1.  Unlike Germany, it now has a legal minimum wage.  Plans to enact legislation limiting working hours.

2.  Much of the property market is controlled by the government

3.  Government bought lots of shares of stock to boost economy during recession.  Still owns many shares.

4. Introduced deposit insurance in 2008.

5.  Stopped accepting foreign doctors in 1997 (unless locally-certified.)

6.  Established anti-trust laws.  As elsewhere, policymakers ignore government-connected monopolies and go after purely private firms.

7.  Government first regulated the 4 stock and derivative exchanges, then forced a merger, then became largest shareholder, then prevented new entrants.

8.  Unlike the Nordic countries, the government is taking over formerly private infrastructure such as tunnels.  Huge new projects are now built and run by the government.

9.  The government is increasingly involved in “industrial policies” despite the ineffectiveness and corruption of its initial forays into planning.

Obviously I’m describing what is almost universally viewed as the most laissez-faire country entity on Earth—Hong Kong.

A few comments:

That’s why I wasn’t impressed a few months back by arguments that Adam Smith did not favor laissez-faire, merely because he favored a few government interventions.  It’s all relative. 

Commenters frequently question my assertion that Singapore is the second most neoliberal economy—pointing to all sorts of government intervention.  If Hong Kong is number one despite all the intervention listed above, you can imagine how little laissez-faire is required to come in second.   

I’m actually not too concerned about these actions, although I agree with The Economist, which is mostly skeptical of how well the new interventions will work.  Indeed they are even critical of a new food labeling law that I didn’t mention.  But this reflects the increasingly democratic nature of Hong Kong.  In my research on neoliberalism and culture, Hong Kong was somewhat of an outlier—much more free market-oriented than you’d expect given it’s not particularly civic-minded culture.  So it’s merely reverting to its natural position.  And there is a lot of ruin in a nation.  Hong Kong will probably continue to come in number one in the various free market rankings for quite some time.  But I expect it to eventually be overtaken by Denmark.

In the long run the challenge is to change culture so that governments respond to the general interest, not special interest.  And the other challenge is to change economic worldviews so that well-meaning government officials (no, not always an oxymoron) understand that free markets are more effective at promoting the general welfare than most people currently believe.  I’m not going to change cultures, but I’m trying to change worldviews.

Under Mao Zedong China had a communist system so rigid it made the Soviet Union seem positively capitalist by comparison.  Since then, the Chinese government allowed farmers to control their own plots of land, allowed private rural enterprises, then welcomed $100s of billions in private foreign investment, then allowed private urban entrepreneurs, then privatized urban dwellings, then privatized many state-owned enterprises, and then set up two stock markets.  That’s a lot of capitalism.  Yet it’s also true that the Chinese state still dominates many parts of the economy, owns all the land, and has lots of controls that make it far less market-oriented than a place like Hong Kong. 

Let’s suppose neoliberalism works.  What should have happened as a result of all those Chinese reforms.  Here are three choices:

1.  China stays as poor (in relative terms) as in 1976.  Comparable to central Africa, or Bangladesh.

2.  China grows rapidly, but even in 2010 remains much poorer than Mexico.

3.  China grows at explosive rates, and became a fully-developed country by 2010.

Which would be the outcome that would vindicate neoliberalism?  And which would refute it?  I could imagine reasonable people saying #2 would vindicate the neoliberal reforms.  That’s what I’d say, and that’s what happened.  I could imagine someone hostile to capitalism insisting that only #3 would count as success.  But I must admit that until I read this book review from John Gray, I could never have imagined someone arguing that only outcome #1 would vindicate neoliberalism.  At least that’s what I think he is saying.  See what you think:

Disdainful or ignorant of the past, Ridley is uninterested in the forces that shape events. He writes hundreds of pages about the wealth-increasing virtues of free markets, but allots post-Mao China only a few lines. This brevity is symptomatic, as China falsifies Ridley’s central thesis; the largest burst of continuous economic growth in history has occurred without the benefit of free markets. Wealth has been created as never before, not as a result of evolutionary change, but as a product of revolution and dictatorship.

Am I misreading Gray, or is he actually saying that all that growth that followed Mao’s death is evidence that market reforms don’t work?  If I met him I’d love to ask him what sort of outcome for China would count as success for their neoliberal reforms.  I’ve noticed that when people have a strong aversion to a particular ideology, the answer is often a null set.  Is it just me, or do you guys think that if China was still as poor as sub-Saharan Africa, Gray would be using that fact as evidence neoliberal reforms don’t work?

At the opposite extreme, this is from an excellent book review written by Ronald McKinnon:

John Williamson (1990) did all a great favor by writing down the rules for what he called “The Washington Consensus” for developing countries to follow to absorb aid efficiently:

1. Fiscal policy discipline.
2. Redirection of public spending from subsidies (“especially in discriminate subsidies”)
toward broad-based provision of key pro-growth, pro-poor services like primary
education, primary health care, and infrastructure;
3. Tax Reform—broadening the tax base and adopting moderate marginal tax rates:
4. Interest rates that are market determined and positive (but moderate) in real terms;
5. Competitive exchange rates;
6. Trade liberalization—with particular emphasis on the elimination of quantitative
restrictions; any trade protection to be provided by low and relatively uniform tariffs;

7. Liberalization of inward foreign direct investment;
8. Privatization of state enterprises;
9. Deregulation—abolish regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions.
10. Legal security for property rights.

To provide perspective on these ten rules, the year 1990, when Williamson wrote, is important. It was just after the fall of the Berlin Wall and the complete collapse of confidence in Soviet-style socialism. The rules reflect the hegemonic confidence that most people then had in liberal market-oriented capitalism—think Ronald Reagan and Margaret Thatcher. But, 20 years later, should the meteoric rise of socialist China—both in its own remarkable growth in living standards, and in the effectiveness of its foreign “aid” to developing countries, undermine our confidence in Williamson’s Washington Consensus?

Surprisingly, no. The Chinese economy itself has evolved step-by-step (feeling the stones) into one that can be reasonably described by Williamson’s 10 rules!

At first glance McKinnon can seem just as out of touch as Gray, albeit in the opposite direction.  After all, we all know that China is following its own “Beijing consensus” which is much more state-led that the US system.  That’s partly true, but McKinnon makes a good case that China is gradually moving in the direction of the Washington consensus, even as we move in the opposite direction.  The book review (which is quite long) also has some very interesting information about China’s involvement in Africa.

McKinnon may be a bit over-optimistic, but he’s much closer to the truth than Gray.  And Gray isn’t just wrong about the China’s economy, he also misses important changes in China’s political system, which is much less based on the whims of a single dictator than Gray suggests.  This book review from The Guardian does a nice job of showing what happens when you really do give absolute power to a single man:

The book’s title is somewhat misleading. Horrific as it was, with its cannibalism and people eating mud in search of sustenance, the famine generated by the Great Leap’s failure and the diversion of labour from farming was only part of a saga of oppression, cruelty and lies on a gargantuan scale. Initially launched to enable China to overtake Britain in steel production, Mao’s programme took on a deadly life of its own. At the apex of the system, the chairman refused to recognise reality, spoke of people eating five meals a day, insisted on maintaining food exports when his country was starving and indulged in macabre throwaway remarks such as: “When there is not enough to eat, people starve to death. It is better to let half of the people die so that the other half can eat their fill.”

.   .   .

Finally, somebody had to confront the leader. As China descended into catastrophe, the second-ranking member of the regime, Liu Shaoqi, who had been shocked at the conditions he found when he visited his home village, forced the chairman to retreat. An effort at national reconstruction began. But Mao was not finished. Four years later, he launched the Cultural Revolution whose most prominent victim was Liu, hounded by Red Guards until he died in 1969, deprived of medicines and cremated under a false name.

The Cultural Revolution is widely remembered, the Great Leap much less so. Having gone through those two experiences, not to mention the mass purges that preceded them and the Beijing massacre of 4 June 1989, it is little wonder if the Chinese of today are set on a very different course that rejects ideology in the interests of material self-advancement.

In my view the most important engine of human progress is not science, but rather the growing acknowledgement that governments should be at least somewhat utilitarian.  Not chasing grand dreams of one sort or another, but rather focused mostly on the well-being of the average person.  China’s hardly a model in that regard, but despite all its problems it is definitely moving in that direction.  It’s a pity that Gray doesn’t understand that the dramatic progress he describes has occurred precisely because China is far less dictatorial and far more market-oriented than in the 1970s. 

Another person who doesn’t seem to get it is Adam Phillips, who seems positively disdainful of the “pursuit of happiness.”  Oddly, he seems to think the monsters of the 20th century were not out fanatically pursuing glorious crusades, but rather merely engaged in the mundane task of making the German, Russian, Chinese and Cambodian people more comfy:

What exactly might it mean to have an “unalienable right” to “the pursuit of happiness”, given that it is fairly obvious that the pursuit of happiness is so morally equivocal – could be, among other things, a threat to the society that promoted it? At first sight it seems to be a pretty good idea; if we are convinced of anything now we are convinced that we are pleasure-seeking creatures, who want to minimise the pain and frustration of our lives. Or at least a “we” could be consolidated around these beliefs. We are the creatures who, possibly unlike any other animal, pursue happiness. But the pursuit of happiness, like the pursuit of liberty – the utopian political projects of the 20th century – has legitimated some of the worst crimes of contemporary history across the political spectrum.

Think about it.  Do you really think Hitler, Stalin and Pol Pot were trying to make people happier?   Does the description of Mao’s reaction to the famine sound like he’s a utilitarian?

One guy who does get it is V.S. Naipaul:

Familiar words, easy to take for granted; easy to misconstrue . . . This idea of the pursuit of happiness is at the heart of the civilization to so many outside it or on the periphery.  I find it marvelous to contemplate to what an extent, after two centuries, and after the terrible history of the earlier part of this century, the idea has come to a kind of fruition.  It is an elastic idea; it fits all men.  It implies a certain kind of society, a certain kind of awakened spirit.  So much is contained in it: the idea of the individual, responsibility, choice, the life of the intellect, the idea of vocation and perfectibility and achievement.  It is an immense human idea.  It cannot be reduced to a fixed system.  It cannot generate fanaticism.  But it is known to exist; and because of that, other more rigid systems in the end blow away.  (Talk given in 1991)

That’s right, the key word isn’t happiness, it’s ‘pursuit.’  Life should be a sort of adventure.  The philosopher kings that are disdainful of markets and democracy want society to embody their ideas.  The utilitarian says “let 6.7 billion adventures bloom.”

HT:  John Taylor, Tyler Cowen, Robin Hanson

Reader comments often inspire new posts, and this is a good example.  In my post on Krugman’s 2005 prediction of a housing bubble, a number of commenters pointed out that Dean Baker made the same call three years earlier, in 2002.  The clear implication was the earlier was better, and that Krugman was late to the game—just copying Baker.  I think that’s wrong.

Just so I am not misunderstood, this post is not a criticism of Dean Baker.  Commenters sent me links to bubble predictions Baker made in 2002 and also 2005.  I am going to argue that the 2002 prediction was neutral, neither particularly good nor bad, and the 2005 prediction was a good one.  All in all a decent record, nothing that deserves criticism.  Rather I’d like to focus on a narrow technical point, and argue his 2005 prediction was actually far superior, even though it came later. 

Precisely what does it mean to predict a housing bubble?  Are people predicting that one will occur in the future?  That prices will rise very rapidly?  Or are they predicting that one is already here, that prices are too high relative to market fundamentals?  I think it is usually the latter.  If the term ‘bubble’ is to have any meaning at all (other than the trite observation that prices have recently risen) there must be an implied prediction that in the not too distant future (i.e. not 100 years out) prices will fall back closer to their fundamental value.  I’ve argued this point ad nauseum, and won’t repeat it here.  My hunch is that people confuse these two issues, which is why many people assume it is easier to spot bubbles than it really is.

Here is what Dean Baker said in 2002:

This paper examines whether the increase in home prices can be grounded in fundamental economic factors or whether it is simply a bubble, similar to the stock market bubble. It concludes that there is a housing bubble. While this process can sustain rising prices for a period of time, it must eventually come to an end.

He does acknowledge prices might rise before dropping, which is of course what happened.  But that comment is so vague that I take it as one of those things you almost have to say.  After all, if prices have been rising fast, only a fool would predict an immediate and sharp decline, especially given that housing prices have a bit more momentum that stock prices.  In a nutshell, I infer that he is mostly saying that housing prices have risen above their fundamental value and that at some point the real price of housing should drop to more reasonable levels. 

In this paper from late 2005, he and David Rosnick again make a bubble prediction.  This time much more accurately, in my view.

In my Krugman post, I used this graph to think about the accuracy of bubble predictions.  I argued that those seeing a bubble in the US in 2005 were right, but in Britain, New Zealand and especially Australia they were wrong (thus far.) 

If you just eyeball the data, to me it looks like these prices occurred in the US:

2002:  200

2005:  300

2006:   350

2010:   250

So it’s fair to say that 2005 bubble predictions turned out to be accurate.  But what about 2002?  Well the actual price seems to have risen about 25% in 8 years.  That’s not too different from the overall inflation rate, and hence I’d say there hasn’t been much change in real housing prices.  So I’d call that a neutral, where lower real prices in 2010 would be a win for Baker, and higher real prices would have been a loss.

I’d like to use an analogy, to suggest why it’s better to be late than early, why Krugman actually deserves credit for being late to the bubble party.  I recall after the 1987 stock market crash that someone praised John K. Galbraith for having predicted a stock crash.  He made the prediction in January 1987, when the Dow was around 1700.  It then rose to 2700 in August, before crashing to 1700 in late October.  So was Galbraith right?   As this post shows, people seem to assume he was.  But I’d say no, as his prediction really didn’t convey useful information:

1.  If you sold stocks on his prediction, you would not have made money—even in the long run.

2.  It was an implied prediction that stocks were overvalued relative to fundamentals.  But today very few people would say the Dow was overvalued in 1987 at 1700, indeed if anything it might have been a bit undervalued.  This shows how hard it is for even a very smart person to know whether something was overvalued in real time.  I could say the same about Boston house prices in 1987, and I’m sure people living in Manhattan, London, Vancouver or San Francisco could provide similar examples of prices that once seemed insane, but now (even in this recession) actually look (in retrospect) like equilibrium prices.

I think a good prediction, a useful prediction, would be someone that predicted a stock market crash in August 1987, not January 1987.  Those are the people who deserve credit if you (unlike me) believe market predictions aren’t just dumb luck.

I can think on one counterargument.  One could argue that an early prediction might have resulted in public policy changes that prevented the worst of the housing bubble.   But I favored those public policy changes even without being able to predict the bubble.  And I’m claiming it’s not obvious there was a bubble in 2002.  I’d hate to have public policy decisions based on inaccurate bubble predictions.

So from now on when someone tells you that Dean Baker predicted the housing bubble back in 2002, the correct response is “You think that’s impressive, well Krugman predicted it in 2005!”  Enjoy the puzzled look in their eyes, and savor the thought that you are soon about to show your superiority by setting them straight.  At least if you’re as big a jerk as I am.

PS.  Take a look at the link discussing Galbraith.  It was from 1994, and they assumed we were in the midst of another speculative bubble—when the Dow was trading in the 3500 to 4000 range.  What do you want to bet that they said “I told you so” in 2003, after the crash brought prices down to 8000?

Other bloggers have recently listed some important mistakes they made.  The trick is to decide on the number.  Pick too few and you will seem too cocky, unable to see your own faults.  But pick too many and people will think you are bragging about how brutally honest you are.  So I’ll pick 10:

1.  In the 1970s I thought we were on the road to serfdom.  I bought the whole Mancur Olson argument that modern democracies gradually became more statist, as they get captured by special interest groups.  (I haven’t read him in a while, so I am probably oversimplifying.)

2.  In the 1970s I thought communism was more of a threat than it turned out to be.  (Ditto for Iraq in 2003.)

3.  In the 1970s I thought monetary policy operated with long and variable lags, and thus fine-tuning would make things worse.

4.  In the 1970s I thought the Nordic economic model was much more seriously flawed than it really is.

5.  I used to think moral and aesthetic beliefs were ‘”mere opinion” and scientific beliefs were “objective facts.”

6.  I used to think I was smarter than other people who are just as intelligent as I am.  Actually I sort of still believe this, but at least now one half of my brain knows how silly the opinion held by the other half of my brain really is.

7.  In 2007 I thought it very unlikely that there would be a severe US banking crisis.

8.  In 2007 I thought the Fed would be able to avoid a Japanese-style zero rate trap.

9.  I predicted that aggressive QE would raise long term interest rates, a view which seemed to be refuted by the response on T-bond yields to the March 2009 Fed QE announcement. 

10.  I thought Brett Favre really was going to retire this year, after he said he was going to.  Arguably my most embarrassing error.

I’d like to talk about number 9 for a moment.  Any effective monetary stimulus would be expected to raise long term rates.  We have plenty of examples of that occurring.  My favorite is the surprise stimulus announcement of January 3, 2001, which caused long term (nominal) rates to soar.   Thus I was shocked to see long term rates fall sharply on the day of the March 2009 QE announcement. 

I don’t have a good theory for why that happened.  One could point to the fact that they quickly reversed, and soon rose far above the pre-announcement level.  So maybe markets made a mistake and I was right all along.  But that means the EMH is wrong, a theory I hold even more dearly.  So either way I’m screwed.

If I had to guess I’d say it might have something to do with the type of stimulus.  It didn’t so much raise the monetary base (indeed the Fed was correct in denying that it really was QE) rather it changed the composition of their balance sheet.  Even so, other markets (stocks, foreign exchange) reacted as if it was bona fide monetary stimulus.  So I am not really satisfied with that explanation either.

I am reluctant to form a firm opinion based on a single observation, so I will watch market reactions to other QE-type actions, to see if a pattern develops.  If I was forced to critique my own blog, the market response to the Fed’s March 2009 “QE” would be my number one weapon.

This Wikipedia entry suggests that illegal immigration is about 700,000 per year, in net terms (1,500,000 gross).   I presume this refers to the trend rate before the recession.  I also found an article in Yahoo that makes the following estimates:

The study released Wednesday estimates that 11.1 million illegal immigrants lived in the U.S. in 2009. That represents a decrease of roughly 1 million, or 8 percent, from a peak of 12 million in 2007.

The study puts the number of illegal immigrants down to about where it was in 2005. They still make up roughly 4 percent of the U.S. population.

The Homeland Security Department’s own estimate of illegal immigrants is slightly lower, at 10.8 million. The government uses a different census survey that makes some year-to-year comparisons difficult.

Of course these are rough estimates, but let’s say a ballpark estimate is that since 2007 we have been losing about 300,000 illegals per year, instead of gaining 700,000 per year.   If so, then it appears population growth in the US might have slowed by about 1 million per year.  Births and deaths don’t change much year to year, and I was also unable to find any indication that legal immigration had changed much in the last three years.  It turns out the data is collected in a very confusing way, and I wasn’t able to find a reliable Census bureau estimate of the components of population growth.  The Census doesn’t show much change in US annual population growth rates, but given they were embarrassed to find 6 million more in the 2000 census than expected, I think it’s fair to say they don’t have a good handle on illegal immigration. 

So let’s suppose US population growth fell by one million after 2007, as a result of both the immigration crackdown and the recession.  Could this have caused the housing crash?  Just to get a rough idea of the magnitudes here, let’s assume a very simple model:

1.  Three people per family.

2.  Normal population growth 3 million per year.

3.  300,000,000 US residents

4.  100,000,000 US housing units

5.  Houses depreciate at 1% per year.

In this model we need a million new houses a year for new population, and another million replacement houses for depreciation.  Total construction should be 2,000,000/year, which was roughly the level of the mid-2000s.  Now assume population growth falls by 1,000,000.  This should reduce steady-state housing construction by 1/6th.  Not enough for a housing crash. 

If the slowdown was concentrated in illegal immigrant-rich areas with fast population growth (California’s Inland Empire, Arizona, Nevada, etc) it could have had a significant effect on local markets—perhaps two or three times as large as the nationwide effect.  That could have triggered a significant housing slump in the sub-prime markets.  On the other hand, some immigrants left for reasons other than the immigration crackdown and the resulting drop in housing construction jobs.  So there is the issue of disentangling the various shocks.  If the immigration crackdown contributed to the decline in housing construction, there would be some sort of multiplier effect, as other immigrants would leave because of the resulting drop in economic activity.  But I don’t want to oversell that multiplier, as most of the recession was in non-housing areas.

Let me also emphasize that I am not trying to explain away bubble-like behavior at the micro level.  None of this explains banks giving mortgages to low income farm workers so they could buy $500,000 homes, rather I am trying to better understand how at the macro level otherwise intelligent investors might have gotten caught off guard by the nationwide housing slump and fall in real estate prices.  One factor propping up prices (rapid immigration) was pulled away unexpectedly.   In other parts of the country, the early stages of the housing slump were much less severe.

Now let’s suppose that some combination of less immigration and ordinary post-bubble problems led to severe banking problems for institutions that held lots of MBSs.  The Fed mishandles this problem and lets NGDP fall 8% below trend.  Now falling NGDP causes housing prices in non-sub-prime areas to begin falling.  Ditto for commercial real estate.  We saw in an earlier post that it was commercial real estate, not subprime housing, which was the main cause of bank failures. 

I actually think immigration was much less than 50% of the initial problem.  But even if it was only 20%, because of the various ripple effects that I just described it is not inconceivable that the ultimate effect of the immigration crackdown could have been quite significant.  In 2008 there may have been a “knife edge” equilibrium, where if the economy had been a bit stronger we might have avoided the zero rate bound.  And if we had avoided that problem, monetary policy might have been able to prevent a steep fall in NGDP.  Maybe immigration is one reason Australia avoided the zero bound and steep recession.  Still, this is all speculation.  Even though I favor a high rate of immigration, the preceding story seems far too speculative to inform our immigration policy.  We are better off learning from other countries that do it better than us (yes, I mean Australia and Canada.)

PS:  There are lots of guesstimates in this post.  My hunch is that immigration slowed, but by less than 1,000,000 per year.  But births have also slowed by a few hundred thousand, which I excluded from the estimates.  Again, I am not looking for a monocausal explanation of the housing crash.  I think it likely that almost all giant economic disasters have multiple causes, whether it be the Great Depression, or the Great Recession.