Deepish Thought

Inspired by reading a review of Bryan Caplan’s book, “The Myth of the Rational Voter: Why Democracies Choose Bad Politics“, I have decided to take on the herculean task of attempting to justify democracy (I am such a hero).

Mr Caplan has apparently taken a careful look at the voters who form the bedrock of the democratic system and come to the (some would say obvious) conclusion that democracy is built on very shaky ground. This is not an entirely new idea. Winston Churchill clearly anticipated Mr Caplan’s case when he observed that, “The best argument against democracy is a five minute conversation with the average voter.”

The problem with Mr Caplan’s argument is the implied assumption that we should expect good government from democracy. Good government, whatever that may be, is far too lofty a goal for any political system. Certainly, I’m not aware of any such system that has consistently provided it.

Flawed as it obviously is, democracy does have two very important benefits that justify Mr Churchill’s other famous observation, “It has been said that democracy is the worst form of government except for all the others that have been tried.”

Firstly, while it does not by any means guarantee good government, functional democracies are reasonably effective at moderating bad government. The worst governments tend to be those in which one narrow section of society is able to seize control and relentlessly pursue their own interests. In a working democracy, the need to capture majority support means that the government is always a coalition of interest groups (although these interest groups may all belong to one “broad church” political party). These interest groups may all want to pursue dubious policies, but they don’t ever all want the same dubious policies. The resulting tension between interest groups within the ruling coalition tends to prevent the government from careening off the rails in obedience to the desires of one narrow section of society.

Secondly, democracy provides a means of transferring power between different groups without resorting to firearms. Whether for demographic, economic, social or technological reasons all societies from time to time experience shifts in the balance of power. In non-democratic countries these shifts are often accompanied by violence, as new power structures forcibly supplant the old. In functional democracies however voting provides a signal to the existing regime that it is time to go. The quid pro quo for a government that accepts the will of the voters is not being subject to retribution from the new regime, and in fact having the opportunity to regain its former perks at some later date.

Since the consequence of losing power in democracy is merely a period of opposition followed by a probable return to power, there is very little incentive for the ruling group to resist being dumped out of office. For this reason there tends to be very little political violence in genuine democracies, an observation that is sadly not true for most non-democratic states.

So while democracy may be a decidedly mediocre system of government dependent on the will of disinterested, ill informed and often wildly irrational voters, it at least avoids the worst pitfalls of the known alternatives.

One of my favorite economics lecturers* once posed a very interesting question.  Why do most house break-ins happen on the poor side of town?

There are several possible answers to this question such as convenience, fewer alarm systems and less police interest.  Another explanation, which had never occurred to me, is that the poor side of town is where all the cash is found.  Wealthy people have bank accounts and credit cards, so they tend not to have a lot of cash lying around.  Poor people on the other hand are often un-banked.  All of their income is either in cash or immediately converted into cash, which they store in their homes.

Breaking into the homes of rich people is often not especially profitable because the goods the thief steals have to be converted into cash via a fence at a rate of cents on the dollar.  Cash stolen from the homes of the poor however, can be spent at full face value and is a lot more convenient to carry.

All of which raises the interesting question of why don’t the poor get bank accounts.  The short answer is that there are fewer banks on the poor side of town.  Banks tend to avoid poor neighborhoods because the deposits are smaller, the creditworthiness of customers is lower and customer service cost higher (especially in immigrant communities where English proficiency is low).

Regulations do exist that attempt to force banks to provide services in disadvantaged communities, however the relative lack of banking services in really poor communities suggest that these measures are at best partially effective.

Fundamentally, government mandates that force businesses to engage in unprofitable operations tend to be unstable for several reasons.  Firstly, the businesses tend to take any opportunity to minimize or close these operations.  Secondly, the oversight agencies tend to be captured by the industries they regulate.  If government officials are recruited from and tend to retire to the industry they oversee it isn’t difficult to predict where their sympathies will lie.  Finally, the regulations tend to be chipped away over time through industry lobbying.

It would be far better if someone came up with a profitable, and thus long term sustainable, model for banking low income communities.  Eventually someone will.  While poor customers may not be that valuable individually, in aggregate that represent a potentially enormous source of new funds and new loan opportunities.

From a historical perspective, Bank of America is now the nation’s largest retail bank at least in part because its founder, Amadeo Giannini, went after middle income customers that his competitors of the time considered too small to bother with.

Perhaps there is a  similar success story awaiting the person who figures out how to profitably provide banking services to poor Americans.

*Dr Michael Brandl of the at the University of Texas (http://brandl.easyjournal.com/)

Recently the political climate in the United States has tilted towards protectionism. Politicians on both sides of the aisle (and more than a few economists) have been loudly proclaiming that the national interest of the United States would be best served by restricting trade. Or at least, in true mercantilist fashion, by restricting imports.

This raises the interesting question of what exactly constitutes the national interest. If the national interest would be best served by maximizing the wealth of the United States then the best policy would be the elimination of trade barriers (a point about which there has no doubt whatsoever since the ‘logic’ of mercantilism was blown out of the water 200 years ago).

But what if wealth maximization is not the primary determinant of the national interest. There are at least three feasible alternative explanations of what our political leaders mean when they refer to the national interest.

(1) The Cynical View:

Our political leaders may simply equate the national interest with the narrow sectional interests of politically important special interest groups. From a politician’s perspective this is entirely logical.

For example, in 2002 it was clearly in the best interests of the nation that President Bush be re-elected (at least in the mind of President Bush), which is why the supposedly free trade supporting President suddenly found it necessary to impose economically asinine tariffs on imported steel (At the time steel producing Ohio, Pennsylvania and West Virginia were expected to be key swing states in the 2004 election).

(2) The Greater Wisdom View:

Wealth is in many ways a rather crude measure of wellbeing. In attempting to maximize the overall wellbeing of the nation, our political leaders may be taking into consideration factors not included in financial calculations. For example, it is plausible to argue that the nation would be better off with fewer goods and a cleaner environment, which is why it might make sense to attach environmental conditions to trade deals.

It may well be that this is how politicians actually think about trade. However, a cynic might point out that there seems to be a surprisingly high correlation between the trade policies that politicians believe will maximize national wellbeing and those that happen to be politically expedient.

(3) The Relative Power View:

It could be that what really matters is relative wealth. Our political leaders may be less interested in the absolute wealth of the United States, than they are in its wealth relative to potential strategic competitors.

While free trade would certainly enhance the wealth of the United States, it would likely benefit other trading nations even more, reducing the economic differential between the United States and the rest of the world. Since military power is highly dependant on economic strength it might be considered better for the United States if its trading partners, in particular China, remained relatively poor, even if this meant failing to maximize the economic potential of the United States.

From a relative power perspective the United States has every incentive to discourage free trade. If you are in the lead there is little incentive to do anything that might help the other guys catch up. Of course it is unlikely that this view would ever be publicly expressed since suggesting that the United States should restrict trade so as to maintain its relative military and economic advantages might be viewed as more than a little mean spirited.

Later this year congress will sit down to consider the 2007 Farm Bill. This multi-billion dollar pork-fest will establish the direction of US farm subsidy programs for the next five years. Unfortunately for US taxpayers neither radical cuts nor outright abolition are on the table.

For America’s politically powerful farmers and rural lobby beholden politicians a rural economy without massive federal subsidies is simply unimaginable. I don’t pretend to know what would happen if congress succumbed to a sudden attack of economic rationality, but there is reason to believe that it might not be all bad.

Consider the experience of New Zealand:

“Many had worried that the end of subsidies would destroy agriculture in the country, yet the agricultural sector grew as a percentage of GDP. Today approximately 90 percent of farm output is exported, making up more than 55 percent of total merchandise exports. Productivity gains have allowed farmers to remain competitive in a world market where they compete with farmers in subsidized countries. Real farm incomes have recovered, and in some sectors income is even higher than it was under subsidies.

Instead of disappearing into the mists, the country’s farm sector became known throughout the world for high-quality, innovative, and efficient agricultural practices. After the initial failures, farm numbers held constant, and the amount of land in agriculture fell only slightly as marginal land went out of production. Decreases in farm employment have been offset by increases in employment in rural tourism. Thus, the percentage of the population living in rural areas remains virtually unchanged. Real land values, which initially plummeted, have recovered and surpassed their pre-reform level.”

This is a fairly reasonable summary of New Zealand’s experience with ending farm support. Farming did not collapse, civilization miraculously survived and, in a not unimportant consideration, the government that whacked the farm support system won the next election by a handsome margin.

So why couldn’t this happen in the US?

Our correspondent omitted to mention the political circumstances that made such a radical move possible. In 1985 the incoming Labor government discovered that the country was essentially bankrupt. New Zealand was in fact on verge of a massive Argentina style debt default. The impending financial meltdown focused minds and made the unthinkable not only possible, but necessary.

While the federal government is undoubtedly on an unsustainable fiscal path, the day of reckoning is still many years away. Only when the US is backed up against the fiscal wall will a radical reform, such as applying the chainsaw of economic rationality to the bloated paunch of farm politics, become possible.

Last week this year’s allocation of H1B visas was exhausted on the day that applications opened. Tech employers led by Microsoft are loudly demanding an increase in, or better still the elimination of, the H1B visa cap. Unfortunately with the increase in protectionist and anti-immigrant sentiment in Congress a cap increase is unlikely.

H1B visa opponents are obsessed with the idea that H1B visa holders put downward pressure on skilled wages and occupy positions that might otherwise go to Americans. This is an economics 101 type argument. As far as their argument goes the critics are correct.

Figure 1:

Consider figure 1. If supply 1 is the total supply of skilled labor (natives plus H1Bs) and supply 2 is the supply of native skilled labor then removing the H1Bs would clearly increase the price of skilled labor. Notice also that the number of Americans holding skilled jobs also increases if the H1Bs disappear (from Native Jobs 1 to Native Jobs 2).So if the H1B visa system were scrapped more Americans would have higher paying jobs. What is not to like?

Unfortunately the world is not so simple. To understand why excluding foreign skilled labor might not be such a hot idea all we need to do is apply a little more economics 101.

Figure 2:

Consider figure 2. By adding a second set of skilled labor demand and supply curves for the rest of the world we can develop a fuller understanding of the impact of ending the H1B visa program. Since H1B visa workers removed from the US labor pool don’t simply evaporate, the supply of skilled workers in the rest of the world increases and rest of the world price for skilled labor decreases. This increases the skilled labor price differential between the US and the rest of the world. This differential is a nice incentive for US employers to offshore their high skill work.

To put it another way, if US employers can move work to India and employ the same people they wanted to employ in the US for less money, what do you think is going to happen?

The point is that keeping foreign high skill workers out of the US is a very simple minded way of trying to improve the lot of skilled Americans. Long term it is likely to result in a decline in American competitiveness and the large scale export of high skill jobs.