One small step for Starbucks...

In most coffee shops these days, you'll find that the small, medium, and large coffee cups all use the same size lid now, whereas even five years ago they used to have different size lids for the different cups. That small change in the geometry of the cups means that somebody can save a little time in setting up the coffee shop, preparing the cups, getting your coffee, and getting out. Millions of little discoveries like that, combined with some very big discoveries, like the electric motor and antibiotics, have made the quality of life for people today dramatically higher than it was 100 years ago.

Paul Romer

Private governance and the shadow of the state



I went to a lunch at the Legatum Institute yesterday to hear Ed Stringham talk about private governance. Ed's argument is that many of the transactions that take place in today's economy happen without the involvement of the state to keep people playing by the rules. Things like reputation are a much bigger factor in keeping contracts enforced and stopping firms from committing fraud, because they reduce the potential for future exchange. Ed aims to write a book of case studies of this "private governance" phenomenon.

One example he used was of Jonathan's Coffeehouse, a private club that preceded the London Stock Exchange. In the 18th century, the government refused to enforce stock exchange contracts, seeing them as a form of gambling. Nevertheless, the Coffeehouse became a centre of commerce and contracts were usually upheld voluntarily. If you were a trader, you could rip somebody off once, but would be barred from the club. For people whose livelihoods were based on stock trading, it wasn't worth it.

The same phenomenon exists today in a whole range of exchanges. When I go to a restaurant and get a bland meal, it's practically certain that I won't sue. Does this mean that profit-maximising restaurants will constantly give out bland meals? No – if it serves bad food, I'll stop going and tell my friends not to go either. Reputational capital, so to speak, is enormously valuable, and losing it can be worse than just losing a court case. As a side-point, the reason that restaurants in touristy areas are usually so bad is down to this fact as well. Tourists typically don't know anything about the restuarants they go to – could things like TripAdvisor bring an end to tasteless, expensive tourist food?

Credit cards are another example of private governance. Dispute resolution is typically left to arbitration and mediation, without recourse to the courts. But there is a "shadow of the state" – it's possible that someone will bring an extreme case to the courts, which may make people more willing to comply with a mediation outcome. It strikes me that this might be the biggest problem with some examples of private governance – that people only acted well because they knew there was a slim chance of a very costly lawsuit – a sort of reverse moral hazard. This isn't always the case – certainly not in the stock market or restaurant examples – but it is a problem for others. The shadow of the state looms large.

Interest rates and the price system


The key thing to realize about market economics is that prices function as signals. They emerge spontaneously, and co-ordinate the actions of millions of people, all over the world, who may not know each other and may have nothing in common.

At the basic level, it's a question of supply and demand. If the supply of X rises relative to the demand for X, then the price of X will fall. That falling price is a signal to entrepreneurs that they should probably switch their investment somewhere else, which in turn leads to lower production. On the other hand, if the supply of X falls relative to the demand for X, then prices will rise. And rising price is a signal to entrepreneurs that they should invest in X, in order to increase production and satisfy market demand. To put it very simply, it is the system of market prices that co-ordinates supply and demand, avoiding big shortages or surpluses.

The problem when government tries to control the price of anything is that prices no longer reflect supply and demand, and no longer serve as a useful guide to entrepreneurial activity and investment. No one has any reliable way of knowing, in the absence of market prices, whether we need more of X or less of it. Inevitably, we end up with a shortage or a surplus. Consider, for example, what has happened when governments have interfered with food prices. In Europe, we've had lakes of milk and mountains of butter. In Africa, they've at times ended up with nothing much at all. Such outcomes are unavoidable when you don't have market prices to guide activity.

Crucially, of course, governments can never 'set' prices correctly – the information they would need to do that is so dispersed, so complex, and so constantly changing, that real market prices can only ever arise spontaneously.

Let’s apply this to interest rates. As I pointed out yesterday, interest rates are prices – in this case, the price of loaned capital. And again, this price is essential for the co-ordination of economic activity. The supply/demand point made above holds true. If savings are in short supply, but demand for borrowing is high, then interest rates will rise. That reduces demand for borrowing (because borrowing is expensive) but also increases the incentive for people to save (because they'll get a better return on their money). As more is saved, more loanable funds become available, and the price of loaned capital (that is, the interest rate) falls. That makes borrowing more attractive, so demand for loans rises. If it starts to outstrip the supply of loanable funds then the whole process starts again. It is like a constant balancing act – the price fluctuates spontaneously in an unplanned effort to match the supply of savings with the demand for credit.

Now, that is a bit of a simplification, because there's actually a more sophisticated point to be made about interest rates, which is that they also express the extent to which people are willing to forgo something now for the prospect of a greater reward in future. In economic jargon, it's called time preference, and it tells entrepreneurs whether they should be investing in capital goods (that is, in things which are used to produce other goods), in ‘durable consumer goods’ (things like cars, fridges, even houses), or in goods for immediate consumption. Again, when governments mess around with interest rates, they distort the allocation of capital – investment goes to the wrong stages of production, and the wrong goods are produced. Supply and demand, once again, does not meet up.

And that’s the fundamental problem with governments, or government agencies setting interest rates. Inevitably, they don’t have the information they need to set the ‘price’ correctly, and so the proper functioning of the market is disrupted. That’s when you get misallocated capital, bubbles, and an exaggerated boom and bust cycle.

Legalize online drug dealing


Today’s call by celebrities for the government to reform its drugs policies (PDF) is a little different from the usual celebrity activism. Behind the famous names like Sting, Dame Judi Dench and Sir Richard Branson are people whose opinions should matter in the drugs debate. Former Home Office minister Bob Ainsworth, former police Chief Constables, high-ranking solicitors and QCs and academics of physiology and criminology have all thrown their weight behind the call too. These are people who know what they’re talking about, and their voices can’t be easily ignored.

At the same time, a report by the Global Commission on Drug Policy has recommended that governments change their approach to drugs, including legalization and regulation in place of outright prohibition. This panel includes Kofi Annan and former presidents of Colombia, Brazil and Mexico – countries that have been torn apart by drugs-funded criminals. Again, these are voices that should carry some weight.

We might be close to a turning point. What remains is for prominent, serving politicians to grasp the nettle and speak out: former ministers and presidents can be influential, but until politicians in office are willing to say these things we won’t see real reform. Like it or not, many people rely on politicians and experts to determine their opinions. I have no doubt that many politicians privately support legalization. What we need is more high-ranking politicians with the courage to speak out.

What might this reform look like? I was intrigued to read about Silk Road this morning, a sort of anonymous eBay for online drug sales. It uses eBay-style seller ratings to avoid scams like bad drugs being sent, or no drugs being sent at all after a payment. The site seems like a relatively cost-effective and safe way for people to buy drugs. Good.

If something similar to this could be legalized for the sale of certain drugs, then many of the fears that people have about drug legalization could be avoided. Let's keep street selling illegal, but let people buy them from licensed sellers online and only use them on private property. Ugly scenes of drug dealers on the streets, like in Lisbon where drugs are decriminalized but not legalized, would be avoided, but people who want to take drugs would still be able to do so in the privacy of their own homes.

This would also have the excellent side effect of choking demand for drugs from street sellers, which would reduce crime significantly in poor urban areas. This would in turn be great for things like social cohesion, employment and school attainment, all of which are currently inhibited by young men regularly being given jail sentences and criminal records for carrying drugs.

If this were proposed, the argument really would become a question of privacy. Am I free to take drugs in the privacy of my own home, or not? If we shift the goalposts so that that really is the question we're asking with respect to drug legalization, it's an argument we can win.

The relationship between saving and borrowing


I wouldn’t normally quote at such length, but I was re-reading Henry Hazlitt’s Economics in One Lesson and came across a very elegant explanation of the relationship between saving and borrowing, and its importance in a market economy. I can’t better it myself, so here it is:

[W]e may define "savings" and "investment" as constituting respectively the supply of and demand for new capital. And just as the supply of and demand for any other commodity are equalized by price, so the supply of and demand for capital are equalized by interest rates. The interest rate is merely the special name for the price of loaned capital. It is a price like any other.

This whole subject has been so appallingly confused in recent years by complicated sophistries and disastrous governmental policies based upon them that one almost despairs of getting back to common sense and sanity about it. There is a psychopathic fear of "excessive" interest rates. It is argued that if interest rates are too high it will not be profitable for industry to borrow and invest in new plants and machines. This argument has been so effective that governments everywhere in recent decades have pursued artificial "cheap money" policies. But the argument, in its concern with increasing the demand for capital, overlooks the effect of these policies on the supply of capital. It is one more example of the fallacy of looking at the effects of a policy only on one group and forgetting the effects on another…

The effect of keeping interest rates artificially low, in fact, is eventually the same as that of keeping any other price below the natural market. It increases demand and reduces supply. It increases the demand for capital and reduces the supply of real capital. It brings about a scarcity. It creates economic distortions. It is true, no doubt, that an artificial reduction in the interest rate encourages increased borrowing. It tends, in fact, to encourage highly speculative ventures that cannot continue except under the artificial conditions that gave them birth. On the supply side, the artificial reduction of interest rates discourages normal thrift and saving. It brings about a comparative shortage of real capital.

The money rate can, indeed, be kept artificially low only by continuous new injections of currency or bank credit in place of real savings. This can create the illusion of more capital just as the addition of water can create the illusion of more milk. But it is a policy of continuous inflation. It is obviously a process involving cumulative danger. The money rate will rise and a crisis will develop if the inflation is reversed, or merely brought to a halt, or even continued at a diminished rate. Cheap money policies, in short, eventually bring about far more violent oscillations in business than those they are designed to remedy or prevent.

Hazlitt wrote this in 1946, but he could just as well be talking about the economic situation today – for this is precisely what has happened in Britain, and elsewhere over the past decade.

The Foundation for Economic Education has Economics in One Lesson available online, for free, in both PDF and HTML.

Merkel does a Bismarck


Having just finished reading Jonathan Steinberg’s excellent 480-page biography of Otto von Bismarck, his legacy of governing - without principle save the retention of power - has apparently been adopted by Germany’s Chancellor, Angela Merkel, who confirmed that all 17 of the nation’s nuclear power stations would close by 2022. With the CDU’s political position weakening, realpolitik has prevailed. The nuclear U-turn was driven by the post-Fukushima surge in support for the Green Party – a likely Coalition partner for the CDU after the next General Election.

However, this controversial decision has wide-ranging repercussions for the EU, whose common energy policy – Germany now being anti-nuclear and France being ardently pro-nuclear – is seriously frayed. Germany will become increasingly reliant on gas-generated power and an expansion of renewables. Both E.On and RWE, Germany’s leading utilities, are furious and may pursue the issue through the courts, unless very large compensation is paid.

For France, this decision provides real long-term opportunities to export nuclear-generated power to other major European countries, including Germany, Italy and Switzerland, all of whom have become anti-nuclear. Expect EdF to build several new plants in Eastern France, as the equivalent of a nuclear Maginot Line. In the UK, Germany’s nuclear U-turn will undoubtedly re-invigorate environmentalist parties.

More specifically, the future of the E.On/RWE Horizon consortium now looks distinctly shaky. Since neither utility can operate nuclear plants in its home market post 2022, it would seem anomalous if either invested £billions to do it elsewhere. This scenario leaves the UK highly exposed and very dependent upon EdF for new nuclear-build. Furthermore, EU gas prices will probably rise sharply due to higher German demand for gas.

Having advanced nuclear physics studies in the inter-war period – fortunately, despite Werner Heisenberg’s efforts, the Manhattan Project surged way ahead in the race for the atomic bomb – Germany’s retreat from nuclear some 90 years later will be a seminal moment.

Looking at global inequality



The chart above is taken from Branco Milanovic's book The Haves and the Have-Nots: A Brief and Idiosyncratic History of Global Inequality, and shows inequality in individual countries relative to the whole world. (Hat tip to City AM's Philip Salter.) The x-axis plots inequality within a country, and the y-axis plots it internationally. Catherine Rampell explains

For example, trace the line for Brazil, a country with extreme income inequality.

Brazil’s bottom ventile — that is, the poorest 5 percent of the Brazilian population, shown as the left-most point on the line — is about as poor as anyone in the entire world, registering a percentile in the single digits when compared to the income distribution worldwide. Meanwhile, Brazil also has some of the world’s richest, as you can see by how high up on the chart Brazil’s top ventile reaches. In other words, this one country covers a very broad span of income groups.

The data points are collected in 5% ventiles, so it isn't a perfect measure. The richest 0.1% in India is a lot richer than the poorest 0.1% in the US. But it's a helpful way of putting things in perspective, and underlines a point I made a few weeks ago: support for a welfare state in the UK is wrongheaded even if you believe that a welfare state is a good way of combating poverty. If throwing money at people improves their long-run living standards, the left should oppose a welfare state in Britain and want to direct all social spending to the developing world. Dalibor Rohac's Does Inequality Matter? explores this argument in more detail.

As a libertarian I have no similar problem. I want equal freedom for everybody, including free trade and open borders, both of which would be an awful lot more effective at reducing poverty here and abroad. But international comparisons of inequality give the lie to the leftist claim to egalitarianism – otherwise, why do they spend so much time trying to help people who are so well-off?

Germany says no to nuclear


atomGermany is a land of environmentalists. The first successful green party in Europe, Die Grünen, won their first seats in the Bundestag in 1983 (compared to Britain's first Green MP in 2010). And much German environmentalism revolves around the rejection of nuclear power. This, when taking into account Germany's history, is not altogether surprising: Germany bowed out of World War II only four months before the first nuclear weapon was dropped on Hiroshima. Afterwards, in the Cold War era, a divided Germany found herself as the potential battleground of a full-scale nuclear war between NATO and the USSR. The seeds of nuclear-rejectionism were planted. After Chernobyl, the German neurosis took another knock.

Then, a few months ago, the fifth most powerful earthquake ever recorded struck Japan, promptly followed by one of the largest tsunamis in history. In the path of these natural disasters was an antiquated, poorly-designed nuclear plant called Fukushima. Was the building reduced to rubble by the earthquake? Nope. Did the subsequent tsunami turn it into radioactive driftwood? Not that either. Were hundreds killed? No. Only one person has been recorded as dying because of the disaster – of a heart attack.

I'm no expert on nuclear power, but it strikes me that Fukushima stood up remarkably well to the worst that mother nature could throw at it. Granted, the designs were not perfect, but improvements in last 40 years must have more than solved these issues.

However, hysteria is often far more attractive than common sense. Although not under any immediate risk of neither a magnitude 9.0 earthquake nor a tsunami, Germany immediately took its nuclear power-plants offline and ordered a review. Only after a few months of stating that Germany wouldn't abandon nuclear power 'on her watch', Merkel allowed exactly this to happen and committed Germany to decades of increased energy costs and the importation of (nuclear) power.

In deciding to shut down all of its nuclear power-plants by 2022, the Chancellor has finally caved in to environmentalist scaremongering. No concrete plans have been laid out about to replace the 23% of formerly-nuclear energy, although it is almost certain that the emphasis will largely be on renewables. Business leaders have criticised this, stating energy costs could rise by 30%. At a time, of growing inflationary pressures, the German electorate may live to regret such decisions, especially considering that nuclear has a lower carbon footprint than wind and hydroelectric power. (PDF)

The German abandonment of nuclear energy is a sad example of a minority of sanctimonious Luddites reversing human progress. Cheap, nuclear energy, especially for one of the world's greatest industrial powers, is the way forward. Instead, the irrational fears of an objectionable few will result in reduced prosperity for the majority.

Ich bin enttäuscht.