Archive for January, 2008

Three things that I learned from watching Japan

Saturday, January 19th, 2008

There was a time in my life when I thought and read a lot about Japan. I was just starting to get interested in economics when Japan was at the height of its boom and everyone was talking about how they were going to take over the world. Then came the crash and Japan became the sick man of the first world. This turnaround fascinated me.

Time constraints and other interests have prevented me from following the subject as I would like. So I can’t say that I have anything really profound or informative to say about Japan. (If you want more up to date thoughts on Japan I recommend checking out Claus Vistesen and Edward Hugh’s Japan Economy Watch site.) But I can’t watch the current crisis unfold in America without comparing and contrasting it to what has been happening in Japan. So I thought that I would lay out some of the things that I learned from watching Japan so as to provide a basis for explaining some of my thoughts on America’s current situation.

1. People save at a rate determined by anticipated needs, not on expected rate of return.

At one time I thought that expected rate of return had a lot to do with the rate at which people saved. So I was inclined to be dismissive when I first came across the idea that lowering the interest rate could actually increase the rate of savings (I don’t remember where I first came across this idea, but it was in the context of somebody arguing that lowering interest rates could actually be counterproductive for Japan). But watching Japan and the people around me in America convinced me that individual savings rate had little to do with expected return.

Given my interest in history, you would have thought that I would have realized this from the get-go. After all, when people saved up food and other supplies in pre-industrial times they were not dissuaded by the fact that their savings had a negative real return. The fact that the rats are going to eat a portion of grain is not going to stop you from stockpiling grain when you know that you are going to have to eat come winter. That is so obvious that it is hardly worth mentioning.

Yet it should also be obvious that an aging population with little in the way of safety nets (either in the form of extended families or governmental entitlements) are going to have a high savings rate no matter what. If people anticipate needs in the future they will save even if the real return is negative.

This is why all the people clamoring for Japan’s central bank to inflate the currency and “force” people to spend more were wrong. Even if Japan had managed to force all savers to pay for the privilege of saving through a drop in buying power (which they never quite managed although they came close), I don’t think they would have accomplished their goal of lowering the savings rate. Japan’s people just have too many good reasons to anticipate future needs for them to stop saving just because returns go negative.

Since the early 90’s up until the present, America has demonstrated the other side the coin. Even though Americans have had a rate of return on their savings that has been high compared to the rest of the world, Americans have not seen fit to increase their savings rate. If anything, the American savings rate has been dropping as the rate of return went up. Instead of taking their outsized returns on their savings as encouragement to save more, Americans seem to have taken it as a sign that they could save less.

I suspect that we will see the savings rate in America go up as the expected rate of return falls (which it likely will as a result of the current economic problems).

2. It is aggregate real expected rates of return that determines how much people will borrow. Not real interest rates.

I am going to have trouble explaining this one so bear with me.

At one point in my life, I would have thought that mentioning real expected rates of return and real interest rates in the same breath would have been a tautology. I always assumed that real expected rates of return and real interest rates could be charted as a kind of supply/demand chart.

That statement is probably meaningless blather to a lot of you so let me try a more detailed explanation. Real interest rate is the interest rate minus the rate of inflation (or plus the rate of deflation) right? So what does this imply?

To my mind it implies that there is a finite amount of “real” money available to be lent out. Otherwise you could change the real interest rate by printing money. But printing money only changes nominal interest rates. Real rates are not affected.
So what cause real interest rates to rise and fall? Demand for the money. What determines the demand for money? Expectations of future returns. People are not going to want to contract to repay money in the future if they think they will have less money in future relative to what they owe, than they have in the present.

In other words, if a company thinks it will make 10 percent on its capital, it will be willing to borrow at 9% to get that capital. Or if consumers think that their incomes are going to go up in the future, they will be more willing to borrow money now. In both cases it is the expected rate of future returns that governs the price they will be willing to pay to borrow money. (Although in the case of consumers, it is the future returns of their labor instead of the future return of their capital that govern their willingness to borrow.)

If this is true, interest rates should be higher when people expect to make a lot of money in the future and lower when people don’t expect to make a lot money. In other words, real interest rates should reflect the expected rate of return.

So far, so good. But there is one big question left unanswered by the above theory. Is the “real money” available to be lent out a relatively fixed sum or is it a variable number? And if it is a variable number can central banks affect that number?

Watching Japan has led me to believe that “real money” is not all that variable in the short term. I think “real money” is a reflection of the production possibilities of a society. Thus, I think the only way a central bank can lower real interest rates is to lower the expected rate of return.

This is what the Bank of Japan did when it tried to lower real interest rates. In the process of trying to lower real interest rates they kept banks with lots of bad loans on the books, construction companies with no work to speak of, and various regional government bodies from going bust. In my opinion, this lowered the expected rate of return faster than the bank was able to lower the real interest rates. And that caused people’s desire to invest or spend in Japan to fall in an equally dramatic fashion. The net result was that Japan as a nation exported more and more capital overseas rather than spend it in their own country.

To understand why this is so, imagine that you want to start a business. Now imagine that your potential employees have a choice between taking an uncertain job with your startup or a certain government job turning Japan into a giant parking lot (common Japanese make work scheme). Or imagine that your start up is going to try to compete with a company that the government has decided is too big to fail. What do you think the impact of these scenarios would be on your expected rate of return?

This is why I say aggregate real expected rates of return are more important than real interest rates. The goal of policy makers should be to insure that real expected rates of return are as high as possible. That will encourage people to borrow and spend in their own country instead of overseas. It will also encourage foreign investors to invest in the country. But if they focus on lowering real interest rates, they will simply lower demand for real money by lowering the expected rate of return. And that is in no one’s interest.

3. The impact of monetary policy on a nation’s economic health is vastly overstated.

To a certain extent, this lesson was implicit in the other two. But it struck me how much the central bank of Japan was being blamed for things it had no control over. I accepted that the Bank of Japan had not acted perfectly. But I came to believe that most of the criticism that was directed against the BOJ stemmed from the fact that most economists attach too much importance to monetary policy.

For example, I remember one paper by a couple of economists who worked for the Fed. They admitted that according to most standard economic theories, the BOJ had done everything right based on the data they had at the time. However, they went on to argue that the data available to BOJ was slightly flawed. They argued that if the BOJ had had better data available to it, Japan’s depression could have been avoided. They essentially argued that minuscule differences in policy would have had massive differences in outcomes.

Needless to say, I did buy their conclusion. But their demonstration of how closely the BOJ had followed standard advice for how central banks should behave was a real eye opener to me. The more I learned about Japan’s problems and the more I read about economics, the more I came to suspect that the importance placed on central banks was a result of confusing correlation with causation.

A good example of what I mean by that is the accusation that central banks are the cause of investment bubbles. I have never seen a good theoretical or empirical argument that even comes close to demonstrating that this is true. I can’t think of anything that would prevent mob behavior from creating over-investment in certain sectors even if monetary policy was “perfect.” It seems to me that in the absence of mob behavior, overly loose monetary policy would cause across the board price rises. Not a more narrowly based investment bubble.

In fact, rather than bubbles being caused by overly loose monetary policy, I suspect that bubbles cause overly loose monetary policy. If mob behavior causes an overinvestment in a particular area (usually because of new technology whose benefits are not yet fully known and thus make it difficult to accurately assess future return) it makes it more difficult to accurately measure inflation. On one hand the bubble could hide an undesirable increase in the money supply because everyone would be rushing to invest in narrow segment of the economy. On the other hand, an overzealous bubble picker could actually cause deflation by trying to end a bubble that was caused by an overly enthusiastic mob as opposed to easy money.

Don’t get me wrong. I fully accept that central banks can cause inflation and deflation. I fully accept that inflation and deflation are bad things. Therefore, I don’t dispute central banks have an important role to play in any national economy. But so do electrical grid operators. Yet nobody blames them for every recession.

Economies have grown in real terms even as they were experiencing deflation. Economies have grown in real terms even as they experienced high rates of inflation. Yet if an economy experiences a contraction with only mild accompanying deflation (as happened to Japan) people have a tendency to place a huge share of blame on the central bank for the contraction. Ditto if an economy is experiencing slightly elevated rates of inflation as it goes into a contraction (say, like what is happening in the US right now).

I don’t believe that perfect monetary policy can prevent contractions. I don’t even believe that perfect monetary policy can prevent long periods of economic contraction. I don’t believe that perfect monetary policy can prevent overinvestment in certain sectors. I don’t believe that perfect monetary policy can prevent government actions that make things much worse. (The tariff bill that Hoover signed into law, for example.)

In Japan’s case, the central bank was faced with a bursting bubble along with an ageing demographic, and a government determined to prevent any kind of readjustment that might threaten social stability (which in practice meant no readjustment whatsoever). It is difficult for me to imagine a policy that the BOJ could have followed that would have prevented the mess that followed.

Monetary policy is only a small part of the sum total of economic behavior. And those who look to monetary policy to solve all their economic problems are going to be sadly disappointed.

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Europe was saved by miracles and heroes

Sunday, January 6th, 2008

Both liberals and conservatives tend to have a Euro-centric view of history. That is to say, both camps tend to view the rise of the Europeans as something that was bound to happen. This view enables liberals to avoid confronting the cultural failings of the countries that were conquered by Europeans on the grounds that you cannot blame the victims for something that was bound to happen. This view enables conservatives to have an inflated sense of the superiority of European culture as compared to their competitors.

A good antidote to this Euro-centric view of history is to study the times when European culture was on the ropes. The rise of the Turks is particularly instructive, for they did to many European countries what the European countries would later go on and do to the rest of the world.

Turkish vs. European battles were battles between professionals and talented amateurs, just as future European conquests would be. Europeans were often more interested in settling scores amongst themselves than they were in fighting the Turkish threat. This was true even after it became clear how serious the Turkish threat was. Again, this is similar to the situation that confronted the European imperial expansion. Those cultures that managed to avoid conquest (such as Thailand, Ethiopia, or Japan) were the ones that managed to stay united. Almost without exception, those countries that fell to Europeans did so because the infighting amongst themselves seriously weakened them.

Yet somehow I never hear liberals using the same kind moral condemnation of the Turkish conquests that they use for the European ones. And I never seem to hear conservatives talk about how the European culture was inferior to the Turkish one in the same way that they talk about the victims of European conquest.

But I think that if you read history without blinders you will see that the only thing that prevented Europe from suffering the same fate as Africa was a few odd miracles and a couple of heroes. Or you could call it luck if you would prefer not to view the world as the medieval Europeans did.

No matter how you look at it, I think a fair-minded person would have to admit that the Turkish success was due largely to their institutions and culture. In other words, you could have placed any average member of Turkish upper class on the throne and it would not have made much difference. The Turkish military machine did not depend on heroes to win its wars. By the same token, when the Turks finally went on the decline it was because their institutions had become utterly corrupted. In those circumstances, even good Turkish leaders had a hard time winning battles.

By contrast, those few successes that the European cultures had at delaying the Turkish advance depended on the character of particular individuals. Once those particular individuals had died or otherwise lost power, the Turkish advance would roll on as before. So in one sense you could argue that those particular individuals did not accomplish a heck of lot in the long term.

But if you see the corrupting of imperial institutions as being a foregone conclusion (as I do), then the Turkish advance into Europe becomes a race against time. How far could they get before their institutions became worthless?

In that context, those individuals who managed to halt the Turkish advance for a time seem pretty significant. If a half dozen people had never been born over a span of a couple hundred years, the Turks would have taken much of Europe. If even one or two of them had never been born, Rome, Vienna, and who knows what else would have fallen.

Attaching such importance to a few individuals is unpopular in this day and age. It is argued that individuals are rarely all that important compared to the broader cultural context. But the fate of Europe was balanced on a hair for a couple of hundred years. It very easily could have gone the other way. In that context, I would argue that a few key individuals did make a dramatic difference.

It would require a book to properly support such a sweeping argument. But if I have aroused your interest, I can suggest some places for you to start reading on your own.

Ironically, one of the best places to start is to read about a man who was not even European. I am speaking of Timur (or Tamerlane as he is sometimes known). This murderous man had the morals of Hitler. But he created an empire on the basis of his own talents as a military commander. And in the process he destroyed the Ottoman Empire at the Battle of Ankara.

This obviously delayed the Turkish expansion by a number of years. They basically had to rebuild their empire from scratch after Timur died. But I think the fact that Ottoman Empire was able to reconstruct itself after the disaster at Ankara was a testament to the strength of their institutions. In contrast, consider how fast Timur’s empire fell apart after he died.

As I have said, this is a common refrain throughout the rise of the Ottoman Empire. There were great captains who managed to halt the Turkish advance for a time, but their influence never lasted long.

But that does not mean that Timur had no effect on history. Think of how much further the Turks would have gotten if Timur had not interrupted them. It took a while to recover from the devastation that he wrought.

Skipping ahead in time, read up on John Hunyadi. If you went back in time and took him out of the picture I think that the Turks would have taken Vienna. Not only did he do more to stop the Turks than any other European captain, but he also seemed to have a clear eyed view of the deficiencies of European institutions. At the very least he understood the importance of establishing a professional army, and he was able to pass on a legacy of sorts to his son Matthias. His victories also gave Skanderbeg a chance to return Albania where he turned into one of the “heroes” who were instrumental in slowing down the Turkish advance.

But like most of other “heroes” his heirs were not able to sustain his legacy. The institutions that Hunyadi tried to start were not able to take root. And in the end Hungary did fall to the Turks. But he bought Europe time.

There are few others that are worth reading about such as Mircea the Elder, Skanderbeg, and Jean Parisot de Valette. I would argue that those who came earlier like Mircea the Elder did more to affect history than those that came later like de Valette. To be sure, nobody expected de Valette to be able to hold on to Malta (least of all the Turks). But in de Valette’s time the Turks were at their peak and their intuitions were starting down the path of decline. So I don’t think the scope of Turkish conquest would have changed much if de Valette had not been around.

By contrast, without the time that Mircea the Elder provided for Europe there might never have been a Hunyadi or a Skanderbeg and the Turkish advance could have swept into Rome and Vienna. But Mircea the Elder is not as well known as de Valette is because the Balkans eventually fell to the Turks and remained under Turkish rule for a long time. One can only wonder how much differently history would have turned out if his advice had been followed at the Battle of Nicopolis.

Would it have really mattered in the long run if the Turks had managed to conquer more of Europe? I suppose the answer to that question depends on how much of the current dysfunctional nature of the Balkans you want to blame on their long period of Turkish rule.

But my point in bringing the history of the period up has more to do with speculation about the future than it does about speculation about the past. The institutions that enabled the Turks to own the Mediterranean degraded to the point that they became “the sick man of Europe.” Is it not possible that Western institutions will degrade in a similar manner? In an eye blink of time on historical scale, Europe was much like Africa is today. What is to keep it from regressing back from whence it came?

Such things seem farfetched now. But I do not think it ever crossed the Turks’ minds that the Europeans that they defeated time and time again would one day make most of the world their thralls.

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The essay that I never posted

Tuesday, January 1st, 2008

I have a new essay up on my essay site called “On Holy Fear”. Well, at least it is new to my readers. I actually wrote it about this time last year (all except for a few paragraphs anyway). But it was so awful I could not stand to post it.

Sad to say, I reread it, and it is still awful. But I am going to post it anyway.

In a way, I think it makes an interesting case study. Its catastrophic failure is more revealing of my peculiarities than some of my essays that were more successful. I suppose that this could be a good thing.

In theory, I agree with Joel Dueck. We should cherish those moments that show us up as we really are. But sometimes I wonder which picture is really me? And how come none of them have ever served to make me kinder?

But I digress. “On Holy Fear” was not a “catastrophic” failure because it failed to live up to my expectations. It certainly failed to meet them, but that is not why I failed to post it. After all, “The Dangers of Historical Symbolism” was a great disappointment to me. But I posted the dang thing anyway.

“The Dangers of Historical Symbolism” at least had the virtue of alerting people to various historical personages who are commonly overlooked. Even if the essay fell short of what I wanted it to accomplish, I could still feel that if a person could overlook the bad writing they might get something of worth out of it.

Unfortunately, I can’t say the same thing for “On Holy Fear.” It will educate no one and it failed to convey what I wanted it to convey. You would not even know the amount of work that I put into. It reads like a stream of consciousness piece. You would think that it was typed as I thought it and unrevised.

I think the fact that “Holy Fear” shows so little sign of having any work is what embarrasses me the most about it. If I had written it up in a day and posted it on my Ape Man site with all the rest of my poorly thought-out blog posts I would not have minded. But to have spent all the time on it that I did and have it still come out like it did was quite dispiriting.

My big mistake was to get cocky. I thought my writing skills had been improving since I had first started writing essays. So I thought I could get away with trying to express a feeling of sorts as opposed to an idea. I have never been good at expressing feelings but I thought that an expression of a particular feeling was a necessary follow up to “Spinoza, Einstein, and The Failure of Reason”.

You see, I knew that most people would see “Spinoza, Einstein, and the Failure of Reason” as some kind of post-modern argument that truth is unknowable. But that was not my intention at all. I firmly believe that the truth is knowable even if it is not provable. (The modern mind always gets those two things mixed up.) Put it another way, just because we cannot encompass the truth does not mean that we can never know any of the truth.

But since I do believe in a sort of common revelation (though I do not mean that term in the same way that most Christians do), so I believe it is possible to search for the truth. In fact, I think that it is imperative that we do so.

So I never intended for “Spinoza, Einstein, and the Failure of Reason” to denigrate the importance of Truth. Nor did I intend to dismiss those who search for the truth in the hopes of finding it. Rather, I wanted to stir up a kind of fear in the hearts and minds of those who feel that the truth matters. To accomplish this end, the false sense of authority that people impute to reason needed to be destroyed.

To most people, the desire to put fear into people’s hearts is a desire to dissuade them from doing something. But to my mind, the truth is dangerous and as such it is important to stay afraid when you pursue it.

But how do you express such a thought or explain why?

Fear is a feeling. Explaining its importance is like trying to explain the importance of love. You might be confident in your mind of it is importance. But try to explain it and all that will happen is that you will sound trite or overly mystical. And that in a nut shell is why I put so much effort into “On Holy Fear” for so little return.
I would write out paragraphs or pages and then I would turn around and delete them all because they were either incoherent or trite. No matter what tack I took the essay always seem to turn out too much like a sermon for my tastes. And I hate sermons.

But after wasting a lot of my time I finally gave up. I gathered up all my voices into an imaginary audience and I set out to write out my essay in the form of a sermon. It was a desperate act based on the theory that if you can’t beat them you might as well join them.

The fact that the wind was blowing hard at the time that I gave in provided me with notion of how to go about using my experience in the trades to explain the importance of fear. The result was that the first part of my essay was stupid and a touch overly macho, but at least it was somewhat coherent.

Unfortunately, explaining the importance of fear was the easy part (which is probably why I spent too much time doing just that). The more important part from my point of view was to explain why the truth was dangerous and why it should be feared even as it should be sought.

This was the part that defeated me. I just could not find the words to express what I wanted to say without sounding trite or incoherent. Since I am prone to overdoing things, I managed to do trite and incoherent at the same time.

In retrospect, I never should have tackled subject. Instead, I should have written an essay about Alexander Solzhenitsyn or Menno Simons. The lives of both of these men always come to my mind when I think of the dangers of the truth. Not because both them were oppressed by the authorities. But rather, how they both became enraptured with the power of the truth that it became a kind of idol to them. So great was what they found that they lost interest is looking for more. It must have seemed to them that they had already become so much greater than their contemporaries that there could hardly have been farther to go. As a result, the truth that they found ceased to become something that ennobled them and instead became something that damned them. (This is truer of Solzhenitsyn than Simons, but Solzhenitsyn has not died yet so maybe I should not rush to pass judgment).

Admittedly, that all seems more mystical than practical. Still, I think it would have been more profitable to write an essay explaining my perception of the life and works of one of those two men than it would have been to take my feeling in the abstract and try to justify it. Originally, I intended to work Solzhenitsyn into my essay. But his life and works deserve an essay all their own. Working him in as a bit player in support of a larger point just did not work. At least, it did not work the first 42 times I tried it.

Anyway, that is why the essay has its bizarre form. Originally I was going to cut the second part of the essay off and post what was left over at my Trade Watcher site. That probably would have been the best way of salvaging something halfway decent to post out of all the work that I put into it. But when I reread it I saw that it would take more work to edit it into a form that would make sense for my Trade Watcher site then it would take to vomit out a few more paragraphs and finish it off.

Laziness won out, naturally. Besides, I figure that a little public (or sort of public) humiliation every now and then is good for the soul.

I would like to think that putting it up will inspire me to make time to write another essay so that people don’t see “On Holy Fear” the first time that they go to my essay site. But I doubt it will work that way.

Changes in my work situation that happened right around when I gave up working on “On holy fear” mean I have less free time to work on my essays. And while that is not really much of an excuse, because you can always find the time for things that are important to you, it means that I have to spend that much more of my free time writing if I want to produce one. That’s work and I am lazy by nature.

I do intend to write at least two new essays this year. But I know myself well enough to know what that is worth.

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