Archive for May 2010


Is it all just a terrible mistake?

Right after I quoted Matt Yglesias in the last post, I saw Tyler Cowen weigh in with his own perspective on Yglesias, and the pro-stimulus crowd in general.  I’d like to separate out several of Tyler’s comments, as a quick reading might lead one to think I am making the same argument as Krugman, DeLong, Thoma, etc.

You can take that [Yglesias] quotation as a stand-in for the more general Keynesian AD views about the current recession.

First, I am fully on board with Scott Sumner-like ideas to boost AD through monetary policy, as is Yglesias and are many other Keynesians.  There is no practical disagreement, but it remains an open question how effective such measures (or a bigger stimulus) would be. 

I feel good about this observation, as when I started making this argument in October 2008, I think it is fair to say that there weren’t many Keynesians, or non-Keynesians, arguing for a more expansionary monetary policy.  Most were saying the Fed had done all it could.  Tyler continues:

Consider a simple model, in which uncertainty goes up, first because of the U.S. financial crisis, now because of Greece and the Euro and the open questions about Spain and how well Europe can cooperate.  I’m not saying that’s the only or even the prime cause of what’s going on, it’s simply an illustrative story.

With higher uncertainty, investors pull back, wait, and exercise option value.  Aggregate supply declines, as does employment.  As a result, aggregate demand declines too, and that includes real aggregate demand, not just nominal aggregate demand.  Until the underlying uncertainty is resolved, the economy remains in the doldrums.

I have a couple responses here.  I think the real problems that Tyler cites are much more closely linked to falling NGDP than most people imagine.  Soon after NGDP (and NGDP expectations) started falling rapidly in August 2008, the financial crisis worsened.  I think those events were related.  It should also be noted that with a well-functioning central bank, these sorts of financial shocks do not reduce AD, or NGDP.  If the Fed targets NGDP, then problems in one sector lead to resources being re-allocated to other sectors.  There may be slightly higher frictional unemployment during this re-allocation, but nothing like the dramatically higher unemployment that results from a fall in the demand for all products (which we saw after August 2008.) 

If Tyler is right, then a more expansionary monetary policy should boost not just AD, but also AS as well.  This is because with higher NGDP, there will be less fear of defaults and bank failures, which is one of the shocks driving the recession in Tyler’s view.  I won’t comment on real AD, as I don’t use that concept in my modeling, and am not sure how it fits into the picture. Tyler continues:

Note that there is still a case for fiscal policy, based on the idea of intertemporal substitution.  With some labor unemployed, a sufficiently finely targeted fiscal policy can build a new road at lower social cost than before, by drawing upon unemployed resources.  But even if that fiscal policy is a good idea, it won’t drive recovery, at least not for plausible values of the multiplier.

There is also still a case for countercyclical monetary policy.  As real AS and real AD are falling (see above), there is also downward pressure on nominal variables.  Aggressive monetary policy, or for that matter the velocity-accelerating aspect of fiscal policy, can limit the negatives of this process and check the second-order fall in employment.

I’m all for countercylical AD management, noting that for other reasons I prefer monetary to fiscal policy in most cases and even if you don’t agree with me there it suffices to note that the monetary authority moves last in any case.

That all said, the countercyclical monetary policy won’t drive recovery either, or set the world right again, it just limits the damage.  We still have to wait for the uncertainty to be cleared up. 

I mostly agree, but will make a few slightly different observations.

1.  I don’t like the concept of “countercylical monetary policy.”  It (often) implicitly suggests that the stance of monetary policy can be measured with interest rates or the money supply.  The idea is that you cut interest rates and raise the money supply in recessions.  But this is not a good way of judging the stance of monetary policy.  The monetary base was increased and the discount rate was cut in the Great Depression.  Yet money was very tight.  My preferred metric for the stance for monetary policy is NGDP expectations.  And I want monetary policy to always aim for an NGDP trend line with a 5% upward trajectory.  I don’t want the Fed to ever say it itself “it’s time to change policy.”  They should always have the same policy, passively adjusting the base until NGDP expectations are on target.   As an analogy, under a gold standard a central bank should not have a policy ready for when the market price of gold falls below target.  Rather they should always stand willing to buy and sell gold at the target price, making that the de facto market price.

2.  If the Fed does this, then there is no case for fiscal policy, even in a recession.  This is because (apart from trivial things like filling potholes) the lag for implementing highway building projects is longer than for monetary policy to impact spending.  I agree with Tyler that when the Fed isn’t doing this, the opportunity cost argument for fiscal policy is defensible.  And I also agree with his skepticism about much we can realistically expect from fiscal policy.

One final point, waiting for that “uncertainty to be cleared up” is mostly (in my view) waiting to find out how much NGDP growth the stingy Fed, ECB and BOJ will allow.  I am pretty sure that Tyler thinks it goes far beyond monetary policy.  Tyler continues:

Reading the Keynesian bloggers, one gets the feeling that it is only an inexplicable weakness, cowardice, stupidity, whatever, that stops policies to drive a more robust recovery.  The Keynesians have no good theory of why their advice isn’t being followed, except perhaps that the Democrats are struck with some kind of “Republican stupidity” virus.  (This is also an awkward point for Sumner, who seems to suggest that Bernanke has forgotten his earlier writings on monetary economics.)  The thing is, that same virus seems to be sweeping the world, including a lot of parties on the Left.

Romer, Geithner, Summers, know all the same economics that Krugman and DeLong and Thoma do.  If a bigger AD stimulus would set so many things right, they’d gladly lay tons of political capital on the line to see it through and proclaim triumph at the end of the road.

Just to be clear, I agree with Romer, et al, about fiscal policy, if indeed she is as skeptical as Tyler claims.  (And based on her academic writings, she may well be.)  I do agree with Tyler that my argument may sound a bit “awkward,” but I will make it anyway.  By the way, I do more than “seems to suggests that Bernanke has forgotten his earlier writings,” I scream it from the rooftops.  I quote Bernanke verbatim on the need for Japan to sharply raise its inflation target (to 3% or more), to do level targeting, that the Japanese problem is falling NGDP (and that banking distress is a symptom), that low interest rates don’t mean money is easy, that liquidity traps do not prevent central banks from boosting inflation.  And I also quote him recently saying that three percent inflation expectations right now would be a bad thing.

But Tyler raises a good point.  Why should people take me seriously when I claim that most of the recession is due to tight money, and could be easily solved with easier money?  Certainly this is not the mainstream view at the elite universities (saltwater or freshwater.)  If it was really this easy, why wouldn’t we have already taken the necessary steps?

This is why I love monetary economics.  It is incredibly counter-intuitive.  I had thought (by 2007) that almost all mainstream economists accepted that low interest rates didn’t mean easy money.  In 2008 I found out I was wrong, very wrong.  (I was lulled into complacency by the assumption that economists believed the concepts that they teach in textbooks like Mishkin.)  Here’s my best argument.  I have made part of it before, but I’ll extend it this time:

1.  During the Great Depression almost all sober thinkers attributed the problems to financial distress.  If you said the Fed could easily cure the Depression merely by a more expansionary policy, you’d be viewed as a crackpot.  Irving Fisher and George Warren were viewed as crackpots for making exactly that argument.  If you want a comparison to Bernanke, consider Keynes.  In 1923 he wrote a quantity theoretic tract which argued that monetary policy could stabilize the economy.  In 1936 he abandoned that view.  Today his 1923 view is more widely accepted.  Almost everyone now agrees that the Fed made a huge mistake in allowing NGDP to fall in half.  The only debate is whether it could have been prevented under the gold standard (Friedman and Schwartz’s view) or whether it would have required abandonment of the gold standard (the new Keynesian view.)  But the Fisher view was not accepted until many decades later.

2.  When I studied at Wisconsin (a mainstream Keynesian university) in 1973, the 1960s inflation was attributed to fiscal stimulus (the Vietnam war deficits) and unions.  I suppose you’d still find a few older microeconomists at obscure state universities teaching this view from their dog-eared copies of Samuelson, but not many economists take this view seriously any more.   This is partly because the deficits were actually pretty small in real terms—the national debt/GDP ratio fell sharply in the 1960s and 1970s.  But in 1973 (when I was at Wisconsin) the professors treated Milton Friedman as a crackpot.  Friedman argued that it was easy money, not fiscal policy, which led to the inflation.  What an absurd idea!  Monetary policy is weak, everyone knows that.  And interest rates had been rising during the 60s. 

Do you notice that on these major issues the vast majority of mainstream economists were wrong at the time?  And do you notice that they were wrong in a particular way?  That they underestimated the role of money in driving NGDP shocks.  Now think about my position vis-a-vis the mainstream view.  I say the recession was caused by tight money.  Most economists say it was caused by financial distress, and in any case, money was obviously easy.  After all, rates are near zero.  Will the Fisher/Friedman view be proved right once again? 

Stay tuned.

Greece: Is there a third way?

Steve Hanke has an interesting Cato piece defending Estonia’s currency board.  Although I recently criticized the tight money in the Baltic states; I should have also mentioned that due to their heavy euro debts, they don’t have any great alternatives at this point.   I also agree with Hanke that Estonia has pretty good economic fundamentals, and may well bounce back surprisingly well.  I know less about Latvia.  Of course not all of the problem was created in the Baltic states.  A part is due to the tight money policy in Europe and America that depressed nominal asset prices all over the world.  This Hanke comment was especially interesting:

Their rescue package fails to address the anti-market (antigrowth) structure of the Greek economy. For those who might question this statement, take a look at the accompanying table that compares the ease of doing business metrics for Greece and Estonia. Without growth, Greece is doomed.

This brings us to the euro. Many notable economists — from Harvard’s Prof. Martin Feldstein to Princeton’s Prof. Paul Krugman — have concluded that Greece is in a euro trap.

They assert that there is no way for Greece to become competitive and grow because it no longer has its own currency, the drachma, to devalue.

As Dr. Domingo Cavallo, Argentina’s former Minister of Economy, and Dr. Joaquín Cottani, former Undersecretary of Economic Policy in Argentina, have shown in a paper that will be presented at Palazzo Mundell in July, the devaluation trap is nonsense.

A Cavallo-Cottani supply-side reform would eliminate Greece’s huge employer contributions to payroll taxes. This would reduce wage costs and enhance competitiveness.

Their reform would also impose Greece’s VAT tax at a single, uniform rate — rather than at its current three rates. These two supply-side tax changes would be roughly fiscallyneutral, when based on conservative static calculations. But what about competitiveness? It would get a big boost, roughly equivalent to a 40%-45% currency devaluation.

This is one of those ideas that sounds good at first glance, but doesn’t sound so good if you know a bit more economics.  But if you know a lot more economics it starts sounding good again.  The proposal would cut Greek labor costs by eliminating the payroll tax, thus making Greek labor more internationally competitive.  Lost revenues would be made up with a VAT, which applies equally to domestic and imported goods, and hence doesn’t distort trade.  So far so good.

If you know a bit more economics you know that, in equilibrium, the effect of a 10% payroll tax cut combined with a 10% higher VAT should be neutral.  Both are consumption taxes.  Employers would pass on the employment cost savings from lower payroll taxes in the form of higher wages.  Indeed 10% higher, just enough to cover the higher VAT.  Nothing real should change.

If you know a lot more economics you know that, because of sticky wages, labor markets aren’t always in equilibrium.  Hanke’s idea is essentially aimed at nudging them back toward equilibrium.  Because of the crisis in Greece, the current Greek wage level is temporarily above the wage required to produce macroeconomic equilibrium.  Hanke’s proposal would cut total employment costs, even as the (sticky) nominal wage received by workers stayed the same.  The trick is that the government controls part of the total employment cost, and thus can adjust wage costs even if workers won’t accept explicit nominal wage cuts. 

This isn’t to say his idea would necessarily work; perhaps Greek workers and pensioners would riot over the VAT increase.  But it is a policy that can in principle work much faster than internal devaluation through long and painful nominal wage cuts.  It certainly deserves to be discussed.  Even if the full proposal cannot be implemented, a smaller payroll tax cut combined with a smaller VAT increase would help.  One thing I don’t know is whether the EU rules have a maximum VAT rate, and whether Greece is at the limit.  But rules can be changed in an emergency.  (There is also the problem of tax evasion, which rises as the VAT rate increases.)

Part 2:  Matt Yglesias in China

Here is Yglesias on China’s lack of mega-rich.

China’s growth has been accompanied by some stark increases in inequality, but it seems noteworthy to me that one area in which the People’s Republic is a real laggard is the development of mega-rich individuals. For example, according to Forbes’ authoritative list the world’s top 100 richest individuals includes zero citizens of mainland China.

.   .   .

As a bonus fun counterpoint fact, egalitarian Sweden has a wildly disproportionate number of mega-rich citizens. With only 9 million people and an overall GDP less than ten percent the size of China’s, Sweden boast two of the fifteen richest people on the planet—the heads of Ikea and H&M. That’s in part just a coincidence, but I also think it reflects the reality that high taxes and high public spending aside the modern-day Nordic countries actually have a very neoliberal underlying economic structure whereas China is very much the reverse.

Does that second paragraph sound slightly familiar?  I guess I have to exempt Yglesias from the group of those on the left who suffer from the following fallacy:

2.  Assuming that Dickensian conditions implies a country must be capitalist.  Many people on the left seem to create left/right mental boxes for countries based on their perception of working conditions.  Thus a country with poor working conditions and low wages (again China is a good example) is assumed to be “capitalist” and a country with good working conditions and a high level of equality (such as Denmark) is assumed to be “socialist.”  Actually it is much more complicated.  Economically speaking, China is a half-communist country with low levels of social insurance, whereas Denmark is an extremely free market economy with a large welfare state. 

Although I am much more free market-oriented than Yglesias on many domestic issues, we often see the big picture in surprisingly similar ways.  His blog posts on China tend to be very good, because he went to China already pretty well-informed on things, and thus was able to put what he saw into proper context.  

Here is Yglesias on the currency issue:

What I’d wished he’d [Yglesias' Chinese host] added is that there really ought to be a way out of this dilemma, namely for revaluation to occur in the context of the U.S., Europe, and Japan committing to more expansionary measures of a monetary or fiscal (or both) nature. For whatever reason, western political leaders seem to have determined that an extended period of badly elevated unemployment is a small price to pay to head off the possibility of hypothetical future inflation. China’s leaders, more sensibly in my view, have the priorities the other way around—trying to keep an eye on inflationary pressures, but predominantly focused on the actual and present danger of labor market collapse. But it’s just really hard for China to pull this off on its own and the Chinese economy simply isn’t big enough to serve as the engine of global demand. Making life easier for China’s economic managers isn’t the reason western leaders ought to do more, but it’s certainly true that better policy in the west would give them more wiggle room in a way that ultimately would make it much easier to resolve the contentious currency issue.

Here is Yglesias on the relative contribution of real and nominal factors in the worldwide recession:

To say that the world has solved its supply-side problems would be absurd. Greece really is overburdened with bureaucracy, Italian governance is a mess, we have too many useless homes in the Inland Empire and the suburbs of Las Vegas, and too much of Ireland’s GDP growth was based on a tax haven accounting gimmick. But Greece and Ireland are tiny, Italian governance has always been a mess, and the value of homes in the Inland Empire and the suburbs of Las Vegas has always been tiny relative to the vast productive capacity of the United States. To think that Greek overborrowing and over-bureaucratization could somehow maroon a global economy that’s featured the invention of the Internet and the liberalization of China and India is slightly insane. We right now have the capacity to produce more—much more—than has ever been produced before in the history of the planet. There are dozens of supply-side policies that could be improved in every country on earth, but that’s not a new fact about the world. What’s new is the lack of demand, the willingness of the key leaders in Tokyo, Frankfurt, Washington, Berlin, and now it seems London as well to tolerate stagnation and disinflation in the face of some of the most exciting fundamental new opportunities for human economic betterment ever.

Good stuff.

Part 3.  If I ran the Washington Post

The first paragraph of this WaPo story:

In a chest-thumping essay and book published 20 years ago, Francis Fukuyama asserted that the end of the Cold War ushered in the everlasting dominance of Western democracy. History, as Fukuyama famously declared, had ended — the evolutionary struggle between ideologies was over, and market democracy had emerged as “the final form of human government.”

Would be followed by:

And in the following 21 years Fukuyama’s predictions came true more than anyone could have imagined, as the world saw an unprecedented move toward democracy and market economies. 

Instead, for the 837th time that I have read something like the first paragraph of the WaPo article, in both newspaper stories and academic articles, it was followed by the following mindless cliche-ridden drivel:

Well, it turns out history lives on. Three convincing new books show that, far from ascending as predicted two decades ago, Western values are under threat in many corners of the world.

I don’t know why people write things like that.  Everyone knows what they will say, so why bother even wasting the ink?  Why not just write “insert cliche #837 here.”  Wouldn’t it be nice to have newspapers that didn’t just pander to our prejudices, that didn’t just tell us things we already know?  I am resolving to never again continue beyond that first paragraph.  After 837 attempts, there is no longer any reason to hold out hope that the rest of the article might contain an ounce of original thought.

Here is the article’s final paragraph:

The assumption among free-market proponents over the past 20 years has been that the globalization of wealth would inspire a growing middle class to lead a march toward ubiquitous democracy. Kampfner takes the reader around the world with him on an engaging first-person journey packed with interviews of locals and finds such optimism sorely misplaced. “It sounds good in theory,” he writes, “but it has not worked out that way.”

It didn’t?  You could’ve fooled me.  (The key phrase is “march toward.”)

PS.  I resolve to soon stop doing these ungainly conglomerate posts, and go shorter.

Monetary policy: The Achilles Heel of the right

I’ve argued that monetary policy is the fatal flaw of the right.  In 1929 the US had an outstandingly efficient model.  Banks were conservatively managed (although branching laws meant there were far too many of them.)  We ran budget surpluses, trade surpluses, zero inflation, low unemployment, low taxes, etc.  Tariffs were a bit too high, but nobodys perfect.  And this policy regime was destroyed by the same people who had built it; conservatives.   The left blamed the Depression on the economic model, not deflation.   Then they proceeded to dismantle the model, which delayed the recovery for six years more than necessary.

In the 1990s Argentina finally started to move away from their statist model.  There were signs they might follow in the footsteps of Chile.  They achieved fast growth from 1991-98, even while bring inflation down from 171% to less than 1%.  But the conservatives always seem to go too far.  If low inflation is better than high inflation, then what’s wrong with deflation?  What’s wrong is that deflation causes depressions, which opens the door to left wing governments.  Sure enough the new Argentine government started moving back toward statism.  Naturally they got a cyclical recovery after a sharp devaluation, but the statist policies will insure years more of economic under-performance in Argentina. 

And now the once-promising Baltic States.  This is from Ed Dolan’s blog:

In contrast, in the Czech Republic, the post-accession boom was accompanied by rapid appreciation of the Czech koruna, which strengthened from 33 per euro to 23 per euro in just 4 years. The strong currency kept import prices low and helped restrain inflation. Without the need to hold the exchange rate fixed, the Czech central bank was able to use monetary policy to avoid excessive wage increases or a housing bubble. When the crisis hit, the koruna depreciated as quickly as it had earlier strengthened, quickly restoring competitiveness. The recession in the Czech Republic was among the mildest in the EU.

The effects of the crisis on Latvia were entirely different. Without a devaluation, the only way Latvia could restore competitiveness was through deflation of prices and wages. This strategy, often called “internal devaluation,” has been extremely painful. The unemployment rate has soared to 22 percent as prices and wages fall. Meanwhile, unemployment in the Czech Republic has risen only slightly and has remained below the EU average throughout the crisis.

When will the right ever learn? 

HT: Tyler Cowen

Fallacies of the left and right

I’ve been surprised how much discussion has occurred in response to my neoliberalism post.  Perhaps that was because Paul Krugman responded.  In any case, I’d like to briefly discuss what I regard as some fallacies of the left and right on the subject of market reforms.  I’ll start with the left:

1.  Forgetting that things were even worse in the past.  Many developing countries have deplorable working conditions, environmental standards, income inequality, human rights abuses, etc.  If these countries have adopted free market reforms, it is easy to look at these problems and forget that conditions were even worse before the reforms occurred.  It is hard for someone who grew up in a rich country to understand just how difficult life is in a developing country.  When you see deplorable conditions, it is hard to imagine how they could have been much worse in previous decades.  But all one has to do is walk across the border from China to North Korea, to see what China was like before the reforms.  As big as China’s problems are (and they are huge) North Korea is far worse off.  China’s living standards aren’t just higher than North Korea, they are dramatically higher.  Most don’t recall that China was poorer than India before the reforms began in 1979.

2.  Assuming that Dickensian conditions implies a country must be capitalist.  Many people on the left seem to create left/right mental boxes for countries based on their perception of working conditions.  Thus a country with poor working conditions and low wages (again China is a good example) is assumed to be “capitalist” and a country with good working conditions and a high level of equality (such as Denmark) is assumed to be “socialist.”  Actually it is much more complicated.  Economically speaking, China is a half-communist country with low levels of social insurance, whereas Denmark is an extremely free market economy with a large welfare state. 

3.  Assuming that economic reforms failed because real GDP growth didn’t increase after 1980.  I’ve already addressed that in another post.  Growth slowed everywhere, but the neoliberal reformers saw growth slow less than the non-reformers

4.  Assuming the Soviet Union went into a depression after economic reforms began.  Actually the real GDP of the Soviet Union collapsed before economic reforms began in 1992.  And the places that reformed the most slowly, recovered the most slowly.  Those that didn’t reform at all (such as North Korea) saw an almost complete collapse of their economies.  Economic reforms didn’t cause a Depression in the Soviet bloc.  Rather a “Great Depression” in the Soviet bloc caused economic reforms to occur.  This misconception occurred because conditions continued to deteriorate for some time after the reforms began in 1992, and this is when people began to focus on the issue in the West.  So they saw horrific economic problems, and assumed they were caused by the reforms.  In Russia, people probably had trouble distinguishing between Gorbachev’s reforms (which weren’t market reforms but rather attempts to make communism work better) and true market reforms.

5.  Assuming neoliberal reforms are associated with authoritarian governments.  Many people seem to think China adopted free market reforms after the 1989 crackdown at Tiananmen.  Exactly the reverse; the free market reformers were discredited by the protesters (who supported reform) and thus the Chinese government moved back toward statist policies.  In Argentina, the generals who ruled the country adopted statist policies, and market reforms were associated with the movement toward democracy in the 1990s.  In Chile, the generals that overthrew Allende opposed free market reforms, and only turned toward them (out of desperation) in 1975 when their statist policies put Chile into a depression.  There is an EXTREMELY strong correlation between neoliberalism and democracy.  Look at the Heritage list of economic freedom and you will see that most of the high scorers are democratic (although the top 2 countries are not, or at least not entirely.)  I plan to read Naomi Klein’s book this summer–I’m told it has some of these misconceptions.

6.  Capitalism is based on greed.  In fact, it is almost impossible to make capitalism work without altruism.  If people are not civic-minded you will not get free markets.  This is because individual producers are much better off if protected from competition.  Businesses generally do not support capitalism in their own industry.  To get a free market system you need people willing to put aside their special interests and support open and transparent economic governance.  After 1980, the countries that moved most rapidly toward free markets (Denmark, New Zealand, etc) were the countries whose citizens score highest on polls of civic-minded attitudes (and generally lowest on corruption indices.)  The most statist of the developed economies (i.e. Greece) also exhibit the least civic-minded attitudes in surveys.  If neoliberalism was a right-wing plot to enrich capitalists, you’d expect exactly the opposite pattern–you’d expect the most civic-minded or idealistic countries to be the least like to adopt neoliberal reforms.

7.  Assuming increased income inequality negates the gains from freer markets.  I’m not saying this can never occur (deregulating the gains in finance while the government continues to socialize the losses might be one counterexample) but in general there is little evidence that free markets produce lots of inequality.  If you look at the 8 categories in the Heritage index other than size of government, then Denmark is actually the most free market economy on earth.  Yet it also has the most equal distribution of income.  International differences in income equality are strongly correlated with ethnic diversity.  Even in relative equal Europe, inequality is associated with the presence of ethnic groups like the Roma (aka gypsies.)  In Australia the greatest inequality is associated with the presence of  indigenous people (aka aborigines.)

8.  European countries have more progressive tax systems than the US.  Not true.  Because supply-side problems are REAL, the more social democratic countries of Europe have found it necessary to have much more regressive taxes than the US.  They need highly efficient tax systems to raise enough revenue for their extensive social insurance programs.

Here are some fallacies on the right:

1.  Countries with big government tend to be poorer.  As Statsguy showed in a recent post, it is just the opposite.  In developed countries governments tend to spend a higher share of GDP.  I do think that, ceteris paribus, beyond 20% of GDP larger government lowers GDP.  But the effect isn’t strong enough to prevent countries like Denmark and Sweden from having high living standards, despite their large governments.

2.  Denmark and Sweden are socialist countries.  I’ve already indicated that they are capitalist countries with high levels of social insurance.  Denmark has freer markets than the USA.

3.  Singapore and Hong Kong are not really capitalist.  This is the opposite from point two.  Just as some on the right focus too much on size of government, others focus too much on  a few deviations from free markets that they have read about in these two countries.  There is a tendency to forget that in every single country in the world the government plays a major role in the economy, including the US.  Singapore and HK do some things we don’t do (for instance their governments control much of the housing stock) but we do lots of things they don’t.  There is always a tendency to notice flaws in others that we don’t notice in ourselves.  I am amazed how often people mention the $500 fine for throwing gum on the sidewalk in Singapore, but I rarely see people mention that we have 500,000 people in prison for using drugs.  Which is the greater outrage?  This isn’t to excuse abuses in other countries (I’d still rather live here), but merely to point out that no country comes close to being the sort of libertarian paradise than many on the right would like to see.  You can have a lot of markets and still be rigidly communist.  Even North Korea occasionally allows farmer’s markets.  And you can have a lot of statism and still be one of the most free market countries in the world.  The US deviates from pure capitalism in literally 1000s of ways.  You can’t even be a hairdresser or a taxi driver w/o a government permit.

4.  Europe/Canada/Australia, etc, are much more socialist than the US.  This is not true.  In the Heritage rankings the US is right in the mix, slightly more capitalist than most, but less capitalist than a few of these countries.  Bryan Caplan recently linked to a survey that showed the US government spends more dollars (PPP) on health care (per capita) than all other countries save oil -rich Norway.  Many of these countries have privatized industries and services that are still traditionally done by government in the US.  (BTW, if we are already spending so much, why do we have to spend even more to pay for Obama-care?  Answer:  It doesn’t include meaningful cost controls.)

5.  Capitalism is based on individualism.  Actually just the opposite.  Fukuyama showed that large private corporations thrive in cultures where people work well in groups, and don’t do well in cultures where people are distrustful of those outside the family.  This is why the Nordic economies are the most multinational corporation-dominated economies on earth.  The industries that are privately-owned in the Nordic countries are often state-run in less group-oriented cultures.  I admit to knowing little about Ayn Rand (and assume I’ll get pushback here) but based on what I have read about her prickly and individualistic personality, I wonder of a country of Ayn Rands could produce a successful capitalist system.

Update 5/29/10:  I hope all my discussion of culture didn’t lead you to think I am a cultural determinist.  I’m not.  Doc Merlin mentioned reverse causation in the comments, and I buy the Adam Smith/Deirdre McCloskey argument that markets make society behave better.

Congratulations to Statsguy

One of my favorite commenters (although we often disagree) is Statsguy.  Tyler Cowen has just called his guest post over at Baseline Scenario a “must-read post.”  Here’s Statsguy:

My primary contention below is that many of these measures used in the composite Heritage Index have nothing to do with less government, and a lot more to do with good government. It is these measures of good government that correlate to economic growth and drive the overall correlation between the “Freedom Index” and positive outcomes. Secondarily, I will argue that many of the other items in the index (like investment freedom) are not causes of growth, but rather outcomes of growth.

I also like the post.  Although I left a comment, I thought it might be useful to repeat the comment here, where more people will see it:

Nice post Statsguy, I mostly agree. It is widely known that richer countries tend to have much bigger governments than poorer countries.  Among really poor countries few people pay income taxes, and it’s hard to collect a lot of revenue. Of course there are exceptions–Brazil has a pretty big government. It’s also true, FWIW, that among rich countries the very richest (Singapore, HK, USA, Australia, Canada, Switzerland, etc) tend to have somewhat smaller governments than the next tier. Norway is an exception.)  My hunch is that the same civic-mindedness that helps countries set up what you call “good government” also tends to lead countries to set up big welfare states (think Denmark.) I believe that in time the Singapore approach to social insurance will be shown to be better.  But despite my right-wing reputation, I regard Denmark and Sweden as highly successful countries.

Tyler Cowen also linked to a very good post at quantoid.

Using the carpentry metaphor, the Heritage Foundation is taking 9 measurements (or 10 depending on the year) to make a single cut. That is, they are using the 10 variables above to produce a single estimate of the economic freedom in every country. A relatively simple investigation shows that both the Fiscal Freedom and Government Spending variables are very poor indicators of economic freedoms and using them will actually produce less accurate estimates of economic freedom. Imagine a very earnest carpenter who takes 10 measurements in order to make precisely the right cut. However, for two of the measurements he was distracted and instead of writing down 12.3 and 12.2 inches, he writes down 21.3 and 21.2 inches. Averaging the 10 measurements will provide a much worse cut than averaging the 9 measurements that were appropriately recorded. I am not arguing that Government Spending and Fiscal Freedom were mis-measured, only that using these will produce a less accurate measure of economic freedom. Technical details of the statistical procedures, theoretical models and investigation that lead to this finding are [here].

I agree that the best way to measure economic freedom is with the 8 non-size of government categories, and when I did this a few years ago I also found Denmark to be the most free market economy.  I prefer the term ‘laissez-faire’ for the small government model measured by Heritage (using all 10 categories) and ‘neoliberal’ for the model of free markets plus social insurance (such as Denmark.)

BTW, In my various recent posts on neoliberalism I took the shortcut of occasionally using the Heritage numbers for all 10 categories, knowing full well that the 8 category subset would have been better.  But I’ve worked with these numbers enough to know that none of my generalizations in those posts would have changed much with the more appropriate figures (which I didn’t have at my fingertips.)