The Chinese Economy suffers from High Corruption that is a Part of Communism

Posted by PITHOCRATES - July 7th, 2012

Week in Review

The American Left likes to look at China as the way we should do business here in America.  Just like they looked at the Japanese in the Eighties and thought the same thing.  For the Left just hates laissez faire free market capitalism.  They want the government inserted into the economy in a big way.  For they believe that only then can we reach our true economic potential.  Despite what happened in Japan (their deflationary spiral and Lost Decade).  And what’s happening in China (see Chinese Corruption Comes in Staggering Sums by Angela Wang posted 7/2/2012 on The Epoch Times).

Corruption is a massive problem for the Chinese Communist Party, and it cuts both ways, as reflected in the Chinese phrase: “Oppose corruption and destroy the Party, don’t oppose corruption and destroy the nation.”

Lacking the legitimacy to rule conferred by elections and institutions like the rule of law, the Chinese communists must rely on an extralegal system of perks and benefits—also known as corruption—to keep their cadres in the system incentivized and at least minimally obedient. The unchecked power is increasingly getting out of control, however, and with the rise of the Internet and social media, the public is increasingly learning more—much to their anger.

So much for the dictatorship of the proletariat.  Guess Karl Marx got that wrong.  For here are communists accumulating private property through corruption.  So it would appear that communism has been nothing but a scam all along to allow the people at the top to accrue power.  And live very comfortably.

Communism is based on corruption.  It cannot work without corruption.  Because in communism it’s all about who you know.  That’s how you get ahead.  And that’s what liberalism is all about.  Who you know.  For the government loves to pick winners and losers in the economy.  Instead of letting the market do that.  As it does in laissez faire free market capitalism.  Under liberalism, as it is under communism, those who please the ruling elite do well.  While those who don’t do not do quite as well.  And the vast majority just get by.

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Rent-Seeking

Posted by PITHOCRATES - June 11th, 2012

Economics 101

Wealth Creators Freely met and Made Trades they felt were Mutually Beneficial

The human race started as subsistence hunters and gatherers.  Our ancestors spent all of their time hunting.  And gathering.  If they were successful they propagated our species.  Making it possible for us to be here.  If they weren’t their family tree was a barren one. 

So that was life.  A rather short and brutish life.  Except that part about propagating the species.  And we lived that way for some 2 million years.  Eating.  Fleeing.  Fighting.  And, of course, propagating.  As we grew more intelligent we did a lot of things that ushered in the modern world.  But perhaps the single greatest advancement that brought on the modern age was our evolution from hunters and gatherers to farmers.  Everything followed from this.  We learned to live together in cities.  And we increased crop yields so much we created food surpluses.  Which gave us time to do other things.  It allowed the rise of artisans.  A middle class.  That built things and traded them for their food.  These new goods helped produce more food.  And the greater food production allowed more people to do other things.  Creating a complex economy.  Where people traveled to market with the things they created.  And traded them for the things other people brought to market.  We traded things of value for other things of value.  Because these traders, these wealth creators, each created something of value.

These wealth creators freely met and made trades they felt were mutually beneficial.  Each felt they came out a winner after their trade.  For they each received something they valued more than what they traded away to get it.  Which means going to the market was where to go to get valuable things.  Which provided an incentive to make more things so you could take them to market.  And trade for things you valued more.  As everyone did this the overall wealth in the economy increased.  People specialized.  Focused on what they were good at.  To produce as much as possible so they could trade for more.  And because they specialized they improved quality.  And used the available resources as efficiently as possible.

Rent-Seeking People took more Wealth from the Market than they Brought to It

There are many competing schools of economics.  But if you go back to where it all began what you find is laissez faire free market capitalism.  Where the profit incentive drove people to create wealth.  Which they then traded for the things they didn’t make.  Then things started to change.  Some people didn’t want to work hard and innovate.  And bring new things to market.  What they wanted was influence.  Privilege.  And a rigged market.  So they could get more in trade than the value of the things they produced for trade.  One of the first vehicles used for this was the artisan guild.

In medieval Europe if you wanted to be a blacksmith you had to join a guild.  If the guild accepted you a long apprenticeship awaited you.  But the guilds denied more people entry than they allowed.  Why?  To limit competition.  So blacksmiths could keep their prices high.  At any given time a city, town or village had a very limited number of blacksmiths.  The guild worked to keep it that way.  For the last thing these blacksmiths wanted was other blacksmiths opening up shop.  Putting more goods onto the market.  And lowering prices.  No, the guild wanted to fix prices above their market value by keeping would-be blacksmiths out of the trade.

The economic term for this is rent-seeking.  Which is sort of the opposite of profit seeking.  In profit-seeking people create wealth to trade (or to pay) for other wealth.  They work hard to earn more so they can buy more.  Both buyer and seller add wealth to the economy.  Not so in rent-seeking.  In rent-seeking you try to garner more wealth not by working harder but by using the power of government.  By getting tariffs placed on foreign competition.  By getting prices fixed above market prices.  By getting onerous regulations enacted to hurt your competition.  By restricting entrance into the industry thus limiting domestic competition.  Such as the guilds did for those medieval blacksmiths.  This interference into laissez faire free market capitalism reduced economic activity.  Because rent-seeking people took more wealth from the market than they brought to it.

The Government caused the Great Depression by Favoring Rent-Seeking over Free Market Capitalism

Some say a better name for rent-seeking is privilege seeking.  For that is what they are seeking.  Special privilege so they don’t have to compete in the free market.  For the cost of a little lobbying can remove the need for innovation.  Maintaining the level of quality.  Or satisfying customers.  For if you have a government-imposed monopoly you don’t have to do any of those things because the people don’t have anywhere else to go.

Rent-seeking is rife in crony capitalism and state capitalism.  Neither of which is true capitalism.  These companies are granted monopolies (or near monopolies) by the government in exchange for political support.  Which they can afford when they can sell their goods above market prices.  They get rich.  Their cronies in government get rich.  But the consumers suffer.  As they have to pay higher prices. Suffer poorer quality.  And less innovation.  Rent-seeking is common in the older industries.  Particularly ones with strong unions.  Who have negotiated costly wage and benefit packages.  Which they can afford to pay until new innovation and new competition enters the market.  Putting out a higher quality product at a lower price.  Prices so low that an old firm saddled with a costly union wage and benefit package simply can’t sell at and pay their bills.  So they go to government.  And lobby for privilege.

What typically happens is that they delay the inevitable.  All the protected industries in the U.S. have failed.  Textile.  Steel.  Even the automobile (well, two of the Big Three have failed.  Ford hasn’t).  For when you take more wealth from the market than you bring to it you’re just transferring wealth.  You’re not creating it.  Which is a problem.  Because you have to create wealth to increase economic activity.  So when you protect an industry you’re just pulling wealth out of the private economy and transferring it to the rent-seekers.  Who give so little in return.   Which results in a decline of economic activity.  And if it spreads enough it can and has caused recessions.  Even a Great Depression.  Such as when domestic industries lobbied government to enact the Smoot-Hawley Tariff.  Which launched an all-out trade war.  All because the government favored rent-seeking over free market capitalism.

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Opportunity Costs

Posted by PITHOCRATES - June 4th, 2012

Economics 101

Those on the Left are all for Choice as long as you Choose what they want you to Choose

Choice.  It’s what life is.  Every day we make hundreds of choices in our life.  The communists called that a burden.  And that their way removed all that stress from our lives.  The stress of constantly having to choose.  They came up with a new freedom.  Freedom from choice.  To live under oppression.  Like a slave.  Where you no longer had the burden of making a choice every waking hour of your day.  You simply took what the government gave you.  And relaxed.  Truly free.

It turned out the people living under communism preferred having that burden of choice.  And took every opportunity to escape the communist ‘freedom’.  To a freedom where you were free to choose whatever you wanted.  Instead of taking what central planners gave you.  Those on the Left always had a soft spot in their hearts for communism.  And Soviet central planners.  For they never cared that much for free markets.  Laissez faire capitalism.  Freedom of choice.  Because people so often chose poorly in their opinion.  For they weren’t as educated and enlightened as they were on the Left.  And therefore chose the wrong kind of foods to eat.  The wrong kind of beverages to drink.  The wrong kind of cars to drive.  The wrong kind of power to generate.  And the wrong people to vote for.

No.  Those on the Left are no fans of choice.  Except, of course, when it comes to abortion.  When it comes to abortion then they are big fans of choice.  But not so much when it comes to us choosing what to eat, drink and drive.  Or how we generate our energy.  So when it comes to choice those on the Left are like the Soviet central planners.  They are all for choice.  As long as you choose what they want you to choose.

When making any Economic Decisions we make our Choice based on Opportunity Costs 

But we choose.  Because we can.  At least with most things.  But how do we choose?  Does price determine what we choose?  Sometimes.  Quality?  Sometimes.  Loyalty?  Sometimes.  Sometimes it’s one of these things.  Sometimes a combination of all of these things.  Sometimes it’s none of these things.  So what is it that makes up your mind when confronted with a choice?  Do you know?  You do.  For obviously you’re making the choice.  But the ‘why’ we may have to coax out of you.  For you will probably not be able to explain why.  At least not as well an economist can.

The study of economics is all about choice.  And trying to determine what influences people’s choices.  So economists can offer economic policies to maximize economic activity.  By maximizing that thing we ultimately trade for.  Which is what?  Happiness.  We choose to increase our happiness.  Or utility in the parlance of economics.  The things we choose are the things that will give us the greatest happiness.  Or the greatest utility.  But if you’re like me you never saw ‘utility’ or ‘happiness’ expressed as units on a price tag in a store.  Price tags show only price.  Which tells us little how happy something will make us.  So how do we choose the things that will maximize our happiness?  Especially if you’re looking at two different things that have the same price?

Easy.  We don’t make our decision by looking at what we’re buying.  We make our decision based on what we’re not buying.  What we are giving up by buying this thing or that service?  What might have been had it not been for this purchase?  What opportunity we’re passing on to make this purchase?  What cost are we paying in lost opportunity by committing to this purchase?  In other words, when making any economic decisions we make our choice based on opportunity costs.  On an amount of happiness we’re giving up to acquire some other amount of happiness.  And whatever the number of our choices the end result is the same.  What we choose gives us more happiness than all other possible alternatives.  Regardless of price, quality or loyalty.  Though they could influence us when there is a tie.

Liberals make us Buy not what Increases our Happiness but what Increases their Happiness

You can’t put a price on happiness.  That’s what they say.  And they are right.  Whoever they are.  For example, luxury cars are nice.  But they are expensive.  Subcompacts are not as nice as luxury cars.  But they are not as expensive either.  So if you were choosing between these two cars which one would you choose?  I can’t tell because I don’t know your income.  But I can guess at your decision process.  You’re going to compare opportunity costs.  Driving a luxury car gives you enormous amounts of happiness.  For the limited time you spend driving it.  Enormous happiness for a limited amount of time.  Okay.  But what are the opportunity costs?

Let’s say your daily commute to and from work is one hour.  But when you get home you enjoy 4 hours between surfing the Internet and watching cable television.  When you’re not at work or home you like to use social media on your smartphone interacting with your friends.  And using your smart phone apps to maximize your fun in the evenings and on the weekend.  You like to spend your Sunday mornings at the coffee shop with you tablet reading the online Sunday papers.  The hours of driving happiness come to 10 hours a week.  And the hours of online/watching cable happiness comes to 32 hours a week.  Now being that you spend more time online or watching cable than driving then it’s safe to say that driving brings you less happiness than those other activities.  Because luxury cars are expensive they come with a high monthly payment and a high insurance premium.  Which means you will have to cut back on other spending to afford the luxury car.  So to afford the luxury car you have to give up your cable and home Internet access.  And cut back on your minutes on your smartphone.

The opportunity cost of the luxury car is giving up cable TV and cutting back on Internet access and smartphone minutes.  The opportunity cost of keeping those things is getting a subcompact car instead of a luxury car.  This is the ultimate decision we make in all of our economic decisions.  Which will cost us more in sacrificed happiness in the long run?  Which makes those decisions easy.  In the above example you would probably have never given the luxury car any serious thought.  This is why free markets work so well.  Why laissez faire capitalism works so well.  Because the economy is full of individuals making these decisions quickly.  Far quicker than any Soviet state planner.  And with far more insight into our own wants and desires than any Soviet state planner.  And in the aggregate this drives economic activity.  Bringing the things we want to market.  The things that give us the greatest amount of happiness.  The things that have the lowest opportunity costs.  Unlike Soviet central planning.  Or American liberal Democrat central planning. 

No.  These people try to change our purchasing decisions.  Making us buy not what increases our happiness.  But what increases their happiness.  Which is why when liberal Democrats are in power there is a general economic decline.  Because they do alter our purchasing decisions.  By increasing the opportunity costs of the things that increase our happiness.  So that we buy fewer of them.  But we don’t buy more of the things they want us to buy.  Because those things don’t increase our happiness.  When they subsidize hybrid cars (paid for with higher taxes from us) to get us to buy them it doesn’t make the hybrid cars give us any more happiness.  It just leaves us with less money because of the higher taxes.  So we buy less of everything else.  And in the aggregate this lowers economic activity.  Leaving us all less happy.

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FT120: “Give a man a fish and he can eat for a day; give him a job and he can have an obesity problem.” -Old Pithy

Posted by PITHOCRATES - June 1st, 2012

Fundamental Truth

In Warfare Starvation and Famine are the most Potent of Weapons

Starvation and famine has plagued mankind since the dawn of time.  It was the driving force in evolution.  Those who took control of their food supply lived.  Those who didn’t disappeared from the evolutionary path.  Like Neanderthal.  And those who came before him.  Our earliest civilizations massed their populations to farm.  And the masses lived in cities.  Setting down roots and saying goodbye to their hunting and gathering ways.  In the Wei River valley.  In the Indus River valley.  The valleys of the Euphrates and Tigris.  In the Nile River valley.  Where modern life took root.  Produced our first food surpluses.  And gave birth to urban life.  And the middle class.

The rise of the middle class allowed civilization to flourish.  For every person that didn’t have to produce food could do something else.  Build better tools.  Create a better government.  Create art.  In general, think about other things.  Those other things that made humans different.  By giving us a more interesting life.  And more sophisticated ways to express ourselves.

But this growth was a double-edged sword.  For large urban populations that made life more enjoyable was also a great threat to the food supply.  A cool and wet summer could destroy crops.  Poor food storage could spoil the food surplus.  A war could see an enemy purposely destroy your crops and your food surplus.  Causing famine.  Where half or your city population could easily die before the next harvest.  Or more.  Especially if the famine resulted from an act of war.   As an act of genocide.  To clear people off land that others want to use for their own food needs.  Which was Hitler’s plan in Russia.  To take the food from the Ukraine.  Kill the indigenous population.  And replace them with Nazis.  Thus creating more living space for the Third Reich.  Or Lebensraum.    Because in warfare starvation and famine are the most potent of weapons.

History has shown that the most Food-Abundant Countries are the most Capitalistic

England led the way in agricultural advances.  Increasing crop yields such that small tracts of land could support greater populations.  As well as produce such huge food surpluses that they had food to export.  As the British Empire spread across the globe so did their advanced agricultural ways.  During the 19th century starvation and famine were becoming rarer in the technologically advanced West.  The 19th century Irish Potato Famine reduced Ireland’s population by up to 25%.  A tragedy of epic proportions.  But it was an exception to the rule.  For food was growing so abundant in the advanced Western World that rarely did people go hungry.  Or feared famine.  And when mechanization and chemistry hit the farm our crop yields exploded.

During the Twentieth Century the Western World produced so much food that food prices plummeted.  Causing the Great Depression.  There was so much food available that farmers couldn’t sell their food at a high enough price to service the debt that they incurred mechanizing their farms.  But not everyone was producing bumper crops in the Twentieth Century.  Both the Soviet Union and the People’s Republic of China set records for death by famine.  As they shunned the ways of the West.  And the state took over their agricultural sectors.  States that were so inept at good farming practices and things economic that crop yields plummeted.  North Korea to this day can’t even grow enough food for her own people.  And has recurring famines.  Because they hold on to the communist ways of Stalin and Mao.  While the Russians and the Chinese have long abandoned them. 

History has shown that the most food-abundant countries are the most capitalistic.  Countries whose agricultural sectors use the latest in technology.  And/or have a rich and vibrant economy that can buy all the food they need if they can’t produce their own.  Like Hong Kong.  Basically a rock off the Chinese mainland.  It has little arable land.  Few natural resources.  But what it does have is low taxation and free trade.  And laissez-faire capitalism.  The Chinese lost Hong Kong to the British Empire (who have since given it back).  And the British used laissez-faire capitalism to make Hong Kong the gem it is today.  Where people are free and in want of little.  And in this island nation that can’t grow enough food to feed their population famine is unheard of.  Why?  Because they have the wealth to trade for all the food they desire.  In fact, while Mao gave the people in the People’s Republic of China famine Hong Kong were doing just fine.  Because they were wealthy and could trade for what they needed.  And they had the Royal Navy protecting her.

In America our Food Supplies are so Abundant and so Cheap that Poor People are becoming Obese

Poverty is the biggest killer.  Famine is prevalent in poor countries.  Like Haiti.  North Korea.  And sub-Saharan Africa.  People suffer in these countries unlike they do in the West.  Despite the amount of aid the West pours into them.  And it’s not because Western nations were blessed with natural resources.  Hong Kong doesn’t have anything other than laissez-faire capitalism.  Protected by the Rule of Law and minimal government interference into the private sector economy.  The very things that are missing from Haiti, North Korea and sub-Saharan Africa.  Where corruption rules supreme.  There is little regard for human rights.  Or property rights.  And no one can protect their people from the abuses of government.  Or from warring neighbors.  Like the Royal Navy protected Hong Kong.  And pretty much the rest of the world during the 19th century.  Just like America’s military might made the world safe for capitalism in the Twentieth Century.

Third world nations are not a victim of first world nations.  They are a victim of themselves.  Where corrupt rulers collect Western aid and live well while their people suffer.  Especially the nations that eschew capitalism.  And embrace socialism.  Like the Soviet Union did.  Like the People’s Republic of China did (the current Chinese regime is enjoying economic growth by allowing some capitalism into their still communist country).  And like North Korea still does.  These socialist utopias were a living hell for their people.  Where they live in fear of their government.  And of famine.

Meanwhile in the Western capitalist nations what do they suffer from?  Especially the poor people in America?  Obesity.  In New York they’re passing laws restricting the size of sugary beverages because they are dangerous to your health.  While they pass out free condoms and birth control as sex is far less risky behavior than a delicious carbonated beverage.  Apparently.  Yes, in America our food supplies are so abundant and so cheap that poor people are becoming obese.  Because capitalism has made those food supplies abundant and cheap.  And capitalism gave people jobs where they could afford to buy so much food that they can give themselves an obesity problem.  A problem they just don’t have in Haiti, North Korea or sub-Saharan Africa.  Because they can’t grow enough food.  Or earn enough money to buy enough food.  For they don’t have an environment conducive to creating jobs.  Which is why these nations are still impoverished and/or suffering famine despite all the aid the West gives them.  Food aid will run out.  And then they’ll just be starving once again.  If they have jobs, though, they’ll be able to buy food whenever they’re hungry.  Because it’s like that old saying.  Give a man a fish and he can eat for a day; give him a job and he can have an obesity problem.

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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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LESSONS LEARNED #27: “Yes, it’s the economy, but the economy is not JUST monetary policy, stupid.” -Old Pithy

Posted by PITHOCRATES - August 19th, 2010

WHAT GAVE BIRTH to the Federal Reserve System and our current monetary policy?  The Panic of 1907.  Without going into the details, there was a liquidity crisis.  The Knickerbocker Trust tried to corner the market in copper.  But someone else dumped copper on the market which dropped the price.  The trust failed.  Because of the money involved, a lot of banks, too, failed.  Depositors, scared, created bank runs.  As banks failed, the money supply contracted.  Businesses failed.  The stock market crashed (losing 50% of its value).  And all of this happened during an economic recession.

So, in 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System (the Fed).  This was, basically, a central bank.  It was to be a bank to the banks.  A lender of last resort.  It would inject liquidity into the economy during a liquidity crisis.  Thus ending forever panics like that in 1907.  And making the business cycle (the boom – bust economic cycles) a thing of the past.

The Fed has three basic monetary tools.  How they use these either increases or decreases the money supply.  And increases or decreases interest rates.

They can change reserve requirements for banks.  The more reserves banks must hold the less they can lend.  The less they need to hold the more they can lend.  When they lend more, they increase the money supply.  When they lend less, they decrease the money supply.  The more they lend the easier it is to get a loan.  This decreases interest rates (i.e., lowers the ‘price’ of money).  The less they lend the harder it is to get a loan.  This increases interest rates (i.e., raises the ‘price’ of money). 

The Fed ‘manages’ the money supply and the interest rates in two other ways.  They buy and sell U.S. Treasury securities.  And they adjust the discount rate they charge member banks to borrow from them.  Each of these actions either increases or decreases the money supply and/or raises or lowers interest rates.  The idea is to make money easier to borrow when the economy is slow.  This is supposed to make it easier for businesses to expand production and hire people.  If the economy is overheating and there is a risk of inflation, they take the opposite action.  They make it more difficult to borrow money.  Which increases the cost of doing business.  Which slows the economy.  Lays people off.  Which avoids inflation.

The problem with this is the invisible hand that Adam Smith talked about.  In a laissez-faire economy, no one person or one group controls anything.  Instead, millions upon millions of people interact with each other.  They make millions upon millions of decisions.  These are informed decisions in a free market.  At the heart of each decision is a buyer and a seller.  And they mutually agree in this decision making process.  The buyer pays at least as much as the seller wants.  The seller sells for at least as little as the buyer wants.  If they didn’t, they would not conclude their sales transaction.  When we multiply this basic transaction by the millions upon millions of people in the market place, we arrive at that invisible hand.  Everyone looking out for their own self-interest guides the economy as a whole.  The bad decisions of a few have no affect on the economy as a whole.

Now replace the invisible hand with government and what do you get?  A managed economy.  And that’s what the Fed does.  It manages the economy.  It takes the power of those millions upon millions of decisions and places them into the hands of a very few.  And, there, a few bad decisions can have a devastating impact upon the economy.

TO PAY FOR World War I, Woodrow Wilson and his Progressives heavily taxed the American people.  The war left America with a huge debt.  And in a recession.  During the 1920 election, the Democrats ran on a platform of continued high taxation to pay down the debt.  Andrew Mellon, though, had done a study of the rich in relation to those high taxes.  He found the higher the tax, the more the rich invested outside the country.  Instead of building factories and employing people, they took their money to places less punishing to capital.

Warren G. Harding won the 1920 election.  And he appointed Andrew Mellon his Treasury secretary.  Never since Alexander Hamilton had a Treasury secretary understood capitalism as well.  The Harding administration cut tax rates and the amount of tax money paid by the ‘rich’ more than doubled.  Economic activity flourished.  Businesses expanded and added jobs.  The nation modernized with the latest technologies (electric power and appliances, radio, cars, aviation, etc.).  One of the best economies ever.  Until the Fed got involved.

The Fed looked at this economic activity and saw speculation.  So they contracted the money supply.  This made it hard for business to expand to meet the growing demand.  When money is less readily available, you begin to stockpile what you have.  You add to that pile by selling liquid securities to build a bigger cash cushion to get you through tight monetary times.

Of course, the economy is NOT just monetary policy.  Those businesses were looking at other things the government was doing.  The Smoot-Hartley tariff was in committee.  Across the board tariff increases and import restrictions create uncertainty.  Business does not like uncertainty.  So they increase their liquidity.  To prepare for the worse.  Then the stock market crashed.  Then it got worse. 

It is at this time that the liquidity crisis became critical.  Depositors lost faith.  Bank runs followed.  But there just was not enough money available.  Banks began to fail.  Time for the Fed to step in and take action.  Per the Federal Reserve Act of 1913.  But they did nothing.  For a long while.  Then they took action.  And made matters worse.  They raised interest rates.  In response to England going off the gold standard (to prop up the dollar).  Exactly the wrong thing to do in a deflationary spiral.  This took a bad recession to the Great Depression.  The 1930s would become a lost decade.

When FDR took office, he tried to fix things with some Keynesian spending.  But nothing worked.  High taxes along with high government spending sucked life out of the private sector.  This unprecedented growth in government filled business with uncertainty.  They had no idea what was coming next.  So they hunkered down.  And prepared to weather more bad times.  It took a world war to end the Great Depression.  And only because the government abandoned much of its controls and let business do what they do best.  Pure, unfettered capitalism.  American industry came to life.  It built the war material to first win World War II.  Then it rebuilt the war torn countries after the war.

DURING THE 1980s, in Japan, government was partnering with business.  It was mercantilism at its best.  Japan Inc.  The economy boomed.  And blew great big bubbles.  The Keynesians in America held up the Japanese model as the new direction for America.  An American presidential candidate said we must partner government with business, too.  For only a fool could not see the success of the Japanese example.  Japan was growing rich.  And buying up American landmarks (including Rockefeller Center in New York).  National Lampoon magazine welcomed us to the 90s with a picture of a Japanese CEO at his desk.  He was the CEO of the United States of America, a wholly owned subsidiary of the Honda Motor Company.  The Japanese were taking over the world.  And we were stupid not to follow their lead.

But there was no invisible hand in Japan.  It was the hand of Japan Inc.  It was Japan Inc. that pursued economic policies that it thought best.  Not the millions upon millions of ordinary Japanese citizens.  Well, Japan Inc. thought wrong. 

There was collusion between Japanese businesses.  And collusion between Japanese businesses and government.  And corruption.  This greatly inflated the Japanese stock market.  And those great big bubbles finally burst.  The powerful Japan Inc. of the 1980s that caused fear and trembling was gone.  Replaced by a Japan in a deflationary spiral in the 1990s.  Or, as the Japanese call it, their lost decade.  This once great Asian Tiger was now an older tiger with a bit of a limp.   And the economy limped along for a decade or two.  It was still number 3 in the world, but it wasn’t what it used to be.  You don’t see magazine covers talking about it owning other nations any more.  (In 2010, China took over that #3 spot.  But China is a managed economy.   Will it suffer Japan’s fate?  Time will tell.)

The Japanese monetary authorities tried to fix the economy.  Interest rates were zero for about a decade.  In other words, if you wanted to borrow, it was easy.  And free.  But it didn’t help.  That huge economic expansion wasn’t real.  Business and government, in collusion, inflated and propped it up.  It gave them inflated capacity.  And prices.  And you don’t solve that problem by making it easier for businesses to borrow money to expand capacity and create jobs.  That’s the last thing they need.  What they need to do is to get out of the business of managing business.  Create a business-friendly climate.  Based on free-market principles.  Not mercantilism.  And let that invisible hand work its wonders.

MONETARY POLICY CAN do a lot of things.  Most of them bad.  Because it concentrates far too much power in too few hands.  The consequences of the mistakes of those making policy can be devastating.  And too tempting to those who want to use those powers for political reasons.  As we can see by Keynesian ‘stimulus’ spending that ends up as pork barrel spending.  The empirical data for that spending has shown that it stimulates only those who are in good standing with the powers that be.  Never the economy.

Sound money is important.  The money supply needs to keep pace with economic expansion.  If it doesn’t, a tight money supply will slow or halt economic activity.  But we have to use monetary policy for that purpose only.  We cannot use it to offset bad fiscal policy that is anti-business.  For if the government creates an anti-business environment, no amount of cheap money will encourage risk takers to take risks in a highly risky and uncertain environment.  Decades were lost trying.

No, you don’t stimulate with monetary policy.  You stimulate with fiscal policy.  There is empirical evidence that this works.  The Mellon tax cuts of the Harding administration created nearly a decade of strong economic growth.  The tax cuts of JFK were on pace to create similar growth until his assassination.  LBJ’s policies were in the opposite direction, thus ending the economic recovery of the JFK administration.  Ronald Reagan’s tax cuts produced economic growth through two decades. 

THE EVIDENCE IS there.  If you look at it.  Of course, a good Keynesian won’t.  Because it’s about political power for them.  Always has been.  Always will be.  And we should never forget this.

www.PITHOCRATES.com

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