The revival of a costly myth

My friend Chandrasekar forwarded this mail to me. It is an interesting article about government spending. The way governments work all over the world, any new scheme has to be gone through with a very fine toothcomb. It is sad but true that any socalled temporary measures on the part of the government tend to linger on quite long after the end of its need. One example that comes to my mind is the Rent Control Act in Bombay, Chennai and other metropoles. Started as a stop-gap arrangement immediately after the end of the Second World War, it is still hanging on creating havoc in the houseowner-tenant relationship, new house constructions, availability of rented accommodation to newcomers to the city and what not.

Yet we do not seem to learn. It is really tiresome the way people have a short memory, so laments Christopher Lingle in "the revival of a costly myth". Over to Christopher Lingle. Dondu N. Raghavan will come afterwards.


Deficit spending to boost a weak economy is an argument that has little justification in fact and reality.

Despite having a stake driven through its heart after being identified as the primary cause of the stagflation of the 1970s, a failed economic policy has risen from the dead. Yet, the consensus at the recent G-20 meeting is that governments can create jobs and end recessions simply by spending more money.

The myth that higher public spending is good economic policy is so resilient that its supporters are unperturbed by all the evidence that contradicts it. Consider that Japan's policymakers began throwing massive amounts of money at the economy in the late 1980s to reignite it. This constant flow of deficits brought only a growing mountain of public sector debt with the economy regaining its long-term growth trajectory. Nor did it deter Japan from ushering in yet another recession.

More recently, the Economic Stimulus Act of 2008 gave so-called tax rebates worth $100 billion to US households in May, June and July. But the rise in spending was very small since most went into savings, including paying down debt.

Numerous studies show that one-time tax rebates cannot bring higher economic activity. This is because temporary increases in disposable income do not create incentives to increase consumption over time. The only certain thing is that stimulus packages based on increased public sector deficit will add to national debt.

Belief in the efficacy of deficit spending rests on a naïve notion that consumption is an important driver of economic growth. It is as though consumer goods and services are merely gifts of nature.

In reality, the path for sustainable economic growth requires more savings so that there can be more capital goods. As it is, capital goods are the basis of higher output and increased wages by boosting productivity. The provision of capital goods requires that consumption be deferred.

It seems that saving is not only a natural instinct, but it is also promoted by many fables, biblical and otherwise, that show the merits of thrift. In recent years, central bankers removed incentives to save by driving interest rates to unsustainable and artificially low levels while inducing more consumption.

This leads to a "paradox of spending" whereby consumers, deterred from saving by low deposit rates, are lured into low-interest borrowing to boost current living standards. This distortion in credit markets induces individuals to make decisions that lead to greater misery in the future for them and for others. Indeed, increased spending may cause incomes to fall by a greater amount since the attempt to buy more today backfires as there are fewer jobs and less to consume later.

By spending beyond means to create jobs, governments undermine or eliminate future employment

Therefore, policies that aim to raise consumption now lead to less capital being available for future production, so there will be less future consumption.

An enduring fable has it that governments can "create" jobs either through public spending to employ people in the public sector or to increase overall demand. During his campaign, Barack Obama promised to use $150 billion to promote windmills, solar panels and "energy efficiency" that would supposedly create five million "green" jobs.

In the first instance, government spending to "create" jobs costs more than jobs created in the private sector, since public sector recruitment involves massive bureaucracies. And since adding workers to the public payroll creates a new burden on taxpayers who have less to spend or invest, this means there can be no net gain to the economy.

In all events, government funding to "create" green jobs may be the worst of both worlds. Much of the support for green projects exists as they are thought to create more jobs because they involve more labour-intensive production. For example, supporters of initiatives for alternative fuels insist they would boost employment than would the building of conventional power stations. But conventional power stations operate with enormous economies of scale that bring lower unit costs so that more jobs can be created throughout the economy.

Job creation based on real economic merit does not require government involvement. But providing subsidies to support inefficient technology raises the labour-to-capital ratio so that the demand for labour will be lower and real wages will fall.

It is bad enough that deficit spending on job creation is simply ineffective. What is worse is that government spending schemes that expand public sector debt impose several burdens on future generations. Most obvious is the additional tax burden they must pay for debts incurred in the present.

By  spending  beyond  their  means to conjure up jobs, governments undermine or eliminate employment that would have been created in the private sector in the future. If increasing the share of GDP claimed by government leads to lower long-term economic growth, "creating" jobs today will mean fewer jobs in the future. The best way to avoid a future of booms and busts is to consign economic theories that support public sector deficits to the dustbin of history.

[Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and a visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Comments are welcome at theirview@livemint.com]

Back to Dondu Raghavan. It is really amazing the naive manner of people faithfully repeating the old mistakes. Creating job is different from creating posts in government departments. As per the Parkinson's law, the more the posts, the more the infructuous efforts and nothing else.

The depression of 1932 is said to have been overcome by Franklin Roosevelt's New Deal. Actually what turned the economy around at that time was the onset of the Second World War creating acute demands for the war effort. Even in Germany the unemployment was reduced mainly due to Hitler's militarization of Germany, which triggered the Second World War.

Can this be repeated? I am afraid that the third world war if it comes may bring about things in such a way that the fourth world war can be fought with just bows and arrows, that too after some hundred years.

Regards,
Dondu N. Raghavan

Henry Hazlitt on the Bailout by Scott A. Kjar

My dear friend Chandrasekaran forwarded me this very interesting article. First the article and then the comments by yours truly Dondu N. Raghavan. Over to Scott A. Kjar. By the way, Scott A. Kjar teaches economics at the University of Dallas.

Treasury Secretary Henry Paulson needs to change his reading list. Instead of reading the balance sheets and income statements of the failing banking industry, he needs to read Henry Hazlitt's classic book Economics in One Lesson. It will cost Paulson far less than the $700 billion that he is spending on the bailout, and he might just learn a little economics in the process.

Hazlitt delivers his "one lesson" in chapter 1, and proceeds to spend the rest of the book giving examples. His lesson, based on the work of Frédéric Bastiat, is that "the art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups."

For example, in chapter 2, Hazlitt delivers the well-known "broken window fallacy" in which a hoodlum breaks a shopkeeper's window with a rock. The common folk see it as a tragedy, but an astute Washington bureaucrat could argue that it creates new jobs for glaziers. As Hazlitt points out, though, any resources that the shopkeeper spends on the new window would have been used elsewhere, perhaps for a new suit. So while the glazier gets new business, the tailor loses the same amount of business. There is no net benefit; in fact there is a net loss. Absent the hoodlum, the shopkeeper would have had both a window and a new suit; given the hoodlum, the shopkeeper has a window but no suit. Even though the damage was to the window, it is the suit that is lost to the shopkeeper and, hence, to society.

In chapter 6, entitled "Credit Diverts Production," Hazlitt discusses government lending policies, such as additional credit to farmers or business owners. However, he points out, the recipients of such programs are rarely the more-productive farmers and business owners. After all, the more-productive people are able to borrow their money from private lenders. It is only the less-productive individuals and firms, unable to get funds on the free market, that must turn to government.

For example, suppose that there is a farm for sale. A private lender would normally be willing to lend money to farmer A who has proven his abilities in the past, rather than to farmer B, who has demonstrated a lower level of productivity than has A. However, because government taxes citizens or borrows money itself in capital markets, private lenders have fewer funds available to lend to A. Instead, government lends the money to B on the grounds that B is underprivileged, in need of a hand, or some other politically based argument. The more productive borrower, A, loses out on the scarce land while the less productive borrower, B, gains the resources. Because the less-productive individual acquires the scarce resource, there will be less total production, and the entire society is worse off.

Further, Hazlitt states, the government takes bigger risks with taxpayers' money than private lenders take with their own money. Private lenders who make bad loans will go bankrupt and be forced out of business. But when the government gets involved, it lends funds for riskier ventures since the bureaucrats who approve the loan face no personal recriminations — much less loss of profit — for error.

In other words, private lenders would take Action A while government lenders would take Action B, and Action B is the less-productive path. After all, there is no need for government to take Action A: it can be handled quite well in the free market.

So it is with the current rash of bailouts. Whatever the final price tag — $500 billion, $750 billion, $1 trillion, more — the fact is that government gets its money either from taxes, borrowing, or the printing press. It is hard to raise taxes by $1 trillion on short notice, and since there is a small hurdle that slows the government's ability to print the money,[1] we know that government will issue bonds. In other words, government will borrow the money from private capital markets.

As Hazlitt points out, though, the private capital markets (those that aren't bankrupt and standing in line for a bailout) would otherwise lend their funds to more-productive ventures. If private capital wants to lend directly to the failing banks, it is already capable of doing so. The fact that such private capital is not lending to the banks is a clear indication that the government's current bailout is contrary to free-market principles.

The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.

So when Henry Paulson argues that it is necessary to pump money into credit markets to prevent them from freezing up, he doesn't bother to realize that the money he pumps into the credit markets is coming directly out of the very same credit markets. He is doing little more than rearranging the deck chairs on the Titanic; shuffling the money from one set of financial intermediaries to another does not increase either liquidity or solvency. It merely delays the problem for a few brief moments.

Even the failing banks pay lip service to their fiduciary responsibility, but any privately funded firm that took money from more-productive people to give it to less-productive people would soon go out of business. Only the government can violate Hazlitt's logic and survive, because only government can socialize its losses through the tax system.

Comment on the blog. As I am writing these lines around ten comments have come up and they do need to be reproduced here.

Comments
Tim Kern
Did anyone note that in the President's speech, after the House rejected the bailout, one of the reasons offered for the necessity of opening such a lending spigot was "to allow businesses to borrow for their day-to-day needs?"
A business that needs to borrow to cover daily operations is in a whole lot of trouble, already!
Lord, save us from more "experts!"

George
Saving in an inflationary environment is costly, borrowing is logical.
"income taxes, inflation, risk"
You can avoid any two, it's the third which is hard to avoid.

Aaron
Atleast the comedians have not drank the Keynesian Kool-Aid... very funny
http://www.sinfest.net/archive_page.php?comicID=2959

Dayle Van Alstine
The article is a timely reminder of the wisdom which is available to those whom have influence in our national economic policies. We can be sure that they are familiar with it. This is what makes our current situation so frustrating. Our economic policy leaders have decided that it is not expedient to follow the the wise counsel and impose the proper prescription.
Our government, fortified and emboldened by a lazy and irresponsible citizenry, has no compunction about disregarding the wisdom and warnings provided by the observations of Messrs. Hazlitt, Mises, or Bastiat. When the ordinary people on the street do not recognize the responsibility they have to understand the consequences of purchasing things that they know they cannot afford; when the political elite reinforce such conduct by demanding that more credit be made available to such people; when financial leaders do not stand firm against such policies; when politicians are more concerned with acquiring and maintaining power and influence than doing what is best for the nation and its people, then we will all have to prepare to contend with the consequences of this folly.
Hazlitt is right, of course; but we in the choir already know that. What to do? Share the wisdom in hopes of enlarging the choir; stay out of debt; develop a portable skill.

Enjoy Every Sandwich
Our "leaders", if they don't already know the principles described in Hazlitt's book, would not be interested in learning them. Following the principles would reduce their power, and that they cannot abide.

Stanley Pinchak
Enjoy Every Sandwich is quite right. The number of men who can follow the course of Cincinnatus is small indeed. We as the people must act on the consul of Étienne de La Boétie. We must remove our consent, refuse to subjugate our fellow man for the false promise of living on the backs of others. We end up as the associates of the tyrant do, subjects of tyrannical action ourselves, or worse when the administration changes. We weld our own bars. We forge the very chains which bind us.
Rothbard calls for radicalism. A radical call for liberty. A radical denunciation of the state and its works. Until we heed this advise we remain prisoners in an open cage, terrified of the unknown just across the threshold. Stuck in a liminal state, abused by our own inaction, fearful of change. Servants willingly submitting to an unworthy master. A master who's hands we have placed around our throats.
The emperor wears no clothes! The state must be itself subjugated. We must throw off the mental yoke, reach out and grasp freedom.

Greg Fisher
The hoodlum breaks a window, it cost the economy a window. If he continues to break windows, he must be stopped before he underminds the economy. And if the shop keepers cannot pay to fix their windows, it would be in the best intersest of the society to help fix the windows to keep the shops open and contributing to society.
Since the world is not static, things change. The unproductive farmer may become more productive with additional capital. Many times it is these people that come up with better ways of doing things and the economy advances.
We need to understand the problem in order to form a solution and the role of society.

Michael A. Clem
And if the shop keepers cannot pay to fix their windows, it would be in the best intersest of the society to help fix the windows to keep the shops open and contributing to society.
If the shopkeepers cannot pay to fix the windows, where do you think the money to fix them is going to come from?? And why should the unproductive farmer become productive, when he's getting paid to remain unproductive? You fail to see the moral hazards of your proposed actions. The problem is that it is the government that is "breaking the windows", instead of some hoodlum, with their flawed policies and interventionism. We do indeed need to stop breaking the windows, but the bailout is like breaking more windows in the hopes that it will fix the other windows.

Eric
The wise entrepreneur would foresee that the hoodlums out there like to break glass and so might invest in Plexiglas.
Alternatively, the entrepreneur might invest in security services. Then only those that remain open for business (with non-broken windows) would continue to make profits. Others, with less business sense, would go bust - and society would benefit from having a smarter class of shop owners in business.
However, if society bails out the shop owner as Greg suggests they should, then society would be subsidizing "mal" shop owner behavior. In addition, not only doesn't this solve the real problem, but it makes any real solution less likely to be discovered.
Moreover, there'd be little incentive for the shop owner to upgrade his windows (or security or whatever else would solve the problem) even if he knew how to solve it. This is the moral hazard produced by bailouts.
Therefore, the same theory that describes bailouts of industry X can be used to analyze the broken window fallacy.

Back to yours truly, Dondu N. Raghavan
As I read the above lines, I am more and more reminded of Ayn Rand's Atlas shrugged. There was in that novel a story about a private owner turning over her ownership to all the workers and every worker started discussing company policy. Since all were responsible no one felt any particular responsibility. Each one was out to get more for himself at the expense of others. One or two with some initiatives were saddled with more work and they too rapidly lost that initiative and kept mum. At the end the factory folded and only the ex-owner was surprised. That she was spat upon is but a feeble comfort to yours truly Dondu N. Raghavan.

Regards,
Dondu n. Raghavan

Rich job offers cause poor response for economics PhDs

This article penned by John Samuel Raja D and forwarded to me by my friend Chandrasekharan (Hayek Order) goes on to add that poor faculty and scholarships also dissuade students.

It reminds me of Agatha Christie's novel 4.50 from Paddington starring the lovable old detective Miss Marple. In this novel she is assisted by one Lucy, who has majored in Mathematics but instead of pursuing a career in mathematics opts for the job of a housekeeper after a thorough study of the market needs. She goes on to become a highly successful housekeeper very well-paid and much in demand.

My reason to mention this is illustrated more starkly in the article referred to above. Now over to the article in bold italics.

D K Srivastava, director of Madras School of Economics (MSE), is disappointed when he sees 50 Master's students graduate every year with lucrative job offers.

He is unhappy because none of the 50 students apply for a PhD or doctoral degree and the Chennai-based institute is finding it difficult to attract high-quality students for this programme.

Like the MSE, the poor response to programmes for Economics PhDs (the abbreviation of the Latin Philosophiæ Doctor) appears to be a chronic problem in India.

"The best brains are going to industry after completing the Master's degree," said Srivastava, who has specialised in public finance and economic forecasting. "This is the malaise of good institutions where highly qualified students don't stay back," he added.

Even the Indira Gandhi Institute of Development Research (IGIDR), a premier institute set up by the Reserve Bank of India (RBI) for research in development issues, found it difficult to attract students for its PhD programme a couple of years ago.

MSE admits two or three students every year for its doctoral programme, a third of what it can accommodate. Aggregate data on the number of students completing their PhD in Economics are not available.

While PhD programmes run by universities across India have faced problems in attracting high-quality students for a long time, it is only now the top economic research institutions are facing the problem of student shortage, given the jobs boom that is attracting the best and brightest among Master's students.

Though there are globally recognised Indian economists like Nobel Prize winner Amartya Sen and trade economist Jagdish Bhagwati, universities based in India have not kept pace with cutting-edge research produced by their counterparts in the United States and Europe, resulting in poor research output.

Three issues — faculty profile, poor scholarship funding and job opportunities — are being cited as reasons Indian universities have failed to attract good quality students, said four economists, including three heads of the institutions, who were contacted for this article.

For the few students who want to pursue a PhD, foreign universities have emerged as a viable option. These overseas institutions are targeting Indian students and are offering liberal scholarships that are hard for Indian counterparts to match, said D M Nachane, director of IGIDR.

Research scholars in Indian institutes are mostly paid between Rs 6,000 per month and Rs14,000, except in a few management institutes where they are offered around Rs 25,000 a month. Compare this with foreign universities that provide a tuition fee waiver and a monthly stipend ranging from $800 to $1,500, depending on the financial strength of the institute and its location.

Both Nachane and Srivastava agree that it's vital to increase the scholarship amount to attract students and provide an alternative within India. Both, MSE and IGIDR are exploring ways to increase their scholarship amount. Delhi School of Economics (DSE) did not respond to a questionnaire.

Students graduating from Master's programme in MSE and IGIDR get job offers in the salary range of Rs 6 lakh and Rs 8 lakh a year -- mostly from banks, financial institutions and consultancies. Candidates even after completing the PhD would get only Rs 50,000 more than what a Master's level students would get, said IGIDR's Nachane.

"The opportunity cost for a student with Masters Degree to pursue a PhD in economics is very high," he added referring to Rs 6 lakh salary the PhD student would have earned for four years, if employed.

Apart from scholarships, the faculty profile and the syllabus play an important role in attracting students. "What I learnt ten years ago is not even offered here in India," said Parth J Shah, economist and former professor of Economics at the University of Michigan.

Lack of quality faculty is often linked to salary structure in Indian universities that fail to differentiate between a professor who has done cutting-edge research with publications in leading journals and faculty who has only concentrated on teaching. "The sixth pay commission will solve this problem because it allows flexibility in salary structure," said Nachane.

But for Shah, who is now involved in a not-for-profit research and education institution Centre for Civil Society, the solution could also lie in giving choices to institutes to decide whom to affiliate.

At present, an institute present in a city has to affiliate in a university based in that city. "The geographical monopoly of the universities should be broken. This will create competition among the institutions," he added.
In the meantime, every year around five students of Madras School of Economics (MSE) come back to pursue research after working for a couple of years in the industry. But, as of now, they come to MSE to prepare for admission to foreign universities and Srivastava is hoping that some will stay back in days to come.

Now back to Dondu Raghavan. I would like to close this topic with an anecdote. A heart specialist calls in a plumber by name John Updike to have his washbasin repaired. After the work is over, John gives him the bill, which is for a hefty amount. The doctor sighs and exclaims, this is way above what I would have earned as consulting physician, whereupon he gets the reply "I know doc from my personal experience as doctor before changing over to plumber profession" from Doctor John Updike.

Regards,
Dondu N. Raghavan