If you put the government in charge of the Sahara Desert, in five years there'd be a shortage of sand.

—Milton Friedman

When a collection of individuals agrees to form a society, they have many options in determining how to organize themselves. The political philosophy of the group will be manifested in its political-economic systems, and the range of possible solutions is wide. This chapter focuses on two key decisions that relate to a society's vulnerability to boom and bust cycles. First, we evaluate the different philosophies relating to property rights. A society's choice to allow private property to exist and to protect such property with corresponding rights is an essential prerequisite for market-determined prices to be “discovered” via supply and demand dynamics. Further, without private property rights, the idea of booms and busts may be moot, as the state owns everything.¹

The chapter evaluates the mechanism through which a society chooses to determine the prices of goods, and the roles that those prices play in the allocation of scarce resources. Although significant gradations exist between the extremes, two primary price-determination methodologies are considered: (i) supply and demand–driven price “discovery” processes that take place through the interaction of buyers and sellers; and (ii) central planning–driven price dictation in which the prices of goods and services are set or influenced by government bureaucrats. Again, the political choice of determining a pricing methodology has significant ramifications for the relative fertility of booms and busts. Market-determined prices are inherently more volatile than state-mandated prices; as such, they create the conditions in which economic dislocations have the potential to snowball into extreme price movements. Societies that have state-mandated prices are unlikely to have extreme price volatility; rather, they may suffer from extreme fluctuations in the availability of goods.

Respected property rights and market-determined prices are two essential ingredients for booms and busts to take place. Political processes in societies having these preconditions are likely to exacerbate financial extremes. Specifically, politically determined price floors and price ceilings can confuse price-discovery processes, and tax policies are prone to either inflate or depress the demand (and supply) for certain goods, sometimes quite dramatically. Let us now turn to the issues of property and prices.

Can Anyone Own Anything?

According to the Concise Encyclopedia of Economics, property rights are defined as:

the exclusive authority to determine how a resource is used, whether that resource is owned by the government or by individuals. … Private property rights have two other attributes in addition to determining the use of a resource. One is the exclusive right to services of the resource … [and the other is] the right to delegate, rent, or sell any portion of the rights by exchange or gift at whatever price the owner determines (provided someone is willing to pay that price).²

Private property rights thus have three primary characteristics: exclusive rights to determine how the property is used, exclusive rights to the services of such property, and exclusive rights to sell or exchange the property.

The spectrum of possible property rights ranges from complete and total state ownership of all property to complete and total private ownership of all property. Private property rights are a hallmark of capitalism, and the lack of private property rights (i.e. state ownership of all assets) is typified by communism. In fact, Karl Marx succinctly captured the essence of communism in the Communist Manifesto when he wrote “The theory of the Communists may be summed up in the single sentence: Abolition of private property.”³

At the root of this objective was a belief that private property rights enabled the accumulation of inequality to compound over time, ultimately leading to disparities of wealth so large as to threaten systemic collapse. Without private property rights, and in a society in which everything was owned by the state, it would be possible to achieve another socialist ideal: a harmonious society in which everyone worked hard to make sure that everyone had what they needed. As noted by Marx and Engels, such an ideal state would be summarized by the slogan, “From each according to his ability, to each according to his needs!”⁴

Although the complete lack of property rights characterizes one extreme of the property rights spectrum, the other extreme is one in which laissez faire capitalism provides for complete private property rights. Property rights are essential for a market mechanism to work. Without property rights, the incentive to drive profits or generate economic returns relies not on economic self-interest, but rather on psychological factors—if it exists at all. If such an economic incentive did not exist, prices would not be determined by market forces—thereby negating the powerful information content they might otherwise contain.

Nationalization also tends to make an asset or market less efficient than it would be under a freely operating private property system. For example, Mexico nationalized its oil industry in 1938,⁵ and since then Pemex has chronically underinvested in research and development. This has placed Mexico in the position of having its reserve balances in long-term decline. The disparity is seen along international border oil and gas fields in the Gulf of Mexico. Large, multi-billion-barrel potential reserves were discovered in the Perdido Fold Belt area early in the last decade. On the U.S. side, Shell Oil started production in 2010 and produces about 100,000 barrels of oil and gas per day. Just over the border, Mexico's national oil company just approved a plan to drill in 2017, after overhauling its regulations to allow private partners to bring in expertise Pemex lacks. Although this is not a perfect example, because U.S. law permits transferable leases of offshore resources, not outright ownership, nonetheless it's illustrative of the speed with which a more freely arranged economy operates than the nationalized version.

Lest we think that nationalizations only take place in commodity-rich countries, Table 4.1 highlights a handful of nationalizations that have taken place since the year 2000, excluding those nationalizations that might be better characterized as bailouts in which the company or industry might have gone bust without the bailout.

Although nationalization is the most extreme form of a change to property rights once granted, equally problematic approaches might include poorly defined property rights, or property rights that are subject to some limitations. A good example of poorly defined property rights might exist in areas of territorial ambiguity. For instance, the Spratly Islands in Southeast Asia are a collection of islands that were claimed by no fewer than six nations. Vietnam, the Philippines, Brunei, Malaysia, China, and Taiwan all claimed ownership of the territorial waters. In the mid-1990s, when it was believed the islands might be sitting on top of significant oil reserves, gunboats actually exchanged fire. Crestone Energy, a Denver-based energy company, had secured what it believed were legitimate rights to drill for oil from the Chinese government. The Vietnamese government disputed this right, claiming territorial sovereignty over the area. When Vietnam later sent a rig into the area, the Chinese responded with a gunship and a naval blockade of the rig to prevent it from receiving needed supplies. Likewise, fishing rights in the Grand Banks were not clearly delineated, resulting in competitive overfishing by both U.S. and Canadian fishermen that ultimately made fishing in the region commercially unviable.

Property rights with limitations are another case of distortion by government interference. Consider the fate of Unocal, a U.S. oil and gas company that tried to sell itself to CNOOC, one of the Chinese national oil companies. The U.S. government effectively blocked the transaction. Consider also the fate of London-based port operator Peninsular & Oriental Steam Navigation Company (P&O) in the sale⁶ of their assets (which included U.S. port operations) to DP World, an investment company controlled by the government of Dubai in the United Arab Emirates. Political forces and public uproar resulted in the Emirates agreeing to divest of the U.S. ports in order to get the transaction completed.

These three property rights “modifiers” (nationalization, ambiguity, and limitation) have a dramatic impact on the likelihood of booms and busts. By mitigating investor desires to participate in markets that lack clearly defined and well-respected property rights, it appears that all modifications to property rights in fact dampen the possibility of booms and busts. Likewise, areas of territorial disputes and property rights ambiguity are likely to deter many investors and limit the risks they are willing to bear. Finally, the ability to exit from investments free and clear of last-minute modification of terms by the government appears a necessary condition for the formation of bubbles. Without this ability, open-ended, believable stories of justified price extremes would meet resistance.

There is also the possibility that financial booms and busts can be enabled via the granting of property rights where they were previously absent. A glance at prices in the privatized housing markets of (former) communist nations (i.e. China, Russia) begins to demonstrate the possibilities.

Venezuelan and Soviet Nationalization: Communism at Work

The argument against market-derived prices is one that fundamentally believes prices are fickle and subject to irrational whims. As such, interpreting information that is supposedly embedded in prices is a fool's game. For this reason, centrally planned economies that generate prices from government decisions do not look to markets or supply–demand dynamics for price generation.

In the former Soviet Union and other socialist economies, prices were set by decree, something like the Federal Reserve sets the price of money in the United States. In some cases, governments attempted to model out what an appropriate market-determined price might be and then dictated that as the price. Stiglitz notes the futility of such an approach:

Even if the government was successful in deciding on an appropriate price, it could do so only after a lengthy bureaucratic process. But economic conditions were changing while the bureaucrats were deliberating, which means the government-announced price was rarely the same as the market price.⁷

By setting prices that were either too high or too low, government interference with market-determined prices resulted in both shortages (when prices were set too low, resulting in excess demand or inadequate supply) and oversupply (when prices were too high, resulting in inadequate demand or excess supply). Not surprisingly, government interference tended to also produce black markets in which illegal transactions were taking place at prices negotiated between sellers and buyers. Despite these problems, the political process of setting prices via central planning was adopted by many countries in the twentieth century.

Let's consider how political decisions to restrict or remove property rights have affected the price mechanism by examining the ongoing nationalization efforts in Venezuela.

Tenaris, the world's leading producer of steel tubes and pipes for the oil and gas industry, had a facility in Venezuela in which it had invested substantial capital. The facility had been performing relatively well economically, and its prospects for future profits were bright. Then, on May 22, 2009, the Venezuelan government informed the management of Tenaris that they would be nationalizing the company's assets and those assets would belong to the state.⁸ What impact might nationalization have on the price mechanism for steel assets in Venezuela? By establishing that private property rights were not respected, the government of Venezuela sent a very clear message to the global investment community. Would a reasonable person or company invest in a country where the rights to their investment might not be respected?

Venezuela is one of what is now a handful of nation's exercising Soviet-style nationalism. Under now-deceased president Hugo Chavez, Venezuela nationalized a series of industries in the past decade, including taking majority stakes in major oil and gas operations, forcing ExxonMobil and Conoco out of the country when they refused to acquiesce. Chavez also nationalized agriculture and fertilizer operations of foreign businesses along with glass, steel, gold, cement, telecom businesses.

At first, when Chavez's regime of nationalization began in earnest in 2007, it seemed positive, at least to the masses of Venezuela. Powered by high oil prices that peaked at $160 per barrel, Chavez was able to spread money in the forms of discounted services to many Venezuelans. The country largely weathered embargoes put on it by the United States. Chavez was even able to tweak the American government by offering discounted home heating oil to poor U.S. residents through Citgo, the U.S. arm of the national oil company PDVSA. Even though nationalization of farmland had made agriculture highly unproductive in the country, Venezuela's oil riches allowed it to import the majority of the food it needed.

But as oil and gas prices fell, the ability of PDVSA to subsidize everyday life for its citizens fell with its revenues. This led to a deep economic crisis which left many residents scrambling to secure basic necessities. When they can, tens of thousands stream into Colombia to buy food and other supplies. During a 2017 trip to Bogota, I witnessed Venezuelan businessmen stuffing their suitcases with toilet paper before returning home. Looting is commonplace. A 2016 study⁹ found that half of sixth graders attending public schools had gone to bed hungry in the past week. Another study determined that the average Venezuelan lost 19 pounds that year due to the lack of food.

Market forces that could begin to correct the problem – privatizing farming again and allowing fixed prices to fluctuate—haven't been permitted. Instead, in 2017, the government turned to more central planning, including introducing Plan Rabbit, a proposed program of giving cages to poor settlements to raise baby rabbits, breed them, and thereby create a sustainable in-home protein source (since rabbits, well, breed like rabbits). A pilot program found most of the recipients treated the bunnies like pets, naming them, putting bows on them, and even letting them sleep in their beds. Some supposedly shared scarce food with the furry additions to their families.¹⁰

That this is happening isn't a surprise. While communist, or central command-style economies, can adjust to market forces of supply and demand, they typically have been much slower to do so than free market economies. And because prices are set, they lack the informational value of market-determined prices, which reflect underlying supply and demand dynamics.

The largest and most successful command-style economy, the Soviet Union, collapsed as dictated prices and uses of economic resources weren't agile or accurate enough to reflect the actual economic cost of production. Basically, farmers and producers of other goods and services refused to sell at state-ordered prices because the prices the state fixed were too low to justify production. This lead to a black market economy.¹¹ The government in essence was trying to control inflation by legislating it out of existence. It didn't work: in just one year (1990), GDP of the Soviet Union fell 8% as the traditional relationships between suppliers and producers collapsed. By the end of 1991, the Soviet Union ceased to exist.

Prices: To Guide or Be Guided?

If property rights are present (and respected), the next logical question for a society might be, “How should we determine the price of an item, and who should be involved in the process?” Although this is a seemingly trivial and innocuous question, it strikes at the heart of different political philosophies ranging from laissez faire capitalism to communism (and everything in between).

Surely it makes sense that an intricate, hand-woven sweater made of cotton that has been spun into yarn, dyed various colors through inks generated by finding and squeezing appropriate fruits and vegetables that have proven to generate such pigments, and finally woven into a wonderfully attractive pattern is worth more than a couple of leaves that have been picked up off the ground and stuck together with the sap of local, readily available trees, right? The intricate sweater has taken a great deal of time to construct, thereby embodying a great deal of labor. Such logic implies the leaf clothing is easier to make, and should therefore have a lower price. The earliest theories of price and value were based on calculations of the amount of labor that went into the good or service. This approach to thinking about prices dates back at least to Adam Smith, who wrote:

The real price of every thing, what every thing costs to the man who wants to acquire it, is the toil and trouble of acquiring it. What every thing is really worth to the man who has acquired it, and who wants to dispose of it or exchange it for something else, is the toil and trouble which it can save to himself, and which it can impose upon other people.¹²

Smith went on to further distinguish between “value in use” and “value in exchange,” noting the seeming paradox between the value of water and the value of a diamond:

Nothing is more useful than water, but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.¹³

It turns out that supply–demand dynamics do a reasonably good job of explaining this paradox. By focusing on the marginal value (i.e. what would one additional unit be worth?) of each good, it becomes easier to understand why each good is priced the way it is. How much would you consider paying for one additional cup of water in your life each year? Most people would not pay very much because, in most parts of the world, water is plentiful. In commenting on the water–diamond paradox presented in The Wealth of Nations, Nobel prize–winning economist Joseph Stiglitz noted, “water has a low price not because the total value of water is low—it is obviously high, since we could not live without it—but because the marginal value … is not very high.”¹⁴

There are two fundamentally different methods through which society can generate prices for its goods and services: market mechanisms through which supply-and-demand dynamics determine a price, or central planning in which prices are dictated by government bureaucrats. These two methods generate different perspectives on the role of prices in a society's allocation of scarce resources. The market-oriented approach to price determination is generally utilized in societies that seek to have prices guide investment and consumption decisions. The central planning approach has historically been used by societies in which the government guides prices in a quest to maintain social or economic stability.

Political Distortions of Property and Price

Political decisions regarding property rights and prices are at the foundation of a market's receptivity to boom and bust cycles. Without private property rights, the incentives to profit are less obvious, thereby tempering—if not eliminating—financial extremes. Just as the removal of property rights (think of Venezuela's nationalizations) dampens investor enthusiasm and decreases, if not eliminates, the likelihood of bubbles forming, the introduction of property rights where they previously did not exist (think of China's housing reform program of the late 1990s) creates a particularly fertile ground on which bubbles may grow. In many ways, private property rights are a measure of a society's willingness to allow successful investors and speculators to keep their winnings.

Modifying or constraining property rights through price ceilings and floors has a ripple-through effect on the market dynamics (i.e. supply and demand) that determine prices. As described previously through the example of minimum wages, price floors tend to keep prices artificially high and therefore incentivize supply and disincentivize demand. Likewise, price ceilings such as rent control tend to keep prices artificially low and incentivize demand and dis-incentivize supply. The result is that politically motivated or mandated price distortions usually exacerbate, rather than mitigate, the problems they seek to address.

It is easy to see how these policies can increase the likelihood of booms and busts occurring. Might consistent underinvestment due to price ceilings result in an eventual supply shortage that is too large to ignore? Could the genuine supply shortage create hoarding mentalities that further exacerbate the problem? How might prices react in such an environment? Likewise, might price floors drive overinvestment that generates excess supply? Might overproduction result in bloated inventory levels that will eventually become too large to ignore? What might happen to prices then?

Just as price ceilings and floors distort supply and demand drivers, so too do taxes have a confounding effect. By effectively subsidizing or penalizing particular consumption and investment behavior, taxes alter underlying demand or supply. One of the most well-known tax policies to do that is the mortgage-interest deduction in the United States. By effectively paying a portion of the interest owed on a mortgage, the U.S. government has lowered the cost of home ownership and increased demand for homes, a dynamic that has the potential to magnify booms (and therefore busts) in the housing market.

Tariffs and Trade Wars

A tariff is a type of tax applied to a specific category of goods that are traded between nations. In America, tariffs have been more like a historical novelty than a tool of modern policy, until recently.

Tariffs as we know them in the modern economy grew out of a nation's desire to protect its domestic industry. Colonial European powers used them to protect and support the domestic industry of the home countries. This policy made it more expensive for goods to be imported to the colonies, thereby protecting specific industries. In the case of the British American colonies, for instance, tariffs were levied by London on imports into the colonies of Caribbean sugar and molasses—because they were products of French and Spanish colonies. This helped ensure that British sugar companies had a profitable market for their production.

Later, the United States and other countries tended to use tariffs to protect growing domestic industries from foreign competition. One argument used to justify these tariffs is that they would eventually increase competition, once the domestic industry matured and the tariffs were removed. The result might be more jobs, lower prices, and better products for consumers. The problem with these “infant-industry” tariffs was their execution, as Austrian-American economist Gottfried Haberler described:

Nearly every industrial tariff was first imposed as an infant-industry tariff under the promise that in a few years, when the industry had grown sufficiently to face foreign competition, it would be removed. But, in fact, this moment never arrives. The interested parties are never willing to have the duty removed. Thus temporary infant-industry duties are transformed into permanent duties to preserve the industries they protect.²⁰

So why are tariffs harmful? They are another form of political intervention in the markets that inflate prices for some things and deflate them for others. Tariffs are inefficient in that they generally make things more expensive and misdirect resources that might be more productively deployed elsewhere.

Consider why we use specialists for all sorts of domestic projects. If you want a closet built in one of your rooms, it is very reasonable to expect that a carpenter could build a fine-looking functional closet with basic raw materials: a hammer, nails, lumber, sheetrock, and paint. However, unless you're a carpenter, you will have to make a financial trade-off at least indirectly of something of value to you. For instance, rather than studying carpentry, you might add skills to your own career that would in turn boost your earning power. Or perhaps you need to take time off from work, surrendering your income to build your closet. While you may pay a carpenter more in direct dollars to build a closet for you, it is likely cheaper if you include all the direct, indirect, and opportunity costs you would incur if you did the project yourself.

The same is true for countries, and the theory of comparative advantage helps explain how trade produces economic gains. In many ways, some countries have different strengths and capabilities than others, which means it's less expensive overall to have another country sell, for instance, coconuts into the United States than to undergo a large replanting of American farmlands to growing coconuts domestically. The land is likely more valuable being used for other desirable plantings that thrive in the U.S. climate and may sell for more per equivalent unit, such as oranges in Florida or almonds in California. David Ricardo articulated the principle of comparative advantage in 1817: every nation, however inefficient in its overall production structure, can always profitably export some goods to pay for its most desired imports.²¹

Not only do tariffs raise costs and curtail comparative advantage, but they also compound the problem by effectively levying a tax on a country's own citizens. They pay the tariff through the higher prices on the goods and services of the imported item, or they pay a higher price for a domestically produced item that is being protected by tariffs.

But cheapness of goods and services is in the extreme isn't beneficial for an economy, either. There is an inherent, if harder to quantify, value in providing jobs for a country's citizenry, even if that would mean higher costs for some items. This is the very argument that leads to trade wars, where one country's imposition of tariffs results in retaliatory tariffs, which in turn lead to successive rounds of escalation.

Tempting as it is to punish another country to protect domestic jobs, history has shown that tariffs and the trade wars they frequently spawn are on the whole destructive processes in which all parties lose. Consider the trade spat (which at the time of this writing appeared to escalating toward a trade war) between the United States and China, in which America imposed a tariff on steel and aluminum imports from China. The move was welcomed by domestic steelmakers but raised the prospect of shutting down companies that use imported metal by making them uncompetitive against those importing finished goods that competed with domestic production. Regardless of how this specific story plays out, the unintended complications and increased expense of grappling with tariff ramifications are clear.

A significant milestone in recognizing the negative impact of tariffs came about through the United States Tariff Act of 1930, known to everyone as the Smoot-Hawley act (after its sponsors). By imposing the highest tariffs in over 100 years to protect American industries suffering during the economic downturn of 1930, the Act led to a global trade war. The United States imposed taxes ranging from 40% to 100% on some goods. In turn, world trading partners imposed retaliatory tariffs on American goods.

The consensus today among economists is that the Smoot-Hawley tariffs were a significant contributor to the length of Great Depression, because world trade fell by about two-thirds from 1929 to 1933, as Table 4.2 shows. Since then, western economists have largely felt Smoot-Hawley was the capstone to the argument that tariffs do more harm than good.

As for the argument that tariffs protect jobs, a study²² by the London School of Economics of 38 years of trade and unemployment data from the 23 members of the Organization for Economic Cooperation and Development didn't find any statistical link between unemployment and imports or exports. More anecdotal evidence shows that over time, highly protectionist countries grow more slowly than more open economies. Argentina, for instance, had a higher per capita income in 1870 than Germany or Japan, but after highly protectionist policies it was well behind both a century later.

Economist David Gould wrote a paper on free trade when he was at the Dallas Federal Reserve Bank in the 1990s that points out that international trade is another way of moving economies to be more efficient. Even if we didn't have international trade or had tariffs so high as to effectively prevent trade, our economy would still face upheavals as new industries replaced old ones.²³

In a capitalist society, progress entails what Joseph Schumpeter called “creative destruction.” Fundamentally, new job opportunities destroy old job opportunities. Jobs in the automobile and airline industries, for example, destroyed jobs in the railroad industry.

In the next chapter, we turn to biology as a lens through which we might gain some insights for our study of booms and busts. Two biologically inspired constructs are emphasized as specifically helpful: the use of an epidemic lens to understand a boom's relative maturity, and the application of an emergence lens to comprehend the processes through which uninformed individuals might form a consensus.