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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Incentive and Competition

Posted by PITHOCRATES - December 19th, 2011

Economics 101

Prices set by the Free Market make Competitors Think and Innovate

Agriculture advances gave us food surpluses.  Food surpluses gave us a division of labor.  The division of labor gave us trade.  Money made that trade more efficient.  Religion and the Rule of Law allowed great gatherings of people to live and work together in urban settings.  Free trade let us maximize this economic output and elevated our standard of living.  Free labor sustained economic growth by increasing the number of people making economic exchanges.  Prices automated the process of assigning value and allocating scarce resources (that have alternative uses).  But that’s not all.  Prices also provide incentive and competition.

High prices signal high profits.  Or the potential for high profits.  Which encourages other people to enter the market to get their piece of these high profits.  People who think they can do a better job.  Make something better.  And sell it for less.  That’s right, to get rich they will sell it for less.  That’s key.  That’s how you gain market share.  The ultimate goal of all businesses.  Because with market share comes profit.  And often times this happens even with a price below that of the competition.

Prices set by the market allow this amazing phenomenon to happen.  It stimulates the creative juices.  It makes competitors think.  And innovate.  Providing incentive.  To improve on an existing idea.  Or replace an existing idea with a better idea.  All the while being guided by market prices.  Which tell them the current value a buyer places on a product or service.  And the final cost they have to remain below to bring their innovation to market.  If they do both they will gain market share.  By giving customers better value at a lower price.  And they will make themselves rich in the process.  The proverbial win-win of the free market.  The hallmark of capitalism.  Incentive and competition.

With Crony Capitalism Government Increases the Cost of Competition, Squelching any Incentive to Innovate

Free market prices are essential for free market capitalism.  If the market is not free to determine prices this amazing phenomenon will not occur.  Consumers will not get more value for less.  And business people and entrepreneurs will not take chances and create more value for less.  Because if there are outside forces influencing prices these forces also create uncertainty.  They throw unknowns into business calculations.  Things businesses have no power over.  Which makes them cautious.  And less prone to risk-taking.

We can see examples of this every time there is unrest in the Middle East.  Which tends to threaten the oil supply.  Everything in a modern economy uses energy.  Nothing comes to market without energy.  So anything that affects energy prices affects all prices.  Another example is government’s regulatory cost.  Such as Obamacare.  Which has caused great uncertainty.  And a lot of unknowns.  For entrepreneurs.  And business owners.  Who don’t know the ultimate regulatory compliance cost.  Freezing hiring.  And business expansion.  Extending the Great Recession.  Causing the economy to spit and sputter along.  Like an engine that just won’t restart.

Typically when government over regulates it’s to reward their friends and cronies.  Hence the term crony capitalism.  Which isn’t even capitalism.  Crony capitalism is about getting rich by who you know in government.  Not by creating more value for less.  The government fixes the game by keeping prices high for their cronies.  By enacting regulations that increase the cost of competition.  Squelching any incentive to innovate.  Leaving consumers stuck paying more for less value.

When Government Interfered with Market Prices they gave us the Great Depression and the Great Recession

Free market prices assign value.  Allocate scarce resources that have alternative uses.  Provide incentive to innovate.  Encourage competition.  Incentive and competition.  The hallmark of capitalism.  Which ultimately provides consumers with more value at lower prices.  And it does all of this automatically.  As long as government doesn’t interfere with this automatic pricing mechanism.

But government often does.  They interfere with this automatic pricing mechanism to reward friends and cronies far too often.  When they do the economy suffers.  And often goes into recession.  And when they really interfere, they cause Great Depressions.  And Great Recessions.

Government regulatory policy turned an ordinary recession into the Great Depression.  One of their greatest anti-business regulations being the Smoot–Hawley Tariff Act.  Which launched an all out trade war.  Killing the economy.  And government regulatory policy in the mortgage industry caused the Great Recession.    First by creating a housing bubble by forcing lenders to qualify the unqualified.  And then enabling this bad policy on a grand scale by having Fannie Mae and Freddie Mac buy the resulting bad subprime mortgages.  Which removed all risk from the lenders so they kept on approving bad subprime mortgages.

Say what you will about the Great Depression and the Great Recession.  But what you can’t say is that they were market failures.  Because they weren’t.  Both were government-made.  Because it was government that interfered with market prices.  Not the free market.  And the consumers paid the price for their crony capitalism.

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