Tragedy of the Commons

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

“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

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

Interest

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

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

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

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:

1. 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.
   
2. 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.
3. 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.