Why Nation’s Fail is an ambitious and worthwhile attempt to understand the origins of power, prosperity, and poverty. It provides a succinct narrative for how institutions may diverge. The many examples that show this divergence are entertaining and informative. However, Acemoglu and Robinson’s unwillingness to incorporate the well-established toolkit of public choice economics hobbles their analytical narrative. Ultimately, they fail to make their case – and make no mistake it is an important case to make – because they ignore the individual and they ignore history.
It should come as no surprise that our country finds itself in yet another internecine squabble regarding questions about how much to, or maybe even if we should, fund governmental operations. It is a source of national embarrassment that the United States hasn’t passed a full slate of Appropriation Bills since Fiscal Year (FY) 2008. Looking back to FY 1977, there have been 17 funding gaps of at least one day or more (Congressional Research Service). The funding gap in Fiscal Year 1997 was, until now, the most highly publicized funding gap. In FY 1997, the U.S. Government shut down from 15 December 1996 until 6 January 1997. While our current shutdown commands the attention of the vast majority of the press, the effects of a shutdown are mostly temporary; they do not extend much past the lost productivity of government workers. There may be very real impacts in specific sectors of the economy. Closed national parks may affects tourism related businesses, closed Headstart facilities would affect the working poor, and closed licensing authorities may affect whether businesses get certain permits or not. However, this could be balanced against the economic activity created by people who substitute their vacation dollars away from national parks or by depending on friends and family for daycare. Moreover, the impact of the shutdown will begin to be felt – even in these sorts of affected sectors – only if the shutdown drags on. Thus, it is hard for us to get overly excited about another crisis of artificial proportions.
The bigger issue associated with yet another game of brinksmanship played by two kids who can’t play nicely on the playground, is the issue of a possible link between this fight and the yet-to-be-had fight over raising the debt ceiling. Even without the current intervention by the Federal Reserve, the United States dollar enjoys reserve currency status, which allows the U.S. to borrow at very low interest rates. Certainly artificially low interest rates hurts U.S. savers, but it is a boon for the U.S. in terms of lessening the burden of servicing the fast-growing U.S. debt. Now, though, we are quickly approaching the date when all extraordinary financial measures will be exhausted and the U.S. will default on its legal obligations. This date is widely believed to be 17 Oct (side note – just approaching the debt-ceiling deadline in 2011 caused the U.S. to suffer a downgrade to its heretofore sterling credit rating; an actual default will potentially have long-lasting implications, as it will most likely raise borrowing costs substantially and it will make asset valuation harder because treasury bonds will not be risk free anymore), but the first large, default-inducing payment comes on the 1st of November when benefit checks are due. Currently there are no indications that countries are actually worried about a default; in fact, the yield on the 10-year U.S. Treasury bond closed unchanged on the first day of the shutdown, which suggests there isn’t any panic selling as of yet. But let’s do some back-of-the-envelope calculations to get an idea of what may transpire. As of 31 August 2013 (latest data available from Treasurydirect.gov), there is $16.7 trillion of total U.S. Treasury securities outstanding. The average interest rate now is 2.4 percent; this equals about $400 billion a year in interest payments. Assuming that a simultaneous credit rating downgrade and a limited default causes a one percentage point increase in the average interest rate from 2.4 percent to 3.4 percent (a rate last seen in August 2009), interest payments will increase by $170 billion a year. To put this in perspective, last year’s Fiscal Cliff deal is projected to raise $617 billion in new revenue over 10 years; all of this new revenue will be subsumed by increased interest payments in less than four years.
A less obvious but more pernicious consequence is the uncertainty that results from nearly five continuous years of partisan gridlock. Businesses and individuals cannot plan if they do not know whether a law will exist or not. This puts a damper on economic activity and job creation. Moreover, to the extent larger businesses have more resources to deal with uncertainty, partisan bickering serves as a tax on small job creating businesses.
— Commentary provided by me and Jeff Smith.
Tenure is part of the compensation package for college professors. However, college administrators view this as a privilege. In fact, the AAUP (effectively a professor’s union) tacitly agree because they make the case for tenure as an institution necessary for academic freedom with no connection to compensation.But let’s concentrate on the idea that tenure is about compensation. How should professors react when tenure is not part of a compensation package?
Consider what tenure does. It is part of a compensation package designed to reduce mobility. It is a barrier to exit in the college professor employment market. Thus it reduces bargaining power for the professoriate effectively by reducing any holdup costs. Professors cannot make a very credible threat to leave if they feel their working conditions are bad or wages are too low. This lack of credibility translates into reduced bargaining power when it comes to wages. This is, of course, a big reason behind the wage compression we see among professors relative to assistant professors. And if there is no way to bargain for higher wages or better working conditions why should the professoriate innovate? After all they cannot retain the fruits of their innovations. So what would happen if tenure went the way of Nineveh and Tyre?
The end of serfdom – similar to tenure insofar as it reduces the bargaining power of labor by restricting mobility – in medieval Europe may provide an object lesson. The reduction in the labor force wrought by the plague had differential impacts in Western and Eastern Europe. In Western Europe small institutional variations led to the end of serfdom as labor became more scarce. This jump started a secular increase in the share of output going to labor. Of course mobility and other institutional changes also promoted innovation and economic growth. In Eastern Europe, however, the problem of scarcity of labor was met with a strengthening of serfdom! The results are obvious and persist to this day.
In other words, removing tenure, like the end of serfdom, should increase the likelihood that the professoriate will innovate to keep themselves competitive and increase their wages. Of course there may be other problems based in agency theory. How will administrators gauge the productivity of the professoriate given the inherent information asymmetry that exists between the professoriate and college administrators? But that’s another post. Watch this space!
Acemoglu and Robinson in their book “Why Nations Fail” argue that Venice — the global superpower of its day — became a museum because inclusive institutions like the “commenda” were slowly replaced by extractive institutions which led to the “La Serrata.” Venice effectively became a hereditary aristocracy because the election system was rigged to favor incumbents and their families. Congressional districts in the United States are often redrawn in a way that favors incumbents. Only people belonging to a certain “family” — political party — can get elected from these districts. This restriction of political competition has echoes of Venice! So will the United States become a pretty museum? Probably not. But it may lose its economic superiority by ignoring inclusive founding principles.
Alan Simpson told Fareed Zakaria that any one who thinks that the current deficit problem can be solved without raising taxes (in some form — either directly or indirectly through inflation and/or high interest rates) has rocks instead of brains. I like the salty rhetoric. But is it true? I suppose it depends on beliefs about the short and long run.
By and large most economists would believe that economies where the government has a light touch — creating and protecting basic institutions that promote economic freedom — are more likely to generate prosperity. Low taxes are part of this mix since taxes are how governments extract rents from creative individuals. Of course there is an optimum amount of taxation necessary to protect the aforesaid institutions. But this is a long term view. As of now we have increasingly an extractive political economy. Rising inequality in the US does not help. Some inequality is of course good since it provides an incentive to work (as a recent book by a Bain Capital colleague of Mitt Romney’s rightly claims). But as inequality increases it enables a class of wealthy individuals to capture the legislative process to their favor. This is a fundamentally anti capitalist process which starts a vicious cycle that reinforces both extractive political and extractive economic institutions (Acemoglu and Robinson make this case in their recent book “Why Nations Fail”). At any rate, the rising deficit also extracts wealth from the economy and the ROI on this deficit spending is at best unclear. But taxation is an extractive process as well. One obvious solution is to get rid of all transfers (social security, medicare, etc.) and gut military spending. But this appears to be politically unfeasible. Another solution is to raise tax REVENUES by simplifying the tax code and cut spending at the same time. This would reduce the power of extractive economic institutions. This is effectively the Bowles Simpson approach and the approach that President Obama claims as his own. Then there is the Mitt Romney approach — cut taxes on his first day in office and do very little for spending. Cutting taxes may appear to be a blow against extractive economic institutions. But runaway spending will continue. Remember that even Paul Ryan’s so called revolutionary plan merely limits the GROWTH of spending! Thus the deficit may be expected to rise. In other words the rise of extractive institutions will in fact be abetted by tax cuts! Current, stated, Republican policy may appear to disfavor extractive political institutions (the tax cuts) but in reality will increase their power (by doing very little for the deficit). Why?
One answer may be that the Republican party has been captured by wealthy interests who wish to capture the legislative process and jumpstart a system of extractive political and economic institutions. In other words, its not a question of rocks instead of brains. This is very intelligent rent seeking at work. I think I disagree with Mr. Simpson. Republicans are not stupid.
Looking at our current economic catastrophe one might wonder why none of the theoretical safeguards of neoclassical capitalism lead to a self correction. Leftists would argue – what safeguards of neoclassical capitalism? Rightists (I hate the moniker “conservative” — what are they conserving? certainly not energy!) claim that it was precisely the lack of capitalism — too much government regulation — that negated any hope that the safeguards of neoclassical capitalism would work. Fair enough. But my question is the following: If untramelled free markets are so wonderful then why don’t they develop organically and then persist as permanent institutions? Why do we have societies like Somalia? It is not enough for economists to claim that there are institutional differences between societies. They still have to explain WHY these differences develop and then why they persist. This is what this blog will investigate.