Lecture One (1-188) ... History of Finance, Key Economic Concepts, and Why the West Got Rich First Flashcards
who wrote the book that sparked the ideas of how the west + Japan got rich first and why was it significant?
Angus Deaton
The Great Escape
Revealed unknown truths about pre-capitalism life (dug through govt. documents to find it)
what did The Great Escape book argue & desribe?
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
what is the bad news bias
“if it bleeds it leads”
emotion grabs attention better than fact
what is the Malthusian equilibrium trap?
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)
what was the escape from Malthus equilibrium?
it turns out:
agricultural output ACTUALLY grows exponentially
population ACTUALLY grows logarithmically
… this allowed the population to be sustained and living standards grew
what happens when incomes reached “middle income” (in relation to population growth)
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
what are the economic implications of birth rates < death rates? … not just that there’s a falling population?
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
population growth actually follows a __________ growth curve. What other factor drags it down and prevents it from being exponential.
logistic
women’s education level
In Thomas Malthus’ Essay on the Principle of Population (1798), what was his key concern + what was his solution
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
what was Charles Darwin’s (1887) perspective on Malthus’ Essay on Prinicple of Population (1798)
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
“Science-based” Neo-Malthusian Policies
describe both of: Poor Laws and Eugenics
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.)
instead of the Malthus equilibrium trap, what ended up happening?
instead … countries escaped one-by-one (West + Japan were first, which led into Needham’s Question)
what was Needham’s Question (1954)
… and what is the mainstream economics answer?
Why did the West escape first?
… adoption of free markets and capitalism first
in economic history, do the left & right wing tend to switch sides?
Yes!
in the 1700s, free markets were a radical left wing idea, as conservatives liked feudal estates, serfs and slaves
what were some of the “other potential solutions” to Needham’s Question
- Absence of imperialism, colonialism and slavery made the West rich
- Climate change made the West rich
- Western Christianity + traditional education made the West rich
did the absence of imperialism, slavery, and colonialism make the West rich?
countries with imperialism and colonialism (Russia, Spain) and Adam Smith argued that these countries had:
TOTAL COSTS > TOTAL BENEFITS
Who argued that imperialist economies actually had total costs > total benefits? Describe his rationale
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
what objectives were used to justify these imperialist nations in Britain, Germany, and Spain
non-economic objectives like “national greatness”
… to make up for the lack of total economic benefits
why was imperialism and slavery unsuccessful
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.
at what point / what catalyst made countries transition from slavery and imperialism to more democratic / just countries
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
what was the ad hominem fallacy (Aristotle)
you’re criticizing the person and not the argument
what did Larry Summers argue was the highest returning investment for economic growth in developing countries? And why?
girls education
… because it gave them the ability to read, write, and make better decisions (like using contraception, legal rights, etc.)
Current trends in finance and demography. Describe the current shape of Canada and China’s population pyramids now and in 2050
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
How can demographics be used to predict stock market performance?
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
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
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)
“[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^ ?
Thomas Hobbes, 1652
even bad government is better than no government … - “_______ _______”
who spit that line ^ ?
Thomas Hobbes !
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
Adam Smith
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
Adam Smith
if there is a lower (middle aged / young worker) ratio, then will the net demand for stocks be higher or lower?
lower middle aged / young worker ratio means lower net demand for stocks … stock prices fall
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.
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
who “perfected” Mercantilism
Jean-Baptiste Colbert (1618 - 1683)
- he was the Finance Minister for the King of Canada & France (King Louis XIV)
what were the Principles of Mercantilism (3)
… hint: it’s about the elites and how they should be treated
served the elites only
- elites were the only ones who could create and enjoy culture
- nations exist to support the elite
- war is grand & uplifting, and wars cost money
T or F: In Mercantilism, the purpose of ordinary people is to pay taxes to increase the greatness of the nation
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
what was the Wealth of Nations and what was its impact on the economy in the 1700s
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
what about free markets made Adam Smith argue for it and resent against Mercantilism? hint: one word
Specialization
argued for free markets over monopolistic nature of mercantilism
Specialization boosts productivity so freer markets make nations wealthier
why do specialists need markets
without markets, specialists starve, die of exposure, … so everyone has to be a generalist and make their own food, clothes and shelter
How free markets work … the invisible hand
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
counties allocate capital through capital budgeting. describe the difference between NPV and MVA (economic value added)
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)
what is the Contradiction in Finance and Economics with economic profits and NPVs
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
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?
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
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 … ?
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
what is the Schumpeter Circular Flow of Capital
does it improve or worsen income inequality
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)
what is Creative Destruction and who invented this idea?
Schumpeter
old firms get displaced by new innovative firms
is there a correlation between successful innovators and rich parents
Smart, creative entrepreneurial people do not reliably have smart, creative entrepreneurial children
If they did, hereditary control of businesses would make sense
why are regressions called regressions and who invented them?
Charles Darwin’s cousin, Francis Galton invented regressions
he examined heriditary traits and showed that outlier characteristics eventually “regress to the mean” over generations
what did Schumpeter understand about economics that Adam Smith and Marx did not
innovation
companies can gain customers without lowering prices and so NPVs don’t fall to zero
what is the main determinant of long-run economic growth in high income countries?
creative destruction & displacement of old firms with new, innovative firms
leads to effective reallocation of capital
T or F: What’s Good for General Motors is Good for America.
- Charles Wilson
False!
Supporting old, non-innovative firms is associated with lower long-run productivity growth
does a lower firm displacement rate lead to a higher or lower Solow Residual (Total Factor Productivity)
it leads to a lower Solow Residual (TFP)
what is the social purpose of finance? … according to Schumpeter
To get people’s savings into the hands of creative and honest entrepreneurs who see NPV > 0 projects that others cannot
what is the Lorentz Curve?
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
what is the Simon Kuznets Curve?
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
what is the Gini Coefficient
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
world income inequality shifted higher in 2010 for the first time in decades. what drove this?
- 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
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
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
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?
actually, YES!
Research shows that the larger a country’s financial system, the better the living standards are!
what is the Solow Residual and what does it measure? and what is the growth rate of the Solow Residual called?
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
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)
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
what is the deep structure of economic growth? (2 words)
technological progress
(example: Moore’s Law)
process vs. product innovation
process innov: falling unit costs per unit of technology
product innov: new tech replaces old tech at a lower cost per unit
Repeated new technology replacements sustain exponentially falling unit costs over a longer time span. Are these lines a straight line down?
No they are “kinky”
This is due to brief periods of intensified innovation which makes other periods of exponential innovation look slower
what is Wright’s Law?
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
connecting Milton Friedman’s view and David Suzuki’s view of economics to Pigouvian taxes, subsidies and regulations, what is the outcome?
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
what is public finance theory (Pigouvian taxes and subsidies)
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
what is the social IRR of an innovation
The social IRR measures the return generated for the whole economy / society
typically it has an return 4-5x the standard IRR
what happened with Emporor Diocletian and his ancient policy errors? (305 AD)
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
describe the fall of the western world 500 - 1500 AD
- 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
what was the recent theory that climate change made the west rich?
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
how did democracies outlast absolute monarchies from a finance perspective?
greater access to capital
democracies had trusting citizens to borrow money from, monarchies did not and couldn’t convince them to lend
how did the Republic of Venice accidentally create bonds
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”
One common theme among countries great escapes
once the stock market + laws/regulation was established … economic growth soon followed
labor and capital are finite resources, but information is infinite
describe how Information Economics contributes to higher social IRRs and positive externalities
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
does limited resources inhibit innovation? (i.e. running out of an ouput)
No, in fact it can increase innovation
- gas lights destroyed whale oil lights
- electric lights destroyed gas oil lights
- LEDs destroyed electric lights
Cardwell’s Law on Innovation
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
what is the savings glut theory of secular stagnation
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)
what is time inconsistency and how does it discourage innovation?
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
what was the patent act of 1474?
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
based on statistical evidence, what what guilds grant more / less patents
older & more religious guilds vs. geographically extensive & less religious guilds
older & more religious guilds: less patents
geographically extensive & less religious guilds: more patents
describe the state of intellectual piracy in the 18th and 19th century.
- 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
how to counter time inconsistency in innovations and what are the issues with it?
government can provide subsidies to counter time inconsistency
BUT this money may not be effectively allocated and may be skewed by political motivations
what is the problem with NPV and Big Governments?
… talk about how it relates to solving the Contradiction in Finance/Econ
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
does the corruption / NPV issue describe why China didn’t get rich along with the West?
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
why did the corruption / NPV issue not affect the West in the same way it did China?
corruption was more profitable than innovation until the Enlightenment (establishment of free markets, just government)
western countries got the circular flow moving first
what is the social NPV of corruption?
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…
is it easier or harder to setup a business in more corrupt countries?
it’s much harder and takes longer
discourages entrepreneurship and innovation, leading to lower Solow Residuals / TFP and less GDP growth
what are the two types of corrupt government officials (bandits)
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
describe corruption and crony capitalism. why is it suboptimal to setup a business in a poor country
- ordinary people can’t get financing
- government has roving bandits that demand bribes, so people prefer to run their business illegally
what is usury ?
the illegal action of charging absurdly high interest on debt
what is political rent seeking?
this is when the corrupt government seeks to take money from people unethically (charging for services that should be charged for, i.e. bribes)
why does corruption deter entry of new firms
- political rent seeking from govt
- monopolies undercut businesses with lower wages (inhibiting new entrants from attracting workers and staying profitable) … hard to reach scale against monopolies
why does corruption disrupt the circular flow of capital?
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
- what is “crony” capitalism?
- what is the key economic driver in a crony capitalism world?
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
describe the nash equilibrium with roving bandits
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
what is the rationale for a rover bandit to transition to a stationary bandit
u-shaped curve with bandits taking 0% - 100% from citizens
sweet spot maximizes theft while still encouraging people to accumulate wealth
describe the transition from stationary bandit to Rule of Law and how that’s influenced by Tiebout Competition
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)
what is Tiebout Competition
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
