Trump vs Friedman or: Democracy isn’t learning

Apparently Trump is actually preparing measures to restrict free trade.
There is universal agreement among economists that restricting free trade is harmful. Since Adam Smith economists have kept pointing out that free trade is beneficial and politicians have kept putting up trade barriers.

All the nonsense Trump is spouting on the topic of international trade has been debunked by one generation of economists after another. Here is, for example, Milton Friedman:

In other words, the system of democracy is not learning but keeps repeating the same mistakes again and again.

 

Competitive Governance, Seasteading and Free Private Cities For Dummies

If you are interested in economics and/or political thought, you may have come across the following three terms:

  • Competitive Governance
  • Seasteading
  • Free Private Cities

The purpose of this post is to explain in a clear and concise manner the economic and political thought behind each of these terms. Of particular importance is to understand how these terms, respectively, the ideas behind them relate to each other.

The Market for Governance

In contrast to other markets, the market for governance has been producing meagre results. Products (the bundle of rules and public goods provided by governments) are low-quality, prices (taxes) are high and the customers (the citizens) are generally unsatisfied.

The reason for this is lack of competition. In a competitive market producers of bad products are weeded out by natural selection. In the governance industry, producers (governments) are not subject to this selection mechanism. Instead, the market for governance is dominated by a series of large geographic monopolies.

There are two reasons for the lack of competition in the governance industry:

On the supply-side there are high barriers of entry. Imagine you have a new idea that would revolutionise the governance industry. In any other industry you would have to convince some investors to give you the necessary capital. Then you could start producing and selling to customers. As things stand today, market entry into the governance industry would be significantly more difficult. You would have to win either an election or a revolution.

On the demand-side there are high barriers of switching. Switching your internet provider means something like having to send an email to customer service. Switching governance providers means either emigration or the election of a new government within your current jurisdiction.

Obtaining permission to immigrate into a country can take years. On top of that, since today’s governments often cover a whole language area, emigration may well entail having to learn a new language. The problem with elections, on the other hand, is that neither you nor anybody else has an incentive to put any effort in making a good choice – as illustrated by David D. Friedman in The Machinery of Freedom:

Imagine buying cars the way we buy governments. Ten thousand people would get together and agree to vote, each for the car he preferred. Whichever car won, each of the ten thousand would have to buy it. It would not pay any of us to make any serious effort to find out which car was best; whatever I decide, my car is being picked for me by other members of the group. Under such institutions, the quality of cars would quickly decline.

If high barriers of entry for producers and high barriers of switching for consumers are causes for the dysfunctionality observed in the market for governance, then it becomes clear that there cannot exist a solution that does not tackle at least one of these causes.

Competitive Governance

The idea underlying Competitive Governance is to minimise the cost of switching governance providers by switching between geographic jurisdictions.

This is to be achieved by geographically decentralizing political power, i.e. increasing the number (decreasing the size) of units of governance among which people could move. Low barriers of exit would mean higher competitive pressure for governments and therefore better governance.

Seasteading

While the focus of Competitive Governance is on the demand-side of the market for governance (the high barriers of switching faced by consumers), the focus of Seasteading is on the high barriers of entry, i.e. on the supply-side of the market for governance.

In contrast to the earth’s land, the ocean is largely unclaimed by states. Seasteaders want to develop the technology to create permanent, autonomous communities on the ocean, arguing that the creation of ocean platforms constitutes a much lower barrier to entry for forming a new government than winning an election or a revolution – or a war. And with technology advancing, the barriers of entry to the market of governance will decline year by year.

By opening up the vast space of the ocean for experimentation with new institutions, an evolutionary process will be started that will led to new and better products in the market for governance.

Proponents of Competitive Governance have argued for more competition in the governance industry, but traditionally they did not provide an explanation for how to effectuate this change. Seasteading can be considered as a a route for getting from here to there, i.e. as a proposal for implementing Competitive Governance.

Free Private Cities

Competitive Governance and Seasteading refer to the level of the governance industry and are agnostic with respect to the shape and form of the units of governance within the governance industry. Put differently: the question of how governance is to be provided is out of scope.

Titus Gebel’s proposal for the foundation of so-called Free Private Cities, on the other hand, provides one answer to this question. Gebel, a German entrepreneur, argues for private, for-profit companies to act as governance providers in defined territories (Free Private Cities) and he has started such a company: Free Private Cities Ltd.

Citizens/customers in a Free Private City would pay a fee for the governance services provided by the company. Each customer’s rights and duties would be laid down in a written agreement between the customer and the governance provider of the respective Free Private City.

Free Private Cities may be established within the territory of an existing state, whereby the parent state (hoping to reap benefits from a potential hub of growth and prosperity) grants the operator the right to set its own rules within a defined territory. Most likely though, the first Free Private City is going to be established via Seasteading on the ocean.

 

Brexit – the long run vs. the short run

There are forecasts that Brexit will precipitate a British recession or at least a significant slowdown of economic growth in the short run.

As Paul Krugman argues here and here, the assumption that the Brexit will be a major negative shock to aggregate demand does not follow from standard macroeconomic theory. Hence, according to Krugman, there is no good reason to expect a UK recession.

I agree with Paul Krugman. There is no strong reason to believe that Brexit will be a major negative shock to aggregate demand. And even if a negative shock to aggregate demand were to occur (for example, because of self-fulfilling negative expectations, i.e. firms believe there will be a recession so they reduce investment which then leads to reduced aggregate demand), monetary policy (maybe even combined with fiscal policy) could offset this negative effect by keeping nominal spending stable.

Of course, Brexit will have an effect on the British economy, namely on the long-run supply side of the economy. Krugman argues that this effect will be negative:

Brexit will almost certainly have an adverse effect on British trade; even if the UK ends up with a Norway-type agreement with the EU, the loss of guaranteed access to the EU market will affect firms’ decisions about investments, and inhibit trade flows.

This reduction in trade relative to what would otherwise happen will, in turn, make the British economy less productive and poorer than it would otherwise have been.

Ceteris paribus, i.e. given all other trade arrangements between Britain and the rest of the world and given the current regulatory framework  in the UK (which is, to a large extent, determined by the EU), Krugman is of course right.

But why would everything else stay equal?

By leaving the EU, Britain will be free to adopt a unilateral free trade policy. Many Brexiteers favour this approach and one can only hope that they will prevail.

Britain would benefit from dispensing with barriers to trade even if other countries did not do the same. It would of course be desirable if other countries also removed their barriers to trade: in this case the gains from trade would be even higher. But moving to free trade unilaterally is the optimal policy for Britain independent of whether or not trade barriers in other countries continue to exist.

Furthermore, Brexit makes it possible for Britain to embark on a new approach to, say, financial regulation. In the UK, there was virtually no government regulation of banking until 1979. Instead, the behavior of banks was subject to tight private regulation. The private regulatory framework for banking was then substituted by government regulation in the 1980s.

This approach has not been a success. Brexit gives Britain the opportunity to return to the principles that served financial markets so well before the 1980s.

Will Britain use the opportunities presented by Brexit – or will Britain’s approach to trade and regulations be more restrictive and intrusive than before?

I don’t know for sure. Nobody knows for sure.

But on the whole I am slightly optimistic. In general, smaller political entities are governed better than larger ones. And many Brexiteers have a fairly libertarian world-view.

The most important effect of Brexit may not (directly) pertain to Britain anyway but to the rest of Europe and the world. Brexit may constitute the beginning of the end of the EU, which – by imposing a large, bureaucratic, uniform governance structure on a diverse continent – is basically the opposite of competitive governance.

Let us hope that, in hindsight, Brexit indeed turns out to be the beginning of a trend towards local autonomy and governance diversity. It would be the best possible outcome.

What’s wrong with the banks?

In the 19th century banks funded themselves with 40% to 50% equity. In 2007, the US banking industry’s equity to asset ratio was 3.8 percent. For the 10 largest banks it was only 2.8 percent. What had happened?

The reason for the drastic decline in capital ratios during the 20th century is simple: since the Great Depression bank debt has been explicitly or implicitly guaranteed by the government. If creditors of a bank will be repaid regardless of the condition of the bank, they stop worrying about the condition of the bank. In particular, they will give the bank a discount on the cost of the funds it borrows and will not demand compensation for a lower capital ratio (i.e. a higher probability of bankruptcy).

In short: the government guarantee is a massive subsidy of debt financing. And minimizing equity to asset ratios maximizes the value of this subsidy to the banks’ shareholders.

The problem is that a razor-thin capital ratio creates perverse incentives for a bank’s investment decisions.

Consider the following example:

A bank is funded by 3 billion of capital and 97 billion of debt. The bank’s management can choose between two alternative strategies:

  1. Strategy A: The bank invests the 100 billion in relatively secure government and company bonds. After one period the return will be either 110 billion or 100 billion (with a probability of 50%, respectively).
  2. Strategy B: The bank invests the 100 billion in US subprime mortgages. After one period the return will be either 65 billion or 125 billion (with a probability of 50%, respectively).

In order to keep things simple, we normalize the interest rate on debt to 0%. Then the different stakeholders’ payoffs for the two possible strategies are given as follows.

Payoffs for strategy A (in billions):

creditors shareholders overall
Investment 97 3 100
return if lucky 97 13 110
return if unlucky 97 3 100
expected profit 0 5 5

Payoffs for strategy B (in billions):

creditors shareholders overall
Investment 97 3 100
return if lucky 97 28 125
return if unlucky 65 0 65
expected profit – 16 11 – 5

 

Note that strategy A is the efficient strategy because it maximizes the expected return from lending. However, by following an inefficiently risky business model (strategy B) the bank can increase the expected profits for its shareholders. If we assume that the bank’s management acts in the interest of the shareholders, it will choose strategy B.

In order to rein in on the perverse incentives created by deposit insurance (which is, of course, not insurance in the true sense of the word but simply a government guarantee) and other more implicit guarantees for bank debt (e.g. in the case of institutions deemed “too big too fail”) , governments around the world have been creating an ever-growing mountain of regulations.

Already before the financial crisis, the banking industry was the most heavily regulated sector in the economy. However, thousands and thousands of pages of regulations are not able to change the perverse incentives introduced by government guarantees for bank debt.

And make no mistake about it: these perverse incentives underlying the banking industry will lead to further crises.

 

The Economics of Politics

Economic growth is based on technological progress. Without technological progress there would be no rise in living standards over time.

One might think living standards would stay at a stable level, if technological progress came to a halt. A given level of technology corresponds to a certain capacity to produce goods and services. If technology neither advanced nor regressed, wouldn’t then living standards stay at the same level over time ?

No, they would not – because of politics. If the negative effect of politics on the economy were no longer offset by technological progress, living standards would decline.

To understand the pernicious effect of politics you can either read Mancur Olson’s The Logic of Collective Action or watch this 2-minute explanation by Patri Friedman: