The Answer Is Transaction Costs

Slavery, Indentured Servitude, and the Problem of Financing Education

• Michael Munger

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Not everyone realizes that the modern financial system has enabled us to end historical practices such as indentured servitude and apprenticeship.  This episode uncovers how financial systems tackled market failures and transaction costs, drawing on insights from Jeffrey Hodgson's "The Wealth of a Nation: Institutional Foundations of English Capitalism." We'll explore the evolution of borrowing against future earnings and how modern financial institutions have streamlined processes that once resembled slavery, fostering the growth of capitalism.

We'll then shift gears to examine Glenn Lowry's groundbreaking views on educational investment, discussed in his book "Late Admissions" and echoed in his 1981 Econometrica paper. Lowry's exploration of intergenerational transfers and parental investments in education reveals significant inefficiencies in the current system, drawing parallels with Michael Hudson's analysis of financial markets. The conversation sheds light on the untapped potential of underprivileged children and the need for better financial instruments to optimize educational funding.

If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !


You can follow Mike Munger on Twitter at @mungowitz


Speaker 1:

This is Mike Munger, the knower of important things from Duke University. Two explanations market failure or transaction costs. The problem borrowing against future earnings to acquire the capital necessary to create those earnings in the first place. Two recent books that make this point, but in different ways A New Twedge, plus this week's letters and more Straight out of Creedmoor. This is Tidy C. I thought they'd talk about a system where there were no transaction costs. It's an imaginary system. There always are transaction costs. When it is costly to transact, institutions matter and it is costly to transact, institutions matter and it is costly to transact. Instead of a book of the week, I wanted to make a new book my main focus for the podcast. The book is the Wealth of a Nation Institutional Foundations of English Capitalism by Jeffrey Hodson. It's from Princeton University Press and it was published this year.

Speaker 1:

There's a fundamental chicken and egg problem with wealth. If I could borrow money against my future earnings, I could put together the capital or resources that I would need to increase those earnings substantially. But there are transaction cost problems, specifically problems of triangulation, transfer and trust. I have to find someone who is willing to invest in my future. Since I don't have the resource to do it, I'm going to have to borrow it. Transfer will actually have to make the payment. We'll have to make arrangements for repayment. We'll have to negotiate the contract and the rate at which the resources are going to be transferred and borrowed. And then, third, trust. Since the money is going to be, the resources are going to be transferred, I'm pretty sure that I'm receiving the actual resources. But the problem is that the person who is giving me the resources to increase my productivity can't be sure that I'm going to pay them back.

Speaker 1:

There are many examples of this. Suppose I'm in Liverpool, england, or in Amsterdam. Now, if I could make it to Virginia or New York, I could earn a much higher wage, maybe buy land and become wealthy. The reason is that land in the new world was cheap. Even close to free Labor was very expensive. If I can leave Liverpool or Amsterdam on a ship, I can fairly quickly make enough money to pay for the cost of the voyage. But that's backwards. I have to pay for the voyage before I can get this big increment to my earnings. So I'm stuck. Now, on the other hand, suppose I'm already in Boston. I'm good at working with my earnings, so I'm stuck. Now, on the other hand suppose I'm already in Boston I'm good at working with my hands. I'd like to pay a silversmith to teach me to work with fine metal. Once I'm a silversmith, once I've acquired the knowledge and education, I can make a very good living. But right now I don't have any money. There's no way to borrow against my future earnings to pay for that education Now.

Speaker 1:

You can think of thousands of more modern examples like this. Generally, the solution to the first problem, in the 17th century at least, was indentured servitude, the second, apprenticeship. But what if it were possible to make loans? Notice that indentured servitude and apprenticeship both smack of slavery, though of course they're voluntary. Real slavery is theft. It's entirely different. But there are elements for indentured servants and for apprentices that help solve the transaction cost problem.

Speaker 1:

The difficulty is that, like slavery and it's only like slavery in this one respect, if I'm an indentured servant or an apprentice, I can't back out, I can't quit, except for very specific and limited circumstances of abuse. For the most part I am required to carry out the tasks that my boss, who owns my labor, requires me to do. So. Indentured servants and apprentices worked for very little to pay off their loan and they lived in abject poverty, to make the period of repayment as short as possible. So the reason I wanted to start in 1680 was because, for the most part, that was before there came to be a more general solution to this problem, which is a financial system. Whereas I can borrow the money from financial intermediaries, rather than having the transaction be essentially barter, where I offer my labor in exchange for the money that provides me with either an education or passage on a ship, if I can borrow the money and repay the money, that's much more efficient. And I don't have to be a slave. If I borrow against future earnings. I don't have to be a silversmith. I can have a startup, in fact, that makes thousands of silver items using machines. So financial system is the beginning of capitalism. That's the central claim of Hodgson's book. Capitalism originated from the solving of the chicken-egg problem of creating something out of nothing so you could make enough money to pay back the loan and lots more besides. There's a great review in Reason Magazine by the estimable Stephen Davies on the Hodgson book.

Speaker 1:

Hodgson criticizes the definition of capital that's used by a great majority of economists and historians, though I should note that's not the definition of capital that we use here. On Tidy C, my definition is much closer to that used by Hudson, but for most people capitalism is a word that means physical goods used to produce other goods or services. That is, it is the use of machinery or capital to produce goods or services. Hudson argues, and I agree, that capitalism properly refers to the purchasing power that's used to acquire those goods, whether as cash or as credit. I have several times defined capitalism as resting on the concept of liquidity. That is, it is possible to have resources that take the form of liquid value that can then be turned into physical production capacity. But it's the liquidity that is the characteristic of capitalism, not the physical tools and things themselves. That may seem like a subtle distinction, but it makes a big difference. It means that finance and liquidity and the institutions that govern and broker those things, that is, getting loans, being able to have loans repaid at relatively low transactions costs that is the essential feature and starting point of capitalism. Markets and wealth are about physical things, but capital is about financial wealth and liquidity. This makes finance and financial institutions central to capitalism. It also makes capitalism historically unique. It's a modern phenomenon that is distinct from the different sorts of market and property relations that have existed in civilizations throughout history. There's a long history of trade, of markets. That's not capitalism.

Speaker 1:

In Hodgson's account, the critical shift stemmed from legal institutional changes, including the financial institution, really in the Netherlands and in England in the 1690s, that made it possible to access more capital and to create it from nothing. In effect, we're creating the power to create things and we're doing it from nothing because we're borrowing against those future earnings. So it's not permanently nothing, but it's nothing right now. And that sleight of hand, that kind of financial ledger domain, is both the most important and the most dangerous feature of capitalism. The central innovation was the amendment of land title law and enforcement to enable far more mortgage finance. So the advantage of a secured loan is that I can use the value that is right now trapped in a large piece of land and borrow against it, and then that means that I can in effect commodify the value of this asset, turn it into liquid capital, which I can then direct at new investment opportunities.

Speaker 1:

The main process, which took a long time to take hold and is actually not fully complete we're still working out the details was the replacement of older feudal forms and rules of tenure by more straightforward title, and so Hernando de Soto's book about capital in Latin American countries, particularly in Peru. The problem is that people don't have straightforward title. They can't borrow against it. It's value that people don't have straightforward title. They can't borrow against it. It's value, but it's not financial value. It can't be turned into financial value.

Speaker 1:

Now, these shifts did not just make the pooling and collection of capital easier. They made it possible to bring credit from the future into the present. You could secure credit against the income that's going to flow from future production, so that you can mobilize resources to create that production in the first place and then use the eventual income to service and liquidate the credit. Hudson argues that growth was held back by a shortage of capital until the middle of the 19th century. That was at the point when the financial system was sufficiently advanced where things really took off.

Speaker 1:

All this reminds me of an earlier book of the week that I mentioned several weeks ago, by Brown University economist Glenn Lowry. That book was Late Admissions. I talked about it a couple of weeks ago but, interestingly, in some ways Lowry is writing about the same problem that Hudson is. With a fascinating twist, there's an interview with Glenn Lowry done by Nick Gillespie also in this past month's Reason magazine. Nick Gillespie asked Professor Lowry about his Lowry's favorite publication and what Glenn said was, and I'm quoting I think my best technical paper was published in Econometrica in 1981.

Speaker 1:

It's called Intergenerational Transfers and the Distribution of Earnings. It applied what at the time were state-of-the-art technical methods in dynamic optimization and the behavior of dynamic, stochastic systems to the problem of inequality. It formalized the idea that young people depend on the resources available to their parents in part to realize their productive potential as workers and economic agents. Investments made early in life by parents in children affect the productivity of children later in life. That productivity is also dependent on other factors beyond parental control that are random, but it depends on the resources that are available.

Speaker 1:

There cannot be perfect markets to allow for borrowing forward against future earnings potential so as to realize the investment possibilities. If a parent doesn't have the resources to fund the investment themselves, there's no place to go to borrow to get piano lessons for a kid who might develop into a virtuoso pianist. As a consequence, inequality has resource allocation consequences. Some parents have a lot of resources, others have very little, but kids all have comparable potential, let's suppose, and there's diminishing returns to investing in kids. The net result is that if you could move money from rich parents to poor parents and indirectly move investment in kids from rich parent families to poor families, the loss in the former would outweigh the gain in the latter End of quote.

Speaker 1:

Let's be careful, he's not advocating redistribution. He's making a very clever argument, and that is at the margin. After I've invested hundreds of thousands of dollars in the education of my own children, the marginal impact of an additional 10 or even an additional $100,000 is not very high, whereas the impact of the first investment of $100,000 in the education of a child who has no access to being able to go to college is going to be much larger. Now, what's interesting about this is that it's actually a brilliant argument about transaction costs. It turns the earlier claim that we made about inability to borrow on its head. So again, suppose I've already invested hundreds of thousands of dollars in educating my child. At the margin, the returns to further investment may still be positive, but they're small.

Speaker 1:

Suppose that I could invest even $10,000 in someone who wants to go to college but can't afford it. The return is likely much higher. That is the increment to their future lifetime income is going to be much higher. It's going to be greater for the first $10,000 invested than the last $10,000 that I spend on my already over-educated child. But triangulation, transfer and trust I have no way of finding such a person. It's hard to make the payment and I can't trust that I will be repaid out of the increment to future earnings. So, whereas for Hodgson we were saying there was no way to borrow, the problem with education is there's no way to invest. There is no way for me to take the money that would produce a high return for this person that I don't know, but who is very smart and has no access to college.

Speaker 1:

Suppose that I could invest in that there was some kind of financial instrument that would allow me to buy a share in their future earnings. They would be happy to accept this because that would mean they'd be able to go to college. Financial instruments such as stocks are a means of giving people reliable and convenient ways of buying shares in company. Why can't we buy shares in educating young people? Well, the answer is transaction costs, and so what we have is a sort of dumb second best solution and second best is not very good instead of being able to buy shares, which then would increase in value and give people an incentive to seek out the smartest, most qualified people that right now are not able to go to college.

Speaker 1:

We make loans. We have centrally planned subsidized student loans. That's actually quite different, because it means that the desire to pay back loans is not very high. There's going to be political incentives for political demagogues to say we will forgive your loan obligations. Well, if we are saying education is free, that's a very different thing. People who get to get an education for free are not necessarily trying to get an increment to their future earnings, it's just recreation. So the interesting thing about these two books and what I thought was the interesting parallel was that Hudson is saying that without financial markets, it is difficult to be able to borrow against future earnings. The creation of a capital system that allowed a firehose of liquidity to be directed at investment opportunities, which came to be perfected somewhere around the middle of the 19th century, caused an enormous increase in growth.

Speaker 1:

What's interesting about Lowry's argument is that it suggests the absence of a market. It's a market failure. Suggest the absence of a market it's a market failure. I am unable to invest in people for whom my money, my resources, would be the highest valued use in terms of the increase in their earning power and productivity, because we can't buy shares in people. Notice that this is slavery of the same sort that indentured servitude might be, but it's one that would operate at much lower transaction costs. What we do instead is kind of dumb, which is to make loans, thereby, in effect, simply subsidizing the demand for college and forcing the tuition costs constantly to go up. And so if we had some way of investing in shares rather than making loans, that would solve Lowry's problem, and Lowry's statement of the problem is actually quite interesting, so I recommend the interview in Reason Magazine. Whoa, that sound means it's time for the twedge.

Speaker 1:

This week's economics joke. I looked around in quite a bit of Twitter from 2022 about student loans and found one where apparently a 25-year-old person tweeted this the student loan company keeps sliding back into my DMs after two years. Baby, we broke up. Stop embarrassing yourself. Well, it's a nice parody. We didn't actually break up. You still have a loan obligation. You signed a contract, you took the money, but it is kind of funny that for a while, we didn't hear very much. The loan companies ghosted us, and now they're trying to get back together. So the analogy to a broken relationship I thought was kind of funny.

Speaker 1:

It's time for letters. I have several letters this week catching up on past letters. First, what about the transaction cost of transaction, that is, credit card fees versus cash only and loss or mistakes from the cashier? I know that there's always some mistakes. With cash Plus it's easier to steal them. How does that compare to credit cards? Or is it theft? It's protecting from C from Montana. End of letter.

Speaker 1:

Well, as I'm sure you already know, the answer is going to be transaction cost. It's really a two-part answer. First, the comparison is going to determine whether a business accepts cash, charges a fee for using a credit card, does both. So there's quite a range of different arrangements and what's interesting about that is that the differences must depend on transaction cost, literally on the cost of transactions. Second, this can change over time quite a bit. Now, economists actually don't know much about this because it's a very applied and granular problem. But if you talk to someone in retail sales, they'll be able to say something about the change over time in the transaction cost of transactions. So C thanks very much, that's a good question.

Speaker 1:

Letter two as you likely guessed, I'm writing in response to your recent episode on bees, oranges and externalities. I thought the movie Die Hard was going to be your money ball in terms of catching your attention. Now the connection is that the original Die Hard movie was the bad guy. Hans, my colleague and I have been debating the best offer in terms of an overseas client who is not accepting our demand of full cash payment up front. It's a classic example of your three Ts.

Speaker 1:

In practice, there is no governing body which can enforce either party's property rights once possession is exchanged or even when it's in process, so the typical market solution is a letter of credit issued by the buyer's bank. Party's property rights once possession is exchanged or even when it's in process. So the typical market solution is a letter of credit issued by the buyer's bank. In short, I, the seller, do not have faith in the buyer due to our lack of transaction history presumably triangulation and likewise the buyer has no recourse if the fertilizer they wish to purchase ends up being snake oil. Enter the banking institution, which has a solid reputation, on which my trust will lie and which will transfer ownership of the fertilizer. Now my bank also plays a minor role, for a lesser fee for me in greasing the wheels of the monetary transfer mechanism.

Speaker 1:

It is potentially true that the buyer's bank may be more vested in the specifics of the transaction or the business of the buyer in general and therefore negate some of the anonymity that your author suggested, but that doesn't seem realistic. Why or how would the bank ignorantly issue a bearer bond to the buyer when it wouldn't do that for any other sort of credit? The point being, transaction costs of letter of credit are high, or more specifically, those of international trade in general. So the example that you gave as hypothetical is something that happens all the time. Kind regards HD. Sturgeon Bay, wisconsin. End of letter. That's great, hd, thank you. I blame the letter writer from last week, rl. Now, of course that was actually Robert Lawson from SMU. And yes, bob, I'm totally throwing you under the bus. Just deal with it. Hd's calling you out. Man, that happens all the time. What kind of economics professor are you? Great letter, though. I have nothing to add except that Bob Lawson's a total loser. Letter three I loved your recent episode regarding parking norms at Wrightsville Beach.

Speaker 1:

I grew up on Salisbury Street, the street where Johnny Mercer's pier is located. My family owned the Palm Room and Raw Bar restaurant, now the Shark Bar. Not only did I watch people trying to get a parking spot, I did so with quite a smug feeling, knowing that I had my own parking spot with full rights to use all the time, unless my dad was mad at me and then withdrew parking and car rights. In fact, I suspect that a number of my friends in high school only hung out with me to acquire temporary rights to the parking spot that my family had at our house. The interesting thing that I really remember was my father, a business owner, complaining about the lack of parking because the people using the parking spots in front of his business were not coming to his business. It was a bar, mostly for college kids and people adjacent to college kids. Plus, it was a dinner owner only restaurant, so it changed in the evening. I also remember that the congestion you mentioned forced me to not drive in the summer but only to ride my bike. He, however, my father, never approached the city about permanently leasing a section of the parking, even though he thought that the lack of parking decreased his business. I wonder how much less than the daily rate the city would have taken to lease him 10 parking spots for the year, thereby generating revenue in the off-season, and then offload their transactions cost of enforcing the property rights from them to him. And I don't recall the city or any other business discussed leasing the public parking. There almost certainly would have been a public outcry.

Speaker 1:

Challenge is scarce resource allocation with significant seasonal volatility. Why does the city only use meters and not have some other pricing mechanism that would allow businesses and perhaps locals with guests with too many cars to bid for longer term use of the space? Why not auction the spaces over the web at the beginning of each day and cut down congestion? The answer, I suspect, is transaction costs, end of letter. Well, that's a very Coasean solution to buy the parking spots. That's a very Coasean solution to buy the parking spots. It would be interesting if it were possible for restaurants to lease parking spots and then resell them only to people that were going to use the restaurants, like they would validate the parking. For other people they would charge a much, much higher rate.

Speaker 1:

Why is it that cities operate parking themselves rather than leasing parking to others? I think the problem is that the city wants people to come to the beach, where business owners want people already at the beach to patronize their business. So that's the difference. The city is operating those parking lots to try to get people to come for long-term, to come to the beach. Business owners, once people are already at the beach, would like them to have convenience, that is, lower transaction costs, access to the business itself, and so the city and business owners want different things.

Speaker 1:

The city certainly could auction off specific parking spots and have reservations. They could charge $40 for a day. The rate right now is $30 a day for the premium lots. They could charge $40 a day and have a reserved spot, which would mean I could show up at 10 am and still get a spot in the L-shaped lot. Now, the L-shaped lot is the biggest lot at Wrightsville Beach and it's really kind of a two-part tariff.

Speaker 1:

As I talked about in the previous episode. It's first come, first served, as a kind of license to be able to pay the $30 a day. They could set aside some parking spots and charge $40, $50, $100 per day. You could reserve them and pay for them in advance, but you wouldn't have to be there at 8.30 in order to get the parking spot. So it wouldn't have to be many. But if you could charge $100 a day and have most of those spots filled, let's say nine of the 10 that you've set aside, that's $900 revenue compared to $300 revenue from having them all full at the thirty dollars rate. So even if only nine out of ten are taken at the hundred dollar rate, you're going to be way ahead.

Speaker 1:

So, uh, I think the answer might be that people are resentful of not having a sort of egalitarian first come, first serve solution. Uh, I'm interested. Somebody may know are there any beaches that you know that have premium reserved spaces that you can pay for in advance and then come and go as you please, where you have a specific license that authorizes you to use that parking space, and you could leave during the day, go to lunch and come back because that parking space is yours. You could charge a whole lot more for that privilege and it wouldn't have to be the whole parking lot. It could be a small number, but it would increase your revenue quite a bit. Well, again, thanks for the letter. The next episode will be released on Tuesday, july 30th. We'll have a new topic, some letters and, of course, a new hilarious twedge. All that and more next week on Tidy C.