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GDP Economics: Fat or Muscle? – Article by David J. Hebert

GDP Economics: Fat or Muscle? – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
November 1, 2014
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Recently, Italy “discovered” it was no longer in a recession. Why? The nation started counting GDP figures differently.

Adding illegal revenue from hookers, narcotics and black market cigarettes and alcohol to the eurozone’s third-biggest economy boosted gross domestic product figures.

GDP rose slightly from a 0.1 percent decline for the first quarter to a flat reading, the national institute of statistics said.

Italian officials are, of course, celebrating. In politics, perceptions are more important than reality. But such celebration is troubling for several reasons, which have less to do with headlines or black markets and more to do with fat.

One of F. A. Hayek’s lasting insights was that aggregate variables mask an economy’s underlying structure. For example, a country’s GDP can be calculated by summing the total amount of consumption, investment, government spending, and net exports in a given year. The higher this number, the better an economy is supposed to be doing. But adding these figures together and looking only at their sum can be wildly misleading.

One way to illustrate why is through the following example: I am currently six foot one and weigh 217 pounds. As it turns out, Adrian Peterson, a running back for the NFL’s Minnesota Vikings, is the same height and weight. Looking at only these two variables, Peterson and I are identical. Obviously, this isn’t true.

Likewise, cross-country GDP comparisons are difficult to make. If two nations grow at the same rate, for example, but one nation “invests” in useless boondoggles while the other grows sustainable businesses, we wouldn’t want to claim that both countries have equally healthy economies.

But what about comparisons of a country’s year-to-year GDP? Is this valuable information? Well, yes and no.

If we know that more stuff is being produced this year than last year, we can infer that more activity is happening. However, this doesn’t mean that government should subsidize production in order to increase activity. In that case, all they’re accomplishing is increasing the number of things that are being done at the expense of other things that could have been done.

What economists should be looking for are increases in economically productive activity from year to year. For example, digging a hole and then filling it back in does increase the measure of activity, but it’s not adding any value to society. Digging a hole in your backyard and filling it with water is also activity, but it’s productive because you now have a swimming pool, which you value enough to employ people to create.

It’s no mystery that Italy is seeing a higher GDP as a result of its change in measurement and that as a result it’s avoided a recession on paper. That is, it’s counting more activities as “productive” than it was previously. It is wrong to conclude, though, that more production is actually happening in Italy. These activities were happening before; they just weren’t being counted in any official statistics.

There are many problems with using GDP as a measure for an economy’s health. Changing what counts toward GDP only introduces yet another confounding factor. When I step on the scale, I can get some basic idea of how healthy I am. But when I take my shoes off and step on the scale again, I didn’t magically become healthier. I just changed what’s counting toward my weight. It would be wrong for me to conclude that I can skip the gym today as a result of this recorded weight loss. Similarly, citizens of Italy should not be celebrating their increased GDP. They still face the same problems as before and must still address them.

David Hebert is an Assistant Professor of Economics at Ferris State University. His interests include public finance and property rights.

This article was originally published by The Foundation for Economic Education.

The Paradox of Public Assistance – Article by David J. Hebert

The Paradox of Public Assistance – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
January 26, 2014
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Let’s put ideology aside for a moment. One might not think it’s morally or politically justifiable to take from one person in order to help another. But for now, let’s ask another question: Does it help?

A lot of people see the existence of “poverty amid plenty,” wherein a few people have acquired a lot of wealth while the overwhelming majority struggles to make ends meet. The standard call is to provide some means of transferring those resources from the haves to the have-nots, either through a progressive tax policy or via some direct transfer program.

The problem with these policies is obviously not in their stated goals. Who could argue against the desire to help people? Nor is it, entirely, the coercive nature of redistribution. The real problem comes in the ability of welfare advocates to actually reduce poverty in an effective and long-lasting manner.

World Coyne

In his latest book, Doing Bad by Doing Good, Chris Coyne discusses problems with delivering effective humanitarian aid to other countries. Coyne identifies two potential problems: the planner’s problem and the incentive problem.

Briefly, the planner’s problem refers to the impossibility of people outside of a society actually to possess the information required to assist in fostering continued economic development. The incentive problem refers to the idea that the planners may face perverse incentives to go ahead and do something that the planner’s problem suggests is impossible to start with.

These points are all well and good, and should be well received at least by readers of this publication. But I think we can go further to urge that the problems Coyne identifies apply equally to issues related to domestic intervention.

Disconnect

The people who advocate most strongly for poverty relief programs are not, in fact, people who are poor. Rather, they are people who are typically either politicians seeking reelection or wealthy people who have some overwhelming desire to do something (usually they want to get other people to give them money to do something). They are not poor, but rather they simply do not like seeing poor people suffer and feel some desire to help. However, because they are not poor themselves, they have absolutely no idea what it is that poor people actually want.

Do they want shelter, clothing, and food? Yes. Do they want education, hygiene, and employment? Of course. But in what order, how much, and of what type? In a world of scarcity, the answers to these questions are of crucial importance if we are to find ways to help the most people as quickly and effectively as possible. And yet, the answers to these questions are wholly unknowable to outside observers.

Similarly, and perhaps more importantly, the incentive problem that the planners face also applies to domestic intervention. Politicians are people who, just like us, are primarily concerned with helping themselves. Given their position, what is in their interest might sometimes in be the interest of the “general public” (providing genuine public goods, the rule of law, etc.) but as James Buchanan and Gordon Tullock rightfully point out in their groundbreaking book, The Calculus of Consent, this is not guaranteed to be true at all times and in all cases. In fact, it may be the case that as a direct result of political involvement, incentives may direct their behavior in ways that enrich concentrated interests and impoverish poor people even more.

The War on Poverty

One answer is that the disparity might be much, much worse without government intervention—that is, the rich would be even richer and the poor would be even poorer. But another possibility is that the war on poverty directly contributes to a burgeoning underclass. How can we adjudicate between these positions?

On the surface, giving people aid seems like a straightforward proposition. We observe people suffering and then send resources to them to alleviate that suffering. On the other hand, as Buchanan pointed out in 1975, we run into problems in which the aid designed to alleviate poverty actually perpetuates it, creating dependency. This dependency, in turn, means that an increasing number of people derive the majority of their income from aid.

Paid to Be Poor

That some of the poor get most of their income from the government is not to argue that welfare recipients are lazy or don’t wish to work. Rather it suggests that the incentives they face may make them reluctant to accept employment opportunities at offered wages. We can think through this proposition logically: Suppose I offer you $240 per week in financial aid while you are between jobs. You would be receiving that money for zero hours of work per week. Being an honest person, you go out and look for work, eventually finding a job that pays you $8 per hour, or $320 per week working full time. Should you take that job?

On the one hand, you would receive more money by taking that job than you would by accepting the aid. However, economics teaches us the value in thinking at the margin. Doing so reveals that you would only receive an additional $120 per week in exchange for your 40 hours of work. In other words, taking into account your opportunity cost, you would really only be earning $3 per hour! While I certainly cannot speak for everyone, I feel reasonably confident in saying that few people in this country value their time at only $3 per hour. Realizing this, it is no puzzle why people receiving aid tend to stay unemployed for so long. The Cato Institute recently published a study offering evidence of the work versus welfare trade-off, which can be found here.

Politics and Perquisites

Now that we understand why domestic aid programs may lead to the perpetuation of poverty among the poor, we’re ready to discuss how they may lead to the enrichment of the already wealthy. When politicians decide to try to do something about an issue, one of the first things that they do is convene special hearings about the issue. Here, they call upon the testimonies of experts to try to figure out (1) what can be done and then (2) how best to do it.

The problem here is that the very people who are best equipped to detail how to solve the problem will typically explain that they themselves (or the people that they represent) are in fact the best to solve the problem and should be awarded the contract to solve the problem. We see this in government all the time. Take, for example, the company that was placed in charge of rebuilding Iraq after the US invasion in 2006: Halliburton, which was formerly run by then-Vice President Dick Cheney. Is it any wonder why this company was awarded these contracts? Kwame Kilpatrick, when he was mayor of Detroit, would routinely award offices and several perks to his friends and family members. Don’t forget about the legendary William Tweed, better known as “Boss Tweed.” The point here is not that all politicians are corrupt, but that knowing a politician who is in a position to award perks puts you in good stead to be the recipient of largesse. And, of course, if that’s true, you have very good reasons to create incentives for the politician to steer favors in your direction. It is the nature of politics.

What to Do

Evidencing the failure of domestic aid to help combat poverty, Abigail Hall has an excellent article, forthcoming in the Journal of Private Enterprise, detailing the failure of the Appalachian Regional Commission. This line of research might lead one to the sobering conclusion that there is little that can be done to alleviate the suffering of the poor. Nothing could be further from the truth, however.

We can take away a couple of things from this type of work:

1) The limits of what can be directly achieved through political means of alleviating poverty; and

2) The idea that the expansion of opportunity ultimately drives economic growth and helps the poor.

Rather than focusing on giving poor people the resources to live well, we should instead focus on removing the barriers that prevent people from discovering ways to be productive. Doing so would not only provide them with the tools to lift themselves out of poverty, but would also provide the basis of dignity.

David Hebert is a Ph.D. student in economics at George Mason University. His research interests include public finance and property rights.

This article was originally published by The Foundation for Economic Education.
That Cold-Hearted Discipline – Article by David J. Hebert

That Cold-Hearted Discipline – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
November 6, 2013
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But of all the duties of beneficence, those which gratitude recommends to us approach nearest to what is called a perfect and complete obligation. What friendship, what generosity, what charity, would prompt us to do with universal approbation, is still more free, and can still less be extorted by force than the duties of gratitude. —Adam Smith, The Theory of Moral Sentiments

A recent article by Wharton Professor Adam Grant has been popping up here and there, most recently in Psychology Today. Grant suggests that studying economics breeds greed, and he cites several studies to support his claim. The studies conclude economics professors give less money to charity than other professions, economics students are more likely to deceive others for personal gain, and people who study economics have less of a concern for fairness and tend to think that “greed” is okay.

To his credit, Grant does consider the alternative: that maybe economics actually attracts greedy people or that greedy people tend to thrive by studying economics. He dismisses these possibilities by noting that “there is evidence for selection . . . but this doesn’t rule out the possibility that studying economics pushes people further toward the selfish extreme.” He goes on to chide practitioners of the discipline for teaching self-interest in the classroom.

Finally, he concludes with four points that are meant to provide evidence of the social harm in studying economics, which can be summarized in two overarching points:

1) Economics justifies greedy behavior, and

2) Studying economics makes people less altruistic.

I want briefly to discuss these two points here.

Economics Justifies Greedy Behavior?

Studying economics, and specifically the role of incentives, teaches us that relying on altruism is a brave assumption that has but limited applicability. For example, among people we know, we can rely on a certain degree of altruism or benevolence. I know, for example, that my family and friends will be there for me not because I pay them to do so, but because they care about me. Similarly, they know I will be there for them. However, I don’t know the same thing about random people I encounter on the street.

And yet in order to enjoy the immense wealth that the division of labor affords us, society demands that we have interactions both with people we know well and people we do not know at all. These two distinct spheres of activity require two distinct forms of cooperation, which one might get from reading Adam Smith’s twin pillars of economics: The Theory of Moral Sentiments and The Wealth of Nations.

More tidily, perhaps, F. A. Hayek describes this situation in The Fatal Conceit by noting the difference between the macroeconomy and the microeconomy. Macro, in this context, refers to society as a whole, while micro refers to just the people to whom we are close. Hayek says that if we were to apply the same rules of the family unit to the macro, as would be the case if we were to allocate resources altruistically, we would destroy the macro. This is because there would be a complete lack of economic calculation, resources would be misallocated, and plans would fail to be coordinated (see these articles for more on economic calculation).

Hayek also notes that the reverse is true: If we were to apply the rules of the market to the family, we would destroy it as well. We don’t need prices and incomes at the dinner table to allocate the food. Even the most ardent defender of markets would agree that having prices and such as the means of allocating food at the dinner table would be wrong, just like paying your friends to help you move across town would be strange. (Beer and pizza don’t count.)

Instead, students of economics recognize not that greed is good, as the saying goes, but that greed can be transformed into the service of others given the proper institutional setting. That institutional setting, which has been thoroughly discussed elsewhere, is one that celebrates the role of property rights, prices, and profits (and losses) and recognizes their role in creating the incentives to properly husband resources, generates the information about the relative scarcities of various goods and transmits this information to consumers and producers in a quick and efficient manner, all of which provides a feedback mechanism to drive continued innovation.

Economics Makes People Less Altruistic?

Grant cites a 2005 article by Neil Gandal et. al. as concluding that “students who planned to study economics rated helpfulness, honesty, loyalty, and responsibility as just as important as students who were studying communications, political science, and sociology,” but that by the third year, economics students rated these values “significantly less important than first-year economics students.”

While the Gandal study does include such conclusions, it also includes much more. For example, economics students attribute less importance to fairness. Evidencing this, Gandal points out that, when questioned about the allocation of radio frequencies to different mobile-phone service providers, students who study economics are more likely to advocate selling the rights to the highest bidder while students of other disciplines are more likely to advocate for allocating the rights to “anybody who meets some minimal eligibility criteria.”

Students of economics do not advocate for property rights because we are greedy; we advocate for property rights because we understand and take seriously potential incentive problems in politics. The notion of minimal eligibility requirements may sound nice, for example, but problems may lie in who gets to draw that line, by what process that line gets drawn, and the incentives faced by the line-drawers. As Madison points out in Federalist 51, “If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary.”

Economics students know men are no angels. And as Nobel laureate James Buchanan points out, government officials are human beings, too, with their own hopes, dreams, and aspirations—and yes, forms of avarice. Supporting the allocation of resources to the highest bidder sidesteps the issues raised by these potential incentive problems. This means that the choice of how to allocate resources fundamentally comes down to a choice of institutions.

We can have a central authority establish guidelines by which anyone who wants can use the radio frequencies, or we can let the market decide. The former leads to a standard tragedy of the commons problem, whereby the radio frequency gets overused. In the case of cell phones, this means that the frequency would be crowded with multiple conversations simultaneously; imagine trying to shout to your friend across a crowded bar. The latter leads to the frequencies being allocated to the person who is best able to utilize them to serve the general population. So AT&T, for example, gets exclusive rights to a certain bandwidth and then tries to figure out how to best serve its customers. In this case, the customer gets to enjoy a clear phone call without the distraction of several other conversations in their ear simultaneously.

In any case, these are not examples of quelling altruism, but of keeping it in its place.

Less Greed, More Cooperation

Viewed in this light, economics does not so much teach greed but rather the beauty of cooperation. How else could we explain how a woolen coat gets made, how Paris gets fed, or how a pencil gets made? And if allocating, say, radio frequencies based on highest valued use makes people learn to discard fairness, well, how exactly is that a bad thing?

David Hebert is a Ph.D. student in economics at George Mason University. His research interests include public finance and property rights.

This article was originally published by The Foundation for Economic Education.

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Editor’s Note by Gennady Stolyarov II: Mr. Hebert’s article is excellent in focusing on the true significance of economics and the need for private property rights. In one important respect, though, my position differs from his when it comes to the allocation of radio frequency to highest bidders such as AT&T and other entities exercising similar coercively granted monopoly and quasi-monopoly powers.

My position, arising out of similar libertarian principles, is that the allocation of radio frequencies to AT&T (and similar local/regional telecommunications monopolies) through the political process would not result in an economically optimal allocation, even if AT&T were the highest bidder. The reason for this is that AT&T’s very bidding ability arises out of (1) its decades-long history as the telephone monopoly in the United States and (2) the protections from competition that it enjoys in certain jurisdictions as a local or regional monopoly provider of certain services wrongly considered “natural monopolies” – such as high-speed cable services. In a pure free-market system, there would likely need to be some sort of allocation process for radio frequencies, so long as the use of radio frequencies by some parties has the physical ability to interfere with the use of the same frequencies by other parties. However, the outcome of such a free-market allocation process would differ considerably from the outcome of a bidding process in today’s status quo, conditioned by decades of deleterious path-dependency arising out of the privileges granted to AT&T and similar local/regional monopolists. Probably, an auction of radio spectrum on a purely free market would result in many smaller firms buying up many smaller ranges of spectrum and competing with one another more vigorously to provide superior customer service than do a handful of large, politically privileged telecommunications companies (AT&T, Comcast, Verizon, et al.) today. In this path-dependent, partially unfree environment it may be, in some cases, that allocations to lower bidders would result in better uses of resources and improved consumer outcomes, as long as institutional political privilege (e.g., enforced monopolies or historical insulation from competition) of the higher bidders can be incorporated into the bidding process in the form of some reasonable handicap used in considering their bids.

Oklahoma: The Economic Storm – Article by David J. Hebert

Oklahoma: The Economic Storm – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
May 25, 2013
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A tornado ravaged Oklahoma last week, destroying hundreds of homes, killing dozens, and injuring hundreds more. Unfortunately, it looks like the citizens of Oklahoma are about to be ravaged by another storm brought on by the Oklahoma Attorney General, Scott Pruitt.

According to ABC News, Mr. Pruitt and his staff began “aggressively combing the region for fraud just hours after the tornado … and immediately [found] businesses violating the law. ”

What laws were the businesses accused of violating?  Anti-price-gouging laws. Using powers granted by the Emergency Price Stabilization Act, Mr. Pruitt is hoping to help the people of Oklahoma by preventing businesses from profiting off of the suffering of the townspeople, many of whom just lost their homes. He goes so far as to say, “[the townspeople] never anticipate or expect that someone would take advantage of them right now, but this situation is what criminals prey upon. ”

While Mr. Pruitt no doubt intends to help the local citizens, his misunderstanding of the workings of the price mechanism will lead only to folly and the prolonged suffering of the very people that he is trying to help. What he is effectively arguing for is a price ceiling on basic commodities, such as water (which is reportedly being sold for $40 per case today as opposed to only $3-$4 just a few weeks ago).

This has very predictable results: a shortage.

When prices are held below their market value, the effect is that there will be a large number of people who are willing to purchase water at that price but very few sellers willing to sell the water at that price. This means that people will compete on non-price margins to acquire water, that is, they will queue, sometimes for hours on end. The time that they spend waiting in line, however, is a deadweight cost as it is value that is forgone but is not captured by anyone. So now, instead of contributing towards the reconstruction of the town, the people are stuck waiting in line for water.

The beauty of the price mechanism is what it accomplishes in situations like this, assuming, of course, officials allow it to function properly. In this situation, demand in Oklahoma rises and producers, seeing an opportunity to profit, reroute trucks/planes to Oklahoma, thus increasing the quantity of water supplied in the area that needs it most.

Absent the rise in price, we would have to rely on the benevolence of these companies to help the people in need (and assume that they knew what the people of Oklahoma wanted to begin with).

This isn’t in and of itself terrible. Obviously companies DO send extra water to places that experience disasters, and the Red Cross DOES send volunteers and such. But notice that nothing in the preceding analysis precludes this benevolence. Why rely merely on benevolence when we can also rely on self-interest? If the goal is to help people get clean drinking water, it stands to reason that we ought to incentivize producers as many ways as possible, be they other-regarding, self-regarding or both.

David Hebert is a Ph.D. Fellow at the Mercatus Center at George Mason University.

This article was originally published by The Foundation for Economic Education.

Ice and Economics – Article by David J. Hebert

Ice and Economics – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
July 21, 2012
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What can ice teach us about economics? We’ll see, but let’s begin with some fundamentals.

Prices, property rights, and profit (and loss) lead to information, incentives, and innovation. This simple statement contains nearly every lesson necessary for a free and prosperous society. But what do these words mean?

Prices convey information about relative scarcities and communicate to us the relative value of competing uses of a resource. They also economize on the acquisition of knowledge. When we see the price of a resource rise, market actors understand the need to use less of the resource. What they don’t know, however, is whether this rise is due to a disaster that destroyed some of the stock of that resource (an inward supply shift) or if a new, more valuable use for that resource has been discovered (an outward demand shift). These facts are irrelevant for a person who is currently using the resource, but from a societal level, her using less is necessary. If there is a disaster, we would want people to use less of it so that everyone else can still use some. If there is a new, more valuable use discovered, we would want the original users to use less so that more could be allocated towards this new use.

The Right to Exclude

Property rights refers not only to the right to use a resource, but also to the right to exclude others from its use. In this sense property rights provide the incentive to allocate the use of a resource efficiently across time, for example, to conserve it for later. With firmly established and enforced property rights, not only does the owner not have to worry about someone else taking his things but he also doesn’t have to rush out to gather the resources as quickly as he can. A situation where there are no property rights is susceptible to what is called the “tragedy of the commons,” where the resource gets depleted too quickly and never has a chance to replenish.

Profit (and loss) leads to innovation. Earning a profit is akin to being rewarded for doing something good. Suffering a loss is the opposite, a punishment for doing something wrong. In this case, the deed being done is the attempt to allocate scarce resources to where their will earn their highest return. People who successfully do this are rewarded with monetary gain, which we call “profit.” People who fail to do this experience what we call “loss.” In doing so, economic actors learn what works and what does not. Reducing the profitability of an activity through taxes or legislation or sheltering people from losses, therefore, acts to retard this learning process and stifles innovation.

This lesson is exemplified in early nineteenth-century Boston with the rise of the American natural ice trade. In 1806 Frederic Tudor sailed a ship full of ice from Boston to the Bahamas. Two years earlier Tudor had begun experimenting with insulation with the goal of bringing ice to the Bahamas.  When he was ready to set sail, he found that the ship captains refused to carry his cargo for fear of damaging their vessels. So he bought his own brig, the Favorite, and set sail February 10, 1806. He arrived in Martinique with a large quantity of ice still intact and began selling. The Bahamians loved the ice, which they had never seen before. Yet that first year Tudor lost a substantial sum of money, although he proved that ice could be shipped to the Bahamas. Now the objective became doing it at a profit.  Convinced his idea would be wildly successful, he continued his attempts to drive down costs and increase demand.

Higher Return

Meanwhile, as the price of the ice on the ponds rose, the people of Boston gained the information that the ice would bring a higher return in the Bahamas, thus they used less themselves and sold the ice to the Bahamians. In 1840 the ponds in the Boston area were explicitly divided, giving each person on the lake the right to exclude everyone else from harvesting any ice that wasn’t theirs. This allowed Tudor, for example, to invest in his ice and let it freeze longer so that it could better survive the long journey from Boston to India, which entailed crossing the equator twice and sailing around the tip of Africa. As Tudor earned profit from his venture, more people were attracted to the ice.

To continue to earn a profit, therefore, he had to find a way to outcompete everyone else. In 1825 Tudor enlisted the help of Nathaniel Wyeth, one of his suppliers. Tudor noticed that Wyeth’s ice was always significantly cheaper than everyone else’s and was cut in neater blocks which packed more easily. Wyeth had converted some old farm plows into ice-cutting plows and had fastened horseshoes with spikes to allow horses to pull these modified plows across the ice. By scoring the ice in such a fashion, Wyeth could break uniform sized blocks much quicker than his competitors, who were using hand saws that produced very rough and uneven edges.

These wouldn’t be the only contributions of Wyeth, as he went on to invent many other cost saving techniques. For example, Wyeth developed a conveyor-belt system that would haul the ice from the pond into the waiting icehouse.  He also invented bigger plows that could cut more blocks at once and poles that were used to guide the floating ice blocks onto the conveyor belt;  refined the above-ground icehouse, which allowed ice to be stored anywhere in the world for months on end without any external source of refrigeration.

New Insulation

Tudor and Wyeth also experimented with new means of insulating the ice from the heat, discovering that sawdust was not only a fantastic insulator but was also cheaply available from the sawmills around Boston. They also taught their customers new ways to use the ice, including making ice cream and storing the ice in iceboxes to preserve foods longer.

In short the three Ps lead to the three Is: Prices, property rights, and profit (and loss) lead to information, incentives, and innovation.  With these firmly in place, a free and prosperous society will follow.

David Hebert is a Ph.D. Fellow at the Mercatus Center at George Mason University.

This article was originally published by The Foundation for Economic Education.