My Books, Essay #8
My book co-authored by Nick Schulz, continued
The next chapter of Invisible Wealth is called “Bugs in the Software Layer.” A society’s economic performance depends on its state capacity and its cultural norms. They tend to reinforce one another, so that
we would expect self-reliant families, effective civil society, and good government to go together…We are likely to see countries cluster at either the high end of prosperity or the low end of poverty. Transitions between these extremes should be relatively rare, and many changes have to occur at once for a transition to take place.
Nick interviews Douglass North, who says,
What particularly bothers me is that the world is evolving more rapidly than it ever did before. The degree to which we can catch up with it and deal with it, I think, is more and more strained now…The time horizon we have to solve problems is much more abbreviated than it used to be; whereas before we could make mistakes and kill a few hundred thousand people, now we can blow everybody up. And we don’t seem to have gotten very far in solving social disorder. I hope I’m wrong.
Think of the evolving capabilities of drone warfare or the startling pace of change in AI. And look at the strains in our political culture.
Entrepreneurs are change agents
In textbook economics, the entrepreneur is the fellow who decides how much to produce. But in the real world, the entrepreneur is trying to innovate. It could be a small innovation, such as starting an ethnic restaurant, or it could be a dramatic innovation. Either way, the entrepreneur must persuade people to adopt something new.
a key role for entrepreneurs is to overcome resistance to change. To do so, entrepreneurs have to engage the attention and win the loyalty of customers, employees, and potential investors. They cannot afford to be bland, or ill-defined…You may not like the entrepreneur (many people could not get along with Jobs or Ellison), but you do not forget your encounters with him or her.
Reading this paragraph in 2024, I think of Elon Musk or Sam Altman.
Financial Intermediation
Nick and I had mostly finished the book before the financial crisis of 2008. But the editorial process dragged out for years, so that we needed a chapter on the financial sector.
In our view, a lack of complete transparency is built into the basic function of financial intermediation.
…Investors never know exactly what risks they are taking…Intermediaries manage risks on behalf of investors…
We described the process of mortgage securitization.
This process is designed to create liquidity by insulating the investor from the need to evaluate all of the risks embedded in individual loans.
We argue against the tradition in finance that follows what is called the Modigliani-Miller theorem and says that investors “see through” financial intermediaries as if they were perfectly transparent.
Risk premiums are not mathematical constants…Risk premiums depend on how well financial intermediaries do their jobs—including how well financial intermediaries convince investors that they are doing their jobs.
I would say that in the stock market today, index funds and the Magnificent 7 tech firms have done a great job of convincing investors to not require as high a risk premium as they would have ten years ago. We will see how that works out.
Adaptive Efficiency vs. Government
Textbook economics looks at static efficiency. How well are resources being allocated relative to a theoretical optimum?
Instead, we look at dynamic efficiency. How well does an economy incorporate innovation? From that perspective we point out the advantages that markets have over government.
Government intervention tends to interfere with dynamic efficiency. The reason is that incumbents have more political power than upstarts…In industries where regulation is entrenched, new entry is likely to be limited…the automobile industry is very difficult to enter, given the myriad regulations for safety, fuel economy, and so forth.
The Future
Writing fifteen years ago, we listed the challenges for the future as:
Determining the status of intellectual property.
Achieving a peaceful transition from underdevelopment to modernity.
Adapting to technological advances in surveillance capability, bio-engineering, artificial intelligence, and virtual reality.
We pointed out that there are conflicting ways to view intellectual property.
One can argue that if property rights derive from mixing one’s labor, then property rights apply as much to the intangible fruits of labor as to its tangible output…
However, one can also make a compelling case that laws to protect intellectual property…promote disorder rather than order…
while tangible property rights serve to limit disputes…intangible property rights create disputes unnecessarily. It is the person who presses a claim to intellectual property who must engage in physical trespass…I have to stop your computer from downloading a song.
Fifteen years ago, we suggested,
One broad alternative to restrictive patents and copyrights would be for a patronage model…
And today we have Substack.
Re-reading Invisible Wealth (or its hardback version From Poverty to Prosperity), I am very pleased with it. It deserves a wider readership than it enjoyed.
Banks and financial institutions want diverse portfolios with uncorrelated investment risk to reduce the impact that a single, poor-performing asset will have. Mortgage-backed securities provided, among other benefits, such diversity. Risk was reduced by packaging “pieces” of mortgages from communities around the country. But nationwide government policies and regulations – among other things – helped to correlate those geographically uncorrelated risks.
Fed monetary policy fed a nationwide housing boom, as did legislation like the Community Reinvestment Act and American Dream Down Payment Initiative. Congress ordered Freddie Mac and Fannie Mae to purchase hundreds of millions of dollars in sub-prime mortgages from around the country, relieving lenders of the need to carefully vet borrowers’ ability to repay their loans. The Basel Accords required financial institutions to define, calculate, and deal with risk in a uniform way. All this regulatory herding led to a regulatory stampede when the Fed tightened its monetary policies.
Ironically, many people blamed the repeal of Glass-Steagall for the collapse – ironic because the repeal had allowed banks to diversify their portfolios, which reduced risk and may have helped to cushion the impact of the housing bust. Similarly, the post-bust consensus that the federal government must financially back institutions that are “too big to fail” creates incentives for institutions to grow and become “too big to fail,” further correlating risk.
FWIW, after reading your Essay #7 and #8, I've purchased the book. Though I'm just getting started, it would have been handy for me umpteen years ago when I took economics as an undergrad. The writing is straightforward, even for a retired business dweeb like myself, and more "real" than what felt pretty abstract to me back then.