Arnold Kling. Specialization and Trade: A Re-introduction to Economics. Washington, D.C.: Cato Institute, 2016.
Summarized by John Teevan, August 2016
Insights from the vast web of specialization that is our global economy:
- Wealth accompanies increased specialization.
- Trade accompanies increased specialization.
- Urbanization accompanies increased specialization
- Social complexity accompanies increased specialization
- Improvements in transportation accompany increased specialization
- Specialization expands as the market expands
- Producers will conspire to stifle competition
- Specialization means that we rely on tasks performed by strangers (trust).
- Financial intermediation entails trust not just of the one-time transaction but over time.
- Capital intensity accompanies increased specialization
- Capital intensity increases the number of steps in the production process.
- Capital intensity increased the gap of time between the initial steps and final sale of goods.
Chapter 1. Filling in Frameworks:
Economics is not a science with verifiable hypotheses; it is characterized by complexity and change. Other things are almost never equal, and the economy evolves too rapidly for meaningful analysis. Therefore, predictions based on models are not falsifiable. Major global disruptions (1 billion Chinese/Indians in the global labor force) as well as significant national changes (the growth of services) are markers of this change, as are the introduction of radical technologies (cell phones, the internet). Markets adapt rapidly. Models plod along.
Chapter 2. Machine as Metaphor:
The economy is not a machine for analysis, math, and models. MIT loves this approach, but if it could work, then Soviet central planning could work. It’s a dream. Instead of specialization and trade, many thought that ‘spending’ would drive the machine as its gas pedal. They forget psychology, the growing wealth in the form of (not old factories) new information. Neither of these is adequately quantifiable for the scientists. The growth of the financial sector (not in GDP) aggravates this. We need a better metaphor than machine: Greg Ip suggests ecosystem. The market focuses on error correction rather than reverting to the economic laws that drive models.
Chapter 3. Instructions and Incentives:
Economic activity is not directed by planners, though companies are. Where specialization cannot be market-driven, a company takes on the tasks within its operations and manages them through command. The company receives market signals (prices and profits) and adjusts accordingly. The government gets no market signals and cannot adjust rationally. Prices and profits are most interesting at the margin, so the marginal producers are most important as they start or fail. These are: experiment, evaluate, and evolve. Those who succeed at correcting are private firms that receive signals, not governments that deal with models and ideals. Rearranging patterns of specialization is constant and increasingly complex. How can a planner observe all these factors, and if he could, how could he respond better to these?
Chapter 4. Choices and Commands:
Choice is reflected in a decentralized market system, though socialists deny it for two erroneous reasons: They wrongly assume that they have the needed info and that they can act rationally, correctly, and timely without falling into the trap of politically motivated action. Planners like the metaphor of the camping trip without recognizing that much infrastructure is already in place. Dreamers like J.K. Galbraith (1950s) thought that the complex economy had moved beyond the simple Adam Smith analysis. He saw the modern corporation (GM) as invulnerable and hostile to the interests of the people. He ignored the problems of information (price without which rationing is useful), innovation (entrepreneurs and the problem of untapped human skills), and incentives (profits). He also lived to see the collapse of Soviet Russia, a collapse that proved him wrong. Ingenuity and innovation are much more useful qualities than organization and planning. Competition is generally preferable to regulation in ensuring that high-quality producers dominate the market. Innovative ideas rearrange patterns of specialization that either work or don’t in providing happier commercial or home customers.
Chapter 5. Specialization and Sustainability:
Conserving specific resources can be market-driven, not by planners who override the price system and impose an earnest, but often miscalculated and failing approach. The idea that we can live without disturbing the environment is based either on romantic assumptions or on a very low population. We can, however, not impoverish our descendants. Leaving institutions and a pattern of social norms that favor productivity can deliver the accumulated knowledge of the ages. Best measure? Profits. Consider water: when it’s nearly free, we waste it; when it’s priced according to use, it goes where it can be used most productively. We use less water than in 1970 and less gas than in 1977, even though the economy has grown 50% since then. Recycling and ethanol are not sustainable, nor is buying local, as they are all more expensive. How can that be sustainable? The US is also greener (covered with trees) than it was 100 years ago.
Chapter 6. Trade and Trust:
Libertarians wrongly assume that the institutional framework needed to support market trade is very minimal. Trust comes from repeated interactions: simple, but easily forgotten or lost. The corollary of gladly collaborating with trusted people (cooperators) is that there must be punishments for trust-rule violators (defectors). Legal systems and brand loyalty reduce investigative time and can be simplified by signals and brand promises. The more you can trust, the more specialized all can become. Signals can be faked, laws can be enforced by the corrupt, and loyalists can betray. Only when trust is present can the ‘optimal outcomes’ of the MIT analysis be considered.
Chapter 7. Finance and Fluctuations:
Financial intermediation enables greater specialization by analyzing, pooling, pricing, and managing risk. This was minimal in 1800…even 1940, compared to now. This is the process of joining savers’ money (short-term bonds) with investors’ entrepreneurs’ spending (long-term debt). This is maturity transformation, while investing is risk transformation. Intermediation has massive amounts of money but is still fragile, leading to FDIC-type federal guarantees. As Minsky noted, the conservative early days of a boom are surely replaced by the speculative, and even wild, Ponzi days of financing debt either within, close to, or wildly beyond the reasonably expected rate of return. The Ponzi stage is often not recognized (!), and it causes the entire economy to burst. Why? Because the initial stages are characterized by ‘world-changing’ discoveries or innovations. Oddly, GDP figures ignore intermediation as it treats the economy as a manufacturing-driven GDP machine.
Chapter 8. Policy in Practice
challenges the notion that market failure is straightforward and that intervention requires nearly obvious methods. In practice, market failure is subtle; nothing is obvious, and even worse, interest groups are strong and pollute the gap between public goods in theory and in practice. With logarithmic increases in specialization networking, curing one or two items is futile and may be foolish. Example? Government intervention in the housing market ended in 2008. Missing MIT’s theoretical, ideal outcome seemed like a fixable market failure. If models could capture the nearly endless networking of specialization, that might help, but it’s impossible.
Chapter 9. Macroeconomics and Misgivings:
Spending is not the gas (only or even main) pedal of the (imagined) economic engine. Specialization and changes in patterns of specialization are much too complex and rapidly changing for this macroeconomic analysis. That’s simple enough; then he takes the gloves off and writes that Keynesian economics of a few formulas and Friedman’s economics of a focus on the money supply are, at best, dated (when we were a manufacturing nation) and, at worst, wrongheaded.
He favors the emphasis on forming new and increasingly complex networks of specialization, which drive entrepreneurship and job creation while simultaneously destroying millions of obsolete job networks that are becoming obsolete month by month. Inflation is merely a set of expectations; off with Friedman’s head (he never mentions Milt). The GDP factory of M x V = P x GDP is a triviality; banish Keynes forever.
I am impressed and confused, and I am reminded that I am already halfway to his view. Here’s why. The MxV=GDPxP is a triviality. Velocity is immaterial, and the price level is not relevant to determining GDP, Savings, or Investment, which are the relevant variables. In considering GDP’s causes and effects, measuring GDP against the price level is trivial, yet that is the only format I’ve seen in all sorts of econ texts over the years. I can still remember pounding the table at the Boathouse in 2005 when I realized that the assigned text made the exact wrong choice, which would complicate my teaching of the Macroeconomics course. Why not measure GDP against Investment, where the amount of Saving (non-consumption) is interesting, and somewhat measured by surprise changes in inventories, rather than discarding savings as a side issue?
Kling is interested in financial intermediation and the role of entrepreneurs in job creation. He calls this a dynamic economy rather than the GDP machine of static/Keynesian economics. I’m with him on that. He notes that various ‘manias’ like the housing or internet booms are disruptive ways of building huge new specialization networks (housing workers, for instance) only to see them dismantled when the bubble bursts. He wisely asks whether stimulus programs (2009), Cash for Clunkers (2010), or subsidized green energy (ongoing) create any new patterns of regular businesses and jobs. No, they are temporary disruptions which are ‘permanent’ only until the subsidy ends.
He makes a pairing between money and fiscal policy by stating that only fiscal overspending drives (hyper) inflation. This leads him to write that “money doesn’t matter.” Did the Fed tame inflation in the 1970s? No, the anomaly of going off the Gold standard in 1971 under Nixon created new patterns that took a long time to settle into the networks of specialization and trade.
JT conclusion
It’s always good to read a man who is so very clear on the basics and yet is a bona fide bad boy when it comes to dissing both Keynesian and Monetarist economic ideas. Until economics abandons Keynesian mechanics in favor of balancing savings and investment in the context of a dynamic economy not overly (and futilely) managed by Uncle Sam or the Fed, I’m open to his and similar ideas.