Leslie Pratch, Ph.d

By Author: Nelson Perkins
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I am not an economist but I certainly was exposed to price theory in business school at the University of Chicago. Recently, I reread a lecture Milton Friedman gave during the 1950s. He argued that a free market is a situation is one in which transactions are voluntary, bilateral, and mutually informed, the idea being that everybody going into the marketplace is well informed believing the transaction will make them better off.

Over the past 10 years, economists have worked on information asymmetries, situations in which the parties are not mutually and equally well informed. The models assume that at least one party to a transaction has relevant information whereas the other does not. Some economists argue that the economy operates at an optimum level (whatever "optimum" means) assuming full employment (i.e., an unemployment rate near 5) even under conditions of asymmetric information. "If we're smarter, we should be richer, right?"

From an economic point of view, from a price theory point of view, there may well be theoretical free market support for this argument. But that doesn't satisfy me from an ethical ...
... point of view. If parties are not mutually and equally well informed, those with more information are likely to wind up with all of the wealth and those with less information will wind up with none of the wealth.

Take subprime housing loans or credit card offerings. The bank says, "All the terms are right there" but when do consumers really have the information? Credit card offerings are turgid, long, and have tiny print. The agreements give the banks all sorts of power and many consumers have gotten into trouble because they lacked information. I get credit card offers at 0% interest until March 2009. Implicit is that after March the rate goes to prime plus 9.5%. Many consumers are not savvy enough to grasp that implication. It is up to consumers to get smarter. Bernard Madoff was recently sentenced to 150 years had information about what he was doing that most of his clients did not have. Maybe his clients should have been smarter. I am heartened by news of rules for mortgage lending that protect consumers (reported in July 24th's Wall Street Journal) which suggest that Richard Thaler's proposal www.nytimes.com/2009/07/05/business/economy/05view.html?scp=1&sq=Thaler%202009/07&st=cse in the New York Times is being enacted.

Institutions work hard to develop information and that information is valuable. The SEC and to a far greater extent, the accounting profession, has a long history (longer than 600 years in the case of double entry accounting) where the essence of the activity is to develop, systematize, and certify information. The accounting profession is sanctified by government regulation (e.g., in recognizing FASB). The government sees it proper to disseminate some information. But when information is not shared, information goes into the direction of greater and greater imbalance. A market in which increasing numbers of parties are deprived of information implies that the performance of the economy will get worse.

The free marketers have said "We want to maximize total wealth creation" but they don't take into consideration the distribution of income. Influence the income distribution in ways that the market would not cause is in the realm of political philosophy or social policy; it is not the economist's job.

Another question economists try not to address is "Over what period of time?" If a highly unequal distribution of wealth and income leads to one level of total wealth output, and a more equal distribution leads to better wealth output would economists say the latter is better?

Information asymmetries have values implications that we should care about (assuming we are not economists). Not interfering with any activity, including the creation and distribution of information is the definition of an efficient market. All information is impounded in a price of a commodity. Greater transparency would be consistent with those who believe intensely in the free market. But relying on the market place to produce a socially satisfactory income distribution is not okay by me.

To continue my previous post on information asymmetries and economic stimulus, Milton Friedman said if you want to stimulate the economy, just give the poor money. That was how the negative income tax was born. I believe in protecting those at the bottom end of the income distribution in times of depression by giving them money to bring them up to the 5th or 8th percentile. But I don't know how to do that. I don't think we can rely on philanthropy. Sometimes the government has to intervene.

I would like to bridge those on the left to those on the right. Those on the left tend to be more in favor of social policies; those on the right say those social policies interfere with legitimate freedoms. The government, for example, shouldn't give out smallpox vaccines. The negative income tax was Friedman's idea of a permanent arrangement to help the poor not be poor targeted at recessions.

Most economists at the University of Chicago do not think government action is prudent because the stimulus is too small and it takes too long to work its way into the system; Joseph Stiglitz and Paul Krugman have made these same points. Investors in the private sector are skilled at making investments and even they make mistakes. Government officials are neither skilled in that activity nor do they make decisions to maximize output; Ted Steven's bridge to nowhere is an example.

Krugman has said for months we ought to substitute government spending for shortfalls in private spending; essentially, government should substitute spending to fill in the gap in spending not filled by the private sector. That seems reasonable but do we have the right incentives in place? Government officials haven't been trained in managing investment projects, and they are motivated by political considerations. That's a recipe for wasting money. The government allocation of spending is subject to political forces in the government which means a lot of it is going to be wasted than if it were done in the private sector.

Sam Pelzman, an industrial economist trained at Chicago (I believe he got his Ph.D. in 1960 or 1961) said this past December that only one policy works: a payroll tax holiday. What this means is that instead of holding wages for social security you let the employee have it. The payroll tax is 7.65%. If you make $40,000 a year, $333/month is taken out for payroll taxes. Pelzman's idea is just don't withhold that money. Total consumer spending will go up by 10%. That is a powerful engine. With 120 million workers times one thousand times four is half a trillion dollars and that amounts to 3-4% of GDP which, if put in consumers' hands, they will spend.

Milton Friedman put forth the idea that people spend what they perceive their permanent income to be. When you have a transitory component of income, you view it as transitory. Friedman's hypothesis is that consumers will invest the transitory component in a durable good such as a car. The essence is that consumers take the transitory income to pay down debt which is like investing in durable goods and the payroll tax holiday would go on for a couple of years.

I believe there are ordinary and natural forces in the economy that produce a correction. I think we are already seeing it. The stock market has been really strong since March 9, 2009, which I believe was the bottom; the Dow is trading above 9,000 and so it's up 2500 points on a 6500 point base. That's a 40% increase in the stock market; each stock market point is worth $15 billion; so we are up 2500 points. That's $15 billion times 2500 - in other words, $4 trillion of added wealth through stock market moves alone. I think the stock market itself will stimulate spending. The economic climate should be good in a year and unemployment by then might be down to 9%. It takes time for labor unemployment to go down, but there is now a lot of slack capacity and eventually that slack capacity will be priced appropriately and then, finally, consumers will spend.

Leslie Pratch, Ph.D. finds ways to assess which high-achieving M.B.A. candidates would be most likely to emerge as successful leaders. Visit us: http://www.pratchco.com/ .