Author Archives: Jonathan Finegold

Leverage and Efficient Finance

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I recently read an argument along the lines of,

Under conditions of ‘sound money,’ taking out loans for purchases like houses, [small?] businesses, et cetera, were much more infrequent. Instead, these things were purchased outright.

My guess is that the implication is that the amount of debt held by the average person today is, in part, owed, directly or indirectly, to ‘unsound’ money. And by ‘unsound’ money, my guess is that this person means the Federal Reserve. I don’t know what period of history he is referring to, but I’d guess the late 19th century. I don’t know if the claim is true, but I think it sounds right, and it doesn’t really matter for the point I’m making. Whether money is ‘sound’ or ‘unsound,’ we should expect, and welcome, the income margin at which people gain access to credit to fall over time.

After the Great Recession, it’s easy to get carried away with looking down on debt. A term that became widely used after the financial crisis is ‘deleveraging,’ which refers to the drawing down of debt. Consumers lived beyond their means; relatively poor people bought houses outside of their budget constraints; businesses took on debt to expand, only to be hit by malinvestment and a demand shortage. But, over-leveraging only makes sense if there is a reference point — an optimal amount of debt —, and we have to remember that this reference point is always moving up.

The optimal amount of debt today is not the same as the optimal amount of debt in 1880, or even 1920 or 1960. Prior to the U.S. Civil War, for example, banking was just beginning to expand westward, and prior to that expansion credit was not really available to large swaths of American society. But, as the banking system grew, and financial intermediation became more efficient and cheaper, new parts of society gained access to credit. Growing the pool of borrowers was an important facet of American growth, because it allowed businessmen to acquire others’ savings to fund investments.

This was one of the main ideas behind securitization, when it was innovated in the 1980s. By pooling loans, and distributing risk, the idea was to make credit cheaper, giving access to credit to poor families, which beforehand had little access. Of course, it seems as if this backfired on the finance industry, given the Great Recession. But, we shouldn’t throw the baby out with the bathwater. That credit was over-expanded, and that these securities would be the very assets that collapsed, warns us against inadequate institutional constraints on banking. But, otherwise, financial innovation is a good thing, and we should be open to it.

Another example of the benefits of growing access to credit is any developing economy. These markets are generally relatively primitive, and this includes their banking sector. Most people in developing countries — even in economies as large as that of Mexico, for example — do not have access to credit, and this is a limit on growth (on their ability to borrow and invest). One sign of progress is financial growth. A country “graduating” to a higher stage in the development process usually does so because they have established some type of credit market; not necessarily for their poorest, but for large business (stock and bond markets) and for government.

Credit markets have, historically, been very volatile. But, this volatility is caused by institutional problems. We shouldn’t look back at some long-gone period of history, when finance was relatively primitive, as the golden age. Instead, we should embrace the positive aspects of financial innovation — which are many —, and be wary of policies that cause instability and capital consumption…policies such as central banking.

Quote of the Week

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The evolution of our monetary system over the last three millennia reflects a tension between two conflicting forces. One is the competitive search for lower-cost media of exchange; the other is the desire of the state to monopolize the supply of money. The tension between them became more acute with the emergence of banking. One the one hand, banking substantially reduced the cost of providing money; on the other, the state could not monopolize banking as effectively as it could monopolize coinage.

— David Glasner, Free Banking and Monetary Reform (Cambridge: Cambridge University Press, 1989), p. 44

Rudimentary Foray into the Minimum Wage & African-American Unemployment

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A commonly cited cause of relatively high African-American unemployment rates is the minimum wage. This argument is often made by libertarians. To detractors: it’s not just white, middle-class males who argue this. Walter Williams is well known for making the case — see his book, Race and Economics. Thomas Sowell, as well. The relationship is intuitive, if you assume that African-Americans, on average, are less productive than whites (and other ethnicities/races with lower unemployment rates) and perfect competition is the best model to apply to low-skill labor markets. My prior is that binding minimum wages do reduce unemployment, and so I’ve too repeated the argument, most recently today.

Knowing that intuition is deceiving, I want to develop a model to test — nothing too fancy, but not necessarily primitive, either. I don’t have that model yet. I’m looking at what data is available, what data is the best to use, and how I should manipulate the data, based on the model (e.g. should I compare rates of change or levels? what should be the functional form?).

In the meantime, here is the quick and dirty result, from the data I do have. All data is for California, including the African-American unemployment rate (BLS) and the inflation (CPI, less food and energy) adjusted minimum wage. The two compared,

Percent Change Minimum Wage v Percent Change African-American Unemployment (California)

The black trendline includes all data points (the blue diamonds); the red trendline excludes the highest blue diamond (-0.01942, 0.1963). The R2 are .0365 and .0311, respectively. Very low. Indeed, percent change in the minimum wage is not statistically significant. Also not statistically significant is the effect on the inflation adjusted minimum wage on the unemployment rate, and neither is the effect of ln(adjusted minimum wage) on ln(unemployment rate) — for those who may not know what the difference is, this last one measures elasticity; i.e. a one percent change in the real minimum wage causes a percent change in unemployment equal to the coefficient estimated for the former.

A “quick look” suggests that maybe the relationship between the minimum wage and African-American unemployment isn’t so obvious (or intuitive), after all.

Advocates of Reason: 7 March 2014

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Man has only one tool to fight error: reason.

— Ludwig von Mises

1. What’s gone wrong with democracy?, asks the Economist. (For political scientists: is there a difference between “top-down” democracy and, say, “grassroots” democracy? I mean that in the sense of a planned democracy v. one that was both, in ways, planned and spontaneously developed.)

2. How unconventional are large-scale asset purchases?

3. The myth of the great wages “decoupling,” Don Boudreaux and Liya Palagashvili.

4. Coordination and the demand for money, Nick Rowe. It reminds me of Hayek, and Hoffman’s and Urbansky’s “Economic Order Displacements and Recurring Business Cycles.”

5. Reddit’s economic article of the week: “The Political Economy of the Rent-Seeking Society,” by Anne Krueger.

6. Can economic sanctions force Putin to retreat on the Crimea issue? Sanctions are an easy option to condemn, and to damage to, an aggressor, but, historically, they rarely work. Here is an old essay of mine on the unintended consequences of sanctions on Iran.

Thoughts on Remittances

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Felix Salmon writes on remittances, over at Reuters, citing a 2013 World Bank report. He discusses how big banks were eager to enter the remittances markets, but how these are pulling back, even while the markets are becoming more competitive. He also notes that, although the World Bank has pushed to reduce prices, remittances have become more expensive in recent years. Finally, he observes that the volume of remittances have been falling where they’re cheaper, and rising where they’re pricier.

Some scattered thoughts,

(1) Salmon, and the World Bank report, cite anti-laundering regulations and interventions as a reason for the contraction of some of the larger banks’ participation in these markets. An alternative explanation is that external economies dominate internal economies of scale, increasing the number of firms, and decreasing the size of larger, individual firms. Or, maybe large banks simply over-estimated the demand for remittances services to certain countries, originally over-expanding, and now contracting.

(2) I wonder how remittances, especially the involvement of large banks, have affected foreign credit markets. Presumably, by drawing large banks’ investment, and creating a financial industry around remittances, this opens the door for cheaper, easier access to credit.

(3) When the financial industry around remittances was relatively undeveloped, demand for remittances services for most countries was probably low. When this industry grew, there was a growth in demand for its services, targeting other countries. This increase in demand has pushed prices for these specific markets up (even while other in markets, such as remittances to Mexico, the price has fallen).

(4) I’m not convinced by Salmon’s theory as to why the volume of remittances to countries with cheaper rates has fallen. He suggests that maybe, when prices are lower, firms are not as interested in providing their customers the service, so they discourage clients from sending remittances. But,

  • A firm lowers its price to remain competitive, and discouraging people from using that service is essentially a move in the opposite direction, and the firm forgoes an opportunity to profit.
  • Maybe sellers have been pushing clients towards pricier alternatives. But, short of fraud, one would have a hard time explaining why a customer will choose the more expensive option for the same end.
  • Factors which reduce supply should push up the price, not down.

Also, remember the rule of thumb: never reason from a price change. My guess is that the causes of a reduced volume of remittances to Mexico are on the demand-side. But, I wouldn’t be able to provide a theory, only speculation. Pew Research suggests that the U.S. recession, which impacted industries that historically employ large numbers of migrant workers (e.g. construction), is a major reason. But, according to the World Bank, migrant employment, in the U.S., has a faster rate of growth than native employment. I suppose that if remittances to Mexico were to continue falling during the next couple of years, it would be difficult to use the Great Recession as an explanation for the cause in the decline.

A Theory of Conquest: Well, A Quarter-Step Into Such a Theory

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Battle of Isus

This isn’t really a theory, but an idea of what such a theory would look like. It tries to explain why countries wage wars of conquest — or, perhaps, why countries with large militaries have a strong incentive to conquer —, and why large nations end up (trying to) conquer small neighbors.

Internal economies of scale: Economies of scale exist when increasing production reduces the long-run average total cost per unit of output. External economies of scale refer to an industry, such as when a growth in the number of firms reduces average total costs for each firm in the industry. Internal economies of scale deals with a firm specifically; that there are internal economies of scale does not mean that there are also external economies of scale. We’re interested in the internal variant. Why would they exist, and why would firms want to exploit them?

Before offering some reasons for why internal economies of scale exist in the specific context of this post, allow me to quickly review my firms want to exploit them. One word: profit. By reducing the long-run average total cost per unit of input, the firm (or, in our case, the country) can increase it’s net revenue. This is because the value of the output is growing at a faster rate than the costs of the inputs. A firm reaches its maximum size when there are constant returns to scale, or both rates (costs and revenue) are the same — too much production, and it starts suffering from diseconomies of scale.

To narrow our focus, let’s assume that a country’s costs of production are those necessary to build a military. The country earns revenue through tax collection. Where are the internal economies of scale? Militaries require large overhead, or fixed, costs. By increasing “output” — the amount of territory occupied —, countries can spread these fixed costs. It interests countries to invest heavily into a military, if it can afford it, because buying inputs in bulk can also reduce their average long-run unit cost. There may also be a learning curve, although this is more of a stretch. One example of how this could work is if a larger number of officers within a military implies more competition in the creation of ideas (strategies, tactics, managerial/organizational techniques, et cetera).

Economies of scale exist only if marginal costs are below long-run average total costs. Therefore, it pays for countries to heavily invest in militaries only if the cost, at the margin, of conquest are low enough. In environments where populations are heavily armed, this might not be the case. But, where occupation is relatively cheap — e.g. the target country has a poor army, or the local population is largely defenseless —, internal economies can be exploited. What this suggests is that this incentive for conquest exists in monopolistically competitive “markets,” especially if there are significant differences in the “market power” of countries.1 I’ll return to this in a bit.

Monopolistic competition and internal economies of scale actually go hand-in-hand, because the greater the latter are the smaller the amount of firms in a market. Suppose an industry as a whole produces x amount of widgets. If there are internal economies of scale, it is more efficient to have less firms producing more output per firm, to take advantage of average unit cost reductions. Therefore, if internal economies exist in the context of countries, then we’d expect a diminution in their number, rather than an increase. Further, if overhead costs are a major driving force, then we’d expect larger nations to gobble up their smaller rivals.

I have not conducted an exhaustive analysis of the evidence. But, consider tendencies in changes in the size of nations before year zero. Borders were volatile, but there was a general pattern of imperial growth. And, usually this growth was exhibited by states which had certain qualities, namely the original value of their means. Prior to the Bronze Age collapse — brought about, perhaps, as a result of a real shock —, the Near East and Balkans were controlled by strong, wealthy states which assimilated poorer, weaker neighbors: for example, Mycenae (in Greece and, later [as a result of conquest], Crete), the Hittites, Assyria, and Egypt. These empires grew until the marginal costs of conquest were equal to or greater than their long-run average unit costs, which was usually when further conquest meant going to war with each other. The Roman Republic and, later, the Roman Empire offer further evidence; they grew until the additional costs of further conquest were too high. When large empires collapsed, there was also a tendency for competitors — who were originally uncompetitive — to exploit the vacuum and the economies of scale.

Where the returns to scale were closer to being constant, country’s territorial sizes were much more limited. Take, for instance, classical Greece. Military power was relatively competitive, and Greek city-states tended to remain small — or, whatever internal economies there were, they were very limited. But, when countries outside of Greece were able to accumulate “market power,” Greek city-states usually fell prey to them, as was the case with the Macedonian conquest of Greece, and later the Roman conquest.

Why have country sizes become smaller over time (in some cases)? This seems to contradict my theory. My explanation is that external economies of scale in related industries tend reduce internal economies of scale over time. Those countries which want to exploit internal economies should be interested in pushing suppliers to exploit external economies. What opportunities for external economies of scale are there? Consider, for example, that the larger the number of suppliers (of military equipment, for example), the greater the scope for a fall in costs if firms can communicate with each other and share (or steal) ideas. If, say, military equipment producers require industry-specific inputs, a relatively large concentration of firms might make these inputs cheaper for each firm. External economies tend to increase the number of firms in a market, lowering the price of output — making it cheaper for other buyers to acquire means of defense. If others are better armed, the marginal costs of conquest rise.

As long as marginal costs to conquest are lower than the average unit cost, countries in a favorable position can exploit internal economies of scale. As long as these exist, the total number of countries will shrink. As defense becomes cheaper, increasing the marginal costs of conquest, internal economies disappear, and the number of countries will rise — large countries now suffer diseconomies, and they break apart.

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Notes:

  1. An interesting implication is the importance of the original distribution of means. The size and power of nations can follow a path-dependency if the original distribution allowed for variations in market power, allowing some countries to exploit economies of scale.

Babysitting Co-Op Crises and Money

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David Gordon discusses Krugman’s use of the babysitting co-op story as an explanation for Keynesian stimulus policies. In his post, Gordon mentions Tim Harford’s critique of Krugman’s pedagogical model. Harford’s criticism teaches us an important message, but I want to distinguish between what it tells us and what it doesn’t.

Some of you who have never read Krugman (2009; 2012), or the original Sweeney and Sweeney (1977) article (ungated), might have no idea about what Gordon, Harford, and I are going on about. The story involves the Capitol Hill Babysitting Cooperative (CHBC), which is an organization that provides babysitting services in a very specific way. Basically, new members are given a certain amount of scrip, worth 20 hours of babysitting; these members are asked to return all 20 hours when they decide to end their membership. This scrip is used as money, where those who demand the service pay those who supply it in scrip. To earn more, then, — for future babysitting services, or to repay your debt to the CHBC —, a member has to supply babysitting services.

On average, members thought that they should hold more scrip before demanding services. Those who increased their demand for scrip would work the jobs they could. But, the increase in demand called for more scrip than existed, causing a shortage. Members, on average, rather babysit than go out, but when nobody goes out there is no demand for babysitting services. Since the price of scrip is fixed, a falling “price level” can’t clear the market for babysitting. If the scrip were allowed to appreciate in value, it would take less scrip to fulfill the average person’s demand for babysitting hour IOUs, and excess notes would be exchanged to those who want them, in return for babysitting services. The solution, instead, is to increase the supply of money, or, in this case, scrip.

Harford, however, tells us that in the real story, the monetarist solution eventually led to an oversupply of scrip. This is confirmed by Wikipedia. The CHBC supplied too much new scrip, members sought to spend excess scrip on babysitting, but since now the average member wanted to go out, there was a shortage of babysitters (rather than a surplus, as was the case originally). One way to interpret this is to reject the babysitting co-op story altogether. I don’t think this is the right approach; rather, the whole story teaches us a lesson on monopolized management of the money supply, but it leaves Krugman’s actual point largely unscathed.

Suppose, for the sake of argument only, that the CHBC knows exactly how much scrip to introduce into its babysitting economy. Assume that it distributes this new scrip at random, so that some will have excess holdings. Those with more scrip than they want will spend it, demanding babysitter services. This allows those with inadequate scrip balances to offer their services and earn babysitting money in return — it allows mutually beneficial trade to take place, whereas originally a rigid price disallowed them (which is why we say that demand shortages lead to output gaps). Thus, the monetary solution is the right one.

The CHBC story does warn of the problems of an issuer that is not disciplined by the market — rather, the issuer and the market(s) it helps coordinate are disciplined once the damage has been done. We want a competitive scrip market, where those who over- or under-issue are disciplined (through reflux or foregone profit, respectively) before the market breaks down, coordinating the supply and demand of scrip (money). Moving from the analogy to the real world, this is why competitive free banking is preferable to central banking.

Central banks are not very good at responding to money shortages and judging excess supply, causing volatility and distortions. A competitive private banking system, however, can achieve better results, because individual banks’ constraints on issuing money are much tighter — excess notes circulate back to the issuer, putting pressure on their assets, and interest on deposits limits their ability to attract them (to the margin where it becomes unprofitable). When the demand for money rises and velocity falls, the pressure on banks’ assets falls and they can issue notes. When the demand for money falls, or after an issue of excess notes, the pressure on their assets rises and they are forced to reduce the number of outstanding liabilities. These pressures are much more muted in the current system, where there are no competing notes (and customers can’t discriminate between them), and the ultimate issuer is the central bank.

The CHBC story illustrates the problem of monetary disequilibrium very well. It also shows why monopolizing the currency system can be so damaging to the economy. Unfortunately, most probably only appreciate one of the two lessons, but never both.