Sunday, October 5, 2008

Colossal Crises Part 2 - Economics

In the last blog, I was leading up to the topic of how I think economics functions in a democracy. I am not an economist by training, but I have taken enough classes and read enough books on economics to at least understand the basics. The basic tenet that any economics text book teaches is that supply and demand are in balance at a price called the “market price”. When there are many producers of “goods” and “services”, and many buyers for these goods and services, it creates an ideal situation where producers compete for market share, and buyers get the best deals. Free and fair competitive markets ensure that goods and services are delivered at the maximum possible productivity. It The key word here is “productivity”. As producers compete, they figure out how to make more things in less time, and productivity increases with time. Higher productivity should theoretically translate into higher wages. After all, the definition of productivity is how much work gets done in a given amount of time. Let us look at how these ideals have become distorted in some areas.

Let me start with two of the key words I introduced, “goods” and “services”. “Goods” are tangible things produced by workers, often in factories. (The kind that have been disappearing from this land.) Apparently, many Asian countries have managed to produce goods at a lower price and higher quality. The American ideal of free and fair competition has been realized in other countries, which produce low cost, high quality items at a much higher productivity. So, we are used to paying the lowest price for an imported car, sometimes lower than it is sold in its home country. But why are so few car makers left here? Why are more American workers not benefiting from the largest free market for automobiles in the world? Why is Toyota today worth 20 times more than Ford and GM COMBINED? Why are Honda, Toyota, and countless other foreign automakers able to make top quality cars in this country, and provide competitive wages to their workers in American factories, when GM and Ford can not?

I could not find any simple answers, but one thing jumped out at me. Decision making in the management of large corporations were decidedly short sighted and speculative. When there was ample evidence that fuel prices would go up in the long run, Detroit was building large SUV factories to cash in on the short term demand. When oil prices jumped, Detroit got caught with large factories that were useless. Now they are asking for a $50 billion bailout from the government (read – taxpayers). Now, it is not the government’s role to tell GM or Ford to build a certain type of vehicle. But it is also true that our representatives buckled under the automobile lobby and did not enforce fuel efficiency standards despite mounting evidence of global warming, and now, increasing fuel prices.

Similarly, in the stock market of the 90’s, when Greenspan made his “irrational exuberance” speech, stocks were valued much higher than their underlying value. But nothing was done by the regulators to check the speculative options trading, or day trading. In the early 2000’s, when there was ample evidence that home prices were going up at a faster rate than wages, mortgage lenders were making sub prime loans at an ever increasing rate. Speculation started controlling the prices of homes, rather than the true underlying demand. The fundamental economic principle where demand and supply were in balance was distorted by speculation, which by definition is not true demand. It is an aberration in demand, anticipating more demand. Again, the government regulators did nothing to curb the lax lending practices.

On the other hand, “services” are not tangible. An accountant preparing your taxes, a doctor prescribing a medicine, a secretary answering phones, are all services which we cannot touch or feel. But there is a common thread between goods and services. Where services are delivered in a competitive market, there has been improvement in productivity, just as in the production of goods. However, when the competitive aspect is taken away, it becomes non ideal, and mediocrity sets in over time. The best example of non ideal conditions I could find was unions. In principle, unions make worker’s life easier by providing a single body to negotiate with management on work hours, working conditions, wages, etc. But this also means the unions are creating a monopoly over how services are delivered. A monopoly is by itself a non ideal condition for the economic principles to operate. With no competition over how services are delivered, productivity remains stagnant. Over time, the loss of productivity starts to strangle the company, and the company loses competitiveness. The unions are slowly killing the goose that lays the golden eggs, so to speak. There are many industries with non-union labor (semiconductors and software, to name a couple), and there are world leading companies still thriving in the US. The difference is that most of these successful companies have dealt with their employees in good faith, at least as much as the circumstances will allow them. I am convinced that the concept of the traditional union, invented during the industrial age, is as obsolete as buggy whips. We need a new paradigm where the distinction between management and labor blurs, and the government needs to be a champion of this change. There are plenty of examples of how this has been done in high tech companies, which evolved in the post industrial era. All that needs to be done is to copy the best practices, and implement them in areas that needs them.

I infer the following common threads from these observations:

1. The economic principles of demand and supply, free and fair markets, are fundamentally sound. Where they have been allowed to operate, these forces have produced the maximum increases in productivity, and higher wages for the workers. Conversely, where they did not exist, the result was market bubbles followed by crashes.

2. The role of the government should be to make sure that the environment within which all goods and services are made adhere to these fundamental principles.

The big question now is, how many of our elected representatives believe in and champion these ideas. I am willing to support all who show me evidence that they do. But from what I have seen, most are happy to be one of the sheep, and line up behind a few manipulative leaders who scare them into action.

Next up - The Environment

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