November 1, 2009

Fiscal Imprudence, Distributive Injustice: the $250 per Social Security Annuitant Plan--Posner

In October, the President announced that $13 billion (some commentators believe a more accurate estimate is $14 billion) of the $787 billion stimulus package enacted this past February would be used to pay every social security annuitant $250 in 2010, ostensibly to "compensate" for the fact that there will no cost of living (inflation) increase in social security benefits. The social security COLA for year t is based on the increase in the Consumer Price Index between the end of the third quarter of t - 1 and the end of the third quarter of t -2. (t is 2010, t - 1 2009, and t - 2 2008.) There will be no cost of living increase in 2010 for the excellent reason that as of the end of the third quarter of this year (September 30, 2009), the cost of living had fallen 1.3 percent from the end of the third quarter of 2008. Social security has a ratchet: benefits increase when the cost of living increases but do not decrease when the cost of living decreases. There is thus nothing to "compensate" social security annuitants for; on the contrary, they will be receiving a windfall in 2010 by virtue of the increase in their real (as distinct from nominal) benefits: their 2010 benefits will buy more.

Transfer payments, moreover, are a poor device for fiscal stimulus. The idea of a fiscal stimulus as an anti-depression device is to increase employment and by doing so restore business and consumer confidence; we are seeing today how high and rising unemployment is sapping that confidence and retarding recovery from the current depression (and it is a depression, not the "Great Recession" as some are calling it, though that's an issue for another day).

Transfer payments are at two removes from putting unemployed people to work. The amount of the transfer that is saved by the recipient in a savings account or other safe haven is (by definition) not spent, and so does not increase demand and therefore supply and therefore employment. And the amount of the transfer that is spent is spent at a store or other retail outlet to purchase a good that has already been produced. It is buying from inventory. Only when the store's inventory falls to a level at which the store has to order a new supply of goods from the manufacturer is there any stimulation of production, and thus of hiring; and of course the stimulation may not be of production by an industry, or in an area, of high unemployment. The dive that the economy took in the wake of the September 2008 financial collapse was unanticipated, and as a result sellers found themselves with excess inventories; until they were worked down, production would remain depressed. In sum, the effect of a transfer payment on employment may therefore be nil.

Apart from its inefficiency as a contribution to the recovery, largesse for the elderly--whose medical expenses, paid for largely by the taxpayer under the Medicare program--are threatening to bankrupt the country, sends the wrong signal: the signal of fiscal profligacy.

Lawrence Summers, the brilliant economist who heads the National Economic Council in the White House, has publicly endorsed the $250 dollar gift to social security recipients. He claims that it corrects an "anomaly." The anomaly he points is that social security recipients received only one $250 stimulus check this year and will receive no cost of living increase next year, whereas the tax benefits in the stimulus plan will be paid next year as well as this year. But social security annuitants received a 5.8 percent cost of living increase this year, whereas few workers received as large a wage increase; and they will be receiving a real as distinct from nominal increase in benefits next year. The only "anomaly" in the picture is the cynical provision of a windfall to a group that has suffered less from the depression than persons of working age, a group whose only claim to a $250 Christmas gift paid for by the federal taxpayer is that it votes more heavily than the young.

What's $13 billion at a time when trillions are spent casually? The real significance of the measure is the insight it gives into the Administration's apparent indifference to fiscal prudence. And not just the Administration. The political parties play leapfrog when it comes to spending--each trying to outdo the other in generosity to powerful voting blocs, and specifically to the elderly--the recipients of enormous social security and Medicare benefits, courtesy of the federal taxpayer. The costs of both the Medicare and social security programs are increasing rapidly as the population ages, and as the population ages the voting power of the elderly increases, placing additional pressure on a budget already disproportionately devoted to supporting the least economically productive members of society. (As a septuagenarian, I claim the right to make politically incorrect remarks about the elderly. Moreover, I am speaking of the average; many elderly people are hard-working and productive.)

Posted by Richard Posner at 5:53 PM | Comments (0) | TrackBack (0)

Fiscal Imprudence and Fiscal Stimulus-Becker

The government's preliminary estimate of the growth in American GDP during the third quarter of 2009 is an impressive annual rate of 3.5%. This figure may be revised downward (or upward) as more data on the third quarter become available, but it surely definitely signals that the US recession is over. In my post on August 9th of this year I already expressed my belief that the recession in the US and the world would end during the third quarter. The end of a recession does not mean that an economy is back to where it would have been without the recession-the US economy is certainly not anywhere near that point yet- nor that the recovery from the recession will be rapid.

The rapidity of the recovery in the US or the world is not yet clear, although many economists who follow short term movements of the economy more closely than I do are predicting a slow and drawn out recovery period in the EU, Japan, and the US. I am not convinced by their forecasts because of the rapid recoveries in Asia, Brazil, and some other countries, and as long as American productivity continues to grow at a rapid rate. To be sure, unemployment is likely to continue to increase for a while since it is what is called a "lagging indicator". However, it almost surely will peak below the 10.8% reached at the end of 1982. During the past couple of years the world went through a severe recession, but it was not appreciably worse in the United States, as measured by the effects on GDP and unemployment, than during some other recession in the past 40 years. Of course, without some of the proactive policies of the Fed and the Treasury, this recession probably would have been deeper and longer.

Not surprisingly, these comments lead me to join Posner in taking a negative view of the plan to pay every social security annuitant a $250 bonus in 2010. The reason given to justify this payment is that the elderly will get no cost of living increase in their social security payments since prices fell rather than rose during the past year. As Posner indicates, this is an illogical and basically nonsensical justification for this bonus to social security recipients. Taxpayers already heavily subsidize the elderly through Medicare and to some extent social security payments, and there is little reason to use spurious arguments to add to that subsidy as part of the stimulus package.

More generally, the $787 billion stimulus-spending package of the Obama administration has made little sense since its inception, as I have argued in several blog posts and elsewhere. Business cycle analysts have long known and documented that fiscal spending programs are not very good at helping to fight recessions since they take a long time to implement. By the time fiscal spending actually occurs. the recessions they were supposed to be combating are usually over. Only about one third of the present stimulus package has yet been spent-and much of it not very well spent. Yet, the recession is already over, although to be sure, the recovery is still at the beginning stages.

I do not believe that inflation due to the Fed's rapid increase in bank reserves is yet a major worry, although it will be in a few years as banks spent these reserves by making additional loans and other investments. Nor do I believe that the huge increase in federal government spending, on the stimulus programs and to help the banks, will be a major cause for concern, as long as American GDP will grow at a much more rapid rate during the next decade than will government spending.

However, the much higher interest payments on the much larger government debt will have to be met either by raising taxes, cutting other government spending, rising tax collections from increased output, or inflation that deflates the real value of these interest payments. I am very much worried that it will be impossible to stop the growth of government spending, so that there will be an enormous, and probably irresistible, temptation to inflate to reduce the real value of the debt, and to raise taxes on higher income persons. Both of these will have negative effects on the growth rate of the American economy.

Posted by Gary Becker at 5:05 PM | Comments (0) | TrackBack (0)

October 28, 2009

Notice

Longtime readers of this blog will be pleased to learn that this month sees its migration into book form. Uncommon Sense: Economic Insights, from Marriage to Terrorism, which collects what we believe are the best, most interesting, and most lasting posts from this blog. The posts selected for the book are representative of the wide range of topics we cover here, and, where appropriate, they've been updated to take account of subsequent events.

The book is available at all good bookstores, on- and offline, as well as directly from the University of Chicago Press: http://www.press.uchicago.edu/presssite/metadata.epl?mode=synopsis&bookkey=1606474.

Posted by Richard Posner at 10:55 AM | Comments (0) | TrackBack (0)

October 25, 2009

Pay Controls Once Again-Becker

I sympathize with all the people who are upset by the very large bonuses, stock options, and other compensation received by heads of some financial institutions that ran their companies into the ground through bad investments. However, I also believe it is a big mistake to have a pay czar, Kenneth Feinberg, impose sharp cuts over the salaries and other compensation of the seven financial institutions, like Citibank, that received the most government bailout money. The Fed has made matters even worse by proposing to implement pay controls over thousands of banks as part of its regular review of their performance.

General controls over wages have frequently been tried in different countries. The usual motivation for wage controls is to reduce inflation by keeping labor costs, and therefore prices, from rising rapidly, although wage controls are invariably combined with general controls over prices as well. Inflationary fears were certainly behind the wage and price controls in almost all countries during World War II, and in the US under President Nixon from 1971-1973. These measures sometimes succeeded in suppressing inflation temporarily, but they also led to rationing of various consumer and producer goods because of weak incentive to produce or work when prices and wages are kept below their market values.

Companies can still compete for employees when higher pay cannot be offered as inducements by increasing fringe benefits to employees, such as longer vacations and subsidized lunches and other meals. US companies began to offer free health insurance to employees during World War II as a way to get around the wartime control over wages. The American health care system has suffered badly since then from this artificially induced connection between employment and subsidized health care.

In some respects, the effects of controls over pay are even more harmful when they apply only to a small subset of all employees, such as the proposed sharp ceilings on management compensation at the seven companies that received the largest amount of government assistance, or the scrutiny of pay of top executives at the thousands of financial institutions under the Fed's supervision. The most talented individuals at these firms will tend to leave because they will receive much higher compensation packages by financial and other companies that do not have their pay set in Washington. So the financial companies that received much government assistance and other banks would lose many of their best people just when they need talented management to help put their companies under a more solid financial foundations. Without the requisite talent, many of these companies may either go under, perhaps not a bad idea, or more likely the government will bail them out once again-not a pleasant prospect.

o prevent an exodus of whatever talent is left and to attract new talent, Feinberg and the Fed may try to differentiate between more and less able executives, and allow much higher pay for the best of them. But can a czar or the Fed perform that task better than the forces of market competition for talent? History indicates that is highly unlikely.

These controls over pay not only will cap salaries, but they would also reduce bonuses and stock options, and prevent the executives affected to cash in options for several years. The reasoning is that this will force executives to take a longer-term view of the risks and other decisions that they take. One irony is that, as pointed out by Yale's Jonathan Macey in a recent Wall Street Journal op-ed piece, Congress in a 1992 Act prevented corporations from deducting as a normal business expense any salaries that exceeded $1 million. As a result, corporations were encouraged to shift their pay to stock options, which received more favorable tax treatment.

I have not seen convincing evidence that either the level or structure of the pay of top financial executives were important causes of this worldwide financial crash. These executives bought large quantities of mortgage-backed securities and other securitized assets because they expected this to increase the average return on their assets without taking on much additional risk through the better risk management offered by derivatives, credit default swaps, and other newer types of securities. They turned out to be badly wrong, but so too were the many financial economists who had no sizable financial stake in these assets, but supported this approach to risk management.

The experience of other financial crashes also does not indicate that either the level or form of compensation of top financial executives were major factors in precipitating these crashes. Thousands of banks failed during the Great Depression, as did hundreds of American savings and loans institutions during the 1980s, without heads of these institutions in either case getting particularly high pay, or pay that was mainly in the form of bonuses and stock options. My impression is that this same conclusion applies to the Mexican bank crisis of the mid 1990s, and the Asian financial crisis at the end of the 1990s.

The generous bonuses and stock options received by financial executives may often have been unwarranted, but they are being used as a scapegoat for other more crucial factors. Financial institutions underrated the systemic risks of the more exotic assets, and apparently so too did the Fed and other regulators of financial institutions. In addition, large financial institutions may have recognized that they were "too big to fail", and that they would be rescued by taxpayer monies if they were on the verge of bankruptcy because they took on excessively risky assets.

Posted by Gary Becker at 4:36 PM | Comments (0) | TrackBack (0)

Pay Caps for Financial Executives--Posner

Limiting the compensation of a handful of employees at a handful of firms can't have any effect except to benefit the firms' competitors by making them more attractive places to work. The limitations are a form of scapegoating designed to appease public anger over the high incomes of financiers who precipitated an economic collapse that has caused widespread suffering, much of it to people who, unlike financiers, bumbling or inattentive government regulators, macroeconomists, members of Congress, and improvident homebuyers and home-equity borrowers, bear no share of blame for the collapse.

There is a slightly better, though still unconvincing, case for regulating (2) compensation structure, as distinct from the level of compensation, of (2) all financial institutions. Since the market for financiers is global (in part because even a very small country can become a major banking center, given the mobility of capital and of financial personnel and the absence of any need for elaborate infrastructure, physical resources, or a large domestic market), effective regulation of compensation structures would require agreement among all major and many minor nations. If that obstacle to effective regulation could be surmounted, the case for regulation would come down to the fact that front-loaded compensation of financial executives can increase macroeconomic risk.

To explain, the risk of the kind of financial collapse that occurred in 2008 was reasonably perceived as small; had it been perceived as large, the banking industry would have reduced its leverage and other sources of risk. The risk of the kind of financial collapse that occurred in 2008 was reasonably perceived as small; had it been perceived as large, the banking industry would have reduced its leverage and other sources of risk. That small-seeming risk was produced by individual risky transactions, and the object of compensation reform is to discourage such transactions. Suppose the transactions were the purchase of triple-A tranches of mortgage-backed securities at an attractive price, but carried a correlated annual risk of 1 percent that the investments would turn out to be worthless and bring down the firm. A financial executive paid salary or bonus based on the expected profit of such a deal would have an incentive to make it despite the slight chance that it would blow up eventually. Merely requiring, say, that a portion of his salary or bonus be placed in escrow for a few years would not deter him; the reduction in his expected compensation would be too small. Suppose 50 percent of the bonus he received on the deal was placed in escrow and the duration of the escrow was five years. Then he would face a 5 percent chance of losing half his bonus. That would be too small an expected penalty to dissuade him from making the deal. The penalty could not be made sufficiently heavy to disuade him without depriving him of most of his current income.

So I think regulating financial compensation is a mistake. At the same time I think financial executives probably are overpaid from a social perspective. The reason is that their high incomes are generated mainly by speculative trading of stocks and bonds and other financial assets. Speculative profits are not net additions to economic welfare, because they are offset by the losses of the speculators on the other side of successful speculators' trades. That is not to say that speculation has no social value. It generates great social value by bringing about improved matching of prices to values, which encourages investment in productive activities. But the amount of profit that a speculator makes is not the measure of the social value of a successfl speculation. The increase in social value is probably only a small fraction of the speculator's profits.

If financial speculation involved a lot of career risk, in the same way that becoming an actor does, then the high incomes of successful speculators, like those of successful film actors, would be compensation for the risk of failure. But financial executives, while they do sometimes lose their jobs because of bad trades, generally experience a soft landing because their training and experience equip them for a variety of good jobs in business, government, or academia.

Recipients of Harvard Ph.D.'s in physics are said to have two career tracks open to them: academia and Wall Street. No doubt many are attracted to Wall Street by the much higher incomes they can expect there. Yet their social value might well be greater in academia.

Higher marginal income-tax rates, or a stiff tax on financial transactions, might go a slight distance toward correcting the financial brain drain, but probably it is a problem that we shall just have to live with.

Posted by Richard Posner at 2:14 PM | Comments (0) | TrackBack (0)

October 19, 2009

The Economics of Organizations--Posner

Oliver Williamson, an economist who won half a Nobel prize last week, has made important contributions to a field of economics that is not as well known as it should be: "organization economics." This is a field, closely related to a branch of sociology called organization theory, to which pioneering contributions were made by Alfred Chandler, Herbert Simon, and Ronald Coase, as well as Williamson; more recent contributors of note include Jacques Crémer, Bengt Holstrom, Luis Garicano, Canice Prendergast, Jean Tirole, and others. I have used organization economics in my academic work on the structure of our national intelligence system; Garicano and I have published an organization-economic study of the FBI's domestic intelligence branch in the Journal of Economic Perspectives, and I have written a review essay on organization economics for a forthcoming issue of the Journal of Institutional Economics.

Oddly, an interest in organizations is a latecomer to economics, even though most economic activity is conducted through organizations. The standard economic model is of trade between individuals, or firms assumed to behave as individuals. For many purposes the model, despite its extreme simplification, is adequate. If one wants to know how cigarette producers will respond to a rise in cigarette taxes, it is enough to assume unrealistically that a cigarette producer is one person rather than a complex organization. But for other questions the assumption is inadequate--most obviously if the question is why some business firms have steeply hierarchical structures and others rather flat ("M-shaped"--"M" standing for multidivisional) ones (this distinction has been a particular emphasis in Williamson's work). Or why compensation practices within firms (or government agencies) take the form they do. Or--most fundamentally--why there are firms at all--why all economic activity isn't carried on by contracts among individuals. Ronald Coase asked that question in a paper entitled "The Nature of the Firm," published in the 1930s. His answer was that a producer has a choice between contracting with independent contractors for the output of the various inputs into this production of the finished product, and contracting with individual workers--employees--not for their output but for the right to direct their work--and that the employer would choose between forms of contract--the contract with the independent producers or the employment contract--on the basis of which was more efficient, given the nature of his business.

Neither form of organizing production is perfect. The arms' length contract form requires detailed specifications that create inflexibility. The command form--the employer directing the work of employees rather than contracting for their output--creates the well-known principal-agent problem (the problem economists call "agency costs")--the employee is supposed to be working to maximize the firm's profits, but what he wants to maximize is his own utility, so the employer has a control problem.

The modern literature emphasizes the principal-agent problem but also moves beyond it by emphasizing another aspect of control within an organization: the creation, transmission, processing, coordination, and use of information. Because the span of supervision by one person is limited, the more employees a firm has, the more supervisors it requires; and the more supervisors it has, the more supervisors of supervisors it requires because the span of control is limited at every tier of the hierarchy. So as an organization expands, the layers of supervisors multiply, and the consequences ared delay in executing orders, loss of information, attenuation of the directions emanating from the top, and in short a weakening of control and coherence. The larger the organization, moreover, the more difficult it will be to correlate the work of a particular employee with the value of the organization's output, and so the employee's incentives will fall further out of alignment with those of the firm. A partial alternative to hierarchy is to decentralize the organization in imitation of the market, by delegating authority to division heads and requiring them to compete with one another for allocations of capital from central management. That is the essence of the "M-form" of corporate organization ("M" standing for multidivisional).

Organization economics emphasizes the variety of agency costs that flourish in complex organizations, such as "influence activities," by which agents try to influence the decisions of their principals, for example by flattery, by being a "yes man" and not "rocking the boat," by doing personal favors, by making alliances with coworkers, by jockeying for promotion, and by hoarding information to make oneself indispensable and reduce the output of one's competitors in the organization.

The challenge to organizations is to generate cooperation without use of the price system, since the employer does not buy the output of his employees. Instead organizations rely on common norms, understandings, customs, and perspectives that substitute for explicit contracting and thus enable cooperation on dimensions of performance that cannot be prescribed by formal directives. This set of informal binding elements (the organization's "culture") includes codes and other shared specific human capital that facilitates communication and coordination among agents. Unfortunately, an organizational culture that is optimal in its current environment may become suboptimal when the environment changes, yet adaptation to the new environment may be difficult because once information channels and other organizing elements are created, an investment has been sunk that will constrain the organization's reaction to a new environment. Change is especially hard because an organization's culture is diffused throughout the organization rather than concentrated in one place (an employment manual, for example) where it could be changed at a stroke. The result is organizational conservatism or inertia, and explains why innovations tend to come from new firms rather than from existing ones.

An important aspect of organizational culture, one that I have emphasized in my academic work, is the awkwardness of combining different cultures in the same organization. An example is the combination of criminal-investigation and security-intelligence functions in the FBI. The former lend themselves to what are called "high-powered" incentives, which are systems of compensation and promotion that are based on objective performance criteria. In the case of criminal investigation these are number of arrests weighted by convictions and sentence. Intelligence work does not lend itself to such performance criteria, because the effect of surveillance and other intelligence activities in preventing terrorism or subversion is usually very difficult to assess. Hence motivation takes the form of creating a "high commitment" environment in which the organization's leaders try to elicit good performance by getting staff to internalize the organization's goals. The problem is that the absence of objective criteria of performance opens the door to "influence activities" by which members of the organization jockey for advancement.

If both types of task are combined in the same organization--those that can be directed by high-powered incentives and those that require high commitment as their motivator, the best employees will tend to gravitate toward the first type of task because they will be confident that they will do well if their performance is judged according to objective criteria. They will be much less certain how well they will do in a job in which influence activities play a large role in determining success.

The problem of culture clash in an organization is further illustrated by the financial collapse of last year. Banks had traditionally been conservative organizations emphasizing risk avoidance, modest compensation, gradual promotion, and secure tenure. When in the deregulation era they were permitted to expand into riskier and (therefore) more lucrative forms of financial intermediation, they attracted a different kind of employee--smarter, more willing to take career as well as financial risks, more independent, and demanding higher pay. Because they were generating more profits for the bank, their influence grew and placed pressure on the traditional bankers to take more risks in order to hold their own in the struggle to control the organization. So one proposal for preventing a recurrence of the financial crisis, since the crisis was due in part to highly risky lending by banks, is to restore the separation codified in the Glass-Steagall Act of conventional banking from high-risk forms of financial intermediation.

The financial collapse illustrated another facet of organization economics as well. The banking industry expanded very rapidly in the low-interest-rate environment created by Greenspan's monetary policy in the early 2000s, and the expansion took the form largely of the expansion of existing firms rather than the creation of new ones. When an organization expands rapidly, there is a danger of loss of control over subordinate employees. The danger in the case of the banking industry's expansion was increased by the fact that many of the new hires consisted of young risk takers whose attitudes and skills were often quite different from those of the higher tiers of management. Senior managers had difficulty in assessing and limiting the highly risky deals engineered by the young hot shots.

Posted by Richard Posner at 3:42 PM | Comments (0) | TrackBack (1)

Competition and Organizational Efficiency-Becker

Oliver Williamson's influential contributions to the theory of firms were the stimulus for our discussion topic this week of the analysis of organizations. Posner gives an excellent discussion of various factors that determine organizational structure and efficiency, such as conflicts between principles, like stockholders, and agents, like employees and managers, the ease of communicating information and knowledge from the bottom to the top of the organization, and the number of "layers" in the command structure. I will concentrate my comments on the environment that organizations face, and especially on the degree of competition they have to deal with.
One of the most compelling observations from highly competitive environments is that many different organizational structures sometimes survive in the same industry. For example, in the retail grocery sector, large "warehouse" types of stores exist alongside small specialized grocery stores. Chains that own many supermarkets, such as Safeway and Whole Foods, compete against small mom and pop stores with few paid employees.

George Stigler argued many years ago in a classic article ("The Economies of Scale", reprinted in his collection of essays called The Organization of Industry) that different types of firms that survive in the competition for profits in very competitive environments must be of rather equal efficiency at producing profits. A corollary is that if a competitive industry were trending over time toward a narrower set of organizational types, this would imply that these types must have become relatively more efficient as the economic and political environments changed over time.

The fact that small supermarkets and large warehouse markets survive the tough competitive pressure of the retail grocery market suggest that both types must be of about the same efficiency in their respective niches of the grocery sector, although the trend seems to be toward larger supermarkets. That steel mills are much larger than textile factories suggest that economies of scale in steel production must be sufficiently larger than the scale economies in the production of textiles to overcome the larger number of command layers and other inefficiencies of a larger production scale in steel but not in textiles.

Also of relevance to understanding the efficiency of different organizational types is that very different types of firms survive in different countries, often even when they are in the same or similar industries. For example, Japan and South Korea (occupied by Japan for about 40 years in the 20th century) have large conglomerates that are active in many different industries, such as Korea's SK company whose products range from an oil refinery to cell phones, whereas Taiwan tends toward smaller firms that are more concentrated in particular sectors (although Taiwan was also occupied by Japan).

Both the inter country and within country evidence indicate that no single organizational form is always the most profitable even in a particular sector of the economy. Different combinations of scale economies, principle-agent problems, compensation practices, thickness of the span of control, and many other variables highlighted in the organizational literature often produce outcomes that are about equally efficient and profitable. The outcome of strong competition is the only really decisive way to determine which are the possibly quite different but about equally efficient combinations of all these different variables.

The major difficulty in evaluating many governmental organizations is that they often do not face such strong competition and they have no simple measure of success, such as profits. These two factors make it difficult to use Stigler's survival test. To take Posner's example, can the criminal catching activities of say the FBI be efficiently combined with a terrorist deterrent function? If this were a competitive industry with many different organizations and good observable measures of success, one could then look at whether such combinations compete successfully in the longer run against more specialized agencies. Lacking either much competition or such measures of success, one has to rely in good part on the insights of analyses of these issues. Similarly, the organization and efficiency of armies is only rarely tested against competition on the battlefield. When so tested, losing armies often try to reorganize so that they can look more like the successful armies, although generals are often accused of reorganizing to fight the last war.

Perhaps then it is best to try to create competition among governmental agencies, such as both the CIA and FBI trying to deter terrorism, and then provide greater resources to the more successful agency. This, however, runs into the difficulty that agencies may withhold information from each other in order to gain an advantage in such competition.

Posted by Gary Becker at 1:38 PM | Comments (0) | TrackBack (0)

October 15, 2009

Notice

We regret to say that because of a technical glitch, our site is not accepting comments. We hope to correct the problem shortly.

Posted by Richard Posner at 9:20 AM | Comments (0) | TrackBack (0)

October 11, 2009

Will World Food Prices Resume their Sharp Increase? Becker

The worldwide recession has slowed the growth in the demand for cereals and other foods as many countries have experienced stagnation or contraction in their GDPs. Now that the recession appears to be over, world GDP will start growing again. Many are forecasting that this growth in world output, especially the growth in developing nations, will put sharp upward pressure on food prices and that of oil, natural gas, and other commodities. Even the Malthusian specter has been raised again that the growth in world population will exceed the capacity of the world to produce the food demanded to improve living standards in the developing world.

The sharp increases in food and other commodity prices during the period from 2002 to 2008 when world GDP was growing rapidly tends to support these fears. The World Bank's index of world food prices increased by 140 percent from 2002 to the beginning of 2008, and by 75 percent after September 2006. The price of oil went up more than fourfold from the beginning of 2002 to its peak at over $145 a barrel during mid 2008. At that time there were many predictions of oil going to $200 a barrel rather quickly, and also of food prices continuing to rise rapidly. The world recession clearly made these predictions obsolete, at least until world GDP begins to grow again.

Rapid growth in world GDP will put strong upward pressure on some commodity prices. However, the supply responses of exhaustible resources, like oil and natural gas, should be distinguished from the supply response of food production. The supply of fossil fuels is obviously ultimately limited by the amounts in the ground. Outputs of oil, coal, and other fossil fuels can be increased by new discoveries, such as the recent discovery of oil off of Brazil, by extracting more of these fuels out of existing fields, and by squeezing oil and other fuels out of shale and other rock formations. Yet, all these ways combined have rather limited effects on total output. This is why, along with OPEC's restrictions on oil output, long run supply responses of oil, gas, and coal to changes in their prices are usually estimated to be quite modest. The long run elasticities of supply in response to rises in the prices of fuels are about +0.4 to +0.5.

The short run response of world food production to increases in food prices may not be large either, although farmers can shift rather quickly among the production of corn, soybeans, wheat, and other crops. In the long run, however, world production of food is quite sensitive to the world price of food. Given time to adjust, farmers can substantially increase the production from given amounts of land devoted to farming by greater use of fertilizers and capital equipment. Higher prices encourage investments in discovering mew methods of improving farm productivity, such as corn and other hybrids, the green revolution, and genetically modified foods. Productivity advances in agricultural output were very rapid at many times during the past century, often outstripping advances in manufacturing and other sectors.

online casino

The amount of land devoted to farming in most countries declined drastically during the past century as urban sprawl, highways, and other land uses took over much of the land formerly used to farm. In the United States, farmers comprising less than 2% of the labor force and using well under half the available land, produce enough farm goods not only to contribute most of the food that feeds the huge American population, but these farmers also export corn, soybeans, wheat, and other farm goods all over the world. With high enough food prices, financial incentives will encourage farmers to take some land back from suburban, ethanol production, and other non-food uses.

World prices of food generally declined during the 20th century when world population and world GDP per capita grew enormously. The reason for these diverse trends is that productivity in the production of food expanded at a more rapid rate than did the demand for food. The advances in production were due to the use of new and more effective fertilizers, better farm machines, and many applications of scientific knowledge to improving the productivity of agriculture. Developed countries spent considerable resources on subsidies to farmers to help keep their prices up, not down. Even though it may not be possible to predict the exact nature of future agricultural innovations, one can reasonably expect similar growth in world farm output during the next several decades, especially if food prices rise by a significant amount.

Rapid growth in future world GDP is likely to greatly raise the prices of oil and other fossil fuels, unless concerns about global warming induce major steps to reduce the demand for these fuels. Rapid growth in world output is also likely to sharply raise the demand for cereals, meat, and other foods in developing countries. However, I have tried to show why food is different from fossil fuels and minerals, like copper, in that the supply of food is not limited by natural bounds on overall quantity. Rather, the efforts and ingenuity of farmers and researchers are able to greatly increase world food supply to meet even very large increases in the world demand for food.

Posted by Gary Becker at 9:57 PM | Comments (0) | TrackBack (0)

Will Food Prices Begin Increasing Again? Posner's Comment

Becker is right to point out the difference in supply conditions between oil (and other minerals, but I will limit my discussion to oil) and agricultural products: it is cheaper to expand output of the latter than of the former. Hence as demand for oil and for food rise as a function of population growth (an important qualification, as I'll explain--population growth is not the only driver of increased demand for food), oil prices will rise faster than food prices. This is fortunate because while there are substitutes for oil, there are no substitutes for food.

A continued increase in world population will increase the demand for both oil and food, and historical experience suggests, as Becker explains, that the increased demand for food can be met at only modestly increased cost even if the world's population expands greatly, though this depends in part on how rapid the expansion is--the more rapid it is and hence the steeper the increase in the demand for food, the higher the cost of meeting that demand will be, as it is easier to increase production in the long run than in the short run. Moreover, a sizable expansion in population would raise the price of farmland by increasing its opportunity cost.

As the world grows wealthier, the rate of expansion of population should, if historical experience is a guide, slow. But even if population stopped growing altogether, the demand for food would continue to rise because more people (perhaps billions more) would be able to afford the rich diet that people in wealthy countries consume. Supplying that rich diet is very costly in agricultural resources, for one of the major components of the diet is meat and the production of meat requires more agricultural output than the production of cereals and vegetables, since the animals that people eat are big consumers of food.

Technological innovations may hold down increases in the price of food that are due to the increased demand for a rich diet as multiplied by increase in population. But those innovations may create substantial externalities even if they do not push up prices (indeed, the less the increase in prices, the greater the output of agricultural commodities and hence the greater the externalities). As more and more countries adopt the most efficient methods of agricultural production, and thus for example converge on the optimally genetically modified variants of crops, genetic diversity will decline, which will increase the potential damage from blights. (It is not only stock portfolios that benefit from diversification.) Agriculture is a heavy user of water, moreover, and global warming appears to be reducing the supply of water usable for irrigation by reducing the size of glaciers. The run off from the seasonal melting of glaciers provides a more usable supply of water than rainfall, because the water from a melting glacier is channeled, while rain that falls outside a river or other body of water is difficult to store for use in irrigation.

I am one of those timid souls who worry about the downside of technological advance and economic growth. I find the prospect of continued increases in population and income, and of the technological innovations necessary to cope with those trends, unsettling.

Posted by Richard Posner at 8:51 PM | Comments (0) | TrackBack (0)