The First Thing a Business has to do to Determine their Selling Price is Determining their Costs
Did you ever think about how businesses price their products? Do they just pull numbers out of the air? Do they just charge as much as they want? No, they don’t. Because they can’t. For if one gas station charges $12 for a gallon of gasoline while the station across the street is only charging $3.50 guess where people are going to buy their gas from. So free market competition prevents businesses from charging whatever they want. So how do they determine what to charge?
Well, some look at what their competitors are charging and match it. Or charge a little less. To steal customers away from the competition. Which can work. But it can also bankrupt a business. For if a business owner doesn’t know his or her costs selling at the market price could fail to recover all of their costs. The market price limits what they can charge. But if their costs are too great to stay in business selling at the prevailing market price they have to do something about reducing their costs. Which they can’t do if they don’t know their costs. So the first thing a business has to do to determine their selling price is determining their costs. Like this.
This is an abbreviated fictional income statement showing last year’s results. And forecasting next year’s results. EBT stands for earnings before taxes. Income taxes for this year are based on the 2011 federal tax tables. Income taxes for next year are based on the proposed Obama tax rates (increasing the top marginal rate from 33% to 39.6%). The business is a subchapter-S where the business earnings pass through to the owners’ personal income tax returns. The owner does not draw a salary but draws $125,000 from retained earnings to support him or herself, his or her stay-at-home spouse and their 3 children. The percentages show each number as a percentage of revenue.
You need to Sell at the Right Price and at the Right Volume to Pay all of the Bills
The difference between this year and next year is the rise in costs. Obamacare and other business regulations increase the cost of sales (direct labor, benefits, direct supplies, etc.) by 2%. And they increase fixed overhead (rent, utilities, administrative labor, benefits, etc.) by 2%. They will have to recover these higher costs in higher prices. Which will likely reduce unit sales. But because each unit will sell for more we assume sales revenue remains the same.
The higher costs cause EBT to fall. A lower EBT means lower federal income taxes. But it also means less retained earnings to invest back into the business. The reduction in retained earnings is $36,604.28. Which limits investments to grow the business. And leaves a much smaller cash cushion after some of those retained earnings are reinvested into the business. To pay for the unexpected. Like a new piece of equipment that fails and halts production. Things worked well in the current year. The business owner would like to have things work as well in the following year. Which means not exposing themselves to such a dangerous cash position. And how do they do that? By raising their prices to make next year’s retained earnings as large as this year’s. By recovering those retained earnings in higher prices. Like this.
Let’s assume these numbers are for a coffee shop that sells only one type and size of drink (say a large espresso-based drink) to simplify this discussion. If we subtract this year’s cost of sales from revenue we arrive with the markup on our direct costs. Dividing this number into cost of sales we get a markup percentage. For this year it was 72%. In the current year let’s assume they sold 302,406 cups of coffee. Which comes to about one cup a minute. Dividing the costs of sales by the number of cups of coffee sold gives a unit cost of $2.58 for a cup of coffee. Adding the 72% markup to this cost brings the selling price to $4.45. Coffee sold at this price and at this volume produced enough revenue to pay all the bills, provided an income for the owner and his or her family while leaving enough left over to invest back into the business. And provide a cash cushion for the unexpected. As well as paying state income taxes, city income taxes, etc.
A Business must bring their Cost Structure in Line to be able to Sell at the Prevailing Market Price
To arrive at the new selling price we added the loss of retained earnings to next year’s revenue. And re-crunched all of these numbers. Because we are raising the price we can expect a small fall in revenue as customers buy less. The higher costs and lower unit sales volume raised the unit cost. The markup percentage is 1 percentage point lower but because the unit cost is higher so is the markup amount in dollars. Which raises the selling price by $0.32. Increasing the price of a cup of coffee to $4.77. But is it enough? As it turns out, no. Because the new price raises revenue enough to push the business into a higher tax bracket. Taking the business owner back to the numbers.
Because of the higher tax bracket, and the higher top marginal tax rate, this higher price still results in a loss of retained earnings. About another $30,000. So going through the whole process again brings the selling price up to $4.87. Adding a total of $0.43 to this year’s price. As long as the prevailing market price is around $4.87 for a large espresso-based drink this business owner should be able to keep his or her cost structure in place and stay in business. However, if this exceeds the prevailing market price the business owner will have to make some spending cuts to bring his or her cost structure in line to sell coffee at the prevailing market price. Make some assumptions. And some adjustments. Then crunch these numbers again. And again. For getting this price right is very important. Too high and people will go elsewhere to buy their coffee. To low and they won’t be able to pay all of their bills.
This may not be how all businesses determine their selling price. But however they do it they have to bring their cost structure in line to be able to sell at the prevailing market price. Because if their price is too high no one will buy from them. If it’s too low everyone will buy from them. Making them happy. Until they realize they can’t pay all of their bills because their prices are too low. The above example was complicated. And that was with only one product. Imagine a store full of products to sell. And trying to calculate new prices on numerous products to cover the costs of new taxes and new regulations. It’s not easy. Which is why business owners don’t like big change coming from Washington. For this change requires important decisions to make. And if they get these decisions wrong and don’t find out until 6 months or so later they may dig themselves into a hole they won’t be able to get out of. Putting them out of business.
Tags: bankrupt, competition, cost of sales, cost structure, costs, free market, free market competition, higher prices, higher tax bracket, income taxes, marginal tax rate, market price, markup, prevailing market price, price, product pricing, retained earnings, revenue, selling price, tax bracket, top marginal tax rate
When Hamilton looked out Across the Vast North American Continent he saw Great Economic Opportunity
Alexander Hamilton was born in the British West Indies. At the age of eleven he had to get a job. As his father abandoned his family after losing all the family money. Young Alexander worked at Cruger and Beckman’s. a New York trading house. A window onto the world. And international trade. Where young Alexander learned about the world. And business. He had a gift for numbers. He was bright. And driven. Born in the British West Indies he was also something else. A Founding Father without any state lineage. With no provincial views. During the prelude to American independence when other patriots talked about the states going their own way he was already thinking of an American union. And only of an American union.
The British response to the Boston Tea Party was the Intolerable Acts. Or the Coercive Acts in Britain. Where the British put the hurt on Boston. And Massachusetts. To separate it and isolate it from the rest of the colonies. Reverend Samuel Seabury took to the papers and argued against uniting the other colonies to support Massachusetts. That the people should support their king. And Parliament. And not the spoiled, trouble-making people of Boston. Hamilton took to the papers and argued in support of union. And Boston. Warning the people that this was just the beginning for Britain. More taxes would certainly follow. Hamilton warned the people to put away their sectional differences. As this attack on one was an attack on all. And that if they gave up on Boston it would only be a matter of time before other colonies met the same fate.
That was all well and fine during the warm months of summer. But the American colonies were part of the British Empire. Which was a mercantilist empire. Whose colonies shipped raw materials to the mother country. And the proceeds from those sales were used to buy manufactured goods made from those raw materials in the mother country. Making the colonists dependent on Britain for their clothing. The lack of which would make a very cold and miserable winter. Which led a lot of people to agree with Reverend Samuel Seabury. But not Hamilton. For he looked out across the American colonies and saw something else. Economic independence. The South had cotton. The North could raise sheep for wool. And they could build factories in the cities to make cloth and clothing. Staffed by skilled immigrants from European factories. This is what Hamilton saw when he looked out across the vast North American continent. Great economic opportunity. Made possible by an American union.
Hamilton spent the Winter Seasons at Valley Forge and Morristown Reading and Studying Economics and Public Finance
When the Revolutionary War came Hamilton joined the Continental Army. Fought bravely. Then ended up as General Washington’s aide-de-camp. Serving in Washington’s inner circle he knew what the commanding general knew. And he knew the sorry state of the army. Half-naked, hungry and unpaid. While some civilians were living the life of Riley. Making a fortune off of hording commodities and selling them at high prices. Which they could do with impunity as the Continental Congress was powerless to stop them. As it was at the mercy of the states. The national congress was broke and had little legal authority. Which let the speculators run roughshod over it. Leaving the people sacrificing the most for independence half-naked, hungry and unpaid. Diminishing the fighting ability of the army. Which greatly increased the risk of defeat.
Hamilton learned an important lesson. The stronger the national government was, and the richer it was, the easier it was to wage war. And the easier it was NOT to be defeated in war. The problem here was that the national government was too weak. While the state governments were too strong. Which was fine for the people living normal lives in their states. But not the soldiers in the field fighting for the nation. Making things worse was inflation. The Continental Congress was printing money. As were the states. And the more they printed the more they depreciated it. Which led to even higher prices. More profits for the speculators. And even more hardship for the army. Which had to at times take things from the local people in exchange for IOUs. Making these people hate the army. And the army hate the people. As they were the ones risking life and limb for what was to them an ungrateful people.
Hamilton spent the winter seasons at Valley Forge and Morristown reading and studying economics and public finance. And set out to solve the inflation problem. What he learned was that a lot of people were benefiting by the rampant inflation. Debtors loved it. For the greater the inflation was the easier it was to repay loans in those depreciated dollars. Especially the farmers. They sold their produce at ever higher prices. Borrowed money to buy land (and repaid those loans in depreciated dollars). While escaping much of the ravages of inflation themselves. Because they were farmers. And were self-sufficient. Eating what they grew. Even making their own clothes. For some inflation was a way to get rich quick at the detriment of others. To help dissuade such activity Hamilton suggested high taxes in kind (if a farm grew wheat that they turned into flour they would pay a portion of their flour to the government as a tax) on those benefitting from inflation who where destroying the confidence in the dollar.
If Hamilton were Alive Today he would likely Endorse the Republican Candidates Mitt Romney and Paul Ryan
Hamilton also suggested a plan for a national bank. To help restore the credit of the United States. And to provide a source of credit for the national government. The bank would be owned half by the government and half by rich investors. By letting the rich investors make money on the bank it would, of course, encourage them to invest in the bank. And provide capital the government could borrow. Hamilton believed in bringing the rich people closer to the government. So the government had access to their money. Both would win in such a partnership. And both would have a vested interest in seeing the government succeed. The Continental Congress used some of Hamilton’s ideas. But not enough to bring his vision to life. He would get another chance, though. When he became America’s first Secretary of the Treasury.
At the end of the Revolutionary War the United State’s finances were in a mess. State governments and the national government owed money. As they used that money to prosecute the war Hamilton believed the national government should assume the states’ debts and roll in into the national debt. And, more importantly, the new national debt would help strengthen the union. By binding the states to the national government. These actions also helped to restore the nation’s credit. Allowing it to borrow money to repay old debts. As well as finance new spending. Hamilton also got his bank. And he produced a report on manufacturers. A plan to use government funds to help launch American industry. So they could catch up to Great Britain. And even surpass the former mother country.
Hamilton pushed for these things because he wanted to use the power of government to make America strong and fiercely independent in the world of nations. With an economic plan that would make the nation wealthy. And allowing it to afford a military that equaled or surpassed Great Britain. He did not want to make America wealthy to implement a massive welfare state. His idea of partnering government with business was to make an American Empire modeled on the British Empire. Making it a rich military superpower. Able to project force. Maintaining peace through strength. Much like the British did with their Pax Britannica that he didn’t live to see. And to protect what it had from anyone trying to take it away from them. So based on this who would he endorse in the 2012 election? The party that had business-friendly policies to encourage economic growth. The party that was more anti-inflation. The party that would best exploit the nation’s resources. And the party that favored a strong military. Which is NOT the Democrat Party. No, if Alexander Hamilton were alive today he would likely endorse the Republican candidates Mitt Romney and Paul Ryan.
Tags: 2012 election, 2012 Endorsements, Alexander Hamilton, American union, Britain, British, British Empire, colonies, Continental Army, Continental Congress, depreciated dollars, dollar, economic opportunity, Economics, factories, Great Britain, Hamilton, higher prices, inflation, military, Mitt Romney, Morristown, national bank, national debt, Paul Ryan, public finance, Republican, Revolutionary War, Romney, Ryan, Secretary of the Treasury, speculators, states, union, Valley Forge, Washington
In the Barter System the Only Way to Get Something you Wanted was to create Something of Value Yourself
What’s more important? Money? Or stuff? Stuff, of course. Because people work to earn money to buy stuff. They don’t work just for the money. Because you can’t eat money. You can’t drink money. You can’t smoke money. You can drive money. You can’t watch or listen to money. You can’t live in money. You can’t surf the Internet with money. No. The only thing money is good for is buying stuff. It’s the stuff we buy that makes our lives more enjoyable. Having money helps. But it is only a means to an end. That end being stuff. And someone has to make that stuff. For if no one does then all the money in the world is worthless.
Early economies were barter economies. People traded stuff. Stuff they created, dug up, grew, manufactured, etc. Instead of working to earn money to buy stuff they created stuff and traded it for other stuff. So the only way to get something you wanted was to create something of value yourself. Money didn’t change this. Money just made trading with other people more efficient. By being a temporary storage of wealth. Because the barter system had a serious flaw. High search costs.
It took time to bring two people together to trade their stuff. If a toolmaker wanted a pottery vase he had to find a potter who wanted a tool the toolmaker made. This could take awhile. Hence the high search costs. Because while these people were seeking each other out they couldn’t make anything else of value. With money, though, you could accept money in trade. And then go and trade that money for what you wanted. This greatly reduced search costs. Because all you had to do was find the things you wanted. And trade your temporary storage of wealth (i.e., money) for them. Allowing them to spend more time creating value. And less time searching.
The North won the American Civil War because the North practiced Free Market Capitalism while the South Didn’t
Advances in agriculture allowed larger and larger food surpluses. Which, in turn, allowed more and more people to do something other than farm. This unleashed human capital. Allowed people to think about other things. Create new things. And improve existing things. This created a middle class of artisans. Craftspeople. The people that created goods and services and brought them to the market place. Creating the complex economy. These people became entrepreneurs. They efficiently used resources and sold things in the market place the people were demanding. Not out of the goodness of their hearts. But because they were pursuing profits.
This is free market capitalism. The economic system that ushered in the modern world. Free people thinking freely. Creating. Bringing their bold new ideas into reality. Giving us the steam engine. The railroad. Machine tools. Electric power. The assembly line. Free market capitalism brought us these things and improved our standard of living. Because they were free to enter the market place. And make profits. Providing a powerful incentive to make the world a better place for everyone else. Because when they took risks and worked hard to make the world a better place they could get rich in the process.
This is why the North won the American Civil War. Because the North practiced free market capitalism. While the South did not. Their economy was a slave economy. Instead of an expanding middle class working and contributing to the economy they had an expanding slave population. That didn’t contribute to the economy. They worked in the fields. With all the proceeds from their labors going to a few plantation owners. Slaves in general didn’t tinker or bring new things to market to enrich their masters. For they had no incentive to do so. They did have an incentive to do as they were told and work the fields. To avoid punishment. And they had no wages to spend in the market. So there was less demand for manufactured goods in the South (in some states of the Deep South slaves made up to a third to half of the population). So there was less manufacturing in the South. Far less. This is why the North exploded in manufacturing. Entrepreneurs could bring things to market. And the manufacturing workers earned wages they could use to buy those things. As well as mass-produce the implements of war. Unlike they could in the South. Because of the economic superiority of the North it was just a matter of time before the South was overwhelmed. And lost.
When the Roman Empire turned into a Welfare State they had to Force People to Make Stuff Against their Will
Governments can print money. They can tax people. They can borrow money. But the one thing they can’t do is create stuff. If they could create stuff (i.e., economic activity) simply by printing money then the South would have matched the North in economic output. But they did not. Which is why they ultimately lost the war. Because they could print Confederate dollars. But that didn’t make muskets, bullets, canon, shoes, food, ships, steam locomotives or railroad track. Creative people had to make these things first before the Confederate government could procure them. Which is why the government didn’t procure them. Because no one made them.
This is why governments just can’t print money and give it to the people. They could. But it would be pointless. Let’s say they gave everyone $100,000 a year. So no one would ever have to work again. A lot of people would vote for the politician that promised that. Of course if no one works who will create all the stuff to buy with that $100,000? Having money is one thing. But if there is nothing to buy with it then that money is worthless.
This is why the welfare state will ultimately fail. As more people collect welfare benefits instead of creating stuff there will be less stuff to buy. When supply shrinks while demand increases prices rise. Higher prices that everyone has to pay. People who create. And people who don’t. So they will raise taxes on those who work to pay for the benefits for those who don’t. So those who don’t work can afford the higher prices, too. Higher taxes are a great disincentive to create. Or to become an entrepreneur. Some may just choose the easier path. Stop creating. And start collecting that government money, too. Further reducing supply and increasing demand. Raising prices further. Reducing overall economic activity. And reducing the standard of living.
This happened in the Roman Empire as they kept raising taxes and debasing their coin to pay for their excessive government spending. It got so bad that people quit their jobs because they couldn’t make any money. Creating great shortages of goods. And food. So the Romans passed laws forbidding people from leaving their jobs. Even tied people and their descendants to the land they farmed. Which grew into European feudalism. And Russian serfdom. Economic systems little better than the slavery of the Deep South. Which stunted innovation. Lowered the standard of living. And led to the fall of the Western Roman Empire. But it was the only way the Romans could get the stuff they needed. By forcing people to make it against their will. Which is what they had to do when the Roman Empire turned into a welfare state. And the creators quit creating.
Tags: American Civil War, barter, barter system, capitalism, demand, economic activity, economy, entrepreneur, free market, free-market capitalism, goods and services, government spending, higher prices, human capital, incentive, manufactured goods, manufacturing, market place, middle class, money, print money, profits, raise taxes, Roman Empire, search costs, slave, slave economy, standard of living, storage of wealth, stuff, supply, tax, trade, trading, value, wealth, welfare state
Competition makes Everything Better for Consumers
Let’s go back a hundred years or so. When the railroads were making their way west. Through barren and unforgiving country. Where a depot is built in the middle of nowhere. One day it will become a city but now is just a shack or two. And a water tower along the tracks to replenish the steam locomotives. This is the closest thing to civilization for hundreds of miles. Railroad building supplies head west on the new track to continue the track further west. And the trains stop to fill their locomotives with water. You look at all that traffic passing that depot and decide to open up a diner/saloon to replenish all those people. Who are earning wages. But have nothing to spend them on for hundreds of miles around.
There’s no electricity yet. Or ice. So the meat shipped to the diner may not be the freshest. But you can cook it with a lot of spices to hide any bad taste in case the meat is rancid. Liquor comes out without any spoilage. It’ll last so long that you can keep watering it down to make more money per bottle. Your diner/saloon can be dirty and overrun with bugs. You can just throw the bugs into the pot to make the meat go further. It doesn’t matter. Because for most of your customers this is the only place to come to eat and drink. Even if they get ill from eating bad meat they’ll keep coming back. Because where else are they going to go?
Your costs are low. And your prices are high. You’re doing very well. It’s nice being the only diner/saloon at this depot. But then a town starts growing around the depot. And another diner/saloon opens. It’s cleaner. They serve fewer bugs in their food. Their meat is less rancid. Their liquor is less watered down. And their prices are lower. Everyone who eats and drinks at this depot-town eats and drinks there. Not at your filthy shack. You quickly go from making a lot of money to making nothing at all. Because this new competition in town took away all of your business. For competition makes everything better for consumers.
When the Government Interferes with the Free Market there is no Incentive to Please their Customers
Competition is key to the free market economy. And it’s the most important thing. Even more important than government regulation. Because with competition you don’t need regulations. You don’t need inspectors. You don’t have to file complaints. You don’t have to wait for corrective action. Because if you have competition you have something that works better. And faster. Pleasing customers. If you don’t please them more than your competition then you will lose your customers to your competition. This is a powerful incentive to lower your prices. Improve the cleanliness of your establishment. And to improve your quality. Competition makes businesses try harder to please their customers. On their own. Without compulsion.
In the above example the first diner/saloon owner could have appealed to the government. Asked the government to prohibit the second establishment from opening. Saying that it was destructive competition. That they were dumping lower-priced food and drink onto the market to put the first establishment out of business. So they could raise their prices higher and lower their quality when they do. That the market wasn’t large enough to support two businesses. That their lower prices mean they will pay their employees less. And a whole host of other bad things that will follow if this second business opens. Of course the second business has none of these complaints. Because they offer better quality at lower prices. They don’t need the help of government. Just a competitive free market.
If the first business should prevail in their request for government help the government will take action. Force the second business to shut down. Make them sell their food and drinks at higher prices. Charge them a special excise tax on all their sales to raise money to transfer to and help the first business. Or some other action to make the market ‘fair’ again. Which means allowing the first establishment to continue to sell lower quality at higher prices. Which they would. For with the power of government helping them they have no incentive to please their customers. So they don’t. So people with no choice have to pay more for lower quality. And this is what happens when the government interferes with the free market.
Free Market Competition delivers High Quality at Low Prices with the Most Efficient Allocation of Resources
Competitive free markets also guarantee that businesses use resources in the most efficient manner. As they try to sell the highest quality at the lowest price they will buy very carefully. They will buy only the things they can sell. And only enough of them to meet their demand. For if they buy more than they can sell it will only raise their prices. As those prices have to pay for the things they sell. And the things they can’t sell. So there is a very strong incentive to buy only what they absolutely need. Leaving things for others to buy. Which is much better than having some government bureaucrat allocate resources.
Suppose the government owned the railroad and all the depot-towns along the line. And each depot has a diner/saloon. Each depot-town is about the same size. So the government bureaucrat ships the same supplies to each depot. One barrel of flour. One barrel of cornmeal. One barrel of salted pork. Two sacks of beans. Four sacks of coffee. Five cases of whisky. And so on. But the people don’t eat and drink the same in each of these depot-towns. Some drink more liquor than others. Some drink more coffee than others. Some eat more meat than others. Some eat more beans than others. Depending on the season. The cattle drives. Whether the farmers are sowing or reaping. The religious pilgrimages. The weather. Etc. The local diner/saloon owners are in tune with the rise and fall of demand. But the government bureaucrat 2,000 miles away isn’t. So some receive more than they can use. Others run out before the next shipment. Making the allocation of resources inefficient. Leading to waste. And higher prices to pay for all of that waste.
Free market competition always works best. And the more problems that we solve by creating more competition the better the solutions are for the people ultimately paying the prices. The consumers. As free market competition delivers high quality at low prices with the most efficient allocation of resources. Giving us things like the high-definition television. The smartphone. The tablet computer. And our morning coffee. Where quality just keeps getting better while prices keep falling. When we don’t use free market competition we get high prices, poor quality and inefficient resource allocation. From cable television that increases rates while lowering quality (we’ll be at your house either sometime in the morning or sometime in the afternoon tomorrow or the day after. Please have someone available at your home to meet our technician). To waiting in line to renew your driver’s license. Which is about as enjoyable as a root canal.
Tags: allocation of resources, better quality at lower prices, competition, competition makes everything, competitive free market, Consumers, costs, customers, demand, efficient, free market, free market competition, free market economy, government bureaucrat, high quality, higher prices, highest quality, incentive, low prices, lower prices, lower quality, pleasing customers, prices, quality, resources
When Spain came to the New World they Brought Home a lot of Gold and Silver and Turned it into Coin
Our first banks were goldsmiths’ vaults. They locked up people’s gold or other valuable metals (i.e., specie) in their vaults and issued these ‘depositors’ receipts for their specie. When a depositor presented their receipt to the goldsmith he redeemed it for the amount of specie noted on the receipt. These notes were as good as specie. And a lot easier to carry around. So these depositors used these notes as currency. People accepted them in payment. Because they could take them to the goldsmith and redeem them for the amount of specie noted on the receipt.
The amount of specie these first bankers kept in their vaults equaled the value of these outstanding notes. Meaning their bank reserves were 100%. If every depositor redeemed their notes at the same time there was no problem. Because all specie that was ever deposited was still in the vault. So there was no danger of any ‘bank runs’ or liquidity crises.
When Spain came to the New World they brought home a lot of gold and silver. And turned it into coin. Or specie. The Spanish dollar entered the American colonies from trade with the West Indies. As the British didn’t allow their colonies to coin any money of their own the Spanish dollar became the dominate money in circulation in commerce and trade in the cities. (Which is why the American currency unit is the dollar). While being largely commodity money in the rural parts of the country. Tobacco in Virginia, rice in the south, etc. Paper money didn’t enter into the picture until Massachusetts funded some military expeditions to Quebec. Normally the soldiers in this expedition took a portion of the spoils they brought back for payment. But when the French repulsed them and they came back empty handed the government printed paper money backed by no specie. For there was nothing more dangerous than disgruntled and unpaid soldiers. The idea was to redeem them with future taxation. But they never did.
Thomas Jefferson believed that the Combination of Money and Politics was the Source of all Evil in Government
During the American Revolutionary War the Americans were starving for specie. They were getting some from the French but it was never enough. So they turned to printing paper money. Backed by no specie. They printed so much that it became worthless. The more they printed the more they devalued it. And the fewer people would take it in payment. Anyone paying in these paper Continentals just saw higher and higher prices (while people paying in specie saw lower prices). Until some just refused to accept them. Giving rise to the expression “not worth a Continental.” And when they did the army had to take what they needed from the people. Basically giving them an IOU and telling the people good luck in redeeming them.
Skip ahead to the War of 1812 and the Americans had the same problem. They needed money. So they turned to the printing presses. With the aid of the Second Bank of the United States (BUS). America’s second central bank. Just as politically contentious as the First Bank of the United States. America’s first central bank. The BUS was not quite like those early bankers. The goldsmiths. Whose deposits were backed by a 100% specie reserve. The BUS specie reserve was closer to 10%. Which proved to be a problem because their bank notes were redeemable for specie. Which people did. And because they did and the BUS was losing so much of its specie the government legislated the suspension of the redemption of bank notes for specie. Which just ignited inflation. With the BUS. And the state banks. Who were no longer bound by the requirement to redeem bank notes for specie either. Enter America’s first economic boom created by monetary policy. A huge credit expansion that created a frenzy of borrowing. And speculation.
When more dollars are put into circulation without a corresponding amount of specie backing them this only depreciated the dollar. Making them worth less, requiring more of them to buy the same stuff they did before the massive inflation. This is why prices rise with inflation. And they rose a lot from 1815 to 1818. Real estate prices went up. Fueling that speculation. Allowing the rich to get richer by buying land that soared in value. While ordinary people saw the value of their currency decline making their lives more difficult. Thanks to those higher prices. The government spent a lot of this new money on infrastructure. And there was a lot of fraud. The very reason that Thomas Jefferson opposed Alexander Hamilton’s first Bank of the United States. The combination of money and politics was the source of all evil in government. And fraud. According to Jefferson, at least. Everyone was borrowing. Everyone was spending. Which left the banks exposed to a lot of speculative loans. While putting so much money into circulation that they could never redeem their notes for specie. Not that they were doing that anyway. Bank finances were growing so bad that the banks were in danger of failing.
Most Bad Recessions are caused by Easy Credit by a Central Bank trying to Stimulate Economic Activity
By 1818 things were worrying the government. And the BUS. Inflation was out of control. The credit expansion was creating asset bubbles. And fraud. It was a house of cards that was close to collapsing. So the BUS took action. And reversed their ruinous policies. They contracted monetary policy. Stopped the easy credit. And pulled a lot of those paper dollars out of circulation. It was the responsible thing to do to save the bank. But because they did it after so much inflation that drove prices into the stratosphere the correction was painful. As those prices had a long way to fall.
The Panic of 1819 was the first bust of America’s first boom-bust cycle. The first depression brought on by the easy credit of a central bank. When the money supply contracted interest rates rose. A lot of those speculative loans became unserviceable. With no easy credit available anymore the loan defaults began. And the bank failures followed. Money and credit of the BUS contracted by about 50%. Businesses couldn’t borrow to meet their cash needs and went bankrupt. A lot of them. And those inflated real estate prices fell back to earth. As prices fell everywhere from their artificial heights.
It was America’s first depression. But it wouldn’t be the last. Thanks to central banking. And boom-bust cycles. We stopped calling these central banking train wrecks depressions after the Great Depression. After that we just called them recessions. And real bad recessions. Most of them caused by the same thing. Easy credit by a central bank to stimulate economic activity. Causing an asset bubble. That eventually pops causing a painful correction. The most recent being the Great Recession. Caused by the popping of a great real estate bubble caused by the central bank’s artificially low interest rates. That gave us the subprime mortgage crisis. Which gave us the greatest recession since the Great Depression. Just another in a long line of ‘real bad’ recessions since the advent of central banking.
Tags: asset bubbles, Bank of the United States, bank reserves, bankers, boom-bust cycles, bus, central bank, coin, commodity money, Continental, credit expansion, currency, depositor, depression, easy credit, economic boom, fraud, gold, gold and silver, goldsmith, Great Depression, Great Recession, higher prices, inflation, interest rates, monetary policy, money, money and politics, money supply, Panic of 1819, paper money, printing paper money, recessions, silver, Spanish dollar, specie, speculation, speculative loans, Thomas Jefferson, vaults
The New Economic Reality of Farming was that we needed Fewer Farmers in the Age of Mechanization
The Roaring Twenties was a decade of solid, real economic growth. The world modernized during the Twenties. Electric power, telephone, radio, motion pictures, air travel, etc. So much of what we take for granted today became a reality during the Roaring Twenties. But there was a downside. Farmers borrowed money to mechanize their farms. As farms mechanized they produced great crop yields. Bringing bumper crops to market. There was so much food brought to market that prices plummeted. Reducing farm incomes so much that they couldn’t service the debt they incurred to mechanize their farms. They defaulted. Causing banks to fail.
By the late Twenties all the European farmers who fought in World War I were back on the farm. And were feeding Europe again. So not only were the Americans producing bumper crops they were losing a large export market. Forcing farm prices down further. There were simply more farmers than the economy was demanding thanks to the new efficiencies in farming. But because there were so many farmers they were an important political constituency. They were still casting a lot of votes. So the politicians stepped in. With a complete disregard to economic principles. And tried to help the farmers. With rent-seeking policies.
The farmers were hurting. So they wanted to transfer some wealth from the masses to the farmers. As in rent-seeking. As opposed to profit-seeking. Instead of creating wealth (profit-seeking) they were transferring wealth (rent-seeking). And they did this with price supports. They raised the price of their crops above market value. Forcing Americans to make sacrifices in their lives so they could afford to pay higher food prices to help the farmers. So the farmers wouldn’t have to adjust to the new economic reality of farming. We need fewer farmers in the age of mechanization. But it just didn’t end with higher prices. The government would buy excess food grown by these ‘too many farmers’ and destroy it. Or pay farmers NOT to grow food. Then they took it up a notch. And slapped tariffs on imported food. Further raising the price of food.
In an Effort to raise Farming Prices the Rent-Seekers caused the Great Deflation of the Great Depression
Food tariffs were just one part of the Smoot-Hawley Tariff Act. This act pretty much raised the tariff on everything the U.S. imported. Greatly increasing the cost of all imports. To protect the domestic producers from cheap foreign competition. But there was a problem with increasing the cost of all imports. It increased the price of whatever we built with those imports. So much so that when they were discussing this act in Congress businesses across America knew the boom of the Twenties would end. As did investors investing in these companies. So even before the bill became law it caused a huge stock selloff. Which led to the stock market crash of 1929.
At first the higher prices helped American businesses. Their revenue increased. Everyone thought the tariff act was a success. But as prices went up costs went up throughout the manufacturing pipeline. Prices grew so high that people stopped buying. Inventories accumulated so they cut production. And then laid people off en masse. Causing a great recession. Then further rent-seeking solutions (more governmental intervention into the free market) turned that recession into the Great Depression. What started out as a problem for overly efficient farmers turned into a national crisis. In an effort to raise farming prices they caused the great deflation of the Great Depression. As prices fell so did revenues. Making it very difficult to service debt. More people defaulted on their debt. And more banks failed.
When the Smoot-Hawley Tariff Act became law our trading partners answered in kind. Leading to a great trade war. So on top of everything else what limited export markets we had shut down as well. As the trade barriers went up economic activity decreased. David Ricardo’s Comparative Advantage worked in reverse. Increasing opportunity costs. When international markets closed less efficient domestic industries took their place. Pulling resources from more efficient uses. Raising the cost of those resources. Adding these cost increases on top of the tariffs. Which further increased prices. And further lowered economic activity. Adding further woe onto the Great Depression.
The Medallion System dates back to the Medieval Guilds and Restricts Entry into the Cabbie Market
As the Great Depression languished on few people filled the streets of New York City (NYC). At least few people with money who had to go places. There were more cabs than people needed. Supply exceeded demand. Putting a downward pressure on taxi fares. And increasing the time a cabbie had to work to earn some decent money. Usually the market steps in and corrects such a situation. Forcing some cabbies out of the cabbie business. But not in NYC. There they used the power of government to address this surplus of supply. And introduced the medallion system.
This was the kind of rent seeking that dated back to those medieval guilds. The medallion restricted entry into the cabbie market. By limiting the number of cabs in NYC. Every cab (at least those who can pick up passengers who hail a cab at the curb) must have a medallion permanently affixed to their cab. Which they must purchase from the city. Or transfer from another cab. Currently, if you want to drive a taxi cab in NYC you better have some deep pockets. Or have the kind of credit that lets you get a very large mortgage. For the medallion system exists to this day. And that medallion may cost you close to a half million dollars.
If you ever wondered why it sometimes takes so long to hail a cab in NYC this is the reason. Rent-seeking. As in the medallion system. Which works just like tariffs. Reducing supply. And increasing prices for consumers. So the rent-seekers can use the power of government to transfer wealth. Instead of using innovation to create wealth. And bringing that wealth to the market place to trade. Instead they choose to take more wealth from the market place than they bring to it. With the help of government. And their rent-seeking policies. Thus reducing overall wealth in the economy. Which reduces economic activity. And does nothing to help lift an economy out of recession. Or out of a Great Depression.
Tags: banks, bumper crops, cabbie, cabs, create wealth, crop yields, debt, deflation, economic activity, economic growth, farmers, farms, great deflation, great deflation of the Great Depression, Great Depression, higher prices, imports, incomes, mechanization, medallion, medallion system, NYC, prices, recession, rent-seeking, Roaring Twenties, Smoot-Hawley Tariff, tariffs, Taxi, transfer wealth, transferring wealth, Twenties, wealth
Mercantilism benefited only Protected Industries which Profited Handsomely from Higher Consumer Prices
The Age of Discovery ushered in the era of mercantilism. An era of trade. But protected trade. Tariffs, quotas, protectionism, restrictions, subsidies, etc. You name it they used it. To favor their trade position and their domestic industries. And to restrict that of everyone else. For mercantilism was a zero-sum game. You only did well if others did not. A thought that still has traction today. Especially in older, inefficient industries. That cannot compete with international competition that provides better quality at lower prices. Such as textiles. Steel. Automobiles. The Americans protected these industries in the face of better foreign competition. Which only hastened their decline.
A protected industry has no incentive to improve. When protective tariffs raise prices of lower-priced and higher-quality imports consumers buy the inferior domestic goods. Because the tariffs make the better goods more costly. So when a business has a captive audience their only focus is in maintaining that protectionism giving them that advantage. Not improving their quality. Or improving their productivity to lower their prices. Why? Because they don’t have to. So prices continue to rise to pay for inefficient labor and management. And quality continues to decline due to the lack of real competition forcing them to continually provide a better product. By improving designs. Production methods. And making capital investments in new machinery and equipment.
This is the cost of protectionism. Poorer quality and higher prices. Because of the misguided belief in the zero-sum game of mercantilism. There was a reason why mercantilism was abandoned for free trade. Because free trade was better. For consumers. Giving them lower prices and higher quality. Whereas mercantilism benefited only those protected industries which profited handsomely from those higher consumer prices. And the government officials who granted those favorable protectionist policies.
The Consumer gets Lower Prices AND Higher Quality thanks to the Division of Labor, Specialization and Comparative Advantage
As civilization advanced so did the division of labor. People began to specialize. Instead of growing our own food, making our own tools, spinning our own pottery, etc., we did only one thing. And did it well. Then we traded the things we made for the things we didn’t make. This division of labor created a middle class. And this middle class would take their goods to market to trade with other middle class artisans. At first bartering with each other. Trading good for good. Then they introduced a temporary storage of value into the economy. Money. Making those trades easier by reducing search times. Trading your goods for money. And your money for goods. Making life a lot simpler at the market.
Let’s take a closer look at the division of labor. Let’s consider two artisans. A toolmaker. And a potter. Both are skilled craftspeople. And can make an assortment of goods. But each excels at one particular skill. The toolmaker can make 10 plows a day. But if he makes 2 pottery bowls he can only make 4 plows in that same day. The potter can make 12 pottery bowls in a day. But if he makes 3 plows he can only make 5 pottery bowls in that same day. Each can make more of their specialty. But when they try to make other things in addition to their specialty they can’t make as much of their specialty as before. So there is a cost to the toolmaker to make pottery. To make 2 bowls cost the toolmaker 6 plows. And there is a cost to the potter to make tools. To make 3 plows cost the potter 7 bowls. So the economy as a whole is better off when the toolmaker and the potter focus all of their energies in their own specialty. When they do we get 10 plows and 12 bowls in one day. When they don’t we only get 7 plows and 7 bowls.
We call this economic principle comparative advantage. Where we look at economic output. Which is what matters. The more we bring to market the better it is for consumers. Because greater quantities mean lower prices. And when these skilled craftspeople focus on their specialty they improve the overall quality of the goods they bring to market. So the consumer gets lower prices AND higher quality. Thanks to the division of labor. Specialization. And comparative advantage.
We will always Have Jobs regardless the Size of our Imports for Having a Job is the Only Way to Buy those Imported Goods
If you multiply this over and over again to represent all the individual economic exchanges throughout the world you see why free trade is better than the protectionist policies of mercantilism. Because it provides consumers with greater economic output at lower prices and higher quality. This is why nations practicing free trade have the highest standards of living. Because their people can walk into large department stores and fill their carts with inexpensive, high quality goods on a moderate paycheck. Which could never happen if the mercantilists had their way.
The old inefficient industries want tariffs to increase the costs of those goods we fill our shopping carts with. Including the food we eat. And the cars we drive. They use lofty arguments about protecting American jobs. But those protectionist policies destroy jobs by increasing costs for businesses throughout the supply chain. Raising consumer prices everywhere. Reducing the amount of things we can buy. Meaning businesses can’t grow and create new jobs. Or they have to cut back production and eliminate existing jobs.
There’s also a lot of talk about the balance of payments. Which actually meant something during the days of the gold standard. For any trade deficits had to be paid for with gold. But we don’t have the gold standard anymore. Governments everywhere abandoned it in favor of irresponsible government spending. So we don’t have to pay for trade deficits with gold. Most money today is just electronic entries in a computer. International capital flows have never been greater. There are currency markets where people actively trade the world’s currencies. So trade deficits don’t mean the same thing they once did in the mercantile world. Then there’s the argument that if all our manufacturing jobs go overseas there will be no jobs for Americans. If we import everything and export nothing there will be jobs everywhere but here. Sounds like a problem. But can that happen? Not unless we get those imports for free. So we will always have jobs regardless the size of our imports. For having a job is the only way to buy the imported goods in those department stores.
Tags: artisans, barter, bowls, comparative advantage, competition, consumer prices, Consumers, division of labor, economic, economic exchanges, economy, export, free trade, gold standard, higher prices, higher quality, import, incentive, international competition, jobs, lower prices, mercantilism, middle class, money, poorer quality, potter, pottery, prices, productivity, protected industry, protectionism, protectionist policies, quality, search times, specialization, specialize, specialty, tariffs, toolmaker, tools, trade, trade deficit, zero-sum
Inflation is Good for those who Owe Money but Bad for Bankers
There is a direct correlation between the amount of money in circulation and prices. The more money the higher the prices. The less money in circulation the lower the prices. During the Great Depression the Federal Reserve contracted the money supply and prices fell. And it caused havoc in the economy. Low prices a problem? Yes. For some. It was good for anyone buying anything for their money was worth more and could buy more. But it wasn’t good for people who owed money. Or banks.
Farmers had borrowed a lot of money to mechanize their farms in the Twenties. So they owed the banks a lot of money. When prices fell so did their earnings as the crops they grew sold for less at market. Good for the consumer. But bad for the farmer. For with that big ‘pay cut’ they took they could not repay their loans. They defaulted. And when a lot of them defaulted they left banks with a lot of bad loans on the books and little cash in their vaults. Causing bank runs and bank failures.
This is why farmers are in favor of inflation. Increasing the amount of money in circulation. Instead of deflation. Decreasing the amount of money in circulation. For when you increase the money supply prices rise. Meaning more money for them at market. Making it easier for them to repay their loans. For although the money supply increased loan balances remained unchanged. Higher earnings. Same old debt. Therefore easier to pay off. Even though the value of the dollar fell. So inflation is good for the farmer. But bad for the banker. Because the dollars they get back when the farmer repays his loan now buy less than they did before the inflation.
To Fully Appreciate the Impact of Inflation we must talk about Real Prices and Real Wages
Think of a grocer. He buys from a food distributor to stock his grocery store shelves. His distributor buys from farmers and food processing companies. These purchases and sales happen BEFORE a consumer buys anything from a grocery store. Now BEFORE the consumer goes shopping let’s say the Federal Reserve doubles the amount of money in circulation. So the consumer goes shopping with a dollar worth HALF of what it was worth when the grocer stocked his shelves. So if the grocer doesn’t raise his prices to account for this inflation he’ll be able to replace only HALF of what he sells with the proceeds from those sales. Because his distributors will have doubled their prices to reflect the halving of the value of the dollar.
Of course doubling prices throughout the food supply chain will ultimately lower sales. Which no one in this chain wants. Which creates somewhat of a problem. Especially when consumers don’t like paying higher prices. Food processing companies will raise their prices. But they can do something else to make it look like they’re not raising their prices that much. They can reduce their packaging. So boxes of cereal and bags of chips get smaller while prices increase only a little. This lessens the perception of inflation on both consumer and seller. At least, for those who can do this. We sell gasoline by the gallon. Which means they have to pass on the full impact of inflation in the price at the pump. Which makes it look like gasoline prices are rising faster than most other prices. Which is why consumers hate oil companies more than food companies.
The price we pay in the grocery store and at the pump are nominal prices. Prices noted in dollars. Nominal prices rise to factor in inflation. But they don’t tell us the real impact of inflation. That is, how it reduces our purchasing power. For prices aren’t the only thing that rise. Our wages do, too. And if our nominal wages rise at the same rate as nominal prices do we won’t really notice a difference in our purchasing power. If our nominal wages rise faster than nominal prices then we gain purchasing power. If nominal prices rise faster than our nominal wages we lose purchasing power. So to fully appreciate the impact of inflation we must talk about real prices and real wages. Not the dollar amount on the price tag. But the affect on our purchasing power. In times of increasing purchasing power a single earner may be able to meet all the financial needs of a family. In times of declining purchasing power it may take a second income to meet the financial needs of the family. This is what we mean when we talk about real prices and real wages.
Government causes the Erosion of Purchasing Power Always and Everywhere
You may get a large raise at work giving you a high nominal wage. But if nominal prices are rising (as in a higher price at the gas pump) real wages are falling. Because you can’t buy as much as you once did. Meaning you’ve lost purchasing power. So even though you got a nominal raise you may have taken a real pay cut. Pretty much everyone today earns more than their father did. Yet today we struggle to have as much as our fathers did. Even with a second income in the family. This is the impact of inflation. Which causes real prices to rise. Real wages to fall. And our standard of living to fall.
As real prices rise and real wages fall we have to make choices. We can’t have the same things we once did. If we lose too much purchasing power our spouse may have to provide a second income, spending less time with his or her children. Or people may work more overtime. Or take a second job. Or simply cut back on things. And enjoy life less. Cut out movie night. Or going out to dinner. Not renew their season tickets. Or give less to charity. This is the true cost of inflation.
This all goes back to the amount of money in circulation. As Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” Meaning that only government can create inflation. Because government controls monetary policy. And the amount of money in circulation. Which means government causes the erosion of purchasing power always and everywhere. Even the price at the pump. As oil is a global commodity priced nominally in U.S. dollars. So whenever the Americans inflate their money supply the oil producers raise their prices to offset the devalued U.S. dollar. So government causes much of the pain at the pump. Whose monetary policies decrease real wages. And increase real prices.
Tags: amount of money in circulation, bank, debt, deflation, dollar, gasoline, gasoline prices, higher prices, impact of inflation, inflation, loans, monetary, monetary policy, money, money in circulation, money supply, nominal prices, nominal wages, oil, price at the pump, prices, purchasing power, real prices, real wages, value, value of the dollar, wages
During the 19th Century Mercantilism gave way to Laissez-Faire Capitalism and Free Trade
Portugal and Spain were superpowers around the 16th and 17th centuries. Great monarchies with mercantilist economic policies. Which was all about trade. Maximize exports. Minimize imports. Settle colonies to mine/harvest raw material. To ship back to the mother country. Where they manufactured goods from the raw materials. And exported them to other countries. Selling them for gold and silver. Which was key. Maximizing the trade surplus in the balance of trade. Finished goods going out. Gold and silver coming in. For the nation that gathered the most gold and silver won in the zero-sum game of mercantilism. Where the monarchy works with business. Picking winners and losers. And rewarding the winners who help enrich the monarchy.
Of course, these policies force a kingdom’s subjects to pay higher prices. By keeping out lower-priced imports. And with special deals favoring some domestic industries so they can sell at monopoly prices. They nationalized their Industries. Creating an aristocratic class. Composed of government officials. And their partners in the nationalized industries. Living the good life on the backs of the poor. Who paid high taxes. And high prices. To support those mercantilist policies. And it was these policies that settled South America. Taking all of their gold and silver (bullion). Shipping it back to the mother country. The surge in bullion in Europe made it less scarce. And less valuable. Meaning it took more of it to buy the same things it once did before this surge. Resulting in higher prices. And inflation. Hurting the consumer more. And leading to the development of the quantity theory of money. And monetarism. Which held that the amount of money in circulation had a direct impact on prices. The more money the higher the prices.
With the rise of Parliament in Britain power shifted from the king to the people. Via their representatives in Parliament. Instead of rule by dictate there was rule by consent. Which made the business of choosing winners and losers more difficult. Parliament had the power. But Parliament was more than one person. It was full of special interests. Which made it more and more difficult to choose any one special interest over another. Unable to curry favor for one’s own interest one didn’t support another’s interest. At least not when that support came at the expense of your interests. So there was another power shift in addition from the king to parliament. There was also one from the king to the markets. So during the 19th century mercantilism gave way to laissez-faire capitalism. And free trade. An economic system that let the British Empire dominate the world during the 19th century. Making it rich. And powerful. Thanks to that vigorous economic activity that could build the world’s most powerful navy. And pay for an army to garrison an empire. Meanwhile the old school mercantilist empires fell from superpower status. And became shadows of their former selves. Soon the Spanish and Portuguese colonies would gain their independence from these dying empires.
Milton Friedman’s Monetarism turned the Chilean Economy Around
The South American nations may have hated their European masters but they liked one thing about them. Their mercantilist policies. Which survived into the 20th century. Where government partnered with business. In the worst of crony capitalism. Where special interests that favored the ruling powers received government favors in return. Usually protected markets. And favorable legislation. That allowed them monopoly prices. Giving them great profits. Generous union wages and benefits. And generous health care and pensions. At least, for those politically connected. So the government rigged the game for them. And they made it worth the government’s while to rig the game. All of this paid for on the backs of the poor. Who paid high taxes. As well as high prices. And suffered abject poverty. Which made for an unhappy people. And a large amount of government turnover through revolution as dictatorships and military juntas overthrew other dictatorships and military juntas.
In 1973 it was Augusto Pinochet’s turn in Chile. Who came to power in a military coup. At the time the country wasn’t doing so well. And in full mercantilism. The economy was in the toilet. There was abject poverty. And hyperinflation (peaking at 1000% or so) as the government printed money to pay for its out of control spending. To try and bribe the angry mob and keep them from overthrowing the latest dictatorship. Pinochet was the guy to fix that. Like everybody that came before him. And after his military junta failed as the previous military juntas failed, he tried something new. Thanks to something called El Ladrillo. And economic plan so thick and heavy they called it ‘the brick’. A plan prepared by the Chicago Boys. Chilean economists schooled in the Chicago school of economics. Pinochet even met with Milton Friedman. Prominent economist of the Chicago school. And monetarist. Who came down to give a speech. (Interestingly, for the American left roundly criticized Friedman for giving a speech in a right-wing dictatorship. Though he received no such criticism for giving the same speech in a left-wing dictatorship – communist China. Showing that the political left was okay with human rights violations as long as they were committed in the left-wing dictatorships they so admired).
Pinochet asked for some economic advice. Friedman gave it. And Pinochet followed it. He ditched the mercantilist policies. Embraced laissez-faire capitalism. Privatized the state industries. Established free trade. Cut government spending. And stopped printing money. Ending the hyperinflation. Replacing it with a strict monetary policy. This didn’t please the politically connected as they lost their privilege. But Friedman’s monetarism turned the Chilean economy around. Creating a prosperous market economy. With a growing middle class. The strong economic growth led to some healthy tax revenue. Which in later years funded antipoverty programs. The Miracle of Chile even replaced the military junta with a democratic government. Chile now has one of the healthiest and freest economies in the world. An economy better and stronger than their former colonial master. Spain. Who maintained enough of their mercantilist policies to pull them into the Eurozone debt crisis. And probably could learn a thing or two from their one-time colony. Who is doing very well these days. Thanks to the Miracle of Chile. Milton Friedman. And the Chicago Boys. Those great Chilean economists given a chance by of all people a military dictator.
Everyone does Better under Free Market Capitalism, not just the Politically Connected
In 2010 a 7.0 earthquake hit Haiti. A country rife with political corruption. With little, if any, free market capitalism. And even less rule of law. Where most people live in abject poverty. In ramshackle housing. This earthquake claimed 230,000 lives. A heart-wrenching loss of life. Especially sad because the impoverished masses suffered the most. As is often the case in countries with poor economic and political institutions.
Later that same year, an 8.8 earthquake hit Chile. Thanks to the economic reforms that rebuilt Chile into a healthy and prosperous democracy, Chileans did not live in ramshackle housing. The higher standard of living created by the Chicago Boys’ economic reforms created better housing. And safer cities. Because of this the far stronger earthquake in Chile killed far fewer people than the lesser earthquake in Haiti. The death toll in Chile was less than 1,000. Which is impressive considering that was one of the most powerful earthquakes in recorded history.
Economics matter. Say what you want about free market capitalism. Malign it all you will. But you can’t change some facts. In particular, everyone does better under free market capitalism. Including the poor. For if this wasn’t the case Chile would have seen the loss of life Haiti saw. But they didn’t. Because there were no impoverished masses living in ramshackle housing in Chile. Because those economic reforms improved the standard of living for all Chileans. Not just the politically connected.
Tags: abject poverty, Augusto Pinochet, balance of trade, bullion, capitalism, Chicago Boys, Chicago school, Chile, Chilean economists, colonies, dictatorships, Economics, economy, El Ladrillo, exports, free market, free trade, free-market capitalism, Friedman, gold and silver, government spending, high prices, high taxes, higher prices, hyperinflation, imports, inflation, laissez faire capitalism, mercantilism, mercantilist, mercantilist economic policies, mercantilist policies, middle class, military junta, military juntas, Milton Friedman, Miracle of Chile, monarchy, monetarism, monetarist, monetary policy, monopoly prices, Parliament, Pinochet, politically connected, printing money, rule of law, South America, Spain, special interests, trade, trade surplus
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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