Morning Cup of Heresy

Fellow laissez-fairites, hang onto your hats…

Adam Smith’s “invisible hand” of free markets garners almost as much reverence as Isaac Newton’s laws of physics.  With good reason:  like Newton, his ideas are proven to govern most human-scale, real-world problems.

But of course, even Newton was wrong at the edges.  Small things and fast things do not obey Newton’s laws, much to Einstein’s and Feynman’s good fortune.  Newton is an approximation, albeit a very good one.

Similarly, it is interesting to at least ask the question:  under what conditions does Adam Smith describe the world poorly?  More specifically…

What if labor markets can actually be too flexible?

This might sometimes be the case in at least two ways.  First, in a deflationary spiral, if layoffs are very easy, then public companies will use them to stabilize quarterly earnings.  But in aggregate, this may actually accelerate the deflationary feedback loop, triggering a depression.

Second, what if too-easy substitution of cheap labor stalls domestic productivity growth per work hour — the only engine of long-term eocnomic advancement?

What if it’s actually a liability to have the reserve currency?

Having the reserve currency permits short-term interest rates to be held artificially low, while delaying the inflationary and exchange-rate consequences for many years.  Artificially low rates foster misallocated resources, including but not limited to investment bubbles.

1.   Individuals:  why save if you get a negative real return? Instead, pile into houses and stock.  If rates are really low, asset prices keep rising, so it’s short-run logical to borrow against your house and either double down on the stock market or buy an Escalade.
2.   Corporations:  why issue equity if you can issue debt almost for free?  Lever up, buy back the stock, go private.  Works great unless rates rise again someday, in which case the firm goes insolvent trying to roll over the debt.

Both of the above are short-run logical, long-run crazy.  But if rates are artificially low, and your currency artificially strong, for over a decade — a condition only possible for the reserve currency — then you start to get adults whose entire adult life has been governed by what should have been a short-run condition.  They know no other reality.

People thus learn lessons that cannot immediately be unlearned.  So if irrational conditions persist too long, their judgment is polluted for a long time. They are surprised, and slow to react and relearn, when rates suddenly spike, or assets suddenly crash.

Yes, this section is particularly heretical, yet fits the historical record:  the only two countries to experience massive industrial hollowing (US and UK) are also the only two modern reserve currencies.  No comparable hollowing occurred at industrial powers with no reserve currency (Japan, Germany).

So the reserve currency is not directly a liability, but perhaps is indirectly a liability, because it delays the consequences of bad financial policy for so many years.  This creates irresistible political temptation.  Riskless in the short run.  But then you get a whole generation of people trained to do dumb stuff.


The common thread of the above

Individuals heavily discount the future, even the likely future, if it is far enough away.  In these cases, Adam Smith may not operate efficiently when short-term optimization has long-term negative externalities.  

There is a very easy way to demonstrate this:  one day we’ll all be dead, but this future, though certain, is discounted to zero by most people day to day.  It is logical to assume the same discount applies to other futures, and thus that Adam Smith doesn’t work well under such circumstances.



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