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Theory and common sense

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Theory and common sense

Theories can be presented in such a way as to sound very convincing. Moreover, when a theory is cast in an elegant mathematical structure, it becomes even more persuasive and at times even intimidating.

Dennis Carlton and Jeff Perloff, the authors of the text book I use for my undergraduate “Industrial Organization” course, claim: “Even though perfect competition is rarely, if ever, encountered in the real world, we study the perfect competition model because it provides an ideal against which to compare other models and markets.”

This model is the mainstay of neoclassical economics. Competition policy is built on this model. Yet despite what Carlton, Perloff and generations of other academic economists claim, the logic implicit in the assumptions and the mathematics of this model lead one to much different conclusions. The perfect competition model falls flat on its face. When a shock is introduced, given the assumptions of this model, it is not possible for equilibrium to be restored. The model becomes unsustainably volatile. Furthermore, there is no incentive for risk taking and innovation in this model. So it is not an ideal for any policy.

Recently, I have come across some other arguments, which if one considers them only at a superficial level, sound rather persuasive. But once we look below the surface, we realize that there is a serious logical flaw in each.

Jack Mintz, a highly respected tax expert, stated in his article in the January 28 edition of the Financial Post: “aging populations, particularly in Europe, Japan and North America, will result in slower growth in the labour force and less capital accumulation as retirees consume their wealth.” Superficially this seems to make sense.

Mintz is implicitly making the argument that the level of savings drives investment spending. Thus, to stimulate investment spending, society must save more. Further, he is implicitly arguing that governments will have to generate increasingly larger budget surpluses to offset lower savings by an aging population.

The problem with this simplistic argument is that economists have assumed that savings drive investment. In this model, entrepreneurship, risk taking and the pursuit of a competitive advantage play no role. More likely, investment spending, the result of decisions to gain a competitive advantage, drives the economy and the aggregate level of savings, including government budget balances. Higher levels of savings will not produce higher levels of investment spending. Rather, higher levels of investment will lead to higher levels of savings. This has much different policy implications.

Alan Arcand and Mario Lefebvre, writing in the January 26 edition of the Financial Post, stated: “taxing any activity discourages that activity…a tax on capital discourages productivity enhancing business investment through the higher cost of capital.”

Accordingly, to stimulate investment and productivity growth, governments in Canada should eliminate the capital tax and further lower corporate income tax rates. Again, at a superficial level, this almost sounds convincing.

But think of the logic of this argument. If one believes Arcand and Lefebvre, senior management of companies are motivated more by modest changes in tax rates than by what Schumpeter has called “destructive competition”. That is, senior management in Canada is not interested in gaining a competitive advantage and dominating their markets. Instead, all they care about is minimizing their tax burdens. Well, if they ignore their competitive positions and do not take the risks to move ahead, they will not have to worry about paying any taxes for their companies will be doomed to fail. Thus, if you buy the Arcand-Lefebvre argument, there is no hope for Canadian companies and the Canadian economy.

Finally, Peter Wallison, writing in the January 25 edition of the Wall Street Journal, commented: “If Mr. Obama’s plan is adopted, many bank holding companies will have to give up profitable businesses or sell off their banks.” He was arguing that the demise of Glass-Steagall and the ability of banks to create bank holding companies, which could engage in non-retail banking activities, made the financial system more stable and prosperous.

Implicit in his argument is the belief that there are synergies between retail banking and investment banking activities, and diversification enables a bank holding company to reduce the systemic risks it faces. As I pointed out in my blog last Friday, the only synergies stem from the ability of the investment banking units to put the balance sheets of their banking units at risk in order to win advisory or underwriting assignments. The synergies for the bank holding companies created greater risks for the financial system as a whole.

As for the benefits of diversification, Finance 101 makes it clear that shareholders can diversify their portfolios much more effectively and cheaply than any company, including a bank holding company.

Policy makers are well advised to dig below the surface of theories to examine whether their logic is flawed before they consider developing a policy based on a theory.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.



  1. Online Degree February 4, 2010

    Splendid article . Will definitely copy it to my blog.Thanks.

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