Friday, September 12, 2008

How Modern Capitalism Works - A Screed

You see a ton of bloviation at all times online about the market capitalist economic system. People on the left often see it as a necessary evil, or even a villain of sorts. Folks on the right revere it as some sort of God. This stuff gets even worse, devolving into the coarsest sorts of crass propaganda, during elections.

Yet it's not particularly often that you see someone, from blog commenters all the way up to highly paid economics commentators who work for big publications, actually describe how the modern capitalist system works. It's an interesting system, and worth discussing!

The rightist view of the market system is that it's essentially perfect, and they are right. Well, right in a sense. The market system is a perfect model for rational behavior in the market run. What that means is that as long as there aren't any significant externalities (that is, factors that the model doesn't account for) and we're dealing with a sufficiently short run of time, then the market system does its job, without any need for outside intervention.

There was a time, many decades ago, when the government regularly tried to monkey with the price system, and the results were not very encouraging. Even the big success stories of government price manipulation (rent control is an example) had negative consequences that offset at least some of the gains.

Fortunately, it's now quite rare that the government actually tries to intervene in the price system as such. There are certainly crisis moments when things go horribly wrong. During the California blackouts, for example, FedGov should have intervened to fix a price system that had completely failed and was being gamed by a malign actor, Enron. But for the most part, the government now stays out of the price system. And that's good!

Big, modern capitalist countries, however, do have an important role for government. In fact, there are many important roles. The anarcho-libertarian idea that government can just "butt out and let the market handle it" neglects the fact that there are major areas of modern capitalist economies that have nothing to do with the price system. "The market" doesn't apply! Not every store is a supermarket, and not every market is like the market for wheat.

For instance, finance markets have to be tightly regulated. Ron Paul is right in that if you did away with the central bank and went back to the gold standard that you wouldn't need tight regulation of financial markets. Unfortunately that describes an economic system that no longer exists and makes no sense in the modern world. It can't happen. So it's a bit silly to talk about it as if it could.

So in finance you need government for oversight, and also for insurance. That's one of the big, important roles government plays in the economy - the role of bagholder. The idea is that the government is supposed to prevent breakdowns in the financial system. When that oversight fails, the government is left holding the bag. If you didn't have that, the people left holding the bag would be whoever didn't have the power to hand the bag off to someone else (which generally means poor people.)

Right now you see that, of course, with Fannie Mae and Freddie Mac. These were government entities originally designed to grease the wheels of the mortgage system, and they were privatized on the theory that this would make them run more efficiently. In that sort of situation, if the privatization experiment fails (as it has done) then the government has to step in because you can't allow a giant piece of the finance system to just fail. If you did, it would cause investors (we often say "foreign investors" but really it's all investors; nothing's stopping Merrill Lynch from putting its money into German bonds instead of American ones) to pull capital out of the US economy, further destabilizing the system until it collapsed.

Another important government role, and one that gets a lot less intelligent attention in the press, is that of dynamic technology investor. There is a sort of pleasing myth about market capitalism that it is a "great driver of innovation." Even leftists who are grumbling about the excesses of evil capitalists will often make some basic obeisance to this idea. Unfortunately, it's not really true in the sense that most people seem to mean it.

In a market system, competition for "rents," which is the word economists use for the money you make over and above what you would make if did something else instead of what you're doing now, is fierce. That fierce competition does drive innovation - rent-seeking innovation! In the short run, firms try to position their capital such that they will continue to collect rents and make profits.

The problem is that in the long run, eventually this model of capitalism will run aground. Rent-seeking innovation doesn't create any long-term benefits to the economy. Those long-term benefits have to come from technological innovation.

Advances in technology were why Malthus' predictions of famine and doom never came true. Most people who pay attention to economics know that. What people don't know is that market economies systematically underinvest in long-term technological innovation. Left to its own devices, technology doesn't move fast enough because everyone is using their money to seek rents, and not enough people are using their money to develop new technology.

In the US, we have a couple of dynamic areas where the government plays a big role. One is the university system, in which state governments run big higher education institutions, turning out vastly more scientists and other technological innovators than would otherwise be the case, and then paying some of them to do academic research.

The other is the Pentagon system, which includes DoD but also other high-tech government entities such as NIH and CDC, where the government pays scientists directly (or through the university system, e.g. MIT) to develop technology the government wants, and then grants licenses to private companies to manufacture and market the results.

These dynamic innovation investments are really, really expensive, and a lot of them are, depending on your perspective, wasteful. (For example, the new jet fighter the Pentagon developed is completely unnecessary for war fighting.) But the money needs to be spent on something. It's an important part of the economy.

The main argument for serious people to have is how much of the government's innovation bankroll should be spent on what type of innovation. Right now, in my view, we spend way too much on tanks and boats and not enough on creating an engineering infrastructure for switching off of fossil fuels. But my view isn't necessarily correct - we should, like, vote about it or something!

In a functioning public square (unlike the silly TV-driven media environment we have) it would be questions like these that we would have in mind when we were driving to the polls to elect leaders. The long-term impact of who called whom a naughty name is, I would imagine, much less.

Too bad for us.


Chris said...

Much of what you have said is absolutely true. The more I experience the reality of the private sector, the more I realize that at-this-very-moment rent-seeking often takes precedence over everything, including a long-term vision for a company. But my frustration at much of this behavior is not limited to the companies themselves. Especially in my area, the role of government as bagholder has created a dangerous game of chicken.

For example, R&D expenditures by pharmaceutical companies (to say nothing of marketing budgets) dwarf the NIH budget. There is sufficient evidence to support the notion that basic science breakthroughs were made on the private dime when it was necessary to get to a product. But the existence of organizations like NIH makes it politically expedient for big pharma to ignore entire therapeutic areas like antibiotics, which their blockbuster model of drug development has no room for. And how did they arrive at this model? By encouraging the mixed market approach and the false "basic/applied" dichotomy so prevalent in science discussion today. In big pharma terms, "basic research" is anything you can't make $700 million/year with, even if it leads directly to a working product.

Essentially, the government has been informed that they will have to deal with the upcoming pathogenic threats; killing MRSA and getting ready for avian flu are important, but not (yet) profitable. Government wants to be seen as doing something, but money is tight. So what happens? If there's enough deadlock, maybe somebody (an NGO, or one of a handful of naive micro-pharmas like mine) will come up with something decent. But try raising money for something that people have decided is the government's job. Those who succeed despite it all will be acquired by big pharma, who will take credit for the good that is done. Crass but at least somewhat self-correcting.

But there's no guarantee that will happen before a major outbreak. We may be waaay behind the curve when it shows up. I am naturally optimistic, but this stuff scares me.

Uncle Kevin said...

I think discussing tanks and fighter jets in the context of innovation research is oxymoronic. The two have little to do with each other. The DoD has something called "technology readiness level" TRL. It has a scale of 1 - 10 with 10 being basically "commercially available". For production contracts, the customer views TRL's below 7 as generally "too risky". For demo's and other specialty items, even anything below about 5 won't get much consideration. I've worked on 1 - 3 stuff occasionally, but that is predominately the stuff of research labs.

The 1-3 stuff is where the government is most helpful. By the time you get to 4-7, often commercial development is a better idea. (They basically focus upon how to make it profitably producible). The only real contribution that the government can make in the 7 - 10 category is by creating a "market" or "customer" for the product until it can find its way into commercial use. That's the contribution of tanks and fighter jets. To Chris' comment about vaccines and antibiotics, I suspect the government could have some role here too.

The problem with the argument about where to spend money is that at TRL levels of 1 - 3 it isn't clear exactly what some stuff will be good for. We don't know if it is something only good for jet fighters, or if it will reduce fuel consumption on all turbine engines. And sometimes that doesn't become clear until after it's already in the fighter jet.

Basically my rule of thumb is that we shouldn't make fighter jets to demonstrate new technologies. We should make them to fight wars. But we conversely shouldn't avoid pursuing technologies whose short term use seems to be to make better fighter jets. And in the end we have to understand that there is more "failure" in development than success. In both nature and business, vastly more things will be tried, and abandoned than will ever move up the TRL scale. That gives the impression of inefficiency. Knowledge has to be understood to be useful. Even knowledge of failure.