Austrian Economics Explained

Tragedy of the Commons

2009-12-24T08:18:00.000-08:00

Garrett Hardin's 1968 article on the tragedy of the commons reads, first like an ode to Malthus, and second like an ode to the state. It is thus no surprise that his premises are Malthusian or that his conclusions and recommendations are Orwellian. Although the primary discussion point of Hardin's essay is the "population problem" and his concern that it cannot be solved technically and thus requires a non-technical Orwellian solution, the influence of his essay today is more for popularizing a pivotal concept necessary in understanding the workings of the state.

Hardin draws on William Forster Lloyds 1833 essay, Two Lectures on the Checks to Population, in describing a situation where several herdsmen are led by their rational, yet self interested, actions to ruin a common piece of land. He terms this the tragedy of the commons. Herein I present a slightly modified formulation, but keeping in the spirit of Hardin's original essay.

Tragedy of the Commons

Imagine a commons, owned by none, and surrounded by privately owned plots of land. On each privately owned plot resides a herdsman with his herd. Each herdsman has a choice of letting his herd graze on his own piece of land or on the commons. When the herd grazes, it depletes the land and thus cannot be allowed to overgraze lest the land be ruined. Since each herdsman owns his own piece of land, he has the incentive to maintain and cultivate it, and thus wishes to prevent his herd from overgrazing and ruining it. But what of the commons? If he allows his herd to graze and deplete the commons, his own piece of land is left pristine. Thus, he accrues the benefits of grazing his herd, with none of the costs. Further, each herdsman knows that every other herdsman has the same incentive, to graze their herd on the commons over their own land, and therein lies the tragedy according to Hardin, for in that rational yet self interested analysis of each herdsmen ensues a mad dash to use up the commons before anyone else can, thereby ruining it.

This simple yet powerfully illustrative example of the tendency for commons to be abused, depleted, and/or ruined is an extremely important concept in understanding pollution, environmental degradation, resource depletion, and similar problems today. But first, a closer examination of the fundamental problem is required. Many readers mistake the tragedy of the commons as an argument against the free market and in favor of the state. Perhaps Hardin himself is partially to blame for this since he concludes that "the tragedy of the commons... must be prevented... by coercive laws or taxing devices," and that "the only kind of coercion I recommend is mutual coercion, mutually agreed upon by the majority of the people affected." To paraphrase: the state must be the arbiter of the commons to prevent its misuse. Unfortunately, the thinking here, in true statist fashion, is completely reversed. Recall the decision each herdsman faced. Since he owned his own piece of land, he had the incentive to maintain and cultivate it. The problem arose because of the existence of the commons, which he and every other herdsman had the incentive to use and deplete before others could. Thus, it was a tragedy of the commons, and not a tragedy of the privately owned plots of land. This is the all-important observation. The fundamental problem is not with the free market or the rationally self interested actions of the herdsman, but rather with the existence of the commons! If the commons had been auctioned off to the highest bidder, or broken up and sold off in smaller pieces, there would be no tragedy. Private property solves the tragedy that is endemic to the existence of public property.

Curiously, despite his clearly anti free market stance, Hardin already recognized this fact. In his original essay he says that "the tragedy of the commons as a food basket is averted by private property," and in a later essay opens with this astute observation:

In 1974 the general public got a graphic illustration of the “tragedy of the commons” in satellite photos of the earth. Pictures of northern Africa showed an irregular dark patch 390 square miles in area. Ground-level investigation revealed a fenced area inside of which there was plenty of grass. Outside, the ground cover had been devastated.

The explanation was simple. The fenced area was private property, subdivided into five portions. Each year the owners moved their animals to a new section. Fallow periods of four years gave the pastures time to recover from the grazing. The owners did this because they had an incentive to take care of their land. But no one owned the land outside the ranch. It was open to nomads and their herds.

Perhaps most damning, however, is this passage regarding his original concern of overpopulation:

If each human family were dependent only on its own resources; if the children of improvident parents starved to death; if, thus, overbreeding brought its own "punishment" to the germ line--then there would be no public interest in controlling the breeding of families. But our society is deeply committed to the welfare state, and hence is confronted with... the tragedy of the commons. [emphasis mine]

Indeed. The welfare state is at the root of the tragedy! And private property is the solution! To an Austrian this is an already well know and well understood concept. Ludwig von Mises discusses this in Human Action decades before Hardin popularized it under the catchy title of the tragedy of the commons:

If land is not owned by anybody, although legal formalism may call it public property, it is utilized without any regard to the disadvantages resulting. Those who are in a position to appropriate to themselves the returns—lumber and game of the forests, fish of the water areas, and mineral deposits of the subsoil—do not bother about the later effects of their mode of exploitation. For them the erosion of the soil, the depletion of the exhaustible resources and other impairments of the future utilization are external costs not entering into their calculation of input and output. They cut down the trees without any regard for fresh shoots or reforestation. In hunting and fishing they do not shrink from methods preventing the repopulation of the hunting and fishing grounds.

Mises hits the nail on the head.

The Tragedy of the State

Although I have shown that the tragedy of the commons is easily averted by the introduction of private property and is, in fact, the natural consequence of the existence of public property, one further observation is necessary. In a follow up article to his original essay, Hardin correctly recognizes that it is not all commons that are subject to the tragedy, but only those that are un-managed.

To judge from the critical literature, the weightiest mistake in my synthesizing paper was the omission of the modifying adjective "unmanaged." In correcting this omission, one can generalize the practical conclusion in this way: "A 'managed commons' describes either socialism or the privatism of free enterprise. Either one may work; either one may fail: 'The devil is in the details.' But with an unmanaged commons, you can forget about the devil: As overuse of resources reduces carrying capacity, ruin is inevitable."

Although private property does avert the tragedy, privatization of certain resources such as air and the seas is sometimes difficult in practice. But that is not to say that we must suffer the tragedy as critics of Hardin's have noted. The free market has a natural tendency towards order, co-operation, and efficient management of scarce resources. It is only with the introduction of mis-management, usually stemming from coercion or politics (read: the state), that the tragedy rears its ugly head. Stefan Molyneux illustrates this wonderfully with his analysis of the destruction of the Newfoundland cod stocks. Rather than belabor the point (certainly one can find many resources on mises.org cogently describing and documenting the phenomenon), I instead wish to draw the readers attention to one particular statement Hardin makes and examine it more closely within the framework developed in this article.

Hardin states that "a 'managed commons' describes either socialism or the privatism of free enterprise," and that "either one may work; either one may fail: 'The devil is in the details.'" That free enterprise solves the tragedy has already been discussed. The free market naturally tends towards order, not failing unless there is external coercive or political influence brought to bear on it. But what of socialism? Can it succeed? Do we expect it to fail? Is the devil really in the details?

It is my contention that socialism is destined to fail as a solution because the "management" it provides does not actually eliminate the crux of the problem, which is the existence of public property. Although it does bring management, that management is itself a commons and thus susceptible to the tragedy as well. In essence, all socialism does is move the tragedy back one level. Whereas previously there was a commons that each herdsman was incentivized to abuse, there is now a public management structure that each herdsmen is incentivized to gain control off so that he can abuse the underlying commons. Since nobody in the public management structure actually owns the land -- they are merely temporary caretakers -- there is still no incentive to preserve the land. Grazing rights will thus be granted to the most vocal lobby, who, recognizing the temporary nature of their ownership, will treat it no differently than a commons and deplete it as quickly as possible before they lose access to it. In fact, this is the root cause of pollution and environmental degradation today. Most of the destroyed land is 'publicly owned' -- meaning the government sells mining/dumping/etc rights to the highest bidder/biggest lobby and sits back and watches as that land is destroyed. Although the pollution and destruction is a result of private actions and thus easily confused for "greedy capitalism", the true flaw is the socialist desire for public property, public ownership, and public management.

If instead of granting usage rights, the government simply auctioned off the land to the highest bidder, that would create the incentive for the new owner to preserve the land, just as each herdsman had the incentive to preserve his own privately owned piece of land. Morris and Linda Tannehill explain this tendency clearly in their discussion on property:

Private owners, because they can hold their property as long as they please or sell it at any time for its market price, are usually very careful to conserve both its present and future value. Obviously, the best possible person to conserve scarce resources is the owner of those resources who has a selfish interest in protecting his investment. The worst guardian of scarce resources is a government official —he has no stake in protecting them but is likely to have a large interest in looting them.

To the extent that he has control over a natural resource (or anything else), a government official has a quasi-ownership of it. But this quasi-ownership ends with the end of his term in office. If he is to reap any advantage from it, he must make hay while his political sun shines. Therefore, government officials will tend to hurriedly squeeze every advantage from anything they control, depleting it as rapidly as possible (or as much as they can get away with).

To take this observation a step further, what is even more tragic about socialism is that it creates new commons where previously they did not exist. An institution with the power to tax and legislate rarely goes unnoticed by the more unscrupulous in society, who are inevitably drawn to its power and seek to control it for their own benefit, or, at least, gain favors from it. A casual look at Washington should be ample evidence of this phenomenon. Lobbies for any and every imaginable special interest are in continuous competition to deplete and ruin the commons that is the public purse. This happens through subsidies, handouts, and juicy contracts where the people footing the bill (the taxpayers) are forced to part with their hard earned and privately owned resources to create this sought after commons.

In addition to the public purse, there is a less visible and far more dangerous commons create by socialism: public courts. While the public purse limits ones control over the citizens to their bank accounts, the control one has via public courts is virtually unlimited. Is it any wonder that throughout history various institutions have tried desperately to control this aspect of the state? In the middle ages the church was able to successfully control it to the extent that it was able to legislate morality and punish through physical violence at the hands of the state those who rejected their dictates. Today, we realize how misguided that partnership was. But the root issue was not the church and its desires, but rather the existence of this particularly dangerous commons that enables certain segments of society, through public courts, to control the lives of every citizen. What could be more dangerous? I realize this may sound quite outlandish to anyone who has never been exposed to the idea of private courts so I will leave the discussion for another time since it is beyond the scope of this article. I only leave the reader with this article and hope that intellectual curiosity leads the reader to explore this idea further.

Conclusion

In this article we have looked at the tragedy of the commons and examined its tendency to arise wherever there is a commons. We have also argued that an understanding of pollution, environmental degradation, and various other negative phenomenon today should be understood by drawing on this concept and tracing their existence to the state. Finally, we have argued, contrary to Hardin, that only free enterprise can solve this tragedy and create a society that values the environment as well as individual freedom. Socialism cannot do this because we realize that the welfare state is not simply at the root of the tragedy, but is the tragedy! And magnified if one begins to broach the subject of political entrepreneurship.

Broken Window Fallacy

2009-03-15T10:23:00.000-07:00

“One of the more enduring myths in Western society,” writes Mike Moffatt, “is that wars are somehow good for the economy.” Indeed, this myth is so prevalent and entrenched today that it has mutated into many other forms. Natural disasters, pollution, and various other economic ills, are all advanced as economic boons based on this same faulty logic. The underlying fallacy, as Mr Moffatt explains, “is an example of something economists call The Broken Window Fallacy.” While I do agree with his appraisal, I must disagree on the fundamental nature of the misunderstanding. The broken window fallacy is certainly one aspect of the problem, but I think the deeper misunderstanding is a failure of the scientisitic approach to economics. In this article I describe the Broken Window Fallacy as I find it best understood in hopes of laying the foundation to better explain the latter concern.

Bastiat’s Parable

The broken window fallacy is so named for Frederic Bastiat’s parable of the broken window, where a child having broken a window is hailed as having created economic activity by the onlookers, who all the while ignore the hidden opportunity cost of the broken window. Bastiat concludes that the flaw in the reasoning is that the onlookers only account for the “seen” (the broken window and consequent activity) and ignore the “unseen” (what would have happened had the window not been broken). For a look at this original formulation of the fallacy, I highly recommend Moffat’s article. However, I find the absurdity illustrated by the fallacy much easier to follow when described in the context of natural disasters.

Natural Disasters

One of the more popular variants of the broken window fallacy is that natural disasters result in economic growth. I remember when Katrina came around, there was no shortage of pundits (recent Nobel laureate Paul Krugman included) describing it as having created economic activity and growth, because, after all, rebuilding all the destruction will add to GDP! But was Katrina really beneficial? Imagine there is a city that is leveled by an earthquake. The residents then rebuild their city. This adds to GDP and is hailed as creating economic activity and growth. But is that an accurate assessment?

First, does it create economic activity? Well, of course it does; it is hard to argue that it does not. However, one must be careful not to reach false conclusions based on this. Doing so, as Bastiat would say, ignores the unseen. It is seen, and definitely true, that the destruction and subsequent rebuilding of the city creates economic activity. However, it is not seen what would have happened had there been no earthquake to begin. In the time the residents lost and rebuilt their city, they could have built a second city, or made improvements to their existing city, or done any number of other things they value. However, because of the earthquake, none of those happened, which is considerable lost opportunity. Thus, although the earthquake creates economic activity (the seen), it does so at the expense of other economic activity (the unseen).

At this point one might respond that the economic activity in response to the earthquake would far exceed anything that might have happened otherwise, especially if the economy was in a recession, where a shortfall of demand, so it is held in the Keynesian paradigm, is responsible for the decline in economic activity. The sophistry in this argument is clearly apparent when one realizes that, despite the economic activity in response to the earthquake, there has actually been no growth! While before there was a city, now, post earthquake, there is again a city and nothing more. Whereas, any economic activity in absence of the earthquake would result in the original city plus whatever was created in addition. Thus, the residents had to work extra hard just to break even.

The Keynesian misunderstanding here is that they do not understand the nature of wealth and economic growth. Real wealth is tangible, physical, goods. Money, as the medium of exchange, is a claim on real wealth. Thus, the earthquake destroys real wealth, which must be restored at great pain. Whereas, no earthquake leaves the residents with ample time and opportunity to create more wealth in addition to what they already have. Stated in this manner, one can easily see that any natural disaster is bad for the economy because it destroys real wealth, and that what the Keynesian is really saying is that we can create growth by destroying our existing wealth. The same is true for wars. Wars destroy wealth. Blowing up cities, killing soldiers or civilians, and everything else that comes with wars destroys wealth. Thus any addition to GDP and decrease in unemployment is only to restore total wealth to its previous state. Not to mention that people would be far better off making shoes, or cars, or anything they actually value and use, rather than munitions, things that get destroyed and destroy other things. As Emmanuel Goldstein famously writes in Orwell's 1984:

The essential act of war is destruction, not necessarily of human lives, but of the products of human labor. War is a way of shattering to pieces, or pouring into the stratosphere, or sinking in the depths of the sea, materials which might otherwise be used to make the masses too comfortable.

How the Keynesian considers this good for the economy escapes me.

Fallacy of GDP

The Keynesian, however, has a further retort, namely that wars and natural disasters boost GDP and lower unemployment. They often mistake the argument above as implying the converse, and since we have clear empirical evidence to support their claim, they conclude that the Austrian criticism must be invalid. However, I do not dispute their claim. In fact, I will gladly admit that GDP receives a boost and unemployment declines. However, the problem is that GDP is an inappropriate concept when discussing economic growth. It is boosted because GDP is a measure of economic output, and not economic growth. You can blow up a city and rebuild it, which creates output, but does nothing for growth. In fact, this is precisely what wars and natural disasters do. They destroy wealth that must be replaced, hence boosting output in the short run. However, the net effect is that there has been zero economic growth, only replacement of the lost wealth. Economic growth is an increase in real wealth, not a temporary increase in output.

And what of lowering unemployment? Surely that is a boon? Actually, no. Employment in and of itself is meaningless unless one considers the kind of employment. We could have half the country dig ditches and the other half fill them up and keep everyone fully employed, but that would be completely useless activity which would make everyone poorer (people would have fewer useful things). Growth is achieved through the process of savings and capital investment which creates the capacity for increased future output of goods that people actually value. The Keynesian misses this simple point because they are concerned not with real economics but silly aggregates that are abstracted to the point where they share little with the underling reality they are intended to model. The Keynesian thus sees rising GDP and falling unemployment and mistakenly concludes economic growth, when what they are really observing is a temporary increase in output to replace destroyed wealth.

To further illustrate this disconnect, consider this simple example: imagine you have a machine that makes widgets. The machine itself is made of widgets. Let us say it can produce 2 widgets a month, and is made of 12 widgets. Every month you take your 2 widgets to the market and buy whatever you need. Thus you produce and consumer 2 widgets every month. Now, consider that instead of selling both widgets every month, you decide to scale back your standard of living and save 1 of the 2 every month. One year later you would have saved 12 widgets and can buy a new machine. Going forward, you can then produce 4 widgets a month and live a better lifestyle. Thus, you gave up present consumption (1 of the 2 widgets) in order to accumulate capital (saved widgets) to ultimately create economic growth (the new machine). While you were saving your widgets, GDP temporarily drops, but ultimately results in real growth.

Conversely, imagine if you had instead of saving 1 widget, taken 1 widget out of the machine every month. With your 3 widgets a month you could live an improved lifestyle for 1 year, until you realize you have completely cannibalized your machine and cannot produce any more widgets. You can increase present consumption by consuming capital, but this ultimately leaves you with no means for future production. However, it does temporarily boost GDP because you are consuming 3 widgets every month, but results in economic contraction once you realize you can no longer produce more widgets with your non existent capital. In reality, capital is not a homogeneous blob as the Keynesians believe, but rather a highly complex structure of production, which is all the more reason to understand that savings and capital investment are the root of economic growth, not consumption, which only creates temporary GDP increases by cannibalizing the productions structure that results in economic contraction.

This simple example should hopefully be illustrative of the fallacy of GDP. More importantly, however, Shostak explains that GDP is a completely empty concept that demonstrates the sheer intellectual bankruptcy of the Keynesian faith.

Krugman Speaks Out

Lest the reader mistake my characterization of the Keynesians as inaccurate, here is a quote straight from the horses mouth:

The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression. [Italics original.]

Or consider this one instead:

What saved the economy [after the great depression], and the New Deal, was the enormous public works project known as World War II, which finally provided a fiscal stimulus adequate to the economy’s needs.

Indeed such naive causal inferences and aggregate based models of the economy shift the discussion from human action towards abstract models, thus losing any connection to catallactics and the underlying processes that comprise the field of economics. A triumph of scientism over truth!

If I am too harsh, dear reader, then I ask you this: do we not rightly condemn witch doctors and snake oil salesman as quacks? Are they not frauds peddling false hope? Then why the double standard with Krugman and his ilk prescribing their own form of snake oil and rain dances for any and every economic malady? Enough people are duped by quacks. Don't be one of them. I hope this article and my blog helps you form the understanding of economics necessary to reject the quackery of Keynes and his scions.

Economic Stimulus Package

2008-05-10T02:12:00.000-07:00

An Austrian analysis of the economic stimulus package at my other blog.

Interest

2008-03-19T15:03:00.000-07:00

In our previous discussion on the nature of savings and lending one issue that was intentionally glossed over was that of interest rates. Interest rates are central to economics. A direct recognition of this fact is that all major treatises have, in some way or the other, included the term interest in the title. Consider Keynes' General Theory of Employment, Interest, and Money, Mises' Theory of Money and Credit, or Bohm-Bawerk's Capital and Interest.

Expectedly, each school has a unique perspective. The Austrian school largely differentiates itself based on the richness of its theory of capital and interest. However, before we discuss the Austrian theory of interest, it might be instructive to examine the nature of interest by invoking as little economics as possible.

Dimensional Analysis of Interest Rates

When posed the question "what is interest?", one common response is that it is the price of money. This is not true. The price of money, like any other good, is the amount of something else that must be traded for it. To see this, consider the converse: what is the price of a tomato? Well, it is the number of dollars that must be given up in exchange for a tomato. Ok, how about the price of a banana? Again, it is the number of dollars that must be given up in exchange for a banana. Because dollars are money the price of all goods is expressed in dollars, whereas the price of dollars is expressed in other goods.

Returning to the tomato, let's say its price is 2 dollars. Price = 2 dollars per tomato. Expressed this way, we find that the price of a tomato has dimensions. Recall from high school physics that all statements about reality have dimensions. Dimensions give meaning beyond the mere quantity. To say I am 6 tall, or 70 tall is meaningless. I should say that I am 6 feet tall, or 70 inches tall. The dimension of my height is length, expressed in feet or inches. Similarly, the price of a tomato has dimensions dollars per tomato. Price = 2 $/tomato. The same is true for bananas. Price = 4 $/banana. In general, the dollar price of X has dimensions $/X. Price = y $/X. Taking the reciprocal, we get: price = 1/y X/$. Price of what? Why, of dollars, of course! By this simple mathematical argument, we determine that the price of dollars is the amount of good X (happens to be 1/y) that must be trade for one dollar. Thus, while the prices of all goods is expressed in dollars, the price of dollars is expressed in terms of other goods. We can further extend this by noting that if the dollar price of tomatoes is 2 and the dollar price of bananas is 4, then the tomato price of bananas -- the number of tomatoes that must be exchanged for one banana -- is 2: 1/2 tomato/$ x 4 $/banana = 2 tomatoes/banana.

So what has this musings about dimensions taught us about interest rates? Well, what are the dimensions of interest rates? Look up any financial source and you will find interest rates quoted as r % per year. Dimensions = 1/year. Thus, without invoking any economics, we can determine that interest rates are the price of time. Economics enters the picture when we begin to question why time has value, and how one determines that value.

Why Time Has Value

Time has value because, all else equal, humans prefer consumption sooner than later. This concept is known as time preference. Historically, the charging of interest, or usury as it was pejoratively referred to, has been much maligned by the church, Marxists, and others. There is no reason for this myopic prejudice. Interest is a natural phenomenon that arises from the voluntary interactions of individuals expressing their subjective preferences.

Robert Murphy discusses this concept in his article Why Do Capitalists Earn Interest Income:

Since no one would be willing to give $10,000 now in exchange for a promise of $1,000 payments for each of the next ten years, it naturally follows that no one would pay $10,000 for our hypothetical tractor. Because of this fact—that present goods are worth more than future goods—the tractor can be purchased for less than $10,000

Robert Murphy also has a great article on Bohm-Bawerks critique of the exploitation theory of interest.

Determining The Price of Time

The concept of time preference is intuitive and should resonate with the reader. The harder question to answer is how one puts a price on time. Wikipedia defines interest as "a fee paid on borrowed capital"; the operative term being capital. Capital is real wealth (tangible physical goods), not paper claims to wealth. In essence, the holder of capital through the act of saving is foregoing consumption today for consumption in the future. He demands payment for this because of his time preference. That the borrower acquiesces to his demand is a result of the wealth generation process: the borrower expects, by acquiring capital today, to be able to repay that capital plus interest in the future. It is the interaction of these two phenomena that established the price of time as the marginal efficiency of capital.

Reasoning with money tends to obfuscate the insight so let's consider a barter economy and then see if we cannot extend the results to a monetary economy. In a barter economy, a saver saves real wealth and an entrepreneur demands real wealth for investment. Assume the baker saves 10 loaves of bread and the shoemaker in order to build a shoe-making machine needs 10 loaves of bread, 1 for each day that he works on the machine and cannot sustain himself through other means. (Aside: this is the concept of the subsistence fund which shows that savings and not consumption (as in the Keynesian framework) are the drivers of economic growth.)

The two agree that in return for the 10 loaves today, the shoemaker will return 11 loaves when his machine is done. By agreeing to part with the 10 loaves today that could have been otherwise used to purchase, say, a new suit, or a squash racket, the baker has expressed him time preference. He willingly foregos consumption today for increased consumption in the future. Had his time preference been higher, he would have demanded a higher rate of interest. The shoemaker, on the other hand, agrees to return 11 loaves because he expects his new machine to enhance his ability to produce shoes. Had the productivity increase been smaller, the interest rate he could afford would be lower. As various savers and entrepreneurs interact with each other to coordinate savings and investment, the savers express their time preference and the entrepreneurs are guided by the productivity gains they hope to achieve, which illustrates that the price of time is the marginal efficiency of capital.

Introducing money into the equation changes nothing. In the barter economy, the shoe maker must find a baker willing to save bread and offer him a rate sufficient to satisfy his time preference and within the productivity gains he expects. This is just another form of the double coincidence of wants. To alleviate this problem, we introduce money into the system, but do not change the essence of the interactions.

This is a simple description of how the free market allocates capital towards investment. Through this coordination the price of time is established. It is what Wicksell termed the neutral rate. For a more detailed explanation, see Shostak's article on marginal utility and interest formation. See also natural and neutral interest rates by Roger Garrison.

Conclusion

We have argued that interest rates are the price of time and that they should be established by allowing the market to clear free of manipulation. When the central bank increases the money supply or private banks increase the money supply through fractional reserve banking, they cause distortions to the market for capital. If entrepreneurs have first access to the new money then they can acquire the goods they need without convincing anyone to actually save those goods. Thus, expanding the money supply is nothing but forced savings. Ideally, a free market on a gold standard will set the interest rate, and not a central bank that has no idea what the interest rate should be. What is most strange is that mainstream economists will agree that the government should play no part in setting the price of goods and services like cars and orange juice. Yet, they all insist that the government should control the most important price in the economy, the price of time.

Austrian Economics in One Article

2008-03-06T13:37:00.000-08:00

Sean Corrigan's contribution to this day and age of fast food and fast living.

Some choice quotes:

Austrians were in the forefront of the Marginalist revolution; an advance which realized that choices are made (and hence valuations formed) "at the margin." This alone was enough to correct errors which had long confounded both classicists and Marxists.

It is the entrepreneur's particular skill—as well as his essential service to society—that he has an enhanced ability to put temporarily underpriced combinations of resources to a more nearly optimal use than can other men.

Mises himself single-handedly destroyed any attempts to construct a socialist rationale in the famous "calculation debate," showing that, without private property and an unhindered price mechanism, production can never be properly coordinated to allocate scarce resources to their best and most urgent uses.

Menger and Boehm-Bawerk, et al.,derived the most satisfying theory of the origins of interest—the so-called natural rate being, essentially, a measure of mortal man’s inherent impatience with any delay in the gratification of his wants and needs.

Hazlitt, developing this theme, wrote that the "One Lesson" of economics is that there is no such thing as a free lunch and that we must always look beyond the immediate results of an action to see its hidden and indirect influences before we pronounce it a success or a failure.

[Austrian economics] does not confuse money with wealth; it knows that production delivers prosperity, not consumption.

Update

2008-02-26T16:16:00.000-08:00

As much as I would like to update this blog weekly with articles on Austrian Economics, it is turning out to be harder than I expected. I simply do not have time as I am currently job hunting.

Also, my interest is more focused towards financial markets than economics per se. As such, I have started a new blog (macrothoughts.blogspot.com) that I will update frequently. As for this blog, I am hoping for a couple of articles a month.

Thanks!

Inflation - part 2/2

2008-02-15T11:55:00.000-08:00

In part 1 we saw that defining inflation as generally rising prices is a red herring. We argued that the definition is meaningless because it cannot be objectively determined. However, rising prices are a phenomenon we observe today, and one that greatly impacts our lives. Ultimately, our goal is to explain rising prices. It is insufficient to simply deconstruct the mainstream view of inflation, we must offer an alternate theory, one that hopefully better explains price movements.

Supply Shocks and Water Levels

Mainstream economists usually attribute inflation to supply shocks (cost-push), increased aggregate demand (demand-pull), or other exogenous circumstances. This is false. A supply shock is a short term event that affects a small segment of the economy; for example, a hurricane damaging an off-shore oil rig temporarily reducing the supply of oil. Price is the intersection between supply and demand. If supply falls and demand is unchanged, then prices must rise in order for the market to clear. This much is true. However, since oil prices have risen, consumers have less money to spend elsewhere. Their demand for other goods and services thus falls. But the supply of those goods and services is unchanged, therefore prices must fall in order for markets to clear. Thus any rise in the price of oil is accompanied by a fall in the price of other goods and services. The rise/fall will not balance perfectly since there is always the human element to consider, but that is not as important for the present discussion and will be sidelined for the present. What is important is that the price of oil rose, while the prices of other goods and services fell. There was no "general rise in prices." (The same logic holds if a sector suddenly experiences an increased demand.)

Consider the following thought experiment. Imagine a glass partially filled with water. Draw a line around the glass at the level of the water. If you tilt the glass in one direction, the water level rises above the line on the tilted side. However, the water level falls below the line on the other side. The average level is unchanged. This is analogous to the supply shock. Think of the water level as the price level. Tilting the glass (the supply shock, or increased demand) raises the water level on one side (the sector experiencing the shock) and reduces the water level on the other side (the rest of the economy) as water flows between the two sides. We cannot raise the average water level simply by tilting the glass.

Too Much Money Chasing Too Few Goods

Let us continue with our thought experiment. Imagine our goal is to raise the water level. How can we achieve this? The obvious answer is to add more water. Another answer, perhaps less obvious, is to pour the existing water into a narrower glass. There is little else we can do. The same observation holds when it comes to rising prices. In our experiment, the water level represents the price level, the amount of water represents the money supply, and the width of the glass represents the size of the economy. To raise the price level (the water level), we must print more money (add more water) or shrink the economy (use a narrower glass). Any sort of tilting (supply shock, or increased demand) will result in money flowing towards that sector from other sectors causing rising prices in that sector and falling prices elsewhere. There cannot be a "general rise in prices".

Many mainstream economists recognize this. To circumvent the problem, there is the oft cited canard of increased aggregate demand. To simplify: every sector of the economy experiences a simultaneous rise in demand. As supply remains constant, prices must adjust upward for markets to clear. Voila!, generally rising prices. They claim the water level has risen without additional water or changes to the glass. So what magic is this? In fact, there is no magic, only faulty reasoning. Recall from our earlier discussions on money that every trade is an exchange of goods or services for other goods or services. An increased demand for chocolate is supported by an availability of, say, cell phones to be traded for it. Without the cell phones to trade for the chocolate, the demand cannot be financed. Thus, increased aggregate demand is a chimera. It is impossible without increased aggregate supply as a source of financing. (Btw, this is the essence of Say's law, that "supply constitutes demand", not that "supply creates demand" as Keynes erroneously stated.)

Our thought experiment demonstrates that a rise in prices is essentially too much money sloshing around the system chasing too few goods. If the growth in money supply exceeds the growth in the real economy, then the average level of prices will rise, and vice versa (straight from the horses mouth). Armed with this understanding we can conclude that the rise in prices since 1913 resulting in a dollar worth only 4 cents today is simply the Federal Reserve printing too much money. Rather than being an inflation "fighter", the Fed is the root cause of inflation. In fact, looking at price indices prior to 1913, we find the price level is essentially unchanged for large periods of time. See for yourself. The standout in the graph is the parabolic growth since 1971 when Nixon closed the gold window. With absolutely no check on the supply of money, the Federal Reserve has inflated at an alarming pace causing large price increases. In the last decade alone the money supply has more than quadrupled, with M3, the broadest measure of money supply, currently growing in the double digits.

The Complete Picture

We have now formally defined inflation as growth in the money supply. This is the correct definition because the fundamental nature of inflation is not rising prices, but falling purchasing power of the currency. Prices of goods may rise, but the truth is that the price of the currency has fallen. All goods have a price, the dollar included. While the prices of goods and services are generally expressed in units of money, the price of money is expressed in units of goods and services. The price of a tomato is the number of dollars that must be traded for it. Similarly, the price of the dollar is the number of tomatoes (or bananas, or cars, or whatever) that must be traded for it. Generally rising prices is a euphemism for falling dollar.

When the central bank increases the money supply, the effect is upward pressure on prices. More water has been added to the glass. This should give us pause for thought, but it is still not the complete picture. Recall that the other variable in our thought experiment was the width of the glass. Our base goal here is to understand changes in the price level. We are being sloppy if we ignore this other variable. Let us now consider all phenomena that influence the average level of prices:

Inflation: defined to be growth in money supply exerts upward pressure on prices. More water is added to the glass. This is what causes generally rising prices.
Productivity gains: exerts downward pressure on prices. When entrepreneurs invest in technologies or processes that increase productivity, they are able to introduce more real wealth into the economy. The glass is made wider and the water level falls.
Government regulation: exerts a decidedly upward pressure on prices because it reduces the size of the economy. In our earlier discussion on supply shocks we had implicitly assumed their effect to be localized. Should the shock extend across multiple sectors or geographies, then it can no longer be considered a supply shock, but rather a system wide problem. Such system wide problems simply do not occur randomly. Hurricanes, earthquakes, tsunamis, or what-have-you do not impact the economy so as to make the glass observably narrower. Only governments through regulation or wars can achieve that end.

The interaction of these factors results in the observed rise/fall in prices. Unfortunately, it is very hard to quantify what part of the rise/fall is attributable to each cause. We can accurately measure money supply growth, but the benefits of productivity gains or the destruction of government regulation is impossible to determine as their is no yard stick in existence. Having a yard stick requires an imagination. An imagination that helps the economist understand what would have transpired had an entrepreneur not invented, or a bureaucracy not stifled, a new technology. That being said, we can make statements about the whole. For instance, with the high-tech industry where newer and better products are consistently offered at lower and lower prices, we conclude that the downward pressure from free market forces delivering productivity gains to the consumer outweighs the upward pressure from money supply growth and the relatively light regulation. Similarly, with the health care industry, where prices are rising in excess of the general economy, we conclude that the controlling effect is not money supply growth, but excessive government regulation that is stifling entrepreneurs from delivering productivity gains to the consumer. (Consider the AMA, the FDA, HMO's, and the tax structure, just as starting points.)

The Hidden Tax

Although inflation causes generally rising prices, it should not be understood as detrimental to all parties involved. It is highly lucrative for the government and the banking industry. When new money is printed (today, created electronically), it greatly benefits the first recipient because assimilating the new money into the economic organism takes time. Those first recipients (government and banks) can purchase goods and services at the old prices. As the money slowly works its way through the economy prices are bid up. Eventually when it reaches the salaried workers, prices have mostly adjusted. This process is a hidden tax on salaried workers, or anyone who receives the money late in the cycle. It is especially detrimental to those on fixed incomes, such as pensioners. Not only does the government understate the effects of inflation in its official numbers, any price decrease that would have occurred as a result of productivity gains are denied to the consumer as well. Inflation is nothing but wealth transfer. The government prints money and buys stuff with it. Prices rise and the salaried worker can buy less stuff. All the stuff the salaried worker could have otherwise bought has accrued to the government. Simple. Politically, it is far more palatable than raising taxes because the process is badly understood and well obfuscated.

Conclusion

Our goal at the outset was to explain rising prices, and we have. Inflation, money supply growth, is the primary cause, with government regulation having sector specific effects depending on how malignant. In a free or lightly regulated market with commodity money, the tendency will be towards generally falling prices. This is a boon to salaried workers and those on fixed incomes who will experience a higher standard of living. See the period 1820 to 1860 here. On the contrary, an inflationary policy causes standard of living declines, which is corroborated by the fact living standards pretty much topped in the early 70's (Sorry, I've been unable to track down the exact statistic. If anyone has it, please forward it to me.)

In the addendum, I will examine the chart of the CPI more closely and attempt to explain the various periods.

References

Inflation in one page, by Ludwig von Mises.

Inflation - part 1/2

2008-02-08T16:32:00.000-08:00

Many people will be surprised to learn that the dollar today is worth only 4 cents of a dollar in 1913 when the Federal Reserve, created for the stated purpose of fighting inflation and managing unemployment, was issued the charge of creating the nations currency. The process by which the dollar has gradually lost value (buys fewer and fewer goods) is known as inflation. Today the dollar can purchase less than one-twentieth of the real wealth (tangible physical goods) it could purchase in 1913 despite significant productivity gains registered over the last few decades. This fact alone should illustrate the importance of inflation with regards to the general standard of living, yet it is one of the most widely misunderstood concepts in economics today. This article is written in 2 parts. Part 1 attempts to deconstruct the mainstream view of inflation, and part 2 attempts to build a more meaningful understanding of the process.

Paasche or Laspeyres? False Choice!

Before we can understand what inflation is, it will be helpful to understand what inflation is not. Inflation is widely regarded as a general rise in prices. Economics by Parkin and Bade defines inflation as

an upward movement in the average level of prices. Its opposite is deflation, a downward movement in the average level of prices. The boundary between inflation and deflation is price stability.

This definition is quite vague and is disputed by Austrian economists, but, for argument, let us assume that Parkin and Bade are indeed correct and examine the consequences. So how precisely does one measure the "average level of prices"? The standard approach is to use a price index, a basket of goods and services considered representative of the economy as a whole. Tracking the change in this "representative" basket of goods, one has a proxy for changes in the "average level of prices". There are many problems with this approach:

It is extremely hard to determine a "representative" basket of goods and services. Every basket must necessarily make simplifying assumptions in order to be tractable.
Should one look at final consumer goods, intermediate goods, or a mixture of the two? In fact, we have the CPI and PPI precisely to make this distinction.
Various sectors of the economy experience different changes in "average prices". For example, higher education has it's own "representative" basket, known as the HEPI.
Most importantly, markets are constantly evolving to better satisfy human wants and needs. New products are introduced and obsolete products removed; existing products are improved and upgraded; how does the price index capture this? Price series either do not exist or may not be comparable.

As we can see, there are various practical problems related to constructing price indices. However, that is not the crux of the issue; there is a deeper philosophical problem: there is no objective manner in which to define a price index.

There is no objective "representative" basket of goods and services. The inclusion (or exclusion) of any good or service from the price index may not be arbitrary, but it is certainly not objectively determined.
With the market constantly upgrading and improving -- not to mention introducing and obsoleting -- various goods and services, how does one objectively compare price series on qualitatively different goods or when no such series exists. The approach here is known as hedonics, which is a quality adjustment made to the price in order to capture improvements and upgrades. Needless to say, this is a highly subjective affair.
As the market is constantly changing, so too are consumer preferences. We do not live in a static world. Consumers, producers, economic actors of all stripes, are continuously evaluating alternatives and taking action based on their perceived self interest. People react to prices and alter their lifestyles accordingly. This cannot be objectively accounted for. It requires the subjective redefinition of the index.

Lies, Damned Lies and Statistics.

We have seen thus far that defining and measuring the "average level of prices" cannot be done in any meaningful objective manner. However, this does not imply that it is arbitrary. While there is much lee way, the "solutions" have a clear pattern: to systematically understate the true rise in prices. John Williams of Shadowstats demonstrates how the government alters economic reporting to paint a rosy picture. For example, looking at pre-Clinton, or pre-Carter methodologies for calculating the CPI shows that inflation is running much higher (7-10%) than the 3% it is currently advertised as. This is perhaps more in line with many peoples anecdotal experience as everyday costs appear completely divorced from government reporting.

To fully understand how the government manipulates CPI numbers, I suggest the reader start with the Boskin Commision. A detailed analysis is beyond the scope of this article, but very briefly, here are the major influencing factors:

Hedonics: as described earlier are quality adjustments made to prices. A new car costs 20% more? Well, it is 30% "better" so the price has actually dropped 10%.
Substitution bias: the price of steak has risen 20%? The price of hamburgers has declined 10%. Well, consumers must have "substituted" away from steak for hamburgers so prices are falling.
Outlet substitution: that new jacket costs 20% more at the mall? Well, if you drive 50 miles to another mall, you can get it at the same price. Hence, no rise in prices.
Redefining the index: housing prices rising? No problem, use rents instead (what is called owners equivalent rent). This was actually the scheme used to keep CPI numbers under control during the housing bubble that topped in 2005, allowing interest rates to remain at historic lows. Now that the bubble has burst expect a redefinition shortly that uses the Case-Shiller housing index (rapidly falling) instead of rents.

Although simplified and trivialized, this is an accurate picture of how easily CPI numbers can be doctored. But what is the motivation? For one, consider the obvious conflict of interest with the government having many liabilities (TIPS, Social Security, etc) linked to CPI "inflation". Even a rudimentary incentives analysis of how economic data impacts the perception and functioning of the government will demonstrate that government statistics are not to be trusted. A more detailed analysis of the methodology (eg shadowstats) confirms this initial impression.

Conclusion

While it is disconcerting that government statistics are so misleading, even more disconcerting is the definition of inflation as rising prices. As mentioned earlier, Austrian economists dispute this definition, and for good reason. First, as we demonstrated, a general rise in prices is a concept that cannot be objectively determined, let alone accurately measured. Second, and more importantly, it does not attempt to understand the root cause of inflation and serves to shift attention away from it by focusing the debate on completely meaningless red herrings related to the price index. To examine the true nature of inflation, we must shine a flashlight through this smoke screen.

One caveat related to our discussion here is that I fully recognize that rising prices are a phenomenon that is important to the general public. I do not mean to shift the discussion away from rising prices, nor do I mean to deride price indices in general. If our stated goal is to measure prices then there is no alternative to using a price index, despite the problems discussed above. However, our stated goal is not to measure prices, it is to understand the causes of inflation. We have not argued that price indices are useless, only that defining inflation as a general rise in prices is inaccurate. Certainly rising/falling prices are the crux of the issue, and we attempt to better understand them in part 2.

References

Inflation in one page, but Ludwig von Mises.

Sound Money

2007-09-27T20:06:00.000-07:00

This article is now a place holder. I realized that to fully attack the question of sound money, I must first discuss inflation and the business cycle. I will re-write this article once I am done with those. In the meanwhile please see the other articles on money. And below are the conclusion and references from previously:

Conclusion

The above discussion yields 3 conclusions. First, that we should affirm the markets choice for money. Second, that a fiat money system removes accountability from government. Third, that fiat money causes structural damage to the production structure and undermines the process of wealth creation. The only viable monetary system is a 100% gold standard (or whatever standard the market selects).

References

The case for the barbarous relic, by Lew Rockwell.
Ludwig von Mises on sound money.
Price stability, by Frank Shostak.
Price stability, by Thorsten Polleit.

Fractional Reserve Banking

2007-09-24T21:46:00.000-07:00

In the previous article we looked at free market banking institutions. We discussed that money is the commodity (historically gold and silver) selected by the market as the preferred medium of exchange, and that gold warehouses serve as an efficient means to store and trade gold. In this article we look at fractional reserve banking, which is the practice of banks lending out their customers deposits in multiples. This appears to be at odds with our discussion in previous articles, so we scrutinize the practice to see if we cannot reconcile the apparent inconsistency.

Savings and lending

Before we discuss fractional reserve banking, it is important to understand the essence of savings and lending. The first myth to dispel is that money is wealth. Money is not wealth; real wealth is tangible physical goods. Your house, your furniture, your car, your golf clubs -- those are real wealth. Money, as the medium of exchange, is a claim on real wealth. Therefore, the act of saving is the expression of an individual’s preference to relinquish his claim on wealth today for a future date. It is very important to understand this. Money is a convenience that arose to facilitate trade. Before money, every trade was an exchange of real wealth (barter). With the introduction of money, every trade is still an exchange of real wealth, just temporally disconnected because the receiver of the money doesn’t complete his side of the trade (receive his goods) until he spends the money he received in exchange for his goods.

This is true of lending as well. Jones borrows $1000 today to purchase goods and services. Tomorrow he repays $1000, but is actually repaying what the money can purchase. He borrows real wealth, and returns real wealth. Therefore, lending entails a transfer of real wealth from lender to borrower. The existence of money tends to obfuscate this insight, but does not change it.

Bank lending

Recall that gold warehouses are storage facilities. An individual depositing money at a warehouse does not relinquish his or her ownership of it, and more importantly, does not relinquish his or her claim on real wealth. The money is still theirs to spend, it is just being safeguarded. This arrangement is a checking account. Alternately, the depositor may instruct the warehouse to lend out their money through a savings account. Here, a depositor relinquishes his or her ownership of the money to the lending institution and thus the would-be borrower. Restated, the depositor relinquishes his or her claim on real wealth in favor of the borrower. In this manner, real wealth is saved, and lent out. The transaction is still a trade of real wealth where money is merely the intermediary.

(The restrictions on savings accounts may actually be quite lax. There is a clear precedent in how mutual funds are structured today.)

Fractional reserve banking

Historically, gold warehouses (or was it goldsmiths?) found that their customers rarely withdrew their deposits; mainly because the receipts to the deposits were as good as the deposits themselves and thus came to be traded in their lieu. Therefore, much of the gold remained in the vaults untouched. Lending this gold at interest, they could make a good profit with repercussions only if more gold was demanded for withdrawal than was currently in the vault. Thus the practice of fractional reserve banking was born. Today, this basic scheme is operate on a large scale by all banks in a government regulated environment. The government establishes a reserve ratio, which sets the fraction of deposits that must be held at the bank. Thus, if the reserve ratio is 0.1, then 10% of all deposits must be held at the bank and 90% are free to be lent out. This has the net effect of allowing 9 times the deposited amount to be lent out. Here is how the process works:

Jones deposits $1,000 at bank A. With a 0.1 reserve ratio, bank A can lend out $900 of that deposit and keep $100 on hand as reserves. Let us say they lend out $900 and it makes its way to Smith – either he borrowed it, or the real borrower used it to pay him. Smith now has $900 that he deposits at another bank, B. Bank B, in turn, keeps $90 as reserve (10% of $900) and lends out $810 to someone else. This $810 is spent and deposited at bank C, which keeps $81 as reserves and lends out $729 to someone else. As this process continues, the total amount lent out by the various banks in the system adds up: $900 + $810 + $729 + …. The sum of this series is $9,000. The total held in reserve also adds up: $100 + $90 + $81 + $72 … = $1,000. Thus $9,000 of lending is supported by $1,000 in reserves. This is why most commentators will state that fractional reserve banking allows the lending of multiples of reserves. Technically, it is not the bank that received the initial deposit that can lend out a multiple, but rather the system as a whole creates it through the process described above.

Having described the mechanism, let us examine it more carefully. When Jones deposits $1,000 in his checking account, bank A issues him a receipt stating that he has $1,000 on deposit. This is a promise to pay $1000 dollars on demand. If bank A lends out $900 of that $1000 then they are no longer capable of honoring their liability to Jones. What they are banking on (excuse the pun), is that Jones will not attempt to withdraw his money before they are paid back on the loan they made. With a single customer, Jones, this is a reasonable risk. However, with hundreds of customers, it becomes far less risky since they can siphon funds between accounts and repay Jones with someone else’s deposit. What they fear then is a run on the bank where a critical mass of customers simultaneously demands withdrawals in excess of total reserves, making them insolvent.

It should be apparent to the reader by now that this is fraud, plain and simple. Some commentators will describe it as counterfeiting, but I think fraud is a more appropriate term as counterfeit bills are not at the root of the fraud. Far more important, however, are the consequences of fractional reserve banking on the economy.

Inflation and the business cycle

If you read my articles on inflation, it should be clear that fractional reserve banking is highly inflationary because it is nothing but an increase in the money supply. This, of course, is accompanied by all the attending ills of inflation, but none more so than the business cycle.

Recall that money is only a claim on real wealth. When Jones deposits his $1000 in his checking account, he does not relinquish this claim; he is merely choosing not to exercise it. When his money is lent out and spent on goods or services, those goods and services are diverted to individuals who would not have otherwise received them. Had Jones instead stuffed his mattress with the cash, he would have maintained his claim on real wealth and not lent out his money. However, placing it in a bank, he has unwittingly been defrauded into relinquishing his claim on real wealth and lending out his money. This is known as forced savings and is vitally important in understanding the business cycle. It is demonstrable that forced savings along with other related factors causes market dislocations that result in booms and busts. The business cycle is not an inherent instability in the free market caused by “animal spirits”. To suggest so betrays a highly superficial and childish understanding of the macro economy and catallactics. The business cycle is, in fact, a direct result of inflation and government intervention as Austrian have carefully detailed beginning with the publication of Von Mises’s masterwork on money and capital, The Theory of Money and Credit. I will explore these ideas more completely in my article on the business cycle. You can read Rothbards introduction here or Gene Callahans explanation here.

Conclusion

It has been shown that savings and lending are voluntary acts on the part of the lender and borrower to trade real wealth now and in the future. Fractional reserve banking undermines this, creating instability in the economy, and resulting in the business cycle. Further, fractional reserve banking should be correctly identified as fraud because it enables the multiplication of money and creates counterfeit claims to the unchanged pool of real wealth. One common argument often put forth by apologists is that the bank, through fractional reserve banking, can pay interest on deposits thus benefiting the depositor. That this argument is actually accepted in debate today is testament to how badly understood the theory of money and banking is. Whatever is gained in nominal interest payments is lost -- and more -- through inflation. The creation of fake receipts does not also coincidentally create real wealth; it only dilutes claims to it. Thus if the depositor had 10% of the money supply before (a claim to 10% of real wealth), he has less than 10% after, thus commanding a smaller claim on real wealth. Even if he has more dollars, those dollars are worth less. Thus, he enjoys a nominal gain, but suffers a real loss.

References

Rothbard on fractional reserve banking.
Rothbards great introduction to money and banking.
Mises on money, by Gary North.
Money, Banking, and the Federal Reserve, complete transcript.

Free Market Banking

2007-09-11T19:19:00.000-07:00

In the previous article we looked at money and how it arises in the market. We determined that money is a commodity that is selected by the market as the medium of exchange. Only a commodity with prior value can gain this status, as exemplified by Mises' regression theorem. The commodity that gained wide acceptance was precisely gold, and to a lesser extent silver. Although money is the lifeblood of the market economy, as physical gold it has not realized its full potential -- for that, we need banking.

Recall that money should be portable, divisible, and durable. Gold is all of these, however, for large transactions, it can still prove cumbersome. There is also the added complication of storage. Even though physical gold eliminates many costs of barter exchange, such as time and effort, it cannot eliminate all costs, particularly transaction and storage costs. However, the market has a solution: money warehouses. I use the term warehouses and not banks because free market banking is different from the current fractional reserve system. In order to understand this difference it is important to first look at how warehouses would function in a free market and then consider the differences with the current banking system.

Banking as a convenience

In a free market, money warehouses function as depositories, much like how any storage facility works today. The owner deposits his gold, pays a storage fee, purchases insurance if desired, and receives a receipt certifying the deposit. This receipt entitles him to immediate withdrawal of his gold at a moments notice. Precisely how the receipt at any storage facility today allows one to retrieve their property whenever they desire.

Storage fees and insurance costs are unavoidable no matter how gold is stored. Storing gold anywhere, whether at home, in the backyard, or buried under a tree incurs costs. Sometimes these are indirect (time, effort, lost opportunity) and not recognized as costs, but they still exist. In addition, there is always the risk of theft and insurance is necessary to protect against this. Clearly the price paid for insurance is commensurate with the safety of the storage facility. Due to the benefits of specialization, money warehouses can offer the lowest storage and insurance costs. In fact, there is a huge economic incentive for money warehouses to forward integrate their business to provide storage as well as insurance. This ensures rock-bottom fees, and aligns the incentives of the customer and warehouse: now neither wants the gold stolen; the customer for obvious reasons, and the warehouse because they are on the hook as sellers of the insurance policy.

Warehouses greatly reduce the cost of storing gold, but what about transaction costs? They serve to lower these as well. Suppose Smith and Jones enter a trade where Smith agrees to pay Jones 100 ounces of gold. To fulfill his commitment, Smith must withdraw gold from his warehouse and deliver it to Jones. Jones then deposits it in his own warehouse for safekeeping. This requires time and effort. Alternately, Smith can write Jones a check, which, when cashed, instructs Smiths warehouse to pay Jones 100 ounces of gold, drawn on Smiths account. Most likely Jones will deposit the check at his own warehouse. If they belong to the same warehouse this is a simple bookkeeping entry. If they are customers of different warehouses this can still be cost effective since the two warehouses can aggregate all such trades between their customers and physically settle in the manner most convenient. Economies of scale ensure that the costs borne are lower than individual transactions. Presumably, Smith and Jones prefer low costs and high convenience so they opt to pay the service fee for using their warehouses rather than making a direct exchange.

We see that money warehouses play an important role in making gold more cost effective as the medium of exchange. Ultimately, however, they are nothing more than a convenience. They merely serve to lower the costs and increase the convenience of trading physical gold. This is not to say that lending institutions paying interest on gold deposits will not exist in a free market. They absolutely will. However, they should be recognized as distinct from money warehouses. This will be discussed more clearly in the next article on fractional reserve banking.

Paper money

While the system above is already a vast improvement over direct exchange, there is still one further improvement we can envision. If the receipts issued by a gold warehouse are redeemable by the bearer of the receipt, then individuals can simply trade receipts as if trading actual gold. These paper receipts, or bank notes, eliminate transaction costs, but introduces a new risk: counterfeiting -- the notes may be fake. However, again due to economies of scale, well known and trusted warehouses can issues hard to counterfeit notes, similar to federal reserve notes (dollars) today. This situation presents the same risk as using dollars today, so it is highly conceivable that it can evolve and be sustained in a free market. In fact, this phenomenon has been observed repeatedly throughout history, but unlike the system today, there will be no monopoly on the issuance of bank notes.

(An interesting corollary is the origin of the word "dollar", which can be traced to thalers, silver money coined by the Count von Schlick. These private coins gained wide reputations for their integrity. Most people recognizing the seal were willing to trust the integrity of the coin, much as anyone recognizing the seal on federal reserve notes today is willing to trust the integrity of the note. Why should it be any different with private bank notes?)

Conclusion

Banking in a free market takes the shape of money warehouses which serve as a secure place to store gold and an efficient way to trade it. Since warehouses issue receipts that are redeemable at a moments notice, they must keep all the gold on the premises at all times. They are not the owners, they are merely the caretakers. To do otherwise is fraud or theft. This will be discussed more clearly in the article on fractional reserve banking. The best known example of free market banking has been the Banca della Piazza del Rialto, which grew to become the center of Venetian commerce. Another example is the Bank of Hamburg, which was eventually compromised when Napolean took control of it.

In the article on fractional reserve banking we will also look at the structure of free market lending institutions. It should be clear, however, that gold warehouses, as described above, are not lending institutions. They are merely storage facilities to lower the costs of transacting in gold.

As for whether bank notes will be widespread, it is very likely so, but it will depend on the relative costs. Only the market can decide. As individuals evaluate alternatives and make choices, they will decide if they prefer checking accounts or bank notes. Each individual, weighing his preferences against the costs and risks and deciding on the former, the latter, or a hybrid of the two, will have the effect of the market selecting the most appropriate solution. When Austrians talk about to the market "selecting" a good or services, it is precisely this phenomenon that they are referring to. It derives from profit-loss accounting, an extremely important concept in understanding how markets function.

References

Rothbard's must read introduction to money and banking.

Money

2007-09-05T15:12:00.000-07:00

For my first post I would like to look at one of the most important aspects of the market economy: money. In fact, I would go as far as to say that the prerequisites for a prosperous and stable society are precisely property rights and sound money. Nothing more, nothing less. I will talk about property rights at a later date once I have gotten the easy stuff out of the way. For now, I think the reader will agree that allowing theft is probably not a good idea if one wants to build a prosperous and stable society.

Origin of money

To understand what money is and how it evolved, we need to look at the role it plays in the market economy. Without money, we would be living in what is called a barter economy. A barter economy is characterized by direct exchange. If Jones the baker wants an apple, he will trade with the grocer by offering the grocer a loaf of bread. They both agree on how many apples each loaf is worth and make an exchange. Easy enough, but what if Smith the economics professor wants to get a haircut? He needs to find a barber willing to trade him a haircut in return for an economics lesson. This may prove quite hard to do. This problem in the barter economy is known as the double coincidence of wants -- both Smith and the barber must be looking for each others services in order for an exchange to take place. As is evident, this greatly reduces the ease with which people can trade and thus undermines the division of labor.

Suppose, instead of Smith, that Jones the baker had wanted to get a haircut. Do you think it would be easier or harder for him to find a barber willing to trade him a haircut for a loaf of bread? Intuitively, it should be apparent that it would be much easier. What about Davis the shoemaker? Presumably he would have an easier time than Smith, but probably have to look a little longer then Jones. This difference in how readily certain goods are accepted in trade is what Menger termed their saleability (marketability, liquidity).

Smith, if he was any good as an economics professor, understands this concept and also that his services are not very saleable. Therefore, in order to satisfy his daily needs, he realizes that he needs to have a reserve of highly saleable goods on hand. If he wants a haircut, instead of looking for a barber that wants an economics lesson, which can be costly in time and effort, he need only dip into his stock of highly saleable goods and get himself a haircut from the closest barber. Further, whenever he gives someone an economics lesson, he can request as payment highly saleable goods and thus build his reserve. By acting in this manner what he is doing is using highly saleable goods not for personal consumption, but rather as a means to facilitate trade in the future. He is using them as a medium of exchange.

In order for something to be effective as a medium of exchange it needs to be

Highly saleable: as we have already discussed.
Portable: so it can be carried to the place of exchange, or just on someone's person in anticipation of an exchange.
Durable: probably wouldn't work to keep it under ones mattress to find it has perished a week later.
Divisible: so exactly as much as needed can be exchanged.

It should be apparent that there are many goods that fit these criteria and are therefore in competition with each other to be used as the preferred medium of exchange. Eventually as more people catch on to Smiths idea, they will exercise their discretion in selecting which highly saleable goods they prefer to use as the medium of exchange. Many people acting on their own independant valuations will have the effect of the market selecting a good (or a few goods) that is most widely used as the medium of exchange. It is at this point that we refer to this good(s) as money.

The definition of money is precisely that good (or goods) which serves as the medium of exchange. At different times and places many goods have been used as the medium of exchange, including lumber, tobacco, and even cell phone airtime in some parts of Africa today. However, the market has selected one good in particular, gold, to be the universally preferred medium of exchange. There are very important reasons for this that will be discussed at length in the article on sound money. The current system, however, is based on government fiat paper money that is not backed by gold, silver, or anything for that matter. It would appear that this undermines our discussion, but it does not for reasons that will become clear shortly.

As one particular good becomes widely accepted as the preferred medium of exchange, it's demand rises. People now value it for whatever reason they valued it earlier, as well as because it has become money. It has its original non-monetary value (industrial or aesthetic), as well as its monetary value (can be readily traded). In the process of gaining monetary value, the good assumes further saleability as people are more likely to accept it in trade because they know still others are more likely to accept it in trade, and so on. This is self-reinforcing, and the end result is that money often gains much more monetary value than non-monetary value. This has been the case with gold; it has become much more valuable after it was widely accepted as money. Even today the major driver of the price of gold is investment demand. Also think about what the most saleable good is today. It is precisely federal reserve notes, what we call money. Remember they are backed by nothing, they are merely pieces of paper, but everyone will readily trade for them because they have monetary value -- can be exchanged for goods and services at a future date.

It should be clear at this point that a good cannot naturally arise in the market as money unless it is already highly saleable (for whatever reason). That is, it must have some original value to form a starting point. This is the essence of Mises' regression theorem. Even the current monetary system does not escape this need. When the federal reserve notes that we use as money today were first issued, they were redeemable in gold. Once they gained monetary value to offset the fact that they are nothing but pieces of paper, Nixon was able to close the gold window and sever any ties they had with gold. They did not fail because they had become saleable on account of acquiring monetary value. However, it is important to realize that they are an "unnatural" phenomenon because they required government force (legal tender laws and false demand in terms of income taxes only payable in federal reserve notes). It is impossible for fiat money to arise in a free market. If a critical mass of people realizes this, fiat money may very well be rejected (it is, in the economic sense, a bubble) and society will return to a commodity based money, such as the gold standard.

Conclusion

We will look at fiat money versus gold in more detail when we discuss sound money. For now it should be clear money is a commodity that naturally arises in the free market as the preferred medium of exchange. Individuals vote by choosing to accept certain goods over others and eventually one is selected as the best. Historically, this has been gold, and to a lesser extent silver. Although fiat money is unnatural, once it has gained monetary value, it is no different than gold in that regard. However, there are other important differences.

Some people will claim that money is a store of value and a unit of account. With the caveat that value is purely subjective and cannot be "stored", this is true. Money tends to maintain its "value" (it's purchasing power). I say tends because there is always the threat of inflation. It is also a unit of account because the prices of all goods are expressed in the monetary unit. However, these are both consequences of it being the medium of exchange.

A final note: the theory of money and credit is one area where Austrian economics clearly differentiates itself mainstream economics. Important books include Mises' Theory of Money and Credit, and Jesus Huerta de Soto's Money, Bank Credit, and Economic Cycles.

Please read the next article on banking.

References

Must read article by Rothbard.
Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto.
Theory of Money and Credit by Ludwig von Mises.
Study guide to money.

References

2007-09-03T14:20:00.001-07:00

An introduction to the Austrian school at mises.org.

Here is a quick list of some important resources on mises.org that I have found useful in the past.

Quiz: a good way to see how familiar one is with the Austrian and other schools of thought. Just fyi, it is actually on the longer side.

It is multiple choice with 4 possible answers, one from each of the following schools of thought: Austrian, Chicago, Neoclassical, Socialist. Once you complete and hit submit, all the answers are listed and identified. If nothing else you can treat the answer page as a FAQ about where each school stands on various issues. I found this very useful when I first started out because it helped my identify the important issues (the questions), and where each major school stands on those (the answers).
Articles: form a great window into Austrian economics.
Study Guide: (almost) exhaustive resource of anything and everything Austrian.
FAQ: on the Mises Institute and Austrian economics.
Mises Blog.

Quotable Mises.

Introduction

2007-09-03T13:28:00.000-07:00

Hello and welcome to my blog. Here I will attempt to explain Austrian Economics in the tradition of Mises and Rothbard. Although both Mises and Rothbard make, what would appear to some, as quite extraordinary claims -– especially in the realm of monetary and capital theory -- they are actually not that for off the beaten path of Nobel laureates Friedman and Hayek, or the great economists of previous centuries, such as Riccardo, Smith, Say, and Cantillon. However, the truly fundamental difference between Austrian and mainstream economics (here I clump Friedman but not Hayek with the mainstream) is the Austrian commitment to an epistemically sound foundation for the field of economics. Specifically, while the mainstream approaches economics (and by extension the rest of the social sciences) with a positivist lens, Austrians recognize that positivism is an incomplete epistemology, especially when dealing with human actors, and thus reject its validity in the social sciences. In this introductory article, I would like to explore this notion briefly and also share some thoughts on the nature of economic inquiry.

The first thing to stress is that, despite the inherent contradictions in positivism (described later in this article), it should not be confused as having failed humanity. Positivism in the natural sciences (physics, chemistry, biology, etc) has been fabulously successful at explaining the world around us. In fact, it has been so successful that it has been mistakenly confused as the scientific method, while the true scientific method has fallen into obscurity and has only really been kept alive by the Austrians. The reason for this is because what is known as the synthetic a priori can only advance so far in the natural sciences that in order to gather any knowledge of the world around us, we must rely on the synthetic a posteriori. Thus, having observed the success of the latter and the apparent failure of the former in the natural sciences, those without a good appreciation of epistemology have mistakenly confused the latter as science and the former as crank science; whereas, in reality, they are two sides of the same coin.

Contrasting the social sciences with the natural sciences, a very curious phenomenon occurs, which is that the deductive based synthetic a priori now becomes far more important than its inductive based cousin, because, while one can build controlled experiments with atoms and molecules, one can do no such thing with human beings. Atoms and molecules obey laws of causality that can be isolated in a laboratory and thus induced from specific observations and controlled experiments. In the social sciences, no such corollary exists. All knowledge, is, and should be, deductive. The reason for this is two fold. First, different people will react differently faced with the same situation since each has his own unique subjective value system. And second, there is a temporal element that the natural sciences do not face. Atoms and molecules will behave identically regardless of when the experiment is performed. The same cannot be said for humans. Thus we cannot understand the science of human action unless we first understand that humans act. No such understanding is necessary in the natural sciences.

At this point I realize that I have used terms somewhat casually assuming familiarity on the part of the reader, so let me attempt to formalize the discussion. Wikipedia describes positivism as

the philosophy that the only authentic knowledge is knowledge that is based on actual sense experience. Such knowledge can come only from affirmation of theories through strict scientific method.

Interestingly, I do not disagree with the first statement. The only valid epistemic position is sense perception. What I disagree with is the latter assertion that such knowledge can only be achieved through the scientific method of observation, experimentation, and hypothesis testing. This latter statement is, at best, incomplete, and at worst, patently false. Consider for a moment its implication on itself; for, if all authentic knowledge must be derived through the scientific method of experimentation and hypothesis testing, then the truth value of that statement too, in order to be considered authentic knowledge, must be derived through the scientific method of experimentation and hypothesis testing, thus rendering it a mere hypothesis that may be falsified at any time and not an absolute truth forming the basis of the positivist philosophy. The contradiction should be apparent. In their zeal to place all knowledge within the a posteriori, the positivist have shot themselves in the foot by making the scientific method -- and thus, by extension, sense perception -- optional. However, the validity of sense perception is not optional. The problem is the positivists naive understanding of epistemology which allows him no room to maneuver out of this dilemma short of special pleading.

And further, at what point has the positivist either proposed or performed an experiment to actually demonstrate his claim? Until he does so, should we not reject its authenticity, per his own urgings?

The argument I have put forward above is detrimental to positivism, but not sense perception. Sense perception has two aspects, the deductive a priori, and the inductive a posteriori. The former is apodictic while the latter is empirical. Placing the validity of sense perception in the former allows us to ascertain, with apodictic certainty, that sense perception is the only valid epistemic framework. In fact, all disciplines, even the natural sciences, will collapse if one fails to recognize the various a priori premises that one implicitly assumes. For example, the physicist is lost if he does not implicitly assume the regularity of nature or the inviolability of logic. Neither of these are determined via hypothesis testing or experimentation. In fact, they are logically prior to any such action; hence the term a priori.

At this point the reader should have noticed that I am using the terms a priori and a posteriori slightly differently than their accepted meaning in scientific circles today. This is not sloppiness; I have very good reasons for doing so. I believe the reason the positivist is so quick to dismiss the a priori is because they are unclear about its correct interpretation. They consider it knowledge prior to experience. However, it is more correctly understood as knowledge post experience, but prior to experimental verification. It is deduced from axioms that are only known because they are observed via the senses. A simple example will illustrate: consider the axiom of consciousness: that i am conscious. I doubt the reader will dispute its status as authentic knowledge of reality. However, it does not need to be experimentally verified because it is self evidently true: it is axiomatic. To see why, try disproving it. Any attempt to do so fails because one must use their conscious faculties to disprove the statement, thus implicitly proving the statement. The act of disproving it results in a performatory contradiction. Further, it is derived from sense perception because I ascertain that I am conscious only having first observed that I am, in fact, conscious. And it is not a posteriori since it does not need to be experimentally verified once observed and determined. In fact, it is impossible to falsify, thus making it "unscientific" according to the positivists, which is clearly absurd since it is very clearly authentic knowledge.

I realize this "introduction" to my blog has, in fact, been quite dense. I promise that the rest of my blog is not, as it is written for the layman with no background in economics or philosophy. This article is a necessary introduction because the biggest problem with economics today is simply the lack of understanding of basic epistemology amongst its practitioners. If the reader has followed the argument outlined here, they are well on their way to understanding why Austrian economics is the correct approach to economics and the mainstream are the pseudo scientists, despite their vehement arguments to the contrary.

For more details, please see here.