Streetwise Professor

March 1, 2009

Neo Soviet Economics

Filed under: Economics,Politics,Russia,Uncategorized — The Professor @ 7:08 pm

No, this is not a post about Russia.  It is about the US and the UK.  And yes, the title is hyperbole.  I am not suggesting that the current statist trajectory is communist or even socialist, or will be accompanied by the repressive horrors of the Soviet state.

But there is an important lesson in Soviet experience (and in Japanese experience in the 1990s) that we are at great risk of ignoring, to our peril.  That is that the economy of the  USSR became ossified in large part because the Soviet state tried to shield vast portions of its economy from change.  “Soft budget constraints” subsidized failing firms and failing industries, preventing their contraction and the flow of resources to higher value uses.  The Soviets tried to shelter their incumbents from the gale of creative destruction, and in so doing, made the collapse of its economy all the more devastating.  

The Japanese did much the same in the lost years of the 1990s, with the government pressuring failing banks to prop up failing industrial and commercial firms.  This also delayed with the adjustment of the economy to changed economic circumstances, and effectively froze into place the inefficiencies that had created the economic problems in the first place.

We are at great risk of repeating these errors today.  There are industries and firms–for instance, automobiles in general, General Motors, Ford, etc. in particular–that should contract.  Similarly, the housing boom (or bubble, call it what you will) fed by unduly expansive credit in the 2000s led to a dramatic expansion in the flow of resources into the construction and housing sectors, and this industry should also contract substantially.  Ditto housing finance, and a good portion of the financial sector.  

But instead of undertaking actions that would facilitate the efficient flow of resources out of these firms and sector to those where they can be employed more effectively, governments in the US and UK (and elsewhere) are looking for ways to delay the necessary adjustments.  The auto bailouts–with billions spent and billions more likely to be spent–are only the most egregious example of this.  The various plans regarding support for those who borrowed too much to purchase homes threatens to have the same effect.  A particularly egregious example is the proposal to reinvigorate Freddie and Fannie to support substantial real estate lending.  These institutions should be euthanized, not revived.  Similarly, the failure to address banking problems head on perpetuates the survival of firms deemed too big to fail, but which are just too big period.  In the UK, the government is pressuring Northern Rock to begin real estate lending under the very same kind of terms that fed an over-expansion in the housing sector.  The Japanese example, and the British example with respect to Northern Rock, provide serious grounds to conclude that increasing government power over the banking sector will be exercised to support incumbent firms and incumbent industries that should contract, and perhaps perish.  Soft budget constraints are proliferating.

This is not surprising.  It is exactly what one would predict on the basis of Chicago School analysis of regulation, or of Mancur Olson’s work.  Incumbents have a decided comparative advantage in influencing the government.  With a massive expansion in the scale of government spending (on budget and off) it is inevitable that incumbents, including losing incumbents, will benefit disproportionately.  Indeed, a Stigler-Peltzman-type analysis predicts that loser industries–industries that should contract–receive extraordinary support.  This cements inefficiencies, rather than facilitating the process of eliminating them.  

Surprising or no, it bodes ill for the future.  There is an adage in the military: don’t reinforce failure.  Similarly, good traders know when to abandon a losing trade.  To perpetuate inefficient resource allocations, to impede the flow of resources to higher value uses, to protect inefficient incumbents, is to commit the error that good strategists and good traders avoid.  It will not build a foundation for future prosperity.  It will only sap efficiency today, defer–but not eliminate–the adjustment that will inevitably come, and make that adjustment far costlier, abrupt, and disruptive than it would otherwise be.  

Russia, and the rest of the former-USSR, learned that the hard way.  So did Japan.  Sadly, it seems that we are hell-bent on repeating their experiences, rather than avoiding them.

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14 Comments »

  1. Welcome to the bandwagon, SWP 🙂

    http://www.sublimeoblivion.com/2009/02/26/usa_ussr_equal/

    Comment by Da Russophile — March 2, 2009 @ 12:17 am

  2. “the efficient flow of resources out of these firms and sector to those where they can be employed more effectively” – What are some of the sectors where we expect to see some growth?

    Comment by Surya — March 2, 2009 @ 2:52 am

  3. Da Russophile, how old are you exactly? You write on your site: “More and more people began to predict Soviet collapse in the late 1980’s.” Who exactly were these people? I, for one, never heard people predicting the collapse of the Soviet Union in 1989 (for the record, I was 20 then). You then use this dubious statement to say: “More and more people are beginning to predict an American collapse now…” I would say this is more a question of wishful thinking IMHO.

    Getting back to the SWP, I would say that he is right in that a lot of money is being spent to maintain a status quo and inefficient ways of doing things. Let’s take the case of the auto industry. Why is it still necessary to go to a dealership to buy a new car? Think how much money could be saved by having clients go online to order the car that they want and that car could then be delivered directly to them. At most the auto companies could have some very small showrooms where people could go take a look at new models and then take them out for a test drive.

    Having to maintain such a large number of dealerships and large volumes of cars on dealership lots is hardly cost effective. Why don’t they change? Well, from what I read in an article on Slate last night, they can’t because of government regulations in the USA both at the federal and the state level. You have a variety of laws and regulations that stop auto manufacturers from selling directly to customers and state (and in Canada provincial) laws that make it more difficult to sell cars across state or provincial boundaries. When people had wads of cash to buy expensive SUV’s this was not a problem given the profit that could be made by selling these vehicles at inflated prices, but now that people want smaller, cheaper and gas efficient vehicles (with much less profit per vehicle), the old model is cracking. One of the advantages of the Japanese automakers is not only that their productions costs tend to be cheaper, but also that they have fewer dealership than GM, for example, which allows them to cut costs and still sell increasing numbers of vehicles.

    I agree with SWP that throwing cash at the problem, won’t make the structural problems go away. If government wants to help, it may have to ask itself whether some of its regulations are still needed. Is it better for example to protect dealerships or to ensure the survival of the American automakers? Maybe we are at the stage where you can’t do both and it is necessary to choose.

    Comment by Michel — March 2, 2009 @ 9:13 am

  4. DR–A sign of the impending apocalypse, perhaps?

    The ProfessorComment by The Professor — March 2, 2009 @ 11:06 am

  5. On another note, the official stats for Canada’s economy are out. According to the Globe and Mail, Canada’s economy contracted at an annualized rate of 3.4%.

    Surprisingly, we are doing better than the rest of the G7: “If there’s a bright spot in the report, it was Canada’s relative strength compared with other big economies. StatsCan noted that the U.S. economy contracted at an annual rate of 6.2 per cent in the fourth quarter, the European Union registered a decline of 5.9 per cent and Japan’s economic output deteriorated 12.7 per cent.”

    What is Russia’s annualized rate? You mentioned somewhere in the 30% ballpark? I am surprised that we are doing so well (relatively speaking). Like Russia we are a resource-dependent export driven country, exporting oil, gas, and other natural resources.

    Comment by Michel — March 2, 2009 @ 12:27 pm

  6. Actually you’d find out if you bothered reading the notes at the bottom.

    “1) Economist Willem Buiter believes there will be a global dumping of $ assets within two to five years. Financial advisor James West writing in SeekingAlpha believes a US debt default and dollar collapse are “altogether likely”. Russia fund investor Eric Kraus has been lamenting the unsustainability of American disbalances for years and predicted the US will fall into a debt trap last November. The economist Nouriel Roubini, one of the few to have foreseen this crisis, predicts this recession will be far longer and deeper than any other post-war recession. Even the Economist mentioned the possibility of a US debt-and-currency crisis in one of its recent issues.

    Dmitri Orlov explicitly compares the US to the USSR, and concludes that the collapse will be worse, at least in social terms, in the former. The Russian economist Mikhail Khazin predicts a 25-40% drop in American GDP. Future and trends analyst Gerard Celente, who succesfully predicted the collapse of the Soviet Union, now foresees an unprecendented fall in US economic output, tax rebellions and food riots. Russian professor Igor Panarin sees disintegration and civil war as soon as this year.”

    Comment by Da Russophile — March 2, 2009 @ 12:50 pm

  7. Da Russophile, you have been reading too much Russian propaganda 😉 Yes, I agree that the American economy is in a crunch. However, unlike all the other countries of the OECD, the United States has much more wiggle room as it taxes are much lower than Europe or the other major economies. What is likely going to happen is that at some point politicians will have no choice but to raise taxes.

    Comment by Michel — March 2, 2009 @ 12:57 pm

  8. 1. It’s a list of people who predicted it, in reply to your accusations I pulled it out of my hat.

    2. Because the likes of Buiter or Celente are on the KGB payroll…

    3. Actually the US is in a much weaker position than the EU because they fund their deficits from domestic savings, unlike the US. This will become clear, paradoxically, when the world starts recovering ceasing the flight to quality (US Treasuries) as investors lose confidence in the will or ability of the US to ever re-balance its budget. But I’m not entirely pessimistic, however. The US still has a lot of arable land, a decent amount of oil production and remnants of a manufacturing base, so we won’t starve. (The same cannot be said of Britain).

    Comment by Da Russophile — March 2, 2009 @ 2:23 pm

  9. Dear Da Russophile,

    When it comes to oil production, look North. You can’t really look at oil production simply based on what the United States produces, but based on what the continent produces. The fact of the matter is that Canada is the United States largest supplier of oil (we ship more oil to the United States than the Saudis) and Mexico is the third largest supplier of oil. As a continent, we have enough oil and other natural resources to last us more than a century.

    As far as Celente, I am doing a bit of research on his “predictions.” However, if a person predicts enough often enough, some of it will come true. When it comes to the general media and most experts in the field, I only know of one French scholar who had predicted the collapse of the Soviet Union.

    Nonetheless, the Soviet Union was very different from the United States, but that would make for a very long post 😉

    Michel

    Comment by Michel — March 2, 2009 @ 2:34 pm

  10. Mexico will soon become a net importer because of Cantarell’s precipitous decline and Canada cannot increase production much because there’s a ceiling to what you can squeeze out of tar sands because of water and natural gas constraints. Speaking of which – http://www.scitizen.com/stories/Future-Energies/2009/01/Over-the-Cliff-for-Natural-Gas-in-North-America/. The view that there’s enough resources for a century in North American is recklessly Pollyannain.

    Really in retrospect invading Iraq was a really smart move. Let’s hope they’re smart enough to exert control over the government there and lock in Iraqi production to the US, regardless of how much (or rather little) the dollar will soon be worth.

    Comment by Da Russophile — March 2, 2009 @ 11:27 pm

  11. I have to say Da Russophile, you are consistent. You are always optimistic about Russia’s future and pessimistic about the United States and North America 😉 When it comes to natural gas production, there is still much that has yet to be tapped. Everybody knows there is much natural gas in the Canadian Arctic but it has not been put into production. And, there is the offshore oil potential off of British Columbia and there is also potential in central British Columbia for oil and gas production.

    Comment by Michel — March 2, 2009 @ 11:54 pm

  12. I am not optimistic or pessimistic, I’m realistic. I base my analysis on economic, social, resource depletion/climate change, technological, demographic, etc, trends.

    I happen to think the evidence points to a major collapse in the US within the next five years, but it will re-emerge strongly by the late 2010’s or early 2020’s although by then its superpower status will be challenged by China (and China in turn is going to face severe problems by the 2030’s).

    I also think that although Russia’s power and wealth will greatly increase in the next 15 years, it will run into many problems that will lead to its weakening or even collapse by the end of the 2020’s.

    In fact I’m planning to write a post (and a book!) on this topic anyway so I’ll just let you know when I do that.

    Comment by Da Russophile — March 3, 2009 @ 12:13 am

  13. […] etc. were the kinds of banking practice that lay at the root of the crisis.)  As I said in Neo Soviet Economics, the housing market and housing finance need to contract.  Substantially.  But instead, driven by […]

    Pingback by Streetwise Professor » They’re Alive! — March 3, 2009 @ 10:26 pm

  14. […] other words, this is an exercise in what I termed NeoSoviet Economics; an attempt to dictate market outcomes in order to sustain an unsustainable status quo.  This is […]

    Pingback by Streetwise Professor » “Because it #%@*s Up Relative Prices!” — March 27, 2009 @ 3:21 pm

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