Some Quick Thoughts

Since I don’t have time right now to sit down and put together anything too in depth, here is a list of news items and my brief commentary.

This kid is a hero. He seems to do reasonably well in school, and clearly has his priorities straight. So he refused to waste his time on a dumb test, and made a mockery of the whole process. Such an afront to the education system can’t be tolerated, so he was punished by being forced to go to school.

Saudi Arabia, home to arguably one of the most repressive states, is the model upon which the GOP would like to build the U.S.

“By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s,” said (who else?) Paul Krugman in 1998. (Via LFB.) Three years later he would imply the Federal Reserve should fix the economy by inflating a real estate bubble, so….

 

Rothbard Teaches Austrian Business Cycle Theory

In today’s work from Robert Wenzel’s 30 day reading list, “Economic Depressions: Their Cause and Cure,” Murray Rothbard explains the business cycle. He first provides a critique of the “New Economics,” or Keynesian understanding of the boom-and-bust cycle, and then presents the Austrian Business Cycle Theory (ABCT).

Rothbard presents three fundamental flaws in the Keynesian viewpoint, which fails to accurately pinpoint the real cause of economic depressions. They are as follows:

1. “[T]here is nothing in the general theory of the market system that would account for regular and recurring boom-and-bust phases of the business cycle.”

He explains that most Keynesian economists separate their theories for how prices form and how the market functions into one theory and in a separate theory explain business cycles. This allows them to hold contradictory views regarding how the economy functions and what should be done to relieve depressions, recessions, and downturns. The Austrian however understands that “knowledge of the economy is either one integrated whole or it is nothing.”

2. “The market economy […] contains a built-in mechanism, a kind of natural selection, that ensures the survival and the flourishing of the superior forecaster and the weeding-out of the inferior ones.”

In other words, the market economy relies on the profit and loss test and in order to survive, firms must endure this constantly to remain in business. What allows them to survive is successfully forecasting the needs and wants of consumers and being able to provide the goods and services that are in demand at the appropriate time. Since many firms do manage to accomplish this, it seems odd that from time to time all or most of these profitable firms find themselves on the verge of bankruptcy at roughly the same time.

Keynesians don’t have a sufficient answer for this, since their typical explanation is a lack of aggregate demand, or under consumption. But a lack of aggregate demand shouldn’t lead to such devastating losses in a group of the best entrepreneurs, and especially not in such a systematic fashion. Something else must account for this phenomenon.

3. “Invariably, the booms and busts are much more intense and severe in the ‘capital goods industries…’”

If under consumption were to blame for the depressions, it follows that the producers of consumers’ goods would be the first and hardest hit, rather than those making higher order goods, which are the ones used to produce final goods. But, just the opposite happens. Rothbard asks if “insufficient spending is the culprit, then how is it that retail sales are the last and the least to fall in any depression, and that depression really hits such industries as machine tools, capital equipment, construction, and raw materials?”

He also notes that it is these industries which see the highest growth in investment during the boom phase of the cycle. Consider the last two major credit bubbles: the bubble in tech stocks a decade ago and the one in housing shortly after. Both bubbles were in industries that supplied capital goods – web space (capital equipment) in the former, and construction in the latter.

Before moving into the ABCT, Rothbard briefly explains fractional reserve banking, and how together with a central bank, the two set the stage for boom-and-bust cycles. He provides an example using a hypothetical credit bubble induced by inflation of the money supply, followed by a contraction and ultimately a bank run.

In essence, banks hold currency (generally gold and silver) and issue paper notes as claims on that currency. The notes can then be used to redeem the specie on demand, but often are used as money in everyday transactions. Banks then issue loans with the deposited funds to investors or consumers, such that more claims to gold or silver are in circulation than actually exist in the bank.

This all works so long as depositors trust that their money is secure in the bank and can still be redeemed. Meanwhile, the increase in available credit and demand deposits (which is inflation) bids up prices and leads to bubbles. Eventually the banks must contract the amount of money in circulation or risk a run; either case amounts to a deflating of the bubble and the bust phase of the cycle begins. Once the bust levels out and banks are comfortable again, the process resumes.

Rothbard is careful to note that such an arrangement as above is not the product of a free market. For all of the banks to inflate as they do in unison, there must be a central bank and government regulations that permit it. He also notes that it was “only when central banking got established that the banks were able to expand for any length of time and the familiar business cycle got underway in the modern world.” So rather than a structural failure in the market economy being the cause, it is the “systematic intervention by government in the market process” that leads to the boom and bust.

And here is where Rothbard introduces and details Ludwig von Mises’ Austrian Business Cycle Theory. Its foundations are in David Ricardo’s observation of the increase in money supply and credit leading to an inflationary boom. But Mises expanded on that analysis and noted that another effect was the lowering of interest rates below their “free market level.” This lowering of rates induces investment in capital goods in anticipation of a higher future demand that is, in reality, nonexistent.

This entire process can take years to manifest itself, all the while the boom persists for years, building slowly into a massive bubble. As long as the banks continue to inflate and the credit keeps coming the bubble will continue and prices will continue to rise as a result of the inflation. But once the inflation slows it all comes crashing down. The classic analogy is of a man who drank too much the night before and has the choice between a hangover and continued drinking. One is immediately painful but short-lived, while the other merely prolongs the ultimate consequence, and only makes things worse in the end.

So we see that Mises’ theory addresses each of the above problems that Keynesian economists fail to answer. The business cycle occurs regularly due to fractional reserve banking enabled by central banks; the natural selection of the market is interrupted and distorted by the manipulation of credit, and entrepreneurs are deceived as to the realities of consumer demand; and the capital goods industries take the brunt of the depressions because lower interest rates induce those firms to invest in new capital more so than in other sectors of the economy.

Lastly, Rothbard gives advice on what should be done to relieve current booms and prevent future busts. His recommendations are: immediately stop inflating, for this is what brings on the cycle and allows bubbles to expand; do not bailout faltering businesses because it prolongs and worsens the depression by propping up failed ventures; do not prop up wages or prices, don’t spur consumer spending and reduce government expenditures. In short, do nothing but allow the market to re-equilibrate.

Basically governments should do exactly the opposite of what has been done for the past four years. Interest rates have been lowered to practically zero through inflation; consumers have been incentivized to buy cars, houses, refrigerators, replacement windows and a whole host of other products; banks, insurers, car manufacturers, energy companies, and entire countries have been bailed out; minimum wage laws have increased, new insurance mandates have been implemented, and government spending has never been higher. And yet, little has really improved.

Mises predicted the crash of 1929 years before it happened, as did a number of Austrians in the years preceding the housing crash, notably congressman Ron Paul. In fact, Austrian economists have a pretty good track record in warning about problems in the economy. It’s high time more people started listening to their warnings and quit paying any attention to the Keynesians who’ve not only been clueless as to the cause of all this malaise, but are promoting the very policies which lead to and prolong depressions.

On that Paul Debate

Robert Wenzel, over at his EconomicPolicyJournal, quotes Tyler Cowen of George Mason University on the ‘Paul vs. Paul’ debate yesterday on Bloomberg TV: “Still, given that Krugman is a Nobel Laureate in economics, and Paul a gynecologist, the score could have been more lopsided than in fact it was.”

All the back and forth about who won the “debate” aside, just think about this for a second: One of these two is an Ivy League university professor and Nobel Laureate; the other is a medical doctor by profession, who’s been a standing member of congress for almost thirty years of his life, and is a self-taught, amateur economist. The fact that anyone is arguing over who did better is a testament to how much a lightweight Krugman is, and how formidable Paul is, in this field.

Another reader at EPJ had this to say regarding the difference between the professions:

There is definitely a difference when it comes to PhDs in ob/gyn and econ. No ob/gyn would try to mandate that all women give birth to 7.2 lb babies on the 300th day of their pregnancy. They at least recognize that every individual has preferences and unique traits that can only be determined on an individual basis. Econ PhDs seem to think they can formulate an algorithm for the cost of money that will work perfectly when applied universally. Hey, maybe we need an ob/gyn running monetary policy.

Salerno on Deflation

The other day Professor Joseph Salerno wrote at The Circle Bastiat about China’s recent brush with price inflation. He referred to a story on CNNMoney that described inflation as the “price of prosperity,” much like Krugman last week calling for inflation to resolve unemployment. But of course, “this is utter nonsense,” as Salerno explains:

[This is] one of the most deeply entrenched myths in both academic economics and media commentary. Basic economic theory demonstrates that ‘economic growth,’ which is nothing but an increase in the supplies of various goods and services, is in and of itself deflationary. An increase in the supply of any good (or service), with the supply of money and all other factors fixed, results in a fall in its price and a growth in its sales, as the excess supply of the good drives the equilibrium price down and expands the quantity demanded. This irrefutable economic truth has been illustrated time and again since the late 1970s by sharp declines in the prices of items like personal computers, video game systems, HDTVs, digital cameras, and cell phones and of (uninsured) medical procedures like Lasik eye surgery and cosmetic surgery. Furthermore, this fall in prices has not caused stagnation in these industries but has instead coincided with their rapid expansion. I have explained this phenomenon of ‘growth deflation’ in more depth elsewhere. 

Krugman and ‘The Lesson’

Updated below

Paul Krugman published this column in the New York Times yesterday, in which he chastises the Right for being so hard on The Ben Bernank. While the right has become critical of the Fed (thanks to Ron Paul), Krugman says that our problems stem from too little action from the central bank. Instead of fretting over the prospect of inflation, we should be concerned that not enough inflation is taking place.

Krugman is dreadfully wrong on his prescription here. He argues that because a lot of businesses are loaded down with large amounts of debt, “modest inflation” would relieve that by “eroding the real value of that debt.”

First, this assumes that all or most of these businesses will receive newly-printed money before prices rise, thus allowing them to pay down their debt with a devalued currency. If not, the alternative would be that, on top of the still-burdensome debt, prices for producers’ goods would rise, thus compounding the problem further. The fact is, new money is never spread evenly, as Henry Hazlitt describes in Chapter 22 of Economics in One Lesson. He uses an example of military expenditures paid for with inflated currency.

Let us call the war contractors and their employees group A, and those from whom they directly buy their added goods and services group B. Group B, as a result of higher sales and prices, will now in turn buy more goods and services from a still further group, C. Group C in turn will be able to raise its prices and will have more income to spend on group D, and so on, until the rise in prices and money incomes has covered virtually the whole nation.

This of course takes time, thereby adversely impacting each successive group, as prices rise before they receive higher wages.

The only way to avoid such an outcome would be to give new money directly to these indebted firms. This is in effect, a bailout. The moral hazard of such a policy would be devastating, and would only incentivize businesses to pile on debt, implicitly knowing they would be covered should they be unable to pay it off.

Second, this rosy scenario presupposes that on net, the economy will be better off with higher prices overall, even if firms have little to no debt. However, if debt were no problem for some businesses, but the money bought less for everyone, I doubt such an economy would be all that robust.

Third, the other part ignored in this is the impact on the credit markets. Inflation tends to benefit borrowers to the harm of lenders, because the notes are repaid with a debauched currency. If we weren’t living in a time of excessive credit spurred on by the Fed it would be wholly immoral to debase the currency in order to benefit some heavily indebted corporations. Given that we don’t have a free market currency or interest rate this I suppose is less dubious, but it’s no less devastating to the poor and anyone on a fixed income.

It doesn’t end there, however. Krugman continues:

Meanwhile, other parts of the private sector (like much of corporate America) are sitting on large hoards of cash; the prospect of moderate inflation would make letting the cash just sit there less attractive, acting as a spur to investment — again, helping to promote overall recovery.

What isn’t considered in this statement is why firms are hoarding cash. If these corporations are already leery of inflation, and are sitting on cash in the event that prices rise, inflation isn’t likely to drive them to spend this money. Instead, such firms, and likely others with them, will only hold cash in greater quantities.

But even if they would be motivated to invest their reserves, this still assumes, as with the above critique, that inflating the currency will be a net benefit to the whole of the economy. In the event these cash-heavy firms started spending their billions, prices would be driven up even further. It isn’t clear prima facie that having newly employed workers will necessarily be a benefit if everyone is stuck paying higher prices.

In his analysis, Krugman shows himself to be the bad economist Hazlitt describes in the opening chapter of his primer:

The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences. The bad economist sees only what the effect of a given policy has been or will be on one particular group; the good economist inquires also what the effect of the policy will be on all groups.

Update:

One of the more inane comments I’ve read online in recent times was posted in Krugman’s column. Doug wrote; “Dr. Krugman it would also be instructive to mention why the right pursues anti-inflationary policies, and why so much of our fiscal policy is directed toward that end – rich people hate inflation.”

For all the supposed “anti-inflationary policies” this guy thinks are being floated out there by the Right, there haven’t been any in the US for decades. Couple that with the fact our two most prolific inflators in American history were nominated by GOP presidents. Alan Greenspan, who orchestrated both credit-induced bubbles of the Tech and housing markets, was nominated by Ronald Reagan, George H.W. Bush, and George W. Bush. The Ben Bernank, who has overseen TARP, QE II, and Operation Twist, was nominated by George W. Bush.

The second part of this absurd claim is that “rich people hate inflation.” As if the poor would love rising prices!

In the first half of last year, Americans spent almost 8 percent of their monthly income on gasoline. Contrast this with a “rich” person; let’s say someone who earns a million bucks a year, who would pay only a fraction of one percent of their income at the pump. Gas prices would only have to rise modestly for it to drastically affect the poor or middle class. However, fuel could increase five or ten fold before our “rich” person would likely even notice. Does Doug really think people like Mitt Romney and George Soros care whether gas is $3 or $30 a gallon?