulatory discretion. At the lending level, that means that lenders should observe the 3Cs of lending rather than optimistic projections. The solution of this financial crisis is on the asset side of bank balance sheets; not on the capital side that can be gamed.

Markets and Financing the Deficit

According to Herodotus, the Persians had no marketplaces.¹³ Free markets are necessary for economic development because they enable entrepreneurs to obtain the inputs and market the products necessary to create wealth. An economist would further claim that free markets lead to optimal, in whatever sense of the word, outcomes. The recent financial crisis, we think, falsifies that assumption. Nonetheless, the directional error-correction of free-markets is better than none at all.¹⁴

During the process of heavy-handed directional error-correction, markets are ruthlessly effective in causing change. The European financial markets are already starting to signal the difficult social changes necessary, to correct the consumption excesses of the previous years. Pimco’s Bill Gross writes:

To begin with, let’s get reacquainted with the fundamental economic problem of our age – lack of global aggregate demand – and how we got to where we are today: (1) Twenty years of accelerated globalization incrementally undermined the real incomes of most developed countries’ workers/citizens, forcing government to promote leverage and asset price appreciation in order to fill in what is known as an “aggregate demand” gap – making sure that consumers keep buying things. When the private sector assumed too much debt and asset prices bubbled (think subprimes and houses, or dotcoms/NASDAQ 5000), American-style capitalism with its leverage, deregulation, and religious belief in lower and lower taxes reached a dead end…In order to get us out of the sinkhole and avoid another Great Depression, the visible fist of government stepped in to replace the invisible hand of Adam Smith….Shaking hands with the government was a brilliant strategy in 2009 when it was assumed that governments had an infinite capacity to leverage themselves.

But what if they didn’t?...What if – to put it simply- you couldn’t get of a debt crisis by creating more debt? ¹⁵

The long-term solution to the financial dilemma Mr. Gross presents for the U.S. is not short-term Keynesian demand management, but real economic growth - increasing real incomes. That requires remedying the budget deficit.

The government budget deficit results in a large trade imbalance with the rest of the world and an economy that emphasizes domestic consumption rather than manufacturing for exports. To illustrate, the first equation ¹⁶ is the expenditure definition of GDP; the second is the income definition:

(1) GDP = Consumption + Investment + Gov. Expenditures + Net Exports

(2) GDP = Consumption + Savings + Taxes

Combining the two equations:

(3) (Imports -Exports) = (Gov. Expenditures - Taxes) + (Investment - Savings)

Assume that (I - S) can be ignored:

(4) (Imports - Exports) = (Gov. Expenditures - Taxes)

This is the twin deficits hypothesis; domestic government deficits cause international trade deficits. To verify this with unreferenced empirical data, using the ocular approximation test (OAT); it can be seen from this article that there is a relationship between government budget deficits and trade deficits. Equation (4) describes the current economic situation. The U.S. is borrowing from foreigners, who grant vendor financing, to purchase their manufacturing goods. This arrangement favors consumption over production; in the long run, it will reduce the nation’s standard of living. The U.S. must start producing exports to justify its consumption of imports.

II) Division of Labor

Why emphasize manufacturing? Because, as is obvious abroad, manufacturing can rapidly raise the standard of living. How so? Recall Smith’s example of a pin factory. It would cost a lot more to make the first pin than the 48,000^th. Consider the new 305 hp Ford V6. It would probably cost millions of dollars to design and manufacture the first engine from scratch, using existing technologies and workforce skills in alloy formulation, combustion chamber design, parts fabrication, and electronic engine control. After overhead allocations, it will probably cost Ford around $4,000 to produce a better 480,000^th engine. Manufacturing increases GDP, and therefore wealth, due to economies of scale. Such possibilities for such increased productivity are not as easily available in the service industries.

Since companies and economies are competitive, profits are always going downhill unless they are replaced by new products carrying higher margins. In advanced economies, R&D is crucial; that requires a workforce that is skilled in science and technology to increase productivity and a business culture that values the long-term. How is the U.S. faring in the task to produce products superior to those presently available abroad? We think, not too well.

Silicon Valley in California is a major center of technical innovation. The Silicon Valley Index is a yearly compilation of the economic state of the Valley. The 2010 edition notes:

1) Between 2007-2009, per capita income dropped 5.0% versus 3.9% in the rest of the United States.

2) The region is becoming increasingly dependent upon foreign science and engineering talent. In 2008, foreign born talent was 60% (sic) of the total s&e work force. At the same time, the number of foreign graduates immigrating to the U.S. has been declining since 2005, due to increased educational and occupational opportunities abroad.

3) Due to California’s budgetary problems, 2008 statewide spending on higher education dropped 18% from the prior year. (Those who live in California know that access to the statewide system of public higher education is being severely compromised.)

4) Venture capital spending in the Valley decreased rapidly from $27 billion in 2000 to around $5 billion in 2009.

The report summarizes, “This is not a time for complacency. At a time when we need to engage more actively in the global economy, the very foundations for that engagement are weakening. We’re disinvesting in education and we’re not cultivating talent. Our state is no longer able to make crucial investments infrastructure. Gridlock in Sacramento has become a major barrier to our ability to compete abroad and solve problems here at home.” ¹⁷

The problem here is both cultural and a matter of government policy. Technical skills are vital to the economy, but a technical education is: 1) Very hard work 2) You have to begin at the beginning, with calculus, physics, and chemistry. The required attitude is exactly the opposite that required by short-term market trading. The problem is not only a matter of cultural attitude. Foreign governments are granting localized incentives to lure high-tech businesses. According to a 3/3/10 NYT article by Thomas Friedman, Intel CEO Paul Otellini said, “A new semiconductor factory at world scale built from scratch is about $4.5 billion – in the United States. If I build that factory in almost any other country in the world, where they have significant incentive programs, I could save $1 billion, because of all the tax breaks these government throw in…the cost of operating when you look at it after tax (are) substantially lower and you have local market access.” Although companies are headquartered in Silicon Valley, they are growing production and jobs abroad.

To re-industrialize the U.S., businesses need new ideas, capital, a skilled work force, and comparable tax incentives. Both education and tax policy are government concerns.

III) Security of Property

The third Smith principle is that of private property, that a person be able to keep the fruits of his labor. This principle has been become a slogan of the far right in the United States, “No new taxes,” to protect our freedoms.

But there must be at least some (if not a perfect) balance in public or private finances. Smith wrote, “What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.” ¹⁸ An inability to achieve budget consensus has resulted in a mad rush to the credit cards.

The Great Recession of 2008 was caused by multiple system failures: of an underegulated financial system that tolerated financial imbalances, a business system that created real imbalances by failing to develop new products and exporting jobs, a cultural attitude that devalued technical skills, and a political system that failed to control the deficit. A solution to the failure of three whole systems is not more free-market rhetoric; because markets in the short-term reflect only what people want. It requires, among other things, that government be made to work better, with an eventual reduction of the deficit a primary goal. No one, we think, would advocate repealing social security and dramatically cutting defense expenditures. Therefore there is a role for government.

We are far from socialism with American characteristics. According to 2007 OECD statistics, the United States has the second lowest percentage of government expenditures as a percent of the entire economy. If you take out defense expenditures, it would be the lowest. Thus, there is ample room for government reform.

2007 Central Government Expenditures as a % GDP

France	52
United Kingdom	44
Germany	44
United States *	37
Japan	36

* U.S. defense expenditures were 4% of GDP

Government reforms, particularly budget reform, require consensus; not political polarization. Elites exist even in democracies; but a 3/22/10 Time magazine article notes, there is an implicit social contract. The elites must keep things running smoothly in order to justify themselves. The solution to the above problems is not to substantially reduce the role of government, but to make government more effective, with opposition criticism useful.

Conclusion

The quintessential expression of freedom and self-interest, the market system is uniquely capable of generating wealth; but its breakdown can cause financial and then political problems, as W.W. II illustrated. In Democracy in America, de Tocqueville (1840) tied together the individual and the community, resulting in a practical synthesis:

The principle of self-interest rightly understood is not a lofty one, but it is clear and sure. It does not aim at mighty objects, but it attains without excessive exertion all those at which it aims. As it lies within the reach of all capacities, everyone can without difficulty learn and retain it. ¹⁹

Footnotes

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In social matters, an historic perspective is always useful. In a paper presented in 2009, Andrew Haldane of the Bank of England wrote:

Over the course of the past 800 years, the terms of trade between the state and the banks have first swung decisively one way and then the other. For the majority of this period, the state was reliant on the deep pockets of the banks to finance periodic fiscal crises (our note: and wars). But for at least the past century the pendulum has swung back, with the (modern) state often needing to dig deep to keep crisis-prone banks afloat.

Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing. Reversing direction will not be easy. It is likely to require a financial sector reform effort every bit as radical as followed the Great Depression. It is an open question whether reform efforts to date, while slowing the swing, can bring about that change of direction….

…in the Middle Ages, perceived risks from lending to the state (were) larger than to some corporations….Then the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks.

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Markets are by nature abstract. In fact, they abstract economic activity from the rest of society, enabling entrepreneurs to assemble land, labor, and capital into productive and gainful enterprises. However, this financial crisis was caused by a finance that had become too abstract or, to put it more accurately, ephemeral. Investors used to invest in actual wealth-creating enterprises; trusting in entrepreneurs, builders who were not motivated by money alone, to create wealth. But prior to this crisis, they invested in structured subprime mortgages and in generally non-productive tradable objects (derivatives), financial contracts that derive their value from some other quantity. The economy is now suffering from the consequences of this massive misinvestment.

This website is about the market; its useful to recall history. In “The Wordly Philosophers, 1999 (ed.), p.p. 20,21,29” Robert Heilbroner described how large-scale markets came about:

For countless centuries man dealt with the problem of survival according to…tradition or command, (there) never gave rise to that special field of study called “economics.”

….the economists waited upon the invention of a third solution to the problem of survival. They waited upon the development of an astonishing arrangement in which society assured its own continuance by allowing each individual to do exactly as he saw fit-provided he followed a central guiding rule. The arrangement as called the “market system,” and the rule was deceptively simple: each should do what was to his best monetary advantage. In the market system the lure of gain, not the pull of tradition or the whip of authority steered the great majority to his (or her) task. And yet, although each was free to go wherever his acquisitive nose directed him, the interplay of one person against another resulted in the necessary tasks of society getting done.

…that the medieval world could not conceive of the market system rested on the good and sufficient reason that it had not yet conceived the abstract elements of production itself. Lacking land, labor, and capital (our note: these were tied to social institutions), the Middle Ages lacked the market; and lacking the market (despite its colorful local marts and traveling fairs), society ran by local command and tradition. The lords gave orders, and production waxed and waned accordingly. Where no orders were given, life went on in its established groove.

…There would be nothing for any economist to do for several centuries-until this great, self-reproducing, self-sufficient world erupted into the bustling, scurrying, free-for-all of the eighteenth century. (We described the effect of this new market system on France in that century.)

This quote illustrates both the power and the chaos of the market social system as it both causes and reflects change. But markets tend to excess, if not regulated to an imperfect equilibrium based upon the fundamentals.

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Since we’re discussing the market system, we might as well explore it to the fullest. For Adam Smith, competition and self-interest in markets were benign. First, because they enabled the full expression of freedom and second because they prevented monopoly, equating supply and demand. For the irascible Karl Marx, however, these two were the motive forces resulting in the destruction of the capitalist economic system itself. Key was the concept of labor surplus value (or profit), that market forces were constantly competing away; and which to counteract, the capitalist would have to introduce labor-saving machinery resulting in unemployment. Marx, as Heilbroner (1999 ed.) pointed out, laid bare capitalism as an abstract system. The operation of this system decreased profits, increased instability, and resulted in the progressive immiseration of the proletariat ending in revolution.

What Marx neglected was the sociopolitical context in which capitalism operates. First, through the operation of democratic politics, the capitalist system was capable of reform. Second, Marxism (and particularly Leninism) viewed human wants as static; whereas (to use a beneficent phrase) the “internal causation” or “self-organization” of the decentralized market system generated for society new possibilities, wants, products – and therefore growth and new profits. At this time of financial crisis and globalization, both reform and new products are necessary in the developed economies to keep Marx’s dark vision from coming to pass.

Marx discovered a social law, but ignored both the contingencies and the conditionalities to which social laws are subject.

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