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Discovering Markets

Mises Institute - Wed, 20/05/2020 - 21:15

Abstract: This paper extends subjective expectations theory to form a new approach called the discovering markets hypothesis (DMH). Market participants form expectations on the basis of subjective knowledge and communicate with each other through narratives to improve their understanding of factual information before acting in markets. Thus, market prices are shaped by the subjective interpretation of emerging facts and shared narratives. To understand how new narratives replace existing ones, we refer to the theory of scientific revolutions. Winning narratives shape market prices until their victory is confirmed by the facts or they are discredited by facts and replaced by new narratives.

JEL Classification: B53, D84, E71

Marius Kleinheyer (marius.kleinheyer@fvsag.com) is a research analyst at the Flossbach von Storch Research Institute in Köln, Germany and PhD candidate at the University Rey Juan Carlos, Madrid. Thomas Mayer (thomas.mayer@fvsag.com) is the founding director of the Flossbach von Storch Research Institute and honorary professor at the Universität Witten-Herdecke.

INTRODUCTION

Prices fluctuate, and especially in financial markets, where they are heavily influenced by expectations of the future. Some economists have explained price fluctuations with the myopia of market participants. For instance, bid and ask prices are based on prices observed in the past, and when supply and demand do not match, prices are adjusted. Other economists have replaced myopia with perfect foresight in their models. According to them, all market participants always have all the necessary information to agree on a price equating supply to demand so that prices change only when they receive new information. However, actual price behavior is neither consistent with complete myopia nor perfect foresight among market participants. Sometimes, prices move as if market participants were myopic, sometimes as if they were forward looking. This has prompted another theory, according to which price fluctuations reflect market participants’ collective oscillation between rational and irrational behavior.

This paper argues that there is a better way to explain price fluctuations in financial markets. Market participants form their price expectations on the basis of information that they collect and interpret with their individual skills and knowledge of economic relations. They act in the market or communicate with others through narratives to improve their understanding of their factual information before acting. Thus, market prices are shaped by the subjective interpretation of emerging facts and shared narratives. The resulting price movements in return influence narratives and the subjective interpretation of facts.

First, the theories of adaptive and rational expectations and the concept of adaptive markets will be discussed. These theories will then be connected to the theory of subjective expectations and an extension to the latter suggested, the discovering markets hypothesis (DMH). Empirical evidence is presented to support this approach, and finally, its utility in making predictions.

OBJECTIVE THEORIES OF EXPECTATIONS

Economist John Hicks took issue with the idea put forward by Léon Walras that transactions take place at prices where demand is equal to supply. Since traders generally could not know what would be supplied and demanded at certain prices, they could only guess. Hence, Hicks (1939) argued, transactions would generally occur at prices which did not equate supply and demand. Following Hicks, we could describe the market as a mechanism that matches expectations and prices, but not necessarily potential supply and demand.

John Maynard Keynes raised the question of how expectations about the future are formed. Where they could, people would rationally calculate subjective probabilities for different outcomes and choose the most likely. But they would also often fall back on whim, sentiment, or chance. The latter was especially the case in capital markets, where participants were driven by “animal spirits.” There, it was often necessary to forecast “what average opinion expects average opinion to be” (Keynes 1936). Keynes left the formalization of his macroeconomic expectations theory to his disciples, which often led to a mechanistic reduction of his arguments. An example of this is the theory of adaptive expectations.

In the adaptive expectations model an expected market price depends on the expected price of the previous period and an “error correction” term that is given as a fraction of the difference between the expected and the actual price in the previous period. This model is not only intuitively appealing but benefits also from the advantage that expected prices can be expressed as a weighted average of past prices. Given its user friendliness the adaptive expectations theory has been built into many macroeconomic models and has been used by many econometricians. However, even its most enthusiastic users have had to admit that it describes the formation of expectations in a very mechanical way that falls far short of Keynes’s more sophisticated view (see also Gertchev 2007).

In the early 1960s, the US economist John Muth contradicted the theory of adaptive expectations. He argued that the expectations of economic agents were nothing more than predictions, which could be made with the appropriate economic theory (Muth 1961). In the formation of rational expectations only the future counted, which would be fathomed with the help of economics. If people used all available information efficiently and knew how the economy really worked, then realized prices would differ from expected prices only as a result of random influences. And if the expected value of random influences were zero, market prices would over the longer run equilibrate supply and demand.

Muth’s theory, originally intended to explain price formation in specific markets, was incorporated into an economy-wide, dynamic general equilibrium model by Robert Lucas. According to Lucas, economic agents form their expectations of the future with full knowledge of all economic relations and using all available information. Based on these expectations they maximize their utility over their lifetime. With his work Lucas not only solved Hicks’s problem of imperfect information but also challenged established Keynesian macroeconomics. He argued that robust economic predictions could be made only with models founded in microeconomic theory because macroeconomic relations observed in the past were unstable over time.1 Economic agents would change their behavior in response to economic policy. For instance, the famous relationship between unemployment and inflation proposed by the Phillips Curve would go up in smoke once people realized that the gains in purchasing power afforded by higher nominal wages were subsequently eroded by higher inflation.

Eugene Fama applied the concept of rational expectations to financial markets and hypothesized that financial prices contained all available information. At a minimum, it should not be possible to use past prices to predict future prices, and at best there would be no difference between market prices and fair prices of financial assets (Fama 1970). Thus, if markets are “weakly efficient,” future prices cannot be predicted on the basis of past prices. Already this rather restrained statement contradicts the theory of adaptive expectations, which assumes that past prices contain valuable information for future prices. Markets are “semi-strongly efficient” when prices reflect all publicly available information. In this case, forecasting on the basis of past price movements as well as by considering new publicly available information is impossible. Finally, Fama classifies markets as “strongly efficient” when prices not only reflect all relevant public information but also proprietary insider knowledge. In this case, market prices and fair values of assets would be identical.

Rational expectations theory and the efficient markets hypothesis (EMH) were not only very successful academically—Robert Lucas and Eugene Fama were both awarded Nobel Memorial Prizes for their work—but also highly influential in business and politics. EMH provided the theoretical foundation for “passive investing” through index funds. If no single fund manager could reliably beat the market, why pay fees for active portfolio management? Greater returns could surely be obtained by investing in the entire market at lower costs. And EMH also had a strong influence on government policies. If the market always knew best, why let government bureaucrats regulate it? “Light” regulation was in this case surely better than heavy-handed intervention.

However, Ricardo Campos Dias de Sousa and David Howden (2015), among others, have shown that EMH suffers from logical contradictions. If, as it stipulates, all market participants have all relevant information and interpret it in the same way, all would agree on a price and there would be no incentive to sell or buy. On the other hand, if only a sufficiently critical mass of market participants interpreted relevant information in the same way, transactions could take place, but the price allowing this transaction would be seen as efficient by one and inefficient by the other group. Thus, “efficient prices for one group requires inefficient prices in the eyes of the other” (Campos Dias de Sousa and Howden 2015, 396).

Rational expectations theory and EMH suffered their first practical setback in the early 2000s, when the “technology stock bubble” burst. Apparently market participants were not just cool-headed homines oeconomici but could get carried away by emotions. The experience gave a big boost to behavioral economics and finance. Until that point, behavioral economics had largely been an experimental science confined to the laboratories of a few universities—its key protagonists, Daniel Kahnemann and Amos Tversky, were Israeli psychologists. US economist Robert Shiller (2000) applied behavioral economics to finance, publishing a book in which he diagnosed the wild rally of technology stocks towards the end of the 1990s as a bubble just as it was peaking. Not least because of the excellent timing of the release of his book, a serious challenge to the EMH had emerged in science and financial business.

Rational expectations and EMH suffered another setback with the Great Financial Crisis of 2007–08. The systematic mispricing of risk, which became apparent when the credit bubble burst, was inconsistent with the idea that people would base their financial decisions on all available information and with a full knowledge of the true “economic model.” Obviously people in the credit markets had based their actions on inadequate information and a false economic model that indicated risk reduction through asset pooling when risks in fact accumulated as a growing number of people acted on this model.

Despite its obvious failure, EMH has remained the predominant theory of market behavior in academics and large parts of the business world simply because there has been no other theory in mainstream economics to displace it.2 In 2017, however, the US financial economist Andrew Lo came up with another challenger to EMH. Conscious of the difficulty of dethroning a theory taught widely at universities and perhaps with the ambition to follow in the footsteps of Nobel Prize winners Fama and Shiller, he named his theory the adaptive market hypothesis (AMH) (Lo 2017).

Lo’s intention was not to scrap EMH entirely, but to restrict its validity to times of continuous market development. During those times people act rationally, based on a wide knowledge of facts and a good understanding of the valid economic model. But when markets are disrupted for whatever reason, people turn from rational analysis to instinctive behavior. They join others in either rushing into markets for fear of missing out or fleeing them for fear of losing their fortunes. Lo (2017, 188) summarizes his theory in five key principles:

1. We are neither always rational nor irrational, but we are biological entities whose features and behaviors are shaped by the forces of evolution.

2. We display behavioral biases and make apparently suboptimal decisions, but we can learn from past experience and revise our heuristics in response to negative feedback.

3. We have the capacity for abstract thinking, specifically forward-looking what-if analysis; predictions about the future based on past experience; and preparations for changes in our environment. This is evolution at the speed of thought, which is different from but related to biological evolution.

4. Financial market dynamics are driven by our interactions as we behave, learn, and adapt to each other, and to social, cultural, political, economic, and natural environments in which we live.

5. Survival is the ultimate force driving competition, innovation, and adaptation.

Thus, during normal market conditions reward increases with risk. But at times of negative disruption people may shun risks irrespectively of the associated reward. The Capital Asset Pricing Model may work in normal times but fail in other market environments. Similarly, portfolio optimization according to Markowitz may work in good times but fail in bad times. When there is contagion among different markets, asset diversification may no longer reduce risk (Lo 2017, 282).

Lo’s AMH is an intriguing effort to overcome the contradiction between EMH and behavioral finance and connect them by making them state dependent. However, why should “rationally” acting professional investors suddenly turn “irrational” in market downturns, and why should “irrationally” acting retail investors suddenly turn “rational” in normal markets? And why do environments change from “normal” and continuous to “abnormal” and discontinuous? Perhaps we can get a better idea of how markets behave when we study more closely the way that market participants process information.3

A SUBJECTIVE THEORY OF PRICE AND EXPECTATIONS FORMATION

Like Hicks, Austrian economists in the tradition of Carl Menger and Eugen von Böhm-Bawerk acknowledged that people act with imperfect knowledge. However, these economists claimed that although prices realized in transactions may not equilibrate potentially available supply and demand they always cleared the market (in the sense that actual supply matches actual demand). The early Austrian economists introduced real-world outcomes as “points of rest” (Menger) or “momentary equilibria” (Böhm-Bawerk), where market exchanges are carried out without the adjustment of buyers´ and sellers´ preferences (Klein 2008, 172). Mises coined the term plain state of rest (PSR) as opposed to the imaginary construct of the final state of rest (FSR) (where all supply equals all demand). He explains: “When the stock market closes, the brokers have carried out all orders which could be executed at the market price. Only those potential sellers and buyers who consider the market prices too low or too high respectively have not sold or bought” (Mises 1949, 245). As an analytical tool, the FSR serves as a hypothetical scenario in which basic data of the market are frozen and market participants have perfect information and knowledge. In the FSR all feasible gains from trade are exhausted (Klein 2008, 173). But in reality the FSR never materializes, because market participants have imperfect knowledge that they continuously seek to improve. Thus, during the market process entrepreneurs shuffle and reshuffle resources and capital combinations in response to new knowledge to take advantage of profit opportunities and avoid losses (Salerno 2006). Hence, realized prices generally can be characterized as representing an “equilibrium with error” (Manish 2014). Since the errors of actors with superior knowledge are smaller than those of others, their profits from transactions are larger. As more profitable actors attract more capital at others’ expense, their influence on the exchange process increases. Thus, competition improves the functioning of markets and the economy at large.

Without perfect information and knowledge about the workings of the economy, prices are based on expectations, which are derived from the subjective interpretation of information (Manish 2017). Mises points out: “As action necessarily is directed toward influencing a future state of affairs, even if sometimes only the immediate future of the next instant, it is affected by every incorrectly anticipated change in the data occurring in the period of time between its beginning and the end of the period for which it aimed to provide” (Mises [1949] 1998, 253) From this it follows, according to Mises (1962), that “Every action is a speculation, i.e. guided by a definite opinion concerning the uncertain conditions of the future.” That is—in short—expectations. Thus, expectations “form a crucial component of every act” (Manish 2007, 209). The knowledge used to form expectations is somewhat different in each individual mind, because it reflects the individual’s experience and the specific and unique ability to collect and interpret information. The knowledge is often implicit. Actors may not be able to articulate it, and it certainly cannot be objectively measured. Mises coined the term thymology to describe a method that allows historians to “understand” a complex historical event (Mises [1985] 2007). In the same way that historians look into the past, market participants look into the future. This means that just as thymological experience serves as the basis for the historian´s interpretative understanding of past events (so far as they depend on social and not natural causes), it also conditions the actor's “specific understanding of future events” (Salerno 1995, 309).

After the Austrian revival in the 1970s, debates about expectations and the market process’s possible convergence towards equilibrium took on a central role. For Lachmann (1976), expectations are radically subjective and as such radically unpredictable. In consequence, he states: “Expectations must be regarded as autonomous, as autonomous as human preferences are” (Lachmann 1976, 130). This radicality has been criticized as nihilistic (Hülsmann 1997, 25). Of course, experience-based knowledge is fundamentally different from experimentally established facts of the natural sciences, but it is still real knowledge (Salerno 1995, 312). As Mises puts it: “To know the future reactions of other people is the first task of acting man.” (Mises [1985] 2007, 311). Kirzner (1973) argued that the alertness of entrepreneurs for profit opportunities leads to a general systematic tendency toward equilibration.

Thus, the market is in a state of continuous disequilibrium but moving toward an equilibrium. Although Mises sees a theoretical final state of equilibrium resulting from the exploitation of profit opportunities from disequilibria by capable entrepreneurs (see above), in reality continuously emerging new facts are changing this equilibrium so that it can never be attained.

THE DISCOVERING MARKETS HYPOTHESIS

In order to shed more light on the formation of expectations, subjective expectations theory will be extended by including two further observations: (i) The subjective reception of complex contents is communicated in narratives, and (ii) shared narratives shape prices and are shaped by them.

The Role of Narratives

Before they act, individuals communicate with each other to cross-check their subjective knowledge against the knowledge of others. Complex knowledge is difficult to communicate. When expressed in the form of narratives it is easier to “get across ideas” (Shiller 2017). Robert Shiller has launched a research program (dubbed ”narrative economics”) to study the influence of popular narratives on seminal events such as the depression of 1920–21 or the Great Depression of the 1930s (Shiller 2019). Among other things he has found that narratives can spread like epidemics and influence people’s behavior, which can feed back into the narratives. While Shiller traces the effects of “big” narratives on historical economic developments, the focus of this text is on the effect of “narrow” narratives on financial market prices. As market participants share narratives and act on them in the market, prices move. In turn, the movement of prices feeds back into the narratives. The legendary stock market trader Jesse Livermore (alias Larry Livingston) explains in the classic book Reminiscences of a Stock Operator: “Observation, experience, memory and mathematics—these are what the successful trader must depend on…He must bet always on probabilities—that is, try to anticipate them,” (Lefevre 1922, 416).

Battles of Narratives

Shiller explains the emergence and disappearance of narratives in terms of contagion and recuperation. This can be well applied to “big” narratives evolving and fading with time. The “small” narratives in financial markets, however, do not die of old age but are replaced by other “small” narratives. To understand how new narratives replace existing ones in financial markets, we recur to the theory of scientific revolutions developed by Thomas Kuhn (1970). He argues that scientific knowledge normally increases around a widely accepted paradigm. In normal times, the paradigm itself is not challenged but is fleshed out more by new insights. However, when a critical mass of new facts emerges that is inconsistent with the ruling paradigm a scientific revolution may occur. Previously widely shared and accepted beliefs are questioned and overturned. Uncertainty and confusion may reign until a new paradigm is found that better explains the new facts. After a turbulent period (“extraordinary science”), scientific work returns to its normal state of work (“ordinary science”).

Imre Lakatos (1976) speaks of research programs that have a paradigm at their core. According to him, however, the paradigm shift is not abrupt, but a tough struggle between the defenders of the old paradigm in the old research programs and the challengers who question it. When new facts put pressure on a paradigm, defenders find supporting auxiliary hypotheses to save it, but the original core of the paradigm is weakening. Lakatos calls this “degenerative problem shift.” The challengers, on the other hand, find new explanations for the facts and develop a theory with a higher explanatory value. This leads to a “progressive problem shift.” In contrast to Kuhn, who combines paradigm shifts with radical breaks, Lakatos sees continuous gains in knowledge through the problem shifts in research programs.

The insights of Kuhn and Lakatos into the creation of new scientific knowledge are valuable guides for understanding the effects of the emergence of new knowledge in the market. Participants acting on a new shared narrative influence market prices. For some time, there may be a battle of the ruling and the new narratives. The new narrative may change or bear new narratives during this battle. And eventually the argument will be settled, and a new narrative will rule until the process begins anew. It is possible that the battle of narratives is intense and the victory of the new one absolute, as Kuhn has described the revolutionary paradigm change in science, or that it is drawn out and the new narrative displaces the old one gradually, as Lakatos has argued.

Continuity and Discontinuity in Price Discovery

When knowledge improves incrementally narratives change only little and the process of price discovery proceeds gradually. Financial markets are then characterized by relatively small spreads between offer and demand prices (or “bid-ask spreads”) for securities and by moderate price volatility. This notwithstanding, market clearing prices are being found through a process of trial and error and may move around until all participants agree on the price that best reflects their shared narrative. A market “equilibrium with error” (or “plain state of rest” according to Mises [1949] 1998)4 has then been established, only we don’t see much of these movements.

One way to illustrate the search process for a market clearing price is the old-fashioned cobweb model shown in Figure 1. The suppliers want to supply quantity Q0 at price P0. However, the price they get when they offer Q0 is much lower than P0. Consequently, many cut their offer so that supply now falls below demand. Excess demand brings suppliers back into the market, but at the new price there is excess supply. They cut back again, only to face excess demand again. The process of trial and error continues until the market clearing price is found.

Figure 1. Finding the Market Clearing Price in a CobwebMarket Clearing Price

In this graph, the market clearing price is found, because the supply curve is more elastic than the demand curve. In consequence, suppliers adjust their prices by large amounts in response to excess supply or demand. But what if suppliers react less and demanders more elastically to excess supply and demand than before? In this case, excess demand and supply grow with each step and a market clearing price cannot be found (Figure 2). This is, incidentally, also true when both sides react with the same elasticity.

Figure 2. Searching for the Market Clearing Price in Vain in a CobwebMarket Clearing Price

Let’s now assume that the combination of a fairly inelastic demand with an elastic supply curve characterizes a market where the demanders represent the “wisdom of the crowd” in the eyes of suppliers. This is how people intending to sell securities probably would look at the market. They would adjust their intentions relatively strongly in response to the feedback they get from the market. This is how markets normally behave, when most people share similar knowledge about market circumstances. New knowledge emerges gradually, and prices converge to clear the market.

However, when new and disturbing knowledge drops like a bombshell into the market there will probably be determined (or even forced) sellers in the market and many demanders will be very unsure about what to make of this. In this case, the demanders overreact to sales by the suppliers, and the suppliers in turn underreact to the demand changes by the demanders. No new equilibrium can be found. Bid-ask spreads widen and price volatility increases, because suppliers and demanders are out of synch with each other. Only when the new knowledge has been absorbed and evaluated by everyone can the market return to its “normal” mode of operation.

Battles of Narratives and Fractal Geometry

Can we identify patterns in the emergence of gradual and revolutionary new narratives in the markets? Fractal geometry, developed by the mathematician Benoit Mandelbrot, may help (Mandelbrot and Hudson 2004). According to Mandelbrot smoothness and roughness alternate in nature and financial markets. There are long periods when little happens and short periods of high turbulence. To borrow from Kuhn, markets are calm when an accepted narrative is not seriously challenged, and they experience heavy turbulence when an accepted narrative is overturned by a radically new one. Or, to borrow from Lakatos, markets shift as new narratives gradually displace old ones. We call the evolution of prices in response to the spread of narratives the discovering markets hypothesis (DMH).

AMH and DMH Compared

Although Lo’s adaptive markets hypothesis and the DMH start with the same insight that markets may alternate between continuity and discontinuity, there are important differences. First, AMH takes the change in states as given while DMH explains it as the way in which knowledge emerges and spreads in the form of narratives. Second, AMH assumes schizophrenic minds in market participants and employs psychology to explain alternating behavior while DMH assumes psychologically stable market participants who act continuously and consistently—in a subjectively rational way. By focusing on the process of augmenting subjective knowledge in a battle of narratives, DMH provides a more consistent framework for analyzing and predicting market behavior.

EMPIRICAL SUPPORT FOR THE DMH

Can we relate market price movements to the emergence of new facts and the spread of new narratives? In this section, DMH is applied to explain a few highly visible market movements, although this does not constitute a test of the theory in the spirit of Karl Popper, in which researchers aim to establish a numerically quantified causal relationship between exogenous and endogenous variables. In view of the complexity of the object of research, F. A. von Hayek’s (1974) “pattern recognition” method is employed. Hayek has argued that numerical predictions based on causal relationships between endogenous and exogenous variables are less reliable the more complex the system to which these variables belong is. The complexity of social systems in particular is such that the establishment of causal relationships between variables and their quantification are next to impossible. But this does not mean that falsifiable hypotheses cannot be created and that predictions are unable to be made (Hayek 1974).

Applying Hayek’s theory to the analysis of markets, it is possible to establish whether or not the DMH can explain the pattern of market price movements. What cannot be expected is to find a theory with which market outcomes can be predicted. Below a number of cases in which existing narratives were suddenly overturned by new ones (cases 1–2) is examined. This is followed by a study of two cases in which new narratives emerged after a battle of narratives (cases 3–4). A look at two cases in which the narrative shifted more gradually (cases 5–6) concludes the analysis.

Case 1: Diesel Shock

On September 22, 2015, the German car company Volkswagen AG (VW) published a profit warning acknowledging that Diesel engines had been manipulated so as to disguise the true level of NO2 exhaust. As Chart 1 shows, this attracted a lot of public attention and news coverage of Volkswagen surged (measured by the number of queries including the term “Volkswagen,” Chart 1).

Chart 1. News Concerning “Volkswagen,” 2014–19Volkswagen Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute.

The share price plunged on the news and then moved along with other share prices represented by the DAX30 stock market index (Chart 2). The observed share price movement is consistent with one-off repricing in response to unexpected news as postulated by the efficient markets hypothesis. It is also consistent with a radical shift of the narrative about the profitability of Volkswagen. From the analysis of the share price development, it is not evident which theory gives a better explanation of the observed pattern.

Chart 2. VW Shares Compared to the DAX30 Equity Price Index, 2015–19 (100 = 01.06.2015)Volkswagen Source: Bloomberg, Flossbach von Storch Research Institute.

However, things become clearer by looking at a corporate bond of the company. Until the release of the news the bond fluctuated around the bond price index iBOXX (Chart 3). In response to the release the price plunged in a way similar to the movement of the share price (though somewhat less) and volatility increased. Both markets seemed to follow the same narrative. Thereafter, however, the price of the bond recovered and returned to the level of the bond price index while volatility declined again. The narrative of a company in deep trouble was superseded by the narrative that the company would survive and creditors were fairly safe. If the market was “efficient,” the bond price should have reacted much more calmly than the stock price. But market participants needed to digest the news and differentiate the new narrative in the stock market from that in the bond market before prices in both markets settled.

Chart 3. Price of VW 4.625 Percent Perpetual Bond and iBOXX, 2015–19Volkswagen Source: Bloomberg, Flossbach von Storch Research Institute.

Likewise, the cost of insuring Volkswagen debt against default rose significantly (Chart 4) in September 2015, but it fluctuated at a lower level in the aftermath of the crisis outbreak.

Chart 4. Price of a Credit Default Swap for Volkswagen (in Basis Points), 2015–18Volkswagen Source: Bloomberg, Flossbach von Storch Research Institute.

Case 2: Brexit

On June 23, 2016, for many people unexpectedly, the British people voted in favor of the country’s exit from the European Union. Unsurprisingly, news coverage surged (Chart 5). The exchange rate of sterling against the US dollar took a dive and volatility surged (Chart 6). Following the nosedive, the exchange rate of sterling continued to weaken as it had done before the unexpected news. After some time, however, the initial shock faded and the exchange rate recovered part of the lost ground. Volatility also fell, suggesting that the initially high level of uncertainty gave way to a more stable pattern of views. The observed pattern is consistent with a weakening of the new Brexit narrative over time. As the debate about the terms of Brexit dragged on and the eventual outcome became ever more obscure, the exchange rate flattened. The confusion prevented any narrative from dominating the market.

Chart 5. News Concerning “Brexit,” 2014–19Brexit Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 6. Price Quotation USD/GBP and Volatility, 2014–19Brexit Prices Currency Pound Dollar Source: Bloomberg, Flossbach von Storch Research Institute.

Case 3: Eurocrisis

Following Greece’s debt restructuring in early 2012 markets moved their focus to Italy. While the Greek debt crisis had posed only a limited threat to the survival of the euro an Italian debt crisis could spell its end. Hence, news reports mentioning a “euro crisis” increased (Chart 7). At the same time, Italian bond yields rose (Chart 8). On July 26, 2012, however, European Central Bank President Draghi said that the ECB would do “whatever it takes” to protect the euro. As a result, the Italian bond yields plunged. However, it took the rest of the year for the new narrative of the ECB’s survival guarantee to find its way fully into market prices. The pattern observed here is consistent with a new narrative (“whatever it takes”) replacing an old one (“euro crisis”) in the market.

Chart 7. News Concerning the “Euro Crisis,” 2004–18Euro Crisis Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 8. Ten-Year Italian Government Bond Yields, 2004–13Italian Bonds Source: Bloomberg, Flossbach von Storch Research Institute.

Case 4: Subprime Crisis

In early 2007 defaults in a segment of the US mortgage market—called “subprime”—received public attention. Initially the events were described as problems caused by the mis-selling of mortgages to financially weak debtors and hence as a limited problem in a relatively small market segment (Chart 9). Money markets in the US and Europe were affected as banks lost trust in each other’s solvency, but the stock market remained calm (Chart 10). The narrative changed with the default of Lehman Brothers, causing news on the subject to surge again (Chart 9). Through the remainder of the year and into 2009 stock prices fell and volatility increased. However, by the end of the first quarter of 2009 the crisis narrative had weakened sufficiently to be superseded by a more positive one, first along the lines of “the worst is over” and then of the recovery beginning. The fear of missing out by sticking to the old narrative was a key motivation in the skeptics becoming optimistic.

Chart 9. News Concerning “Subprime,” 2005–18Subprime Crisis Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 10. S&P 500 Price and Historical Volatility, 2006–09SP500 Source: Bloomberg, Google, Flossbach von Storch Research Institute.

Case 5: Recession

Although during the Great Recession of 2007/08 money markets were already experiencing severe tensions as of mid-2007, recession fears in the US gained momentum only in August 2007 and peaked in December 2007 (as measured by the number of queries for the word “recession” on Google and Bloomberg, Chart 11). Fears subsided during the first half of 2008 but surged again in August 2008, peaking in October 2008, one month after the bankruptcy of Lehman Brothers. Recession fears eased again during the second quarter of 2009.

The absolute peak of Google recession queries in the observation period occurred just at the beginning of the recession in the US in the first quarter of 2008. The return to a more normal level of recession fears in mid-2009 coincided with the (later proclaimed) official end of recession in the US. At the beginning of 2008 the stock market (as measured by the S&P 500 price index) broke below its 2007 trading range but remained in this range until the end of August. Only after the news of the Lehman bankruptcy on September 15 did stock prices plunge. They reached a nadir in early March 2009, coinciding with the easing of recession fears (measured by the number of Google and Bloomberg queries).

Chart 11. News Concerning “Recession” and Year-on-Year Percent Change of S&P 500 (Inverted)SP500 Recession Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute.

Case 6: Austrian Economics

Conventional New Keynesian economists had not seen the financial crisis and recession coming. This created renewed interest in the explanation of credit and investment cycles in Austrian economics, an explanation which became a narrative of its own. Chart 12 shows queries for “Austrian economics” worldwide. Queries surged in October 2008, the month after Lehman Brothers’s bankruptcy. They jumped to an even higher level in January 2012, when fears rose that Italy would crash out of the European Monetary Union (EMU). As central banks flooded the banking sector with money and Mario Draghi, president of the ECB, effectively guaranteed the existence of the EMU by promising to do “whatever it takes” to preserve the euro, the narrative of “Austrian economics” lost some of its attraction. Past experience suggests that interest will increase again when the financial system comes under renewed pressure in the next economic downturn.

Chart 12. Queries for “Austrian Economics”Austrian Economics Source: Google Trends. PATTERN PREDICTIONS WITH THE DMH

Having found the DMH to explain the pattern of market movements as a competition between different narratives, its use in making “pattern predictions” can now be discussed. Hayek uses the example of a ball game to illustrate what can and cannot be predicted: if we knew precisely the skills and fitness of the opposing teams in addition to the rules of the game, we should in principle be able to predict the outcome with a relatively high degree of certainty. However, the closer the teams come in skills and fitness, the greater will be the role of chance in determining the outcome (Hayek 1974).

The legendary German coach Sepp Herberger once said: “People go to soccer games because they don’t know how the game ends.” In reality, no one has precise information about the skills and fitness of the players at the time of the game, so that not only pure chance but also a lack of information will prevent a reliable anticipation of the outcome. Nevertheless, knowing the rules of the game helps observers focus their attention on what is important to the result. Moreover, as people observe the game they acquire more information about players’ ability and can improve their prediction of the outcome. It is obviously easier to correctly predict the result of a soccer match at halftime than at the beginning, but even then a lot of uncertainty remains.

All this implies that one should not expect to be able to predict market outcomes. But by understanding how markets move we can better focus on what is important to the outcome. Observation of the important drivers of market developments can then help us narrow down the possible range of outcomes. Specifically, the discovering markets hypothesis suggests that we focus on how new facts influence narratives, which shape prices and are themselves reshaped by them. By identifying narratives shared by a large number of people and by finding out whether they are ascending or descending, we may be able to assess the persistence of market price movements. In some cases, narratives that precede price movements may even be identifiable. This is illustrated in Figure 3.

Figure 3. Formation of PricesPrice Formation

Facts create subjective knowledge, which may induce financial market participants to act. More likely, however, they will exchange this knowledge with other participants with a view to identifying shared narratives, which have a more powerful influence on prices than individual action does.

SUMMARY AND CONCLUSION

Expectations of the future shape the movement of prices, which clear markets, although not necessarily at the point where potential supply is equal to potential demand. This paper followed the argument of Lachmann and Mises that market participants form their expectations on the basis of their ability to collect information and interpret it. In keeping with Shiller, it was observed that market participants tend to communicate their views about the future in the form of narratives and that they learn by listening to the narratives of others. Narratives compete, and winners emerge by knocking out or gradually wrestling down competitors. Winning narratives shape market prices until the facts confirm their victory or until they are discredited by the facts and replaced by new narratives. When we understand how market prices form we can predict the way they adjust to changing economic conditions.

Could artificial intelligence and machine learning replace human actors in financial markets? Those who believe in more mechanical models of expectations—assuming “rational,” “irrational,” or state-dependent “rational/irrational” behavior—may be inclined to say yes. However, if market participants indeed act subjectively rationally and interdependently based on proprietary knowledge accumulated through experience and incomplete information transmitted through narratives—as described in the discovering markets hypothesis—the hurdle to clear for artificial intelligence to beat human intelligence seems fairly high.

  • 1. Lucas‘s challenge to Keynesian macroeconomics went down in the history of economics as the "Lucas Critique."
  • 2. The confusion in academics about how markets work became evident with the awarding of the 2013 Nobel Memorial Prize to both Eugene Fama and Robert Shiller.
  • 3. Lo’s auxiliary assumption of shifting market environments to retain the EMH could be interpreted, in Lakatos’s (1976) words, as a “degenerative problem shift” in a descending research program (see below).
  • 4. At the “plain state of rest” markets are cleared, but not necessarily in an equilibrium free of all market participant error. This is the “final state of rest,” towards which the market is pushed by competition but which may never be reached in reality.
Categories: Current Affairs

Krugman: We Need More Unemployment—to Save Us from Unemployment

Mises Institute - Wed, 20/05/2020 - 20:45

Paul Krugman is now claiming that reopening the economy and allowing people to go to work almost surely will cause a depression.

This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.

Original Article: "Krugman: We Need More Unemployment—to Save Us from Unemployment"

Categories: Current Affairs

The Bitcoin Standard: The Decentralized Alternative to Central Banking

Mises Institute - Wed, 20/05/2020 - 20:45

The Bitcoin Standard: The Decentralized Alternative to Central Banking
Saifedean Ammous
Hoboken, N.J.: John Wiley and Sons, 2018
xviii + 286 pp.

Abstract: Treating bitcoin from the point of view of Austrian economics, Saifedean Ammous’ The Bitcoin Standard relates bitcoin to the theory of the market economy as a whole. Bitcoin is not necessarily an alternative to gold, but can function as a global reserve currency and disrupt the role of central banks. Though the book is entertaining and enlightening, there are some aspects of monetary theory, monetary history, and the theory of banking that warrant critique. Overall, Ammous has succeeded in producing a book that clearly demonstrates the possible usefulness of bitcoin under present conditions.

monetary policy — austrian economics — central bank — gold standard — bitcoin

Kristoffer M. Hansen (kristoffi@gmail.com) is a Ph.D. candidate at the University of Angers and a Mises Institute research fellow.

From time to time, bitcoin enthusiasts vent their frustration at the preference of benighted investors for gold. At the time of writing, the digital assets management company Grayscale Investments, LLC, has launched another crusade against the barbarous relic, encouraging investors to #DropGold. The seriousness of their marketing campaign can be judged from the fact that their main arguments are that one, gold represents the past (after all, Nixon dropped gold already in the ’70s!) and two, gold is physically very heavy.1

In such an environment, it is always with some trepidation that I read a new book on bitcoin. Is this going to be a fanatical screed or a thoughtful study that tries to advance our knowledge? Happily, Professor Ammous of the Lebanese American University has written a book that falls squarely in the latter category. Treating bitcoin from the point of view of Austrian economics, Ammous not only discusses it in terms of monetary theory but also relates it to the theory of the market economy as a whole. His assessment of bitcoin is conservative but still optimistic. Bitcoin is not necessarily an alternative to gold, he argues, but it can function as a global reserve currency and disrupt the role of central banks.

The Bitcoin Standard goes over all the basics of money, investment, and production, the role of time preference, the importance of sound money, and the history of money before he introduces bitcoin. Although this may seem roundabout, there is a clear and reasonable method to this approach: we must know what money is and how society functions before we can understand what possible function bitcoin could have in the modern economy.

Along the way, we are treated to Ammous’s very amusing descriptions of modern art:

A stroll through a modern art gallery shows artistic works whose production requires no more effort or talent than can be mustered by a bored 6-year-old. Modern artists have replaced craft and long hours of practice with pretentiousness, shock value, indignation, and existential angst as ways to cow audiences into appreciating their art, and often added some pretense to political ideals, usually of the puerile Marxist variety, to pretend-play profundity. (pp. 100–01)

And:

Only with unsound money could we have reached this artistic calamity where the two largest economic, military, and political behemoths in the world were actively promoting and funding tasteless trash picked by people whose artistic tastes qualify them for careers in Washington and Moscow spy agencies and bureaucracies. (p. 102)

There is also an acerbic commentary on Keynesians and Monetarists woven through the book. Ammous’s brutal putdown of Friedman and Schwartz’s Monetary History of the United States alone is worth the price of the book:

it is an elaborate exercise in substituting rigor for logic. The book systematically and methodically avoids ever questioning the causes of the financial crises that have affected the US economy over a century, and instead inundates the reader with impressively researched data, facts, trivia, and minutiae. (p. 121)

The book is thus very entertaining as well as enlightening, but also, at times, very frustrating. For although Ammous presents economic theory and history lucidly, it seems that at times he does not get it exactly right. There are three points that merit critique in particular: some aspects of monetary theory, of monetary history, and of the theory of banking.

When it comes to monetary theory, Ammous begins quite correctly with the state of barter and the problem of the double coincidence of wants. He goes on to present a theory of salability, showing the different criteria that a good medium of exchange needs to fulfill: salability across scales, across space, and across time (pp. 2–4). These clearly correspond to the classic criteria for a good medium of exchange: divisibility, portability, and durability, and his presentation of them is very lucid. The problem arises when we turn to the supply of money. Here Ammous focuses on the relation between stock and flow, existing supply and current production of the monetary commodity. This relation, he says, is a good indicator of how hard or sound a money is, and monetary history shows how harder money wins out over easier money—up to and including the displacement of silver by gold. Gold has a much higher stock-to-flow ratio than silver; it is therefore a better money and was eventually chosen as money on this basis (pp. 5–7, 19–25).

This telling of monetary history is, however, not entirely correct, and the claims about the importance of the relation between stock and flow are specious.2 Let’s take the last point first: money is always demanded to be held—it is always in somebody’s cash balance. Any commodity that is used for monetary purposes will therefore exist in large quantities, spread out between the different holders of money, and the very fact of its being used as money will lead it to have a high stock-to-flow ratio.

Present production obviously cannot be expanded infinitely, since this would mean that the factors of production are not scarce. Rather, production of the money commodity will be directed by the search for profits on the part of entrepreneurs, and in the long run the law of costs will hold—meaning that there is no special profit to be gained from producing money and increasing the money supply. What will happen is that increased production of the money commodity will cause an excess supply of money at the given price or purchasing power of money (PPM). If the commodity is only used for monetary purposes, all that would happen is that the increased supply of money would lead to a fall in PPM and an increase in the quantity of money demanded until demand and stock were again equal. However, both gold and silver are commodities that also have use value in consumption and production. A higher supply leading to a lower PPM would therefore lower the opportunity cost of using the money for a nonmonetary purpose, and the commodity would flow from monetary holdings to consumption and industrial use. Not only would this increase production of consumer goods and thereby the satisfaction of consumers, it would also mitigate the effect of increased production of the monetary commodity on the PPM and on monetary demand.3

All this is not to say that there is no meaningful distinction to be made between hard and easy, sound and unsound money. But focusing on the stock-to-flow ratio is, to my mind, a red herring; the important distinction is between a money that can be increased at will (fiat money), and one that must be produced like any other commodity. That silver has (and had) a lower stock-to-flow ratio than gold is therefore not a reason to conclude that it is a less hard form of money—it may simply be used more for nonmonetary purposes than gold is and was. Figure 3 on page 33 of the book itself gives clear confirmation that the proportion of stock to flow is not important: it depicts the gold/silver price ratio from 1687 to 2017. What is remarkable is the stability of the ratio, with very little fluctuation from year to year (within the band between 14 and 16) until the early 1870s. Now, what changed in the early 1870s? There were no source discoveries or advances in mining that radically changed the stock-to-flow ratio of silver. There was, however, a radical change in the monetary systems of the industrial world, as virtually all countries adopted a monometallic gold standard, leading to the virtual disappearance of monetary demand for silver.4 But if stock-to-flow ratios are of crucial importance, why did silver have an almost constant value in terms of gold until it was demonetized even though it does not have the same stock-to-flow ratio?

This brings me to the problems with Ammous’s description of monetary history. He describes the evolution of money and especially the change from silver to gold as a consequence of the gradual realization of the inherent superiority of the gold standard. There is no mention of Gresham’s law or of the problems of bimetallism. It would be much closer to the truth to say that the gold standard was the unintended consequence of monetary manipulations and attempts to set a legal ratio between the prices of gold and silver, first in England at the Royal Mint,5 then in France after Napoleon. When Germany and the Scandinavian countries adopted the gold standard in the early 1870s, it was a conscious governmental decision, not the spontaneous outcome of an unimpeded market process.

The other reason for the dominance of gold, according to Ammous, is the growth of banking and specifically the fact that it was necessary to centralize gold holdings, first in banks and then in central banks, in order to facilitate payment (pp. 37–38). This argument, I must confess, baffles me. Now, it is true that international clearing and settlement is a good way to minimize the need to transport gold between countries, and it is also true that this clearing increasingly took place between central banks—but it is quite a leap to say that therefore gold holdings had to be centralized. Banking is not the only way to facilitate clearing, as merchants can facilitate it just as well through the use of bills of exchange. Indeed, perhaps the first discussion of clearing and international trade, by Richard Cantillon, is conducted in terms of bills of exchange drawn on correspondent banks (Cantillon 2010, 195–201). The growth of banking systems pyramided on top a central bank cannot be explained by the need to store gold in clearinghouses, as a decentralized system could function just as well, if not better. The history behind the growth of central banking is, rather, one of government privilege given to banks seeking profit through credit expansion, and of government involvement in this business to get a share of those profits. Ammous is clearly familiar with banking theory, and it is a shame that this part of the book is not informed by it.

Finally, this brings us to Ammous’s case for bitcoin. What role can bitcoin play in the modern economy? The discussion of the pros and cons of bitcoin is both clear and frank. The advantage of bitcoin is seen against modern banking institutions: with bitcoin, we need not rely on trust in third parties of dubious repute to facilitate payments around the world (p. 208). This can be done simply via the medium of bitcoin. Although it is not strictly correct to say that it eliminates third parties—the whole network becomes, in effect, the third party to any and all transactions—it is correct to assert that the need for trust is completely eliminated. The discussion of possible challenges to bitcoin is also very convincing, although some will certainly be upset with Ammous’s dismissal of alternatives to bitcoin as inherently inferior.

Does this mean that bitcoin will replace cash? The conclusion arrived at is, surprisingly, no. It is simply too expensive to transact in bitcoin, especially since we can expect transaction fees to rise as demand for bitcoin increases. There are also inherent constraints to the technology, which limit how many transactions can be performed. The bitcoin network will never, in Ammous’s estimation, be able to compete with the likes of Visa and Mastercard when it comes to processing payments (pp. 233–34). It will simply be too costly in terms of processing power. The role of bitcoin, argues Ammous, will rather be to settle transactions between large institutions such as central banks. Here it is superior, because there is no need for trust in a third party, and auditing is extremely cheap—anyone can look at the blockchain. A supporting infrastructure will then be built around bitcoin that allows the common man to exchange using tokens or through institutions based on bitcoin. The growth of the lightning network that is being adopted now is one possible way that this can come about, but how exactly digital cash based on bitcoin will be made available is up to entrepreneurial experimentation.

Although he argues convincingly, Ammous’s conclusion fails to persuade in the end. It seems to rest on the spurious problem of centralized gold holdings criticized above, and on seeing trust in third parties as a problem. But there is no reason that trust should be a problem—on the market, we trust third parties all the time, and generally without issues. The problem is government control over and involvement in monetary affairs. Governments and privileged banks have again and again proven themselves untrustworthy, as they have engaged in destructive and antisocial policies again and again, while bamboozling the general public. In the absence of government involvement, it does not seem probable that bitcoin would win out over gold as the money of choice of a free society.

This does not mean that bitcoin is useless, or perhaps just a speculative bubble fed by easy money and ideological fervor. Ammous has pinpointed exactly what the function of bitcoin is in the present context: just as owning money in general is a hedge against uncertainty, so too is owning bitcoin a hedge against a specific kind of uncertainty. Owning bitcoin is a way to get around capital controls and embargoes, and other obstacles governments place in the way of free exchange. In short, owning bitcoin is a hedge against what Robert Higgs called regime uncertainty (Higgs 1997). As such, it will regrettably prove very useful for many people in the foreseeable future.

Its weaknesses notwithstanding, however, The Bitcoin Standard is a book well worth reading. Ammous’s treatment of bitcoin, though marred by some of the issues I have criticized above, is very good, and any blockchain enthusiast would do well to consider Ammous’s strictures on the utility of blockchain technology. The book is full of many thought-provoking remarks about the relations between money and a host of economic and social issues, about art, about the family, and about the impact of easy money on food quality. One is left feeling that a whole monograph could be written on each of these topics. Above all, Ammous has succeeded in producing a book that clearly demonstrates the possible usefulness of bitcoin under present conditions.

  • 1. See Drop Gold, Grayscale Investments, LLC, 2019, https://dropgold.com.
  • 2. With thanks to Chris Calton.
  • 3. On the workings of the gold standard, see Salerno (2010), Skousen (1996), and White (1999).
  • 4. The interested reader can check this development by referring to Officer and Williamson (2020).
  • 5. See Cantillon (2010, 213–16), for a contemporary discussion of the policies of the Royal Mint critical of Newton’s role.
Categories: Current Affairs

We’re All in This Together. But Not in the Way You Think.

Mises Institute - Wed, 20/05/2020 - 20:00

We are all in this together. No, by that I do not mean what Andrew Horney calls “all those cloyingly saccharine, feel-good public service announcements being delivered by famous faces on television and social media platforms, telling us "we're all in this together." We are all interdependent through the production of goods and services that constitutes the market order. Some critics of the current crisis see it as yet another case of the rich getting one over on the rest of us. I will argue that this cannot be correct, because the rich as well as the poor (and the middle class) depend on the freedom to produce, and are all harmed by the lack of it.

Angelika Albaladejo writes, "The Rich Are Getting Richer," citing a new report that “shows that some American billionaires are making substantial gains during the global health crisis.” Wilamette Week asks, "How Will the Rich Get Richer During the Pandemic-Fueled Economic Collapse?"

Israel Shamir in "Deep Pockets Love Lockdown" suggests that the rich do not like the widespread availability of travel:

No more travels for us. The very rich folks will regain their solitary possession of Venice, the Côte d’Azur, and all the other elite destinations so recently inundated by mass tourism. Once again they will have it as good as they had it in the 19th century. Travel is a luxury, and ordinary people do not deserve luxury. They tried to keep us away by making travel as unpleasant as possible with body searches, but it didn’t help. If this global pandemic doesn’t stop us, they are simply going to cut us off.

The greatest influence on everyone's standard of living is the overall production of the society they live in. Under the current prohibitions, some businesses gain market share—a larger piece, but sliced from a much smaller pie. The rich, who enjoy and can afford luxury goods, depend on the productivity of all members of society for these goods. Those who can afford to fly first class, or perhaps in their own private planes, depend on the engineering advances from the mass production of airplanes that have reduced the cost and made private jets "affordable." Time-shared private aviation costs in the low six figures.

High-end travelers rely on the proliferation of airports made possible by the masses of middle-class travel worldwide; on the sizable labor pool of skilled pilots with commercial air travel experience to fly their private planes; on the development of air traffic control through the management of millions of flights annually; and on the gradual improvements in air traffic control to improve air travel safety.

Fine hotels where the rich stay in suites exist nearly everywhere due to middle-class and business travel. International brands are able to bring quality hotels online and up to international standards quickly due to experience operating in many global markets, and they are able to staff new hotels with experienced managers from existing properties, where they have honed their skills.

The private chefs that the rich hire to cook for them emerged from a vast food service industry consisting of culinary schools and fine restaurants even in small- to mid-market cities, where chefs learn their craft. The ingredients are available because of demand to feed the millions. Restaurants are often funded by investors who either specialize in the restaurant sector or made their money in another business. The top-tier chefs who work privately for wealthy people have reached the top of a competitive pyramid through years of restaurant experience, travel, studying under other experienced chefs, and trying out different restaurant concepts to develop recipes and techniques. The Gordon Ramseys of the world stand atop a vast competitive pyramid of chefs.

The writers who suggest that the lockdown is another means for the rich to get richer, perhaps by buying up discounted assets in a financial panic and eventually monopolizing all commerce, lack an understanding of capital markets.

Financier and political advisor Bernard Baruch is reported to have gone to cash, to have shorted the US stock market in the late 1920s leading up to the crash of 1929, to have advised friends to do the same, and to have made millions on the trade. Kennedy family patriarch Joseph P. is reported to have done likewise, realizing that the market was at a top when shoeshine boys gave him stock tips.

Fortunes have been made by shorting bubbles before market crashes or buying up assets on the cheap in the aftermath—but does that benefit "the rich"? This ignores that for every Bernard Baruch who sold millions of dollars in assets there had to be another buyer who bought them near the top and suffered the losses that Baruch avoided.

Those who own most of the assets are by definition "the rich." A rich person is someone whose property consists mostly of capital goods—directly owned, through businesses or through stocks and bonds, which are claims on capital goods. When Baruch wishes to sell $1 million in assets, which, as Dr. Evil has observed, used to be a lot of money, there must be a buyer who has that much cash on hand to pay for them. This buyer can only be another rich person, or an organization that represents a large number of individuals—a pension fund, a life insurance company.

Collectively all assets are at all times owned by someone. "The rich" as a whole can not exit asset ownership, because there is no external population of Martians who will take those assets off their hands (unless the Fed buys the entire stock and bond market, which I don’t rule out, and perhaps the Fed governors are from another planet).

Most of the world’s wealth is in capital goods; those who own the most of them are the rich. When markets are repriced—downward—the rich as a whole suffer most of the market value losses. Those who cashed out at the top benefit at the expense of those who held the assets on the way down. And anyone, at any size, who has cash finds that the purchasing power of their cash has gone up when measured in terms of assets. The position of small investors who have cash on hand improves relative to the rich when asset markets crash. Even those who do not invest in capital goods at all find their position improved in relative terms, because the ability of the rich to bid for consumption goods by offering capital goods has diminished.

At any moment in time, the upward or downward price movements in capital markets are a zero-sum game. But there is a more fundamental way in which we are interdependent. The capital goods underlying financial assets derive their market value from their role in the production of consumer goods. The value of a corporation is derived from consumer demand for its products. Many of the rich became so by starting a business that they still own which grew by satisfying consumer demand. Others have sold a business or inherited wealth which they try to preserve through the ownership (direct or indirect) of capital goods through financial assets.

And from where do consumers derive their ability to demand? We know from Say’s law that consumers demand by supplying their own production to the market. Everyone who works and produces a good or a service, by supplying it to the market, demands some other good or service. In the general glut debate, the proponents of Say’s law used it to show that because every instance of supply constitutes a demand, and vice versa, aggregate supply and aggregate demand are not only equal, but simply different ways of looking at the totality of transactions that occur in the market as a whole.

The demand that the rich depend on to support the valuation of their assets is largely not from other rich people demanding Cartier jewelry, Rolex watches, yachts, and custom basement wine cellars. It is largely from the mass market of consumers through division of labor, which provides the goods and services that we all depend on. The ability of the poor and middle classes to demand comes mostly from their wages, which they earn through their contribution to the production of a range of goods and services. Their supply in turn constitutes the demand for other—different—goods and services, which supports the valuations of businesses, and therefore financial assets.

And although the rich consume higher-quality goods and services than the rest of us, they depend equally on the flow of goods and services, the division of labor, and the development of new products. Although they may cherry-pick the best off the top, there has to be a chocolate sundae underneath to support the cherry.

Most mass consumer goods start out as luxury goods. Then, as the manufacturers work out the kinks and capital investment enables production at a larger scale, these goods become mass market goods. The 1987 movie Wall Street featured actor Michael Douglas in the role as a hedge fund titan. In one scene he is shown carrying what at the time passed for a mobile phone (a luxury good only available to the super rich) about the size of a large brick. When I have traveled in low- to middle-income countries (back in the days when we were allowed to travel more than one hundred yards from our residences), smartphones were ubiquitous. While it is true that the middle class and eventually low-income consumers benefit from the adoption of new products by the rich, the fall in these goods' costs also makes the rich man’s dollar go further. Improvements in the design and function of the products through generations of products and mass production make better products available to all classes.

Even the government depends on the market, innovation, progress, and falling costs for its nefarious objectives. Governments would like to surveil us all—even more than they already do. According to the BBC News, “More than a million Australians have downloaded a coronavirus contact tracing app within hours of it being released by the government.” The plan is clear enough, but if no people can afford a modern mobile phone with GPS any longer and lack the ability to pay for their data plan, this effort might fall a bit short. The phone, the network, and the existence of either wifi or a mobile signal nearly everywhere are due to carriers' vast capital investment and the dramatic fall in these technologies' prices. We can all afford these things because of our participation in the market, producing other goods and services.

I will be the first to say that I do not understand why our insect overlords are attempting to damage social trust (though "snitch" portals) and to destroy our civilization itself through the prohibition of commerce, education, healthcare, athletics, professional sports, entertainment, dating and family formation, the arts, music, dining, family gatherings, religious observance, and all other forms of civilized life. Nor can I explain the "mask hysteria" that is spreading like a highly contagious virus on social networking websites such as NextDoor.com. Without an explanation that makes any sense, where does that leave us? What keeps me up at night is that we have not yet seen the end game, and that when we do it may be worse than what anyone can imagine.

Categories: Current Affairs

Do Lockdowns Work? Mounting Evidence Says No

Mises Institute - Wed, 20/05/2020 - 19:45

The coerced economic "shutdowns"—enforced with fines, arrests, and revoked business licenses—are not the natural outgrowth of a pandemic. They are the result of policy decisions taken by politicians who have suspended constitutional institutions and legal recognition of basic human rights. These politicians have instead imposed a new form of central planning based on an unproven, theoretical set of ideas about police-enforced "social distancing."

Suspending the rule of law and civil rights will have enormous consequences in terms of human life counted in suicides, drug overdoses, and other grave health problems resulting from unemployment, denial of "elective" medical care, and social isolation.

None of that is being considered, however, since it is now fashionable to have governments determine whether or not people may open their businesses or leave their homes. So far, the strategy for dealing with the resulting economic collapse is no more sophisticated than record-breaking deficit spending, followed by debt monetization via money printing. In short, politicians, bureaucrats, and their supporters have insisted a single policy goal—ending the spread of a disease—be allowed to destroy all other values and considerations in society.

Has it even worked? Mounting evidence says no.

In The Lancet, Swedish infectious disease clinician (and World Health Organization (WHO) advisor) Johan Giesecke concluded:

It has become clear that a hard lockdown does not protect old and frail people living in care homes—a population the lockdown was designed to protect. Neither does it decrease mortality from COVID-19, which is evident when comparing the UK's experience with that of other European countries.

At best, lockdowns push cases into the future, they do not lower total deaths. Gieseck continues:

Measures to flatten the curve might have an effect, but a lockdown only pushes the severe cases into the future—it will not prevent them. Admittedly, countries have managed to slow down spread so as not to overburden health-care systems, and, yes, effective drugs that save lives might soon be developed, but this pandemic is swift, and those drugs have to be developed, tested, and marketed quickly. Much hope is put in vaccines, but they will take time, and with the unclear protective immunological response to infection, it is not certain that vaccines will be very effective.

As a public policy measure, the lack of evidence that lockdowns work must be balanced with the fact that we have already observed that economic destruction is costly in terms of human life.

Yet in the public debate, lockdown enthusiasts insist that any deviation from the lockdown will result in total deaths far exceeding those places where there are lockdowns. So far, there is no evidence of this.

In a new study titled "Full Lockdown Policies in Western Europe Countries Have No Evident Impacts on the COVID-19 Epidemic," author Thomas Meunier writes, "total deaths numbers using pre-lockdown trends suggest that no lives were saved by this strategy, in comparison with pre-lockdown, less restrictive, social distancing policies." That is, the "full lockdown policies of France, Italy, Spain and United Kingdom haven't had the expected effects in the evolution of the COVID-19 epidemic."

The premise here is not that voluntary "social distancing" has no effect. Rather, the question is to whether "police-enforced home containment" works to limit the spread of disease. Meunier concludes it does not.

Meanwhile a study by polititical scientist Wilfred Reilly compared lockdown policies and COVID-19 fatalities among US states. Reilly writes:

The question the model set out to ask was whether lockdown states experience fewer Covid-19 cases and deaths than social-distancing states, adjusted for all of the above variables. The answer? No. The impact of state-response strategy on both my cases and deaths measures was utterly insignificant. The "p-value" for the variable representing strategy was 0.94 when it was regressed against the deaths metric, which means there is a 94 per cent chance that any relationship between the different measures and Covid-19 deaths was the result of pure random chance.

Overall, however, the fact that good-sized regions from Utah to Sweden to much of East Asia have avoided harsh lockdowns without being overrun by Covid-19 is notable.

Another study on lockdowns—again, we're talking about forced business closures and stay-at-home orders here—is this study by researcher Lyman Stone at the American Enterprise Institute. Stone notes that areas where lockdowns were imposed either had already experienced a downward trend in deaths before the lockdown could have possibly shown effects or showed the same trend as the year prior. In other words, lockdown advocates have been taking credit for trends that had already been observed before lockdowns were forced on the population.

Stone writes:

Here’s the thing: there’s no evidence of lockdowns working. If strict lockdowns actually saved lives, I would be all for them, even if they had large economic costs. But the scientific and medical case for strict lockdowns is paper-thin.

Experience increasingly suggests that a more targeted approach is better for those who actually want to limit the spread of disease among the most vulnerable. The overwhelming majority—nearly 75 percent—of deaths from COVID-19 occur in patients over sixty-five years of age. Of those, approximately 90 percent have other underlying conditions. Thus, limiting the spread of COVID-19 is most critical among those who are already engaged with the healthcare system and are elderly. In the US and Europe, more than half of COVID-19 deaths are occuring in nursing homes and similar institutions.

This is why Matt Ridley at The Spectator quite reasonably observes that testing, not lockdowns, appears to be the key factor in limiting deaths from COVID-19. Those areas where testing is widespread have performed better:

Yet it is not obvious why testing would make a difference, especially to the death rate. Testing does not cure the disease. Germany’s strange achievement of a consistently low case fatality rate seems baffling—until you think through where most early cases were found: in hospitals. By doing a lot more testing, countries like Germany might have partly kept the virus from spreading within the healthcare system. Germany, Japan and Hong Kong had different and more effective protocols in place from day one to prevent the virus spreading within care homes and hospitals.

The horrible truth is that it now looks like in many of the early cases, the disease was probably caught in hospitals and doctors’ surgeries. That is where the virus kept returning, in the lungs of sick people, and that is where the next person often caught it, including plenty of healthcare workers. Many of these may not have realised they had it, or thought they had a mild cold. They then gave it to yet more elderly patients who were in hospital for other reasons, some of whom were sent back to care homes when the National Health Service made space on the wards for the expected wave of coronavirus patients.

We could contrast this with the policies of Governor Andrew Cuomo in New York, who mandated that nursing homes accept new residents without testing. This method nearly ensures that the disease will spread quickly among those who are most likely to die from it.

Meanwhile, Governor Cuomo saw fit to impose police-enforced lockdowns on the entire population of New York, ensuring economic ruin and ruined health for many non-COVID patients who were then cut off from vital treatments. Yet, disturbingly, lockdown fetishists like Cuomo are hailed as wise statesmen who "acted decisively" to prevent the spread of disease.

But this is the sort of regime we now live under. In the minds of many, it is better to abolish human rights and consign millions to destitution in the name of pursuing trendy unproven policies. The prolockdown party has even turned basic fundamentals of policy debate upside down. As Stone notes:

At this point, the question I usually get is, "What’s your evidence that lockdowns don’t work?"

It’s a strange question. Why should I have to prove that lockdownsdon’t work? The burden of proof is to show that they do work! If you’re going to essentially cancel the civil liberties of the entire population for a few weeks, you should probably have evidence that the strategy will work. And there, lockdown advocates fail miserably, because they simply don’t have evidence.

With economic output crashing worldwide and unemployment soaring to Great Depression levels, governments are already looking for a way out. Don't expect to hear any mea culpas from politicians, but we can already see how governments are quickly moving toward a voluntary social-distancing, nonlockdown strategy. This comes even after politicians and disease "experts" have been insisting that lockdowns must be imposed indefinitely until there's a vaccine.

The longer the lockdown-created economic destruction continues, the greater will be the threat of social unrest and even economic free fall. The political reality is thst the current situation cannot be sustained without threatening the regimes in power themselves. In an article for Foreign Policy titled "Sweden’s Coronavirus Strategy Will Soon Be the World’s," authors Nils Karlson, Charlotta Stern, and Daniel B. Klein suggest that regimes will be forced to retreat to a Swedish model:

As the pain of national lockdowns grows intolerable and countries realize that managing—rather than defeating—the pandemic is the only realistic option, more and more of them will begin to open up. Smart social distancing to keep health-care systems from being overwhelmed, improved therapies for the afflicted, and better protections for at-risk groups can help reduce the human toll. But at the end of the day, increased—and ultimately, herd—immunity may be the only viable defense against the disease, so long as vulnerable groups are protected along the way. Whatever marks Sweden deserves for managing the pandemic, other nations are beginning to see that it is ahead of the curve.

Categories: Current Affairs

Beyond Calculation: The Austrian Business Cycle in the Socialist Commonwealth

Mises Institute - Wed, 20/05/2020 - 17:15

Abstract: This paper extends Austrian business cycle theory to the command economy and demonstrates that Mises’s socialist commonwealth would not be free from Rothbardian error cycles, which J. Guido Hülsmann has argued must originate in “institutions in which the error of many persons is inherent.” Booms and busts are shown to be unavoidable under socialism because (1) the central planner’s incomplete understanding of the opportunity costs associated with any given rate of growth would result in growth targets that are unsustainably high and (2) the planner would be blind to the resulting imbalances until they became sufficiently severe to become “visible” in the statistical data that form her only picture of the world. In this case, Hülsmann’s “erroneous institution” is central planning, which misidentifies the state’s image of the economy with the totality of economic reality.

JEL Classification: B51, B53, E32, P21, P51

Mark A. DeWeaver (madeweaver@gmail.com) is an adjunct professor at American University’s Kogod School of Business and cofounder of the fund management company Ithaca Advisors, LLC. The author would like to thank the participants at the 2019 Libertarian Scholars Conference and an anonymous referee for their helpful comments and suggestions.

“Economic construction proceeds in wave-like fashion with its ups and downs, and one wave chasing another. This is to say that there are balance, disruption, and balance restored after disruption.”
–Mao Zedong (1959)

It is often supposed that business cycles would not occur under central planning. Indeed, in most business cycle models a central planner should be able to improve upon the “anarchy of the market.” Keynes’s ([1936] 1997) animal spirits could be eliminated, the adaptive expectations of Samuelson’s (1939) accelerator/multiplier model could be replaced by a rational program, the planner’s supposed informational advantages would solve the incomplete information problem in the Lucas (1972) rational expectations story, and, in the absence of the “exploitation” of labor by capital, Marx’s ([1863] n.d., chapter XVII, part 6) “crises of accumulation” would not occur.

Although most business cycle theorists have not explicitly advocated central planning, explanations based on the limitations of private actors can easily be misinterpreted as implying that eliminating market forces would be an improvement. Keynes ([1936] 1997, 320) makes this claim explicitly, arguing that “the duty of ordering the current volume of investment cannot safely be left in private hands.” Here the implicit assumption is that the state official will behave more rationally than the businessperson, a view entirely consonant with Keynes’s lifelong advocacy of socialist policies (Fuller 2019). His argument is a good example of what Demsetz (1969) calls the “nirvana approach”—a case for state intervention made by contrasting real-world free market outcomes with what an ideal government could achieve in a “first best” world. Keynes is essentially saying that a system directed by angels would be preferable to one run by fallible human beings.

In the Austrian tradition the planner tends to be seen as demonic rather than angelic. Here too, however, we find claims that central planning would not generate economic fluctuations. In Human Action, for example, Ludwig von Mises ([1949] 1998) argues that the periodic crises experienced in free enterprise economies, which he attributes to incompatibilities among the plans of different economic actors, would not occur under socialism, which would allow for only one plan—that of the dictator. “If the dictator invests more and thus curtails the means available for current consumption,” he writes, “the people must eat less and hold their tongues. No crisis emerges because the subjects have no opportunity to utter their dissatisfaction” (566). Although rational decision-making would be impossible in his socialist commonwealth, there would at least be no booms and busts.

Similarly, for Huerta de Soto (2006) the claim that “an economy of real socialism offers the advantage of eliminating economic crises is tantamount to affirming that the advantage of being dead is immunity to disease.” If cycles are not observed in socialist countries, this is not the mark of a superior system but rather a sign that they are “are continually and permanently in a situation of crisis and recession” (472–73).

Yet the economic history of socialist countries includes boom-bust episodes that in many cases have been even more extreme than those observed elsewhere. Kornai’s (1992) classic study of the Soviet Union and Eastern Europe found that “while some socialist economies grow relatively smoothly, others show wild fluctuations, even larger ones than in many capitalist countries” (187). He noted that the coefficients of variation for annual investment growth in Yugoslavia, Poland, and Hungary were 278 percent, 187 percent, and 171 percent, respectively, all higher than those for the capitalist countries in his sample, which covers the period from 1960 to 1989. (Of these, Ireland had the highest value, at 159 percent.) Similarly, the Chinese economy has experienced dramatic cycles in fixed asset investment going back to the Great Leap Forward in 1958 (Eckstein 1976; Fan and Zhang 2004; Wang 2008; DeWeaver 2012).

Research on Soviet-type economies has generally attributed cyclical fluctuations to inconsistencies in the central plan. Wellisz (1964, 233), for example, describes the plan as being “fitted together like a jig-saw puzzle,” where “an individual piece cannot be trimmed or replaced without spoiling the whole picture.” This meant that “a weakness is tolerated as long as possible in order to avoid rearrangement of all the pieces. Finally, when the situation becomes unbearable, radical steps are taken to remedy it. Thus, the economy proceeds by starts and jolts, with successive drives or campaigns to eliminate this or that mistake.”

Winiecki (1988) shows how this state of affairs resulted from enterprises’ efforts to have their projects included in the five-year plan (FYP) by exaggerating the projected benefits and underestimating the costs. “In consequence,” he finds, “the FYP typically starts with significant built-in distortions in its investment component. These distortions exercise, over time, an increased pressure on aggregate equilibrium…shortages multiply and excess demand begins to grow.” In the majority of cases, the cycle peaked in the second or third year of the plan, at which point the planners “resign themselves to the fact that all planned investment projects will not be completed by the end of the FYP…many projects are ‘mothballed’, with further construction postponed until the next FYP, and some others discontinued altogether” (1988, 20–21).

In practice, it is evident that central planning has never been an antidote for economic fluctuations. It might still be argued, however, that these historical precedents do not rule out in principle the possibility of a stabilizing role for the planner. If administrative arrangements specific to the countries involved account for the volatility of the socialist economies, perhaps the system might somehow be “perfected,” for example by improving the incentives facing enterprise managers and local-level officials. Under ideal conditions, socialism without booms and busts might yet be achievable.

Here my objective is to show that this is not the case. I extend Austrian business cycle theory to the command economy by showing that malinvestment will still occur under central planning whenever any form of economic growth is prioritized. The model, which combines Friedrich Hayek’s (1945) insights on the importance of local knowledge with Scott’s (1998) concept of “legibility,” assumes a planning authority with a limited, though time-varying, statistics-based picture of economic conditions. Cycles then correspond to changes in what can be “read” through statistical data. I find that Mises’s calculation problem implies not only static but also dynamic inefficiency.

The fundamental issue is the planner’s lack of access to local knowledge, which makes comprehensive planning an impossibility regardless of how the plan is formulated. Ideal local-level officials might selflessly follow the leadership’s directives in every particular but will find that these are incomplete. Much will still have to be left to the discretion of the “cadre on the spot,” as Hayek might have put it, who will have to set aside his local-knowledge advantage to focus on plan fulfillment. Investment fluctuations will be unavoidable, because (1) the planner’s incomplete understanding of the opportunity costs associated with any given rate of growth will result in growth targets that are unsustainably high and (2) the planner will be blind to the resulting imbalances until they became sufficiently severe to become “visible” at the aggregate level.

Although the institutional setting is different—administratively set targets take the place of monetary expansions—these dynamics are essentially the same as those described in Austrian business cycle theory. In both cases, faulty signaling of society’s rate of time preference leads to the misallocation of resources into more roundabout production, resulting in distortions that must inevitably be corrected through an investment slowdown. When shortages become sufficiently severe, the central planner will be forced to restore order through administrative measures much as central banks in today’s market economies have to “take away the punch bowl” when faced with rising inflation.

Today, the socialist business cycle is not only of theoretical and historical interest but also of great practical importance. In China the investment cycle continues to be primarily a state-led phenomenon, operating in much the same way as it did in the pre-reform era (DeWeaver 2012). Booms continue to be driven by investment promotion at the local government level while busts result from central government administrative interventions designed to reimpose macroeconomic stability. Although prior to the beginning of the “reform and opening” period in 1978, the Chinese economy’s ups and downs had relatively little relevance to the outside world, today they impact everyone from Swiss watchmakers to Zambian copper miners.

The business cycle in the socialist commonwealth can be considered as an example of what Hülsmann (1998), following Rothbard ([1962] 2004, ch. 11), calls an “error cycle.” The root cause of any business cycle, he argues, is what he refers to as an “illusion”—an error that is independent of time and place and can therefore give rise to recurring erroneous behavior. In this case, the illusion is built into the very idea of central planning. It is the misidentification of the image of the economy that is visible to the planner with the totality of economic reality.

The remainder of this paper traces the origins of this illusion, demonstrates why it gives rise to booms and busts, and describes how Austrian business cycle theory can be extended to the centrally planned economy to account for these aberrations. Part I shows how socialism was built on a denial of the economic significance of local knowledge, which made it possible for theorists to believe in the possibility of an all-seeing planner. Part II presents a model of fluctuations in an ideal socialist commonwealth and demonstrates that these fluctuations can be considered as a subspecies of the Austrian business cycle where state-set output targets play the role of free market interest rates as a signal of society’s rate of time preference. In part III, I review Hülsmann’s argument and argue that his “essentialist” error-cycle approach is particularly well suited to this case. Part IV concludes.

I. THE BIRTH OF AN ILLUSION

The founders of the Soviet system believed that industrial modernization would give rise to the conditions necessary for central planning to work by eliminating the relevance of local knowledge. This idea is implicit in Marx’s claim that with advanced factory technology “the motion of the whole system does not proceed from the workman but from the machinery,” implying that “a change of persons can take place at any time without an interruption of the work.” (Marx [1887] 1999, 285). Standardization and automation would leave Hayek’s man on the spot with no particular informational advantages. Anyone could take his place.

Similarly, Engels ([1894] 1975) believed that modern industry had “freed production from restrictions of locality.” “Water power,” he noted, “was local; steam power is free” (351). Where “knowledge of the particular circumstances of time and place” (Hayek, 1945) would obviously be important for siting a water-powered mill, replacing water with steam could potentially make an understanding of locality-specific geographic conditions largely irrelevant. Engels expected that it would become possible for any factory to be located practically anywhere as technological progress swept aside the myriad local differences that had formerly constrained economic development and would allow “industry to be distributed over the whole country…on the basis of one single vast plan” (Engels [1894] 1975, 351).

Lenin (1920) later updated this conception, replacing steam with electric power. Capitalism, he claimed, “depends on small-scale production and there is only one way of undermining it, to place the economy…on a new technical basis, that of modern large-scale production. Only electricity provides this basis.” Hence his famous dictum, “Communism is Soviet power plus the electrification of the whole country.”

The backwardness of peasant Russia, he went on, would be transformed by power stations, which would become “strongholds of enlightenment.” Electricity would not only light up the night but would also create a manufacturing base free from the idiosyncrasies of traditional economic arrangements. The central planner would not be groping in the dark but able to see clearly. Lenin was aiming at something much more than the electrification of the whole country. He hoped to leverage the rationalizing potential of technology to achieve what Scott (1998) refers to as the “thoroughly legible society,” which “eliminates local monopolies of information and creates a kind of national transparency” (78).

There would then be no need for the “new dispositions made every day in the light of circumstances not known the day before” that Hayek (1945, 524) argued were essential to the “continuous flow of goods and services.” Instead, as Nikolai Bukharin and Evgenii Preobrazhensky claimed in their 1920 book The ABC of Communism, the state will “know in advance how much labor to assign to the various branches of industry, which products are required and how much of each it is necessary to produce; how and where machines must be provided” ([1920, trans. 1922] 2001, chap. 3). Chaotic interactions among privately owned firms would give way to a smoothly functioning state-directed mechanism.

In China, where Bukharin and Preobrazhensky’s readers included Mao Zedong, Deng Xiaoping (Wu and Ma 2016, 23), Beijing mayor and Politburo member Peng Zhen, and People’s Liberation Army founder Zhu De (Snow 1968, 271, 335), this notion was taken up uncritically by the Chinese Communist Party. It is, for example, the unstated assumption behind the “chessboard strategy” described in the famous 1959 People’s Daily editorial “The Whole Country as a Chess Game” [Quan guo yi pan qi]. Written in response to the chaos following the launch of the Great Leap Forward in the previous year, it called for a return to disciplined central planning, likening the national economy to a chessboard, on which the movements of each piece must conform to an overall strategy based on the rules of the game. Implicit in this analogy is the idea that it would be possible for economic life to be just as transparent to the planner as a board game is to the players.

In practice, of course, technology has not created anything like the level of national transparency envisaged by any of these authors. The operations of a large-scale factory can no more be reduced to a straightforward set of rules than the techniques of the traditional artisan. Modern forms of communication have not eliminated “knowledge silos” in complex organizations. Computer algorithms seem unlikely ever to penetrate fully the opacity of asset markets.

Innovations may render older categories of economically significant local knowledge obsolete but may be equally likely to create new ones. Consider the case of the defense aerospace industry. There, Gilli and Gilli (2018) note that “the number of components in military platforms has risen dramatically: in the 1930s, a combat aircraft consisted of hundreds of components, a figure that surged into the tens of thousands in the 1950s and to 300,000 in the 2010s.” As a result, “the number of potential incompatibilities and vulnerabilities” has increased “geometrically” (150) and “the knowledge related to a given weapon system has become increasingly less codifiable—it has become tacit” (163). Unlike the knowledge required to produce a World War I era biplane, which could to a large extent be derived from a blueprint, the essential knowledge resources behind a platform such as Lockheed-Martin’s Joint Strike Fighter are primarily local, residing in the collective memory of an organization and difficult if not impossible to express in any explicit form. From this example it is easy to see that advances in technology can have exactly the opposite effect from that expected by the early socialists, making the workings of the industrial system ever more opaque.

There can thus be no central planning that does not rely on “state simplifications” that are “always some distance from the full reality these abstractions are meant to capture,” as Scott (1998, 77) puts it. These, he argues, differ from the full reality because they (1) “cover only those aspects of social life that are of official interest,” (2) “are nearly always written,” implying that nondeclarative knowledge is necessarily left out, and are (3) “typically static,” (4) “aggregate,” and (5) “standardized.” In the real world, where the relevance of different types of information is constantly changing and the particular circumstances of time and place continue to be economically relevant, there will unavoidably be significant blind spots in the planner’s “synoptic” view.

The problem, as Hayek (1988, 85) pointed out, is that “what cannot be known cannot be planned.” But even in the absence of an adequate basis for decision-making, plans will still be made. Decisions will be taken based on whatever the central planners can “see” at any particular time as the bureaucracy collectively succumbs to the illusion that this is a complete picture. Policy goals will necessarily be limited to targets for “synoptically observable abstractions” while the unobservable details of their implementation are left to officials at the local level. The extent to which such a system gives rise to booms and busts will thus depend critically on the activities of these lower-level cadres.

II. BOOMS AND BUSTS UNDER CENTRAL PLANNING

The local cadre’s responsibility for realizing targets for aggregate variables will be economically destabilizing, because he will be incentivized to generate outcomes that the central government can observe but not to take the associated unobservable economic costs into consideration. As a result, resources will be diverted into planned policy priorities at the expense of activities that are not emphasized, or even contemplated, by the plan. There will be chronic contradictions between the needs of the actual economy and the plans of the economic decision-makers.

When increasing economic output is the primary objective, as has generally been the case historically, this may in principle be achieved through either extensive or intensive growth. But only the former (increasing output by using more inputs) falls within the competence of the planner. Intensive growth, which relies on increased productivity, is intrinsically unplannable. It is straightforward to set material targets for specific items (tons of steel, kilometers of railway lines), as was commonly done in the Soviet Union (Davies 1974), or goals for aggregate measures such as provincial or municipal GDP growth, which have been typical in post-reform China (Zhou 2004). But similar “state simplifications” (e.g., number of patents issued) do a poor job of incentivizing genuine innovation.

Attempts to transform the “mode of economic growth” in the Soviet Union and, more recently, in China have been notably unsuccessful. In the 1980s, the Soviets adopted the policy of uskorenie (acceleration), “subordinating everything to the aim of making the economy more intensive and achieving higher production outputs with smaller inputs and less resources” (Tikhonov 1981, 24), which was to be facilitated through the “universal introduction of fundamentally new machinery and materials and the large-scale use of highly efficient energy- and material-saving technology” (Tikhonov 1981, 29–30). This produced few breakthroughs. The difficulties can be seen from the experience of the machine-building industry, a top priority sector, where of the three thousand new products introduced in 1986 to satisfy innovation targets, 40 percent were found to have involved “no substantial shifts” in technology (Matosich and Matosich 1988).

Similarly, every Chinese five-year plan since 1981 has emphasized the importance of greater economic efficiency for the country’s future development (DeWeaver 2012, chap. 9). Yet levels of excess capacity in industrial sectors such as steel, cement, float glass, and aluminum—to name but a few—have skyrocketed while China’s incremental capital-output ratio has been on a steady uptrend since 2007. And although the jury is still out on Beijing’s “National Medium- and Long-Term Plan for the Development of Science and Technology (2006–2020),” its goals illustrate the difficulty of transitioning to intensive growth using command economy methods: R&D expenditure is supposed to increase to 2.5 percent of GDP, reliance on foreign technology must fall to 30 percent, China must reach fifth place globally in number of patent filings, and so on (McGregor 2010).

Given the obvious problems with raising productivity by fiat, the planner will generally find that extensive growth is the only viable option. As she cannot be aware of all of the opportunity costs associated with any given growth rate, she will necessarily set growth-rate objectives (whether for the entire economy or for specific sectors) that are unsustainably high. The cadre on the spot will respond by investing in infrastructure and the manufacturing base. Hitting material targets will require additional fixed assets once the existing capital stock is fully employed. Investment drives will also be the surest route to an aggregate output benchmark, both because fixed asset accumulation is itself a part of aggregate output in the period in which it occurs and because it makes it possible to increase output in subsequent periods. Although the cadre might conceivably attempt to introduce local-level productivity enhancements, his first choice will be to mobilize factors of production that he perceives as having an opportunity cost of zero because they are currently employed in activities that lie outside the planner’s field of vision.

Murray Rothbard ([1962, 1970] 2004, 337) notes that intertemporal transactions may take the form of either credit extension or the “purchase of producer goods and services.” The latter, he points out, are effectively “future goods” because they will be converted into final products in future periods. In the socialist commonwealth, although money and credit may not exist at all, it will be no less true that the employment of producer goods and services constitutes a substitution of future for present output. And in the absence of changes in productivity or in the availability of land and labor, any growth rate set by the planner will imply a specific requirement for additional capital, which will in turn require some particular increase in investment at the expense of consumption.

Thus, under central planning, state-set targets for output increases based on an extensive growth strategy play an analogous role to the interest rate in a free market system. Both are signals of the rate at which society is willing to sacrifice present for future consumption, that is, of its rate of time preference. Prioritizing economic growth under central planning will therefore give rise to the same outcome as artificially lowering interest rates in a credit-based economy: resources will be shifted into more roundabout production processes. Growth targets have essentially the same effect on the cadre on the spot as do interest rate cuts on Hayek’s man on the spot. Both skew the investment decision-maker’s incentives in favor of subsequent periods, resulting in a mismatch between the aggregate requirements of investment projects and the means available to carry them out.

Alfred Zauberman (1964, 25) notes that historically central planners have generally behaved as “managers of a joint stock company whose shareholders are future generations.” In other words, we may think of them as assigning a discount rate of zero to outcomes occurring at some indefinite date in the future. That Austrian business cycle theory, with its emphasis on faulty signals of society’s true rate of time preference, should be applicable to “actually existing socialism” is thus unsurprising.

In both the socialist and free market cases the outcome will be the same: an initial boom that eventually leads to a crisis as the resulting imbalances become unsustainable. Although in a free market such a crisis can be resolved more or less spontaneously, in the absence of price signals a resolution will not be possible until the essential features of the situation at last come clearly into focus for the planner.

Even under central planning a course correction will eventually be possible, because the planner’s picture of the world, although always incomplete, will not be unvarying. The presence of widespread problems in parts of the economy that the planner cannot see will eventually manifest itself through the aggregated information that she can see, revealing disruptions such as raw materials shortages, crop failures, power outages, and transportation bottlenecks. At this point, the threat to longer-term economic growth will force the planner’s attention to shift from growth targets to the alleviation of shortfalls. Investment plans will have to be cancelled or put on hold as resources are redirected toward previously neglected activities. This will lead to a crisis analogous to those observed in the free market case, though centrally directed rather than the result of a multitude of individual decisions. Given that the planner is the only truly autonomous decision maker, there will be only a single determination that the plan is incompatible with the available resources rather than the mass panic that occurs when “all or nearly all businessmen find that their investments and estimates have been in error” (Rothbard [1962] 2004, ch. 11). Rather than running for the exits on their own, the local cadres will have to be instructed to do so. “The brake” as Kornai tells us, “is applied by central control,” after which a period of austerity will be necessary until such time as the leadership is “reassured that tension has fallen, or even a measure of slack, an apparent underuse of resources, has appeared” (Kornai 1992, 190, 192).

These socialist slowdowns will be no less prone to inefficiencies than the booms that precede them. Lacking the ability to determine whether or not specific activities make economic sense, the planner will have to use arbitrary criteria such as project size or industry type in determining which investments to halt. There will be no way to avoid throwing out the baby with the bathwater.

Just as in a free market economy, the fact that decision-makers have experienced one cycle does not mean that they will be able to avoid another. The details may be different the next time—novel investment rationales may be imagined, innovative technologies may be employed, new sectors may be involved. But as long as economic growth remains the priority, the fact that planning must be conducted in the absence of local knowledge guarantees that recurring rounds of malinvestment will be unavoidable.

Investment booms are not merely a possibility under central planning, but a logical inevitability. This conclusion follows from the following three premises:

(1) The planner’s primary objective is economic growth, whether this be growth in an aggregate measure such as GDP or in output statistics for particular priority sectors.

(2) Local knowledge will be economically significant regardless of how the economy is organized.

(3) Plan fulfillment is the sole objective of the cadre on the spot.

Premise (3) means that the cadre on the spot will take advantage of the lacunae in the plan resulting from premise (2) to meet the planner’s targets. And because (1) implies that future output increases will be targeted, it will be optimal for him to overinvest in roundabout production processes regardless of the resulting malinvestment at the macroeconomic level.

Busts are a logical inevitability as well if we add the following two additional premises:

(4) The macroeconomic effects of malinvestment must eventually become general knowledge.

(5) These effects will pose a threat to longer-term economic growth if left uncorrected.

These imply that the planner must at some point become aware of the intertemporal distortions resulting from the extensive growth strategy and introduce new policies to resolve them, thereby terminating the boom. Although the subjects may have “no opportunity to utter their dissatisfaction” and initially have to “eat less and bite their tongues,” as Mises argued, this state of affairs will obviously have to end at some point before the entire population has starved to death.

III. SOCIALIST ERROR CYCLES

J. Guido Hülsmann (1998) presents an alternative approach to modeling business cycles based on what he refers to as an “essentialist” account of the errors in investment decision-making that drive them. He believes that conventional “consequentialist” stories are unsatisfactory because “as long as human beings choose, that is, as long as they are beings with free will, the correctness of choice must in principle be unrelated to preceding events and choices” (8). The problem with traditional Austrian business cycle theory (ABCT) specifically, he argues, is that it is not generally valid to claim that increases in the money supply cause entrepreneurs to invest in projects that will later turn out to be unprofitable. There is no reason in principle why they could not foresee that these investments would fail and choose not to make them.

During a boom a significant number of people make the same mistake at the same time. Consequentialism explains this clustering of errors as the result of an event (e.g., a money supply increase) that leads decision-makers to err in some particular way. Hülsmann proposes that we instead take error as “the ultimate given.” The question then becomes not “how does error come about?” but rather how can we explain the “repetitive occurrence of more or less synchronous errors of many persons.” This requires identifying “more or less permanent patterns of action (institutions) in which the error of many persons is inherent.” Such an institution must be built upon “a kind of error that is independent of time and place,” which Hülsmann calls an “illusion” (1998, 8–9).

For Hülsmann, this institution is government, which he sees as founded on the illusion that society cannot function in the absence of the institutionalized violence of the state. The task for the theorist is then to “identify particular instances of government intervention and spell out precisely where the illusion is manifest.” There will be “various specific error cycle theories (the economic aspect of which would be specific business cycle theories)” (1998, 14).

My argument in part II is consequentialist—error is caused by the planner’s failure to access local knowledge, which results in the provision of malincentives to her subordinates. Note that this model differs from conventional ABCT in that the faulty decision-making is centralized. While in both explanations the malinvestments occur at the local level, these are only truly errors for the man on the spot. The cadre on the spot is a representative of the state, not an autonomous individual. His activity consists solely in carrying out instructions, using the resources at his disposal in a manner that is optimal for his plan-fulfillment objective. Ultimately it is the planner who errs by mistaking statistics for reality, thereby choosing means that must ultimately prove suboptimal for achieving her long-term goal of maintaining economic growth. This difference is a natural consequence of the cadre’s relative lack of decision-making autonomy. Unlike his free market counterpart, he is not really at liberty to decide whether or not to invest. This decision is imposed on him by the logic of a system set in motion by a single authority acting in the name of the “people” as a collectivity rather than by the aggregation of decisions made by the individual citizens themselves via the market process.

On a more fundamental level, reformulating the story in essentialist terms reveals that the socialist cycle may be thought of as a particular instance of Hülsmann’s general theory. If government is indeed an “illusory institution,” under socialism, where economic life is entirely dominated by the state, recurring erroneous behavior will be unavoidable, though this behavior will be concentrated in the person of the planner, who is uniquely empowered to set the objectives for society as a whole. (Alternatively, we may think of Hülsmann’s “synchronous errors of many persons” as being made by ideal cadres whose individuality has been entirely merged into a single collective “popular will” and therefore err collectively rather than individually.) And we may identify central planning as being “precisely where the illusion is manifest.” Indeed, we can be even more certain that “it is not money but government intervention that accounts for the business cycle,” as Hülsmann concludes, in a commonwealth where interest rates are not relevant to investment and money, at least in a theory, might not even exist at all.

Mihai Macovei (2015, 433) finds that “the essentialist approach is useful, but lacks convincing arguments to become a general theory of business cycles”. He challenges Hülsmann’s claim to generality on two counts. First, a story premised on the idea that government is essentially a form of institutionalized aggression can easily be rejected by anyone who does not happen to share this view. Second, “except for the ABCT, Hülsmann only mentions two other possible examples, such as the ‘military-imperialistic’ and the ‘social security’ cycle. He does not develop them further in order to explain their workings, which is a clear shortcoming in terms of expounding a theory that claims to be general and all-encompassing” (2015, 427). Furthermore, Macovei argues that even the “argumentation” underlying the essentialist reconstruction of the ABCT is “not irrefutable” (2015, 433).

Our consideration of the socialist business cycle, although not relevant to Macovei’s specific objections to this argumentation, suggests possible counterarguments to his two more general points. It suggests, first of all, that the key characteristic of the state for the purposes of business cycle theory may be blindness rather than violence. This position is defensible given the obvious economic importance of local knowledge and the fact that planning is no less a part of any government’s activity than coercion. In addition, one can point to the socialist cycle as an additional special case, thereby strengthening the assertion that the theory is “general and all-encompassing.”

We may think of central planning as one specific instance in which the illusion of government, as Hülsmann characterizes it, is manifested, thereby arriving at a specific version of his general theory appropriate to the socialist commonwealth. But we may also restate this general theory by considering faith in governments’ ability to plan, rather than belief in the necessity of state property rights violations, to be the illusion underlying government itself—not an unreasonable view given that the former must presumably precede the latter. The business cycle then becomes less a consequence of the expropriation of private property than of the state’s inability to use what it has taken in an efficient manner. This restatement has the advantage of making the essentialist position easier to defend while leaving it basically intact.

IV. CONCLUSION

In Economic Calculation in the Socialist Commonwealth, Mises argues that without access to the local knowledge embedded in the price system, the socialist economic order will end up “floundering in the ocean of possible and conceivable economic combinations without the compass of economic calculation” (23). In the absence of any rational basis for decision-making, “the wheels will turn, but will run to no effect” (19).

Here, I have made a case for going beyond Mises’s essentially static framework to explore his argument’s dynamic implications. The planner may never see a complete picture of the economy, but what she does see can nevertheless be expected to vary over time. As a result, her mistakes will be serially correlated, leading to a pattern of alternating overinvestment and austerity not unlike a series of private sector manias and panics. Although the wheels will “run to no effect,” they will run faster during some periods than others.

The incentive issues and political factors characteristic of real-world socialism complicate the story without changing its essential features. The main difference between our idealized commonwealth and existing socialist countries is that real cadres will find ways to influence the contents of the plan and strive to overachieve its goals (Winiecki 1988, Kornai 1992, Zhou 2004). Their priority is typically not plan fulfillment per se but advancing their own careers. But the basic problem—the diversion of resources from activities outside the planner’s field of vision—will be the same, though exacerbated by cadres’ attempts to game the system. The possibility of eliminating booms and busts through administrative reforms can also be ruled out. Central planning is inherently destabilizing.

It is straightforward to generalize Austrian business cycle theory to include both planned and market economies. In either setting, the essential features of the cycle are: (1) an expansionary impulse resulting in (2) a distorted signal of society’s rate of time preference, followed by (3) malinvestment, (4) excess demand, and finally (5) contraction. Under socialism, we simply have the planner in the role of the banker, with the planner’s economic growth policy replacing money supply increases as the expansionary impulse and unrealistically high output targets taking the place of below equilibrium interest rates as the distorter of the time preference signal. In either case, the result is malinvestment, while the excess demand may be manifested either directly, as physical shortages, or indirectly, as inflation. The final contraction will provide the same necessary readjustment whether it results from administratively imposed austerity or interest rate increases.

Far from being an impossibility, as many have imagined, the socialist business cycle may in fact be the state-driven business cycle par excellence. Without markets and private property, policy does not have to be transmitted indirectly to the private sector through a monetary or fiscal “transmission mechanism” nor are there any truly independent decision-makers. The state’s economic management will have a direct and immediate impact and cannot fail to produce booms and busts under the five assumptions enumerated at the end of section II.

The socialist business cycle is also arguably the Hülsmannian error cycle par excellence. Where there are no private sector “animal spirits,” the source of the “recurring erroneous behavior” is unambiguous. It can only be the state’s blindness to the “particular circumstances of time and place,” whether considered as a specific manifestation of the illusion of government or as this illusion’s ultimate source.

Categories: Current Affairs

The Japanese Love of Keynesian Economics Might Finally Be Coming to an End

Mises Institute - Wed, 20/05/2020 - 17:00

Even those fortunate enough to have escaped infection by the Wuhan coronavirus will by now have noticed one of the virus’ many secondary effects: the disruption of the supply chain. Sick workers at meat plants, closed restaurants, hoarding, and the sudden spike in demand for things like ventilators, masks, and comestibles with long shelf lives have thrown the global flow of goods and services into disarray. Shelves are empty, crops are rotting in the fields—supply and demand are no longer matched, and the global economy is tying up in knots.

Even the mails are bogged down. I went to a Japanese post office two days ago and was told something by the clerk there that I didn’t expect to hear in my lifetime: “Sorry, we can no longer send any letters to the USA.”

This secondary effect is giving rise to a tertiary one, namely, concerns over dependency on supply chains that rely on Chinese goods. Given Japan’s proximity to China, and China’s increasing turn toward authoritarianism, many Japanese are hoping there are ways to do business without China.

But whatever one thinks of the level of danger posed by the Chinese regime, the fact remains that it would be wise for the Japanese to start thinking seriously about how to encourage domestic industries.

For a hint on how to do this, we might look at some interesting new developments in the former second-biggest economy itself.

Japan rose from the rubble of World War II and came eventually to rival its erstwhile vanquisher by dint of what many began to call Japan, Inc., which is the general appellation for how things used to work here—the “iron triangle” of industry, bureaucracy, and Liberal Democratic Party (LDP) political rule that provided the general framework for making big decisions about economic directionality at the top of the Japanese political-economic food chain. The Ministry of International Trade and Industry (MITI; now METI, the Ministry of Economy, Trade, and Industry), and the LDP politicians who (as Harvard legal and economic historian Mark Ramseyer has shown) kept MITI on political track, together directed state resources such as power grids and research funds toward industries deemed by the government to be good for Japan as a whole. Hence, Japan, Inc.—the corporation the size of a country, with a private sector hemmed in by a set-piece relationship among keiretsu captains, bureaucratic heavyweights, and political insiders.

This all worked well for a while. Until it didn’t. One of my first real jobs was at a factory in Ibaraki Prefecture, Japan. The factory used to make printers, but production had been shipped to rural Vietnam to cut costs and the only people left in the printer section were the office workers and engineers. People from our section used to travel to Vietnam often to coordinate the supply chain and make sure that QC (quality control) was up to Japanese standards. But all the printer-making jobs that used to be in Ibaraki had gone to Southeast Asia—which, ironically, had been raised to the level of being able to host Japanese manufacturing in the first place thanks to enormous economic aid (i.e., “official development assistance”) from Tokyo after the end of World War II. Japan, Inc. had bifurcated itself. One half wanted to maintain the cradle-to-grave welfare and employment stability for which postwar Japan was justly famous. The other half wanted to increase its influence and foster goodwill among the rest of Asia. What two generations of postwar Japanese people enjoyed was largely denied to a third. Japan, Inc. began to be seen by many here to be more nostalgia and empty promise than substantial boon for the majority of workers and their families. It lost its luster, especially when the bottom fell out of the economy after the government-fueled loose money speculative bubble and inevitable crash now more than two lost decades ago.

This, coupled with a series of serious scandals in which the Japanese government proved itself much more inept than many had realized—from the massive Lockheed bribery scandal beginning in the 1950s to the botched response to the Fukushima triple disaster in 2011—put an end to Japan, Inc. in fact if not yet in name. Abenomics, the attempt by the present prime minister, Abe Shinzō, to resuscitate the Japanese economy by means of yet more Keynesian cash, is Japan, Inc.’s last gasp. Many here are beginning to advocate true free market solutions that are a big departure from the economic paternalism of decades past.

As proof, Ezaki Michio, a policy analyst and researcher who is a professed devotee of the free market and small government, published an op-ed earlier this month in the Sankei Shimbun—the newspaper of record for fiscal sanity and political clearheadedness—calling for strengthening the Japanese domestic economy and countering the perceived geopolitical threat posed by Japan’s communist neighbor on steroids China by…drumroll please…cutting taxes. Across the board. Touting the Trump tax cuts of 2017 and the deep and positive effect that those cuts had on the American economy, Ezaki advocated that Japan follow suit. This bucks the trend in Japan, to be sure. Just last year the consumption tax here was raised to 10 percent, and the outlays now moving through the political sausage-making machine to deal with the economic fallout of the Wuhan virus are surely going to translate to even higher taxes down the line. Pleading over that siren song, Ezaki says to cut taxes, and he also says to cut regulations and let businesses make money again. Hooah.

There’s an added benefit to all this, Ezaki argues: a business-friendly Japan is an economically diverse Japan, and an economically diverse Japan need not rely on any one country for the majority of its essential needs. One silver lining to the coronavirus pandemic may be that it wakes the sleeping giant of Japanese R&D (research and development) and strengthens the Japanese economy—now in a Keynesian coma—back into fighting form again.

Categories: Current Affairs

The School Closures Are a Big Threat to the Power of Public Schools

Mises Institute - Wed, 20/05/2020 - 17:00

For many parents, the ongoing closure of public schools will just reinforce growing suspicions that public schools just aren't worth it anymore. Maybe they never were.

This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.

Original Article: "The School Closures Are a Big Threat to the Power of Public Schools"

Categories: Current Affairs

Adam Smith and Benevolence

Mises Institute - Wed, 20/05/2020 - 16:00

Buyers and sellers in the free market do indeed act from self-interest, but Adam Smith never argued that this excludes friendly feelings for those they do business with.

This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.

Original Article: "Adam Smith and Benevolence"

Categories: Current Affairs

Price gouging and price controls in Italy

Adam Smith Institute - Wed, 20/05/2020 - 15:37

Meddling with prices is an irresistible temptation for governments, particularly in times of crisis. So, to avoid price gouging, the Italian government capped the price of surgical face masks on April 26. I’ve written on the issue for the Wall Street Journal, here.

A couple of things stand out in this story. First, the price was fixed at a level clearly below any sensible appraisal of the market price. The government itself was buying at 38 cents a mask, wholesale, and pre-tended retailers sell at 50 cents a mask. Why? If the price was fixed at, say, one euro a mask, perhaps it would have produced little damage, and the government could still claim it put an end to “speculation”.

So, why did they do something different? Well, I suppose the simplest answer is, alas, the closest to the truth: 50 cents sounded better than one euro. One euro is the price of an espresso. What a wonderful government, the one that allows you to buy two pieces of a life-saving device with the same money it will take you to buy a coffee!

Now, here comes an interesting development. The Italian Commissioner for the Coronavirus emergency made sure to clarify that he was regulating the price at which face masks ought to be sold, not the price at which face masks ought to be bought by retailers. Since retailers already bought masks at a higher price, this was meant to be a green light: go ahead, sell under costs, the government will step in and refund you. Pharmacists I talked with, however, did not do so: they were quite hesitant in taking the Italian government’s word for granted. So far, the subsidy has not yet been agreed.

Many comments on the WSJ website are humorous and funny. One claims that Italians now have received free face masks in the mail, by the government. Indeed, some Italians did receive one or a couple of masks for free, by their regional governments. Still, it is worth remembering that a surgical one is supposed to be a single used, disposable device.

Mr. Mingardi is director general of Istituto Bruno Leoni, Italy’s free-market think tank, an adjunct scholar with the Cato Institute, and a presidential scholar in political theory at Chapman University.

Categories: Current Affairs

Let's Hope Deflation Is Headed Our Way

Mises Institute - Wed, 20/05/2020 - 12:00

The yearly growth rate of the US consumer price index (CPI) fell to 0.4 percent in April from 2 percent in April last year while the annual growth of the producer price index (PPI) plunged to –1.2 percent last month against 2.4 percent in April 2019.

Furthermore, the yearly growth rate of the import price index fell to –6.8 percent in April from –0.2 percent in April last year.

A general decline in the prices of goods and services is regarded as bad news since it is associated with major economic slumps such as the Great Depression of the 1930s.

In July 1932, during the Great Depression, the yearly growth rate of industrial production stood at –31 percent whilst the yearly growth rate of the CPI bottomed out at –10.7 percent in September 1932.

According to commentators for the US central bank—the Fed—the possibility of deflation is a major worry. That is because when prices fall it is harder for borrowers to pay down existing debts, leading to rising defaults, while banks become reluctant to extend credit. The logic runs that these two factors combine to generate a downward spiral in credit creation and resultant economic activity. Furthermore, most experts regard a general fall in prices as always “bad news,” for it slows down people’s propensity to spend, which in turn undermines investment in plants and machinery. These factors are further argued to set in motion an economic slump. Moreover, as the slump further depresses the prices of goods, the pace of economic decline intensifies.

It is for these reasons that most economists are of the view that it is the duty of the central bank, the Fed in the US, to prevent deflation. In his 2002 speech before the National Economists Club in Washington, DC, entitled “Deflation – Making Sure ‘It’ Doesn’t Happen Here,” Ben Bernanke, then a Fed governor, laid out measures that the central bank could use to combat deflation—such as buying longer-maturity Treasury debt. He also mentioned Milton Friedman’s “helicopter money.”

For most experts the key reason for the need to pump money into the economy is to boost the demand for goods and services. To them, all that is required is to strengthen aggregate demand. Once this happens the supply of goods and services follows suit. But why should an increase in demand result in an increase in supply? Without suitable production infrastructure, no amount of expansion in supply is going to result from an increase in demand.

Also, to suggest that consumers postpone their buying of goods because prices are expected to fall would mean that people have abandoned any desire to live in the present. However, without the maintenance of life in the present no future life is conceivable. Note that the rising purchasing power of money, i.e., declining prices, is the mechanism that makes a great variety of goods produced accessible to many people. A prime example is that of computers: decades of declining prices have not stopped people from continuing to purchase computers.

On this Murray Rothbard wrote in What Has Government Done to Our Money?,

Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards. (p. 17)

Even if we were to accept that declines in prices in response to an increase in the production of goods promotes the well-being of individuals, what about the argument that a fall in prices is associated with a decline in economic activity? Surely, this type of deflation is bad news and must be countered.

Why Central Bank Monetary Pumping Makes Things Much Worse

Whenever a central bank pumps money into the economy this benefits various individuals engaged in activities that sprang up on the back of that loose monetary policy at the expense of wealth generators. Through loose monetary policy, the central bank gives rise to a class of people who unwittingly become consumers without the prerequisite of contributing to the pool of real saving. These recipients’ consumption of newly created money is made possible through the diversion of real savings from wealth producers. They only take from the pool of real savings without contributing anything in return.

Observe that consumption and production are equally important in the fulfilment of people’s ultimate goal, which is the maintenance of life and well-being. Consumption depends on production, while production depends on consumption. The loose monetary policy of the central bank breaks this unity by creating an environment where it appears possible to consume without production.

Not only does the easy monetary policy push the prices of existing goods up, but the monetary pumping also gives rise to the production of goods or assets that are demanded by non–wealth producers. An example might be property, stocks, or fast cars, or nifty electronic goods. Now, goods that are consumed by wealth producers are never wasted, for these goods sustain them as they produce goods and services. But this is not so with non–wealth producers, who consume but produce nothing in return.

As long as the pool of real savings continues to grow, various goods and services that are patronized by non–wealth producers appear to be profitable. However, once the central bank reverses its loose monetary stance, the diversion of real savings from wealth producers to non–wealth producers is arrested. This undermines non–wealth producers’ demand for those goods and services, exerting downward pressure on their prices.

The tighter monetary stance halts the bleeding of wealth generators, undermining the bubble activities that had been sustained by loose monetary policy. The fall in the prices of various goods and services simply comes in response to the arrest of the impoverishment of wealth producers and hence signifies the beginning of economic healing. Obviously, to reverse the monetary stance in order to prevent these price declines amounts to the renewal of the pillaging of wealth generators.

Loose Monetary Policy Only “Works” as Long as Real Savings Grow

As a rule, what the central bank tries to stabilize is the so-called price index. The “success” of this policy, however, hinges on the state of real savings. As long as the pool of real savings is expanding, the reversal of the tighter stance creates the illusion that loose monetary policy is the right remedy. This is because the loose monetary stance enriches non–wealth producers, propping up their demand for goods and services and thereby halting or even reversing price deflation.

Furthermore, while the pool of real savings is growing, the pace of economic growth stays positive. Hence the mistaken belief that a loose monetary stance that reverses a fall in prices is the key to reviving economic activity. The illusion that monetary pumping can keep the economy going is shattered once the pool of real savings begins to decline.

Once this happens, the economy begins its downward plunge. The most aggressive loosening of monetary policy will not reverse it. In fact, the reversal of the tight monetary stance will further eat into the pool of real savings, deepening the economic slump. But even if loose monetary policies were to succeed in lifting prices and inflationary expectations, they could not revive the economy as long as the pool of real savings is declining.

Contrary to the popular view, price deflation is always good news for the economy. When prices decline in response to the expansion of real wealth, it means that people's living standards are rising.

But even when prices fall because of the bursting of a financial bubble, it is also good news for the economy. It indicates that the impoverishment of wealth producers is finally being arrested.

Categories: Current Affairs

Patent pools, vaccines and coronavirus cures

Adam Smith Institute - Wed, 20/05/2020 - 07:01

Given age, general grumpiness and our correct if rare worldview we rarely see newspaper articles - those not written by ourselves that is - that we entirely agree with. An exception is Matthew Lynn on patent pools for vaccines and treatments for the coronavirus:

One iron law of politics and economics is always this: there is no crisis quite so bad that the European Union cannot find a way to make it a little bit worse. This week, the EU is leading efforts to create a so-called “voluntary patent pool” that would suspend intellectual property rules so that a vaccine or drug to fight Covid-19 can be rolled out quickly around the world.

At the same time, charities such as Oxfam are leading a campaign for a “People’s Vaccine” and Left-leaning economists are arguing that companies shouldn’t be allowed to stop treatments being made available to everyone.

People, runs the argument, need to be put before profits.

But hold on. That’s crazy. In truth, we should increase the incentives to find vaccines and drugs to combat the virus – not reduce them.

Quite so.

We face a large and expensive problem. We’d like to mobilise the collective resources of the species to solve it. Our only question is what is the best manner of doing this?

One potential answer is that we ask governments to do it. The problem being that governments do not currently employ the people able to do this and there’s insufficient time to go through a civil service hiring process. This before we even consider the likely outcome of asking PHE to do anything other than berate the population on their girth. Another touted possibility is that we ask the private sector - who do employ the right people already - to do it and then tell them they’ll get nothing more than a pat on the back for doing so. This does work in certain circumstances - it is what medals and titles are for, incentives to action - but rather better with individuals than collectives. This is a collective, not individual, endeavour.

We are thus rather left with the thing that already does operate as the incentive for private sector economic activity - money. It’s a vaccine, most rich world doses will be bought by governments, so it’s going to be taxpayer cash spent here. However it’s done poor world doses are going to be supplied at something like cost plus a tiny bit as near all vaccines are today.

Our two options now being that governments can offer a prize for the treatment or vaccine or governments can offer a prize for a treatment or vaccine. The first could be a large lump sum payment for whoever gets there first with something that works. The second would be the award of a patent - therefore the ability to profit from the use of - for whatever works. Which is the best system?

It is unlikely that governments will agree to pay the sorts of sums that would provide the correct incentive. This is an expensive problem, it is immediate, a week makes a difference to the true cost - we should be talking billions as that prize. Politics will not pay that sum, it is not conceivable that it would, not as one lump sum to the winner of the race.

It is also true that we don’t in fact want the one treatment or vaccine. We want as many as actually manage to do something. Governments are most certainly not going to pay out billions each time for multiple solutions, partial solutions or complete. We don’t and cannot know now which of any of the multiplicity of possible solutions will prove most valuable. We don’t know now that is, it’s something we’re going to have to try and see.

So, our only useful and viable solution is that each of those - partial or complete - solutions get out there, be used, then people get paid some sum dependent upon how effective they are. That effectiveness being estimated by how often they’re used. This being exactly what the patent system does do.

That is, we already have the system in place to deal with this immediate and expensive problem. Pay people a small fee for each use of their developed solution - patents.

Why is anyone arguing about this?


Categories: Current Affairs

John Tamny On America’s Uniquely Productive Entrepreneurial Flywheel

Mises Institute - Wed, 20/05/2020 - 02:00
Key Takeaways and Actionable Insights

A growth business is what John Rossman, in episode #50, termed a flywheel. Using Amazon.com as an example, he gave us this simple image.

E4E Flywheel

The flywheel looks simple, but in reality it’s quite nuanced. Lower prices and a great customer experience will bring customers in, Bezos reasoned. High traffic will lead to higher sales numbers, which will draw in more third-party, commission-paying sellers. Each additional seller will allow Amazon to get more out of fixed costs like fulfillment centers and the servers needed to run the website. This greater efficiency will then enable it to lower prices further. More sellers will also lead to better selection. All of these effects will come full circle back to a better customer experience.

John Tamny sees the American entrepreneurial economy as a beautiful and productive flywheel (see Mises.orgE4E_66_PDF​).

Why are Americans so entrepreneurially focused? We descend from “the crazies” — the other thinkers who came from around the world, dissatisfied with their lives, and willing to cross oceans and borders to get to a place that offers no security but offers freedom. They took the ultimate entrepreneurial leap. We got the nut cases. Steve Jobs, for example, was of Syrian descent. Could he have started Apple in Syria? No.

Entrepreneurs lead us to a better place.

John’s definition of an entrepreneur is someone who has a vision that everyone else thinks is ridiculous, yet they follow it anyway. They have no time for the way things are done today. They want something different. And to win consumer acceptance, what’s different must also be better. So they quite literally lead us to a better place. Horse drawn carriages weren’t enough, so Henry Ford gave people something different. Everyone wanted Blackberry phones when Steve Jobs brought out the iPhone, and he quickly demonstrated its superiority. Every entrepreneurial act is speculation — there is never certainty that people are going to want the new product. That’s what is so important about entrepreneurs.

Entrepreneurs need to attract intrepid finance and intrepid financiers.

Silicon Valley is littered with VC’s who turned down Facebook, and turned down Amazon. Founding entrepreneurs think differently and have a vision that is far out of the norm, and they need to be matched with financiers who can be strong supporters and collaborators on the path to a better place. Irrespective of whether it is from Wall Street or Sand Hill Road, or from visionary friends and family, it’s critically important that we figure out a way to get financing to brilliant people. Government restrictions on entrepreneurial activity are certainly barriers to growth, but so is failure of imagination on the part of capitalists.

Intrepid lending takes place far away from banks. Unspent wealth is the source, and the more unspent wealth one person has, the more risks they can take.

We tend to complain about the antiquated and sclerotic banking system, but it has nothing to do with entrepreneurs and innovation. Banks make loans to entities they know will pay them back. Entrepreneurs fail 90% of the time. Banks want nothing to do with innovation.

Those with unspent wealth are the most crucial people in the economy when they match their unspent wealth with entrepreneurial talent and vision. The more unspent wealth they have – and the less the government takes away from them in taxes — the more intrepid they can be in investing it. When we tax away the wealth if the richest, we tax away the most important wealth of all — that which has the highest odds of being directed towards new ideas that, while they look promising, have high odds of failure.

More and more of us have the opportunity to become entrepreneurs, if we harness the flywheel of original ideas that attract intrepid capital.

One of John’s many books, The End Of Work, describes how we are all now so enabled with interconnectivity to resources that we have the chance to make money by doing what we love. Our passion can become our job. If we are able to imagine a future place that is better — that improves the lives of individuals — we can create a growing business. The more of us who can do this, the more we grow the whole economy — which, after all, is made up of individuals. If we can also attract that intrepid capital that John refers to, growth becomes faster and higher.

Besides The End Of Work: Why Your Passion Can Become Your Job, John’s books include Popular Economics: What The Rolling Stones, Downton Abbey and LeBron James Can Teach You About Economics, and Who Needs The Fed: What Taylor Swift, Uber, and Robots Tell Us About Money, Credit, and Why We Should Abolish America's Central Bank.

Additional Resource

"John Tamny's Entrepreneurial Flywheel" (PDF): Mises.orgE4E_66_PDF

Categories: Current Affairs

Thanks to Shutdowns, Many Will Learn That Public Schooling Isn't All That Essential After All

Mises Institute - Tue, 19/05/2020 - 23:00
Panic over the COVID-19 virus has led to the closure of many schools and new forays into education outside the government school system. Many will find that they don't need the state's schools at all.

This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.

Original Article: "Thanks to Shutdowns, Many Will Learn That Public Schooling Isn't All That Essential After All"

Categories: Current Affairs

Krugman: We Need More Unemployment—to Save Us from Unemployment

Mises Institute - Tue, 19/05/2020 - 20:00

It has been a long time since I read anything by Paul Krugman, and seeing his most recent column simply reminds me why I’ve not missed anything. As both an extreme Keynesian and political partisan, he long ago abandoned economic analysis for something economists should recognize as nothing less than what Mises called metaphysics.

Nonetheless, my curiosity got the best of me when he wrote that reopening the economy and allowing people to go to work almost surely will cause a depression. He writes:

Last week the Bureau of Labor Statistics officially validated what we already knew: Just a few months into the Covid-19 crisis, America already has a Great Depression level of unemployment. But that’s not the same thing as saying that we’re in a depression. We won’t know whether that’s true until we see whether extremely high unemployment lasts for a long time, say a year or more.

Unfortunately, the Trump administration and its allies are doing all they can to make a full-scale depression more likely.

Now, many of us believe that the massive monetary and “fiscal” interventions into the US economy from both federal and state governments are likely to create a depression and make the current rates of unemployment grow even more. That, however, is not Krugman’s point. In fact, Krugman seems to believe that there isn’t enough government intervention, which is a regular theme in his writings. Instead, Krugman is alleging that reopening the economy is what will usher in the next depression.

We have been there before. Who can forget Krugman’s 2011 clarion call to form real defenses against an imaginary invasion by space aliens in order to revitalize the economy? Anyone who has read (or taught) Keynesian economics knows that according to Keynesians, the economy always is a slip away from going into massive unemployment unless government (a) cuts interest rates until they cannot be cut anymore, and (b) engages in massive new spending to increase “aggregate demand” because “full employment” only can be reached when government intervenes, period.

But even I will admit that this column took me by surprise, although he has his usual partisan snipes. To the question of how we avoid an out-and-out depression, Krugman replies that we need to “stay the course” (in his words) and keep everyone locked up even longer. His reasoning is that if Americans are let out of home confinement now, all of the so-called gains that this country supposedly has made against the ravages of COVID-19 will be lost and then the rock will roll back down to the bottom of the hill. Krugman writes:

If we could get the coronavirus under control, recovery could indeed be very rapid. True, recovery from the 2008 financial crisis took a long time, but this had a lot to do with problems that had accumulated during the housing bubble, notably an unprecedented level of household debt. There don’t seem to be comparable problems now.

But getting the virus under control doesn’t mean “flattening the curve,” which, by the way, we did—we managed to slow the spread of Covid-19 enough that our hospitals weren’t overwhelmed. It means crushing the curve: getting the number of infected Americans way down, then maintaining a high level of testing to quickly spot new cases, combined with contact tracing so that we can quarantine those who may have been exposed.

To get to that point, however, we would need, first, to maintain a rigorous regime of social distancing for however long it takes to reduce new infections to a low level. And then we would have to protect all Americans with the kind of testing and tracing that is already available to people who work directly for Donald Trump, but almost nobody else.

The closest thing to this kind of thinking is AP correspondent Peter Arnett’s infamous quote after American air strikes decimated the village of Ben Tre: “It became necessary to destroy the town to save it.” In modern parlance, it means that in order to “save” the US economy, the government must enact and enforce policies that will severely hamper economic activity. However, Krugman, being Krugman, believes that there is an easy interim “solution” to enabling the economy to work just fine—without working, of course. He writes:

At the same time, the administration and its allies are apparently dead set against providing the financial aid that would let us sustain social distancing without extreme financial hardship. Extend enhanced unemployment benefits, which will expire July 31? “Over our dead bodies,” says Senator Lindsey Graham. Aid to state and local governments, which have already laid off a million workers? That, says, Mitch McConnell, would be a “blue-state bailout.” (Emphasis mine)

This statement truly exposes the extreme Keynesian mentality: printing money is the near-direct equivalent of actually producing something. Like all Keynesians, Krugman commits the fallacy of composition, believing that what might be good for one person (or a few persons) thus is good for everyone.

For example, we already have seen that thanks to current government policies, many workers are receiving unemployment benefits that are more than the wages they would receive if they returned to work, so, not surprisingly, they are staying off the job. According to the Keynesian-supporting journalists at CNBC, that is a “good thing.”

No, that is a disaster in the making. Although it might be good for me if the government gave me a million dollars a week not to work, it would be effective only if I’m the only one receiving the benefit. Although the rest of society actually would be worse off under such a policy—since it would be nothing but a naked wealth transfer from everyone else to me—I could claim that it really is a “good thing,” because, in Keynesian-speak, it would increase “aggregate demand.”

Think of this on a very large scale, and one has an idea of what Krugman is advocating in the name of preventing a depression. Although it is clear that the Trump administration has engaged in one policy disaster after another by flooding the economy with new money in hopes (vain hopes) that it can “replace” the permanent economic losses due to mandatory business shutdowns, one senses that Krugman believes that these so-called stimulus packages are not enough. Indeed, one can interpret his attack on Trump and Senate Republicans as saying that they are refusing to go as far as Krugman apparently wants: to put nearly the entire workforce on the dole.

One is reminded of J.M. Keyne’s quote that credit expansion from thin air “turns stones into bread.” Krugman essentially is saying the same thing; government via massive monetary injections into the economy magically is substituting money for the real thing: production of actual and consumable goods and services. Unfortunately, too many people in authority believe this nonsense and believe it to our demise.

Like so many others on the left, Krugman believes that we are faced with a stark choice: lock down everyone and defeat the coronavirus or allow people to live their lives without government interference and so get sick and die. As Michael Accad recently wrote, this is not about that kind of tradeoff. Given that the original policies which Krugman has endorsed came about because of an outright fraudulent epidemiological model by Neil Ferguson of Imperial College of London, which predicted a whopping 2.2 million American deaths unless government acted immediately to quarantine the whole country, it is just as hard to take Krugman the epidemiologist seriously as it is to take Krugman the economist with anything but a huge block of salt.

To sum up Krugman’s latest outburst, we have the following progression: (a) shutting down businesses across the country has resulted in massive layoffs and depression-level rates of unemployment; (b) letting people go back to work will result in even greater levels of illness than before, which will really spur unemployment; (c) therefore, print lots of money and keep people inside and everything will be fine.

The logical fallacies here are overwhelming. If governments continue to keep businesses shuttered and people locked up, unemployment rates soon will skyrocket to unprecedented levels and we will be in an even worse depression. However, Krugman adds that if governments vastly expand credit that is now beyond already unrecognizable levels, then the glorified money printing will keep everything in check.

This is logic worthy of not just Keynes, but of cranks like Silvio Gesell and the gaggle of modern monetary theory (MMT) advocates. To be honest, the only thing missing from Krugman’s latest fantasy is the beginning line, “Once upon a time….”

Categories: Current Affairs

Hacksawing the Economy: How Lockdowns Are in the Tradition of Civil War Surgeons

Mises Institute - Tue, 19/05/2020 - 19:00

Hacking off soldiers' limbs was a favorite technique of Civil War surgeons, largely because doctors wanted to avoid blame for later cases of gangrene. So doctors erred on the "safe" side. Many patients may have disagreed.

This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.

Original Article: "https://mises.org/wire/hacksawing-economy-how-lockdowns-are-tradition-civil-war-surgeons"

Categories: Current Affairs

How Modern Economics Has Lost Its Way: It's All About the "Unseen"

Mises Institute - Tue, 19/05/2020 - 17:00

Economics has lost its way and the study has become both impotent and lacking in relevance. It's easy to see how and why once we recognize that proper economic thinking takes place two steps beyond the apparent. Noneconomists typically take none of these steps, while modern economics has lost the ability to go beyond the first.

This can, I think, be explained by economics's increasing adoption of and reliance on mathematical and equilibrium models, which typically disallow the second step.

What are the steps?

They involve going beyond what is directly observed to uncover first the immediate or atemporal tradeoff and then the temporal dimension of the tradeoff in an overall process.

Frederic Bastiat famously distinguished good and bad economists by their ability (and inability, respectively) to see the "unseen."

What he meant by this is that there is always a tradeoff: something else could have taken place had it not been for the immediate cause of the observed situation. In other words, it focuses on proper economizing through imagining the counterfactual. Proper social theorizing can go nowhere without this fundamental insight.

For Bastiat, it is illustrated by a shopkeeper's broken window. Since the window was broken, the shopkeeper will give the glazier more business. Isn't that a good thing? Yes, considering only what we can see, this obviously means more business for the glazier, who in turn can, perhaps, invest in his business, buy more inputs, etc. But to be able to assess this situation from an economic point of view, notes Bastiat, we must also take into account what would otherwise have happened. If we only consider the broken window's outcome, then it would appear as though destroying things would overall be a good investment. Or, to put it differently, a war would make us much more prosperous than peace.

Similarly, by this analogy you should set your own house on fire. 

This is a preposterous thought, and it is so because it does not consider the counterfactual.

Bastiat notes that had the shopkeeper's window not been broken, he would have done something else with that money, perhaps bought shoes. So by breaking the window, the glazier gets more business but the shoemaker gets less. In both cases there would be beneficial exchange. So we cannot say that breaking stuff is better because it leads to certain actions. In fact, it is worse, because the shopkeeper (and "society") loses the value of the window.

Breaking the window sets us back; it does not take us forward (unless we are the glazier).

But although Bastiat's point is important, it is not enough to properly think about the economy. In fact, modern economic models and equilibrium theorizing are based on this fundamental tradeoff. Economists understand and can point to the real tradeoff, which explains why they are often disliked by those who conceive of quick fixes and present them as solutions, basing their reasoning solely on the "seen." Taking the "unseen" into account changes the analysis and makes it much harder to improve things.

The difference between modern economics and proper economic thinking lies in taking the next step after having arrived at the "unseen" to what I refer to as the "unrealized." Rather than relatively simple comparisons (or comparative statics) taking the immediate tradeoff into account, the "unrealized" recognizes that the economy is an ever unfolding process of actions that, fundamentally, are economizing using the imaginable tradeoffs.

This goes beyond the multiplier effect that is semipresent in Bastiat's story.

Even the multiplier, that an investment spreads through the economy as the money changes hands, only considers (and follows) one change. The rest of the economy is (theoretically) held constant as the money "ripples" are traced step by step. This is a simplification, and it is an important one to recognize, since it is only a simplification. It can help to uncover a specific process or the implications of a specific action, but it does not help us understand the overall market process.

The "unrealized" recognizes the historic processes and the tradeoffs in it as well as the future.

In other words, it doesn't simply take our situation as it is and theorizes from it, but asks where this situation comes from.

Specifically, the economy is all of our actions and interactions aggregated. But our choices (and our actions) are made in reaction to the options we are presented with.

The shopkeeper in Bastiat's example had the choice between replacing the window and buying shoes. But what else could there have been, and what else would there have been were it not for the many specific prior influences on people's choices?

This becomes a necessary tool when assessing the impact of historic regulations and, more importantly, the possible outcome of introducing new regulations.

Perhaps we want certain restrictions on a specific unsavory behavior. But what does this restriction mean in terms of the choices that can be made by people in the future? It is not as simple as Bastiat's tradeoff between window and shoes. The glazier's won business leads to different behavior than had it not happened. It, in turn, affects choices made by yet others, whose "choice set" (the types and number of choices available to them in any situation) is affected by the glazier's actions.

Had Bill Gates not formed a business around MSDOS and Windows, what options for employment would young people of today have?

This is important, because it traces the "ripples" of actions and changes through the economy over time, and recognizes that there is more than one tradeoff—that one choice influences one's and other people's future choices.

It can be argued that any forced change can have enormous consequences in seemingly unrelated situations, as I do in my book The Seen, the Unseen, and the Unrealized: How Regulations Affect Our Everyday Lives.

For instance, the sweatshop is often argued to be much better employment for people in developing countries than any and all options they have. This is true, and the argument emphasizes the tradeoff these people are facing: they choose between working in the sweatshop or something much more terrible. But what this analysis fails to recognize is why these are the only options available. Why is it that sweatshops can be established in poor countries, but other options are not nearly as beneficial? If one sweatshop can function in some location, why are there not many sweatshops there to compete for workers with (even) higher wages and better work conditions?

It should be obvious that the present economy can facilitate the one sweatshop, which means it can also facilitate more sweatshops. So why is this not the case?

Why do those other job opportunities remain unrealized?

The answer lies in costs and frictions imposed on the economy somewhere. But as it is an integrated system, these impositions may not be where the sweatshops are. In fact, the sweatshop phenomenon can be a result of, for example, international trade regulations and trade agreements, and even regulations in other nations entirely. What appears to be a low-cost policy or regulation in one country can indirectly affect options for distant peoples and thus their conditions.

It is thus possible (even likely) that domestic regulations in developing countries are the cause, or at last contribute to, the lack of economic development in other countries.

A restriction on one person generates different choices than there otherwise would have been, which changes the choice set of all those affected—of those who are "stripped" of options that otherwise would be available and those who "gain" options.

These are real distortions that must be taken into account to properly understand regulations. And proper economic reasoning recognizes these processes, and their vast and important effects.

We may not be able to trace them in detail, or measure them empirically, but they must be considered when studying and attempting to understand the economy.

Proper economic thinkers take two steps ahead, from the seen through the unseen to the unrealized.

Formatted from Twitter @PerBylund, edited for clarity.

Categories: Current Affairs

Hacksawing the Economy: How Lockdowns Are in the Tradition of Civil War Surgeons

Mises Institute - Tue, 19/05/2020 - 12:00

Politicians and government health officials’ justification for decreeing shutdowns of vast swaths of American life has been deterring the spread of COVID-19. According to Federal Reserve chairman Jerome Powell, almost 40 percent of households earning less than $40,000 per year have a member who has lost their job in recent months. Depression, drug abuse, and suicide are spiking as a result of the lockdowns and “shelter-in-place” commands.

Infection rates and deaths have soared despite severe restrictions on daily life. However, politicians and government health officials continue to claim victory because otherwise more people would have been infected by COVID-19. Most of the media coverage applauds politicians and officials who champion extending lockdowns regardless of the collateral damage to American life.

The political response to COVID-19 is eerily similar to Civil War surgeons’ rationales. Amputation was the most common surgical practice during that war, and more than fifty thousand soldiers had limbs hacked off after battles. Amputation was a reflexive “solution,” because limbs were sometimes shattered by Minié balls and also because that was the only trick that many untrained “surgeons” knew. Surgeons were derided as butchers and were usually utterly negligent about hygiene, leading to far more unnecessary deaths.

Surgeons justified fetching out their hacksaws, because otherwise many soldiers would die from their gangrened wounds. It didn’t matter how many soldiers died from unnecessary or botched amputations as long as surgeons didn’t get blamed for deaths from gangrene.

Politicians in many states are justifying their COVID-19 shutdowns with rationales that resemble those surgeons’. It doesn’t matter how many individuals lose their jobs, businesses, or robust health due to the shutdowns. As long as politicians claim that things would be worse if they had not amputated much of the economy, they can pirouette as saviors.

Actually, there is a closer analogy between the Civil War surgeons and contemporary politicians. Politicians have razed much of the economy purportedly to prevent anyone from getting infected at some unknown point in the future. This is like a Civil War surgeon sending his assistants to roam the countryside to seize hapless young men and saw off their arms in order to prevent them from being casualties in future battles.

Here’s how New York governor Andrew Cuomo justified shutting down his state’s economy and confining almost 20 million people to their homes two months ago: “If everything we do saves just one life, I’ll be happy.” At the time of Cuomo’s decree, five or fewer people had tested positive for coronavirus in most counties in New York State. Cuomo’s formula exemplifies how politicians reap media applause for dramatic actions that have little or nothing to do with public safety.

At the same time that Cuomo practically put his state under house arrest, he also ordered New York nursing homes to admit COVID patients. His disastrous dictate contributed to the more than five thousand COVID deaths in New York nursing homes. Cuomo absolves himself, because some states have a higher percentage of COVID fatalities occurring in nursing homes than does New York—but no state has anywhere near five thousand dead in nursing homes. Most of the media is still scoring Cuomo as a heroic benefactor thanks to his shutdown to save “just one life.”

“We have saved lives” is also the self-exoneration trumpeted by Michigan governor Gretchen Whitmer after she imposed the most punitive restrictions in the nation. Whitmer prohibited “all public and private gatherings of any size” (prohibiting people from visiting friends) and also prohibited purchasing seeds for spring planting in stores after she decreed that a “nonessential” activity. (Purchasing state lottery tickets was still an “essential” activity, though.) Many Michigan counties have less than a handful of COVID cases and have had few if any fatalities. But their economies have been obliterated by Whitmer’s statewide decrees, which have driven unemployment up to 24 percent.

In the old days, politicians could always put forward some economist who had discovered a Keynesian “multiplier” to justify more boondoggle spending. Nowadays, “science” is the magic word used to justify any and every restriction on American freedom.

Whitmer, for instance, exonerates herself: “We’ve got to make decisions based on where the science leads us.” Unfortunately, the COVID-19 pandemic has already seen a long series of debacles by “science.” The national response to the coronavirus threat was sabotaged, because incompetent Centers for Disease Control scientists contaminated key samples for creating a test in February and because Food and Drug Administration scientist-bureaucrats blocked innovative private testing. It is also difficult to treat scientists’ warnings and forecasts as originating on Mt. Sinai when there is fierce dispute among experts about the most prudent policies to curb the pandemic.

Another parallel with Civil War surgeons is that contemporary politicians pay no price for the unnecessary damage they inflict. Many crippled Union and Confederate soldiers spent decades hobbling around after the war. It remains to be seen how many millions of Americans suffer long-term handicaps as a result of the draconian decrees now afflicting much of the nation. But it is unlikely that politicians will ever be held liable for the lives they have unnecessarily maimed.

After Civil War battles, the tents where surgeons did their sawing were renowned as one of the most horrible places that many soldiers ever encountered. Even those who recovered from their wounds were often left with perpetual nightmares over the screaming they heard and the sight of the gory stacks of severed arms and legs.

In contrast, the politicians and government health czars who have shut down much of the nation’s economy have not witnessed such traumatic venues. Instead, they have their meetings—perhaps on Zoom—and then issue decrees which their friends in the media are certain to applaud. Unemployment rates are rising even faster than the amputation piles of the 1860s. But the agony occurs far away from the palatial offices that governors enjoy—in quiet homes where families desperately agonize over pending rent and mortgage payments, and in the sinking businesses where owners see their life dreams dying week by week.

Categories: Current Affairs

The draft trade treaty that should be presented to the European Union

Adam Smith Institute - Tue, 19/05/2020 - 07:01

The government is to prepare and publish the draft of a trade treaty to govern interactions between the UK and the remnant European Union.

British negotiators fear Michel Barnier has been unable to get EU leaders to focus on Brexit trade and security talks as a result of the coronavirus pandemic, as Downing Street prepares to publish a draft treaty this week in an effort to reboot the process.

Sadly, it will not be the correct one. For, as we’ve said before and will no doubt have to again, the correct treaty is short, simple and goes full blown unilateral free trade on them:

1.There will be no tariff or non-tariff barriers on imports into the UK.

2.Imports will be regulated in exactly the same manner as domestic production.

3.You can do what you like.

4.Err, that’s it.

Nothing else is required. Well, except for all to understand the most basic point about trade. The purpose of which, the very reason we interact with those foreigners beyond our silver girt islands, is in order to gain access to those things they do better than we do. There are, after all, some such things. As Adam Smith noted, it is possible to grow grapes and make wine in Scotland but for the effort required it’s better to buy it in from Bourdeaux. What would middle class life be without prosecco? That swapping of port for cloth is the very basis of comparative advantage. And while Savile Row tailoring is all very well Hugo Boss was known for some pretty spiffy outfits in his time.

The rules on what we may export to others are of mild interest. What we may buy from others and how much we charge ourselves for doing so are vital. Imports, that is, are the point of trade, exports just being the work we do to get them.

Thus the only correct attitude toward trade is free trade. Unilateral free trade that is, as we did in 1846 with the Corn Laws. Which is what our draft treaty should be.

Of course, the world is more complex now, there are such things as patents and intellectual property rights to consider too. But that’s OK, we’ll not bother with asserting our copyright on the above treaty.

Categories: Current Affairs

Malawi church leaders urge end to political violence

Anglican Ink - Tue, 19/05/2020 - 03:51

Church leaders in Malawi have urged calm in the face of rising political tensions before the 2 July 2020 elections. Last week a building belonging to the United Transformation Movement (UTM) was firebombed, killing members of a family that resided on the premises.

General elections were held in Malawi on 21 May 2019. Incumbent President Peter Mutharika of the Democratic Progressive Party was re-elected, with his party remaining the largest in the National Assembly. However, on 3 Feb 2020, the country’s constitutional court annulled the election results due to evidence of irregularities, and ordered fresh elections. The UTM led by President Saulos Chiima after he broke with President Mutharika in 2018 is the president’s main rival.

The Public Affairs Committee (PAC), Malawi’s interfaith coalition, released a statement last week denouncing the rising political violence.  “The incident is condemnable in strongest terms as it violates human rights and aims at intimidating the democratic contestation of ideas and at silencing alternative voices”, the statement signed by its chairman Msgr. Patrick Thawale, Vicar General of the Catholic Archdiocese of Lilongwe and Publicity Secretary Bishop Gilford Emmanuel Matonga from the Evangelical Association.

The “barbaric, cowardly and uncivilized acts of violence manifest a sense of desperation as Malawi moves towards the fresh Presidential Election”.

They called for an investigation into the attack “so that perpetrators are held accountable for their actions without discrimination”, and called “for an open and inclusive dialogue in dealing withpolitical disputes – a mechanism that has full support of all peace-loving Malawians. We also call on all citizens to remain law-abiding and eschew all forms of political violence.”

The post Malawi church leaders urge end to political violence appeared first on Anglican Ink © 2020.

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