Say’s Law

Posted by PITHOCRATES - August 6th, 2012

Economics 101

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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As the Brazilian Economy cools Rousseff looks to Tax Cuts and Privatization to Restore Economic Momentum

Posted by PITHOCRATES - July 29th, 2012

Week in Review

The president of Brazil is Dilma Rousseff.  She belongs to the Workers’ Party.  A party that enjoys strong support from the labor unions.  Because it leans towards socialism.  At least in state-ownership of some state assets.  In particular those that employ a lot of people.  But the great Brazilian economic growth is sputtering.  Like an engine no longer firing on all cylinders.  Because of her party affiliation one would expect Rousseff to adopt Keynesian policies.  To stimulate their economy with some government spending.  But no.  She’s talking about doing something completely different (see UPDATE 1-Rousseff ‘very worried’ about Brazil economy by Alonso Soto and Brian Winter posted 7/23/2012 on Reuters).

President Dilma Rousseff is pessimistic about Brazil’s chances for a meaningful economic recovery this year and is pushing ahead with new measures aimed at lowering taxes and increasing investment, hoping they might give the economy a lift by 2013, government officials told Reuters.

The measures include a consolidation of some overlapping federal taxes; a new round of concessions that would allow the private sector to manage more of the country’s congested airports and seaports; and a more aggressive effort to reduce electricity costs for manufacturers and others, the officials said on condition of anonymity because they were discussing private policy discussions…

Rousseff, a trained economist, has reacted with several targeted tax cuts and more than half a dozen packages aimed at stimulating consumption and investment. However, many business leaders and foreign investors have complained that her policies have been too ad hoc and narrow in scope, citing forecasts that now see growth as low as 1.5 percent this year…

Some business leaders have called for Rousseff to take even more dramatic measures, such as an omnibus reform package that could substantially reduce or simplify Brazil’s tax load. Rousseff has opted instead to pursue more targeted reforms to help struggling sectors on a case-by-case basis, believing that Congress would block a more ambitious, organized effort.

So Rousseff would have been a more aggressive tax cutter if it weren’t for Congress.  So one can hardly blame her for her ad hoc ways.  You have to do the best you can with the cards you’re dealt.  Especially when your party tends to favor state ownership of industry and higher taxation to pay for the labor in those state-owned industries.

Lowering taxes and electricity costs?  Privatization?  Other than that part about consumption one would think that Rousseff’s economic training was of the Austrian school variety rather than the Keynesian brand.  Whatever her economic roots with policies like these Brazil should rebound well from this momentary interruption in their economic growth.

The move most likely to stir investors, for both practical and symbolic reasons, is the new round of port concessions. Airports and seaports are routinely cited as some of the country’s most crippling bottlenecks, slowing everything from commodities exports to business travel, as public investment failed to keep up with the boom in the economy over the past decade…

The officials declined to say which additional airports Rousseff was considering, but one of the targets could be Rio de Janeiro’s international airport, which needs renovations ahead of the 2014 World Cup and 2016 Olympics. Rio’s governor, Sergio Cabral, described the airport in an interview with Reuters last year as being like “a third-rate bus station…”

The Brazilian economy had been roaring thanks to the private sector.  What wasn’t keeping up with the private sector was the public sector.  While people were doing remarkable things in the private sector the best the government could do was make Rio de Janeiro’s international airport “a third-rate bus station.”  Which just goes to show you that for the best economic activity you have to release the human capital of the people.  When you let these people think.  When you let them create.  When you let them create the things they thought about you get the kind of explosive economic activity that put Brazil in the BRICS emerging economies.  While running ‘third-rate bus stations’ just doesn’t quite do it.

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Argentina’s Keynesian Policies have given them the Weakest Economy in the Hemisphere

Posted by PITHOCRATES - July 22nd, 2012

Week in Review

The Argentines are strong advocates of Keynesian economics.  And they’ll embrace it till the bitter end.  Even as their economy goes into the crapper (see WRAPUP 3-Argentina economy shrinks in May for first time since 2009 by Hilary Burke posted 7/21/2012 on Reuters).

Latin America’s No. 3 economy is decelerating sharply after posting China-like growth rates for much of the past nine years. High inflation, a sluggish global economy, waning demand from neighboring Brazil, falling grains production as well as new trade and currency controls have prompted the slowdown.

“Stagflation arrived with a vengeance. Argentina now has the weakest economy and the highest inflation in the hemisphere,” wrote Alberto Ramos, a senior economist at Goldman Sachs, adding that private estimates put inflation at closer to 24 percent a year…

Argentina’s unorthodox economic approach centers on heavy state participation in the economy to foment high growth, job creation and domestic demand. The government does not publicly acknowledge the cost of this, which is double-digit inflation.

“We are taking active policies, using our own resources, to generate the virtuous cycle of spending, consumption, investment. You have more demand, more production and that feeds back into more spending, more production, more consumption.”

This is pure Keynesian economics.  Like in the Carter years.  But even Jimmy Carter didn’t have an inflation rate as high as 24%.  So the Argentine stagflation may outdo the Carter stagflation.  No doubt beating Carter on the misery index, too (the sum of the unemployment rate and the inflation rate).  Proving once again that Keynesian economics doesn’t work.

Still this is exactly what President Obama wants to do with the U.S. economy.  And it’s what the leading Keynesian economists are advising him to do.  Invest.  Spend.  To stimulate the economy the only way the federal government can.  By deficit spending.  Financed with more borrowing.  Taking the federal debt to new heights.  Or simply by printing money.  As in another round of quantitative easing.  Even though none of this has worked in the last three and half years under President Obama.  Or in the Seventies during the Carter years.  Or even in Argentina today.

So when will they learn?  When will they abandon Keynesian economics?  Never.  Because governments love to spend money.  And Keynesian economics is all about spending money.  Why, some even call this spending virtuous.  But there is a price in being virtuous.  Asset bubbles (as in Japan resulting in their Lost Decade or in America during their subprime mortgage crisis resulting in their Great Recession).  A sluggish economy.  And double digit-inflation.  Things that never end well.  Just ask the Japanese.  The Americans.  Or the Argentines.

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The Chinese Economy is mostly Bad Investments, Savings and little Domestic Consumption

Posted by PITHOCRATES - May 26th, 2012

Week in Review

The Chinese economic juggernaut is losing steam.  The communist 5-year plans in infrastructure projects isn’t having the magic it once did.  Exports are down thanks to a worldwide recession.  And worse of all for Keynesians everywhere savings are outpacing consumption.  People across China are acting responsibly.  And this just won’t do (see Chinese urged to spend more, save less by Mure Dickie posted 5/25/2012 on The Washington Post).

Yet with China’s economy slowing — to a relatively modest annual rate of 8.1 percent growth in the first quarter — some observers fret that consumption could be faltering. Retail spending in April was weaker than expected. And while Wen Jiabao, the premier, last week signaled action to shore up growth, the government appears to have set its policy focus on promoting investment rather than consumption…

Indeed, [Andrew] Batson [research director at GK Dragonomics] suggests that the present slowdown could promote a much-heralded rebalancing of China’s economy, away from reliance on increasingly unproductive investment to a healthier consumption-driven model.

While the government has long talked of such a shift, the proportion of gross domestic product accounted for by investment actually soared to 46 percent in 2010, while household consumption’s share of GDP slumped to just 35 percent…

So China’s investment is increasingly unproductive.  Perhaps their high-speed train program isn’t the only black hole for their investment capital to disappear in.  The Chinese have invested a fortune in their high-speed trains but so far that has been an investment earning a negative return.  Sure, it created a lot of jobs but their high-speed trains can’t turn a profit.  So far they’re only accumulating debt.  But they keep spending this money.  Adherents to Keynesian economics that they are.  For the Keynesians say anything that puts more money into a workers pocket is good.  Because that worker will spend that money.  Even if we pay him to dig a ditch.  And then pay him to fill it back in.  Or pay him to build a very costly high-speed railway that the people don’t need.  Or can ever pay for itself.  A Keynesian will say that’s good.  Because it will give the worker money.  And that worker will spend that money.  Thus increasing consumption.  Unless that worker does something stupid like put it in the bank.

Some economists say the government needs to do more to promote this rebalancing in a country where citizens still save a far larger proportion of their incomes than do their counterparts in developed economies…

Lower-income consumers also save fiercely. In the village of Wuti in northern Hebei province, house builder Li Moxiang and his farmer wife aim to set aside $3,150 or more a year to help raise their future grandchild — even though stingy state-set interest rates mean such savings are constantly eroded by inflation…

A big motivation for such saving is the lack of a social security system to cushion Chinese in old age or ill health. Serious illness or accident often spells household bankruptcy. For most rural people, children have to play the role of pension provider.

In a report this week, the World Bank said fiscal measures to support consumption — including targeted tax cuts, social welfare spending and other social expenditures — should be Beijing’s top priority as it seeks to avert an economic “hard landing.”

Some economists would like to see mass privatization to shift wealth out of the dominant and domineering state sector.

Keynesians hate savings.  They want people to spend their money.  And not be responsible and save for their retirement.  Or to save to pay for any unexpected expenses.  Why they hate savings so much that they constantly inflate the currency to dissuade you from saving.  For if you do save you’ll only see inflation eat away the value of your savings.  Sort of like putting an expiration date on your money.  Telling you saving is for fools.  That consumption is the smart way to go.  And so what if you can’t afford food or housing in your retirement.  Or pay for medical care.  That’s what family is for.  So you can be a burden to them.

Right now the social democracies of Europe are imploding from the massive debts they incurred from their social spending.  And the World Bank is encouraging Beijing to increase their social spending.  To be as irresponsible as the Europeans were.  Unbelievable.  Europe is burning because of the social expenditures they can no longer afford to pay.  And the people are rather reluctant to give up.  So when the government tries to live within their means with a touch of austerity the people reply with riots.  And this is what the World Bank is advising the Chinese to do.

History repeats.  For everything the Chinese are doing, or trying to do, or are being advised to do has been done by every nation with a spending and debt problem.  Sure, China is still enjoying 8% GDP growth.  But a lot of that growth is from building stuff that the market isn’t demanding.  Consumer spending in China is only at 35%.  With the worldwide recession hurting Chinese exports that leaves that 35% as a large component of their market-driven spending.  And you can rarely sustain economic growth from making stuff the market isn’t demanding.  Instead this artificial growth usually leads to some kind of a bubble.  And a painful recession to correct the mess the government made while artificially increasing economic output.

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The Chicago School of Economics

Posted by PITHOCRATES - March 5th, 2012

Economics 101

Monetarists believe in Laissez-Faire Capitalism and Fiat Money

Keynesian economics supports hands-on government management of the economy.  Using fiscal and monetary policy to move the aggregate demand curve at will to end business cycles.  The boom bust cycles between inflation and recession.  Leaving only the inflationary boom times.   Using tax and spend fiscal policies.  Or simply printing money for government expenditures.  For in Keynesian economics consumption is key.  The more of it the better.  And when people stop buying things the government should step in and pick up the consumption slack.

The Austrian school is a more hands-off approach.  The markets should be free.  Laissez-faire capitalism.  And the business cycle should remain.  For it is a necessary part of the economy.  Part of the automatic pricing mechanism that adjusts supply to meet demand.  When people demand more prices go up.  Encouraging businesses to expand production to sell at these higher prices (inflationary expansion).  Then when supply exceeds demand businesses have excessive inventory that they can’t sell anymore at those higher prices.  So they cut their prices to sell off this excessive supply (deflationary recession).  Also, that hands-off approach means no playing with monetary policy.  Austrians prefer a gold standard to prevent central bank mischief that results in inflation.

The Chicago school of economics takes a little from each of these schools.  Like the Austrians they believe that government should take a hands-off approach in the economy.  Markets should be free with minimum government intervention.  But unlike Austrians, they hate gold.  And blame the gold standard for causing the Great Depression.  Instead, they believe in the flexibility of fiat money.  As do the Keynesians.  But with a strict monetary policy to minimize inflation (which is why proponents of this school were also called monetarists).  Unlike the Keynesians.  For monetarists believe only a government’s monetary policy can cause runaway inflation.

(This is a gross simplification of these three schools.  A more detailed and comprehensive study would be a bit overwhelming as well as extremely boring.  But you get the gist.  At least, for the point of this discussion.)

We used Gold and Silver for Money because it was Durable, Portable, Divisible, Fungible, Scarce, Etc.

At the heart of the difference between these schools is money.  So a refresher course on money is in order.  Money stores wealth temporarily.  When we create something of value (a good or a service) we can use that value to trade for something we want.  We used to barter with other creative people who made value of their own.  But as the economy got more complex it took more and more time to find people to trade with.  You had to find someone who had what you wanted who also wanted what you had.  If you baked bread and wanted shoes you had to find a shoemaker who wanted bread.  Not impossible.  But it took a lot of time to find these people to trade with.

Then someone had a brilliant idea.  They figured they could trade their good or service NOT for something THEY wanted but something OTHER people would want.  Such as tobacco.  Whiskey.  Or grain.  These things were valuable.  Other people would want them.  So they could easily trade their good or service for one of these things.  And then later trade it for what they wanted.  And money was born.  For various reasons (durable, portable, divisible, fungible, scarce, etc.) we chose gold and silver as our money of choice.  Due to the inconvenience and danger of carrying these precious metals around, though, we stored our precious metals in a vault and used ‘receipts’ of that deposit as currency.  And the gold standard was born.

To understand the gold standard think of a balance scale.  The kind where you put weights on one side to balance the load on the other.  When the scale balances the weight of the load equals the sum of the weights needed to make the scale balance.  Now imagine a scale like this where the VALUE of all goods and services (created by talented people) are on one side.  And all the precious metal in the gold standard are on the other.  These must be in balance.  And the sum of our currency must equal the amount of precious metal.  (Because they are ‘receipts’ for all that gold and silver we have locked up someplace.)  This prevents the government from creating inflation.  If you want to issue more money you have to put more precious metal onto the scale.  You just can’t print money.  For when you do and you don’t increase the amount of precious metal on the scale you depreciate the currency.  Because more of it equals the same amount of precious metal.  For more currency to equal the same amount of precious metal then each unit of currency has to be worth less.  And when each unit is worth less it takes more of them to buy the same things they bought before.  Thus raising prices.  If a government prints more currency without adding more precious metals on the scale they increase the value of that precious metal when MEASURED in that currency.  It becomes worth more.  In other words, you can trade that precious metal for more of that depreciated currency than before they depreciated it.  You do this too much and eventually people will prefer the precious metal over the currency.  They’ll lose faith in the currency.  And when that happens the economy collapses.  As people move back towards a barter system.

Milton Friedman wanted the Responsibility of the Gold Standard without Gold’s Constraint on increasing the Money Supply

A healthy economy needs a stable currency.  One that people don’t lose faith in.  Imagine trying to shop without money.  Instead, taking things to trade for the groceries you need.  Not very efficient.  So we need a stable currency.  And the gold standard gives us that.  However, the thing that makes gold or silver a stable currency, its scarcity, creates a liability.  Let’s go back to that balance scale.  To the side that contains the value of all goods and services.  Let’s say it increases.  But the precious metal on the other side doesn’t.  Which means the value of that precious metal increases.  The currency must equal the value of that precious metal.  So the value of the currency increases.  And prices fall.  It takes less of it to buy the same things it bought before.  Not a bad thing for consumers.  But it plays havoc with those who borrowed money before this appreciation.  Because they now have to repay money that is worth more than when what is was worth when they borrowed it.  Which hurt farmers during the 1920s.  Who borrowed a lot of money to mechanize their farms.  Which helped to greatly increase farm yields.  And increased food supplies while demand remained unchanged.  Which, of course, lowered farm prices.  The supply increased on the scale.  But the amount of gold didn’t.  Thus increasing the value of the gold.  And the currency.  Making prices fall.  Kicking off the deflationary spiral of the Great Depression.  Or so say the monetarists.

Now the monetarists wanted to get rid of the gold supply.  The Keynesians did, too.  But they wanted to do it so they could print and spend money.  Which they did during the Seventies.  Creating both a high unemployment rate and a high inflation rate.  Something that wasn’t supposed to happen in Keynesian economics.  For their solution to fix unemployment was to use inflation to stimulate aggregate demand in the economy.  Thus reducing unemployment.  But when they did this during the Seventies it didn’t work.  The Keynesians were befuddled.  But not the monetarists.  Who understood that the expansion of the money supply (printing money to spend) was responsible for that inflation.  People understood this, too.  And had rational expectations of how that Keynesian policy was going to end.  Higher prices.  So they raised prices before the stimulus could impact unemployment.  To stay ahead of the coming inflation.  So the Keynesian stimulus did nothing to reduce unemployment.  It just caused runaway inflation.  And raised consumer prices.  Which, in turn, decreased economic activity.  And further increased unemployment.

Perhaps the most well known economist in the Chicago school was Milton Friedman.  Who wanted the responsibility of the gold standard.  But without gold’s constraint on increasing the money supply to meet demand.  The key to monetarism.  To increase the money supply to match the growth in the economy.  To keep that scale balanced.  But without gold.  Instead, putting the money supply directly on the scale.  Printing fiat money as needed.  Great power.  But with great power comes great responsibility.  And if you abuse that power (as in printing money irresponsibly) the consequences of that abuse will be swift.  Thanks to the rational expectations of the people.  Another tenet of the Chicago school.

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The Austrian School of Economics

Posted by PITHOCRATES - February 27th, 2012

Economics 101

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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Versailles Treaty, Marshall Plan, Post-War Japan, MITI, Asian Tigers, Japan Inc., Asset Bubbles, Deflationary Spiral and Lost Decade

Posted by PITHOCRATES - February 21st, 2012

History 101

Douglas MacArthur brought some American Institutions into Japan and unleashed a lot of Human Capital

At the end of World War I the allies really screwed the Germans.  The Treaty of Versailles made for an impossible peace.  In a war that had no innocents the Allies heaped all blame onto Germany in the end.  And the bankrupt Allies wanted Germany to pay.  Placing impossible demands on the Germans.  Which could do nothing but bankrupt Germany.  Because, of course, to the victors go the spoils.  But such a policy doesn’t necessarily lead to a lasting peace.  And the peace following the war to end all wars wasn’t all that long lasting.  Worse, the peace was ended by a war that was worse than the war to end all wars.  World War II.  All because some corporal with delusions of grandeur held a grudge.

The Americans wouldn’t repeat the same mistake the Allies made after World War II.  Instead of another Versailles Treaty there was the Marshal Plan.  Instead of punishing the vanquished the Americans helped rebuild them.  The peace was so easy in Japan that the Japanese grew to admire their conqueror.  General Douglas MacArthur.  The easy peace proved to be a long lasting peace.  In fact the two big enemies of World War II became good friends and allies of the United States.  And strong industrial powers.  Their resulting economic prosperity fostered peace and stability in their countries.  And their surrounding regions.

MacArthur changed Japan.  Where once the people served the military the nation now served the people.  With a strong emphasis on education.  And not just for the boys.  For girls, too.  And men AND women got the right to vote in a representative government.   This was new.  It unleashed a lot of human capital.  Throw in a disciplined work force, low wages and a high domestic savings rate and this country was going places.  It quickly rebuilt its war-torn industries.  And produced a booming export market.  Helped in part by some protectionist policies.  And a lot of U.S. investment.  Especially during the Korean War.  Japan was back.  The Fifties were good.  And the Sixties were even better. 

By the End of the Seventies the Miracle was Over and Japan was just another First World Economy 

Helping along the way was the Ministry of International Trade and Industry (MITI).  The government agency that partnered with business.  Shut out imports.  Except the high-tech stuff.  Played with exchange rates.  Built up the old heavy industries (shipbuilding, electric power, coal, steel, chemicals, etc.).  And built a lot of infrastructure.  Sound familiar?  It’s very similar to the Chinese economic explosion.  All made possible by, of course, a disciplined workforce and low wages.

Things went very well in Japan (and in China) during this emerging-economy phase.  But it is always easy to play catch-up.  For crony capitalism can work when playing catch-up.  When you’re not trying to reinvent the wheel.  But just trying to duplicate what others have already proven to work.  You can post remarkable GDP growth.  Especially when you have low wages for a strong export market.  But wages don’t always stay low, do they?  Because there is always another economy to emerge.  First it was the Japanese who worked for less than American workers.  Then it was the Mexicans.  Then the South Koreans.  The three other Asian Tigers (Hong Kong, Singapore and Taiwan).  China.  India.  Brazil.  Vietnam.  It just doesn’t end.  Which proves to be a problem for crony capitalism.  Which can work when economic systems are frozen in time.  But fails miserably in a dynamic economy.

But, alas, all emerging economies eventually emerge.  And mature.  By the end of the Seventies Japan had added automobiles and electronics to the mix.  But it couldn’t prevent the inevitable.  The miracle was over.  It was just another first world economy.  Competing with other first world economies.  Number two behind the Americans.  Very impressive.  But being more like the Americans meant the record growth days were over.  And it was time to settle for okay growth instead of fantastic growth.  But the Japanese government was tighter with business than it ever was.  In fact, corporate Japan was rather incestuous.  Corporations invested in other corporations.  Creating large vertical and horizontal conglomerates.  And the banks were right there, too.  Making questionable loans to corporations.  To feed Japan Inc.  To prop up this vast government/business machine.  With the government right behind the banks to bail them out if anyone got in trouble.    

Low Interest Rates caused Irrational Exuberance in the Stock and Real Estate Markets

As the Eighties dawned the service-oriented sector (wholesaling, retailing, finance, insurance, real estate, transportation, communications, etc.) grew.  As did government.  With a mature economy and loads of new jobs for highly educated college graduates consumption took off.  And led the economy in the Eighties.  Everyone was buying.  And investing.  Businesses were borrowing money at cheap rates and expanding capacity.  And buying stocks.  As was everyone.  Banks were approving just about any loan regardless of risk.  All that cheap money led to a boom in housing.  Stock and house prices soared.  As did debt.  It was Keynesian economics at its best.  Low interest rates encouraged massive consumption (which Keynesians absolutely love) and high investment.  Government was partnering with business and produced the best of all possible worlds.

But those stock prices were getting way too high.  As were those real estate prices.  And it was all financed with massive amounts of debt.  Massive bubbles financed by massive debt.  A big problem.  For those high prices weren’t based on value.  It was inflation.  Too much money in the economy.  Which raised prices.  And created a lot of irrational exuberance.  Causing people to bid up prices for stocks and real estate into the stratosphere.  Something Alan Greenspan would be saying a decade later during the dot-com boom in the United States.  Bubbles are bombs just waiting to go off.  And this one was a big one.  Before it got too big the government tried to disarm it.  By increasing interest rates. But it was too late.

We call it the business cycle.  The boom-bust cycle between good times and bad.  During the good times prices go up and supply rushes in to fill that demand.  Eventually too many people rush in and supply exceeds demand.  And prices then fall.  The recession part of the business cycle.  All normal and necessary in economics.  And the quicker this happens the less painful the recession will be.  But the higher you inflate prices the farther they must fall.  And the Japanese really inflated those prices.  So they had a long way to fall.  And fall they did.  For a decade.  And counting.  What the Japanese call their Lost Decade.  A deflationary spiral that may still be continuing to this day.

As asset prices fell out of the stratosphere they became worth less than the debt used to buy them.  (Sound familiar?  This is what happened in the Subprime Mortgage Crisis.)  Played hell with balance sheets throughout Japan Inc.  A lot of debt went bad.  And unpaid.  Causing a lot problems for banks.  As they injected capital into businesses too big to fail.  To help them service the debt used for their bad investments.  To keep them from defaulting on their loans.  Consumption fell, too.  Making all that corporate investment nothing but idle excess capacity.  The government tried to stop the deflation by lowering interest rates.  To stimulate some economic activity.  And a lot of inflation.  But the economy was in full freefall.  (Albeit a slow freefall.  Taking two decades and counting.)  Bringing supply and prices back in line with real demand.  Which no amount of cheap money was going to change.  Even loans at zero percent.

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Keynesian Economics

Posted by PITHOCRATES - February 20th, 2012

Economics 101

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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Consumption, Savings, Fractional Reserve Banking, Interest Rates and Capital Markets

Posted by PITHOCRATES - January 23rd, 2012

Economics 101

Keynesians Prefer Consumption over Savings because Everyone Eventually Dies

Consumer spending accounts for about 70 percent of total economic activity.  This consumption drives the economy.  In fact, someone built a school of economics around consumption.  Keynesian economics.  And he loved consumption.  John Maynard Keynes even created a formula for it.  The consumption function.  Which basically says the more income a person has the more that person will consume.  Even created a mathematical formula for it.  No doubt about it, Keynesians are just gaga for consumption.

Of course, Keynesians don’t love everything.  They aren’t all that fond of saving.  Which they see as a drain on economic activity.  Because if people are saving their money they aren’t doing as much consuming as they could.  In fact, their greatest fear when they propose stimulus spending (by giving people more money to spend) to jump-start an economy out of a recession is that people may take that money and save it.  Or, worse yet, pay down their credit card balances.  Which is something most responsible people do during bad economic times.  To lower their monthly bills so they can still pay them if they find themselves living on a reduced income.  Of course, being responsible doesn’t increase consumption.  Nor does it make Keynesians happy.

Keynesians don’t like people behaving responsibly.  They want everyone to live beyond their means.  To borrow money to buy a house.  To buy a car.  Or two.  To use their credit cards.  To keep shopping.  Above and beyond the limits of their income.  To spend.  And to keep spending.  Always consuming.  Creating endless economic activity.  And never worry about saving.  Because everyone eventually dies.  And what good will all that saving be then?

To Help Create more Capital from a Low Savings Rate we use Fractional Reserve Banking

Intriguing argument.  But too much consuming and not enough saving can be a problem, though.  Because before we consume we must produce.  And those producing the things we consume need capital.  Large sums of money businesses use to pay for buildings, equipment, tools and supplies.  To make the things consumers consume.  And where does that capital come from?  Savings.

A low savings rate raises the cost of borrowing.  Because businesses are competing for a smaller pool of capital.  Which raises interest rates.  Because capital is an economic commodity, subject to the law of supply and demand.  Also, with people living beyond their means by consuming far more than they are saving has caused other problems.  Borrowing to buy houses and cars and using credit cards to consume more has led to dangerous levels of personal debt.  Resulting in record personal bankruptcies.  Further raising the cost of borrowing.  As these banks have to increase their interest rates to make up for the losses they incur from those personal bankruptcies.

To help create more capital from a low savings rate we use fractional reserve banking.  Here’s how it works.  If you deposit $100 into your bank the bank keeps a fraction of that in their vault.  Their cash reserve.  And loan out the rest of the money.  When lots of people do this the banks have lots of money to loan.  Which people and businesses borrow.  Who borrow to buy things.  And when buyers buy things sellers will then take their money and deposit it into their banks.  The buyer’s borrowed funds become the seller’s deposited funds.  These banks will keep a fraction of these new deposits in their vaults.  And loan out the rest.  Etc.  As this happens over and over banks will create money out of thin air.  Providing ever more capital for businesses to borrow.  Which all works well.  Unless depositors all try to withdraw their deposits at the same time.  Exceeding the cash reserve locked up in a bank’s vault.   Creating a run on the bank.  Causing it to fail.  Which can also raise the cost of borrowing.  Or just make it difficult to find a bank willing to loan.  Because banks not only loan to consumers and businesses.  They loan to other banks.  And when one bank fails it could very well cause problems for other banks.  So banks get nervous and are reluctant to lend until they think this danger has passed.

A Keynesian Stimulus Check may Momentarily Substitute for a Paycheck but it can’t Create Capital

Consumption, savings, investment and production are linked.  Consumption needs production.  Production needs investment.  And investment needs savings.  Whether it is someone depositing their paycheck into a bank that lends it to others.  Or rich investors who amassed and saved great wealth.  Who invest directly into a corporation by buying new shares of their stock (from an underwriter, not in the secondary stock market).  Or by buying their bonds.

Collectively we call these capital markets.  Where businesses go when they need capital.  If interest rates are low they may borrow from a bank.  Or sell bonds.  If interest rates are high they may issue stock.  Generally they have a mix of financing that best fits the investing climate in the capital markets.  To protect them from volatile movements in interest rates.  And from competition from other corporations issuing new stock that could draw investors (and capital) away from their new stock issue.  Even to secure capital when no one is lending.  By going contrary to Keynesian policy and saving for a rainy day.  By buying liquid investments that earn a small return on investment and carrying them on their balance sheet.  They don’t earn much but can be sold quickly and converted into cash when no one is lending.

A lot must happen before consumers can consume.  In fact, high consumption can pull capital away from those who make the things they consume.  Because without capital businesses can’t expand production or hire more workers.  And no amount of Keynesian stimulus can change that.  Because there are two things necessary for consumption.  A paycheck.  And consumer goods produced with capital.  A stimulus check may momentarily substitute for a paycheck.  But it can’t create capital.  Only savings can do that.

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