Post Mortem on the 1998 U.S. Elections

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Bill Clinton emerged from one more difficult challenge, with his political career alive and well. Republicans, who hoped to reap significant benefits from the Monica Lewinski affair were gravely disappointed in the mid-term elections. Why did the American voter not punish Bill Clinton?

The roots of this result lie in the sociological structure underlying the US political system. In Europe, where governments exercise direct control over almost 50% of GDP and regulate to some degree almost every aspect of life, elections are a matter of utmost importance. Every individual can find plenty of issues within the power of government that can directly affect his own welfare. In the US, where the role of government is more limited, elections have a personal significance only for a relatively small portion of society. As a result, in Europe, the silent majority turns out for elections, while in the US it usually does not. In the US, elections are decided not only by the ability of parties to sway more swing voters their way but also by the ability of parties to get a higher turnout from their die hard constituency.

At a turnout of 37%, Americans who vote Democrat are not at the polls due to their personal like or dislike of President Clinton. They are the trade union members, civil servants, teachers and lawyers. They are the women, blacks and hispanics which have personal issues at stake. Bill Clinton sleeping with Monica Lewinski is not the main concern of a black youth not being able to go to the University of California due to the abolishing of affirmative action. Whether Bill Clinton slept with Monica Lewinski or not, a woman in favor of abortion rights will not vote for a Republican who is against abortion rights. Most women will concentrate not on whether Bill Clinton’s actions with Monica Lewinski is demeaning to all women, but rather on what will happen to her life if Republicans outlaw abortion.

The swing voters generally do not participate in size in US elections. However there is undoubtedly a certain percentage that do, and it may also be useful to analyze their motivation in this particular election. Even if most of the Democratic support in this election comes from a higher turnout among die hard supporters, there may have been some help from swing voters. Let’s concentrate on three kinds of swing voters: The socially liberal, economically libertarian group, the socially conservative supporters of the welfare state and the true centrists.

Bill Clinton in some ways exemplifies the American dream. He comes from a disadvantaged background. He was a poor but talented youth gradually climbing the steps leading to power. The lower and lower middle class white population, which is socially conservative but at the same time benefits from the welfare state is where Clinton came from. They may identify with him much more than any other social group. They were not pleased with the intensity of the attack against him.

The people out there who are social liberals and economic libertarians often have a difficult choice between the two parties. This group includes, among others, the well-to-do black or hispanic professionals, the suburban intellectuals, the well-to-do gay professionals, the upper-middle class single mothers and the housewives who were students in the 1960s. The aggressive campaign to oust President Clinton may have significantly affected the voting pattern of this group. The Republicans, focusing on President Clinton’s shortcomings more than cutting taxes, may have led this group to believe that their social conservatism is much more deep-rooted than their economic libertarianism.

Finally, the true centrists. These are often the people who don’t have strong ideological convictions but vote exclusively on issues. They jumped on the Republican bandwagon in 1994 because of their clear commitment to issues. Now they leave the bandwagon as the commitment to concrete issues on the Republican side has withered away.

Republicans rose to power on the promise of lower taxes and freedom of choice in schools. Republican governors who implemented these promises won hands down in this election. However, the Republican Congress of 1996 got their priorities mixed up just like the 1992 Democratic Congress. In the face of strong support from the public, politicians sometimes assume that the public agrees with their convictions. More often than not, the public actually agrees with their agenda. After 1992, Democrats who promised a better future for the middle class decided to put more priority on providing healthcare for the poor. They got punished immediately. After 1996, Republicans who promised lower taxes and school choice decided to put more priority on the integrity of President Clinton. This issue was already “priced in” by people who voted President Clinton into office in 1996. As a result, the Republicans got punished unexpectedly.

Politics and political philosophy are different disciplines. Philosophical stance is a complex concept. Even simple words can be defined quite differently by different people. It is very hard to be sure whether the public is in tune with a politician’s philosophy. It is much easier to check whether they agree with his agenda. Confronted with the question whether an electorate which has voted him agrees with his philosophical stance or his agenda, a politician is almost always better off choosing his agenda. Making concrete promises and sticking to them wins votes. Rediscovering ideological zeal right after an election loses votes.

The extensive coverage given to the Monica Lewinski affair in the media led many people to despair about the state of the American society. The elections of 1998 can be considered a relief from this perspective. The clear lack of interest of voters on the affair and the clear focus on issues may indicate that it is the media and not the voters at large who are unnecessarily preoccupied with scandals. Let us hope that both political parties get the message.

Brainstorming on Financial Crises

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Introduction

The world financial system is claimed to be on the brink of collapse. An initial local crisis in Southeast Asia driven primarily by a few companies spending and investing beyond their means have slowly spread around the world, claiming Japan and Russia, Latin America, USA and Europe.

What is different in today’s world from twelve months ago? Has there been a massive unexpected setback in the field of software development? Has the internet come crumbling down? Has biotechnology been rendered useless? Has oil suddenly run out? The answer to all these questions is obviously no. The crisis that we are experiencing today is explained in terms of confidence. People of the world, traders of major funds and banks even more than consumers to be precise, are apparently no longer confident of the future.

However, a close examination of this assertion brings out the fact that there is something fundamentally wrong with this line of thought. Lack of confidence in the future leads to three major developments in the economy: private consumption drops, overall GDP drops and personal wealth is shifted from stocks to bonds. A lack of confidence of society in the future is conceptually parallel to the plight of an individual who discovers that a fortune in the future he was expecting to get will not materialize. What would such an individual do? Increase production, increase investment at the expense of consumption, and attempt to shift his savings into higher yielding investments. It is obvious that the rational choices of an individual faced with a lack of confidence in the future is markedly different from the observed response of society under a similar case? What has gone wrong here?

In this article I will attempt to examine this issue in three steps. First, which elements in the nature of the current social and economic organization cause financial crises. Second, how do the prevalent belief in liberalism and capitalism stand up in the face of these crises. Finally, what can be done to alleviate or to prevent them.

1. The Cause

Society appears to be unable to think and act like a rational individual in the case of economic crises. On the other hand, all the achievements of mankind in the fields of law, politics, economics and most importantly, education are designed primarily to help society as a whole act like a rational individual rather than a chaotic mob. The observed response of society in financial crises is clearly contrary to rational behavior. Therefore, we must question the legal, political and economic structure, as well as the education system and determine how they lead society from time to time down this self-destructive path.

I will assert that the primary reason behind the vicious cycle of less confidence, less consumption, less production, lower wages and lesser jobs and finally a further fall of confidence is people’s understanding of income versus wealth.

Money plays many roles in a civilized society. It is a facilitator of exchange, an instrument of measurement and a store of wealth. The fact that money has performed exceptionally well in all of these domains sometimes blurs the fact that they are separate purposes. The properties required of a good facilitator of exchange may not always be the same as those required of an instrument of measurement or a store of wealth. The widespread failure to recognize the difference between these different functions of money and the characteristics required by each of them causes a confusion between income and wealth, which in turn leads to the vicious cycle described above.

To illustrate this point more concretely, let us examine each of the three functions under the light of examples. First, the medium of exchange function. A can of Coke can be purchased at 50 cents in New York City. A daily copy of the New York Times can be purchased at 50 cents also. Money allows people who produce Coke and New York Times to exchange their production with each other and all other producers and consumers in the world. Although the presence of money does not increase production and consumption directly, it increases the world’s productive capacity by dramatically speeding up exchange and thus facilitating division of labor.

Second comes money as an instrument of measurement. Money allows producers to convert the value of all the resources that are required to make their product into one medium, add them up, and compare the sum to the value of the product they are planning to make. By enabling such a comparison, money prevents (in most cases) society from producing goods or services that are not good enough. By allowing producers to determine the added value of every act of production, money allows society to maximize the productive capacity of its available resources.

Finally, the store of wealth function. One Microsoft share is worth around 100 dollars today. At this current value, all of Microsoft is valued at about 250 billion dollars. This represents the future productive potential of the organization called Microsoft. The accumulated capital and knowledge of Microsoft imply a level of production for future years. By putting an estimated value on this, money allows people to trade consumption today against consumption in the future. This way, people can compare the value of consumption versus saving today, and decide the way they allocate their incomes.

Each of these definitions are quite clear and useful. It is their combination that appears to spin people’s heads. Here is how: From the above definition of money and the current prices, we can deduce that a share of Microsoft is convertible to two hundred cans of Coke. This is an accurate conclusion. One can sell a share of Microsoft, take the money out of the brokerage account, go to the grocer and buy two hundred cans of Coke. But the same valuation also claims that the full market cap of Microsoft is 250 billion dollars and hence equivalent to 50 trillion cans of Coke. Does this exchange make any sense? No, because there are not 50 trillion cans of Coke in this world.

We can also illustrate the same problem in a macroeconomic framework. The annual GDP of the United States is about 6 trillion dollars. The combined value of stock, bond and other security portfolios is well above 10 trillion dollars. This 10 trillion dollars is not physically meaningful from a current consumption perspective, as there are not enough goods and services to exchange for it. It is just an estimate of the future productive potential of the United States divided by the rate at which people are willing to exchange current and future consumption. To exchange a small portion of the 6 trillion dollar current production with a small portion of the 10 trillion dollar present value of future production makes perfect sense. However, to try to exchange most or all the 10 trillion potential production against the 6 trillion dollars of current production clearly leads to a problem. There is simply not enough “current value” around to counter the selling pressure on “future value”. The result is a breakdown of the market tying “current value” with “future value”, leading to an overall panic. In financial crises, people realize that future offers less potential than they originally thought. This induces them to attempt to exchange it for as much in current goods as possible before anyone else realizes this revaluation. But people trying to anticipate and run away from collapse happens to be the root cause of the collapse itself.

The lack of confidence of society, which starts this vicious cycle, may have many economic or political reasons. The first one that comes to mind is that returns on investments are generally lower, leading to expectations of lower living standards in the future given a constant level of investments today. But whatever the reasons of the lack of confidence is, it can be described quantitatively as a reduction in the sum of current and future consumption. If returns on investments are discovered to be lower than originally thought, the original future consumption targets can only be achieved at the cost of higher investments and lower consumption today. Or, alternatively, a constant level of consumption and investments today lead to lower levels of consumption in the future compared to the levels originally expected. There is clearly a trade-off. Society can keep current consumption constant at the expense of future consumption, or vice versa. Or it can choose a point in the middle, taking to some extent the benefits as well as costs of both strategies. However, this theoretical trade-off is not the one that society is facing today. By cutting consumption today without increasing investment, society today is facing the worst of both worlds. Lower consumption today coupled with lower consumption tomorrow. No wonder people are depressed and political unrest looms in less developed countries. As consumption falls today without an increase in investment, production falls as a whole leading to increased unemployment and a worsening of income distribution.

2. The Judgement

Is there something inherently wrong with free markets? What are we to do? I think one must be very careful in defining free markets. Free markets represent freedom built on a very fine and complex order that exists in society. People are free to produce and consume what they choose, but they are not free to kill each other, deceive each other or steal from each other. To be precise, people give up their natural right, or ability, to lay their hands on anything they see in order to achieve much higher consumption in the long term. The question that society faces now is, should inividuals be allowed to stampede each other to desperation when “confidence” drops?

If this situation does not call for government or inter-government activism, nothing ever can. An advanced society agrees that screaming fire in a crowded movie theater is a bad thing. Attempting to sell any and every financial instrument one owns when one is panicking is just as bad as screaming fire in a crowded movie theater. I am not a fan of government direction of the economy at all. Under normal periods, government control on resources appears to generally lead to inefficient allocation. However, to defend free markets without taking note of what makes them succeed is also unreasonable. When one knows the causes of the success of individualism under normal scenarios, one can also determine when the underlying assumptions for avoiding government intervention break.

Free markets are often justified from two different directions - philosophical and practical. The practical jusification is a case based on strong performance. Free markets from this perspective mean competitive markets. Competition breeds success, because for change for the better to take place, change has to take place, and for change to take place, dissent has to be tolerated. From the philosophical perpective, free markets are good because they enhance the freedom and rights of the individual. But just as individuals are alive above and beyond their cells, societies are alive above and beyond their individuals. A society which has taken ill has just as much right to defend itself as an individual attacked by illness. Given that organized society has done so much to enhance the lives of individuals, it is reasonable to suggest that at times of crisis at the very least, some government intervention may be justified to salvage previous accomplishments. Just as the government educates young children and interns criminals for the benefit of all, it can also spend some effort trying to induce some reason in market participants in panic at times of crisis. The right style of government intervention in the economy may not be a little control at all times, but no intervention most times coupled with swift and decisive action in times that the market collapses. Along the same line of thought, rather than thinking of what to do in times of economic booms, governments may be better off preparing for times of crisis and put defense mechanisms in place that will allow them to act swiftly at times of crisis.

Civilization is all about organization. Rather than hunting and gathering at their own will, people have decided to live together and achieve a better future for all. People coordinate and organize to fight disease. They coordinate to cross oceans and skies. They should coordinate to deal with financial crises.

3. The Remedy

Having established why the financial crises happen and why the government would be justified to intervene to defend society as a whole, we can venture into thinking about what can be done to remedy the problem. Modern governments have two policy tools at their disposal to intervene in markets. The two tools are monetary policy and fiscal policy. More specific intervention is also possible, but has proven mostly unproductive through economic history.

Monetary policy in times of economic crisis can be described as countering an illusion with another illusion. When people decide to spend less and simultaneously refuse to invest more to keep capacity utilisation high, the government can enter the market, print (or otherwise create by manipulating interest rates or reserve requirements) more money and induce people to feel richer. So the feeling of loss of wealth due to the crisis can be countered by inducing a feeling of easier wealth due to easier money and credit. If the government can successfully fool people this way, the inflationary effect of printing money can counter the deflationary effect of the lack of confidence.

The alternative to monetary policy is fiscal policy. In this case, the government employs people rather than printing money. This extra employment is generally financed by debt. People consume less and hold cash or government paper rather than stocks in times of crisis. In response, the government can take the money flowing towards it and circulate it back to the market by employing new people to counter the deflationary trend. If private savings are flowing into government debt, the government is already in possession of the necessary funds. If private savings are flowing into cash, the government issues the necessary new paper.

What is most important in fiscal policy is what the government does while creating new employment. In most of post world war two history, this side of the coin has largely been ignored. Textbooks do not sufficiently explore the nature of increased government spending.
One pathological example frequently seen in textbooks is the government employing two people and paying them, one digging a hole and the other filling it. However, it is not clear why this would be any different than printing money. At least if the government limited itself to printing money, the leisure of the two poor souls would be saved. In real life, this pathological case of fiscal policy appears as governments indulging in vague and disorganized programs of “public works” that fail to stimulate the economy fully and waste enormous amounts of valuable resources. One has to look at fiscal policy from a real economic perspective. The goal that motivates governments to employ fiscal expansions in times of crisis is to prevent the decline of total GDP, the sum of consumption and investment. One should note that employment for the sake of employment without results enhances GDP only on paper.

There may be a third alternative to fiscal and monetary easing, which is better than both. This would be the government to directly intervene in the asset markets to cure the ills that start from the asset markets in the first place.
Financial crises often start in asset markets - the stock market, the credit market and the real estate market. Monetary policy directly deals with the money market, hoping that the effects will trickle down to the asset markets. Fiscal policy deals with the goods and services markets, again hoping that the effects will trickle down to the asset markets. Rather than intervening far away from the source of problems, governments might be better off addressing the issue directly at its source. If a sharp fall in asset prices destabilizes the economy and causes panic among producers and consumers that also debilitates goods and services markets, the government can intervene in the asset markets to start the stabilization there.

This aproach is clearly counter to the prevalent economic thinking of current times. The best example of the hostility of current economists to asset market interventions was observed in Hong Kong this year. The monetary authority of Hong Kong has been critised strongly for using its reserves to buy equities. On the other hand, the Federal Reserve Bank of the United States has been urged by the same people to cut interest rates to avert the world financial crises. This couple of demands is not justified by common sense. If the government is concerned with people selling stocks, it implies that it has placed a higher value on stock than those who are selling them. In this case, what is wrong with government buying the stock that people sell? Rather than giving people easy money and hoping that they will buy stock with it, the government is perfectly sensible to consider buying stocks itself. This method of intervention would prevent the eventuality of people buying things other than stocks with the easy money. In this sense, it is a less inflationary form of intervention. People selling stocks on one hand and hoarding cash on the other just reduces to productive capacity of a country by reducing consumption and investment at once. People selling stocks on one hand and buying goods on the other is plain inflationary. Buying stocks is clearly superior to the other two alternatives.

Different problems under different conditions call for radically different answers. In the 1930s, at the beginning of the Great Depression, using fiscal policy as a tool to combat cyclical downturns was widely criticised. Time showed that supporters were right and opponents were wrong. Intervention in the asset markets might just be a parallel case. The suggestion of Keynes to use fiscal policy as a crisis management tool was conceived in the world of 1930s. Governments were small back then. They did few things, but the things they did covered absolute necessities such as maintaining courts or the police force. Since then, the share of governments in the world economy has risen from 5 percent to over 30 percent of GDP. No one in 1930 could even imagine the black hole that some governments have become today. In the 1930s, asset markets were small, and the supply and demand of money was in tune more with the goods and services markets than the asset markets. Therefore, based on the higher significance of goods and services markets coupled with the small size of governments that allowed considerable flexibility on the budget front, the answer to the crisis of 1930s was fiscal policy. Today, based on the higher significance of asset markets and the lack of flexibility on the budget front, asset market intervention might be a more attractive solution. The wealth of experience accumulated in world central banks and their strong balance sheet put them in a much better position to properly execute asset market intervention.

Summary

This essay is an attempt to explore the causes of financial crises from a philosophical angle. The assertion is that financial crises happen due to the inability of the market system to deal with falling expectations of market participants. This inability owes its existence largely to a mistaken understanding of wealth versus income. As a result, financial crises of today arise mostly from asset markets. Given this fact, governments might be better off trying to address the problem at the source and consider asset market intervention alternatives over traditional methods of monetary and fiscal policy.