Month: March 2017

The must-read book for libertarians, socialists, conservatives, progressives as well as the politically confused

Finally, a book showing the way to strike at the root of bad government is out.

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In Seasteading: How Floating Nations Will Restore the Environment, Enrich the Poor, Cure the Sick, and Liberate Humanity from Politicians Joe Quirk and Patri Friedman set out how creating permanent, autonomous communities on the ocean will create a vibrant start-up government sector – a Silicon Valley of the Sea – with many small groups experimenting with innovative ideas as they compete to serve their citizens’ needs better.

Disrupting the Largest Industry in the World

When viewed as an industry, governance is the largest in the world, representing about 30 percent of global GDP. And today, this industry exhibits a serious lack of competition. There are extremely high barriers to market entry because putting a new idea into practice means having to win either an election, a war or a revolution.

As a result, products (the bundle of rules and public goods provided by governments) are low-quality, prices (taxes) are high and customers (citizens) are generally unsatisfied.

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.

A Silicon Valley of the Sea, where those who wish to experiment with building new societies can demonstrate their ideas in practice would apply the scientific principle of trial and error to governance.

Science Fiction Fact

The technology to create floating cities is basically already there. Take, for example, the Portunus Project, a plan to build six floating mega ports surrounding the United States, each four hundred acres in size and located twenty to forty miles offshore.

The Dutch architectural firm Waterstudio, on the other hand, has designed a floating stadium that could travel the world hosting the Olympic Games.

In 2014, India began installing a solar power plant on a 1.27-million-square-meter floating platform and by 2025, Shimizu Corporation, a Japanese construction giant, plans to have self-sufficient, carbon-negative botanical skyscrapers floating in Tokyo Bay.

A Technology rather than an Ideology

Seasteading is a technology for anybody to try their vision of society. Seasteaders are from all political spectrums – and some simply identify as politically confused. They share the conviction that experiments are the source of all progress and that humanity needs more experiments in governance. They have realised that arguing about politics is a waste of time and that trial and error is the way to go.

I recently argued that the most important book for every libertarian to read was The Machinery of Freedom by David Friedman. Seasteading by Joe Quirk and Patri Friedman, on the other hand, is a must-read for anybody who believes that not all political systems are equally good. Seasteading, not arguing, is the way to find out what works best.

The Social Machine, Hayek and Politicians

Don Boudreaux at Cafe Hayek points us to the following gem of a quote by Kevin Williamson:

The people who have an explicit legal obligation to work not on our behalf but on behalf of their shareholders do a pretty good job of giving us what we want; the people who vow to work on our behalf do not. That is a paradox only if you do not think about it too much, and not thinking about it too much is the business that politicians are in.

If capitalism – which is to say, human ingenuity set free to follow its own natural course – is a kind of social machine, then politicians are something like children who take apart complex machines without understanding what they do or how to put them back together. (At their worst, they are simply saboteurs.) When they rail against capitalism, automation, trade, and the like, they resemble nothing so much as those hominids at the beginning of 2001: A Space Odyssey, shrieking hysterically at something that is simply beyond their comprehension.

The thought of F. A. Hayek, who, incidentally, died 25 years ago today, shines through this quote. Hayek’s key insight was the concept of Spontaneous Order. The market system was not designed, it emerged and evolved.  When people traded, prices emerged. And prices contain all the information needed for the system to work.

This delicate social machine is different from an ordinary mechanical one, but you can still throw sand in the gears, which appears to be something politicians can’t stop doing.

The question is: what can be done about that? And this question leads us from Hayek to the topics of Polycentric Law and Competitive Governance, which happen to be main foci of this blog and will be examined in much more detail in future posts.

The Most Important Book For Every Libertarian To Read

I recently saw a list of Ten Books Every Libertarian Should Read on the website of the Adam Smith Institute, which did not include the one book I consider to be (by far) the most important for every libertarian to read.

I am talking about The Machinery of Freedom by David Friedman.

Machinery_Of_Freedom_Cover_Dave_Aiello

The book shows that libertarianism cannot be stated as a simple and convincing moral principle from which everything else follows. Instead, economic analysis is used to arrive at libertarian conclusions.

The obvious way to find out what the laws of a society ought to be is to start with general principles of justice and see what laws are necessary to implement them. David Friedman argues that that cannot be done and gives a long list of questions which cannot be answered using libertarian principles. For example, libertarian principles of justice provide no way of deciding what ought to be included in property rights, how they may legitimately be defended, or how violations ought to be punished.

Friedman argues that, while libertarian principles provide no answer to the relevant questions, they are all questions that can, at least in principle, be answered by using economic theory to discover what rules maximize human happiness.

Friedman shows that a system in which legal rules are generated by firms competing in a private market can be expected to produce efficient rules and goes on to use the tools of economic analysis to show under what circumstances such a legal system would or would not be stable.

The reason why, in my opinion, The Machinery of Freedom is the most important book to read for a libertarian is this application of economics to the field of law.

So, if you are a libertarian, go and read The Machinery of Freedom by David Friedman. And if you aren’t a libertarian, still read it. It’s stellar economics and a hell of a lot of fun to read.

The Root of the Root of the Perverse Incentives in the Banking Sector: the Wrong Monetary Policy Regime

As I have described before, the banking sector is a mess – or as Mervyn King put it: “Of all the many ways of organising banking, the worst is the one we have today.”

At the root of the problem are explicit and implicit government guarantees for bank debt. These constitute a subsidy of debt financing and provide an incentive for banks to minimize equity to asset ratios. Razor-thin capital ratios again incentivize banks to take on excessive risk. At some point excessively risky investment behavior will produce heavy losses and lead to a solvency crisis.

Government guarantees for bank debt do not only stand at the beginning of this causal chain – they also stand in the way of a solution to the solvency crisis. Undercapitalized banks do not necessarily need to engage in credit rationing. The much simpler solution would be to issue more capital. But the taxpayer subsidy for debt has made capital artificially expensive relative to debt. Hence, banks are reluctant to issue more capital and the solvency crisis drags on.

So, if the government abolished deposit insurance (which is, of course, not insurance in the true sense of the word but simply a government guarantee) and also announced that there would be no bailing out of creditors any more in the future, would this eliminate the perverse incentives in the financial industry?

Without being accompanied by certain changes in the institutional environment (described below) such an announcement would simply not be credible and hence not effective: there are, at the moment, banks that are (potentially) “too important to fail”. Hence, the government has a strong incentive to renege on its promise and rescue such banks in the event of a crisis.

Anticipating this too-important-to-fail problem facing the government, the creditors of such banks will be content with relatively low risk-premiums. Again, the capital structure irrelevance principle will not hold and the banks will still be able to reduce their weighted average cost of capital by increasing their leverage to astronomical levels.

Without first solving the too-important-to-fail problem, the government cannot credibly commit to not bail out failed banks. But is there a solution to this problem at all?

The failure of a sufficiently large bank (or several banks) may well cause a massive negative shock to aggregate demand that cannot be offset by conventional monetary policy (i.e. by cutting the nominal safe interest rate). The economic cost associated with such an outcome (especially the cost in the form of a potentially significant rise in unemployment) may well be deemed too high to be politically acceptable.

The fact that the central bank’s power to offset negative aggregate demand shocks by cutting the safe nominal interest rate is limited (namely by the zero lower bound) is the main argument put forward to rescue failed banks with taxpayers’ money.

However, while there is obviously a limit to reductions in nominal interest rates, there is no limit to the extent to which the central bank can increase the money supply. That was Milton Friedman’s point when he complained about the failure of US monetary policy in the 1930s.

Of course, it is not enough to just increase the money supply. In order for the expansion of the money supply to increase aggregate demand, markets have to believe the increase of the money supply will be permanent. In short: the central bank has to commit to temporarily higher inflation (NGDP growth) in the future.

A fixed inflation target cuts off the Friedmanite money expansion route to boosting aggregate demand at the zero lower bound. If the central bank does not commit to deviate from its inflation target, market participants know that the central bank will collect the newly printed money again as soon as the economy is not subject to the aggregate demand shock any more. Hence, the effect of the monetary expansion on spending will be negligible.

The problem is that at the moment central banks across the world have a fixed inflation target, which means that the central bank’s power to offset negative aggregate demand shocks caused by the failure of sufficiently large banks is limited by the zero lower bound, which is again the root of the too-important-to-fail problem.

Why the Eurozone will break apart

The basis of a monetary union is the agreement of all member states on a uniform development of the price level across the member states and nothing else.

If, for example, the monetary union’s central bank has an inflation target of 2%, this means that the price level in each of the member states is to increase by 2% each year.

This fundamental basis for the functioning of a monetary union has been utterly disregarded in the case of the European Monetary Union (EMU), resulting in a huge gap in competitiveness between Germany on the one hand and Southern European countries on the other.

The following chart shows the development of the prices of new, domestically produced, final goods and services in the largest economy (Germany) and the third-largest economy (Italy) of the Eurozone as well as the development of Unit Labour Costs (ULC) in these two countries.

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Unit Labour Cost growth, which is roughly equal to the growth in nominal wages minus the growth in labour productivity, closely corresponds with the development of the price level over time: if nominal wages grow by more than labour productivity, prices will rise. Assume, for example, that nominal wages increase by 5% and labour productivity increases by 3%. Then Unit Labour Costs have increased by (about) 2% and will eventually translate into (roughly) 2% inflation.

As the chart demonstrates, the development of Unit Labour Costs (and therefore of the prices of goods and services) within the Eurozone has been dramatically divergent. Furthermore, the European strategy of “internal devaluation”, which means expecting Italy to cut wages and thereby restore competitiveness has failed to achieve a significant reduction in the competitiveness gap vis-a-vis Germany.

The meagre results of Italian internal devaluation have been associated with tremendous economic and social costs. What would have been needed was German boom-and-inflation helping internal devaluation in Italy. Alas, Germany, which has never been big on basic macroeconomics, has been ruled by a curious obsession with fiscal probity, so the much needed German boom-cum-inflation has not happened.

Closing the competitiveness gap vis-a-vis Germany inside the Eurozone may well be too painful to be politically feasible. Already, all of Italy’s opposition parties favour exiting the euro. As is common in democracies, they will eventually come to power.

But even if the Eurozone managed to emerge from the ongoing crisis intact, the next euro crisis would not be far away because the EMU has no mechanism to prevent asymmetric shocks from leading to substantial differences in Unit Labour Costs between member states. Instead of a fiscal rule requiring member states to set the budget balance in such a way that Unit Labour Costs and prices develop in line with inflation in the EMU as a whole, there is a nonsensical deficit limit of 3%.

That is, the EMU would be as unprepared for the next asymmetric shock as it has been for the last. And given how painful and costly the not-yet-completed realignment of the regional price levels within the EMU has turned out to be, I cannot imagine Europeans would be willing to go through that all over again.