Capital Flows and Currency Exchange

Posted by PITHOCRATES - March 10th, 2014

Economics 101

(Originally published July 30th, 2012)

Before we buy a Country’s Exports we have to Exchange our Currency First

What’s the first thing we do when traveling to a foreign country?  Exchange our currency.  Something we like to do at our own bank.  Before leaving home.  Where we can get a fair exchange rate.  Instead of someplace in-country where they factor the convenience of location into the exchange rate.  Places we go to only after we’ve run out of local currency.  And need some of it fast.  So we’ll pay the premium on the exchange rate.  And get less foreign money in exchange for our own currency.

Why are we willing to accept less money in return for our money?  Because when we run out of money in a foreign country we have no choice.  If you want to eat at a McDonalds in Canada they expect you to pay with Canadian dollars.  Which is why the money in the cash drawer is Canadian money.  Because the cashier accepts payment and makes change in Canadian money.  Just like they do with American money in the United States.

So currency exchange is very important for foreign purchases.  Because foreign goods are priced in a foreign currency.  And it’s just not people traveling across the border eating at nice restaurants and buying souvenirs to bring home.  But people in their local stores buying goods made in other countries.  Before we buy them with our American dollars someone else has to buy them first.  Japanese manufacturers need yen to run their businesses.  Chinese manufacturers need yuan to run their businesses.  Indian manufacturers need rupees to run their businesses.  So when they ship container ships full of their goods they expect to get yen, yuan and rupees in return.  Which means that before anyone buys their exports someone has to exchange their currency first.

Goods flow One Way while Gold flows the Other until Price Inflation Reverses the Flow of Goods and Gold

We made some of our early coins out of gold.  Because different nations used gold, too, it was relatively easy to exchange currencies.  Based on the weight of gold in those coins.  Imagine one nation using a gold coin the size of a quarter as their main unit of currency.  And another nation uses a gold coin the size of a nickel.  Let’s say the larger coin weighs twice as much as the smaller coin.  Or has twice the amount of gold in it.  Making the exchange easy.  One big coin equals two small coins in gold value.  So if I travel to the country of small coins with three large gold coins I exchange them for six of the local coins.  And then go shopping.

The same principle follows in trade between these two countries.  To buy a nation’s exports you have to first exchange your currency for theirs.  This is how.  You go to the exporter country with bags of your gold coins.  You exchange them for the local currency.  You then use this local currency to pay for the goods they will export to you.  Then you go back to your country and wait for the ship to arrive with your goods.  When it arrives your nation has a net increase in imported goods (i.e., a trade deficit).  And a net decrease in gold.  While the other nation has a net increase in exported goods (i.e., a trade surplus).  And a net increase in gold.

The quantity theory of money tells us that as the amount of money in circulation increases it creates price inflation.  Because there’s more of it in circulation it’s easy to get and worth less.  Because the money is worth less it takes more of it to buy the same things it once did.  So prices rise.  As prices rise in a nation with a trade surplus.  And fall in a nation with a trade deficit.  Because less money in circulation makes it harder to get and worth more.  Because the money is worth more it takes less of it to buy the same things it once did.  So prices fall.  This helps to make trade neutral (no deficit or surplus).  As prices rise in the exporter nation people buy less of their more expensive exports.  As prices fall in an importer nation people begin buying their less expensive exports.  So as goods flow one way gold flows the other way.  Until inflation rises in one country and eventually reverses the flow of goods and gold.  We call this the price-specie flow mechanism.

In the Era of Floating Exchange Rates Governments don’t have to Act Responsibly Anymore

This made the gold standard an efficient medium of exchange for international trade.  Whether we used gold.  Or a currency backed by gold.  Which added another element to the exchange rate.  For trading paper bills backed by gold required a government to maintain their domestic money supply based on their foreign exchange rate.  Meaning that they at times had to adjust the number of bills in circulation to maintain their exchange rate.  So if a country wanted to lower their interest rates (to encourage borrowing to stimulate their economy) by increasing the money supply they couldn’t.  Limiting what governments could do with their monetary policy.  Especially in the age of Keynesian economics.  Which was the driving force for abandoning the gold standard.

Most nations today use a floating exchange rate.  Where countries treat currencies as commodities.  With their own supply and demand determining exchange rates.  Or a government’s capital controls (restricting the free flow of money) that overrule market forces.  Which you can do when you don’t have to be responsible with your monetary policy.  You can print money.  You can keep foreign currency out of your county.  And you can manipulate your official exchange rate to give you an advantage in international trade by keeping your currency weak.  So when trading partners exchange their currency with you they get a lot of yours in exchange.  Allowing them to buy more of your goods than they can buy from other nations with the same amount of money.  Giving you an unfair trade advantage.  Trade surpluses.  And lots of foreign currency to invest in things like U.S. treasury bonds.

The gold standard gave us a fixed exchange rate and the free flow of capital.  But it limited what a government could do with its monetary policy.  An active monetary policy will allow the free flow of capital but not a fixed exchange rate.  Capital controls prevent the free flow of capital but allows a fixed exchange rate and an active monetary policy.  Governments have tried to do all three of these things.  But could never do more than two.  Which is why we call these three things the impossible trinity.  Which has been a source of policy disputes within a nation.  And between nations.  Because countries wanted to abandoned the gold standard to adopt policies that favored their nation.  And then complained about nations doing the same thing because it was unfair to their own nation.  Whereas the gold standard made trade fair.  By making governments act responsible.  Something they never liked.  And in the era of floating exchange rates they don’t have to act responsibly anymore.

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Federal Reserve System, Great Depression, Banking Crises, Gold Reserves, Gold Exchange Standard, Interest Rates and Money Supply

Posted by PITHOCRATES - July 31st, 2012

History 101

The Gold Exchange Standard provided Stability for International Trade

Congress created the Federal Reserve System (the Fed) with the passage of the Federal Reserve Act in 1913.  They created the Fed because of some recent bad depressions and financial panics.  Which they were going to make a thing of the past with the Fed.  It had three basic responsibilities.  Maximize employment.  Stabilize prices.  And optimize interest rates.  With the government managing these things depressions and financial panics weren’t going to happen on the Fed’s watch.

The worst depression and financial panic of all time happened on the Fed’s watch.  The Great Depression.  From 1930.  Until World War II.  A lost decade.  A period that saw the worst banking crises.  And the greatest monetary contraction in U.S. history.  And this after passing the Federal Reserve Act to prevent any such things from happening.  So why did this happen?  Why did a normal recession turn into the Great Depression?  Because of government intervention into the economy.  Such as the Smoot-Hawley Tariff Act that triggered the great selloff and stock market crash.  And some really poor monetary policy.  As well as bad fiscal policy.

At the time the U.S. was on a gold exchange standard.  Paper currency backed by gold.  And exchangeable for gold.  The amount of currency in circulation depended upon the amount of gold on deposit.  The Federal Reserve Act required a gold reserve for notes in circulation similar to fractional reserve banking.  Only instead of keeping paper bills in your vault you had to keep gold.  Which provided stability for international trade.  But left the domestic money supply, and interest rates, at the whim of the economy.  For the only way to lower interest rates to encourage borrowing was to increase the amount of gold on deposit.  For with more gold on hand you can increase the money supply.  Which lowered interest rates.  That encouraged people to borrow money to expand their businesses and buy things.  Thus creating economic activity.  At least in theory.

The Fed contracted the Money Supply even while there was a Positive Gold Flow into the Country

The gold standard worked well for a century or so.  Especially in the era of free trade.  Because it moved trade deficits and trade surpluses towards zero.  Giving no nation a long-term advantage in trade.  Consider two trading partners.  One has increasing exports.  The other increasing imports.  Why?  Because the exporter has lower prices than the importer.  As goods flow to the importer gold flows to the exporter to pay for those exports.  The expansion of the local money supply inflates the local currency and raises prices in the exporter country.  Back in the importer country the money supply contracts and lowers prices.  So people start buying more from the once importing nation.  Thus reversing the flow of goods and gold.  These flows reverse over and over keeping the trade deficit (or surplus) trending towards zero.  Automatically.  With no outside intervention required.

Banknotes in circulation, though, required outside intervention.  Because gold isn’t in circulation.  So central bankers have to follow some rules to make this function as a gold standard.  As gold flows into their country (from having a trade surplus) they have to expand their money supply by putting more bills into circulation.  To do what gold did automatically.  Increase prices.  By maintaining the reserve requirement (by increasing the money supply by the amount the gold deposits increased) they also maintain the fixed exchange rate.  An inflow of gold inflates your currency and an outflow of gold deflates your currency.  When central banks maintain this mechanism with their monetary policy currencies remain relatively constant in value.  Giving no price advantage to any one nation.  Thus keeping trade fair.

After the stock market crash in 1929 and the failure of the Bank of the United States in New York failed in 1930 the great monetary contraction began.  As more banks failed the money they created via fractional reserve banking disappeared.  And the money supply shrank.  And what did the Fed do?  Increased interest rates.  Making it harder than ever to borrow money.  And harder than ever for banks to stay in business as businesses couldn’t refinance their loans and defaulted.  The Fed did this because it was their professional opinion that sufficient credit was available and that adding liquidity then would only make it harder to do when the markets really needed additional credit.  So they contracted the money supply.  Even while there was a positive gold flow into the country.

The Gold Standard works Great when all of your Trading Partners use it and they Follow the Rules

Those in the New York Federal Reserve Bank wanted to increase the money supply.  The Federal Reserve Board in Washington disagreed.  Saying again that sufficient credit was available in the market.  Meanwhile people lost faith in the banking system.  Rushed to get their money out of their bank before it, too, failed.  Causing bank runs.  And more bank failures.  With these banks went the money they created via fractional reserve banking.  Further deflating the money supply.  And lowering prices.  Which was the wrong thing to happen with a rising gold supply.

Well, that didn’t last.  France went on the gold standard with a devalued franc.  So they, too, began to accumulate gold.  For they wanted to become a great banking center like London and New York.  But these gold flows weren’t operating per the rules of a gold exchange.  Gold was flowing generally in one direction.  To those countries hoarding gold.  And countries that were accumulating gold weren’t inflating their money supplies to reverse these flows.  So nations began to abandon the gold exchange standard.  Britain first.  Then every other nation but the U.S.

Now the gold standard works great.  But only when all of your trading partners are using it.  And they follow the rules.  Even during the great contraction of the money supply the Fed raised interest rates to support the gold exchange.  Which by then was a lost cause.  But they tried to make the dollar strong and appealing to hold.  So people would hold dollars instead of their gold.  This just further damaged the U.S. economy, though.  And further weakened the banking system.  While only accelerating the outflow of gold.  As nations feared the U.S. would devalue their currency they rushed to exchange their dollars for gold.  And did so until FDR abandoned the gold exchange standard, too, in 1933.  But it didn’t end the Great Depression.  Which had about another decade to go.

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Capital Flows and Currency Exchange

Posted by PITHOCRATES - July 30th, 2012

Economics 101

Before we buy a Country’s Exports we have to Exchange our Currency First

What’s the first thing we do when traveling to a foreign country?  Exchange our currency.  Something we like to do at our own bank.  Before leaving home.  Where we can get a fair exchange rate.  Instead of someplace in-country where they factor the convenience of location into the exchange rate.  Places we go to only after we’ve run out of local currency.  And need some of it fast.  So we’ll pay the premium on the exchange rate.  And get less foreign money in exchange for our own currency.

Why are we willing to accept less money in return for our money?  Because when we run out of money in a foreign country we have no choice.  If you want to eat at a McDonalds in Canada they expect you to pay with Canadian dollars.  Which is why the money in the cash drawer is Canadian money.  Because the cashier accepts payment and makes change in Canadian money.  Just like they do with American money in the United States.

So currency exchange is very important for foreign purchases.  Because foreign goods are priced in a foreign currency.  And it’s just not people traveling across the border eating at nice restaurants and buying souvenirs to bring home.  But people in their local stores buying goods made in other countries.  Before we buy them with our American dollars someone else has to buy them first.  Japanese manufacturers need yen to run their businesses.  Chinese manufacturers need yuan to run their businesses.  Indian manufacturers need rupees to run their businesses.  So when they ship container ships full of their goods they expect to get yen, yuan and rupees in return.  Which means that before anyone buys their exports someone has to exchange their currency first.

Goods flow One Way while Gold flows the Other until Price Inflation Reverses the Flow of Goods and Gold

We made some of our early coins out of gold.  Because different nations used gold, too, it was relatively easy to exchange currencies.  Based on the weight of gold in those coins.  Imagine one nation using a gold coin the size of a quarter as their main unit of currency.  And another nation uses a gold coin the size of a nickel.  Let’s say the larger coin weighs twice as much as the smaller coin.  Or has twice the amount of gold in it.  Making the exchange easy.  One big coin equals two small coins in gold value.  So if I travel to the country of small coins with three large gold coins I exchange them for six of the local coins.  And then go shopping.

The same principle follows in trade between these two countries.  To buy a nation’s exports you have to first exchange your currency for theirs.  This is how.  You go to the exporter country with bags of your gold coins.  You exchange them for the local currency.  You then use this local currency to pay for the goods they will export to you.  Then you go back to your country and wait for the ship to arrive with your goods.  When it arrives your nation has a net increase in imported goods (i.e., a trade deficit).  And a net decrease in gold.  While the other nation has a net increase in exported goods (i.e., a trade surplus).  And a net increase in gold.

The quantity theory of money tells us that as the amount of money in circulation increases it creates price inflation.  Because there’s more of it in circulation it’s easy to get and worth less.  Because the money is worth less it takes more of it to buy the same things it once did.  So prices rise.  As prices rise in a nation with a trade surplus.  And fall in a nation with a trade deficit.  Because less money in circulation makes it harder to get and worth more.  Because the money is worth more it takes less of it to buy the same things it once did.  So prices fall.  This helps to make trade neutral (no deficit or surplus).  As prices rise in the exporter nation people buy less of their more expensive exports.  As prices fall in an importer nation people begin buying their less expensive exports.  So as goods flow one way gold flows the other way.  Until inflation rises in one country and eventually reverses the flow of goods and gold.  We call this the price-specie flow mechanism.

In the Era of Floating Exchange Rates Governments don’t have to Act Responsibly Anymore

This made the gold standard an efficient medium of exchange for international trade.  Whether we used gold.  Or a currency backed by gold.  Which added another element to the exchange rate.  For trading paper bills backed by gold required a government to maintain their domestic money supply based on their foreign exchange rate.  Meaning that they at times had to adjust the number of bills in circulation to maintain their exchange rate.  So if a country wanted to lower their interest rates (to encourage borrowing to stimulate their economy) by increasing the money supply they couldn’t.  Limiting what governments could do with their monetary policy.  Especially in the age of Keynesian economics.  Which was the driving force for abandoning the gold standard.

Most nations today use a floating exchange rate.  Where countries treat currencies as commodities.  With their own supply and demand determining exchange rates.  Or a government’s capital controls (restricting the free flow of money) that overrule market forces.  Which you can do when you don’t have to be responsible with your monetary policy.  You can print money.  You can keep foreign currency out of your county.  And you can manipulate your official exchange rate to give you an advantage in international trade by keeping your currency weak.  So when trading partners exchange their currency with you they get a lot of yours in exchange.  Allowing them to buy more of your goods than they can buy from other nations with the same amount of money.  Giving you an unfair trade advantage.  Trade surpluses.  And lots of foreign currency to invest in things like U.S. treasury bonds.

The gold standard gave us a fixed exchange rate and the free flow of capital.  But it limited what a government could do with its monetary policy.  An active monetary policy will allow the free flow of capital but not a fixed exchange rate.  Capital controls prevent the free flow of capital but allows a fixed exchange rate and an active monetary policy.  Governments have tried to do all three of these things.  But could never do more than two.  Which is why we call these three things the impossible trinity.  Which has been a source of policy disputes within a nation.  And between nations.  Because countries wanted to abandoned the gold standard to adopt policies that favored their nation.  And then complained about nations doing the same thing because it was unfair to their own nation.  Whereas the gold standard made trade fair.  By making governments act responsible.  Something they never liked.  And in the era of floating exchange rates they don’t have to act responsibly anymore.

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The Gold Standard

Posted by PITHOCRATES - March 12th, 2012

Economics 101

As long as Imports equal Exports the Balance in the Trade Account is Zero and there is no Trade Deficit or Surplus 

Imagine two wine shops in an affluent suburb.  Let’s call one Fine Wines.  And the other The Wine Shoppe.  They both feature a wide selection of wines from around the world.  And each specializes in wines from a specific region.  So they sell much of the same wines.  But some of the most exclusive and most expensive wines can only be found at one store or the other.  Now wine retailers typically have a loyal clientele.  There is a relationship between proprietor and customer.  To enhance the wine drinking experience.  So proprietors will cater to their customers to keep them as customers.  And provide whatever wine they wish.  Even if they don’t stock it.  Or don’t have a normal purchasing channel to the wine they wish to buy.

Both stores have similar relationships with their clientele.  And they share something else in common.  The wines one seller doesn’t sell the other seller sells.  Which produces a special relationship between these two stores.  They buy and sell wines from each other as needed to meet the needs of their customers.  So customers at either store can purchase any wine they sell in both stores.  Allowing each store to maintain their special proprietor-customer relationship.  Without losing customers to the other store.

Most of the time the value of the wine they buy and sell from each other in these inter-store sales net out.  Sometimes one store owes the other.  And vice versa.  But it usually isn’t much.  And the stores take turns owing each other.  The overall cost for this inter-store trade is negligible.  And pleases customers at both stores.  So maintaining this trade is a win-win.  With no negative impact on either store’s business.  As long as ‘imports’ equal ‘exports’.  And the balance in this ‘trade account’ is kept close to zero.  So they continue to ‘trade’ bottles of wine.  Without exchanging any money.  Most of the time, that is.  Until a trade deficit develops.  

If the Currency is Backed by Gold the only way to create new Dollars is to put more Gold into the Vault 

Let’s say for whatever reason Fine Wines runs a trade deficit.  Fine Wines sells more of The Wine Shoppe wines than The Wine Shoppe sells of theirs.  Which means Fine Wines imports more from The Wine Shoppe than they export to The Wine Shoppe.  Creating the trade deficit.  They’re not trading bottles for bottles anymore.  Fine Wines delivers one case of wine to The Wine Shoppe and returns with 3 cases.  And now has an outstanding balance owed to The Wine Shoppe.  Which they must settle by sending money to The Wine Shoppe.  If sales continue like this Fine Wines will become a net importer and run chronic trade deficits.  While The Wine Shoppe will become a net exporter.  And have a running trade surplus.

If the clientele of Fine Wines keeps buying the imported wine from The Wine Shoppe instead of the ‘domestic’ Fine Wines, Fine Wines will have cash problems.  Because they owe their distributors for the wine they bought and stocked.  But when they sell The Wine Shoppe’s wine it doesn’t bring any cash into their store.  Because Fine Wines has to give that money to The Wine Shoppe.  For it was, after all, The Wine Shoppe’s wine that Fine Wines sold.  That they sold as a courtesy to their customers.  To keep them loyal customers.  So a portion of their total sales doesn’t even count as income (income = total sales – imports).  And if Fine Wines divides their income by the total number of bottles they sold they see a sad truth.  The impact of those imports has lowered the average price per bottle of wine.  This price deflation will make it very difficult to pay the bills they incurred before this deflation.  As they are now selling wine at lower prices than they paid for it from their distributors.

And that’s similar to how the gold standard works.  We back the money in circulation (i.e., the money supply) by gold.  Which we lock away in some vault.  To increase the money supply you need to increase the gold supply.  To decrease the money supply you need to decrease the gold supply.  This makes it very difficult for governments to be irresponsible and print money.  Because if the currency is backed by gold the only way to create new dollars is to put more gold into that vault.  Ergo, responsible government spending.  And an automatic mechanism to fix trade deficits.

Fixed Exchange Rates based on Gold made International Trade Simple and Fair

This is where our wine stores example comes in.  If a government runs a trade deficit under the gold standard gold moves between countries.  Just like money did between the two wine stores.  And a net exporter of gold (a net importer of goods paying for the resulting trade deficit with gold) will see a reduction in price levels.  Just like Fine Wines did.  (And the net importer of gold will see the opposite).  But here’s what else happens.  Those lower prices now make the importer more cost competitive.  (And the higher prices make the exporter less competitive).  Because people prefer buying less expensive things.  So the net importer’s sales increase thanks to lower prices.  While the net exporter’s sales decrease because of higher prices.  Moving the balance in the trade account back towards zero.  Where it will always try to be under normal market conditions. 

This built-in responsibility didn’t stop governments from misbehaving, though.  And some have printed more money than they had the gold reserves to back it.  For governments like to spend money.  Especially when they’re trying to buy votes.  So they have turned on those printing presses at times.  And increased the money supply.  Without putting more gold into the vault.  The result?  A larger money supply backed by the same amount of gold?  It depreciated the currency by inflating the money supply.  Which can be a problem when the money is backed by gold.  Especially when you have an exchange rate based on gold.

To buy goods from a foreign country you first exchanged your currency for theirs.  Because you buy foreign goods in the foreign currency.  And you based this exchange rate on gold.  And fixed each currency to an amount of gold.  Which made this currency exchange simple.  And fair.  Unless someone was depreciating their currency by printing it without putting more gold into the vault.  But if they did other nations would find out.  And stop exchanging their currency for the depreciated currency which would buy less.  They, instead, exchanged the foreign currency they had for gold instead.  So they could buy more.  Exchanging a depreciated currency at an exchange rate based on a non-depreciated currency.  Leaving the nation with a swollen money supply full of a depreciated currency.  And no gold.  Giving the nation runaway inflation.  And a crashed economy.  A very strong incentive not to depreciate your currency while on a gold standard.

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Monetarism, Laissez-Faire Capitalism, Augusto Pinochet, Chile, Hyperinflation, El Ladrillo, Chicago Boys, Milton Friedman and Miracle of Chile

Posted by PITHOCRATES - March 6th, 2012

History 101

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. 

www.PITHOCRATES.com

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