Tag Archives: United States

What Just Happened?

I have tried in the past, with some success, to explain how economies work with the help of The Model Village, so let me try again.  This time I will try to explain how the American Economy got into the situation it is in. These, by the way, are the fundamental reasons that I will be explaining. There are many, equally valid and mutually consistent ways of looking at the situation. I will be explaining just one aspect of it, which I hope, cuts to the heart of the matter.
So, in The Model Village, there was a huge Zamindari. By huge, I mean really huge. It was a mini-economy by itself. Many crops grew on its lands, it had cattle, goats and chicken. It also had small factories that processed the produce of its land into finished goods that could be sold outside.

Of course, this Zamindari, while enormously productive, did not produce everything it needed. What it did not, it would buy from the traders of The Model Village. And while the Zamindari was extremely rich, it still needed credit to smooth out its consumption cycle – it needed to borrow early during the planting cycle and repay when the harvest came in. Also, the Zamindar was focused on making improvements in his lands and factories, and he needed credit for that.

The way the Zamindari got credit was to issue IOUs in return for whatever they needed, and those IOUs could later be redeemed for fixed quantities of wheat, rice, etc. (And oh – by the way – this was a primitive model village, so no one had bothered to issue currency yet. They were still using barter.) But the IOUs suited the traders just fine. They knew that they’d get something of value later in return for those IOUs, so they applied the time value of money to calculate how much they could offer in return now. The Zamindari was extremely well-run, so its IOU was seen as extremely stable. It would soon perform the function of money. People in The Model Village traded Zamindari IOUs among themselves, their savings consisted of these IOUs, and so on.
After a time, the Zamindar announced a change. He said that these IOUs would no longer be redeemable against fixed quantities of wheat or rice. Instead, the Zamindari would buy whatever it wanted against the IOUs, and when it came to redeeming the IOUs, he’d auction the produce of his estate, and the price, in IOUs, would be determined by the results of the auction. When asked why he was introducing this change, the Zamindar gave an honest answer – he needed the flexibility to print IOUs to finance his estate’s expansion, and he found the constant need to worry about making sure that the IOUs were good constraining. But surely, the traders did not need to worry about? In any case, the IOUs were backed by the good credit of the Zamindari, and as long as the Zamindari’s lands were fertile and its people hardworking,  there was no need to worry – after all, if the Zamindari was too reckless in issuing IOUs,  it would not be in a position to buy what it needed next time round.

The traders saw the logic of this – and in any case, they had no choice. The Zamindari was the biggest deal in The Model Village, and not trading with it was not an option.

Things went fine for a while. The Zamindari continued to be well-managed, and the Zamindar was prudent in issuing IOUs. The IOUs continued to strengthen their position as the de facto currency of The Model Village. Its value began to be determined less by what the Zamindari could pay for it and more by what other traders would. Traders in turn began to measure their success by the number of IOUs they could accumulate.  The rest of The Model Village got prosperous and began to produce a lot of stuff, much of which was sold to the Zamindari in return for IOUs.

The prosperity of The Model Village grew so much that very few took notice of the fact that the output of the Zamindari was in fact slowing down. The old Zamindar had died and his son had taken over. The new Zamindar was, compared to his father, a reckless man, and he had not failed to notice that the traders’ willingness to accept his IOUs was rather out of proportion to his ability to repay. His lands were turning infertile and his workers older, and he needed to keep issuing IOUs to keep up the expenses of his Zamindari, and so he did.

From the point of view of the traders, they were behaving prudently.   While they intellectually understood the views of those who pointed out that this was a classic bubble, the fact was that they were working hard, making sales, making money (they no longer thought of it as IOUs) and saving. Everything they were doing was exactly what their wise men had told them to do. How could that be wrong?

But of course, things were bound to go wrong. Very, very wrong. It was just a question of how.

By now, most of you would have understood the elements of the allegory. The Zamindari is the United States of America.  The IOUs are dollars. The Zamindar’s decision to cease setting the value of his IOUs is analogous to Nixon’s decision to take the dollar off the gold standard. The traders are those countries who, over the past few decades, have run an export surplus with the US – Japan, China, India, to name a few.

You will notice that it is rather difficult to fix the blame here. Was going off the Gold standard the mistake? Perhaps, but it also presents advantages – and which other country is on the Gold Standard? Was the Zamindar too reckless? Well yes, he was, but not too much. He issued the IOUs because there were always greater fools to buy them. Were the traders at fault? Yes, but it isn’t easy to notice at first glance, because, after all, they are doing what they should be doing – selling stuff, making “money” and saving it – the problem of course is that they shouldn’t have treated those IOUs as money.

You will also notice that this edition of The Model Village was not particularly difficult to understand. It is  not even very controversial. In many bubbles, you will find many sensible people disagreeing over whether  we are in fact in a bubble – if there weren’t such people, we wouldn’t have bubbles. But you won’t find that to be the case here. If you stop two mainstream economists who are vehemently arguing over the Debt ceiling debate and ask them if they, in essence, agree that the parable of the Zamindari is a valid model of the US economy, they will agree before moving on to argue over the specifics of how long  the bubble will last, whether the bubble will burst or slowly lose steam and how to deflate it. And yet, we ended up here.

I Wasn’t Talking to You

The dark lord says:

The typical arguments are made by the right too. If the economy is going good “see, the deregulation has brought about unprecedented wealth. How can you propose more regulation?”

When the economy goes bad, we get the answer “see, the crisis is brought about due to regulation in the housing mortgage market. How can you propose more regulation?”

Yes, the libertarian right makes this argument, but there is a consistency in it. We believe that most regulations do harm, and that a lightly regulated economy works best.

If the socialist left made the counter-argument, that too would be internally consistent. If you really wanted to regulate the economy all the way to the Soviet Union, you could justifiably claim that both the US and India are variants of the same system. But in my post, I wasn’t arguing with the socialist left – I don’t need to, as history has already answered them.

My argument is with those who say that “we need a free market with some regulations, but that doesn’t mean that we should be socialist”. If you hold that belief, I would expect you to believe that there is some point at which additional regulations do more harm than good, so you’d support some regulations and oppose others. But what I notice is that for supporters of regulation, the right amount of regulation is always “A little more than we have now”.

We Always Need More Regulations

As Ajay Shah points out, we don’t just regulate our financial system, we micro-manage it. When things are going well in the US, and we make the case for deregulation, we get the answer: “See, even in the US, we don’t have a completely free market system. Even they have regulations. How can you propose that we junk ours?”

When things go wrong in the US, we get the answer: “See what happened to the US because they followed a free market system? How can you propose that we junk our regulations? We need more.”

This bias ensures that we will always follow suit when the US moves left, never when it moves to the right.

Presidential and Parliamentary Systems

Rishi wants to know how I can claim that the Presidential System underdelivers change, and Ritwik angrily objects to my claim that in the Parliamentary System, the Prime Minister can handpick legislators. Both of them have missed an important qualifier: popular.

Change is rare in any mature democracy. This is as it should be. Obviously, I prefer change in the direction of less government and limited powers and others may prefer otherwise, but whatever the direction of your preferred change, I think that we should be wary of a system where a Chief Executive can, on the basis of just one election, bring about fundamental and drastic change in the structure of the polity.

Continue reading

American Incentives

It is too early  for me to claim vindication for this post.  Given the high expectations that President Obama came to power with, and the enormity of the task before him, it was inevitable that his first 100 days would disappoint. But I want to make a point about he American political system that many people do not appreciate. The point is that:

The American political system tends to overpromise, but underdeliver change.

Why? Because of the preponderance of  direct elections. Presidential candidates have to win many direct elections before they come to power.  To win direct elections, you have to establish yourself as your own man even if you are in the same party as the incumbent.  In other democracies, handpicked successors tend to gain the organizational backing of the ruling party. In the US, because of the unique organization of parties, there is very little to gain. Even if the incumbent was hugely popular, 8 years of him would have wearied the voters, and his successor needs to be wary of promising 4 more years of the same.  George W Bush was, to put it mildly, not very popular in November 2008, which is why you had both candidates promising change, but similar dynamics would have applied even in 1988, when George Bush was running to succeed Reagan.

So why would it be difficult to deliver change? Because of direct elections again. Both the President and Congressmen are directly elected. Neither is beholden to  the other branch. In a Parliamentary system, a popular Prime Minister would be able to handpick his legislators – in fact, he would have to, because otherwise there would be a chance that he would get dislodged despite his popularity. In the US presidential system, there is

a) structurally no way for  a President to pick his legislators

b) no need for a President to do the same and

c) a risk if he attempted it, because the unpopularity of some legislators may drag him down.

For these reasons, a President, even if he is elected on a mandate for change, will find it difficult to push his legislative agenda through.

None of these explains Obama’s failure so far. That is another story.

Shameful Piece by the Economist

Five years ago, the Economist was cheering not only the invasion of Afghanistan, but also that of Iraq. Now, when it comes to India’s response to the Mumbai terror attacks, the Economist has declared  that we should not emulate the US “mistakes” like… the invasion of Afghanistan.  Worse still, now it turns out that the US incursions into Pakistan – the threat of which is the only thing that is keeping Pakistan in check, are also a bad idea.