Lecture One (1-188) ... History of Finance, Key Economic Concepts, and Why the West Got Rich First

Question 1

who wrote the book that sparked the ideas of how the west + Japan got rich first and why was it significant?

Answer 1

Angus Deaton

The Great Escape

Revealed unknown truths about pre-capitalism life (dug through govt. documents to find it)

Question 2

what did The Great Escape book argue & desribe?

Answer 2

it seeked to discover why western econonomies + Japan were the first to escape poverty

argued that “now” is the best time ever to be alive

Question 3

what is the bad news bias

Answer 3

“if it bleeds it leads”

emotion grabs attention better than fact

Question 4

what is the Malthusian equilibrium trap?

Answer 4

argued that agricultural output grew arithmetically/linearly, while population grew exponentially

population rises until deaths = births and the population stabilizes

… at this point, everyone is barely surviving (nearly starving)

Question 5

what was the escape from Malthus equilibrium?

Answer 5

it turns out:

agricultural output ACTUALLY grows exponentially

population ACTUALLY grows logarithmically

… this allowed the population to be sustained and living standards grew

Question 6

what happens when incomes reached “middle income” (in relation to population growth)

Answer 6

births tended to stabilize / flatten out once GDP per capita reached $15,000 (i.e. hit middle income)

some countries, like Canada would actually have falling populations if it weren’t for immigration

Question 7

what are the economic implications of birth rates < death rates? … not just that there’s a falling population?

Answer 7

looming economic problem:
- fewer taxpayers to pay for medicare, pensions, social benefits
- not as many young investors to buy stocks / bonds that you invested in

Question 8

population growth actually follows a __________ growth curve. What other factor drags it down and prevents it from being exponential.

Answer 8

logistic

women’s education level

Question 9

In Thomas Malthus’ Essay on the Principle of Population (1798), what was his key concern + what was his solution

Answer 9

Malthus argued that government policies to “help the poor” were counterproductive

instead, he argued for government measures to suppress population growth: euthanization, sterilization, and child birth limits

Question 10

what was Charles Darwin’s (1887) perspective on Malthus’ Essay on Prinicple of Population (1798)

Answer 10

argued that during times of hardship, favorable human variations would be preserved and weaker ones would be destroyed

… the result would be the formation of new species

Question 11

“Science-based” Neo-Malthusian Policies

describe both of: Poor Laws and Eugenics

Answer 11

Poor Laws concentrated the poor in sex-separated workhouses, & spiked the gruel with chemicals thought to suppress sex drives

Eugenics was a “settled science” and a scientifically inaccurate theory where humans can be improved through selective breeding of the population

• NAZI eugenics was initially supported by Western progressives (i.e. sterilizing the poor, cognitively diverse, etc.)

Question 12

instead of the Malthus equilibrium trap, what ended up happening?

Answer 12

instead … countries escaped one-by-one (West + Japan were first, which led into Needham’s Question)

Question 13

what was Needham’s Question (1954)

… and what is the mainstream economics answer?

Answer 13

Why did the West escape first?

… adoption of free markets and capitalism first

Question 14

in economic history, do the left & right wing tend to switch sides?

Answer 14

Yes!

in the 1700s, free markets were a radical left wing idea, as conservatives liked feudal estates, serfs and slaves

Question 15

what were some of the “other potential solutions” to Needham’s Question

Answer 15

1. Absence of imperialism, colonialism and slavery made the West rich
2. Climate change made the West rich
3. Western Christianity + traditional education made the West rich

Question 16

did the absence of imperialism, slavery, and colonialism make the West rich?

Answer 16

countries with imperialism and colonialism (Russia, Spain) and Adam Smith argued that these countries had:

TOTAL COSTS > TOTAL BENEFITS

Question 17

Who argued that imperialist economies actually had total costs > total benefits? Describe his rationale

Answer 17

Adam Smith

• large military spending, colony administration, rebellions and depressed wages harmed the economy

… while low taxes from colonies under dominance didn’t support it

Question 18

what objectives were used to justify these imperialist nations in Britain, Germany, and Spain

Answer 18

non-economic objectives like “national greatness”

… to make up for the lack of total economic benefits

Question 19

why was imperialism and slavery unsuccessful

Answer 19

made few people very rich and many people very poor

Britain’s middle classes would have been richer if Britain had avoided colonialism, slavery, imperialism, etc.

Question 20

at what point / what catalyst made countries transition from slavery and imperialism to more democratic / just countries

Answer 20

once the middle class became politically important, they ended slavery and granted colonies independence

Euro countries with huge slave populations became less rich than countries without slavery / colonial empires

Question 21

what was the ad hominem fallacy (Aristotle)

Answer 21

you’re criticizing the person and not the argument

Question 22

what did Larry Summers argue was the highest returning investment for economic growth in developing countries? And why?

Answer 22

girls education

… because it gave them the ability to read, write, and make better decisions (like using contraception, legal rights, etc.)

Question 23

Current trends in finance and demography. Describe the current shape of Canada and China’s population pyramids now and in 2050

Answer 23

Canada: shows baby boom at age 50 today and high elderly population in 2050 supported by few younger workers … (Canada’s solution is to increase immigration)

China: very large working population, small elderly population (Mao era deaths), and very small child population … leading to 2050 population with very large elderly population and very few working-age people

Question 24

How can demographics be used to predict stock market performance?

Answer 24

in theory, people borrow when they’re young and buy stocks when they’re old

in the 1980s baby boomers borrowed to buy homes and in the 2000s invested in the stock market once mortgages were paid off. This helps describe the run up in stock market valuation in the early 2000s

Question 25

governments and corruption played a huge role in helping countries escape poverty; who advocated for the importance of government in the 1600s and what did he argue

Answer 25

Thomas Hobbes argued that any form of government was better than no government, as it encouraged people to accumulate wealth (without the fear of it being taken away)

Question 26

“[When] men live without a common power to keep them all in awe, [it is] every man against every man [and] life is solitary, poor, nasty, brutish and short”. who spit that line^ ?

Answer 26

Thomas Hobbes, 1652

Question 27

even bad government is better than no government ... - "_______ _______" who spit that line ^ ?

Answer 27

Thomas Hobbes !

Question 28

who is this philosopher (1700s era) - Lived at the beginning of the UK's high growth era - Connected many ideas together to create economics - Outspoken liberal

Answer 28

Adam Smith

Question 29

who is this philosopher: - argued that slavery harmed productivity (unethical and economically inefficient) - colonies should all be made independent - argued that the economy's goal should be to create widespread wealth - decisions should be made with rational thinking

Answer 29

Adam Smith

Question 30

if there is a lower (middle aged / young worker) ratio, then will the net demand for stocks be higher or lower?

Answer 30

lower middle aged / young worker ratio means lower net demand for stocks ... stock prices fall

Question 31

what were countries "escaping" from, how did they live in the 1500s, 1600s, and 1700s - answer from both an economic perspective (one word) and a social / living conditions perspective.

Answer 31

Mercantilism Life back then was nasty, brutish and short where there was rampant disease, plagues, short life spans, short height people, and people lived like they were in a third world country everywhere

Question 32

who "perfected" Mercantilism

Answer 32

Jean-Baptiste Colbert (1618 - 1683) - he was the Finance Minister for the King of Canada & France (King Louis XIV)

Question 33

what were the Principles of Mercantilism (3) ... hint: it's about the elites and how they should be treated

Answer 33

served the elites only 1. elites were the only ones who could create and enjoy culture 2. nations exist to support the elite 3. war is grand & uplifting, and wars cost money

Question 34

T or F: In Mercantilism, the purpose of ordinary people is to pay taxes to increase the greatness of the nation

Answer 34

True - they aimed to maximize taxes on the poor while elites paid no tax - entire economy was monopolized with no competition - high trade barriers - laws/regulations were set by elites who bought the rights to set laws

Question 35

what was the Wealth of Nations and what was its impact on the economy in the 1700s

Answer 35

written by Adam Smith, it brought Mercantilism to an end - flipped principles of mercantilism upside down and argued for uplifting the middle class and not focusing on national greatness ... was a part of a broader movement called the Enlightenment

Question 36

what about free markets made Adam Smith argue for it and resent against Mercantilism? hint: one word

Answer 36

Specialization argued for free markets over monopolistic nature of mercantilism Specialization boosts productivity so freer markets make nations wealthier

Question 37

why do specialists need markets

Answer 37

without markets, specialists starve, die of exposure, ... so everyone has to be a generalist and make their own food, clothes and shelter

Question 38

How free markets work … the invisible hand

Answer 38

Free markets are guided by the self interests of individuals, not their benevolence (according to Smith) The prices of goods signal what specialists are needed Free markets are self-organizing complex systems

Question 39

counties allocate capital through capital budgeting. describe the difference between NPV and MVA (economic value added)

Answer 39

MVA subtracts out the annualized cost of capital (cost of providing returns to investors) also, MVA is the sum of economic value added for each year (accept if MVA > 0)

Question 40

what is the Contradiction in Finance and Economics with economic profits and NPVs

Answer 40

if you rearrange the formulas, NPV actually equals MVA We assume in ECON that economic profits fall to zero in competitive markets however, if this was true, then NPV would always = 0, meaning no projects could be pursued

Question 41

who spotted the Contradiction in Finance and Economics. Also, which one of them had a very obscure view of what would happen in the economic cycle?

Answer 41

Karl Marx and Joseph Schumpeter ... Marx argued that zero economic profits would lead NPVs to zero, then investment would fall, unemployment would rise, and wages would fall until NPVs became positive again, encouraging new investment he argued this would repeat itself until wages hit zero and the economy would collapse into communism

Question 42

what do people think of Marx and Marxism today? Plus, what were some of his famous contributions and at what time in the economy do his ideas usually come back to light ... ?

Answer 42

still popular among some people (not young people) his ideas are brought to light after financial crises occur Marx coined the term industrial revolution + he said that religion was used to keep the masses docile

Question 43

what is the Schumpeter Circular Flow of Capital does it improve or worsen income inequality

Answer 43

moves money from people with money and no ideas to people with no money and lots of ideas Successful innovators get rich (narrowing income inequality)

Question 44

what is Creative Destruction and who invented this idea?

Answer 44

Schumpeter old firms get displaced by new innovative firms

Question 45

is there a correlation between successful innovators and rich parents

Answer 45

Smart, creative entrepreneurial people do not reliably have smart, creative entrepreneurial children If they did, hereditary control of businesses would make sense

Question 46

why are regressions called regressions and who invented them?

Answer 46

Charles Darwin's cousin, Francis Galton invented regressions he examined heriditary traits and showed that outlier characteristics eventually "regress to the mean" over generations

Question 47

what did Schumpeter understand about economics that Adam Smith and Marx did not

Answer 47

innovation companies can gain customers without lowering prices and so NPVs don't fall to zero

Question 48

what is the main determinant of long-run economic growth in high income countries?

Answer 48

creative destruction & displacement of old firms with new, innovative firms leads to effective reallocation of capital

Question 49

T or F: What's Good for General Motors is Good for America. - Charles Wilson

Answer 49

False! Supporting old, non-innovative firms is associated with lower long-run productivity growth

Question 50

does a lower firm displacement rate lead to a higher or lower Solow Residual (Total Factor Productivity)

Answer 50

it leads to a lower Solow Residual (TFP)

Question 51

what is the social purpose of finance? ... according to Schumpeter

Answer 51

To get people’s savings into the hands of creative and honest entrepreneurs who see NPV > 0 projects that others cannot

Question 52

what is the Lorentz Curve?

Answer 52

an income inequality graph that plots the % of the population against the % of wealth held in a perfect world the line would be 45º and 50% of population would hold 50% of wealth ... however, this is not the case and smaller % of the population hold disproportionately large amounts of the total wealth

Question 53

what is the Simon Kuznets Curve?

Answer 53

measures the Gini index against the log of GDP per capita the U-Shaped curve suggests that income inequality rises at first as a country develops (from capital being only in the hands of owners), and eventually decreases over time as wealth redistribution occurs, good and services improve, and social benefits increase Canada, Japan, USA, Australia, and the Nordic countries are at the tail end of this curve ... with high Gini index and high GDP per capita

Question 54

what is the Gini Coefficient

Answer 54

measures income dispersion 0 means everyone has equal wealth, 1 means one person holds all the wealth (higher the worse it gets) - it's on the same chart as the Lorentz Curve, measuring income inequality

Question 55

world income inequality shifted higher in 2010 for the first time in decades. what drove this?

Answer 55

- Increased job opportunities and higher wages paid to specialized workers in developing countries - This led to rising wealth of the “global middle class” and in turn created a more equal world economy

Question 56

In Thomas Pliketty's book 'Capital' he argues that income inequality widened in the 20th century. What was his main argument and what were the challenges to his theory

Answer 56

his argument was that blue collar workers earned only 2%/yr while capitalists earned 8%/yr Challenges: - are tax returns an accurate measure of wealth - does not consider % of wealth held in workers' pension funds - higher returns mean higher risk which may have caused some ppl to lose all their wealth

Question 57

does finance make the world a better place? even though the finance sector lures smart people with high pay who may have otherwise helped the world?

Answer 57

actually, YES! Research shows that the larger a country’s financial system, the better the living standards are!

Question 58

what is the Solow Residual and what does it measure? and what is the growth rate of the Solow Residual called?

Answer 58

the Solow Residual is unexplained economic growth it measures the pace of NPV > 0 investment (pace of innovation) total factor productivity (TFP) is the growth rate of the Solow Residual

Question 59

For a while, Schumpeter's idea of creative destruction disappeared due to difficulty of quantifying it in math. Who solved this issue and what did they call it (there's two)

Answer 59

Paul Romer replicated this through the Endogenous Growth Theory which calculates the Solow Residual as the sum of all firms' NPVs / yr Philippe Aghion also replicated this more accurately/effectively 8 yrs later

Question 60

what is the deep structure of economic growth? (2 words)

Answer 60

technological progress (example: Moore's Law)

Question 61

process vs. product innovation

Answer 61

process innov: falling unit costs per unit of technology product innov: new tech replaces old tech at a lower cost per unit

Question 62

Repeated new technology replacements sustain exponentially falling unit costs over a longer time span. Are these lines a straight line down?

Answer 62

No they are "kinky" This is due to brief periods of intensified innovation which makes other periods of exponential innovation look slower

Question 63

what is Wright's Law?

Answer 63

posits that "we learn by doing" and the cost of each unit produced decreases as a function of the total number of units produced it is a version of Power Law pairing

Question 64

connecting Milton Friedman's view and David Suzuki's view of economics to Pigouvian taxes, subsidies and regulations, what is the outcome?

Answer 64

Friedman argues that all firms should maximize shareholder wealth, Suzuki argues that this is wrong b/c it doesn't consider the negative externalities. Coupling this with Pigouvian's / Public finance theory on externalities, the state should subsidize firms with positive externalities and tax/fine firms with negative externalities

Question 65

what is public finance theory (Pigouvian taxes and subsidies)

Answer 65

Public sector governance (public finance) is the branch of economics about how governments can promote laws and ethical norms to do this best - State should subsidize firms that generate positive externalities - State should tax and fine firms that generate negative externalities

Question 66

what is the social IRR of an innovation

Answer 66

The social IRR measures the return generated for the whole economy / society typically it has an return 4-5x the standard IRR

Question 67

what happened with Emporor Diocletian and his ancient policy errors? (305 AD)

Answer 67

ran large deficits that were financed by debasing the currency tried to solve abandoned/failing businesses with price and wage fixing, forcing children to work in their parents profession this disrupted free markets and prevented class mobility

Question 68

describe the fall of the western world 500 - 1500 AD

Answer 68

- challenging period due to illness (plagues) and adverse weather (volcanic winter) - collapse of public water supply - collapse of imperial finances from successive invasions ... sharp population decline

Question 69

what was the recent theory that climate change made the west rich?

Answer 69

argued that the ice age during the 1800s encouraged the west to find other ways of getting food (which also sparked increases in trade activity) ... didn't end up being valid

Question 70

how did democracies outlast absolute monarchies from a finance perspective?

Answer 70

greater access to capital democracies had trusting citizens to borrow money from, monarchies did not and couldn't convince them to lend

Question 71

how did the Republic of Venice accidentally create bonds

Answer 71

Venice govt borrowed $ to build the Navy and fight Byzantine, would pay back with war proceeds They lost the war and agreed to repay 6% of loans / yr, then citizens began trading the rights to these payments and called them "bonds"

Question 72

One common theme among countries great escapes

Answer 72

once the stock market + laws/regulation was established ... economic growth soon followed

Question 73

labor and capital are finite resources, but information is infinite describe how Information Economics contributes to higher social IRRs and positive externalities

Answer 73

information is "non-rivalry" meaning it can be used again and again by multiple people this enables people to share innovations and create many positive NPV projects boosting the social IRR

Question 74

does limited resources inhibit innovation? (i.e. running out of an ouput)

Answer 74

No, in fact it can increase innovation - gas lights destroyed whale oil lights - electric lights destroyed gas oil lights - LEDs destroyed electric lights

Question 75

Cardwell's Law on Innovation

Answer 75

this is the idea that a single economy can move inexorably to a state of stagnant technological innovation ... this was true until the past few centuries

Question 76

what is the savings glut theory of secular stagnation

Answer 76

1) central banks print after '08 crisis and '20 pandemic, pushing up stock mkt and interest rates fall 2) capital flight from emerging mkts, savings pile up in high income countries, and interest rates fall 3) as people get richer, they consume less and save more, and interest rates fall ... why take risks investing in innovation when firms' stock prices rise themselves? (from falling int. rates)

Question 77

what is time inconsistency and how does it discourage innovation?

Answer 77

a problem is time inconsistent if solving the problem changes conditions to make the solution suboptimal (i.e. if a pandemic breaks out, then a lifesaving drug makes high profits in year 1, but then in year 2 it may be subsidized by the government and firms' profits free fall) ... why solve the problem if you know

Question 78

what was the patent act of 1474?

Answer 78

granted patents for new & ingenious technologies which allowed the patent-owner: - the right to a monopoly over the innovation - the right to enter a guild affected by the patent

Question 79

based on statistical evidence, what what guilds grant more / less patents older & more religious guilds vs. geographically extensive & less religious guilds

Answer 79

older & more religious guilds: less patents geographically extensive & less religious guilds: more patents

Question 80

describe the state of intellectual piracy in the 18th and 19th century.

Answer 80

- Chinese firms used western ideas without paying royalties - American inventors actually used European ideas (i.e. Ford's automobile, Lowell's textile weaving machine) ... countries didn't care about other countries' patents

Question 81

how to counter time inconsistency in innovations and what are the issues with it?

Answer 81

government can provide subsidies to counter time inconsistency BUT this money may not be effectively allocated and may be skewed by political motivations

Question 82

what is the problem with NPV and Big Governments? ... talk about how it relates to solving the Contradiction in Finance/Econ

Answer 82

the bigger the government, the higher the NPV of corrupting them solves the contradiction in fin/econ because it get create NPV > 0 projects when economic profits = 0

Question 83

does the corruption / NPV issue describe why China didn't get rich along with the West?

Answer 83

Partly, because China had more advanced technology but failed to apply it to the country Highest NPV projects from Imperial China were not from innovation but from corruption

Question 84

why did the corruption / NPV issue not affect the West in the same way it did China?

Answer 84

corruption was more profitable than innovation until the Enlightenment (establishment of free markets, just government) western countries got the circular flow moving first

Question 85

what is the social NPV of corruption?

Answer 85

SNPV < 0 SNPV < 0 because political rent-seeking undermines free markets ALSO, $ is allocated to elite schools while the rest are left without basic education ... and uneducated girls don't produce demographic transitions...

Question 86

is it easier or harder to setup a business in more corrupt countries?

Answer 86

it's much harder and takes longer discourages entrepreneurship and innovation, leading to lower Solow Residuals / TFP and less GDP growth

Question 87

what are the two types of corrupt government officials (bandits)

Answer 87

roving bandits: everytime you try to do something new, there's a new corrupt official demanding pay stationary bandits: there's one corrupt official you encounter once and pay a large sum to

Question 88

describe corruption and crony capitalism. why is it suboptimal to setup a business in a poor country

Answer 88

1. ordinary people can't get financing 2. government has roving bandits that demand bribes, so people prefer to run their business illegally

Question 89

what is usury ?

Answer 89

the illegal action of charging absurdly high interest on debt

Question 90

what is political rent seeking?

Answer 90

this is when the corrupt government seeks to take money from people unethically (charging for services that should be charged for, i.e. bribes)

Question 91

why does corruption deter entry of new firms

Answer 91

1. political rent seeking from govt 2. monopolies undercut businesses with lower wages (inhibiting new entrants from attracting workers and staying profitable) ... hard to reach scale against monopolies

Question 92

why does corruption disrupt the circular flow of capital?

Answer 92

money isn't flowing from savers to honest innovators - large monopolies get money from the government, not capital markets - when capital providers (savers) think that corporations are untrustworthy, they won't invest

Question 93

1. what is "crony" capitalism? 2. what is the key economic driver in a crony capitalism world?

Answer 93

where money is allocated to the "cronies" of government officials, not the most creative entrepreneurs - to become a crony of political leaders is the key driver of economic development

Question 94

describe the nash equilibrium with roving bandits

Answer 94

each bandit thinks "if I don't steal from this person then someone else will." every bandit steals everything he can find and this discourages people from accumulating wealth

Question 95

what is the rationale for a rover bandit to transition to a stationary bandit

Answer 95

u-shaped curve with bandits taking 0% - 100% from citizens sweet spot maximizes theft while still encouraging people to accumulate wealth

Question 96

describe the transition from stationary bandit to Rule of Law and how that's influenced by Tiebout Competition

Answer 96

stationary (corrupt) bandit shifts from being an effective dictator to non-corrupt government system (Rule of Law) as it becomes more challenging to compete for taxpayers (Tiebout Competition)

Question 97

what is Tiebout Competition

Answer 97

where governments/countries have to compete for taxpayers by offering the best public services, business environment, legal systems for the lowest tax rate ... people move from corrupt countries to non-corrupt countries