We've just released a new paper by Arnold Kling, "Patterns of Sustainable Specialization and Trade: A Smith-Ricardo Theory of Macroeconomics". Kling has been writing about patterns of sustainable specialization and trade (PSST) for some time now at EconLog, and I was delighted when he agreed to lay out his case in an ASI monograph. His argument is simple, but devastating to the current consensus view of macroeconomics: that unemployment (and recessions) are consequences not of insufficient aggregate demand, but of system-wide changes in the patterns of trade and specialization that people engage in. Some have termed this the "recalculation" view of recessions, but Kling gives the perspective a deep rooting in classical economic theory — hence the subtitle, "A Smith-Ricardo Theory of Macroeconomics".

If Kling is correct, the world's governments have been doing precisely the opposite of what they should be in order to curb unemployment. Economic stimulus and government job creation distort the signals that unemployed workers use to figure out what pattern of trade they should be engaging in now. As Kling says in his Wall Street Journal article on his monograph today, the government cannot create sustainable jobs.

This paper is the second (following Scott Sumner's last year) in a new series of irregular papers we are releasing at the Adam Smith Institute in which we try to present some of the most interesting and important new ideas in economics for the intelligent layperson. It's more important than ever that ideas like Klings are understood by people both inside and outside the world of academia. As Keynes said, "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." With papers like this, we hope to change that.

Download: Patterns of Sustainable Specialization and Trade (PDF)

In all the panicky talk of haircuts and economic Armageddon, it might be wise to step back and consider the two basic options: Euro or no Euro.  The Euro is only a means not an end and preserving it at all costs makes little sense.  With hindsight it might just look like an interesting experiment.

German leaders are keen on the Euro, even if their electors are not, because its weakness keeps German exports competitive, it lowers exchange costs and it is a step towards the United States of Europe governed from Berlin.  To the extent that the current troubles lead to central, i.e. German, management of national finances throughout the Eurozone, the pain is worth the gain.  There was a price for bringing East Germany in from the cold and there is now a price for fiscal union in the Eurozone.  But there is a limit to the subsidies German electors will tolerate and Angela Merkel is walking a tightrope.

So the long term Euro retention option boils down to whether Germany is prepared to pay the costs of fiscal union in the Eurozone.  The northern fiscally correct countries will play along albeit with some nervousness about the end game.  The Mediterranean group will focus on how they can appear to be conforming to the rules whilst actually clearing the till each night.  In other words the costs will not stop with the current round of negotiations.

Even Bismarck had to accept that there were limits to German expansion in his day and Germany may now decide the game is not worth the candle in which case the question becomes how to dismantle the Euro with least economic cost.

My friend Richard Warner, a banker from the days when bank bonuses were modest, has figured out that the solution is for the strongest currency to secede first, followed by the next and so on.  His reasoning is that if the weakest, say Greece, leaves first, no one will believe the initial Euro:Drachma exchange rate and the drama will continue even though the Greeks can then hoist interest rates.  We had a taste of that with the ERM.  Double digit interest rates only scared the markets more.

On the other had, if Germany exits first the Euro:Deutschmark exchange rate would be regarded and fairly stable and the two currencies could settle at their own levels allowing the next most stable, the Netherlands perhaps, to exit next.

He has a point, don’t you think?

In their ongoing campaign for plain packaging of cigarettes, Action on Smoking and Health have dismissed fears of a slippery slope, saying:

Tobacco is not like any other product, it is the only legal product on the market which is lethal when used as intended... Plain packs for tobacco would not set a precedent for other products.

This is the same mantra we hear from self-described health campaigners every time the Trojan horse of tobacco is to used to expand state interference in lifestyle choices. Meanwhile, back in the real world, the latest issue of Nature provides the most shameless indication yet that policies once seen as unique to cigarettes will be applied to food and drink. In an article entitled 'The Toxic Truth about Sugar', three San Francisco-based public health advocates argue that sugar is a poisonous substance of abuse which is too readily cheap and too available. 75 per cent of all US healthcare expenditure is, they claim, spent on treating sugar-related diseases.

The seriousness of the journal precludes the possibility that it is a spoof, but one can still enjoy the moments of unintentional hilarity, as when the authors make this appeal to nature:

Evolutionarily, sugar was available to our ancestors as fruit for only a few months a year (at harvest time), or as honey, which was guarded by bees.

"Nature," they add, "made sugar hard to get; man made it easy." The millions of people who live in sugarcane-growing regions—for whom nature made wurzels hard to get—may raise a quizzical eyebrow at this, but even if it were true, anyone who understands medicine, as opposed to the nebulous and debased concept of 'public health', knows that nature is to be feared and defeated. Mother Nature brings us disease, malnutrition and infant mortality; mankind bring us vaccines, cures and plenty. Few doctors would recommend abstaining from fruit for months on end because Gaia has willed it, and even the most primitive religions do not regard bees as gatekeepers of unhealthy vices.

The authors note that infectious diseases now kill fewer people than "non-communicable diseases" and that more people are obese than are undernourished. Man's triumph over starvation and parasitic killers is a jolly good thing, but in the glass-half-empty world of public health, it only serves to show that government action is more urgent than ever. "Non-communicable disease"—what we die of if malaria and tuberculosis don't get us first—is set to be the medical establishment's buzzword of the 2010s. It covers all the ailments that have traditionally been beyond the remit of public health and it is so broadly defined as to allow almost any intrusion into our private lives.

Denmark already has a fat tax and many US states have some form of soda tax, but these are usually set so low as to be stealth taxes by any other name. Public health crusaders would like to go much further. The authors of the Nature article suggest banning the sale of sugary drinks to the under-17s, banning the advertising of sugary products on television, banning vending machines, removing sugar from the Food and Drug Administration's list of products which are Generally Regarded as Safe (GRAS), doubling the price of soda drinks, reducing opening times of shops that sell sugar-containing products and limiting the number of fast-food restaurants and confectioners that can operate in a district. "We’re not talking about prohibition," says Dr Laura Schmidt, one of the authors, "We're not advocating a major imposition of the government into people’s lives." One wonders how heavy the government's hand would have to be for Dr Schmidt to recognise a major imposition.

Libertarian objections to one side, fat taxes and soda taxes are phenomenally ineffective. A recent study found that a penny-per-ounce soda tax, as proposed in the Nature article, would reduce consumption by just nine calories a day. A 10% fat tax on milk and fizzy drinks, as proposed in the British Journal of Nutrition recently, would have even less effect.

Sin taxes of whatever variety are useless when set at low levels and spawn a host of unpleasant, unintended consequences when set at high levels. The repeated failure of such neo-prohibitionist policies will not be enough to deter the rampaging public health industry from taking an ever more draconian line on what we eat and drink. Governments, meanwhile, are so desperate for cash that the unholy alliance between taxman and puritan is only likely to get stronger.

Well, we’ve stripped those Royal Bank of Scotland rascals of their titles and bonuses and the surge of optimism pulsing through the economy is palpable. The stock market is soaring, businesses have launched ambitious investment schemes and dole queues are disappearing.

If only.

We’re somewhat ambivalent about this whole executive bashing brouhaha that is substituting for serious thought on stimulating economic growth. Before moving on, though, here’s one small point. Britain is a big player in the premier league of top executive talent. Earlier this week, the world’s most successful company Apple appointed Dixons CEO John Browett as head of Apple’s retail store operation. Born in Rutland and a graduate of Cambridge University and Wharton Business School, Mr Browett worked at Boston Consulting and Tesco before moving to Dixons. In short, he’s a serious player on the global stage.

Let’s remember that before we penalise top talent for the sins of RBS. The UK’s biggest industry by far consists of professional services like lawyers, accounts and architects and business services like IT, security, training and catering. Together, they’re 17% of the economy compared with 11% for manufacturing and 10% for financial services. We need a cultural climate that allows the likes of Mr Browett to come and to go, to teach and to learn.

Then there’s the collective waste of energy and hot air expended on the matter of executive compensation – the dispiriting politics of envy that won’t launch a single new business or entice existing ones to expand. How much better to spend that scarce time and political capital on liberating the economy.

For example, Europe continues embroiled in its financial crisis – floundering with grand plans for debt relief and squeezing taxpayers for every last penny. The surest way forward is to complete the Single Market project, especially since that which remains to be done applies to those very professional and business services that the UK is so good at. Now that we’ve got our RBS scalps, let’s put the same effort into finishing the Single Market.

Here’s one quickie – a single pan-European patent regime has been stalled by a squabble over where to locate the main patent court: London, Paris or Munich. For goodness sake, just give it to Germany, the biggest issuer of patents, and let’s get on with it. European patent protection and any consequent litigation now costs five times as much as in the US because of the filings required for each country.

This is a costless measure that will spur far more growth than any hocked knighthood or confiscated bonus. We need growth more than we need spiteful envy. 

Until a couple of years ago, any suggestion that the great experiment of European Monetary Union was in trouble met with a hostile response, but since then the problem has become more obvious and much has been written on it in the daily and weekly press. The 10th anniversary of the introduction of the currency and an apparent period of relative calm seems an excellent opportunity to stand back and look at the broader context. Where are we now, how did we get there and where do we go from here?

European Monetary Union (not an obvious "optimum currency area") was launched with fatal design faults: the long awaited, but disappointing, 1995 Green Paper [2] completely failed to address the real economic problems which those of us looking sympathetically but critically at the project had identified. The rules adopted made the change "irreversible" with no provision for countries to leave, or be expelled from, the union and no mechanism for dealing with asymmetric shocks. Creating the euro in such an inflexible form was a disaster waiting to happen, but had believed and hoped that, given the political will behind the project, the need for changes would be recognised and acted on before it was too late. This has not happened and the taxpayer’s money has been thrown at a futile attempt to “save the euro”, when the real problem is to prevent a financial catastrophe. Whether this was deliberate is a matter for future political historians but Peter Oborne and Frances Weaver (CPS September 2011) think they were `Guilty Men’.

Read this article.

Ayn Rand, author of the novels The Fountainhead, Atlas Shrugged and books on the philosophy of capitalism like The Virtue of Selfishness and Capitalism: The Unknown Ideal, was born in Russia 107 years ago today. Rand is a divisive figure, often misunderstood, but her writings have served as the "gateway drug" into libertarianism for many people. (There's even a book called It Usually Begins With Ayn Rand!) Most recently, her magnum opus Atlas Shrugged, which tells the story of a crumbling dystopian world in which creative people have gone on strike, has been enjoying a resurgence in popularity in these troubled times.

What's special about Ayn Rand is how, unlike economists like Mises, Hayek and Friedman, she gave a moral foundation to the capitalist system. Not only does a capitalist system enrich the lives of its inhabitants by making efficient use of resources, Rand said, it allows them to flourish by living productive, independent lives. There's something very appealing about that view of humanity — that, absent the slaver's whip and the taxman's calculator, men and women can better themselves by thinking, creating and producing new things, by remaking the world as they want to.

Many of Rand's critics focus on her personal failings, ignoring her deeply humanistic philosophy, which cherished ideas and creative people. On her birthday, it's worth reflecting on what makes Ayn Rand so important to so many people, and what her writings have to offer us at a time when bold creators and new ideas are sorely needed.

Madsen's videos have proved to be a lot more popular than we expected, so we've decided to speed up their release to keep up the momentum. They're all based on his excellent new book, Economics Made Simple, which makes a terrific introduction to economics and markets, going from value and trade all the way up to banking and finance. We've mentioned the book on the blog before, but what I've only just noticed is how affordable the Kindle edition is — £2.40 for the full book! As a digital media enthusiast like me, that's exciting: as the overheads of book publishing fall, books like Madsen's will become even more available to everyone. Of course, the Youtube videos are free. Even if you don't buy the book, do share Madsen's videos far and wide.

Here's a playlist of the videos so far, and here's where you can subscribe to our YouTube channel so you don't miss any of our other great videos either.

The BBC has an article today that shows the harm that the benefit cap would do to an average family on benefits. The graph, above, summarizes their income and expenditures.

It's distressing enough that Ray, the father of the family, can say "The market for my skills dried up 10 years ago - there's a total lack of work in my area of expertise [educational software writing]". In that ten years, has he tried doing something else? He also says, "I see eight people here having to choose between eating or heating." Grim stuff, but is this true?

£82.40 a week is no small sum, but look closely at what those expenditures include: Sky TV, 24 cans of lager, 200 cigarettes and a large pouch of tobacco. Frankly, I find it unbelievable that a family of eight could spend £240 a week on groceries without being able to cut down, but let's leave food expenditures aside, along with the nebulous categories like "entertainment" and "shows". Here are the weekly costs of just this family's luxuries:

Sky TV - £15

24 cans of lager - £20

200 cigarettes - £70

Large pouch of tobacco - £12

Total - £117

If they're choosing between "eating or heating" without thinking about cutting the above expenses, well, OK. Some people have unusual priorities, and good luck to them. I'm in favour of as many people as possible who want to smoke doing so, if only to annoy the health fascists at ASH and the BMA. But that's not something taxpayers should be paying for.

In Facebook's drive to annoy its users to the point of madness, our The Next Generation (TNG) group for under-30s (this is quite a strict rule, I'm afraid) has been archived so it's no longer useful. Our Next Generation events are hugely popular monthly events for under-30s with a short speech by a person of interest and an informal reception afterwards. If you'd like to subscribe to our Next Generation emails and come along to future TNG events, please enter your email address in this form.

You should also like us on Facebook — much as we'd love to leave Facebook behind, it has its uses.

Our next TNG is being held on Tuesday 7th Feb with Nick Pickles, Director of Big Brother Watch. Details here.

Following his landslide win in the Florida primary election last night, it now seems certain that Mitt Romney will be the Republican party's presidential nominee. Romney will be the first presidential candidate to have spent most of his career in the financial sector, specifically private equity, a sector many view with suspicion and fear. Romney's opponents have made much of the fact that he succeeded at his job by "firing people". Although I'm not much of a Romney fan, this is a slur caused mainly by the confusion surrounding private equity.

Writing in the National Review, Reihan Salam has a great piece on what private equity is and why firms like Romney's Bain Capital are so important to modern economies:

Successful firms such as Apple change the larger competitive landscape by threatening the very survival of competitors. Chad Syverson, an economist at the University of Chicago’s Booth School of Business, found that what separates top firms from bottom firms is, typically, a large difference in productivity, with the top ones producing almost twice as much with the same measured input. This creates an almost irresistible temptation for investors. If Firm X, languishing at the 10th percentile in terms of productivity, could somehow be overhauled to match the productivity levels achieved by Firm A, at the 90th percentile, the potential for profit would be huge. Note, however, that halving “measured input” in order to double productivity will often mean shedding the weakest performers and giving those who remain the tools they need to do their jobs better and faster. Private equity does exactly this.

What Mitt Romney discovered was that American corporations sometimes had to be dragged, wailing and whining, into a state of efficiency. As a management consultant at Bain & Company, Romney had studied successful firms and then told other firms how to replicate their strategies. But those firms had come of age in the fat years of American corporate dominance, when many believed that the Japanese could do little more than manufacture cheap toys and textiles, and many were reluctant to accept his newfangled advice. . . .

The typical pattern, at Bain and at other private-equity firms like it, was to buy a company by spending some portion of their capital (augmented by debt — usually somewhere between 60 to 90 percent of the total purchase price). They would then offer supercharged incentives for top managers, both among the investment professionals at the private-equity firm itself and at the firms they acquired. CEOs of newly acquired firms would be enticed with stock options and performance incentives. When the system worked, as it often did, CEOs started making sums that were unheard of in the 1960s.

We can trace the enormous increase in compensation among top earners to this embrace of performance-based compensation among the CEOs of privately held firms. This relation between huge paydays and the work of private equity is one of many reasons the field is so controversial. Equally controversial is the use of debt. Having bought a company with borrowed money, private-equity firms had to extract the mortgage payments, as it were, out of the company’s cash flow. This was a new expense for management, and it was also a source of discipline: If you couldn’t make the payments, you’d kiss your performance incentives goodbye, and you might even end up going bust. But loading up a company with debt could also hasten its demise, especially if management failed to cut costs.

When people like Ed Miliband talk about "predator capitalism" and "asset strippers", this is usually the sort of thing they have in mind. And, in Ed's case at least, they're usually utterly, desperately uninformed about what they're talking about. Private equity is, essentially, management outsourcing. Anybody who understands how markets work will realize that a successful streamlining of a company saves it from eventual extinction. Bringing in new ideas and new structures to a company is often rough on the workers, but in the long run it's what preserves the jobs they have. As Salam says: 

Private-equity firms have taken the process of turning around failing businesses and made it into an industrial process. The hostile reaction to this industrialization of corporate cost-cutting evokes the revolt of the Luddites, the 19th-century textile artisans who sabotaged the mechanical looms that threatened their familiar way of life. These artisans had no objection to buying and selling textiles — that was how they made their living. Rather, they objected to the scale of the new factories, their speed, and the rate at which they were displacing skilled workers. The balance of power had shifted from a few skilled artisans to the owners of capital and the managers of the new factories, who could now draw upon a much larger labor pool. Management is no longer the work of artisans. Just as the young consultants at Bain & Company hoped, it has evolved into a rigorous, unsentimental, data-driven enterprise dominated by sophisticated investment professionals.

The only downside? The more sophisticated an industrial process becomes, the more opaque it is to outsiders; the more opaque something that might threaten your job is, the louder the cries that "something must be done".