Asymmetrical Information

Glad to see you're feeling better!!! No comment to make on this post otherwise

Governments sometimes can pick winners, and private investors sometimes can pick losers. But over time, private investors are much better at telling the difference. That is, over time, private investors will pull money out of bad bets and put their money into better ones. The government does not do so. The best example of this is Japan, where the state-led banking system is still heavily invested in companies that should have been interred over a decade ago.

And by the way, what is this mysterious "job" of yours? I thought you promised to reveal more about it.

True dollarization -- where the currency used is the USD -- has significantly different effects than Argentine-style false dollarization.

Since the government held the dollars and merely promised pesos would be redeeemable, it could spend the reserves twice -- first as a peso promised to be worth a dollar, then by spending the actual dollar and repudiating the promise. If they had used actual dollars instead of pesos and a large reserve, they wouldn't have had a pile of dollars sitting around to be looted.

The government itself would have still had to default on its loans, and the fiscal crisis would have been worse. But the people and companies themselves would have still had fully-valued dollars useful in international trade, softening the economic crisis.

Argentina's trouble wasn't that it was "dollarized", but that it wasn't -- the pesos in the end were promissory notes to its people that it defaulted on as surely as it defaulted on its other debts.

I can't really argue that states make lousy investment decisions too, but the libertarian argument that "the more the state intervenes the worse things get" seems like the kind of thing that's just an article of faith, not something actually backed up by anything in the real world.

I know you won't agree and I guess there's no point in saying this, but the general success of modern fiscal controls in general and the Fed in particular in smoothing out the business cycle in the post-WWII era strikes as a spectacular success of government intervention.

An article of faith? Kevin, go look at the Economist's index of freedom -- the growth rates form a pretty nice curve. Europe's growth rates are stalled permanently below those of the US -- except for Ireland, which achieved a lot of its growth with a 10% corporate income tax. You've selected a couple instances where you think controls work well. You're editing out all the places where it didn't work -- the S&L scandals, for example, made possible by FSLIC, the stagflation and ugly recession brought on by the Keynsian monetary policy of the 60's/70's, the ugly end of the Bretton Woods system -- and that's just the US, where no one's advocating currency controls. In Europe, it's certainly not "an article of faith" that the structural rigidities imposed on the labor market, for example, are a serious drag on economic growth -- even liberal Paul Krugman subscribes to that notion. And in the countries where currency controls are being recommended, there is a long history of horrific effects from government interventions, including currency controls.

My problem with liberal theorists, such as Krugman and DeLong, is that they generally seem to make their recommendations as if they're going to be implemented by God, rather than the corrupt, inept regime that got the country into the mess the currency controls are supposed to get it out of. Krugman's pieces on Japan seemed to assume that the LDP would simply vanish and be replaced by someone competent.

“I can't really argue that states make lousy investment decisions too, but the libertarian argument that "the more the state intervenes the worse things get" seems like the kind of thing that's just an article of faith, not something actually backed up by anything in the real world.”

The politicians of New York built the very successful Erie Canal. I’m sure that one can also point to other beneficial government projects. Thus, it’s more accurate to instead assert “the more the state intervenes, the more likely that things will get worse.” The odds increase significantly that the government will fail more often than the private sector. Why is this a fairly established dogma? The reason is because there is far more accountability in the private sector. One thinks twice before investing their own money. A politician is essentially spending other peoples’ money. It’s really that simple. There is no reason to overcomplicate the obvious.

Another reason governments should stay out of the business of picking winners and losers the the effect such governmental activity has on politics. The more control over the economy government has, the more it matters who is elected. The more it matters who is elected, the more likely people will try to influence the outcome (lawfully or otherwise). Want to get money out of politics? First, get government out of controling the economy.

Random thoughts:

1) I don't read lefty bloggers because so many of them love to start their posts with a string of prepositional phrases. Why is that? I visit Yglesias and it's the middle of the sentence before I know what he's talking about. The main reason I love Reynolds is his subject/verb constructions. Clarity saves time. Saving time is good.

2) The value of the Erie Canal shouldn't be judged on a pass/fail basis as beneficial or not, but as better or worse than whatever the money would have otherwise been spent on.

3) If one is a fan of the Austrian or "hangover" theory of the business cycle, then it was indeed the government central bank itself that was behind "the dissipation of a trillion dollars in the space of a couple of years on valueless dotcoms and redundant optical fibre". Malinvestments, they calls 'em. Not even "the world's most sophisticated financial markets" can accurately judge market situations if price signals keep getting fudged by Greenspan et. al.

4) David Walser's quite right.

The dot.com market was insane. No one thought that profits were important and every company had to show a 300% growth rate. A huge amount of programming went into the dot.coms most of which is now useless. Even the companies who did not have anything to do with the internet went nuts. The internet fever was responsible for Enron, Worldcom et al. going out of control.

The free market is always logical in the long run. It’s logic was proven again when almost all dot.coms went bust, the crooks were found out and sanity returned to the investment markets.

If government was involved, it would have tried to keep all of those companies alive.

As an example of a *government* project which misallocated resources, it's instructive to consider Stalin's White Sea Canal project. It's been estimated that 100,000 people died during the construction of this canal...and, after it was finally done, it turned out to have little economic significance.

"Argentina was in a moderately bad multi-year recession because of Brazil's beggar-thy-neighbor devaluation. But governments shouldn't borrow so much money that they are unable to meet their financial obligations if they have a moderately bad multi-year recession, since such events are hardly unheard of. It was the huge debt, and the deficits, that made creditors reluctant to renew their outstanding loans, forcing Argentina to both default and devalue. Currency pegs have problems, certainly, but blaming all Argentina's economic and fiscal woes on its currency, rather than the massive supply-side problems introduced by government regulatory action, cronyism, and state ownership of industrial assets; and the profligate, uncontrollable government spending; is like blaming the Great Depression on Herbert Hoover's tailor."

The reason various people have been toying with the concept that short-run currency controls/big-time devaluations might be necessary is that it's apparently impossible for a third-world country (and possibly first-world countries) with any level of outside debt to insure themselves against a feedback loss of confidence scenario; there was absolutely no good reason for the asian panics of the 1990s.

That outside debt is a another word for "foreign investment," by the way.

Three points:

1. Overinvestment booms like that of the dot com era come along far more often than "once every sixty years"; there was one in the "Go-Go Years" of the 1960s, to simply pick an example off the top of my head.

2. Japan's stimulus programmes have demonstrably not been "ineffective", as proved by the fact that Japan's GDP grew by 1% compound during the 1990s.

3. The World Bank's loan book is not bad at all, partly because of their having taken equity investments in South Korea at pre-pre-pre-money prices (Lucky Goldstar, anyone?); the World Bank's main problem these days is a shortage of projects to deploy its capital in. The IMF has also been a very shrewd user of its capital, unless you can think of anyone else buying Mexican bonds in 1994.

Other than that, I thought that this article was poorly researched and much longer on glib slippery-slope assertions than actual argument.

I saw Greenspan speak a few months ago. He was catching plenty of flack for not cooling the bubble. He deferred the questions for a while, then finally:

"Look. If the question is do I know how to prevent bubbles, the answer is yes.

When private investors back foolish investments, they lose their own money. When governments do, they lose money that has been forcibly taken from others. I know that liberals see no moral difference here, but some people think it important.

Government performance would have to be far, far better than the market to justify intervention.

D^2 -- so spending 100% of GDP to generate 1% of GDP is an effective program?

We've certainly had speculative bubbles in between the Great Depression and now. But we haven't had anything on the scale of the bubbles of the late twenties or nineties, which was the point. The speculative booms between were smaller, shorter in duration, and far more limited in participation. Since the collapsing wealth effect seems to be a major component of the damage, the distinction is non-trivial.

As for Argentina, correct me if I'm wrong, but the problem isn't capital flight -- it's refusal to inject new money, which the government desperately needs to prop up its unsustainable policies. I fail to see how currency controls would help. As I said, there are theoretical places where currency controls seem to work. But since we only have one country where they appear to have done so, it's a little early to bet the farm on it. And we know of numerous places where currency controls fail badly, so we'll have to wait to see whether governments can actually implement the good sort of controls reliably, and then whether they work. My money's against it.

What D^2 was saying was that Japan had real GDP growth of about 1% a year through the 1990s not that real GDP grew by 1% over the entire 90s.

By the way I was very curious about the "Japan increased its government spending by 100% during the 90s" stat. The Bank of Japan data you can get online shows that from 1991-2002

nominal GDP growth of 0.85% per year
real GDP growth of 1.18% per year
government spending growth of 1.53% a year

You probably used some data that the BOJ is not classifying under government expenditures (perhaps capital expenditures?). Could you please let me know where I can get that info.

I didn't say their spending grew 100% -- their debt has ballooned to 160% of GDP.

Is it really the case that the private banking system did a marvelous job of managing the money supply in the US prior to 1913? My recall of the relevant history suggests otherwise.

Is it also the case that countries faced with financial crises that, unlike Malaysia, did not impose currency controls, came through just fine?

Your claim that
"I didn't say their spending grew 100% -- theirdebt has ballooned to 160% of GDP."

seems to be contradicted by the main post in which you state

"This was, after all, the decade when Japan spent over 100% of its GDP on redundant construction projects and similarly ineffective stimulus"

and your response to D^2 in which you said

"spending 100% of GDP to generate 1% of GDP is an effective program?"

What am I missing here?

Ah, I think I understand now! You are saying that total government spending over those 10 years adds up to more than 100% of GDP therefore we should get more bang for the buck than 1% growth.

But that seems to be a pretty tough way of doing calculations. I mean in the U.S. private consumption is about 65% of GDP, so over 10 years consumers spend about 650% of GDP and only achieve about a 3-4% annual growth rate of GDP. Yet one would not make the claim that private individuals wastefully spend money.

I think I agree with the idea that Japan's spending should have been accompanied by a more thorough economic restructuring. However, I also agree with D^2 that in the absence of monetary policy, being able to generate 1% GDP growth and stave off economic collapse through fiscal policy is a reasonable accomplishment

Apropos of nothing, the constant insistence that Japan is stuck in a permanent near-recession because they refuse to "restructure" their economy is nearing absurdity. How the hell did that inefficient economy grow so much from '60 to '90?

"As for Argentina, correct me if I'm wrong, but the problem isn't capital flight -- it's refusal to inject new money, which the government desperately needs to prop up its unsustainable policies. I fail to see how currency controls would help. As I said, there are theoretical places where currency controls seem to work. But since we only have one country where they appear to have done so, it's a little early to bet the farm on it. And we know of numerous places where currency controls fail badly, so we'll have to wait to see whether governments can actually implement the good sort of controls reliably, and then whether they work. My money's against it."

Krugman:

"Now, Argentina does, by law (the so-called 'convertibility law',) have an undeniably strong currency. A peso is worth a U.S. dollar, and that promise is made credible by the legal requirement that every peso in circulation be backed by a dollar's worth of foreign exchange reserves. In other words, short of actually abandoning its own currency in favor of the U.S. dollar--a measure that has been discussed quite a bit lately--Argentina has done everything possible to make that currency credible and secure. This 'currency board' system was introduced in 1991, when hyperinflation was a recent memory and most people expected it to return in due course, and you can make a reasonable case that Argentina should stick with its currency board for some time to come. (Domingo Cavallo, who as finance minister was the architect of the board, suggested a few months back that it should endure for a decade or so.) But you can no longer brush off the argument that the system is a sort of economic straitjacket, one that is becoming increasingly onerous.

The problem, you see, is that the same rules that prevent Argentina from printing money for bad reasons--to pay for populist schemes or foolish wars--also prevent it from printing money for good reasons such as fighting recessions or rescuing the financial system. Argentina came very close to financial collapse in 1995 when it turned out that the convertibility law left no leeway to rush cash to troubled banks. It has since established various safety nets to prevent a repeat of that crisis, but some observers doubt whether those nets are really strong enough. And now the country faces what is basically a garden-variety recession, the sort of thing that happens to every economy now and then--except that unlike the United States, or even a similar-sized First World country such as Australia, it cannot try to cushion the slump by lowering interest rates and pushing more money into the system.

Now, these problems with a rigidly fixed exchange rate are not news. But for a while, currency-board enthusiasts managed to convince themselves that they weren't significant. They argued that as long as governments themselves followed stable policies--and as long as the economy was sufficiently 'flexible' (the all-purpose answer to economic difficulties)--there would be few serious recessions.

But it turns out that history does not stop just because the currency is stable. And faced with a politically inconvenient recession, the Peronists find that there is nothing they can do. They cannot print money. They cannot even borrow money for some employment-generating public spending, because fiscal indiscipline would undermine the peso's hard-won credibility. You can understand why Duhalde might be tempted to appeal to a higher authority."

For those arguing the government should be more active in preventing bubbles, let's take a closer look at another example of a large market bubble: the real estate bubble of the late 1980s which led to the S&L crisis. The real estate bubble was almost entirely created by government action -- the early '80s tax cuts created huge incentives to invest in real estate and changes in the banking laws made it far easier for the S&Ls to fund such projects. Money flowed into commercial real estate and by 1986 many cities had rising vacancy levels.

Government "helped" by changing the tax law in 1986. The changes not only removed the incentives to invest in real estate, Congress choose to add disincentives to real estate investment. Overnight, the market value of commercial real estate dropped 25% to 50% (and many "good loans" became "bad loans", etc.).

Even the 1990s stock market bubble was made worse by the government's helping hand. Investors preferred receive their returns as capital gains instead of dividends (because of the tax law) and the SEC and Congress pressured the accounting industry to "modernize" its procedures to allow companies, such as Enron, to report their assets on a "fair value" instead of "historical cost" basis.

None of this is to say government does not have a legitimate role to play. I think the Fed is generally a good idea and government should be there to help enforce contracts and prevent (or punish) fraud. On the other hand, it seems government tends to create problems (in the case of the real estate bubble) or make them worse (in the case of the '90s stock market bubble). Given that an assertive government creates an incentive for corruption and that even good intentions frequently lead to poor results, I'd prefer a lot less help from the government in the economy than we are currently getting.

Jason, statism works best when starting from a low base, in an environment of revolutionary upheaval, whether it be in post Czarist Russia, or post WWII Japan. As the factions that benefit from statism mature, a society ossifies and what was once revolutionary becomes reactionary, to the detriment of society as a whole. Japan is now the grips of reactionary forces unwilling to abandon what worked in 1967, but no longer does, because statism eventually ALWAYS deteriorates into reactionary failure, since the factions that control coercive state power will fight to the last man any attempt to change the rules that have benefited them. Ironically, an uber-statist like Mao recognized this phenomena, but then tried to combat it by instituting permanent revolution via state organs, with the predictable murderous results.

Markets, for all their faults, and the attempts by powerful factions to rig them (ususally by gaining access to state power, of course) are the best innoculative agents to deploy against the trend to reactionary sclerosis that every society is subject to. Some exercise of state power is required, of course, to allow people to interact with the security and confidence that is a component of propserity, and how much state power is needed to create that environment is subject to much legitimate debate. It must be recognized, however, that every act of coercion carries with it a high price, in that it forcloses the ability of individuals to opt out of arrangements and transactions that they find unsatisfactory, and to seek arrangements and transactions that they prefer, which is essential to fostering the revolutionary dynamism upon which prosperity also depends.

“2) The value of the Erie Canal shouldn't be judged on a pass/fail basis as beneficial or not, but as better or worse than whatever the money would have otherwise been spent on.”

“As an example of a *government* project which misallocated resources, it's instructive to consider Stalin's White Sea Canal project. It's been estimated that 100,000 people died during the construction of this canal...and, after it was finally done, it turned out to have little economic significance.”

The two above posts remind me once again why I’m not an absolutist Libertarian. There have have been successful government projects that have greatly benefitted the overall economy. Dragging in horror stories about the former Soviet Union and nitpicking the Erie Canal does not change this unimpeachable fact. Moreover, my previously cited example of the Erie Canal has been replicated many times over by our government’s highway systems. I cannot in any way, shape, or form, imagine how the private sector could have pulled this off.

I have absolutely no problem whatsoever in warning about the public sector’s wastefulness and non-accountability. The private sector does a far better job in most instances. I even strongly advocate for government entities such as the post office to be turned over to private entrepreneurs. Still, I refuse to push my arguments to the point of absurdity.

Just a note that the White Sea canal project probably cost closer to 25,000 lives (the 100,000 fig is Solzhenitsyn's, which is probably inflated).

Okay, JT, only 25,000 lives. Now the canal seems worthwhile.

It's funny how Kevin gets just about all of it right except the most important part. Speculative markets always have a potential for becoming bubbles for one very important reason: ignorance. When the majority of the people investing are ignorant of even the gross details of what they're investing in things can spiral out of control rapidly. Even many sophisticated Venture Capilists didn't have a good understanding of even the most basic aspects of the telecom or dot-com industry, and the unsophisticated ones saw the dollars being made by others and followed along blindly. The solution is not adding another layer of uninformed people into the process. The solution is to create more knowledgeable investors. And the best way to do that is the same ol' Darwinian process of putting idiots in the poor house and giving smart folks more money (in other words, investors who do so foolishly go broke and lose their power to invest, investors who do so intelligently grow their money and increase their power to invest) combined with the equally powerful motivation of investors protecting their own money.

The only serious danger of such speculative bubbles is when they grow so large they have the potential to throw the economy into depression or collapse. Bringin governments into things and addings elements of socialism actually ups the ante and makes things worse by putting more on the line, not better. If you think government involvement leads to saner spending then you really need a history lesson bad.

Spelling -5: teh = the.

Apropos of nothing, the constant insistence that Japan is stuck in a permanent near-recession because they refuse to "restructure" their economy is nearing absurdity. How the hell did that inefficient economy grow so much from '60 to '90?

Through a complex state-market dynamic that did not emphasize individual entrepreneurship, and whose efficiency was enhanced by being able to pass off labor-intensive industries, and later low-level manufacturing, to Korea once the Japanese market was ready to move to the next level. Needless to say this sort of dynamic couldn't continue in the same vein once Japan achieved a diversified economy, and once Korea was mostly developed.

See also: Developmental State theory, then read Will Allen's post on statism.

It's interesting to note that, among other things, Japan has more recently begun taking a greater interest in promoting the concept of the individual businessman. However if you haven't been raised with that concept, it can take a while to establish.

“Through a complex state-market dynamic that did not emphasize individual entrepreneurship, and whose efficiency was enhanced by being able to pass off labor-intensive industries, and later low-level manufacturing, to Korea once the Japanese market was ready to move to the next level. Needless to say this sort of dynamic couldn't continue in the same vein once Japan achieved a diversified economy, and once Korea was mostly developed.”

I have no doubt that government spending can sometimes get the economic ball rolling in the right direction. It did so regarding the Eric Canal project and most assuredly there are other examples in both the United States and Japan that can be highlighted. Politicians, however, rarely, if ever, know when to stop with the patronage. The crap inevitably hits the fan when the nascent industry must abandon its training wheels and be allowed to succeed or fail on its own. Sadly, by that time, the managers and employees have learned how to play the political game for all its worth. Protectionist measures are the result---and thus the gods of creative destruction are not permitted to carry out their duties.

Moreover, my previously cited example of the Erie Canal has been replicated many times over by our government’s highway systems. I cannot in any way, shape, or form, imagine how the private sector could have pulled this off.

You can't imagine how the private sector could build a road? Come on down here and drive on the Dulles Greenway. Privately built, privately owned, privately operated, maintenance funded by tolls.

Excellent discussion Jane. Intelligent, thoughtful debate of this quality is the rare exception in blog comments. Congratulations. Surely this reflects your own openness, thoughtfulness and intelligence.

I have a very contrarian opinion to add. I have done a broad survey of asset bubbles over the past two hundred years. There is a particular type of bubble that recurs regularly - the new technology infrastructure bubble. It seems that bubbles are the preferred means of building out general purpose technology infrastructure. Railroads, canals, radio, electricity, sattelites all had associated bubbles. If one stands back and looks at the growth of Internet infrastructure and technology from 1996 - 2001, a case can be made that the bubble was, systemically, a neccesary and healthy economic event.

Economist Carlota Perez does the best analysis on this phenomenon in her book: Technology Revolutions and Financial Capital.

As for private vs. public investment, Jane Jacobs nailed the issue is 'Systems of Survival' with her distinction between the Commercial Moral Syndrome and the Gaurdian Moral Syndrome. Corruption is always the result of asking one system to act like the other system. She manages to make the distinction without dissing either role.

Nice point, Mr. Philip. I always get uneasy when people declaim "government should be run like a business". The last thing I want is a profit seeking institution that no longer has to please me individually in order to obtain my property, because it can obtain violently coercive power through others' consent, and then force me to submit.

“You can't imagine how the private sector could build a road? Come on down here and drive on the Dulles Greenway. Privately built, privately owned, privately operated, maintenance funded by tolls.”

And I hope that this is the wave of the future. Nonetheless, there is no realistic way that this could have occurred in the distant past. Please note that I also previously stated that the government had to start off our national post office. Today, I adamantly contend that the U.S. Postal service should be handed over to the private sector.

"Moreover, my previously cited example of the Erie Canal has been replicated many times over by our government’s highway systems. I cannot in any way, shape, or form, imagine how the private sector could have pulled this off."

In the absence of government highways and draconian aircraft rules, the private sector could have responded with better and cheaper aircraft.

"Is it really the case that the private banking system did a marvelous job of managing the money supply in the US prior to 1913? My recall of the
relevant history suggests otherwise."

It did a damn sight better before 1913 than it did in 1929.

“In the absence of government highways and draconian aircraft rules, the private sector could have responded with better and cheaper aircraft.”

Are you possibly suggesting that everybody should have an airplane in their garage instead of a car? If so, I’m not buying this at all. It would result in a daily logistical nightmare. Cars are far more practical for driving a few miles from our house. Alas, my garage would also have to be a lot bigger!

An interesting implication of an all private road system is that rural America would completely disappear. Unless you think there's a market incentive to building thousand-mile roads to 100 people.....

Jason,

I don't think that rural America would disappear. I will cede that I think rural road quality would degrade, with respect to the current state. Much of rural America does in fact have private roads. If enough people need a road, they'll build it themselves.

As a Chicago grad, I have a hard time seeing why the rest of the country should subsidize people to live somewhere that's uneconomical without the subsidy.

Jason McCullough should leave the small towns out of his argument. He is on far safer ground limiting his comments to our large interstate highways. I cannot imagine a way that the private sector alone could have built these roads.

Said people tend to find that the property taxes are a lot lower in such regions. Also, until a few decades ago, those people tended to produce our food supply.

CARRUMBA!

Jane Jacobs has written five books I didn't know about!

Thanks for mentioning one of them, Mr. Philp. Now, when will I get time to read them?

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