Morepraisefor

nakedeconomics

byCharlesWheelan

“Irecommendthisbooktoanyonewhowantstogainanunderstandingofbasiceconomicswithlittlepainandmuchpleasure.”

—GaryBecker,1992NobelPrizewinnerinEconomics

“IdevouredNakedEconomicswhole, start to finish.Finallyaneconomistwasspeakingmylanguage!FinallyIcouldgraspnotonlythemeaningsofallthoseacronymsIonlypretendedtounderstand,buthowtheinstitutionsandconceptsforwhichtheystandmight—anddo—impactmylife.Bravo,CharlesWheelan,for doing the impossible: making the study of economics fascinating,comprehensible,andlaugh-out-loudfunny.”

—DeborahCopakenKogan,authorofShutterbabe:AdventuresinLoveandWar

“From simple supply and demand to the much more frightening subject ofmonetarypolicy,thisbookmanagestoexplainourglobaleconomyinawaythatis(gasp!)actuallyentertaining.”

—BookMagazine

“Translatesthearcaneandofteninscrutablejargonoftheprofessionaleconomistintolanguageaccessibletotheinquiringbutfrustratedlayman….Clear,concise,informative,[and]witty.”

—ChicagoTribune

“In just a few easy lessons,…Wheelan can teach themost innocent reader tothinklikeaneconomist.”

—KirkusReviews

“Makes economics accessible, comprehensible and appealing….Wheelan’s simplicity does not mask the detailed encapsulation ofcomplicated issues, such as relative wealth, globalization and theimportance of human capital. He smartly shows that while economicconsequencescanbeglobal,theyarealsoapartofeverydaylife.” —PublishersWeekly

nakedeconomics

UndressingtheDismalScience

fullyrevisedandupdated

CHARLESWHEELAN

ForewordbyBurtonG.Malkiel

W.W.Norton&CompanyNewYork•London

Copyright©2010,2002byCharlesWheelanForewordcopyright©2002byBurtonG.Malkiel

Allrightsreserved

“Mum’s theWord” reprintedwithpermission.Further reproductionprohibited.©1998TheEconomistNewspaperGroup,Inc.www.economist.com.

“TwoCheersforSweatshops,”HeartsandHeads,”and“ILoveD.C.”reprintedwithpermissionoftheNewYorkTimes.

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LibraryofCongresshascataloguedanearliereditionasfollows:

Wheelan,CharlesJ.Nakedeconomics:undressingthedismalscience/CharlesWheelan;forewordbyBurtonG.Malkiel.—Fullyrev.andupdated.p.cm.Includesbibliographicalreferences.ISBN:978-0-393-07975-3

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ForLeah

Contents

ForewordbyBurtonG.Malkiel

Introduction

Acknowledgments

1ThePowerofMarkets:WhofeedsParis?

2IncentivesMatter:Whyyoumightbeabletosaveyourfacebycuttingoffyournose(ifyouareablackrhinoceros)

3Government and the Economy: Government is your friend (and aroundofapplauseforallthoselawyers)

4Government and the Economy II: The army was lucky to get thatscrewdriverfor$500

5Economics of Information: McDonald’s didn’t create a better

hamburger

6Productivity andHumanCapital:Why is Bill Gates somuch richerthanyouare?

7Financial Markets:What economics can tell us about getting richquick(andlosingweight,too!)

8ThePowerofOrganizedInterests:Whateconomicscantellusaboutpolitics

9KeepingScore:Ismyeconomybiggerthanyoureconomy?

10TheFederalReserve:Whythatdollarinyourpocketismorethanjustapieceofpaper

11International Economics: How did a nice country like Iceland gobust?

12TradeandGlobalization:ThegoodnewsaboutAsiansweatshops

13DevelopmentEconomics:Thewealthandpovertyofnations

EpilogueLifein2050:SevenQuestions

Notes

Foreword

byBurtonG.Malkiel

It is widely believed that Scotsman Thomas Carlyle labeled economics the“dismal science” well over one hundred years ago because it seemed boring,uninteresting,unclear,andfullof“ontheonehand,ontheotherhand.”Indeed,HarryTrumanisreportedtohavesaidthattoavoidambiguity,hewantedtohave“one-armedeconomists.”Infact,Carlylehadsomethingverydifferentinmind.What Carlyle reminded us was that scarcity was pervasive—that we have tomake choices between competing satisfactions, between jam today and jamtomorrow, andbetween conflictingvalues andgoals.Above all, the dourScotemphasized that everything has a cost and nothing can be produced withoutworkandsacrifice.

To be sure, many people do believe that economics and economists aredismalinthepopularsense,thatis,extraordinarilydull.Asonedefinitiongoes:“An economist is someone who is good with numbers but does not have thepersonalitytobeanaccountant.”Thetarnishedimageofeconomistsisinlargepart earned by their tendency to opaquewriting, their use of often inscrutablediagrams,and theirexcessiveuseofmathematics.Moreover, theyoften fail toadmitwhattheydon’tknow.

Why is economics the butt of somany jokes, andwhy do students oftenbecome glassy-eyed when confronted with the study of economics as adiscipline?Thereasons,Ithink,arethateconomistsgenerallydonotwritewellandthatmosteconomicstextsrelyfartoomuchonalgebraicmanipulationandcomplex diagrams. Moreover, few economists are able to transmit theconsiderable excitement of economic analysis or to show its relevance toeverydaylife.ThisbookbyCharlesWheelanchangesall that.Wheelanhasananti-Midastouch.Ifhetouchedgoldhewouldturnittolife.

Thisisatrulyuniquebook.Itcontainsnoequations,noinaccessiblejargon,andnoinscrutablediagrams.Whileequationsanddiagramsmaywellbebehindmany of the ideas in economics,Wheelan shows that they can be reduced to

plainEnglish.Heboilseconomicsdownto itsessentials.Hedemonstrates thattheterm“lucideconomist”isnotanoxymoron.

In these pages, we see how many of the criticisms of economists areundeserved.Economic analysis is ahard andcomplex subject—inmanycasesfarmorecomplex thananalysis in thephysical sciences.Physicscanelegantlyexplainsimplecontainedsystemssuchastheplanetsrevolvingaroundthesunorelectronsinorbitaroundanatom.Buteventhephysicalscienceshavedifficultyunderstanding phenomena in nature. Weather forecasting is a case in point.Despitecomplexsatelliteobservationsandintricateweatherforecastingmodels,meteorologistsoftencannot improveonverynaive forecastingmodels suchas“Theweathertomorrowwillbeexactlylikeit is today.”Tobesure, theinertiamodelmissesalltheturningpointsbutretainsanexcellentoverallrecord.Andwhen forecastersareasked tomake longer-runprojectionson such subjects asglobal warming, their range of forecasts makes economic forecasts appearprecisebycomparison.

Economics ismore difficult than the physical sciences becausewe cannotusuallyruncontrolledlaboratoryexperimentsandbecausepeopledonotalwaysbehavepredictably.Awholenewbranchofbehavioraleconomicshasattractedconsiderable attention by combining the insights of psychologists andeconomists, but we still are unable to predict individual behavior with anyprecision.Butthatwearefarfromunderstandingeverythingdoesnotmeanthatwe understand nothing. We do know that individual behavior is stronglyinfluencedby incentives.Wedoknow that therearemany logical regularities,and we have enjoyed a steady accumulation of knowledge.We do know thateverysaleinvolvesapurchaseandthatobviousopportunitiesforprofitarerarelyoverlooked—the basic idea behind the theory that our securities markets areremarkablyefficient.

Andas inexact as economic sciencemaybe, it has adirect impactonourlivesandithasacriticalroletoplayingovernmentpolicymaking.Economistsinfluenceallbranchesofgovernment.Thetasksofpromotingeconomicgrowthandhighemploymentwhileavoidinginflationhavelongbeenrecognizedasthedomain of government economists. Remember Bill Clinton’s most successfulcampaign slogan during the 1992 election? “It’s the economy, stupid!”Promoting competition and restraining monopolies (Justice Department),limiting pollution (Environmental Protection Agency), and providing medicalcare (Health and Human Services) are examples of major activities withindifferent cabinet departments that have crucially important economic

components. Indeed, it is hard to think of any political decisions, be they onsocial,taxandexpenditure,international,agricultural,ornationalsecurityissues,thatdonothaveeconomicconsequences.Andhoweverskepticalpoliticiansmaybe about the ability of economists to solve these problems, the economists’advice isnot ignored. Indeed,as JohnMaynardKeynesoncewrote,“Practicalmen,whobelievethemselvestobequiteexemptfromanyintellectualinfluence,are usually the slaves of some defunct economist.Madmen in authority, whohearvoicesintheair,aredistillingtheirfrenzyfromsomeacademicscribblerofafewyearsback.”

The influence of economists is also increasingly pervasive in the businessand financial communities. Peter Lynch, the former manager of Fidelity’sMagellanmutualfund,onceopinedthatifyouspentfourteenminutestalkingtoaneconomistyouwouldhavewastedtwelveminutes.Perhapsitisironicthattheinvestmentperformanceofprofessionalmutualfundmanagersisnowregularlyevaluated based on techniques developed by financial economists. Moreover,economists influence countless other business decisions. They project productdemand for companies as diverse as General Motors and Procter & Gamble.They are employed in large numbers by consulting firms engaged in businesstasks fromstrategicplanning to inventory control.Theyhelp investment firmsfashion portfolios of securities by analyzing the trade-offs between expectedreturnandrisk.Theyadvisechieffinancialofficersofcorporationsondividendpolicyandontheeffectofdebtonthepriceofthefirm’scommonstock.Inourfinancialmarkets, option traders on the floors of themajor options exchangescarryhand-heldcomputersprogrammedwithaneconomicmodeltotellthemthepricesatwhichtheyshouldtradeputandcalloptions.Thefactisthateconomicanalysis is incredibly useful for investors and producers as well as forgovernmentpolicymakers.

Ordinary consumers will also find that economics can illuminate manyperplexing everyday issues. Why is it so hard for individuals to buy healthinsurance?WhydowestopatMcDonald’salongahighwayeventhoughmanyother establishments may make better hamburgers? Why do so many peopleapply to “prestige” colleges even thoughmany other institutions offer just asgood an education at far lower prices? Have you ever wondered what suchcommon terms as “adverse selection,” “public goods,” and “the prisoner’sdilemma”havetodowitheverydaylife?Theseareamongthesubjectstreatedinthisdelightfulbook.

It’softensaidthatifyouaskteneconomiststhesamequestionyouwillget

tendifferentanswers.ButI’llwagerthatifyouaskedteneconomistswhythereisashortageofcabsandapartmentsinNewYorkCity,alltenwouldtellyouthatlimitationson thenumberof taximedallions and rent control arewhat restrictthe supply of these goods and services. There are certainlymany areaswhereeconomists are in virtual unanimous agreement. Economists overwhelminglyagree that free international trade can improve the standard of living of thetrading countries and that tariffs and import quotas reduce general welfare.Economistsgenerallyagreethatrentcontrolsreducethevolumeandqualityofhousing.EconomistswerevirtuallyunanimousintheirforecastthatthehorrifictragedyofSeptember11,2001,wouldleadtoacontractionofeconomicactivity.Myownexperienceingovernmentsuggeststhatthereisfarlessdifferenceintheviews of economists (be they conservative Republicans or liberal Democrats)thanthereisbetweeneconomistsandthosewhocomefromdifferentdisciplines.Economists of contrasting political views agree among themselves on mostissues. A bipartisan majority of economists is quite likely to unite on theoppositesideofabipartisancoalitionofpoliticians.

Thereason,Ibelieve,isthateconomistshaveauniquewayofviewingtheworld and thinking about how to solve problems. Thinking like an economistinvolves chains of deductive reasoning in conjunctionwith simplifiedmodelssuchassupplyanddemand. It involves identifying trade-offs in thecontextofconstraints.Itmeasuresthecostofonechoiceintermsoftheforegonebenefitsof another. It involves the goal of efficiency—that is, getting themost out oflimited resources. It takes amarginalist or incremental approach. It asks howmuchextrabenefitcanbeachievedbyincurringsomeextracost. It recognizesthatresourceshavemanydiverseusesandthatsubstitutionscanbemadeamongdifferent resources to achieve desired results. Finally, the economist has apredilectiontobelievethatwelfareisincreasedbyallowingindividualstomaketheir own choices and to argue that competitive markets are a particularlyefficientmechanismforgivingexpression to individualchoices.Andwhilealleconomic problems involve normative issues (views about what should be),thinkinglikeaneconomistinvolvesananalyticalapproachthatusuallyabstractsfromoratleastdownplays“value”issues.

Thisgemofabookisbothwellbalancedandextremelycomprehensive.Itrecognizesthebenefitsofthefreemarketinmakingourlivesbetterandshowswhy centrally controlled economies ultimately fail to increase the livingstandards of their citizens. At the same time it recognizes the crucial role ofgovernmentincreatingthelegalframeworkthatmakesmarketspossibleandin

providingpublicgoods.Italsounderstandstheroleofgovernmentincorrectingsituations when the free market creates undesirable externalities such asenvironmentalpollutionorwhereprivatemarketswill fail toproduce someofthegoodsthecountry’scitizensdesire.

Didyoueverwonderwhymohairfarmersearnedasubsidyfromthefederalgovernmentfordecades?Wheelanexplainshowpoliticsandeconomicscanleadtosuchresults.DoyoureallyunderstandwhyBenBernankeisoftenreferredtoasthesecondmostpowerfulpersonintheUnitedStates?Wheelandemystifiestheeffectofmonetarypolicyoneconomicactivity.Didyoueverconsider thatyouneverfullyunderstoodthefinalscenefromthemovieTradingPlaceswhenthebadguyswerewipedoutinthecommoditiesfuturesmarket?Wheelanmakesthe theory of supply and demand completely accessible. Have you everwonderedifthepeoplewhoprotestagainstglobalizationhaveagoodpointandwhethereitherthedevelopedordevelopingnationswouldbebetteroffwithlesseconomic integration?Wheelan will make the issues crystal-clear.When youreadthenewspapersaboutdisputesconcerningcurrenteconomicissues,areyouoften perplexed and dismayed at the cacophony of competing arguments?Wheelan parses the jargon and pierces the politics to lay bare the essentialissues. In sodoing,he successfully transforms thedismal science intoa livelyweaving of economics and politics into the fabric of national discourse andpolicy.

Wheelanhasproducedadelightfullyreadableguidetoeconomicliteracy.Byboilingeconomicsdowntoitsessentials,hemakesthereaderamoreinformedcitizen who can better understand the major economic issues of the day. Heshows that economics can be explainedwithout graphs, charts, and equations.Hedemonstrates thateconomicanalysiscanbe intensely interesting.Thebookshouldprovideausefulsupplementforthecollegeandhighschoolbasiccourseon theeconomy.More important, itcanstandon itsownasan introduction tothefieldthatwillchangetheviewsofthosepeoplewhohaverejectedthestudyof economics as incredibly tedious and terminally boring. I have oftenconsidered writing a basic introduction to economics myself, but competingprojectsalwaysintervened.HadIdoneso,thisisthebookIwouldhavewantedtowrite.

BURTONG.MALKIELPrinceton,NewJerseyJanuary2010

Introduction

The scene is strikingly familiar. At a large American university, a graduatestudentstandsatthefrontofagrandlecturehalldrawinggraphsandequationsonachalkboard.HemayspeakproficientEnglish;hemaynot.Thematerialisdry and mathematical. Come exam time, students may be asked to derive ademandcurveordifferentiateatotalcostfunction.ThisisEconomics101.

Studentsarerarelyasked,astheymightbe,whybasiceconomicsmadethecollapse of the Soviet Union inevitable (allocating resources without a pricesystem is overwhelmingly difficult in the long run), what economic benefitsmokersprovidefornonsmokers(theydieearlier,leavingmoreSocialSecurityand pension benefits for the rest of us), or why mandating more generousmaternityleavebenefitsmayactuallybedetrimentaltowomen(employersmaydiscriminateagainstyoungwomenwhenhiring).

Somestudentswillstickwiththedisciplinelongenoughtoappreciate“thebig picture.” The vast majority will not. Indeed, most bright, intellectuallycurious college students suffer throughEcon101, are happy to pass, and thenwavegoodbyetothesubjectforever.Economicsisfiledawaywithcalculusandchemistry—rigoroussubjectsthatrequiredalotofmemorizationandhavelittletodowithanything thatwillcome later in life.And,ofcourse,a lotofbrightstudentsavoidthecourseinthefirstplace.Thisisashameontwolevels.

First, many intellectually curious people are missing a subject that isprovocative,powerful, andhighly relevant toalmosteveryaspectofour lives.Economicsoffers insight intopolicyproblems ranging fromorgandonation toaffirmative action. The discipline is intuitive at times and delightfully

counterintuitive at others. It is peppered with great thinkers. Some, such asAdam Smith and Milton Friedman, have captured mainstream attention. Butothers,suchasGaryBeckerandGeorgeAkerlof,havenotgottentherecognitionoutsideofacademethat theydeserve.Toomanypeoplewhowouldgladlycurlupwithabookon theCivilWarorabiographyofSamuelJohnsonhavebeenscaredawayfromasubjectthatshouldbeaccessibleandfascinating.

Second,manyofourbrightestcitizensareeconomicallyilliterate.Themediaare fullof references to thepowerfulBenBernanke,whohasplayedacrucialrole in the U.S. government response to the global financial crisis. But howmany people can explain what exactly he does? Even many of our politicalleaderscoulduseadoseofEcon101.Justabouteverypoliticaldebateincludesan assertion by one or more candidate that outsourcing and globalization are“stealing”Americanjobs,leavinguspoorerandmorelikelytobeunemployed.Internationaltrade,likeanykindofmarket-basedcompetition,doescreatesomelosers.But thenotion that itmakesuscollectivelyworseoff iswrong. In fact,thosekindsofstatementsaretheeconomicequivalentofwarningthat theU.S.Navyisatriskofsailingovertheedgeoftheworld.Inmylifetime,theguywhomadethemostcolorfulassertionalongtheselineswasRossPerot,aquirkythirdpartycandidatein1992(whenBillClintonandGeorgeH.W.Bushwererunningasthemainstreamcandidates);Perotarguedemphaticallyduringthepresidentialdebates that theNorthAmericanFreeTradeAgreementwould lead toa“giantsucking sound” as jobs left the United States for Mexico. The phrase wasmemorable;theeconomicswerewrong.Itdidn’thappen.

ThePerotcampaignwas,ashemighthaveputit,“adogthatdidn’thunt.”Butthatdoesnotmeanthatthoseworldleaderswhodogetthemselveselectedhave a solid grasp of basic economics. The French government in 2000undertookaprogramtotacklechronicdouble-digitunemploymentwithapolicythatwas the economic equivalentof fool’sgold.TheSocialist-ledgovernmentloweredthemaximumworkweekfromthirty-ninehourstothirty-fivehours;thesupposedlogicwasthatifallpeoplewithjobsworkfewerhours,thentherewillbe work left over for the unemployed to do. The policy did have a certainintuitiveappeal;thenagain,sodoesusingleechestosucktoxinsoutofthebody.Sadly,neither leechesnorashorterworkweekwillcauseanythingbutharminthelongrun.

TheFrenchpolicywasbasedonthefallacythatthereareafixednumberofjobsintheeconomy,whichmustthereforeberationed.It’sutternonsense.TheAmerican economy has createdmillions of new Internet-related jobs over the

lastthreedecades—jobsthatnotonlydidn’texistin1980,butthatnoonecouldhaveevenimagined—allwithoutthegovernmenttryingtodivvyupworkhours.

In 2008, the French government underNicolas Sarkozy passed legislationallowing companies and workers to negotiate away the thirty-five-hourworkweek,inlargepartbecausethepolicydidnothingtofixtheunemploymentproblem.Nosaneeconomistever thought itwould—whichdoesn’tnecessarilymean thatpoliticians (and thepeoplewhoelect them)werewilling to listen tothatadvice.

Which isnot to say thatAmericadoesn’thave itsowneconomic issues todealwith.AntiglobalizationprotestersfirsttooktothestreetsinSeattlein1999,smashingwindowsandoverturningcarstoprotestameetingoftheWorldTradeOrganization.Weretheprotestersright?Willglobalizationandburgeoningworldtraderuin theenvironment,exploitworkers in thedevelopingworld,andputaMcDonald’s on every corner? Or was New York Times columnist ThomasFriedmanclosertothemarkwhenhecalledtheprotesters“aNoah’sarkofflat-earthadvocates,protectionist tradeunionsandyuppieslookingfortheir1960’sfix”?1

Duringthe2008presidentialprimaries,BarackObamacriticizedtheNorthAmericanFreeTradeAgreement,whichwasnegotiatedduringthepresidencyoffellowDemocratBillClinton.WereObama’scommentsgoodeconomics,orjustgood politics (since he happened to be running against Bill Clinton’s wife)?AfterChapter12,youcandecide.

Iofferonlyonepromiseinthisbook:Therewillbenographs,nocharts,andno equations. These tools have their place in economics. Indeed,mathematicscan offer a simple, even elegant way of representing the world—not unliketelling someone that it is seventy-two degrees outside rather than having todescribehowwarmorcool itfeels.Butatbottom,themost important ideasineconomicsareintuitive.Theyderivetheirpowerfrombringinglogicandrigortobear on everyday problems. Consider a thought exercise proposed by GlennLoury, a theoretical economist at Boston University: Suppose that ten jobapplicantsarevyingforasingleposition.Nineof the jobcandidatesarewhiteandoneisblack.Thehiringcompanyhasanaffirmativeactionpolicystipulatingthatwhenminorityandnonminoritycandidatesareofequalmerit,theminoritycandidatewillbehired.

Furthersupposethattherearetwotopcandidates;oneiswhite,theotherisblack.True topolicy, the firmhires theblackcandidate.Loury (who isblack)makesthissubtlebutsimplepoint:Onlyoneofthewhitecandidateshassuffered

fromaffirmativeaction;theothereightwouldn’thavegottenthejobanyway.Yetall nine white candidates go away angry, feeling that they have beendiscriminatedagainst. Loury is not necessarily a foe of affirmative action.Hemerelyaddsnuancetoadiscussionthatusuallyhasnone.Affirmativeactioncanharmtheveryracerelationsthatitseekstoheal.

Or consider the periodic campaign to mandate that insurance companiescover the cost of two nights in the hospital for women who have deliveredbabies, rather than justone.PresidentBillClinton found this issuesufficientlyimportantthathevowedinhis1998StateoftheUnionaddresstoend“drive-bydeliveries.”But there isacost tosuchaplan thatshouldbemadeexplicit.Anextra night in the hospital is not medically necessary in most cases, but it isexpensive,whichiswhynewparentsdon’tpayforitthemselvesandinsurancecompaniesdon’twant topayfor iteither.If insurancecompaniesareforcedtooffer this benefit (or any other new benefitmandated by law), then theywillrecovertheirextracostsbyraisingpremiums.Andwhenpremiumsgoup,somepeopleonthemarginwillnolongerbeabletoaffordanyhealthinsuranceatall.Sotherealpolicyquestionis:Arewewillingtopassalawthatwillmakemanywomenmorecomfortable if itmeans that amuch smallernumberofmenandwomenwilllosecoverageforbasiccare?

The tradeoff underlying that seemingly narrow question has enormousresonanceasAmericadebateshealth care reform.Themoregenerous ahealthcaresystemis in thebenefits itguarantees, themore it isgoing tocost.That’strueregardlessofwhetherthegovernmentisoperatingthesystemornot.Infact,themostimportantquestionrelatedtohealthcarereformoftengetsfartoolittleattention:Given the proliferation of fabulously expensivemedical technology,some ofwhich produces great results and some ofwhich doesn’t, howdowedesignasystemthatsays“yes”toproceduresthatjustifytheircostand“no”tothosethatdon’t?

Iseconomicsonebigadvertisementfor theRepublicanParty?Notexactly.EvenMiltonFriedman, aNobel laureate in economics and themost articulatespokesmanforfreemarkets,wouldconcedethatunfetteredmarketscanleadtodeeply flawed outcomes. Consider the American lust for the automobile. Theproblemisnotthatwelikecars;theproblemisthatwedon’thavetopaythefullcost of driving them. Yes, we buy the car and then pay for maintenance,insurance, and gasoline. But we don’t have to pay for some of the othersignificantcostsofourdriving: theemissionswe leavebehind, thecongestionwecause, thewear and tearonpublic roads, thedangerwepose todrivers in

smallercars.TheeffectisabitlikeanightonthetownwithDad’screditcard:Wedoa lotof thingsthatwewouldn’tdoifwehadtopaythewholebill.Wedrivehuge cars,we avoidpublic transportation,wemove to far-flung suburbsandthencommutelongdistances.

Individualsdon’tgetthebillforthisbehavior,butsocietydoes—intheformofairpollution,globalwarming, andurban sprawl.Thebestway todealwiththisgrowingproblemisnotthestuffthatlaissez-faireconservativesusuallytalkabout.Itishighertaxesongasolineandcars.Onlywiththosekindsofmeasures,asweshallexploreinChapter3,willthecostofclimbingbehindthewheelofacar (or a hulking SUV) reflect the real social cost of that activity. Similarly,larger subsidies for public transportation would properly reward thosecommuterswhosparetherestofusbynotgettingintotheircars.

Meanwhile, economists have done some of themost substantive work onsocial issues like discrimination. Have the world’s symphony orchestrashistorically discriminated against women? Harvard economist Claudia GoldinandPrincetoneconomistCeciliaRousecameupwithanovelwayoffindingout.Inthe1950s,Americanorchestrasbegantouse“blind”auditions,meaningthatthe aspiring orchestra member would perform behind screens. Judges did notknow the identity or gender of themusician trying out.Didwomen do betterunder this blind system than they did when judges knew their gender? Yes,decidedlyso.Once theauditionsbecameanonymous,womenwere roughly50percentmorelikelytomakeitpastthefirstroundandseveraltimesmorelikelytomakethefinalcut.2

Economics presents us with a powerful, and not necessarily complex, set ofanalyticaltoolsthatcanbeusedtolookbackandexplainwhyeventsunfoldedthe way they did; to look around and make sense of the world; and to lookforwardsothatwecananticipatetheeffectsofmajorpolicychanges.Economicsislikegravity:Ignoreitandyouwillbeinforsomerudesurprises.

The demise of the investment bank Lehman Brothers, which declaredbankruptcy on September 15, 2008, ushered in “the financial crisis,” whichdeservesitsfrequentdescriptionastheworsteconomicdownturnsincetheGreatDepression.Howdidithappen?Howdidsomanyconsumers,whoaresupposedtohavea rationalunderstandingof theirownwell-being, endupcrushedbyahousing “bubble”? Who were the knuckleheads who loaned them all thatmoney? Why did Wall Street create things like “CDOs” and credit-default

swaps,andwhydidtheyprovesodevastatingtothefinancialsystem?Chapter2makesthecasethatmostof therecklessbehavior that ledtothe

financialcrisiswaspredictable,giventheincentivesbuiltintothesystem.Whydidmortgagebrokersoriginatesomanyrecklessloans?Becauseitwasn’ttheirmoney!Theywerepaidoncommissionbythebanksthatmadetheloans.Moremortgages meant more commissions, and bigger mortgages meant biggercommissions.

Sowhywere thebankswilling toputsomuchof theirowncapitalat risk(particularly given the incentives of themortgage brokers whowere bringingthemcustomers)?Becausebanks typically“sell”mostof theirmortgage loans,meaning that theygeta lumpsumofcashnowfromsomethird-party investorwho gets the stream of future mortgage payments in return. (You may nowrecognizethissituationasanadultversionof“hotpotato”itdoesn’tmatterhowbadaloanisaslongasyoucanpassitontosomeoneelsebeforetheborrowerdefaults.)

Okay,thenwhowouldbuytheseloans?That’swhatChapter2explains.I’llgiveyouonecluenow:WallStreetgetsinvolvedanditdoesn’tendwell.

Havingwrittenallthat,Imustadmitthatthereissomesoulsearchinggoingonintheeconomicsprofession.Asobviousasthefinancialcrisisseemsafterthefact, few economists saw it coming (with some notable exceptions). Virtuallynoneanticipatedhowsevereitmightbe.Inthefallof2005,severalprominenteconomistswroteinaprestigiousjournal,“Asoftheendof2004,ouranalysisrevealslittleevidenceofahousingbubble.”3

Wrong.Actually the articlewasworse thanwrong, because itwaswrittenexplicitly to refute the signs of a bubble that had become obvious to manylaypeople—whichiskindoflikethefiredepartmentshowingupatahousewithsmokewaftingfromtheroofanddeclaring,“No,that’snotafire,”onlytohaveflamesstartleapingfromtheattictwentyminuteslater.Therewasabubble.Anditcanbeexplainedbestbyincorporatingpsychologyintoeconomics,namelythetendencyofindividualstobelievethatwhateverishappeningnowiswhat’smostlikelytohappeninthefuture.

Economicsisevolving,likeeverydiscipline.Oneofthemostinterestingandproductiveareasofinquiryisthefieldofbehavioraleconomics,whichexploreshow individualsmake decisions—sometimes inways that aren’t as rational aseconomists have traditionally theorized.We humans underestimate some risks(obesity)andoverestimateothers (flying);we letemotioncloudour judgment;we overreact to both good news and bad news (rising home prices and then

fallinghomeprices).Most of this was obvious to Shakespeare, but it’s relatively new to

mainstream economics. As New York Times columnist David Brooks noted,“Economicbehavior canbe accurately predicted through elegantmodels.Thisview explains a lot, but not the current financial crisis—how somany peoplecouldbe so stupid, incompetentand self-destructiveall atonce.Thecrisishasdeliveredablowtoclassicaleconomicsandtakenabodyofpsychologicalworkthatwasattheedgeofpublicpolicythoughtandbroughtittofrontandcenter.”4

Of course, most of the old ideas are still pretty darn important. FederalReservechairmanBenBernankewasascholarof theGreatDepressionbeforeleavingacademe, a fact that hashad implications farbeyond the IvoryTower.Chapter 10 will make the case that Bernanke’s creative and aggressiveinterventionsattheFederalReserve,manyofwhichwereinspiredbywhatwentwronginthe1930s,preventedabadsituationfromgettingmuch,muchworse.

This book walks through some of the most powerful concepts in economicswhile simplifying the building blocks or skipping them entirely. Each chaptercoverssubjectsthatcouldbemadeintoanentirebook.Indeed,thereareminorpointsineverychapterthathavelaunchedandsustainedentireacademiccareers.I have glossed over or skippedmuch of the technical structure that forms thebackbone of the discipline.And that is exactly the point:One need not knowwhere to place a load-bearingwall in order to appreciate the genius of FrankLloydWright. This book is not economics for dummies; it is economics forsmartpeoplewhoneverstudiedeconomics(orhaveonlyavaguerecollectionofdoingso).Mostofthegreatideasineconomicsareintuitivewhenthedressingsofcomplexityarepeeledaway.Thatisnakedeconomics.

Economics shouldnotbe accessibleonly to the experts.The ideas are tooimportantandtoointeresting.Indeed,nakedeconomicscanevenbefun.

Acknowledgments

Manywavesofpeoplehavehelpedtobringthisprojecttofruition,almostlikearelayracewithfreshlegspushingmetowardthefinishlineateverystage.Inthe beginning, Tifanny Richards was a strong believer that there would be amarket for an accessible book on economics. Her wonderful encouragementmovedthisbookoff thestartingline.TabithaGriffinbrought theproject toW.W.Norton,somethingforwhichIwillalwaysbegrateful.

Then came the second leg. When Tifanny and Tabitha went on to otheropportunities, I was fortunate to end up in excellent hands once again. TinaBennettiseverythingthatonecouldhopeforinanagent:smart,supportive,andalwaysinterestedinnewideas.Meanwhile,IwasluckytohaveDrakeMcFeelytakeonthetaskofeditingthebook.Whoknowshowthemancanfindtimetorunthecompany,editbooks,andcavortwithNobelPrizewinners,buthedoesandIamabeneficiaryofhisexperienceandjudgment.Ofcourse,EveLazovitzistheonewhomadeDrake’strainsrunontimeforthefirstedition,albeitwithadelicate touch. Jeff Shreve was a kind but stern taskmaster for the secondedition. Without their support (and deadlines), this book would still be anunfinishedmanuscriptscrawledonlegalpads.

Mary Ellen Moore and Danielle Kutasov offered excellent researchassistance, finding the facts, figures, and anecdotes that had eludedme.Threeaccomplished economists were kind enough to take time from their busyschedules to read the first edition manuscript and make helpful comments:BurtonMalkiel,RobertWillis,andKennethRogoff.Thesethreemenaregiantsof the profession, and each hadmany other things that theymight have done

with their time. Robert Johnson was kind enough to read the internationaleconomics chapter that has been added to the second edition. I appreciate hiswillingnesstosharehisexpertiseonthetopic.

IoweadebttomyformereditorsatTheEconomist.JohnMicklethwaitwasgenerous in allowing me to disappear for a stretch while I finished the firstedition of this book andwas alsowilling to read andmake comments on thefinished product. I oweAnnWroe credit for her clever subtitle. The fact thatbothJohnandAnnfindtimetoeditoneoftheworld’sgreatpublicationswhilealso raising families and writing books of their own continues to be aninspiration.

More recently, the Harris School of Public Policy at the University ofChicago andDartmouthCollege have both offeredme an intellectual “home”where I have the privilege of teaching great students andworking on projectslikethisone.AttheHarrisSchool,formerDeanSusanMayerwasaparticularlyenthusiastic supporter ofmy ongoing quest tomake important academic ideasmoreaccessibletothelaypublic.AtDartmouth,BruceSacerdotehasbeenbothaterrificintellectualcompanionandagreatwater-skibuddy.

Ialsooweadifferentkindofdebt.ThevastmajorityofideasIdescribeinthisbookarenotmyown.Rather,Iamatranslatorwhoseworkderivesitsvaluefromthebrillianceoftheoriginal,whichinthiscaseiscenturiesofworkdonebygreatthinkers.Ihopethisbookreflectsmyenormousrespectforthatwork.

Last, I would like to acknowledge those who inspired my interest in thesubjects that make up this book. I’ve made the case that economics is oftenpoorlytaught.Thatistrue.Butit’salsotruethatthedisciplinecancomealiveinthehandsoftherightperson,andIwasfortunatetoworkandstudywithmanyofthem:GaryBecker,BobWillis,KenRogoff,RobertWillig,ChristinaPaxson,DuncanSnidal,AlanKrueger,PaulPortney,SamPeltzman,DonCoursey,PaulVolcker.My hope is that this bookwill help to transmit their knowledge andenthusiasmtomanynewreadersandstudents.

nakedeconomics

CHAPTER1

ThePowerofMarkets:

WhofeedsParis?

In1989,as theBerlinWallwas toppling,Douglas Ivester,headofCoca-ColaEurope(andlaterCEO),madeasnapdecision.HesenthissalesforcetoBerlinand told them to start passing out Coke. Free. In some cases, the Coca-Colarepresentativeswereliterallypassingbottlesofsodathroughholes in theWall.He recalls walking around Alexanderplatz in East Berlin at the time of theupheaval,tryingtogaugewhethertherewasanyrecognitionoftheCokebrand.“Everywherewewent,weaskedpeoplewhat theyweredrinking,andwhethertheylikedCoca-Cola.Butwedidn’tevenhavetosaythename!Wejustshapedourhandslikethebottle,andpeopleunderstood.WedecidedwewouldmoveasmuchCoca-Colaaswecould,asfastaswecould—evenbeforeweknewhowwewouldgetpaid.”1

Coca-Colaquicklysetupbusiness inEastGermany,giving freecoolers tomerchants who began to stock the “real thing.” It was a money-losingproposition in the short run; the East German currency was still worthless—scrapsofpapertotherestoftheworld.Butitwasabrilliantbusinessdecisionmade faster than any government body could ever hope to act. By 1995, percapitaconsumptionofCoca-Cola in the formerEastGermanyhadrisen to thelevelinWestGermany,whichwasalreadyastrongmarket.

Inasense, itwasAdamSmith’s invisiblehandpassingCoca-Colathroughthe Berlin Wall. Coke representatives weren’t undertaking any greathumanitarian gesture as they passed beverages to the newly liberated EastGermans. Nor were they making a bold statement about the future ofcommunism.Theywerelookingafterbusiness—expandingtheirglobalmarket,boostingprofits,andmakingshareholdershappy.Andthat is thepunchlineofcapitalism:Themarketalignsincentivesinsuchawaythatindividualsworkingfor theirownbest interest—passingoutCoca-Cola,spendingyears ingraduate

school, planting a field of soybeans, designing a radio that will work in theshower—leads to a thriving and ever-improving standard of living for most(thoughnotall)membersofsociety.

Economists sometimes ask, “Who feeds Paris?”—a rhetorical way ofdrawingattentiontothemind-numbingarrayofthingshappeningeverymomentofeveryday tomakeamoderneconomywork.Somehow the rightamountoffreshtunamakesitswayfromafishingfleetintheSouthPacifictoarestauranton the Rue de Rivoli. A neighborhood fruit vendor has exactly what hiscustomers want every morning—from coffee to fresh papayas—even thoughthose products may come from ten or fifteen different countries. In short, acomplexeconomyinvolvesbillionsoftransactionseveryday,thevastmajorityofwhichhappenwithoutanydirectgovernmentinvolvement.Anditisnotjustthat things get done; our lives grow steadily better in the process. It isremarkable enough thatwe cannow shop for a television twenty-four hours aday from the comfort of our ownhomes; it is equally amazing that in 1971 atwenty-five-inchcolortelevisionsetcostanaverageworker174hoursofwages.Today,atwenty-five-inchcolortelevisionset—onethatismoredependable,getsmore channels, and has better reception—costs the average worker abouttwenty-threehoursofpay.

Ifyou think that abetter, cheaper television set isnot thebestmeasureofsocialprogress(areasonablepoint,Iconcede),thenperhapsyouwillbemovedbythefactthat,duringthetwentiethcentury,Americanlifeexpectancyclimbedfromforty-sevenyearstoseventy-seven,infantmortalityplungedby93percent,andwewiped out or gained control over diseases such as polio, tuberculosis,typhoid,andwhoopingcough.2

Ourmarketeconomydeservesalotofthecreditforthatprogress.ThereisanoldColdWarstoryaboutaSovietofficialwhovisitsanAmericanpharmacy.Thebrightly lit aisles are linedwith thousands of remedies for every problemfrombadbreath to toe fungus. “Very impressive,” he says. “Buthowcanyoumakesurethateverystorestocksalloftheseitems?”Theanecdoteisinterestingbecauseitbetraysatotallackofunderstandingofhowamarketeconomyworks.InAmerica,thereisnocentralauthoritythattellsstoreswhatitemstostock,astherewasintheSovietUnion.Storesselltheproductsthatpeoplewanttobuy,and, in turn, companies produce items that stores want to stock. The Sovieteconomy failed in large part because government bureaucrats directedeverything,fromthenumberofbarsofsoapproducedbyafactoryinIrktusktothenumberofuniversitystudentsstudyingelectricalengineeringinMoscow.In

theend,thetaskprovedoverwhelming.Of course, those of us accustomed to market economies have an equally

poorunderstandingofcommunistcentralplanning.IwasoncepartofanIllinoisdelegationvisitingCuba.BecausethevisitwaslicensedbytheU.S.government,eachmemberofthedelegationwasallowedtobringback$100worthofCubanmerchandise,includingcigars.Havingbeenraisedintheeraofdiscountstores,weallsetoutlookingforthebestpriceonCohibassothatwecouldgetthemostbang for our $100 allowance.After several fruitless hours,we discovered thewholepointofcommunism:Thepriceofcigarswasthesameeverywhere.Thereisnocompetitionbetweenstoresbecausethereisnoprofitasweknowit.Everystoresellscigars—andeverythingelsefor thatmatter—atwhateverpriceFidelCastro(orhisbrotherRaul)tellsthemto.Andeveryshopkeepersellingcigarsispaid the governmentwage for selling cigars,which is unrelated to howmanycigarsheorshesells.

GaryBecker,aUniversityofChicagoeconomistwhowontheNobelPrizein1992,hasnoted(borrowingfromGeorgeBernardShaw)that“economyistheartofmakingthemostoflife.”Economicsisthestudyofhowwedothat.Thereisafinitesupplyofeverythingworthhaving:oil,coconutmilk,perfectbodies,cleanwater,peoplewhocanfixjammedphotocopymachines,etc.Howdoweallocatethesethings?WhyisitthatBillGatesownsaprivatejetandyoudon’t?He is rich,youmight answer.Butwhy ishe rich?Whydoeshehavea largerclaimontheworld’sfiniteresourcesthaneveryoneelse?Atthesametime,howis it possible in a country as rich as the United States—a place where AlexRodriguezcanbepaid$275milliontoplaybaseball—thatoneinfivechildrenispoororthatsomeadultsareforcedtorummagethroughgarbagecansforfood?NearmyhomeinChicago,theThreeDogBakerysellscakesandpastriesonlyfor dogs. Wealthy professionals pay $16 for birthday cakes for their pets.Meanwhile, the Chicago Coalition for the Homeless estimates that fifteenthousandpeoplearehomelessonanygivennightinthatsamecity.

Thesekindsofdisparitiesgrowevenmorepronouncedaswe lookbeyondthebordersof theUnitedStates.Three-quartersof thepeople inChadhavenoaccesstocleandrinkingwater,letalonepastriesfortheirpets.TheWorldBankestimatesthathalfoftheworld’spopulationsurvivesonlessthan$2aday.Howdoesitallwork—or,insomecases,notwork?

Economics startswithonevery importantassumption: Individualsact tomake

themselves as well off as possible. To use the jargon of the profession,individuals seek to maximize their own utility, which is a similar concept tohappiness,onlybroader.Ideriveutilityfromgettingatyphoidimmunizationandpayingtaxes.Neitherof thesethingsmakesmeparticularlyhappy,but theydokeepmefromdyingoftyphoidorgoingtojail.That,inthelongrun,makesmebetteroff.Economistsdon’tparticularlycarewhatgivesusutility; theysimplyacceptthateachofushashisorherown“preferences.”Ilikecoffee,oldhouses,classicfilms,dogs,bicycling,andmanyotherthings.Everyoneelseintheworldhaspreferences,whichmayormaynothaveanythingincommonwithmine.

Indeed, this seemingly simple observation that different individuals havedifferentpreferencesissometimeslostonotherwisesophisticatedpolicymakers.For example, rich people have different preferences than poor people do.Similarly, our individual preferences may change over the course of our lifecycleaswe(wehope)growwealthier.Thephrase“luxurygood”actuallyhasatechnicalmeaningtoeconomists;itisagoodthatwebuyinincreasingquantitiesaswe grow richer—things like sports cars and Frenchwines. Less obviously,concernfortheenvironmentisaluxurygood.WealthyAmericansarewillingtospendmoremoneytoprotecttheenvironmentasafractionoftheirincomesthanare lesswealthyAmericans.Thesamerelationshipholds trueacrosscountries;wealthy nations devote a greater share of their resources to protecting theenvironmentthandopoorcountries.Thereasonissimpleenough:WecareaboutthefateoftheBengaltigerbecausewecan.Wehavehomesandjobsandcleanwaterandbirthdaycakesforourdogs.

Here is a nettlesome policy question: Is it fair for those of us who livecomfortablytoimposeourpreferencesonindividualsinthedevelopingworld?Economistsarguethatitisnot,thoughwedoitallthetime.WhenIreadastoryin the SundayNew York Times about South American villagers cutting downvirgin rain forest and destroying rare ecosystems, I nearly knock over myStarbucks latte in surpriseanddisgust.But Iamnot they.Mychildrenarenotstarvingoratriskofdyingfrommalaria.Iftheywere,andifchoppingdownavaluable wildlife habitat enabled me to afford to feed my family and buy amosquitonet, then Iwould sharpenmyaxandstart chopping. Iwouldn’t carehowmanybutterfliesorspottedweaselsIkilled.Thisisnottosuggestthattheenvironmentinthedevelopingworlddoesnotmatter.Itdoes.Infact,therearemanyexamplesofenvironmentaldegradationthatwillmakepoorcountriesevenpoorerinthelongrun.Cuttingdownthoseforestsisbadfortherestofus,too,sincedeforestationisamajorcontributortorisingCO2emissions.(Economists

often argue that rich countries ought to pay poor countries to protect naturalresourcesthathaveglobalvalue.)

Obviously if the developed world were more generous, then Brazilianvillagersmightnothavetodecidebetweendestroyingtherainforestandbuyingmosquitonets.Fornow, thepoint ismorebasic:It issimplybadeconomics toimpose our preferences on individuals whose lives are much, much different.Thiswillbeanimportantpointlaterinthebookwhenweturntoglobalizationandworldtrade.

Letmemakeoneotherimportantpointregardingourindividualpreferences:Maximizing utility is not synonymouswith acting selfishly. In 1999, theNewYorkTimespublishedtheobituaryofOseolaMcCarty,awomanwhodiedattheageofninety-oneafterspendingherlifeworkingasalaundressinHattiesburg,Mississippi. She had lived alone in a small, sparsely furnished house with ablack-and-white television that received only one channel. What made Ms.McCartyexceptionalisthatshewasbynomeanspoor.Infact,fouryearsbeforeherdeathshegaveaway$150,000totheUniversityofSouthernMississippi—aschoolthatshehadneverattended—toendowascholarshipforpoorstudents.

DoesOseolaMcCarty’s behavior turn the field of economics on its head?AreNobel Prizes being recalled to Stockholm?No. She simply derivedmoreutilityfromsavinghermoneyandeventuallygivingitawaythanshewouldhavefromspendingitonabig-screenTVorafancyapartment.

Okay,but thatwas justmoney.HowaboutWesleyAutrey,a fifty-year-oldconstructionworkerinNewYorkCity.HewaswaitingforthesubwayinUpperManhattan with his two young daughters in January 2007 when a strangernearbybeganhavingconvulsionsandthenfellonthetraintracks.Ifthiswasn’tbadenough,theNumber1trainwasalreadyvisibleasitapproachedthestation.

Mr. Autrey jumped on the tracks and shielded the man as five train carsrolledoverbothofthem,closeenoughthatthetrainleftasmudgeofgreaseonMr. Autrey’s hat.When the train came to a stop, he yelled from underneath,“We’reO.K. down here, but I’ve got two daughters up there. Let them knowtheirfather’sO.K.”3Thiswasalltohelpacompletestranger.

Weallroutinelymakealtruisticdecisions,albeitusuallyonasmallerscale.Wemaypayafewcentsextrafordolphin-safetuna,orsendmoneytoafavoritecharity,orvolunteertoserveinthearmedforces.Allofthesethingscangiveusutility;nonewouldbeconsideredselfish.Americansgivemorethan$200billiontoassortedcharitieseveryyear.Weholddoorsopenforstrangers.Wepracticeremarkableactsofbraveryandgenerosity.Noneofthisisincompatiblewiththe

basic assumption that individuals seek to make themselves as well off aspossible, however theyhappen to define that.Nor does this assumption implythatwealwaysmakeperfect—orevengood—decisions.Wedon’t.Buteachofus does try to make the best possible decision given whatever information isavailableatthetime.

So, after only a few pages, we have an answer to a profound, age-oldphilosophical question: Why did the chicken cross the road? Because itmaximizedhisutility.

Bear in mind that maximizing utility is no simple proposition. Life iscomplexanduncertain.Thereareaninfinitenumberofthingsthatwecouldbedoingatany time. Indeed,everydecision thatwemake involvessomekindoftrade-off.Wemaytradeoffutilitynowagainstutilityinthefuture.Forexample,youmayderivesomesatisfactionfromwhackingyourbossontheheadwithacanoepaddleattheannualcompanypicnic.Butthatmomentaryburstofutilitywouldpresumablybemorethanoffsetbythedisutilityofspendingmanyyearsinafederalprison.(Butthosearejustmypreferences.)Moreseriously,manyofourimportantdecisionsinvolvebalancingthevalueofconsumptionnowagainstconsumptioninthefuture.Wemayspendyearsingraduateschooleatingramennoodles because it dramatically boosts our standard of living later in life.Or,conversely,wemayuseacreditcard topurchaseabig-screen television todayeventhoughtheinterestonthatcreditcarddebtwilllessentheamountthatwecanconsumeinthefuture.

Similarly,webalanceworkandleisure.Grindingawayninetyhoursaweekasaninvestmentbankerwillgeneratealotofincome,butitwillalsoleavelesstime to enjoy the goods that can be purchasedwith that income.My youngerbrother beganhis career as amanagement consultantwith a salary that had atleastonemoredigitthanminehasnow.Ontheotherhand,heworkedlongandsometimesinflexiblehours.Onefallwebothexcitedlysignedupforaneveningfilm class taught by Roger Ebert.My brother proceeded tomiss every singleclassforthirteenweeks.

Howeverlargeourpaychecks,wecanspendthemonastaggeringarrayofgoodsandservices.Whenyoubought thisbook,you implicitlydecidednot tospendthatmoneysomewhereelse.(Evenifyoushopliftedthebook,youcouldhavestuffedaStephenKingnovelinyourjacketinstead,whichisflatteringinitsownkindofway.)Meanwhile, timeisoneofourmostscarceresources.Atthemoment,youarereadinginsteadofworking,playingwiththedog,applyingtolawschool,shoppingforgroceries,orhavingsex.Lifeisabouttrade-offs,and

soiseconomics.In short, getting out of bed in themorning andmakingbreakfast involves

morecomplexdecisionsthantheaveragegameofchess.(Willthatfriedeggkillmeintwenty-eightyears?)Howdowemanage?Theansweris thateachofusimplicitly weighs the costs and benefits of everything he or she does. Aneconomistwouldsaythatweattempttomaximizeutilitygiventheresourcesatourdisposal;mydadwouldsaythatwetrytoget themostbangforourbuck.Bearinmindthatthethingsthatgiveusutilitydonothavetobematerialgoods.Ifyouarecomparingtwojobs—teachingjuniorhighschoolmathormarketingCamel cigarettes—the latter job would almost certainly pay more while theformer job would offer greater “psychic benefits,” which is a fancy way ofsayingthatattheendofthedayyouwouldfeelbetteraboutwhatyoudo.Thatisa perfectly legitimate benefit to be compared against the cost of a smallerpaycheck.Intheend,somepeoplechoosetoteachmathandsomepeoplechoosetomarketcigarettes.

Similarly,theconceptofcostisfarricher(pardonthepun)thanthedollarsandcentsyouhandoveratthecashregister.Therealcostofsomethingiswhatyoumustgiveupinordertogetit,whichisalmostalwaysmorethanjustcash.Thereisnothing“free”aboutconcert ticketsifyouhavetostandinlineintherainforsixhourstogetthem.Takingthebusfor$1.50maynotbecheaperthantakinga taxi for$7 ifyouare running late forameetingwithapeevishclientwhowillpulla$50,000accountifyoukeepherwaiting.Shoppingatadiscountstoresavesmoneybut itusuallycosts time. Iamawriter; Igetpaidbasedonwhat I produce. I could drive ninety miles to shop at an outlet in Kenosha,Wisconsin, to save $50 on a new pair of dress shoes. Or I could walk intoNordstromonMichiganAvenueandbuytheshoeswhileIamoutfor lunch. Igenerallychoosethelatter;thetotalcostis$225,fifteenminutesofmytime,andsomehectoringfrommymother,whowillinvariablyask,“Whydidn’tyoudrivetoKenosha?”

Everyaspectofhumanbehaviorreactstocostinsomeway.Whenthecostof something falls, it becomes more attractive to us. You can learn that byderiving a demand curve, or you can learn it by shopping the day afterChristmas,when people snap up things that theyweren’twilling to buy for ahigherprice severaldaysearlier.Conversely,when thecostof somethinggoesup,weuselessofit.Thisistrueofeverythinginlife,evencigarettesandcrackcocaine.Economistshavecalculatedthata10percentdecreaseinthestreetpriceofcocaineeventuallycausesthenumberofadultcocaineuserstogrowbyabout

10 percent. Similarly, researchers estimated that the first proposed settlementbetweenthetobaccoindustryandthestates(rejectedbytheU.S.Senatein1998)wouldhaveraised thepriceofapackofcigarettesby34percent. In turn, thatincrease would have reduced the number of teenage smokers by a quarter,leading to 1.3 million fewer smoking-related premature deaths among thegenerationofAmericansseventeenoryoungerat the time.4Of course, societyhasalreadyraisedthecostofsmokinginwaysthathavenothingtodowiththeprice of a pack of cigarettes. Standing outside an office building when it isseventeendegreesoutsideisnowpartofthecostofsmokingatwork.

Thisbroadviewofcostcanexplainsomeveryimportantsocialphenomena,oneofwhichistheplummetingbirthrateinthedevelopedworld.Havingachildis more expensive than it was fifty years ago. This is not because it is moreexpensivetofeedandclotheanotherlittleurchinaroundthehouse.Ifanything,those kinds of costs have gone down, because we have become far moreproductiveatmakingbasicconsumergoodslikefoodandclothing.Rather, theprimarycostofraisingachildtodayisthecostoftheearningsforgonewhenaparent,stillusuallythemother,quitsorcutsbackonworktolookafterthechildat home. Because women have better professional opportunities than everbefore,ithasgrownmorecostlyforthemtoleavetheworkforce.Myneighborwasaneurologistuntilhersecondchildwasborn,atwhichpointshedecidedtostayhome.It’sexpensivetoquitbeinganeurologist.

Meanwhile, most of the economic benefits of having a large family havedisappeared in thedevelopedworld.Youngchildrenno longerhelpouton thefarm or provide extra income for the family (though they can be taught at ayoung age to fetch a beer from the refrigerator).We no longer need to havemanychildren inorder to ensure that someof them live through childhoodorthatwehaveenoughdependentstoprovideforusinretirement.Eventhemostdour of economistswould concede thatwe derive great pleasure from havingchildren.Thepointisthatitisnowmoreexpensivetohaveelevenofthemthanitused tobe.Thedataspeak to thatpoint:TheaverageAmericanwomanhad3.77childrenin1905;shenowhas2.07—a45percentdrop.5

Thereisasecondpowerfulassumptionunderpinningallofeconomics:Firms—which can be anything from one guy selling hot dogs to a multinationalcorporation—attempt tomaximize profits (the revenue earned by selling stuffminus thecostofproducing it). Inshort, firms try tomakeasmuchmoneyas

possible.Hence,wehaveananswertoanotheroflife’sburningquestions:Whydidtheentrepreneurcrosstheroad?Becausehecouldmakemoremoneyontheotherside.

Firms take inputs—land, steel, knowledge, baseball stadiums, etc.—andcombinetheminawaythataddsvalue.ThatprocesscanbeassimpleassellingcheapumbrellasonabusycornerinNewYorkCitywhenitstartstorain(wheredo those guys come from?) or as complex as assembling Boeing’s 787Dreamliner(apassengerjetthatrequired800,000hoursonCraysupercomputersjust todesign).Aprofitable firm is likeachefwhobringshome$30worthofgroceriesandcreatesan$80meal.Shehasusedhertalentstocreatesomethingthat isworth farmore than the cost of the inputs. That is not always an easything todo.Firmsmustdecidewhat toproduce,howandwhere toproduce it,howmuch toproduce, andatwhatprice to sellwhat theyproduce—all in thefaceofthesamekindsofuncertaintiesthatconsumersdealwith.

How? These aremassively complex decisions. One powerful feature of amarket economy is that it directs resources to theirmost productiveuse.Whydoesn’tBradPitt sellautomobile insurance?Because itwouldbeanenormouswasteofhisuniquetalents.Yes,heisacharismaticguywhocouldprobablysellmore insurance policies than the average salesman. But he is also one of ahandfulofpeopleintheworldwhocan“open”amovie,meaningthatmillionsofpeoplearoundtheworldwillgotoseeafilmjustbecauseBradPitt is init.ThatismoneyinthebankintheriskyHollywoodmoviebusiness,sostudiosarewillingtopayhandsomelytoputBradPittinastarringrole—about$30millionafilm.InsuranceagencieswouldalsobewillingtopayforthePittcharisma—butmorelike$30,000.BradPittwillgowhereheispaidthemost.AndhewillbepaidthemostinHollywoodbecausethatiswherehecanaddthemostvalue.

Pricesarelikegiantneonbillboardsthatflashimportantinformation.Atthebeginning of the chapter, we asked how a restaurant on the Rue de Rivoli inParis has just the right amount of tuna onmost nights. It is all about prices.When patrons start ordering more of the sashimi appetizer, the restaurateurplacesalargerorderwithhisfishwholesaler.Iftunaisgrowingmorepopularatother restaurants, too, then the wholesale price will go up, meaning thatfishermensomewhereinthePacificwillgetpaidmorefortheirtunacatchthantheyusedto.Somefishermen,recognizingthattunanowcommandsapremiumoverotherkindsoffish,willstartfishingfortunainsteadofsalmon.Meanwhile,sometunafishermenwillkeeptheirboatsinthewaterlongerorswitchtomoreexpensive fishingmethods that can now be justified by the higher price their

catchwillfetch.Theseguysdon’tcareaboutupscaledinersinParis.Theycareaboutthewholesalepriceoffish.

Money talks. Why are the pharmaceutical companies scouring the rainforestslookingforplantswithrarehealingproperties?Becausetheblockbusterdrugs they may uncover earn staggering amounts of money. Other kinds ofentrepreneurialactivitytakeplaceonasmallerscalebutareequallyimpressiveintheirownway.ForseveralsummersIcoachedaLittleLeaguebaseballteamnearCabriniGreen,which isoneofChicago’s rougherneighborhoods.Oneofour teamcustomswas togooutperiodicallyforpizza,andoneofourfavoritespotswasChester’s,asmallshackatthecornerofDivisionandSedgwickthatwas a testimony to the resiliency and resourcefulness of entrepreneurs. (It hassince been demolished to make way for a new park as part of an aggressivedevelopment of Cabrini Green.) Chester’smade decent pizza andwas alwaysbusy.Thus,itwasbasicallyanarmedrobberywaitingtohappen.Butthatdidnotdeter the management at Chester’s. They merely installed the same kind ofbulletproof glass that one would find at the drive-up window of a bank. Thecustomers placed their money on a small carousel, which was then rotatedthroughagapinthebulletproofglass.Thepizzacameouttheotherdirectiononthesamecarousel.

Profitopportunitiesattractfirmslikesharkstoblood,evenwhenbulletproofglassisrequired.Welookforboldnewwaystomakemoney(creatingthefirstrealityTVshow);failingthat,welooktogetintoabusinessthatismakinghugeprofitsforsomeoneelse(therebycreatingthenexttwentyincreasinglypatheticrealityTVshows).Allthewhile,weareusingpricestogaugewhatconsumerswant.Ofcourse,noteverymarketiseasytoenter.WhenLeBronJamessignedathree-year $60 million contract with the Cleveland Cavaliers, I thought tomyself, “I need to play basketball for theClevelandCavaliers.” Iwould havegladly played for $58 million, or, if pressed, for $58,000. Several thingsprecludedmefromenteringthatmarket,however:(1)I’mfive-ten;(2)I’mslow;and(3)whenshootingunderpressure,Ihaveatendencytomissthebackboard.Why isLeBronJamespaid$20millionayear?Becausenobodyelsecanplaylikehim.Hisunique talentscreateabarrier toentry for the restofus.LeBronJames is also the beneficiary of what University of Chicago labor economistSherwinRosendubbedthe“superstar”phenomenon.Smalldifferencesintalenttend to becomemagnified into huge differentials in pay as amarket becomesvery large, suchas theaudience forprofessionalbasketball.Oneneedonlybeslightlybetterthanthecompetitioninordertogainalarge(andprofitable)share

ofthatmarket.Infact,LeBron’ssalaryischumpchangecomparedtowhattalk-showhost

Rush Limbaugh is now paid. He recently signed an eight-year $400 millioncontractwithClearChannelCommunications, thecompany that syndicateshisradioprogramaroundthecountry.IsRushthatmuchbetterthanotherpoliticalwindbagswillingtooffertheiropinions?Hedoesn’thavetobe.Heneedonlybeatinybitmoreinterestingthanthenextbestradiooptionatthattimeofdayinorder toattractahugeaudience—20million listenersdaily.Nobody tunes intotheir second-favorite radio station, so it’s winner-take-all when it comes tolistenersandtheadvertiserswillingtopaybigbuckstoreachthem.

Manymarketshavebarriersthatpreventnewfirmsfromentering,nomatterhowprofitablemakingwidgetsmaybe.Sometimestherearephysicalornaturalbarriers. Truffles cost $500 a pound because they cannot be cultivated; theygrow only in the wild and must be dug up by truffle-hunting pigs or dogs.Sometimestherearelegalbarrierstoentry.Don’ttrytosellsildenafilcitrateonastreetcorneroryoumayendupinjail.Thisisnotadrugthatyousnortorshootup,norisitillegal.IthappenstobeViagra,andPfizerholdsthepatent,whichisalegalmonopolygrantedbytheU.S.government.Economistsmayquibbleoverhowlongapatentshouldlastorwhatkindsofinnovationsshouldbepatentable,butmostwouldagree that theentrybarriercreatedbyapatent isan importantincentiveforfirmstomakethekindsofinvestmentsthatleadtonewproducts.Thepoliticalprocess creates entrybarriers fordubious reasons, too.When theU.S.autoindustrywasfacingintensecompetitionfromJapaneseautomakersinthe1980s, theAmericancarcompanieshad twobasicoptions: (1)Theycouldcreatebetter,cheaper,morefuel-efficientcarsthatconsumersmightwanttobuy;or (2) they could invest heavily in lobbyistswhowould persuadeCongress toenacttariffsandquotasthatwouldkeepJapanesecarsoutofthemarket.

Some entry barriers are more subtle. The airline industry is far lesscompetitivethanitappearstobe.Youandsomecollegefriendscouldstartanewairline relatively easily; theproblem is thatyouwouldn’t be able to landyourplanes anywhere.There are a limited number of gate spaces available atmostairports, and they tend to be controlled by the big guys.AtChicago’sO’HareAirport, one of theworld’s biggest and busiest airports,American andUnitedcontrolsome80percentofall thegates.6OrconsideradifferentkindofentrybarrierthathasbecomehighlyrelevantintheInternetage:networkeffects.Thebasic idea of a network effect is that the value of some goods rises with thenumberofotherpeopleusingthem.Idon’tthinkMicrosoftWordisparticularly

impressive software, but I own it anyway because I spendmy days e-mailingdocumentstopeoplewhodolikeWord(oratleasttheyuseit).Itwouldbeverydifficulttointroducearivalword-processingpackage—nomatterhowgoodthefeaturesorhowlowtheprice—aslongasmostoftheworldisusingWord.

Meanwhile, firmsarenot just choosingwhatgoodsor services toproducebut also how to produce them. I will never forget stepping off a plane inKathmandu;thefirstthingIsawwasateamofmensquattingontheirhaunchesastheycuttheairportgrassbyhandwithsickles.LaborischeapinNepal;lawnmowersareveryexpensive.Theopposite is truein theUnitedStates,whichiswhywedon’tseemanyteamsoflaborersusingsickles.ItisalsowhywehaveATMsandself-servicegasstationsandthoseterriblyannoyingphonetrees(“Ifyouarenowfrustratedtothepointofviolence,pleasepressthepoundkey”).Allarecaseswherefirmshaveautomatedjobsthatusedtobedonebylivingbeings.After all, oneway to raise profits is by lowering the cost of production. Thatmaymean laying off twenty thousandworkers or building a plant inVietnaminsteadofColorado.

Firms, like consumers, face a staggeringarrayof complex choices.Again,the guiding principle is relatively simple:What is going tomake the firm themostmoneyinthelongrun?

Allofwhichbringsustothepointwhereproducersmeetconsumers.Howmuchareyougoingtopayforthatdoggieinthewindow?Introductoryeconomicshasaverysimpleanswer: themarketprice.This is thatwholesupplyanddemandthing.Thepricewillsettleatthepointwherethenumberofdogsforsaleexactlymatches the number of dogs that consumers want to buy. If there are morepotentialpetownersthandogsavailable,thenthepriceofdogswillgoup.Someconsumerswill thendecide tobuy ferrets instead, and somepet shopswill beinducedbytheprospectofhigherprofitstooffermoredogsforsale.Eventuallythesupplyofdogswillmatchthedemand.Remarkably,somemarketsactuallywork this way. If I choose to sell a hundred shares of Microsoft on theNASDAQ, Ihavenochoicebut toaccept the“marketprice,”which is simplythe price at which the number of Microsoft shares for sale on the exchangeexactlyequalsthenumberofsharesthatbuyerswouldliketopurchase.

Mostmarketsdonot lookquitesomuchlike the textbooks.There isnota“marketprice”forGapsweatshirtsthatchangesbytheminutedependingonthesupplyanddemandofreasonablypricedouterwear.Instead,theGap,likemost

otherfirms,hassomedegreeofmarketpower,whichmeansverysimplythattheGaphassomecontroloverwhatitcancharge.TheGapcouldsellsweatshirtsfor$9.99,ekingoutarazor-thinprofitoneach.Oritcouldsellfarfewersweatshirtsfor $29.99, but make a hefty profit on each. If you were in the mood to docalculusatthemoment,orIhadanyinterestinwritingaboutit,thenwewouldfind theprofit-maximizingprice rightnow. I’mpretty sure I had todo it on afinalexamonce.ThebasicpointisthattheGapwillattempttopickapricethatleads to the quantity of sales that earn the company the most money. Themarketing executives may err either way: They may underprice the items, inwhichcasetheywillsellout;ortheymayoverpricetheitems,inwhichcasetheywillhaveawarehousefullofsweatshirts.

Actually,thereisanotheroption.Afirmcanattempttosellthesameitemtodifferentpeopleatdifferentprices. (Thefancynameis“pricediscrimination.”)Thenexttimeyouareonanairplane,trythisexperiment:Askthepersonnexttoyouhowmuchheorshepaidfortheticket.It’sprobablynotwhatyoupaid;itmaynotevenbeclose.Youaresittingonthesameplane,travelingtothesamedestination,eatingthesamepeanuts—yetthepricesyouandyourrowmatepaidforyourticketsmaynotevenhavethesamenumberofdigits.

Thebasicchallengefortheairlineindustryistoseparatebusinesstravelers,whoarewillingtopayagreatdealforaticket,frompleasuretravelers,whoareontighterbudgets.Ifanairlinesellseveryticketatthesameprice,thecompanywill leave money on the table no matter what price it chooses. A businesstraveler may be willing to pay $1,800 to fly round trip from Chicago to SanFrancisco;someoneflying tocousinIrv’sweddingwillshelloutnomore than$250.Iftheairlinechargesthehighfare,itwillloseallofitspleasuretravelers.Ifitchargesthelowfare,itwilllosealltheprofitsthatbusinesstravelerswouldhave beenwilling to pay.What to do? Learn to distinguish business travelersfrompleasuretravelersandthenchargeeachofthemadifferentfare.

Theairlinesareprettygoodatthis.WhywillyourfaredropsharplyifyoustayoveraSaturdaynight?BecauseSaturdaynightiswhenyouaregoingtobedancingatcousinIrv’swedding.Pleasuretravelersusuallyspendtheweekendattheirdestination,whilebusinesstravelersalmostneverdo.Buyingthetickettwoweeksaheadoftimewillbemuch,muchcheaperthanbuyingitelevenminutesbeforetheflightleaves.Vacationersplanaheadwhilebusinesstravelerstendtobuy tickets at the lastminute.Airlines are themost obvious example of pricediscrimination,butlookaroundandyouwillstarttoseeiteverywhere.AlGorecomplainedduring the2000presidentialcampaign thathismotherandhisdog

weretakingthesamearthritismedicationbutthathismotherpaidmuchmoreforherprescription.Nevermind thathemadeup thestoryafter readingabout thepricing disparity between humans and canines. The example is still perfect.Thereisnothingsurprisingaboutthefactthatthesamemedicinewillbesoldtodogsandpeopleatdifferentprices.It’sairlineseatsalloveragain.Peoplewillpaymore for their ownmedicine than theywill for their pet’s. So the profit-maximizingstrategyistochargeonepriceforpatientswithtwolegsandanotherpriceforpatientswithfour.

Pricediscriminationwillbecomeevenmoreprevalentastechnologyenablesfirms togathermore informationabout theircustomers. It isnowpossible, forexample,tochargedifferentpricestocustomersorderingon-lineratherthanoverthephone.Or,a firmcanchargedifferentprices todifferenton-linecustomersdepending on the pattern of their past purchases. The logic behind firms likePriceline (a website where consumers bid for travel services) is that everycustomer could conceivably pay a different price for an airline ticket or hotelroom.Inanarticleentitled“HowTechnologyTailorsPriceTags,”theWallStreetJournalnoted,“Grocerystoresappeartobethemodelofonepriceforall.Buteven today, they post one price, charge another to shoppers willing to clipcoupons and a third to those with frequent-shopper cards that allow stores tocollectdetaileddataonbuyinghabits.”7

Whatcanweinferfromallofthis?Consumerstrytomakethemselvesaswelloff as possible and firms try tomaximize profits.Those are seemingly simpleconcepts,yettheycantellusatremendousamountabouthowtheworldworks.

Themarketeconomyisapowerfulforceformakingourlivesbetter.Theonlyway firms canmakeprofits is by delivering goods thatwewant to buy.Theycreate new products—everything from thermal coffee mugs to lifesavingantibiotics.Ortheytakeanexistingproductandmakeitcheaperorbetter.Thiskindofcompetition is fabulouslygoodforconsumers. In1900,a three-minutephonecallfromNewYorktoChicagocost$5.45,theequivalentofabout$140today.Now the same call is essentially free if you have amobile phonewithunlimitedminutes.Profitinspiressomeofourgreatestwork,eveninareaslikehighereducation,thearts,andmedicine.HowmanyworldleadersflytoNorth

Koreawhentheyneedopen-heartsurgery?

At the same time, the market is amoral. Not immoral, simply amoral. Themarketrewardsscarcity,whichhasnoinherentrelationtovalue.Diamondsareworththousandsofdollarsacaratwhilewater(ifyouareboldenoughtodrinkitoutofthetap)isnearlyfree.Iftherewerenodiamondsontheplanet,wewouldbeinconvenienced;ifallthewaterdisappeared,wewouldbedead.Themarketdoesnotprovidegoodsthatweneed;itprovidesgoodsthatwewanttobuy.Thisisacrucialdistinction.Ourmedicalsystemdoesnotprovidehealthinsuranceforthe poor. Why? Because they can’t pay for it. Our most talented doctors doprovidebreastenhancementsandface-liftsforHollywoodstars.Why?Becausethey can pay for it. Meanwhile, firms can make a lot of money doing nastythings.WhydoEuropeancrimesyndicateskidnapyounggirlsinEasternEuropeandsellthemintoprostitutioninwealthiercountries?Becauseit’sprofitable.

In fact, criminals are some of the most innovative folks around. Drugtraffickers can make huge profits by transporting cocaine from where it isproduced(inthejunglesofSouthAmerica)towhereitisconsumed(inthecitiesand townsacross theUnitedStates).This is illegal,of course;U.S. authoritiesdevote a great amount of resources to interdicting the supply of such drugsheadedtowardpotentialconsumers.Aswithanyothermarket,drugrunnerswhofindcleverwaysofeludingtheauthoritiesarerewardedwithhugeprofits.

Customs officials are pretty good at sniffing out (literally inmany cases)largecachesofdrugsmovingacross theborder,sodrug traffickers figuredoutthatitwaseasiertoskipthebordercrossingsandmovetheircontrabandacrosstheseaandintotheUnitedStatesusingsmallboats.WhentheU.S.CoastGuardbegan tracking fishing boats, drug traffickers invested in “go fast” boats thatcouldoutruntheauthorities.AndwhenU.S.lawenforcementadoptedradarandhelicopters tohuntdownthespeedboats, thedrugrunners innovatedyetagain,creating the trafficking equivalent of Velcro or the iPhone: homemadesubmarines. In 2006, the Coast Guard stumbled across a forty-nine-footsubmarine—handmade in the junglesofColombia—thatwas invisible to radarandequippedtocarryfourmenandthreetonsofcocaine.In2000,Colombianpolice raidedawarehouseanddiscoveredaone-hundred-footsubmarineunderconstruction thatwould have been able to carry two hundred tons of cocaine.CoastGuardRearAdmiralJosephNimmichtoldtheNewYorkTimes,“Likeanybusiness, if you’re losing more and more of your product, you try to find a

differentway.”8The market is like evolution; it is an extraordinarily powerful force that

derives its strength from rewarding the swift, the strong, and the smart. Thatsaid, it would be wise to remember that two of the most beautifully adaptedspeciesontheplanetaretheratandthecockroach.

Our system uses prices to allocate scarce resources. Since there is a finiteamount of everythingworth having, themost basic function of any economicsystem is to decidewho getswhat.Who gets tickets to the SuperBowl?Thepeoplewhoarewillingtopaythemost.WhohadthebestseatsfortheSupremeSoviet Bowl in the old USSR (assuming some such event existed)? TheindividualschosenbytheCommunistParty.Priceshadnothingtodowithit.IfaMoscow butcher received a new shipment of pork, he slapped on the officialstate price for pork. And if that price was low enough that he had morecustomersthanporkchops,hedidnotraisethepricetoearnsomeextracash.Hemerelysoldthechopstothefirstpeopleinline.Thoseattheendofthelinewereoutofluck.Capitalismandcommunismbothrationgoods.Wedoitwithprices;theSovietsdiditbywaitinginline.(Ofcourse,thecommunistshadmanyblackmarkets;itisquitelikelythatthebutchersoldextraporkchopsillegallyoutthebackdoorofhisshop.)

Because we use price to allocate goods, most markets are self-correcting.Periodically the oil ministers from the OPEC nations will meet in an exoticlocale and agree to limit the global production of oil. Several things happenshortlythereafter:(1)Oilandgaspricesstarttogoup;and(2)politiciansbeginfalling all over themselves with ideas, mostly bad, for intervening in the oilmarket.Buthighpricesarelikeafever;theyarebothasymptomandapotentialcure.WhilepoliticiansarepuffingawayontheHousefloor,someothercrucialthings start to happen. We drive less. We get one heating bill and decide toinsulatetheattic.WegototheFordshowroomandwalkpasttheExpeditionstotheEscorts.

When gas prices approached $4 a gallon in 2008, the rapid response ofAmerican consumers surprised even economists. Americans began buyingsmallercars(SUVsalesplungedwhilesubcompactsalesrose).Wedrovefewer

totalmiles(thefirstmonthlydropin30years).Weclimbedonpublicbusesandtrains,often for the first time; transit ridershipwashigher in2008 thanat anytimesincethecreationoftheinterstatehighwaysystemfivedecadesearlier.9

Not all such behavioral changes were healthy.Many consumers switchedfromcarstomotorcycles,whicharemorefuelefficientbutalsomoredangerous.Afterfallingsteadilyforyears,thenumberofU.S.motorcycledeathsbegantoriseinthemid-1990s,justasgaspricesbegantoclimb.AstudyintheAmericanJournalofPublicHealthestimatedthatevery$1increaseinthepriceofgasolineisassociatedwithanadditional1,500motorcycledeathsannually.10

Highoilpricescause things tostarthappeningon thesupplyside, too.OilproducersoutsideofOPECstartpumpingmoreoiltotakeadvantageofthehighprice; indeed, the OPEC countries usually begin cheating on their ownproductionquotas.Domestic oil companies beginpumpingoil fromwells thatwerenoteconomicalwhenthepriceofpetroleumwaslow.Meanwhile,alotofverysmartpeoplebeginworkingmoreseriouslyonfindingandcommercializingalternativesourcesofenergy.Thepriceofoilandgasolinebeginstodriftdownassupplyrisesanddemandfalls.

Ifwefixpricesinamarketsystem,privatefirmswillfindsomeotherwaytocompete.Consumersoftenlookbacknostalgicallyatthe“earlydays”ofairplanetravel,when the foodwas good, the seatswere bigger, and people dressed upwhentheytraveled.Thisisnotjustnostalgiaspeaking;thequalityofcoachairtravelhasfallensharply.Butthepriceofairtravelhasfallenevenfaster.Priorto1978,airline fareswere fixedby thegovernment.Every flight fromDenver toChicago cost the same, but American and United were still competing forcustomers.Theyusedqualitytodistinguishthemselves.Whentheindustrywasderegulated, price became the primary margin for competition, presumablybecausethatiswhatconsumerscaremoreabout.Sincethen,everythingrelatedtobeing inornearanairplanehasbecome lesspleasant,but theaverage fare,adjustedforinflation,hasfallenbynearlyhalf.

In 1995, I was traveling across South Africa, and I was struck by theremarkableserviceatthegasstationsalongtheway.Theattendants,dressedinsharpuniforms,oftenwithbowties,wouldscurryouttofillthetank,checktheoil,andwipethewindshield.Thebathroomswerespotless—afarcryfromsomeof the scary things I’ve seen driving across theUSA.Was there some specialservicestationmentalityinSouthAfrica?No.Thepriceofgasolinewasfixedby

thegovernment.So service stations,whichwere stillprivate firms, resorted tobowtiesandcleanbathroomstoattractcustomers.

Everymarkettransactionmakesallpartiesbetteroff.Firmsareactingintheirownbestinterests,andsoareconsumers.Thisisasimpleideathathasenormouspower.Consideraninflammatoryexample:TheproblemwithAsiansweatshopsisthattherearenotenoughofthem.Adultworkerstakejobsintheseunpleasant,low-wage manufacturing facilities voluntarily. (I am not writing about forcedlabor or child labor, both ofwhich are different cases.) So one of two thingsmustbetrue.Either(1)workerstakeunpleasantjobsinsweatshopsbecauseitisthe best employment option they have; or (2) Asian sweatshop workers arepersonsofweakintellectwhohavemanymoreattractivejoboffersbutchoosetoworkinsweatshopsinstead.

Most arguments against globalization implicitly assume number two. Theprotesters smashing windows in Seattle were trying to make the case thatworkersinthedevelopingworldwouldbebetteroffifwecurtailedinternationaltrade, therebyclosingdownthesweatshops thatchurnoutshoesandhandbagsforthoseofusinthedevelopedworld.Buthowexactlydoesthatmakeworkersinpoorcountriesbetteroff?Itdoesnotcreateanynewopportunities.Theonlywayitcouldpossiblyimprovesocialwelfareisiffiredsweatshopworkerstakenew, better jobs—opportunities they presumably ignored when they went toworkinasweatshop.WhenwasthelasttimeaplantclosingintheUnitedStateswashailedasgoodnewsforitsworkers?

SweatshopsarenastyplacesbyWesternstandards.Andyes,onemightarguethatNikeshouldpayitsforeignworkersbetterwagesoutofsheeraltruism.Buttheyareasymptomofpoverty,notacause.Nikepaysatypicalworkerinoneofits Vietnamese factories roughly $600 a year. That is a pathetic amount ofmoney. It also happens to be twice an average Vietnamese worker’s annualincome.11 Indeed, sweatshops played an important role in the development ofcountrieslikeSouthKoreaandTaiwan,aswewillexploreinChapter12.

Giventhateconomicsisbuiltupontheassumptionthathumansactconsistentlyin ways that make themselves better off, one might reasonably ask: Are wereallythatrational?Notalways,itturnsout.Oneofthefiercestassaultsonthe

notion of “strict rationality” comes from a seemingly silly observation.EconomistRichardThalerhostedadinnerpartyyearsagoatwhichheservedabowlofcashewsbeforethemeal.Henoticedthathisguestswerewolfingdownthenutsatsuchapacethattheywouldlikelyspoiltheirappetitefordinner.SoThalertookthebowlofnutsaway,atwhichpointhisgueststhankedhim.12

Believe it or not, this little vignette exposes a fault in the basic tenets ofmicroeconomics: In theory, it should never be possible to make rationalindividualsbetteroffbydenying themsomeoption.Peoplewhodon’twant toeattoomanycashewsshouldjuststopeatingcashews.Buttheydon’t.Andthatfinding turns out to have implications far beyond salted nuts. For example, ifhumanslacktheself-disciplinetodothingsthattheyknowwillmakethemselvesbetteroffinthelongrun(e.g.,loseweight,stopsmoking,orsaveforretirement),then society could conceivablymake them better off by helping (or coercing)themtodothingstheyotherwisewouldnotorcouldnotdo—thepublicpolicyequivalentoftakingthecashewbowlaway.

The field of behavioral economics has evolved as a marriage betweenpsychology and economics that offers sophisticated insight into how humansreallymake decisions. Daniel Kahneman, a professor in both psychology andpublicaffairsatPrinceton,wasawardedtheNobelPrizeinEconomicsin2002for his studies of decisionmaking under uncertainty, and, in particular, “howhuman decisions may systematically depart from those predicted by standardeconomictheory.”13

Kahnemanandothershaveadvanced theconceptof“boundedrationality,”whichsuggeststhatmostofusmakedecisionsusingintuitionorrulesofthumb,kindoflikelookingattheskytodetermineifitwillrain,ratherthanspendinghours poring over weather forecasts. Most of the time, this works just fine.Sometimes it doesn’t. The behavioral economists study ways in which theserulesofthumbmayleadustodothingsthatdiminishourutilityinthelongrun.

For example, individualsdon’t alwayshaveaparticularly refined senseofriskandprobability.ThispointwasbroughthometomerecentlyasIadmiredalargeHarleyDavidsonmotorcycleparkedonasidewalk inNewHampshire (astatethatdoesnotrequiremotorcyclehelmets).Theownerambledupandsaid,“Doyouwanttobuyit?”Irepliedthatmotorcyclesarealittletoodangerousforme,towhichheexclaimed,“You’rewillingtoflyonaplane,aren’tyou!”

In fact, ridingamotorcycle is2,000 timesmoredangerous than flying foreverykilometertraveled.That’snotanentirelyfaircomparisonsincemotorcycletripstendtobemuchshorter.Still,anygivenmotorcyclejourney,regardlessof

length, is 14 times more likely to end in death than any trip by plane.Conventional economics makes clear that some people will ride motorcycles(withorwithouthelmets)becausetheutilitytheygetfromgoingfastonatwowheeleroutweighstheriskstheyincurintheprocess.That’sperfectlyrational.Butifthepersonmakingthatdecisiondoesn’tunderstandthetrueriskinvolved,thenitmaynotbearationaltrade-offafterall.

Behavorial economics has developed a catalog of these kinds of potentialerrors,manyofwhich are an obvious part of everyday life.Manyof us don’thavealltheself-controlthatwewouldlike.EightypercentofAmericansmokerssaytheywanttoquit;mostofthemdon’t.(ReportsfrominsidetheWhiteHousesuggested that President Obama was still trying to kick the habit even aftermovinginto theOvalOffice.)Someveryprominenteconomists, includingoneNobel Prize winner, have argued for decades that there is such a thing as“rational addiction,” meaning that individuals will take into account thelikelihood of addiction and all its future costs when buying that first pack ofCamels. MIT economist Jonathan Gruber, who has studied smoking behaviorextensively, thinks that is nonsense.He argues that consumers don’t rationallyweigh thebenefits of smoking enjoyment against futurehealth risks andothercosts, as the standard economicmodel assumes.Gruberwrites, “Themodel ispredicated on a description of the smoking decision that is at odds withlaboratoryevidence,thebehaviorofsmokers,econometric[statistical]analysis,andcommonsense.”14

Wemayalsolackthebasicknowledgenecessarytomakesensibledecisionsin some situations. Annamaria Lusardi of Dartmouth College and OliviaMitchell of theWharton School at theUniversity of Pennsylvania surveyed alargesampleofAmericansovertheageoffiftytogaugetheirfinancialliteracy.Onlyathirdcoulddosimpleinterestratecalculations;mostdidnotunderstandthe concept of investmentdiversification. (If youdon’t knowwhat thatmeanseither, you will after reading Chapter 7.) Based on her research, ProfessorLusardihasconcludedthat“financialilliteracy”iswidespread.15

Thesearenotmerelyesotericfunfactsthatpipe-smokingacademicsliketokickaroundinthefacultylounge.Baddecisionscanhavebadoutcomes—forallofus.Theglobalfinancialcrisisarguablyhasitsrootsinirrationalbehavior.Oneofourbehavioral“rulesofthumb”ashumansistoseepatternsinwhatisreallyrandomness; as a result, we assume that whatever is happening now willcontinuetohappenin thefuture,evenwhendata,probability,orbasicanalysissuggestthecontrary.Acointhatcomesupheadsfourtimesinarowis“lucky”a

basketballplayerwhohashitthreeshotsinarowhasa“hothand.”Ateamofcognitivepsychologistsmadeoneoftheenduringcontributionsto

this field by disproving the “hot hand” in basketball using NBA data and byconductingexperimentswiththeCornellvarsitymen’sandwomen’sbasketballteams. (This is the rare academic paper that includes interviews with thePhiladelphia76ers.)Ninety-onepercentofbasketballfansbelievethataplayerhas“abetterchanceofmakingashotafterhavingjustmadehislasttwoorthreeshotsthanhedoesafterhavingjustmissedhislasttwoorthreeshots.”Infact,there is no evidence that aplayer’s chancesofmaking a shot aregreater aftermakingapreviousshot—notwithfieldgoalsforthe76ers,notwithfreethrowsfor theBostonCeltics, andnotwhenCornell players shot baskets aspart of acontrolledexperiment.16

Basketball fans are surprised by that—just as many homeowners weresurprisedin2006whenrealestatepricesstoppedgoingup.Lotsofpeoplehadborrowedalotofmoneyontheassumptionthatwhatgoesupmustkeepgoingup; the result has been a wave of foreclosures with devastating ripple effectsthroughouttheglobaleconomy—whichisaheckofalotmoresignificantthaneating toomanycashews.Chapter3discusseswhat, if anything,publicpolicyoughttodoaboutourirrationaltendencies.

AsJohnF.Kennedyfamouslyremarked,“Lifeisnotfair.”Neitheriscapitalisminsomeimportantrespects.Isitagoodsystem?

Iwill argue that amarket economy is to economicswhat democracy is togovernment:adecent, ifflawed,choiceamongmanybadalternatives.Marketsare consistent with our views of individual liberty. We may disagree overwhetheror not thegovernment should compelus towearmotorcyclehelmets,butmostofusagreethatthestateshouldnottelluswheretolive,whattodofora living, or how to spend our money. True, there is no way to rationalizespendingmoney on a birthday cake formy dogwhen the samemoney couldhave vaccinated several African children. But any system that forces me tospend money on vaccines instead of doggy birthday cakes can only be heldtogether by oppression. The communist governments of the twentieth centurycontrolled their economies by controlling their citizens’ lives. They oftenwrecked both in the process. During the twentieth century, communistgovernmentskilledsome100millionoftheirownpeopleinpeacetime,eitherbyrepressionorbyfamine.

Marketsareconsistentwithhumannatureandthereforewildlysuccessfulatmotivating us to reach our potential. I amwriting this book because I love towrite.IamwritingthisbookbecauseIbelievethateconomicswillbeinterestingtolayreaders.AndIamwritingthisbookbecauseIreallywantasummerhomeinNewHampshire.Weworkharderwhenwebenefit directly fromourwork,andthathardworkoftenyieldssignificantsocialgains.

Last and most important, we can and should use government to modifymarketsinallkindsofways.Theeconomicbattleofthetwentiethcenturywasbetweencapitalismandcommunism.Capitalismwon.Evenmy leftist brother-in-lawdoesnotbelieve incollective farmingorgovernment-owned steelmills(thoughhedidoncesaythathewouldliketoseeahealthcaresystemmodeledafter theU.S.PostOffice).On theotherhand, reasonablepeople candisagreesharply overwhen and how the government should involve itself in amarketeconomyorwhatkindofsafetynetweshouldoffer to thosewhomcapitalismtreatsbadly.Theeconomicbattlesof the twenty-firstcenturywillbeoverhowunfetteredourmarketsshouldbe.

CHAPTER2

IncentivesMatter:

Whyyoumightbeabletosaveyourfacebycuttingoffyournose(ifyouareablackrhinoceros)

Theblackrhinocerosisoneofthemostendangeredspeciesontheplanet.Some4,000ofthemroamsouthernAfrica,downfromabout65,000in1970.Thisisanecologicaldisasterinthemaking.Itisalsoasituationinwhichbasiceconomicscantelluswhythespeciesisinsuchtrouble—andperhapsevenwhatwecandoaboutit.

Why do people kill black rhinos? For the same reason they sell drugs orcheatontheirtaxes.Becausetheycanmakealotofmoneyrelativetotheriskofgettingcaught.InmanyAsiancountries,thehornoftheblackrhinoisbelievedto be a powerful aphrodisiac and fever reducer. It is also used to make thehandles on traditionalYemenese daggers.As a result, a single rhino horn canfetch$30,000ontheblackmarket—aprincelysumincountrieswherepercapitaincome is around$1,000ayear and falling. Inotherwords, theblack rhino isworthfarmoredeadthanalivetothepeopleofimpoverishedsouthernAfrica.

Sadly, this is a market that does not naturally correct itself. Unlikeautomobilesorpersonalcomputers,firmscan’tproducenewblackrhinosastheysee the supply dwindling. Indeed, quite the opposite force is at work; as theblackrhinobecomesmoreandmoreimperiled,theblackmarketpriceforrhinohorn rises, providing even more incentive for poachers to hunt down theremaininganimals.Thisviciouscircle iscompoundedbyanotheraspectof thesituationthat iscommontomanyenvironmentalchallenges:Mostblackrhinosarecommunalpropertyratherthanprivateproperty.Thatmaysoundwonderful.Infact,itcreatesmoreconservationproblemsthanitsolves.Imaginethatallofthe black rhinoswere in the hands of a single avaricious rancherwho had noqualmsaboutmakingrhinohornsintoYemenesedaggers.Thisrancherhasnotasingle environmental bone in his body. Indeed, he is somean and selfish that

sometimeshekickshisdogjustbecauseitgiveshimutility.Wouldthisogreofarhinorancherhavelethisherdfallfrom65,000to4,000inthirtyyears?Never.Hewouldhavebredandprotectedtheanimalssothathewouldalwayshavealarge supply of horns to ship off tomarket—much as cattle ranchersmanagetheir herds.This has nothing to dowith altruism; it has everything to dowithmaximizingthevalueofascarceresource.

Communal resources, on the other hand, present some unique problems.First,thevillagerswholiveincloseproximitytothesemajesticanimalsusuallyderivenobenefit fromhaving themaround.Tothecontrary, largeanimals likerhinosandelephantscancausemassivedamagetocrops.Toputyourselfintheshoesoflocalvillagers,imaginethatthepeopleofAfricasuddenlytookakeeninterestinthefutureoftheNorthAmericanbrownratandthatacrucialpieceoftheconservationstrategyinvolvedlettingthesecreaturesliveandbreedinyourhouse.Furtherimaginethatapoachercamealongandofferedyoucashtoshowhim where the rats were nesting in your basement. Hmm. True, millions ofpeople around theworld derive utility from conserving species like the blackrhinoorthemountaingorilla.Butthatcanactuallybepartoftheproblem;itiseasytobea“freerider”andletsomeoneelse,orsomeotherorganization,dothework. Last year, howmuch time andmoney did you contribute to preservingendangeredspecies?

Tourandsafarioperators,whodomakealotofmoneybybringingwealthytourists to see rare wildlife, face a similar “free rider” problem. If one tourcompanyinvestsheavily inconservation,other tourcompanies thathavemadenosuchinvestmentstillenjoyallthebenefitsoftherhinosthathavebeensaved.So the firm that spends money on conservation actually suffers a costdisadvantageinthemarket.Theirtourswillhavetobemoreexpensive(ortheywillhavetoacceptalowerprofitmargin)inordertorecouptheirconservationinvestment.Obviouslythereisaroleforgovernmenthere.Butthegovernmentsinsub-SaharanAfricaarelowonresourcesatbestandcorruptanddysfunctionalatworst.Theonepartywhohasaclearandpowerful incentive is thepoacher,whomakesaking’sransombyhuntingdowntheremainingrhinos,killingthem,andthensawingofftheirhorns.

This is pretty depressing stuff. But economics also offers at least someinsightintohowtheblackrhinoandotherendangeredspeciescanbesaved.Aneffectiveconservationstrategymustproperlyaligntheincentivesof thepeoplewho live in or near the black rhino’s natural habitat. Translation: Give localpeople some reason to want the animals alive rather than dead. This is the

premiseofthebuddingeco-tourismindustry.Iftouristsarewillingtopaygreatamountsofmoneytospotandphotographblackrhinos,and,moreimportant,iflocal citizens somehow share the profits from this tourism, then the localpopulationhasalargeincentivetokeepsuchanimalsalive.Thishasworkedinplaces like Costa Rica, a country that has protected its rain forests and otherecological features by setting aside more than 25 percent of the country asnational parks. Tourism currently generates over $1 billion in annual revenue,accountingfor11percentofthenationalincome.1

Sadly, thisprocess isworking in reverseat themomentwith themountaingorilla, another seriously endangered species (made famous by Dian Fossey,authorofGorillasintheMist).Itisestimatedthatonly620mountaingorillasareleft in the dense jungles of East Africa. But the countries that make up thisregion—Uganda, Rwanda, Burundi, and Congo—are embroiled in a series ofcivilwars that havedevastated the tourism trade. In thepast, local inhabitantshavepreservedthegorillas’habitatnotbecausetheyhaveanygreatrespectforthemountaingorilla,butbecausetheycanmakemoremoneyfromtouriststhantheycanbychoppingdown the forests thatmakeup thegorillas’habitat.Thathaschangedastheviolenceintheregiongrindson.OnelocalmantoldtheNewYorkTimes,“[Thegorillas]areimportantwhentheybringintourists.Ifnot,theyarenot.Ifthetouristsdon’tcome,wewilltryourluckintheforest.Beforethis,weweregoodtimbercutters.”2

Meanwhile,conservationofficialsareexperimentingwithanother idea thatis about as basic as economics can be. Black rhinos are killed because theirhorns fetch a princely sum. If there is no horn, then presumably there is noreason to poach the animals. Thus, some conservation officials have begun tocaptureblackrhinos,sawofftheirhorns,andthenreleasetheanimalsbackintothe wild. The rhinos are left mildly disadvantaged relative to some of theirpredators,buttheyarelesslikelytobehunteddownbytheirmostdeadlyenemy,man. Has it worked? The evidence is mixed. In some cases, poachers havecontinuedtokilldehornedrhinos,foranumberofpossiblereasons.Killingtheanimalswithouthornssavesthepoachersfromwastingtimetrackingthesameanimalagain.Also,thereissomemoneytobemadefromremovingandsellingeventhestumpofthehorn.And,sadly,deadrhinos,evenwithouthorns,makethespeciesmoreendangered,whichdrivesupthevalueofexistinghornstocks.

Allofthisignoresthedemandsideoftheequation.Shouldweallowtradeinproducts made from endangered species?Most would say no. Making rhino-horn daggers illegal in countries like the United States lowers the overall

demand,whichdiminishestheincentiveforpoacherstohuntdowntheanimals.Atthesametime,thereisacredibledissentingview.Someconservationofficialsargue that selling a limited amount of rhino horn (or ivory, in the case ofelephants) that has been legally stockpiledwould have two beneficial effects.First, itwould raisemoney tohelpstrappedgovernmentspay forantipoachingefforts. Second, it would lower the market price for these illicit items andthereforediminishtheincentivetopoachtheanimals.

Aswith any complex policy issue, there is no right answer, but there aresomewaysof approaching theproblem that aremore fruitful thanothers.Thepointisthatprotectingtheblackrhinoisatleastasmuchabouteconomicsasitis about science.We know how the black rhino breeds,what it eats,where itlives.Whatweneed to figureout ishow to stophumanbeings fromshootingthem.Thatrequiresanunderstandingofhowhumansbehave,notblackrhinos.

Incentives matter.When we are paid on commission, we work harder; if thepriceofgasolinegoesup,wedriveless;ifmythree-year-olddaughterlearnsthatshewillgetanOreoifshecrieswhileI’mtalkingonthephone,thenshewillcrywhileIamtalkingonthephone.ThiswasoneofAdamSmith’sinsightsinTheWealthofNations:“Itisnotfromthebenevolenceofthebutcher,thebrewer,orthebakerthatweexpectourdinner,butfromtheirregardtotheirowninterest.”BillGatesdidnotdropoutofHarvardtojointhePeaceCorps;hedroppedouttofound Microsoft, which made him one of the richest men on the planet andlaunched the personal computer revolution in the process—making all of usbetter off, too. Self-interestmakes theworld go around, a point that seems soobvious as to be silly.Yet it is routinely ignored. The old slogan “From eachaccordingtohisabilities,toeachaccordingtohisneeds”madeawonderfulfolksong;asaneconomicsystem,ithasledtoeverythingfrominefficiencytomassstarvation.Inanysystemthatdoesnotrelyonmarkets,personalincentivesareusually divorced from productivity. Firms and workers are not rewarded forinnovationandhardwork,noraretheypunishedforslothandinefficiency.

How bad can it get? Economists reckon that by the time the BerlinWallcrumbled, some East German car factories were actually destroying value.Because themanufacturingprocesswasso inefficientand theendproductwasso shoddy, the plants were producing cars worth less than the inputs used tomakethem.Basically,theytookperfectlygoodsteelandruinedit!Thesekindsof inefficiencies can also exist in nominally capitalist countries where large

sectorsof theeconomyareownedandoperatedbythestate,suchasIndia.By1991,theHindustanFertilizerCorporationhadbeenupandrunningfortwelveyears.3Everyday,twelvehundredemployeesreportedtoworkwiththeavowedgoal of producing fertilizer. Therewas just one small complication:The planthad never actually produced any salable fertilizer. None. Governmentbureaucrats ran the plant using public funds; themachinery thatwas installednever worked properly. Nevertheless, twelve hundred workers came to workevery day and the government continued to pay their salaries. The entireenterprise was an industrial charade. It limped along because there was nomechanism to force it to shut down. When government is bankrolling thebusiness,thereisnoneedtoproducesomethingandthensellitformorethanitcosttomake.

Theseexamples seem funny in theirownway,but theyaren’t.Rightnow,the North Korean economy is in such shambles that the country cannot feeditself,nordoesitproduceanythingvaluableenoughtotradetotheoutsideworldin exchange for significant quantities of food. The nation is on the brink offamine, according to diplomats,UnitedNations officials, and other observers.Thismassstarvationwouldbeatragicrepeatofthe1990s,whenfaminekilledsomethingontheorderofamillionpeopleandleft60percentofNorthKoreanchildren malnourished. Journalists described starving people eating grass andscouring railroad tracks for bits of coal or food that may have fallen frompassingtrains.

In the United States, there is a great deal of hand-wringing about twoenergy-related issues: our dependence on foreign oil and the environmentalimpactofCO2emissions.Toeconomists, thefixfortheseinterrelatedissuesisas close to a no-brainer as we ever get: Make carbon-based energy moreexpensive. If it costsmore,wewilluse less—and thereforepollute less, too. Ihavepowerfulchildhoodmemoriesofmyfather,whohasnogreataffectionfortheenvironmentbutcouldsqueezeanickeloutofastone, stalkingaround thehouse closing the closet doors and telling us that he was not paying to air-conditionourclosets.

Meanwhile,AmericanpubliceducationoperatesalotmorelikeNorthKoreathanSiliconValley. Iwill notwade into the school voucher debate, but Iwilldiscussone strikingphenomenon related to incentives ineducation that IhavewrittenaboutforTheEconomist.4ThepayofAmericanteachersisnotlinkedinanywaytoperformance;teachers’unionshaveconsistentlyopposedanykindofmeritpay. Instead,salaries innearlyeverypublicschooldistrict in thecountry

aredeterminedbyarigidformulabasedonexperienceandyearsofschooling,factors that researchershavefoundtobegenerallyunrelated toperformance intheclassroom.Thisuniformpayscalecreatesasetofincentivesthateconomistsrefer toasadverseselection.Sincethemost talentedteachersarealsolikelytobegoodatotherprofessions,theyhaveastrongincentivetoleaveeducationforjobsinwhichpayismorecloselylinkedtoproductivity.Fortheleast talented,theincentivesarejusttheopposite.

Thetheoryisinteresting;thedataareamazing.Whentestscoresareusedasaproxyforability,thebrightestindividualsshuntheteachingprofessionateveryjuncture. The brightest students are the least likely to choose education as acollegemajor.Amongstudentswhodomajorineducation,thosewithhighertestscores are less likely to become teachers. And among individuals who enterteaching, those with the highest test scores are the most likely to leave theprofession early. None of this proves that America’s teachers are being paidenough.Manyof themarenot, especially thosegifted individualswho stay inthe profession because they love it. But the general problem remains: Anysystemthatpaysall teachers thesameprovidesastrongincentivefor themosttalentedamongthemtolookforworkelsewhere.

Humanbeingsarecomplexcreatureswhoaregoingtodowhateverittakestomakethemselvesaswelloffaspossible.Sometimesitiseasytopredicthowthatwillunfold;sometimesitisenormouslycomplex.Economistsoftenspeakof“perverse incentives,”which are the inadvertent incentives that canbe createdwhenwesetout todosomethingcompletelydifferent.Inpolicycircles, this issometimes called the “law of unintended consequences.” Consider a well-intentionedproposaltorequirethatallinfantsandsmallchildrenberestrainedincarseatswhileflyingoncommercialairlines.DuringtheClintonadministration,FAA administrator Jane Garvey told a safety conference that her agency wascommitted to “ensuring that children are accorded the same level of safety inaircraft as are adults.” James Hall, chairman of the National TransportationSafetyBoard at the time, lamented that luggage had to be stowed for takeoffwhile “themost precious cargoon that aircraft, infants and toddlers,were leftunrestrained.”5GarveyandHallcitedseveralcasesinwhichinfantsmighthavesurvivedcrasheshadtheybeenrestrained.Thus,requiringcarseatsforchildrenonplaneswouldpreventinjuriesandsavelives.

Orwouldit?Usingacarseatrequiresthatafamilybuyanextraseatontheplane,whichdramatically increases thecostof flying.Airlinesno longeroffersignificant children’sdiscounts; a seat is a seat, and it is likely tocost at least

several hundred dollars.As a result, some familieswill choose to drive ratherthanfly.Yetdriving—evenwithacarseat—isdramaticallymoredangerousthanflying.Asaresult,requiringcarseatsonplanesmightresultinmoreinjuriesanddeathstochildren(andadults),notfewer.

Consider another example inwhich good intentions led to a bad outcomebecausetheincentiveswerenotfullyanticipated.MexicoCityisoneofthemostpollutedcitiesintheworld;thefoulairtrappedoverthecitybythesurroundingmountains and volcanoes has been described by the New York Times as “agrayish-yellow pudding of pollutants.”6 Beginning in 1989, the governmentlaunchedaprogramtofightthispollution,muchofwhichiscausedbyautoandtruckemissions.Anewlawrequiredthatallcarsstayoff thestreetsonedayaweekonarotatingbasis(e.g.,carswithcertainlicenseplatenumberscouldnotbedrivenonTuesday).Thelogicoftheplanwasstraightforward:Fewercarsontheroadwouldleadtolessairpollution.

Sowhatreallyhappened?Aswouldbeexpected,manypeopledidnotlikethe inconvenienceofhaving their drivingdays limited.They reacted in awaythat analysts might have predicted but did not. Families who could afford asecondcarboughtone,orsimplykepttheiroldcarwhenbuyinganewone,sothattheywouldalwayshaveonecarthatcouldbedrivenonanygivenday.Thisproved tobeworse foremissions thannopolicyatall, since theproportionofold cars on the roadwent up, and old cars are dirtier than new cars. The neteffectofthepolicychangewastoputmorepollutingcarsontheroad,notfewer.Subsequent studies found that overall gas consumption had increased and airquality did not improve at all. The policy was later dropped in favor of amandatoryemissionstest.7

Goodpolicyusesincentivestosomepositiveend.Londonhasdealtwithitstrafficcongestionproblemsbyapplyingthelogicofthemarket:Itraisedthecostof driving during the hours of peak demand. Beginning in 2003, the city ofLondonbegancharginga£5($8)congestionfeeforalldriversenteringaneight-square-milesectionofthecentralcitybetween7:00a.m.and6:30p.m.8In2005,thecongestionchargewasraisedto£8($13),andin2007,thesizeofthezoneforwhichthefeemustbepaidwasexpanded.Driversareresponsibleforpayingthe charge by phone, Internet, or in selected retail shops.Video cameraswereinstalledinsome700locationstoscanlicenseplatesandmatchthedataagainstrecords of motorists who have paid the charge. Motorists caught driving incentralLondonwithoutpayingthefeearefined£80($130).

Theplanwasdesignedtotakeadvantageofoneofthemostbasicfeaturesof

markets:Raisingpricesreducesdemand.Raisingthecostofdrivingdiscouragessomedriversandimprovestheflowoftraffic.Expertsalsopredictedanincreaseintheuseofpublictransit,bothbecauseitisacheapalternativetodriving,butalsobecausebuseswouldbeabletomovemorequicklythroughcentralLondon.(Fastertripslowertheopportunitycostoftakingpublictransit.)Withinamonth,theresultswerestriking.Trafficfell20percent(settlingafterseveralyearsat15percentlower).Averagespeedinthecongestionzonedoubled;busdelayswerecut in half; and the number of bus passengers climbed 14 percent. The onlyunpleasantsurprisewasthattheprogramhadsuchasignificantdeterrenteffecton car traffic that revenues from the feewere lower than expected.9 Retailershave also complained that the fee discourages shoppers from visiting centralLondon.

Good policy uses incentives to channel behavior toward some desiredoutcome.Badpolicyeitherignoresincentives,orfailstoanticipatehowrationalindividualsmightchangetheirbehaviortoavoidbeingpenalized.

Thewonder of the private sector, of course, is that incentivesmagically alignthemselves in away thatmakes everyone better off.Right?Well, not exactly.From top to bottom, corporate America is a cesspool of competing andmisaligned incentives.Haveyouever seen somevariationof the signnear thecashregisteratafast-foodrestaurant thatsays,“Yourmeal isfreeifyoudon’tget a receipt. Please see a manager”? Does Burger King have a passionateinterestinprovidingareceiptsothatyourfamilybookkeepingwillbecomplete?Ofcoursenot.BurgerKingdoesnotwantitsemployeesstealing.Andtheonlyway employees can stealwithout getting caught is by performing transactionswithout recording them on the cash register—selling you a burger and frieswithout issuinga receiptand thenpocketing thecash.This iswhateconomistscall a principal-agent problem. The principal (BurgerKing) employs an agent(thecashier)whohasanincentivetodoalotofthingsthatarenotnecessarilyinthe best interest of the firm. Burger King can either spend a lot of time andmoneymonitoringitsemployeesfortheft,oritcanprovideanincentiveforyoutodoitforthem.Thatlittlesignbythecashregisterisaningeniousmanagementtool.

Principal-agent problems are as much a problem at the top of corporateAmerica as they are at the bottom, in large part because the agents who runAmerica’s large corporations (CEOs and other top executives) are not

necessarily the principalswhoown those companies (the shareholders). I ownsharesinStarbucks,butIdon’tevenknowtheCEO’sname.HowcanIbesurethathe (she?) isacting inmybest interest? Indeed, there isampleevidence tosuggest that corporatemanagers are no different fromBurgerKing cashiers—they have some incentives that are not always in the best interest of the firm.Theymaystealfromthecashregisterfigurativelybyshoweringthemselveswithprivatejetsandcountryclubmemberships.Ortheymaymakestrategicdecisionsfromwhichtheybenefitbutshareholdersdonot.Forexample,ashockingtwo-thirdsofallcorporatemergersdonotaddvaluetothemergedfirmsandathirdof themleaveshareholdersworseoff.WhywouldverysmartCEOsengagesoofteninbehaviorthatseemstomakelittlefinancialsense?

One partial answer, economists have argued, is that CEOs benefit frommergers even when shareholders are left with losses. A CEO draws a lot ofattention tohimselfbyengineeringa complexcorporate transaction.He is leftrunningabiggercompany,whichisalmostalwaysmoreprestigious,evenifthenewentityislessprofitablethanthemergedcompanieswerewhentheywereontheirown.Bigcompanieshavebigoffices,bigsalaries,andbigairplanes.Ontheother hand, some mergers and takeovers make perfect strategic sense. As anuninformed shareholderwith a large financial stake in the company, howdo Itellthedifference?IfIdon’tevenknowthenameoftheCEOofStarbucks,howcanIbesurethatshe(he?)isnotspendingthebulkofherdaychasingattractivesecretariesaroundheroffice?Hell,thisisharderthanbeingamanageratBurgerKing.

Fora time,clevereconomistsbelieved that stockoptionswere theanswer.TheyweresupposedtobetheCEOequivalentofthesignnearthecashregisteraskingifyoureceivedyourreceipt.MostAmericanCEOsandother importantexecutives receive a large share of their compensation in the form of stockoptions.Theseoptionsenable therecipient topurchase thecompany’sstock inthe future at some predetermined price, say $10. If the company is highlyprofitableandthestockdoeswell,climbingtosay$57,thenthosestockoptionsare very valuable. (It is good to be able to buy something for $10when it issellingontheopenmarketfor$57.)Ontheotherhand,ifthecompany’sstockfallsto$7,theoptionsareworthless.Thereisnopointinbuyingsomethingfor$10 when you can buy it on the open market for $3 less. The point of thiscompensationschemeistoaligntheincentivesoftheCEOwiththeinterestsofthe shareholders. If the share price goes up, the CEO gets rich—but theshareholdersdowell,too.

ItturnsoutthatwilyCEOscanfindwaystoabusetheoptionsgame(justascashierscanfindnewwaystostealfromtheregister).Beforethefirsteditionofthis book came out, I asked Paul Volcker, former chairman of the FederalReserve,togiveitareadsincehehadbeenaprofessorofmine.Volckerreadthebook.Helikedthebook.ButhesaidthatIshouldnothavewrittenadmiringlyabout stock options as a tool for aligning the interests of shareholders andmanagementbecausetheyare“aninstrumentofthedevil.”

PaulVolckerwasright.Iwaswrong.Thepotentialproblemwithoptionsisthatexecutivescandothingstogoosethefirm’sstockintheshortrunthatarebadordisastrousforthecompanyinthelongrun—aftertheCEOhassoldtensof thousands of options for an astronomical profit.Michael Jensen, aHarvardBusiness School professor who has spent his career on issues related tomanagementincentives,isevenharsherthanPaulVolcker.Hedescribesoptionsas “managerial heroin,”because they create an incentive formanagers to seekshort-termhighswhiledoingenormouslong-termdamage.10Studieshavefoundthatcompanieswithlargeoptionsgrantsaremorelikelytoengageinaccountingfraudandmorelikelytodefaultontheirdebt.11

Meanwhile, CEOs (with or without options) have their own monitoringheadaches. Investment banks like Lehman Brothers and Bear Stearns wereliterallydestroyedbyemployeeswhotookhugerisksatthefirm’sexpense.Thisisacrucial link in thechainofcausality for the financialcrisis;WallStreet iswhereabadproblembecamedisastrous.Banksacrossthecountrycouldaffordto feed the real estate bubble with reckless loans because they could quicklybundletheseloanstogether,or“securitize”them,andsellthemofftoinvestors.(Abanktakesyourmortgage,bundlesittogetherwithmymortgageandlotsofothers,andthensellsthepackageofftosomepartywillingtopaycashnowinexchangeforafuturestreamofincome—ourmonthlymortgagepayments.)Thisis not inherently a bad thingwhen done responsibly; the bank gets its capitalback right away,whichcan thenbeused tomakenew loans.However, if youtaketheword“responsibly”outofthatsentence,itdoesbecomeabadthing.

Simon Johnson, former chief economist for the International MonetaryFund,wroteanexcellentpostmortemof the financialcrisis forTheAtlantic in2009.Henotes,“Majorcommercialandinvestmentbanks—andthehedgefundsthat ran alongside them—were the big beneficiaries of the twin housing andequity-market bubbles of this decade, their profits fed by an ever-increasingvolume of transactions founded on a relatively small base of actual physicalassets.Eachtimealoanwassold,packaged,securitized,andresold,bankstook

their transactionfees,andthehedgefundsbuyingthosesecuritiesreapedever-largerfeesastheirholdingsgrew.”12

Each transaction carries some embedded risk. The problem is that thebankersmakinghugecommissionsonthebuyingandsellingofwhatwouldlaterbecomeknownas“toxicassets”donotbearthefullriskofthoseproducts;theirfirmsdo.Headstheywin,tailsthefirmloses.InthecaseofLehmanBrothers,that’s a pretty accurate description of what happened. Yes, the Lehmanemployeeslosttheirjobs,butthosemostresponsibleforthecollapseofthefirmdon’thavetogivebackthehugebonusestheymadeinthegoodyears.

Oneotherculpablepartydeservesmention,andagainmisalignedincentiveswas a key problem.The credit rating agencies—Standard&Poor’s,Moody’s,andothers—aresupposedtobetheindependentauthoritiesthatevaluatetheriskofthesenewfangledproducts.Manyofthe“toxicassets”nowattheheartofthefinancial meltdown were given stellar credit ratings. Part of this was pureincompetence.Itdidn’thelp,however,thatthecreditratingagenciesarepaidbythefirmssellingthebondsorsecuritiesbeingrated.That’salittlelikeausedcarsalesmanpayinganappraisertostandaroundthelotandprovidehelpfuladviceto customers. “HeyBob,whydon’tyoucomeoverhere and tell the customerwhetherheisgettingagooddealornot.”Howusefuldoyouthinkthatwouldbe?

These corporate incentiveproblems remainunresolved as far as I can tell,both forseniorexecutives inpubliccompaniesand forotheremployees takingriskswith their firm’s capital. There is a fundamental tension that is tough toresolve.On the one hand, firms need to reward innovation, risk, insight, hardwork,andsoon.Thesearegoodthingsforthefirm,andemployeeswhodothemwell should be paid handsomely—even astronomically in some cases. On theother hand, the employees doing fancy things (like designing new financialproducts)will always havemore information aboutwhat they are really up tothantheirsuperiorswill;andtheirsuperiorswillhavemoreinformationthantheshareholders. The challenge is to reward good outcomes without creatingincentivesforemployeestogamethesysteminwaysthatdamagethecompanyinthelongrun.

Oneneednotbeacorporate titan todealwithprincipal-agentproblems.Thereare plenty of situations inwhichwemust hire someonewhose incentives aresimilarbutnotidenticaltoourown—andthedistinctionbetween“similar”and

“identical”canmakeallthedifference.Takerealestateagents,aparticularbreedof scoundrel who purport to have your best interest at stake but may not,regardlessofwhetheryouarebuyingorsellingaproperty.Let’slookatthebuysidefirst.Theagentgraciouslyshowsyoulotsofhousesandeventuallyyoufindone that is just right.Sofar,sogood.Nowit is time tobargainwith thesellerover the purchase price, oftenwith your agent as your chief adviser.Yet yourreal estate agentwillbepaidapercentageof theeventualpurchaseprice.Themoreyouarewilling topay, themoreyour agentmakesand the less time thewholeprocesswilltake.

Thereareproblemson thesell side, too, though theyaremoresubtle.Thebetterpriceyougetforyourhouse,themoremoneyyouragentwillmake.Thatisagoodthing.Buttheincentivesarestillnotperfectlyaligned.Supposeyouaresellingahouseinthe$300,000range.Youragentcanlistthehousefor$280,000andsellitinabouttwentyminutes.Orshecouldlistitfor$320,000andwaitforabuyerwhoreallylovestheplace.Thebenefittoyouofpricingthehousehighishuge:$40,000.Yourrealestateagentmayseethingsdifferently.Listinghighwould mean many weeks of showing the house, holding open houses, andbaking cookies to make the place smell good. Lots of work, in other words.Assuming a 3 percent commission, your agent can make $8,400 for doingvirtually nothingor $9,600 for doingmanyweeksofwork.Whichwouldyouchoose?Onthebuysideorthesellside,youragent’smostpowerfulincentiveistogetadealdone,whetheritisatapricefavorabletoyouornot.

Economicsteachesushowtogettheincentivesright.AsGordonGekkotoldusinthemovieWallStreet,greedisgood,somakesurethatyouhaveitworkingonyourside.YetMr.Gekkowasnotentirelycorrect.Greedcanbebad—evenforpeoplewhoareentirelyselfish.Indeed,someofthemostinterestingproblemsineconomics involve situations inwhich rational individuals acting in their ownbest interest do things that make themselves worse off. Yet their behavior isentirelylogical.

The classic example is the prisoner’s dilemma, a somewhat contrived buthighlypowerfulmodelofhumanbehavior.Thebasicideaisthattwomenhavebeen arrested on suspicion ofmurder. They are immediately separated so thatthey can be interrogated without communicating with one another. The caseagainst themisnot terriblystrong,and thepoliceare lookingforaconfession.Indeed, theauthoritiesarewillingtoofferadeal ifoneof themenratsout the

otherasthetriggerman.If neither man confesses, the police will charge them both with illegal

possessionofaweapon,whichcarriesafive-yearjailsentence.Ifbothofthemconfess, theneachwillreceiveatwenty-five-yearmurdersentence.Ifonemanratsout theother, then thesnitchwill receivea light three-yearsentenceasanaccompliceandhispartnerwillgetlifeinprison.Whathappens?

Themenarebestoffcollectivelyif theykeeptheirmouthsshut.Butthat’snot what they do. Each of them starts thinking. Prisoner A figures that if hispartner keeps hismouth shut, thenhe canget the light three-year sentencebyrattinghimout.Thenitdawnsonhim:Hispartnerisalmostcertainlythinkingthesamething—inwhichcasehehadbetterconfesstoavoidhavingthewholecrime pinned on himself. Indeed, his best strategy is to confess regardless ofwhathispartnerdoes: It eithergetshim the three-year sentence (ifhispartnerstaysquiet)orsaveshimfromgettinglifeinprison(ifhispartnertalks).

Ofcourse,PrisonerBhasthesameincentives.Theybothconfess,andtheybothgettwenty-fiveyearsinprisonwhentheymighthaveservedonlyfive.Yetneitherprisonerhasdoneanythingirrational.

Theamazing thingabout thismodel is that itoffersgreat insight intoreal-world situations inwhich unfettered self-interest leads to poor outcomes. It isparticularlyapplicabletothewayinwhichrenewablenaturalresources,suchasfisheries, are exploited when many individuals are drawing from a commonresource. For example, if Atlantic swordfish are harvested wisely, such as bylimiting the number of fish caught each season, then the swordfish populationwill remain stable or even grow, providing a living for fishermen indefinitely.But no one “owns” theworld’s swordfish stocks,making it difficult to policewhocatcheswhat.Asaresult,independentfishingboatsstarttoactalotlikeourprisoners under interrogation.They can either limit their catch in the name ofconservation,ortheycantakeasmanyfishaspossible.Whathappens?

Exactly what the prisoner’s dilemma predicts: The fishermen do not trusteach other well enough to coordinate an outcome that would make them allbetter off.Rhode Island fisherman John Sorlien told theNewYorkTimes in astoryondwindlingfishstocks,“Rightnow,myonlyincentiveistogooutandkillasmanyfishas Ican. Ihaveno incentive toconserve thefishery,becauseanyfishIleaveisjustgoingtobepickedupbythenextguy.”13Sotheworld’sstocks of tuna, cod, swordfish, and lobster are fished away. Meanwhile,politicians oftenmake the situationworse by bailing out struggling fishermenwith assorted subsidies. This merely keeps boats in the water when some

fishermenmightotherwisequit.Sometimesindividualsneedtobesavedfromthemselves.Oneniceexample

ofthisisthelobsteringcommunityofPortLincolnonAustralia’ssoutherncoast.Inthe1960s,thecommunitysetalimitonthenumberoftrapsthatcouldbesetandthensoldlicensesforthosetraps.Sincethen,anynewcomercouldenterthebusiness only by buying a license from another lobsterman. This limit on theoverall catch has allowed the lobster population to thrive. Ironically, PortLincoln lobstermen catchmore than theirAmerican colleagueswhileworkingless. Meanwhile, a license purchased in 1984 for $2,000 now fetches about$35,000. As Aussie lobsterman Daryl Spencer told the Times, “Why hurt thefishery?It’smyretirementfund.Noone’sgoingtopayme$35,000apotiftherearenolobstersleft.IfIrapeandpillagethefisherynow,intenyearsmylicenseswon’tbeworthanything.”Mr.Spencerisnotsmarterormorealtruisticthanhisfishing colleagues around the world; he just has different incentives. Oddly,someenvironmentalgroupsopposethesekindsoflicensedquotasbecausethey“privatize”apublicresource.Theyalsofearthatthelicenseswillbeboughtupbylargecorporations,drivingsmallfishermenoutofbusiness.

Sofar,theevidencestronglysuggeststhatcreatingprivatepropertyrights—givingindividualfishermentheright toacertaincatch, includingtheoptionofsellingthatright—isthemosteffectivetoolinthefaceofcollapsingcommercialfisheries.A2008studyoftheworld’scommercialfisheriespublishedinSciencefoundthatindividualtransferablequotascanstoporevenreversethecollapseoffishingstocks.Fisheriesmanagedwithtransferablequotaswerehalfaslikelytocollapseasfisheriesthatusetraditionalmethods.14

Twootherpointsregardingincentivesareworthnoting.First,amarketeconomyinspireshardworkandprogressnotjustbecauseitrewardswinners,butbecauseit crushes losers. The 1990swere a great time to be involved in the Internet.Theywerebadyearstobeintheelectrictypewriterbusiness.ImplicitinAdamSmith’sinvisiblehandistheideaof“creativedestruction,”atermcoinedbytheAustrianeconomistJosephSchumpeter.Marketsdonotsufferfoolsgladly.TakeWal-Mart, a remarkablyefficient retailer thatoften leavescarnage in itswake.Americans flock to Wal-Mart because the store offers an amazing range ofproducts cheaper than they can be purchased anywhere else. This is a goodthing.Beingable tobuygoodscheaper isessentially thesame thingashavingmore income. At the same time,Wal-Mart is the ultimate nightmare for Al’s

GlassandHardwareinPekin,Illinois—andformom-and-popshopseverywhereelse.Thepatterniswellestablished:Wal-Martopensagiantstorejustoutsideoftown;severalyearslater,thesmallshopsonMainStreetareclosedandboardedup.

Capitalism can be a brutal, cruel process. We look back and speakadmiringly of technological breakthroughs like the steam engine, the spinningwheel, and the telephone. But those advances made it a bad time to be,respectively, a blacksmith, a seamstress, or a telegraph operator. Creativedestruction isnot just something thatmighthappen inamarketeconomy. It issomethingthatmusthappen.Atthebeginningofthetwentiethcentury,halfofallAmericansworkedinfarmingorranching.15Nowthat figure isaboutone inahundredandstillfalling.(Iowaisstilllosingroughlyfifteenhundredfarmersayear.) Note that two important things have not happened: (1) We have notstarved to death; and (2) we do not have a 49 percent unemployment rate.Instead,Americanfarmershavebecomesoproductivethatweneedfarfewerofthem to feed ourselves. The individualswhowould have been farming ninetyyears ago are now fixing our cars, designing computer games, playingprofessionalfootball,etc.JustimagineourcollectivelossofutilityifSteveJobs,StevenSpielberg,andOprahWinfreywerecornfarmers.

Creativedestructionisatremendouspositiveforceinthelongrun.Thebadnews is that people don’t pay their bills in the long run. The folks at themortgagecompanycanbe real sticklersaboutgetting that checkeverymonth.Whenaplantclosesoranindustryiswipedoutbycompetition,itcanbeyearsor even an entire generation before the affected workers and communitiesrecover. Anyone who has ever driven through New England has seen theabandonedorunderutilizedmillsthataremonumentstothedayswhenAmericastillmanufacturedthingsliketextilesandshoes.OronecandrivethroughGary,Indiana,wheremilesofrustingsteelplantsareareminderthatthecitywasnotalwaysmostfamousforhavingmoremurderspercapita thananyothercity intheUnitedStates.

Competitionmeans losers,which goes a longway toward explainingwhywe embrace it heartily in theory and then often fight it bitterly in practice.Acollege classmate of mine worked for a congressman from Michigan shortlyafter our graduation.My friend was not allowed to drive his Japanese car towork,lestitbespottedinoneoftheMichigancongressman’sreservedparkingspaces.Thatcongressmanwillalmostcertainlytellyouthatheisacapitalist.Ofcoursehebelieves inmarkets—unlessaJapanesecompanyhappens tomakea

better, cheaper car, in which case the staff member who bought that vehicleshould be forced to take the train to work. (I would argue that theAmericanautomakerswouldhavebeenmuchstrongerinthelongruniftheyhadfacedthisinternationalcompetitionhead-oninsteadoflookingforpoliticalprotectionfromthefirstwaveofJapaneseimportsinthe1970sand1980s.)Thisisnothingnew;competitionisalwaysbestwhenit involvesotherpeople.DuringtheIndustrialRevolution,weavers in ruralEnglanddemonstrated,petitionedParliament,andevenburneddowntextilemillsinanefforttofendoffmechanization.Wouldwebebetteroffnowiftheyhadsucceededandwestillmadeallofourclothesbyhand?

Ifyoumakeabettermousetrap, theworldwillbeatapathtoyourdoor; ifyou make the old mousetrap, it is time to start firing people. This helps toexplain our ambivalence to international trade and globalization, to ruthlessretailers likeWal-Mart,andeventosomekindsof technologyandautomation.Competition also creates some interesting policy trade-offs. Governmentinevitably faces pressure to help firms and industries under siege fromcompetition and to protect the affected workers. Yet many of the things thatminimizethepaininflictedbycompetition—bailingoutfirmsormakingithardto lay offworkers—slowdownor stop the process of creative destruction.Toquotemyjuniorhighschoolfootballcoach:“Nopain,nogain.”

Oneothermatterrelatedtoincentivesvastlycomplicatespublicpolicy:Itisnoteasytotransfermoneyfromtherichtothepoor.Congresscanpassthelaws,butwealthytaxpayersdonotstandidlyby.Theychangetheirbehaviorinwaysthat avoid as much taxation as possible—moving money around, makinginvestments that shelter income, or, in extreme cases, moving to anotherjurisdiction.WhenBjornBorgdominatedthetennisworldduringmychildhood,theSwedishgovernmenttaxedhisearningsatanextremelyhighrate.Borgdidnot lobby the Swedish government for lower taxes orwrite passionate op-edsabout the roleof taxes in theeconomy.Hemerely transferredhis residence toMonaco,wherethetaxburdenismuchlower.

At least hewas still playing tennis.Taxesprovide a powerful incentive toavoid or reduce the activity that is taxed. In America, where much of ourrevenue comes from the income tax, high taxes discourage…income? Willpeoplereallystoporstartworkingbasedontaxrates?Yes—especiallywhentheworker involved is thefamily’ssecondearner.VirginiaPostrel,acolumnistoneconomics for theNew York Times, has declared that tax rates are a feministissue. Because of the “marriage tax,” second earners in families with high

household incomes, who aremore likely to bewomen, pay an average of 50centsintaxesforeverydollartheyearn,whichprofoundlyaffectsthedecisiontowork or stay home. “By disproportionately punishingmarriedwomen’swork,thetaxsystemdistortswomen’spersonalchoices.Andbydiscouragingvaluablework, it lowers our overall standard of living,” she writes. She offers someinterestingevidence.Asa resultof the1986 tax reform,marginal tax rates forwomen in the highest income brackets fell more sharply than tax rates forwomenwithlowerincomes,meaningthattheysawamuchsharperdropintheamount that the government takes from every paycheck. Did they responddifferently fromwomenwho did not get the same large tax break?Yes, theirparticipationintheworkforcejumpedthreetimesasmuch.16

Onthecorporateside,hightaxescanhaveasimilareffect.Hightaxeslowerafirm’sreturnoninvestment,therebyprovidinglessincentivetoinvestinplants,research,andotheractivities that lead toeconomicgrowth.Onceagainwearefacedwithanunpleasanttrade-off:RaisingtaxestoprovidegenerousbenefitstodisadvantagedAmericanscansimultaneouslydiscouragethekindsofproductiveinvestmentsthatmightmakethembetteroff.

If tax rates get high enough, individuals and firms may slip into the“underground economy” where they opt to break the law and avoid taxesentirely. Scandinavian countries, which offer generous government programsfunded by highmarginal tax rates, have seen large growth in the size of theirblack market economies. Experts estimate that the underground economy inNorwaygrewfrom1.5percentofgrossnationalproduct in1960to18percentby the mid-1990s. Cheating the tax man can be a vicious circle. As moreindividualsandfirmsslip into theundergroundeconomy, tax ratesmustgoupfor everyone else in order to provide the same level of government revenue.Higher taxes in turn cause more flight to the underground economy—and soon.17

The challenge of transferring money from rich to poor is not just on thetaxation side. Government benefits create perverse incentives, too. Generousunemployment benefits diminish the incentive to find work. Welfare policy,prior to reform in 1996, offered cash payments only to unemployed singlewomenwithchildren,whichimplicitlypunishedpoorwomenwhoweremarriedor employed—two things that the government generally does not try todiscourage.

Thisisnottosuggestthatallgovernmentbenefitsgotopoorpeople.Theydon’t. The largest federal entitlement programs are Social Security and

Medicare, which go to all Americans, even the very rich. By providingguaranteedbenefitsinoldage,bothprogramsmaydiscouragepersonalsavings.Indeed, this is the subject of a longsimmering debate. Some economists arguethat government old-age benefits cause us to save less (thereby lowering thenational savings rate) becauseweneed to set aside lessmoney for retirement.Others argue that Social Security and Medicare do not reduce our personalsavings; theymerely allow us to pass alongmoremoney to our children andgrandchildren.Empiricalstudieshavenotfoundaclearansweronewayor theother. This is notmerely an esoteric squabble among academics. Aswe shallexplore later in the book, a low savings rate can limit the pool of capitalavailabletomakethekindsofinvestmentsthatallowustoimproveourstandardofliving.

None of this should be interpreted as a blanket argument against taxes orgovernment programs. Rather, economists spend much more time thanpoliticians thinking about what kind of taxes we should collect and how weshouldstructuregovernmentbenefits.Forexample,bothagasoline taxandanincome tax generate revenue. Yet they create profoundly different incentives.Theincometaxwilldiscouragesomepeoplefromworking,whichisabadthing.Thegasolinetaxwilldiscouragesomepeoplefromdriving,whichcanbeagoodthing. Indeed, “green taxes” collect revenue by taxing activities that aredetrimentaltotheenvironmentand“sintaxes”dothesamethingforthelikesofcigarettes,alcohol,andgambling.

Ingeneral,economiststendtofavortaxesthatarebroad,simple,andfair.Asimple tax is easily understood and collected; a fair tax implies only that twosimilar individuals,suchas twopeoplewith thesameincome,willpaysimilartaxes;abroadtaxmeansthatrevenueisraisedbyimposingasmalltaxonaverylargegroupratherthanimposingalargetaxonaverysmallgroup.Abroadtaxishardertoevadebecausefeweractivitiesareexempted,and,sincethetaxrateislower,thereislessincentivetoevadeitanyway.Weshouldnot,forexample,imposealargetaxonthesaleofredsportscars.Thetaxcouldbeavoided,easilyand legally,bybuyinganothercolor—inwhich case everybody ismadeworseoff.Thegovernmentcollectsnorevenueandsportscarenthusiastsdonotgettodrivetheirfavoritecolorcar.Thisphenomenon,wherebytaxesmakeindividualsworseoffwithoutmakinganyoneelsebetteroff, is referred toas“deadweightloss.”

Itwouldbepreferabletotaxallsportscars,orevenallcars,becausemorerevenue could be raised with a much smaller tax. Then again, a gasoline tax

collectsrevenuefromdrivers,justasataxonnewcarsdoes,butitalsoprovidesan incentive toconserve fuel.Thosewhodrivemorepaymore.Sonowwe’reraisingagreatdealofrevenuewithatinytaxanddoingalittlesomethingfortheenvironment, too.Manyeconomistswouldgoyetone step further:We shouldtax the use of all kinds of carbon-based fuels, such as coal, oil, and gasoline.Suchataxwouldraiserevenuefromabroadbasewhilecreatinganincentivetoconserve nonrenewable resources and curtail the CO2 emissions that causeglobalwarming.

Sadly, this thought process does not lead us to the optimal tax.We havemerelyswappedoneproblemforanother.Ataxonredsportscarswouldbepaidonlybytherich.Acarbontaxwouldbepaidbyrichandpooralike,butitwouldprobably cost the poor a larger fraction of their income. Taxes that fall moreheavily on the poor than the rich, so-called regressive taxes, often offend oursenseofjustice.(Progressivetaxes,suchastheincometax,fallmoreheavilyontherichthanthepoor.)Here,aselsewhere,economicsdoesnotgiveusa“rightanswer”—onlyananalyticalframeworkforthinkingaboutimportantquestions.Indeedthemostefficienttaxofall—onethatisperfectlybroad,simple,andfair(in the narrow, tax-related sense of the word)—is a lump-sum tax, which isimposeduniformlyon every individual in a jurisdiction.FormerBritishPrimeMinisterMargaretThatcheractuallytrieditin1989withthecommunitycharge,or “poll tax.”What happened? Britons rioted in the streets at the prospect ofevery adult paying the same tax for local community services regardless ofincomeorpropertywealth(thoughthereweresomereductionsforstudents,thepoor, and the unemployed). Obviously good economics is not always goodpolitics.

Meanwhile, not all benefits are created equal either. One of the biggestpoverty-fighting tools in recent years has been the earned income tax credit(EITC),anideathateconomistshavepushedfordecadesbecauseitcreatesafarbetter set of incentives than traditional social welfare programs. Most socialprogramsofferbenefitstoindividualswhoarenotworking.TheEITCdoesjustthe opposite; it uses the income tax system to subsidize low-wageworkers sothat their total income is raised above the poverty line. A worker who earns$11,000 and is supporting a family of four might get an additional $8,000through theEITC andmatching state programs. The ideawas to “makeworkpay.”Indeed,thesystemprovidesapowerfulincentiveforindividualstogetintothe labor force,where it is hoped they can learn skills and advance tohigher-paying jobs. Of course, the program has an obvious problem, too. Unlike

welfare, the EITC does not help individuals who cannot find work at all; inreality,thosearethefolkswhoarelikelytobemostdesperate.

WhenIappliedtograduateschoolmanyyearsago,Iwroteanessayexpressingmypuzzlementathowacountry thatcouldputamanon themooncouldstillhave people sleeping on the streets. Part of that problem is political will; wecould take a lot of people off the streets tomorrow if we made it a nationalpriority.ButIhavealsocometorealizethatNASAhaditeasy.Rocketsconformtotheunchanginglawsofphysics.Weknowwherethemoonwillbeatagiventime;weknowpreciselyhowfastaspacecraftwillenterorexittheearth’sorbit.If we get the equations right, the rocket will land where it is supposed to—always. Human beings aremore complex than that. A recovering drug addictdoesnotbehaveaspredictablyasarocketinorbit.Wedon’thaveaformulaforpersuading a sixteen-year-old not to drop out of school. But we do have apowerfultool:Weknowthatpeopleseektomakethemselvesbetteroff,howevertheymay define that. Our best hope for improving the human condition is tounderstand why we act the way we do and then plan accordingly. Programs,organizations,andsystemsworkbetterwhentheyget the incentivesright.It islikerowingdownstream.

CHAPTER3

GovernmentandtheEconomy:

Government is your friend (and a round of applause for all thoselawyers)

ThefirstcarIeverownedwasaHondaCivic.Ilovedthecar,butIsolditwithalotofgoodmilesleftinit.Why?Tworeasons:(1)Itdidn’thaveacupholder;and(2)mywifewaspregnant,andIhadbecomefearfulthatourwholefamilywouldget flattenedbyaChevySuburban. Icouldhavegottenbeyond thecupholder problem. But putting a car seat in a vehicle that weighed a quarter asmuchastheaverageSUVwasnotanoption.SoweboughtaFordExplorerandbecamepartoftheproblemforallofthosepeoplestilldrivingHondaCivics.*

Thepointisthis:MydecisiontobuyanddriveanSUVaffectseveryoneelseontheroad,yetnoneofthosepeoplehasasayinmydecision.Idonothavetocompensateall theownersofHondaCivics for the fact that Iamputting theirlivesslightlymoreatrisk.NordoIhavetocompensateasthmaticchildrenwhowill bemade worse off by the exhaust I generate as I cruise around the citygettingninemilestothegallon.AndIhavenevermailedoffachecktopeopleliving on small Pacific islands who may someday find their entire countriesunderwaterbecausemyCO2emissionsaremeltingthepolaricecaps.Yetthesearerealcostsassociatedwithdrivingalessfuel-efficientcar.

Mydecision tobuyaFordExplorercauseswhateconomistsrefer toasanexternality,whichmeansthattheprivatecostsofmybehavioraredifferentfromthesocialcosts.WhenmywifeandIwenttotheBertWeinmanFordDealershipandthesalesman,Angel,asked,“Whatis itgoingtotakeformetoputyouinthis car?,” we tallied up the costs of driving an Explorer rather than a Civic:moregas,moreexpensiveinsurance,highercarpayments.Therewasnothingonour tally sheet about asthmatic children, melting polar ice caps, or pregnantwomen driving Mini Coopers. Are these costs associated with driving an

Explorer?Yes.Dowehavetopaythem?No.Therefore,theydidnotfigureintoourdecision(otherthanasavaguesenseofguiltaswecontemplatedtellingourenvironmentallyconsciousrelativeswholiveinBoulder,Colorado,andflushthetoiletonlyonceadayinordertoconservewater).

Whenanexternality—thegapbetweentheprivatecostandthesocialcostofsomebehavior—is large, individuals have an incentive to do things thatmakethembetteroffattheexpenseofothers.Themarket,leftalone,willdonothingto fix this problem. In fact, themarket “fails” in the sense that it encouragesindividuals and firms to cut corners inways thatmake societyworse off as aresult. If this conceptwere reallyasdryasmost economics textbooksmake itseem,thenamovielikeMichaelClaytonwouldnothavemademillionsat theboxoffice.Afterall,thatfilmisaboutasimpleexternality:Alargeagribusinesscompanystandsaccusedofproducingapesticidethatisseepingintolocalwatersupplies and poisoning families.There is nomarket solution in this case; themarket is the problem. The polluting companymaximizes profits by selling aproductthatcausescancerininnocentvictims.Farmerswhoareunawareof(orindifferentto)thepollutionwillactuallyrewardthecompanybybuyingmoreofitsproduct,whichwillbecheaperormoreeffectivethanwhatcanbeproducedbycompetitorsthatinvestinmakingtheirproductsnontoxic.Theonlyredressinthis film example (like Erin Brockovich and A Civil Action before it) wasthrough a nonmarket, government-supported mechanism: the courts. And, ofcourse,GeorgeClooneylooksgoodmakingsurejusticeisdone(asJuliaRobertsandJohnTravoltadidbeforehim).

Consider a more banal example, but one that raises the ire of most citydwellers:peoplewhodon’tpickupaftertheirdogs.Inaperfectworld,wewouldallcarrypooperscoopersbecausewederiveutility frombehaving responsibly.But we don’t live in a perfect world. From the narrow perspective of someindividual dogwalkers, it’s easier (“less costly” in economist speak) to ignoreFido’sunsightlypileandwalkblithelyon.(Forthosewhothinkthisisatrivialexample, an average of 650 people a year break bones or are hospitalized inParis after slipping in dog waste, according to the New York Times.)1 Thepooper-scooperdecisioncanbemodeledlikeanyothereconomicdecision;adogownerweighsthecostsandbenefitsofbehavingresponsiblyandthenscoopsordoesnotscoop.Butwhospeaksforthewomanrunningtocatchthebusthenextmorningwhomakes onemisstep and is suddenly having a very bad day?Noone,which iswhymost citieshave laws requiringpetowners topickupaftertheiranimals.

Thankfully there is a broader point:One crucial role for government in amarketeconomyisdealingwithexternalities—thosecasesinwhichindividualsorfirmsengageinprivatebehaviorthathasbroadersocialconsequences.InotedinChapter1thatallmarkettransactionsarevoluntaryexchangesthatmaketheinvolvedpartiesbetteroff.That’sstilltrue,butnotetheword“involved”thathasleftmesomewiggleroom.Theproblemisthatalloftheindividualsaffectedbyamarkettransactionmaynotbesittingatthetablewhenthedealisstruck.Myformer neighbor Stuart,withwhomwe shared an adjoiningwall,was an avidbongodrumplayer.I’msurethatbothheandthemusicshopownerwerebothpleasedwhenhepurchasedanewsetofbongos.(Basedonthenoiseinvolved,hemayevenhavepurchased somekindofhigh-techamplifier.)But Iwasnothappyaboutthattransaction.

Externalitiesareattherootofallkindsofpolicyissues,fromthemundanetothosethatliterallythreatentheplanet:

The Economist has suggested somewhat peevishly that familiestravelingwithsmallchildrenonairplanesshouldberequiredtoflyatthebackoftheplanesothatotherpassengersmightenjoya“child-freezone.” An editorial in the magazine noted, “Children, just likecigarettesormobilephones, clearly imposeanegativeexternalityonpeoplewhoarenearthem.Anybodywhohassuffereda12-hourflightwith a bawling baby in the row immediately ahead or a boredyoungsterviciouslykicking their seat frombehind,willgrasp thisasquickly as theywould love to grasp the youngster’s neck.Here is aclearcaseofmarketfailure:parentsdonotbearthefullcosts(indeedyoungbabiestravelfree),sotheyaretooreadytotaketheirnoisybratswiththem.Whereistheinvisiblehandwhenitisneededtoadministeragoodsmack?”2Mobilephoneuseisunderstricterscrutiny,bothinpublicplaces,suchas restaurants andcommuter trains,where thebehavior is fabulouslyannoying,butalsoinvehicles,whereithasbeenlinkedtoahigherrateof accidents.Texting is the second-mostdangerous thingyoucandowhiledrivingacar,nexttodrivingdrunk.InChicago,MayorRichardDaleyattemptedtoimposea1-centtaxonevery$2oftake-outfoodpurchases,arguingthatthe“littertax”would

reimburse the city for the costs of picking up litter, much of whichconsists of discarded fast-food containers. The mayor’s economicswere sound—litter is a classic externality—but a judge ruled theordinance unconstitutional because it was “vague and lacking inuniformity” in the way it dealt with different kinds of fast-foodcontainers.Nowthereistalkatthefederallevelofajunkfoodtax(ora soda tax) to deal with a different kind of food-related externality:obesity.Thehealthcarecostsassociatedwithobesityarenowroughlyashighasthoserelatedtosmoking.Societypicksupatleastsomeofthetabforthosebillsthroughthecostsofgovernmenthealthprogramsandhigher insurancepremiums—givingmea reason tocarewhetheryouhaveaBigMacforlunchornot.Globalwarmingisoneofthemostdifficultinternationalchallengesinlargepartbecausefirms thatemit largeamountsofgreenhousegasespayonlyasmallshareofthecostofthoseemissions.Indeed,eventhecountriesinwhichtheyresidedonotbearthefullcostofthepollution.A steel plant in Pennsylvania emits CO2 that may one day cause afloodinBangladesh.(Meanwhile,acidraincausedbyU.S.emissionsisalreadykillingCanadianforests.)Thesamethingistrueinallkindsof factories around the world. Any solution to global warming willhave to raise the cost of emitting greenhouse gases in away that isbindinguponalloftheearth’spolluters—nottheeasiestoftasks.

It is worth noting that there can be positive externalities as well; anindividual’sbehaviorcanhaveapositiveimpactonsocietyforwhichheorsheisnotfullycompensated.IoncehadanofficewindowthatlookedoutacrosstheChicagoRiverattheWrigleyBuildingandtheTribuneTower,twoofthemostbeautiful buildings in a city renowned for its architecture.On a clear day, theview of the skyline, and of these two buildings in particular, was positivelyinspiring.ButIspentfiveyearsinthatofficewithoutpayingfortheutilitythatIderived from thiswonderful architecture. I didn’tmail a check to theTribuneCompany every time I glanced out thewindow.Or, in the realmof economicdevelopment, a businessmay invest in a downtrodden neighborhood in awaythatattractsotherkindsofinvestment.Yetthisbusinessisnotcompensatedforanchoring what may become an economic revitalization, which is why local

governmentsoftenoffersubsidiesforsuchinvestment.Someactivitieshavebothpositiveandnegativeexternalities.Cigaretteskill

peoplewhosmokethem;thatisoldnews.Responsibleadultsarefreetosmokeor not smoke as they choose. But cigarette smoke can also harm those whohappen to be lingering nearby, which is why most office buildings considersmoking to be slightly less acceptable than running through the halls naked.Meanwhile, all fifty states filed suit against the tobacco industry (andsubsequentlyaccepted large settlements)on thegrounds that smokersgenerateextrahealthcarecoststhatmustbebornebystategovernments.Inotherwords,my taxes go to remove part of some smoker’s lung. (Private insurancecompanies do not have this problem; they simply recoup the extra cost ofinsuringsmokersbychargingthemhigherpremiums.)

At thesame time,smokersdoprovideabenefit to therestofus.Theydieyoung.According to theAmericanLungAssociation, theaveragesmokerdiessevenyearsearlierthantheaveragenonsmoker,whichmeansthatsmokerspayintoSocialSecurityandprivatepensionfundsforalloftheirworkinglivesbutthen don’t stick around very long to collect the benefits. Nonsmokers, onaverage,getmoreback relative towhat theypaid in.Thegood folksatPhilipMorrishaveevenquantifiedthisbenefitforus.In2001,theyreleasedareportontheCzechRepublic (justasparliamentwasconsideringraisingcigarette taxes)showing that premature deaths from smoking save the Czech governmentroughly $28 million a year in pension and old-age housing benefits. The netbenefit of smoking to the government, including taxes and subtracting publichealthcosts,wasreckonedtobe$148million.3

How does a market economy deal with externalities? Sometimes thegovernment regulates the affected activity. The federal government issuesthousands of pages of regulations every year on everything from groundwatercontamination to poultry inspection. The states have their own regulatorystructures; California, for example, has a strict set of emissions standards forautomobiles.Local governmentshave zoning laws that forbidprivatepropertyownersfromimpingingontheirneighborsbyconstructingbuildingsthatmaybeunsafe, inappropriate for the neighborhood, or simply ugly. The island ofNantucket allows only a few select colors of exterior paint lest irresponsiblepropertyownersuseneoncolors thatwoulddestroythequaintcharacterof theisland. I live inahistoricneighborhood inwhicheveryexternalchange toourhomes—from thecolorofnewwindows to the sizeofa flowerbox—mustbeapprovedbyanarchitecturecommittee.

There is another approach to dealing with externalities that tends to befavoredinsomecasesbyeconomists:taxingtheoffendingbehaviorratherthanbanning it. I’ve conceded thatmyFordExplorerwas amenace to society.AsCornelleconomistRobertFranknotedinanop-edfortheNewYorkTimes,wearelockedinanSUVarmsrace.“Anyfamilycanonlychoosethesizeofitsownvehicle.Itcannotdictatewhatothersbuy.Anyfamilythatunilaterallyboughtasmallervehiclemightthusputitselfatriskbyunilaterallydisarming,”hewrote.4ShouldtheHummerbebanned?ShouldDetroitbeorderedtomanufacturesafer,morefuel-efficientcars?

Economists, includingMr. Frank, would argue not. The primary problemwithSUVs—andallvehicles,forthatmatter—isthattheyaretoocheaptodrive.TheprivatecostofdrivingaHummertothegrocerystoreisobviouslyfarlowerthan the social cost.Soraise theprivatecost.AsMr.Frankwrites, “Theonlypracticalremedy,giventheundeniablefactthatdrivingbulky,pollutingvehiclescausesdamage toothers, is togiveourselvesan incentive to take thisdamageintoaccountwhendecidingwhatvehiclestobuy.”IftherealcosttosocietyofhavinganExplorerontheroadis75centsamileinsteadofthe50centsamilethat it costs thevehicle’sowner tooperate thevehicle, then tackona tax thatequatesthetwo.Thismightbeaccomplishedwithagastax,oranemissionstax,or aweight tax, or some combination thereof. The resultwillmake driving aHummertothegrocerystorealotlessattractive.

But nowwe have entered strange terrain. Is it appropriate to allow somedrivers topay for theprivilegeof driving avehicle sobulky that itmight runover a Mini Cooper without even spilling the sixty-four-ounce drink in themonstercupholder?Yes,forthesamereasonthatmostofuseaticecreameventhoughitcausesheartdisease.WeweighthehealthcostsofStarbucksAlmondFudgeagainstthatdivine,creamytasteanddecidetohaveapinteveryonceinawhile. We don’t quit ice cream entirely, nor do we have it with every meal.Economicstellsusthattheenvironmentrequiresthesamekindsoftrade-offsaseverything else in life. We should raise the cost of driving an SUV (or anyvehicle)toreflectitstruesocialcostandthenlet individualdriversdecideif itstillmakessensetocommuteforty-fivemilestoworkinaChevyTahoe.

Taxingabehaviorthatgeneratesanegativeexternalitycreatesalotofgoodincentives. First, it limits the behavior. If the cost of driving a Ford Explorergoes to 75 cents a mile, then there will be fewer Explorers on the road. Asimportant, those peoplewho are still driving them—andpaying the full socialfreight—willbethosewhovaluedrivinganSUVthemost,perhapsbecausethey

actuallyhaulthingsordriveoff-road.Second,agas-guzzlertaxraisesrevenue,whichabanoncertainkindsofvehiclesdoesnot.Thatrevenuemightbeusedtopay for someof thecostsofglobalwarming (suchas research intoalternativeenergysources,orat leastbuildingadikearoundsomeof thosePacific islandnations).Or itmightbeused to reduce someother tax, such as the incomeorpayrolltax,thatdiscouragesbehaviorwewouldratherencourage.

Third, a tax that falls most heavily on hulking, fuel-hungry vehicles willencourageDetroit to buildmore fuel-efficient cars, albeit with a carrot ratherthana stick. IfWashingtonarbitrarilybansvehicles thatget less thaneighteenmilespergallonwithoutraisingthecostofdrivingthosevehicles,thenDetroitwill produce a lot of vehicles that get—no big surprise here—about eighteenmiles a gallon. Not twenty, not twenty-eight, not sixty using new solartechnology.On the other hand, if consumers are going to be stuckwith a taxbasedon fuelconsumptionand/or themassof thevehicle, then theywillhaveverydifferent preferenceswhen they step into the showroom.The automakerswill respond quickly, and other products like theHummerwill be sentwheretheybelong,tosomekindofmuseumformutantindustrialproducts.

Istaxingexternalitiesaperfectsolution?No,farfromit.Theautoexamplealonehasanumberofproblems,themostobviousofwhichisgettingthesizeofthetaxright.Scientistsarenotyetincompleteagreementonhowquicklyglobalwarmingishappening,letalonewhatthecostsmightbe,or,manystepsbeyondthat,whattherealcostofdrivingaHummerforamilemightbe.Istherighttax$0.75,$2.21,$3.07?Youwillnevergetagroupofscientiststoagreeonthat,letalonetheCongressoftheUnitedStates.Thereisanequityproblem,too.Ihavestipulatedcorrectly that ifweraise thecostofdrivinggasguzzlers, then thosewhovaluethemmostwillcontinuetodrivethem.Butourmeasureofhowmuchwevaluesomethingishowmuchwearewillingtopayforit—andtherichcanalways pay more for something than everyone else. If the cost of driving anExplorer goes to $9 a gallon, then the people driving themmight be haulingwine and cheese to beach parties onNantucketwhile a contractor inChicagowhoneedsapickuptrucktohaullumberandbrickscannolongeraffordit.Whoreally “values” their vehicle more? (Clever politicians might get around theequityissuebyusingataxongasguzzlerstooffsetataxthatfallsmostheavilyon the middle class, such as the payroll tax, in which case our Chicagocontractor would pay more for his truck but less to the IRS.) And last, theprocessoffindingandtaxingexternalitiescangetoutofcontrol.Everyactivitygeneratesanexternalityatsomelevel.Anythoughtfulpolicyanalystknowsthat

someindividualswhowearspandexinpublicshouldbetaxed,ifnotjailed.IliveinChicago,wherehordesofpastypeople,havingspentthewinterindoorsonthecouch,flockoutsideinskimpyclothingonthefirstdayinwhichthetemperaturerises above fifty degrees. This can be a scary experience for those forced towitness it and is certainly something thatyoungchildren shouldneverhave toexperience.Still,ataxonspandexisprobablynotpractical.

I’vewandered frommy original,more important point.Anyonewho tellsyouthatmarketslefttotheirowndeviceswillalwaysleadtosociallybeneficialoutcomesistalkingutternonsense.Marketsalonefailtomakeusbetteroffwhenthereisalargegapbetweentheprivatecostofsomeactivityandthesocialcost.Reasonablepeoplecanandshoulddebatewhattheappropriateremedymightbe.Oftenitwillinvolvegovernment.

Ofcourse,sometimesitmaynot.Thepartiesinvolvedinanexternalityhaveanincentivetocometoaprivateagreementontheirown.ThiswastheinsightofRonaldCoase,aUniversityofChicagoeconomistwhowontheNobelPrizein1991.Ifthecircumstancesareright,onepartytoanexternalitycanpaytheotherparty to change their behavior. When my neighbor Stuart started playing hisbongos,Icouldhavepaidhimtostop,ortotakeupalessannoyinginstrument.Ifmydisutility fromhis noise is greater than his utility fromplaying, I couldtheoreticallywritehimachecktoputthebongosawayandleaveusbothbetteroff.Somecontrivednumberswillactuallyhelptomakethepoint.IfStuartgets$50 of utility from banging away, and I feel the noise does $100 an hour ofdamagetomypsyche,thenwe’rebothbetteroffifIwritehimacheckfor$75totakeupknitting.Hegetscashthatdoeshimmoregoodthanthebongos;Ipayforsilence,whichisworthmoretomethanthe$75itcosts.

Butwaitaminute:IfStuartistheguymakingthenoise,whyshouldIhavetopayhimtostop?MaybeIdon’t.OneofCoase’skey insights is thatprivatepartiescanonlyresolveanexternalityontheirowniftherelevantpropertyrightsareclearlydefined—meaningthatweknowwhichpartyhastherighttodowhat.(Aswe’ll explore later in the chapter, property rights often involve things farmore complicated than just property.) Does Stuart have the right to makewhatever noise he wants? Or do I have the right to work in relative quiet?Presumably the statutes for the city of Chicago answer that question. (Theanswermaydependontimeofday,givinghimtherighttomakenoiseupuntilsome specified hour and giving me the right to silence during the nighttimehours.)

IfIhavetherighttoworkinpeace,thenanypaymentwouldhavetogothe

oppositedirection.Stuartwouldhave topayme tostartbangingaway.Buthewouldn’t do that in this case, because it’s not worth it to him. As atemperamentalwriter,thesilenceisworth$100tome,soStuartwouldhavetopaymeatleastthatmuchtoendurethenoise.Playingthebongosisonlyworth$50 to him. He’s not going to write a check for $100 to do something thatprovidesonly$50ofutility.SoIgetmysilenceforfree.

This explains Coase’s second important insight: The private parties willalwayscometo thesameefficientsolution(theone thatmakes thebestuseofthe resources involved) regardless of which party starts out with the propertyright. The only difference is who ends up paying whom. In this case, thedisputedresourceisourcommonwallandthesoundwavesthatmovebackandforthacrossit.Themostefficientuseofthatresourceistokeepitquiet,sinceIvaluemypeacefulwritingmorethanStuartvalueshisbongoplaying.IfStuarthastherighttomakenoise,I’llpayhimtostop—andIgettowriteinpeace.IfIhavetherighttosilence,Stuartwon’tbewillingtopayenoughformetoaccedetohisbongos—andIgettowriteinpeace.

Remarkably, this kind of thing actually happens in real life. My favoriteexample is the Ohio power company that neighbors claimed was emitting “abizarreblueplume”thatwascausingdamagetopropertyandhealth.TheCleanAir Act gave the town’s 221 residents the right to sue the utility to stop thepollution.SotheAmericanElectricPowercompanyhadadecisiontomake:(1)Stoppolluting;or(2)paytheentiretowntomovesomewhereelse.5

TheNewYorkTimesreportedontheanswer:“UtilityBuysTownItChoked,Lock, Stock and Blue Plume.” The company paid the residents roughly threetimeswhattheirhouseswereworthinexchangeforasignedagreementnevertosueforpollution-relateddamages.For$20million,theutility’sproblemspackedup andwent away—literally. Presumably thismade financial sense. TheNewYorkTimes reported that this settlementwas believed to be the first deal by acompany to dissolve an entire town. “It will help the company avoid theconsiderableexpenseandpublic-relationsmessofindividuallawsuits,legalandenvironmentalexpertssaid.”

Coasemade one final point: The transactions costs related to striking thiskindofdeal—everythingfromthetimeittakestofindeveryoneinvolvedtothelegal costs of making an agreement—must be reasonably low for the privatepartiestoworkoutanexternalityontheirown.StuartandIcanhaggleoverthefence in the backyard. TheAmericanElectric Power company canmanage tostrikeadealwith221homeowners.Butprivatepartiesarenotgoingtoworkout

achallengelikeCO2emissionsontheirown.EverytimeIgetintomycarandturnontheengine,Imakeallofthesixbillioninhabitantsoftheplanetslightlyworseoff.Ittakesalongtimetowritecheckstosixbillionpeople,particularlywhenyouarealreadylateforwork.(Andit’sarguablethatsomepeopleincoldclimateswillbenefit fromclimatechange,somaybetheyshouldpayme.)Theproperty rights related togreenhousegasesarestillambiguous, too.DoIhavethe right to emit unlimited CO2? Or does someone living in a Pacific islandnationhavetherighttostopmefromdoingsomethingthatmightsubmergetheirentirecountry?Thisisoneconflictthatgovernmentshavetotackle.

But let’s back up for a moment. Government does not just fix the roughedgesofcapitalism;itmakesmarketspossibleinthefirstplace.Youwillgetalotofapprovingnodsatacocktailpartybyassertingthatifgovernmentwouldsimply get out of the way, then markets would deliver prosperity around theglobe.Indeed,entirepoliticalcampaignsarebuiltaroundthisissue.Anyonewhohas ever waited in line at the Department of Motor Vehicles, applied for abuilding permit, or tried to pay the nanny taxwould agree. There is just oneproblemwiththatcocktailpartysentiment:It’swrong.Goodgovernmentmakesamarket economy possible. Period. And bad government, or no government,dashescapitalismagainst therocks,whichisonereasonthatbillionsofpeopleliveindirepovertyaroundtheglobe.

To begin with, government sets the rules. Countries without functioninggovernmentsarenotoasesoffreemarketprosperity.Theyareplacesinwhichitisexpensiveanddifficulttoconducteventhesimplestbusiness.Nigeriahasoneof the world’s largest reserves of oil and natural gas, yet firms trying to dobusiness there face a problem known locally as BYOI—bring your owninfrastructure.6 Angola is rich with oil and diamonds, but the wealth hasfinanced more than a decade of civil war, not economic prosperity. In 1999,Angola’srulersspent$900millioninoilrevenuestopurchaseweapons.Nevermindthatonechildinthreediesbeforetheageoffiveandlifeexpectancyisashockingforty-twoyears.7Thesearenotcountriesinwhichthemarketeconomyhasfailed;theyarecountriesinwhichthegovernmenthasfailedtodevelopandsustaintheinstitutionsnecessarytosupportamarketeconomy.Areport issuedby the United Nations Development Program placed much of the blame forworldpovertyonbadgovernment.Withoutgoodgovernance,relianceontrickle-down economic development and a host of other strategieswill notwork, thereportconcluded.8

Therealityisthatnobodyeverlikestheumpire,butyoucan’tplaytheWorldSerieswithoutone.Sowhataretherulesforafunctionalmarketeconomy?First,the government defines and protects property rights. You own things: yourhome,yourcar,yourdog,yourgolfclubs.Withinreasonablelimits,youcandowith that property as you wish. You can sell it, or rent it, or pledge it ascollateral.Most important, you canmake investments in your propertyhavingfull confidence that the returns from that investment will also belong to you.Imagineaworldinwhichyouspendallsummertendingtoyourcorncropandthen your neighbor drives by in his combine,waves cheerily, and proceeds toharvest thewholecropforhimself.Doesthatsoundcontrived?Notifyou’reamusician—becausethatisprettymuchwhatNapsterdidbyallowingindividualsto download music without paying any compensation to the musicians whocreated it or to the record companies that owned the copyrights. The musicindustrysuccessfullysuedNapsterforfacilitatingpiracy.

Propertyrightsarenotjustabouthouses,cars,andthingsyoucanstackinacloset.Someof themost importantpropertyrights involveownershipof ideas,artwork, formulas, inventions, and even surgical procedures. This book is asgoodanexampleasany. Iwrite the text.Myagentsells it toapublisher,whocontracts tohave thebookprintedanddistributed.Thebook is sold inprivatestores,whereprivatesecurityguardsarehiredtohandlethemassive,potentiallyunrulycrowdstryingtogetasignedcopy.Ateveryjuncture,onlyprivatepartiesare involved. These would appear to be straightforward market transactions;governmentcouldonlygetintheway.Indeed,Imightcursethegovernmentfortaxingmyincome,taxingthesaleofthebook,eventaxingthesalarythatIpaythenannytolookaftermychildrenwhileIwrite.

Infact,thewholetransactionismadepossiblebyonething:copyrightlaw,whichisacrucialformofpropertyrightforthoseofuswhowriteforaliving.The United States government guarantees that after I invest my time inproducing amanuscript, no company can steal the text and publish itwithoutcompensatingme.Anyprofessorwhophotocopiesittouseitinaclassmustpaythepublishera royalty first. Indeed, thegovernmentenforcessimilar rights forMicrosoftsoftware,andarelatedpropertyright,apatent,forthepharmaceuticalcompany that inventedViagra.Thecaseofpatents isan interestingone that isoftenmischaracterized.TheingredientsinViagracostpenniesapill,butbecausePfizer has a patent onViagra that gives it amonopoly on the right to sell theproduct for twentyyears, the company sells eachpill for asmuch as $7.Thishuge markup, which is also common with new HIV/AIDS drugs and other

lifesaving products, is often described as some kind of social injusticeperpetrated by rapacious companies—the “big drug companies” that areperiodically demonized during presidential campaigns.What would happen ifothercompanieswereallowedtosellViagra,orifPfizerwereforcedtosellthedrugmorecheaply?Thepricewouldfalltothepointwhereitwasmuchcloserto the cost of production. Indeed,when a drug comesoff patent—thepoint atwhich generic substitutes become legal—the price usually falls by 80 or 90percent.

SowhydoweallowPfizertofleeceViagrausers?BecauseifViagradidnotgetpatentprotection,thenPfizerneverwouldhavemadethelargeinvestmentsthat were necessary to invent the drug in the first place. The real cost ofbreakthroughdrugsistheresearchanddevelopment—scouringtheworld’srainforests for exotic tree barks with medicinal properties—not making the pillsoncetheformulaisdiscovered.Thesameistruewithdrugsforanyotherillness,nomatterhowseriousorevenlife-threatening.*Theaveragecostofbringinganew drug tomarket is somewhere in the area of $600million.And for everysuccessfuldrug,therearemanyexpensiveresearchforaysthatendinfailure.Isthere a way to provide affordable drugs to low-income Americans—or poorindividualselsewhere in theworld—withoutdestroying the incentive to inventthosedrugs?Yes;thegovernmentcouldbuyoutthepatentwhenanewdrugisinvented.Thegovernmentwouldpay a firmup front a sumequal towhat thefirmwouldhaveearnedoverthecourseofitstwenty-yearpatent.Afterthat,thegovernmentwouldownthepropertyrightandcouldchargewhateverprice forthedrugsitdeemedappropriate.It’sanexpensivesolutionthatcomeswithsomeproblems of its own. For example,which drug patentswould the governmentbuy?Isarthritisseriousenoughtojustifyusingpublicfundstomakeanewdrugmoreaffordable?Howaboutasthma?Still,thiskindofplanisatleastconsistentwith the economic reality: Individuals and firms will make investments onlywhentheyareguaranteedtoreapwhattheysow,literallyorfiguratively.

Ioncestumbledonacuriousexampleofhowambiguouspropertyrightscanstifle economic development. I was working on a long story on AmericanIndians forThe Economist. Having spent time on a handful of reservations, Inoticed that there was very little private housing stock. Tribalmembers livedeitherinhousesthathadbeenfinancedbythefederalgovernmentorintrailers.Why? One principal reason is that it is difficult, if not impossible, to get aconventionalhomemortgageonanIndianreservationbecausethelandisownedcommunally.Atribalmembermaybegivenapieceoflandtouse,butheorshe

doesnotownit;theIndianNationdoes.Whatthatmeanstoacommercialbankis thatamortgage thathas fallendelinquentcannotbe foreclosed. Ifabank isdenied thatunpleasantbutnecessaryoption, then the lender is leftwithoutanyeffectivecollateralonitsloan.Atrailer,ontheotherhand,isdifferent.Ifyoufalldelinquentonyourpayments,thecompanycanshowuponedayandhaulitoffthe reservation.But trailers, unlike conventional housing, do not support localbuilding trades.Theyare assembled thousandsofmiles away in a factory andthen transported to the reservation. That process does not provide jobs forroofers, and masons, and drywallers, and electricians—and jobs are whatAmerica’sIndianreservationsneedmorethananythingelse.

Governmentlowersthecostofdoingbusinessintheprivatesectorinallkindsofways: by providing uniform rules and regulations, such as contract law; byrooting out fraud; by circulating a sound currency. Government builds andmaintains infrastructure—roads, bridges, ports, and dams—that makes privatecommercelesscostly.E-commercemaybeamodernwonder,butlet’snotlosesightof thefact thatafteryouorderkhakisfromGap.com,theyaredispatchedfromadistributioncenter ina truckbarrelingalongan interstate. In the1950sand1960s,newroads,includingtheinterstatehighwaysystem,accountedforasignificant fraction of new capital created in the United States. And thatinvestmentininfrastructureisassociatedwithlargeincreasesinproductivityinindustriesthatarevehicle-intensive.9

Effectiveregulationandoversightmakemarketsmorecredible.Becauseofthediligenceof theSecurities andExchangeCommission (SEC), one canbuyshares in a newcompany listedon theNASDAQwith a reasonable degree ofcertainty that neither the company nor the traders on the stock exchange areengaging in fraud. In short, government is responsible for the rule of law.(Failureoftheruleoflawisonereasonwhynepotism,clans,andotherfamily-centered behavior are so common in developing countries; in the absence ofbindingcontractualagreements,businessdealscanbeguaranteedonlybysomekind of personal relationship.) Jerry Jordan, former president of the FederalReserveBankofCleveland,oncemusedon something that is obviousbut toooften taken forgranted:Our sophisticated institutions,bothpublicandprivate,make it possible to undertake complex transactions with total strangers. Henoted:

It seems remarkable, when you think about it, that we often takesubstantial amounts ofmoney to our bank andhand it over to peoplewehave never met before. Or that securities traders can send millions ofdollarstopeopletheydon’tknowincountriestheyhaveneverbeenin.Yetthisoccursall the time.Wetrust that the infrastructure isset inplace thatallows us not toworry that the person at the bankwho takes ourmoneydoesn’tjustpocketit.OrthatwhenweusecreditcardstobuyanewCDortennis racquet over the Internet, from a business that is located in someother stateorcountry,weareconfidentwewillgetourmerchandise, andtheyareconfidenttheywillgetpaid.10

Shakespearemayhaveadvisedustogetridofallthelawyers,buthewasaplaywright,notaneconomist.Therealityisthatweallcomplainaboutlawyersuntilwehavebeenwronged,atwhichpointwerunoutandhirethebestonewecan find. Government enforces the rules in a reasonably fair and efficientmanner. Is it perfect?No.But rather than singing the praises of theAmericanjustice system, let me simply provide a counterexample from India. AbdulWaheedfiledalawsuitagainsthisneighbor,amilkmerchantnamedMohammadNanhe,whohadbuiltseveraldrainsattheedgeofhispropertythatemptiedintoMr.Waheed’s front yard.Mr.Waheeddidnot like thewater drainingontohisproperty,inpartbecausehehadhopedtoaddathirdroomtohiscementhouseandhewasworriedthatthedrainswouldcreateaseepageproblem.Sohesued.ThecasecametotrialinJune2000inMoradabad,acitynearNewDelhi.11

Thereisonemajorcomplicationwiththiscivildispute:Thecasehadbeenfiled thirty-nine years earlier; Mr. Waheed was dead and so was Mr. Nanhe.(Their relatives inherited the case.) By one calculation, if no new cases werefiledinIndia,itwouldstilltake324yearstoclearalltheexistingcasesfromthedocket.Thesearenotjustcivilcases.Inlate1999,aseventy-five-year-oldmanwasreleasedfromaCalcuttajailafterwaitingthirty-sevenyearstobetriedonmurdercharges.Hewasreleasedbecausethewitnessesandinvestigatingofficerwerealldead.(Ajudgehaddeclaredhimmentallyincompetenttostandtrialin1963buttheactionwassomehowlost.)Bearinmindthatbydevelopingworldstandards, Indiahasrelativelygoodgovernment institutions. InSomalia, thesekindsofdisputesarenotresolvedinthecourts.

All the while, government enforces antitrust laws that forbid companiesfromconspiringtogetherinwaysthaterasethebenefitsofcompetition.Having

threeairlinesthatsecretlycolludewhensettingfaresisnobetterthanhavingoneslovenlymonopoly.Thebottomlineisthatalltheseinstitutionsformthetracksonwhich capitalism runs. Thomas Friedman, foreign affairs columnist for theNewYorkTimes,oncemade thispoint inacolumn.“DoyouknowhowmuchyouraverageRussianwouldgiveforaweekof[theU.S.DepartmentofJustice]bustingRussia’soligarchsandmonopolists?”hequeried.12Hepointedout thatwithmanyoftheworld’seconomiesplaguedbyendemiccorruption,particularlyinthedevelopingworld,hehasfoundthatforeignersoftenenvyusfor…holdonto your latte here…ourWashington bureaucrats; “that is, our institutions, ourcourts,ourbureaucracy,ourmilitary,andourregulatoryagencies—theSEC,theFederalReserve,theFAA,theFDA,theFBI,theEPA,theIRS,theINS,theU.S.PatentOfficeandtheFederalEmergencyManagementAgency.”

Thegovernmenthasanothercrucialrole:Itprovidesawidearrayofgoods,so-called “public goods,” that make us better off but would not otherwise beprovidedbytheprivatesector.SupposeIdecidetobuyanantimissilesystemtoprotectmyselffrommissileslobbedbyroguenations.(ItwouldbesimilartotheDirecTVsatellitedish,onlyalotmoreexpensive.)IaskmyneighborEtienneifhewouldliketosharethecostofthissystem;hesaysno,knowingfullwellthatmymissiledefensewillshieldhishousefromanymissilesthatNorthKoreamaysend our way. Etienne, and most of my other neighbors, have a powerfulincentivetobe“freeriders”onmysystem.Atthesametime,Idonotwant topay the full cost of the systemmyself. In the end,we get nomissile defensesystemeventhoughitmighthavemadeusallbetteroff.

Publicgoodshavetwosalientcharacteristics.First, thecostofofferingthegoodtoadditionalusers—eventhousandsormillionsofpeople—isveryloworeven zero. Think of that missile defense system; if I pay to knock terroristmissilesoutofthesky,themillionsofpeoplewholiverelativelyclosetomeintheChicagometropolitanareagetthatbenefitfree.Thesameistrueofaradiosignaloralighthouseoralargepark;onceitisoperationalforoneperson,itcanservethousandsmoreatnoextracost.Second,itisveryhard,ifnotimpossible,toexcludepersonswhohavenotpaidforthegoodfromusingit.Howexactlydoyoutellaship’scaptainthathecan’tusealighthouse?Doyoumakehimclosehiseyesashesailsby?(“AttentionUSSBritannica:Youarepeeking!”)IoncehadaprofessoratPrincetonwhobeganhis lectureonpublicgoodsbysaying,“Okay,whoarethesuckerswhoactuallycontributetopublicradio?”

Freeriderscancrippleenterprises.AuthorStephenKingonceattemptedanexperimentinwhichheofferedhisnewnoveldirectlytoreadersviatheInternet.

Theplanwasthathewouldoffermonthlyinstallmentsforreaderstodownloadin exchange for a$1paymentbasedon thehonor system.Hewarned that thestory would fold if fewer than 75 percent of readers made the voluntarypayment. “If you pay, the story rolls. If you don’t, it folds,” hewrote on thewebsite. The outcome was sadly predictable to economists who have studiedthese kinds of problems. The story folded.At the time “The Plant”went intohibernation, only 46 percent of readers had paid to download the last chapteroffered.

Thatisthebasicproblemifpublicgoodsarelefttoprivateenterprise.Firmscannot force consumers to pay for these kinds of goods, nomatter howmuchutilitytheymayderivefromthemorhowoftentheyusethem.(Rememberthelighthouse.)Andanysystemofvoluntarypaymentsfallspreytothefreeriders.Thinkaboutthefollowing:

Basicresearch.Wehavealreadydiscussedthepowerfulincentivesthatprofits create for pharmaceutical companies and the like.But not allimportant scientific discoveries have immediate commercialapplications.Exploringtheuniverseorunderstandinghowhumancellsdivide or seeking subatomic particles may be many steps removedfrom launching a communications satellite or developing a drug thatshrinkstumorsorfindingacleanersourceofenergy.Asimportant,thiskindofresearchmustbesharedfreelywithotherscientistsinordertomaximizeitsvalue.Inotherwords,youwon’tgetrich—orevencoveryourcostsinmostcases—bygeneratingknowledgethatmaysomedaysignificantly advance the human condition.Most ofAmerica’s basicresearchisdoneeitherdirectlybythegovernmentatplaceslikeNASAandtheNationalInstitutesforHealthoratresearchuniversities,whicharenonprofitinstitutionsthatreceivefederalfunding.Law enforcement. There is no shortage of private security firms—“rent-a-cops”asweusedtocallthemincollegeastheyaggressivelysoughtout twenty-year-oldbeerdrinkers.But thereisa limit towhattheycanorwilldo.Theywillonlydefendyourpropertyagainstsomekind of trespass. They will not proactively seek out criminals whomight someday break into your house; they will not trackMexicandrugkingpinsorstopfelonsfromenteringthecountryorsolveother

crimes so that the perpetrator does not eventually attack you.All ofthesethingswouldmakeyouandyourpropertysaferinthelongrun,but they have inherent free rider problems. If I pay for this kind ofsecurity,everyoneelseinthecountrybenefitsatnocost.Everywherein the world, most kinds of law enforcement are undertaken bygovernment.Parksandopenspace.Chicago’s lakefront is thecity’sgreatestasset.For some thirty miles along Lake Michigan, there are parks andbeachesownedbythecityandprotectedfromprivatedevelopment.Ifthis is thebestuseof theland,whichIfirmlybelieveit is, thenwhywouldn’taprivate landowneruseit for thesamepurposes?Afterall,we’vejuststipulatedthatprivateownershipofanassetensuresthatitwill be put to its most productive use. If I owned thirty miles oflakefront, why couldn’t I charge bicyclists and roller bladers andpicnickers inorder tomakeahealthyprofit onmy investment?Tworeasons:First,itwouldbealogisticalnightmaretopatrolsuchalargeareaandchargeadmission.More important,manyof thepeoplewhovalueanopenlakefrontdon’tactuallyuseit.Theymayenjoytheviewfromthewindowofahigh-riseapartmentorastheydrivealongLakeShoreDrive.Aprivate developerwould never collect anything fromthesepeople andwould thereforeundervalue theopen space.This istrueformanyofAmerica’snaturalresources.YouhaveprobablyneverbeentoPrinceWilliamSoundinAlaskaandmaynevergothere.YetyoualmostcertainlycaredwhenthehugeoiltankerExxonValdez ranagroundanddespoiledthearea.Governmentcanmakeuscollectivelybetteroffbyprotectingthesekindsofresources.

Obviously not all collective endeavors require the hand of government.Wikipediaisaprettyhandyresource,evenforthosewhodon’tmakevoluntarycontributionstokeepitupandrunning.Everyschool,church,andneighborhoodhas a group of eager beavers who do more than their fair share to provideimportant public benefits, to the great benefit of a much larger group of freeriders.Thoseexamplesnotwithstanding,therearecompellingreasonstobelievethatsocietywouldunderinvest in things thatwouldmakeusbetteroffwithoutsomekindofmechanism to forcecooperation.Asmuchas I love the spiritof

Wikipedia,I’mcomfortableleavingcounterterrorisminthehandsoftheFBI—thegovernmentinstitutionwe’vecreated(andpayforwithtaxes)toactonourbehalf.

Government redistributeswealth.We collect taxes from some citizens andprovide benefits to others. Contrary to popular opinion, most governmentbenefits do not go to the poor; they go to the middle class in the form ofMedicareandSocialSecurity.Still,governmenthas the legalauthority toplayRobin Hood; other governments around the world, such as the Europeancountries,dosoquiteactively.Whatdoeseconomicshavetosayaboutthis?Notmuch,unfortunately.Themostimportantquestionsrelatedtoincomedistributionrequire philosophical or ideological answers, not economic ones.Consider thefollowing question:Whichwould be a better state of theworld, one inwhicheverypersoninAmericaearned$25,000—enoughtocoverthebasicnecessities—or the status quo, in which some Americans are wildly rich, some aredesperately poor, and the average income is somewhere around $48,000?Thelatterdescribesabiggereconomicpie;theformerwouldbeasmallerpiemoreevenlydivided.

Economicsdoesnotprovidethetoolsforansweringphilosophicalquestionsrelatedtoincomedistribution.Forexample,economistscannotprovethattakingadollarforciblyfromSteveJobsandgivingittoastarvingchildwouldimproveoverall social welfare. Most people intuitively believe that to be so, but it istheoretically possible that Steve Jobswould losemore utility fromhaving thedollar taken from him than the starving childwould gain. This is an extremeexample of a more general problem:We measure our well-being in terms ofutility, which is a theoretical concept, not a measurement tool that can bequantified,comparedamongindividuals,oraggregatedforthenation.Wecannotsay,forexample,thatCandidateA’staxplanwouldgenerate120unitsofutilityforthenationwhileCandidateB’staxplanwouldgenerateonly111.

ConsiderthefollowingquestionposedbyAmartyaSen,winnerofthe1998NobelPrizeinEconomics.13Threemenhavecometoyoulookingforwork.Youhaveonlyonejobtooffer;theworkcannotbedividedamongthethreeofthemandtheyareallequallyqualified.Oneofyourgoalsistomaketheworldabetterplacebyhiringthemanwhoneedsthejobthemost.

Thefirstmanisthepoorestofthethree.Ifimprovinghumanwelfareisyourprimaryaim,thenpresumablyheshouldgetthejob.Ormaybenot.Thesecondman is not the poorest, but he is the unhappiest because he has only recentlybecomepoorandheisnotaccustomedtothedeprivation.Offeringhimthejob

willcausethegreatestgaininhappiness.Thethirdmanisneitherthepoorestnortheunhappiest.Buthehasachronic

health problem, borne stoically for his whole life, that can be cured with thewages from the job. Thus, giving him the jobwould have themost profoundeffectonanindividual’squalityoflife.

Whoshouldgetthejob?AswouldbeexpectedofaNobelPrizewinner,Mr.Senhasmanyinterestingthingstosayaboutthisdilemma.Butthebottomlineisthatthereisnorightanswer.Thesamethingistrue—contrarytowhatpoliticiansonbothsidesof thepoliticalspectrumwill tellyou—with issuesrelated to theredistributionofwealth inamoderneconomy.Willa tax increase that fundsabetter safety net for the poor but lowers overall economic growth make thecountry better off?That is amatter of opinion, not economic expertise. (Notethateverypresidentialadministrationisabletofindveryqualifiedeconomiststosupport its ideologicalpositions.)Liberals(in theAmericansenseof theword)often ignore thefact thatagrowingpie,even ifunequallydivided,willalmostalwaysmakeeventhesmallpieceslarger.Thedevelopingworldneedseconomicgrowth(towhichinternationaltradecontributesheavily)tomakethepoorbetteroff. Period. One historical reality is that government policies that ostensiblyserve thepoor canbe ineffectiveor even counterproductive if theyhobble thebroadereconomy.

Meanwhile,conservativesoftenblithelyassumethatweshouldallrushoutinto the street and cheer for any policy that makes the economy grow faster,neglecting the fact that there are perfectly legitimate intellectual grounds forsupporting other policies, such as protecting the environment or redistributingincome, thatmay diminish the overall size of the pie. Indeed, some evidencesuggests that our sense of well-being is determined at least as much by ourrelativewealthasitisbyourabsolutelevelofwealth.Inotherwords,wederiveutilitynotjustfromhavingabigtelevisionbutfromhavingatelevisionthatisasbigasorbiggerthantheneighbors.’

Then there is one of the most controversial questions of all: Shouldgovernmentprotectpeoplefromthemselves?Shouldsocietyexpendresourcestostopyoufromdoingstupidthingsthatdon’taffecttherestofus?Oristhatyourbusiness?Themostimportantthingtorealizeisthattheanswertothisquestionis philosophical; the best economics can do is frame the range of defensibleviews.Atoneendofthecontinuumisthebeliefthatindividualsarerational(oratleastmorerationalthangovernment),meaningthatindividualcitizensarethebestjudgeofwhatisgoodforthem,nottherestofus.Ifyouliketosniffglue

andthenrollbackwarddownthebasementsteps,goodforyou.Justmakesurethatyoupayallyourownhealth care costs anddon’tdrivea car afteryou’vebeenintotheglue.

The behavioral economists have provided plenty of ammunition for theoppositeendof thecontinuum,wherereasonablepeoplearguethatsocietycanandshouldstoppeople fromdoing things thatare likely to turnoutbadly.Wehave good evidence that human decision making is prone to certain kinds oferrors, such as underestimating risk or planning poorly for the future. As apracticalmatter,thosemistakesoftendospillovertoaffecttherestofus,aswesawintherealestatecollapseandtheaccompanyingmortgagemess.

Andthereisarangeofviewsinbetween(e.g.,you’reallowedtosniffglueand roll down the steps but onlywhilewearing a helmet).One intriguing andpractical middle ground is the notion of “libertarian paternalism,” which wasadvancedinaninfluentialbookcalledNudgebyRichardThaler,aprofessorofbehavioral science and economics at the University of Chicago, and CassSunstein, a Harvard Law School professor now serving in the Obamaadministration.Theideabehindbenignpaternalismisthatindividualsdomakesystematicerrorsofjudgment,butsocietyshouldnotforceyoutochangeyourbehavior(that’sthelibertarianpart);instead,weshouldmerelypointyouintherightdirection(that’sthepaternalismpart).

OneofThalerandSunstein’skey insights is thatourdecisionsareoftenaproductof inertia. Ifour employer automatically signsusup for somekindofinsurancecoverage,thenwe’llstickwiththat,evenifsixotherplansareoffered.Conversely,wemaynotsignupforanyplanatallifitrequiressomeproactivebehavioronourpart—readingabenefitsmanual, fillingoutaform,goingtoastupidhumanresourcesseminar,ordoinganythingelse that involves timeandeffort. Thaler and Sunstein propose that inertia (and other decision-makingfoibles) can be used to some advantage. If policymakers are concerned aboutsome individual behavior, such as inadequate retirement savings, then thelibertarian paternalistic option is to make the default option one thatautomatically puts a decent amount of money from every paycheck into aretirementaccount.That’sthe“nudge.”Anyoneisfreetochooseanotheroptionatanytime.Butashockinglyhighproportionofpeoplewillstaywhereveryouputtheminthefirstplace.

Thisideahasprofoundimplicationswhenitcomestosomethinglikeorgandonation. Spain, France, Norway, Israel, andmany other countries have “opt-out” (orpresumedconsent) lawswhen itcomes toorgandonation.Youarean

organdonorunlessyouindicateotherwise,whichyouarefreetodo.(Incontrast,the United States has an “opt-in” system, meaning that you are not an organdonor unless you sign up to be one.) Inertia matters, even when it comes tosomethingasseriousasorgandonation.Economistshave found thatpresumedconsentlawshaveasignificantpositiveeffectonorgandonation,controllingforrelevantcountrycharacteristicssuchas religionandhealthexpenditures.Spainhas the highest rate of cadaveric organ donations in the world—50 percenthigherthantheUnitedStates.14Truelibertarians(asopposedtothepaternalistickind) reject presumed consent laws, because they imply that the government“owns”yourinternalorgansuntilyoumakesomeefforttogetthemback.

Good governmentmatters. Themore sophisticated our economy becomes, themore sophisticated our government institutions need to be. The Internet is aperfectexample.Theprivatesectoristheengineofgrowthforthewebeconomy,butitisthegovernmentthatrootsoutfraud,makeson-linetransactionslegallybinding,sortsoutpropertyrights(suchasdomainnames),settlesdisputes,anddealswithissuesthatwehavenoteventhoughtaboutyet.

One sad irony of September 11 was that one simple-minded view ofgovernment—that“taxpayersknowbetterwhattodowiththeirmoneythanthegovernmentdoes”—wasexposedforitshollowness.Individualtaxpayerscannotgather intelligence, trackdown a fugitive in themountains ofAfghanistan, doresearch on bioterrorism, or protect planes and airports. It is true that if thegovernment takesmoneyoutofmypaycheck, then thereare things thatwouldhavegivenmeutilitythatIcannolongerbuy.Butit isalsotruethat therearethingsthatwouldmakemebetteroffthatIcannotbuyformyself.Icannotbuildamissiledefensesystem,orprotectendangeredspecies,orstopglobalwarming,or install traffic lights,or regulate theNewYorkStockExchange,ornegotiatelowertradebarrierswithChina.Governmentenablesustoworkcollectivelytodothosethings.

CHAPTER4

GovernmentandtheEconomyII:

Thearmywasluckytogetthatscrewdriverfor$500

Bynowyouareprobablyreadytoextolthevirtuesofbureaucracyatyournextdinner party. Not so fast. If government were so wonderful, then the mostgovernment-intensivecountriesintheworld—placeslikeNorthKoreaandCuba—wouldbeeconomicpowerhouses.They’renot.Governmentisgoodatdoingsome things and tragically bad at doing others. Government can deal withsignificant externalities—or it can regulate an economy to the point of ruin.Government can provide essential public goods—or it can squander enormoustaxrevenuesonineffectiveprogramsandpetprojects.Governmentcantransfermoney from thewealthy to the disadvantaged—or it can transfermoney fromcommonfolktothepoliticallywell-connected.Inshort,governmentcanbeusedto create the foundations for a vibrant market economy or to stifle highlyproductivebehavior.Thewisdom,ofcourse,liesintellingthedifference.

Thereisanoldjoke,oneofRonaldReagan’sfavorites,thatgoessomethinglikethis:

ASovietwomanistryingtobuyaLada,oneofthecheapautomobilesmadeintheformerSovietUnion.Thedealertellsherthatthereisashortageofthesecars, despite their reputation for shoddy quality. Still, the woman insists onplacinganorder.Thedealergetsoutalarge,dustyledgerandaddsthewoman’snametothelongwaitinglist.“ComebacktwoyearsfromnowonMarch17th,”hesays.

Thewomanconsultshercalendar.“Morningorafternoon?”sheasks.“Whatdifferencedoesitmake?”thesurlydealerreplies.“That’stwoyears

fromnow!”“Theplumberiscomingthatday,”shesays.If theUSSR taughtusanything, it is thatmonopoly stifles anyneed tobe

innovative or responsive to customers. And government is one very large

monopoly.Whyistheclerkat theDepartmentofMotorVehiclesploddingandsurly? Because she can be. What would your business look like if yourcustomers, by law, could not go anywhere else? It would certainly make methink twice about working late, or, for that matter, working at all on warmsummerdayswhentheCubswereplayingathome.

Government operations are often described as inefficient. In fact, theyoperate exactly as we would expect given their incentives. Think about theDepartment of Motor Vehicles, which has a monopoly on the right to grantdriver’s licenses. What is the point of being friendly, staying open longer,makingcustomerscomfortable,addingclerkstoshortenlines,keepingtheofficeclean, or interrupting a personal callwhen a customer comes to thewindow?Noneofthesethingswillproduceevenonemorecustomer!Everysinglepersonwho needs a driver’s license already comes to theDMV andwill continue tocomenomatter howunpleasant the experience.There are limits, of course. Ifservicebecomesbadenough,thenvotersmaytakeactionagainstthepoliticiansin charge. But that is an indirect, cumbersome process. Compare that to youroptions in the private sector. If a rat scampered across the counter at yourfavoriteChinesetake-outrestaurant,youwould(presumably)juststoporderingthere. End of problem. The restaurant will get rid of the rats or go out ofbusiness.Meanwhile, if you stop going to theDepartment ofMotorVehicles,youmayendupinjail.

This contrast was illustrated to me quite sharply when a check I wasexpectingfromFidelity,themutualfundcompany,failedtoshowupinthemail.(Ineededthemoneytopaybackmymother,whocanbeafiercecreditor.)Dayafter daywent by—no check.Meanwhile,mymotherwas “checking in”withincreasingfrequency.Oneoftwopartieswasguilty,FidelityortheU.S.PostalService,andIwasgettingprogressivelymoreangry.FinallyIcalledFidelitytodemandproofthatthecheckhadbeenmailed.Iwaspreparedtomoveallofmy(relatively meager) assets to Vanguard, Putnam, or some other mutual fundcompany (or at least make the threat). Instead, I spoke with a very friendlycustomer assistant who explained that the check had been mailed two weeksearlierbutapologizedprofuselyformyinconvenienceanyway.Shecanceledthecheckandissuedanotheroneinamatterofseconds.Thensheapologizedsomemoreforaproblemthat,itwasnowapparent,hercompanydidnotcause.

The culprit was the post office. So I got even angrier and then…I didnothing. What exactly was I supposed to do? The local postmaster does notacceptcomplaintsbyphone.Ididnotwanttowastetimewritingaletter(which

mightneverarriveanyway).Norwouldithelptocomplaintoourlettercarrier,who has never been consumed by the quality of his service. Roughly once amonthhegets“off”byahouseanddeliverseveryfamily’smailtothehouseonedoortothewest.Thepoint,carefullydisguisedinthisdiatribe,is thattheU.S.PostalServicehasamonopolyonthedeliveryoffirst-classmail.Anditshows.

There are two broader lessons to be learned from this. First, governmentshouldnotbethesoleproviderofagoodorserviceunlessthereisacompellingreason to believe that the private sector will fail in that role. This exclusionleaves plenty for government to do in areas ranging from public health tonational defense. Having just lambasted the Department ofMotor Vehicles, Imust admit that issuing driver’s licenses is probably a function that shouldremaininthehandsofgovernment.Privatefirmsissuingdriver’slicensesmightnotcompeteonlyonpriceandqualityof service; theywouldhaveapowerfulincentive to attract customersby issuing licenses todriverswhodon’tdeservethem.

Still, that leaves a lot of things that government should not be doing.Deliveringmail is one of them.A century ago the governmentmay have hadlegitimate reasons for being in the mail business. The U.S. Postal Serviceindirectlyassistedunderdevelopedregionsof thecountrybyguaranteeingmaildelivery at a subsidized rate (since delivering mail to remote areas is moreexpensivethandeliveringtoametropolitanareabutthestampcoststhesame).The technologywasdifferent, too. In1820, itwasunlikely thatmore thanoneprivate firm would have made the massive investment necessary to build asystemthatcoulddelivermailanywhereinthecountry.(Aprivatemonopolyisno better—and perhaps worse—than a government monopoly.) Times havechanged.FedExandUPShaveprovedthatprivatefirmsareperfectlycapableofbuildingworldwidedeliveryinfrastructures.

Is there a huge economic cost associated with mediocre mail service?Probably not.But imagine theU.S. Postal Service controlling other importantsectorsoftheeconomy.Elsewhereintheworld,thegovernmentrunssteelmills,coalmines,banks,hotels,airlines.Allthebenefitsthatcompetitioncanbringtothesebusinessesarelost,andcitizensaremadeworseoffasaresult.(Foodforthought: One of the largest government monopolies remaining in the UnitedStatesispubliceducation.)

There isasecondmoresubtlepoint.Even ifgovernmenthasan importantrole to play in the economy, such as building roads and bridges, it does notfollow thatgovernmentmust actuallydo thework.Government employeesdo

not have to be the ones pouring cement. Rather, government can plan andfinanceanewhighwayand thensolicitbids fromprivatecontractors todo thework.Ifthebiddingprocessishonestandcompetitive(big“ifs”inmanycases),thentheprojectwillgotothefirmthatcandothebestworkatthelowestcost.Inshort,apublicgoodisdeliveredinawaythatharnessesallthebenefitsofthemarket.

This distinction is sometimes lost on American taxpayers, a point thatBarackObamamadeduringoneofhistownhallmeetingsonhealthcarereform.He said, “I got a letter the other day from awoman. She said, ‘I don’t wantgovernment-runhealthcare.Idon’twantsocializedmedicine.Anddon’ttouchmyMedicare.’”Theirony,ofcourse,isthatMedicareisgovernment-runhealthcare;theprogramallowsAmericansoverage65toseekcarefromtheirprivatedoctors,whoare then reimbursedby the federalgovernment.Even theCentralIntelligenceAgencyhastakenthis lessontoheart.TheCIAneedstobeonthecuttingedgeoftechnology,yetitcannotprovidethesameincentivestoinnovateastheprivatesectorcan.SomeonewhomakesabreakthroughdiscoveryattheCIAwill not find himself or herselfworth hundreds ofmillions of dollars sixmonthslater,asmighthappenataSiliconValleystartup.SotheCIAdecidedtousetheprivatesectorforitsownendsbyusingmoneyappropriatedbyCongresstoopenitsownventurecapitalfirm,namedIn-Q-It(inaslyreferencetoQ,thetechnologyguruwhodevelopsgadgetsforJamesBond).1AnIn-Q-Itexecutiveexplainedthatthepurposeoftheventurewasto“moveinformationtechnologytotheagencymorequicklythantraditionalGovernmentprocurementprocessesallow.” Like any other venture capital firm, In-Q-It will make investments insmallfirmswithpromisingnewtechnologies.In-Q-Itandthefirmsitbankrollswillmakemoney—perhaps a lot ofmoney—if these technologies turn out tohavevaluablecommercialapplications.Atthesametime,theCIAwillretaintheright to use any new technology with potential intelligence-gatheringapplications. A Silicon Valley entrepreneur funded by In-Q-It may develop abetter way to encrypt data on the Internet—something that e-commerce firmswouldsnapup.Meanwhile,theCIAwouldendupwithabetterwaytosafeguardinformationsenttoWashingtonbycovertoperativesaroundtheworld.

Intheprivatesector,marketstelluswheretodevoteourresources.Whilesittingin the center-field seats at a Chicago White Sox game, I spotted a vendorwalking through the stands wearing what was prominently advertised as the

Margarita Space Pak. This piece of technology enabled the vendor to makefrozenmargaritasonthespot;somehowhemixedthedrinksinhisbackpack-likedevice and then poured them through a hose into plastic cups. The ostensiblesocialbenefitofthisbreakthroughtechnologywasthatbaseballfanscouldnowenjoymargaritas,ratherthanjustbeer,withoutleavingtheirseats.Isuspectthatsomeofourcountry’stopengineeringminds—ascarceresource—devotedtheirtimeandefforttocreatingtheMargaritaSpacePak,whichmeansthattheywerenot spending their time searching for a cheaper, cleaner source of energyor abetter way to deliver nutrients to malnourished children in Africa. Does theworld need the Margarita Space Pak? No. Could the engineering minds thatcreatedithavebeenputtosomemoresociallyusefulpurpose?Yes.But—thisisanimportantpoint—that’smyopinionandIdon’truntheworld.

Whengovernmentcontrolssomeelementoftheeconomy,scarceresourcesareallocatedbyautocratsorbureaucratsorpoliticiansratherthanbythemarket.In the formerSovietUnion,massivesteelplantschurnedout tonsofsteel,buttheaveragecitizencouldn’tbuysoapordecentcigarettes.Inhindsight,itshouldnothavebeenasurprisethattheUSSRwasthefirsttosendarocketintoorbit(and equally obvious that it would not invent theMargarita Space Pak). Thegovernmentcouldsimplymandatethatresourcesbespentonthespaceprogram,even if peoplewould ratherhavehad freshvegetablesor tube socks.Someofthese resource allocation decisions were tragic. For example, Soviet centralplanners did not consider birth control to be an economic priority.TheSovietgovernment could havemade contraceptives available to all; any country thatcan build intercontinental ballisticmissiles has the know-how tomake a birthcontrol pill, or at least a condom. But contraception simply was not wherecentralplannerschosetochannelthecountry’sresources,leavingabortionastheonly formof familyplanning. In theyearsofcommunism, therewere roughlytwoabortionsforeverysinglelivebirth.SincethecollapseoftheSovietUnion,Westerncontraceptiveshavebecomewidelyavailableandtheabortionratehasfallenbyhalf.

Even indemocraticcountries, thepoliticalprocesscandevote resources tosome pretty strange places. I once interviewed a technology expert about thegovernment’splansatthetimetobuildahigh-speedparticleaccelerator(agoodexampleofbasicresearch).Theacceleratorwouldbringjobsandfederalmoneytothelocationthatlandedtheproject.Thiswasintheearly1990s,andthetwoleading siteswerenorthern Illinois and somewhere inTexas.According to thefellow I was speaking with, Illinois was the more attractive site because it

already had a particle accelerator and amajor federal laboratory.Much of thescientific infrastructure was in place and would not have to be duplicated.Despitethat,theprojectwassitedinTexas.“Why?”Iasked.Thisguylookedatme as if I were some kind of idiot. “Because George [H. W.] Bush waspresident,”he answered, as if there couldbenomoreobvious reason toput agiantparticleacceleratorinTexas.Intheend,thegovernmentspentroughly$1billionontheprojectandthenabandonedit.

The private sector allocates resources where they will earn the highestreturn. In contrast, the government allocates resources wherever the politicalprocesssendsthem.(Considerafront-pageheadlineintheWallStreetJournal:“IndustriesThatBackedBushAreNowSeekingReturnonInvestment.”)2

Is that because Republicans are particularly prone to this kind ofmoney-grubbingpoliticalinfluence?Perhaps.Butthatwouldn’texplainthismorerecentNewYorkTimesheadline:“InWashington,OneBankChiefStillHoldsSway.”The story began, “Jamie Dimon, the head of JPMorgan Chase, will hold ameetingofhisboardhere in thenation’s capital for the first timeonMonday,witha specialguestexpected: theWhiteHousechiefof staff,RahmEmanuel.Mr.Emanuel’sappearancewouldunderscorethepullofMr.Dimon,whoamidthedisgraceofhis industryhasemergedasPresidentObama’sfavoritebanker,and in turn, theenvyofhisWallStreet rivals. Italsoreflectsagoodreturnonwhat Mr. Dimon has labeled his company’s ‘seventh line of business’—governmentrelations.”3

There is nothing inherently wrong with this. Politics is a necessary butimperfectprocess,andeveryonehasarighttoseekinfluence.MilitarybasesgetbuiltorclosedinawaythatreflectsthemakeupoftheSenateArmedServicesCommitteeasmuchasormorethanthemilitaryneedsofthecountry.Aprivatearmyisnotanoption,sothisisthebestwecanreasonablyexpect.Butthelessthe economy is left to politics, the better. Powerful politicians should not bedeciding,forexample,whogetsbankcreditandwhodoesnot.Yetthatisexactlywhathappens inautocraticnations likeChinaand indemocraticcountries likeIndonesia where politicians play “crony capitalism.” Projects that have thepotentialtobehighlyprofitabledonotgetfinancingwhiledubiousundertakingssponsoredbythepresident’sbrother-in-lawarelavishedwithgovernmentfunds.Consumersloseintwoways.First,theirtaxmoneyissquanderedwhenprojectsthatnevershouldhavebeenfundedinthefirstplacegobust(orwhenthewholebanking system needs to be bailed out because it is full of rotten, politicallymotivated loans). Second, the economy does not develop as quickly or

efficientlyasitmightbecausecredit(afiniteresource)ischanneledawayfromworthwhile projects: car plants don’t get built; students don’t get loans;entrepreneursdon’t get funding.As a result, resources are squandered and theeconomydoesnotperformanywherenearitspotential.

Governmentneednot runsteelmillsorparceloutbank loans tomeddle in theeconomy. The more subtle and pervasive kind of government involvement isregulation.Marketsworkbecauseresourcesflowtowheretheyarevaluedmost.Government regulation inherently interferes with that process. In the worldpainted by economics textbooks, entrepreneurs cross the road to earn higherprofits.Intherealworld,governmentofficialsstandbytheroadanddemandatoll,iftheydon’tblockthecrossingentirely.Theentrepreneurialfirmmayhavetoobtainalicensetocrosstheroad,orhaveitsvehicleemissionstestedbytheDepartmentofTransportationasitcrossestheroad,orprovetotheINSthattheworkerscrossingtheroadareU.S.citizens.Someoftheseregulationsmaymakeusbetteroff.It’sgoodtohavegovernmentofficialsblockingtheroadwhenthe“entrepreneur” is carrying seven kilos of cocaine. But every single regulationcarriesacost,too.

MiltonFriedman,whowasadelightfulwriterandanarticulatespokesmanforalessintrusivegovernment(andafarmoresubtlethinkerthanmanyofthewriterswhohaunt theop-edpages thesedayspurporting to have inheritedhismantle),makesthispointinCapitalismandFreedombyrecountinganexchangebetweenaneconomistandarepresentativeoftheAmericanBarAssociationatalarge meeting of lawyers.4 The economist was arguing before the group thatadmission to the bar should be less restrictive. Allowing more lawyers topractice, including thosewhomight not be the sharpest knives in the drawer,would lower the cost of legal services, he argued. After all, some legalprocedures, such as basic wills and real estate closings, do not require theservicesofabrilliantConstitutionalscholar.HearguedbyanalogythatitwouldbeabsurdforthegovernmenttorequirethatallautomobilesbeCadillacs.Atthatpoint, a lawyer in the audience rose and said, “The country cannot affordanythingbutCadillaclawyers!”

In fact, demanding only “Cadillac lawyers” completely misses all thateconomicsseekstoteachusabouttrade-offs(forreasonsthathavenothingtodowith the fact that General Motors is a basket case). In a world with onlyCadillacs, most people would not be able to afford any transportation at all.

Sometimes there is nothing wrong with allowing people to drive ToyotaCorollas.

For a striking international example of the effects of regulation on theeconomy,considerthecivilunrestin2000inDelhi,India.5Delhi isoneof themostpollutedcitiesintheworld.AftertheSupremeCourtofIndiamadeamajordecisionregardingindustrialpollution,thousandsofDelhiresidentstooktothestreetsinviolentprotest.“Mobstorchedbuses,threwstones,andblockedmajorroads,” theNew York Times reported. Here is the twist: The protesters weresupportingthepolluters.TheSupremeCourtheldthecityofDelhiincontemptfor failing to close some ninety thousand small factories that pollute the area.Thosefactoriesemployedroughlyamillionpeoplewhowouldbethrownoutofwork. The headline on the story nicely encapsulated the trade-off: “A CruelChoiceinNewDelhi:Jobsvs.aSaferEnvironment.”

HowaboutDDT,oneofthenastierchemicalsmankindhasunleashedontheenvironment?DDTisa“persistentorganicpollutant”thatworksitswayintoandupthefoodchain,wreakinghavocalongtheway.Shouldthisnoxiouspesticidebebannedfromtheplanet?TheEconomisthasmadeaconvincingargumentthatitshouldnot.6Muchof thedevelopingworld is ravagedbymalaria;some300millionpeoplesuffer fromthediseaseeveryyearandmore thanamilliondie.(Of course,malaria is not adisease thatweareparticularly sensitive to in thedeveloped world, since it was eradicated in North America and Europe fiftyyearsago.TanzanianresearcherWenKilamaoncefamouslypointedout that ifseven Boeing 747s, mostly filled with children, crashed intoMt. Kilimanjaroeveryday,thentheworldwouldtakenotice.Thatisthescaleonwhichmalariakillsitsvictims.)7

Harvard economist Jeffrey Sachs has estimated that sub-Saharan Africawould be almost a third richer today if malaria had been eradicated in 1965.Now, back to DDT, which is the most cost-effective way of controlling themosquitoes that spread the disease. The next best alternative is not only lesseffectivebutalsofourtimesasexpensive.DothehealthbenefitsofDDTjustifyitsenvironmentalcosts?

Yes, argue some groups—like the Sierra Club, the Endangered WildlifeTrust, Environmental Defense Fund, and theWorldHealthOrganization. Yes,you read those names correctly. They have all embraced DDT as a “usefulpoison” for fighting malaria in poor countries. When the United Nationsconvened representatives from 120 countries in South Africa in 2000 to ban“persistentorganicpollutants,”thedelegatesagreedtoexemptDDTinsituations

whereitisbeingusedtofightmalaria.8Meanwhile,notallregulationsarecreatedequal.Therelevantquestionisnot

always whether or not government should involve itself in the economy; themore important issue may be how the subsequent regulation is structured.University of Chicago economist and Nobel laureate Gary Becker spends hissummersonCapeCod,whereheisafondconsumerofstripedbass.9Becausethestocksofthisfisharedwindling,thegovernmenthasimposedalimitonthetotalcommercialcatchofstripedbassallowedeveryseason.Mr.Beckerhasnoproblemwith that; hewould like tobe able to eat stripedbass tenyears fromnow,too.

Instead, he raised the issue in a column forBusinessWeek about how thegovernment chose to limit the total catch. At the time he was writing, thegovernmenthadimposedanaggregatequotaonthequantityofstripedbassthatcouldbeharvestedeveryseason.Mr.Beckerwrote,“Unfortunately,thisisaverypoorwaytocontrolfishingbecauseitencourageseachfishingboattocatchasmuch as it can early in the season, before other boats bring in enough fish toreach the aggregate quota that applies to all of them.” Everybody loses: Thefishermen get low prices for their fishwhen they sell into a glut early in theseason;then,aftertheaggregatequotaisreachedearlyintheseason,consumersareunable togetanystripedbassatall.Severalyears later,Massachusettsdidchange its system so that the striped bass quota is divided among individualfishermen;thetotalcatchisstilllimitedbutindividualfishermencanfulfilltheirquotaanytimeduringtheseason.

Thekeytothinkinglikeaneconomistisrecognizingthetrade-offsinherentto fiddlingwithmarkets. Regulation can disrupt themovement of capital andlabor, raise the cost of goods and services, inhibit innovation, and otherwiseshackle the economy (suchasby lettingmosquitoes escape alive).And that isjusttheregulationinspiredbygoodintentions.Atworst,regulationcanbecomeapowerful toolforself-interestasfirmsworkthepoliticalsystemtotheirownbenefit. After all, if you can’t beat your competitors, then why not have thegovernment hobble them for you? University of Chicago economist GeorgeStiglerwontheNobelPrizeinEconomicsin1982forhistrenchantobservationand supporting evidence that firms and professional associations often seekregulationasawayofadvancingtheirowninterests.

ConsideraregulatorycampaignthattookplaceinmyhomestateofIllinois.The state legislature was being pressured to enact more stringent licensingrequirements for manicurists. Was this a grassroots lobbying campaign being

waged by the victims of pedicures gone terribly awry? (One can just imaginethemlimpinginpainupthecapitalsteps.)Notexactly.ThelobbyingwasbeingdonebytheIllinoisCosmetologyAssociationonbehalfofestablishedspasandsalons that would rather not compete with a slew of immigrant upstarts. Thenumberofnail salonsgrew23percent in justoneyear in the late1990s,withdiscountsalonsofferingmanicuresforaslittleas$6,comparedto$25inafull-service salon. Stricter licensing requirements—which almost always exemptexisting service providers—would have limited this fierce competition bymakingitmoreexpensivetoopenanewsalon.

MiltonFriedmanhaspointedout that thesame thinghappenedonawiderscale in the 1930s. After Hitler came to power in 1933, large numbers ofprofessionalsfledGermanyandAustriafortheUnitedStates.Inresponse,manyprofessions erected barriers such as “good citizenship” requirements andlanguageexamsthathadatenuousconnectiontothequalityofserviceprovided.Friedmanpointedout that thenumberof foreign-trainedphysicians licensed topracticeintheUnitedStatesinthefiveyearsafter1933wasthesameasinthefive years before—which would have been highly unlikely if licensingrequirementsexistedonly to screenout incompetentdoctorsbutquite likely ifthe licensing requirements were used to ration the number of foreign doctorsallowedintotheprofession.

By global standards, the United States has a relatively lightly regulatedeconomy (though try making that argument at a Chamber of Commercemeeting).Indeed,onesadironyofthedevelopingworldisthatgovernmentsfailintheirmostbasictasks,suchasdefiningpropertyrightsandenforcingthelaw,whilepilingonotherkindsofheavy-handed regulation. In theory, thiskindofregulation could protect consumers from fraud, improve public health, orsafeguard theenvironment.On theotherhand,economistshaveaskedwhetherthis kind of regulation is less of a “helping hand” for society and more of a“grabbinghand”forcorruptbureaucratswhoseopportunitiestoextortbribesrisealong with the number of government permits and licenses required for anyendeavor.

Agroupofeconomists studied the“helpinghand”versus“grabbinghand”question by examining the procedures, costs, and expected delays associatedwithstartingupanewbusinessinseventy-fivedifferentcountries.10Therangewas extraordinary. Registering and licensing a business in Canada requires ameretwoprocedurescomparedtotwentyinBolivia.Thetimerequiredtoopenanewbusiness legally ranges from twodays, again inCanada, to sixmonths in

Mozambique. The cost of jumping through these assorted government hoopsrangesfrom0.4percentofpercapitaGDPinNewZealandto260percentofpercapita GDP in Bolivia. The study found that in poor countries like Vietnam,Mozambique,Egypt,andBoliviaanentrepreneurhastogiveupanamountequaltoone to two timeshisannual salary (notcountingbribesand theopportunitycostofhistime)justtogetanewbusinesslicensed.

SoareconsumerssaferandhealthierincountrieslikeMozambiquethantheyare in Canada or New Zealand? No. The authors find that compliance withinternational quality standards is lower in countrieswithmore regulation.Nordoesthisgovernmentredtapeappeartoreducepollutionorraisehealthlevels.Meanwhile, excessive regulation pushes entrepreneurs into the undergroundeconomy,wherethereisnoregulationatall.Itishardesttoopenanewbusinessincountrieswherecorruptionishighest,suggestingthatexcessiveregulationisapotentialsourceofincomeforthebureaucratswhoenforceit.

India has over a billion people, many of whom are desperately poor.Educationhasclearlyplayedaroleinmovingthenation’seconomyforwardandlifting millions of citizens out of poverty. Higher education in particular hascontributed to the creation and expansion of a vibrant information technologysector; however, a recent shortage of skilled workers has been a drag oneconomic growth. So it’s no great economic conundrum as to why apharmaceuticalcollege inMumbaiwouldseek touseemptyspace in itseight-storybuildingtodoublestudentenrollment.

The problem is that this action turned the college administration intocriminals. It’s true—the Indian government imposes strict regulations on itstechnical colleges that protect against something as reckless and potentiallydangerousasusingemptyspacetoeducatemorestudents.Specifically,thelawstipulatesthatatechnicalcollegemustprovide168squarefeetofbuildingspaceforeachstudent(toensureadequatespaceforlearning).ThatformulaprecludesthePrincipalK.M.KundnaniCollegeofPharmacyfromteachingmorethan300students—regardlessof thefact thatall the lecturehallsonthe topfloorof thebuildingarepadlockedforlackofuse.

AccordingtotheWallStreetJournal,“Therulesalsostipulatetheexactsizefor libraries and administrative offices, the ratio of professors to assistantprofessors and lecturers, quotas for student enrollment and the number ofcomputerterminals,booksandjournalsthatmustbeonsite.”11

Thankfully,governments sometimes rollback thesekindsof regulation. InNovember2008, theEuropeanUnionactedboldly to legalize…ugly fruitsand

vegetables.Priortothattime,supermarketsacrossEuropewereforbiddenfromselling“overlycurved,extraknobblyoroddlyshaped”produce.ThiswasatrueactofpoliticalcouragebyEuropeanUnionauthorities,giventhatrepresentativesfromsixteenofthetwenty-sevenmembernationstriedtoblockthederegulationwhileitwasbeingconsideredbytheEUAgriculturalManagementCommittee.12

IwishIweremakingthisstuffup.

Let’s step out of our cynical mode for a moment and return to the idea thatgovernment has the capacity to do many good things. Even then, whengovernment is doing the things that it is theoretically supposed to do,governmentspendingmustbefinancedbylevyingtaxes,andtaxesexertacostontheeconomy.This“fiscaldrag,”asBurtonMalkielhascalledit,stemsfromtwo things. First, taxes take money out of our pockets, which necessarilydiminishesourpurchasingpowerandthereforeourutility.True,thegovernmentcancreatejobsbyspendingbillionsofdollarsonjetfighters,butwearepayingforthosejetswithmoneyfromourpaychecks,whichmeansthatwebuyfewertelevisions,wegivelesstocharity,wetakefewervacations.Thus,governmentisnotnecessarilycreatingjobs;itmaybesimplymovingthemaround,or,onnet,destroying them. This effect of taxation is less obvious than the new defenseplant at which happy workers churn out shiny airplanes. (When we turn tomacroeconomicslaterinthebook,wewillexaminetheKeynesianpremisethatgovernment can increase economic growth by stoking the economy duringeconomicdownturns.)

Second, and more subtly, taxation causes individuals to change theirbehavior in ways that make the economy worse off without necessarilyprovidingany revenue for thegovernment.Thinkabout the income tax,whichcanbeashighas50cents for everydollar earnedby the timeall the relevantstateandfederaltaxesaretalliedup.Someindividualswhowouldprefertoworkif theywere takinghomeeverydollar theyearnmaydecide to leave the laborforcewhenthemarginaltaxrateis50percent.Everybodylosesinthissituation.Someone whose preference is to work quits his or her job (or does not startworkinginthefirstplace),yetthegovernmentraisesnorevenue.

As we noted in Chapter 2, economists refer to this kind of inefficiencyassociatedwith taxationas“deadweight loss.” Itmakesyouworseoffwithoutmakinganyoneelsebetteroff.Imaginethataburglarbreaksintoyourhomeandstealsassortedpersonalpossessions;inhishaste,hemakesoffwithwadsofcash

butalsoatreasuredfamilyphotoalbum.Thereisnodeadweightlossassociatedwith thecashhehasstolen;everydollarpurloinedfromyoumakeshimbetteroffbyadollar. (Perversely, it is simplya transferofwealth in theeyesofouramoral economists.) On the other hand, the stolen photo album is puredeadweightloss.Itmeansnothingtothethief,whotossesitinaDumpsterwhenhe realizeswhathehas taken.Yet it isa tremendous loss toyou.Anykindoftaxationthatdiscouragesproductivebehaviorcausessomedeadweightloss.

Taxescandiscourage investment, too.Anentrepreneurwho is consideringmakingariskyinvestmentmaydosowhentheexpectedreturnis$100millionbutnotwhen theexpected return,diminishedby taxation, isonly$60million.An individualmay pursue a graduate degree thatwill raise her income by 10percent.Butthatsameinvestment,whichiscostlyintermsoftuitionandtime,maynotbeworthwhileifherafter-taxincome—whatsheactuallyseesafterallthose deductions on the paycheck—only goes up 5 percent. (On the day myyoungerbrothergothisfirstpaycheck,hecamehome,openedtheenvelope,andthen yelled, “Who the hell is FICA?”) Or consider a family that has a spare$1,000 and is deciding between buying a big-screen television and squirrelingthe money away in an investment fund. These two options have profoundlydifferently impacts on the economy in the long run. Choosing the investmentmakes capital available to firms that build plants, conduct research, trainworkers. These investments are themacro equivalents of a college education;theymakeusmoreproductive in the longrunand thereforericher.Buying thetelevision,on theotherhand, iscurrentconsumption. Itmakesushappy todaybutdoesnothingtomakeusrichertomorrow.

Yes,moneyspentonatelevisionkeepsworkersemployedat thetelevisionfactory.But if thesamemoneywere invested, itwouldcreate jobssomewhereelse, say for scientists in a laboratory orworkers on a construction site,whilealsomakingusricherinthelongrun.Thinkaboutthecollegeexample.Sendingstudents to college creates jobs for professors. Using the samemoney to buyfancysportscarsforhighschoolgraduateswouldcreatejobsforautoworkers.Thecrucialdifferencebetweenthesescenariosisthatacollegeeducationmakesayoungpersonmoreproductivefortherestofhisorherlife;asportscardoesnot.Thus,college tuition isan investment;buyingasportscar isconsumption(thoughbuyingacarforworkorbusinessmightbeconsideredaninvestment).

Sobacktoourfamilywithaspare$1,000.Whatwilltheychoosetodowithit?Their decisionwill depend on the after-tax return the family can expect toearnbyinvestingthemoneyratherthanspendingit.Thehigherthetax,suchasa

capitalgainstax,thelowerthereturnontheinvestment—andthereforethemoreattractivethetelevisionbecomes.

Taxation discourages both work and investment. Many economists arguethatcuttingtaxesandrollingbackregulationunleashesproductiveforcesintheeconomy. This is true. Themost ardent “supply-siders” argue further that taxcuts can actually raise the amount of revenue collected by the governmentbecauseweallwillworkharder,earnhigherincomes,andenduppayingmoreintaxeseventhoughtaxrateshavefallen.ThisistheideabehindtheLaffercurve,whichprovidedtheintellectualunderpinningsforthelargeReagan-erataxcuts.Economist Arthur Laffer theorized in 1974 that high tax rates discourage somuch work and investment that cutting taxes will earn the government morerevenue,notless.(Hefirstsketchedagraphofthisideaonarestaurantnapkinwhilehavingdinnerwithagroupof journalistsandpoliticians.Inoneof life’sdeliciousironies,itwasDickCheney’snapkin.)13Atsomeleveloftaxation,thisrelationshipmustbetrue.Ifthepersonalincometaxis95percent,forexample,then no one is going to do a whole lot of work beyondwhat is necessary tosubsist. Cutting the tax rate to 50 percent would almost certainly boostgovernmentrevenues.

Butwould the same relationship hold true in theUnitedStates,where taxratesweremuchlowertobeginwith?BoththeReagantaxcutsandtheGeorgeW. Bush tax cuts provided an answer: no. These large tax cuts did not boostgovernmentrevenues(relativetowhat theywouldhavebeenin theabsenceofthetaxcut);*theyledtolargebudgetdeficits.InthecaseoftheReagantaxcuts,Mr. Laffer’s conjecture did appear to hold true for the wealthiest Americans,whoendedupsendingmoremoneytotheTreasuryaftertheirtaxrateswerecut.Of course, this may be mere coincidence. As we shall explore in Chapter 6,highlyskilledworkerssawtheirwagesrisesharplyoverthelastseveraldecadesas the economy increasingly demanded more brains than brawn. Thus, thewealthiestAmericansmayhavepaidmoreintaxesbecausetheirincomeswentupsharply,notbecausetheywereworkingharderinresponsetolowertaxrates.

IntheUnitedStates,wheretaxratesarelowrelativetotherestoftheworld,supply-sideeconomicsisachimera:Inallbutuniquecircumstances,wecannotcuttaxesandhavemoremoneytospendongovernmentprograms—apointthatconservativeeconomistsreadilyconcede.BruceBartlett,anofficial inboththeReaganandtheGeorgeH.W.Bushadministrations,haspubliclylamentedthatthe term “supply-side economics” has morphed from an important anddefensibleidea—thatlowermarginaltaxratesstimulateeconomicactivity—into

the“implausible”notion“thatalltaxcutsraiserevenue.”14WhenSenatorJohnMcCaintoldtheNationalReviewin2007thattaxcuts“asweallknow,increaserevenues,” Harvard economist GregMankiw (who served as chairman of theCouncilofEconomicAdvisersforGeorgeW.Bush)posedthelogicalfollow-upquestion on his blog: “If you think tax cuts increase revenue, why advocatespending restraint? Can’t we pay for new spending programs with more taxcuts?”15IfIsoundratheremphaticinmakingthispoint,Iam.Theproblemwiththe tax-cuts-increase-revenue fallacy is that it confuses the debate over ourpublicfinancesbygivingtheillusionthatwecangetsomethingfornothing.Youshouldrecognizebynowthatthisisnotusuallythecaseineconomics.Therearealotofgoodthingsabouttaxcuts.Theyleavemoremoneyinourpockets.Theystimulate hard work and risk-taking. In fact, the increased economic activitycaused by lower tax rates usually does help to make up for some of the lostrevenue.Onedollarintaxcutsmayonlycostthegovernmenteightycentsinlostrevenue(orfiftycentsinextremecases),asgovernmentistakingasmallersliceofabiggerpie.

Thinkaboutasimplenumericalexample.Supposethetaxrateis50percentand the tax base is $100 million. Tax revenues would be $50 million. Nowsupposethatthetaxrateiscutto40percent.Somepeopleworkextrahoursnowthat they get to keepmore of their earnings; a few spouses take second jobs.Assumethatthetaxbasegrowsto$110million.Governmentrevenueisnow40percentofthatbiggereconomy,or$44million.Governmenthaslostrevenuebytaking a smaller percentage of preexisting economic activity, but someof thatloss isoffsetby takingapercentageof theneweconomicactivity. If therehadbeennoeconomicresponsetothetaxcut,the10percentagepointcutinthetaxratewouldhavecost thegovernment$10millionin lostrevenue; instead,only$6million is forgone. (In the case of a tax increase, the samephenomenon islikely in reverse:The increase in new revenueswill beoffset in part by someshrinking of the economic pie.) Tax experts typically take these behavioralresponsesintoaccountwhenprojectingtheeffectsofataxcutorataxincrease.

In all but themost extraordinary of circumstances, there is no free lunch.Lower tax rates mean less total government revenue—and therefore fewerresourcestofightwars,balancethebudget,catchterrorists,educatechildren,ordo anything else governments typically do. That’s the tradeoff. Thebastardization of supply-side economics has taken an important intellectualdebate—whether we should pay more in taxes to get more in governmentservices, or pay less and get less—and transformed it into an intellectually

dishonestpremise:thatwecanpaylessandgetmore.Iwishthatweretrue,justasIwishthatIcouldgetrichbyworkinglessorloseweightbyeatingmore.Sofar,ithasn’thappened.

Having said all that, the proponents of smaller government have a point.Lowertaxescanleadtomoreinvestment,whichcausesafasterlong-termrateofeconomicgrowth.Itisfaciletodismissthisasabadideaorapolicythatstrictlyfavorstherich.Agrowingpieisimportant—perhapsevenmostimportant—forthosewith the smallest slices.When the economy grows slowly or sinks intorecession,itissteelworkersandbusboyswhoarelaidoff,notbrainsurgeonsanduniversity professors. In 2009, in the midst of the recession induced by thefinancial crisis, the American poverty rate was more than 13 percent—thehighestrateinmorethanadecade.

Conversely, the 1990s were pretty good for those at the bottom of theeconomic ladder. Rebecca Blank, a University of Michigan economist andmember of the Council of Economic Advisers in the Clinton administration,lookedbackontheremarkableeconomicexpansionofthe1990sandnoted:

I believe that the first and most important lesson for anti-povertywarriorsfromthe1990sis thatsustainedeconomicgrowthisawonderfulthing. To the extent that policies can help maintain strong employmentgrowth, low unemployment, and expanding wages amongworkers, thesepolicies may matter as much or more than the dollars spent on targetedprograms for the poor. If there are no job opportunities, or if wages arefalling, it is much more expensive—both in terms of dollars spent andpolitical capital—for government programs alone to lift people out ofpoverty.16

So, for two chapters now I have danced around the obvious “Goldilocks”question:IstherolethatgovernmentplaysintheUnitedStateseconomytoobig,toosmall,or justaboutright?Icanfinallyofferasimple,straightforward,andunequivocal answer: It depends on whom you ask. There are smart andthoughtfuleconomistswhowouldliketoseealarger,moreactivistgovernment;there are smart and thoughtful economists who would prefer a smallergovernment;andthereisacontinuumofthinkersinbetween.

In somecases, the expertsdisagreeover factualquestions, just as eminentsurgeonsmaydisagreeovertheappropriateremedyforopeningacloggedartery.

Forexample,thereisanongoingdisputeovertheeffectsofraisingtheminimumwage.Theorysuggeststhat theremustbeatrade-off:Ahigherminimumwageobviouslyhelpsthoseworkerswhosewagesareraised;atthesametime,ithurtssomelow-wageworkerswholosetheirjobs(ornevergethiredinthefirstplace)becausefirmscutbackonthenumberofworkerstheyemployatthenewhigherwage. Economists disagree (and present competing research) over howmanyjobs are lost when the minimum wage goes up. This is a crucial piece ofinformationifoneistomakeaninformeddecisiononwhetherornotraisingtheminimumwageisagoodpolicyforhelpinglow-wageworkers.Overtime,itisaquestionthatcanbeansweredwithgooddataandsolidresearch.(Asonepolicyanalystoncepointedouttome,itmaybeeasytoliewithstatistics,butit’saloteasiertoliewithoutthem.)

More often, economics can merely frame issues that require judgmentsbased onmorals, philosophy, and politics—somewhat as a doctor lays out theoptions to a patient. The physician can outline the medical issues related totreating an advanced cancer with chemotherapy. The treatment decisionultimately resideswith thepatient,whowill interjecthisorherownviewsonquality of life versus longevity, willingness to experience discomfort, familysituation, etc.—all perfectly legitimate considerations that have nothing to dowith medicine or science. Yet making that decision still requires excellentmedicaladvice.

In thatveinof thought,wecanpresentaframeworkfor thinkingabout theroleofthegovernmentintheeconomy.

Government has the potential to enhance the productive capacity of theeconomy andmake us much better off as a result. Government creates andsustainsthelegalframeworkthatmakesmarketspossible;itraisesourutilitybyprovidingpublicgoodsthatweareunabletopurchaseforourselves;itfixestherough edges of capitalism by correcting externalities, particularly in theenvironmentalrealm.Thus,thenotionthatsmallergovernmentisalwaysbettergovernmentissimplywrong.

That said, reasonable people can agree with everything above and stilldisagreeoverwhethertheU.S.governmentshouldbebiggerorsmaller.Itisonethingtobelieve,intheory,thatgovernmenthasthecapacitytospendresourcesin ways that will make us better off; it is another to believe that the falliblepoliticianswhomakeupCongressaregoingtochoosetospendmoneythatway.

IsaGerman-RussianmuseuminLawrenceWelk’sbirthplaceofStrasburg,NorthDakota, really apublicgood?Congress allocated$500,000 for themuseum in1990(andthenwithdrewitin1991whentherewasapublicoutcry).Howabouta$100millionappropriationtosearchforextraterrestriallife?SearchingforETmeetsthedefinitionofapublicgood,sinceitwouldbeimpracticalforeachofustomounthisorherownindividualsearchforlifeinouterspace.Still,IsuspectthatmanyAmericanswouldprefertoseetheirmoneyspentelsewhere.

If Iwere topollonehundredeconomists,nearlyeveryoneof themwouldtell me that significantly improving primary and secondary education in thiscountry would lead to large economic gains. But the same group would bedividedoverwhetherornotweshouldspendmoremoneyonpubliceducation.Why?Becausetheywoulddisagreesharplyoverwhetherpouringmoremoneyintotheexistingsystemwouldimprovestudentoutcomes.

Somegovernmentactivityshrinks thesizeof thepiebutstillmaybesociallydesirable. Transferring money from the rich to the poor is technically“inefficient”inthesensethatsendingacheckfor$1toapoorfamilymaycosttheeconomy$1.25whenthedeadweightcostsoftaxationaretakenintoaccount.Therelativelyhightaxationnecessarytosupportastrongsocialsafetynetfallsmostheavilyonthosewithproductiveassets, includinghumancapital,makingcountrieslikeFranceagoodplacetobeachildbornintoapoorfamilyandabadplacetobeanInternetentrepreneur(whichinturnmakesitabadplacetobeahigh-techworker).Overall,policiesthatguaranteesomepieforeverybodywillslowthegrowthofthepieitself.PercapitaincomeintheUnitedStatesishigherthanpercapitaincomeinFrance;theUnitedStatesalsohasahigherproportionofchildrenlivinginpoverty.

Having said all that, reasonable people can disagree over the appropriatelevel of social spending.First, theymayhavedifferent preferences about howmuchwealththeyarewillingtotradeoffformoreequality.TheUnitedStatesisa richerbutmoreunequal place thanmostofEurope.Second, thenotionof asimple trade-off between wealth and equality oversimplifies the dilemma ofhelpingthemostdisadvantaged.EconomistswhocaredeeplyaboutthepoorestAmericans may disagree over whether the poor would be helped more byexpensivegovernmentprograms,suchasuniversalhealthcare,orbylowertaxesthatwouldencourageeconomicgrowthandputmorelow-incomeAmericanstoworkathigherwages.

Last, some government involvement in the economy is purely destructive.Heavy-handedgovernmentcanbelikeamillstonearoundtheneckofamarketeconomy. Good intentions can lead to government programs and regulationswhosebenefitsaregrosslyoutweighedbytheircosts.Badintentionscanleadtoall kinds of laws that serve special interests or corrupt politicians. This isespeciallytrueinthedevelopingworld,wheremuchgoodcouldbedonejustbygettinggovernmentout of areasof the economywhere it doesnot belong.AsJerry Jordan, former president and CEO of the Federal Reserve Bank ofCleveland,hasnoted,“Whatseparatestheeconomic‘haves’fromthe‘have-nots’is whether the role of an economy’s institutions—particularly its publicinstitutions—istofacilitateproductionortoconfiscateit.”17

In short,government is likea surgeon’s scalpel: It is an intrusive tool thatcanbeusedforgoodorforill.Wieldedcarefullyandjudiciously,itwillfacilitatethe body’s remarkable ability to heal itself. In the wrong hands, or wieldedoverzealouslywitheventhebestofintentions,itcancausegreatharm.

CHAPTER5

EconomicsofInformation:

McDonald’sdidn’tcreateabetterhamburger

When Bill Clinton ran for president in 1992, he floated the idea of HopeScholarships. The Clinton plan (based on an earlier experiment at Yale) wasseeminglyelegant:Studentscouldborrowmoneyforcollegeandthenrepaytheloansaftergraduationwithapercentageof theirannual incomerather than theusual fixed payments of principal plus interest. Graduates who went on tobecome investment bankers would owe more in student loans than graduateswhocounseleddisadvantaged teens inpoorneighborhoods,whichwasexactlythepoint.Theplanwasdesignedtoaddresstheconcernthatstudentsgraduatingwithlargedebtsareforcedtodowellratherthandogood.Afterall,itishardtobecome a teacher or a socialworker after graduatingwith $75,000 in studentloans.

Intheory,theprogramwouldfinanceitself.Administratorscoulddeterminethe average postgraduation salary for eligible students and then calculate thepercentageofincometheywouldhavetopayinorderfortheprogramtorecoupits costs—say 1.5 percent of annual income for fifteen years. Students whobecamebrainsurgeonswouldpaybackmorethanaverage;studentswhofoughttropicaldiseasesinTogowouldpayless.Onaverage,thehighandlowearnerswouldcanceleachotheroutandtheprogramwouldbreakeven.

There was just one problem: The Hope Scholarships had no hope ofworking,atleastnotwithoutalarge,ongoinggovernmentsubsidy.Theproblemwasacrucialasymmetryofinformation:Studentsknowmoreabouttheirfuturecareer plans than loan administrators do. College students never know theirfuture plans with certainty, but most have a good idea whether theirpostgraduation incomewill bemoreor less thanaverage—which is enough todetermine if a Hope Scholarship would be more or less expensive than aconventionalloan.AspiringWallStreetbaronswouldavoidtheprogrambecause

it’sabaddealforthem.Whowantstopayback1.5percentof$5millioneveryyear for fifteen years when a conventional loan would be much cheaper?Meanwhile,theworld’sfuturekindergartenteachersandPeaceCorpsvolunteerswouldoptin.

Theresultiscalledadverseselection;futuregraduatessortthemselvesinoroutoftheprogrambasedonprivateinformationabouttheircareerplans.Intheend, the program attracts predominantly low earners. The repaymentcalculations,basedontheaveragepostgraduationsalary,nolongerapplyandtheprogramcannotrecoveritscosts.OnemayassumethatMr.ClintonignoredwhathisadvisersalmostcertainlytoldhimabouttheYaleexperiment:Itwasquietlycanceledafterfiveyears,bothbecauserepaymentsfellshortofprojectionsandbecausetheadministrativecostswereprohibitive.

What we don’t know can hurt us. Economists study how we acquireinformation,whatwedowithit,andhowwemakedecisionswhenallwegettoseeisabook’scover.Indeed,theSwedishAcademyofSciencesrecognizedthispoint in 2001 by awarding the Nobel Prize in Economics to George Akerlof,MichaelSpence,andJosephStiglitzfortheirseminalworkontheeconomicsofinformation.Theirworkexplores theproblems that arisewhen rationalpeopleare forced to make decisions based on incomplete information, or when oneparty to a transaction knowsmore than another. Their insights are relevant tosomeofourmostpressingsocialissues,fromgeneticscreeningtodiscriminationintheworkplace.

Consider a small law firm interviewing two job candidates, onemale andone female.Bothcandidatesare recentHarvardLawSchoolgraduatesandareeminentlyqualifiedfortheposition.Ifthe“best”candidateforthejobistheonewho will earn the most money for the firm, which seems a reasonableassumption, then I will argue that the rational choice is to hire theman. Theinterviewerhasnospecificinformationonthefamilyplansofthecandidatesathand (and is forbidden by law from asking about them), but can make areasonable inference based on what everyone knows about America at thebeginningofthetwenty-firstcentury:Womenstillbearthebulkofchild-rearingresponsibilities. Demographics suggest that both candidates are likely to startfamiliesinthenearfuture.Yetonlythefemalecandidatewilltakepaidmaternityleave.Moreimportant,shemaynotreturntoworkafterhavingthechild,whichleavesthefirmwiththecostoffinding,hiring,andtraininganotherlawyer.

Isanyofthiscertain?No.Themalecandidatemayhavedreamsofstayinghomewithhisfivechildren; thefemalecandidatemayhavedecidedyearsago

that she has no interest in having children. But these are not the most likelyscenarios.Thefemalecandidateispunishedbecausethefirmhasnoinformationonherspecificcircumstancesbutgooddataonbroadsocialtrends.Isthisfair?No.(Andit’snotlegaleither.)Yetthefirm’slogicmakessense.Inotherwords,itis rational to discriminate in this case, which turns the whole idea ofdiscrimination on its head. Discrimination is usually irrational. As Nobellaureate Gary Becker pointed out in The Economics of Discrimination,employerswith a “taste for discrimination” sacrifice profits because they passoverminoritiesinfavoroflessqualifiedwhites.1Apatientwhorefusestoseeaneminent black doctor because of his skin color is a fool. A law firm thatminimizesemployeeturnoverbyplayingthestatisticalaveragesmayoffendoursensibilitiesandviolatefederallaw—butitisnotfoolish.

When we approach this situation as an information problem, there areseveralcrucialinsights.First,firmsarenottheonlyvillains.Whenprofessionalwomen choose to have a child, take paidmaternity leave, and then quit theircompanies,theyimposeacost,arguablyunfair,ontheirfirms.Moreimportant,theyimposeacostonotherwomen.Firmsthatfeeltheyhavebeen“burned”byemployees who take maternity leave and then quit are more likely todiscriminateagainstyoungwomeninthehiringprocess(particularlythosewhoare alreadypregnant) and less likely to offer generousmaternity benefits.Thegoodnewsisthatthereisaquickandeasysolution:agenerousbutrefundablematernitypackage.Keepitifyoucomebacktowork,returnitifyoudon’t.Thatsimplepolicychangegivesusnearlyeverythingwewant.Firmsnolongerhavetobe concernedaboutpayingbenefits towomenwhowill not return towork.Indeed,itbecomespossibletooffermoregenerousbenefitswithoutprovidinganincentiveforworkerstotakethemoneyandrun.Women,inturn,donotfacethesamelevelofdiscriminationinthehiringprocess.

Statisticaldiscrimination,orso-called“rationaldiscrimination,”takesplacewhen an individual makes an inference that is defensible based on broadstatisticalpatternsbut(1)islikelytobewronginthespecificcaseathand;and(2) has a discriminatory effect on some group. Suppose an employer has noracial prejudice but does have an aversion to hiring workers with a criminalbackground.That’scertainlyareasonablepreference,forallkindsofreasons.Ifthis employer has to make a hiring decision without access to applicants’criminal backgrounds (either because he doesn’t have the timeor resources togathersuchinformation,orperhapsbecauseheisforbiddenbylawfromasking),then it’s entirely plausible that he will discriminate against black male

applicants,who are farmore likely tohave served time inprison (28percent)thanwhitemaleapplicants(4percent).

Of course, all this employer cares about is whether or not the personstandinginfrontofhimhasacriminalrecord.Ifhecanacquirethatinformationwithcertainty,thenthebroadersocialpatternsdon’tmatter.Intheory,wewouldexpect access to criminal background checks to reduce discrimination againstblackmenwithout criminal records. In fact, that iswhat the data show us.Agroup of economists compared hiring decisions at firms that conduct criminalbackground checkswith hiring decisions at firms that don’t. They concluded,“WefindthatemployerswhocheckcriminalbackgroundsaremorelikelytohireAfrican-Americanworkers,especiallymen.Thiseffectisstrongeramongthoseemployers who report an aversion to hiring those with criminal records thanamongthosewhodonot.”2

Withrace,moreinformationisusuallybetter.Thecorrespondingimplicationisthatlessinformationcanbeworse.TheUnitedStateshasahugeex-offenderpopulation.(Americahasahighincarcerationrate,andmostpeoplewhogotoprisoneventuallygetout; themediansentence is less than twoyears.)Policiesthat seek to help exoffenders by suppressing information on their criminalbackgroundsmaybebadforamuchwiderpopulation.Theauthorsofthestudycitedabovewarned that their results“suggest thatcurtailingaccess tocriminalhistoryrecordsmayactuallyharmmorepeoplethanithelpsandaggravateracialdifferencesinlabormarketoutcomes.”

Thischapterisnotaboutdiscrimination.Itisaboutinformation,whichliesattheheartofmanydiscrimination-relatedproblems.Informationmatters,particularlywhenwedon’thaveallthatweneed.Marketstendtofavorthepartythatknowsmore.(Haveyoueverboughtausedcar?)Butiftheimbalance,orasymmetryofinformation,becomestoolarge,thenmarketscanbreakdownentirely.Thiswasthefundamentalinsightof2001NobellaureateGeorgeAkerlof,aneconomistatthe University of California, Berkeley. His paper entitled “The Market forLemons” used the used-car market to make its central point. Any individualsellingausedcarknowsmoreaboutitsqualitythansomeonelookingtobuyit.This creates an adverse selection problem, just as it did with the HopeScholarships.Carownerswhoarehappywiththeirvehiclesarelesslikelytosellthem.Thus,used-carbuyersanticipatehiddenproblemsanddemandadiscount.Butonce there is adiscountbuilt into themarket, ownersofhigh-quality cars

becomeevenlesslikelytosellthem—whichguaranteesthemarketwillbefulloflemons.Intheory,themarketforhigh-qualityusedcarswillnotwork,muchtothedetrimentofanyonewhomaywanttobuyorsellsuchacar.(Inpractice,suchmarketsoftendoworkforreasonsexplainedbythegentlemenwithwhomMr.AkerlofsharedhisNobelprize;moreonthatinamoment.)

“TheMarketforLemons”ischaracteristicofthekindsofideasrecognizedby theNobelcommittee. It is, in thewordsof theRoyalSwedishAcademyofSciences,“asimplebutprofoundanduniversalidea,withnumerousimplicationsand widespread applications.” Health care, for example, is plagued withinformationproblems.Consumersofhealth care—thepatients—almost alwayshave less informationabout theircare than theirdoctorsdo. Indeed,evenafterwe see a doctor, we may not know whether we were treated properly. Thisasymmetryofinformationisattheheartofourhealthcarewoes.

Underany“feeforservice”system,doctorschargeafeeforeachprocedurethey perform. Patients do not pay for these extra tests and procedures; theirinsurancecompanies(orthefederalgovernment,inthecaseofolderAmericanswho are eligible for Medicare) do. At the same time, medical technologycontinues to present all kinds of new medical options, many of which arefabulouslyexpensive.Thiscombinationisattheheartofrapidlyrisingmedicalcosts:Doctorshavean incentive toperformexpensivemedicalproceduresandpatientshavenoreasontodisagree.Ifyouwalkintoyourdoctor’sofficewithaheadacheandthedoctorsuggestsaCATscan,youwouldalmostcertainlyagree“justtobesure.”Neitheryounoryourdoctorisactingunethically.Whencostisnotafactor,itmakesperfectsensetoruleoutbraincancerevenwhentheonlysymptomisaheadache themorningafter theholidayofficeparty.Yourdoctormightalsoreasonablyfearthatifshedoesn’torderaCATscan,youmightsueforbigbuckslaterifsomethingturnsouttobewrongwithyourhead.

Medicalinnovationisterrificinsomecasesandwastefulinothers.Considerthe current range of treatments for prostate cancer, a cancer that afflictsmanyoldermen.One treatment option is “watchful waiting,”which involves doingnothing unless and until tests show that the cancer is gettingworse. This is areasonablecourseofactionbecauseprostatecancerissoslow-growingthatmostmendieofsomethingelsebeforetheprostatecancerbecomesaseriousproblem.Another treatment option is proton radiation therapy,which involves shootingatomicparticlesatthecancerusingaprotonacceleratorthatisroughlythesizeof a football field. Doing nothing essentially costs nothing (more or less);shootingprotonsfromanacceleratorcostssomewhereintherangeof$100,000.

The cost difference is not surprising; the shocking thing is that protontherapy has not been proven any more effective than watchful waiting. Ananalysis by the RAND Corporation concluded, “No therapy has been shownsuperiortoanother.”3

Health maintenance organizations were designed to control costs bychangingtheincentives.UndermanyHMOplans,generalpractitionersarepaidafixedfeeperpatientperyear,regardlessofwhatservicestheyprovide.Doctorsmayberestrictedinthekindsoftestsandservicestheycanprescribeandmayevenbepaidabonusiftheyrefrainfromsendingtheirpatientstoseespecialists.That changes things. Now when you walk into the doctor’s office (still at adisadvantage in terms of information about your own health) and say, “I’mdizzy, my head hurts, and I’m bleeding out my ear,” the doctor consults theHMOtreatmentguidelinesandtellsyoutotaketwoaspirin.Asexaggeratedasthatexamplemaybe,thebasicpointisvalid:Thepersonwhoknowsmostaboutyour medical condition may have an economic incentive to deny you care.Complaintsabouttoomuchspendingarereplacedbycomplaintsabouttoolittlespending. Every HMO customer has a horror story about wrangling withbureaucrats over acceptable expenses. In the most extreme (and anecdotal)stories,patientsaredeniedlifesavingtreatmentsbyHMObeancounters.

Somedoctorsarewillingtodobattlewiththeinsurancecompaniesonbehalfoftheirpatients.Otherssimplybreaktherulesbydisguisingtreatmentsthatarenot covered by insurance as treatments that are. (Patients aren’t the only onessuffering fromanasymmetryof information.)Politicianshave jumped into thefray, too,demanding things likedisclosureof the incentivespaid todoctorsbyinsurancecompaniesandevenapatient’sbillofrights.

Theinformationproblemattheheartofhealthcarehasnotgoneaway:(1)Thepatient,whodoesnotpaythebill,demandsasmuchcareaspossible;(2)thedoctormaximizesincomeandminimizeslawsuitsbydeliveringasmuchcareaspossible; (3) the insurance companymaximizes profits by paying for as littlecareaspossible;(4)technologyhasintroducedanarrayofmassivelyexpensiveoptions,someofwhicharemiraclesandothersofwhichareawasteofmoney;and(5)itisverycostlyforeitherthepatientortheinsurancecompanytoprovethe“right”courseoftreatment.Inshort,informationmakeshealthcaredifferentfromtherestoftheeconomy.Whenyouwalkintoanelectronicsstoretobuyabig-screenTV,youcanobservewhichpicturelooksclearest.Youthencomparepricetags,knowingthatthebillwillarriveatyourhouseeventually.Intheend,youweighthebenefitsofassortedtelevisions(whosequalityyoucanobserve)

against the costs (that youwill have to pay) and you pick one.Brain surgeryreallyisdifferent.

The fundamental challenge of health care reform is paying for the “right”treatment—the “product” that makes the most sense relative to what it costs.Thisisanexercisethatconsumersperformontheirowneverywhereelseintheeconomy. Bean counters should not automatically say no to super-expensivetreatments; somemay be wonderfully effective and worth every penny. Theyshouldsaynotoexpensivetreatmentsthatarenotdemonstrablybetterthanlessexpensiveoptions.Theyshouldalsosaynotodoingsometests“justtobesure,”both because these diagnostics are expensive, but also because whenadministeredtohealthypeopletheytendtogenerate“falsepositives,”whichcanbreedexpensive,unnecessary,andpotentiallydangerousfollow-upcare.

There is an old aphorism in advertising: “I know I’m wasting half mymoney;IjustwishIknewwhichhalf.”Healthcareissimilar,andifthegoalofhealthcarereformistorestrainrapidlyrisingcosts,thenanypolicychangewillhave to focusonquality andoutcomes rather than justpaying for inputs.NewYork Times financial columnist David Leonhardt describes the treatment forprostate cancer (where fabulously expensive technologydoesnot appear to bedeliveringbetterhealth)ashisown“personallitmustest”forhealthcarereform.Hewrites, “The prostate cancer test will determinewhether President ObamaandCongressputtogetherabillthatbeginstofixthefundamentalproblemwithourmedical system: the combination of soaring costs andmediocre results. Iftheydon’t,themedicalsystemwillremaindeeplytroubled,nomatterwhatotherimprovementstheymake.”

Butwe’renotdonewithhealthcareyet.Thedoctormayknowmoreaboutyourhealth thanyoudo,butyouknowmoreaboutyour long-termhealth thanyourinsurancecompanydoes.Youmaynotbeabletodiagnoserarediseases,butyouknowwhetherornotyouleadahealthylifestyle,ifcertaindiseasesruninyourfamily,ifyouareengaginginriskysexualbehavior,ifyouarelikelytobecomepregnant, etc.This information advantagehas thepotential towreakhavocontheinsurancemarket.

Insurance is about getting the numbers right. Some individuals requirevirtuallynohealthcare.Othersmayhavechronicdiseasesthatrequirehundredsofthousandsofdollarsoftreatment.Theinsurancecompanymakesaprofitbydetermining the average cost of treatment for all of its policyholders and then

chargingslightlymore.WhenAetnawritesagrouppolicyfor20,000fifty-year-oldmen,andtheaveragecostofhealthcareforafifty-year-oldmanis$1,250ayear, thenpresumably thecompanycan set theannualpremiumat$1,300andmake$50—onaverage—foreachpolicyunderwritten.Aetnawillmakemoneyonsomepoliciesandlosemoneyonothers,butoverallthecompanywillcomeoutahead—ifthenumbersareright.

Is thisexamplestarting to look like theHopeScholarshipsor theused-carmarket?Itshould.The$1,300policyisabaddealforthehealthiestfifty-year-oldmenandaverygooddealfortheoverweightsmokerswithafamilyhistoryofheartdisease.So,thehealthiestmenaremostlikelytooptoutoftheprogram;thesickestguysaremostlikelytooptin.Asthathappens,thepopulationofmenon which the original premium was based begins to change; on average, theremainingmenarelesshealthy.Theinsurancecompanystudiesitsnewpoolofmiddle-agedmenandreckonsthattheannualpremiummustberaisedto$1,800inordertomakeaprofit.Doyouseewherethisisgoing?Atthenewprice,moremen—themosthealthyoftheunhealthy—decidethatthepolicyisabaddeal,sotheyoptout.Thesickestguysclingtotheirpoliciesas tightlyastheirdisease-addled bodies will allow. Once again the pool changes and now even $1,800does not cover the cost of insuring themenwho sign up for the program. Intheory, thisadverseselectioncouldgoonuntil themarket forhealth insurancefailsentirely.

That does not actually happen. Insurance companies usually insure largegroups whose individuals are not allowed to select in or out. If Aetna writespolicies for allGeneralMotors employees, for example, then therewill be noadverseselection.Thepolicycomeswith the job,andallworkers,healthyandunhealthy, are covered.They have no choice.Aetna can calculate the averagecostofcarefor this largepoolofmenandwomenandthenchargeapremiumsufficienttomakeaprofit.

Writing policies for individuals, however, is a much scarier undertaking.Companiesrightfullyfearthatthepeoplewhohavethemostdemandforhealthcoverage (or life insurance) are thosewho need it most.This will be true nomatterhowmuchan insurancecompanycharges for itspolicies.Atanygivenprice—even$5,000amonth—theindividualswhoexpecttheirmedicalcoststobehigherthanthecostofthepolicywillbethemostlikelytosignup.Ofcourse,the insurance companies have some tricks of their own, such as refusingcoveragetoindividualswhoaresickorlikelytobecomesickinthefuture.Thisis often viewed as some kind of cruel and unfair practice perpetrated on the

public by the insurance industry.On a superficial level, it does seemperversethat sickpeoplehave themost troublegettinghealth insurance.But imagine ifinsurance companies did not have that legal privilege. A (highly contrived)conversationwithyourdoctormightgosomethinglikethis:

DOCTOR:I’mafraidIhavebadnews.Fourofyourcoronaryarteriesare fully or partially blocked. I would recommend open-heart surgery assoonaspossible.

PATIENT:Isitlikelytobesuccessful?DOCTOR:Yes,wehaveexcellentoutcomes.PATIENT:Istheoperationexpensive?DOCTOR: Of course it’s expensive. We’re talking about open-heart

surgery.PATIENT:ThenIshouldprobablybuysomehealthinsurancefirst.DOCTOR:Yes,thatwouldbeaverygoodidea.

Insurance companies ask applicants questions about family history, healthhabits, smoking, dangerous hobbies, and all kinds of other personal things.WhenIappliedfortermlifeinsurance,arepresentativefromthecompanycametomyhouseanddrewbloodtomakesurethatIwasnotHIV-positive.Heaskedwhethermyparentswerealive, if I scubadive, if I racecars. (Yes,yes,no.) Ipeed in a cup; I goton a scale; I answeredquestions about tobaccoand illicitdruguse—allofwhichseemedreasonablegiventhatthecompanywasmakingacommitment to pay my wife a large sum of money should I die in the nearfuture.

Insurancecompanieshaveanothersubtletool.Theycandesignpolicies,or“screening”mechanisms, thatelicit informationfromtheirpotentialcustomers.This insight, which is applicable to all kinds of othermarkets, earned JosephStiglitz,aneconomistatColumbiaUniversityanda formerchiefeconomistofthe World Bank, a share of the 2001 Nobel Prize. How do firms screencustomers in the insurance business? They use a deductible. Customers whoconsider themselves likely to stayhealthywill signup forpolicies thathaveahigh deductible. In exchange, they are offered cheaper premiums. Customerswho privately know that they are likely to have costly bills will avoid thedeductibleandpayahigherpremiumasaresult.(Thesamethingistruewhenyouareshoppingforcarinsuranceandyouhaveasneakingsuspicionthatyour

sixteen-year-old son is an even worse driver than most sixteen-year-olds.) Inshort, the deductible is a tool for teasing out private information; it forcescustomerstosortthemselves.

Any insurance question ultimately begs one explosive question: How muchinformation is too much? I guarantee that this will become one of the mostnettlesome policy problems in coming years.Here is a simple exercise. Pluckonehairfromyourhead.(Ifyouaretotallybald,takeaswabofsalivafromyourcheek.)Thatsamplecontainsyourentiregeneticcode.Intherighthands(orthewronghands),itcanbeusedtodetermineifyouarepredisposedtoheartdisease,certainkindsofcancer,depression,and—if thesciencecontinuesat itscurrentblistering pace—all kinds of other diseases. With one strand of your hair, aresearcher(orinsurancecompany)maysoonbeabletodetermineifyouareatriskforAlzheimer’sdisease—twenty-fiveyearsbeforetheonsetofthedisease.Thiscreatesadilemma. Ifgenetic information issharedwidelywith insurancecompanies,thenitwillbecomedifficult,ifnotimpossible,forthosemostproneto illness to get any kind of coverage. In other words, the people who needhealthinsurancemostwillbetheleastlikelytogetit—notjustthenightbeforesurgery, but ever. Individualswith a family history ofHuntington’s disease, ahereditarydegenerativebraindisorder that causesprematuredeath, arealreadyfindingithardorimpossibletogetlifeinsurance.Ontheotherhand,newlawsare forbidding insurance companies from gathering such information, leavingthemvulnerabletoseriousadverseselection.Individualswhoknowthattheyareathighriskofgettingsickinthefuturewillbetheoneswholoadupongenerousinsurancepolicies.

AneditorialinTheEconomistnotedthis loomingquandary:“Governmentsthus face a choice between banning the use of test results and destroying theindustry, or allowing their use and creating an underclass of people who areeitheruninsurableorcannotaffordtoinsurethemselves.”TheEconomist,whichis hardly a bastion of left-wing thought, suggested that the private healthinsurance market may eventually find this problem intractable, leavinggovernmentwith amuch larger role toplay.Theeditorial concluded: “Indeed,genetic testing may become the most potent argument for state-financeduniversalhealthcare.”4

Any health care reform that seeks to make health insurance both moreaccessibleandmoreaffordable,particularly for thosewhoaresickor likely to

get sick,will havedevastatingadverse selectionproblems.Thinkabout it: If Ipromisethatyoucanbuyaffordableinsurance,regardlessofwhetherornotyouarealreadysick,thentheoptimaltimetobuythatinsuranceisintheambulanceonthewaytothehospital.Theonlyfixforthisinherentproblemistocombineguaranteedaccesstoaffordableinsurancewitharequirementthateveryonebuyinsurance—healthy and sick, young and old—a so-called “personalmandate.”The insurance companies will still lose money on the policies that they areforced to sell tobad risks, but those losses canbeoffset by theprofits earnedfrom healthy people who are forced to buy insurance. (Any country with anationalhealthcare systemeffectivelyhasapersonalmandate; all citizensareforcedtopaytaxes,andinreturntheyallgetgovernment-fundedhealthcare.)

This is the approach that Massachusetts took as part of a state plan toprovide universal access to health insurance. State residents who can affordhealth insurance but don’t buy it are fined on their state tax return. HillaryClinton supported a personal mandate in the 2008 Democratic presidentialprimaries; Barack Obama did not, though that arguably had more to do withdistinguishinghimself fromhis toughestDemocraticopponent than itdidwithhis analysis of adverse selection. Obviously, forcing healthy people to buysomething that they would otherwise not buy is a heavy-handed use ofgovernment; it’s also the only way to pool risk (which is the purpose ofinsurance)whenthedistributionofriskisnotrandom.

Herearetherelevanteconomics:(1)Weknowwhoissick;(2)increasinglyweknowwhowillbecomesick;(3)sickpeoplecanbeextremelyexpensive;and(4) private insurance doesn’t work well under these circumstances. That’s allstraightforward.The toughpart isphilosophical/ideological:Towhatextentdowewanttosharehealthcareexpensesanyway(ifatall),andhowshouldwedoit?ThosewerethefundamentalquestionswhenBillClintonsoughttooverhaulhealth care in 1993, and again when the Obama administration took it up in2009.

This chapter started with the most egregious information-related problems—cases inwhichmissing informationcripplesmarkets andcauses individuals tobehave in ways that have serious social implications. Economists are alsointrigued by more mundane examples of how markets react to missinginformation. We spend our lives shopping for products and services whosequalitywe cannot easily determine. (You had to pay for this book before you

wereable toreadit.) In thevastmajorityofcases,consumersandfirmscreatetheir ownmechanisms to solve information problems. Indeed, therein lies thegeniusofMcDonald’sthatinspiredthetitleofthischapter.The“goldenarches”have as much to do with information as they do with hamburgers. EveryMcDonald’shamburger tastes thesame,whether it is sold inMoscow,MexicoCity, or Cincinnati. That is not a mere curiosity; it is at the heart of thecompany’s success. Suppose you are driving along Interstate 80 outside ofOmaha,havingneverbeeninthestateofNebraska,whenyouseeaMcDonald’s.Immediatelyyouknowallkindsofthingsabouttherestaurant.Youknowthatitwill be clean, safe, and inexpensive. You know that it will have a workingbathroom. You know that it will be open seven days a week. Youmay evenknowhowmanypicklesareonthedoublecheeseburger.Youknowallof thesethingsbeforeyougetoutofyourcarinastateyou’veneverbeenin.

ComparethattothebillboardadvertisingChuck’sBigBurger.Chuck’smayofferoneofthebestburgerswestoftheMississippi.Oritmightbealikelyspotforthenation’snextlargeE.coliout-break.Howwouldyouknow?IfyoulivedinOmaha, thenyoumightbe familiarwithChuck’s reputation.Butyoudon’t;you are driving through Nebraska at nine o’clock at night. (What time doesChuck’sclose,anyway?)Ifyouarelikemillionsofotherpeople,eventhosewhofind fast food relatively unappealing, you will seek out the golden archesbecauseyouknowwhatliesbeneaththem.McDonald’ssellshamburgers,fries,and,mostimportant,predictability.

This idea underlies the concept of “branding,” whereby companies spendenormoussumsofmoneytobuildanidentityfortheirproducts.Brandingsolvesaproblemforconsumers:Howdoyouselectproductswhosequalityorsafetyyou can determine only after you use them (and sometimes not even then)?Hamburgers are just one example. The same rule applies in everything fromvacationstofashion.Willyouhavefunonyourcruise?Yes,becauseitisRoyalCaribbean—orCelebrityorVikingorCunard.Ihaveapoorsenseoffashion,soI am reassured thatwhen I buy aTommyHilfiger shirt Iwill look reasonablypresentablewhenIleavethehouse.MichelintireadvertisementsfeaturebabiesplayinginsideofMichelintireswiththetagline“Becausesomuchisridingonyour tires.” The implicit message is clear enough. Meanwhile, Firestone hasmost likely destroyedmuch of the value of its brand as the result of the linkbetweenfaultytiresanddeadlyrolloversinFordExplorers.

Brandinghascomeunderassaultasatoolbywhichavariciousmultinationalcorporationspersuadeus topayextortionatepremiumsforgoodsthatwedon’t

need.Economicstellsadifferentstory:Brandinghelpstoprovideanelementoftrust that is necessary for a complex economy to function. Modern businessrequiresthatweconductmajortransactionswithpeoplewhomwe’venevermetbefore.IregularlymailoffcheckstoFidelityeventhoughIdonotknowasinglepersonatthecompany.Harriedgovernmentregulatorscanonlyprotectmefromthemostegregiouskindsoffraud.Theydonotprotectmefromshoddybusinesspractices,manyofwhichareperfectlylegal.Businessesroutinelyadvertisetheirlongevity. That sign outside the butcher proclaiming “Since 1927” is a politicwayofsaying,“Wewouldn’tstillbehereifwerippedoffourcustomers.”

Brandsdothesamething.Likereputations,theyarebuiltovertime.Indeed,sometimes the brand becomesmore valuable than the product itself. In 1997,SaraLee,acompanythatsellseverythingfromunderweartobreakfastsausages,declared that it would begin selling off its manufacturing facilities. No moreturkeyfarmsortextilemills.Instead,thecompanywouldfocusonattachingitsprestigiousbrandnames—Champion,Hanes,Coach,JimmyDean—toproductsmanufactured by outside firms. One business magazine noted, “Sara Leebelieves that its soul is in itsbrands, and that thebestuseof its energies is tobreathecommercial life intotheinertmattersuppliedbyothers.”5The irony islovely:SaraLee’sstrategyforgrowthandprofitsistoproducenothing.

Brandingcanbeaveryprofitablestrategy.Incompetitivemarkets,pricesaredrivenrelentlesslytowardthecostofproduction.If itcosts10centstomakeacanofsodaandIsellitfor$1,someoneisgoingtocomealongandsellitfor50cents.Soonenough,someoneelsewillbepeddlingitforaquarter,then15cents.Eventually, some ruthlessly efficient corporationwill be peddling soda for 11cents a can. From the consumer’s standpoint, this is the beauty of capitalism.Fromtheproducer’sstandpoint,itis“commodityhell.”ConsiderthesorrylotoftheAmericanfarmer.Asoybeanisasoybean;asaresult,anIowafarmercannotchargeevenonepennyabovethemarketpriceforhiscrop.Oncetransportationcostsaretakenintoaccount,everysoybeanintheworldsellsforthesameprice,which,inmostyears,isnotawholelotmorethanitcosttoproduce.

Howdoes a firm save itsprofits from thedeath spiralof competition?Byconvincingtheworld(rightfullyornot)thatitsmixtureofcornsyrupandwaterisdifferentfromeveryoneelse’smixtureofcornsyrupandwater.Coca-Colaisnot soda; it’s Coke. Producers of branded goods create a monopoly forthemselves—and price their products accordingly—by persuading consumersthat theirproductsarelikenoother.Nikeclothesarenotpiecesoffabricsewntogetherbyworkers inVietnam; theyareTigerWoods’sclothes.Evenfarmers

have taken this message to heart. At the supermarket, one finds (and pays apremiumfor)Sunkistoranges,Angusbeef,Tysonchickens.

Sometimes we gather information by paying outsiders to certify quality.RogerEbert’sjobistoseelotsofbadmoviessothatIdon’thaveto.Whenheseestheoccasionalgem,hegivesita“thumbsup.”Inthemeantime,IamsparedfromseeingthelikesofTomcats,afilmthatMr.Ebertawardedzerostars.IpayforthisinformationintheformofmysubscriptiontotheChicagoSun-Times(orby looking at ads that the Sun-Times is paid to display on its free website).ConsumerReports provides the samekindof informationonconsumergoods;Underwriters Laboratories certifies the safety of electrical appliances;Morningstar evaluates the performance of mutual funds. And then there isOprah’sbookclub,whichhas thecapacity tosendobscurebooksrocketingupthebest-sellerlists.

Meanwhile,firmswilldowhatevertheycanto“signal”theirownqualitytothe market. This was the insight of 2001 Nobel laureateMichael Spence, aneconomistatStanfordUniversity.SupposethatyouarechoosinganinvestmentadviserafteragoodstrokeoffortuneinthePowerballlottery.Thefirstfirmyouvisit has striking wood paneling, a marble lobby, original Impressionistpaintings,andexecutiveswearinghandmadeItaliansuits.Doyouthink:(1)Myfeeswillpay forall thisverynice stuff—whata ripoff!;or (2)wow, this firmmustbeextremelysuccessfulandIhopetheywilltakemeonasaclient.Mostpeoplewouldchoose2. (Ifyou’renotconvinced, thinkabout it theotherway:Howwould you feel if your investment adviserworked in a dank officewithtwenty-year-oldgovernment-surplusWANGwordprocessors?)

Thetrappingsofsuccess—thepaneling,themarble,theartcollection—havenoinherentrelationtotheprofessionalconductofthefirm.Rather,weinterpretthemas“signals”thatreassureusthatthefirmistop-notch.Theyaretomarketswhat a peacock’s bright feathers are to a prospective mate: a good sign in aworldofimperfectinformation.

What signals success when you walk into an office in parts of Asia?Ridiculouslycoldtemperatures.Theblastoffrigidairtellsyouimmediatelythatthisfirmcanaffordlotsofair-conditioning.Evenwhenthetemperatureismorethanninetydegreesoutside,officetemperaturesaresometimessocoldthatsomeworkers use space heaters. The Wall Street Journal reports, “Frosty airconditioning is away forbusinesses andbuildingowners to show that they’reaheadof thecurveoncomfort. InostentatiousAsiancities,bosses like tosendoutthemessage:Wearesoluxurious,we’rearctic.”6

Hereisarelatedquestionthateconomistsliketoponder:Harvardgraduatesdoverywell in life, but is that because they learned things atHarvard thatmadethemsuccessful,orisitbecauseHarvardfindsandadmitstalentedstudentswhowould have done extraordinarily well in life anyway? In other words, doesHarvardaddgreatvalue to its students,ordoes it simplyprovideanelaborate“signaling”mechanismthatallowsbrightstudentstoadvertisetheirtalentstotheworldbybeingadmittedtoHarvard?AlanKrueger,aPrincetoneconomist,andStacyDale, an economist at theMellon Foundation, have done an interestingstudy to get at this question.7 They note that graduates of highly selectivecollegesearnhighersalarieslaterinlifethangraduatesoflessselectivecolleges.For example, the average student who entered Yale, Swarthmore, or theUniversityofPennsylvaniain1976earned$92,000in1995;theaveragestudentwho entered a moderately selective college, such as Penn State, Denison, orTulane, earned $22,000 less. That is not a particularly surprising finding, nordoes it get at the question of whether the students at schools like Yale andPrincetonwouldearnmore than theirpeersat lesscompetitiveschoolseven iftheyplayedbeerpongandwatchedtelevisionforfouryears.

So Mr. Krueger and Ms. Dale took their analysis one step further. Theyexaminedtheoutcomesofstudentswhowereadmittedtobothahighlyselectiveschool and a moderately selective school. Some of those students headed toplacesliketheIvyLeague;otherschosetheirlessselectiveoption.Mr.Kruegerand Ms. Dale’s chief finding is best summarized by the title of the paper:“Children Smart Enough toGet intoElite SchoolsMayNotNeed toBother.”Theaverageearningsofstudentsadmittedtobothahighlyselectiveschoolandamoderatelyselectiveschoolwereroughlythesameregardlessofwhichtypeofcollege they attended. (The one exception was students from lower-incomefamilies for whom attending a more selective school increased earningssignificantly.)Overall,thequalityofstudentappearstomattermorelaterinlifethanthequalityoftheuniversityheorsheattended.

Isitirrationaltospend$150,000ormoretoattendanIvyLeagueuniversity?Not necessarily. At a minimum, a Princeton or Yale diploma is the résuméequivalentofRogerEbert’s“thumbsup.”Itpronouncesyouhighlyqualifiedsothat others in life—employers, spouses, in-laws—will have fewerdoubts.Andthereisalwaysthepossibilitythatyoumaylearnsomethingwhilehuddlingforfouryearswiththeworld’sgreatminds.Still,Mr.Kruegeroffersthisadviceto

studentsapplyingtocollege:“Don’tbelievethattheonlyschoolworthattendingis one that would not admit you…. Recognize that your own motivation,ambitionandtalentswilldetermineyoursuccessmorethanthecollegenameonyourdiploma.”

The notion that bright, motivated individuals (with similarly motivatedparents)will dowell, howeverorwherever they are schooled, is often lost onAmerica’s school reformers. In Illinois, each fall isgreetedwith the releaseofthe state’s school report cards.Every school in the state is evaluatedbasedonhowwell its studentshaveperformedonabatteryof standardizedexams.Themedia quickly seize on these school report cards to identify the state’s “best”schools, most of which are usually in affluent suburbs. But does this processreally tell us anything about which schools are the most effective? Notnecessarily. “In many suburban communities, students would do well onstandardizedtestsevenif theywent toschoolandsat inacloseteverydayforfouryears,”saysUniversityofRochestereconomistEricHanushek,anexpertonthesomewhattenuousrelationshipbetweenschoolinputsandstudentoutcomes.Thereisafundamentalpieceofmissinginformation:Howmuchvalueisreallybeing added at these “high-performing schools”? Do they have exceptionalteachersandadministrators,oraretheyrepositoriesforprivilegedstudentswhowoulddowellonstandardizedtestsregardlessofwheretheywenttoschool?It’stheHarvardquestionalloveragain.

This chapter started with a serious social issue, and so it will end. Racialprofilingisaninformationproblem.Therearetwosimplequestionsattheheartof the issue. First, does race or ethnicity—alone or in conjunctionwith someother circumstance—convey meaningful information related to potentialcriminalactivity?Ifso,whatdowedoaboutit?Theanswertothefirstquestiongetsmostoftheattention.AftertheattacksofSeptember11,onecouldcertainlymake the case that thirty-five-year-old Arab men posed a greater risk to thecountrythansixty-five-year-oldPolishwomen.Policeofficershavelongarguedthatracecanbeatip-off;well-dressedwhitekidsinpoorblackneighborhoodsare often looking to buy drugs. Criminal organizations have racial or ethnicaffiliations. At the same time President Clinton was declaring racial profiling“morally indefensible,” the website of his drug czar, Barry McCaffrey, wasdoing just that. InDenver, the sitenoted, theheroindealersarepredominantlyMexican nationals. In Trenton, crack dealers are predominantly African-

AmericanmalesandthepowderedcocainedealersarepredominantlyLatino.8Indeed,weallprofileinourownway.Wearetaughtfromayoungagethat

oneshouldneverjudgeabookbyitscover.Butwemust;itisoftenallwegettosee. Imagine you are walking in a parking garage at night when you hearfootstepsbehindyou.Ideally,youwouldaskthispersonforarésuméyouandhewouldsitdownforcoffeeanddiscusshisgoals,hisjob,hisfamily,hispoliticalphilosophy,and,mostimportant,thereasonheiswalkingbehindyouinadarkparkinggarage.Youwoulddoacriminalbackgroundcheck.Then,withallthisinformationinhand,youwoulddecidewhetherornottohitthepanicbuttononyourkeyring.Thereality,ofcourse,isdifferent.Yougetonequickglanceoveryour shoulder. What information matters? Sex? Race? Age? Briefcase?Clothing?

I’llneverforgetmyownexperienceasavictimofracialprofiling.IboardedawestboundbusfromdowntownChicagojustasitstartedtogetdark.Chicagois a very segregated city; most of the neighborhoods west of downtown arepredominantlyAfrican-American.Iwaswearingasuit,andafterafewblocksIwas the onlywhite guy on the bus. Around that time, an older blackwomanaskedkindly,“Oh,aretheBullsplayingtonight?”TheChicagoBullsplayattheChicagoStadium,whichisalsodirectlywestofthecitycenter.Thiswomanhadinferred,innocentlyenough,thattheonlyreasonawhiteguyinasuitwouldbeonthisbusaround7:00p.m.wouldbetogotoaBullsgame.Obviouslyitwasunfair and potentially hurtful for her to draw any conclusion about mydestination based only onmy skin color and style of dress. The really weirdthingisthatIwasonmywaytotheBullsgame.

Race, age, ethnicity, and/or country of origin can convey information insomecircumstances,particularlywhenotherbetterinformationislacking.Froma social policy standpoint, however, the fact that these attributesmay conveymeaningful information is a red herring. The question thatmatters is:Arewewilling to systematically harass individuals who fit a broad racial or ethnicprofilethatmay,onaverage,havesomestatisticalsupportbutwillstillbewrongfar more often than it is right? Most people would answer no in mostcircumstances. We’ve built a society that values civil liberties even at theexpense of social order. Opponents of racial profiling always seem to getdragged into the quagmire of whether or not it is good police work or aneffectivecounterterrorismtool.That’snottheonlyrelevantpoint—anditmaybecompletelyirrelevantinsomecases.Ifeconomicsteachesusanything,it’s thatweoughttoweighcostsandbenefits.Thecostsofharassingtenortwentyorone

hundred law-abiding people to catch one more drug dealer are not worth it.Terrorism is trickier because the potential costs of letting just one person slipthrough the cracks are so devastatingly high. So what exactly should we doaboutit?Thatisoneofthetoughtrade-offsinthepost–September11world.

IntheworldofEcon101,allpartieshave“perfectinformation.”Thegraphsareneat and tidy; consumers and producers know everything they could possiblywanttoknow.TheworldoutsideofEcon101ismoreinteresting,albeitmessier.Astatepatrolmanwhohaspulledovera1990GrandAmwithabrokentaillightonadesertedstretchofFloridahighwaydoesnothaveperfectinformation.Nordoesayoungfamily looking forasafeanddependablenanny,oran insurancecompany seeking to protect itself from the extraordinary costs of HIV/AIDS.Informationmatters.Economistsstudywhatwedowithit,and,sometimesmoreimportant,whatwedowithoutit.

CHAPTER6

ProductivityandHumanCapital:

WhyisBillGatessomuchricherthanyouare?

Like many people, Bill Gates found his house a little cramped once he hadchildren. The software mogul moved into his $100million dollar mansion in1997;notlongafter,itneededsometweaking.The37,000-square-foothomehasa twenty-seat theater,a receptionhall,parking for twenty-eightcars,an indoortrampolinepit,andallkindsofcomputergadgetry,suchasphonesthatringonlywhenthepersonbeingcalledisnearby.Butthehousewasnotquitebigenough.1According to documents filed with the zoning board in suburban Medina,Washington,Mr.Gatesandhiswifeaddedanotherbedroomandsomeadditionalplayandstudyareasfortheirchildren.

TherearealotofthingsonemightinferfromMr.Gates’shomeaddition,butone of them is fairly obvious: It is good to be Bill Gates. The world is afascinatingplaygroundwhenyouhave$50billionorso.Onemightalsopondersomelargerquestions:Whydosomepeoplehaveindoortrampolinesandprivatejets while others sleep in bus station bathrooms? How is it that roughly 13percentofAmericansarepoor,whichisanimprovementfromarecentpeakof15percentin1993butnotsignificantlybetterthanitwasduringanyyearinthe1970s?Meanwhile,oneinfiveAmericanchildren—andastaggering35percentof black children—live in poverty.Of course,America is the rich guy on theblock. At the dawn of the third millennium, vast swathes of the world’spopulation—somethreebillionpeople—aredesperatelypoor.

Economists studypoverty and income inequality.They seek to understandwhoispoor,whytheyarepoor,andwhatcanbedoneaboutit.AnydiscussionofwhyBillGatesissomuchricherthanthemenandwomensleepinginsteamtunnelsmustbeginwithaconcepteconomistsrefertoashumancapital.Humancapital is the sum total of skills embodied within an individual: education,intelligence, charisma, creativity, work experience, entrepreneurial vigor, even

theabilitytothrowabaseballfast.Itiswhatyouwouldbeleftwithifsomeonestripped away all of your assets—your job, your money, your home, yourpossessions—andleftyouonastreetcornerwithonlytheclothesonyourback.HowwouldBillGates fare in such a situation?Verywell. Even if hiswealthwereconfiscated,othercompanieswouldsnaphimupasaconsultant,aboardmember, a CEO, a motivational speaker. (When Steve Jobs was fired fromApple,thecompanythathefounded,heturnedaroundandfoundedPixar;onlylater did Apple invite him back.) How would Tiger Woods do? Just fine. Ifsomeonelenthimgolfclubs,hecouldbewinningatournamentbytheweekend.

How would Bubba, who dropped out of school in tenth grade and has amethamphetamineaddiction,fare?Notsowell.Thedifferenceishumancapital;Bubbadoesn’t havemuch. (Ironically, somevery rich individuals, such as thesultanofBrunei,mightnotdoparticularlywellinthisexerciseeither;thesultanisrichbecausehiskingdomsitsatopanenormousoilreserve.)Thelabormarketis no different from themarket for anything else; some kinds of talent are ingreater demand than others. Themore nearly unique a set of skills, the bettercompensated their ownerwill be.AlexRodriguezwill earn $275millionovertenyearsplayingbaseballfortheNewYorkYankeesbecausehecanhitaroundballtravelingninety-plusmilesanhourharderandmoreoftenthanotherpeoplecan. “A-Rod”will help theYankeeswin games,whichwill fill stadiums, sellmerchandise, and earn television revenues.Virtuallynoone elseon theplanetcandothataswellashecan.

As with other aspects of themarket economy, the price of a certain skillbearsnoinherentrelationtoitssocialvalue,onlyitsscarcity.IonceinterviewedRobert Solow, winner of the 1987 Nobel Prize in Economics and a notedbaseball enthusiast. I asked if it botheredhim that he received lessmoney forwinningtheNobelPrizethanRogerClemens,whowaspitchingfortheRedSoxatthetime,earnedinasingleseason.“No,”Solowsaid.“Therearealotofgoodeconomists, but there is only one Roger Clemens.” That is how economiststhink.

WhoiswealthyinAmerica,oratleastcomfortable?Softwareprogrammers,hand surgeons, nuclear engineers, writers, accountants, bankers, teachers.Sometimestheseindividualshavenaturaltalent;moreoftentheyhaveacquiredtheirskillsthroughspecializedtrainingandeducation.Inotherwords,theyhavemade significant investments in human capital. Like any other kind ofinvestment—from building a manufacturing plant to buying a bond—moneyinvested today in human capitalwill yield a return in the future.Avery good

return. A college education is reckoned to yield about a 10 percent return oninvestment,meaningthatifyouputdownmoneytodayforcollegetuition,youcan expect to earn that money back plus about 10 percent a year in higherearnings. Few people on Wall Street make better investments than that on aregularbasis.

Human capital is an economic passport—literally, in some cases.When Iwasanundergraduate in the late1980s, ImetayoungPalestinianmannamedGamalAbouali.Gamal’s family,who lived inKuwait,were insistent that theirson finish his degree in three years instead of four.This required taking extraclasses each quarter and attending school every summer, all ofwhich seemedratherextreme tomeat the time.Whatabout internshipsand foreignstudy,orevenawinterinColoradoasaskibum?IhadlunchwithGamal’sfatheronce,andheexplainedthatthePalestinianexistencewasitinerantandprecarious.Mr.Aboualiwasanaccountant,aprofessionthathecouldpracticenearlyanywhereintheworld—because,heexplained,thatiswherehemightendup.ThefamilyhadlivedinCanadabeforemovingtoKuwait;theycouldeasilybesomewhereelseinfiveyears,hesaid.

Gamalwasstudyingengineering,asimilarlyuniversalskill.Thesoonerhehadhisdegree,hisfatherinsisted,themoresecurehewouldbe.Notonlywouldthe degree allow him to earn a living, but itmight also enable him to find ahome.Insomedevelopedcountries,therighttoimmigrateisbasedonskillsandeducation—humancapital.

Mr. Abouali’s thoughts were strikingly prescient. After SaddamHussein’sretreat from Kuwait in 1990, most of the Palestinian population, includingGamal’s family, was expelled because the Kuwaiti government felt that thePalestinians had been sympathetic to the Iraqi aggressors. Mr. Abouali’sdaughter gave him a copy of the first edition of this book.When he read theabovesection,heexclaimed,“See,Iwasright!”

Theoppositeistrueattheotherendofthelaborpool.Theskillsnecessarytoask“Wouldyoulikefrieswiththat?”arenotscarce.Thereareprobably150millionpeople in America capable of selling value meals at McDonald’s. Fast-foodrestaurantsneedonlypayawagehighenoughtoputwarmbodiesbehindalloftheircashregisters.Thatmaybe$7.25anhourwhentheeconomyisslowor$11anhourwhenthelabormarketisespeciallytight;itwillneverbe$500anhour,which is the kind of fee that a top trial lawyer can command. Excellent trial

lawyers are scarce; burger flippers are not. The most insightful way to thinkaboutpoverty, in this countryor anywhere else in theworld, is as a dearthofhumancapital.True,peoplearepoorinAmericabecausetheycannotfindgoodjobs.Butthatisthesymptom,nottheillness.Theunderlyingproblemisalackofskills,orhumancapital.ThepovertyrateforhighschooldropoutsinAmericais 12 times the poverty rate for college graduates. Why is India one of thepoorestcountriesintheworld?Primarilybecause35percentofthepopulationisilliterate(downfromalmost50percentintheearly1990s).2Orindividualsmaysuffer from conditions that render their human capital less useful. A highproportion of America’s homeless population suffers from substance abuse,disability,ormentalillness.

Ahealthyeconomymatters, too. Itwaseasier tofinda job in2001than itwasin1975or1932.Arisingtidedoesindeedliftallboats;economicgrowthisa very good thing for poor people. Period. But even at high tide, low-skilledworkers are clinging to driftwood while their better-skilled peers are havingcocktails on their yachts. A robust economy does not transform valet parkingattendants into college professors. Investments in human capital do that.Macroeconomic factors control the tides;humancapitaldetermines thequalityoftheboat.Conversely,abadeconomyisusuallymostdevastatingforworkersattheshallowendofthelaborpool.

Consider this thought experiment. Imagine that on someMondaymorningwedroppedoff100,000highschooldropoutsonthecornerofStateStreetandMadisonStreetinChicago.Itwouldbeasocialcalamity.Governmentserviceswouldbestretchedtocapacityorbeyond;crimewouldgoup.BusinesseswouldbedeterredfromlocatingindowntownChicago.Politicianswouldpleadforhelpfrom the state or the federal government: Either give us enough money tosupport these people or help us get rid of them. When business leaders inSacramento, California, decided to crack down on the homeless, one strategywastoofferthemone-waybusticketsoutoftown.3(Atlantareportedlydidthesamebeforethe1996Olympics.)

Now imagine the same corner and let’s drop off 100,000 graduates fromAmerica’stopuniversities.ThebusesarriveatthecornerofStateandMadisonand begin unloading lawyers, doctors, artists, geneticists, software engineers,and a lot of smart, motivated people with general skills. Many of theseindividualswould find jobs immediately. (Remember,humancapital embodiesnot only classroom training but also perseverance, honesty, creativity—virtuesthat lend themselves to findingwork.) Some of these highly skilled graduates

wouldstart theirownbusinesses;entrepreneurial flair iscertainlyan importantcomponentofhumancapital.Someofthemwouldleaveforotherplaces;highlyskilled workers are more mobile than their low-skilled peers. In some cases,firmswouldrelocatetoChicagooropenupofficesandplantsinChicagototakeadvantage of this temporary glut of talent. Economic pundits would laterdescribe this freak unloading of buses as a boon for Chicago’s economicdevelopment,muchaswavesofimmigrationhelpedAmericatodevelop.

Ifthisexamplesoundscontrived,considerthecaseoftheNavalAirWarfareCenter (NAWC) in Indianapolis, a facility that produced advanced electronicsfor the navy until the late 1990s. NAWC, which employed roughly 2,600workers,wasslatedtobeclosedaspartofthemilitary’sdownsizing.We’reallfamiliarwiththeseplant-closingstories.Hundredsorthousandsofworkerslosetheirjobs;businessesinthesurroundingcommunitybegintowitherbecausesomuch purchasing power has been lost. Someone comes on camera and says,“When theplantclosedback in [someyear], this town justbegan todie.”ButNAWC was a very different story.4 One of its most valuable assets was itsworkforce,some40percentofwhomwerescientistsorengineers.Astutelocalleaders,ledbyMayorStephenGoldsmith,believedthattheplantcouldbesoldto a private buyer. Seven companies filed bids; Hughes Electronics was thewinner.

On a Friday in January 1997, the NAWC employees went home asgovernmentemployees;thefollowingMonday,98percentofthemcametoworkasHughesemployees.(AndNAWCbecameHAWC.)TheHughesexecutivesIinterviewedsaidthat thevalueof theacquisitionlayinthepeople,not just thebricksandmortar.Hugheswasbuyingamassiveamountofhumancapitalthatitcouldnoteasilyfindanywhereelse.Thisstorycontrastssharplywiththeplantclosings that Bruce Springsteen sings about, where workers with limitededucation find that their narrow sets of skills have no value once themill/mine/factory/plant is gone. The difference is human capital. Indeed,economists can even provide empirical support for those Springsteen songs.Labor economistRobertTopelhas estimated that experiencedworkers lose25percentoftheirearningscapacityinthelongrunwhentheyareforcedtochangejobsbyaplantclosing.

Nowisanappropriatetimetodispatchoneofthemostperniciousnotionsinpublicpolicy:thelumpoflaborfallacy.Thisisthemistakenbeliefthatthereisafixedamountofworktobedonein theeconomy,andthereforeeverynewjobmustcomeattheexpenseofajoblostsomewhereelse.IfIamunemployed,the

mistakenargumentgoes,thenIwillfindworkonlyifsomeoneelseworksless,or not at all. This is how the French government used to believe the worldworked,anditiswrong.Jobsarecreatedanytimeanindividualprovidesanewgoodorservice,orfindsabetter(orcheaper)wayofprovidinganoldone.

Thenumbersprovethepoint.TheU.S.economyproducedtensofmillionsof new jobs over the past three decades, including virtually the entire Internetsector. (Yes, the recession that began in 2007 destroyed lots of jobs, too.)Millions ofwomen entered the labor force in the secondhalf of the twentiethcentury, yet our unemployment rate was still extremely low by historicalstandardsuntil thebeginningof the recentdownturn.Similarly,hugewavesofimmigrantshavecometowork inAmerica throughoutourhistorywithoutanylong-run increase in unemployment. Are there short-term displacements?Absolutely;someworkerslosejobsorseetheirwagesdepressedwhentheyareforcedtocompetewithnewentrantstothelaborforce.Butmorejobsarecreatedthan lost.Remember, newworkersmust spend their earnings elsewhere in theeconomy, creating new demand for other products. The economic pie getsbigger,notmerelyresliced.

Here is the intuition: Imagine a farming community in which numerousfamiliesownandfarmtheirownland.Eachfamilyproducesjustenoughtofeeditself; there isno surplusharvestorunfarmed land.Everyone in this townhasenough to eat; on the other hand, no one lives particularlywell.Every familyspends large amounts of time doing domestic chores. They make their ownclothes, teach theirownchildren,makeand repair theirownfarm implements,etc.Supposeaguywandersintotownlookingforwork.Inscenarioone,thisguyhasnoskills.Thereisnoextralandtofarm,sothecommunitytellshimtogetbackonthetrain.Maybetheyevenbuyhimaone-wayticketoutoftown.Thistownhas“nojobs.”

Nowconsiderscenariotwo:TheguywhoamblesintotownhasaPh.D.inagronomy.Hehasdesignedanewkindofplow that improvescornyields.Hetrades his plow to farmers in exchange for a small share of their harvests.Everybody isbetteroff.Theagronomistcansupporthimself; the farmershavemoretoeat,evenafterpayingfortheirnewplows(orelsetheywouldn’tbuytheplows).Andthiscommunityhasjustcreatedonenewjob:plowsalesman.Soonthereafter,acarpenterarrivesatthetrainstation.Heofferstodoalltheoddjobsthatlimittheamountoftimefarmerscanspendtendingtotheircrops.Yieldsgoupagainbecausefarmersareabletospendmoretimedoingwhattheydobest:farming.Andanothernewjobiscreated.

At this point, farmers are growing more than they can possibly eatthemselves, so they “spend” their surplus to recruit a teacher to town. That’sanother new job. She teaches the children in the town, making the nextgeneration of farmers better educated andmore productive than their parents.Overtime,ourcontrivedfarmingtown,whichhad“nojobs”atthebeginningofthis exercise, has romancenovelists, firefighters, professionalbaseball players,andevenengineerswhodesign iPhonesandMargaritaSpacePaks.This is theone-pageeconomichistoryoftheUnitedStates.Risinglevelsofhumancapitalenabled an agrarian nation to evolve into places as rich and complex asManhattanandSiliconValley.

Notallisrosyalongtheway,ofcourse.Supposeoneofournewlyeducatedfarmersdesignsaplow thatproduces evenbetteryields,putting the firstplowsalesman out of business—creative destruction. True, this technologicalbreakthrough eliminates one job in the short run. In the long run, though, thetownisstillbetteroff.Remember,allthefarmersarenowricher(asmeasuredbyhigher corn yields), enabling them to hire the unemployed agronomist to dosomething else, such as developnewhybrid seeds (whichwillmake the townricheryet).Technologydisplacesworkers in theshort runbutdoesnot lead tomass unemployment in the long run.Rather,we become richer,which createsdemand for new jobs elsewhere in the economy.Of course, educatedworkersfare much better than uneducated workers in this process. They are moreversatile in a fast-changing economy, making them more likely to be leftstandingafteraboutofcreativedestruction.

Humancapital isaboutmuchmore thanearningmoremoney. Itmakesusbetterparents,moreinformedvoters,moreappreciativeofartandculture,moreabletoenjoythefruitsoflife.Itcanmakeushealthierbecauseweeatbetterandexercisemore. (Meanwhile, good health is an important component of humancapital.)Educatedparentsaremore likely toput theirchildren incarseatsandteachthemaboutcolorsandlettersbeforetheybeginschool.Inthedevelopingworld,theimpactofhumancapitalcanbeevenmoreprofound.Economistshavefoundthatayearofadditionalschoolingforawomaninalow-incomecountryisassociatedwitha5to10percentreductioninherchild’slikelihoodofdyinginthefirstfiveyearsoflife.5

Similarly,ourtotalstockofhumancapital—everythingweknowasapeople—defines howwell offwe are as a society.We benefit from the fact thatweknow how to prevent polio or make stainless steel—even if virtually no onereadingthisbookwouldbeabletodoeitherofthosethingsifleftstrandedona

desertedisland.EconomistGaryBecker,whowasawardedtheNobelPrizeforhis work in the field of human capital, reckons that the stock of education,training,skills,andeventhehealthofpeopleconstitutesabout75percentofthewealthofamoderneconomy.Notdiamonds,buildings,oil,orfancypurses—butthingsthatwecarryaroundinourheads.“Weshouldreallycalloureconomya‘humancapitalisteconomy,’forthatiswhatitmainlyis,”Mr.Beckersaidinaspeech. “While all forms of capital—physical capital, such as machinery andplants,financialcapital,andhumancapital—areimportant,humancapitalisthemostimportant.Indeed,inamoderneconomy,humancapitalisbyfarthemostimportantformofcapitalincreatingwealthandgrowth.”6

There is a striking correlation between a country’s level of human capitaland its economic well-being. At the same time, there is a striking lack ofcorrelation between natural resources and standard of living. Countries likeJapan and Switzerland are among the richest in the world despite havingrelativelypoorendowmentsofnaturalresources.CountrieslikeNigeriaarejustthe opposite; enormous oil wealth has done relatively little for the nation’sstandard of living. In some cases, the mineral wealth of Africa has financedbloodycivilwarsthatwouldhaveotherwisediedout.IntheMiddleEast,SaudiArabiahasmostoftheoilwhileIsrael,withnonaturalresourcestospeakof,hasahigherpercapitaincome.

Highlevelsofhumancapitalcreateavirtuouscycle;well-educatedparentsinvest heavily in the human capital of their children. Low levels of humancapitalhavejusttheoppositeeffect.Disadvantagedparentsbegetdisadvantagedchildren,asanypublicschoolteacherwilltellyou.Mr.Beckerpointsout,“Evensmall differences among children in thepreparationprovidedby their familiesare frequently multiplied over time into large differences when they areteenagers.Thisiswhythelabormarketcannotdomuchforschooldropoutswhocanhardlyreadandneverdevelopedgoodworkhabits,andwhyitissodifficulttodevisepoliciestohelpthesegroups.”7

Why does human capital matter so much? To begin with, human capital isinextricably linked to one of the most important ideas in economics:productivity. Productivity is the efficiency with which we convert inputs intooutputs.Inotherwords,howgoodareweatmakingthings?Doesittake2,000hours foraDetroitautoworker tomakeacaror210hours?Canan Iowacornfarmergrowthirtybushelsofcornonanacreoflandor210bushels?Themore

productiveweare,thericherweare.Thereasonissimple:Thedaywillalwaysbetwenty-fourhourslong;themoreweproduceinthosetwenty-fourhoursthemore we consume, either directly or by trading it away for other stuff.Productivity is determined in part by natural resources—it is easier to growwheatinKansasthanitisinVermont—butinamoderneconomy,productivityismore affected by technology, specialization, and skills, all of which are afunctionofhumancapital.

AmericaisrichbecauseAmericansareproductive.Wearebetteroff todaythan at any other point in the history of civilization because we are better atproducing goods and services than we have ever been, including things likehealthcareandentertainment.Thebottomlineisthatweworklessandproducemore. In 1870, the typical household required 1,800 hours of labor just toacquireitsannualfoodsupply;today,ittakesabout260hoursofwork.Overthecourse of the twentieth century, the average work year has fallen from 3,100hourstoabout1,730hours.Allthewhile,realgrossdomesticproduct(GDP)percapita—an inflation-adjusted measure of how much each of us produces, onaverage—has increased from$4,800 tomore than $40,000.Even the poor arelivingextremelywellbyhistoricalstandards.Thepovertylineisnowatalevelof real income that was attained only by those in the top 10 percent of theincomedistributionacenturyago.AsJohnMaynardKeynesoncenoted,“Inthelongrun,productivityiseverything.”

Productivity is the concept that takes the suck out of Ross Perot’s “giantsuckingsound.”WhenRossPerotranforpresidentin1992asanindependent,oneofhisdefiningpositionswasopposition to theNorthAmericanFreeTreeAgreement(NAFTA).PerotreasonedthatifweopenedourborderstofreetradewithMexico,thenmillionsofjobswouldfleesouthoftheborder.Whywouldn’ta firm relocate toMexico when the averageMexican factory worker earns afractionofthewagespaidtoAmericanworkers?Theanswerisproductivity.CanAmericanworkers compete against foreignworkerswhoearnhalf asmuchorless?Yes,mostofuscan.WeproducemorethanMexicanworkers—muchmorein many cases—because we are better-educated, because we are healthier,becausewehavebetteraccess tocapitaland technology,andbecausewehavemore efficient government institutions and better public infrastructure. Can aVietnamesepeasantwithtwoyearsofeducationdoyourjob?Probablynot.

Of course, there are industries in which American workers are notproductiveenoughtojustifytheirrelativelyhighwages,suchasmanufacturingtextiles and shoes. These are industries that require relatively unskilled labor,

which ismore expensive in this country than in the developingworld. Can aVietnamesepeasantsewbasketballshoestogether?Yes—andforalotlessthantheAmericanminimumwage.Americanfirmswill lookto“outsource”jobstoother countries only if thewages in those countries are cheap relative towhatthoseworkerscanproduce.Aworkerwhocostsatenthasmuchandproducesatenth as much is no great bargain. A worker who costs a tenth as much andproduceshalfasmuchprobablyis.

WhileRossPerotwaswarningthatmostoftheU.S.economywouldmigrateto Guadalajara, mainstream economists predicted that NAFTA would have amodestbutpositiveeffectonAmericanemployment.SomejobswouldbelosttoMexican competition; more jobs would be created as exports to Mexicoincreased.WearenowmorethanadecadeintoNAFTA,andthatisexactlywhathappened. Economists reckon that the effect on overall employment waspositive,albeitverysmallrelativetothesizeoftheU.S.economy.

Willourchildrenbebetteroffthanweare?Yes,iftheyaremoreproductivethan we are, which has been the pattern throughout American history.Productivity growth is what improves our standard of living. If productivitygrows at 2 percent a year, then we will become 2 percent richer every year.Why?Becausewecantakethesameinputsandmake2percentmorestuff.(Orwecouldmakethesameamountofstuffwith2percentfewerinputs.)OneofthemostinterestingdebatesineconomicsiswhetherornottheAmericaneconomyhas undergone a sharp increase in the rate of productivity growth. Someeconomists,includingAlanGreenspanduringhistenureasFedchairman,haveargued that investments in information technology have led to permanentlyhigher rates of productivity growth. Others, such as Robert Gordon atNorthwestern University, believe that productivity growth has not changedsignificantlywhenoneinterpretsthedataproperly.

The answer to that debate matters enormously. From 1947 to 1975,productivitygrewat anannual rateof2.7percent ayear.From1975until themid-1990s, for reasons that are still not fully understood, productivity growthslowed to 1.4 percent a year. Then it got better again; from 2000 to 2008,productivitygrowthreturnedtoamuchhealthier2.5percentannually.Thatmayseemlikeatrivialdifference;infact,ithasaprofoundeffectonourstandardofliving.Onehandytrickinfinanceandeconomicsistheruleof72;divide72byarateofgrowth (ora rateof interest) and theanswerwill tellyou roughlyhowlong itwill takeforagrowingquantity todouble (e.g., theprincipal inabankaccount paying 4 percent interest will double in roughly 18 years). When

productivity grows at 2.7 percent a year, our standard of living doubles everytwenty-sevenyears.At1.4percent,itdoubleseveryfifty-oneyears.

Productivitygrowthmakesus richer, regardlessofwhat isgoingon in therestoftheworld.Ifproductivitygrowsat4percentinJapanand2percentintheUnitedStates,thenbothcountriesaregettingricher.Tounderstandwhy,gobacktoour simple farmeconomy. Ifone farmer is raising2percentmorecornandhogseveryyearandhisneighborisraising4percentmore,thentheyareeatingmoreeveryyear(ortradingmoreaway).Ifthisdisparitygoesonforalongtime,oneofthemwillbecomesignificantlyricherthantheother,whichmaybecomeasourceofenvyorpoliticalfriction,buttheyarebothgrowingsteadilybetteroff.Theimportantpointisthatproductivitygrowth,likesomuchelseineconomics,isnotazero-sumgame.

WhatwouldbetheeffectonAmericaif500millionpeopleinIndiabecamemore productive and gradually moved from poverty to the middle class?Wewouldbecomericher,too.Poorvillagerscurrentlysubsistingon$1adaycannotafford to buy our software, our cars, our music, our books, our agriculturalexports. If they were wealthier, they could. Meanwhile, some of those 500millionpeople,whosepotentialiscurrentlywastedforlackofeducation,wouldproducegoodsandservices thatare superior towhatwehavenow,makingusbetter off. One of those newly educated peasants might be the person whodiscovers an AIDS vaccine or a process for reversing global warming. Toparaphrase the United Negro College Fund, 500 million minds are a terriblethingtowaste.

Productivitygrowthdependson investment—inphysicalcapital, inhumancapital, in research and development, and even in things like more effectivegovernmentinstitutions.Theseinvestmentsrequirethatwegiveupconsumptionin the present in order to be able to consumemore in the future. If you skipbuying aBMWand invest in a college education instead, your future incomewillbehigher.Similarly,asoftwarecompanymayforgopayingitsshareholdersa dividend and plow its profits back into the development of a new, betterproduct. The government may collect taxes (depriving us of some currentconsumption)tofundresearchingeneticsthatimprovesourhealthinthefuture.Ineachcase,wespendresourcesnowsothatwewillbecomemoreproductivelater.Whenweturntothemacroeconomy—ourstudyoftheeconomyasawhole—one important concernwill bewhether or notwe are investing enough as anationtocontinuegrowingourstandardofliving.

Our legal, regulatory, and tax structures also affect productivity growth.

High taxes, bad government, poorly defined property rights, or excessiveregulation can diminish or eliminate the incentive to make productiveinvestments. Collective farms, for example, are a very bad way to organizeagriculture. Social factors, such as discrimination, can profoundly affectproductivity. A society that does not educate its women or that deniesopportunities tomembersofaparticularraceorcasteor tribe is leavingavastresourcefallow.Productivitygrowthalsodependsagreatdealoninnovationandtechnological progress, neither of which is understood perfectly.Why did theInternet explode onto the scene in the mid-1990s rather than the late 1970s?How is it thatwehave cracked the humangenomeyetwe still do not have acheap source of clean energy? In short, fostering productivity growth is likeraisingchildren:WeknowwhatkindsofthingsareimportantevenifthereisnoblueprintforraisinganOlympicathleteoraHarvardscholar.

The study of human capital has profound implications for public policy.Most important, it can telluswhywehaven’tall starved todeath.Theearth’spopulation has grown to six billion; how havewe been able to feed somanymouths? In the eighteenth century,ThomasMalthus famouslypredicted a dimfuture forhumankindbecausehebelieved thatassocietygrewricher, itwouldcontinuously squander those gains through population growth—having morechildren. These additional mouths would gobble up the surplus. In his view,humankind was destined to live on the brink of subsistence, recklesslyprocreating during the good times and then starving during the bad. As PaulKrugmanhaspointedout,forfifty-fiveofthelastfifty-sevencenturies,Malthuswasright.Theworldpopulationgrew,butthehumanconditiondidnotchangesignificantly.

OnlywiththeadventoftheIndustrialRevolutiondidpeoplebegintogrowsteadily richer. Even then,Malthuswas not far off themark.AsGaryBeckerpoints out, “Parents did spendmore on childrenwhen their incomes rose—asMalthus predicted—but they spent a lot more on each child and had fewerchildren, as human capital theory predicts.”8The economic transformationsofthe Industrial Revolution, namely the large productivity gains, made parents’time more expensive. As the advantages of having more children declined,peoplebeganinvestingtheirrisingincomesinthequalityof theirchildren,notmerelythequantity.

Oneofthefallaciesofpovertyisthatdevelopingcountriesarepoorbecausethey have rapid population growth. In fact, the causal relationship is bestunderstoodgoing theotherdirection:Poorpeoplehavemanychildrenbecause

the cost of bearing and raising children is low. Birth control, no matter howdependable,works only to the extent that families prefer fewer children.As aresult,oneofthemostpotentweaponsforfightingpopulationgrowthiscreatingbetter economic opportunities for women, which starts by educating girls.Taiwandoubledthenumberofgirlsgraduatingfromhighschoolbetween1966and1975.Meanwhile,thefertilityratedroppedbyhalf.Inthedevelopedworld,where women have enjoyed an extraordinary range of new economicopportunities for more than a half century, fertility rates have fallen near orbelowreplacementlevel,whichis2.1birthsperwoman.

Webegan this chapterwith a discussion ofBillGates’s home,which is, I amfairlycertain,biggerthanyours.Atthedawnofthethirdmillennium,Americaisaprofoundlyunequalplace.Is thenationgrowingmoreunequal?Thatanswer,by almost any measure, is yes. According to analysis by the CongressionalBudget Office, American households in the bottom fifth of the incomedistributionwere earning only 2 percentmore in 2004 (adjusted for inflation)thantheywerein1979.That’saquartercenturywithnorealincomegrowthatall.Americansinthemiddleoftheincomedistributiondidbetteroverthesamestretch;theiraveragehouseholdincomegrew15percentinrealterms.Thoseinthe top quintile—the top 20 percent—saw household income growth of 63percent(adjustedforinflation).9

AsAmerica’slongesteconomicboominhistoryunfolded,therichgotricherwhile the poor ran in place, or even got poorer.Wages for male high schooldropoutshavefallenbyroughlyaquartercomparedtowhattheirdadsearnedifthey were also high school dropouts. The recession that began in 2007 hasnarrowed the gap between America’s rich and poor slightly (by destroyingwealthatthetop,notbymakingthetypicalworkerbetteroff).Mosteconomistswouldagree that the long-termtrend isagrowinggapbetweenAmerica’s richandpoor.Themoststunningactionhasbeenatthetopofthetop.In1979,thewealthiest1percentofAmericansearned9percentofthenation’stotalincome;nowtheyget16percentofAmerica’sannualcollectivepaycheck.

Why?Human capital offers themost insight into this social phenomenon.Thelastseveraldecadeshavebeenareal-lifeversionofRevengeoftheNerds.Skilled workers in America have always earned higher wages than unskilledworkers;thatdifferencehasstartedtogrowataremarkablerate.Inshort,humancapital has become more important, and therefore better rewarded, than ever

before. One simple measure of the importance of human capital is the gapbetweenthewagespaidtohighschoolgraduatesandthewagespaidtocollegegraduates. College graduates earned an average of 40 percentmore than highschoolgraduatesatthebeginningofthe1980s;nowtheyearn80percentmore.Individuals with graduate degrees do even better than that. The twenty-firstcenturyisanespeciallygoodtimetobearocketscientist.

Oureconomyisevolving inways that favorskilledworkers.Forexample,the shift towardcomputers innearly every industry favorsworkerswhoeitherhavecomputerskillsoraresmartenoughtolearnthemonthejob.Technologymakes smart workers more productive while making low-skilled workersredundant. ATMs replaced bank tellers; self-serve pumps replaced gas stationattendants; automated assembly lines replaced workers doing mindless,repetitive tasks. Indeed, the assembly line atGeneralMotors encapsulates themajortrendintheAmericaneconomy.Computersandsophisticatedrobotsnowassemble themajor components of a car—which creates high-paying jobs forpeople who write software and design robots while reducing the demand forworkerswithnospecializedskillsotherthanawillingnesstodoanhonestday’swork.

Meanwhile, international trade puts low-skilled workers in greatercompetitionwith other low-skilledworkers around the globe. In the long run,internationaltradeisapowerfulforceforgood;intheshortrun,ithasvictims.Trade,liketechnology,makeshigh-skilledworkersbetteroffbecauseitprovidesnewmarketsforourhigh-techexports.BoeingsellsaircrafttoIndia,Microsoftsells software to Europe, McKinsey & Company sells consulting services toLatin America. Again, this is more good news for people who know how todesignafuel-efficientjetengineorexplaintotalqualitymanagementinSpanish.Ontheotherhand,itputsourlow-techworkersincompetitionwithlow-pricedlaborers in Vietnam. Nike can pay workers $1 a day to make shoes in aVietnamesesweatshop.Youcan’tmakeBoeingairplanesthatway.Globalizationcreatesmoreopportunitiesforskilledworkers(NakedEconomicsispublishedinelevenlanguages!)andmorecompetitionforunskilledworkers.

There is still disagreement about the degree towhich different causes areresponsible for this shifting gap in wages. Unions have grown less powerful,givingblue-collarworkers less clout at thebargaining table.Meanwhile,high-wage workers are logging more hours on the job than their low-wagecounterparts, which exacerbates the total earnings gap.10 More and moreindustries are linkingpay toperformance,which increaseswagegapsbetween

those who are more and less productive. In any case, the rise in incomeinequalityisreal.Shouldwecare?Economistshavetraditionallyarguedthatweshould not, for two basic reasons. First, income inequality sends importantsignalsintheeconomy.Thegrowingwagegapbetweenhighschoolandcollegegraduates, for example, will motivate many students to get college degrees.Similarly, thespectacularwealthearnedbyentrepreneursprovidesanincentiveto take the risks necessary for leaps in innovation,many ofwhich have hugepayoffs for society.Economics is about incentives, and theprospectofgettingrichisabigincentive.

Second, many economists argue that we should not care about the gapbetweenrichandpooraslongaseverybodyislivingbetter.Inotherwords,weshouldcareabouthowmuchpiethepooraregetting,nothowmuchpietheyaregetting relative toBillGates. Inhis1999presidentialaddress to theAmericanEconomics Association, Robert Fogel, a Nobel Prize–winning economichistorian,pointedoutthatourpoorestcitizenshaveamenitiesunknowneventoroyaltyahundredyearsago.(Morethan90percentofpublichousingresidentshaveacolortelevision,forexample.)Envymaybeoneofthesevendeadlysins,but it is not something to which economists have traditionally paid muchattention.MyutilityshoulddependonhowmuchIlikemycar,notonwhetherornotmyneighborisdrivingaJaguar.

Of course, common sense suggests otherwise. H. L.Mencken once notedthatawealthymanisamanwhoearns$100ayearmorethanhiswife’ssister’shusband. Some economists have belatedly begun to believe that hewas on tosomething.11DavidNeumarkandAndrewPostlewaitelookedatalargesampleofAmericansistersinanefforttounderstandwhysomewomenchoosetoworkoutsideof thehomeandothersdonot.When the researcherscontrolled forallthe usual explanations—unemployment in the local labor market, a woman’seducationandworkexperience,etc.—theyfoundpowerfulevidence tosupportH.L.Mencken’swryobservation:Awoman in their samplewas significantlymore likely to seekpaidemployment ifher sister’shusbandearnedmore thanherown.

Cornell economist Robert Frank, author of Luxury Fever, has made apersuasive case that relative wealth—the size of my pie compared to myneighbor’s—is an important determinant of our utility. He offered surveyrespondentsachoicebetweentwoworlds:(A)Youearn$110,000andeveryoneelseearns$200,000;or(B)youearn$100,000andeveryoneelseearns$85,000.As he explains, “The income figures represent real purchasing power. Your

incomeinWorldAwouldcommandahouse10percentlargerthantheoneyoucould afford in World B, 10 percent more restaurant dinners and so on. BychoosingWorldB,you’dgiveupasmallamountofabsolute incomein returnfora large increase in relative income.”Youwouldbe richer inWorldA;youwouldbelesswealthyinWorldBbutricherthaneveryoneelse.Whichscenariowouldmakeyouhappier?Mr.FrankfoundthatamajorityofAmericanswouldchooseB.Inotherwords,relativeincomedoesmatter.Envymaybepartoftheexplanation. It is also true, Mr. Frank points out, that in complex socialenvironmentsweseekwaystoevaluateourperformance.Relativewealthisoneofthem.

There isasecond,morepragmaticconcernabout rising incomeinequality.Mightthegapbetweenrichandpoor—ethicsaside—becomelargeenoughthatitbeginstoinhibiteconomicgrowth?Isthereapointatwhichincomeinequalitystopsmotivatingustoworkharderandbecomescounterproductive?Thismighthappenforallkindsofreasons.Thepoormightbecomedisenfranchisedto thepoint that they reject important political and economic institutions, such aspropertyrightsortheruleoflaw.Alopsideddistributionofincomemaycausethe rich to squander resources on increasingly frivolous luxuries (e.g., doggybirthdaycakes)whenotherkindsofinvestments,suchashumancapitalforthepoor,wouldyield a higher return.Or classwarfaremay lead tomeasures thatpunish the rich without making the poor any better off.12 Some studies haveindeed foundanegative relationshipbetween income inequality and economicgrowth; others have found just the opposite. Over time, data will inform thisrelationship. But the larger philosophical debate will rage on: If the pie isgrowing,howmuchshouldwecareaboutthesizeofthepieces?

Thesubjectofhumancapitalbegssomefinalquestions.Willthepooralwaysbewithus,asJesusonceadmonished?Doesourfreemarketsystemmakepovertyinevitable?Musttherebelosersiftherearehugeeconomicwinners?No,no,andno. Economic development is not a zero-sum game; theworld does not needpoorcountriesinordertohaverichcountries,normustsomepeoplebepoorinorderforotherstoberich.FamilieswholiveinpublichousingontheSouthSideofChicagoarenotpoorbecauseBillGateslivesinabighouse.Theyarepoordespite the fact that Bill Gates lives in a big house. For a complex array ofreasons,America’spoorhavenot shared in theproductivitygains spawnedbyMicrosoftWindows.BillGatesdidnottaketheirpieaway;hedidnotstandin

thewayoftheirsuccessorbenefitfromtheirmisfortunes.Rather,hisvisionandtalent created an enormous amount ofwealth that not everybody got to share.There isacrucialdistinctionbetweenaworld inwhichBillGatesgetsrichbystealingotherpeople’scropsandaworldinwhichhegetsrichbygrowinghisownenormousfoodsupplythatheshareswithsomepeopleandnotothers.Thelatterisabetterrepresentationofhowamoderneconomyworks.

In theory, a world in which every individual was educated, healthy, andproductivewouldbeaworldinwhicheverypersonlivedcomfortably.Perhapswewillnevercure theworldof theassortedphysicalandmental illnesses thatpreventsomeindividualsfromreachingtheirfullpotential.But that isbiology,noteconomics.Economicstellsusthatthereisnotheoreticallimittohowwellwecanliveorhowwidelyourwealthcanbespread.

Canthatreallybetrue?IfweallhadPh.D.s,whowouldpassoutthetowelsat the Four Seasons? Probably no one. As a population becomes moreproductive, we begin to substitute technology for labor. We use voice mailinsteadofsecretaries,washingmachinesinsteadofmaids,ATMsinsteadofbanktellers, databases instead of file clerks, vending machines instead ofshopkeepers, backhoes instead of ditch diggers. The motivation for thisdevelopmentharksbacktoaconceptfromChapter1:opportunitycost.Highlyskilledindividualscandoallkindsofproductivethingswiththeirtime.Thus,itisfabulouslyexpensivetohireanengineertobaggroceries.(HowmuchwouldyouhavetobepaidtopassouttowelsattheFourSeasons?)Therearefarfewerdomestic servants in the United States than in India, even though the UnitedStatesisarichercountry.Indiaisawashwithlow-skilledworkerswhohavefewother employment options; America is not, making domestic labor relativelyexpensive (as anyone with a nanny can attest).Who can afford a butler whowouldotherwiseearn$50anhourwritingcomputercode?

Whenwecannotautomatemenial tasks,wemayrelegate themtostudentsandyoungpeopleasameansfor themtoacquirehumancapital. Icaddiedformore than a decade (most famously for George W. Bush, long before heascended to the presidency);mywifewaited tables. These jobs provideworkexperience, which is an important component of human capital. But supposetherewassomeunpleasanttaskthatcouldnotbeautomatedaway,norcoulditbedone safely by young people at the beginning of their careers. Imagine, forexample,ahighlyeducatedcommunitythatproducesallkindsofvaluablegoodsandservicesbutgeneratesadisgustingsludgeasaby-product.Furtherimaginethat collecting the sludge is horrible,mind-numbingwork.Yet if the sludge is

not collected, then thewhole economywill grind to a halt. If everyone has aHarvarddegree,whohaulsawaythesludge?

The sludge hauler does.And he or she, incidentally,would be one of thebest-paidworkers in town. If theeconomydependsonhauling thisstuffaway,and no machine can do the task, then the community would have to inducesomeonetodothework.Thewaytoinducepeopletodoanythingistopaythema lot. The wage for hauling sludge would get bid up to the point that someindividual—adoctor, or an engineer, or awriter—wouldbewilling to leave amorepleasantjobtohaulsludge.Thus,aworldrichinhumancapitalmaystillhaveunpleasanttasks—proctologistspringstomind—butnoonehastobepoor.Conversely,many peoplemay accept lessmoney to do particularly enjoyablework—teaching college students comes to mind (especially with the summeroff).

Humancapitalcreatesopportunities. Itmakesus richerandhealthier; itmakesusmorecompletehumanbeings;itenablesustolivebetterwhileworkingless.Most important from a public policy perspective, human capital separates thehaves from the have-nots. Marvin Zonis, a professor at the University ofChicago Graduate School of Business and a consultant to businesses andgovernmentsaround theworld,made thispointwonderfully inaspeech to theChicagobusinesscommunity.“Complexitywillbethehallmarkofourage,”henoted.“Thedemandeverywherewillbeforeverhigherlevelsofhumancapital.Thecountriesthatgetthatright,thecompaniesthatunderstandhowtomobilizeandapply thathumancapital, and the schools thatproduce it…willbe thebigwinnersofourage.Fortherest,morebackwardnessandmoremiseryfortheirowncitizensandmoreproblemsfortherestofus.”13

CHAPTER7

FinancialMarkets:

What economics can tell us about getting rich quick (and losingweight,too!)

WhenIwasanundergraduatemanyyearsago,anewdietsweptthroughoneofthesororitiesoncampus.Thiswasnoordinarydiet;itwasthegrapefruitandicecreamdiet. The premise, as the namewould suggest,was that one could loseweight by eating large amounts of grapefruit and ice cream. The diet did notwork,ofcourse,buttheincidenthasalwaysstuckwithme.Iwasfascinatedthataverysmartgroupofwomenhadtossedasidecommonsensetoembraceadietthatcouldnotpossiblywork.Nomedicalordietaryinformationsuggestedthateating grapefruit and ice cream would cause weight loss. Still, it was anappealingthought.Whowouldn’twanttoloseweightbyeatingicecream?

Iwasremindedofthegrapefruitandicecreamdietrecentlywhenoneofmyneighborsbegantosharehisinvestmentstrategy.Hehadtakenabighitoverthepast year because his portfolio was laden with Internet and tech stocks, heexplained,buthewasplungingbackintothemarketwithanewandimprovedstrategy.Hewasstudying thechartsofpastmarketmovements forshapes thatwouldsignalwherethemarketwasgoingnext.Icannotrememberthespecificshapes he was looking for. I was distracted at the time, both because I waswatering flowers and because my mind was screaming, “Grapefruit and icecream!” My smart neighbor, who is both a doctor and a university facultymember,wasventuringfarfromthehallsofsciencewithhisinvestmentstrategy,and that is the broader lesson.When it comes to personal finance (and losingweight), intelligent people will toss good sense aside faster than you can say“miracle diet.” The rules for investing successfully are strikingly simple, butthey require discipline and short-term sacrifice. The payoff is a slow, steadyaccumulation ofwealth (with plenty of setbacks along theway) rather than aquick windfall. So, faced with the prospect of giving up consumption in the

present for plodding success in the future, we eagerly embrace faster, easiermethods—andarethenshockedwhentheydon’twork.

Thischapter isnotaprimeronpersonal finance.Therearesomeexcellentbooksoninvestmentstrategies.BurtonMalkiel,whowaskindenoughtowritetheforewordfor thisbook,haswrittenoneof thebest:ARandomWalkDownWallStreet.Rather,thischapterisaboutwhatabasicunderstandingofmarkets—the ideas covered in the first two chapters—can tell us about personalinvesting.Anyinvestmentstrategymustobeythebasiclawsofeconomics,justasanydietisconstrainedbytherealitiesofchemistry,biology,andphysics.ToborrowthetitleofWallyLamb’sbest-sellingnovel:Iknowthismuchistrue.

Atfirstglance,thefinancialmarketsareremarkablycomplex.Stocksandbondsarecomplicatedenough,but thenthereareoptions,futures,optionsonfutures,interest rate swaps, government “strips,” and the now infamous credit defaultswaps.AttheChicagoMercantileExchange,itisnowpossibletobuyorsellafutures contract based on the average temperature in Los Angeles. At theChicagoBoardofTrade, one canbuy and sell the right to emitSO2.Yes, it’sactuallypossibletomake(orlose)moneybytradingsmog.Thedetailsofthesecontractscanbemind-numbing,yetatbottom,mostofwhatisgoingonisfairlystraightforward. Financial instruments, like every other good or service in amarket economy, must create some value. Both the buyer and seller mustperceive themselves as better off by entering into the deal. All the while,entrepreneursseektointroducefinancialproductsthatarecheaper,faster,easier,or otherwise better than what already exists. Mutual funds were a financialinnovation;sowere the indexfunds thatBurtMalkielhelped tomakepopular.Attheheightofthefinancialcrisisin2008,itbecameclearthatevenWallStreetexecutivesdidnot fullyunderstand someof theproducts that their firmswerebuyingandselling.Still,allfinancialinstruments—nomatterhowcomplexthebellsandwhistles—arebasedonfoursimpleneeds:

Raisingcapital.Oneofthefascinatingthingsinlife,particularlyinAmerica,isthat we can spend large sums of money that don’t belong to us. Financialmarkets enable us to borrow money. Sometimes this means that Visa andMasterCardindulgeoureagernesstoconsumetodaywhatwecannotafforduntil

next year (if then); more often—and more significant to the economy—borrowingmakes possible all kinds of investment.We borrow to pay collegetuition.Weborrowtobuyhomes.Weborrowtobuildplantsandequipmentortolaunchnewbusinesses.Weborrowtodothingsthatmakeusbetteroffevenafterwe’vepaidthecostofborrowing.

Sometimeswe raise capitalwithout borrowing;wemay sell shares of ourbusinesstothepublic.Thus,wetradeanownershipstake(andthereforeaclaimon future profits) in exchange for cash. Or companies and governments mayborrowdirectlyfromthepublicbyissuingbonds.Thesetransactionsmaybeassimple as anewcar loanor as complexas amultibillion-dollarbailoutby theInternationalMonetaryFund.Thebottomlineneverchanges:Individuals,firms,andgovernmentsneedcapital todo things today that theycouldnototherwiseafford;thefinancialmarketsprovideittothem—ataprice.

Moderneconomies cannot survivewithout credit. Indeed, the internationaldevelopment community has begun to realize that making credit available toentrepreneursinthedevelopingworld,evenloansassmallas$50or$100,canbe a powerful tool for fighting poverty.Opportunity International is one such“microcredit” lender. In 2000, the organization made nearly 325,000 low-collateral or non-collateral loans in twenty-four developing countries. Theaverage loan size was a seemingly paltry $195. Esther Gelabuzi, a widow inUganda with six children, represents a typical story. She is a professionalmidwife,andsheuseda tinyloanbyWesternstandards tosetupaclinic(stillwithout electricity). She has since delivered some fourteen hundred babies,chargingpatientsfrom$6to$14each.OpportunityInternationalclaimstohavecreated some 430,000 jobs. As impressive, the repayment rate on the micro-loansis96percent.

Storing,protecting,andmakingprofitableuseofexcesscapital.ThesultanofBrunei earnedbillionsofdollars inoil revenues in the1970s.Supposehehadstuffedthatcashunderhismattressandleftitthere.Hewouldhavehadseveralproblems.First,itisverydifficulttosleepwithbillionsofdollarsstuffedunderthemattress.Second,withbillionsofdollarsstuffedunderthemattress,thedirtylinens would not be the only thing that disappeared every morning. Nimblefingers,nottomentionsophisticatedcriminals,wouldfindtheirwaytothestash.Third, and most important, the most ruthless and efficient thief would beinflation.IfthesultanofBruneistuffed$1billionunderhismattressin1970,it

wouldbeworthonly$180milliontoday.Thus, the sultan’s first concernwould be protecting hiswealth, both from

theft and from inflation, eachofwhichdiminisheshispurchasingpower in itsown way. His second concern would be putting his excess capital to someproductive use. The world is full of prospective borrowers, all of whom arewilling topay for theprivilege.Wheneconomists slap fancy equationson thechalkboard,thesymbolfortheinterestrateisr,noti.Why?Becausetheinterestrate is considered to be the rental rate—r—on capital. And that is the mostintuitive way to think about what is going on. Individuals, companies, andinstitutions with surplus capital are renting it to others who can make moreproductiveuseofit.TheHarvardUniversityendowmentisroughly$25billion.This is the Ivy League equivalent of rainy-day money; stuffing it under themattressesof students and facultywouldbeboth impractical and awasteof atremendous resource. Instead, Harvard employs nearly two hundredprofessionals tomanage thishoard inawaythatgeneratesahealthyreturnforthe universitywhile providing capital to the rest of theworld.1 Harvard buysstocksandbonds,investsinventurecapitalfunds,andotherwiseputs$25billioninthehandsofpeopleandinstitutionsaroundtheglobewhocandoproductivethingswithit.From1995to2005,theendowmentearnedanaverage16percentannualreturn,whichisalotmoreproductivefortheuniversitythanleavingthecash lying around campus. (Harvard also managed to lose 30 percent of itsendowment during the financial crisis, so we’ll come back to the Harvardendowmentwhenwetalkabout“riskandreward.”)2

Financial markets do more than take capital from the rich and lend it toeveryoneelse.Theyenableeachofustosmoothconsumptionoverourlifetimes,whichisafancywayofsayingthatwedon’thavetospendincomeatthesametimeweearn it.Shakespearemayhaveadmonishedus tobeneitherborrowersnorlenders;thefactisthatmostofuswillbebothatsomepoint.Ifwelivedinan agrarian society,wewould have to eat our crops reasonably soon after theharvest or find some way to store them. Financial markets are a moresophisticatedwayofmanagingtheharvest.Wecanspendincomenowthatwehavenotyet earned—asbyborrowing for collegeor ahome—orwecanearnincomenowandspenditlater,asbysavingforretirement.Theimportantpointis that earning income has been divorced from spending it, allowing usmuchmoreflexibilityinlife.

Insuringagainstrisk.Lifeisariskyproposition.Weriskdeathjustgettingintothebathtub,nottomentioncommutingtoworkorbungeejumpingwithfriends.Letusconsidersomeofthewaysyoumightfacefinancialruin:naturaldisaster,illnessordisability,fraudortheft.Oneofourprimaryimpulsesashumanbeingsis to minimize these risks. Financial markets help us to do that. The mostobviousexamplesarehealth,life,andautoinsurance.AswenotedinChapter4,insurancecompanieschargemoreforyourpolicythantheyexpecttopayouttoyou, on average. But “average” is a really important term here. You are notworried about average outcomes; you are worried about theworst things thatcould possibly happen to you.A bad draw—the tree that falls in an electricalstorm and crushes your home—could be devastating. Thus, most of us arewillingtopayapredictableamount—evenonethatismorethanweexpecttogetback—inordertoprotectourselvesagainsttheunpredictable.

Almostanythingcanbeinsured.Areyouworriedaboutpirates?Youshouldbe,ifyoushipgoodsthroughtheSouthChinaSeaortheMalaccaStrait.AsTheEconomistexplains,“Piratesstillpreyonshipsandsailors.Andfarfrombeingjolly sortswithwooden legsandeyepatches, today’spiratesarenasty fellowswithrocket-propelledgrenadesandspeedboats.”Therewere266actsofpiracy(orattempts)reportedtotheInternationalMaritimeOrganizationin2005.Thisiswhyfirmssendingcargothroughdangerousareasbuymarineinsurance(whichalsoprotectsagainstotherrisksatsea).WhentheFrenchoiltankerLimbergwasrammedbyasuicidebomberinaspeedboatpackedwithexplosivesoffthecoastof Yemen in 2002, the insurance company ended up writing a check for $70million—justlikewhensomeonebacksintoyourcarintheSafewayparkinglot,onlyamuchbiggerclaim.3

The clothing and shoe companyFila should have bought insurance beforethe2009U.S.Open tennis tournament,butdidn’t.Likeother suchcompanies,Filaendorsesathletesandpays them largebonuseswhen theydogreat things.FilaendorsesBelgiantennisplayerKimClijsters,winneroftheU.S.Open,butoptednottobuy“wininsurance”fortheroughly$300,000inbonusmoneytheyhadpromisedherforavictory.(Thiswasanexpensivedecision,butperhapsalsoan insulting one for Ms. Clijsters.) The insurance would have been cheap;Clijsterswasunseeded,hadplayedonlytwotournamentssinceleavingthegameto have a baby, and was considered a 40–1 long shot by bookies before thetournament.4

The financial markets provide an array of other products that look

complicatedbutbasically function likean insurancepolicy.Afuturescontract,for example, locks in a sale price for a commodity—anything from electricalpowertosoybeanmeal—atsomedefineddateinthefuture.OntheflooroftheBoardofTrade,onetradercanagreetosellanothertraderathousandbushelsofcorn for$3.27abushel inMarchof2010.What’s thepoint?Thepoint is thatproducersandconsumersof thesecommoditieshavemuch to fear fromfuturepriceswings.Cornfarmerscanbenefit fromlockinginasalepricewhile theircornisstillintheground—orevenbeforetheyplantit.Mightthefarmersgetabetterpricebywaitingtosellthecropuntilharvest?Absolutely.Ortheymightget amuch lower price, leaving themwithout enoughmoney to pay the bills.They,liketherestofus,arewillingtopayapriceforcertainty.

Meanwhile, big purchasers of commodities can benefit from being on theother side of the trade. Airlines use futures contracts to lock in a predictablepriceforjetfuel.Fast-foodrestaurantscanenterintofuturescontractsforgroundbeef, pork bellies (most of which are made into bacon), and even cheddarcheese. I don’t know any Starbucks executives personally, but I have a prettygood idea what keeps them awake at night: the world price of coffee beans.Americanswillpay$3.50foragrandeskimdecaflatte,butprobablynot$6.50,which is why I would be willing to bet the royalties from this book thatStarbucksusesthefinancialmarketstoprotectitselffromsuddenswingsinthepriceofcoffee.

Otherproductsdealwithotherrisks.Consideroneofmypersonalfavorites:catastrophe bonds.5 Wall Street dreamed up these gems to help insurancecompanieshedgetheirnaturaldisasterrisk.Remember, the insurancecompanywritesacheckwhena treefallsonyourhouse; ifa lotof treesfallona lotofhouses,thenthecompany,oreventheentireindustry,hasaproblem.Insurancecompaniescanminimizethatriskbyissuingcatastrophebonds.Thesebondspayasignificantlyhigherrateofinterestthanothercorporatebondsbecausethereisatwist:Ifhurricanesorearthquakesdoseriousdamagetoacertainareaduringaspecifiedperiodoftime,thentheinvestorsforfeitsomeoralloftheirprincipal.TheUnitedServicesAutomobileAssociationdidoneofthefirstdealsinthelate1990stiedtothehurricaneseasonontheEastCoast.Ifasinglehurricanecaused$1.5 billion in claims ormore, then the catastrophe bond investors lost all oftheirprincipal.Theinsurancecompany,ontheotherhand,wasabletooffsetitsclaimslossesbyavoidingrepaymentonitsdebt.Ifahurricanedidbetween$1billion and $1.5 billion in damage, then investors lost a fraction of theirprincipal. If hurricanes did relatively little damage that year, then the

bondholdersgot theirprincipalbackplusnearly12percent in interest—averynicereturnforabond.

The same basic idea is now being used to protect against terrorism. TheWorldFootballFederation,whichgovernsinternationalsoccer,insuredthe2006WorldCupagainstdisruptionduetoterrorism(andotherrisks)byissuing$260millionin“cancellationbonds.”Ifthetournamentwentoffwithoutahitch(asitdid), the investorsget theircapitalbackalongwithahandsomeprofit. If therehadbeenadisruptionseriousenoughtocanceltheWorldCup,theinvestorslosesome or all of their money, which is used instead to compensate the WorldFootballFederationforthelostrevenue.Thebeautyoftheseproductsliesintheway they spread risk. The party selling the bonds avoids ruin by sharing thecostsofanaturaldisasterora terroristattackwithabroadgroupof investors,each of whom has a diversified portfolio and will therefore take a relativelysmallhitevenifsomethingtrulyawfulhappens.

Indeed,one roleof the financialmarkets is toallowus to spreadoureggsaround generously. I must recount one of those inane experiences that canhappen only in high school. Some expert in adolescent behavior at my highschooldecidedthatstudentswouldbelesslikelytobecometeenparentsiftheyrealized how much responsibility it required. The best way to replicateparenthood, the experts reckoned,wouldbe tohave each student carry an eggaround school. The egg represented a baby and was to be treated as such—handleddelicately,neverleftoutofsight,andsoon.Butthiswashighschool.Eggs were dropped, crushed, left in gym lockers, hurled against the wall bybullies, exposed to secondhand smoke in the bathrooms, etc. The experiencetaughtme nothing about parenthood; it did convinceme forever that carryingeggsisariskyproposition.

The financial marketsmake it cheap and easy to put our eggs intomanydifferentbaskets.Witha$1,000investmentinamutualfund,youcaninvestinfive hundred ormore companies. If youwere forced to buy individual stocksfromabroker,youcouldneveraffordsomuchdiversitywithamere$1,000.For$10,000, you can diversify across a wide range of assets: big stocks, smallstocks,internationalstocks,long-termbonds,short-termbonds,junkbonds,realestate.Someofthoseassetswillperformwellatthesametimeothersaredoingpoorly, protecting you from Wall Street’s equivalent of bullies hurling eggsagainst thewall.Oneattractionof catastrophebonds for investors is that theirpayout is determined by the frequency of natural disasters, which is notcorrelatedwiththeperformanceofstocks,bonds,realestate,orothertraditional

investments.Eventhemuch-malignedcreditdefaultswapshavealegitimateinvestment

purpose.Acreditdefault swap is really justan insurancepolicyonwhetherornot some third partywill pay back its debts. Suppose your husband pressuresyouto loan$25,000toyourne’er-do-wellbrother-in-lawsothathecanfinallycomplete his court-man-dated anger management program and turn his lifearound.Youhave grave concerns aboutwhether youwill ever see any of thismoneyagain.Whatyouneedisacreditdefaultswap.Youcanpaysomeotherparty (presumably with a more favorable view of your brother-in-law’screditworthiness) to enter into a contract with you that promises to pay you$25,000 in theevent thatyourbrother-in-lawdoesnotpayback thecash.Thecontractfunctionsasinsuranceagainstdefault.Likeanyotherkindofinsurance,youpayforthisprotection.Ifyourbrother-in-lawgetshisacttogetherandpaysback the loan, you will have purchased the credit default swap for nothing(which ishowtheotherparty to the transaction,or thecounterparty,makes itsmoney).Howcouldsomethingsosimpleandseeminglyusefulcontributetothenearcollapseoftheglobalfinancialsystem?Readon.

Speculation.Ofcourse,onceanyfinancialproductiscreated,itfulfillsanotherbasichumanneed:theurgetospeculate,orbetonshort-termpricemovements.One can use the futures market to mitigate risk—or one can use the futuresmarkettobetonthepriceofsoybeansnextyear.Onecanusethebondmarkettoraisecapital—oronecanuseittobetonwhetherornotBenBernankewillcutinterestratesnextmonth.Onecanusethestockmarket toinvest incompaniesandsharetheirfutureprofits—oronecanbuyastockat10:00a.m.inhopesofmakingafewbucksbynoon.Financialproductsaretospeculationwhatsportingevents are to gambling. They facilitate it, even if that is not their primarypurpose.

Thisiswhatwentwrongwithcreditdefaultswaps.Thecuriousthingaboutthesecontracts is that anyonecanget into theaction, regardlessofwhetherornot they are a party to the debt that is being guaranteed. Let’s stick with theexample of your loser brother-in-law. It makes sense for you to use a creditdefault swap to protect yourself against loss.However, that samemarket alsoallowstherestofustobetonwhetherornotyourbrother-in-lawwillpaybackthe loan. That’s not hedging a bet; that’s speculation. So for any single debt,theremaybehundredsor thousandsof contracts tied towhetherornot itgets

repaid.Think aboutwhat thatmeans if your brother-in-law starts skipping hisanger management classes and defaults. At that point, a $25,000 loss getsmagnifiedthousandsoftimesover.

If thepartiesguaranteeing thatdebthaven’tdone theirhomework (so theydon’ttrulyunderstandwhataloseryourbrother-in-lawis),oriftheydon’tcare(becausetheyearnbigbonusesformakingdubiousbetswiththefirm’scapital),then an otherwise small set of economic setbacks can explode into somethingbigger. That’s what happened when the American economy hit a real-estate-relatedspeedbumpin2007.AIGwasthefirmattheheartofthecreditdefaultdebaclebecauseitguaranteedalotofdebtthatwentbad.Inhisexcellent2009assessment of the financial crisis, former chief economist for the InternationalMonetaryFundSimonJohnsonwrites:

Regulators, legislators, and academics almost all assumed that themanagers of these banks knewwhat theywere doing. In retrospect, theydidn’t.AIG’sFinancialProductsdivision, for instance,made$2.5millionin pretax profits in 2005, largely by selling underpriced insurance oncomplex, poorly understood securities. Often described as “picking upnickels in front of a steamroller,” this strategy is profitable in ordinaryyears, and catastrophic in bad ones.As of last fall,AIG had outstandinginsurance on more than $400 billion in securities. To date, the U.S.government, in an effort to rescue the company, has committed to about$180 billion in investments and loans to cover losses that AIG’ssophisticatedriskmodelinghadsaidwerevirtuallyimpossible.6

Raisingcapital.Protectingcapital.Hedging risk.Speculating.That’s it.All thefranticactivityonWallStreetorLaSalleStreet(homeofthefuturesexchangesinChicago)fitsintooneormoreofthosebuckets.Theworldofhighfinanceisoftendescribedasarichman’sversionofLasVegas—risk,glamour,interestingpersonalities, and lots of money changing hands. Yet the analogy is terriblyinappropriate.EverythingthathappensinLasVegasisazero-sumgame.Ifthehousewinsahandofblackjack,youlose.Andtheoddsarestackedheavily infavorofthehouse.Ifyouplayblackjacklongenough—atleastwithoutcountingcards—itisamathematicalcertaintythatyouwillgobroke.LasVegasprovidesentertainment,butitdoesnotserveanybroadersocialpurpose.WallStreetdoes.Mostofwhathappensisapositive-sumgame.Thingsgetbuilt;companiesare

launched; individuals and companies manage risk that might otherwise bedevastating.

Not every transaction is a winner, of course. Just as individuals makeinvestments they later regret, the capital markets are perfectly capable ofsquanderinghuge amountsof capital; chooseyour favorite faileddot-comandthinkofthatasanexample.Billionsofdollarsofcapitalflowedintobusinessesthat didn’twork.The real estate bubble and theWallStreetmeltdowndid thesameonanevenbiggerscale.AdamSmith’sinvisiblehandhashurledalotofcapital into the ocean, never to be seen again. Meanwhile, some potentiallyprofitable enterprises are starved for capital because they have insufficientcollateral.Economistsworry, for example, that too little credit is available forpoorfamilieswhowouldliketoinvestinhumancapital.Acollegedegreeisanexcellentinvestment,butitisnotsomethingthatcanberepossessedintheeventofdefault.

Still, the financial markets do for capital what other markets do foreverythingelse:allocateitinahighlyproductive,albeitimperfect,way.Capitalflowstowhereitcanearnthehighestreturn,whichisnotabadplacetohaveitflowing (asopposed to, say, intobusinesses runby topcommunistofficialsorfriendsoftheking).Aswiththerestoftheeconomy,governmentcanbeenemyorfriend.Governmentcanmessupthecapitalmarketsinthesamewaysitcanmess up anything else—with overly burdensome taxes and regulations, bydiverting capital into pet projects, by refusing to allow creative destruction toworkitsharshlyefficientways.Orgovernmentcanmakethefinancialmarketsworkbetter:byminimizingfraud,forcing transparencyonthesystem,creatingand enforcing a regulatory framework, providing public goods that lower thecost of doing business, and so on. Once again, thewisdom lies in telling thedifference.

Obviously the current crisis has presented some teachable moments. Thefinancial regulatory system needs to be patched up, if not completelyoverhauled. The challenge will be to protect what a modern financial systemdoesbest—allocatingcapital toproductive investmentsandprotectingus fromriskswecan’tafford—whilecurtailingtheexcesses—stupidbetsthatenrichthefolksmaking thembeforeeventually leavingamess for the restofus tocleanup.

Allthatiswellandgood.Buthowdoesonegetrichinthemarkets?Oneofmy

former colleagues atTheEconomist suggested that this book should be calledAreYouRichEnough?Hislogicwasthatmostpeoplewouldanswernoandripthebookoff the shelves.Sadly, I’mnot abigbeliever in surefire strategies totrade your way to riches. Just as miracle weight-loss programs violate nearlyeverythingweknowabouthealthandnutrition,get-rich-quickschemesviolatethemostbasicprinciplesofeconomics.

Letmebeginwithanexample.SupposeyouareshoppingforahomeintheLincoln Park neighborhood of Chicago. After many weeks of searching, youfindthatathree-storysingle-familybrownstonewillcostyousomewhereintherange of $500,000. Some homes are listed for $450,000 but they need work;othersarelistedfor$600,000becausetheyhaveextraamenities.Justwhenyoubegin to despair that youwill have to spend$500,000 for a home, you find abrownstonelistedfor$250,000thatmeetsallofyourspecifications.Whenyouinvestigate,youlearnthatthishomeiseverybitasniceastheonesyou’vebeenlookingat—same location, samesize, samestructural integrity.Stillwary,youaskyourrealestateagentforherassessment.Sheassuresyouthatthishouseisindeed a remarkable bargain and should be selling for $500,000. In herprofessional opinion, there is no doubt that you could buy this house for$250,000andsell itonlymonthslaterfor$500,000ormore.Thenyouseethefinalpieceofevidence.Anarticleonpage3ofCrain’sChicagoBusinesshasascreamingheadline:“BargainoftheMonth:LincolnParkBrownstoneListedfor$250,000.”

Soyousnapupthehousefor$250,000.Sureenough,sixmonthslateryousellitfor$500,000—doublingyourmoney.*

How many things are wrong with this story? Quite a few. A reasonablepersonmightbeginbyaskingsomeofthefollowingquestions:

1. Ifthishousewasreallyworth$500,000,whowasthemoronsellingitfor $250,000? Was this person not willing or able to do the threeminutesofworknecessarytodeterminethatcomparablehousesintheneighborhoodwere selling for twice asmuch? If not,wasn’t there afamilymemberorarealestateagent—whosecommissionisbasedonthesaleprice—willingtopointoutthisenormousdiscrepancy?

2. Maybenot. In thatcase,whyhasn’tmy realestateagentbought thishouse for herself? If this house is a “sure thing” to double in price,

why is sheworking formy3percent commissionwhen$250,000 isstaringherintheface?

3. Perhapsmyrealestateagentisamoron,too.Inthatcase,wherearealloftheotherbuyerslookingforbargains,especiallyafterthishouseisfeatured in Crain’s Chicago Business? If this brownstone is atremendous bargain—and has been widely advertised as such—thenpresumablyallkindsofpeoplearegoingtowanttobuyit.Abiddingwarwouldresult,withpotentialbuyersofferinglargerandlargersumsuntilthepricereacheditsfairmarketvalue,whichisaround$500,000.

Inotherwords,thereisvirtuallynochancethatyouwillfindaLincolnParkbrownstone(withoutsomesurpriselurkinginthebasement)for$250,000.Why?Becauseofthemostbasicideaineconomics.Youaretryingtomaximizeyourutility—and so is everyone else. In a world in which everyone is looking tomake profitable investments, no one is going to leave $250,000 sitting on thetable.Yetpeopleassumethestockmarketworkslikethisallthetime.Webelievethatafterreadingabouta“hotstock”inBusinessWeek,orreadingaWallStreetanalyst’sbuyrecommendation(offeredtoallthefirm’sclients),wecanloaduponstocksthatwilltrouncethemarketaverage.Butthosesupposed“hotstocks”aremerelytheLincolnParkbrownstoneindifferentclothing.Here’swhy:

Let’sstartwithastunninglysimplebutoftenoverlookedpoint:Everytimeyoubuyastock(oranyotherasset),someonehastosellittoyou.Theguywhosells you this “hot stock” has decided that hewould rather have cash.He haslooked at the current “bargain price” and he wants out—right when you aregettingin.Sure,hemayneedthemoneyforsomethingelse,butheisstillgoingto demand a fairmarket price, just as wewould expect someonewho has tomoveoutofLincolnParktoask$500,000forabrownstone,not$250,000.Thestockmarket,asthenamewouldsuggest,isamarket.Thepriceofastockatanygiven time is the price at which the number of buyers equals the number ofsellers.Halfoftheinvestorstradingyour“hotstock”aretryingtogetridofit.

Ormaybeyouknowsomethingthatthesellersdon’t.PerhapsallthepeopleunloadingXYZCorp.missed theWallStreetJournalarticleaboutXYZ’snewblockbusterdrugformale-patternbaldness.Okay,thatmighthappen.Butwherearetheworld’sothersophisticatedbuyers?Thisstockisasurethingat$45,yetfor some reason Warren Buffett, the traders at Goldman Sachs, and the top

Fidelityportfoliomanagersarenotsnappingitup.(Iftheywere,thestockwouldbebiduptoamuchhigherprice,justliketheLincolnParkbrownstone.)Doyouknow something that no one else onWall Street knows (bearing inmind thattradingonanyinformationnotavailabletothepublicisagainstthelaw)?

OrmaybesomeoneonWallStreetispitchingyouthisstockidea.America’sbrokeragehousesemployacadreofanalystswhospendtheirdayskicking thetiresofcorporateAmerica.Isallthatinformationwrong?No—thoughthereareplenty of cases of incompetence and conflict of interest. Analysts provide allkindsof legitimate information, just likeyour real estate agent.Whenyouareshopping for a home, your agent can tell you about neighborhoods, schools,taxes,crime—thekindsof things thatmatter.WallStreetanalystsdo thesamethingsforcompanies;theyreportonmanagement,futureproducts,theindustry,thecompetition.Butthatdoesnothingtoguaranteethatyouaregoingtoearnanabove-averagereturnonthestock.

Theproblemisthateveryoneelsehasaccesstothesameinformation.Thisistheessenceoftheefficientmarketstheory.Themainpremiseofthetheoryisthatassetpricesalready reflectall available information.Thus it isdifficult, ifnotimpossible,tochoosestocksthatwilloutperformthemarketwithanydegreeofconsistency.Whycan’tyoubuyabrownstoneinLincolnParkfor$250,000?Becausebuyersandsellersrecognizethatsuchahomeisworthmuchmore.Ashare of XYZ Corp. is no different. Stock prices settle at a fair price giveneverythingthatweknoworcanreasonablypredict;priceswillriseorfallinthefutureonlyinresponsetounanticipatedevents—thingsthatwecannotknowinthepresent.

Picking stocks is a lot like trying to pick the shortest checkout line at thegrocerystore.Dosomelinesmovefasterthanothers?Absolutely,justassomestocksoutperformothers.Aretherethingsthatyoucanlookforthatsignalhowfastonelinewillmoverelativetoanother?Yes.Youdon’twanttobebehindtheguywithtwofullshoppingcartsortheoldwomanclutchingafistfulofcoupons.Sowhyisitthatweseldomendupintheshortestlineatthegrocerystore(andmost professional stock pickers don’t beat the market average)? Becauseeveryoneelseislookingatthesamethingsweareandactingaccordingly.Theycanseetheguywithtwoshoppingcarts,thecashierintrainingatregisterthree,thecouponqueenlinedupatregistersix.Everybodyatthecheckouttriestopickthefastestline.Sometimesyouwillberight;sometimesyouwillbewrong.Overtimetheywillaverageout,sothatifyougotothegrocerystoreoftenenough,you’llprobablyspendaboutthesameamountoftimewaitinginlineaseveryone

else.Indeed,wecan take theanalogyonestepfurther.Suppose thatsomewhere

near theproduceaisleyousawanoldwomanstuffingwadsofcoupons inherpockets.Whenyouarriveat thecheckoutandseeher in line,youwiselysteeryour cart somewhere else. As she gets out her coin purse and begins slowlyhanding coupons to the cashier, you smugly congratulate yourself. Momentslater,however,yourealize theguyaheadofyouforgot toweighhisavocados.“Pricecheckonavocadosatregisterthree!”yourcashierbarksrepeatedlyasyouwatch the coupon lady push her groceries out of the store. Who could havepredictedthat?Noone,justasnoonewouldhavepredictedthatMicroStrategy,a high-flying software company,would restate its incomeonMarch19, 2000,essentiallywipingmillions of dollars of earnings off its books. The stock fell$140inoneday,a62percentplunge.DidtheinvestorsandportfoliomanagerswhoboughtMicroStrategysharesthinkthiswasgoingtohappen?Ofcoursenot.It’sthethingsyoucan’tpredictthatmatter.Indeed,thenexttimeyouaretemptedtoinvestalargesumofmoneyinasinglestock,eventhatofalargeandwell-established firm, repeat thesemagicwords:Enron,Enron,Enron.OrLehman,Lehman,Lehman.

Proponents of the efficient markets theory have advice for investors: Justpick a line and stand in it. If assets are priced efficiently, then a monkeythrowingdartsat thestockpagesshouldchooseaporfoliothatwillperformaswell, on average, as the portfolios picked by the Wall Street stars. (BurtonMalkiel has pointed out that since diversification is important, the monkeyshould actually throw a wet towel at the stock pages.) Indeed, investors nowhave access to their ownmonkeywith a towel: index funds. Index funds aremutualfunds thatdonotpurport topickwinners. Instead, theybuyandholdapredeterminedbasketofstocks,suchas theS&P500, theindexthatcomprisesAmerica’slargestfivehundredcompanies.SincetheS&P500isabroadmarketaverage,wewouldexpecthalfofAmerica’sactivelymanagedmutualfunds toperform better, and half to perform worse. But that is before expenses. Fundmanagers charge fees for all the tire-kicking they do; they also incur costs asthey trade aggressively. Index funds, like towel-throwing monkeys, are farcheapertomanage.

But that’sall theory.Whatdo thedata show? It turnsout that themonkeywithatowelcanbeaninvestor’sbestfriend.AccordingtoMorningstar,afirmthat tracksmutual funds,slightly fewer thanhalfof theU.S.activelymanageddiversified funds beat the S&P 500 over the past year.Amore impressive 66

percent of actively-managed funds beat theS&P500 over the past five years.Butlookwhathappensasthetimeframegetslonger:Only45percentofactivelymanaged funds beat the S&P over a twenty-year stretch, which is the mostrelevanttimeframeforpeoplesavingforretirementorcollege.Inotherwords,55 percent of themutual funds that claim to have some special stock-pickingability did worse over two decades than a simple index fund, our modernequivalentofamonkeythrowingatowelatthestockpages.

Ifyouhadinvested$10,000intheaverageactivelymanagedequityfundin1973, when Malkiel’s heretical book A Random Walk Down Wall Street firstcameout, itwouldbeworth$355,091 today (manyeditions later). If youhadinvestedthesameamountofmoneyinanS&P500indexfund,itwouldnowbeworth$364,066.

Datanotwithstanding,theefficientmarketstheoryisobviouslynotthemostpopularideaonWallStreet.Thereisanoldjokeabouttwoeconomistswalkingdownthestreet.Oneofthemseesa$100billlyinginthestreetandpointsitouttohisfriend.“Isthata$100billlyinginthegutter?”heasks.

“No,”hisfriendreplies.“Ifitwerea$100bill,someonewouldhavepickeditupalready.”

Sotheywalkonby.Neitherthehousingmarketnorthestockmarkethasbehavedlatelyinways

consistentwithsuchasensibleandorderlyviewofhumanbehavior.Someofthebrightest minds in finance have been chipping away at the efficient marketstheory.Behavioraleconomistshavedocumented theways inwhich individualsmakeflaweddecisions:Weareprone toherd-likebehavior,wehave toomuchconfidenceinourownabilities,weplacetoomuchweightonpasttrendswhenpredicting the future, and so on. Given that a market is just a collection ofindividuals’decisions,itstandstoreasonthatifindividualsgetthingswronginsystematicways(likeoverreactingtogoodandbadnews),thenmarketscangetthingswrong,too(likebubblesandbusts).

There is even a new field, neuroeconomics, that combines economics,cognitiveneuroscience,andpsychologytoexploretherolethatbiologyplaysinour decision making. One of the most bizarre and intriguing findings is thatpeoplewith brain damagemay be particularly good investors.Why?Becausedamage to certain parts of the brain can impair the emotional responses thatcause the restofus todo foolish things.A teamof researchers fromCarnegieMellon, Stanford, and the University of Iowa conducted an experiment thatcomparedtheinvestmentdecisionsmadebyfifteenpatientswithdamagetothe

areas of the brain that control emotions (but with intact logic and cognitivefunctions) to the investment decisions made by a control group. The brain-damaged investors finished the game with 13 percent more money than thecontrolgroup, largely, theauthorsbelieve,becausetheydonotexperiencefearand anxiety. The impaired investors took more risks when there were highpotentialpayoffsandgotlessemotionalwhentheymadelosses.7

Thisbookisnotprescribingbraininjuryasaninvestmentstrategy.However,behavioraleconomistsdobelieve thatbyanticipating theflaweddecisions thatregular investors are likely tomake,we canbeat themarket (or at least avoidbeingravagedbyit).YaleeconomistRobertShillerfirstchallengedthetheoryofefficientmarketsintheearly1980s.HebecamemuchmorefamousforhisbookIrrational Exuberance, which argued in 2000 that the stock market wasovervalued.Hewasright.Fiveyearslaterhearguedthattherewasabubbleinthehousingmarket.Hewasrightagain.

If irrational investorsare leaving$100bills strewnabout, shouldn’twebeable to pick them up somehow? Yes, argues Richard Thaler, a University ofChicagoeconomist(andtheguywhotookawaythebowlofcashewsfromhisguestsbackinChapter1).Thalerhasevenbeenwillingtoputhismoneywherehistheoryis.Heandsomecollaboratorscreatedamutualfundthatwouldtakeadvantageofourhumanimperfections:thebehavioralgrowthfund.IwillevenadmitthatafterIinterviewedMr.ThalerforChicagopublicradio,Idecidedtotoss asidemy strong belief in efficientmarkets and invest a small sum in hisfund.Howhasitdone?Verywell.Thebehavioralgrowthfundhasproducedanaveragereturnof4.5percentayearsinceitsinception,comparedtoanaverageannualreturnof2.3percentfortheS&P500.

Theefficientmarkets theory isn’t going anywhere soon. In fact, it’s still acrucial concept for any investor to understand, for two reasons. First,marketsmaydoirrationalthings,butthatdoesn’tmakeiteasytomakemoneyoffthosecrazymovements,atleastnotforlong.Asinvestorstakeadvantageofamarketanomaly,saybybuyingupstocks thathavebeenirrationallyunderpriced, theywillfixtheveryinefficiencythattheyexploited(bybiddingupthepriceoftheunderpriced stocks until they aren’t underpriced anymore). Think about theoriginalanalogyof trying tofind thefastestcheckout lineat thegrocerystore.Suppose you do find one line thatmoves predictably faster than the others—maybe it has a really fast cashier and a nimble bagger. This outcome isobservable toothershoppers; theyaregoing topile intoyourspecial lineuntilit’snotparticularly fastanymore.Thechancesofyoupicking theshortest line

week after week are essentially nil. Mutual funds work the same way. If aportfoliomanagerstartsbeatingthemarket,otherswillseehisoversizedreturnsand copy the strategy,making it less effective in the process. So even if youbelievethattherewillbeanoccasional$100billlyingontheground,youshouldalsorecognizethatitwon’tbelyingthereforlong.

Second, themost effective critics of the efficientmarkets theory think theaverageinvestorprobablycan’tbeatthemarketandshouldn’ttry.AndrewLoofMITandA.CraigMacKinlayoftheWhartonSchoolaretheauthorsofabookentitled A Non-Random Walk Down Wall Street in which they assert thatfinancialexpertswithextraordinaryresources,suchassupercomputers,canbeatthemarketbyfindingandexploitingpricinganomalies.ABusinessWeekreviewofthebooknoted,“Surprisingly,perhaps,LoandMacKinlayactuallyagreewithMalkiel’sadvicetotheaverageinvestor.Ifyoudon’thaveanyspecialexpertiseorthetimeandmoneytofindexperthelp,theysay,goaheadandpurchaseindexfunds.”8

Warren Buffett, arguably the best stock picker of all time, says the samething.9 Even Richard Thaler, the guy beating the market with his behavioralgrowth fund, told theWall Street Journal that he puts most of his retirementsavings in index funds.10 Indexing is to investingwhat regular exercise and alow-fatdietaretolosingweight:averygoodstartingpoint.Theburdenofproofshouldfallonanyonewhoclaimstohaveabetterway.

AsI’vealreadynoted,thischapterisnotaninvestmentguide.I’llleaveittoothers to explain thepros andconsof college savingsplans,municipalbonds,variableannuities,andalltheothermoderninvestmentoptions.Thatsaid,basiceconomics can give us a sniff test. It provides uswith a basic set of rules towhichanydecentinvestmentadvicemustconform:

Save.Invest.Repeat.Let’sreturntothemostbasicideainthischapter:Capitalisscarce.Thisistheonlyreasonthatanykindofinvestingyieldsreturns.Ifyouhavesparecapital,thensomeonewillpayyoutouseit.Butyou’vegottohavethesparecapitalfirst,andtheonlywaytogeneratesparecapitalistospendlessthanyouearn—i.e.,save.Themoreyousave,andthesooneryoubeginsavingit,themorerentyoucancommandfromthefinancialmarkets.Anygoodbookon personal finance will dazzle you with the virtues of compound interest.Suffice ithere tonote thatAlbertEinstein issaid tohavecalled it thegreatest

inventionofalltime.Theflipside,ofcourse,isthatifyouarespendingmorecashthanyouearn,

thenyouwillhaveto“rent”thedifferencesomewhere.Andyouwillhavetopayforthatprivilege.Payingtherentoncapitalisnodifferentfrompayingtherentonanythingelse:Itisanexpensethatcrowdsoutotherthingsyoumaywanttoconsumelater.Thecostof livingbetter in thepresent is living lesswell in thefuture.Conversely,thepayoffforlivingfrugallyinthepresentislivingbetterinthefuture.Sofornow,setasidequestionsaboutwhetheryour401(k)shouldbeinstocksorbonds.Thefirststepisfarmoresimple:Saveearly,saveoften,andpayoffthecreditcards.

Takerisk,earnreward.Okay,nowwe’lltalkaboutwhetheryour401(k)shouldbe in stocksorbonds.Supposeyouhavecapital to rent, andyouaredecidingbetweentwooptions:lendingittothefederalgovernment(atreasurybond),orlending it toyourneighborLance,whohasbeen tinkering inhisbasement forthreeyearsandclaimstohaveinventedaninternalcombustionenginethatrunsonsunflowerseeds.Both thefederalgovernmentandyourneighborLancearewillingtopayyou6percentinterestontheloan.Whattodo?UnlessLancehasphotosofyouinacompromisingposition,youshouldbuythegovernmentbond.Thesunflowercombustionengineisariskyproposition;thegovernmentbondisnot.Lancemayeventuallyattractthecapitalnecessarytobuildhisinvention,butnot by offering a 6 percent return. Riskier investments must offer a higherexpected return in order to attract capital. That is not some arcane law offinance; it is simply markets at work. No rational person will invest moneysomewhere when he or she can earn the same expected return with less risksomewhereelse.

The implication for investors is clear:Youwill be compensated for takingmore risk. Thus, the more risky your portfolio, the higher your return—onaverage. Yes, it’s that pesky concept of “average” again. If your portfolio isrisky,italsomeansthatsomeverybadthingswilloccasionallyhappen.Nothingencapsulates this point better than an old headline in theWall Street Journal:“BondsLetYouSleepatNightbutataPrice.”11Thestoryexaminedstockandbond returns from 1945 to 1997.Over that period, a portfolio of 100 percentstocks earned an average annual return of 12.9 percent; a portfolio of 100percentbondsearnedarelativelymeager5.8percentaverageannualreturnoverthesameperiod.Soyoumightaskyourself,whoarethechumpsholdingbonds?

Not so fast. The same story then examined how the different portfoliosperformedintheirworstyears.Thestockportfoliolost26.5percentofitsvalueinitsworstyear;thebondportfolioneverlostmorethan5percentofitsvalueinasinglebadyear.Similarly,thestockportfoliohadnegativeannualreturnseighttimes between 1945 and 1997; the bond portfolio lostmoney only once. Thebottomline:Riskisrewarded—ifyouhaveatoleranceforit.

ThatbringsusbacktotheHarvardendowment,whichlostaboutathirdofits value during the 2008 financial crisis. And Yale lost a quarter of itsendowment in one year alone. Meanwhile, over the same stretch of dismaleconomiccircumstances,mymother-in-lawearnedabouta3percent returnbykeepingnearlyallofherassetsincertificatesofdepositandacheckingaccount.Ismymother-in-lawaninvestmentgenius?ShouldHarvardhavedirectedmoreofitsassetstoagiantcheckingaccount?Noandno.Mymother-in-lawalwayskeeps her assets in safe but low-yielding investments because she has a smallappetiteforrisk.Sheisprotectedwhentimesarebad;ofcourse,thatalsomeansthatifthestockmarketpostsan18percentgainoneyear,sheearns…3percent.Meanwhile,HarvardandYaleandotherschoolswithlargeendowmentsearnedenormous returns during the boom years by taking large risks and makingrelatively illiquid investments. (Liquidity is the reflection of how quickly andpredictablysomethingcanbeturnedintocash.Illiquidinvestments,likerareartor Venezuelan corporate bonds, must pay a premium to compensate for thisdrawback;ofcourse,whenyouneedtogetridofthemquicklytoraisecash,it’sa problem.) These institutions pay an occasional price for their aggressiveportfolios, but those bumps should be more than offset in the long run withreturns that are a heck of a lot better than a certificate of deposit. Mostimportant, the endowments are different than the typical investor planning forcollegeorretirement;theirinvestmenthorizonistheoreticallyinfinite,meaningthat they can afford some really bad years, or even decades, if it maximizesreturnsoverthenextonehundredortwohundredyears(althoughbothHarvardand Yale have had to make serious budget cuts lately to make up for lostendowmentrevenue).YalePresidentRichardLevintoldtheWallStreetJournal,“Wemade huge excess returns on the way up.When it’s all over and thingsstabilizeIthinkwe’llfindtheoveralllong-runperformance[oftheendowment]is better than ifwe didn’t.”12 I suspect he’s right, but that doesn’t necessarilymakeitawisestrategyformymother-in-law.

Diversify.WhenI teachfinance, I like tohavemystudents flipcoins. It is thebest way to make certain points. Here is one of them: A well-diversifiedportfoliowillsignificantlylowertheriskofseriouslosseswithoutloweringyourexpectedreturn.Let’sturntothecoins.Supposethereturnonthe$100,000youhavetuckedawayina401(k)dependsontheflipofacoin:Heads,itquadruplesinvalue;tails,youloseeverything.Theaverageoutcomeofthisexerciseisverygood.(Yourexpectedreturnis100percent.)*Theproblem,ofcourse,isthatthedownside is unacceptably bad. You have a 50 percent chance of losing yourwholenestegg.Tryexplainingthattoaspouse.

Solet’sbringinsomemorecoins.Supposeyouspreadthe$100,000inyour401(k)intotendifferentinvestments,eachwiththesamepayoffscheme:Heads,the investmentquadruples invalue; tails, it becomesworthless.Your expectedreturnhasnotchangedatall:Onaverage,youwillflipfiveheadsandfivetails.Five of your investments would quadruple in value, and five would becomeworthless.Thatworksouttothesamehandsome100percentreturn.Butlookatwhathashappenedtoyourdownsiderisk.Theonlywayyoucanloseyourentire401(k)isbyflippingtentails,whichishighlyunlikely.(Theprobabilityislessthanoneinathousand.)Nowimaginethesameexerciseifyoubuyseveralindexfundsthatincludethousandsofstocksfromaroundtheworld.†Thatmanycoinswillnevercomeupalltails.

Of course, you better make darn sure that all those investments haveoutcomesthataretrulyindependentofoneanother.It’sonethingtoflipcoins,wheretheoutcomeofoneflipisuncorrelatedwiththeoutcomeofthenextflip.It’s quite another to buy shares of Microsoft and Intel and then assume thatyou’ve safely split your portfolio into two baskets. Yes, they are differentcompanieswith different products and differentmanagement, but ifMicrosofthasareallybadyear,thereisaprettygoodchancethatIntelwillsuffer,too.Oneofthemistakesthatcompoundedthefinancialcrisiswasthebeliefthatbundlinglots of mortgages together into a single mortgage-backed security created aninvestmentthatwassaferandmorepredictablethananysinglemortgage—likeflipping one hundred coins instead of just one. If you are a bank with onemortgage loan outstanding, it could go into default, taking all of your capitalwith it. But if you buy a financial product constructed from thousands ofmortgages,most of themwill be fine,whichoffsets the risk of the occasionaldefault.

During normal times, that’s probably true. A mortgage goes into default

whensomeonegetssickorlosesajob.That’snotlikelytobehighlycorrelatedacrosshouseholds; ifonehouseon theblockgoes intoforeclosure, there isnoreason to believe that others will, too. When a real estate bubble pops,everything is different. Housing prices were plummeting all over the country,andtheaccompanyingrecessionmeant that lotsandlotsofpeoplewerelosingjobs.Theseeminglycleversecuritiesbackedbyrealestate loansmorphed intothe“toxicassets”thatwe’vebeentryingtocleanupeversince.

Invest for the long run.Have you ever been in a casinowhen someonewinsbig?Thecasinooperators are just ashappyas everybodyelse.Why?Becausetheyaregoingtomakeanextraordinaryamountofmoneyinthelongrun;thisisjustoneminorhiccupalongtheway.Thebeautyofrunningacasinoisthatthenumbersarestackedinyourfavor.Ifyouarewillingtowaitlongenough—andposehappilyforphotosasyougiveagiantchecktotheoccasionalbigwinner—thenyouwillgetrich.

Investinghasthesamebenefitsasrunningacasino:Theoddsarestackedinyourfavorifyouarepatientandwillingtoenduretheoccasionalsetback.Anyreasonable investment portfolio must have a positive expected return.Remember, you’ve rented capital to assorted entities and you expect to getsomethingbackinreturn.Indeed,theriskiertheventures,themoreyouexpecttogetback,onaverage.Sothelongeryouholdyour(diversified)investments,thelonger you have for probability towork itsmagic.Wherewill theDow closetomorrow?Ihavenoclue.Wherewillitbenextyear?Idon’tknow.Wherewillit be in five years? Probably higher than it is today, but that’s no sure thing.Wherewillitbeintwenty-fiveyears?Significantlyhigherthanitistoday;I’mreasonablycertainofit.Theidiocyofdaytrading—buyingastockinhopesofsellingitseveralhourslaterataprofit—isthatit incursallthecostsoftradingstocks (commissions and taxes, not tomention your time)without any of thebenefitsthatcomefromholdingequitiesforthelongrun.

So there you have it—the sniff test for personal investing. The next time aninvestmentadvisercomestoyoupromisinga20or40percentreturn,youknowthatoneofthreethingsmustbetrue:(1)Thismustbeaveryriskyinvestmentinordertojustifysuchahighexpectedreturn—thinkHarvardendowment;(2)your

investment adviser has stumbledupon anopportunity still undiscoveredby alltheworld’ssophisticatedinvestors,andhehasbeenkindenoughtoshareitwithyou—please call me; or (3) your investment adviser is incompetent and/ordishonest—thinkBernieMadoff.Alltoooftentheansweris(3).

The fascinating thing about economics is that the fundamental ideas don’tchange.Monarchs in theMiddleAgesneeded to raise capital (usually to fightwars),justasbiotechstartupsdotoday.Ihavenoideawhattheplanetwilllooklike inonehundredyears.Perhapswewill be settlingMarsor converting saltwater into a clean, renewable sourceof energy. I doknow that eitherof thoseundertakingswouldusethefinancialmarketstoraisecapitalandtomitigaterisk.And I’m positive that Americans will not have become thin and healthy byeatingonlygrapefruitandicecream.

CHAPTER8

ThePowerofOrganizedInterests:

Whateconomicscantellusaboutpolitics

ManyyearsagoItookavacationwithagroupoffriends.Asthesoleacademicamongthebunch,Iwastheobjectofmildcuriosity.WhenIexplainedthatIwasstudyingpublic policy, oneofmypeers asked skeptically, “If people know somuchabout publicpolicy, thenwhy is everything somessedup?”On theonehand,thequestionwasidiotic;it’sabitlikeasking,“Ifweknowsomuchaboutmedicine,why do people keep dying all the time?”One can always come upwith clever rejoinders a decade later. (At the time, Imumbled something like“Well, it’s complicated.”) Imight havepointedout that in the realmof publicpolicy,asinmedicine,wehaveachievedsomeprettygoodwins.Americansarehealthier, richer, better-educated, and less vulnerable to economic booms andbusts than at any time in our history—the recent economic downturnnotwithstanding.

Still,thequestionhasstuckwithmeforyears,inlargepartbecauseithintsat an importantpoint:Evenwheneconomists reachconsensusonpolicies thatwouldmakeusbetteroff, thosepoliciesoftenrunintoabrickwallofpoliticalopposition. International trade isaperfectexample. Iamnotawareofasinglemainstreameconomistwhobelievesthatinternationaltradeisanythinglessthancrucialtothewell-beingofrichandpoorcountriesalike.Thereisjustonesmallproblem: It’s an issue that literally causes riots in the streets. Even before theviolentantiglobalizationprotestsinplaceslikeSeattleandGenoa,agreementstoexpand trade, such as the North American Free Trade Agreement, causedferociouspoliticalbattles.

Meanwhile,pork-barrellegislationsailsthroughCongress,lavishingmoneyon small projects that cannot possibly be described as promoting the nationalinterest. For nearly forty years, the federal budget included a cashpayment toAmericanmohair farmers. (MohaircomesfromtheAngoragoatand isawool

substitute.)Themohairsubsidywascreatedin1955atthebehestofthearmedforcestoensureasufficientsupplyofyarnformilitaryuniformsintheeventofawar.Iwon’tquibblewiththat.Butthemilitaryswitchedtosyntheticfibersforitsuniformsaround1960.Thegovernmentcontinued togive largecashpaymentsto mohair farmers for another thirty-five years. The mohair subsidy waseventually eliminatedwhen it became the poster child for pork-barrel politicsandwasdoomedbyitssheerabsurdity.

Andthen,whentherestofusturnedourattentionelsewhere,itcameback.The 2008 farm bill includes subsidies for wool andmohair producers for thecropyears2008to2012.Howdoesthishappen?

Itisnotbecausethemohairfarmersareenormouslypowerful,wellfunded,orpoliticallysophisticated.Theyarenotanyof those things. Infact, thesmallnumberofmohairfarmersisanadvantage.Whatthemohairfarmershavegoingfor them is that they can get large payments from the government withouttaxpayers ever really noticing. Suppose there are a thousand mohair farmers,each of whom gets a check from the federal government for $100,000 everyspring,justforbeingamohairfarmer.Thefarmerswhogetthatsubsidycarealotabout it—probablymorethantheycareaboutanyothergovernmentpolicy.Meanwhile, the restofus,whopaymerepenniesextra in taxes topreserveanunnecessary supply ofmohair, don’t caremuch about it at all. Any politicianwithapreferenceforjobsecuritycancalculatethatavoteforthemohairsubsidywillearnthestrongsupportofthemohairfarmerswhilecostingnothingamongothervoters.It’sapoliticalno-brainer.

Theproblemisthatmohairfarmersaren’ttheonlygrouplininguptogetasubsidy,orataxbreak,ortradeprotection,orsomeothergovernmentpolicythatputsmoneyintheirpockets.Indeed,themostsavvypoliticianscantradefavorswith one another—if you support the mohair farmers in my district, then I’llsupport the Bingo Hall of Fame in your district. During my days as aspeechwriterforthegovernorofMaine,weusedtorefertothestatebudgetasaChristmastree.Everylegislatorcouldhanganornamentortwo.Icurrentlylivein the Illinois Fifth Congressional District, the seat held for decades by DanRostenkowski (and laterbyRahmEmanuel).WeChicagoanscandrivearoundthecityand literallypoint to the things thatRostybuilt.WhentheMuseumofScienceandIndustryneededtensofmillionsofdollarstobuildanundergroundparking garage, Dan Rostenkowski found federal funds.1 Should taxpayers inSeattleorruralVermonthavepaidforaparkinggarageataChicagomuseum?Ofcoursenot.Butwhen I tookmychildren to themuseum lastweekend ina

downpour,Iwasdelightedtobeabletoparkindoors.ThathelpstoexplainwhyDanRostenkowski,notlongoutoffederalprison,canstillcommandastandingovationatpoliticalgatheringsinChicago.

Thestimulusbillpassedby theObamaadministrationduring thedepthsof thefinancial crisiswas a giant legislativeChristmas tree. Iwill argue in the nextchapterthatthestimuluswasareasonablethingtodounderthecircumstances.No sane person, however, would have designed that particular bill, whichincluded funding for things ranging from “green” golf carts to a polar icebreaker.Yes,theprocessthathasgenerateddecadesofcashpaymentsformohairfarmersisaliveandwell.Let’stalkaboutethanol,acorn-basedgasolineadditivewithputativeenvironmentalbenefits.Gasolineblendedwithethanolistaxed5.4centslesspergallonthanpuregasoline,ostensiblybecauseitburnsmorecleanlythan pure gasoline and because it lowers our dependence on foreign oil. Ofcourse, neither scientists nor environmentalists are convinced that ethanol issuchagreatthing.A1997studybytheGeneralAccountingOffice(whichlaterchanged its name to the Government Accountability Office), the nonpartisanresearch arm of Congress, found that ethanol had little effect on either theenvironment or our dependence on foreign oil. The ethanol subsidy had,however,costtheTreasury$7.1billioninforgonetaxrevenues.Worse,ethanolmayactuallymakesomekindsofairpollutionworse. Itevaporates faster thanpuregasoline,contributingtoozoneproblemsinhottemperatures.A2006studypublished in the Proceedings of theNationalAcademy of Sciences concludedthat ethanol does reduce greenhouse gas emissions by 12 percent relative togasoline,butitcalculatedthatdevotingtheentireU.S.corncroptomakeethanolwould replace only a small fraction of American gasoline consumption. Cornfarming also contributes to environmental degradation due to runoff fromfertilizerandpesticides.2

Buttodwellonthescienceistomissthepoint.AstheNewYorkTimesnotedinthethroesof the2000presidentialrace,“Regardlessofwhetherethanol isagreatfuelforcars,itcertainlyworkswondersinIowacampaigns.”3Theethanoltax subsidy increases the demand for corn, which puts money in farmers’pockets.JustbeforetheIowacaucuses,cornfarmerMarvinFliertoldtheTimes,“Sometimes I think [the candidates] just comeout andpander to us,” he said.Thenheadded,“Ofcourse,thatmaynotbetheworstthing.”TheNationalCornGrowersAssociationfiguresthattheethanolprogramincreasesthedemandfor

corn,whichadds30centstothepriceofeverybushelsold.BillBradleyopposedtheethanolsubsidyduringhisthreetermsasasenator

from New Jersey (not a big corn-growing state). Indeed, some of his mostimportant accomplishments as a senator involved purging the tax code ofsubsidiesandloopholesthatcollectivelydomoreharmthangood.ButwhenBillBradleyarrivedinIowaasaDemocraticpresidentialcandidatebackin1992,he“spoketosomefarmers”andsuddenlyfounditinhishearttosupporttaxbreaksforethanol.Inshort,herealizedthatethanoliscrucialtoIowavoters,andIowais crucial to the presidential race. Since then, every mainstream presidentialcandidatehas supported the ethanol subsidy, exceptone: JohnMcCain.Tohiscredit, Senator McCain generally opposed ethanol subsidies during hispresidentialrunsinboth2000and2008.WhileSenatorMcCain’s“straighttalk”isadmirable,letusremindourselvesofoneimportantdetail:JohnMcCainisnotcurrently president of the United States. That would be Barack Obama—anethanolsubsidysupporter.

Ethanol isnotacaseofapowerfulspecial interestpounding therestofusintosubmission.Farmersareascant2or3percentofthepopulation;evenfewerofthemactuallygrowcorn.Ifsqueezingfavorsoutofthepoliticalprocessweresimplyamatterofbrutestrength,thenthoseofuswhocan’ttellaheiferfromasteer should be kicking the farmers around. Indeed, America’s right-handedvoterscouldbandtogetheranddemandtaxbreaksattheexpenseofthelefties.Andwe could really have our waywith thosemohair farmers. But that’s notwhathappens.

Economistshavecomeupwithatheoryofpoliticalbehaviorthatfitsbetterwithwhatweactuallyobserve.Whenitcomestointerestgrouppolitics,itpaystobesmall.GaryBecker, the sameUniversityofChicagoNobelPrizewinnerwho figured so prominently in our thinking about human capital, wrote aseminal paper in the early 1980s that nicely encapsulated what had becomeknownastheeconomicsofregulation.Buildingonworkthatwentall thewayback toMiltonFriedman’sdoctoraldissertation,Becker theorized that, all elseequal,small,well-organizedgroupsaremostsuccessfulinthepoliticalprocess.Why?Becausethecostsofwhateverfavorstheywrangleoutofthesystemarespreadoveralarge,unorganizedsegmentofthepopulation.

Think about ethanol again. The benefits of that $7 billion tax subsidy arebestowedonasmallgroupoffarmers,makingitquitelucrativeforeachoneofthem. Meanwhile, the costs are spread over the remaining 98 percent of us,putting ethanol somewhere below good oral hygiene on our list of everyday

concerns.Theoppositewouldbe truewithmyplan tohave left-handedvoterspay subsidies to right-handed voters. There are roughly nine right-handedAmericans for every lefty, so if every right-handed voter were to get somegovernmentbenefitworth$100,theneveryleft-handedvoterwouldhavetopay$900tofinanceit.Theleftieswouldbehoppingmadabouttheir$900taxbills,probablytothepointthatitbecametheirpreeminentpoliticalconcern,whiletherighties would be only modestly excited about their $100 subsidy. An adeptpolitician would probably improve her career prospects by voting with thelefties.

Hereisacuriousfindingthatmakesmoresenseinlightofwhatwe’vejustdiscussed. In countries where farmers make up a small fraction of thepopulation, such as America and Europe, the government provides largesubsidies for agriculture. But in countries where the farming population isrelativelylarge,suchasChinaandIndia,thesubsidiesgotheotherway.Farmersareforcedtosell theircropsatbelow-marketpricessothaturbandwellerscangetbasicfooditemscheaply.Intheonecase,farmersgetpoliticalfavors;intheother,theymustpayforthem.Whatmakestheseexampleslogicallyconsistentisthatinbothcasesthelargegroupsubsidizesthesmallergroup.

In politics, the tail can wag the dog. This can have profound effects on theeconomy.

Deathbya thousandsubsidies.ThecostofDanRostenkowski’sundergroundparkinggarageattheMuseumofScienceandIndustryisinsignificantinthefaceofour$14trillioneconomy.Soistheethanolsubsidy.Soisthetradeprotectionfor sugar producers, and the tax break for pharmaceutical companies withoperationsinPuertoRico,andthepricesupportsfordairyfarmers.Butintotal,these things—and the tens of thousands of others like them—are significant.Little inefficiencies begin to disrupt the most basic function of a marketeconomy: taking inputs and producing goods and services as efficiently aspossible.Ifthegovernmenthastosupportthepriceofmilk,therealproblemisthattherearetoomanydairyfarmers.ThebestdefinitionI’veeverheardofataxshelterissomekindofinvestmentorbehaviorthatwouldnotmakesenseintheabsence of tax considerations. And that is exactly the problem here:

Governmentsshouldnotbeinthebusinessofprovidingincentivesforpeopletodothingsthatwouldnototherwisemakesense.

Chapter 3 outlined all the reasons why good government is not justimportant,butessential.YetitisalsotruethatwhenCongressturnsitsattentiontoaproblem,alotofornamentsendupontheChristmastree.ThelateGeorgeStigler, aUniversity ofChicago economistwhowon theNobelPrize in 1982,proposed and defended a counterintuitive notion: Firms and industries oftenbenefit from regulation. In fact, they can use the political process to generateregulationthateitherhelpsthemorhobblestheircompetitors.

Does thatsoundunlikely?Consider thecaseof teachercertification.Everystate requires public school teachers to do or achieve certain things beforebecominglicensed.Mostpeopleconsiderthattobequitereasonable.InIllinois,the requirements for certification have risen steadily over time. Again, thatseemsreasonablegivenourstrongemphasisonpublicschoolreform.Butwhenonebeginstoscrutinizethepoliticsofcertification,thingsbecomemurkier.Theteachers’ unions, one of the most potent political forces in America, alwayssupport reforms that require more rigorous training and testing for teachers.Read the fine print, though. Almost without exception, these laws exemptcurrent teachers from whatever new requirement is being imposed. In otherwords, individualswhowould like to become teachers have to take additionalclasses or pass new exams; existing teachers do not.That doesn’tmakemuchsenseifcertificationlawsarewrittenforthebenefitofstudents.Ifdoingcertainthings is necessary in order to teach, then presumably anyone standing at thefrontofaclassroomshouldhavetodothem.

Other aspects of certification law don’t make much sense either. Privateschool teachers, many of whom have decades of experience, cannot teach inpublic schools without jumping through assorted hoops (including studentteaching) that are almost certainly unnecessary.Nor can university professors.When Albert Einstein arrived in Princeton, New Jersey, he was not legallyqualifiedtoteachhighschoolphysics.

Themoststriking(andfrustrating)thingaboutallofthisisthatresearchershave found that certification requirements have virtually no correlation withperformance in the classroom whatsoever. The best evidence on this point(which is consistent with all other evidence that I’ve seen) comes from LosAngeles.WhenCalifornia passed a law in the late 1990s to reduce class sizeacrossthestate,LosAngeleshadtohireahugenumberofnewteachers,manyofwhomwereuncertified.LosAngelesalsocollectedclassroom-leveldataon

theperformanceofstudentsassignedtoanygiventeacher.AstudydonefortheHamilton Project, a public policy think tank, looked at the performance of150,000 students over three years and came to two conclusions: (1) Goodteachersmatter. Students assigned to the best quarter of teachers ended up 10percentile points ahead of students given the worst quarter of teachers(controlling for the students’ initial levelof achievement); and (2) certificationdoesn’t matter. The study “found no statistically significant achievementdifferencesbetweenstudentsassignedtocertifiedteachersandstudentsassignedto uncertified teachers.” The authors of the study recommend that stateseliminate entry barriers that keep talented people from becoming publicschoolteachers.4Moststatesaredoingtheopposite.

Mr.Stiglerwouldhaveargued thatallof this iseasy toexplain.Just thinkabout how the process benefits teachers, not students. Making it harder tobecomeateacherreducesthesupplyofnewentrantsintotheprofession,whichis a good thing for those who are already there. Any barrier to entry looksattractivefromtheinside.

I have a personal interest in all kinds of occupational licensure (cases inwhich states require that individuals become licensedbefore practicing certainprofessions).MydoctoraldissertationsetouttoexplainaseeminglyanomalouspatterninIllinois:Thestaterequiresbarbersandmanicuriststobelicensed,butnot electricians. A shoddy electrical job could burn down an entireneighborhood;abadmanicureorhaircutseemsrelativelymorebenign.Yetthebarbers and manicurists are the ones regulated by the state. The shortexplanation for thepattern is twowords: interestgroups.Thebestpredictorofwhetheror not a profession is licensed in Illinois is the size andbudget of itsprofessional association. (Every profession is small relative to the state’s totalpopulation, so all of these groups have the mohair advantage. The size andbudgetof theprofessional association reflects the extent towhichmembersoftheprofessionhaveorganizedtoexploitit.)Remarkably,politicalorganizationisabetterpredictoroflicensurethanthedangermembersoftheprofessionposetothe public (asmeasured by their liability premium).George Stiglerwas right:Groupsseektogetthemselveslicensed.

Small,organizedgroupsflyunder theradarandprevailupon legislators todo things that do not necessarily make the rest of us better off. Economists,particularlythoseamongthemorefree-market“Chicagoschool,”aresometimesperceived to be hostile toward government. It would be more accurate todescribethemasskeptical.Thebroaderthescopeofgovernment,themoreroom

thereisforspecialintereststocarveoutdealsforthemselvesthathavenothingtodowiththelegitimatefunctionsofgovernmentdescribedinChapter3.

Tyrannyof the statusquo. If small groups cangetwhat theywantout of thelegislative process, they can also stop what they don’t want, or at least try.Joseph Schumpeter, who coined the term “creative destruction,” describedcapitalismasaprocessofincessantlydestroyingtheoldstructureandcreatinganewone.Thatmaybegoodfortheworld;itisbadforthefirmsandindustriesthatmakeupthe“oldstructure.”Theindividualsstandingincapitalism’spathofprogress—ordestruction,fromtheirstandpoint—willuseeverytooltheyhavetoavoid it, including politics. And why shouldn’t they? The legislative processhelps those who help themselves. Groups under siege from competition mayseek trade protection, a government bailout, favorable tax considerations,limitations on a competing technology, or some other special treatment.Withlayoffs or bankruptcy looming, the plea to politicians for help can be quitecompelling.

Sowhat’stheproblem?Theproblemisthatwedon’tgetthebenefitsofthenew economic structure if politicians decide to protect the old one. RogerFerguson, Jr., former vice chairman of the board of governors of the FederalReserve,explains,“Policymakerswhofailtoappreciatetherelationshipbetweentherelentlesschurningofthecompetitiveenvironmentandwealthcreationwillend up focusing their efforts onmethods and skills that are in decline. In sodoing, they establish policies that are aimed at protecting weak, outdatedtechnologies,andintheend,theyslowtheeconomy’smarchforward.”5

Bothpoliticsandcompassionsuggestthatweoughttoofferahandtothosemowed over by competition. If some kind of wrenching change generatesprogress, then thepiemustgetbigger.And if thepiegetsbigger, thenat leastsomeofitoughttobeofferedtothelosers—beitintheformoftransitionaid,jobretraining,orwhateverelsewillhelpthosewhohavebeenknockedovertogetbackon their feet.Oneof the features thatmade theNorthAmericanFreeTradeAgreementmorepalatablewasaprovision thatofferedcompensation toworkers whose job losses could be tied to expanded trade with Mexico.Similarly,manystatesareusingmoneyfromthemassive legalsettlementwiththe tobacco industry to compensate tobacco farmers whose livelihoods arethreatenedbydecliningtobaccouse.

Thereisacrucialdistinction,however,betweenusingthepoliticalprocessto

buildasafetynetforthoseharmedbycreativedestructionandusingthepoliticalprocess to stop that creative destruction in the first place. Think about thetelegraphandthePonyExpress.ItwouldhavebeenonethingtohelpdisplacedPonyExpressworkersbyretrainingthemastelegraphoperators;itwouldhavebeen quite another to help them by banning the telegraph. Sometimes thepolitical process does the equivalent of the latter for reasons related to themohairproblem.Theeconomicbenefitsofcompetitionarehugebutspreadoveralargegroup;thecoststendtobesmallerbuthighlyconcentrated.Asaresult,the beneficiaries of creative destruction hardly notice; the losers chainthemselves to their congressman’sofficedoor seekingprotection, as anyofusmightifourlivelihoodorcommunitywereatrisk.

Such is the case in the realm of international trade. Trade is good forconsumers.We pay less for shoes, cars, electronics, food, and everything elsethatcanbemadebetterormorecheaplysomewhereelseintheworld(orismademore cheaply in this country because of foreign competition). Our lives aremadebetterinthousandsoflittlewaysthathaveasignificantcumulativeeffect.Looking back on the Clinton presidency, former Treasury secretary RobertRubin reflected, “Theeconomicbenefitsof the tariff reductionswenegotiatedoverthelasteightyearsrepresentthelargesttaxcutinthehistoryoftheworld.”6

Cheaper shoeshere, abetter television there—stillprobablynot enough togettheaveragepersontoflysomewhereandmarchinfavoroftheWorldTradeOrganization (WTO).Meanwhile, thosemostdirectlyaffectedbyglobalizationhave amore powerful motivation. In onememorable case, the AFL-CIO andotherunionsdidsendsomethirtythousandmemberstoSeattlein1999toprotestagainstbroadeningtheWTO.Theflimsypretextwasthattheunionisconcernedabout wages andworking conditions in the developingworld. Nonsense. TheAFL-CIOisworriedaboutAmericanjobs.Moretrademeanscheapergoodsformillions of American consumers and lost jobs and shuttered plants. That issomething that will motivate workers to march in the streets, as it has beenthroughouthistory.TheoriginalLudditeswerebandsofEnglishtextileworkerswho destroyed textile-making machinery to protest the low wages andunemploymentcausedbymechanization.Whatiftheyhadgottentheirway?

Considerthatat thebeginningofthefifteenthcentury,Chinawasfarmoretechnologically advanced than the West. China had a superior knowledge ofscience, farming, engineering, even veterinary medicine. The Chinese werecastingironin200B.C.,somefifteenhundredyearsbeforetheEuropeans.Yetthe Industrial Revolution took place in Europe while Chinese civilization

languished. Why? One historical interpretation posits that the Chinese elitesvalued stabilitymore than progress. As a result, leaders blocked the kinds ofwrenchingsocietalchangesthatmadetheIndustrialRevolutionpossible.Inthefifteenth century, for example, China’s rulers banned long-sea-voyage tradeventures,chokingofftradeaswellastheeconomicdevelopment,discovery,andsocialchangethatcomewiththem.

We have designed some institutions to help the greater good prevail overnarrow (if eminentlyunderstandable) interests.For example, thepresidentwilloften seek “fast-track authority” from Congress when the administration isnegotiating international trade agreements. Congressmust still ratifywhateveragreementisreached,butonlywithanupordownvote.Thenormalprocessbywhichlegislatorscanaddamendmentsiswaived.Thelogicisthatlegislatorsarenotallowedtoevisceratetheagreementbyexemptingassortedindustries;atradeagreementthatoffersprotectiontoafewspecialinterestsineverydistrictisnotradeagreementatall.Thefast-trackprocessforcespoliticianswhotalkthetalkoffreetradetowalkthewalk,too.

The unfairly maligned World Trade Organization is really just aninternationalversionof the fast-trackprocess.Negotiating tobringdown tradebarriersamongmanycountries—eachladenwithdomesticinterestgroups—isamonumentaltask.TheWTOmakestheprocessmorepoliticallymanageablebydefining the things that countries must do in order to join: open markets,eliminate subsidies, phase out tariffs, etc. That is the price of membership.Countries that are admitted gain access to the markets of all the existingmembers—a huge carrot that gives politicians an incentive to say no to themohairfarmersoftheworld.

Cutthepoliticiansabreak.Inthefallof2000,apromisingpoliticalcareerwaslaunched. I was elected president of the Seminary Townhouse Association.(Perhaps“elected”istoostrongaword;theoutgoingpresidentaskedifIwoulddo it, and Iwas too naive to say no.)At about that time, theChicagoTransitAuthority(CTA)announcedplanstoexpandanelevatedtrainstationveryclosetoourhomes.Theproposedexpansionwouldbringthestationintocompliancewith theAmericanswithDisabilitiesAct and allow theCTA to accommodatemore riders. It would also move the elevated train tracks (and all theaccompanyingnoise)thirtyfeetclosertoourhomes.Inshort,thisplanwasgoodforChicagopublictransportationandbadforourtownhouseassociation.Under

my excellent leadership, we wrote letters, we held meetings, we consultedarchitects,wepresentedalternativeplans (someofwhichwouldhave requiredcondemninganddemolishinghomeselsewhere in theneighborhood).FullertonAvenue eventually got a new elevated train station, but not before we dideverythinginourpowertodisrupttheproject.

Yes, ladiesandgentlemen,wearethespecial interests.Allofus.Youmaynot raise Angora goats (the source of mohair); you may not grow corn (thesourceofethanol).Butyouarepartofsomegroup—probablymanyofthem—thathasuniqueinterests:aprofession,anethnicgroup,ademographicgroup,aneighborhood, an industry, a part of the country. As the old saying puts it,“Where you stand depends on where you sit.” It is facile to declare thatpoliticians should just do the right thing. The hoary old cliché about toughdecisionsistrue.Doingtherightthing—makingadecisionthatgeneratesmorebenefitsforthenationthancosts—willnotcausepeopletostandupandcheer.Itis farmore likely that themany people you havemade better off will hardlynoticewhilethesmallgroupyouhaveharmedwillpeltyourcarwithtomatoes.

In 2008, my unpromising political career got more interesting (but notnecessarily any more promising). President Obama appointed CongressmanRahmEmanueltobehischiefofstaff,whichleftanopeningintheIllinoisFifthCongressionalDistrict.That’smycongressionaldistrict,andI,alongwithmorethan twenty other candidates, decided to run in the special election to fill theseat. (Ourraceshouldnotbeconfusedwith thevacantIllinoisSenateseat thatformerGovernorRodBlagojevichtriedtosell.)IfiguredthatifIwasgoingtowritebookslikethisonethatcriticizedpublicpolicies,thenIoughttobewillingtostepintothering,ratherthanjustcastrocksfromtheoutside.(Fortherecord,Iopposedtheethanolsubsidy—arelativelymeaninglesspositiongiventhattheFifthCongressionalDistrictisentirelyurbanandhasnotasinglefarmer.)

The punch line of this chapter can be encapsulated in a single experiencefrom that campaign. At the first candidates’ forum, the moderator, a politicalcolumnistforaChicagonewspaper,askedeachcandidatetocommentonhisorherviewoffederalearmarks.Earmarksare themechanismbywhichmembersofCongressinsertporkintobills;anearmarkdirectsfederalmoneytoaspecificprojectinamember’sdistrictandisthereforeinsulatedfromanyformalreviewas to whether the project makes sense or not. For example, an earmark in atransportation bill, such as the notorious “bridge to nowhere” in Alaska,allocatesmoney for thebridgeeven if theDepartmentofTransportationneverwould have funded it. The subject of earmarks had come up because the first

spending bill signed by President Obama had nearly nine thousand earmarks.(No,thatisnotanexaggeration.)

Onebyone,eachcandidateexcoriatedboththeconceptofearmarksandthepoliticianswhosupport them.Onecandidateevenproposedarrestingmembersof Congress who cut such deals. But the earmark question was a trap, and aclever one at that. Themoderator asked a follow-up question, something like,“So each of you would oppose an earmark to support Children’s MemorialHospital?”Asyoumayhaveinferred,thisparticularchildren’shospitalisintheFifthCongressionalDistrict,about300yards fromwhereweweresitting.Theanswerstothefollow-upquestionwerelessemphaticthantheoriginalassaultonearmarks and included comments like, “Of course, a hospital is different” and“Thatparticularearmarkinvolveschildren”and“IwilldoeverythingIcanasacongressman to support Children’s Memorial Hospital” and so on. No onesuggestedthatpoliticianswhosupportanearmarkforthehospitalshouldgotoprison.

Everyonedespises earmarks, except for their own.AmemberofCongresswho secures special funding to expand Children’s Memorial Hospital is asuccess.Aribbon-cuttingceremonywillcelebratetheproject,withcupcakesandjuiceandspeecheslaudingthispolitician’shardworkinCongress.Howdidthefundingcometopass?Notbecausethisonepoliticiangaveaspeechonthefloorof theHouse thatwas so emotional and inspiring that the other 534membersdecided to lavish funds on a children’s hospital in Illinois. He did it bysupportingabillwithninethousandearmarks,oneofwhichwashis.Suchisthepolitical reality in a democratic system:We love our congressman who findsfundingforthehospital;whatwehatearepoliticianswhosupportearmarks.

Would campaign finance reform change anything?At themargins, if that.Money is certainly one tool for grabbing a politician’s attention, but there areothers.Ifthedairyfarmers(whobenefitfromfederalpricesupports)can’tgivemoney, they will hire lobbyists, ring doorbells, hold meetings, write letters,threatenhunger strikes, andvoteasabloc.Campaign finance reformdoesnotchangethefactthatthedairyfarmerscaredeeplyabouttheirsubsidywhilethepeoplewhopayforitdon’tcaremuchatall.Thedemocraticprocesswillalwaysfavor small,well-organizedgroupsat theexpenseof large,diffusegroups. It’snot justhowmanypeoplecareonewayor theother; it’showmuch theycare.Twopercentwhocaredeeplyaboutsomethingareamorepotentpoliticalforcethan the 98 percent who feel the opposite but aren’t motivated enough to doanythingaboutit.

Bob Kerrey, former Democratic senator from Nebraska, has said that hedoesn’tthinkcampaignfinancereformwouldleadtomuchchangeatall.“Themostimportantcorruptionthathappensinpoliticsdoesn’tgoawayevenifyouhadfullpublicfinancingofcampaigns,”hetoldTheNewYorker.“Andthatis:Idon’twanttotellyousomethingthat’sgoingtomakeyounotlikeme.IfIhadachoice between getting a round of applause by delivering a twenty-six-secondapplauselineandgettingaroundofboosbytellingyouthetruth,I’drathergettheroundofapplause.”7

So,ifIwereaskedagainwhyourgrowingknowledgeofpublicpolicydoesnotalways translate intoaperfectworld, thischapterwouldbemymorecompleteanswer.

CHAPTER9

KeepingScore:

Ismyeconomybiggerthanyoureconomy?

AsIhavementioned,inthelate1980sIwasayoungspeechwriterworkingforthe governor ofMaine.One ofmyprimary responsibilitieswas finding jokes.“Funny jokes,” he would admonish me. “Belly laughs, not chuckles.” Twodecadeslater,oneofthosejokesstandsout,notsomuchbecauseitisfunnynow,but rather for what it tells us about what we were thinking then. Recall thatGeorge Bush, Sr., was president and Dan Quayle was vice president. NewEnglandwasinthemidstofaneconomicslumpandMainewasparticularlyhardhit.Meanwhile, Japan appeared to be the world’s economic powerhouse. Thejokegoeslikethis:

WhilevacationingatKennebunkport,GeorgeH.W.Bushishitontheheadwithoneofhisbelovedhorseshoes.Heslipsintoacoma.Ninemonthslater,heawakensandPresidentQuayleisstandingathisbedside.“Areweatpeace?”Mr.Bushasks.

“Yes.Thecountryisatpeace,”saysPresidentQuayle.“Whatistheunemploymentrate?”Mr.Bushasks.“About4percent,”saysPresidentQuayle.“Inflation?”queriesMr.Bush.“Undercontrol,”saysPresidentQuayle.“Amazing,”saysMr.Bush.“Howmuchdoesaloafofbreadcost?”PresidentQuaylescratcheshisheadnervouslyandsays,“About240yen.”Believeitornot,thatwasgoodforabellylaugh.Someofthehumorderived

from the prospect ofDanQuayle as president, butmostly itwas an outlet foranxietyoverthepopularnotionthatJapanwasonthebrinkofworldeconomicdomination.Obviouslytimeschange.WenowknowthatJapanwentontosufferfrommorethanadecadeofeconomicstagnationwhiletheUnitedStatesmovedintowhatwouldbecomethelongesteconomicexpansioninthenation’shistory.

TheNikkeiIndex,whichreflectspricesontheJapanesestockmarket,peakedat38,916justaroundthetimethegovernorofMainewastellingthatjoke.TodaytheNikkeiisjustover10,000.

Of course, Americans aren’t gloating about that these days. After fifteenyearsofagenerallystrongeconomyintheUnitedStates,westumbledintotheworst economic downturn since the Great Depression. Why is it that alleconomies, richandpoor,proceed in fits and starts, stumbling fromgrowth torecessionandbacktogrowthagain?Duringtherobustgrowthofthe1990s,thelabormarketwassotightthatfast-foodrestaurantswerepayingsigningbonuses,collegegraduatesweregettingstockoptionsworthmillions,andanyonewithapulse was earning double-digit returns in the stock market. Consumers werebuoyedbyrisinghomeandstockprices.Capitalflowedinfromtherestof theworld,mostnotablyChina,makingiteasyforAmericanstoborrowcheaply.

And then everything went wildly off track, like one of those NASCARwrecks. Consumers were suddenly overburdened with debt and stuck withhomes they couldn’t sell. The stock market plunged. The unemployment rateclimbed toward 10 percent. America’s biggest banks were on the brink ofinsolvency. The Chinese started musing publicly about whether they shouldcontinuetobuyAmericantreasurybonds.Welikeditbetterthefirstway.Whathappened?

To understand the cycle of recession and recovery—the “business cycle,” aseconomistscallit—weneedtofirstlearnaboutthetoolsformeasuringamoderneconomy. If the president really did wake up from a coma after suffering ahorseshoeaccident, it’safairbetthathewouldaskforonenumberfirst:grossdomestic product, or GDP, which represents the total value of all goods andservices produced in an economy. When the headlines proclaim that theeconomygrew2.3percentinaparticularyear,theyarereferringtoGDPgrowth.It means simply that we as a country produced 2.3 percent more goods andservices thanwedidtheyearbefore.Similarly, ifwesaythatpubliceducationpromoteseconomicgrowth,wearesayingthatitraisestherateofGDPgrowth.OrifwewereaskedwhetheranAfricancountryisbetteroffin2010thanitwasin2000,ouranswerwouldbegin(thoughcertainlynotend)withadescriptionofwhathappenedtoGDPoverthecourseofthedecade.

Canwereallygaugeourcollectivewell-beingbythequantityofgoodsandservices thatwe produce?Yes and no.We’ll startwith “yes,” thoughwewill

cometo“no”beforethechapterisdone.GDPisadecentmeasureofourwell-beingforthesimplereasonthatwhatwecanconsumeisconstrainedbywhatwecan produce—either becausewe consume those goods directly or becausewetradethemawayforgoodsproducedsomewhereelse.AcountrywithaGDPpercapitaof$1,000cannotconsume$20,000percapita.Whereexactlyaretheother$19,000worthof goods and services going to come from?Whatwe consumecandeviate fromwhatweproduce for short stretches, just as family spendingcandeviate from family income for awhile. In the long run, however,what acountryproducesandwhatitconsumesaregoingtobenearlyidentical.

Imustmaketwoimportantqualifications.First,whatwecareaboutisrealGDP,whichmeansthatthefigurehasbeenadjustedtoaccountforinflation.Incontrast,nominal figureshavenotbeenadjusted for inflation. IfnominalGDPclimbs 10 percent in 2012 but inflation is also 10 percent, then we haven’tactuallyproducedmoreofanything.We’vejustsoldthesameamountofstuffathigherprices,whichhasnotmadeusanybetteroff.Yoursalarywillhavemostlikelygoneup10percentaswell,butsowillhavethepriceofeverythingyoubuy. It’s the economic equivalent of swapping a $10 bill for ten $1 bills—itlooksgoodinyourwallet,butyou’renotanyricher.Wewillexploreinflationingreaterdepthinthenextchapter.Fornow,sufficeittosaythatourstandardoflivingdependsonthequantityofgoodsandserviceswetakehomewithus,notonthepricethatshowsupattheregister.

Second,wecareaboutGDPpercapita,whichisanation’sGDPdividedbyitspopulation.Again,thisadjustmentisnecessarytopreventwildlymisleadingconclusions. India has aGDPof $3.3 trillionwhile Israel has aGDPof $201billion.Whichistherichercountry?Israelbyfar.IndiahasmorethanabillionpeoplewhileIsraelhasonlysevenmillion;GDPpercapitainIsraelis$28,300compared to only $2,900 in India. Similarly, if a country’s economy grows 3percentinagivenyearbutthepopulationgrows5percent,thenGDPpercapitawill fall. The country is producing more goods and services, but not enoughmoretokeepupwithapopulationthatisgrowingfaster.

IfwelookatrealGDPinAmerica,ittellsusseveralthings.First,theAmericaneconomyismassivebyglobalstandards.AmericanGDPisroughly$14trillion,which is only slightly smaller than all the countries of the European Unioncombined. The next-largest single economy is China, which has a GDP ofaround$8 trillion.Onapercapitabasis,weare rich,bothbyglobalstandards

and by our own historical standards. In 2008,America’sGDP per capitawasroughly $47,000, slightly less than Norway, Singapore, and a few smallcountrieswithalotofoil,butstillnearlythehighestintheworld.OurrealGDPpercapitaismorethantwicewhatitwasin1970andfivetimeswhatitwasin1940.

Inotherwords,theaverageAmericanisfivetimesasrichasheorshewouldhavebeenin1940.Howcouldthatbe?TheanswerisbackinChapter5:We’remoreproductive.Thedayisnotanylonger,butwhatwecangetdoneintwenty-fourhourshaschangeddramatically.TheFederalReserveBankofDallascameupwith a novelway to express our economic progress over the course of thetwentiethcentury:Comparehowlongwehadtoworkin2000tobuybasicitemswithhowlongwehadtoworktobuythesameitemsin1900.Astheofficialsatthe Dallas Fed explain, “Makingmoney takes time, so when we shop, we’rereallyspendingtime.Therealcostoflivingisn’tmeasuredindollarsandcentsbutinthehoursandminuteswemustworktolive.”1

So here goes: A pair of stockings cost 25 cents in 1900. Of course, theaveragewageatthetimewas14.8centsanhour,sotherealcostofstockingsatthebeginningof the twentieth centurywasonehour and forty-oneminutes ofwork for the average American. If you walk into a department store today,stockings(pantyhose)areseeminglymoreexpensive than theywere in1900—butthey’renot.By2000,thepricehadgoneup,butourwageshadgoneupevenfaster. Stockings in 2000 cost around $4, while America’s average wage wasover$13anhour.Asaresult,apairofstockingscost theaverageworkeronlyeighteenminutesof time,a stunning improvement fromanhourand forty-oneminutesacenturyearlier.

The same is true formostgoodsovermost long stretchesof time. Ifyourgrandmotherweretocomplainthatachickencostsmoretodaythanitdidwhenshewasgrowingup,shewouldbecorrectonlyinthemosttechnicalsense.Thepriceofathree-poundchickenhasindeedclimbedfrom$1.23in1919to$3.86in 2009.But grandma really has nothing to complain about.The “work time”necessary to earn a chicken has dropped remarkably. In 1919, the averageworkerspenttwohoursandthirty-sevenminutestoearnenoughmoneytobuyachicken (and, I’mguessing, at least another forty-fiveminutes for themashedpotatoes). In short, youwouldworkmost of yourmorning just to earn lunch.How long does it take to “earn” a chicken these days? Just under thirteenminutes.Cutoutonepersonalphonecall andyou’vegotSundaydinner takencareof.Skipsurfingthewebforalittlewhileandyoucouldprobablyfeedthe

neighbors,too.Do you remember the days when it was novel, perhaps even mildly

impressive,toseesomeonespeakingonacellularphoneinarestaurant?(Okay,itwasashortstretchof time,butacellphonedidhaveacertaincachet in themid-1980s.)Nowonder;backthenacellphone“cost”about456hoursofworkfortheaverageAmerican.Almostthreedecadeslater,cellphonesarejustplainannoying,inlargepartbecauseeveryonehasone.Thereasoneveryonehasoneis that they now “cost” about nine hours ofwork for the averageworker—98percentlessthantheycosttwentyyearsago.

We take thismaterial progress for granted;we shouldn’t.A rapidly risingstandardof livinghasnotbeen thenormthroughouthistory.RobertLucas,Jr.,winner of the Nobel Prize in 1995 for his numerous contributions tomacroeconomics,hasarguedthatevenintherichestcountries,thephenomenonof sustained growth in living standards is only a few centuries old. Othereconomists have concluded that the growth rate ofGDP per capita in Europebetween500and1500wasessentiallyzero.2Theydon’tcallittheDarkAgesfornothing.

Weshouldalsomakeclearwhatitmeansforacountrytobepoorbyglobalstandardsatthebeginningofthetwenty-firstcentury.AsI’venoted,IndiahasapercapitaGDPof$2,900.Butlet’stranslatethatintosomethingmorethanjustanumber.ModernIndiahasmorethan100,000casesofHansen’sdisease,betterknowntotheworldasleprosy.Leprosyisacontagiousdiseasethatattacksthebody’s tissues and nerves, leaving horrible scars and limb deformities. Thestriking thing about Hansen’s disease is that it is easily cured, and, if caughtearly,recoveryiscomplete.Howmuchdoesitcosttotreatleprosy?One$3doseofantibioticwillcureamildcase;a$20regimenofthreeantibioticswillcureamoreseverecase.TheWorldHealthOrganizationevenprovidesthedrugsfree,butIndia’shealthcareinfrastructureisnotgoodenoughtoidentifytheafflictedandgetthemthemedicinetheyneed.3

So,more than100,000people inIndiaarehorriblydisfiguredbyadiseasethatcosts$3tocure.ThatiswhatitmeanstohaveapercapitaGDPof$2,900.

Havingsaidallthat,GDPis,likeanyotherstatistic,justonemeasure.Figureskating andgolf notwithstanding, it is hard to collapse complex entities into asinglenumber.ThelistofknocksagainstGDPasameasureofsocialprogressisalongone.GDPdoesnotcountanyeconomicactivitythatisnotpaidfor,suchasworkdoneinthehome.Ifyoucookdinner,takecareofthekids,andtidyuparound the house, none of that counts toward the nation’s official output.

However,ifyouorderoutfood,dropyourkidsoffatachildcarecenter,andhirea cleaning lady, all of that does. Nor does GDP account for environmentaldegradation;ifacompanyclear-cutsavirginforesttomakepaper,thevalueofthepapershowsupintheGDPfigureswithoutanycorrespondingdebitfortheforestthatisnowgone.

Chinahastakenthis lastpoint toheart.ChineseGDPgrowthoverthepastdecadehasbeentheenvyoftheworld,butithascomeatthecostofsignificantenvironmentaldegradation.Ofthetwenty-fivemostpollutedcitiesintheworld,sixteen are in China (you’ve never heard of most of them). China’s StateEnvironmentalProtectionAdministrationhasbegun to calculate “GreenGDP”figures, which seek to evaluate the true quality of economic growth bysubtracting the costs of environmental damage. Using this metric, China’s 10percentGDPgrowthin2004wasreallycloserto7percentwhenthe$64billioninpollutioncostsaretakenintoaccount.GreenGDPhasanobviouslogic.TheWall Street Journal explains, “WhileGDP looks at themarket value of goodsand services produced in a country each year, it ignores the fact that a nationmightbefuelingitsexpansionbypollutingorburningthroughnaturalresourcesin an unsustainableway. In fact, the usualmethods of calculatingGDPmakedestroyingtheenvironmentlookgoodfortheeconomy.Ifanindustrypollutesintheprocessofmanufacturingproducts,andthegovernmentpaystocleanupthemess,bothactivitiesaddtoGDP.”4

There are no value judgments whatsoever attached to traditional GDPcalculations. A dollar spent building a prison or cleaning up after a naturaldisaster boosts GDP, even thoughwewould be better off if we did not needprisons and if there were no disasters to clean up after. Leisure counts fornothing.Ifyouspendagloriousdaywalkingintheparkwithyourgrandmother,you are not contributing to GDP and may actually be subtracting from it ifyou’vetakenthedayofftodoit.(True,ifyoutakegrandmabowlingortothemovies,themoneyyouspendwillshowupintheGDPfigures.)GDPdoesnottakeintoaccountthedistributionofincome;GDPpercapitaisasimpleaveragethatcanmaskenormousdisparitiesbetweenrichandpoor.Ifasmallminorityofa country’s population grow fabulously rich while most citizens are gettingsteadilypoorer,percapitaGDPgrowthcouldstilllookimpressive.

TheUnitedNationshascreatedtheHumanDevelopmentIndex(HDI)asabroaderindicatorofnationaleconomichealth.TheHDIusesGDPasoneofitscomponentsbutalsoaddsmeasuresoflifeexpectancy,literacy,andeducationalattainment.TheUnitedStatesrankedthirteenthinthe2009report;Norwaywas

numberone,followedbyAustraliaandIceland.HDIisagoodtoolforassessingprogressindevelopingcountries;ittellsuslessaboutoverallwell-beinginrichcountrieswherelifeexpectancy,literacy,andeducationalattainmentarealreadyrelativelyhigh.

ThemosteffectiveknockagainstGDPmaysimplybethatitisanimperfectmeasureofhowwelloffwereallyconsiderourselves tobe.Economicshasanoverly tautologicalviewofhappiness:The thingswedomustmakeushappy;otherwisewewouldnotdothem.Similarly,growingrichermustmakeusbetteroff becausewe cando andhavemore of the things thatwe enjoy.Yet surveyresults tell us something different.Richermay not be happier.Remember thatrobustgrowthofthe1990s?Itdidn’tseemtodomuchgoodforourpsyches.Infact, the period of rising real incomes from 1970 to 1999 coincided with adecreaseinthosewhodescribedthemselvesas“veryhappy”from36percentto29 percent.5 Economists are belatedly beginning to probe this phenomenon,albeit in their own perversely quantitative way. For example, DavidBlanchflower and AndrewOswald, economists at Dartmouth College and theUniversity of Warwick, respectively, found that a lasting marriage is worth$100,000 a year, since married people report being as happy, on average, asdivorced (and not remarried) individualswho have incomes that are $100,000higher. So, before you go to bed tonight, be sure to tell your spouse that youwouldnotgivehimorherupforanythinglessthan$100,000ayear.

Someeconomistsarestudyinghappinessdirectly,byaskingparticipants tokeepdaily journals inwhich they recordwhat they are doing at various timesandhowitmakesthemfeel.Notsurprisingly,“intimaterelations”isatthetopofthelistintermsofpositiveexperiences;themorningcommuteisatthebottom,lowerthancooking,housework,theeveningcommute,andeverythingelse.6Thefindingsarenot trivial, as theycan illuminateways inwhich individuals thinkthey aremaking themselves happy but aren’t really. (Yes, you should see theinfluenceof thebehavioral economistshere.)Forexample, that longcommutemaynotbeworthwhatitbuys(usuallyabiggerhouseandahighersalary).Notonlyisthecommuteunpleasant,butitoftencarriesahighopportunitycost:lesstime spent socializing, exercising, or relaxing—all of which rate as highlypleasurableactivities.Meanwhile,wequicklybecomeinured to thebenefitsofthegoods thatwepreviouslycoveted (kindof likegettingused toahotbath),whereas the happiness generated by experiences (family vacations and theirlingering memories) is more durable. The Economist summarizes theprescriptionsof the research so far: “Ingeneral, the economicarbitersof taste

recommend‘experiences’overcommodities,pastimesoverknick-knacks,doingoverhaving.”7

IfGDPisaflawedmeasureofeconomicprogress,whycan’twecomeupwithsomethingbetter?

Wecan,arguesMarcMiringhoff,aprofessorofsocialsciencesatFordhamUniversity,whobelievesthatthenationshouldhavea“socialreportcard.”8Heproposedasocialhealthindexthatwouldcombinesixteensocialindicators,suchas child poverty, infantmortality, crime, access to health care, and affordablehousing.ConservativeauthorandcommentatorWilliamBennettagreeswithhalfofthatanalysis.WedoneedameasureofprogressthatisbroaderthanGDP,heargues.Butditchallthatliberalclaptrap.Mr.Bennett’s“indexofleadingculturalindicators” includes the kinds of things that he considers important: out-of-wedlockbirths,divorcerates,druguse,participation inchurchgroups,and theleveloftrustingovernment.

French President Nicolas Sarkozy instructed the French national statisticsagency in 2009 to develop an indicator of the nation’s economic health thatincorporatesbroadermeasuresofqualityoflifethanGDPalone.Twoprominenteconomistsand formerNobelPrizewinners, JosephStiglitzandAmartyaSen,chaired a panel convened by Sarkozy to examine a seeming paradox: RisingGDP seems to come with a perception that life is getting more stressful anddifficult,notless.Sarkozywantsameasurethatincorporatesthejoysofartandleisure and the sorrows of environmental destruction and stress.9 Measuringtheseelementsofthehumanconditionisanoblegesture—butasinglenumber?TheWallStreetJournalcommented,“ChapeausofftoMessrs.StiglitzandSeniftheycanputanumberonsuchspiritualmatters—butdon’tholdyourbreath.”

So you begin to see the problem. Any measure of economic progressdependsonhowyoudefineprogress.GDP just addsup thenumbers.There issomethingtobesaidforthat.Allelseequal,itisbetterforanationtoproducemoregoodsandservices thanfewer.WhenGDPturnsnegative, thedamage isreal: jobs lost, businesses closed, productive capacity turned idle. But whyshouldweeverhavetodealwiththatanyway?Whyshouldamoderneconomyswitch from forward to reverse? If we can produce and consume $14 trillionworthofstuff,andputmostAmericanstoworkdoingit,whyshouldwetossabunchofpeopleoutofworkandproduce5percentlessthefollowingyear?

Thebestansweristhatrecessionsarelikewars:Ifwecouldpreventthem,wewould.Eachoneisjustdifferentenoughfromthelasttomakeithardtowardoff.(Thoughpresumablypolicymakershavepreventedbothwarsandrecessionson numerous occasions; it’s only when they fail that we notice.) In general,recessions stem from some shock to the economy. That is, something badhappens.Itmaybethecollapseofastockmarketorpropertybubble(theUnitedStates in 1929 and 2007, Japan in 1989); a steep rise in the price of oil (theUnitedStates in1973);orevenadeliberateattemptby theFederalReserve toslow down an overheated economy (the United States in 1980 and 1990). Indevelopingcountries, theshockmaycomefromasuddenfall in thepriceofacommodityonwhichtheeconomyisheavilydependent.Obviouslytheremaybea combination of causes. TheAmerican slowdown that began in 2001 had itsroots in the “tech wreck”—the overinvestment in technology that ultimatelyendedwiththeburstingoftheInternetbubble.ThattroublewascompoundedbytheterroristattacksofSeptember11andtheiraftermath.

Nomatterthecause,themostfascinatingthingaboutrecessionsishowtheyspread. Let’s start with a simple one, and then work our way to the “GreatRecession” of 2007.Youprobably didn’t notice, but around2001 the price ofcoffee beans plunged from $150 to $50 per hundred pounds.10 Although thatdrop may have made your Starbucks latte habit modestly more affordable,CentralAmerica, amajor coffeeproducing region,was reeling. TheNew YorkTimesreported:

Thecollapseof the [coffee]markethassetoffachain reaction that isfeltthroughouttheregion.Townshavebeenlefttoscrapebyastaxreceiptsdrop,forcingthemtoscalebackservicesandlayoffworkers.Farmshavescaled back or closed, leaving thousands of the area’s most vulnerablepeoplewith nomoney to buy food or clothes or to pay their rent. Smallgrowers, in debt to banks and coffee processorswho lent themmoney tocare for the crops and workers, have been idled, and some of them arefacingthelossoftheirland.

Whether you live in Central America or Santa Monica, someone else’seconomicdistresscanbecomeyourproblemveryquickly.Therecessionof2007(which erupted into a financial crisis in 2008) has been the scariest in a longtime.Theeconomic“shock”inthiscaseoriginatedwithsharpdropsinboththe

stock and housing markets, both of which left American households poorer.Christina Romer, chair of President Obama’s Council of Economic Advisers,estimates thatU.S. householdwealth fell 17 percent betweenDecember 2007andDecember 2008—five times the size of the decline in 1929 (when fewerfamilies owned stocks or houses).11When consumers sustain a shock to theirincome, they spend less, which spreads the economic damage. This is anintriguing paradox:Our natural (and rational) reaction to precarious economictimesistobecomemorecautiouswithourspending,whichmakesourcollectivesituationworse.Thelossofconfidencecausedbyashocktotheeconomymayturnout tobeworse than the shock itself.My thrift—adecision to curtailmyadvertisingbudgetortobuyacarnextyearinsteadofthisyear—maycostyouyour job, which will in turn hurt my business! Indeed, if we all believe theeconomyis likely togetworse, then itwillgetworse.And ifweallbelieve itwillgetbetter,thenitwillgetbetter.Ourbehavior—tospendornottospend—isconditioned on our expectations, and those expectations can quickly becomeself-fulfilling.FranklinDelanoRoosevelt’sadmonitionthatwehave“nothingtofearbutfearitself”wasbothexcellentleadershipandgoodeconomics.Similarly,RudyGiuliani’sexhortationthatNewYorkersshouldgooutanddotheirholidayshoppingintheweeksaftertheWorldTradeCenterattackwasnotaswackyasitsounded.Spendingcangenerateconfidencethatgeneratesspendingthatcausesarecovery.

UnfortunatelytheGreatRecessionthatbeganin2007hadotheraspectstoitthat spread the economicdamage in virulent and scaryways.ManyAmericanhouseholdswere “excessively leveraged,”meaning that theyhadborrowed farmore than they couldmanage.Thehousingboomhad encouraged ever biggerhouses with ever bigger mortgages. Meanwhile, the down payments—theamount of their ownmoney buyers had to spend to get a loan—were gettingsmaller relative towhatwasbeingborrowed.Subprimemortgages (a financialinnovation, one must admit) made it easier for people to borrow who wereotherwise not creditworthy and for other people to borrow in particularlyaggressiveways(e.g.,withnodownpaymentatall).Thisallworksfinewhenhousing prices are going up; someone who falls behind on their mortgagepaymentscanalwayssellthehousetorepaytheloan.Whenthehousingbubbleburst, however, the numbers became a disaster. Overleveraged Americanfamilies found that they could not afford their mortgage payments, nor couldthey sell their homes. Millions of houses and condos were thrown intoforeclosurebywhateverbankorfinancialinstitutionownedthemortgage.When

thesepropertiesweredumpedon themarket, it drovepricesdown further andexacerbatedalltherealestate–inducedproblems.

But we haven’t even arrived at the scary part yet. America’s mortgageproblemspreadtothefinancialsectorthroughtworelatedchannels.First,bankswereplaguedwithlotsofbadrealestateloans,whichmadethemlessableandwillingtomakenewloans.Anyonelookingtobuyahomehadtroubledoingso,even with good credit and a large down payment. (You guessed it: Thiscompounded the real estate problems yet again.) Meanwhile, Wall Streetinvestment banks and hedge funds had loaded up on real estate derivatives—fancyproductslikemortgage-backedsecuritieswhosevaluewassomehowtiedtotheplungingrealestatemarket.LikeAmericanhomeowners,theseinstitutionshad borrowed heavily to make such investments, so they too faced creditors.Much of this debt was “insured” with the credit default swaps described inChapter7,wreakinghavoconfirmswiththatexposure.

There was a stretch of time in the fall of 2008 when it looked likeWallStreet—and therefore the global financial system—would implode. The mostseriousmoment camewhen the investment bankLehmanBrothers recognizedthat it could not meet its short-term debt obligations—meaning that withoutsomeinfusionofoutsidecapital,thefirmwouldhavetodeclarebankruptcy.TheU.S. Treasury and the Federal Reserve were unable, or unwilling, to saveLehman. (Earlier in the year they had saved Bear Stearns, another troubledinvestmentbank,byarranginga takeoverbyJPMorganChase.)WhenLehmandeclaredbankruptcy,leavingallofitscreditorshighanddry,theglobalfinancialsystemessentiallyseizedup.ATreasuryofficialdescribedthecascadeofpanictoTheNew Yorker: “Lehman Brothers begat the Reserve collapse [a money-market fund],which begat themoney-market run, so themoney-market fundswouldn’tbuycommercialpaper[short-termloanstocorporationslikeGE].Thecommercial-paper market was on the brink of destruction. At this point, thebankingsystemstopsfunctioning.”12

Sensible people started talking about surviving by raising goats in thebackyard. (Okay, that was me.) My college roommate, who has gone on tobecometheCEOofamajorcompany,admittedlaterthathehadhidden$10,000in a cowboy boot in his closet. (Iwas leftwondering primarilywhy he ownscowboy boots.)Wewere not alone. James Stewart has described the Lehmancollapse and all its attendant damage in a brilliant piece forThe New Yorker.Hereisonesample:

Geithner [then president of the Federal Reserve Bank of New York]said,“It’shard todescribehowbad itwasandhowbad it felt.”Hegotacallfroma“titanofthefinancialsystem,”whosaidhewasworriedbuthewas doing fine. His voice was quavering. After hanging up, Geithnerimmediatelycalledthemanback.“Don’tcallanyoneelse,”Geithnersaid.“Ifanyonehearsyourvoice,you’llscaretheshitoutofthem.”

Youdon’thave to like investmentbankers tocareaboutallof this (and toappreciatewhythefederalgovernmentneededtostopthepaniconWallStreet).Once the financial system seizes up, noonegets credit.At that point, healthycompanies become less healthy because they don’t have access to loans thatallow them to do things that are necessary for business, such as buyinginventory.ThedamageofthefinancialcrisisspreadtoeverycornerofAmericansociety.In2009,pre-ordersalesforGirlScoutcookiesplunged19percentfromtheyearbefore.13Meanwhile, thenumberofadult filmsproduced inSouthernCaliforniafellfromfiveorsixthousandfilmsayeartothreeorfourthousand.TheEconomistreportedonthemacroeconomiceffectsoflessporn:“Somefirmshave shut down, others are consolidating or scraping by. For the 1,200 activeperformers in the [San Fernando] Valley this means less action and morehardship…Foreveryperformer,thereareseveralpeopleinsupport,fromsound-techtocateringand(yes)wardrobe,saysMs.Duke[aspokespersonfortheadultfilmindustry],sotheoveralleffectontheValleyeconomyislarge.”14

Recessions can spread quickly across international borders. If the U.S.economyweakens,thenwebuyfewergoodsfromabroad.PrettysoonMexico,whichsendsmorethan80percentofitsexportstotheUnitedStates,isreeling.Inbusinessasinsports,yourcompetitor’smisfortuneisyourgain.Atthegloballevel, theopposite is true.Ifotherpowerfuleconomies fall intorecession, theystop buying our goods and services—and vice versa. Think about it: IfunemploymentdoublesinJapanorGermany,howexactlyisthatgoingtomakeyoubetteroff?Duringthefinancialcrisis, theproblemsonWallStreetquicklyspread to other countries. Americans—who are collectively the biggestconsumersintheworld—boughtfewerimportedgoods,whichharmedexportingeconomiesaroundtheglobe.America’sGDPcontractedatanannualrateof5.4percent in the fourthquarterof2008.You thoughtwehad itbad?Singapore’seconomyfellinthesamequarteratanannualrateof16percent,andJapan’sby12percent.15

Howdo thingsgetbetter?Thereareoftenunderlying issues thatneed toworkthemselvesout. In thecaseof the“techwreck,”wemassivelyoverinvested inInternet businesses and related technology. Some firmswent bust; other firmscut back their IT spending. Resources were reallocated, at which point thereweremoreU-HaulsgoingoutofSiliconValleythanin.Or,inthecaseofhigherenergyprices,wereorganizeoureconomytodealwithaworld inwhichoil is$100abarrelinsteadof$10.Intherun-uptothefinancialcrisis,consumersandfirmsborrowedtoomuch;speculatorsbuilthousesthatnevershouldhavebeenbuilt; Wall Street grew fat dealing in products with limited economic value.Thesethingsarenow(painfully)fixingthemselves.Recessionsmayactuallybegoodfor long-termgrowthbecause theypurge theeconomyof lessproductiveventures,justasaharshwintermaybegoodforthelong-termhealthofaspecies(ifnotnecessarilyforthoseanimalsthatfreezetodeath).

The business cycle takes a human toll, as the layoffs splashed across theheadlinesattest.Policymakersareincreasinglyexpectedtosmooththisbusinesscycle;economistsaresupposedto tell themhowtodoit.Governmenthas twotoolsatitsdisposal:fiscalpolicyandmonetarypolicy.Theobjectiveofeachisthe same: to encourage consumers and businesses to begin spending andinvestingagainsothattheeconomy’scapacitynolongersitsidle.

Fiscalpolicyusesthegovernment’scapacitytotaxandspendasaleverforprying the economy from reverse into forward. If nervous consumers won’tspend, thenthegovernmentwilldoit for them—andthatcancreateavirtuouscircle. While consumers are sitting at home with their wallets tucked firmlyunder the mattress, the government can start to build highways and bridges.Constructionworkers go back towork; their firms place orders formaterials.Cementplantscallidledworkersback.Astheworldstartstolooklikeabetterplace, we feel comfortable making major purchases again. The cycle wedescribed earlier begins towork in reverse. This is the logic of theAmericanRecovery and Reinvestment Act of 2009—the stimulus bill that was the firstmajorpieceof legislationunder theObamaadministration.TheActauthorizedmore than $500 billion in federal spending on things ranging from expandedunemploymentbenefitstoresurfacingthemainhighwaynearmyhouse.(Thereis a big sign on the side of the road tellingme that’swhere themoney camefrom.)

The government can also stimulate the economy by cutting taxes. The

AmericanRecoveryandReinvestmentActdidthat,too.Thefinalbillhadnearly$300 billion in assorted tax cuts and credits. The economic logic is thatconsumers,findingmoremoneyintheirpaychecksattheendofthemonth,willdecidetospendsomeofit.Again,thisspendingcanhelptobreakthebackoftherecession.Purchasesgeneratedbythetaxcutputworkersbackonthejob,whichinspiresmorespendingandconfidence,andsoon.

Thenotionthatthegovernmentcanusefiscalpolicy—spending,taxcuts,orboth—to “fine-tune” the economy was the central insight of John MaynardKeynes.Thereisnothingwrongwiththeidea.Mosteconomistswouldconcedethat, in theory, government has the tools to smooth the business cycle. Theproblem is that fiscalpolicy isnotmade in theory; it’smade inCongress.Forfiscalpolicytobeasuccessfulantidotetorecession,threethingsmusthappen:(1)Congressandthepresidentmustagreetoaplanthatcontainsanappropriateremedy;(2)theymustpasstheirplaninatimelymanner;and(3)theprescribedremedy must kick in fast. The likelihood of nailing all three of theserequirementsisslim.Remarkably,inmostpostwarrecessions,Congressdidnotpass legislation in response to the downturn until after it had ended. In oneparticularly egregious example, Congress was still passing legislation inMay1977 todealwith the recession thatended inMarch1975.16At theendof therelatively mild 2001–2002 recession, the New York Times ran the followingheadline:“FedChiefSeesDeclineOver;HousePassesRecoveryBill.”I’mnotmakingthisstuffup.

WhatabouttheObamastimulus?TheAmericanRecoveryandReinvestmentActwas seemingly timely, butmost of themoneywas not spent immediately(though there still can be a psychological benefit, and therefore an economicbenefit, to simply announcing that lots of spending is coming).Critics of thishugeeconomicinterventionarguethatitlavishedborrowedgovernmentmoneyon all kinds of unimaginable projects, some of them quite silly, andwill addhuge sums to the national debt. Proponents of the stimulus, such as Obama’schairoftheCouncilofEconomicAdvisers,ChristinaRomer,makethecasethatthe$787billionstimulusraisedrealGDPgrowthby2to3percentagepointsandsaved a million jobs.17 As far as I can tell, they’re both right. I was acongressionalcandidateat the time,somyviewsareamatterofpublic record(forthesmallnumberofpeoplewhopaidattentiontothem).Theeconomywascaught in dangerous negative feedback loops—foreclosures were causingbankingproblemswhichwerecausinglayoffswhichwerecausingforeclosures,andsoon.Iwasfondofsaying,“Abadstimulusisbetterthannostimulus,anda

badstimulusiswhatwegot.”Thegovernmentneededtodosomethingtobreakthecycle(inpartbecausemonetarypolicywasnotworking,aswillbeexplainedin amoment). Iwould have preferred that the government targetmore of thespending toward infrastructure and human capital investments to improve thelong-term productive capacity of the nation. I agree that rising governmentindebtednessisaproblem,aswillbediscussedinChapter11.Thatsaid,giventhe financial panic described earlier in the chapter and the capacity for badeconomic events to beget more bad economic events, there is a reasonableargumenttobemadethatevenpayingpeopletodigholesandthenfilltheminwouldhavebeenabetterpolicychoicethandoingnothing.

Thesecondtoolatthegovernment’sdisposalismonetarypolicy,whichhasthepotentialtoaffecttheeconomyfasterthanyoucanreadthisparagraph.ThechairmanoftheFederalReservecanraiseorlowershort-terminterestrateswithonephonecall.NohagglingwithCongress;nowaitingyearsfortaxcuts.Asaresult, thereisnowaconsensusamongeconomiststhatnormalbusinesscyclesarebestmanagedwithmonetarypolicy.Thewholenextchapterisdevotedtothemysterious workings of the Federal Reserve. For now, suffice it to say thatcutting interest ratesmakes it cheaper for consumers to buy houses, cars, andotherbig-ticketitemsaswellasforfirmstoinvestinnewplantsandmachinery.CheapmoneyfromtheFedprieswalletsopenagain.

During the depths of the “Great Recession” of 2007, however, the Fedcouldn’tmakemoneyanycheaper.TheFedpushedshort-terminterestratesallthewaydowntozero,forallintentsandpurposes,butconsumersandbusinessesstillweren’twilling toborrowandspend(andunhealthybankswere inapoorposition to lend). At that point, monetary policy can’t do anything more; itbecomeslike“pushingonawetnoodle,”asKeynesoriginallydescribedit.Thisistheeconomicrationaleforturningtoafiscalstimulusaswell.

IconcededearlierinthischapterthatGDPisnottheonlymeasureofeconomicprogress. Our economy consists of hundreds of millions of people living invarious states of happiness or unhappiness. Any president recovering from ahorseshoeaccidentwoulddemandahandfulofothereconomicindicators,justasemergencyroomphysiciansaskforapatient’svitalsigns(oratleastthatiswhattheydoonGrey’sAnatomy).Ifyouweretotakethevitalsignsofanyeconomyon the planet, here are the economic indicators, along with GDP, thatpolicymakerswouldaskforfirst.

Unemployment.Mymother does not have a job, but she is not unemployed.How could that be? This is not one of those strange logic riddles. Theunemploymentrateisthefractionofworkerswhowouldliketoworkbutcannotfind jobs. (My mother is retired and has no interest in working.) America’sunemployment rate fell below 4 percent during the peak of the boom in the1990s; it has since climbed over 10 percent. Even that may understate thenumberofpeopleoutofwork.WhenAmericanswithoutjobsgiveuponfindingone, they no longer count as unemployed and instead become “discouragedworkers.”

Anyone who cares about unemployment should care about economicgrowth, too.Thegeneral rule of thumb, basedon researchdoneby economistArthur Okun and known thereafter as Okun’s law, is that GDP growth of 3percent a yearwill leave the unemployment rate unchanged. Faster or slowergrowthwillmovetheunemploymentrateupordownbyone-halfapercentagepointforeachpercentagepointchangeinGDP.Thus,GDPgrowthof4percentwouldlowerunemploymentbyhalfapercentagepoint,andGDPgrowthofonly2 percentwould cause unemployment to rise by half a percentage point. Thisrelationship is not an iron law; rather, it describes the relationship inAmericabetweenGDPgrowthandunemploymentoverthefive-decadeperiodstudiedbyMr.Okun,roughly1930to1980.

Poverty.Eveninthebestoftimes,adrivethroughChicago’shousingprojectsisampleevidencethatnoteverybodyhasbeeninvitedtotheparty.ButhowmanyAmericansarepoor?Indeed,whatexactlyconstitutes“poor”?Inthe1960s,theU.S.governmentcreatedthepovertylineasa(somewhatarbitrary)definitionofthe amount of income necessary to buy the basic necessities. Having beenadjusted for inflation, the poverty level remains as the statistical threshold forwhoispoorinAmericaandwhoisnot.Forexample,thecurrentpovertylinefora single adult is $10,830; the poverty line for a family of two adults and twochildrenis$22,050.

The poverty rate is simply the fraction of Americans whose incomes fallbelowthepovertyline.Roughly13percentofAmericansarepoor,whichisnobetter than we were doing in the 1970s. The poverty rate rose steadilythroughout the1980sand thendrifteddown in the1990s.Theoverallpoverty

ratedisguisessomefiguresthatwouldotherwiseleapoffthepage:RoughlyoneinfiveAmericanchildrenispoorasarenearly35percentofblackchildren.Ouronlyresoundingsuccessispovertyamongtheelderly,whichhasfallenfrom30percentinthe1960stobelow10percent,largelyastheresultofSocialSecurity.

Incomeinequality.Wecareaboutthesizeofthepie;wealsocareabouthowitissliced.Economistshavea tool thatcollapses incomeinequality intoasinglenumber,theGiniindex.*Onthisscale,ascoreofzerorepresentstotalequality—astateinwhicheveryworkerearnsexactlythesame.Attheotherend,ascoreof100 represents total inequality—a state in which all income is earned by oneindividual.Thecountriesof theworldcanbearrayedalong thiscontinuum.In2007, theUnitedStateshadaGini indexof45,comparedto28forFrance,23for Sweden, and 57 for Brazil. By thismeasure, theUnited States has grownmoreunequaloverthepastseveraldecades.America’sGinicoefficientwas36.5in1980and37.9in1950.

Sizeofgovernment. Ifwe are going to complain about “biggovernment,”weought to at least know how big that government is. One relatively simplemeasureofthesizeofgovernmentistheratioofallgovernmentspending(local,state, and federal) to GDP. Government spending in America has historicallybeenaround30percentofGDP,whichislowbythestandardsofthedevelopedworld. It’s climbing right now, both because the stimulus is driving upgovernmentspending(thenumerator)andbecauseGDPhasbeenshrinking(thedenominator).GovernmentspendinginBritainisroughly40percentofGDP.InJapan,itisover45percent;inFranceandSwedenitismorethan50percent.Ontheotherhand,Americaistheonlydevelopedcountryinwhichthegovernmentdoesnotpayforthebulkofhealthcareservices.Ourgovernmentissmaller,butwegetless,too.

Budgetdeficit/surplus. The concept is simple enough; a budget deficit occurswhenthegovernmentspendsmorethanitcollects inrevenuesandasurplus istheopposite.Themoreinterestingquestioniswhethereitheroneofthesethingsis good or bad. Unlike accountants, economists are not sticklers for balanced

budgets.Rather, the prescription ismore likely to be that governments shouldrun modest surpluses in good times and modest deficits in tough times; thebudgetneedonlybalanceinthelongrun.

Hereiswhy:Iftheeconomyslipsintorecession,thentaxrevenueswillfalland spending on programs such as unemployment insurancewill rise. This islikelytoleadtoadeficit;itisalsolikelytohelptheeconomyrecover.Raisingtaxesorcuttingspendingduringarecessionwillalmostcertainlymakeitworse.Herbert Hoover’s insistence on balancing the budget in the face of the GreatDepressionisconsideredtobeoneofthegreatfiscalfolliesofalltime.Ingoodtimes, theopposite is true:Tax revenueswill rise and somekindsof spendingwill fall, leading to a surplus, aswe saw in the late1990s. (Wealso sawhowquickly it disappeared when the economy turned south.) Anyway, there isnothingwrongwithmodestdeficitsandsurplusesaslongastheycoincidewiththebusinesscycle.

Letmeoffertwocaveats,however.First,ifagovernmentrunsadeficit,thenitmustmakeup thedifferencebyborrowingmoney. In thecaseof theUnitedStates,weissuetreasurybonds.Thenationaldebtistheaccumulationofdeficits.Beginningaround2001,theUnitedStateshasbeenconsistentlyspendingmorethanwetakein.Itaddsup.TheU.S.nationaldebthasclimbedfromarecentlowof33percentofGDPin2001toaprojected68percentofGDPby2019.Ifthedebt becomes large enough, investors may begin to balk at the prospect oflendingthegovernmentmoremoney.

Second, there is a finite amount of capital in the world; the more thegovernmentborrows,thelessthatleavesfortherestofus.Largebudgetdeficitscan“crowdout”private investmentbyraisingreal interestrates.AsAmerica’slarge budget deficits began to disappear (temporarily) during the 1990s, oneprofoundlybeneficialeffectwasafallinlong-termrealinterestrates,makingitcheaperforallofustoborrow.

Currentaccountsurplus/deficit.TheU.S. current accountdeficit in2008wasaround$700billion.Isittimetorushtothesupermarkettostockuponcannedgoodsandbottledwater?Maybe.Thecurrentaccountbalance,whichcanbeinsurplusordeficit,reflectsthedifferencebetweentheincomethatweearnfromthe rest of theworld and the income that they earn fromus.The bulk of thatincome comes from trade in goods and services. Thus, our balance of trade,whichagaincanbeinsurplusordeficit,isthelargestcomponentofthecurrent

account.Ifwearerunningatradedeficitwiththerestoftheworld,thenwewillalmostalwaysberunningacurrentaccountdeficit,too.(Forthepurists,theU.S.current account would also include dividends paid to Americans who ownforeignstocks,remittancessenthomebyAmericansworkingoverseas,andothersourcesofincomeearnedabroad.)

Whenthecurrentaccountisindeficit,asoursisnow,itisusuallybecauseacountryisnotexportingenoughto“pay”forallofitsimports.Inotherwords,ifweexport$50billionofgoodsandimport$100billion,ourtradingpartnersaregoing towant something inexchange for thatother$50billionworthof stuff.Wecanpay themoutofoursavings,wecanborrowfromthemto finance thegap, orwe can sell them some of our assets, such as stocks and bonds.As anation,weareconsumingmorethanweareproducing,andwehavetopayforthedifferencesomehow.

Oddly,thiscanbeagoodthing,abadthing—orsomewhereinbetween.Forthe first century ofAmerica’s existence,we ran large current account deficits.Weborrowedheavilyfromabroadsothatwecouldimportgoodsandservicestobuildupourindustrialcapacity.Thatwasagoodthing.Indeed,acurrentaccountdeficit can be a sign of strength as money pours into countries that show apromisingpotentialforfuturegrowth.If,ontheotherhand,acountryissimplyimportingmorethanitexportswithoutmakinginvestmentsthatwillraisefutureoutput, then there is a problem, just as you might have a problem if yousquandered$100,000instudentloanswithoutgettingadegree.Younowhavetopaybackwhatyouborrowed,plus interest,butyouhavedonenothingtoraiseyourfutureincome.Theonlywaytopaybackyourdebtwillbetocutbackonyour future consumption, which is a painful process. Countries that run largecurrent account deficits are not necessarily in financial trouble; on the otherhand, countries that have gotten themselves into financial trouble are usuallyrunninglargecurrentaccountdeficits.

National savings.We all tuckmoney away for our individual needs: college,retirement, etc. Businesses save money, too, by retaining profits rather thanpaying them out to the owners of the firm. Those private savings decisions,alongwiththegovernment’sdecisiontorunadeficitorsurplus,haveaprofoundimpact on our economy. The simple reason is that savings are necessary tofinance investment, and investment is what makes us more productive as asociety.Ifyouput10percentofyourincomeinthebank,thensomewhereelse

in the country thatmoneywill end up building a plant or financing a collegeeducation. If Americans do not collectively put savings in the bank, then wemust either forgo important investments or borrow from abroad. Again, thisassumesthatforeigninvestorsarewillingtolendatareasonablerate,whichmaynot be the case for an economy in a precarious state. Over time, countries’investmentratesshowastrikingcorrelationwiththeirdomesticsavingsrates.

TheU.S. national savings rate tells a cautionary tale. Personal saving fellsteadilyfromover9percentinthe1960sand1970sto6percentinthe1980stobelow 5 percent in themid-1990s to roughly zero by the end of the 1990s.18Whentherecessionhitin2007,thepersonalsavingsratestartedtoclimbagain.Governments (Washington,D.C.,and thestates)havebeenrunningdeficits,or“dissaving.”(U.S.businessesweretheonlyonessettinganymoneyasideuntilhouseholds were shocked into saving by the recession.) We can and haveborrowed from abroad to finance our national investment—at a cost. Nobodylendsmoneyfornothing;borrowingfromabroadmeansthatwemustpaysomeof our investment returns to our foreign lenders.Any countrywith significantexposure to foreign lendersmust alwaysworry thatwhen timesget tough, theherdofinternationalinvestorswillgetspookedandfleewiththeircapital.

Demographics. Americans are getting older, literally. As economist PaulKrugman has noted, the age distribution in America will eventually begin tolook as it does in Florida. That is good for the companies that manufactureshuffleboardequipment.Itisnotsogoodforgovernmentfinances.Thebulkofgovernment benefits, notably Social Security and Medicare, are bestowed onAmericans who are retired. These programs are financed with payroll taxesimposed on younger Americans who are still working. If the ratio of youngAmericans to older Americans begins to change, then the financial health ofprogramslikeSocialSecurityandMedicarebeginstochange,too.

Indeed, we can explain the importance of demographics and fix SocialSecurity all in the next two paragraphs. Social Security is a “pay-as-you-go”program.When American workers pay into Social Security (that large FICAdeduction on your paycheck), themoney does not get invested somewhere sothat you can draw on it twenty or thirty years later, as it would in a privatepension fund.Rather, thatmoney isused topaycurrent retirees.Straight fromyoungPetertooldPaul.Theprogramisonebigpyramidscheme,and,likeanygoodpyramidscheme,itworksfineaslongasthereareenoughworkersonthe

bottomtocontinuepayingtheretireesatthetop.Therein lies the problem.Americans are having fewer children and living

longer.Thisshiftmeansthattherearefewerworkerstopayforeveryretiree—alotfewer.In1960,therewerefiveworkersforeveryretiree.Nowtherearethreeworkers for every retiree. By 2032, there will be only two. Imagine SocialSecurity(orMedicare)asaseesawinwhichpaymentsmadebyworkersareonone side and benefits collected by retirees are on the other. The program issolventas longas theseesawbalances.As thenumberofworkersononesideshrinkswhilethenumberofretireesontheothersidegrows,theseesawbeginsto tip. In theory, fixing the problem is easy.We can take more from currentworkers,eitherbyincreasingthepayrolltaxorbymakingthemmoreproductiveandraisingtheirincomes(sothatthesametaxgeneratesmorerevenues).Orwecan give less to retirees, either by cutting their benefits or by raising theretirementage.Thatistheverysimpleeconomiccruxoftheproblem.Ofcourse,ifyouthinkanyofthesesolutionswouldbepoliticallypalatable,pleasegobackandreadChapter8again.

Totalnationalhappiness.Youdecide.Wedon’thaveanumberforthatoneyet.

AnautoworkerinDetroitwhohasspenthiscareergettinglaidoffformonthsata timeandthencalledbacktoworkisgoingtoaskasimplequestion:Arewegettinganybetteratallofthis?Yes,weare.TheUnitedStateshasgonethroughelevenrecessionssinceWorldWarII.19None,includingtherecessionthatbeganin2007,isevenofthesameorderofmagnitudeastheGreatDepression.From1929to1933,realGDPfellby30percentwhileunemploymentclimbedfrom3percentto25percent.PriortotheGreatDepression,theUnitedStatesregularlyexperienced deep recessions, including financial panics, far worse than whatwe’regoingthroughnow.20Wehaven’tmadetheeconomicbumpsgoaway,buttheyaresmallerbumps.

Onecanalsoarguethatwhatwe’velearnedfrompasteconomicdownturns,andtheGreatDepressioninparticular,hashelpedwithpoliciesthistimearound.Fedchairman(andformerPrincetonprofessor)BenBernankeisascholaroftheGreat Depression. So is Obama’s chair of the Council of Economic Advisers(and formerUCBerkeley professor) ChristinaRomer. I can promise you that

economists will still be arguing fifty years from now about what should orshouldn’thavebeendoneinresponsetotherecessionandsubsequentfinancialcrisis.However,eventhetoughestcriticsshouldconcedethatofficialsattheendof the Bush administration and the beginning of the Obama administrationavoided the worst mistakes of the 1930s, when the Federal Reserve raisedinterest rates in the face of theGreatDepression andCongress raised taxes—thrustingbothmonetaryandfiscalpolicyinthewrongdirection.

There is something to be said for not doing exactly the wrong thing. Isuspecthistorywilljudgethatpolicymakersdidevenbetterthanthat.

CHAPTER10

TheFederalReserve:

Whythatdollarinyourpocketismorethanjustapieceofpaper

Sometimessimplestatementsspeakloudly.OnSeptember11,2001,hoursafterthe terrorist attacks on the United States, the Federal Reserve issued thefollowing statement: “TheFederalReserveSystem isopenandoperating.Thediscountwindowisavailabletomeetliquidityneeds.”

Those terse and technical two sentences had a calming effect on globalmarkets. The following Monday, as America’s markets opened for their firsttrading sessions after the attack, the Federal Reserve cut interest rates by 0.5percent, another act that moderated the financial and economic impact of theterroristassaults.

Howexactlydoesanineleganttwo-sentencestatementhavesuchaprofoundeffectontheworld’slargesteconomy—indeed,onthewholeglobaleconomy?

The Federal Reserve has tools with more direct impact on the globaleconomy than any other institution in theworld, public or private.During theeconomic crisis that began to unfold in 2007, the Federal Reserve usedeverythinginthattoolkit—andthenacquiredsomenewgadgets—towrestlethefinancialsystembackfromthebrinkofpanic.Sincethen,somehavecriticizedthe Fed and its chairman, Ben Bernanke, for doing too much; some havecriticized theFed for doing too little.Everyone agrees thatwhat theFeddoesmattersenormously.

From where does the Federal Reserve, an institution that is not directlyaccountabletothevotingpublic,derivesuchpower?AndhowdoesthatpoweraffectthelivesofeverydayAmericans?Theanswertoallthosequestionsisthesame:TheFederalReservecontrols themoney supplyand therefore thecredittapfortheeconomy.Whenthattapisopenwide,interestratesfallandwespendmorefreelyonthingsthatrequireborrowedmoney—everythingfromnewcarsto new manufacturing plants. Thus, the Fed can use monetary policy to

counteracteconomicdownturns(orprevent theminthefirstplace).Anditcaninject money into the financial system after sudden shocks, such as the 1987stockmarketcrashortheterroristattacksofSeptember11ortheburstingoftheAmericanrealestatebubble,whenconsumersandfirmsmightotherwisefreezein place and stop spending.Or the Fed can tighten the tap by raising interestrates.When the cost of borrowed funds goes up, our spending slows. It is anawesome power. PaulKrugman oncewrote, “If youwant a simplemodel forpredictingtheunemploymentrateintheUnitedStatesoverthenextfewyears,hereitis:ItwillbewhatGreenspanwantsittobe,plusorminusarandomerrorreflecting the fact that he is not quite God.” The same is now true of BenBernanke.

God does not have to manage by committee; Ben Bernanke does. TheFederalReserveSystemismadeupoftwelveReserveBanksspreadacrossthecountry and a seven-person board of governors based in Washington. BenBernankeischairmanoftheboardofgovernors—he’sthe“Fedchairman.”TheFederal Reserve regulates commercial banks, supports the bankinginfrastructure,andgenerallymakes theplumbingof thefinancialsystemwork.Thosejobsrequirecompetence,notgeniusorgreatforesight.Monetarypolicy,the Federal Reserve’s other responsibility, is different. It might reasonably bedescribedastheeconomicequivalentofbrainsurgery.Economistsdonotagreeon how theFederalReserve ought tomanage ourmoney supply.Nor do theyevenagreeonexactlyhoworwhychangesinthemoneysupplyhavetheeffectsthattheydo.Yeteconomistsdoagreethateffectivemonetarypolicymatters;theFedmustfeedjusttherightamountofcredittotheeconomytokeepitgrowingsteadily. Getting it wrong can have disastrous consequences. RobertMundell,winnerofthe1999NobelPrizeinEconomics,hasarguedthatbungledmonetarypolicy in the 1920s and 1930s caused chronic deflation that destabilized theworld.Hehasargued,“Hadthepriceofgoldbeenraisedinthelate1920s,or,alternatively, had the major central banks pursued policies of price stabilityinstead of adhering to the gold standard, there would have been no GreatDepression,noNazirevolution,andnoWorldWarII.”1

The jobwouldnotappear tobe thatcomplicated. If theFedcanmake theeconomygrowfasterbyloweringinterestrates,thenpresumablylowerinterestratesarealwaysbetter.Indeed,whyshouldtherebeanylimittotherateatwhichthe economy can grow? If we begin to spendmore freelywhen rates are cutfrom7percentto5percent,whystopthere?Iftherearestillpeoplewithoutjobsandotherswithoutnewcars,thenlet’spressonto3percent,oreven1percent.

Newmoneyforeveryone!Sadly,therearelimitstohowfastanyeconomycangrow. If low interest rates, or “easy money,” causes consumers to demand 5percentmorenewPTCruisersthantheypurchasedlastyear,thenChryslermustexpand production by 5 percent. Thatmeans hiringmoreworkers and buyingmoresteel,glass,electricalcomponents,etc.Atsomepoint,itbecomesdifficultor impossible for Chrysler to find these new inputs, particularly qualifiedworkers.Atthatpoint,thecompanysimplycannotmakeenoughPTCruiserstosatisfy consumer demand; instead, the company begins to raise prices.Meanwhile,autoworkersrecognize thatChrysler isdesperatefor labor,andtheuniondemandshigherwages.

The story does not stop there. The same thing would be happeningthroughout theeconomy,not justatChrysler. If interest ratesareexceptionallylow, firms will borrow to invest in new computer systems and software;consumers will break out their VISA cards for big-screen televisions andCaribbeancruises—alluptoapoint.WhenthecruiseshipsarefullandDellisselling every computer it can produce, then those firmswill raise their prices,too. (Whendemand exceeds supply, firms can chargemore and still fill everyboat or sell every computer.) In short, an “easymoney”policy at theFed cancauseconsumerstodemandmorethantheeconomycanproduce.Theonlywaytorationthatexcessdemandiswithhigherprices.Theresultisinflation.

ThestickerpriceonthePTCruisergoesup,andnooneisbetteroffforit.True,Chrysleristakinginmoremoney,butitisalsopayingmoretoitssuppliersandworkers.Thoseworkersareseeinghigherwages,but theyarealsopayinghigherprices for theirbasicneeds.Numbersarechangingeverywhere,but theproductive capacity of our economy and the measure of our well-being, realGDP,hashitthewall.Oncestarted,theinflationarycycleishardtobreak.Firmsand workers everywhere begin to expect continually rising prices (which, inturn,causescontinuallyrisingprices).Welcometothe1970s.

Thepace atwhich the economycangrowwithout causing inflationmightreasonablybeconsidereda“speedlimit.”Afterall, thereareonlyahandfulofways to increase the amount that we as a nation can produce.We can worklonger hours. We can add new workers, through falling unemployment orimmigration (recognizing that theworkersavailablemaynothave the skills indemand).Wecanaddmachinesandotherkindsofcapitalthathelpustoproducethings. Or we can become more productive—produce more with what wealreadyhave,perhapsbecauseofaninnovationoratechnologicalchange.Eachofthesesourcesofgrowthhasnaturalconstraints.Workersarescarce;capitalis

scarce;technologicalchangeproceedsatafiniteandunpredictablepace.Inthelate1990s,Americanautoworkersthreatenedtogoonstrikebecausetheywerebeingforcedtoworktoomuchovertime.(Don’twewishwehadthatproblemnow…)Meanwhile,fast-foodrestaurantswereofferingsigningbonusestonewemployees.Wewereat thewall.Economistsreckonthat thespeedlimitof theAmericaneconomyissomewhereintherangeof3percentgrowthperyear.

Thephrase“somewhereintherange”givesyouthefirstinklingofhowhardthe Fed’s job is. The Federal Reserve must strike a delicate balance. If theeconomygrowsmoreslowlythanitiscapableof,thenwearewastingeconomicpotential.PlantsthatmakePTCruiserssitidle;theworkerswhomighthavejobsthere are unemployed instead.An economy that has the capacity to growat 3percentinsteadlimpsalongat1.5percent,orevenslipsintorecession.Thus,theFedmustfeedenoughcredittotheeconomytocreatejobsandprosperitybutnotsomuchthat theeconomybeginstooverheat.WilliamMcChesneyMartin,Jr.,FederalReservechairmanduringthe1950sand1960s,oncenotedthattheFed’sjobistotakeawaythepunchbowljustasthepartygetsgoing.

Or sometimes theFedmust rein in the party long after it has gone out ofcontrol.TheFederalReservehasdeliberatelyengineeredanumberofrecessionsinordertosqueezeinflationoutofthesystem.Mostnotably,FedchairmanPaulVolcker was the ogre who ended the inflationary party of the 1970s. At thatpoint, naked people were dancing wildly on the tables. Inflation had climbedfrom3percent in 1972 to 13.5percent in 1980.Mr.Volcker hit themonetarybrakes,meaning that he cranked up interest rates to slow the economy down.Short-term interest rates peaked at over 16 percent in 1981. The result was apainfulunwindingoftheinflationarycycle.Withinterestratesindoubledigits,there were plenty of unsold Chrysler K cars sitting on the lot. Dealers wereforcedtocutprices(orstopraisingthem).Theautocompaniesidledplantsandlaidoffworkers.Theautoworkerswhostillhadjobsdecidedthatitwouldbeabadtimetoaskformoremoney.

The same thing, of course, was going on in every other sector of theeconomy. Slowly, and at great human cost, the expectation that prices wouldsteadilyrisewaspurgedfromthesystem.Theresultwastherecessionof1981–1982, during which GDP shrank by 3 percent and unemployment climbed tonearly10percent.Intheend,Mr.Volckerdidclearthedancersoffthetables.By1983,inflationhadfallento3percent.Obviouslyitwouldhavebeeneasierandlesspainfulifthepartyhadnevergoneoutofcontrolinthefirstplace.

WheredoestheFedderivethisextraordinarypoweroverinterestrates?Afterall,commercial banks are private entities. The Federal Reserve cannot forceCitibanktoraiseorlowertheratesitchargesconsumersforautoloansandhomemortgages.Rather,theprocessisindirect.RecallfromChapter7thattheinterestrate is really just a rental rate for capital, or the “price of money.” The FedcontrolsAmerica’smoneysupply.We’llgettothemechanicsofthatprocessinamoment. For now, recognize that capital is no different from apartments: Thegreaterthesupply,thecheapertherent.TheFedmovesinterestratesbymakingchanges in the quantity of funds available to commercial banks. If banks areawashwithmoney,theninterestratesmustberelativelylowtoattractborrowersfor all the available funds.When capital is scarce, the opposite will be true:Bankscanchargehigherinterestratesandstillattractenoughborrowersforallavailablefunds.It’ssupplyanddemand,withtheFedcontrollingthesupply.

Thesemonetarydecisions—thedeterminationwhetherinterestratesneedtogoup,down,orstaythesame—aremadebyacommitteewithintheFedcalledthe FederalOpenMarketCommittee (FOMC),which consists of the board ofgovernors, the president of the Federal Reserve Bank of New York, and thepresidents of four other Federal Reserve Banks on a rotating basis. The Fedchairman is also thechairmanof theFOMC.BenBernankederiveshispowerfromthefact thathe issittingat theheadof the tablewhen theFOMCmakesinterestratedecisions.

If the FOMC wants to stimulate the economy by lowering the cost ofborrowing, thecommitteehas twoprimarytoolsat itsdisposal.Thefirst is thediscountrate,whichis theinterestrateatwhichcommercialbankscanborrowfundsdirectlyfromtheFederalReserve.TherelationshipbetweenthediscountrateandthecostofborrowingatCitibankisstraightforward;whenthediscountratefalls,bankscanborrowmorecheaplyfromtheFedandthereforelendmorecheaplytotheircustomers.Thereisonecomplication.BorrowingdirectlyfromtheFedcarriesacertainstigma;itimpliesthatabankwasnotabletoraisefundsprivately.Thus,turningtotheFedforaloanissimilartoborrowingfromyourparentsafteraboutagetwenty-five:You’llgetthemoney,butit’sbettertolooksomewhereelsefirst.

Instead, banks generally borrow from other banks. The second importanttool in theFed’smoneysupplykit is thefederalfundsrate, therate thatbankscharge other banks for short-term loans. The Fed cannot stipulate the rate at

whichWellsFargolendsmoneytoCitigroup.Rather,theFOMCsetsatargetforthefederalfundsrate,say4.5percent,andthenmanipulatesthemoneysupplytoaccomplishitsobjective.Ifthesupplyoffundsgoesup,thenbankswillhavetodrop their prices—lower interest rates—to find borrowers for the new funds.Onecanthinkofthemoneysupplyasafurnacewiththefederalfundsrateasitsthermostat.IftheFOMCcutsthetargetfedfundsratefrom4.5percentto4.25percent, then the Federal Reserve will pump money into the banking systemuntil the rate Wells Fargo charges Citigroup for an overnight loan falls tosomethingverycloseto4.25percent.

All of which brings us to our final conundrum: How does the FederalReserveinjectmoneyintoaprivatebankingsystem?DoesBenBernankeprint$100millionofnewmoney,loaditintoaheavilyarmoredtruck,anddriveittoaCitibankbranch?Notexactly—thoughthatimageisnotabadwaytounderstandwhatdoeshappen.

BenBernanke and theFOMCdo create newmoney. In theUnitedStates,theyalonehavethatpower.(TheTreasurymerelymintsnewcurrencyandcoinsto replace money that already exists.) The Federal Reserve does deliver newmoney tobanks likeCitibank.But theFeddoesnotgive funds to thebank; ittradesthenewmoneyforgovernmentbondsthatthebankscurrentlyown.Inourmetaphorical example, the Citibank branch manager meets Ben Bernanke’sarmored truck outside the bank, loads $100 million of new money into thebank’s vault, and then hands the Fed chairman $100 million in governmentbondsfromthebank’sportfolioinreturn.NotethatCitibankhasnotbeenmadericherbythetransaction.Thebankhasmerelyswapped$100millionofonekindof asset (bonds) for $100million of a different kind of asset (cash, or, moreaccurately,itselectronicequivalent).

Banksholdbondsfor thesamereasonindividual investorsdo;bondsareasafe place to park funds that aren’t needed for something else. Specifically,banks buy bondswith depositors’ funds that are not being loaned out. To theeconomy, the fact that Citibank has swapped bonds for cash makes all thedifference.When a bank has $100million of deposits parked in bonds, thosefundsarenotbeingloanedout.Theyarenotfinancinghouses,orbusinesses,ornew plants. But afterBenBernanke’smetaphorical armored truck pulls away,Citibankisleftholdingfundsthatcanbeloanedout.Thatmeansnewloansforall thekindsof things thatgenerateeconomicactivity. Indeed,money injectedinto the banking system has a cascading effect. A bank that swaps bonds formoneyfromtheFedkeepssomefractionofthefundsinreserves,asrequiredby

law,andthenloansouttherest.Whoeverreceivesthoseloanswillspendthemsomewhere, perhaps at a car dealership or a department store. That moneyeventuallyendsup inotherbanks,whichwillkeep some funds in reserveandthenmakeloansoftheirown.AmovebytheFedtoinject$100millionofnewfundsintothebankingsystemmayultimatelyincreasethemoneysupplyby10timesasmuch.

Of course, the Fed chairman does not actually drive a truck to aCitibankbranchtoswapcashforbonds.TheFOMCcanaccomplishthesamethingusingthebondmarket(whichworksjustlikethestockmarket,exceptthatbondsarebought and sold).Bond tradersworkingonbehalf of theFedbuybonds fromcommercial banks and pay for them with newly created money—funds thatsimplydidnotexisttwentyminutesearlier.(Presumablythebankssellingtheirbondswill be thosewith themost opportunities tomakenew loans.)TheFedwill continue to buy bonds with new money, a process called open marketoperations,untilthetargetfederalfundsratehasbeenreached.

ObviouslywhattheFedgiveth,theFedcantakeaway.TheFederalReservecanraiseinterestratesbydoingtheoppositeofeverythingwe’vejustdiscussed.TheFOMCwouldvotetoraisethediscountrateand/orthetargetfedfundsrateandissueanordertosellbondsfromitsportfoliotocommercialbanks.Asbanksgiveuplendablefundsinexchangeforbonds,themoneysupplyshrinks.Moneythatmighthavebeenloanedouttoconsumersandbusinessesisparkedinbondsinstead. Interest rates go up, and anything purchased with borrowed capitalbecomesmoreexpensive.Thecumulativeeffectisslowereconomicgrowth.

Themechanicsof theFed’shandiworkshouldnotobscure thebigpicture.TheFederalReserve’smandateistofacilitateasustainablepaceofeconomicgrowth.Butlet’sclarifyhowdifficultthatjobreallyis.First,weareonlyguessingattherate at which the economy can expand without igniting inflation. One debateamong economists is over whether or not computers and other kinds ofinformationtechnologyhavemadeAmericanssignificantlymoreproductive.Ifso,asMr.Greenspansuggestedduringhistenure,thentheeconomy’spotentialgrowth rate may have gone up. If not, as other economists have arguedconvincingly,thentheoldspeedlimitstillapplies.Obviouslyitishardtoabidebyaspeedlimitthatisnotclearlyposted.

Butthatisonlythefirstchallenge.TheFedmustalsoreckonwhatkindofimpact a change in interest rates will have and how long it will take.Will a

quarter-pointratecutcausetwelvepeopletobuynewPTCruisersinDesMoinesor421?When?Nextweekorsixmonthsfromnow?Meanwhile,theFedhasthemostcontrolovershort-terminterestrates,whichmayormaynotmovein thesamedirectionaslong-termrates.Whycan’tBenBernankeworkhismagiconlong-term rates, too? Because long-term rates do not depend on the moneysupplytoday;theydependonwhatthemarketspredictmoneysupply(relativetodemand)willbeten,twenty,oreventhirtyyearsfromnow.BenBernankehasnocontrol over themoney supply in 2015.Also remember thatwhile the Fed istryingtousemonetarypolicytohitaparticulareconomictarget,Congressmaybedoingthingswithfiscalpolicy—governmentdecisionsontaxesandspending—that have a different effect entirely (or have the same effect, causing Fedpolicytoovershoot).

Solet’sstickwithourspeedlimitanalogyandrecapwhatexactlytheFedischargedwith doing.TheFedmust facilitate a rate of economicgrowth that isneithertoofastnortooslow.Bearinmind:(1)Wedonotknowtheeconomy’sexact speed limit. (2) Both the accelerator and the brake operate with a lag,meaningthatneitherworksimmediatelywhenwepressonit.Instead,wehavetowaitawhileforaresponse—anywherefromafewweekstoafewyears,butnot with any predictable pattern. An inexperienced driver might pressprogressively harder on the gas, wondering why nothing is happening (andenduring all kinds of public assaults on his pathetically slowdriving), only tofindthecarscreamingoutofcontrolninemonthslater.(3)Monetaryandfiscalpolicyaffecttheeconomyindependently,sowhiletheFedisgentlyapplyingthebrake, Congress and the president may be jumping up and down on theaccelerator.OrtheFedmaytapontheacceleratoreversoslightlyonlytohaveCongressweigh it downwith a brick. (4)Last, there is theobstacle courseofworldevents—afinancialcollapsehere,aspikeinthepriceofoilthere.Thinkofthe Fed as always driving in unfamiliar terrain with a map that’s at least tenyearsoutofdate.

BobWoodward’s biography ofAlanGreenspanwas titledMaestro. In the1990s, as the American economy roared through its longest expansion ineconomichistory,Mr.Greenspanwasgivencreditforhis“Goldilocks”approachtomonetarypolicy—doingeverythingjustright.Thatreputationhassincecomepartiallyunraveled.Mr.Greenspanisnowcriticizedforabettingthehousingandstock market bubbles by keeping interest rates too low for too long. “Cheapmoney” didn’t cause inflation by sending everyone to buy PT Cruisers andCaribbean cruises. Instead we bought stocks and real estate, and those rising

assetpricesdidn’tshowupintheconsumerpriceindex.Addonenewchallengetomonetary policy:Wewere speeding even though the gaugeswe’re used tolookingatsaidweweren’t.

It’sahard job.Still, thatconclusion isa longwayfromNobel laureateRobertMundell’s dire claim that badmonetary policy laid the groundwork forWorldWarII.Tounderstandwhyirresponsiblemonetarypolicycanhavecataclysmiceffects, we must first make a short digression on the nature of money. Toeconomists,money is quite distinct fromwealth.Wealth consists of all thingsthathavevalue—houses,cars,commodities,humancapital.Money,atinysubsetofthatwealth,ismerelyamediumofexchange,somethingthatfacilitatestradeandcommerce.Intheory,moneyisnotevennecessary.Asimpleeconomycouldgetalongthroughbarteralone.Inabasicagriculturalsociety,it’seasyenoughtoswap five chickens for a newdress or to pay a schoolteacherwith a goat andthree sacks of rice.Barterworks lesswell in amore advanced economy. Thelogistical challenges of using chickens to buy books at Amazon would beformidable.

In nearly every society, some kind of money has evolved to make tradeeasier.(Theword“salary”comesfromthewagespaidtoRomansoldiers,whowerepaidinsacksofsal—salt.)Anymediumofexchange—whetheritisagoldcoin, a whale tooth, or an American dollar—serves the same basic purposes.First, it serves as ameans of exchange, so that Imight enjoy pork chops fordinner tonight even though the butcher has no interest in buying this book.Second,itservesasaunitofaccount,sothatthecostofallkindsofgoodsandservicescanbemeasuredandcomparedusingonescale.(Imaginelifewithoutaunitofaccount:TheGapissellingjeansforthreechickensapairwhileTommyHilfiger has similar pants on sale for eleven beaver pelts. Which pants costmore?)Third,moneymust beportable anddurable.Neither bowlingballs norrosepetalswould serve thepurpose.Last,moneymust be relatively scarce sothatitcanserveasastoreofvalue.

Cleverpeoplewillalwaysfindamediumofexchangethatworks.Cigaretteslong served as themedium of exchange in prisons, where cash is banned. (Itdoesn’tmatterwhetheryousmoke;cigaretteshavevalueaslongasenoughotherinmates smoke.)Sowhathappenedwhensmokingwasbanned inU.S. federalprisons? Inmates turned to another portable, durable store of value: cans ofmackerel.AccordingtotheWallStreetJournal,asinglecanofmackerel,or“the

mack”isthestandardunitofcurrencybehindbars.(Someprisonshavemovedfromcanstoplasticpouches,becausethecanscanbefashionedintoweapons.)In a can or pouch,mackerel doesn’t spoil, it can be bought on account in thecommissary,and itcostsaboutadollar,making theaccountingeasy.AhaircutcoststwomacksintheLompocFederalCorrectionalComplex.2

For much of American history, commerce was conducted with papercurrencybackedbypreciousmetals.Priortothetwentiethcentury,privatebanksissued their ownmoney. In 1913, theU.S. government banned privatemoneyand became the sole provider of currency. The basic idea did not change.Whethermoneywaspublicorprivate,papercurrencyderiveditsvaluefromthefactthatitcouldberedeemedforasetquantityofgoldorsilver,eitherfromabankor from thegovernment.Then something strangehappened. In1971, theUnitedStatespermanentlywentoffthegoldstandard.Atthatpoint,everypaperdollarbecameredeemablefor…nothing.

Examinethatwadof$100billsinyourwallet.(Ifnecessary,$1billscanbesubstituted instead.) Those bills are just paper. You can’t eat them, you can’tdrinkthem,youcan’tsmokethem,and,mostimportant,youcan’ttakethemtothe government and demand anything in return. They have no intrinsic value.And that is true of nearly all theworld’s currencies. Left alone on a desertedisland with $100 million, you would quickly perish. On the other hand, lifewouldbegood ifyouwere rescuedandcould take thecashwithyou.Thereinliesthevalueofmoderncurrency:Ithaspurchasingpower.Dollarshavevaluebecausepeoplepeddlingrealthings—food,books,pedicures—willacceptthem.Andpeoplepeddling real thingswill acceptdollarsbecause theyareconfidentthatotherpeoplepeddlingotherreal thingswillaccept them,too.Adollar isapieceofpaperwhosevaluederivessolelyfromourconfidence thatwewillbeabletouseittobuysomethingweneedinthefuture.

To give you some sense of how modern money is a confidence game,considerabizarrephenomenoninIndia.MostIndiansinvolvedincommerce—shopkeepers,taxidrivers,etc.—willnotacceptatorn,crumpled,oroverlysoiledrupee note. Since other Indians know thatmany of their countrymenwill notaccepttornnotes,theywillnotacceptthemeither.Finally,whentouristsarrivein thecountry, theyquickly learn toacceptonly intactbills, lest theybe stuckwith the torn ones. The whole process is utterly irrational, since the IndianCentralBankconsidersanynotewithaserialnumber—torn,dirty,crumpled,orotherwise—tobelegaltender.Anybankwillexchangetornrupeesforcrispnewones. That doesn’t matter; rational people refuse legal tender because they

believe that it might not be accepted by someone else. The whole bizarrephenomenonunderscores thefact thatour faith inpapercurrency ispredicatedonthefaiththatothersplaceinthesamepaper.

Since paper currency has no inherent worth, its value depends on itspurchasing power—something that can change gradually over time, or evenstunninglyfast.Inthesummerof1997,IspentafewdaysdrivingacrossIowa“taking the pulse of the American farmer” for The Economist. SomewhereoutsideofDesMoines,Ibeganchattingwithacorn,soybean,andcattlefarmer.Ashegavemeatourofhisfarm,hepointedtoanoldtractorparkedoutsidethebarn. “That tractor cost $7,500new in 1970,” he said. “Now look at this,” hesaidangrily,pointingtoashinynewtractorrightnexttotheoldone.“Costme$40,000.Canyouexplainthat?”*

I could explain that, though that’s not what I told the farmer, who wasalreadysuspiciousofthefactthatIwasyoung,fromthecity,wearingatie,anddrivingaHondaCivic.(Thefollowingyear,whenIwasaskedtowriteasimilarstoryonKentuckytobaccofarmers,Ihadthegoodsensetorentapickuptruck.)My answer would have been one word: inflation. The new tractor probablywasn’t anymore expensive than the old tractor in real terms,meaning that hehadtodothesameamountofwork,orless,inordertobuyit.Thestickerpriceonhistractorhadgoneup,butsohadthepricesatwhichhecouldsellhiscropsandcattle.

Inflationmeans, quite simply, that average prices are rising. The inflationrate,or thechangeintheconsumerpriceindex, is thegovernment’sattempttoreflect changing priceswith a single number, say 4.2 percent. Themethod ofdetermining this figure is surprisingly low-tech; government officialsperiodically check the prices of thousands and thousands of goods—clothes,food, fuel, entertainment, housing—and then compile them into a number thatreflectshowthepricesofabasketofgoodspurchasedbytheaverageconsumerhaschanged.

Themostinstructivewaytothinkaboutinflationisnotthatpricesaregoingup,butrather that thepurchasingpowerof thedollar isgoingdown.Adollarbuys less than itused to.Therein lies the linkbetweentheFederalReserve,orany central bank, and economic devastation.A paper currency has value onlybecauseitisscarce.Thecentralbankcontrolsthatscarcity.Thereforeacorruptorincompetentcentralbankcanerode,orevencompletelydestroy,thevalueofourmoney.Supposeprisonofficials,inafitofgoodwill,decidedtogiveeveryinmate500cansofmackerel.Whatwouldhappentothepriceofaprisonhaircut

in “macks”? And mackerel is better than paper, in that it at least has someintrinsicvalue.

In1921,aGermannewspapercostroughlyathirdofamark;twoyearslater,a newspaper cost 70 million marks. It was not the newspaper that changedduring that spell; itwas theGermanmark,whichwas rendered useless as thegovernment printed newoneswith reckless abandon. Indeed, themark lost somuchvaluethatitbecamecheaperforhouseholdstoburnthemthantousethemtobuyfirewood.InflationwassobadinLatinAmerica in the1980sthat therewerecountrieswhoselargestimportbecamepapercurrency.3Inthelate1990s,theBelarussianrublewasknownasthe“bunny,”notonlyforthehareengravedonthenotebutalsoforthecurrency’sremarkableabilitytopropagate.InAugust1998,theBelarussianrublelost10percentofitspurchasingpowerinoneweek.

Massive inflationdistorts the economymassively.Workers rush to spend theircashbeforeitbecomesworthless.Acultureemergesinwhichworkersrushoutto spend theirpaychecksat lunchbecausepriceswillhavegoneupbydinner.Fixed-rateloansbecomeimpossiblebecausenofinancialinstitutionwillagreetobe repaid a fixed quantity ofmoneywhen thatmoney is at risk of becomingworthless. Think about it: Anyone with a fixed-rate mortgage in Germany in1921couldhavepaidoffthewholeloanin1923withfewermarksthanitcosttobuy a newspaper. Even today, it is not possible to get a thirty-year fixedmortgage inmuch of LatinAmerica because of fears that inflationwill comeroaringback.

Americahasneversufferedhyperinflation.Wehavehadboutsofmoderateinflation;thecostsweresmallerandmoresubtlebutstillsignificant.Atthemostbasic level, inflation leads tomisleadingor inaccuratecomparisons.Journalistsrarelydistinguishbetween realandnominal figures,as theyought to.Supposethat American incomes rose 5 percent last year. That is a meaningless figureuntil we know the inflation rate. If prices rose by 7 percent, then we haveactuallybecomeworseoff.Ourpaycheckmaylookbiggerbutitbuys2percentfewer goods than it did last year. Hollywood is an egregious offender,proclaimingsummerafter summer that somemediocre filmhas set anewboxofficerecord.Comparinggrossreceiptsin2010togrossreceiptsin1970or1950isasillyexerciseunlesstheyareadjustedforinflation.AtickettoGonewiththeWindcost19cents.AtickettoDude,Where’sMyCar?cost$10.Ofcoursethegrossreceiptsaregoingtolookbigbycomparison.

Evenmoderateinflationhasthepotentialtoeatawayatourwealthifwedonotmanage our assets properly.Anywealth held in cashwill lose value overtime. Even savings accounts and certificates of deposit, which are considered“safe” investments because the principal is insured, are vulnerable to the lessobviousrisk that their lowinterestratesmaynotkeepupwith inflation.It isasadironythatunsophisticatedinvestorseschewthe“risky”stockmarketonlytohave their principal whittled away through the back door. Inflation can beparticularly pernicious for individuals who are retired or otherwise living onfixed incomes. If that income is not indexed for inflation, then its purchasingpowerwillgradually fadeaway.Amonthlycheck thatmadeforacomfortablelivingin1985becomesinadequatetobuythebasicnecessitiesin2010.

Inflationalsoredistributeswealtharbitrarily.SupposeIborrow$1,000fromyou and promise to pay back the loan, plus interest of $100, next year. Thatseemsafairarrangementforbothofus.Nowsupposethatawildlyirresponsiblecentralbankerallowsinflationtoexplodeto100percentayear.The$1,100thatI pay back to you next year will be worth much less than either of us hadexpected; itspurchasingpowerwillbecut inhalf. In real terms, Iwillborrow$1,100fromyouandpayback$550.Unexpectedboutsofinflationaregoodfordebtorsandbadforlenders—acrucialpointthatwewillcomebackto.

As a side note, you should recognize the difference between real andnominal interest rates.Thenominal rate is used to calculatewhat youhave topayback; it’s thenumberyou seepostedon thebankwindoworon the frontpage of a loan document. If Wells Fargo is paying a rate of 2.3 percent onchecking deposits, that’s the nominal rate. This rate is different from the realinterest rate, which takes inflation into account and therefore reflects the truecostof“renting”capital.Therealinterestrateisthenominalrateminustherateofinflation.Asasimpleexample,supposeyoutakeoutabankloanforoneyearatanominal rateof5percent,and that inflation isalso5percent thatyear. Insuchacase,yourrealrateofinterestiszero.Youpayback5percentmorethanyouborrowed,but thevalueof thatmoneyhasdepreciated5percentover thecourseoftheyear,sowhatyoupaybackhasexactlythesamepurchasingpoweraswhatyouborrowed.Thetruecosttoyouofusingsomeoneelse’scapitalforayeariszero.

Inflationalsodistortstaxes.Takethecapitalgainstax,forexample.Supposeyou buy a stock and sell it a year later, earning a 10 percent return. If theinflation ratewas also10percent over that period, thenyouhavenot actuallymadeanymoney.Your returnexactlyoffsets the fact that everydollar inyour

portfoliohaslost10percentofitspurchasingpower—apointlostonUncleSam.You owe taxes on your 10 percent “gain.” Taxes are unpleasantwhen you’vemademoney;theyreallystinkwhenyouhaven’t.

Having said all that, moderate inflation, were it a constant or predictablerate, would have very little effect. Suppose, for example, that we knew theinflationratewouldbe10percentayearforever—nohigher,nolower.Wecoulddealwiththateasily.Anysavingsaccountwouldpaysomerealrateofinterestplus10percenttocompensateforinflation.Oursalarieswouldgoup10percenta year (plus, we would hope, some additional sum based onmerit). All loanagreements would charge some real rental rate for capital plus a 10 percentannualpremiumtoaccountforthefactthatthedollarsyouareborrowingarenotthesameasthedollarsyouwillbepayingback.Governmentbenefitswouldbeindexedforinflationandsowouldtaxes.

Butinflationisnotconstantorpredictable.Indeed,theauraofuncertaintyisoneofitsmost insidiouscosts.Individualsandfirmsareforcedtoguessaboutfuture priceswhen theymake economic decisions.When the autoworkers andFordnegotiateafour-yearcontract,bothsidesmustmakesomeestimatesaboutfutureinflation.Acontractwithannualraisesof4percentisverygenerouswhenthe inflation rate is 1percent but a lousydeal forworkers if the inflation rateclimbsto10percent.Lendersmustmakeasimilarcalculation.Lendingsomeonemoney for thirty years at a fixed rate of interest carries a huge risk in aninflationaryenvironment.Sowhen lenders fear future inflation, theybuild inabuffer.Thegreaterthefearofinflation,thebiggerthebuffer.Ontheotherhand,if a central bank proves that it is serious about preventing inflation, then thebuffer gets smaller. One of themost significant benefits of the persistent lowinflationofthe1990swasthatlendersbecamelessfearfuloffutureinflation.Asa result, long-term interest ratesdropped sharply,makinghomesandotherbigpurchasesmoreaffordable.RobertBarro,aHarvardeconomistwhohasstudiedeconomic growth in nearly one hundred countries over several decades, hasconfirmedthatsignificantinflationisassociatedwithslowerrealGDPgrowth.

It seems obvious enough that governments and central bankswouldmakefighting inflationapriority.Even if theymadehonestmistakes trying todrivetheireconomiesatthe“speedlimit,”wewouldexpectsmallburstsofinflation,not prolonged periods of rising prices, let alone hyperinflation.Yet that is notwhatweobserve.Governments,richandpooralike,havedriventheireconomiesnot just faster than the speed limit, but at engine-smoking, wheels-screechingkindsofspeeds.Why?Becauseshortsighted,corrupt,ordesperategovernments

canbuythemselvessometimebystokinginflation.Wespokeaboutthepowerofincentivesall thewaybackinChapter2.Still,seeifyoucanpiecethispuzzletogether:(1)Governmentsoftenowelargedebts,andtroubledgovernmentsoweevenmore; (2) inflation isgood fordebtorsbecause it erodes thevalueof themoneytheymustpayback;(3)governmentscontroltheinflationrate.Additup:Governmentscancuttheirowndebtsbypullingtheinflationripcord.

Ofcourse,thiscreatesallkindsofvictims.Thosewholentthegovernmentmoneyarepaidback the facevalueof thedebtbut in a currency thathas lostvalue. Meanwhile, those holding currency are punished because their moneynowbuysmuch less.And last, even future citizens are punished, because thisgovernmentwill find itdifficultor impossible toborrowat reasonable interestrates again (though bankers do show an odd proclivity to make the samemistakesoverandoveragain).

Governmentscanalsobenefitintheshortrunfromwhateconomistsrefertoas the“inflation tax.”Supposeyouare runningagovernment that isunable toraise taxes through conventional means, either because the infrastructurenecessarytocollecttaxesdoesnotexistorbecauseyourcitizenscannotorwillnot paymore.Yet you have governmentworkers, perhaps even a large army,whodemandtobepaid.Hereisaverysimplesolution.Buysomebeer,orderapizza(orwhateveranappropriatenationaldishmightbe),andbeginrunningtheprinting presses at the national mint. As soon as the ink is dry on your newpesos, or rubles, or dollars, use them to pay your government workers andsoldiers.Alas,youhavetaxedthepeopleofyourcountry—indirectly.Youhavenot physically taken money from their wallets; instead, you’ve done it bydevaluingthemoneythatstaysintheirwallets.TheContinentalCongressdiditduring the Revolutionary War; both sides did it during the Civil War; theGermangovernmentdiditbetweenthewars;countrieslikeZimbabwearedoingitnow.

Agovernment doesnot have to beon thebrinkof catastrophe to play theinflationcard.Eveninpresent-dayAmerica,cleverpoliticianscanusemoderateinflation to their benefit.One feature of irresponsiblemonetary policy—like apartyheadedoutofcontrol—is that itcanbefunforawhile. In theshort run,easymoneymakeseveryonefeelricher.WhenconsumersflocktotheChryslerdealershipinDesMoines, theowner’sfirstreactionis thatheisdoingareallygood jobof selling cars.Orperhapshe thinks thatChrysler’s newmodels aremoreattractivethantheFordsandToyotas.Ineithercase,heraisesprices,earnsmoreincome,andgenerallybelievesthathislifeisgettingbetter.Onlygradually

does he realize that most other businesses are experiencing the samephenomenon.Sincetheyareraisingprices,too,hishigherincomewillbelosttoinflation.

By then, the politiciansmay have gottenwhat theywanted: reelection. Acentralbankthatisnotsufficientlyinsulatedfrompoliticscanthrowawildpartybeforethevotesarecast.Therewillbelotsofdancingonthetables;bythetimevoters become sick with an inflation-induced hangover, the election is over.MacroeconomiclorehasitthatFedchairmanArthurBurnsdidsuchafavorforRichard Nixon in 1972 and that the Bush family is still angry with AlanGreenspan for not adding a little more alcohol to the punch before the 1992election,whenGeorgeH.W.Bushwas turned out of office following amildrecession.

Politicalindependenceiscrucialifmonetaryauthoritiesaretodotheirjobsresponsibly. Evidence shows that countries with independent central banks—thosethatcanoperaterelativelyfreeofpoliticalmeddling—haveloweraverageinflationratesovertime.America’sFederalReserveisamongthoseconsideredtoberelativelyindependent.Membersofitsboardofgovernorsareappointedtofourteen-yeartermsbythepresident.Thatdoesnotgivethemthesamelifetimetenure as Supreme Court justices, but it does make it unlikely that any newpresidentcouldpacktheFederalReservewithcronies.Itisnotable—andevenasource of criticism—that the most important economic post in a democraticgovernmentisappointed,notelected.Wedesigneditthatway;wehavemadeademocratic decision to create a relatively undemocratic institution. A centralbank’seffectivenessdependson its independenceandcredibility,almost to thepoint thatareputationcanbecomeself-fulfilling.Iffirmsbelievethatacentralbankwillnottolerateinflation,thentheywillnotfeelcompelledtoraiseprices.Andiffirmsdonotraiseprices,thentherewillnotbeaninflationproblem.

Fedofficials are prickly about politicalmeddling. In the spring of 1993, Ihad dinner with Paul Volcker, former chairman of the Federal Reserve. Mr.VolckerwasteachingatPrinceton,andhewaskindenoughtotakehisstudentstodinner.PresidentClintonhadjustgivenamajoraddresstoajointsessionofCongress and Fed chairman Alan Greenspan, Volcker’s successor, had beenseatednexttoHillaryClinton.WhatIremembermostaboutthedinnerwasMr.Volcker grumbling that itwas inappropriate forAlanGreenspan to have beenseatednexttothepresident’swife.Hefeltthatitsentthewrongmessageaboutthe Federal Reserve’s independence from the executive branch. That is howseriouslycentralbankerstaketheirpoliticalindependence.

Inflationisbad;deflation,orsteadilyfallingprices,ismuchworse.Evenmodestdeflation can be economically devastating, as Japan has learned over the pasttwo decades. It may seem counterintuitive that falling prices could makeconsumersworseoff(especiallyifrisingpricesmakethemworseoff, too),butdeflationbegetsadangerouseconomiccycle.Tobeginwith,fallingpricescauseconsumerstopostponepurchases.Whybuyarefrigeratortodaywhenitwillcostless next week? Meanwhile, asset prices also are falling, so consumers feelpoorerandlessinclinedtospend.Thisiswhytheburstingofarealestatebubblecauses somucheconomicdamage.Consumerswatch thevalueof theirhomesdrop sharply while their mortgage payments stay the same. They feel poorer(because they are).Asweknow from the last chapter,when consumers spendless,theeconomygrowsless.Firmsrespondtothisslowdownbycuttingpricesfurtherstill.Theresultisaneconomicdeathspiral,asPaulKrugmanhasnoted:

Prices are falling because the economy is depressed; nowwe’ve justlearnedthattheeconomyisdepressedbecausepricesarefalling.Thatsetsthestageforthereturnofanothermonsterwehaven’tseensincethe1930s,a “deflationary spiral,” in which falling prices and a slumping economyfeedoneachother,plungingtheeconomyintotheabyss.4

Thisspiralcanpoisonthefinancialsystem,evenwhenbankersarenotdoingirresponsible things.Banksandother financial institutionsgetweakeras loansgo bad and the value of the real estate and other assets used as collateral forthoseloansfalls.Somebanksbegintohavesolvencyproblems;othersjusthaveless capital formaking new loans, which deprives otherwise healthy firms ofcredit and spreads the economic distress. The purpose of the Troubled AssetRelief Program (TARP) intervention at the end of the George W. Bushadministration—the so-called Wall Street bailout—was to “recapitalize”America’s banks and put them back in a position to provide capital to theeconomy.Thedesignoftheprogramhaditsflaws.Communicationaboutwhattheadministrationwasdoingandwhytheyweredoingitwasabysmal.Buttheunderlyingconceptmadealotofsenseinthefaceofthefinancialcrisis.

Monetary policy alone may not be able to break a deflationary spiral. InJapan, thecentralbankcutnominal interest rates tonearzeroa long timeago,

which means that they can’t go any lower. (Nominal interest rates can’t benegative.Anybankthatloanedout$100andaskedforonly$98backwouldbebetteroffjustkeepingthe$100inthefirstplace.)*Yetevenwithnominalratesnear zero, the rental rate on capital—the real interest rate—might actually bequite high. Here is why. If prices are falling, then borrowing $100 today andpaying back $100 next year is not costless. The $100 you pay back hasmorepurchasingpowerthanthe$100youborrowed,perhapsmuchmore.Thefasterpricesarefalling,thehigheryourrealcostofborrowing.Ifthenominalinterestrateiszero,butpricesarefalling5percentayear,thentherealinterestrateis5percent—a cost of borrowing that is too steepwhen the economy is stagnant.Economistshave longbeenconvinced thatwhat Japanneeds is a stiff doseofinflation to fix all this. One very prominent economist went so far as toencouragetheBankofJapantodo“anythingshortofdroppingbanknotesoutofhelicopters.”5 To hark back to the politics of organized interests covered inChapter 8, one theory forwhy Japanese officials have not donemore to fightfalling prices is that Japan’s aging population, many of whom live on fixedincomesorsavings,seedeflationasagoodthingdespite itsdireconsequencesfortheeconomyasawhole.

The United States has had its own encounters with deflation. There is aconsensusamongeconomists thatbotchedmonetarypolicywasat theheartoftheGreatDepression.From1929 to1933,America’smoneysupply fellby28percent.6TheFeddidnotdeliberatelyturnoffthecredittap;rather,itstoodidlybyasthemoneysupplyfellofitsownvolition.Theprocessbywhichmoneyiscirculated throughout the economy had become unhitched. Because ofwidespread bank failures in 1930, both banks and individuals began to hoardcash.Moneythatwasstuffedunderamattressor locked inabankvaultcouldnot be loaned back into the economy. The Fed did nothing while America’screditdriedup(andactually raised interest ratessharply in1931 todefend thegoldstandard).Fedofficialsshouldhavebeendoingjusttheopposite:pumpingmoneyintothesystem.

In September 2009, the one-year anniversary of the collapse of LehmanBrothers,thechairoftheCouncilofEconomicAdvisers,ChristinaRomer,gaveatalkominouslyentitled“BackfromtheBrink,”whichlaidmuchofthecreditforourescape fromeconomicdisasterat thedoorof theFederalReserve.Sheexplained, “The policy response in the current episode, in contrast [to the1930s],hasbeenswiftandbold.TheFederalReserve’screativeandaggressiveactionslastfalltomaintainlendingwillgodownasahighpointincentralbank

history. As credit market after credit market froze or evaporated, the FederalReserve createdmany new programs to fill the gap andmaintain the flow ofcredit.”

Didwedropcashoutofhelicopters?Almost.ItturnsoutthatthePrincetonprofessorwhoadvocatedthisstrategy(notliterally)adecadeagoforJapanwasnoneother thanBenBernanke(earninghimthenickname“HelicopterBen” insomequarters).

Beginningwith the first glimmers of trouble in 2007, the Fed used all itsconventionaltoolsaggressively,cuttingthetargetfederalfundsrateseventimesbetweenSeptember2007andApril2008.Whenthatbegantofeellikepushingon awet noodle, the Fed started to do things that one recent economic paperdescribedas“notinthecurrenttextbookdescriptionsofmonetarypolicy.”TheFed isAmerica’s “lender of last resort,”making it responsible for the smoothfunctioningof the financial system,particularlywhen that system is at riskofseizingupforlackofcreditandliquidity.Inthatcapacity,theFedisvestedwithawesome powers. Article 13(3) of the Federal Reserve Act gives the Fedauthoritytomakeloans“toanyindividual,partnership,orcorporationprovidedthat the borrower is unable to obtain credit from a banking institution.” BenBernankecancreate$500andloanittoyourgrandmothertofixtheroof,ifthelocalbankhassaidnoandhedecidesthatitmightdosomegoodfortherestofus.

Bernankeandcrewpulledoutthemonetarypolicyequivalentofducttape.TheFederalReserveurgedcommercialbanks toborrowdirectly from theFedviathediscountwindow,gavebankstheabilitytoborrowanonymously(sothatitwouldnot send signalsofweakness to themarket), andoffered longer termloans.TheFedalsoloanedfundsdirectlytoaninvestmentbank(BearStearns)for the first timeever;whenBearStearnsultimately faced insolvency, theFedloaned JPMorgan Chase $30 billion to take over Bear Stearns, sparing themarket from the chaos that later followed the Lehman bankruptcy. In caseswhereinstitutionsalreadyhadaccesstoFedcapital,therulesforcollateralwerechangedsothattheborrowerscouldpledgeilliquidassetslikemortgage-backedsecurities—meaning that when grandma asked for her $500 loan, she couldpledge all that stuff in the attic as collateral, even if it was not obvious whowouldwanttobuyitoratwhatprice.Thatgetsmoneytoyourgrandmatofixtheroof,whichwasthepointofallthis.7

Monetary policy is tricky business.Done right, it facilitates economic growthandcushionstheeconomyfromshocksthatmightotherwisewreakhavoc.Donewrong, it can cause pain and misery. Is it possible that all the recentunconventional actions at the Federal Reserve have merely set the stage foranothersetofproblems?Absolutely.It’smorelikely,atleastbasedonevidenceso far, that the Fed averted a more serious crisis and spared a great deal ofhumansufferingasaresult.PresidentBarackObamaappointedFederalReservechairmanBenBernanke to a second four-year termbeginning in 2010.At theceremony, the president said, “As an expert on the causes of the GreatDepression, I’m sure Ben never imagined that he would be part of a teamresponsible for preventing another. But because of his background, histemperament,hiscourage,andhiscreativity,that’sexactlywhathehashelpedtoachieve.”8That’shighpraise.Fornow,itseemslargelyaccurate.

CHAPTER11

InternationalEconomics:

HowdidanicecountrylikeIcelandgobust?

In1992,GeorgeSorosmadenearly$1billioninasingledayfortheinvestmentfundshemanaged.Mostpeopleneedseveralweekstomakeabilliondollars,orevenamonth.Sorosmadehisbillionona singleday inOctoberbymakingahugebetonthefuturevalueoftheBritishpoundrelativetoothercurrencies.Hewasright,makinghimarguablythemostfamous“currencyspeculator”ever.

Howdidhedoit?In1992,BritainwaspartoftheEuropeanExchangeRateMechanism,orERM.ThisagreementwasdesignedtomanagelargefluctuationsintheexchangeratesbetweenEuropeannations.Firmsfounditmoredifficulttodo business across the continent when they could not predict what the futureexchange rateswould likelybe amongEurope’smultiple currencies. (A singlecurrency,theeuro,wouldcomeroughlyadecadelater.)TheERMcreatedtargetsfortheexchangeratesamongtheparticipatingcountries.Eachgovernmentwasobligated to pursue policies that kept its currency trading on internationalcurrency markets within a narrow band around this target. For example, theBritishpoundwaspeggedto2.95Germanmarksandcouldnotfallbelowafloorof2.778marks.

Britainwasinthemidstofarecession,anditscurrencywasfallinginvalueas international investors sold the pound and looked for more profitableopportunitieselsewhereintheworld.Currenciesarenodifferentthananyothergood; the exchange rate, or the “price” of one currency relative to another, isdeterminedbysupplyrelativetodemand.Asthedemandforpoundsfell,sodidthevalueofthepoundoncurrencymarkets.TheBritishgovernmentvowedthatitwould“defendthepound”tokeepitfromfallingbelowitsdesignatedvalueintheERM.Sorosdidn’tbelieveit—andthatwaswhatmotivatedhisbigbet.

The British government had two tools for propping up the value of thepoundinthefaceofmarketpressurepushingitdown:(1)Thegovernmentcould

use its reserves of other foreign currencies to buy pounds—directly boostingdemand for the currency; or (2) the government could usemonetary policy toraise real interest rates, which, all else equal, makes British bonds (and thepounds necessary to buy them)more lucrative to global investors and attractscapital(orkeepsitfromleaving).

ButtheBritshadproblems.Thegovernmenthadalreadyspenthugesumsofmoney buying pounds; the Bank of England (the British central bank) riskedsquandering additional foreign currency reserves to no better effect. Raisinginterestrateswasnotanattractiveoptionforthegovernmenteither.TheBritisheconomywas in bad shape; raising interest rates during a recession slows theeconomyevenfurther,whichmakesforbadeconomicsandevenworsepolitics.Forbes explained in a postmortemof theSoros strategy, “AsBritain and Italy[withsimilarproblems]struggledtomaketheircurrenciesattractive,theywereforced tomaintainhigh interest rates to attract foreign investmentdollars.Butthiscrimpedtheirabilitytostimulatetheirsaggingeconomies.”1

Nonetheless, Prime Minister John Major declared emphatically that his“over-riding objective”was to defend the pound’s targeted value in theERM,even as that task seemed ever more difficult. Soros called the government’sbluff.HebetthattheBritswouldeventuallygiveuptryingtodefendthepound,atwhichpoint itsvaluewouldfallsharply.Themechanicsofhisbillion-dollardayarecomplex,*buttheessenceisstraightforward:Sorosbetheavilythatthevalue of the pound would fall, and he was right.2 On September 16, 2002—“Black Wednesday”—Britain withdrew from the ERM and the poundimmediatelylostmorethan10percentofitsvalue.Thepound’slosswasSoros’sgain—bigtime.

International economics shouldn’t be any different than economics withincountries. National borders are political demarcations, not economic ones.Transactionsacrossnationalbordersmuststillmakeallpartiesbetteroff,orelsewewouldn’tdothem.YoubuyaToyotabecauseyouthinkitisagoodcaratagoodprice;Toyotasellsittoyoubecausetheycanmakeaprofit.Capitalflowsacross international borders for the same reason it flows anywhere else:Investors are seeking the highest possible return (for any given level of risk).Individuals,firms,andgovernmentsborrowfundsfromabroadbecauseitisthecheapestwayto“rent”capitalthatisnecessarytomakeimportantinvestmentsortopaythebills.

Everything I’ve just described could be Illinois and Indiana, rather thanChinaandtheUnitedStates.However,internationaltransactionshaveanadded

layerofcomplexity.Differentcountrieshavedifferentcurrencies;theyalsohavedifferent institutions for creating andmanaging those currencies. The Fed cancreateAmerican dollars; it can’t domuchwithMexican pesos.You buy yourToyotaindollars.ToyotamustpayitsJapaneseworkersandexecutivesinyen.Andthatiswherethingsbegintogetinteresting.

TheAmericandollarisjustapieceofpaper.Itisnotbackedbygold,orrice,ortennisballs,oranythingelsewithintrinsicvalue.TheJapaneseyenisexactlythesame.Soaretheeuro,thepeso,therupee,andeveryothermoderncurrency.When individuals and firms begin trading across national borders, currenciesmustbeexchangedatsomerate.IftheAmericandollarisjustapieceofpaper,and the Japaneseyen is just apieceofpaper, thenhowmuchAmericanpapershouldweswapforJapanesepaper?

Therateatwhichonecurrencycanbeexchangedforanotheristheexchangerate.Wehavealogicalstartingpointforevaluatingtherelativevalueofdifferentcurrencies.AJapaneseyenhasvaluebecauseitcanbeusedtopurchasethings;adollar has value for the same reason. So, in theory,we ought to bewilling toexchange$1forhowevermanyyenorpesosorrubleswouldpurchaseroughlythesameamountofstuffintherelevantcountry.Ifabundleofeverydaygoodscosts $25 in the United States, and a comparable bundle of goods costs 750rublesinRussia,thenwewouldexpect$25tobeworthroughly750rubles(and$1shouldbeworthroughly30rubles).This is the theoryofpurchasingpowerparity,orPPP.

By the same logic, if the value of the ruble is losing 10 percent of itspurchasingpowerwithinRussiaeveryyearwhile theU.S.dollar isholding itsvalue, wewould expect the ruble to lose value relative to theU.S. dollar (ordepreciate)atthesamerate.Thisisn’tadvancedmath;ifonecurrencybuyslessstuff than itused to, thenanyone trading for thatcurrency isgoing todemandmoreofittocompensateforthediminishedpurchasingpower.*

Ilearnedthislessononce—thehardway.IarrivedinGuangzhou,China,inthe spring of 1989 by train from Hong Kong. At the time, the Chinesegovernmentdemanded that touristsexchangedollars for renminbiat ridiculous“official” rates thathadnoconnection to therelativepurchasingpowersof thetwocurrencies.Forabetterdeal,backpackerstypicallyexchangedmoneyontheblackmarket. Ihadstudiedmyguidebook,sowhenIarrivedat thestation inGuangzhouIknewroughlywhat theblackmarket ratefordollarsought tobe,subjecttotheusualbargaining.Ifoundacurrencytraderrightawayandmadeanopeninghardballoffer—whichthetraderacceptedimmediately.Hedidn’teven

quibble,letalonebargain.It turned out thatmy guide bookwas old; theChinese currency had been

steadily losing value ever since publication. I had swapped my $100 for theChineseequivalentofabout$13.50.

Purchasingpowerparity isahelpfulconcept. It is the toolusedbyofficialagenciestomakecomparisonsacrosscountries.Forexample,whentheCIAorthe United Nations gathers data on per capita income in other countries andconverts that figure into dollars, they often use PPP, as it presents the mostaccurate snapshot of a nation’s standard of living. If someone earns 10,000Jordaniandinars a year, howmanydollarswould a personneed in theUnitedStatestoachieveacomparablestandardofliving?

In the long run, basic economic logic suggests that exchange rates shouldroughly align with purchasing power parity. If $100 can be exchanged forenough pesos to buy significantlymore stuff inMexico,whowouldwant the$100?Manyofuswouldtradeourdollarsforpesossothatwecouldbuyextragoods and services in Mexico and live better. (Or, more likely, cleverentrepreneurswouldtakeadvantageoftheexchangeratetobuycheapgoodsinMexico and import them to the United States at a profit.) In either case, thedemandforpesoswouldincreaserelativetodollarsandsowouldtheir“price”—which is the exchange rate. (Theprices ofMexicangoodsmight rise, too.) Intheory,rationalpeoplewouldcontinuetoselldollarsforpesosuntiltherewasnolonger any economic advantage in doing so; at that point, $100 in theUnitedStateswouldbuyroughlythesamegoodsandservicesas$100worthofpesosinMexico—which is also the point at which the exchange rate would reachpurchasingpowerparity.

Hereisthestrangething:Officialexchangerates—therateatwhichyoucanactually tradeone currency for another—deviatewidely and for long stretchesfrom what PPP would predict. If purchasing power parity makes economicsense,whyisitoftenapoorpredictorofexchangeratesinpractice?Theanswerlies in the crucial distinction between goods and services that are tradable,meaningthattheycanbetradedinternationally,andthosethatarenottradable,which are (logically enough) called nontradable. Televisions and cars aretradablegoods;haircutsandchildcarearenot.

Inthatlight,let’srevisitourdollar-pesoexample.Supposethatattheofficialpeso-dollarexchangerate,aSonytelevisioncostshalfasmuchinTijuanaasitdoesinSanDiego.Acleverentrepreneurcanswapdollarsforpesos,buycheapSony televisions inMexico, and then sell them foraprofitback in theUnited

States. Ifhedid thisonabigenoughscale, thevalueof thepesowouldclimb(andprobablythepriceoftelevisionsinMexico),movingtheofficialexchangerate in the direction that PPP predicts.Our clever entrepreneur would have ahardtimedoingthesamethingwithhaircuts.Ortrashremoval.Orbabysitting.Orrentalhousing.Inamoderneconomy,morethanthree-quartersofgoodsandservicesarenontradable.

Atypicalbasketofgoods—thesourceofcomparisonforpurchasingpowerparity—contains both tradable and nontradable goods. If the official exchangerate makes a nontradable good or service particularly cheap in some country(e.g.,youcanbuyamealinMumbaifor$5thatwouldcost$50inManhattan),thereisnothinganentrepreneurcandotoexploitthispricedifference—soitwillpersist.

Using the sameMumbaimeal example, you should recognizewhyPPP isthe most accurate mechanism for comparing incomes across countries. Atofficialexchangerates,aMumbaisalarymaylookverylowwhenconvertedtodollars, but because many nontradable goods and services are much lessexpensiveinMumbaithanintheUnitedStates,aseeminglylowsalarymaybuyamuchhigherstandardoflivingthantheofficialexchangeratewouldsuggest.

Currencies that buy more than PPP would predict are said to be“overvalued”currenciesthatbuylessare“undervalued.”TheEconomistcreatedatongue-in-cheektoolcalledtheBigMacIndexforevaluatingofficialexchangerates relative to what PPP would predict. The McDonald’s Big Mac is soldaround the world. It contains some tradable components (beef and thecondiments) and lots of nontradables (local labor, rent, taxes, etc.). TheEconomist explains, “In the long run, countries’ exchange rates should movetowardsratesthatwouldequalizethepricesofanidenticalbasketofgoodsandservices.OurbasketisaMcDonald’sBigMac,producedin120countries.TheBigMacPPPistheexchangeratethatwouldleavehamburgerscostingthesameinAmericaaselsewhere.Comparingthesewithactualratessignalsifacurrencyisunder-orovervalued.”3

InJuly2009,aBigMaccostanaverageof$3.57intheUnitedStatesand12.5 renminbi in China, suggesting that $3.57 should be worth roughly 12.5renminbi(and$1worth3.5renminbi).Butthatwasnotevenclosetotheofficialexchange rate. At the bank, $1 bought 6.83 renminbi—making the renminbimassively undervalued relative to what “burgernomics” would predict.(Conversely,thedollarisovervaluedbythesamemeasure.)Thisisnotafreakoccurrence; theChinese government has promoted economicpolicies that rely

heavilyona“cheap”currency.Oflate,thevalueoftherenminbirelativetothedollar has been a significant source of tension between theUnited States andChina—atopicwe’llcomebacktolaterinthischapter.

ExchangeratescandeviatequitesharplyfromwhatPPPwouldpredict.Thatinvitestwoadditionalquestions:Why?Andsowhat?

Let’sdealwiththesecondquestionfirst.Imaginecheckingintoyourfavoritehotel inParis,onlytodiscoverthat theroomsarenearlytwiceasexpensiveastheywerewhenyoulastvisited.Whenyouprotesttothemanager,herepliesthatthe room rates have not changed in several years. And he’s telling the truth.What has changed is the exchange rate between the euro and the dollar. Thedollarhas“weakened”or“depreciated”against theeuro,meaning thateachofyourdollarsbuysfewereurosthanitdidthelasttimeyouwereinFrance.(Theeuro,ontheotherhand,has“appreciated.”)Toyou, thatmakesthehotelmoreexpensive.TosomeonevisitingParisfromelsewhereinFrance,thehotelisthesamepriceasithasalwaysbeen.Achangeintheexchangeratemakesforeigngoodscheaperormoreexpensive,dependingonthedirectionofthechange.

Thatisthecrucialpointhere.IftheU.S.dollarisweak,meaningthatitcanbe exchanged for feweryenor euros thannormal, then foreigngoodsbecomemoreexpensive.WhatistruefortheParishotelisalsotrueforGuccihandbagsandToyotatrucks.Thepriceineurosoryenhasn’tchanged,butthatpricecostsAmericansmoredollars,whichiswhattheycareabout.

At thesametime,aweakdollarmakesAmericangoodslessexpensivefortherestoftheworld.SupposeForddecidestopricetheTaurusat$25,000intheUnitedStatesandatthelocalcurrencyequivalent(atofficialexchangerates)inforeignmarkets. If theeurohasgrownstronger relative to thedollar,meaningthat every euro buys more dollars than it used to, then the Taurus becomescheaperforParisiancarbuyers—butFordstillbringshome$25,000.It’sthebestofallworldsforAmericanexporters:cheaperpricesbutnotlowerprofits!

Thegoodnews forForddoesnotend there.Aweakdollarmakes importsmore expensive for Americans. A car priced at 25,000 euros used to cost$25,000intheUnitedStates;nowitcosts$31,000—notbecausethepriceofthecarhasgoneup, but because thevalueof thedollar has fallen. InToledo, thesticker price jumps on every Toyota andMercedes,making Fords cheaper bycomparison. Or Toyota and Mercedes can hold their prices steady in dollars(avoidingthehassleofrestickeringeverycaronthelot)buttakefeweryenandeurosbacktoJapanandGermany.Eitherway,Fordgetsacompetitiveboost.

In general, a weak currency is good for exporters and punishing for

importers.In1992,whentheU.S.dollarwasrelativelyweak,aNewYorkTimesstory began, “The declining dollar has turned theworld’swealthiest economyinto the Filene’s basement of industrial countries.”4 A strong dollar has theopposite effect. In 2001,when the dollarwas strong by historical standards, aWall Street Journal headline proclaimed, “G.M. Official Says Dollar Is TooStrong for U.S. Companies.” When the Japanese yen appreciates against thedollarbyasingleyen,aseeminglytinyamountgiventhatthecurrentexchangerate is one dollar to 90 yen, Toyota’s annual operating earnings fall by $450million.5

Thereisnothinginherentlygoodorbadabouta“strong”or“weak”currencyrelativetowhatPPPwouldpredict.Anundervaluedcurrencypromotesexports(and therefore the industries that produce them). At the same time, a cheapcurrencyraises thecostsof imports,which isbad forconsumers. (Ironically,aweak currency can also harm exporters bymaking any imported inputsmoreexpensive.) A government that deliberately keeps its currency undervalued isessentially taxing consumers of imports and subsidizing producers of exports.An overvalued currency does the opposite—making imports artificially cheapandexportslesscompetitivewiththerestoftheworld.Currencymanipulationislikeanyotherkindofgovernmentintervention:Itmayservesomeconstructiveeconomic purpose—or it may divert an economy’s resources from their mostefficientuse.Wouldyousupporta tax thatcollectedasignificant feeoneveryimported good you bought and used the revenue tomail checks to firms thatproduceexports?

How do governments affect the strength of their currencies? At bottom,currencymarketsarelikeanyothermarket:Theexchangerateisthefunctionofthedemandforsomecurrencyrelativetothesupply.Themostimportantfactorsaffecting the relative demand for currencies are global economic forces. Acountrywithaboomingeconomywilloftenhaveacurrencythatisappreciating.Stronggrowthpresentsinvestmentopportunitiesthatattractcapitalfromtherestof theworld. Tomake these local investments (e.g., to build amanufacturingplantinCostaRicaorbuyRussianstocks),foreigninvestorsmustbuythelocalcurrency first. The opposite happens when an economy is flagging. Investorstaketheircapitalsomewhereelse,sellingthelocalcurrencyontheirwayout.

Allelseequal,greatdemandforacountry’sexportswillcauseitscurrencyto appreciate.When global oil prices spike, for example, theMiddle East oilproducers accumulate huge quantities of dollars. (International oil sales aredenominatedindollars.)Whentheseprofitsarerepatriatedtolocalcurrency,say

back to Saudi Arabia, they cause the Saudi riyal to appreciate relative to thedollar.

Higher interestrates,whichcanbeaffectedin theshortrunbytheFederalReserve in theUnitedStates or the equivalent central bank in other countries,make a currency more valuable. All else equal, higher interest rates provideinvestors with a greater return on capital, which draws funds into a country.Suppose aBritish pound can be exchanged for a $1.50 and the real return ongovernment bonds in both the United Kingdom and the United States is 3percent.IftheBritishgovernmentusesmonetarypolicytoraisetheirshort-terminterest rates to 4 percent, American investors would be enticed to sell U.S.treasurybondsandbuyBritishbonds.Todoso,ofcourse,theyhavetousetheforeignexchangemarkettoselldollarsandbuypounds.Ifnothingelsechangesin theglobaleconomy(anunlikelyscenario), the increaseddemandforBritishpoundswouldcausethepoundtoappreciaterelativetothedollar.

Of course, “all else equal” is a phrase that never actually applies to theglobal economy. Economists have an extremely poor record of predictingmovements in exchange rates, in part because so many complex globalphenomenaareaffectingtheforeignexchangemarketsatonce.Forexample,theU.S.economywasgroundzerofortheglobalrecessionthatbeganin2007.WiththeU.S. economy in suchapoor state,onewouldhaveexpected thedollar todepreciaterelativetoothermajorglobalcurrencies.Infact,U.S.treasurybondsare a safe place to park capital during economic turmoil. So as the financialcrisis unfolded, investors from around the world “fled to safety” in U.S.treasuries, causing the U.S. dollar to appreciate despite the flounderingAmericaneconomy.

Countries can also enter the foreign exchange market directly, buying orsellingtheircurrenciesinanefforttochangetheirrelativevalue,astheBritishgovernment tried to do while fighting off the 1992 devaluation. Given theenormoussizeoftheforeignexchangemarket—withliterallytrillionsofdollarsin currencies changing hands every day—most governments don’t have deepenoughpockets tomakemuchof a difference.As theBritishgovernment andmanyothershave learned,acurrency interventioncanfeel like trying towarmup a coldbathtubwithone spoonful of hotwater at a time, particularlywhilespeculators are doing the opposite. As the British government was buyingpounds,Sorosandothersweresellingthem—effectivelydumpingcoldwaterinthesametub.

Westillhaven’t reallyanswered thebasicquestionat thebeginningof the

chapter:Howmanyyenshouldadollarbeworth?Orrubles?Orkrona?Thereare a lot of possible answers to that question, depending in large part on theexchange rate mechanism that a particular country adopts. An array ofmechanismscanbeusedtovaluecurrenciesagainstoneanother:

The gold standard. The simplest system to get yourmind around is the goldstandard.Nomodernindustrializedcountryusesgoldanylonger(otherthanforoverpriced commemorative coins), but in the decades followingWorldWar IIthe gold standard provided a straightforward mechanism for coordinatingexchangerates.Countriespeggedtheircurrenciestoafixedquantityofgoldandtherefore, implicitly, to each other. It’s like one of those grade-school mathproblems:Ifanounceofgoldisworth$35inAmericaand350francsinFrance,whatistheexchangeratebetweenthedollarandthefranc?

Oneadvantageofthegoldstandardisthatitprovidespredictableexchangeranges.Italsoprotectsagainstinflation;agovernmentcannotprintnewmoneyunless it has sufficient gold reserves to back the new currency. Under thissystem,thepaperinyourwalletdoeshaveintrinsicvalue;youcantakeyour$35anddemandanounceofgoldinstead.The“goldstandard”hasaniceringtoit;however, the system made for catastrophic monetary policy during the GreatDepression and can seriously impair monetary policy even during normalcircumstances. When a currency backed by gold comes under pressure (e.g.,because of aweakening economy), foreigners start to demand gold instead ofpaper.Inordertodefendthenation’sgoldreserves,thecentralbankmustraiseinterest rates—even though a weakening economy needs the opposite.EconomistPaulKrugman,who earned aNobelPrize in 2008 for hisworkoninternational trade, explained recently, “In the early 1930s this mentality ledgovernments to raise interest rates and slash spending, despite massunemployment, in an attempt to defend their gold reserves. And even whencountrieswentoffgold,theprevailingmentalitymadethemreluctanttocutratesandcreatejobs.”6IftheUnitedStateshadbeenonthegoldstandardin2007,theFedwould have been largely powerless toward off the crisis.Under the goldstandard, a centralbankcanalwaysdevalue thecurrency (e.g., declare that anounceofgoldbuysmoredollarsthanitusedto),butthatessentiallydefeatsthepurposeofhavingagoldstandardinthefirstplace.

In 1933, Franklin Roosevelt ended the right of individual Americans toexchangecashforgold,butnationsretainedthatrightwhenmakinginternational

settlements. In 1971, Richard Nixon ended that, too. Inflation in the UnitedStateswasmakingthedollarlessdesirable;givenachoicebetween$35andanounceofgold,foreigngovernmentswereincreasinglydemandingthegold.AfteraweekendofdeliberationatCampDavid,Nixonunilaterally“closed thegoldwindow.” Foreign governments could redeem gold for dollars on Friday—butnot on Monday. Since then, the United States (and all other industrializednations)haveoperatedwith“fiatmoney,”which isa fancywayof saying thatthosedollarsarejustpaper.

Floating exchange rates. The gold standard fixes currencies against oneanother; floating rates allow them to fluctuate as economic conditions dictate,even minute by minute. Most developed economies have floating exchangerates; currencies are traded on foreign exchange markets, just like a stockexchangeoreBay.Atanygiventime,theexchangeratebetweenthedollarandyenreflectsthepriceatwhichpartiesarewillingtovoluntarilytradeonefortheother—justlikethemarketpriceofanythingelse.WhenToyotamakesloadsofdollarssellingcarsintheUnitedStates,theytradethemforyenwithsomepartythat is looking to do the opposite. (Or Toyota can use the dollars to payAmericanworkers,makeinvestmentsinsidetheUnitedStates,orbuyAmericaninputs.)

Withfloatingexchangerates,governmentshavenoobligationtomaintainacertainvalueoftheircurrency,astheydounderthegoldstandard.Theprimarydrawback of this system is that currency fluctuations create an added layer ofuncertaintyforfirmsdoinginternationalbusiness.FordmaymakehugeprofitsinEuropeonly to losemoney in theforeignexchangemarketswhen it tries tobring theeurosbackhome.So far, exchange ratevolatilityhasproven tobeadrawbackoffloatingrates,thoughnotafatalflaw.Internationalcompaniescanusethefinancialmarketstohedgetheircurrencyrisk.Forexample,anAmericanfirmdoingbusinessinEuropecanenterintoafuturescontractthatlocksinsomeeuro-dollarexchangerateataspecifiedfuturedate—justasSouthwestAirlinesmight lock in future fuel prices or Starbucksmight use the futuresmarket toprotectagainstanunexpectedsurgeinthepriceofcoffeebeans.

Fixedexchange rates (or currencybands).Fixedor “pegged” exchange rates

arealotlikethegoldstandard,exceptthatthereisnogold.(Thismayseemlikeaproblem—anditoftenis.)Countriespledgetomaintaintheirexchangeratesatsomepredeterminedratewithagroupofothercountries—suchasthenationsofEurope.The relevantcurrencies trade freelyonmarkets,buteachparticipatinggovernmentagreestoimplementpoliciestokeepitscurrencytradingwithinthepredeterminedrange.TheEuropeanExchangeRateMechanismdescribedatthebeginningofthischapterwassuchasystem.

Theprimaryproblemwitha“peg”isthatcountriescan’tcrediblycommittodefendingtheircurrencies.Whenacurrencybeginstolookweak,asthepounddid, then speculators pounce, hoping to make millions (or billions) if thecurrencyisdevalued.Ofcourse,whenspeculators(andothersconcernedaboutdevaluation) aggressively sell the local currency—as Soros did—thendevaluationbecomesallthemorelikely.

Borrowing someone else’s strong reputation.At the endof 1990, inflation inArgentinawasmorethan1,000percentayear, tonoone’sgreatsurprisegiventhe country’s history of hyperinflation. Is that a currency you want to own?Argentinahadlongbeentheworld’sinflationbadboy—themonetaryequivalentofsomeonewhostandsyouupforthreestraightdatesandthentriestotellyouthat the fourth timewill be different. It won’t be, and everyone knows it. SowhenArgentinafinallygotseriousaboutfightinginflation,thecentralbankhadtodo something radical.Basically, ithired theUnitedStatesasachaperon. In1991,Argentinadeclaredthatitwasrelinquishingcontroloveritsownmonetarypolicy. No more printing money. Instead, the government created a currencyboardwithstrictrulestoensurethathencefortheveryArgentinepesowouldbeworth oneU.S. dollar. Tomake that possible (and credible to theworld), thecurrencyboardwouldguaranteethateverypesoincirculationwouldbebackedbyoneU.S.dollarheldinreserve.Thus,thecurrencyboardwouldbeallowedtoissue new pesos only if it had new dollars in its vaults to back them up.Moreover, every Argentine peso would be convertible on demand for a U.S.dollar. In effect, Argentina created a gold standard with the U.S. dollarsubstitutingforthegold.

It worked for a while. Inflation plummeted to double digits and then tosingledigits.Alas,therewasahugecost.RememberallthosewonderfulthingstheFedchairmancandotofine-tunetheeconomy?TheArgentinegovernmentcouldnotdoanyofthem;ithadabdicatedcontroloverthemoneysupplyinthe

nameoffightinginflation.NordidArgentinahaveanyindependentcontroloveritsexchangerate;thepesowasfixedagainstthedollar.Ifthedollarwasstrong,thepesowasstrong.Ifthedollarwasweak,thepesowasweak.

This lack of control over themoney supply and exchange rate ultimatelytook a steep toll.Beginning in the late 1990s, theArgentine economy slippedintoadeeprecession;authoritiesdidnothavetheusualtoolstofightit.Tomakemattersworse,theU.S.dollarwasstrongbecauseofAmerica’seconomicboom,making theArgentine peso strong.That punishedArgentine exporters and didfurtherharm to the economy. In contrast,Brazil’s currency, the real, fellmorethan 50 percent between 1999 and the end of 2001. To the rest of theworld,Brazil had thrown a giant half-price sale andArgentina could do nothing butstand by and watch. As the Argentine economy limped along, economistsdebatedthewisdomofthecurrencyboard.Theproponentsarguedthatitwasanimportant source of macroeconomic stability; the skeptics said that it wouldcausemore harm than good. In 1995,MauriceObstfeld andKenneth Rogoff,economists atUCBerkeley andPrinceton, respectively, hadpublished a paperwarning that most attempts to maintain a fixed exchange rate, such as theArgentinecurrencyboard,werelikelytoendinfailure.7

Time proved the skeptics right. In December 2001, the long-sufferingArgentine economy unraveled completely. Street protests turned violent, thepresidentresigned,andthegovernmentannouncedthatitcouldnolongerpayitsdebts, creating the largest sovereigndefault in history. (Ironically,KenRogoffhad by then made his way from Princeton University to the InternationalMonetary Fund,where, as chief economist, he had to dealwith the economicwreckage thathehadwarnedagainstyearsearlier.)TheArgentinegovernmentscrapped its currency board and ended the guaranteed one-for-one exchangebetweenthepesoandthedollar.Thepesoimmediatelyplungedsome30percentinvaluerelativetothedollar.

Funnymoney. Some currencies have no international value at all. In 1986, IcrossedthroughtheBerlinWallintoEastBerlin,behindtheIronCurtain.Whenwe crossed into East Germany at “Checkpoint Charlie,” we were required tochangeacertainamountof“hardcurrency”(dollarsorWestGermanmarks)fora certain amount of East German currency. How was that exchange ratedetermined? Make believe. The East German mark was a “soft” currency,meaning that it did not trade anywhere outside of the communist world and

thereforehadnopurchasingpoweranywhereelse.Theexchangeratewasmoreorlessarbitrary,thoughI’mfairlycertainthatthepurchasingpowerofwhatwegotwasworth less thanthepurchasingpowerofwhatwegaveup.Infact,weweren’tevenallowedtotakeourEastGermanmoneyoutof thecountrywhenweleft.Instead,theEastGermanborderguardstookwhatwehadleftand“putitonaccount” (that’s reallywhat theysaid) forournextvisit.Somewhere in thenowunifiedGermany, there is an accountwithmynameon it that contains asmallamountofworthlessEastGermancurrency.SoI’vegotthatgoingforme.

Soft currencies were amore serious problem for the fewU.S. companiesdoing business in communist countries with soft currencies. In 1974, Pepsistruck a deal to sell its products in the SovietUnion.Communists drink cola,too.Butwhat theheckwasPepsigoingtodowithmillionsofrubles?Instead,PepsiandtheSovietgovernmentoptedforold-fashionedbarter.Pepsiswappeditssoft-drinksyruptotheSovietgovernmentinexchangeforStolichnayavodka,whichdidhaverealvalueintheWest.8

Thatallsoundssoorderly,exceptfortheriotsinthestreetsinArgentina.Infact,theArgentina-typecurrencymeltdownissurprisinglyfrequent.Let’srevisitalinefromafewpagesago:“Investorstaketheircapitalsomewhereelse,sellingthelocalcurrencyontheirwayout.”Onlynow,let’sdressthatstatementuptomore closely approximate reality: “Investors panic,weeping and screaming astheysellassetsandditchthelocalcurrency—asmuchaspossible,forwhateverpriceispossible—inhopesofgettingoutthedoorbeforethemarketcompletelycollapses!”

Argentina,Mexico,Russia,Turkey,SouthKorea,Thailand,andthecountryforwhichwe’ve named the chapter, Iceland.What do they have in common?Not geography.Not culture. Certainly not climate. They are all countries thathavesufferedcurrencycrises.Notwocrisesareexactlythesame.Theydohaveapattern,usuallyaplayin threeacts:(1)Acountryattractssignificantforeigncapital. (2) Something bad happens: a government borrows too heavily andstands at risk of default; a property bubble bursts; a country with a peggedexchange rate facesdevaluation; abanking system is exposedas rifewithbadloans—orsomecombinationofallof these things. (3)Foreign investors try tomovetheircapitalsomewhereelse—preferablybeforeeveryoneelsedoes.Assetprices fall (as foreigners sell) and the currency plunges. Both of these thingsmake theunderlyingeconomicproblemsworse,which causes asset prices andthecurrencytoplungefurther.Thecountrypleadswiththerestoftheworldtohelpstopthedownwardeconomicspiral.

Togetasenseofhowthisallplaysout,let’slookatthemostrecentvictim:Iceland.Icelandisnotapoor,developingcountry.Infact,IcelandwasatthetopoftheUNHumanDevelopmentIndexrankingsin2008.HereareIceland’sthreeacts,asbestIcanfigurethemout:

Act I. In the first decade of the twenty-first century, Iceland’s currency, theIcelandickrona,wasextremelystrong,andrealinterestrateswerehighbyglobalstandards.Iceland’srelativelyunregulatedbankswereattractingcapitalfromallovertheworldasinvestorssoughthighrealreturns.Atthepeak,Iceland’sbankshadassets10timesthesizeofthecountry’sentireGDP.Thebankswereusingthis huge pool of capital to make the kinds of investments that seemed verysmartin2006.Meanwhile,thehighdomesticinterestratesinducedIcelanderstoborrowinothercurrencies,evenforrelativelysmallpurchases.AneconomistattheUniversityofIcelandtoldCNNMoney,“Whenyouboughtacar,you’dbeasked,‘Howdoyouwantthefinancing?Halfinyenandhalfineuros?’”9

Act II. The global financial crisis was bad for the world and disastrous forIceland. Iceland’s banks suffered huge losses from bad investments andnonperformingloans.Bythefallof2008,thecountry’sthreemajorbanksweredefunct; thecentralbank,whichhad takencontrolof the largestprivatebanks,was technically in default as well. The New York Times reported a story inNovember 2008 that began, “People go bankrupt all the time. Companies do,too.Butcountries?”

As the krona plummeted, the cost of all those consumer loans in foreigncurrencies skyrocketed. Think about it: If you borrow in euros, and the kronaloseshalf itsvaluerelative to theeuro, themonthlypayment inkronaonyourloandoubles.Ofcourse,manyoftheassetsthatIcelandershadpurchasedwiththose loans, such as homes and property, were simultaneously plummeting invalue.

Act III. The Icelandic krona lost half its value. The stock market fell by 90percent;GDPfell10percent;unemploymenthitaforty-yearhigh.Peoplewereangry—just like in Argentina. One woman told The Economist, “If I met a

banker,I’dkickhisasssohardmyshoeswouldbestuckinside.”Andshewasapreschoolteacher.10

Even theBigMac Indexhada sadpostscript in Iceland. InOctober2009,Iceland’s three McDonald’s restaurants closed after becoming victims of thefinancial crisis.McDonald’s required that its Iceland franchises buy their foodinputsandpackagingfromGermany.Becausethekronahadplummetedinvaluerelativetotheeuroandbecausethegovernmenthadimposedhighimporttariffs,the cost of these inputs from Germany roughly doubled. The owner of theIcelandfranchisessaidthattomakea“decentprofit,”aBigMacwouldhavehadtosellfortheequivalentofmorethansixdollars—higherthananywhereelseintheworldandanuntenablepriceforacountryinthemidstofadeeprecession.McDonald’scloseditsdoorsinIcelandinstead.11

Theeconomicwreckage that results timeafter timeas investors fleeacountrysuggestsanobviousfix:Maybeitshouldbehardertoflee.Somecountrieshaveexperimentedwith capital controls,whichplace various kinds of limits on thefree flow of capital. Like many obvious fixes, this one has less obviousproblems. If foreign investorscan’t leaveacountrywith theircapital, theyarelesslikelytoshowupinthefirstplace.It’sabitliketryingtoimproverevenuesatadepartmentstorebybanningallreturns.Agroupofeconomistsstudiedfifty-twopoorcountriesbetween1980and2001toexaminetherelationshipbetweenfinancial liberalization (making it easier to move capital in and out of thecountry)andeconomicperformance.Thereisatradeoff:Countriesthatimposesome kind of capital controls also grow more slowly. The Economistsummarized the study’s findings: “An occasional crisis may be a price worthpayingforfastergrowth.”12

Okay, what if we all had the same currency? Wouldn’t that help avoidcurrency-relatedheadaches?Afterall,Iowahasneverhadafinancialmeltdownbecause Illinois investors took their capital back across theMississippi River.Therearebenefitstobroadeningacurrencyzone;thiswasthelogicoftheeuro,which replacedmostof the individual currencies inEurope.Asinglecurrencyacross Europe (and in the fifty U.S. states) reduces transaction costs andpromotes price transparency (meaning that it’s easier to spot and exploit pricediscrepancieswhen goods are all priced in the same currency). But here, too,there is a trade-off. Remember, monetary policy is the primary tool that any

government possesses to control the “speed” of its economy. A central bankraises or lowers interest rates by making its currency more or less scarce.Countries that share a currency with other nations, such as the Europeancountries thatadopted theeuro,mustgiveupcontrolover theirownmonetarypolicy.TheEuropeanCentralBanknowcontrolsmonetarypolicyforthewholeeurozone.(ObviouslyLouisianaandCaliforniadonothavetheirownmonetarypolicyeither.)This canbeaproblem ifonepartof thecurrencyzone is in aneconomic slump and would benefit from lower interest rates while anotherregion at the same time is growing quickly and must raise rates to ward offinflation.

Wedon’treallycareaboutcurrenciesperse;whatwereallycareaboutistheunderlyingflowofgoodsandservices.Thesetradesacrossinternationalbordersarewhatmakeusbetteroff;currenciesaremerelyatoolforfacilitatingmutuallybeneficialtransactions.Inthelongrun,wewouldexpectthevalueofthegoodsandservicesthatwesendtoothercountriestobemoreorlessequaltothevalueofwhattheysendtous.Ifnot,someoneisgettingareallybaddeal.Evenlittlekidstradingsnacksinthelunchroomrecognizethatwhatyougiveupshouldbeworthwhatyougetback.

Except for theUnited States.We’re the guys in the lunchroom giving upliverwurstsandwichesandgettingaturkeysandwich,pluschips,cookies,juice,andapeanut-freesnack.TheUnitedStateshasbeenrunninglargeandpersistentcurrentaccountdeficitswiththerestoftheworld,meaningthatyearafteryearwearegettingmoregoodsandservicesfromtherestoftheworldthanweselltothem.(Thecurrentaccountmeasuresincomeearnedabroadfromtradeingoodsandservices,plussomeothersourcesofforeignincome,suchasdividendsandinterestonoverseasinvestmentsaswellasremittancessenthomebyAmericansworkingabroad.)Howarewegettingawaywiththat?Mightitbeaprobleminthe long run? The answer to the second question is yes. The first question ismorecomplicated.

As noted in Chapter 9, there is nothing inherently bad about a currentaccount deficit, nor anything inherently good about a current account surplus;countries like Algeria and Equatorial Guinea were running current accountsurpluses in 2007, but that does notmake them economic powerhouses. Still,there is an unavoidable economic reality lurking here: A country running acurrentaccountdeficitisearninglessincomefromtherestoftheworldthanitispaying out. Consider a simple example: If we buy $100million in cars fromJapanandsellthem$50millioninplanes,thenwe’vegota$50millioncurrent

account deficit. The Japanese are not sending us an extra $50 million inmerchandisebecausewe’re friendlyandgood looking; theyexpectus tomakeupthedifference.Todothat,wehaveonlyacoupleofoptions.OneoptionistosellourJapanesetradingpartnersassetsinstead—stocks,bonds,realestate,andsoon.

For example,wemight sell Japanese firms $25million inManhattan realestate and $25 million of equity in American firms (stocks). Now the ledgermakessense.Americansget$100millionofgoodsandservicesfromJapan;inexchange, we send over $50 million in goods (the planes), and another $50millioninassets.That’sanevendeal.Itcomeswithaprice,however;theassetsthatwe’regivingup(realestateandstocks)wouldhavegeneratedincomeforusin the future (rents and dividends). Now that income will go to our tradingpartnerinstead.We’rebuyingcarsnowbygivingupfutureincome.

That’snotouronlychoice.Wecanbuyourmerchandiseoncredit.Wecanasksomewillingpartyintheglobalfinancialcommunitytoloanus$50million.Inthatcase,we“payfor”our$100millioninJapanesecarswith$50millioninplanesand$50millioninborrowedcapital.That,too,hasobviousfuturecosts.Wehave topayback the loans,with interest.Again,wearepayingforcurrentconsumptionbyborrowingagainstthefuture—literallyinthiscase.

Why is the United States running chronic current account deficits? It hasvirtually nothing to do with the quality of our goods and services or thecompetitivenessofour laborforce,asconventionalwisdomwouldhave it. (Tomyearlierpoint,doyouthinkAlgeriaandEquatorialGuineaarerunningcurrentaccountsurplusesbecausetheyareproducingbetterstuffwithmoreproductiveworkers?)TheUnitedStatesisrunningchroniccurrentaccountdeficitsbecauseyearafteryearweareconsumingmorethanweproduce.Inotherwords,wearedoingtheoppositeofsaving(inwhichyouproducemorethanyouconsumeandset the extra aside). As a nation, we are literally doing what economists call“dissaving.”

Theconnectionbetweenthecurrentaccountbalanceandanation’ssavingsrate is crucial.Any country that is consumingmore than it producesmust bydefinition be running a current account deficit because (1) the stuff you areconsuming beyondwhat you producemust come from somewhere else in theworld;and(2)youcan’ttradegoodsandservicesfortheextrastuffthatyou’regetting from the rest of the world because you’ve consumed everything youhave.

Asusual,afarminganalogywillhelp.SupposeFarmerAmericagrowscorn.

Heisahighlyproductivefarmer,handsomeandsmart,whousesonlythemostmodern farming techniques. (These details are irrelevant here, just as they arewhendescribingwhetheranationaleconomyrunsacurrentaccountsurplusordeficit.)ThereareonlyfourbroadthingsthatFarmerAmericacandowithwhathe grows: He can eat it (consumption); he can plant it for next year’s crop(investment);hecansendittothegovernmenttopayforservices(governmentspending);orhecantradeitforotherstuff(exportstradedforimports).That’sit.Solet’simaginethatFarmerAmerica’syearlookslikethefollowing:

Hegrows100bushelsofcorn.Heeats70.Hesends30tothegovernment.Heneeds20 toplantnextyear.But ifyoudo themath,you’llsee thatFarmerAmerica is using 120bushels a year but growingonly 100.Hemust be a netborrower of corn—20bushels in this case.That is the equivalent of a currentaccountdeficit,andit’sjustmath—ifheusesmorecornthanhegrows,theresthastocomefromsomewhereelse.

Farmer China works across the way. He grows only 65 bushels of corn,because he is new to farming and uses relatively primitive methods. FarmerChina consumes20bushels, sends 10 to the government, and sets 15 aside toplantnextyear.Again,somequickmathsuggeststhatFarmerChinaisnotusingeverythinghegrows.Hehasanextra20bushels.Asconveniencewouldhaveit,these bushels can be traded to Farmer America, who has come up short. Ofcourse, FarmerAmerica doesn’t have any crops to trade, so he offers an IOUinstead.FarmerChinagivesFarmerAmericathecorn(an“export”)—andloanshimthemoneytobuyit.

Let’s jump from farm analogies to reality: So far, theUnited States owesChinaaboutatrilliondollars.

Normallythesekindsofglobalimbalanceshaveself-correctingmechanisms.Thecurrencyofacountrywithalargecurrentaccountdeficitwillusuallybegintodepreciate.AssumethatNewZealandisrunningacurrentaccountdeficit.TherestoftheworldissteadilyaccumulatingNewZealanddollarsbecausetheyaresellingmoregoodstoNewZealandthantheyarebuyingfromit;foreignfirmswill want to trade their accumulated New Zealand dollars for their homecurrency.On the foreign exchangemarket, the supplyofNewZealanddollarsforsalewillexceedthedemandforthem,pushingthevalueoftheNewZealanddollar down relative to the currencies of its trading partners. The fallingNewZealanddollar helps to correct the trade imbalance bymakingNewZealand’sexportsmorecompetitiveandimportsmoreexpensive.Forexample,iftheNewZealand dollar depreciates relative to the yen, then Toyotas become more

expensive in New Zealand while New Zealand’s farm products (kiwis?) lookcheaperinJapan.Meanwhile,thesamethinghappenswithothercountries;NewZealand will begin to import less and export more, narrowing the currentaccountdeficit.

ThecurrentsituationinvolvingChinaandtheUnitedStatesisdifferent.Thetwocountriesarearguablylockedinanunhealthysymbioticrelationshipthathasthepotential tocomeungluedatanytime.Chinahascreatedaverysuccessfuldevelopmentstrategybuiltupon“export-ledgrowth,”meaningthat thebulkofjob growth and prosperity has been generated by firms making products forexport.ManyofthoseexportscometotheUnitedStates.

China’s export-oriented development strategy depends on keeping therenminbirelativelycheap.Toaccomplishthat,theChinesegovernmentrecyclesaccumulateddollarsprimarily intoU.S. treasurybonds,whichare loans to theU.S.federalgovernment.Bothpartiesgetwhat theywant(orneed),at least inthe short run. TheChinese government has used exports to generate jobs andgrowth.AmericahasfundeditsdissavingswithenormousloansfromChina.Thesituationreallyisn’tmuchdifferentthanFarmerChinaandFarmerAmerica:TheUnitedStatesgetsloansfromChinatobuyitsexports.

Inthelongrun,thesituationposesseriousrisksforbothparties.TheUnitedStates has become a large debtor nation.Debtors are always vulnerable to thewhims and demands of their creditors.America has a borrowing habit; Chinafeeds it. James Fallows has noted, “Without China’s billion dollars a day, theUnited States could not keep its economy stable or spare the dollar fromcollapse.”13 Worse, China could threaten to dump its huge hoard of dollar-denominatedassets.Thatwouldbearuinousthingtodo.AsFallowspointsout,“Their years of national savings are held in the same dollars that would beruined;inapanic,they’dgetonlyasmallshareoutbeforethevaluefell.”Still,that’s an awfully powerful weapon to give a nation with which we oftendisagree.

TheChinesehave itworse.SupposeAmerica’sdebtburdengrowsbeyondwhatU.S.taxpayerscan(orarewilling)topayback.TheU.S.governmentcoulddefault—simply refuse to honor its debts. That is highly unlikely, mostlybecause there is another irresponsible option that ismore subtle:America can“inflateaway”muchofitsdebttoChina(andothercreditors)byprintingmoney.If we recklessly print dollars, the currency will lose value—and so will ourdollar-denominateddebts.Ifinflationclimbsto20percent,thentherealvalueofwhatwehavetopaybackwillfallby20percent.Ifinflationis50percent,then

halfofourdebttoChinaeffectivelygoesaway.Isthisalikelyoutcome?No.Butif someoneowedmea trilliondollarsandalsohad theauthority toprint thosedollars,Iwouldspendalotoftimeworryingaboutinflation.

Thisdysfunctionaleconomicrelationshipwillend.Thecrucialquestionsarewhen,why,andhow.JamesFallowshassummarizedwherewestandnow:“Ineffect,everypersoninthe(rich)UnitedStateshasoverthepast10yearsorsoborrowedabout$4,000fromsomeoneinthe(poor)People’sRepublicofChina.Like somany imbalances in economics, this one can’t go on indefinitely, andthereforewon’t.Butthewayitends—suddenlyversusgradually,forpredictablereasons versus during a panic—willmake an enormous difference to theU.S.andChineseeconomiesoverthenextfewyears,tosaynothingofbystandersinEuropeandelsewhere.”14

Given thestakes involved,areanyadultssupervisingallof this?Yes,but theyaregettinglonginthetooth.InthewaningdaysofWorldWarII,representativesof theAlliednationsgathered at theMt.WashingtonHotel inBrettonWoods,NewHampshire. (It’sadelightfulplace inbothsummerandwinter, ifyouarelooking for a New England getaway.) Their mission was to create a stablefinancial infrastructure for the postwar world. They created two internationalinstitutions,or“thetwosisters.”

The institution at the center of the global fight against poverty is theWashington-basedWorldBank. (The first $250million loanwas to France in1947forpostwar reconstruction.)TheWorldBank,which isownedby its183member countries, raises capital from its members and by borrowing in thecapitalmarkets.Thosefundsareloanedtodevelopingnationsforprojectslikelytopromoteeconomicdevelopment.TheWorldBankisatthecenterofmanyoftheinternationaldevelopmentissuescoveredinChapter13.

IftheWorldBankistheworld’swelfareagency,thenitssisterorganization,the InternationalMonetary Fund (IMF), is the fire department responsible fordousinginternationalfinancialcrises.IcelandcalledtheIMF.SodidArgentina,Mexico,andalltheothers.TheIMFwasalsoconceivedatBrettonWoodsasacooperative global institution.Members pay funds into the IMF; in exchangethey can borrow in times of difficulty “on condition that they undertakeeconomicreformstoeliminate thesedifficultiesfor theirowngoodandthatofthe entiremembership.”Nocountry is ever required to accept loansor advicefrom either the IMFor theWorldBank.Both organizations derive power and

influencefromthecarrotstheywield.FewinstitutionshaveattractedasmuchcriticismastheWorldBankandthe

IMF from such a broad swath of the political spectrum. The Economist oncecommented, “If the developing countries had a dollar for every proposal tochange the ‘international financial architecture,’ the problem of third-worldpovertywouldbesolved.”15ConservativeschargethattheWorldBankandtheIMFare bureaucratic organizations that squandermoneyon projects that havefailed to lead nations out of poverty. They also argue that IMF bailoutsmakefinancial crises more likely in the first place; investors make imprudentinternationalloansbecausetheybelievetheIMFwillcometotherescuewhenacountry gets into trouble. In 2000, the Republican-led Congress convened acommissionthatrecommendedshrinkingandoverhaulingboththeWorldBankandtheInternationalMonetaryFund.16

At the other end of the political spectrum, the antiglobalization coalitionaccuses the World Bank and IMF of acting as capitalist lackeys, forcingglobalizationon thedevelopingworldand leavingpoorcountriessaddledwithlargedebtsintheprocess.Theorganizations’meetingshavebecomeanoccasionforviolentprotest.WhenthetwoinstitutionsheldtheirfallmeetinginPraguein2000,thelocalKentuckyFriedChickenandPizzaHutbothorderedreplacementglassaheadoftime.

As the global recession of 2007 unfolded, theUnited States criticized severalEuropeannationsfornotdoingmoretostimulatetheireconomies.Thespecificcriticismisdebatable,butitmakesacrucialpointnonetheless.FortheAmericaneconomytorecover,theEuropeaneconomiesneededtorecover,too.AndJapan.AndChina.Andeveryothermajoreconomy.Nationsarenotcompetitorsinthetraditionalsenseoftheword.Afterall,theRedSoxwouldnevercomplainthatthe Yankees were not doing enough in the off-season to improve their team.Baseball is a zero-sum game. Only one team can win the World Series.International economics is the opposite. All countries can become richer overtime, even as individual firms within those countries compete for profits andresources. Global GDP has grown steadily for centuries. We’re richercollectively thanwewere in1500.Whogotpoorer tomake thatpossible?Noone.Thegoalofglobaleconomicpolicyshouldbetomakeiteasierfornationstocooperatewithoneanother.Thebetterwedoit,thericherandmoresecurewewillallbe.

CHAPTER12

TradeandGlobalization:

ThegoodnewsaboutAsiansweatshops

Imagine a spectacular invention: a machine that can convert corn into stereoequipment.Whenrunningatfullcapacity,thismachinecanturnfiftybushelsofcorn intoaDVDplayer.Orwithone switchof thedial, itwill convert fifteenhundred bushels of soybeans into a four-door sedan.But thismachine is evenmore versatile than that; when properly programmed, it can turn WindowssoftwareintothefinestFrenchwines.OraBoeing777intoenoughfreshfruitsandvegetablestofeedacityformonths.Indeed,themostamazingthingaboutthisinventionisthatitcanbesetupanywhereintheworldandprogrammedtoturn whatever is grown or produced there into things that are usually muchhardertocomeby.

Remarkably,itworksforpoorcountries,too.Developingnationscanputthethings they manage to produce—commodities, cheap textiles, basicmanufacturedgoods—into themachine andobtain goods thatmight otherwisebedeniedthem:food,medicine,moreadvancedmanufacturedgoods.Obviously,poorcountriesthathaveaccesstothismachinewouldgrowfasterthancountriesthat did not. We would expect that making this machine accessible to poorcountrieswouldbepartofourstrategyforliftingbillionsofpeoplearoundtheglobeoutofdirepoverty.

Amazingly,thisinventionalreadyexists.Itiscalledtrade.IfIwritebooksforalivingandusemyincometobuyacarmadeinDetroit,

there is nothing particularly controversial about the transaction. It makes mebetteroff,anditmakesthecarcompanybetteroff,too.That’sChapter1kindofstuff.Amoderneconomyisbuiltontrade.Wepayotherstodoormakethingsthatwecan’t—everything frommanufacturingacar to removinganappendix.As significant, we pay people to do all kinds of things that we could do butchoosenotto,usuallybecausewehavesomethingbettertodowithourtime.We

pay others to brew coffee,make sandwiches, change the oil, clean the house,even walk the dog. Starbucks was not built on any great technologicalbreakthrough.The company simply recognized that busypeoplewill regularlypayseveraldollars foracupofcoffeerather thanmake theirownordrink thelousystuffthathasbeensittingaroundtheofficeforsixhours.

Theeasiestwaytoappreciatethegainsfromtradeistoimaginelifewithoutit.Youwouldwakeupearlyinasmall,draftyhousethatyouhadbuiltyourself.Youwouldputonclothes thatyouwoveyourselfafter shearing the twosheepthatgraze inyourbackyard.Thenyouwouldplucka fewcoffeebeansoff thescragglytreethatdoesnotgrowparticularlywellinMinneapolis—allthewhilehoping that your chicken had laid an egg overnight so that you might havesomethingtoeatforbreakfast.Thebottomlineisthatourstandardoflivingishigh becausewe are able to focus on the tasks thatwe do best and trade foreverythingelse.

Whywould thesekindsof transactionsbedifferent if aproductor serviceoriginated inGermanyor India?They’re not, really.We’ve crossed a politicalboundary, but the economics have not changed in any significant way.Individualsandfirmsdobusinesswithoneanotherbecauseitmakesthembothbetteroff.ThatistrueforaworkerataNikefactoryinVietnam,anautoworkerin Detroit, a Frenchman eating a McDonald’s hamburger in Bordeaux, or anAmericandrinkingafineBurgundyinChicago.Anyrationaldiscussionoftrademust beginwith the idea that people inChad or Togo or SouthKorea are nodifferent from you orme; they do things that they hopewillmake their livesbetter.Tradeisoneofthosethings.PaulKrugmanhasnoted,“Youcouldsay—andIwould—thatglobalization,drivennotbyhumangoodnessbutbytheprofitmotive,hasdonefarmoregoodforfarmorepeoplethanalltheforeignaidandsoft loans ever provided by well-intentioned governments and internationalagencies.”Thenheaddswistfully,“Butinsayingthis,IknowfromexperiencethatIhaveguaranteedmyselfabarrageofhatemail.”1

Such is the nature of “globalization,” the term that has come to represent theincrease in the international flow of goods and services. Americans andmostothers on the planet aremore likely than ever to buy goods or services fromanothernationandtosellgoodsandservicesabroadinreturn.Inthelate1980s,I was traveling through Asia while writing a series of articles for a dailynewspaper in New Hampshire. In a relatively remote part of Bali, I was so

surprised to find a Kentucky Fried Chicken that I wrote a story about it.“Colonel Sanders has succeeded in putting fast-food restaurants in the mostremote areas of the world,” I wrote. Had I realized that the idea of “culturalhomogenization” would become a flashpoint for civil unrest a decade later, Imight have become rich and famous as one of the earliest commentators onglobalization. Instead, I merely noted, “In this relatively undisturbedenvironment,KentuckyFriedChickenseemsoutofplace.”2

ThatKFCrestaurantwasmorethanthecuriositythatImadeitouttobe.Itwas a tangible sign ofwhat the statistics clearly show: Theworld is growingmore economically interdependent. The world’s exports as a share of globalGDP have climbed from 8 percent in 1950 to around 25 percent today.3 U.S.exportsasafractionofGDPgrewfrom5percenttonearly10percentoverthesame stretch. It is worth noting that the bulk of the American economy stillconsistsofgoodsandservicesproducedfordomesticconsumption.Atthesametime,becauseof thesheersizeof thateconomy,America isoneof theworld’slargest exporters, behind only China and Germany in total value. The UnitedStateshasmuchtogainfromanopen,internationaltradingsystem.Thenagain,sodoestherestoftheworld.

Havingmade thatcase inmanydifferentvenues,nowIgethatemail, too.Sometimes it’s actually kind of clever.My favorite is an e-mail that came inresponsetoacolumnarguingthataricher,rapidlygrowingIndiaisgoodfortheUnited States. After the usual introduction arguing that my job should beoutsourcedtosomelowwagecountryassoonaspossible,thee-mailconcluded,“Whydon’t you andTomFriedman [authorof thepro-globalizationbookTheWorld IsFlat] get a room together?Theworld isn’t flat, it’s just your head!”Others tend to be less subtle, such as the e-mail with the subject line: YOUSUCK!!!!!!!!!!!!!!!!!!!!!!!!(Yes,thatistheexactnumberofexclamationpoints.)

Allthoseexclamationpointsnotwithstanding,nearlyalltheoryandevidencesuggestthatthebenefitsofinternationaltradefarexceedthecosts.Thetopicisworthy of an entire book; some good ones wade into everything from theadministrativestructureof theWTOto the fateof sea turtlescaught in shrimpnets.Yet thebasic ideas underlying the costs andbenefits of globalization aresimpleandstraightforward.Indeed,nomodernissuehaselicitedsomuchsloppythinking. The case for international trade is built on the most basic ideas ineconomics.

Trade makes us richer. Trade has the distinction of being one of the mostimportant ideas in economics and also one of the least intuitive. AbrahamLincoln was once advised to buy cheap iron rails from Britain to finish thetranscontinental railroad. He replied, “It seems tome that if we buy the railsfromEngland, thenwe’ve got the rails and they’ve got themoney.But ifwebuild the rails here, we’ve got our rails and we’ve got our money.”4 Tounderstand the benefits of trade, we must find the fallacy in Mr. Lincoln’seconomics. Let me paraphrase his point and see if the logical flaw becomesclear:IfIbuymeatfromthebutcher,thenIgetthemeatandhegetsmymoney.ButifIraiseacowinmybackyardforthreeyearsandslaughteritmyself,thenI’ve got the meat and I’ve got my money. Why don’t I keep a cow in mybackyard?Because itwouldbea tremendouswasteof time—time that Icouldhave used to do something else far more productive. We trade with othersbecauseitfreesuptimeandresourcestodothingsthatwearebetterat.

SaudiArabia canproduceoilmore cheaply than theUnitedStates can. Inturn,theUnitedStatescanproducecornandsoybeansmorecheaplythanSaudiArabia. The corn-for-oil trade is an example of absolute advantage. Whendifferent countries are better at producing different things, they can bothconsumemorebyspecializingatwhattheydobestandthentrading.PeopleinSeattle should not grow their own rice. Instead, they should build airplanes(Boeing),write software (Microsoft), andsellbooks (Amazon)—and leave therice-growingtofarmersinThailandorIndonesia.Meanwhile,thosefarmerscanenjoy the benefits of Microsoft Word even though they do not have thetechnology or skills necessary to produce such software. Countries, likeindividuals,havedifferentnaturaladvantages.ItdoesnotmakeanymoresenseforSaudiArabiatogrowvegetablesthatitdoesforTigerWoodstodohisownautorepairs.

Okay, but what about countries that don’t do anything particularly well?After all, countries are poor because they are not productive. What canBangladeshoffer to theUnitedStates?Agreat deal, it turns out, becauseof aconceptcalledcomparativeadvantage.WorkersinBangladeshdonothavetobebetter thanAmericanworkersatproducinganythingfor there tobegainsfromtrade. Rather, they provide goods to us so that we can spend our timespecializingatwhateverwedobest.Hereisanexample.ManyengineersliveinSeattle.Thesemenandwomenhavedoctorates inmechanicalengineeringandprobablyknowmoreaboutmanufacturingshoesandshirtsthannearlyanyonein

Bangladesh.Sowhywouldwebuy imported shirts and shoesmadebypoorlyeducatedworkersinBangladesh?BecauseourSeattleengineersalsoknowhowto design andmanufacture commercial airplanes. Indeed, that iswhat they dobest,meaning thatmakingjetscreates themostvaluefor their time.ImportingshirtsfromBangladeshfreesthemuptodothis,andtheworldisbetteroffforit.

Productivity is what makes us rich. Specialization is what makes usproductive. Trade allows us to specialize. Our Seattle engineers are moreproductive at making planes than they are at sewing shirts; and the textileworkersinBangladesharemoreproductiveatmakingshirtsandshoesthantheyareatwhateverelsetheymightdo(orelsetheywouldnotbewillingtoworkina textile factory). I amwriting at themoment.Mywife is running a softwareconsulting firm. A wonderful woman named Clementine is looking after ourchildren.WedonotemployClemenbecausesheisbetterthanweareatraisingour children (though there are moments when I believe that to be true). WeemployClemenbecausesheenablesustoworkduringthedayatthejobswedowell, and that is thebestpossiblearrangement forour family—not tomentionforClemen,forthereadersofthisbook,andformywife’sclients.

Trademakesthemostefficientuseoftheworld’sscarceresources.

Trade creates losers. If trade transports the benefits of competition to the farcorners of the earth, then the wreckage of creative destruction cannot be farbehind. Try explaining the benefits of globalization to shoeworkers inMainewhohavelostjobsbecausetheirplantmovedtoVietnam.(Remember,IwasthespeechwriterforthegovernorofMaine;Ihavetriedtoexplainthat.)Trade,liketechnology,candestroyjobs,particularlylow-skilledjobs.IfaworkerinMaineearns $14 anhour for something that canbe done inVietnam for $1 anhour,then he had better be 14 times as productive. If not, a profit-maximizing firmwill choose Vietnam. Poor countries lose jobs, too. Industries that have beenshieldedfrominternationalcompetitionfordecades,andhavethereforeadoptedall the bad habits that come from not having to compete, can be crushed byruthlesslyefficientcompetitionfromabroad.HowwouldyouliketohavebeentheproducerofThumbs-UpColainIndiawhenCoca-Colaenteredthemarketin1994?

Inthelongrun,tradefacilitatesgrowthandagrowingeconomycanabsorbdisplaced workers. Exports rise and consumers are made richer by cheapimports;bothof those thingscreatedemand fornewworkers elsewhere in the

economy. Trade-related job losses inAmerica tend to be small relative to theeconomy’scapacitytoproducenewjobs.Onepost-NAFTAstudyconcludedthatanaverageof37,000jobsperyearwerelostfrom1990to1997becauseoffreetrade with Mexico, while over the same period the economy was creating200,000jobspermonth.5Still,“inthelongrun”isoneofthoseheartlessphrases—along with “transition costs” or “short-term displacement”—that overlyminimizethehumanpainanddisruption.

Maine shoeworkers are expected to pay theirmortgages in the short run.The sad reality is that they may not be better off in the long run, either.Displaced workers often have a skills problem. (Far more workers are maderedundantbynewtechnologythanbytrade.)Ifanindustryisconcentratedinageographicarea,astheyoftenare,laidoffworkersmaywatchtheircommunitiesandwayoflifefadeaway.

TheNewYorkTimesdocumentedthecaseofNewtonFalls,acommunityinupstate New York that grew up around a paper mill that opened in 1894. Acentury later, thatmill closed, inpartbecauseofgrowing foreigncompetition.It’snotpretty:

SinceOctober—aftera last-ditcheffort tosave themill fell through—NewtonFalls has edged closer to becoming a case study of doleful ruralsociology:adyingtown,wherethefewpeopleleftgivemournfultestamentto having their community wind down like an untended clock, tickinginexorablytowardafinaltock.6

Yes, the economic gains from trade outweigh the losses, but the winnersrarely write checks to the losers. And the losers often lose badly. WhatconsolationisittoaMaineshoeworkerthattradewithVietnamwillmakethecountryasawholericher?He’spoorerandprobablyalwayswillbe.I’vegottenthosee-mails,too.

Indeed,we’reback to thesamediscussionaboutcapitalism thatwehadatthebeginningof thebookandagain inChapter8.Marketscreateanew,moreefficientorderbydestroying theoldone.There isnothingpleasantabout that,particularly for individuals and firms equipped for the old order. Internationaltrademakesmarketsbigger,morecompetitive,andmoredisruptive.MarkTwainanticipated the fundamentaldilemma:“I’mall forprogress; it’schange Idon’tlike.”

MarvinZonis,aninternationalconsultantandaUniversityofChicagoBoothSchool ofBusiness professor, has called thepotential benefits of globalization“immense,” particularly for the poorest of the poor. He has also noted,“Globalizationdisrupts everything, everywhere. It disrupts establishedpatternsof life—between husband and wife, parents and children; between men andwomen,youngandold;betweenbossandworker,governorandgoverned.”7Wecandothingstosoftenthoseblows.Wecanretrainorevenrelocateworkers.Wecan provide development assistance to communities harmed by the loss of amajor industry.We can ensure that our schools teach the kinds of skills thatmakeworkersadaptabletowhatevertheeconomymaythrowatthem.Inshort,wecanmakesurethat thewinnersdowritechecks(if indirectly) tothelosers,sharingatleastpartoftheirgains.It’sgoodpoliticsandit’stherightthingtodo.

KennethScheve,aYalepoliticalscienceprofessor,andMatthewSlaughter,aneconomistattheTuckSchoolofBusinessatDartmouth,wroteaprovocativepiece in Foreign Affairs arguing that the United States should adopt a“fundamentallymoreprogressivefederaltaxsystem”(e.g.,taxtherichmore)asthe best way of saving globalization from a protectionist backlash. What’sinteresting is that these guys are not left-wing radicalswearing tie-dye shirts;MattSlaughterservedintheGeorgeW.Bushadministration.Rather,theyarguethatthehugebenefitsfortheU.S.economyasawholearebeingputatriskbythe fact that too many Americans aren’t seeing their paychecks get bigger.ScheveandSlaughterexplain:

[U.S.] policy is becoming more protectionist because the public isbecomingmoreprotectionist,andthepublicisbecomingmoreprotectionistbecause incomes are stagnating or falling. The integration of the worldeconomyhasboostedproductivityandwealthcreationintheUnitedStatesandmuchoftherestoftheworld.Butwithinmanycountries,andcertainlywithintheUnitedStates,thebenefitsofthisintegrationhavebeenunevenlydistributed—andthisfact is increasinglybeingrecognized.Individualsareasking themselves, “Is globalization good for me?” and, in a growingnumberofcases,arrivingattheconclusionthatitisnot.

The authors propose “a New Deal for globalization—one that linksengagementwiththeworldeconomytoasubstantialredistributionofincome.”Remember,thisisn’thippytalk.Thesearethecapitalistswhoseeangryworkers

withpitchforksloiteringoutsidethegatesofaveryprofitablefactory,andtheyaremaking a very pragmatic calculation: Throw these people some food (andmaybesomemovieticketsandbeer)beforeweallendupworseoff.8

Protectionism saves jobs in the short runand slows economicgrowth in thelongrun.We can save the jobs of thoseMaine shoeworkers.We canprotectplaces like Newton Falls. We can make the steel mills in Gary, Indiana,profitable.Weneedonlygetridoftheirforeigncompetition.Wecanerecttradebarriers that stop thecreativedestructionat theborder.Sowhydon’twe?Thebenefitsofprotectionismareobvious;wecanpointtothejobsthatwillbesaved.Alas, the costs ofprotectionismaremore subtle; it is difficult topoint to jobsthatarenevercreatedorhigherincomesthatareneverearned.

To understand the costs of trade barriers, let’s ponder a strange question:Would the United States be better off if we were to forbid trade across theMississippiRiver?Thelogicofprotectionismsuggeststhatwewould.Forthoseofuson theeast sideof theMississippi,new jobswouldbecreated, sincewewould no longer have access to things like Boeing airplanes or NorthernCalifornia wines. But nearly every skilled worker east of the Mississippi isalready working, and we are doing things that we are better at than makingairplanesorwine.Meanwhile,workersintheWest,whoarenowverygoodatmaking airplanes orwine,would have to quit their jobs in order tomake thegoodsnormallyproducedintheEast.Theywouldnotbeasgoodatthosejobsasthe people who are doing them now. Preventing trade across the Mississippiwould turn the specialization clock backward. We would be denied superiorproductsandforcedtodojobsthatwe’renotparticularlygoodat.Inshort,wewouldbepoorerbecausewewouldbecollectivelylessproductive.Thisiswhyeconomists favor trade not just across the Mississippi, but also across theAtlantic and the Pacific. Global trade turns the specialization clock forward;protectionismstopsthatfromhappening.

America punishes rogue nations by imposing economic sanctions. In thecaseofseveresanctions,weforbidnearlyallimportsandexports.ArecentNewYorkTimes article commentedon thedevastating impactof sanctions inGaza.SinceHamascametopowerandrefusedtorenounceviolence,Israelhaslimitedwhat cango in andoutof the territory, leavingGaza“almost entirely shutofffrom normal trade and travel with the world.” Prior to the Iraq War, our(unsuccessful) sanctionson Iraqwere responsible for thedeathsof somewhere

between100,000and500,000children,dependingonwhomyoubelieve.9Morerecently, theUnitedNations has imposed several rounds of increasingly harshsanctions on Iran for not suspending its clandestine nuclear program. TheChristian Science Monitor explained the economic logic: Tougher sanctions“wouldhittherulingmullahshardbyraisingIran’salreadyhighunemployment,andperhapsforcetrickle-upregimechange.”

CivilWar buffs should remember that one key strategy of the North wasimposinganavalblockadeontheSouth.Why?BecausethentheSouthcouldn’ttrade what it produced well (cotton) to Europe for what it needed most(manufacturedgoods).

So here’s a question: Why would we want to impose trade sanctions onourselves—which is exactly what any kind of protectionism does? Can theantiglobalization protesters explain how poor countries will get richer if theytradelesswithrestoftheworld—likeGaza?Cuttingofftradeleavesacountrypoorerandlessproductive—whichiswhywetendtodoittoourenemies.

Trade lowers the cost of goods for consumers,which is the same as raisingtheirincomes.Forgetaboutshoeworkersforamomentandthinkaboutshoes.WhydoesNikemakeshoesinVietnam?BecauseitischeaperthanmakingthemintheUnitedStates,andthatmeanslessexpensiveshoesfortherestofus.Oneparadox of the trade debate is that individuals who claim to have thedowntrodden at heart neglect the fact that cheap imports are good for low-incomeconsumers(andfortherestofus).Cheapergoodshavethesameimpactonour livesashigher incomes.Wecanafford tobuymore.Thesame thing istrue,obviously,inothercountries.

Tradebarriersareatax—albeitahiddentax.SupposetheU.S.governmenttacked a 30-cent tax on every gallon of orange juice sold in America. Theconservativeantigovernmentforceswouldbeupinarms.Sowouldliberals,whogenerally take issue with taxes on food and clothing, since such taxes areregressive,meaningthattheyaremostcostly(asapercentageofincome)forthedisadvantaged.Well, the government does add 30 cents to the cost of everygallonoforangejuice,thoughnotinawaythatisnearlyastransparentasatax.TheAmerican government slaps tariffs onBrazilian oranges and orange juicethat canbe as high as 63percent.Parts ofBrazil arenearly ideal for growingcitrus, which is exactly what has American growers concerned. So thegovernment protects them. Economists reckon that the tariffs on Brazilian

orangesandjuicelimitthesupplyofimportsandthereforeaddabout30centstothe price of a gallon of orange juice. Most consumers have no idea that thegovernment is taking money out of their pockets and sending it to orangegrowersinFlorida.10Thatdoesnotshowuponthereceipt.

Loweringtradebarriershasthesameimpactonconsumersascuttingtaxes.Theprecursor to theWorldTradeOrganizationwas theGeneralAgreementonTariffsandTrade(GATT).FollowingWorldWarII,GATTwasthemechanismbywhichcountriesnegotiatedtobringdownglobaltariffsandopenthewayformoretrade.In theeightroundsofGATTnegotiationsbetween1948and1995,averagetariffsinindustrialcountriesfellfrom40percentto4percent.Thatisamassive reduction in the “tax” paid on all imported goods. It has also forceddomestic producers to make their goods cheaper and better in order to staycompetitive.Ifyouwalkintoacardealershiptoday,youarebetteroffthanyouwerein1970fortworeasons.First,thereisawiderchoiceofexcellentimports.Second,Detroithasresponded(slowly,belatedly,andincompletely)bymakingbettercars,too.TheHondaAccordmakesyoubetteroff,andsodoestheFordTaurus,whichisbetterthanitwouldhavebeenwithoutthecompetition.

Tradeisgoodforpoorcountries,too.Ifwehadpatientlyexplainedthebenefitsof trade to the protesters in Seattle or Washington or Davos or Genoa, thenperhaps theywouldhave laiddown theirMolotovcocktails.Okay,maybenot.The thrust of the antiglobalization protests has been that world trade issomethingimposedbyrichcountriesonthedevelopingworld.IftradeismostlygoodforAmerica,thenitmustbemostlybadforsomewhereelse.Atthispointinthebook,weshouldrecognizethatzero-sumthinkingisusuallywrongwhenit comes to economics. So it is in this case. Representatives from developingnationsweretheoneswhocomplainedmostbitterlyaboutthedisruptionoftheWTO talks in Seattle. Some believed that the Clinton administration secretlyorganizedtheproteststoscuttlethetalksandprotectAmericaninterestgroups,suchasorganizedlabor.Indeed,afterthefailureoftheWTOtalksinSeattle,UNchiefKofiAnnanblamedthedevelopedcountriesforerectingtradebarriersthatexclude developing nations from the benefits of global trade and called for a“GlobalNewDeal.”11TheWTO’scurrentroundoftalkstoreduceglobaltradebarriers,theDohaRound,hasstalledinlargepartbecauseablocofdevelopingnationsisdemandingthattheUnitedStatesandEuropereducetheiragriculturalsubsidiesandtradebarriers;sofartherichcountrieshaverefused.

Tradegivespoorcountriesaccesstomarketsinthedevelopedworld.Thatiswheremost of theworld’s consumers are (or at least the oneswithmoney tospend).ConsidertheimpactoftheAfricanGrowthandOpportunityAct,alawpassed in2000 that allowedAfrica’spoorest countries toexport textiles to theUnitedStateswithlittleornotariff.Withinayear,Madagascar’stextileexportsto the United States were up 120 percent, Malawi’s were up 1,000 percent,Nigeria’swereup1,000percent,andSouthAfrica’swereup47percent.Asonecommentatornoted,“Realjobsforrealpeople.”12

Tradepavesthewayforpoorcountriestogetricher.Exportindustriesoftenpay higher wages than jobs elsewhere in the economy. But that is only thebeginning.Newexport jobscreatemorecompetition forworkers,which raiseswages everywhere else.Even rural incomes can go up; asworkers leave ruralareasforbetteropportunities,therearefewermouthstobefedfromwhatcanbegrownonthelandtheyleavebehind.Otherimportantthingsaregoingon,too.Foreigncompaniesintroducecapital,technology,andnewskills.Notonlydoesthatmakeexportworkersmoreproductive;itspillsoverintootherareasoftheeconomy.Workers“learnbydoing”andthentaketheirknowledgewiththem.

InhisexcellentbookTheElusiveQuest forGrowth,WilliamEasterly tellsthestoryoftheadventoftheBangladeshigarmentindustry,anindustrythatwasfounded almost by accident. The Daewoo Corporation of South Korea was amajor textile producer in the 1970s. America and Europe had slapped importquotas onSouthKorean textiles, soDaewoo, ever theprofit-maximizing firm,skirtedthetraderestrictionsbymovingsomeoperationstoBangladesh.In1979,DaewoosignedacollaborativeagreementtoproduceshirtswiththeBangladeshicompanyDeshGarments.Mostsignificant,Daewootook130Deshworkers toSouthKoreafortraining.Inotherwords,Daewooinvestedinthehumancapitalof its Bangladeshi workers. The intriguing thing about human capital, asopposedtomachinesorfinancialcapital,isthatitcanneverbetakenaway.OncethoseBangladeshiworkersknewhowtomakeshirts,theycouldneverbeforcedtoforget.Andtheydidn’t.

Daewoo later severed the relationshipwith itsBangladeshipartner,but theseeds foraboomingexport industrywerealreadyplanted.Of the130workerstrained by Daewoo, 115 left during the 1980s to start their own garment-exporting firms.Mr.Easterly argues convincingly that theDaewoo investmentwas an essential building block for what became a $3 billion garment exportindustry.Lestanyonebelievethat tradebarriersarebuilt tohelpthepoorestofthepoor,orthatRepublicansaremoreaversetoprotectingspecialintereststhan

Democrats, it should be noted that the Reagan administration slapped importquotasonBangladeshitextilesinthe1980s.IwouldbehardpressedtoexplaintheeconomicrationaleforlimitingtheexportopportunitiesofacountrythathasapercapitaGDPof$1,500.

Most famously, cheap exports were the path to prosperity for the Asian“tigers”—Singapore, South Korea, Hong Kong, and Taiwan (and for Japanbeforethat).Indiawasstrikinglyinsularduringthefourdecadesafterachievingindependence fromBritain in 1947; itwas one of theworld’s great economicunderachievers during that stretch. (Alas, Gandhi, like Lincoln, was a greatleader and a bad economist; Gandhi proposed that the Indian flag have aspinning wheel on it to represent economic self-sufficiency.) India reversedcourse in the1990s,deregulating itsdomesticeconomyandopeningup to theworld. The result is an ongoing economic success story. China, too, has usedexportsasalaunchingpadforgrowth.Indeed,ifChina’sthirtyprovinceswerecounted as individual countries, the twenty fastest-growing countries in theworld between 1978 and 1995 would all have been Chinese. To put thatdevelopment accomplishment in perspective, it took fifty-eight years forGDPpercapita todouble inBritainafter the launchof the IndustrialRevolution. InChina,GDPpercapitahasbeendoublingeverytenyears.InthecasesofIndiaandChina,we’retalkingabouthundredsofmillionsofpeoplebeingliftedoutofpoverty and, increasingly, into the middle class. Nicholas Kristof and SherylWuDunn,AsiancorrespondentsfortheNewYorkTimesforoveradecade,havewritten:

We and other journalistswrote about the problems of child labor andoppressive conditions in bothChina andSouthKorea.But, lookingback,our worries were excessive. Those sweatshops tended to generate thewealthtosolvetheproblemstheycreated.IfAmericanshadreactedtothehorrorstoriesinthe1980sbycurbingimportsofthosesweatshopproducts,then neither southern China nor South Korea would have registered asmuchprogressastheyhavetoday.13

China and Southeast Asia are not unique. The consultancy AT Kearneyconducted a studyof howglobalizationhas affected thirty-four developed anddevelopingcountries.Theyfoundthatthefastest-globalizingcountrieshadratesof growth that were 30 to 50 percent higher over the past twenty years than

countries less integrated into theworldeconomy.Thosecountriesalsoenjoyedgreater political freedom and received higher scores on the UN HumanDevelopment Index. The authors reckon that some 1.4 billion people escapedabsolute poverty as a result of the economic growth associated withglobalization. There was bad news, too. Higher rates of globalization wereassociatedwithhigherratesofincomeinequality,corruption,andenvironmentaldegradation.Moreonthatlater.

But there is an easierway tomake the case for globalization. If notmoretrade and economic integration, then what instead? Those who oppose moreglobal trade must answer one question, based on a point made by Harvardeconomist Jeffrey Sachs: Is there an example in modern history of a singlecountrysuccessfullydevelopingwithouttradingandintegratingwiththeglobaleconomy?14

No,thereisnot.Which is why Tom Friedman has suggested that the antiglobalization

coalitionoughttobeknownas“TheCoalitiontoKeeptheWorld’sPoorPeoplePoor.”

Trade is based on voluntary exchange. Individuals do things that makethemselvesbetteroff.Thatobviouspointisoftenlostintheglobalizationdebate.McDonald’s does not build a restaurant in Bangkok and then force people atgunpoint toeat there.Peopleeat therebecause theywant to.Andif theydon’twant to, they don’t have to.And if no one eats there, the restaurantwill losemoneyandclose.DoesMcDonald’schangelocalcultures?Yes.ThatwaswhatcaughtmyattentionadecadeagowhenIwroteaboutKentuckyFriedChickenarrivinginBali.Iwrote,“IndonesianshavetheirownversionoffastfoodthatismorepracticalthantheColonel’scardboardboxesandStyrofoamplates.Amealbought at a food stall is wrapped in a banana leaf and newspaper. The largegreenleafretainsheat, is impermeabletogrease,andcanbefoldedintoaneatpackage.”

By and large, the banana leaves of the world appear to be losing tocardboard.NotlongagoIattendedabusinessgatheringwithmywifeinPuertaVallarta,Mexico.PuertaVallartaisalovelycitythatspillsdownfromthehillstothePacificOcean.Thefocalpointofthecityisapromenadethatrunsalongtheocean.Nearthemiddleofthatpromenadeisapointthatjutsoutintotheocean,andattheendofthatpoint,onwhatIwouldreckonisoneofthemostvaluable

piecesofrealestateinthecity,isaHootersrestaurant.WhenourgroupspottedthisinfamousAmericanexport,onemangrumbled,“Thatisjustwrong.”

AHooters inall theworld’sgreatcities isprobablynotwhatAdamSmithhadinmind.UniversityofChicagoprofessorMarvinZonishasnoted,“Certainaspects of American popular culture—the depravity and the coarseness, theviolence and the sexuality—are eminently worth resenting.”15 The threat of“culturalhomogenization”—theworstofitcomingfromAmerica—isacommonknockagainstglobalization.Butitisanissuethatleadsusbacktoacrucialpointfrom Chapter 1: Who decides? I was not happy to see a Hooters in PuertaVallarta, but, as I pointed out many pages ago, I don’t run the world. Moreimportant, Idon’t liveorvote inPuertaVallarta.Neitherdo the rock-throwingthugsinSeattleorGenoaorPittsburgh(orwhereverelsetheytendtoshowup).

Aretherelegitimatereasonstolimittheproliferationoffast-foodrestaurantsandthelike?Yes, theypresentclassicexternalities.Fast-foodrestaurantscausetrafficandlitter;theyareuglyandcancontributetosprawl.(Beforemyvaluableworkopposinganew train stationonFullertonAvenue, Iwaspartof agrouptrying to prevent aMcDonald’s frommoving in across the street.) These arelocaldecisionsthatoughttobemadebythepeopleaffected—thosewhomighteat in thesafe,cleanenvironmentofaMcDonald’s restaurantaswellas thosewhomayhavefast-foodwrappersblownintheirgutters.Freetradeisconsistentwith one of our most fundamental liberal values: the right to make our ownprivatedecisions.

There is now aMcDonald’s inMoscowand aStarbucks in theForbiddenCity in Beijing. Stalin neverwould have allowed the former;Maowould nothaveallowedthelatter.Whichisapointworthpondering.

Theculturalhomogenizationargumentmaynotbe trueanyway.Culture istransmitted in all directions. I can now rent Iranian movies from Netflix.NationalPublicRadiorecentlyranasegmentoncraftsmenandartistsinremoteregionsoftheworldwhoaresellingtheirworkviatheInternet.Onecanlogonto Novica.com and find a virtual global marketplace for arts and crafts.KatherineRyan,whoworksforNovica,explains,“There’sacommunityinPeruwheremostoftheartistshadgonetoworkinthecoalmines.Andnow,becauseofthesuccessofoneartistinNovica,hehasbeenabletohiremanyofhisfamilymembersandneighborsback into theweavingbusiness,and they’reno longercoalminers.They’renowdoingwhatformanygenerationstheirfamilydid,andthat’sweaveincredibletapestries.”16JohnMicklethwaitandAdrianWooldridge,authorsoftheglobalizationtractAFuturePerfect,pointoutthatintherealmof

business, a previously obscure Finnish company like Nokia has been able tothumpAmericanbehemothslikeMotorola.

We’restilljustwarmingupwhenitcomestothesideeffectsofglobalization.AHooters in PuertaVallarta is amild headache relative to the horrors ofAsiansweatshops.Yetthesameprinciplesapply.NikedoesnotuseforcedlaborinitsVietnamesefactories.Whyareworkerswillingtoacceptadollarortwoaday?Becauseit isbetterthananyotheroptiontheyhave.AccordingtotheInstitutefor International Economics, the average wage paid by foreign companies inlow-incomecountriesistwicetheaveragedomesticmanufacturingwage.

Nicholas Kristof and Sheryl WuDunn described a visit with MongkolLatlakorn, a Thai laborer whose fifteen-year-old daughter was working in aBangkokfactorymakingclothesforexporttoAmerica.

Sheispaid$2adayforanine-hourshift,sixdaysaweek.Onseveraloccasions, needles have gone through her hands, and managers havebandagedherupsothatshecouldgobacktowork.

“Howterrible,”wemurmuredsympathetically.Mongkollookedup,puzzled.“It’sgoodpay,”hesaid.“Ihopeshecan

keepthatjob.There’sallthistalkaboutfactoriesclosingnow,andshesaidtherearerumorsthatherfactorymightclose.Ihopethatdoesn’thappen.Idon’tknowwhatshewoulddothen.”17

The implicit message of the antiglobalization protests is that we in thedeveloped world somehow know what is best for people in poor countries—wheretheyoughttoworkandevenwhatkindofrestaurantstheyoughttoeatin.AsThe Economist has noted, “The skeptics distrust governments, politicians,international bureaucrats and markets alike. So they end up appointingthemselvesasjudges,overrulingnotjustgovernmentsandmarketsbutalsothevoluntary preferences of the workers most directly concerned. That seems agreatdealtotakeon.”18

Thecomparativeadvantageofworkersinpoorcountriesischeaplabor.That

isalltheyhavetooffer.TheyarenotmoreproductivethanAmericanworkers;theyarenotbettereducated;theydonothaveaccesstobettertechnology.TheyarepaidverylittlebyWesternstandardsbecausetheyaccomplishverylittlebyWesternstandards.Ifforeigncompaniesareforcedtoraisewagessignificantly,thenthereisnolongeranyadvantagetohavingplantsinthedevelopingworld.Firmswillreplaceworkerswithmachines,ortheywillmovesomeplacewherehigherproductivity justifieshigherwages. If sweatshopspaiddecentwagesbyWestern standards, theywould not exist. There is nothing pretty about peoplewillingtoworklonghoursinbadconditionsforafewdollarsaday,butlet’snotconfusecauseandeffect.Sweatshopsdonotcauselowwagesinpoorcountries;rather, theypay lowwagesbecause thosecountriesofferworkersso fewotheralternatives.Protestersmightaswellhurlrocksandbottlesathospitalsbecausesomanysickpeoplearesufferingthere.

Nordoes itmakesense thatwecanmakesweatshopworkersbetteroffbyrefusing to buy the products that they make. Industrialization, howeverprimitive, sets in motion a process that can make poor countries richer. Mr.KristofandMs.WuDunnarrivedinAsia in the1980s.“LikemostWesterners,we arrived in the regionoutraged at sweatshops,” they recalled fourteenyearslater.“In time, though,wecametoaccept theviewsupportedbymostAsians:that the campaign against sweatshops risks harming the very people it isintended to help. For beneath their grime, sweatshops are a clear sign of theindustrial revolution that is beginning to reshape Asia.” After describing thehorrific conditions—workers denied bathroom breaks, exposed to dangerouschemicals, forced toworksevendaysaweek—theyconclude,“Asianworkerswouldbeaghast at the ideaofAmericanconsumersboycottingcertain toysorclothinginprotest.ThesimplestwaytohelpthepoorestAsianswouldbetobuymorefromsweatshops,notless.”19

You’re not convinced? Paul Krugman offers a sad example of goodintentionsgoneawry:

In 1993, child workers in Bangladesh were found to be producingclothing for Wal-Mart and Senator Tom Harkin proposed legislationbanning imports from countries employing underage workers. The directresult was that Bangladeshi textile factories stopped employing children.Butdid thechildrengoback toschool?Did they return tohappyhomes?Not according to Oxfam, which found that the displaced child workersended up in even worse jobs, or on the streets—and that a significant

numberwereforcedintoprostitution.20

Oops.

Preferenceschangewithincome,particularlywithregardtotheenvironment.Poorpeoplecareaboutdifferentthingsthanrichpeopledo.Byglobalstandards,poordoesnotmeansettlingforaFordFiestawhenyoureallywantedtheBMW.Pooriswatchingyourchildrendieofmalariabecauseyoucouldnotafforda$5mosquitonet. Inpartsof theworld,$5 is fivedaysof income.By those samestandards, anyone reading this book is rich. The fastest way to end anymeaningfuldiscussionofglobalizationistowavetheenvironmentcard.Butlet’sdo a simple exercise to illustratewhy itmay be terriblywrong to impose ourenvironmentalpreferenceson the rest of theworld.Here is the task:Ask fourfriendstonametheworld’smostpressingenvironmentalproblem.

It’safairbetthatatleasttwoofthemwillsayglobalwarmingandnonewillmentioncleanwater.Yet inadequateaccess to safedrinkingwater—aproblemeasily cured by rising living standards—kills two million people a year andmakes another half billion seriously ill. Is globalwarming a serious problem?Yes.Would itbeyourprimaryconcern ifchildren inyour townroutinelydiedfromdiarrhea?No.Thefirstfallacyrelatedtotradeandtheenvironmentisthatpoor countries should be held to the same environmental standards as thedeveloped world. (The debate over workplace safety is nearly identical.)Producing things causes waste. I remember the first day of an environmentaleconomics course when visiting professor Paul Portney, former head ofResourcesfortheFuture,pointedoutthattheveryactofstayingaliverequiresthat we produce waste. The challenge is to weigh the benefits of what weproduce against the costs of producing it, including pollution. Someone livingcomfortably inManhattanmay view those costs and benefits differently fromsomeone livingon thebrinkofstarvation in ruralNepal.Thus, tradedecisionsthataffecttheenvironmentinNepaloughttobemadeinNepal,recognizingthatenvironmentalproblemsthatcrosspoliticalboundarieswillbesettledthesameway they always are, which is through multilateral agreements andorganizations.

Thenotionthateconomicdevelopmentisinherentlybadfortheenvironmentmay be wrong anyway. In the short run, just about any economic activity

generateswaste.Ifweproducemore,wewillpollutemore.Yetitisalsotruethataswegetricher,wepaymoreattentiontotheenvironment.Hereisanotherquiz.InwhatyeardidairqualityinLondon(thecityforwhichwehavethebestlong-termpollutiondata)reachitsworstlevelever?Tomakeiteasier,let’snarrowthechoices:1890;1920;1975;2001.Theansweris1890.Indeed,thecity’scurrentairquality isbetter thanat any time since1585. (There isnothingparticularly“clean” about cooking over an open fire.) Environmental quality is a luxurygoodinthetechnicalsenseoftheword,whichmeansthatweplacemorevalueonitaswegetricher.Thereinliesoneofthepowerfulbenefitsofglobalization:Trademakes countries richer; richer countries caremore about environmentalquality and have more resources at their disposal to deal with pollution.Economists reckon that many kinds of pollution rise as a country gets richer(when every family buys a motorcycle) and then fall in the later stages ofdevelopment(whenwebanleadedgasolineandrequiremoreefficientengines).

Criticsoftradehaveallegedthatallowingindividualcountriestomaketheirownenvironmentaldecisionswill leadtoa“racetothebottom”inwhichpoorcountries compete for business by despoiling their environments. It hasn’thappened. The World Bank recently concluded after six years of study,“Pollutionhavens—developingcountriesthatprovideapermanenthometodirtyindustries—havefailedtomaterialize.Instead,poorernationsandcommunitiesare acting to reduce pollution because they have decided that the benefits ofabatementoutweighthecosts.”21

Climate change is a trickier case, in that carbon emissions are a zero-sumsituation,atleastindevelopingcountriesinthenearterm.Big,rapidlygrowingcountrieslikeChinaandIndiahaveavoraciousappetiteforenergy;tomeetthatneed, they turn mostly to carbon-based fuels. China is heavily dependent oncoal, which is a particularly bad CO2 offender. Trade makes these countriesricher.Astheygetricher, theywillusemoreenergy.Astheyusemoreenergy,theirCO2emissionswillrise.That’saproblem.Sowhatisthebestremedy?

Ifyouthinkitistocurtailtrade,letmepresentaslightlydifferentversionofthesamebasicchallenge.Chinaand Indiaare sendingmoreandmoreof theircitizens to university (while extending basic education more widely, too).Education ismakingChinaand India richer.As theyget richer, theyusemoreenergy…Doyouseewherethisisgoing?Shouldwebaneducation?

No.TheanswertotheCO2problemistopromotegrowth—inIndia,China,the United States, and everywhere else—in ways that minimize the

environmentaldamage.Thebestwaytodothatistodiscouragetheuseofdirtyfuelsbyimposingsomekindofcarbontaxthatisharmonizedacrosscountries—sooner rather than later, because India and China are making developmentdecisions, suchasbuildingpowerplants, that aregoing tobewithus for fiftyyears.

The case for keeping people poor because it’s good for the planet iseconomicallyandmorallybankrupt.

Povertyisabitch.TheprincipalofahighschoolnearChicago’sRobertTaylorhousing projects once told me that when I was writing a story on urbaneducation.Hewastalkingaboutthechallengesofteachingkidswhohadgrownuppooranddeprived.Hemightaswellhavebeentalkingaboutthestateoftheworld.Manypartsoftheworld—placeswerarelythinkabout,letalonevisit—are desperately poor.We ought to make them richer; economics tells us thattrade is an important way to do it. Paul Krugman has nicely summarized theanxiety over globalization with an old French saying: Anyone who is not asocialistbeforeheisthirtyhasnoheart;anyonewhoisstillasocialistafterheisthirtyhasnohead.Hewrites:

Ifyoubuyaproductmadeinathird-worldcountry,itwasproducedbyworkerswhoarepaid incredibly littlebyWestern standards andprobablyworkunderawfulconditions.Anyonewhoisnotbotheredbythosefacts,atleast some of the time, has no heart. But that doesn’t mean thedemonstratorsareright.Onthecontrary,anyonewhothinksthattheanswerto world poverty is simple outrage against global trade has no head—orchooses not to use it. The anti-globalization movement already has aremarkabletrackrecordofhurtingtheverypeopleandcausesitclaimstochampion.22

Thetrendtowardmoreglobaltradeisoftendescribedasanunstoppableforce.Itisnot.We’vebeendownthisroadbefore,onlytohavetheworldtradingsystemtorn apart bywar and politics.One of themost rapid periods of globalizationtook place during the end of the nineteenth century and the beginning of thetwentieth. John Micklethwait and Adrian Wooldridge, authors of A Future

Perfect, have noted, “Look back 100 years and you discover a world that bymany economicmeasures wasmore global than it is today: where you couldtravelwithoutapassport,wherethegoldstandardwasaninternationalcurrency,andwheretechnology(cars,trains,ships,andtelephones)wasmakingtheworldenormously smaller.” Alas, they point out, “That grand illusion was shot topiecesontheplayingfieldsoftheSomme.”23

Political boundaries still matter. Governments can slam the door onglobalization,astheyhavebefore.Thatwouldbeashameforrichcountriesandpoorcountriesalike.

CHAPTER13

DevelopmentEconomics:

Thewealthandpovertyofnations

Let us briefly contemplate the life of Nashon Zimba, a twenty-five-year-oldmanwholiveswithhiswifeandbabydaughterinMalawi.ThereisnoquestionthatMr.Zimbaisahardworkingman.Hebuilthisownhome,asTheEconomistdescribes:

Hedigsupmud, shapes it intocuboidsand thendries it in the sun tomakebricks.Hemixeshisowncement,alsofrommud.Hecutsbranchestomakebeams,and thatches the roofwithsisalorgrass.Hisonly industrialinputisthemetalbladeonhisaxe.Workingonhisown,whileatthesametime growing food for his family,Mr. Zimba has erected a house that isdark,cramped,coldinthewinter,steamyinsummerandhasrunningwateronlywhentropicalstormscomethroughtheroof.1

Forall thatwork,Mr.Zimba isapoorman.Hiscash incomein2000wasroughly$40.Heishardlyalone.MalawianGDPpercapitawaslessthan$200atthetimethatstorywaswritten.Eventoday,thenation’sentireannualeconomicoutputisonlyabout$12billion—orabouthalfthesizeofVermont’seconomy.Lestanyonenaivelybelievethatthereissomethingpleasantlysimpleaboutthisexistence,itshouldbepointedoutthat30percentofyoungchildreninMalawiaremalnourished;morethantwoofeverytenchildrenwilldiebeforetheyreachtheirfifthbirthday.

According to the UN’s Food and Agriculture Organization, there are abillionpeopleintheworldwhodon’tgetenoughtoeat.Thevastmajorityareinthedevelopingworld;roughlyhalfareinIndiaandChina.Howisthatpossible?

Atatimewhenwecansplittheatom,landonthemoon,anddecodethehumangenome,whydo2billionpeopleliveonlessthan$2aday?2

The short answer is that their economies have failed them. At bottom,creating wealth is a process of taking inputs, including human talent, andproducing thingsofvalue.Pooreconomiesarenotorganized todo that. Inhisexcellentbookoneconomicdevelopment,TheElusiveQuestforGrowth,WorldBankeconomistWilliamEasterlydescribesastreetsceneinLahore,Pakistan:

Peoplethrongthemarketsintheoldcity,wherethelanesaresonarrowthat the crowds swallow the car. People buying, people selling, peopleeating,peoplecooking.Everystreet,everylanecrammedwithshops,eachshop crammed with people. This is a private economy with a lot ofdynamism.3

Itisalso,henotes,acountrythatislargelyilliterate,illhoused,andillfed.ThePakistani government has built nuclear weapons but is unable to conduct animmunization program against measles. “Wonderful people,” writes Mr.Easterly.“Terriblegovernment.”Anditisaterriblegovernmentthathasbecomeincreasinglydangerousfortherestoftheworld.Wecan(probably)safelyignoreMalawi.NotPakistan.

Everycountryhas resources, ifonly thewits andhardworkof thepeoplewho inhabit it.Mostcountries, includingsomeof thepoorestnationsonearth,have far more resources than that. Let me get the bad news out of the way:Economistsdonothavearecipeformakingpoorcountriesrich.True,therehavebeensomefabuloussuccessstories,suchas theoriginalAsian“tigers”—HongKong,Singapore,SouthKorea,andTaiwan—whichsawtheireconomiesgrowmorethan8percentayearfornearlythreedecades.ChinaandIndiahavehadaterrificdecade,muchtothebenefitofhundredsofmillionsofpeople.Butwedonot have a proven formula for growth that can be rolled out in country aftercountry like some kind of development franchise. Just think about China andIndia:Oneistheworld’slargestdemocracy;theotherisnotdemocraticatall.

On the other hand,we do have a good understanding ofwhatmakes richcountriesrich.Ifwecancatalogthekindsofpoliciesthatfunctionaleconomieshave in common, then we can turn our attention to Nobel laureate DouglassNorth’scommon-sensequery“Whydon’tpoorcountriessimplyadoptpoliciesthatmakeforplenty?”4

Thefollowingisasampleofthekindsofpoliciesand,insomecases,luckygeographical endowments that development economists have come to believemakethedifferencebetweenthewealthandpovertyofnations.

Effectivegovernment institutions.Togrowandprosper,acountryneeds laws,lawenforcement,courts,basicinfrastructure,agovernmentcapableofcollectingtaxes—and a healthy respect among the citizenship for each of these things.Thesekindsofinstitutionsarethetracksonwhichcapitalismruns.Theymustbereasonablyhonest.Corruptionisnotmerelyaninconvenience,asitissometimestreated; it is a cancer that misallocates resources, stifles innovation, anddiscourages foreign investment.While American attitudes toward governmentrangefromindifferencetohostility,mostothercountrieswouldlovetohaveitsogood, asNewYorkTimes foreign affairs columnistTomFriedmanhas pointedout:

ItookpartinaseminartwoweeksagoatNanjingUniversityinChina,and I can still hear a young Chinese graduate student pleading for ananswertoherquestion:“Howdowegetridofallourcorruption?”Doyouknow what your average Chinese would give to have a capital likeWashingtontoday,withitsreasonablyhonestandefficientbureaucracy?Doyouknowhowunusualweare in theworld thatwedon’thave topayoffbureaucratstogetthesimplestpermitissued?5

The relationship between government institutions and economic growthprompted a clever and intriguing study. Economists Daron Acemoglu, SimonJohnson, and James Robinson hypothesized that the economic success ofdeveloping countries that were formerly colonized has been affected by thequalityoftheinstitutionsthattheircolonizersleftbehind.6TheEuropeanpowersadopteddifferentcolonizationpoliciesindifferentpartsoftheworld,dependingonhowhospitabletheareawastosettlement.InplaceswhereEuropeanscouldsettlewithoutserioushardship,suchastheUnitedStates,thecolonizerscreatedinstitutionsthathavehadapositiveandlong-lastingeffectoneconomicgrowth.In placeswhereEuropeans could not easily settle because of a highmortalityratefromdisease,suchastheCongo,thecolonizerssimplyfocusedontakingas

muchwealthhomeasquicklyaspossible,creatingwhattheauthorsrefertoas“extractivestates.”

Thestudyexaminedsixty-fourex-coloniesandfoundthatasmuchasthree-quartersofthedifferenceintheircurrentwealthcanbeexplainedbydifferencesin the quality of their government institutions. In turn, the quality of thosegovernment institutions isexplained,at least inpart,by theoriginal settlementpattern.Thelegaloriginofthecolonizers—British,French,Belgian—hadlittleinfluence (though the British come out looking good because they tended tocolonizeplacesmorehospitabletosettlement).

Basically,goodgovernancematters.TheWorldBankrated150countriesonsix broad measures of governance, such as accountability, regulatory burden,rule of law, graft (corruption), etc. There was a clear and causal relationshipbetweenbettergovernanceandbetterdevelopmentoutcomes,suchashigherpercapita incomes, lower infantmortality, and higher literacy.7We don’t have tolove the Internal Revenue Service, but we ought to at least offer it somegrudgingrespect.

Propertyrights.Privatepropertymayseemlikeaprovinceoftherich;infact,itcanhaveacrucialimpactonthepoor.Thedevelopedworldisfullofexamplesofinformalpropertyrights—homesorbusinessesbuiltonlandthatiscommunalor owned by the government and ignored (such as the shantytowns on theoutskirts of many large cities). Families and entrepreneurs make significantinvestmentsintheir“properties.”Butthereisacrucialdifferencebetweenthoseassetsandtheircounterpartsinthedevelopedworld:Theownershavenolegaltitletotheproperty.Theycannotlegallyrentit,subdivideit,sellit,orpassitontofamily.Perhapsmostimportant,theycannotuseitascollateraltoraisecapital.

Peruvian economist Hernando de Soto has argued convincingly that thesekindsofinformalpropertyarrangementsshouldnotbeignored.Hereckonsthatthe total value of property held but not legally owned by poor people in thedevelopingworldisworthmorethan$9trillion.Thatisalotofcollateralgonetowaste,or“deadcapital”ashecallsit.Toputthatnumberinperspective,itis93timestheamountofdevelopmentassistancethattherichcountriesprovidedtothedevelopingworldoverthepastthreedecades.

The Economist tells a story of a Malawian couple who make a livingslaughteringgoats.Sincebusinessisgood,theywouldliketoexpand.Todoso,however,would requirean investmentof$250—or$50more than theaverage

annual income inMalawi. This couple “owns” a homeworthmore than that.Might theyborrowagainst thevalueof their landand thebungalow theyhavebuiltonit?No.Thehomeisbuilton“customary”landthathasnoformaltitle.The couple has a contract signed by the local village chief, but it is notenforceableinacourtoflaw.TheEconomistgoesontonote:

About two-thirds of the land in Malawi is owned this way. Peopleusually till the land their parents tilled. If there is a dispute aboutboundaries,thevillagechiefadjudicates.Ifafamilyoffendsgravelyagainstthe rules of the tribe, the chief can take their land away and give it tosomeoneelse.8

Those informalproperty rightsare likebarter—theywork fine ina simpleagrariansociety,butarewoefullyinadequateforamorecomplexeconomy.Itisbad enough that poor countries are poor; it is all the worse that their mostvaluableassetsarerenderedlessproductivethantheymightbe.

Property rights have another less obvious benefit: They enable people tospend less time defending their possessions, which frees them up to domoreproductive things. Between 1996 and 2003, the Peruvian government issuedproperty rights to 1.2 million urban squatter households, giving them formalownershiptowhattheyhadpreviouslyinformallyclaimedastheirown.HarvardEconomistEricaFielddeterminedthatpropertyrightsenabledresidentstoworkmore hours in the formal labormarket. She surmises that property rights givemore flexibility topeoplewhopreviouslyhad to stayhome,orhad tooperateimprovisedbusinessesoutoftheirhome,inordertoprotecttheirproperty.Shealsomakes another important point:Most programsdesigned to help the poorreduce their work effort. (This is the Samaritan’s dilemma; if I ease yourhardship, you have less incentive to help yourself.) Providing formal propertyrightsdoestheopposite:Itencourageswork.9

Noexcessiveregulation.Governmenthasplenty todo—andevenmore that itshouldnotdo.Marketsmustdo theheavy lifting.Let’s talkaboutarticles575and615oftheRussiancivilcode.TheseregulationswouldbeveryimportantifyouwereafirminMoscowdoingsomethingassimpleas installingavending

machine. Article 575 forbids firms from giving anything away free, whichincludesthespacethatafirm“gives”toCoca-Colawhenavendingmachineisinstalled. Meanwhile, article 615 forbids subletting property without thelandlord’s consent; the squaremeter taken up by the vendingmachine can beconstrued as a sublease. In addition, the tax collector forbids commercialenterprises(e.g.,vendingmachines)tooperatewithoutacashregister.Andsincesellingsoftdrinksfromamachineconstitutesretailtrade,thereareassortedfire,health,andsafetyinspections.10

Excessive regulation goes hand in glove with corruption. Governmentbureaucratsthrowuphurdlessothattheycanextortbribesfromthosewhoseektogetoveroraround them. Installingavendingmachine inMoscowbecomesmucheasierifyouhiretheright“securityfirm.”Whataboutopeningabusinesselsewhereinthedevelopedworld?Again,PeruvianeconomistHernandodeSotohas done fascinating work. He and fellow team members documented theirefforts toopenaone-personclothingstallontheoutskirtsofLimaasalegallyregisteredbusiness.Heandhisresearchersvowedthattheywouldnotpaybribessothattheireffortswouldreflectthefullcostofcomplyingwiththelaw.(Intheend,theywereaskedforbribesontenoccasionsandpaidthemtwicetopreventtheprojectfromstallingcompletely.)Theteamworkedsixhoursadayforforty-two weeks in order to get eleven different permits from seven differentgovernment bodies. Their efforts, not including the time, cost $1,231, or 31timesthemonthlyminimumwageinPeru—alltoopenaone-personshop.11

Chapter 4 outlined all the reasons government should stick to the basics.HarvardeconomistRobertBarro’sclassicstudyofeconomicgrowthinroughlyonehundredcountriesoverthreedecadesfoundthatgovernmentconsumption—total government spending excluding education and defense—was negativelycorrelatedwithper capitaGDPgrowth.Heconcluded that such spending (andtherequiredtaxation)isnotlikelytoincreaseproductivityandwillthereforedomore harm than good. The Asian tigers, the all-star team in the economicdevelopment league,made theireconomicascentwithgovernmentspending intherangeof20percentofGDP.Elsewhereintheworld,hightaxratesthatareapplied unevenly distort the economy and provide opportunities for graft andcorruption.Manypoorgovernmentsmightactuallycollectmorerevenueiftheyimplementedtaxesthatwerelow,simple,andeasytocollect.

The Internethasahugepotential to improve transparencyeverywhere,butparticularly in poor countries. Something as simple as posting on-line theamount of money allocated by the central government for a specific local

project, suchas a roador ahealth clinic, canenable citizens to comparewhattheywere supposed to get towhat actually showed up. “We got $5,000 for acommunitycenter?Thatdoesn’tlooklikea$5,000communitycenter.Let’sgotalktothemayor.”

Human capital. Human capital is what makes individuals productive, andproductivityiswhatdeterminesourstandardofliving.AsUniversityofChicagoeconomist andNobel laureateGary Becker has pointed out, all countries thathave had persistent growth in income have also had large increases in theeducationandtrainingoftheirlaborforces.(Wehavestrongreasonstobelievethattheeducationcausesthegrowth,nottheotherwayaround.)Hehaswritten,“These so-called Asian tigers grew rapidly by relying on a well-trained,educated,hard-working,andconscientiouslaborforce.”12

Inpoorcountries,humancapitaldoesallthegoodthingswewouldexpect,andthensome.Educationcanimprovepublichealth(whichis,inturn,aformofhuman capital). Some of the most pernicious public health problems in thedevelopingworld have relatively simple fixes (boilingwater, digging latrines,using condoms, etc.). Higher rates of education for women in developingcountriesareassociatedwithlowerratesofinfantmortality.Meanwhile,humancapital facilitates the adoption of superior technologies from developedcountries.Onecauseforoptimisminthedevelopmentfieldhasalwaysbeenthatpoorcountriesshould,intheory,beabletonarrowthegapwithrichernationsbyborrowing their innovations. Once a technology is invented, it can be sharedwithpoorcountriesatvirtuallynocost.ThepeopleofGhananeednotinventthepersonalcomputerinordertobenefitfromitsexistence; theydoneedtoknowhowtouseit.

Now formore bad news. InChapter 6, I described an economy inwhichskilled workers generate economic growth by creating new jobs or doing oldjobs better. Skills are whatmatter—for individuals and for the economy as awhole. That is still true, but there is a glitch when we get to the developingworld:Skilledworkersusuallyneedother skilledworkers inorder to succeed.Someonewho is trainedasaheart surgeoncansucceedonly if therearewell-equipped hospitals, trained nurses, firms that sell drugs andmedical supplies,and a population with sufficient resources to pay for heart surgery. Poorcountries can become caught in a human capital trap; if there are few skilledworkers,thenthereislessincentiveforotherstoinvestinacquiringskills.Those

whodobecome skilled find that their talents aremorevaluable in a regionorcountrywithahigherproportionofskilledworkers,creatingthefamiliar“braindrain.”AsWorldBankeconomistWilliamEasterlyhaswritten,theresultcanbeaviciouscycle:“Ifanationstartsoutskilled,itgetsmoreskilled.Ifitstartsoutunskilled,itstaysunskilled.”13

Asasidenote,thisphenomenonisrelevantinruralAmerica,too.Notlongago, Iwrote a story forThe Economist thatwe referred to internally as “TheIncredibleShrinkingIowa.”14Astheworkingtitlewouldsuggest,partsofIowa,andother large swathesof the ruralMidwest, are losingpopulation relative tothe rest of the country. Remarkably, forty-four of Iowa’s ninety-nine countieshadfewerpeoplein2000thantheyhadin1900.Partofthatdepopulationstemsfrom rising farm productivity; Iowa’s farmers have literally grown themselvesout of jobs. But something else is going on, too. Economists have found thatindividuals with similar skills and experience can earn significantly higherwagesinurbanareasthantheycanelsewhere.Why?Oneplausibleexplanationisthatspecializedskillsaremorevaluableinmetropolitanareaswherethereisadensityofotherworkerswithcomplementaryskills.(ThinkSiliconValleyoracardiac surgery center in Manhattan.) Rural America has a mild case ofsomething that deeply afflicts the developing world. Unlike technology orinfrastructure or pharmaceuticals, we cannot export huge quantities of humancapitaltopoorcountries.Wecannotairlift tenthousanduniversitydegreestoasmallAfricannation.Yet as long as individuals in poor countries face limitedopportunities,theywillhaveadiminishedincentivetoinvestinhumancapital.

Howdoesacountrybreakoutofthetrap?Rememberthatquestionwhenwecometotheimportanceoftrade.

Geography.Hereisaremarkablefigure:OnlytwoofthirtycountriesclassifiedbytheWorldBankasrich—HongKongandSingapore—liebetweentheTropicofCancer (whichruns throughMexicoacrossNorthAfricaand throughIndia)andtheTropicofCapricorn(whichrunsthroughBrazilandacrossthenortherntipofSouthAfricaandthroughAustralia).Geographymaybeawindfallthatwein the developed world take for granted. Development expert Jeffrey Sachswroteaseminalpaperinwhichhepositedthatclimatecanexplainmuchoftheworld’s income distribution.Hewrites, “Given the varied political, economic,and social histories of regions around the world, it must be more thancoincidencethatalmostallof the tropicsremainunderdevelopedat thestartof

the twenty-firstcentury.”15TheUnitedStatesandallofEurope lieoutside thetropics; most of Central and South America, Africa, and Southeast Asia liewithin.

Tropicalweatheriswonderfulforvacation;whyisitsobadforeverythingelse?Theanswer,according toMr.Sachs, is thathigh temperaturesandheavyrainfallarebadforfoodproductionandconducivetothespreadofdisease.Asaresult,twoofthemajoradvancesinrichcountries—betterfoodproductionandbetter health—cannot be replicated in the tropics.Why don’t the residents ofChicago suffer from malaria? Because cold winters control mosquitoes—notbecausescientistshavebeatenthedisease.Sointhetropics,wefindyetanotherpovertytrap;mostofthepopulationisstuckinlow-productivityfarming.Theircrops—and therefore their lives—areunlikely toget better in the faceofpoorsoil,unreliablerainfall,andchronicpests.

Obviously countries cannot pickup andmove tomore favorable climates.Mr. Sachs proposes two solutions. First, we ought to encourage moretechnologicalinnovationaimedattheuniqueecologyofthetropics.Thesadfactis that scientists, like bank robbers, go where the money is. Pharmaceuticalcompanies earn profits by developing blockbuster drugs for consumers in thedevelopedworld.Ofthe1,233newmedicinesgrantedpatentsbetween1975and1997, only thirteen were for tropical diseases.16 But even that overstates theattentionpaidtotheregion;nineofthosedrugscamefromresearchdonebytheU.S.military for the VietnamWar or from research for the livestock and petmarket.How do we make private companies care as much about sleepingsickness(onwhichnomajorcompanyisdoingresearch)astheydoaboutcanineAlzheimer’s (for which Pfizer already has a drug)? Change the incentives. In2005,BritishPrimeMinisterGordonBrownembracedan idea thateconomistshavelongkickedaround:Identifyadiseasethatprimarilyafflictsapoorpartofthe world and then offer a large cash prize to the first firm that develops avaccine that meets predetermined criteria (e.g., is effective, is safe for use inchildren, doesn’t need refrigeration, etc.). Brown’s plan was actually moresophisticated;heproposedthatrichgovernmentsprecommittobuyingacertainnumberofdosesofthe“winning”vaccineatacertainprice.Poorpeoplewouldget lifesaving drugs. The pharmaceutical companywould getwhat it needs tojustify the vaccine research: a return on investment, just as it does whendeveloping drugs that consumers in rich countries will buy. (The Britishgovernment has been thinking this way for a long time. In 1714, after twothousandsailorsdrownedwhenafleetgotlost,crashedintotherockycoast,and

sunk, theBritishgovernmentoffered20,000pounds toanyonewhodevelopedaninstrumentformeasuring longitudeatsea.Theprize led to the inventionofthechronometer.)17

Theotherhopeforpoorcountries in the tropics,saysMr.Sachs, is tostepoutofthetrapofsubsistenceagriculturebyopeningtheireconomiestotherestof theworld.Henotes, “If the countrycanescape tohigher incomesvianon-agricultural sectors (e.g., through a large expansion ofmanufactured exports),theburdensofthetropicscanbelifted.”18Whichbringsusonceagaintoouroldfriendtrade.

Openness to trade.We’ve had a whole chapter on the theoretical benefits oftrade.Sufficeittosaythatthoselessonshavebeenlostongovernmentsinmanypoorcountriesinrecentdecades.Thefallaciouslogicofprotectionismisalluring—the idea that keeping out foreign goods will make the country richer.Strategiessuchas“self-sufficiency”and“stateleadership”werehallmarksofthepostcolonial regimes, such as India andmuch ofAfrica. Trade barrierswould“incubate” domestic industries so that they could grow strong enough to faceinternational competition. Economics tells us that companies shielded fromcompetitiondonotgrowstronger; theygrowfatand lazy.Politics tellsus thatonce an industry is incubated, it will always be incubated. The result, in thewordsofoneeconomist,hasbeena“largelyself-imposedeconomicexile.”19

Atgreatcost,itturnsout.Thepreponderanceofevidencesuggeststhatopeneconomies grow faster than closed economies. In one of the most influentialstudies, Jeffrey Sachs, now director of The Earth Institute at ColumbiaUniversity, and Andrew Warner, a researcher at the Harvard Center forInternational Development, compared the economic performance of closedeconomies, as defined by high tariffs and other restrictions on trade, to theperformanceofopen economies.Amongpoor countries, the closed economiesgrew at 0.7 percent per capita annually during the 1970s and 1980swhile theopen economies grew at 4.5 percent annually. Most interesting, when apreviously closed economy opened up, growth increased by more than apercentagepointayear.Tobefair,someprominenteconomistshavetakenissuewiththestudyonthegrounds(amongotherquibbles)thateconomiesclosedtotradeoftenhavea lotofotherproblems, too. Is it the lackof trade thatmakesthese countries grow slowly, or is it generalmacroeconomic dysfunction? For

thatmatter,does tradecausegrowthor is it something that justhappenswhileeconomies are growing for other reasons?After all, the number of televisionssold rises sharply during extended spells of economic growth, but watchingtelevisiondoesnotmakecountriesricher.

Convenientlyforus,arecentpaperintheAmericanEconomicReview,oneof the most respected journals in the field, is entitled “Does Trade CauseGrowth?”Yes,theauthorsanswer.Allelseequal,countriesthattrademorehavehigher per capita incomes.20 Jeffrey Frankel and David Romer, economists atHarvardandUCBerkeley, respectively,conclude,“Ourresultsbolster thecasefortheimportanceoftradeandtrade-promotingpolicies.”

Researchershaveplentylefttoquibbleabout.Thatiswhatresearchersdo.Inthe meantime, we have strong theoretical reasons to believe that trade makescountriesbetteroffandsolidempiricalevidencethattradeisonethingthathasseparatedwinnersfromlosersinrecentdecades.Therichcountriesmustdotheirpartbykeepingtheireconomiesopentoexportsfrompoorcountries.Mr.Sachshascalledfora“NewCompactforAfrica.”Hewrites,“Thecurrentpatternofrich countries—to provide financial aid to tropical Africa while blockingAfrica’s chances to export textiles, footwear, leather goods, and other labor-intensive products—may be worse than cynical. It may in fact fundamentallyundermineAfrica’schancesforeconomicdevelopment.”21

Responsiblefiscalandmonetarypolicy.Governments,likeindividuals,willgetthemselvesinserioustroubleiftheyconsistentlyoverspendonthingsthatdonotraise future productivity. At a minimum, large budget deficits require thegovernment to borrowheavily,which takes capital out of thehandsof privateborrowers,whoarelikelytouseitmoreefficiently.Chronicdeficitspendingcanalsosignalotherfutureproblems:higher taxes(topaybackthedebt), inflation(toerodethevalueofthedebt),orevendefault(justgivinguponthedebt).

All of these problems are compounded if the government has borrowedheavilyfromabroadtofinanceitsprofligatespending.Ifforeigninvestorsloseconfidence and decide to take their money and go home—as skittish globalinvestorsarewonttodo—thenthecapitalthatwasfinancingthedeficitdriesup,orbecomesprohibitivelyexpensive.Inshort,themusicstops.Thegovernmentisleft on the brink of default, which we have seen in countries ranging fromMexico toTurkey. (There is,by theway, somemodestconcern that thiscouldhappentotheUnitedStates.)

On the monetary side, Chapter 10 made clear the dangers of letting themoneypartygetoutofcontrol.Ithappensoftenanyway.Argentinaistheposterchild for irresponsible monetary policy; from 1960 to 1994, the averageArgentineinflationratewas127percentperyear.Toputthatinperspective,anArgentineinvestorwhohadtheequivalentof$1billioninsavingsin1960andkept all of it in Argentine pesos until 1994 would have been left with theequivalent spending power of one-thirteenth of a penny. Economist WilliamEasterlyhasnoted,“TryingtohavenormalgrowthduringhighinflationisliketryingtowinanOlympicsprinthoppingononeleg.”

Naturalresourcesmatterlessthanyouwouldthink.Israel,whichhasnooiltospeakof, isafarrichercountrythannearlyallofitsMiddleEasternneighborsthathavelargepetroleumreserves.IsraeliGDPpercapitais$28,300comparedto $20,500 for Saudi Arabia and $12,800 for Iran.Meanwhile, resource-poorcountries likeJapanandSwitzerlandhavefaredmuchbetter thanresource-richRussia.22Orconsideroil-richAngola.Thecountrytakesinsome$3.5billionayearfromitsoilindustry.23Whathashappenedtothepeoplewhomightbenefitfromthistreasureintheground?Muchoftheoilmoneygoestofundanever-ending civilwar that has ravaged the country.Angola has theworld’s highestrate of citizensmaimed by landmines (1 out of 133). One-third of Angola’schildrendiebeforeagefive; lifeexpectancyis forty-two.Largeswathesof thecapital have no electricity, no running water, no sewers, and no garbagepickup.24

These are not anecdotal examples carefully picked to make a point.Economistsbelievethatarichendowmentofnaturalresourcesmayactuallybeadetriment to development. All else equal, it is great to discover the world’slargest zinc deposit. But all else is not equal. Commodity-rich countries arechangedbytheexperienceinwaysthatcandomoreharmthangood.Onestudyofeconomicperformanceinninety-sevencountriesovertwodecadesfoundthatgrowthwashigher incountries thatwere lessendowedwithnatural resources.Ofthetopeighteenfastest-growingnations,onlytwowererichinthingsthatcanbetakenoutoftheground.Why?

Mineral riches changean economy.First, theydivert resources away fromotherindustries,suchasmanufacturingandtrade,thatcanbemorebeneficialtolong-termgrowth.Forexample,theAsiantigerswereresource-poor;theirpath

to prosperity began with labor-intensive exports and progressed into moretechnology-intensiveexports.Thecountriesgrewsteadilyricherintheprocess.Second,resourcericheconomiesbecomefarmorevulnerabletowildswingsinthepriceofcommodities.Acountrybuiltonoilwillhavearoughstretchwhenthe barrel price drops from $90 to $15. Meanwhile, demand for a nation’scurrencyrisesastherestoftheworldbeginstobuyitsdiamondsorbauxiteoroil or natural gas. Thatwill cause the currency to appreciate,which,we nowknow, makes the country’s other exports, such as manufactured goods, moreexpensive.

Economists started referring to the perverse effects of abundant naturalresources as “Dutch disease” after observing the economic effects of anenormousNorthSeanaturalgasdiscoverybytheNetherlandsinthe1950s.ThespikeinnaturalgasexportsdroveupthevalueoftheDutchguilder(astherestoftheworlddemandedmoreguildersinordertobuyDutchnaturalgas),makinglife more difficult for other exporters. The government also used the gasrevenues to expand social spending, which raised employers’ social securitycontributions and therefore their production costs.TheDutch had long been anationoftraders,withexportsmakingupmorethan50percentofGDP.Bythe1970s, other export industries, the traditional lifeblood of the economy, hadgrownfar lesscompetitive.Onebusinesspublicationnoted,“Gassodistendedanddistortedtheworkingsoftheeconomythatitbecameamixedblessingforatradingnation.”25

Last, and perhaps most important, countries could use the revenues fromnatural resources to make themselves better off—but they don’t. Money thatmight be spent on public investments with huge returns—education, publichealth, sanitation, immunizations, infrastructure—is more often squandered.AftertheWorldBankhelpedtobuildanoilpipelinethatoriginatesinChadandruns through Cameroon to the ocean, Chad’s president, Idriss Déby, used thefirst$4.5millioninstallmentofoilmoneytobuyweaponsforfightingrebels.26

Democracy.Doesmaking the trains runon timemattermore to the economicgrowthofpoorcountries thanniceties like freedomofexpressionandpoliticalrepresentation?No;theoppositeistrue.Democracyisacheckagainstthemostegregious economic policies, such as outright expropriation of wealth andproperty. Amartya Sen, a professor of economics and philosophy at Harvard,wasawardedtheNobelPrizeinEconomicsin1998forseveralstrandsofwork

relatedtopovertyandwelfare,oneofwhichishisstudyoffamines.Mr.Sen’smajor finding is striking: The world’s worst famines are not caused by cropfailure;theyarecausedbyfaultypoliticalsystemsthatpreventthemarketfromcorrectingitself.Relativelyminoragriculturaldisturbancesbecomecatastrophesbecauseimportsarenotallowed,orpricesarenotallowedtorise,orfarmersarenot allowed togrowalternativecrops,orpolitics in someotherway interfereswith the market’s normal ability to correct itself. He writes, “[Famines] havenever materialized in any country that is independent, that goes to electionsregularly, that has opposition parties to voice criticisms and that permitsnewspapers to report freely and question the wisdom of government policieswithout extensive censorship.”27 China had the largest recorded famine inhistory;thirtymillionpeoplediedastheresultofthefailedGreatLeapForwardin1958–1961.Indiahasnothadafaminesinceindependencein1947.

EconomistRobertBarro’s seminal studyof economicgrowth in someonehundredcountriesovermanydecadesfoundthatbasicdemocracyisassociatedwith higher economic growth. More advanced democracies, however, sufferslightly lower rates of growth. Such a finding is consistent with ourunderstandingofhow interestgroupscanpromotepolicies that arenot alwaysgoodfortheeconomyasawhole.

War is bad. Now there is a real shocker. Still, the data on the proportion ofextremely poor countries involved in armed conflict are strikingly high. PaulCollier, head of the Oxford Center for the Study of African Economies andauthorof thebookTheBottomBillion, points out that nearly three-quarters oftheworld’sbillionpoorestpeoplearecaughtinacivilwarorhaverecentlybeenthroughone.It’shardtorunabusinessorgetaneducationinthemidstofawar.(Obviously the causality runs in both directions: War devastates countries;nations in a shambles aremore likely to collapse into civilwar.)Once again,natural resources canmake thingsworseby financingweaponsandgiving thefactions something to fight over. (Collier coined the sadly clever phrase“Diamondsareaguerilla’sbestfriend.”)28Theimportantpointisthatsecurityisaprerequisiteformostoftheotherthingsthathavetohappenforaneconomytoflourish.In2004,TheEconomistpublishedastoryaboutthechallengesofdoingbusiness in Somalia, a country that had been in the throes of civil war forthirteen years. The story noted, “There are two ways to run a business inSomalia.Youcanpayoffthelocalwarlord,notalwaysthemosttrustworthyof

chaps,andhopehewillstophismilitiamenfrommurderingyourstaff.Oryoucantellhimtogetstuffedandhireyourownmilitia.”29

Womanpower. Imagine twofarmers,eachwitha thousandacres.Oneof themcultivatesallofhislandeveryyear;theotherleaveshalfofhislandfallow,yearafteryear.Whowillgrowmore?It’snotatrickquestion.Theguywhousesallofhislandcangrowmore.Whatdoesthishavetodowithwomen?BillGatesmadetheconnectionwhenspeakingabouttechnologicalprogresstoanaudiencesegregatedbysex inSaudiArabia.ANewYorkTimesMagazine articleon theroleofwomenineconomicdevelopmentrecountstheincident:

Four-fifths of the listenersweremen, on the left. The remaining one-fifthwerewomen, all covered in black cloaks and veils, on the right. Apartition separated the two groups. Toward the end, in the question-and-answersession,amemberoftheaudiencenotedthatSaudiArabiaaimedtobe one of the Top 10 countries in the world in technology by 2010 andaskedifthatwasrealistic.“Well,ifyou’renotfullyutilizinghalfthetalentinthecountry,”Gatessaid,“you’renotgoingtogetclosetotheTop10.”30

TheSaudis shouldn’thavebeen surprised.TheArabHumanDevelopmentReport came to the same basic conclusion (in a lotmore pages) several yearsearlier.Inthe2002report,severalprominentArabscholarssoughttoexplainthepaltryrateofgrowthinthetwenty-twocountriesthatmakeuptheArabLeague.Overtheprevioustwodecades,realpercapitaincomegrowthhadbeenapaltry0.5percentayear,lowerthananyplaceintheworldexceptsub-SaharanAfrica.Oneofthethreekeyproblemsidentifiedbytheauthorswas“women’sstatus.”(Theothertwowerealackofpoliticalfreedomsandadearthofhumancapital.)TheEconomist reported on the findings: “One in every twoArabwomen stillcan neither read nor write. Their participation in their countries’ political andeconomiclifeisthelowestintheworld.”31Investingingirlsandwomencanbelikeplantingtheotherhalfofthat1,000acrefield.Thereisanothersubtle(andmildlyamusing)partof“womenpower.”Womeninthedevelopingworld(andmaybeelsewhere)dosmarterthingswiththeirmoney.Aswomengetwealthier,theyspendmoremoneyonthefamily’snutrition,medicine,andhousing.When

men get wealthier, they spend more money on alcohol and tobacco. Really.Therewas anelegant little experimenton thispoint in the IvoryCoast,wheremenandwomentraditionallygrowdifferentcrops.Insomeyearsthemen’scashcropsarebountiful;inotheryearsthewomen’scashcropsdoparticularlywell.MITeconomistEstherDuflofound thatwhen themenhaveabanneryear, thehouseholdspendsmoreondrinkingandsmoking;whenthewomenrakeinthecash,thehouseholdspendsmoreonfood.32Developmentofficialshavelearnedthatiftheygivecashtothefemaleheadofhousehold,itwilldomoregood.

Expertscouldtickoffmanyotherthingsthatmatterinthedevelopmentprocess:savings and investment rates, fertility rates, ethnic strife, colonial history,culturalfactors,etc.Allofwhichraisesaquestion:Ifwehaveadecentideaofwhat constitutes good policy, why is the path out of poverty so steep andtreacherous? The answer lies in the difference between describing why TigerWoodsisagreatgolferandactuallyplayinglikehim.Itisonethingtoexplainwhat makes rich countries work; it is quite another to develop a strategy fortransforming the developingworld.Consider some simple examples:Buildingeffective government institutions is easier when the population is literate andeducated,yetdecentpubliceducationrequireseffectivegovernmentinstitutions.Publichealthiscrucial,butit’shardtobuildhealthclinicswhenhugeamountsofmoneyarelosttocorruptofficials.Andsoon.

There is a broad continuum of expert opinion on what, if anything, richcountriescando to improve lifeelsewhere in theworld.JeffreySachsanchorsoneendofthatcontinuum.Asyoumayhaveinferredfromsomeoftheresearchin thischapter,Sachsbelieves that impoverishednationsarecaught inpovertytraps,andonlycapitalfromthedevelopedworldwillrescuethem.Ifweweretocare and spend more in the developed world, we could jump-start thedevelopmentprocessinpoorcountries—likegettingabigbouldermovingatthetopof ahill.For example,Sachs argues that theworld’s rich countries shouldundertake a comprehensive program to fightAIDS inAfrica.He reckons thatAmerica’sshareofsuchaprogramwouldcostabout$10aperson—thepriceofamovieandpopcorn.33Sofar,U.S.contributionstosucheffortshavebeenfarsmaller. Indeed, America’s total foreign aid budget comes to one-tenth of 1percentofGDP—afractionofwhatwearecapableofanda thirdofwhat theEuropeansgive.Mr.Sachswarned longbeforeSeptember11 thatweought toinvest in the developing world, “not only for humanitarian reasons, but also

because even remote countries in turmoil become outposts of disorder for therestoftheworld.”34

WilliamEasterly,whoseworkhasalsobeencitedextensivelyhere,anchorsthe other end of that continuum.He believes that the whole development aidprocess is broken. His views are best encapsulated by an old joke about thefaileddevelopment strategies that havegone in andout of favor over the pasthalfcentury:

Apeasant discovers thatmanyof his chickens are dying, so he seeksadvice froma priest.Thepriest recommends that the peasant sayprayersfor his chickens, but the chickens continue to die. The priest thenrecommendsmusicforthechickencoop,butthedeathscontinueunabated.Pondering again, the priest recommends repainting the chicken coop inbrightcolors.Finally,allthechickensdie.“Whatashame,”thepriesttellsthepeasant,“Ihadsomanymoregoodideas.”35

Easterlyshouldknow.HespentdecadesworkingattheWorldBank,wherehewastheguytryingtosavethedyingchickens.HearguesinTheWhiteMan’sBurden and other works that traditional aid projects are inflexible andineffective.Theresultsaremiserable,bothatthemicrolevel(aidagencieshandoutmosquitonetsthatendupgettingusedasfishingnetsorweddingveils)andat themacro level (we can’t show thatwhatwe’re doing ismaking countriesbetter off). Instead, we focus on inputs—how generous are we?—which hecomparestoevaluatingaHollywoodmoviebythesizeofitsbudget.

Easterlysaysthattraditionaldevelopmentaidhasbeenamistake—becausewestillhaven’tfiguredouthowtodoit.36HewritesintheAmericanEconomicReview:

Economists are reasonably confident that some combination of freemarkets and good institutions has an excellent historical track record ofachieving development (as opposed to, say, totalitarian control of theeconomybykleptocrats).Itisjustthatwedon’tknowhowtogetfromhereto there; which specific actions contribute to free markets and goodinstitutions; how all the little pieces fit together. That is, we don’t knowhowtoachievedevelopment.37

Easterly doesn’t think we should give up trying to help people in poorcountries. Instead, we should do small, context-sensitive projects withmeasurablebenefits.Hewrites,“[Aid]couldseek tocreatemoreopportunitiesforpoorindividuals,ratherthantrytotransformpoorsocieties.”

Tobefair,theprimarystumblingblocktodevelopmentinpoorcountriesisnotbadadvicefromrichcountries.Thebestideasforeconomicgrowtharequitesimple, yet, as this chapter has pointed out, there are plenty of leaders in thedeveloping world doing the economic equivalent of smoking, eatingcheeseburgers,anddrivingwithouttheirseatbelts.AstudydonebytheHarvardCenter for InternationalDevelopment of global growth patterns between 1965and 1990 found thatmost of the difference between the huge success of EastAsiaandtherelativelypoorperformanceofSouthAsia,sub-SaharanAfrica,andLatinAmericacanbeexplainedbygovernmentpolicy. In that respect, foreignaid presents the same kind of challenges as any other welfare policy. Poorcountries, like poor people, often have very bad habits. Providing support canprolongbehaviorthatneedstobechanged.Onestudycametotheunsurprisingconclusion that foreignaidhasapositiveeffectongrowthwhengoodpoliciesare already in place, and has little impact on growth when they are not. Theauthorsrecommendedthataidbepredicatedongoodpolicy,whichwouldmaketheaidmoreeffectiveandprovidean incentive forgovernments to implementbetterpolicies.38(Similarcriteriahavebeenproposedforrelievingthedebtsofheavily indebtedpoor countries.)Of course, turningourbackson theneediestcases(anddenyingbailoutstocountriesincrisis)iseasierintheorythanitisinpractice. In2005, theWorldBankpublishedadocument thatmightqualify asbureaucratic introspection—Economic Growth in the 1990s: Learning from aDecadeofReform.Policymakerswerealotmoreconfidentthattheyknewhowto fix theworld in 1990 than they are today.Harvard development economistDani Rodrik describes the tone of the report, which seems to incorporateWilliamEasterly’sskepticismwithoutabandoningJeffreySach’sresolve:“Thereare no confident assertions here of what works and what doesn’t—and noblueprintsforpolicymakerstoadopt.Theemphasisisontheneedforhumility,for policy diversity, for selective and modest reforms, and forexperimentation.”39

Last,much of theworld is poor because the rich countries have not triedvery hard to make it otherwise. I realize that pointing out the failure of

developmentaidandthenarguingformoreofitislikeYogiBerracriticizingarestaurant for having bad food and small portions. Still, things become betterwhenthereisanoverwhelmingpoliticalwilltomakethembetter.Thatisbiggerthaneconomics.

Epilogue

Lifein2050:SevenQuestions

Economicscanhelpus tounderstandand improvean imperfectworld. In theend,though,itisjustasetoftools.Wemustdecidehowtousethem.Economicsdoes not foreordain the future any more than the laws of physics made itinevitable thatwewould explore themoon. Physicsmade it possible; humanschose todo it—in largepartbydevotingresources thatmighthavebeenspentelsewhere.JohnF.Kennedydidnotalterthelawsofphysicswhenhedeclaredthat theUnitedStateswouldputamanonthemoon;hemerelysetagoal thatrequiredgoodsciencetogetthere.Economicsisnodifferent.Ifwearetomakethebestuseof these tools,weought to thinkaboutwhereweare tryingtogo.Wemustdecidewhatourprioritiesare,whattrade-offswearewillingtomake,what outcomes we are or are not willing to accept. To paraphrase economichistorianandNobellaureateRobertFogel,wemustfirstdefinethe“goodlife”before economics can help us get there. Here are seven questions worthpondering about life in 2050, not for the sake of predicting the future, butbecausethedecisionsthatwemakenowwillaffecthowwelivethen.

How many minutes of work will a loaf of bread cost? It’s the productivityquestion. From amaterial standpoint, it’s prettymuch all thatmatters.Nearlyeverything else we’ve discussed—institutions, property rights, investment,humancapital—isameanstowardthisend(andotherends,too).Ifproductivity

growsat1percentayearoverthenextfourdecades,ourstandardoflivingwillbe some50percenthigherby2050. Ifproductivitygrowsat2percent ayear,then our standard of living will more than double in the same time frame—assumingwe continue towork as hard aswe do now. Indeed, that leads to asubquestionthatIfindmoreinteresting:Howrichisrichenough?

Americans are richer than most of the developed world; we also workharder,takelessvacation,andretirelater.Willthatchange?Thereissomethingin labor economics called the “backward-bending labor supply curve.”Thankfully, the idea is simpler and more interesting than the name wouldsuggest.Economictheorypredictsthatasourwagesgoup,wewillworklongerhours—uptoapoint,andthenwewillbegintoworkless.Timebecomesmoreimportantthanmoney.Economistsjustaren’tquitesurewherethatcurvestartstobendbackward,orhowsharplyitbends.

Productivity growth gives us choices.We can continue to work the sameamountwhileproducingmore.Orwecanproducethesameamountbyworkingless. Or we can strike some balance. Assuming Americans continue to growsteadilymoreproductive,willwechoosetoworksixtyhoursaweekin2050andliverichly(inamaterialsense)asaresult?Orwilltherecomeatimewhenwedecidetoworktwenty-fivehoursaweekandlistentoclassicalmusicintheparkforthebalance?IhaddinnernotlongagowithaportfoliomanagerforalargeinvestmentcompanywhoisconvincedthatAmericansaregoingtowakeuponedayanddecidethattheyworktoohard.Ironically,hewasnotplanningtoworkless hard himself; he was planning to invest in companies that make leisuregoods.

HowmanypeoplewillbesleepingunderWackerDrive?Thisisthepie-slicingquestion.In2000,IwasassignedbyTheEconomisttowriteastoryonpovertyinAmerica.Withtheeconomystillbooming,IsoughtsomewaytoexpressthestrikingdichotomybetweenAmerica’srichandpoor.Ifounditrightoutsidethefrontdoorofmyofficebuilding:

AstrolldownWackerDrive, inChicago,offersan instantsnapshotofAmerica’s surging economy. Young professionals stride along, barkingorders into mobile phones. Shoppers stream towards the smart shops onMichiganAvenue. Construction cranes tower over amassive new luxury

condominium building going up on the horizon.All is bustle, glitter andboom.

ButthereisalessglamoroussidetoWackerDrive,literallybelowthesurface.LowerWacker is the subterranean service road that runs directlybeneathitssophisticatedsister,allowingdeliverytruckstomaketheirwaythrough the bowels of the city. It is also a favourite refuge for the city’shomeless, many of whom sleep in cardboard encampments between thecementprops.Theyareoutofsightofallthatgleamsabove,andlargelyoutofmind.AsWackerDrive,soAmerica.1

What are we willing to promise the most disadvantaged? The marketeconomiesof thedevelopedworld liealongacontinuum,withAmericaatoneend and the relatively paternalistic European economies, such as France andSweden, at the other. Europe offers the kinder, gentler version of a marketeconomy—atsomecost.Ingeneral,theEuropeannationsaremoreprotectiveofworkersandhaveamoresubstantialsafetynet.Generousbenefitsaremandatedbylaw;healthcareisabirthright.Thisleadstoamorecompassionatesocietyinmanyways.Europeanpovertyrates,particularlyforchildren,arefarlowerthanthoseintheUnitedStates.Incomeinequalityislower,too.

Italsoleadstohigherunemploymentandaslowerrateofinnovationandjobcreation.Workers,bundledwithlotsofmandatorybenefits,areexpensive.Sinceemployeescannotbefiredeasily,firmsareslowtohiretheminthefirstplace.Meanwhile,generousunemploymentandwelfarebenefitsmakeworkersslowerto take jobs thatmight be offered.The result iswhat economists refer to as a“sclerotic” labor market. During normal economic times, Europeanunemployment rates tend to be significantly higher than the American rate,particularlyforyouth.

The American system is a richer, more dynamic, more entrepreneurialeconomy—andharsherandmoreunequal.Itisconducivetocreatingabigpieinwhichthewinnersgethugeslices.TheEuropeansystemisbetteratguaranteeingatleastsomepieforeverybody.Capitalismcomesinallkindsofflavors.Whichonewillwechoose?

Will we use the market in imaginative ways to solve social problems? Theeasiest and most effective way to get something done is to give the people

involvedareasontowantitdone.Weallnod,asifthiswerethemostobviouspoint in the world—and then we go out and design policies that do just theopposite.Wehaveanentirepublicschoolsystemthatstilldoesnotreallyrewardteachersandprincipalswhentheirstudentsdowell(orpunishthemwhentheirstudentsdopoorly).Wetalkabouthowimportanteducationis,butwemakeitdifficult and time-consuming for smart people to become teachers (despiteevidence that this traininghas little impact).Wedon’tpaygood teachersmorethanbadones.

We make it artificially cheap to travel by car, implicitly subsidizingeverythingfromurbansprawltoglobalwarming.Weassessmostofourtaxesonproductive activity, like work, savings, and investment, when we might raiserevenueandconserveresourceswithmore“greentaxes.”

Ifwegettheincentivesright,wecanusemarketstodoallkindsofthings.Considerthecaseofrarediseases.Howeverbaditistohaveaseriousillness,itisworsetohaveaseriousillnessthatisalsorare.Atonepoint,thereweresomefive thousand diseases considered so rare that drug companies ignored thembecausetheyhadnohopeofrecoveringtheirresearchcostseveniftheyfoundacure.2 In 1983, Congress passed the Orphan Drug Act, which providedincentives tomakesuchworkmoreprofitable: researchgrants, taxcredits,andexclusive rights tomarket and price drugs for rare diseases—so-called orphandrugs—for seven years. In the decade before the act, fewer than ten orphandrugscametomarket.Sincetheact,roughlytwohundredsuchdrugshavecometomarket.

Or something as simple as deposits for cans and bottles.Not surprisingly,recycling rates aremuch higher in stateswith deposits than in stateswithout.Thereisalsolesstrashandlitter.Andiflandfillspaceisatapremium—whichitis in most places—shouldn’t we be paying to dispose of our household trashbasedonthevolumewegenerate?Whateffectdoyouthinkthatwouldhaveonthequantityofconsumerpackaging?

Marketsdon’tsolvesocialproblemsontheirown(orelsetheywouldn’tbesocialproblems).Butifwedesignsolutionswiththeproperincentives,itfeelsalotmorelikerowingdownstream.

Willwehavestripmalls in2050?Nothing says thatwemustacceptwhat themarkettossesus.NewYorkTimescolumnistAnthonyLewispaidhomagetothebeauty of Italy’s Tuscany andUmbria regions (“The silvery olive groves, the

fieldsofsunflowers, thevineyards, thestonehousesandbarns”)and lamentedthatsuchsmallfarmsarenoteconomicalinaworldofcorporateagriculturebutsaystheyshouldbepreservedanyway.Hewrote,“Italyisevidencethatthereismore to life—acivilized life—than theunregulatedcompetitionof themarket.There are values of humanity, culture, beauty, community that may requiredeviationsfromthecoldlogicofmarkettheory.”3Thereisnothingineconomicsthat says he’s wrong.Wemay well collectively decide that we would like toprotectawayoflife,orsomethingthatisaestheticallypleasing,evenifitmeanshigher taxes,moreexpensivefood,or lesseconomicgrowth.Toaneconomist,andtoMr.Lewis,lifeisaboutmaximizingutility,notincome.Sometimesutilitymeanspreserving anolivegroveor anoldvineyard—justbecausewe like thewayitlooks.Aswegrowwealthier,weareoftenmorewillingtoputaestheticsabove the pocketbook.Wemay invest resources in ruralAmerica because it’simportanttoouridentityasanation.WemaysubsidizesmallfarmsinVermontbecausethey’rebeautiful,notbecauseitwillmakemilkcheaper.Andsoon.

Thatpointcomeswithseveralheavydosesofcaution.First,wemustalwaysmakeexplicit thecostsof fiddlingwithmarkets,whatever thosecostsmaybe.Howistheoutcomedifferentthanitwouldhavebeen,andwhopays?Second,we should take care that these costs fallmost heavily on thosewho enjoy thebenefits.Lastandmostimportant,weshouldmakesurethatonegroup(suchasthose of us who think that strip malls are hideously ugly) does not use thepolitical and regulatory process to impose its aesthetic preferences on anothergroup (those who own strip malls and the people who enjoy the cheap andconvenientshoppingthere).Thatsaid,thereisnothingtostopusfromdreamingofaworldwithoutstripmalls.

Dowereallyhavemonetarypolicyfiguredout?Iaskedthatquestioninthefirstedition of this book, back in 2002.Here is part of the answer: “The Japaneseeconomy—thatmiracleofthe1980s—remainsstubbornlyresistanttotraditionalmonetary and fiscal fixes, prompting what theWall Street Journal has called‘one of the great economic debates of the age.’”4 Could something similarhappenhere?

It did, beginning in 2007. That doesn’t make me a genius (as I’ve alsopredictedthattheCubswillwintheWorldSeriesonmultipleoccasions).Itdoesprovethatwehavenotconqueredthebusinesscycle(theeconomicebbandflowthat leads to periodic recessions).We thought we had it tamed, and then the

financialcrisisnearly tookus rightoff the rails.Theseswings in theeconomytakealotofinnocentvictimswiththem.

BenBernanke and the Fed seem to have done a lot of things right.Whathave they done wrong that we don’t know about yet? Remember, AlanGreenspanwas a genius (keeping inflation in check) until hewasn’t anymore(becauseloosemoneyfueledtheassetbubbles).

There is a regulatory challenge aswell. (Thediscussionshave started, butwe’renotanywherenearasolution.)Howdowemanagethe“systemicrisk”inaninterdependentfinancialsystem?Theironlawofcapitalismisthatfirmsthatfail should fail.Wedid thatwithLehmanBrothersand itnearly tookallofuswith them. The global financial system does not look like a textbook modelwherestrongfirmsthriveinacrisisandweakfirmsfail;it’smorelikeagroupofmountain climbers tethered together on the edge of a precipice. How do weallowthemarkettopunishwrongdoerswithoutsendingallofusspillingdownthemountain?

Infortyyears,will“Africantigers”refertowildlifeortodevelopmentsuccessstories?Hereisanexercise:Findayoungchild,sayageeightornine,andtrytoexplain to him or her why much of the world lives comfortably, evenluxuriously, while millions of people elsewhere on the planet are starving todeathandbillionsmorearebarelygettingby.Atsomepoint,theexplanationjuststarts to feel inadequate. Clearlywe do not have a silver bullet for economicdevelopment.Wedon’thaveoneforcancereither,butwehaven’tgivenup.Willtheworldbesignificantlylesspoorin2050?Thatanswerisnotobvious.Wecanimagine an East Asian scenario in which countries transform themselves in amatterofdecades.Orwecan imaginea sub-SaharanAfrica scenario inwhichcountries stumble from decade to decade without any significant economicgrowthatall.Onescenariowillliftbillionsofpeopleoutofpovertyandmisery;theotherwon’t.

Whenwe askwhether poor countrieswill still be poor four decades fromnow, the question seems distant and abstract, almost as if the answer will bedetermined by some future alignment of the stars. But when we break thatquestionintoitscomponentparts—whenweaskaboutthethingsthatweknowwilldistinguishrichcountries frompoorcountries—thenglobalpovertyseemsmoretractable.Willgovernmentsindevelopingcountriescreateandsustainthekindsof institutions that support amarket economy?Will theydevelopexport

industriesthatenablethemtobreakoutofthetrapofsubsistenceagriculture—andwilltheUnitedStatesopenitshugemarkettothoseproducts?Willtherichcountries use their technology and resources to fight the diseases that areravagingthedevelopingworld,especiallyAIDS?WillthefamilyofababygirlborntomorrowinruralIndiahaveanincentivetoinvestinherhumancapital?

Can America get its fiscal house back in order? The United States is theworld’slargestdebtor.WeoweChinesebondholdersmorethanatrilliondollars.We’vehadtoborrowheavilytopayourbillsforthepastdecade.Thesoberingpart is thatsomeofourmostsignificantgovernmentexpenses lieaheadas theBaby Boomers retire and begin to claim Social Security and Medicare. The“peace dividend” at the end of the ColdWar lasted about 45minutes, so weseemstuckwithlargedefensebudgetsfortheforeseeablefuture.Mathismath;every reasonable calculation I’ve seen shows that our fiscal trajectory isunsustainable.

So what will we do about it? U.S. society has developed not merely anaversiontohighertaxes,butapalpablehostility.Thatwouldbefineifwewerewilling to trimgovernment to a size thatwecould fund.Butwehaven’tdonethateither.

Think about what thatmeans. Going forward, somehowwe have to raiseenoughrevenueto(1)payforwhatevergovernmentwechoosetohave,whichwearen’tdoingfullynow;(2)paytheinterestwe’veaccumulatedonpastbills;and (3) pay for the new expenses associated with an aging population andexpensiveentitlementpromises.

That’s going to require serious political leadership and recognition byAmericansthatthestatusquoisnotanoption.SimonJohnson,whohadplentyof experience with financial crises as the former chief economist for theInternational Monetary Fund, has noted, “Overborrowing always ends badly,whetherforanindividual,acompany,oracountry.”5Duringthefirstdecadeofthenewmillennium,threepartiesborrowedheavily:consumers,financialfirms,andtheU.S.government.Sofar,twohavepaidahugepriceforthatleverage.Isthereanothershoetodrop?

Those are justmy questions.Myhope is that by nowyou havemore of your

own.Theremarkablethingabouteconomicsisthatonceyou’vebeenexposedtothebigideas,theybegintoshowupeverywhere.ThesadironyofEcon101isthatstudents toooftensuffer throughdull,esoteric lectureswhileeconomicsisgoingonallaroundthem.Economicsoffersinsightintowealth,poverty,genderrelations, the environment, discrimination, politics—just to name a few of thethingswe’vetouchedupon.Howcouldthatpossiblynotbeinteresting?

Notes

Introduction 1.ThomasFriedman,“SenselessinSeattle,”NewYorkTimes,December1,

1999.2. Claudia Goldin and Cecilia Rouse, “Orchestrating Impartiality: TheImpactof‘Blind’AuditionsonFemaleMusicians,”AmericanEconomicReview,September2000.

3. Charles Himmelberg, Christopher Mayer, and Todd Sinai, “AssessingHighHousePrices:Bubbles,FundamentalsandMisperceptions,”JournalofEconomicPerspectives,vol.19,no.4(Fall2005).

4. David Brooks, “An Economy of Faith and Trust,” New York Times,January16,2009.

CHAPTER1.THEPOWEROFMARKETS 1.M.DouglasIvester,RemarkstotheEconomicClubofChicago,February

25,1999.2.StephenMooreandJulianSimon,TheGreatestCenturyThatEverWas:25 Miraculous Trends of the Past 100 Years, Cato Institute PolicyAnalysis, No. 364 (Washington, D.C.: Cato Institute, December 15,1999).

3.CaraBuckley,“AManDown,aTrainArriving,andaStrangerMakesaChoice,”NewYorkTimes,January3,2007.

4. Michael Grossman, “Health Economics,” NBER Reporter, Winter1998/99.

5. “America Then and Now: It’s All in the Numbers,”New York Times,December31,2000.

6.“RelievingO’Hare,”TheEconomist,January10,1998.7.June21,2001,p.A1.8. David Kushner, “The Latest Way to Get Cocaine Out of Colombia?Underwater,”NewYorkTimesSundayMagazine,April26,2009.

9.Michael Cooper, “Transit Use Hit Five-Decade High in 2008 as GasPricesRose,”NewYorkTimes,March9,2009.

10.FernandoA.Wilson,JimStimpson,andPeterE.Hilsenrath,“GasolinePrices and Their Relationship to Rising Motorcycle Fatalities, 1990–2007,” American Journal of Public Health, vol. 99, no. 10 (October2009).

11.JaimeSneider,“GoodPropaganda,BadEconomics,”NewYorkTimes,May16,2000,p.A31.

12.RichardH.ThalerandCassR.Sunstein,Nudge: ImprovingDecisionsabout Health, Wealth, and Happiness (New Haven, Conn.: YaleUniversityPress,2008).

13.PressreleasefromTheRoyalSwedishAcademyofSciences,October9,2002.

14.JonathanGruber,“Smoking’s‘Internalities,’”Regulation,vol.25,no.4(Winter2002/2003).

15. Annamaria Lusardi, “The Importance of Financial Literacy,” NBERReporter:ResearchSummary,no.2(2009).

16.ThomasGilovich,RobertVallone,andAmosTversky,“TheHotHandinBasketball:OntheMisperceptionofRandomSequences,”CognitivePsychology17(1985).

CHAPTER2.INCENTIVESMATTER 1.CostaRicanEmbassy,Washington,D.C.

2. Ian Fisher, “Victims ofWar: The Jungle Gorillas, and Tourism,”NewYorkTimes,March31,1999.

3.Daniel Yergin and Joseph Stanislaw, The Commanding Heights (NewYork:Simon&Schuster,1998),pp.216–17.

4.“PayingTeachersMore,”TheEconomist,August24,2000.

5. David Stout, “Child Safety Seats to Be Required for CommercialPlanes,”NewYorkTimes,December16,1999,p.A20.

6.JuliaPreston,“Mexico’sPoliticalInversion:TheCityThatCan’tFixtheAir,”NewYorkTimes,February4,1996,Sect.4,p.4.

7.Ibid.;LucasW.Davis,“TheEffectofDrivingRestrictionsonAirQualityinMexicoCity,”JournalofPoliticalEconomy,vol.116,no.1(February2008).

8.“AvoidingGridlock,”TheEconomist,February17,2003.9.“Ken’sCoup,”TheEconomist,March20,2003.10.“HowtoPayBosses,”TheEconomist,November16,2002.11.FloydNorris,“StockOptions:DoTheyMakeBossesCheat?”NewYorkTimes,August5,2005.

12.SimonJohnson,“TheQuietCoup,”TheAtlantic,May2009.13.JohnTierney, “ATale ofTwoFisheries,”NewYorkTimesMagazine,

August27,2000,p.38.14.“ARisingTide,”TheEconomist,September20,2008.15.DirkJohnson,“LeavingtheFarmfortheOtherRealWorld,”NewYorkTimes,November7,1999,p.3.

16. Virginia Postrel, “The U.S. Tax System Is Discouraging MarriedWomenfromWorking,”NewYorkTimes,November2,2000,p.C2.

17.FriedrichSchneiderandDominikH.Enste,“ShadowEconomies:Size,Causes, and Consequences,” Journal of Economic Literature, March2000.

CHAPTER3.GOVERNMENTANDTHEECONOMY 1. Donald G. McNeil, Jr., “A Fouled City Puts Its Foot Down, but

Carefully,”NewYorkTimes,November9,1999.2.“Mum’stheWord,”TheEconomist,December5,1998.3. “Czechs Puff Away to the Benefit of State Coffers,” United PressInternational,July17,2001.

4. Robert Frank, “Feeling Crash-Resistant in an SUV,”New York Times,May16,2000.

5.Katharine Q. Seelye, “Utility Buys Town It Choked, Lock, Stock andBluePlume,”NewYorkTimes,May13,2002.

6.“Here’sHoping:ASurveyofNigeria,”TheEconomist,January15,2000.7. BlaineHarden, “Angolan Paradox:OilWealthOnlyAdds toMisery,”

NewYorkTimes,April9,2000.8.BarbaraCrossette, “U.N.SaysBadGovernment IsOften theCause ofPoverty,”NewYorkTimes,April5,2000,p.A11.

9. John G. Fernald, “Roads to Prosperity? Assessing the Link BetweenPublicCapital andProductivity,”AmericanEconomicsReview, vol. 89,no.3(June1999),pp.619–38.

10.JerryL.Jordan,“HowtoKeepGrowing‘NewEconomies,’”EconomicCommentary,FederalReserveBankofCleveland,August15,2000.

11.BarryBearak,“InIndia,theWheelsofJusticeHardlyMove,”NewYorkTimes,June1,2000.

12. Thomas L. Friedman, “I LoveD.C.,”New York Times, November 7,2000,p.A29.

13.AmartyaSen,DevelopmentasFreedom (NewYork:AlfredA.Knopf,1999).

14.GiacomoBalbinottoNeto,AnaKatarinaCampelo,andEvertonNunesda Silva, “The Impact of PresumedConsent Law onOrganDonation:An Empirical Analysis from Quantile Regression for LongitudinalData,”BerkeleyPrograminLaw&Economics,Paper050107–2(2007).

CHAPTER4.GOVERNMENTANDTHEECONOMYII 1. John Markoff, “CIA Tries Foray into Capitalism,” New York Times,

September29,1999.2.March6,2001.3.JackieCalmesandLouiseStory,“InWashington,OneBankChiefStillHoldsSway,”NewYorkTimes,January19,2009.

4. Milton Friedman, Capitalism and Freedom (Chicago: University ofChicagoPress,1982).

5. Celia W. Dugger, “A Cruel Choice in New Delhi: Jobs vs. a SaferEnvironment,”NewYorkTimes,November24,2000.

6.“AUsefulPoison,”TheEconomist,December14,2000.7.“FightingMalaria,”TheEconomist,May1,2003.8.“AUsefulPoison,”TheEconomist,December14,2000.9.Gary Becker and Guity Nashat Becker, The Economics of Life (NewYork:McGraw-Hill,1996).

10. Simeon Djankov, Rafael La Porta, Florencio Lopez-de-Silanes, andAndrei Shleifer, The Regulation of Entry, NBER Working Paper No.

W7892(NationalBureauofEconomicResearch,September2000).11.Geeta Anand, “India’s Colleges Battle a Thicket of Red Tape,”WallStreetJournal,November13,2008.

12. Stephen Castle, “Europe Relaxes Rules on Sale of Ugly Fruits andVegetables,”NewYorkTimes,November13,2008.

13.NicholasLemann,“TheQuietMan:HowDickCheneyRosetoPower,”TheNewYorker,May7,2001.

14. Bruce Bartlett, “How Supply-Side Economics Trickled Down,”NewYorkTimes,April6,2007.

15.GregMankiw’sblog,March11,2007.16. Rebecca M. Blank, “Fighting Poverty: Lessons from Recent U.S.

History,” Journal of Economic Perspectives, vol. 14, no. 2 (Spring2000).

17.JerryL.Jordan,“HowtoKeepGrowing‘NewEconomies,’”EconomicCommentary,FederalReserveBankofCleveland,August15,2000.

CHAPTER5.ECONOMICSOFINFORMATION 1.GaryBecker,TheEconomicsofDiscrimination(Chicago:Universityof

ChicagoPress,1971).2. Harry Holzer, Steven Raphael, and Michael Stoll, “PerceivedCriminality, Criminal Background Checks, and the Racial HiringPractices of Employers,” Journal of Law and Economics, vol. XLIX(October2006).

3.David Leonhardt, “In Health Reform, a Cancer Offers an Acid Test,”NewYorkTimes,July8,2009.

4.“TestingTimes,”TheEconomist,October19,2000.5.“Outsourcing:SeparateandLift,”TheEconomist,September20,1997.6.GeoffreyA.Fowler,“KindofBlue:InAsia,EliteOfficesShowOffwithIcyTemperatures,”WallStreetJournal,August24,2005.

7.AlanB.Krueger,“ChildrenSmartEnoughtoGetintoEliteSchoolsMayNotNeedtoBother,”NewYorkTimes,April27,2000,p.C2.

8.Allof theracialprofilingexamplescomefromaprovocativearticleonthesubject:JeffreyGoldberg,“TheColorofSuspicion,”NewYorkTimesMagazine,June20,1999.

CHAPTER6.PRODUCTIVITYANDHUMANCAPITAL

1. Brier Dudley, “Gates Wants to Expand Mega-House,” Seattle Times,February28,2001.

2.“TheRichGetRicher:ASurveyof India’sEconomy,”The Economist,June2,2001.

3. Evelyn Nieves, “Homeless Defy Cities’ Drives toMove Them,”NewYorkTimes,December7,1999.

4.“FromBoots to Electronics: ShuttingMilitaryBases,”The Economist,June21,1997.

5.T.PaulSchultz,“HealthandSchoolingInvestmentsinAfrica,”JournalofEconomicPerspectives,vol.13,no.3(Summer1999),pp.67–88.

6.GaryBecker,“EconomicEvidenceontheValueofEducation,”RemarkstoexecutivesoftheLotusDevelopmentCorporation,January1999.

7. Gary S. Becker, Ryerson Lecture at the University of Chicago, asreprinted in Becker, Human Capital (Chicago: University of ChicagoPress,1993),p.21.

8.Ibid.,p.23.9. Roger Lowenstein, “The Inequality Conundrum,” New York TimesSundayMagazine,June10,2007.

10.Dora Costa, “TheWage and the Length of theWorkDay: From the1890sto1991,”JournalofLaborEconomics,January2000.

11.Alloftheincomeinequalityinformation,includingtheH.L.Menckenquotations,comesfromRobertH.Frank,“WhyLivinginaRichSocietyMakesUsFeelPoor,”NewYorkTimesMagazine,October15,2000.

12.PhilippeAghion,EveCaroli,andCeciliaGarcia-Penalosa,“InequalityandEconomicGrowth:ThePerspectiveof theNewGrowthTheories,”JournalofEconomicLiterature,vol.37(December1999),pp.1615–60.

13. Marvin Zonis, Remarks Presented at the University of ChicagoBusinessForecastLuncheon,December6,2000.

CHAPTER7.FINANCIALMARKETS 1.JohannaBerkman,“Harvard’sHoard,”NewYorkTimesMagazine, June

24,2001.2. Richard Bradley, “Drew Gilpin Faust and the Incredible ShrinkingHarvard,”BostonMagazine,June18,2009.

3.“ForThoseinPeril,”TheEconomist,April22,2006.4.DarrenRovell,SportsBiz,CNBC,September15,2009.

5.JosephTreaster,“EvenNatureCanBeTurnedintoaSecurity;HighYieldandBigRiskwithCatastropheBonds,”NewYorkTimes,August6,1997.

6.SimonJohnson,“TheQuietCoup,”TheAtlantic,May2009.7.JaneSpencer,“Lessons from theBrain-Damaged Investor,”Wall StreetJournal,July21,2005.

8.PeterCoy,“CanYouReallyBeattheMarket?”BusinessWeek,May31,1999.

9.BurtonG.Malkiel,“ThePriceIs(Usually)Right,”WallStreetJournal,June10,2009.

10. Jon E. Hilsenrath, “As Two Economists Debate Markets, the TideShifts,”WallStreetJournal,October18,2004.

11.RuthSimon,“BondsLetYouSleepatNightbutataPrice,”WallStreetJournal,September8,1998.

12. Matthew Kaminski, “The Age of Diminishing Endowments,” WallStreetJournal,June6–7,2009.

CHAPTER8.THEPOWEROFORGANIZEDINTERESTS 1.RobertDavis,“MuseumGarageIsaFineCut;ItMayBePork,butCity

Hungry,”ChicagoTribune,May5,1994.2.JasonHill, ErikNelson,David Tilman, Stephen Polasky, andDouglasTiffany,“Environmental,Economic,andEnergeticCostsandBenefitsofBiodieselandEthanolBiofuels,”ProceedingsoftheNationalAcademyofSciences,vol.103,no.30(July25,2006).

3.NicholasKristof,“Ethanol,forAllItsCritics,FuelsFarmerSupportandIowa’sRoleinPresidentialRaces,”NewYorkTimes,January21,2000.

4. Robert Gordon, Thomas Kane, and Douglas O. Staiger, “IdentifyingEffectiveTeachersUsingPerformanceontheJob,”TheHamiltonProjectPolicyBriefNo.2006–01,April2006.

5. Roger Ferguson, Jr., “Economic Policy for Our Era: The OhioExperience,” Economic Commentary, Federal Reserve Bank ofCleveland,May15,2000.

6.JoeKlein, “EightYears: Bill ClintonLooksBack onHis Presidency,”TheNewYorker,October16,2000,p.201.

7.ElizabethKolbert,“BacktoSchool,”TheNewYorker,March5,2001.

CHAPTER9.KEEPINGSCORE

1.Michael Cox and Richard Alm, TimeWell Spent: The Declining RealCostofLivinginAmerica,FederalReserveBankofDallas,1997AnnualReport.

2.OdedGalorandDavidN.Weil,“Population,Technology,andGrowth:From Malthusian Stagnation to the Demographic Transition andBeyond,”AmericanEconomicReview,vol.20,no.4(September2000).

3.MiriamJordan,“LeprosyRemainsaFoeinCountryWinningtheFightAgainstAIDS,”WallStreetJournal,August20,2001.

4. Jane Spencer, “Why Beijing Is Trying to Tally the Hidden Costs ofPollutionasChina’sEconomyBooms,”WallStreetJournal,October 2,2006.

5.DavidLeonhardt,“IfRicher Isn’tHappier,What Is?”NewYorkTimes,May19,2001.

6.DanielKahneman,AlanB.Krueger,DavidSchkade,NorbertSchwarz,and Arthur Stone, “Toward NationalWell-Being Accounts,” AmericanEconomicReview,vol.94,no.2(May2004).

7. “Economics Discovers Its Feelings,” The Economist, December 23,2006.

8.AlexanderStille,“AHappinessIndexwithaLongReach:BeyondGNPtoSubtlerMeasures,”NewYorkTimes,May20,2000,p.A17.

9.EdwardHadasandRichardBeales,“SarkozyImagines:NoGDP,”WallStreet Journal, January 10, 2008; David Jolly, “G.D.P. Seen asInadequateMeasure ofEconomicHealth,”NewYorkTimes, September15,2009.

10. David Gonzalez, “A Coffee Crisis’ Devastating Domino Effect inNicaragua,”NewYorkTimes,August29,2001.

11. Christina D. Romer, “Back from the Brink,” speech delivered at theFederalReserveBankofChicago,September24,2009.

12. James B. Stewart, “Eight Days: The Battle to Save the AmericanFinancialSystem,”TheNewYorker,September21,2009.

13. Rebecca Kern, “Girl Scout Cookie Sales Crumble,” USA Today,February20,2009.

14.“HardTimes,”TheEconomist,September10,2009.15. Christina D. Romer, “The Economic Crisis: Causes, Policies, and

Outlook,” testimony before the Joint Economic Committee, April 30,2009.

16.BruceBartlett,“WhatTaxCutsCan’tDo,”NewYorkTimes,December

20,2000.17.Romer,ChicagoFederalReservespeech.18.JagadeeshGokhale,“AreWeSavingEnough?”EconomicCommentary,

FederalReserveBankofCleveland,July2000.19.“WhataPeculiarCycle,”TheEconomist,March10,2001.20. JamesW. Paulsen,Economic and Market Perspective, Wells Capital

Management,October1999.

CHAPTER10.THEFEDERALRESERVE 1.R.A.Mundell,“AReconsiderationoftheTwentiethCentury,”American

EconomicReview,vol.90,no.3(June2000),pp.327–40.2.JustinScheck,“MackerelEconomicsinPrisonLeadstoAppreciationforOilyFilets,”WallStreetJournal,October2,2008.

3. David Berreby, “All About Currency Printers: The Companies ThatMakeMoneyfromMakingMoney,”NewYorkTimes,August23,1992.

4.PaulKrugman,“FearItself,”NewYorkTimesMagazine,September30,2001.

5. Stephanie Strom, “Deflation Shackles Japan, Blocking Hope ofRecovery,”NewYorkTimes,March12,2001.

6.N.GregoryMankiw,PrinciplesofEconomics(FortWorth,Tex.:DrydenPress,1998),p.606.

7.StephenG.Cecchetti,“CrisisandResponses:TheFederalReserveintheEarlyStagesoftheFinancialCrisis,”JournalofEconomicPerspectives,vol.23,no.1(Winter2009).

8.“TheVeryModelofaCentralBanker,”TheEconomist,August27,2009.

CHAPTER11.INTERNATIONALECONOMICS 1. Thomas Jaffe andDyanMachan, “How theMarket Overwhelmed the

CentralBanks,”Forbes,November9,1992.2.AnatoleKaletsky, “HowMr.SorosMade aBillion byBettingAgainstthePound,”TheTimesofLondon,October26,1992

3.“BigMacCurrencies,”TheEconomist,April25,2002.4.SylviaNasar,“WeakDollarMakesU.S.World’sBargainBazaar,”NewYorkTimes,September28,1992.

5.IanRowley,“WhyJapanHasn’tStoppedtheYen’sRise,”BusinessWeek

(online),January15,2009.6. Paul Krugman, “Misguided Monetary Mentalities,” New York Times,October12,2009.

7.MauriceObstfeldandKennethRogoff,“TheMirageofFixedExchangeRates,”NationalBureauofEconomicResearchWorkingPaperW5191,July1995.

8.AnthonyRamirez,“PepsiWillBeBarteredforShipsandVodkainDealWithSoviets,”NewYorkTimes,April9,1990.

9.PeterGumble,“Iceland:TheCountryThatBecameaHedgeFund,”CNNMoney.com,December4,2008.

10.“CracksintheCrust,”TheEconomist,December11,2008.11. Associated Press, as reported by Yahoo! Finance. “Iceland Says

GoodbyetotheBigMac,”October26,2009.12.“NoPain,NoGain,”TheEconomist,December13,2003.13. James Fallows, “The $1.4 Trillion Question,” The Atlantic,

January/February2008.14.Ibid.15.“ReformingtheSisters,”TheEconomist,February17,2001.16.Ibid.

CHAPTER12.TRADEANDGLOBALIZATION 1. Paul Krugman, “TheMagicMountain,”New York Times, January 23,

2001.2.CharlesWheelan,“FastFood,BalineseStyle,”ValleyNews,January25,1989,p.18.

3.“TheBattleinSeattle,”TheEconomist,November27,1999.4.“EconomicNationalism:BashingForeigners in Iowa,”The Economist,September21,1991.

5. Mary E. Burfisher, Sherman Robinson, and Karen Thierfelder, “TheImpact of NAFTA on the United States,” Journal of EconomicPerspectives,vol.15,no.1(Winter2001).

6.DanBarry, “AMill Closes, and aHamlet Fades to Black,”New YorkTimes,February16,2001.

7. Marvin Zonis, “Globalization,” National Strategy Forum Review:StrategicOutlook2001,NationalStrategyForum,Spring2001.

8. Kenneth F. Scheve and Matthew J. Slaughter, “A New Deal for

Globalization,”ForeignAffairs,July/August2007.9. David Cortright and George A. Lopez, eds., The Sanctions Decade:Assessing UN Strategies in the 1990s (Boulder, Colo.: Lynne Rienner,2000).

10.AnthonyDePalma and SimonRomero, “Orange Juice Tariff HindersTradePactforU.S.andBrazil,”NewYorkTimes,April24,2000,p.A1.

11.“UNChiefBlamesRichNationsforFailureofTradeTalks,”NewYorkTimes,February13,2000,p.12.

12.ThomasFriedman,“ProtestingforWhom?”NewYorkTimes,April24,2001.

13. Nicholas D. Kristof and Sheryl WuDunn, “Two Cheers forSweatshops,”NewYorkTimesMagazine,September24,2000,pp.70–71.

14.Thomas Friedman, “Parsing the Protests,”NewYorkTimes, April 14,2000,p.31.

15.Zonis,“Globalization.”16.“WebSitesProvideOpportunityforArtisansAroundtheWorldtoSell

TheirWaresThusIncreasingLivingStandards,”NationalPublicRadio,September11,2000.

17.KristofandWuDunn,“TwoCheersforSweatshops.”18.“ASurveyofGlobalization,”TheEconomist,September29,2001.19.KristofandWuDunn,“TwoCheersforSweatshops.”20.PaulKrugman,“HeartsandHeads,”NewYorkTimes,April22,2001.21.“EconomicMan,CleanerPlanet,”TheEconomist,September29,2001.22.Krugman,“HeartsandHeads.”23. John Micklethwait and Adrian Wooldridge, “Why the Globalization

BacklashIsStupid,”ForeignPolicy,September/October2001.

CHAPTER13.DEVELOPMENTECONOMICS 1.“NoTitle,”TheEconomist,March31,2001.

2. World Development Report 2008, World Bank (New York: OxfordUniversityPress,2000).

3.WilliamEasterly,TheElusiveQuestforGrowth(Cambridge,Mass.:MITPress,2001),p.285.

4. World Development Report 2002: Building Institutions for Markets,WorldBank,OxfordUniversityPress,p.3.

5. Thomas L. Friedman, “I Love D.C.,”New York Times, November 7,2000,p.A29.

6.DaronAcemoglu, Simon Johnson, and James Robinson,TheColonialOrigins of Comparative Development: An Empirical Investigation,NBER Working Paper No. W7771 (National Bureau of EconomicResearch,June2000).

7.Daniel Kaufmann, Aart Kraay, and Pablo Zoido-Lobatón,GovernanceMatters(Washington,D.C.:WorldBank,October1999).

8.“NoTitle,”TheEconomist,March31,2001.9.EricaField,“EntitledtoWork:UrbanPropertyRightsandLaborSupplyinPeru,”undatedmanuscript.

10.“ACokeandaFrown,”TheEconomist,October7,2000,p.73.11.“NoTitle,”TheEconomist,March31,2001.12.GaryS.Becker,HumanCapital,p.24.13.Easterly,TheElusiveQuestforGrowth,p.160.14.“FareTheeWell,Iowa,”TheEconomist,August18,2001.15.JeffreySachs,TropicalUnderdevelopment,NBERWorkingPaperNo.

W8119(NationalBureauofEconomicResearch,February2001).16.DonaldG.McNeil,“DrugCompaniesandThirdWorld:ACaseStudy

inNeglect,”NewYorkTimes,May21,2000.17. Rachel Glennerster and Michael Kremer, “A Better Way to Spur

MedicalResearchandDevelopment,”Regulation,vol.23,no.2.18.JeffreySachs,“Nature,Nurture,andGrowth,”TheEconomist,June14,

1997.19. Jeffrey Sachs, “Growth in Africa: It Can Be Done,” The Economist,

June29,1996.20. Jeffrey A. Frankel and David Romer, “Does Trade Cause Growth?”AmericanEconomicReview,vol.89,no.3(June1999),pp.379–99.

21.Sachs,“GrowthinAfrica.”22. Jeffrey D. Sachs and Andrew M. Warner, “The Big Push: Natural

Resource Booms and Growth,” Journal of Development Economics,June1999,ascitedinEconomicIntuition,Montreal,Fall1999.

23.“TrackingAngola’sOilMoney,”TheEconomist, January15,2000,p.48.

24.BlaineHarden,“AngolanParadox:OilWealthOnlyAdds toMisery,”NewYorkTimes,April9,2000.

25.“OpentotheWinds:ANationofTraders,”TheEconomist,September

12,1987.26.NorimitsuOnishiandNeelaBanerjee,“Chad’sWaitforItsOilRiches

MayBeLong,”NewYorkTimes,May16,2001.27.AmartyaSen,DevelopmentasFreedom (NewYork:AlfredA.Knopf,

1999),p.152.28. Paul Collier, The Bottom Billion: Why the Poorest Countries AreFailingandWhatCanBeDoneAboutIt(NewYork:OxfordUniversityPress),2007.

29.“CokaandAl-Qaeda,”TheEconomist,April3,2004.30. Nicholas D. Kristof and Sheryl WuDunn, “The Women’s Crusade,”NewYorkTimesMagazine,August23,2009.

31.“Self-DoomedtoFailure,”TheEconomist,July6,2002.32.KristofandWuDunn,“TheWomen’sCrusade.”33. Jeffrey Sachs, “The Best Possible Investment in Africa,” New YorkTimes,February10,2001.

34.“What’sGoodforthePoorIsGoodforAmerica,”TheEconomist,July14,2001.

35. Jeffrey Sachs, “Growth in Africa: It Can Be Done,” The Economist,June29,1996.

36.WilliamEasterly,TheWhiteMan’sBurden(NewYork:Penguin,2007).37.WilliamEasterly,“WasDevelopmentAssistanceaMistake,”AmericanEconomicReview,vol.97,no.2(May2007).

38. Craig Burnside and David Dollar, “Aid, Policies, and Growth,”AmericanEconomicReview,vol.90,no.4(September2000),pp.847–68.

39. Dani Rodrik, “Goodbye Washington Consensus, Hello WashingtonConfusion? A Review of the World Bank’s Economic Growth in the1990s: Learning from a Decade of Reform,” Journal of EconomicLiterature,vol.XLIV(December2006).

EPILOGUE.LIFEIN2050 1.“OutofSight,OutofMind,”TheEconomist,May18,2001.

2.DeniseGrady, “InQuest toCureRareDiseases, SomeGet LeftOut,”NewYorkTimes,November16,1999.

3.AnthonyLewis, “ACivilized Society,”New York Times, September 8,2001.

4. Phred Dvorak, “A Puzzle for Japan: Rock-Bottom Rates, but FewBorrowers,”WallStreetJournal,October25,2001.

5.SimonJohnson,“TheQuietCoup,”TheAtlantic,May2009.

*WhenourFordExplorerrolledoverat65mphonaninterstatethreeyearslater,weboughtaVolvo.

* I cannot fully explain why the pharmaceutical companies were so resistant to providing low-costHIV/AIDS drugs to Africa. These countries will never be able to pay the high prices charged in thedevelopedworld,sothecompanieswouldnotbeforgoingprofitsbysellingthedrugscheaply.InplaceslikeSouthAfrica, it’seithercheapdrugsornodrugs.Thiswouldappeartobeaperfectopportunityforpricediscrimination:MakethedrugscheapinCapeTownandexpensiveinNewYork.True,pricediscriminationcouldcreateanopportunityforablackmarket;drugssoldcheaplyinAfricacouldberesoldillegallyathighprices inNewYork. But that seems amanageable problem relative to the huge public relations cost ofdenyingimportantdrugstolargeswathesoftheworld’spopulation.

*Thereisasubtlebutimportantanalyticalpointhere.Thosewhoarguethattaxcutsincreasegovernmentrevenuesoftenpointout,correctly,thatgovernmentrevenuesarehigherafteramajortaxcutthanbefore.But this is not the appropriate comparison tomake.The questionwe should ask iswhether governmentrevenuesafterthetaxcutarehigherthantheywouldhavebeeniftherehadnotbeenataxcut.Thereasonthisdistinctionmattersis thatinflationandeconomicgrowthpushgovernmentrevenueshigheryearafteryear evenwhen the tax rate isunchanged.So it’s entirelyplausible that revenueswouldhaveclimbed5percentwithoutthetaxcut;iftheyclimb2percentwiththetaxcut,governmentrevenuesareindeedhigherthantheyearbefore—butlowerthantheywouldhavebeenwithoutthetaxcut.Ifspendinggrowthisnotcurtailedtomatchthisnewrevenuereality,thenbudgetdeficitswillresult,whichisusuallywhathappens.

*Your actual returnwould bemuch higher, sincemuch of the purchasewould be financed. If you put$50,000down,forexample,youwouldhaveearned$250,000ona$50,000investment(minustheinterestyoupaidtocarrythemortgageduringtheperiodyouownedthehouse).

* The expected return is 0.5($400,000) + 0.5($0) = $200,000, which is a 100 percent return on your$100,000investment.

†Thisexerciseissomewhatoversimplified.Theflipsofacoinareindependent,whiletheperformanceofindividual stocksarenot.Someevents, suchasan interest ratehike,will affect thewholemarket.Thus,buyingtwostockswillnotofferasmuchdiversificationaswouldsplittingyourportfoliobetweentwoflipsofacoin.Nonetheless,thebroaderpointisvalid.

*ToderivetheGiniindex,thepersonalincomesinacountryarearrangedinascendingorder.Aline,theLorenzcurve,plots the cumulative shareofpersonal incomeagainst the cumulative shareofpopulation.Totalequalitywouldbea45-degreeline.TheGinicoefficientistheratiooftheareabetweenthediagonalandtheLorenzcurvetothetotalareaunderthediagonal.

*Ican’tremembertheexactnumbers,buttheyweresomethingalongtheselines.

*Okay, that’s not exactly true.At the height of the financial crisis, right around the time that LehmanBrothersdeclaredbankruptcy,theyieldonthree-monthU.S.Treasurynotesfellbelowzero,whichmeansthatthenominalinterestratehadturnednegative.Remarkably,investorswerepayingmoreforsomethingthan it promised to pay them back in three months. For policymakers, this was a sign of panic. KeithHennessey,directoroftheNationalEconomicCouncilintheWhiteHouse,toldJamesStewartofTheNewYorker,“Treasuryrateswentnegative!Peoplewerelockinginalossjusttoprotecttheirmoney.”

*SorosborrowedahugesuminBritishpoundsandimmediatelytradedthemforstrongercurrencies,suchastheGermandeutschemark.WhentheBritseventuallydroppedoutoftheERManddevaluedthepound,heswappedhiscurrencyholdingsbackformorepoundsthanhehadoriginallyborrowed.Hepaidbackhisloans andkept thedifference.Numbersmake this allmore intuitive.SupposeSorosborrowed10billionpoundsandswappedthemimmediatelyfor10billiondeutschemarks.(Theexchangeratesandamountsarecontrived to make the numbers easier.)When the pound was devalued, its value fell by more than 10percent, so that10billiondeutschemarks subsequentlybought11billionpounds.Soros swappedhis10billion deutschemarks for 11 billion pounds. He paid back his 10-billion-pound loan and kept the tidybalanceforhimself(or,moreaccurately,forhisinvestmentfunds).SorossupplementedhiscurrencygainswithancillarybetsrelatedtohowthedevaluationwouldaffectEuropeanstocksandbonds.

*Economistsmakeadistinctionbetweenthenominalexchangerate,whichistheofficialrateatwhichonecurrencycanbeexchangedforanother(thenumberspostedontheboardatthecurrencyexchange),andtherealexchangerate,whichtakesinflationintoaccountinbothcountriesandisthereforeabetterindicatorofchangesinpurchasingpowerofonecurrencyrelativetoanother.Forexample,assumethattheU.S.dollarcanbeexchangedatyour localbankfor10pesos.Furtherassumethat (1) inflation iszero in theUnitedStates and 10 percent annually inMexico; and (2) a year later your local bankwill exchange $1 for 11pesos.Innominalterms,theU.S.dollarhasappreciated10percentrelativetothepeso(eachdollarbuys10percentmorepesos).Buttherealexchangeratehasn’tchangedatall.Youwillget10percentmorepesosatthecurrencyexchangewindowthanyoudidlastyear,butbecauseofinflationoverthecourseoftheyear,eachpesonowbuys10percentlessthanitusedto.Asaresult,thetotalpurchasingpowerofthepesosthatyouget from thebank teller this year for your$100 is exactly the sameas thepurchasingpowerof the(fewer)pesosyougotforyour$100lastyear.Anyreferencetoexchangeratesinthebalanceofthischapterreferstorealexchangerates.