Saturday, February 20, 2010

The Audacity Of Running For President Without Knowing Any Economics

Barack Obama said last week, in reference to the large bonuses paid to Jaime Dimon of JP Morgan Chase and Lloyd Blankfein of Goldman Sachs that:

“I know both those guys; they are very savvy businessmen... I, like most of the American people, don’t begrudge people success or wealth. That is part of the free-market system.”

He also said:

“There are some baseball players who are making more than that and don’t get to the World Series either, so I’m shocked by that as well.”

Well, our president obviously does not know what a free-market system is, but he ought to know at least this: We don't have one. Not in banking anyway - the market for banking services in the U.S. is just about the least free of all markets that we have. There are no bailouts in a free market.

These two men, far from being successful businessmen, are among the primary beneficiaries of anti-free market policies. They have not earned their money by being good bankers, but by effective lobbying. They are good at convincing powerful people that they deserve wealth that other people have earned. In fact, they have destroyed wealth and, in a free-market system, would earn no more than a subsistence wage.

Economic activity is all about production and trade. What we produce can be consumed or saved. What we save can sit idle or be used to produce things for future consumption. When we use savings for the latter it is called investment. Savings (also called wealth) is really just an uncertain claim on future consumption. It is uncertain because an investment may or may not work out well. For example, building a house that no one wants to live in is an investment with a negative return; making a small machine that can store and play thousands of songs that is consumed by millions of people has a positive return.

The role of bankers is an important one in any economy, but it is often performed quite poorly. Actually, the role of a banker is simple - he is the middleman between savers and investors. Savers are not necessarily good at producing things that can be consumed in the future, so they take their money to a banker. In theory, the banker knows people who are good at producing. They make a deal that gives the investors access to the savers' resources and all three share the proceeds in some way that they agree to among themselves.

Now, some of these investments fail and some succeed, but in a free market, we can expect that, on average, they will have a positive return. This is true, not because the group of bankers and investors are inherently skilled, but because those who are not skilled will fail and move into other professions. An investor who consistently has negative returns will eventually lose the trust of the bankers and lose access to the resources of savers; a banker who consistently funnels money to failed enterprises will lose savers as customers.

But this process of weeding out incompetent bankers only happens if the bankers must rely on their own success to make a living. If an outside entity, like the government, gives bankers an opportunity to continue banking after they have failed, the system falls apart.

Bailouts accomplish exactly that, and Goldman Sachs and JP Morgan Chase were among those at the front of the bailout line.