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KQED | Programs A-Z: Forum: Home: Wed, Dec 13, 2006 -- 9:00 AM:

Interest Rate Update -- Forum discusses the impact of the Federal Reserve's decision to leave interest rates unchanged.

Guests include:

• Brad De Long, professor of economics at UC Berkeley and research assistant at the National Bureau of Economic Research;
• John Karevoll, analyst at Data Quick Information Systems, a nationwide real estate information service;
• Adam Posen, senior fellow at the Peterson Institute for International Economics, member of the Council on Foreign Relations, and former economist at the Federal Reserve Bank of New York.

Host: with Michael Krasny

KQED Forum 20061213

KQED Public Radio

Let us start with John Stuart Mill's prayer: "Lord, enlighten thou our enemies," prayed nineteenth-century British economist and moral philosopher John Stuarrt MIll: http://olldownload.libertyfund.org/Texts/MillJS0172/Works/Vol10/PDFs/Mill_1277.pdf. "Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength..."

In economics, John Stuart Mill's prayer have been answered. We neoliberal types are, I think, a bare plurality, but the Chicago School is powerful, articulate, brilliant, and energetic. On our left thing are less healthy, but improving: the left has escaped its destructive embrace of Marxism. And there are signs of a fundamental rethinking of economics in embryo as the borderland between economics, sociology, and psychology becomes more active.

Outside economics, however, things are much less healthy. John Stuart Mill's prayer has not been answered. Witness Mark Bauerline in the Chronicle of Higher Education, which leads me to beg: Can we please ask the Chronicle of Higher Education to print the works of a smarter class of conservatives? Calls for a diversified intellectual portfolio fall flat when the conservative assets on offer are intellectual shell corporatilns. The benefits of a Millian clash of views to stimulate and deepen our thoughts are nonexistent when one side in the battle of wits is unarmed.

I mean, what can one make of Mark Bauerlein's charge that liberals--like The Baffler's Thomas Frank--are biased against Friedrich Hayek because they talk about what Hayek actually said in his 1956 preface to The Road to Serfdom?

The Chronicle: 12/15/2006: How Academe Shortchanges Conservative Thinking: Public intellectuals are less parochial, and even some of those on the left do acknowledge Hayek's eminence -- but too often with just a dismissive tack.... Thomas Frank, the editor of The Baffler, briefly summarizes Hayek's legacy with a run of high-handed jibes. He mentions Hayek's seminal The Road to Serfdom, but only to disparage it for equating "British-style socialism with the Nazi obscenity."...

But, Mark, Thomas Frank is right. I am a Hayek fan, or at least somebody who thinks it is important to wrestle with Hayek at least once once a month. Nevertheless, here is Hayek, in the 1956 preface to The Road to Serfdom:

Of course, six years of socialist government in England have not produced anything resembling a totalitarian state. But those who argue that this has disproved the thesis of The Road to Serfdom have really missed one of its main points: that "the most important change which extensive government control produces is a psychological change, an alteration in the character of the people." This is necessarily a slow affair... attitude[s] toward authority are as much the effect as the cause of... political institutions under which it lives.... [T]he change undergone... not merely under its Labour government but in the course of the much longer period during which it has been enjoying the blessings of a paternalistic welfare state, can hardly be mistaken.... Certainly [Weimar Germany's] Social Democrats... never approached as closely to totalitarian planning as the British Labour government has done.... The most serious development is the growth of a measure of arbitrary administrative coercion and the progressive destruction of the cherished foundation of British liberty, the Rule of Law... [E]conomic planning under the Labour government [has] carried it to a point which makes it doubtful whether it can be said that the Rule of Law still prevails in Britain...

In other circumstances, I might cavil at Thomas Frank--I would say that Hayek draws a line connecting Britain's Labour Party and Germany's Nazi Party, but that he does not quite equate them: In Hayek's view, the Labour Party has not established Nazi-like serfdom, but only placed Britain on the road to Nazi-like serfdom. However, not hear: the Road to Serfdom that the Labour Party placed Britain on leads, in Hayek's estimation, to serfdom and nowhere else. And I cannot read Bauerlein's complaint as anything other than saying that it is rude and biased for Thomas Frank to, you know, talk about things Hayek actually believed and cite things Hayek actually wrote.

Bauerline is similarly irate at Michael Berube for "bias." What is the bias? It is pointing out that George Will, Michelle Malkin, and David Horowitz self-identify as conservatives. An unbiased writer, Bauerline claims, would pretend that Will, Malkin, and Horowitz do not exist at all. To note their existence is "stigmatizing" and unfair to conservatives:

In What's Liberal... ?, conservatism suffers similarly from stigmatizing references. [Michael] Bérubé focuses on the anti-academic conservatives and fills his descriptions with diagnostic asides. Gay-rights debates "transform otherwise reasonable cultural conservatives into fumbling, conspiracy-mongering fanatics." The columnist George Will is "furious," and the columnist Michelle Malkin writes "shameful" books pressing "'interpretations' that no sane person countenances," while Horowitz exaggerates "hysterically." Such psychic wants explain why, according to Bérubé, "we just don't trust cultural conservatives' track record over the long term, to be honest. We think they're the heirs of the people who spent decades dehumanizing African-Americans and immigrants, arguing chapter and verse that the Bible endorses slavery and the subjection of women"...

Note the lineage: Not a line of reasoning, but a swell of mad wrath. Not Burke, Alexis de Tocqueville, T.S. Eliot, and Leo Strauss, but slaveholders, nativists, and sexists. Nothing from Elizabeth Fox-Genovese, E.D. Hirsch Jr., Harvey C. Mansfield, and the late Philip Rieff, to cite more-recent writers who may be termed "educational conservatives." The scholarly conservative case against higher education is overlooked, while Bérubé devotes too many words to the claims of discrimination by a conservative student on television's Hannity & Colmes, to a worry by a state legislator about "leftist totalitarianism," and so on...

I truly don't get Bauerlein here. First, by what warrant does Bauerline call Alexis de Tocqueville a "conservative"? Why not call John Maynard Keynes, Max Weber, and Oliver Cromwell "conservatives" as well? Burke, too, has conservative moods but is only a conservative thinker in a modern American sense if you take a chainsaw and reduce him to selected passages from Reflections on the Revolution in France. In Reflections Burke does make the argument that we should respect the traditions and institutions we have inherited because they incorporate the Wisdom of the Ancestors, but he only makes that argument because he thinks that in this case the Ancestors--not his personal ancestors, note--were wise. The argument that it was one of the traditions and institutions of Englishmen that they would conquer, torture, and rob wogs cut no ice with Edmund Burke when he was trying to prosecute Warren Hastings. The argument that it was one of the traditions and institutions of England that power flowed to Westminster cut no ice with Burke when he was arguing for conciliation with and a devolution of power to the American colonists. To Burke, conservative arguments based on respect for the Wisdom of the Ancestors are to be deployed in support of traditions, institutions, and practices that he approves of--they are not trumps. Burke is no more a conservative than Adam Smith is a Thatcherite. And anyone who classifies Burke as a conservative has not read much beyond scattered selections from Reflections on the Revolution in France.

Second, does Bauerline really think that Berube's take on Leo "The Text Means What I Say It Means" Strauss or Harvey C. Mansfield--a man who regards the admission of Blacks to Harvard as the cause of the baneful curse of grade inflation--would be significantly different than his take on Will, Malkin, Horowitz? I agree that we should get Michael to write on Mansfield as soon as possible. But I guarantee you that it won't lead to a more favorable view of modern American conservatism.

And I truly don't get what Bauerlein means when he says "the scholarly conservative case against higher education is overlooked." Does he mean that Michael Berube overlooks the scholarly conservative case against higher education? If so, then why not say so: what is Bauerlein's purpose in removing the active subject from his sentence by placing it in the passive voice? And what is "the scholarly conservative case against higher education" anyway? Is it that people shouldn't learn about science because it will undermine their trust in throne and altar? Is it that only a small, narrow elite should go to college because the masses will get bad ideas if they read Voltaire? Bauerline never says.

Lord, enlighten thou our enemies. Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength...

The intelligent and thoughtful Felix Salmon makes a subtle and interesting error--an error that I would make on at least a monthly basis had Robert Waldmann not patiently explained all this to me in the winter of 1986--in discussing Kelly risk analysis. Pushing leverage beyond the Kelly point does not decrease expected return. Rather, it decreases the likelihood of organizational survival and the chance that you will be wealthy. If you are acting as one of many agents for a well-diversified principal, you will in general want to ignore the Kelly point and leverage yourself up to the gills. If your objective is, instead, to maximize your own chances of remaining in the game with boasting rights, you will position yourself at the Kelly point.

A stark way of seeing this difference is to think of the following situation: Matt Rabin from the office beneath mine comes up the stairs and offers me the following: I start with a stake $1. I can wager none, some, or all of my stake. He flips a fair coin. If it is tails, I lose my wager. If it is heads, I win twice my wager. We do this ten times in a row, with my stake growing or shrinking.

To maximize expected return--this is, after all, a very advantageous game for me--I should be my whole stake, and let it ride time after time. After 10 rounds, there is one chance in 1024 that I have $59,049 and 1023 chances in 1024 that I have zero, for an expected portfolio value of $57.67.

The Kelly point, by contrast, says that I should wager 1/4 of my current stake each round. If Matt flips ten heads, then I have only $57.67 instead of $59,049. And my expected final wealth is only $3.25 instead of $57.67. But my median final wealth is not $0 but is instead $1.80. I make money not 1/1024 of the time but 638/1024 of the time. And if Robert were here he could prove in five lines that as the number of rounds goes to infinity an agent wagering according to the Kelly criterion almost surely ends up wealthier than an agent choosing his wager from his or her stake according to any other rule. The Kelly point makes sense if you are risk averse (and if this portfolio is a major component of your wealth) or if organizational survival and relative organizational prosperity is your major goal.

If Matt showed up at my office and announced that we were going to play this game on each of the next 1024 days, I would have no trouble choosing to follow the bet-the-limit strategy rather than the Kelly strategy on each day. 1024 x $3.25 is only $3328, which is a lot less than 1024 x $57.67 = $59049. But what if Matt says that this is my one and only one day? The right way to think about it is that my marginal utility of wealth is surely pretty flat over the range of $50,000 or so, and so I ought to be risk-neutral in this particular situation. The right way to think about it is that I "buy" lots of lottery tickets of various types during my life, and that the right strategy is to maximize the expected value of each lottery ticket--not to apply the Kelly criterion to each situation individually. (Of course, the generalized Kelly criterion--maximizing the expected value of the log of your portfolio--for 1024 rounds is not to apply the Kelly criterion to each round independently.)

But I would find it hard. I would have a hard time giving the 1/1024 chance of winning $59049 its proper weight in the face of the 1023/1024 chance of suffering the humiliation of bankruptcy.

In the end, however, I would be the limit. The humiliation for an economist like me of violating the axioms of expected utility is much worse than the humiliation of losing my entire stake.

Kelly Criterion finger exercises at: http://spreadsheets.google.com/pub?key=p_zylRhg4towI71xZsP62Fg

Partha Dasgupta makes a mistake. This is a rare, rare, rare event. Dasgupta writes, criticizing the Stern Review:

http://www.econ.cam.ac.uk/faculty/dasgupta/Stern.pdf: To give you an example of what I mean, suppose, following the Review, we set delta equal to 0.1% per year and eta equal to 1 in a deterministic economy where the social rate of return on investment is, say, 4% a year. It is an easy calculation to show that the current generation in that model economy ought to save a full 97.5% of its GDP for the future! You should know that the aggregate savings ratio in the UK is currently about 15% of GDP. A 97.5% saving rate is so patently absurd that we must reject it out of hand. To accept it would be to claim that the current generation in the model economy ought literally to starve itself so that future generations are able to enjoy ever increasing consumption levels...

In the "deterministic economy where the social rate of return on investment is, say, 4% a year" model that Dasgupta is using, the concept of "output" Y is Haig-Simons output--what you could consume and still leave the economy next year with the same productive capacity as it has this year. With that definition of output Y, with consumption level C, and with social rate of return on investment r, it is indeed the case that the growth rate g(Y) of a zero-population-growth economy is:

g(Y) = r(1 - C/Y)

Take the expression for the rate of growth of consumption g(C) as a function of the parameters δ and η:

g(C) = (r - δ)/η

And see that the assumed values for r, δ, and η give us a 3.9% per year growth rate of consumption. If you impose the steady-state requirement that the growth rates of consumption and output be the same, you do indeed get a 97.5% savings rate--that consumption is 2.5% of Haig-Simons output:

C/Y = .025

because with r=4% per year that is the only way to get g(Y)=3.9%

But suppose that you use a different concept of output--GDP--and say that productive capacity increases not just because you save some of GDP but also because of improvements in knowledge and technology g(A), so that:

g(Y) = r(1 - C/Y) + g(A)

with worldwide g(A) equal, say, to 3% per year. Then our g(C) equation still gives us a 3.9% per year total economic growth rate, but our g(Y) equation is then:

3.9% = g(Y) = r(1 - C/Y) + g(A) = 4%(1 - C/Y) + 3%

which gives us a savings rate not of 97.5% of Haig-Simons output but rather of 22.5% of GDP, leaving 77.5% of GDP for consumption.

A consumption-to-output ratio of 77.5% is far from absurd, and so Dasgupta's critique of Stern fails. His mistake is in failing to remember that in his model Haig-Simons output is very, very different indeed from standard reported GDP.

That being said, I agree with most of Dasgupta's major point: the action here is in the choice of the parameter η. I think it's appropriate to consider different ηs in the range from 1 to 5, and think the Stern Review should have done so.

(I'm also enough of a utilitarian fundamentalist to believe that the right value for δ is zero, and that Nordhaus's δ of 3% per year is unconscionable--it means that somebody born in 1960 "counts" for twice as much as somebody born in 1995, who in turn "counts" for twice as much as somebody born in 2020; somebody born in 1960 "counts" for 256 times as much as somebody born in 2160. That's not utilitarianism.)

J. Bradford DeLong (2006), "A Man Who Hated Government," Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/

Also see:

Sam Brittan at the Financial Times: Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/
Greg Ip at the Wall Street Journal: http://online.wsj.com/article/SB116369744597625238.html?mod=hps_us_at_glance_most_pop
Steven Pearlstein at the Washington Post: http://www.washingtonpost.com/wp-dyn/content/article/2006/11/16/AR2006111601779_pf.html

---

J. Bradford DeLong (2006), "A Man Who Hated Government," Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/

"Lord, enlighten thou our enemies," prayed nineteenth-century British economist and moral philosopher John Stuart Mill in his Essay on Coleridge http://olldownload.libertyfund.org/Texts/MillJS0172/Works/Vol10/PDFs/Mill_1277.pdf. "Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength."

For every left-of-center American economist in the second half of the twentieth century, Milton Friedman (1912-2006) was the incarnate answer to John Stuart Mill's prayer. His wits were smart, his perceptions acute, his arguments strong, his reasoning powers clear, coherent, and terrifyingly quick. You tangled with him at your peril. And you left not necessarily convinced, but well aware of the weak points in your own argument.

General William Westmoreland, testifying before President Nixon's Commission on an All-Volunteer [Military] Force, denounced the idea, saying that he did not want to command an army of mercenaries. Milton Friedman interrupted him: "General, would you rather command an army of slaves?" Westmoreland got angry: "I don't like to hear our patriotic draftees referred to as slaves." And Friedman got rolling: "I don't like to hear our patriotic volunteers referred to as mercenaries. If they are mercenaries, then I, sir, am a mercenary professor, and you, sir, are a mercenary general." And he did not stop: "We are served by mercenary physicians, we use a mercenary lawyer, and we get our meat from a mercenary butcher" http://www.davidrhenderson.com/articles/0199_thankyou.html. As George Shultz likes to say: "Everybody loves to argue with Milton, particularly when he isn't there."

Thinking as hard as he could until he got to the root of the issues was his most powerful skill. "Even at 94," Chicago economist and Freakonomics http://www.amazon.com/exec/obidos/ASIN/006073132x/ author Steve Levitt wrote on his website yesterday, "he would teach me something about economics whenever we talked" http://www.freakonomics.com/blog/2006/11/16/sad-news-milton-friedman-has-died/. In this morning's New York Times http://www.nytimes.com/2006/11/17/business/17milton.html?ex=1321419600&en=a0db578046e72e19&ei=5088&partner=rssnyt&emc=rss, Chicago economist Austen Goolsbee quotes from Milton Friedman's Nobel autobiography:

Friedman said that when he arrived [at the University of Chicago] in the 1930s, he encountered a "vibrant intellectual atmosphere of a kind that I had never dreamed existed."

"I have never recovered."

His world-view began with a bedrock faith in people, in their ability to make judgments for themselves, and thus an imperative to maximize individual freedom. On top of that was layered a deep faith and conviction that free markets were almost always the best and most magical way of coordinating every conceivable task. On top of that was layered a powerful conviction that a look at the empirical facts--a marking-to-market of your beliefs to reality--would generate the right conclusions. And on top of that was layered a fear and suspicion of government as an easily-captured tool for the enrichment of cynical and selfish interests that sought to grab whatever they could. Suffusing all was a faith in the power of argument and the utility of reason. He was an optimist: people could be taught the truths of economics, and if they were properly taught then institutions could be built to protect all against the corruption and overreach of the government.

And he did fear the government. He hated government's and society's sticking their nose into people's private business. And he interpreted "people's private business" extremely widely. He hated the War on Drugs, which he saw as a cruel and destructive breeder of crime and violence. He scorned government licensing of professions--especially doctors, who heard over and over again about how their incomes were boosted by restrictions on the number of doctors that made Americans sicker. He feared deficit spending: cynical politicians could pretend that the costs of government were less than they were by pushing the raising of taxes to pay for spending off into the future. He sought to innoculate citizens against such political games of three-card-monte: "Remember," he would say, "to spend is to tax."

This did not mean that government had no role to play. Enforcement of property rights, adjudication of contract disputes--the standard powerful rule-of-law underpinnings of the market--plus a host of other government interventions when empirical circumstances made them appropriate: Mayor Ken Livingstone's congestion tax on cars in central London is Milton Friedman's. Friedman's negative income tax is one of the parents of what is now America's largest anti-poverty program: the Earned Income Tax Credit. And, most important, government had a very powerful and necessary role to play in keeping the monetary system working smoothly through proper control of the money stock. If there was always sufficient liquidity in the economy--enough but not too much--then you could trust the market system to do its job. If not, you got the Great Depression, or hyperinflation.

In his belief that the government was required to undertake relatively narrow but crucially important strategic interventions in order to stabilize the macroeconomy--keep production, employment, and prices on an even keel--Milton Friedman was in the same chapter if not on the same page as John Maynard Keynes, the economic giant of the previous generation whose doctrines and influence Friedman worked tirelessly to supplant and minimize. The Great Depression had convinced Keynes that central bankers alone could not rescue and stabilize the market economy. In Keynes's view, stronger and more drastic strategic interventions were needed to boost or curb demand directly. Friedman and his coauthor Anna J. Schwartz argued in their Monetary History of the United States that this was a misreading of the lessons of the Great Depression, which in Friedman's view was caused by monetary mismanagement or perhaps could have been rapidly alleviated by skillful monetary management alone. Over the course of forty years, Friedman's position carried the day. Federal Reserve Chair Ben Bernanke right now holds Milton Friedman's view, not John Maynard Keynes's, of what kind of strategic interventions in the economy are necessary to provide for maximum production, employment, and purchasing power, and stable prices.

Milton Friedman's thought is, I believe, best seen as the fusion of two strongly American currents: libertarianism and pragmatism. Friedman was a pragmatic libertarian. He believed that--as an empirical matter--giving individuals freedom and letting them coordinate their actions by buying and selling on markets would produce the best results. It was not that he thought this was natural law--that markets always worked best. It was, rather, that he believed that places where markets failed were atypical; that where markets did fail there were almost always enormous profit opportunities from entrepreneurial redesign of institutions; that the market system would create now opportunities for trade that would route around market failures; and that government failure was pervasive--that any expansion of government beyond the classical liberal state would be highly likely to cause more trouble than it could solve.

For right-of-center American libertarian economists, Milton Friedman was a powerful leader. For left-of-center American liberal economists, Milton Friedman was an enlightened adversary. We are all the stronger for his work. We will miss him.