The Austrian School of Economics

Posted by PITHOCRATES - March 3rd, 2014

Economics 101

(Originally published February 27th, 2012)

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us.  The computer?  The Internet?  The cell phone?  The car?  The jumbo jet?  Television?  Air conditioning?  The automatic dishwasher?  No.  Amazingly, economists did not invent any of these brilliant inventions.  And economists didn’t predict any of these inventions.  Not a one.  Despite how brilliant they are.  Well, brilliant by their standard.  In their particular field.  For economists really aren’t that smart.  Their ‘expertise’ is in the realm of the social sciences.  The faux sciences where people try to quantify the unquantifiable.  Using mathematical equations to explain and predict human behavior.  Which is what economists do.  Especially Keynesian economists.  Who think they are smarter than people.  And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity.  The Austrian school.  Where Austrian economics began.  In Vienna.  Where the great Austrian economists gathered.  Carl Menger.  Ludwig von Mises.  And Friedrich Hayek.  To name a few.  Who understood that economics is the sum total of millions of people making individual human decisions.  Human being key.  And why we can’t reduce economics down to a set of mathematical equations.  Because you can’t quantify human behavior.  Contrary to what the Keynesians believe.  Which is why these two schools are at odds with each other.  With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school.  Because it calls for the government to interfere with market forces.  To manipulate them.  To make markets produce different results from those they would have if left alone.  Something governments love to do.  Especially if it calls for taxing and spending.  Which Keynesian economics highly encourage.  To fix market ‘failures’.  And recessions.  By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire.  They believe more in the separation of the government from things economic.  Economic exchanges are best left to the invisible hand.  What Adam Smith called the sum total of the millions of human decisions made by millions of people.  Who are maximizing their own economic well being.  And when we do we maximize the economic well being of the economy as a whole.  For the Austrian economist does not believe he or she is smarter than people.  Or markets.  Which is why an economist never gave us any brilliant invention.  Nor did their equations predict any inventor inventing a great invention.  And why economists have day jobs.  For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs.  When they’re able to do that we should start listening to them.  But not before.

Low Interest Rates cause Malinvestment and Speculation which puts Banks in Danger of Financial Collapse

Keynesian economics really took off with central banking.  And fractional reserve banking.  Monetary tools to control the money supply.  That in the Keynesian world was supposed to end business cycles and recessions as we knew them.  The Austrian school argues that using these monetary tools only distorts the business cycle.  And makes recessions worse.  Here’s how it works.  The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money).  Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc.  This new economic activity encourages businesses to hire new workers to meet the new demand.  Ergo, recession over.  Simple math, right?  Only there’s a bit of a problem.  Some of our worst recessions have come during the era of Keynesian economics.  Including the worst recession of all time.  The Great Depression.  Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse.  (Economists debate the causes of the Great Depression to this day.  Understanding the causes is not the point here.  The point is that it happened.  When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions.  They’re artificial ones.  Created by cheap credit.  Which the central bank creates by forcing interest rates below actual market interest rates.  Which causes a whole host of problems.  In particular corrupting the banking system.  Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now.  This is where savings (or investment capital) come from.  Banks pay depositors interest on their deposits.  And then loan out this money to others who need investment capital to start businesses.  To expand businesses.  To buy businesses.  Whatever.  They borrow money to invest so they can expand economic activity.  And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply.  Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later).  So they borrow to expand operations.  All because of the false signal of the artificially low interest rates.  They borrow money.  Over-invest.  And make bad investments.  Even speculate.  What Austrians call malinvestments.  But there was no shift from consumption to investment.  Savings haven’t increased.  In fact, with all those new loans on the books the banks see a shift in the other direction.  Because they have loaned out more money while the savings rate of their depositors did not change.  Which produced on their books a reduction in the net savings rate.  Leaving them more dangerously leveraged than before the credit expansion.  Also, those lower interest rates also decrease the interest rate on savings accounts.  Discouraging people from saving their money.  Which further reduces the savings rate of depositors.  Finally, those lower interest rates reduce the income stream on their loans.  Leaving them even more dangerously leveraged.  Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation.  Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.).  This alters the natural order of things.  The automatic pricing mechanism of the free market.  And reallocates resources to these higher prices.  Away from where the market would have otherwise directed them.  Creating great shortages and high prices in some areas.  And great surpluses of stuff no one wants to buy at any price in other areas.  Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap.  (But not quite that bad.)  Then comes the day when all those investments don’t produce any returns.  Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it.  They drove up prices.  Created great asset bubbles.  Overbuilt their capacity.  Bought assets at such high prices that they’ll never realize a gain from them.  They know what’s coming next.  And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning.  By keeping interest rates low.  But that only allows asset bubbles to get bigger.  Making the inevitable correction more painful.  But eventually the central bank has to step in and raise interest rates.  Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level.  And sparks off some nasty inflation.  So rates go up.  Credit becomes more expensive.  Often leaving businesses and speculators to try and refinance bad debt at higher rates.  Debt that has no income stream to pay for it.  Either forcing business to cut costs elsewhere.  Or file bankruptcy.  Which ripples through the banking system.  Causing a lot of those highly leveraged banks to fail with them.  Thus making the resulting recession far more painful and more long-lasting than necessary.  Thanks to Keynesian economics.  At least, according to the Austrian school.  And much of the last century of history.

The Austrian school believes the market should determine interest rates.  Not central bankers.  They’re not big fans of fractional reserve banking, either.  Which only empowers central bankers to cause all of their mischief.  Which is why Keynesians don’t like Austrians.  Because Keynesians, and politicians, like that power.  For they believe that they are smarter than the people making economic exchanges.  Smarter than the market.  And they just love having control over all of that money.  Which comes in pretty handy when playing politics.  Which is ultimately the goal of Keynesian economics.  Whereas the Austrian school is more about economics.

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FT202: “You can’t indulge selfishness, narcissism and hedonism and expect the young to give up their life of consumption and gratification.” —Old Pithy

Posted by PITHOCRATES - December 27th, 2013

Fundamental Truth

The Generation that won World War II Sacrificed and Saved for the Future

The generation that lived through the Great Depression and World War II were a hardy people.  They knew a thing or two about sacrifice.  And going without.  For their wants often went unfulfilled.  And they were a skinny people.  As there was not a lot of food to eat.  First because of the Great Depression.  When people could barely afford to stay alive.  And then World War II.  Where the government rationed almost everything for the war effort.

So they spent little.  Saved what they could.  Got used to not having what they wanted.  And always worked hard for a better future.  Sound familiar?  No.  Of course not.  No one’s like this today.  That hardy generation survived the Great Depression and won World War II.  Making the world safe for democracy to flourish.  Their free market capitalism made a prosperous world of plenty.  So their children would never have to live in a world they had lived in.  As it turned out, though, that was a mistake.

Their children were not like their parents.  These baby boomers were not as hardy as their parents were.  While they struggled and went without the baby boomers didn’t.  The baby boomers became the Me Generation.  Because it was all about them.  They rejected the hard work and sacrifice of their parents.  And didn’t save for a better tomorrow.  No.  For them it was all about the here and now.

The Me Generation rebelled against their Parents and became Anti-Parents

The Me Generation didn’t save like their parents.  They spent.  Changing the economy forever.  From one made strong and healthy driven by private savings that banks converted into investment capital.  To a Keynesian one.  Where Keynesian economists viewed savings as economic leaks from the economy.  No.  Spending was better.  Consumption was better than saving.  Besides, what did we have to save for anymore with the Federal Reserve printing money?  And the government paying our way for us in retirement?

The Me Generation was only too happy to help transform the government from one of savings and investment to one of consumptionand gratification.  And they lived Life in the Fast Lane (by Joe Walsh, Glenn Frey and Don Henley, recorded by the Eagles in 1976 on the studio album Hotel California).   “Everything all of the time.”  And when that wasn’t enough there was cocaine to fill the remaining emptiness.  “There were lines on the mirror, lines on her face.”  Sometimes the drug use became so intense it interfered with another past time of the Me Generation.  Sex.  “He was too tired to make it, she was too tired to fight about it.”

So while their parents won the Second World War they were partying and getting high and having as much casual sex as their excessive drug use allowed.  And because of it the Seventies gave us a new drug in the Eighties.  Crack.  And a war on drugs.  As well as AIDS.  Thank you, Me Generation.  For rebelling against your parents and becoming anti-parents.  Destroying our past culture and traditions.  And our religion.  Just so you can have “everything all of the time.”  Right now.  Without ever waiting to gratify an urge or desire.

Obamacare will Fail because the Young won’t give up their Life of Consumption and Gratification

The counterculture (i.e., the anti-parents) movement then entered academia.  Took over the curriculum in our public schools.  And our colleges and universities.  Where they taught our kids that everything their parents told them was wrong.  That they are destroying the environment.  That American imperialism is the greatest threat to world peace.  That the Founding Fathers were rich white slave owners who wrote the Constitution to further their greed.  That free market capitalism is cruel, callous and unfair.  While government is kind, feeling and fair.

The Me Generation learned something valuable as they entered academia.  And government.  That there are a lot of young people who vote.  And because many of them grew up already rebelling against their parents they pushed these people closer to them.  The anti-parents.  Helping them to hold on to political power.  So they appealed to all the things young people want.  Such as sex.  By providing free birth control and access to abortion.  They attack Christianity and tell their students there is nothing wrong with their life of consumption and gratification.  And, of course, they favor decriminalizing drugs.  And are making great headway in that area with marijuana.  I mean, kids just love the Democrats.  For they indulge their every want and desire.  Without parenting them to sacrifice and save for their future.  Like their insufferable parents.

So our young have never been defined more by selfishness, narcissism and hedonism.  Always living for the moment.  Without a care in the world for the future.  Making even the Me Generation seem selfless.  Who lived in relative anonymity in their narcissistic world.  Unlike today’s youth.  Who can’t survive without Instagram, Twitter and Facebook.   And must share every iota of their existence with the entire world.  Because it’s all about them.  The world revolves around them and the pursuit of their life of consumption and gratification.  So it is rather ironic that the very thing that keeps Democrats in power—indulging in the youth voters’ selfishness, narcissism and hedonism—could deal such a threatening blow to their power.  For Obamacare to work they need these young voters to be more like their parents and less like the people they are.  Thanks to the Democrat indoctrination in our public schools, colleges and universities.  To sacrifice some of their wants and desires to help their parent’s generation.  To consume less.  So the people they rebelled against can have free medical care.

This is why Obamacare (the Affordable Care Act) will fail.  The young and healthy do not want to give up their life of consumption and gratification.  Which means they’re not buying health insurance.  Only the old and sick are.  Because they need health care.  While the young and healthy don’t.  So they are not going to buy costly health insurance policies that they feel they will never use.  Instead they’ll pay the lower-cost fine.  So they can continue to live their life of consumption and gratification.  That the Democrats told them all their life was what they should do.  Not to save for the future.  Or sacrifice.  For their parents.  Their community.  Or their God.  So the Affordable Care Act will fail.  Because you can’t indulge selfishness, narcissism and hedonism and expect the young to give up their life of consumption and gratification.

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Keynesian Economics

Posted by PITHOCRATES - October 14th, 2013

Economics 101

(Originally published February 20th, 2012)

John Maynard Keynes said if the People aren’t Buying then the Government Should Be

Keynesian economics is pretty complex.  So is the CliffsNotes version.  So this will be the in-a-nutshell version.  Keynesian economics basically says, in a nut shell, that markets are stupid.  Because markets are full of stupid people.  If we leave people to buy and sell as they please we will continue to suffer recession after recession.  Because market failures give us the business cycle.  Which are nice on the boom side.  But suck on the bust side.  The recession side.  So smart people got together and said, “Hey, we’re smart people.  We can save these stupid people from themselves.  Just put a few of us smart people into government and give us control over the economy.  Do that and recessions will be a thing of the past.”

Well, that’s the kind of thing governments love to hear.  “Control over the economy?” they said.  “We would love to take control of the economy.  And we would love to control the stupid people, too.  Just tell us how to do it and our smart people will work with your smart people and we will make the world a better place.”  And John Maynard Keynes told them exactly what to do.  And by exactly I mean exactly.  He transformed economics into mathematical equations.  And they all pretty much centered on doing one thing.  Moving the demand curve.  (A downward sloping graph showing the relationship between prices and demand for stuff; higher the price the lower the demand and vice versa).

In macroeconomics (i.e., the ‘big picture’ of the national economy), Keynes said all our troubles come from people not buying enough stuff.  That they aren’t consuming enough.  And when consumption falls we get recessions.  Because aggregate demand falls.  Aggregate demand being all the people put together in the economy out there demanding stuff to buy.  And this is where government steps in.  By picking up the slack in personal consumption.  Keynes said if the people aren’t buying then the government should be.  We call this spending ‘stimulus’.  Governments pass stimulus bills to shift the demand curve to the right.  A shift to the right means more demand and more economic activity.  Instead of less.  Do this and we avoid a recession.  Which the market would have entered if left to market forces.  But not anymore.  Not with smart people interfering with market forces.  And eliminating the recession side of the business cycle.

Keynesians prefer Deficit Spending and Playing with the Money Supply to Stimulate the Economy

Oh, it all sounds good.  Almost too good to be true.  And, as it turns out, it is too good to be true.  Because economics isn’t mathematical.  It’s not a set of equations.  It’s people entering into trades with each other.  And this is where Keynesian economics goes wrong.  People don’t enter into economic exchanges with each other to exchange money.  They only use money to make their economic exchanges easier.  Money is just a temporary storage of value.  Of their human capital.  Their personal talent that provides them business profits.  Investment profits.  Or a paycheck.  Money makes it easier to go shopping with the proceeds of your human capital.  So we don’t have to barter.  Exchange the things we make for the things we want.  Imagine a shoemaker trying to barter for a TV set.  By trading shoes for a TV.  Which won’t go well if the TV maker doesn’t want any shoes.  So you can see the limitation in the barter system.   But when the shoemaker uses money to buy a TV it doesn’t change the fundamental fact that he is still trading his shoemaking ability for that TV.  He’s just using money as a temporary storage of his shoemaking ability.

We are traders.  And we trade things.  Or services.  We trade value created by our human capital.  From skill we learned in school.  Or through experience.  Like working in a skilled trade under the guidance of a skilled journeyperson or master tradesperson.  This is economic activity.  Real economic activity.  People getting together to trade their human capital.  Or in Keynesian terms, on both sides of the equation for these economic exchanges is human capital.  Which is why demand-side economic stimulus doesn’t work.  Because it mistakes money for human capital.  One has value.  The other doesn’t.  And when you replace one side of the equation with something that doesn’t have value (i.e., money) you cannot exchange it for something that has value (human capital) without a loss somewhere else in the economy.  In other words to engage in economic exchanges you have to bring something to the table to trade.  Skill or ability.  Not just money.  If you bring someone else’s skill or ability (i.e., their earned money) to the table you’re not creating economic activity.  You’re just transferring economic activity to different people.  There is no net gain.  And no economic stimulus.

When government spends money to stimulate economic activity there are no new economic exchanges.  Because government spending is financed by tax revenue.  Wealth they pull out of the private sector so the public sector can spend it.  They take money from some who can’t spend it and give it to others who can now spend it.  The reduction in economic activity of the first group offsets the increase in economic activity in the second group.   So there is no net gain.  Keynesians understand this math.  Which is why they prefer deficit spending (new spending paid by borrowing rather than taxes).  And playing with the money supply.

The End Result of Government Stimulus is Higher Prices for the Same Level of Economic Activity

The reason we have recessions is because of sticky wages.  When the business cycle goes into recession all prices fall.  Except for one.  Wages.  Those sticky wages.  Because it is not easy giving people pay cuts.  Good employees may just leave and work for someone else for better pay.  So when a business can’t sell enough to maintain profitability they cut production.  And lay off workers.  Because they can’t reduce wages for everyone.  So a few people lose all of their wages.  Instead of all of the people losing all of their wages by a business doing nothing to maintain profitability.  And going out of business.

To prevent this unemployment Keynesian economics says to move the aggregate demand curve to the right.  In part by increasing government spending.  But paying for this spending with higher taxes on existing spenders is a problem.  It cancels out any new economic activity created by new spenders.  So this is where deficit spending and playing with the money supply come in.  The idea is if the government borrows money they can create economic activity.  Without causing an equal reduction in economic activity due to higher taxes.  And by playing with the money supply (i.e., interest rates) they can encourage people to borrow money to spend even if they had no prior intentions of doing so.  Hoping that low interest rates will encourage them to buy a house or a car.  (And incur dangerous levels of debt in the process).  But the fatal flaw in this is that it stimulates the money supply.  Not human capital.

This only pumps more money into the economy.  Inflates the money supply.  And depreciates the dollar.  Which increases prices.  Because a depreciated dollar can’t buy as much as it used to.  So whatever boost in economic activity we gain will soon be followed by an increase in prices.  Thus reducing economic activity.  Because of that demand curve.  That says higher prices decreases aggregate demand.  And decreases economic activity.  The end result is higher prices for the same level of economic activity.  Leaving us worse off in the long run.  If you ever heard a parent say when they were a kid you could buy a soda for a nickel this is the reason why.  Soda used to cost only a nickel.  Until all this Keynesian induced inflation shrunk the dollar and raised prices through the years.  Which is why that same soda now costs a dollar.

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Say’s Law

Posted by PITHOCRATES - September 2nd, 2013

Economics 101

(originally published August 6, 2012)

Keynesians believe if you Build Demand Economic Activity will Follow

People hate catching a common cold.  And have long wanted a cure for the common cold.  For a long time.  For hundreds of years.  But no one had ever filled this incredible demand.  All this time doctors and scientists still haven’t been able to figure that one out.  Despite knowing with that incredible demand, and our patent rights, whoever does figure that one out will become richer than Bill Gates.  Which is quite the incentive for figuring out the ingredients to make one little pill.  So why hasn’t anyone found the cure for the common cold?

There are many reasons.  But let’s just ignore them.  Like a Keynesian economist ignores a lot of things in their economic formulas.  In fact, let’s try and enter the head of some Keynesian economists.  And have them answer the question why there isn’t a cure for the common cold.  Based on their economic analysis you might hear them say that we have a cure for the common cold.  Because a high demand makes anything happen.  Or you might hear them say we don’t have a cure because enough people haven’t caught a cold yet.  And that we need to get more people to catch colds so we increase the demand for a cure.

Keynesians believe if you build demand economic activity will follow.  Like in that movie where they build a baseball diamond in a cornfield and those dead baseball players come back to play on it.  So Keynesians believe in government spending.  And love stimulus spending.  As well as taxing people to give their money to other people to spend.  Because having money to spend stimulates demand.  Consumers will consume things.  And increase consumption.  So suppliers will bring more things to market.  And create more jobs to meet that consumption demand.  Unless people save that money.  Which is something Keynesians hate.  Because saving reduces consumption.   Which is about the worst thing you could do in the universe of Keynesian economics.  Save money.  For in that universe spending trumps saving.  In fact, spending trumps everything.  No matter how you create that spending.  Keynesians actually believe taxing people so they can pay other people to dig a ditch and then fill that ditch back in stimulates economic activity.  Because these ditch diggers/fillers will take their paycheck and spend it.

Today People wait Anxiously for the next Apple Release to Learn what the Next Thing is that they Must Have

Of course there is a problem with this economic theory.  When you take money away from others they haven’t created new economic activity.  They just transferred that spending to someone else.  The people who earned that money spend less while the people who didn’t earn it spend more.  It’s a wash.  Some spending goes down.  While some spending goes up.  Actually there is a net loss in economic activity.  Because that money has to pass through government hands.  Where some of it sticks.  Because bureaucrats have to eat, too.  So the people receiving this money don’t receive as much as what was taxed away.  So Keynesian stimulus doesn’t really stimulate.  It actually reduces economic activity from what it might have been.  Because of the government’s cut.

And it gets worse.  Because this consumption demand doesn’t really create jobs.  We get nothing new out of it.  What do people demand?  Things they see.  Things they know about.  For it is hard to demand something that doesn’t exist.  You see a commercial for another incredible Apple product and you want it.  Thanks to some great advertising that explained why you must have it.  In other words, when you give money to people all they will do is buy things they’ve always wanted.  Things that already exist.  Old stuff.  It’s sort of the chicken and the egg thing.  Which came first?  Wanting something?  Or the thing that people want?

Raising taxes on Apple to create a more egalitarian society by redistributing their wealth will let people buy more of the old stuff.  But it won’t help Apple create more new things to bring to market.  Things we don’t even know about yet.  If we tax them so much that it leaves little left for them to invest in research and development how are they going to develop new things?  Things we don’t even know about yet?  Things that we will learn that we must have?  Once upon a time no one was asking for portable cassette players.  Then Sony came out with the Walkman.  And everyone had to have one.  Once upon a time there were no MP3 players.  No smartphones.  No tablet computers.  Now people must have these things.  After their manufacturers told us why we must have them.  Today people wait anxiously for the next Apple release to learn what the next thing is that they must have.

Say’s Law states that Supply Creates Demand

Supply leads demand.  We can’t ask for the unknown.  We can only ask for what the market has shown us.  Which is why Keynesian economics doesn’t work.  Because focusing on demand doesn’t work.  Giving people money to spend doesn’t stimulate creativity in the market place.  Because that money was taxed out of the market place.   Reducing profits.  Leaving less for businesses to invest into research and development.  And reducing their incentive to take big risks to bring the next big thing to market.  Like a phone you can talk to and ask questions.  Again something no one was demanding.  But now it’s something everyone wants.

Jean-Baptiste Say (1767–1832) was a French economist.  Another brilliant French mind that contributed to the Enlightenment.  And helped advance Western Civilization.  He observed how supply led demand.  Understood production was key in the economy.  He knew to create economic activity you had to focus on the producers.  Not the consumers.  Because if we encourage brilliant minds to bring brilliant things to market the demand will follow.  As history has shown.  And continues to show.  Every time a high-tech company brings something new to market that they have to explain to us before we realize we must have it.  Or said in another way, supply creates demand.  A little law of economics that we call Say’s law.

If Keynesian economics worked no one would have to have a job.  The government could print money for everyone.  And the people could take their government dollars and consume whatever was in the market place.  Which, of course, would be pretty sparse if no one worked.  If there were no Steve Jobs out there thinking of brilliant things to bring to market.  Because supply creates demand.  Demand doesn’t create supply.  For fists full of money won’t stimulate any economic activity if there is nothing to buy.  So using Keynesian stimulus as a cure for a recession is about as effective as someone’s homemade cure for the common cold.  You take the homemade concoction and in a week or two it cures you.  Of course, the cold just ran its course.  Which is how recessions end.  After they run their course.  Which can be a short course if there isn’t too much Keynesian intervention.

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Saving, Investing and the Paradox of Thrift

Posted by PITHOCRATES - August 12th, 2013

Economics 101

(Originally published August 27th, 2012)

Healthy Sales can Support just about any Bad Decision a Business Owner Makes

“Industry, Perseverance, & Frugality, make Fortune yield.”  Benjamin Franklin (1744).  He also said, “A penny saved is a penny earned.”  Franklin was a self-made man.  He started with little.  And through industry, perseverance and frugality he became rich and successful.  He lived the American dream.  Which was having the liberty to work hard and succeed.  And to keep the proceeds of his labors.  Which he saved.  And all those pennies he saved up allowed him to invest in his business.  Which grew and created more wealth.

Frugality.  And saving.  Two keys to success.  Especially in business.  For the business that starts out by renting a large office in a prestigious building with new furniture is typically the business that fails.  Healthy sales can support just about any bad decision a business owner makes.  While falling sales quickly show the folly of not being frugal.  Most businesses fail because of poor sales revenue.  The less frugal you’ve been the greater the bills you have to pay with those falling sales. Which speeds up the failing process.  Insolvency.  And bankruptcy.  Teaching the important lesson that you should never take sales for granted.  The importance of being frugal.  And the value of saving your pennies.

Saving and frugality also hold true in our personal lives.  Especially when we start buying things.  Like big houses.  And expensive cars.  As a new household starting out with husband and wife gainfully employed the money is good.  The money is plentiful.  And the money can be intoxicating.  Because it can buy nice things.  And if we are not frugal and we do not save for a rainy day we are in for a rude awakening when that rainy day comes.  For if that two income household suddenly becomes a one income household it will become very difficult to pay the bills.  Giving them a quick lesson in the wisdom of being frugal.  And of saving your pennies.

The Money People borrow to Invest is the Same Money that Others have Saved

Being frugal lets us save money.  The less we spend the more we can put in the bank.  What we’re doing is this.  We’re sacrificing short-term consumption for long-term consumption.  Instead of blowing our money on going to the movies, eating out and taking a lot of vacations, we’re putting that money into the bank.  To use as a down payment on a house later.  To save for a dream vacation later.  To put in an in-the-ground pool later.  What we’re doing is pushing our consumption out later in time.  So when we do spend these savings later they won’t make it difficult to pay our bills.  Even if the two incomes become only one.

Sound advice.  Then again, Benjamin Franklin was a wise man.  And a lot of people took his advice.  For America grew into a wealthy nation.  Where entrepreneurs saved their money to build their businesses.  Large savings allowed them to borrow large sums of money.  As bank loans often required a sizeable down payment.  So being frugal and saving money allowed these entrepreneurs to borrow large sums of money from banks.  Money that was in the bank available to loan thanks to other people being frugal.  And saving their money.

To invest requires money.  But few have that kind of money available.  So they use what they have as a down payment and borrow the balance of what they need.  The balance of what they need comes from other people’s savings.  Via a bank loan.  This is very important.  The money people borrow to invest is the same money that others have saved.  Which means that investments are savings.  And that people can only invest as much as people save.  So for businesses to expand and for the economy to grow we need people to save their money.  To be frugal.  The more they save instead of spending the greater amount of investment capital is available.  And the greater the economy can grow.

The Paradox of Thrift states that Being Frugal and Saving Money Destroys the Economy

Once upon a time this was widely accepted economics.  And countries grew wealthy that had high savings rates.  Then along came a man named John Maynard Keynes.  Who gave the world a whole new kind of economic thought.   That said spending was everything.  Consumption was key.  Not savings.  Renouncing centuries of capitalism.  And the wise advice of Benjamin Franklin.  In a consumption-centered economy people saving their money is bad.  Because money people saved isn’t out there generating economic activity by buying stuff.  Keynes said savings were nothing more than a leak of economic activity.  Wasted money that leaks out of the economy and does nothing beneficial.  Even when people and/or businesses are being frugal and saving money to avoid bankruptcy.

In the Keynesian world when people save they don’t spend.  And when they don’t spend then businesses can’t sell.  If businesses aren’t selling as much as they once were they will cut back.  Lay people off.  As more businesses suffer these reductions in their sales revenue overall GDP falls.  Giving us recessions.  This is the paradox of thrift.  Which states that by doing the seemingly right thing (being frugal and saving money) you are actually destroying the economy.  Of course this is nonsense.  For it ignores the other half of saving.  Investing.  As a business does to increase productivity.  To make more for less.  So they can sell more for less.  Allowing people to buy more for less.  And it assumes that a higher savings rate can only come with a corresponding reduction in consumption.  Which is not always the case.  A person can get a raise.  And if they are satisfied by their current level of consumption they may save their additional income rather than increasing their consumption further.

Many people get a raise every year.  Which allows them to more easily pay their bills.  Pay down their credit cards.  Even to save for a large purchase later.  Which is good responsible behavior.  The kind that Benjamin Franklin would approve of.  But not Keynesian economists.  Or governments.  Who embrace Keynesian economics with a passion.  Because it gives them a leading role.  When people aren’t spending enough money guess who should step in and pick up that spending slack?  Government.  So is it any wonder why governments embrace this new kind of economic thought?  It justifies excessive government spending.  Which is just the kind of thing people go into government for.  Sadly, though, their government spending rarely (if ever) pulls a nation out of a recession.  For government spending doesn’t replicate what has historically created strong economic growth.  A high savings rate.  That encourages investment higher up in the stages of production.  Where that investment creates jobs.  Not at the end of the stages of production.  Where government spending creates only inflation.  Deficits.  And higher debt.  All things that are a drag on economic activity.

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Phillips Curve

Posted by PITHOCRATES - September 17th, 2012

Economics 101

A High Savings Rate provides Abundant Capital for Banks to Loan to Businesses

Time.  It’s what runs our lives.  Well, that, and patience.  Together they run our lives.  For these two things determine the difference between savings.  And consumption.  Whether we have the patience to wait and save our money to buy something in the future.  Like a house.  Or if we are too impatient to wait.  And choose to spend our money now.  On a new car, clothes, jewelry, nice dinners, travel, etc.  Choosing current consumption for pleasure now.  Or choosing savings for pleasure later.

We call this time preference.  And everyone has their own time preference.  Even societies have their own time preferences.  And it’s that time preference that determines the rate of consumption and the rate of savings.  Our parents’ generation had a higher preference to save money.  The current generation has a higher preference for current consumption.  Which is why a lot of the current generation is now living with their parents.  For their parents preference for saving money over consuming money allowed them to buy a house that they own free and clear today.  While having savings to live on during these difficult economic times.  Unlike their children.  Whose consumption of cars, clothes, jewelry, nice dinners, travel, etc., left them with little savings to weather these difficult economic times.  And with a house they no longer can afford to pay the mortgage.

A society’s time preference determines the natural rate of interest.  A higher savings rate provides abundant capital for banks to loan to businesses.  Which lowers the natural rate of interest.  A high rate of consumption results with a lower savings rate.  Providing less capital for banks to loan to businesses.  Which raises the natural interest rate.  High interest rates make it more difficult for businesses to borrow money to expand their business than it is with low interest rates.  Thus higher interest rates reduce the rate of job creation.  Or, restated another way, a low savings rate reduces the rate of job creation.

The Phillips Curve shows the Keynesian Relationship between the Unemployment Rate and the Inflation Rate

Before the era of central banks and fiat money economists understood this relationship between savings and employment very well.  But after the advent of central banking and fiat money economists restated this relationship.  In particular the Keynesian economists.  Who dropped the savings part.  And instead focused only on the relationship between interest rates and employment.  Advising governments in the 20th century that they had the power to control the economy.  If they adopt central banking and fiat money.  For they could print their own money and determine the interest rate.  Making savings a relic of a bygone era.

The theory was that if a high rate of savings lowered interest rates by creating more capital for banks to loan why not lower interest rates further by just printing money and giving it to the banks to loan?  If low interests rates were good lower interest rates must be better.  At least this was Keynesian theory.  And expanding governments everywhere in the 20th century put this theory to the test.  Printing money.  A lot of it.  Based on the belief that if they kept pumping more money into the economy they could stimulate unending economic growth.  Because with a growing amount of money for banks to loan they could keep interest rates low.  Encouraging businesses to keep borrowing money to expand their businesses.  Hire more people to fill newly created jobs.  And expand economic activity.

Economists thought they had found the Holy Grail to ending recessions as we knew them.  Whenever unemployment rose all they had to do was print new money.  For the economic activity businesses created with this new money would create new jobs to replace the jobs lost due to recession.   The Keynesians built on their relationship between interest rates and employment.  And developed a relationship between the expansion of the money supply and employment.  Particularly, the relationship between the inflation rate (the rate at which they expanded the money supply) and the unemployment rate.  What they found was an inverse relationship.  When there was a high unemployment rate there was a low inflation rate.  When there was a low unemployment rate there was a high inflation rate.  They showed this with their Phillips Curve.  That graphed the relationship between the inflation rate (shown rising on the y-axis) and the unemployment rate (shown increasing on the x-axis).  The Phillips Curve was the answer to ending recessions.  For when the unemployment rate went up all the government had to do was create some inflation (i.e., expand the money supply).  And as they increased the inflation rate the unemployment rate would, of course, fall.  Just like the Phillips Curve showed.

The Seventies Inflationary Damage was So Great that neither Technology nor Productivity Gains could Overcome It

But the Phillips Curve blew up in the Keynesians’ faces during the Seventies.  As they tried to reduce the unemployment rate by increasing the inflation rate.  When they did, though, the unemployment did not fall.  But the inflation rate did rise.  In a direct violation of the Phillips Curve.  Which said that was impossible.  To have a high inflation rate AND a high unemployment rate at the same time.  How did this happen?  Because the economic activity they created with their inflationary policies was artificial.  Lowering the interest rate below the natural interest rate encouraged people to borrow money they had no intention of borrowing earlier.  Because they did not see sufficient demand in the market place to expand their businesses to meet.  However, business people are human.  And they can make mistakes.  Such as borrowing money to expand their businesses solely because the money was cheap to borrow.

When you inflate the money supply you depreciate the dollar.  Because there are more dollars in circulation chasing the same amount of goods and services.  And if the money is worth less what does that do to prices?  It increases them.  Because it takes more of the devalued dollars to buy what they once bought.  So you have a general increase of prices that follows any monetary expansion.  Which is what is waiting for those businesses borrowing that new money to expand their businesses.  Typically the capital goods businesses.  Those businesses higher up in the stages of production.  A long way out from retail sales.  Where the people are waiting to buy the new products made from their capital goods.  Which will take a while to filter down to the consumer level.  But by the time they do prices will be rising throughout the economy.  Leaving consumers with less money to spend.  So by the times those new products built from those capital goods reach the retail level there isn’t an increase in consumption to buy them.  Because inflation has by this time raised prices.  Especially gas prices.  So not only are the consumers not buying these new goods they are cutting back from previous purchasing levels.  Leaving all those businesses in the higher stages of production that expanded their businesses (because of the availability of cheap money) with some serious overcapacity.  Forcing them to cut back production and lay off workers.  Often times to a level below that existing before the inflationary monetary expansion intended to decrease the unemployment rate.

Governments have been practicing Keynesian economics throughout the 20th century.  So why did it take until the Seventies for this to happen?  Because in the Seventies they did something that made it very easy to expand the money supply.  President Nixon decoupled the dollar from gold (the Nixon Shock).  Which was the only restraint on the government from expanding the money supply.  Which they did greater during the Seventies than they had at any previous time.  Under the ‘gold standard’ the U.S. had to maintain the value of the dollar by pegging it to gold.  They couldn’t depreciate it much.  Without the ‘gold standard’ they could depreciate it all they wanted to.  So they did. Prior to the Seventies they inflated the money supply by about 5%.  After the Nixon Shock that jumped to about 15-20%.  This was the difference.  The inflationary damage was so bad that no amount of technological advancement or productivity gains could overcome it.  Which exposed the true damage inflationary Keynesian economic policies cause.  As well as discrediting the Phillips Curve.

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Keynesian Multiplier

Posted by PITHOCRATES - September 3rd, 2012

Economics 101

At the Heart of Keynesian Stimulus Spending is the Keynesian Multiplier

Key to Keynesian economics is spending.  That’s the reason why governments everywhere embrace it.  Because Keynesian economics say government MUST spend money.  And that’s the kind of economics politicians like.  “I must spend?  Well, okay.  If you say so.  Forgive me, my constituents, for spending money I don’t have.  But it’s not me.  It’s our Keynesian economists saying we must spend.  And they’re smart.  Real smart.  They even have Ivy League degrees.  So who are we to question them?”

And it’s not just any kind of spending.  Well, actually, it is.  There’s nothing special about it.  You could pass a trillion dollar stimulus bill to pay people to dig holes with a shovel.  Fill them back in with the dirt they just shoveled out.  And then repeat.  Again and again.  Accomplishing nothing beneficial with these efforts.  But a Keynesian economist will approve of this spending and call it a good thing.  Why?  Because of trickle-down economics.  But of the Keynesian kind.

At the heart of Keynesian stimulus spending is the Keynesian multiplier.  That’s the ‘trickle down’ part.  But before we get to that we must discuss one other thing.  Savings.  Keynesians hate it.  They call money that leaks out of the economy into savings accounts wasted money.  Just as if you flushed it down the toilet.  This brings up another Keynesian concept.  The marginal propensity to consume (MPC).  Note the word ‘consume’.  This is what all that government spending is about.  Consumption.  Consumer spending.  Which is why Keynesians hate savings.  Because if people save their money they’re not spending it.  And not creating economic activity.

Politicians prefer Government Spending over Tax Cuts because People may Save Part of a Tax Cut

Now back to the multiplier.  When people receive money they do two things.  They save some of it.  And spend what they don’t save.  This is where the MPC comes in.  An MPC 0f 80% means that people will spend 80% of an amount of money they receive (paycheck, government benefit, etc.) and save 20% of it.  So they use 80% of that money to generate economic activity.  By spending it.  But it doesn’t end there.  Because what they spend other people receive as money.  And these people then save some of it.  And spend what they don’t save.  And so on.  At a MPC of 80% if a person receives $100 they will spend $80 and save $20.  Those who receive that $80 will spend $64 and save $16.  Those who receive $64 will spend $51.20 and save $12.80.  And on and on until people are only spending pennies.  In the end that original $100 will create a total of $500 in new economic activity.  Or five times the original amount.  So the Keynesian multiplier is five.  Or, mathematically, 1/(1-MPC) where MPC = 0.80.

Think of the multiplier as a pyramid of champagne glasses at a wedding.  As you pour champagne in the top glass it overflows into the next layer of glasses down.  When these glasses fill they overflow into the next layer of glasses below them.  The multiplier is kind of like that.  Starting by pouring into one glass.  By the time the champagne bottle is empty champagne fills many glasses.  And spilt champagne represents savings.  Or leakage.  That’s how the multiplier works.  Trickle down.  And the less champagne spilled the more champagne fills glasses.  As shown by the multiplier formula.  The larger the MPC is (as in the more people spend) the larger the multiplier.  In fact if they spent all of their money (an MPC = 1) the formula reduces to 1/0.  And what happens when you divide by zero?  You get infinity.  That’s right, according to the Keynesian multiplier equation if everybody spent all of their money and saved none there would be an infinite amount of economic activity.

In the Keynesian world it doesn’t matter what the money is spent on as long as it’s spent.  Even digging worthless holes is good enough to make this miracle of economic activity out of nothing work.  That’s why their advice is always for the government to tax, borrow or print money to spend.  Because spending is good.  And they prefer government spending over tax cuts to stimulate private spending.  Why?  When the government spends money that top champagne glass will have an MPC of 1.  The government will spend it all.  Less the administrative costs, of course.  Whereas an equivalent amount of money given to the people via a tax cut (letting them keep more of their earnings to spend) will not have an MPC of 1.  Because these people may do something foolish like save their money.  Or pay down debt.  Which is leakage.  Leakage reduces the multiplier.  And a lower multiplier reduces economic activity.

Governments Embrace Keynesian economics because it tells them to Always Spend More Money

It all seems too good to be true.  And there’s a reason for that.  Because it IS too good to be true.  And the proof is in the pudding.  The Seventies was the decade of unrestrained Keynesian economics.  And it didn’t work.  They spent like there was no tomorrow in the Seventies.  But all that Keynesian spending failed to pull the economy out of recession.  All it did was create high inflation.  So there was high unemployment AND high inflation.  Something that was impossible in the Keynesian universe.  But it happened.  Why?  Because they make a lot of assumptions to make their formulas work.  Like that MPC.  And their war on savings.  Their thinking is flawed.  Because savings ARE spending.  Someone’s savings is someone else’s investment.  And investments are spending.  Ever see It’s a Wonderful Life when the people were asking for their deposits back?  The savings and loans had some money.  But they didn’t have everyone’s money.  Then George Bailey (Jimmy Stewart) told his depositors where their money was.  And he ran down a list of all the new houses their savings built.  Thanks to their loans to those new homeowners.  Building those houses generated a lot of economic activity.  So savings are good.  They’re not leakage.  They cause real economic activity.

Let’s return to that pyramid of champagne glasses.  Let’s say it takes 3 bottles of champagne to fill all the glasses in the pyramid.  If you pour the champagne back from the glasses into the bottles you will not have three full bottles of champagne.  Because of all that spillage.  Or leakage.  This is the same with Keynesian stimulus spending.  Stimulus money has to come from somewhere.  Whether government raises it with taxes, borrows it or prints it.  And like that champagne it just moves from one place in the economy to another.  With no net change in economic activity.  Higher taxes mean we have less money to spend.  If they borrow money they reduce private investment.  Because investors are buying government bonds instead if investing in businesses or entrepreneurs.  If they print money they cause inflation.  Which makes our money worth less and prices higher.  Which buys us less after the inflation than before it.  So whatever government spends there is a corresponding reduction in economic activity elsewhere in the economy.  Worse, when the government redistributes this money there is leakage.  Like the spillage of champagne.  For administrative costs.  Because politicians and government bureaucrats don’t work for free.

Printing money is especially harmful to the economy.  For it can cause a short-term boom in economic activity.  But by the time that new money works its way through the economy prices begin to rise.  Raising the cost of businesses.  Who have to raise their prices.  As they do their sales fall.  And they have to lay people off.  So the Keynesian stimulus spending to end a recession results in a new recession.  Which tends to be more painful than the first one.  So eventually a recessionary bust follows the artificial boom in economic activity.  Which brings those artificially high prices back down to normal market prices.  The greater the stimulus spending the higher those prices go.  The farther they have to fall.  And the more painful the recession.  Making the multiplier nothing but smoke and mirrors.  But governments still embrace Keynesian economics.  Because it is the only economic system that tells them to spend more money.  And they are always looking for something to justify more spending.

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Saving, Investing and the Paradox of Thrift

Posted by PITHOCRATES - August 27th, 2012

Economics 101

Healthy Sales can Support just about any Bad Decision a Business Owner Makes

“Industry, Perseverance, & Frugality, make Fortune yield.”  Benjamin Franklin (1744).  He also said, “A penny saved is a penny earned.”  Franklin was a self-made man.  He started with little.  And through industry, perseverance and frugality he became rich and successful.  He lived the American dream.  Which was having the liberty to work hard and succeed.  And to keep the proceeds of his labors.  Which he saved.  And all those pennies he saved up allowed him to invest in his business.  Which grew and created more wealth.

Frugality.  And saving.  Two keys to success.  Especially in business.  For the business that starts out by renting a large office in a prestigious building with new furniture is typically the business that fails.  Healthy sales can support just about any bad decision a business owner makes.  While falling sales quickly show the folly of not being frugal.  Most businesses fail because of poor sales revenue.  The less frugal you’ve been the greater the bills you have to pay with those falling sales. Which speeds up the failing process.  Insolvency.  And bankruptcy.  Teaching the important lesson that you should never take sales for granted.  The importance of being frugal.  And the value of saving your pennies.

Saving and frugality also hold true in our personal lives.  Especially when we start buying things.  Like big houses.  And expensive cars.  As a new household starting out with husband and wife gainfully employed the money is good.  The money is plentiful.  And the money can be intoxicating.  Because it can buy nice things.  And if we are not frugal and we do not save for a rainy day we are in for a rude awakening when that rainy day comes.  For if that two income household suddenly becomes a one income household it will become very difficult to pay the bills.  Giving them a quick lesson in the wisdom of being frugal.  And of saving your pennies.

The Money People borrow to Invest is the Same Money that Others have Saved

Being frugal lets us save money.  The less we spend the more we can put in the bank.  What we’re doing is this.  We’re sacrificing short-term consumption for long-term consumption.  Instead of blowing our money on going to the movies, eating out and taking a lot of vacations, we’re putting that money into the bank.  To use as a down payment on a house later.  To save for a dream vacation later.  To put in an in-the-ground pool later.  What we’re doing is pushing our consumption out later in time.  So when we do spend these savings later they won’t make it difficult to pay our bills.  Even if the two incomes become only one.

Sound advice.  Then again, Benjamin Franklin was a wise man.  And a lot of people took his advice.  For America grew into a wealthy nation.  Where entrepreneurs saved their money to build their businesses.  Large savings allowed them to borrow large sums of money.  As bank loans often required a sizeable down payment.  So being frugal and saving money allowed these entrepreneurs to borrow large sums of money from banks.  Money that was in the bank available to loan thanks to other people being frugal.  And saving their money.

To invest requires money.  But few have that kind of money available.  So they use what they have as a down payment and borrow the balance of what they need.  The balance of what they need comes from other people’s savings.  Via a bank loan.  This is very important.  The money people borrow to invest is the same money that others have saved.  Which means that investments are savings.  And that people can only invest as much as people save.  So for businesses to expand and for the economy to grow we need people to save their money.  To be frugal.  The more they save instead of spending the greater amount of investment capital is available.  And the greater the economy can grow.

The Paradox of Thrift states that Being Frugal and Saving Money Destroys the Economy

Once upon a time this was widely accepted economics.  And countries grew wealthy that had high savings rates.  Then along came a man named John Maynard Keynes.  Who gave the world a whole new kind of economic thought.   That said spending was everything.  Consumption was key.  Not savings.  Renouncing centuries of capitalism.  And the wise advice of Benjamin Franklin.  In a consumption-centered economy people saving their money is bad.  Because money people saved isn’t out there generating economic activity by buying stuff.  Keynes said savings were nothing more than a leak of economic activity.  Wasted money that leaks out of the economy and does nothing beneficial.  Even when people and/or businesses are being frugal and saving money to avoid bankruptcy.

In the Keynesian world when people save they don’t spend.  And when they don’t spend then businesses can’t sell.  If businesses aren’t selling as much as they once were they will cut back.  Lay people off.  As more businesses suffer these reductions in their sales revenue overall GDP falls.  Giving us recessions.  This is the paradox of thrift.  Which states that by doing the seemingly right thing (being frugal and saving money) you are actually destroying the economy.  Of course this is nonsense.  For it ignores the other half of saving.  Investing.  As a business does to increase productivity.  To make more for less.  So they can sell more for less.  Allowing people to buy more for less.  And it assumes that a higher savings rate can only come with a corresponding reduction in consumption.  Which is not always the case.  A person can get a raise.  And if they are satisfied by their current level of consumption they may save their additional income rather than increasing their consumption further.

Many people get a raise every year.  Which allows them to more easily pay their bills.  Pay down their credit cards.  Even to save for a large purchase later.  Which is good responsible behavior.  The kind that Benjamin Franklin would approve of.  But not Keynesian economists.  Or governments.  Who embrace Keynesian economics with a passion.  Because it gives them a leading role.  When people aren’t spending enough money guess who should step in and pick up that spending slack?  Government.  So is it any wonder why governments embrace this new kind of economic thought?  It justifies excessive government spending.  Which is just the kind of thing people go into government for.  Sadly, though, their government spending rarely (if ever) pulls a nation out of a recession.  For government spending doesn’t replicate what has historically created strong economic growth.  A high savings rate.  That encourages investment higher up in the stages of production.  Where that investment creates jobs.  Not at the end of the stages of production.  Where government spending creates only inflation.  Deficits.  And higher debt.  All things that are a drag on economic activity.

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JFK, Tax Cuts, Vietnam, LBJ, Great Society, Hippies, Race Riots, Keynesian Spending, Nixon, Carter and Ronald Reagan

Posted by PITHOCRATES - August 21st, 2012

History 101

Ronald Reagan would follow the Kennedy Example of Cutting Taxes to Grow the Economy

In 1961 West German Chancellor Ludwig Erhard gave John F. Kennedy (JFK) some good advice.  During JFK’s visit he told him not to make the same mistake the British had.  He told Kennedy NOT to follow their policy of high taxation.  Because it killed economic activity.  And economic growth.  England was suffering from her bad tax policy.  He urged the American president not to make the same mistake.

JFK heeded Erhard’s advice.  And cut tax rates.  This did not please liberals in his Democrat Party.  Who were all Keynesians.  And believed in large government interventions into the private sector.  Funded by large government expenditures.  Which in the Keynesian world you got in one of three ways.  Tax, borrow or print money.  You did not cut tax rates.  Which was blasphemous in Keynesian doctrine.  You never, ever, cut tax rates.  But Kennedy did.  Arguing that “an economy hampered by restrictive tax rates will never produce enough revenue to balance the budget—just as it will never produce enough jobs or enough profits.”

A message Ronald Reagan would give time and again some 20 years later.  And would follow the Kennedy example of cutting taxes to grow the economy.  Generating more tax revenue without having to cut spending.  The result of JFK’s ‘trickle-down’ economics were impressive.  He cut the top marginal tax rate from 91% to 70%.  And cut the 20% rate to 14% at the other end of the scale.  What did people do with these tax savings?  They saved.  And invested.  Savings rose from an annual growth rate of 2% to 9%.  Business investment from 2% to 8%.  New jobs grew at a rate of 100%.  And unemployment fell by one third.  With GDP rising some 40% in two years.  And despite cutting tax rates tax revenue rose.  The booming economy generating more tax revenue even at the lower rates.  Even more than the Keynesians said Kennedy was going to cost the government with his tax cuts.

The Social Upheavals of the Sixties, the Race Riots and his Unpopular Vietnam War all took their Toll on LBJ

Liberals love JFK.  But for none of these reasons.  They prefer to wax poetically about his fight to end economic and racial injustice.  Which were in reality low on his priority list.  Addressing civil rights only after trouble was escalating in the south.  But that’s the Left’s cherished memory of him.  And of Camelot.  The American royal family.  They don’t talk about JFK’s trickle-down economics.  His Bay of Pigs fiasco (the plan to oust Fidel Castro from Cuba that he withdrew support from after it met difficulty on the beaches).  His Cuban missile crisis (near nuclear war with the Soviet Union) which his indecision at the Bay of Pigs may have invited.   Or his war in Vietnam.  No.  They stay silent on the best part of his presidency.  As well as the worst parts.  And focus instead on the fairy tale that was Camelot.  Ignoring completely his excellent economic policies and the strong economy they gave us.  And all that tax revenue that poured into the treasury.  Yes, they may have liked having that money.  But they didn’t have to like how it got there.

Following JFK’s assassination Lyndon Baines Johnson (LBJ) ascended to the presidency.  An old school politician that knew how to make deals to advance legislation.  And boy did he.  He declared unconditional war on poverty.  And unleashed the Great Society to spend America out of poverty.  Keynesian to the core.  Pure demand-side economics.  Give poor people money which they will use to buy consumer goods.  That Keynesian consumption that was so crucial to a healthy economy.  So Johnson made good use of all that tax revenue JFK created with his tax cuts.  And LBJ’s Great Society consumed enormous amounts of that tax revenue.  As did JFK’s Vietnam War.  Now LBJ’s war.  Which LBJ escalated.  Government expenditures exploded during the Johnson administration.  And the spending obligations he put into place were only going to escalate future expenditures.  Oh, and we were also trying to land a man on the moon during this time.  All during a time when the world was changing.  When a bunch of filthy hippies began to protest anything that didn’t somehow gratify them (their rallying cry was sex, drugs and rock & roll).  And racial tensions simmered to the boiling point in our crowded cities.

The social upheavals of the Sixties.  The race riots.  The unpopular war on our living room televisions.  They all took their toll on LBJ.  The race riots especially hurt him as he had spent so much money on ending economic and racial injustice.  On a televised address he told the nation that he was through being the president.  He wasn’t going to run for another term.  And he wouldn’t accept a nomination for a second term.  He basically thanked an ungrateful nation.  And planned for his retirement.  Leaving a fiscal mess for the next president.  As well as a mess in Vietnam.  And the job for cleaning up these messes fell to Richard Milhous Nixon.

When Nixon entered the Presidency all those Spending Obligations of the Great Society were Coming Due

Nixon had a lot of liberal tendencies.  He was actually a member of the NAACP since 1950.  Long before JFK or LBJ talked of civil rights.  He believed in New Deal economics.  Of the good government could do.  He was also an environmentalist.  Giving us the Environmental Protection Agency (EPA).  And giving us emissions standards for our cars.  He gave us the Occupational and Safety Health Administration (OSHA).  And a flurry of other regulations.  Not what you would expect from a Republican these days.  Of course, few probably know this.  But they probably do know about Watergate.  At least the word ‘Watergate’.  Which was pretty tame by today’s standards.  Spying on the political opposition.  Then lying about it.

When Nixon entered the presidency all those spending obligations of the Great Society were coming due.  The cost of LBJ’s Great Society really hit the Nixon administration hard.  Enormous amounts of money were flowing out to poor people (so they could spend it and buy consumer goods).  To the war in Vietnam.  To the Cold War.  To the space program.  To the enlarged federal government.  Government spending was going off the chart.  But it wasn’t having the affect on the economy the Keynesians said it would.  They were taxing, borrowing and printing money like good little Keynesians.  But they were devaluing the dollar in the process.  And igniting inflation.  Worse, the U.S. dollar was the reserve currency of the world.  Foreign nations pegged their currency to the U.S. dollar.  The U.S. pegged the dollar to gold.  As the Americans devalued the dollar, though, the foreign countries traded their dollars for gold.  Gold began to fly out of the country.  So Nixon did what any responsible Keynesian would do.  Instead of playing by the rules of the game he changed the rules.  And decoupled the dollar from gold.  The Nixon Shock.  Ushering in the era of unfettered Keynesian economics.  Deficit spending.  Growing debt.  High inflation.  High unemployment.  Stagflation.  And malaise.

Jimmy Carter would see the worse of LBJ’s Great Society.  As it left his economy in a mess.  Despite all of that government spending.  And Carter suffered because he, too, was a Keynesian.  He believed in that GDP formula where GDP equaled the sum of consumption, investment, government expenditures and net exports (exports – Imports).  And the formula clearly states that the way to increase GDP (and increase the number of jobs) was to increase government spending to give money to people so they could buy consumer goods (increasing government spending and consumption in the formula).  It was simple arithmetic.  But the formula left out about half of all economic activity.  The intermediate business spending that takes place before any consumer goods enter our stores.  Think of things consumers don’t buy.  Like railroad track, blast furnaces, construction front-end loaders, etc.  Economic activity that JFK encouraged with his tax cuts.  As Ronald Reagan did so, too, some 20 years later.  Which is why the JFK and the Reagan economies were far better than any Keynesian administration.

Even after more than a decade of unfettered Keynesian spending consumption was only 34% of all economic activity in 1982.  Even though official GDP figures reported it at 65%.  Why the discrepancy?  Intermediate business spending.  The stages of production before consumer goods.  Coming in at 54% of real economic activity in 1982.  Which is why the tax-cut policies of JFK and Ronald Reagan worked.  And the spending policies of JBJ, Nixon and Carter didn’t.  Trickle-down works.  Because it creates jobs.  And those lower tax rates generate higher tax revenues because more people are working and paying taxes.  All things a Keynesian wants.  But they will reject them because they resulted from the ‘wrong’ policies.  Because Keynesians want to tax, borrow and print.  Regardless of their effect on the economy.

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Production vs. Consumption

Posted by PITHOCRATES - August 20th, 2012

Economics 101

To Prevent another Great Depression Keynes said the Key was Government Spending

John Maynard Keynes was a noted economist who analyzed the Great Depression.  And came to the opinion the problem was that there wasn’t enough consumption.  Consumers weren’t buying enough stuff.  That is, they weren’t spending enough money.  Which is key to consumption.  And a healthy economy.  According to Keynes.  And the people who embraced his economic theories.  What we now call Keynesian economics.

It was a whole new way to look at economics.  Consumption.  Or demand-side economics.  Which said demand created supply.  Contrary to Say’s law.  Which basically stated supply creates demand.  Tomáto.  Tomàto.  To most people.  All they understood was that it was better to have a job than to be unemployed.  Because if you had a job you could buy food for your family.  Pay for heat in the winter.  And pay a doctor if your child was sick.

To prevent another Great Depression Keynes said the key was government spending.  To make up for any decline in consumption.  The government could tax, borrow or print money as necessary to get money to spend.  Putting people to work on government projects.  Building things.  Like roads and bridges.  Or digging ditches.  So when businesses lay off people the government can put them back to work.  And pay them with the money they taxed, borrowed or printed.  These people would then take that money and spend it.  A priming of the economic pump as it were.  That, in theory, will provide consumption until the private sector begins hiring again.  Therefore eliminating recessions once and for all.

Economists attribute about 90% of GDP to Consumer Spending and Government Expenditures

There have been about 12 recessions since Keynes figured out how to end them once and for all.  The recent one being the worst since the Great Depression.  Even surpassing the misery of the Jimmy Carter economy.  A time when the impossible happened.  In the world of Keynesian economics, at least.  Government spending designed to decrease unemployment actually increased unemployment.  It turns out there was a downside to printing money.  Massive inflation.  And rational expectations that printing money will lead to massive inflation.  So while the Keynesian way worked in theory it failed in practice.  And not just once.  But a lot.  Yet it is still the model of most governments.  And it’s what colleges teach their students.  Why?  After it’s been so thoroughly debunked?  The answer to that question brings us back to consumption.  And Gross Domestic Product (GDP).

GDP is a measure of a country’s goods and services during a period of time.  That is, it is a measure of economic activity.  The bigger it is the better the economy.  And the more people that have jobs.  The formula for GDP is the sum of consumption, investments, government expenditures and net exports (exports – imports).  It’s this formula that keeps Keynesian economics alive.  Because of consumption.  And government expenditures.  This formula sanctions government spending because, according to the formula, it increases economic activity.  It is the driver of all stimulus spending.  And the welfare state.  Because government spending puts money ultimately into the pockets of consumers who spend it.  That is, government spending creates private consumption.  And consumption creates jobs (demand creates supply).  In the Keynesian world, that it.  There is only one problem.  The formula leaves out a lot of economic activity.

Using this formula economists report that consumption makes up about 70% of GDP.  And government spending about 20%.  These numbers are huge.  That’s about 90% of GDP attributed to consumer spending and government expenditures.  Which is why Keynesians love this formula.   Because it empowers them to tax, borrow and print so they can spend.  All in the name of creating jobs.  And GDP.  But what about the things people make or do that consumers don’t buy?  Like engineering and design services.  Printing presses and ink.  The extraction of raw materials?  Coal mining.  Blast furnaces making steel for use in manufacturing?  Heavy construction equipment?  Machine tools and production equipment?  Assembly lines?  Robots on the assembly line?  Locomotive engines and rolling stock?  Airplanes?  All the people and equipment in the transportation industry?  Etc.  There is a lot of economic activity that makes things or does things that consumers don’t buy.  So where is it in the GDP formula?  Don’t look for it.  Because it’s just not there.

Intermediate Business Spending accounts for about Half of all Economic Activity

Before Keynes the focus was on production.  Not consumption.  Before Keynes we looked at the stages of production.  All of that economic activity that happens before you can buy anything in a store.  Everything between the extraction of raw materials to the final finished good.  Where millions of workers are engaged in economic activity that a consumer knows nothing about when they buy a consumer good.  If you factor in this economic activity into the GDP equation it changes things.  And it changes it in a way that Keynesians and government officials don’t like.

Consumption is the last stage in the stages of production.  The final step in a flurry of economic activity that preceded it.  If you count up this intermediate business spending it comes to about half of all economic activity.  It’s about twice consumer spending.  And about four times government expenditures.  Greatly reducing the roles of consumption and government expenditures in the GDP equation.  And in the economy.  As well as providing the answer to why Keynes didn’t end recessions once and for all with his new economic theory.  Because his new economic theory was wrong.  You don’t create jobs by giving money to people to spend.  You create jobs by making it easy for businesses to hire people.

So demand does NOT create supply like Keynes said.  Supply creates demand.  Like Say said.  And what’s the conclusion we can draw?  Big activist governments do not help a country’s economy.  They just pull money out of the stages of productions.  Where it can create jobs.  And puts it into government.  Where it creates unemployment and inflation.  As demonstrated by all the big Keynesian governments of Europe.  Those social democracies struggling under the weight of their government spending.  Who borrowed money to sustain that spending.  Bringing on the European sovereign debt crisis.  Because of that GDP equation that said they could tax, borrow and print to spend to their heart’s content.  Thanks to a man named Keynes.

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