The great unraveling (maybe) - Part 2

I wrote yesterday about the big financial crisis, addressing one of the longer-term questions that I have, namely, what will we be able to accomplish following this bailout. Unlike Brad DeLong and Larry Summers, I have serious doubts that anything on the candidates' agendas will be attainable once we plunge our nation into further debt. Summers believes that, despite the current debt and baby-boomer fueled rise in entitlements, adding this bailout and fiscal stimulus to deal with a major recession will somehow be made up through eventual growth. I have my doubts.

But, today, I want to take up the second big question I have, and I'll meander around to it in my usual way. Let me ask you, the reader, a question: Why do things cost what they do? Why do we look at a certain house and know that it's $200,000 (or whatever number we can ascribe to it in this market), or know that a secretary makes about $35,000 a year, and so forth?

I'm not asking about relative prices; I understand why some jobs pay more than others, I understand why that house is about six times the secretary's annual pay. That's supply and demand, which explains (loosely) why that same house costs more if plunked down in Malibu, less if placed in Minot. I'm talking about the absolute level, the nominal price of something.

This question is not relevant in a closed system. If there's nothing to which to compare these prices, the numbers themselves are pretty much arbitrary. Let's say every financial figure in a closed economy were changed by the same factor overnight, everyone would adjust and move on. The $200,000 house would now cost $20,000, but the secretary would make $3,500, and so on, and everything would be fine (but I'm saying every financial figure, even contractual ones and the value of cash - otherwise, we're creating winners and losers and that's not my point here).

Let's do another thought experiment. Let's say we have two towns, A and B, with pretty much the same natural resources and population, but they have no contact with each other. There is no trade, no movement between them. Let each grow for, say, 50 years; would you expect their prices for similar goods to be the same, their wages for the same jobs to be the same?

Some people would say yes, believing that there is a "natural" amount we pay for a bag of nuts or for an accountant, but I disagree. I'd be very surprised to see even relative prices be the same, given the number of random things that can occur over such a period of time.

My point is that pricing structures are arbitrary, that they rely on beliefs and prejudices and historical accidents and just plain random events, that there is no "natural" price of anything. We see evidence of that in the real world all the time. Why can Canada sell prescription drugs at a lower price than that at which they're sold in the U.S.? We know that's due to Canadian price controls, but controls are part of a pricing structure. Why can the same job be done more cheaply in China or India than in the United States? We say it's because their workers are willing to accept a lower standard of living, but what does that mean?

The simple reality is that prices and wages are so high in the United States, relative to other countries, because we can afford for them to be. But that's circular logic, and not very helpful. Other people have tried to explain this by arguing for an American premium, that our "higher" economy is supportable because of our social structures, our legal protections, our stable financial system, our government. We pay more, have a higher price structure, because there's more built in to the price of every item. We earn more because our investment in education has created a class of workers who are more valuable.

So here's the nub of my second question: What if this crisis has demonstrated that the value of the American premium is less than we had supposed, and that our pricing structure is insupportably high?

What I am saying here is that our inability to insulate ourselves from foreign pricing structures (not that that's possible or desirable, just that it's historically true) is creating a revaluation of American pricing. The condo for which you'd pay $1,000,000 in Manhattan will cost somewhat less in Shanghai (I don't know, let's say $250,000), and maybe that multiplier of 4 is no longer valid; maybe it should be 2 (I still want to believe there is some American premium, because I still think this is the best country in the world). If that's true, then the "real" price of that condo is closer to $500,000; good if you're buying, not if you're selling.

If this were happening across the board, and we had a closed economy, this would be no problem, as I pointed out above. We would make less, but things would cost less, and our purchasing power would be the same. But neither of those assumptions is true.

And this is why people are not so sanguine about our financial situation, and this was true even before the current banking crisis erupted. If, say, a computer programmer job is no longer worth $40,000, but $30,000, it may make less sense to pay $20,000 or more for each year at college. And it takes a lot longer to push tuition down than to push down salaries.

There may well be benefits to bringing our price structure more in line with that of other nations. It could be a boon to the developing world. But it will create a lot of losers, many of whom will be Americans, and no amount of blathering about how we can just adjust to the new world will help actual people; if you depend on the American premium for the value of your retirement savings, and that premium drops, telling 75-year-olds to adapt, to be nimble, will be of little help.

Other people are seeing the extent to which our arbitrary valuations are starting to be seen as empty. The value we used to add to real products is being replaced by false, Ponzi-scheme value, and is the basis for much of our economy. To quote Hank Williams:

The truth is our economy has been in trouble for a long time. It is the “too smart for the room” guys that, at some point in, I would imagine the 90’s, figured out how to make money without actually creating any value.

The boom in the financial community economy was always a sham because it produced absolutely nothing. The boom in the real estate market was a sham because it was based on nothing.

There is no reason that moving money from column A to column B should be so disproportionately valuable.

And it's not valuable, not at all.

There are those who believe that housing prices won't naturally rebound, that they are artificially high; if that's true, then we will not see massive profits from the government bailout. Those questionable assets that we will own will not ever come back to current levels, and we will see a big loss (contra Larry Summers). Via Andrew Sullivan, an article by Harvard economist Edward Glaeser:

If this reasoning is right, then prices have plenty of room to continue falling. That’s good news for ordinary Americans looking for cheaper housing. It’s bad news, however, for the financial markets — and possibly also for the return the government can expect to receive on the taxpayer-financed purchase of Wall Street’s troubled assets.

There's a lot of talk about rebuilding the infrastructure, our bridges and roads. Some people throw our educational system into the mix. But our infrastructure is everything included in the American premium, and it includes our regulatory system and our financial system, and we have had almost 30 years in which those things have been dismantled. Political orthodoxy has trumped the maintenance of the American system, and the financial meltdown is only a symptom of the whole problem. And it is very possible that we no longer have the spare cash lying around to fix these things - we have likely waited too long, and we may have to suffer the consequences.