If you put the government in charge of the Sahara Desert, in five years there'd be a shortage of sand.
When a collection of individuals agrees to form a society, they have many options in determining how to organize themselves. The political philosophy of the group will be manifested in its political-economic systems and the range of possible solutions is wide. This chapter focuses on two key decisions that relate to a society's vulnerability to boom and bust cycles. First, we evaluate the different philosophies relating to property rights. A society's choice to allow private property to exist and to protect such property with corresponding rights is an essential prerequisite for market-determined prices to be "discovered" via supply and demand dynamics. Further, without private property rights, the idea of booms and busts may be moot, as the state owns everything.[114]
The chapter evaluates the mechanism through which a society chooses to determine the prices of goods, and the roles that those prices play in the allocation of scarce resources. Although significant gradations exist between the extremes, two primary price determination methodologies are considered: first, supply and demand–driven price "discovery" processes that take place through the interaction of buyers and sellers, and second, central planning–driven price dictation in which the prices of goods and services are set or influenced by government bureaucrats. Again, the political choice of determining a pricing methodology has significant ramifications for the relative fertility of booms and busts. Market-determined prices are inherently more volatile than state-mandated prices; as such, they create the conditions in which economic dislocations have the potential to snowball into extreme price movements. Societies that have state-mandated prices are unlikely to have extreme price volatility; rather, they may suffer from extreme fluctuations in the availability of goods.
Respected property rights and market-determined prices are two essential ingredients for booms and busts to take place. Political processes in societies having these preconditions are likely to exacerbate financial extremes. Specifically, politically determined price floors and price ceilings can confuse price discovery processes, and tax policies are prone to either inflate or depress the demand (and supply) for certain goods, sometimes quite dramatically. Let us now turn to the issues of property and prices.
According to the Concise Encyclopedia of Economics, property rights are defined as:
the exclusive authority to determine how a resource is used, whether that resource is owned by the government or by individuals... Private property rights have two other attributes in addition to determining the use of a resource. One is the exclusive right to services of the resource... [and the other is] the right to delegate, rent, or sell any portion of the rights by exchange or gift at whatever price the owner determines (provided someone is willing to pay that price).[115]
Private property rights thus have three primary characteristics: exclusive rights to determine how the property is used, exclusive rights to the services of such property, and exclusive rights to sell or exchange the property.
The spectrum of possible property rights ranges from complete and total state ownership of all property to complete and total private ownership of all property. Private property rights are a hallmark of capitalism, and the lack of private property rights (i.e., state ownership of all assets) is typified by communism. In fact, Karl Marx succinctly captured the essence of communism in the Communist Manifesto when he wrote "The theory of the Communists may be summed up in the single sentence: Abolition of private property."[116]
At the root of this objective was a belief that private property rights enabled the accumulation of inequality to compound over time, ultimately leading to disparities of wealth so large as to threaten systemic collapse. Without private property rights, and in a society in which everything was owned by the state, it would be possible to achieve another socialist ideal: a harmonious society in which everyone worked hard to make sure that everyone had what they needed. As noted by Marx and Engels, such an ideal state would be summarized by the slogan, "From each according to his ability, to each according to his needs!"[117]
Although the complete lack of property rights characterizes one extreme of the property rights spectrum, the other extreme is one in which laissez faire capitalism provides for complete private property rights. Property rights are essential for a market mechanism to work. Without property rights, the incentive to drive profits or generate economic returns relies not on economic self-interest, but rather on psychological factors—if it exists at all. If such an economic incentive did not exist, prices would not be determined by market forces—thereby negating the powerful information content they might otherwise contain. Let's consider how political decisions to restrict or remove property rights have affected the price mechanism by examining recent nationalization efforts in Venezuela.
Tenaris, the world's leading producer of steel tubes and pipes for the oil and gas industry, had a facility in Venezuela in which they had invested substantial capital. The facility had been performing relatively well economically, and its prospects for future profits were bright. Then, on May 22, 2009, the Venezuelan government informed the management of Tenaris that they would be nationalizing the company's assets and they would belong to the state.[118] What impact might nationalization have on the price mechanism for steel assets in Venezuela? By establishing that private property rights were not respected, the government of Venezuela sent a very clear message to the global investment community. Would a reasonable person or company invest in a country where the rights to their investment might not be respected? Not surprisingly, global investors seem to have lost their appetite to invest in Venezuela.
Lest we think that nationalizations only take place in countries controlled by commodity-enriched dictators, Table 4.1 highlights a handful of nationalizations that have taken place since the year 2000, excluding those nationalizations that might be better characterized as bailouts in which the company or industry might have gone bust without the bailout.
Although nationalization is the most extreme form of a change to property rights once granted, equally problematic approaches might include poorly defined property rights, or property rights that are subject to some limitations. A good example of poorly defined property rights might exist in areas of territorial ambiguity. For instance, the Spratly Islands in Southeast Asia are a collection of islands that were claimed by no fewer than six nations. Vietnam, the Philippines, Brunei, Malaysia, China, and Taiwan all claimed ownership of the territorial waters. In the mid-1990s, when it was believed the islands might be sitting on top of significant oil reserves, gunboats actually exchanged fire. Crestone Energy, a Denver-based energy company, had secured what they believed were legitimate rights to drill for oil from the Chinese government. The Vietnamese government disputed this right, claiming territorial sovereignty over the area. When Vietnam later sent a rig into the area, the Chinese responded with a gunship and a naval blockade of the rig to prevent it from receiving needed supplies.
Likewise, fishing rights in the Grand Banks were not clearly delineated, resulting in competitive overfishing by both U.S. and Canadian fishermen that ultimately made fishing in the region commercially unviable.
Table 4.1. Selected Nationalizations since 2000
Country | Year | Target |
|---|---|---|
Bolivia | 2006 | Natural gas industry |
Germany | 2008 | Federal print office |
New Zealand | 2001, 2008 | Rail networks |
United Kingdom | 2001 | Rail networks |
United States | 2001 | Airport security services |
Property rights with limitations are another case of distortion by government interference. Consider the fate of Unocal, a U.S. oil and gas company that tried to sell itself to CNOOC, one of the Chinese national oil companies. The U.S. government effectively blocked the transaction. Consider also the fate of London-based port operator Peninsular & Oriental Steam Navigation Company (P&O) in the sale[119] of their assets (which included U.S. port operations) to DP World, an investment company controlled by the government of Dubai in the United Arab Emirates. Political forces and public uproar resulted in the Emiraties agreeing to divest of the U.S. ports in order to get the transaction completed.
These three property rights "modifiers" (nationalization, ambiguity, and limitation) have a dramatic impact on the likelihood of booms and busts. By mitigating investor desires to participate in markets that lack clearly defined and well-respected property rights, it appears that all modifications to property rights in fact dampen the possibility of booms and busts. It seems extraordinarily unlikely that frenzied buying of companies will take place in Venezuela after Hugo Chavez nationalized various industries. Likewise, areas of territorial disputes and property rights ambiguity are likely to deter many investors and limit the risks they are willing to bear. Finally, the ability to exit from investments free and clear of last-minute modification of terms by the government appears a necessary condition for the formation of bubbles. Without this ability, open-ended, believable stories of justified price extremes would meet resistance.
There is also the possibility that financial booms and busts can be enabled via the granting of property rights where they were previously absent. A glance at prices in the privatized housing markets of (former) communist nations (i.e. China, Russia) begins to demonstrate the possibilities.
If property rights are present (and respected), the next logical question for a society might be "How should we determine the price of an item and who should be involved in the process?" Although a seemingly trivial and innocuous question, this question strikes at the heart of different political philosophies ranging from laissez faire capitalism to communism (and everything in between).
Surely it makes sense that an intricate, hand-woven sweater made of cotton that has been spun into yarn, dyed various colors through inks generated by finding and squeezing appropriate fruits and vegetables that have proven to generate such pigments, and finally woven into a wonderfully attractive pattern is worth more than a couple of leaves that have been picked up off the ground and stuck together with the sap of local, readily available trees, right? The intricate sweater has taken a great deal of time to construct, thereby embodying a great deal of labor. Such logic implies the leaf clothing is easier to make, and should therefore have a lower price. The earliest theories of price and value were based on calculations of the amount of labor that went into the good or service. This approach to thinking about prices dates back at least to Adam Smith, who wrote:
The real price of every thing, what every thing costs to the man who wants to acquire it, is the toil and trouble of acquiring it. What every thing is really worth to the man who has acquired it, and who wants to dispose of it or exchange it for something else, is the toil and trouble which it can save to himself, and which it can impose upon other people.[120]
Adam Smith goes on to further distinguish between "value in use" and "value in exchange," noting the seeming paradox between the value of water and the value of a diamond:
Nothing is more useful than water, but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.[121]
It turns out that supply–demand dynamics do a reasonably good job of explaining this paradox. By focusing on the marginal value (i.e., what would one additional unit be worth) of each good, it becomes easier to understand why each good is priced the way it is. How much would you consider paying for one additional cup of water in your life each year? Most people would not pay very much because, in most parts of the world, water is plentiful. In commenting on the water–diamond paradox presented in The Wealth of Nations, Nobel prize–winning economist Joseph Stiglitz noted "water has a low price not because the total value of water is low—it is obviously high, since we could not live without it—but because the marginal value...is not very high."[122]
There are two fundamentally different methods through which society can generate prices for its goods and services: market mechanisms through which supply-and-demand dynamics determine a price, or central planning in which prices are dictated by government bureaucrats. These two methods generate different perspectives on the role of prices in a society's allocation of scarce resources. The market-oriented approach to price determination is generally utilized in societies that seek to have prices guide investment and consumption decisions. The central planning approach has historically been used by societies in which the government guides prices in a quest to maintain social or economic stability.
Let us first turn to the market-oriented approach to price determination. In addition to being deemed efficient and effective, an important argument made in favor of market-determined prices is that prices contain tremendous information about the appropriate allocation of scarce property: "Market prices condense, in as objective a form as possible, information on the value of alternative uses of...property."[123]
Suppose an entire block of central midtown Manhattan suddenly became available for sale today. For simplicity's sake, let's say it's between 53rd and 54th Street, and between 5th and 6th Avenue. There is no skyscraper on it, no pavement, just some overgrown grass and a rickety old fence. The price at which this block will sell is a reflection of all the alternative uses for the block and is therefore "informationally rich" and useful in guiding the appropriate investment decisions related to the block's use. Should a pig farmer purchase the block and arrange to construct the world's most modern pig-slaughtering facility on it? Perhaps an entrepreneur should buy it and build an underwater basket-weaving training facility on the block?
Though there is nothing wrong with investing to create a pig-slaughtering or underwater basket-weaving facility on this block, we might agree that neither of those uses for the land is the "best" use of the land. Surely a commercial real estate developer will recognize the value he might create through the building of an office tower or residential condominium building and outbid our prospective pig farmer. In fact, it is highly likely that the person or firm that sees the highest value for the land (perhaps a hotelier enters the scene and outbids our residential condo developer) will bid the price up to a point where the land will be used in an economically optimal manner.
If the land sale takes place as an auction, with the opening bid starting at $1.00, it is easy to see how the rising price will eliminate inappropriate investments on the land and effectively select the investment on the land that will maximize its value or use. Ten-year-old Johnnie takes the bus in from New Jersey to attend the auction and believes a lemonade stand would thrive on that block. He bids $9.28, the amount of money in his piggy bank. He is outbid by a young couple from a third-world country thinking that this plot of land might suit them to build a small house for themselves in which they could start a family (with a bid of $25,000). Next comes along an entrepreneurial college student who wants to convert the block into a training center for the homeless. Believing learning is most effective in an environment similar to one's home, he proposes to not build anything (with a bid of $100,000). After him comes a parking lot company that believes a shortage of parking lots would justify high prices to park on this block, and proposes an investment to create a three-story parking garage (it bids $500,000). Our underwater basket-weaving school builder is next, bidding a cool $1 million, beaming with confidence that she will be addressing one of Manhattan's largest unmet needs.
Next come the folks from the pork industry, armed with projections of the sausage revival that is expected to imminently displace chicken breasts on grocery shelves. They limit their bid to $10 million, knowing that the facility will cost a pretty penny to construct in such an inconvenient location. Following our pig farmers are the executives of Cheapo Motel, Inc. They see the global economic recession driving more and more travelers (business and leisure alike) to seek "clean beds, by the hour if necessary." Their projections justify a bid of $50 million. The penultimate bidder is a commercial office developer. He thinks he can build a 30-floor tower and fill it with office tenants. After estimating construction and operating costs, he believes he can pay $250 million for the land and still generate a profit. The final bidder is a hotel development company that believes it can build the city's finest six-star hotel and convince Seasons Carlton (one of the world's best hospitality companies) to manage it. At an estimated occupancy rate of 97 percent and average daily rate assumption of $750 per night, the company justifies a bid of $1 billion. The gavel falls: "Sold."
As this process demonstrated, the price of the property informed bidders of potential uses. It ensured that a pig-slaughtering facility did not end up in midtown Manhattan, and channeled our underwater basket-weaving school to the suburbs. Ultimately, it was the price of the property that resulted in the allocation of the scarce land to its most "valuable" use. Because market-determined prices are dynamic, it is conceivable that the property may in time find a more valued use.
Suppose for a moment that scientists at the Massachusetts Institute of Technology, in close cooperation with the National Institutes of Health and the Centers for Disease Control and Prevention, determine that natural pork, if cooked within four hours of slaughtering, has meaningful life-extending health qualities by materially reducing cholesterol, lowering blood pressure, improving metabolism, generating muscle mass, and increasing memory and overall brainpower. Upon completion of this research, professors at Johns Hopkins Medical School determine that such pork, when combined with a diet of hummus and red wine, removes the need for any and all pharmaceutical treatments for cholesterol, high blood pressure, diabetes, and a host of other common ailments. Not surprisingly, the price of "local pork" skyrockets from $5 to $1,000 per pound—supported by its qualification for health insurance reimbursements. Most consumers (depending on their medical coverage) are now entitled to three servings of local pork a week for the cost of their medical co-payment (typically between $10 and $20).
Given these dynamics, our aforementioned pork-slaughtering executives return to Manhattan and present an offer to our real-estate developer. Perhaps due in part to the lack of local pork offerings in New York City, many businesses had moved to New Jersey to improve employee welfare. As a result, rents in Manhattan are down materially. These new market conditions enable our pig men to buy the block from our real-estate developer, knock down the building, and build their pork-slaughtering facility. Within two years, the facility is recognized as the most profitable pork slaughterhouse in the world by the Global "Local Pork for Health" Slaughterhouse Federation.
The dynamics described above would not have been possible without informationally rich price signals. The higher pork prices provided a valuable incentive for our pork men to invest in Manhattan. The lower rents led our real-estate developer to sell. These decisions were informed and facilitated by the knowledge and information embedded in prices. In a nutshell, this is the basic argument in favor of market-determined prices.
The argument against market-derived prices is one that fundamentally believes prices are fickle and subject to irrational whims. As such, interpreting information that is supposedly embedded in prices is a fool's game. For this reason, centrally planned economies that generate prices from government decisions do not look to markets or supply–demand dynamics for price generation.
In the former Soviet Union and other socialist economies, prices were set by decree. In some cases, governments attempted to model out what an appropriate market-determined price might be and then dictated that as the price. Stiglitz notes the futility of such an approach:
Even if the government was successful in deciding on an appropriate price, it could do so only after a lengthy bureaucratic process. But economic conditions were changing while the bureaucrats were deliberating, which means the government-announced price was rarely the same as the market price.[124]
By setting prices that were either too high or too low, government interference with market-determined prices resulted in both shortages (when prices were set too low, resulting in excess demand or inadequate supply) and oversupply (when prices were too high, resulting in inadequate demand or excess supply). Not surprisingly, government interference tended to also produce black markets in which illegal transactions were taking place at prices negotiated between sellers and buyers. Despite these problems, the political process of setting prices via central planning was adopted by many countries in the twentieth century.
Representative governments are often beholden to popular sentiment in a manner that makes them highly likely to respond to outcries relating to unfair prices. There are many ways to deal with seemingly unfair prices, the most rapid of which is to simply apply a price ceiling (or floor) on the price of the good or service and require all citizens to adhere to the mandated price. Not unlike the communist approach, such a method is prone to creating excess supply or excess demand and inadequate demand or inadequate supply. If one thinks of prices as the symptoms and underlying supply and demand fundamentals as the cause, mandating a price is addressing the symptom but not acknowledging its cause.
Price Floors and Price Ceilings Governments tend to utilize price controls and price ceilings because they provide an easy-to-implement method of assuring citizens that they will be able to afford goods and services, or that an important supplier/constituent will be given a fair price for his production. Rather than addressing the issues that may be driving the price to be higher or lower than their constituents might like (i.e., too much production or supply in the case of low prices or too much demand or inadequate supply in the case of high prices), governments find it easier to simply mandate a price via decree. When prices in a society are generally free to move (and interpreted as providing valuable resource allocation information), but certain prices are constrained from moving completely freely, however, unintended consequences arise with respect to both the supply and demand. In short, as governments interfere with the price mechanism, both producers and consumers react to the artificial price signals. The end result is suboptimal resource allocation and a higher likelihood of booms and busts.
Perhaps the most common example of a price floor that adversely affects price discovery is the policy of mandating minimum wages. Although the labor market is generally one that utilizes supply and demand fundamentals to determine prices (i.e., wages), government intervention constrains the free movement of prices. By setting a price for unskilled labor that is higher than the price justified by supply and demand fundamentals, the policy of minimum wages incentivizes more workers to enter the workforce while simultaneously discouraging companies from hiring as many workers as they may in fact seek at a market price. The result is higher unemployment than might exist without such a policy. This perverse outcome is unfortunately often exacerbated at times of economic hardship when the political expediency of raising the minimum wage generates short-term political gain at the expense of employment.
In terms of price ceilings, the most often cited example is rent control. Although price ceilings are able to ensure that consumers can afford to rent a home, the unintended consequence of such a policy is a shortage of available rental units. This is the simple result of having more people trying to rent apartments than there are apartment owners willing to rent their units. Owners have no incentive to increase the supply of rental units because they are not compensated for doing so. Rent control is a particularly intractable problem to overcome because the political value in the short run (citizens pay less for housing) is accompanied by a long-term cost (the supply of rental apartments is not increased). Thus, although well intended, rent control actually creates artificial scarcity and magnifies (rather than mitigates) the problem. Might this policy then result in more home buyers than might otherwise be the case as the supply of rental units becomes inadequate? What impact does such a policy have for the likelihood of housing booms and busts?
Tax Policies The section of the U.S. Tax Code titled "Election to expense certain depreciable business assets" (Title 26, Subtitle A, Chapter 1, Subchapter B, Part VI, Section 179) effectively paid for a portion of my 2004 purchase of a BMW X5. Why is it that the U.S. government paid for a portion of my vehicle purchase?
As it turns out, Section 179 is commonly known among tax accountants as the "SUV deduction." Originally intended to help farmers needing to purchase expensive vehicles, the deduction applied to vehicles with a gross weight above 6000 lbs. Global automobile manufacturers studied these laws and, surprise surprise, my BMW X5 had a gross vehicle weight of 6005 lbs. I guess the Germans were nervous enough to add a bit of an extra weight to accommodate those who might opt not to have a CD player and such. Because I was running my own business at the time, I was able to expense virtually the entire amount of the vehicle against my income for that year. This was equivalent to the federal government paying approximately 40 percent of my car's cost.
When speaking with the sales representatives at various dealerships during my car search process, I learned of what various salesmen had termed the "mad December dash" in which all sorts of business-owning executives come into the showroom and are willing to pay full price for 6000lb+ SUVs. Virtually every year, dealerships sell out of these cars during the last week of the year. As you might imagine, such a policy artificially inflates demand for certain cars by effectively subsidizing their purchase. What might these cars cost if such a deduction did not exist? What is the real demand for a $100,000 Hummer?
This example is just one illustration of how government tax policies can dramatically affect supply and demand dynamics. Similar influences can be found with tax breaks for hybrid automobiles, as well as the much-discussed mortgage interest deduction (which we shall discuss in a case study of the housing boom in a later chapter). Hundreds of examples exist (electric vehicles, window replacements, solar energy installations, biofuel facilities, etc.), and unlike property rights interferences, which tend to dampen the likelihood of booms and busts, government interference with the price mechanism tends to amplify the likelihood of booms and busts.
Political decisions regarding property rights and prices are at the foundation of a market's receptivity to boom and bust cycles. Without private property rights, the incentives to profit are less obvious, thereby tempering—if not eliminating—financial extremes. Just as the removal of property rights (think of Venezuela's nationalizations) dampens investor enthusiasm and decreases, if not eliminates, the likelihood of bubbles forming, the introduction of property rights where they previously did not exist (think of China's housing reform program of the late 1990s) creates a particularly fertile ground on which bubbles may grow. In many ways, private property rights are a measure of a society's willingness to allow successful investors and speculators to keep their winnings.
Modifying or constraining property rights through price ceilings and floors has a ripple-through effect on the market dynamics (i.e., supply and demand) that determine prices. As described previously through the example of minimum wages, price floors tend to keep prices artificially high and therefore incentivize supply and dis-incentivize demand. Likewise, price ceilings such as rent control tend to keep prices artificially low and incentivize demand and dis-incentivize supply. The result is that politically motivated or mandated price distortions usually exacerbate, rather than mitigate, the problems they seek to address.
It is easy to see how these policies can increase the likelihood of booms and busts occurring. Might consistent underinvestment due to price ceilings result in an eventual supply shortage that is too large to ignore? Could the genuine supply shortage create hoarding mentalities that further exacerbate the problem? How might prices react in such an environment? Likewise, might price floors drive overinvestment that generates excess supply? Might overproduction result in bloated inventory levels that will eventually become too large to ignore? What might happen to prices then?
Just as price ceilings and floors distort supply and demand drivers, so too do taxes have a confounding effect. By effectively subsidizing or penalizing particular consumption and investment behavior, taxes alter underlying demand or supply. One of the most well-known tax policies to do that is the mortgage-interest deduction in the United States. By effectively paying a portion of the interest owed on a mortgage, the U.S. government has lowered the cost of home ownership and increased demand for homes. Although Chapter 10 will address this specific topic in greater depth, the bottom line is obvious: by increasing demand for housing, the policy has the potential to magnify booms (and therefore busts) in the U.S. housing market.
In the next chapter, we turn to biology as a lens through which we might gain some insights for our study of booms and busts. In particular, two biologically inspired constructs are emphasized as specifically helpful: the use of an epidemic lens to understand a boom's relative maturity, and the application of an emergence lens to comprehend the processes through which uninformed individuals might form a consensus.
[1] Alan Greenspan, "We Need a Better Cushion against Risk." Financial Times supplement on "The Future of Capitalism" (March 27, 2009).