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.


Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

LESSONS LEARNED #25: “War is costly. Peace, too.” -Old Pithy

Posted by PITHOCRATES - August 5th, 2010

AT THE HEIGHT of the Roman Empire, the empire reached from North Africa to Britannia (England), from Hispania (Spain) to Mesopotamia (approximately modern day Iraq).  When Roman power ruled the civilized world, there was peace.  The Pax Romana (Roman Peace).  The Romans built empire through conquest.  And Rome grew rich with the spoils of conquest.  For awhile, peace was only those quiet intervals between growth and conquest.  But with secure borders, a uniform government, a rule of law, a stable currency, bustling trade & markets and a military to be the world’s policeman, peace broke out.  For some 200 years.

Life was good for the Roman citizen.  As well as for those living in the empire.  The Romans modernized the provinces they conquered.  Made life better.  Even for the conquered people.  Although there were those who hated being subjugated by a foreign power.

Reg: They bled us white, the bastards. They’ve taken everything we had. And not just from us! From our fathers, and from our father’s fathers.

Loretta: And from our father’s father’s fathers.

Reg: Yeah.

Loretta: And from our father’s father’s father’s fathers.

Reg: Yeah, all right Stan, don’t belabor the point. And what have they ever given us in return?

Revolutionary I: The aqueduct?

Reg: What?

Revolutionary I: The aqueduct.

Reg: Oh. Yeah, yeah, they did give us that, ah, that’s true, yeah.

Revolutionary II: And the sanitation.

Loretta: Oh, yeah, the sanitation, Reg. Remember what the city used to be like.

Reg: Yeah, all right, I’ll grant you the aqueduct and sanitation, the two things the Romans have done.

Matthias: And the roads.

Reg: Oh, yeah, obviously the roads. I mean the roads go without saying, don’t they? But apart from the sanitation, the aqueduct, and the roads…

Revolutionary III: Irrigation.

Revolutionary I: Medicine.

Revolutionary IV: Education.

Reg: Yeah, yeah, all right, fair enough.

Revolutionary V: And the wine.

All revolutionaries except Reg: Oh, yeah! Right!

Rogers: Yeah! Yeah, that’s something we’d really miss Reg, if the Romans left. Huh.

Revolutionary VI: Public bathes.

Loretta: And it’s safe to walk in the streets at night now, Reg.

Rogers: Yeah, they certainly know how to keep order. Let’s face it; they’re the only ones who could in a place like this.

All revolutionaries except Reg: Hahaha…all right…

Reg: All right, but apart from the sanitation, the medicine, education, wine, public order, irrigation, roads, the fresh-water system and public health, what have the Romans ever done for us?

Revolutionary I: Brought peace?

Reg: Oh, peace! Shut up!

(From Monty Python’s The Life of Brian, 1979.)

Maintaining a peaceful empire is costly.  As people got more accustomed to peace and plenty, they began to complain about taxes.  Citizens refused to volunteer to serve in the Roman Legions maintaining that peace.  Barbarians began to serve in the Legions.  Some rose to command them.  Some Roman commanders came from the very people they were fighting in the border regions.  Soon Rome would rely on mercenaries (hired soldiers) to defend their borders.  All of this cost the empire.  It had to pay more and more to maintain the loyalty of the military.  Ditto for the huge bureaucracy administrating the empire.  And they lost control.  Trouble on the borders and economic collapse ended the peace.  And, ultimately, the empire.  The civilized world broke down and collapsed.  And barbarian leaders on the borders, hungry for conquest, attacked.  Plunging the former Roman provinces into war and instability.

RISING FROM THE ashes of the Roman Empire were the seeds of new empires.  And the ground that proved most fertile was the northern limit of the old empire.  England.

England started to assert herself with the growth of her navy.  With her borders secured, a uniform government, a rule of law, a stable currency, bustling trade & markets and a military to be the world’s policeman, peace broke out.  Again.  For about a hundred years.  During the Industrial Revolution.  After the defeat of Napoleon. 

Imperial Britain stretched across the globe.  The sun never set on the British Empire.  And wherever she went, she brought the rule of law, modernity, a sound economy and political stability.  Her old colonial possessions went on to be some of the richest, most prosperous and peaceful nations in the world.  India.  Australia.  New Zealand.  South Africa.  Canada.  And, of course, the United States of America.  She achieved her century of peace (Pax Britannia) by a balance of power.  She maintained peace by intervening in disputes, often on the side of the weaker nation.  She prevented stronger, aggressive nations from threatening her weaker neighbors.   And she provided a safe environment for the weaker nation to live peacefully in the shadows of stronger, more aggressive neighbors.

For a hundred years Britannia kept the peace.  In large part due to her Royal Navy, the most powerful and potent navy at the time.  If you ate any imported food or used any imported goods, it was thanks to the Royal Navy that kept the world’s sea lanes safe.  But this peace came with a price.  The rise of nationalism, the quest of new empires to establish their own overseas colonies and a change in the balance of power in Europe with the rise of Germany added to that price.  And then a shot fired in Sarajevo by a Serbian terrorist ignited a tinderbox.  The assassination of Archduke Franz Ferdinand by Gavrilo Princip started World War I.  The most bloody and expensive war at the time, it bankrupted Great Britain and ended her empire.  And left the world a less safe place. 

From the ashes of World War I rose new leaders with aspirations of world conquest.  Fascist Italy led by Benito Mussolini.  Nazi Germany led by Adolf Hitler.  Communist Russia led by Joseph Stalin.  Imperial Japan led by Hideki Tojo.  And the nation that led the victors in World War II would, by default, become the new world power.  The new world policeman.  The United States of America.

SO WHAT HAPPENED during the inter-war years that led to World War II?  War exhausted Britain and France.  Neither had the stomach for another war.  Britain continued to rely on the Royal Navy for protection (as an island nation, sea power is indispensable).  France built fixed fortifications (the Maginot Line).  Both were primarily defensive strategies. 

In America, General Billy Mitchell demonstrated the vulnerability of battleships to air power by sinking a battleship with an airplane (greatly flustering the naval high command).  Colonel George S. Patton developed an armored doctrine for an unenthused army and eventually transferred back to the horse cavalry.  Meanwhile, Imperial Japan was building aircraft carriers.  And Nazi Germany, Fascist Italy and Communist Russia developed air and armored doctrine while fighting in the Spanish Civil War.

Fascist Italy attacked Ethiopia in 1935 to rebuild the Roman Empire and make the Mediterranean Sea a Roman lake once again.  Nazi Germany launched World War II in 1939 by an armored assault on Poland with tactical air support.  Poland resisted with horse cavalry.  And lost.  Imperial Japan attacked Pearl Harbor in 1941 to destroy American naval power in the Pacific.  They did a lot of damage.  But the American carriers, their prime objective, were at sea.  They would eventually meet those carriers later at the Battle of Midway.  Where they would lose four of their best carriers and many of their best aviators.  This tipped the balance of power in the Pacific to the Americans.

America was ill-prepared for war.  But American industry, the Arsenal of Democracy, ramped up and built the planes, tanks, guns, rifles and ships that would win the war.   It would come with a heavy price tag.  Global wars typically do.  Had there been a balance of power that would have checked the territorial ambitions of the aggressor nations, it would have been a different story.  Of course, having the power is one thing.  How you use it is another. 

France had more tanks than Germany before the outbreak of hostilities.  But the Nazis quickly overran France.  Why?  Doctrine.  France’s doctrine was to hide behind the security of the Maginot Line.  It was a defensive-only strategy.  She developed no armored doctrine.  The lesson they learned from World War I was that armies killed themselves attacking fixed defenses.  Germany, too, learned that lesson.  So their doctrine called for going around fixed defenses with fast-moving armor spearheads with tactical air support (i.e., blitzkrieg).  Formidable though the Maginot Line was, it could not attack.  And if the Nazis didn’t attack it, it did nothing but concentrate men and firepower away from the battle.

WHEN WE PULLED out of South Vietnam, we agreed to use American air power if North Vietnam violated the terms of the treaty ending that war.  Watergate changed all of that.  Even though JFK got us into Vietnam, it became Nixon’s war.  And a vindictive Congress wouldn’t have anything more to do with it.  The North tested the American will.  Saw that there was none.   Attacked.  And overran South Vietnam.  The message was clear to tyrants.  America will quit in the long run.  Especially after a large loss of life.

Other ‘retreats’ would reinforce this perception.  Especially in the Arab world.  The withdrawal from Lebanon after the bombing of the Marines’ barracks.  The withdrawal from Somalia after the Somalis dragged dead American troops through the streets of Mogadishu.  The Arab world even saw the victory in Desert Storm as a retreat.  The anti-American Arab world said that our invasion was about oil.  That what we really wanted was to topple Saddam Hussein and take his oil.  It was just another Christian Crusade into holy Islamic lands.  When we didn’t do that, the Arab world saw it as another American retreat.  That America didn’t have the will to endure a bloody battle to conquer Iraq. 

So some in the Arab world would test America.  Al Qaeda.  Headed by Osama bin Laden.  They started small and became more daring.  World Trade Center bombing.  Tanzanian Embassy bombing.  Kenyan Embassy bombing.  Khobar Towers bombing.  The USS Cole attack.  And they paid little for these attacks.  America didn’t fight back.  But their luck ran out on September 11, 2001.  Because America finally fought back.

PUBLIC ENEMY NUMBER one, Osama bin Laden, belonged to the conservative Sunni sect of Islam called Wahhabi.  They have a large following in Saudi Arabia.  The Wahhabi have a delicate relationship with the Saudi Royal family.  They disapprove of the Western displays of wealth in the House of Saud. 

Al-Qaeda was a shadowy enemy.  We confronted them in the mountains of Afghanistan where the Taliban gave them a safe sanctuary.  We attacked.  Knocked the Taliban from power.  Drove al-Qaeda underground.  But we could not stop their funding.

Wahhabi money from Saudi Arabia financed 9/11.  And the money continued to flow.  The Saudis would not intervene on behalf of America.  They feared any crackdown on the Wahhabi could unleash a civil war.  So America needed leverage to get Saudi cooperation.  And they found it in an old nemesis, Saddam Hussein. 

A Sunni minority ruled Iraq.  The Saudis did not like Saddam Hussein.  However, they liked the balance of power he offered to Iran.  Iran was Shiite.  As much as the Saudis did not like Saddam, they disliked Shiite Iran more.  This was the American lever.

After some diplomatic gymnastics, the invasion of Iraq was set.  The Saudis thought we were bluffing.  They didn’t believe we would invade Iraq.  Never in a million years.  If we didn’t do it in Desert Storm when we had the force in place to do it and didn’t, there was no way the Americans would amass another coalition and redeploy forces to the region again.  Especially because America doesn’t like long, drawn out, bloody wars.  Which an invasion of Iraq would surely be.

They asked us to remove our forces from the Saudi bases.  We did.  Now they were getting nervous.  That was the political game.  Make some noise to show the Arab world you weren’t an American toady.  But, secretly, you want those American forces to remain.  That American presence did provide security.  And stability.  After the invasion of Kuwait, it sure looked like Saudi Arabia would be next.  It was only that large American force in the desert that changed that inevitability. 

The Americans invaded.  And conquered.  Now the Saudis had a vested interest in helping the Americans.  They needed them to be successful in Iraq.  To contain Iran.  The lever worked.  The Saudis stemmed the flow of Wahhabi money to al-Qaeda.  The invasion of Iraq proved to be one of the most effective battles in the war on terrorism.  

HISTORY HAS SHOWN that a balance of power can lead to peace.  It has also shown that a superpower can enforce a larger peace.  But it also has shown that there is good and bad when it comes to power.  The Romans could be cruel, but so were most in that time.  The road to empire, after all, started out simply as a quest to provide a buffer between Rome and the hostile barbarians on her borders.  Rome, then, expanded in pursuit of peace.  (Initially, at least.)  And then used her power to maintain peace.

Many view Great Britain as the successor to the Roman Empire.  And many view America as the successor to the British Empire.  These powers share many things (rule of law, an advanced civilization, political stability, etc.).  Perhaps the greatest, though, is a powerful military.  And how it was/is used.  As a powerful deterrent to an aggressor nation.  To protect trade routes.  To maintain peace.  Malign these empires/nations all you will, but the greatest periods of world peace were due to their military power.  And their will to use that military power.  Expensive as that was.  Is.

So, yes, wars are costly.  Peace, too.  Sometimes, though, we must fight wars.  But we can avoid a lot of them.  By a peace-time military force that acts as a deterrent.  Because there are bad guys out there.  Who only respect one thing.  And it isn’t diplomacy.  Often the only thing preventing them from waging a cruel war of conquest is a potent military and a willing leader to use it.  If a tyrant knows he will face a military consequence for acting, he may not act.  When he knows that consequence will be devastating, he will not act.  But if he knows a nation hasn’t the military power or the will to use military power, he will act.  Just as Hitler did.  As Mussolini did.  As Tojo did.  And as Osama bin Laden did.


Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,