December 31, 2013

Balance - by Glenn Hubbard and Tim Kane

Balance - by Glenn Hubbard and Tim Kane
The economics of great powers from ancient Rome to Modern America
[Authors were members of Mitt Romney economic advisers. It includes 8 case studies of Great Power imbalance - Rome, Ottoman, Spanish, British, Japan, European Union, & California)]

Recent research by Harvard economists Carmen Reinhart and Kenneth Rogoff suggests that countries with a total debt to gross domestic product (GDP) ratio that exceeds 90 percent face a tipping point of decline. And the US, with annual deficits that now amount to 5-10 % of annual GDP and a debt-to-GDP ratio of around 70%, is rapidly heading toward a critical level of imbalance.

Some sports, notably soccer and baseball, tend to be conservative, allowing few rule changes. In contrast, American football and basketball have been much more open to revising their rules. The evolution of play in those games has made them popular - and economically successful.

Presidents and legislators often know good policy from bad, but their incentives are short-term reelection rather than long-term national growth, a specific problem for representative democracies. When nations agree to open their borders with ‘free’ trade agreements by lowering tariffs, many industries lobby for non-tariff barriers (for restriction on imported beef in Japan or modified crops from Europe). Even though economists since Adam Smith haven argued that mercantilism is unproductive, the lure of managed trade is siren song during election season. The policy may be irrational economically while perfectly rational politically.

The lowest recent level of US debt held by the public relative to the size of the economy was 23.9% of GDP in 1974, which in real dollars was $344 bn. Today, the level is around 75% of GDP or $11,578bn (this figure does not include debt held in govt. accounts). By contrast, the European Central Bank reports that 2010 debt among member countries ranged from 119 % of GDP in Italy to 143 % in Greece and 6.6% in Estonia. Interest payment on higher debt level is a major expenditure category that crowds out normal government functions if interest rates rise.

Roman might have fallen one, three or five centuries before it ultimately did. That lesson should not be lost on modern nations. Sweden showed the way large European welfare states can succeed with reforms. By contrast, Greece today seems determined to show how reform can fail. What has been lingering in Japan for 2 decades, haunting Europe in recent years and now loose in the US is the beginning, not the end of a global fiscal reform.

“Wealth, as Mr. Hobbes says, is power - Adam Smith”
“In Europe and America, there’s growing feeling of hysteria....
We share the same biology, regardless of ideology - Sting, “Russians”

Daniel Kahneman (Nobel literate, 2011) says, The humans described by prospect theory are guided by the immediate emotional impact of gains and losses. His three summary points of the prospect theory are paraphrased here:

1. People have reference points. Outcomes better than the reference points are gains, while those worse than the reference points are losses

2. Behavior follows a principle of diminishing sensitivity. We think in terms of relative and not absolute values. As our reference endowment increases (that is, as we move from $100 to $1,000,000), the prospect of losing or gaining another $100 diminishes in importance

3. People have loss aversion. Equivalent losses loom larger than gains.

The application of prospect theory to Great Power behavior is this: a collective sense of loss aversion makes countries hesitant to change their economies, even when they see trading partners and perceived competitor nations growing and changing.

Research by economists on institutions has aimed at the following questions: Why did the industrial revolution begin there and then, and not 1650 or even around the year 50, about the time Hero of Alexandria had developed a steam engine? And why England and not in China or the Roman Empire, states brimming with technical genius? Why did Hero’s contemporaries not use steam engine to power instruments of production, instead of using them to wow tourists with magical toy?

Again, from economists: institutions. The economic revolution finally happened in England, in about 1750, because of institutions. As a consequence of the Glorious Revolution of 1688, the British government was able to commit to upholding private rights, protecting wealth, and eliminating arbitrary increase in taxes. These institutional changes gave entrepreneurs the incentives to make investments necessary to make the most technological inventions - the spinning jenny and the water frame, for example. Though a sophisticated economy at the same time, China, by contrast, lacked the intentions to allow entrepreneurship to flourish.

Economist Anne Krueger coined the term in describing the behavior of the third-world bureaucrats who were technically corrupt - selling business licenses to applicants who preferred to skip the regulatory waiting period. The existence of long waiting periods for licenses is usually a sign of rent-seeking. In modern economies, special interests often seek rents in the tax code by lobbying legislators. Monopolistic firms are natural rent-seekers, as are labor unions and guilds that expend their resources to limit competition.

This line of inquiry recognizes that explaining the emergence of growth requires a theory as to why some nations prosper while others fail to do so. Institutional explanations have centered on historical foundations - such as the rule of law, an independent judiciary and property rights.

Perhaps the way to think about this paradox is that there is no perfect set of economic rules that guarantee growth. The rules of capitalism circa 1820 were great for promoting growth in 1820, but were insufficient for 1920 industrial capitalism and certainly for 2020 techno capitalism.

Every decade that a Great Power can maintain balance is a triumph because the pressures to fall are natural, powerful and constant. Here are the key factors to watch for:

Bounded rationality means rulers are limited in their ability to choose the ideal economic policies.

National identity makes for strong cultural, political, and economic institutions, which are essential for growth and power, but that strength also implies conservatism in the sense of resistance to structural change.

With loss aversion, leaders rarely innovate, since they are averse to losing their status as leaders

Time preference matters too. Even when officials are cognizant of the need for reform, they defer necessary changes for another day or year,. Voters too, habitually discount the future value of higher prosperity tomorrow and avoid making painful choices in the present.

“The mind of the superior man dwells on righteousness; the mind of a little man dwells on profit - Confucius, Analects”.

“The Egyptians had a great secret, which they did not forget for thirty centuries. They feared and hated change, and they avoided it wherever possible - Charges Van Doren, The History of Knowledge”.

“Gold is the corpse of value,” says Goto Dengo....”The General didn’t care about gold. He understood that the real gold is here,” he points to his head, “in the intelligence of the people, and here,” he holds out his hands, “in the work that they do. Getting rid of our gold was the best thing that ever happened to Nippon. It made us rich” - Neal Stephenson, Cryptonomicon.

Following our tour of Great Power history, here then are seven lessons we draw:

1. Nothing is inevitable. At any moment in time, no great power is destined to succeed or to fail. Long-lived states such as Rome or Ottoman Turkey did not appreciate the reality of their demise.

2. People are people. There was never such thing as ‘Jewish physics’. That is, however, how many nationalist Germans in the early 20th century characterized the research of their country man Albert Einstein. In the same vein, we are typical or economists who reject the idea of ethnic economics. Supply & demand curves operate the same way in Beijing, Munich, Boston and Mumbai. Growth will accelerate in any country that establishes superior institutions with incentives for commerce, entrepreneurship, and technological change.

3. The existential threat is internal. In every case study, we saw Great Powers decline internally centuries before external threats toppled them.

4. Ignorance if the ultimate bind. Time and again, Great Powers decline because their wise and brave rulers do not know something essential about their economy. However, as we observed throughout our text, nobody else alive knew it, either.

5. Governments are the most dangerous ‘faction’. Every country has a diverse population, though outside observers often miss this fact, as they are prone to generalizations. Even supposedly homogenous ethnic nations such as Japan, Israel or Nigeria have, in reality sharp internal divisions. The task of a well-run democracy is to balance the interests of these inevitable factions, an outcome aided by freedom of expression. When the people who control the levers of government are able to enrich themselves at taxpayers’ expense, and when such centralized rent-seeking is unchecked, the situation can deteriorate toward fiscal ruin.

6. Loss aversion threatens innovations. In most cases of imperial decline, there was some faction that controlled the government and insisted on preservation of the status quo. When such a faction, like the Janissaries, for example, inserts itself into the economy, tolerance for economic innovation disappears. Because innovation routinely threatens traditional production methods (and profits), resistance to economic innovation is common among all growing economics, as for example, with 19th century Luddites’ resistance to the substitution of mechanical devices for artisans’ labor or contemporary resistance of some office workers to information technologies that substitute for them.

7. Under-stretch is a greater threat than over-stretch. Finally, as we reflect back of Paul Kennedy’s book ‘The Rise and Fall of the Great Powers’ and his argument that ‘imperial overstretch’ led to imperial decline, it seems clear that the economic history of Great Powers does not support that thesis. The data collected and assembled in the quarter century since then provide more evidence to the contrary.

Here are four modifications that will enhance the traditional text, improve its odds of becoming law, and just may be preempt the coming fiscal crisis:

1. The annual constraint on expenditure should be defined by the median federal inflation-adjusted revenues of the previous seven years, not the current year.

2. Any amendment should be simple, focused only to fiscal balance

3. Any new rule or balanced budget amendment should use escalating super-majorities for exemptions that are universal.

4. The balanced budget act should provide a glide path to a lower debt-to-GDP ratio.

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