Financial Markets: Recent Episodes
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Financial Markets includes works on the stock market and other financial markets. Historical and theoretical studies are included. Investment is covered here.
In this week's episode, Mark looks at PPI—the Producer Price Index—which provides evidence of the costs for suppliers in various industries, macroeconomic instability, and the potential for economic recovery. Here, very low prices provide the potential for recovery; and rising prices can indicate both recovery in the economy, as well as inflationary pressures moving forward. The Covid Bubble and restrictions caused a 50% increase in producer prices, and since the peak in 2022, PPI has only corrected about 10%.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
"Producer Price Index by Commodity: All Commodities" (PPIACO): Mises.org/Minor_PPI
Peter Lewin joins Bob to discuss his work with Nicolás Cachanosky on uniting Austrian capital theory with mainstream finance.
Peter's New Book on Capital and Finance: Mises.org/LewinBookJoin us in Nashville on September 23rd for a no-holds-barred discussion against the regime. Use Code "HA23" for $45 off admission: Mises.org/Nashville23
Mark Thornton joins Ryan and Tho on Radio Rothbard to take a closer look at the state of the US dollar and how price inflation and economic crises are likely to play out in the months and years ahead.
New Radio Rothbard mugs are now available at the Mises Store. Get yours at Mises.org/RothMug
PROMO CODE: RothPod for 20% off
In this week's episode, Mark looks back at the history of the Inverted Yield Curve. While many observers have now dismissed the significance of the yield curve inversion in 2022—and no recession, yet—Mark shows that the history of the IYC may back a completely opposite interpretation.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
As we enter the dog days of summer, I have heard several media conversations and a few private ones that express exasperation over languishing capital markets. Why do things take so long to unravel? What will happen next? When will X, Y, or Z happen? Why are tech stocks so bullish now? The market takes time to process the information that it already has — or is in "process" — and everyday brings new data.
The Austrian perspective highlights the role of reality in the market process. This is especially important in this period of unprecedented government intervention and the chaos it has generated in markets.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
While talk of high gas prices is no longer a headline issue, energy economics is still a vitally important aspect of understanding the economy, including the business cycle. Mark explains the basics, tells us where we now stand, and what the major implications are for the near future.
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Be sure to follow Minor Issues at Mises.org/MinorIssues.
Despite the soothing hot air from the White House and Fed officials, the financial system is becoming increasingly fragile and unstable. Maybe all of that intervention the past decade was not wise.
Original Article: "Finance Discovers Sting: "How Fragile We Are""
Mark takes a look at all the wrong predictions of recession in recent years, including those of Austrian School economists. While the MSM and Fed officials try to downplay the coming of a recession, many of the statistics and facts that Austrian consider important are indicating a looming recession, if not a full-blown economic crisis.
Check out Anatomy of the Crash: The Financial Crisis of 2020, edited by Tho Bishop: Mises.org/AnatomyOfTheCrash
Be sure to follow Minor Issues at Mises.org/MinorIssues.
This episode of Good Money with Tho Bishop features guest Ryan Griggs of Griggs Capital Strategies. During the show, Ryan discusses his work with Bob Murphy on an Austrian understanding of inverted yield curves as a signal for recessions and how it differs from the mainstream analysis. He also discusses Nelson Nash's infinite banking strategy as a means for capital accumulation, in contrast to traditional investment approaches.
Ryan and Bob Murphy on the Austrian understanding of inverted yield curves: Mises.org/GM7aGriggs Capital Strategies: Mises.org/GM7b
On this episode of Radio Rothbard, Ryan McMaken and Tho Bishop tackle the debt ceiling debate. As negotiations continue in Washington, the corporate financial press is hard at work warning about the potential for disaster. Ryan and Tho cut through the nonsense to look at the real state of America's finances, potential ramifications in the short term, and US defaults of the past and the inevitable future.
New Radio Rothbard mugs are now available at the Mises Store. Get yours at Mises.org/RothMug
PROMO CODE: RothPod for 20% off
Recommended Reading"Three Lies They're Telling You about the Debt Ceiling" by Ryan McMaken: Mises.org/RR_135_A
"Yes, the US Government Has Defaulted Before" by Ryan McMaken: Mises.org/RR_135_B
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
In this week's episode, Mark explains why the market for existing homes has been diverging from the market for new houses. The Fed ZIRP, QE and Covid bailouts have locked Americans into their mortgages and low payments, reducing the supply of existing homes. This keeps them off the market and home prices high in an economy that is headed for a recession or crisis. Buyers have been diverted to newly constructed homes where builders have more flexibility to sell and there are no existing homeowners locked into mortgages.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
After a long series of rate hikes, Fed officials and asset markets are expecting a long series of interest rate cuts. This is based on the tried and hue Phillips Curve analysis. In color theory, "hue" is the technical appearance of color that can be described mechanically as a number. Let's hope interest rate expectations are not being distorted by other factors of reality, and that current Phillips Curve model perceptions of hue are also true.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Bank reserves are seldom mentioned except in cases of bank runs. The other possible mention is all the interest money the Fed pays to banks simply for holding reserves. Mark explains the role of bank reserves in the current "system" and gives a brief explanation of why the Austrian view is better and actually gets the job done.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Mark discusses something bigger than the Disney layoffs: the Wall Street Journal's April 25 frontpage article on investing in gold. It would seem that the recent rise of the price of gold is the result of tired, dumb, and disillusioned crypto currency investors throwing in the towel to "chase shiny new object—gold." Mark explains that the rational reasons for investing in gold loom larger than the entire Magic Kingdom!
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Ryan McMaken and Dr. Mark Thornton cover the state of the dollar as global reserve currency, and why employers are laying off more and more of their highest paid workers.
PROMO CODE: RothPod for 20% off
Subscribe to Mark's weekly Minor Issues podcast at Mises.org/MinorIssues.
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
Mark looks at the price of Apple stock—one of the best performing stocks over the last quarter century, and one of the largest holdings in stock indexes, mutual funds, and Berkshire Hathaway portfolio. Market watchers have kept a keen eye on Apple as it heads for a new all-time high; but, Mark is concerned that a downturn would have a huge ripple effect on the overall market—possibly equivalent to a tsunami.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Like the arsonist who then heroically fights the fire he set, the Fed is increasing its efforts to bail out banks both at home and abroad. This does not end well.
Original Article: "Is the Fed Trying to Bail Out the World? Sure Looks Like It"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Welcome to Whose Economy Is It, Anyway?, where the rules are made up and the dollars don’t matter. Or at least that seems to be the view of the Yellen regime.
Original Article: "A Bank Crisis Was Predictable. Was the Fed Lying or Blind?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
On the heels of rising stock markets, record low unemployment rates, and even the plunge in the price of gasoline, Mark discusses the latest government economic reports including the hot retail sales numbers, recent increases in the CPI, and the increases in business inventories. What can be made of these confusing numbers?
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Mark Thornton takes a look back at US stock markets, the national debt, and Fed policy (ZIRP, money supply, and its balance sheet).
"After the Boom Must Come the Bust" (Radio Rothbard): Mises.org/MI_06_A
Austrian Economic Research Conference: AustrianEconomics.org
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Mark Thornton looks at how much money Americans will spend on the Super Bowl this year and discusses the accuracy of the Super Bowl Stock Market Indicator.
Be sure to follow Minor Issues at Mises.org/MinorIssues.
Mises Institute scholar and Troy University business school Dean Allen Mendenhall is among the leading critics of woke capital. He leads a new initiative against the perverse investment practices demanded by ESG/DEI commissars, and joins Jeff Deist to discuss both the origins of "stakeholder" capitalism and what we can do to push back against ideological purity tests in capital markets and corporate America.
AllenMendenhall.com
"Troy University tackles 'woke' business practices head-on with new program": Mises.org/HAP382a
Back in January Jeff Deist joined the Austrian Economics Discord Server for a live event concerning trends in 2023. Jeff makes the case for viewing today's economy as quite unlike that of 2007—due to steady increases in CPI, more fiscal stimulus relative to monetary stimulus, and ongoing supply shock issues from COVID.
This is a far-ranging discussion of the landscape for the Fed, persistent inflation, and a looming recession. Includes Q and A from the audience.
Professor Per Bylund of Oklahoma State University, author of How to Think About the Economy joins Jeff and Bob to dissect how economics went so badly wrong. A discipline rooted in theory, axioms, and deduction has devolved into statistics, models, and hard science envy. Is the economics profession doing any good, or active harm?
Per's new book How to Think About the Economy: Mises.org/Primer
Gary North and Walter Block debate "Is it Smart to Get a PhD in Economics": Mises.org/HAP380a
Hunter Hastings of Economics for Business joins Jeff for a thoroughgoing discussion of how monetary and fiscal policy distort capital markets and create perverse incentives for financialization rather than real production.
Jeff Deist, "Does M&A benefit the economy?": Mises.org/HAP373-ARothbard's America's Great Depression: Mises.org/AGDThe Economics for Business Podcast: Mises.org/E4Bpod
As inflation ravages the economy, easy money is disappearing, with political and legal consequences to follow.
Original Article: "As Easy Money Crashes, the Political and Legal Effects Appear"
This Audio Mises Wire is generously sponsored by Christopher Condon.
American political, educational, and economic life is increasingly dominated by "experts." We should not be surprised that they fail most of the time.
Original Article: "Relying on Experts: A Proven Path to Failure"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The woes of Britain's financial sector have been exacerbated by UK financial regulators' failures.
Original Article: "The Near Collapse of the UK Pension Sector Exposes Failures by Financial Regulators"
This Audio Mises Wire is generously sponsored by Christopher Condon.
All of the excess of unproductive debt issued during the period of complacency will exacerbate the problem in 2023 and 2024.
Original Article: "Will Global Rate Hikes Set Off a Global Debt Bomb?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Ponzi game known as selling US government debt is nearing its end. The seller is running out of suckers.
Original Article: "The Petrodollar-Saudi Axis Is Why Washington Hates Iran"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
Typical teaching on stock prices says they are little more than a random walk. But people's purposeful actions are behind every economic transactions.
Original Article: "Short-Term Market Volatility Is Not Entirely Random"
This Audio Mises Wire is generously sponsored by Christopher Condon.
New York City’s subways have become a nightmare, with rampant crime, delays, derailments, and poorly capitalized. This is a gift from "backdoor socialism."
Original Article: "New York City Subways: The Woes of Socialist Enterprises"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The efficient market hypothesis, which is popular in neoclassical economics circles, holds that markets are so "efficient" that entrepreneurial profits are generated randomly.
Original Article: "Profits Are Not Random. They're How Entrepreneurs Help Allocate Resources Efficiently."
This Audio Mises Wire is generously sponsored by Christopher Condon.
High CPI inflation, popular explanations and their problems, and M1 vs. M2.
Download the slides from this lecture at Mises.org/MU22_PPT_33.
Recorded at the Mises Institute in Auburn, Alabama, on 28 July 2022.
It's going to take more than a 0 percent policy interest rate and a newly invented name for QE to really address years of monetary inflation.
Original Article: "Like the Fed, the ECB Is Still a Long Way from "Normal" Monetary Policy"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Jeff and Bob discuss the effect of rising interest rates on Uncle Sam's ability to service debt—and promote the increasingly less radical idea that a default on Treasury debt is both inevitable and good.
Jeff's article on rising rates: Mises.org/HAP351-1 House Budget Committee report on higher interest rates and US debt service: Mises.org/HAP351-2 Rothbard on the ethics of debt repudiation: Mises.org/HAP351-3
The United States economy may have delivered no growth in the first half of 2022 after the decline in the first quarter, narrowly avoiding a technical recession.
Original Article: "US Household Saving Rate Vanishes, Credit Card Debt Soars"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Forget Jerome Powell's fanciful "soft landing" or the notion that the Fed can pull another rabbit from its hat. The banking system is headed for a crash and monetary authorities likely will make things worse.
Original Article: "A Perfect Storm Is Brewing in Banking and Finance"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Anyone who doubts whether we are in a recession can stop doubting. The Fed's reverse repos show that we're headed for a crash.
Original Article: "The Great Crash of 2022"
This Audio Mises Wire is generously sponsored by Christopher Condon.
In this episode of Radio Rothbard, Ryan McMaken and Tho Bishop discuss recent inflation news, broader chaos in financial markets, and another round of funding for Ukraine.
Recommended Reading "Inflation Up, Wages Down as Biden Passes the Buck to the Do-Nothing Fed" by Ryan McMaken: Mises.org/RR_81_A
"From El Salvador to Africa, the Next Currency War Pits Populists against Bankers" by Tho Bishop: Mises.org/RR_81_B
"Biden: Inflation Is Everybody’s Fault but Mine" by Ryan McMaken: Mises.org/RR_81_C
"Noninterventionism Is Not Isolationism: The US Government Should Stop Arming Ukraine" by Daniel Martin: Mises.org/RR_81_D
"Forget What the 'Experts' Claim about Deflation: It Strengthens the Economy" by Frank Shostak: Mises.org/RR_81_E
Be sure to follow Radio Rothbard at Mises.org/RadioRothbard.
This week Jeff is solo with very special guest Jimmy Rogers, the famed investor, Alabama native, and fan of Austrian economics.
Jeff talks to Keith Weiner of Monetary Metals about why gold still plays a major role in the global economy.
Listen to Bob's interview with Keith at mises.org/BMS234 Find out more about Monetary Metals at monetary-metals.com
Keith Weiner is founder and CEO of Monetary Metals, an investment firm that pays interest on gold, and the founder of the Gold Standard Institute USA. Weiner’s mission is to provide entrepreneurial services and education to help restore gold as the world’s money par excellence.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this interviewKeith Weiner’s bio at Monetary MetalsWeiner’s Forbes article on gold and silver coins not circulating For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.
Bob and Jeff get into the weeds of Disney's shareholders, revenues, and holdings in light of the company's recent spat with Florida Governor Ron DeSantis.
States continue to seek new ways to make the financial system an “economic chokepoint” enabling the state to crack down on specific organizations, individuals, or activities.
Original Article: "The West's Russia Sanctions Show Why States Want to Weaponize the Financial System"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Bloomberg suggests that individuals should not be permitted to make their own stock selections because they are not "qualified" to make such decisions. Instead, governments should help direct their investment choices.
Original Article: "Should Government Be Your Stockbroker? Maybe So, Says Bloomberg"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Thanks to central banks' easy money policies, historically low interest rates and a desperate search for yield have created new danger zones for investors trying to stay out of trouble.
Original Article: "Thanks to Central Banks, the Old Investment Rules Don't Apply Anymore"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Fans of Austrian economics know hedge fund manager Mark Spitznagel as a brilliant thinker thoroughly steeped in Menger, Böhm-Bawerk, Mises, and Rothbard. His excellent 2013 book The Dao of Capital was rooted in Austrian capital theory and "roundaboutness," and his application of of that theory has proven highly beneficial for his investors.
Now Spitznagel is back with a new book that directly challenges our understanding of risk. Safe Haven asks, and answers, a fundamental question: Can mitigating risk actually add to the bottom line? Can safe havens be truly cost-effective, by adding to CAGR? Mises Institute Senior Fellow Robert Murphy, who consulted on the book, joins the show for a fascinating look at Spitznagel's penetrating and contrarian thesis. If you're interested in the intersection of investing and Austrian economics, don't miss this episode!
Mark Spitznagel's Safe Haven: Investing for Financial Storms on Amazon: Mises.org/SafeHaven
And, Spitznagel's 2013 book The Dao of Capital: Austrian Investing in a Distorted World on Amazon: Mises.org/Dao
Unlike the ongoing price inflation that is typically caused by central-bank expansion of the money supply, the price inflation generated by diminished supplies of goods is a one-shot affair.
Original Article: "Is There Such a Thing as Good Inflation?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
As the world’s second-largest economy attempts to return to its precrisis glory days, Beijing could potentially deal with a new pandemic that could have a sweeping effect on financial markets at home and abroad: a bond default crisis.
Original Article: "China's New Pandemic: A Bond Default Crisis"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Medium of exchange and store of value are very different products.
Original Article: "No, Dogecoin Does Not Compete with Bitcoin"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Stephan Livera hosts a popular podcast on Bitcoin and Austrian economics. He recently had Bob on to discuss, appropriately enough, the economics of Bitcoin from an Austrian perspective.
Mentioned in the Episode and Other Links of Interest: Stephan Livera’s YouTube pageBob and Silas Barta’s guide to BitcoinBMS ep. 191 clarifying the debate over Bitcoin For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Stitcher, Spotify, and via RSS.
Federal regulators are claiming "socially responsible investing" can be just as good as traditional investing in terms of gaining returns for retired workers. But if that's true there's no need for regulations pushing these investments at all.
Original Article: "The Feds Are Pushing Pension Funds toward "Socially Responsible Investing""
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
An explosion in the money supply has driven many corporate managers to turn to stock buybacks as a safe alternative to holding on to depreciating cash. This means many companies are decapitalizing.
Original Article: "How the Fed's Inflation Is Driving Stock Buybacks"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
The GameStop saga—can we call it an insurrection?—wants easy heroes and villains. Both are available.
Original Article: "Playing Games with Stocks"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Shorting more than the total outstanding shares isn’t perverse or fraudulent, whereas naked short selling—depending on the context—might be.
Original Article: "When Is Short Selling Fraudulent?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Behavioral economists and psychologists define as irrational anything that doesn't fit into a narrow model of behavior. Anything "irrational"—like buying the "wrong" stock—must be fixed with government regulation.
Original Article: "Economists and Psychologists Are Weaponizing Psychology and the Idea of "Rationality""
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Jeff Deist joins David Gornoski to talk about the GameStop Wall Street Saga. He highlights how the media narrative seeks to manipulate the masses to view Reddit traders as fascistic and Hedge Funds as the victims. Is there really any difference between what the Wall Street elites are doing and what the Reddit traders did? What exactly is Robin Hood? What is Stake Holder theory? Listen to the entire segment to find out and more.
Find more from David Gornoski on A Neighbor's Choice.
There's a lot of excessive optimism about the economy during the next four years in America. However, the US still comes out on top when compared to Europe and China.
Original Article: "Compared to Europe and China, America Is Still a Safe Bet"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
No matter how bleak the economy may be, the Keynesians are likely to say, “It would have been worse without us.”
Original Article: "The Fed Won't Save Us from the Growing Jobs Recession"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
The Left has often claimed that privatization is a neoliberal scam. But actual experience suggests privatization schemes have improved access to goods and services while raising productivity and real incomes.
Original Article: "Yes, Privatization Makes Us Better Off"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
There are ominous signs on the horizon that governments want to move toward mandating "socially responsible investing" for pensions and fund managers. This is a terrible idea, to say the least.
Original Article: "The Problem with Mandatory 'Socially Responsible Investing'".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
The central banks can be thanked for all bubbles, including those in cryptocurrencies.
Original Article: "Central Banks Put Wind at Bitcoin's Back".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Circa casino’s new three-story, 78 million–pixel, high-definition screen in its sportsbook gambling compound may represent a new frontier in mega–building trends similar to those of skyscrapers.
Original Article: "The Rise of Mega–Gambling Facilities: A New Skyscraper Curse?".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Remember savings bonds? They were popular before the central bank made sure that safe, low-interest investments became a thing of the past.
Original Article: "The US Savings Bond Scam".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Useful goods and services, and the productive resources needed to create useful goods and services, are wealth. Money is not wealth, and creating more money without first creating wealth is a big problem.
Original Article: "Stop Confusing Money with Wealth"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
If the current thinking continues, the world’s central banks will buy whatever paper governments issue. The result by the end of the decade will be a Federal Reserve balance sheet totaling $40 to $50 trillion.
Original Article: "The Fed's Balance Sheet May Be Headed to $40–$50 Trillion".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
The stock market does not have a life of its own. In a relatively free economy, success or failure of investment in stocks depends ultimately on the same factors that determine success or failure of any business.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Original Article: "Should Investors Focus on Risk Rather Than Profit?".
A rising price of gold and silver in US dollars, euros, Chinese renminbi, Japanese yen, etc. means this: the higher the price of this precious metal, the lower the exchange value of official currencies.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Gold Prices Show There's a "Big Short" Going on in Official Currencies".
Central bankers are saying two things at once. First, they say that negative interest rates are a natural historical development. But then they say negative rates are an essential tool central banks are using to manipulate the economy.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Are Negative Rates a Natural Historical Development?".
The crisis we faced in 2008 has not gone away, as we failed to heed its warning to change course and reduce debt levels. Instead, it has become bigger and more dangerous.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Throwing Printed Money at This Problem Won't Make It Go Away".
Kodak's newly announced $765 million loan is just another case of DC picking winners and losers.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Swamponomics: Trump's Fed Pick, a Kodak Moment, and GDP Misinformation".
As a follow-up to his discussion on MMT with Rohan Grey (in ep. 130), Bob goes solo to explain the basic cash balance framework for thinking about money, inflation, and debt. Specifically, Bob will explain why he thinks it's far more important to know how the government finances a deficit rather than knowing what it spends the money on.
Mentioned in the Episode and Other Links of Interest: BMS ep. 130 with Rohan Grey.Bob’s infamous inflation bet: response to Krugman/DeLong and his explanation years later for reason.com.Rothbard’s critique of the “equation of exchange,” MV=PQ.Bob’s QJAE article on the economics of fractional reserve banking. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
According to Keynesians, wealth effects result from money creation, and they have a beneficial impact. The Keynesians are right that wealth effects exist. But they're wrong about who benefits.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Yes, QE Creates Wealth Effects".
Our current position on debt seems to be akin to saying the only way to keep from drowning is pouring more water over the victim.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Gorging on Debt to Survive the COVID-19 Economy".
When confidence is extreme, there's no scrutiny. There's always a "this time it's different" mindset, the belief that anything is possible.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Stocks Always Go Up. Until They Don't."
Download the slides from this lecture at Mises.org/MU20_PPT_14.
Recorded at the Mises Institute in Auburn, Alabama, on 14 July 2020.
In the midst of a stock market bubble like this one, everyone from Warren Buffet down to the shoeshine boy has some great tips for you..
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "As the Fed Pumps, the Stock Market Is Increasingly the Only Game in Town".
Like during the 1930s, governments are turning to new programs and schemes that will only prolong the crisis and makes things worse.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "After the Lockdowns, Government "Fixes" for the Economy Will Make Things Even Worse".
Central bank policies that rely on ultralow interest rates have been shown to bring economic stagnation. Unfortunately, central bankers don't seem to have any other ideas.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Central Bankers Will Bring Us Economic Stagnation".
A no-holds-barred discussion of the economy after the coronavirus shutdown and George Floyd protests. Are we facing another Great Depression? Can there be a V-shaped recovery or is this wishful thinking? What will all the new money and credit created by Congress and the Fed mean for the dollar? What kind of economic mess will Trump or Biden inherit in 2021? How far will Fed chair Powell go to keep markets propped up? And how can you protect yourself and your savings?
Recorded at Avondale Brewing Company in Birmingham, Alabama, on June 6, 2020. Special thanks to Mark Walker for sponsoring this event.
Put simply, if it were not for accommodative monetary policy, these firms would have otherwise shut down by now. Once again, the Fed is refusing to allow the invisible hand to rein in the excess for fear of a liquidity crisis, credit crunch, and worse.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "There's No End in Sight to the Zombie Economy"
Some claim "the rich" will be fine—or even better off—after the COVID panic destroys the economy for most of us. But there's a problem: the wealthy depend heavily on an economy fueled by the production and consumption of all workers and entrepreneurs.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "We’re All in This Together. But Not in the Way You Think."
Jeff Deist and economist Daniel Lacalle present a special live seminar on the COVID-19 crisis and what it means for your economic future.
Is the world headed for another Great Depression, or will we enjoy a V-shaped recovery later this year as the virus fades and economies reopen? Are governments and central banks making the situation better or worse? Will stocks bounce back? Do we all face a less prosperous new normal, or will markets and human ingenuity overcome the economic tailwinds?
Mr. Lacalle and host Jeff Deist take an unflinching look at the economic reality.
Topics include:
Prospects for inflation vs. deflationFed and ECB responses to the crisisEffects of government "stimulus"Unemployment and small businessHousing and commercial real estateEquities and bondsOil and commoditiesGold and Bitcoin
The EU has now become essentially a makeshift, lawless regime designed to prop up bankrupt states. So much so, in fact, that even the German supreme court has become alarmed.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Germany Pushes Back against the ECB's Bailouts"
Why would an investor buy a bond that pays a negative interest rate? The answer lies in understanding how central banks manipulate the economy.
Narrated by Daniella Bassi.
Original Article: "Negative Interest Rates: Rewarding Profligacy"
In this crisis the money supply has already increased far more than during the last crisis. But it's hard to say when this will produce inflation because we're still in the midst of a demand shock and a collapse in oil prices.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "How This Crisis Differs from the 2008–2009 Financial Crisis"
Prices of consumer goods have grown rather slowly in spite of sizable money supply growth. Why is there a gap?
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Why Has There Been So Little Consumer Price Inflation?"
Many argue that unregulated markets would fail due to lack of consumer knowledge, or information asymmetry. But competition in free markets actually gives rise to all kinds of mechanisms that help consumers make informed decisions. This is as true of medical tests for any other good.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Testing Deregulation Can Help Fight COVID-19"
The COVID-19 panic may have sped up the beginning of this economic crisis, but the virus wasn’t the cause. The real cause of the crisis was the boom that came before it.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "This Bust Wasn't Caused by a Virus"
Wouldn’t you feel great knowing that your stock picking is fully insured by the Fed? Billionaires and wealthy hedge fund managers know the feeling.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Why Markets Are Rallying as Millions Become Unemployed"
Jeff Deist joins Rick Sanchez on RT America to discuss the immense stimulus package proposed by the Trump administration to help the failing US economy.
Bob Murphy first gives some thoughts on the stock market crash and coronavirus, then discusses the jaw-dropping discussion between Brian Williams and a member of the New York Times editorial board regarding Mike Bloomberg’s claimed ability to give every American $1 million.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Harry Dent is the founder of Dent Research, which provides economic forecasting and financial recommendations. He is the author of numerous books, including Zero Hour (2017). Harry argues that demographic trends set the U.S. economy up for a major adjustment that the Federal Reserve merely postponed with its easy-money policies in 2008 and beyond. Harry now believes that a major crash is coming, which will probably begin this year.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Dr. Bob Murphy joins the Human Action Podcast to discuss one of the most important issues of all: how money and credit work in today's society. Jeff Deist recently commissioned Murphy to write a series of articles on money mechanics (Mises.org/MoneyMechanics), an exceedingly important topic for critics of the Fed — and today's podcast serves as an introduction to the project. The articles will be compiled into an e-book, with plenty of graphics to simplify the basic process of money creation in a fractional reserve system. If you want to understand how the Fed works, how money and credit come into being, how interest rates arise, and what it all means for you, don't miss this great upcoming series at mises.org.
Additional Resources Jeff Deist on Understanding Fed Money Mechanics
Jeff Snider is Head of Global Research at Alhambra Investments. He talks with Bob about the recent spike in lending rates in the repo markets, and how the Fed’s attempted solution fails to address the real problem. He then relates the repo problem to the global monetary system, which has suffered from major imbalances going back to 2007 that have yet to be corrected.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Europe and Asia are awash with $13 trillion in negative yield sovereign and corporate bonds. Alan Greenspan says negative interest rates are coming to America. And the Fed just announced another rate cut, even while Chair Jay Powell and Mr. Trump assure us the economy is better than ever. Economist Bob Murphy joins Jeff Deist to make sense of the nonsensical world of negative interest rates.
Bob Murphy gives a quick explanation of the Mises-Hayek theory of the boom-bust cycle, and how Bob used it to forecast the financial crisis in 2008 a year ahead of time. He then explains the significance of an "inverted yield curve," and shows how the Austrians can understand its predictive power much better than Keynesians like Paul Krugman can.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Money and Government: The Past and Future of EconomicsRobert SkidelskyYale University Press, 2018xiv + 402 pages
The title of Murray Rothbard’s Power and Market provides a useful entry to understanding Robert Skidelsky’s long and learned book. Rothbard drew a contrast between peaceful cooperation through the free market and State coercion. Which do you support, he asks: power or market? Skidelsky, a historian and economist who has written admiring biographies of Keynes and the British fascist Oswald Mosley, is for the most part clear in his answer: power should prevail over the market.
Thus, although he notes that mercantilism rests on economic fallacies, he still thinks this system has much to be said for it. “Rising prices were associated with prosperity; falling prices with dearth. This correlation led a group of seventeenth-century thinkers called mercantilists to identify money with wealth. The more money a kingdom had, the wealthier it was; the less, the poorer.” This view is mistaken: mercantilism was based on the “fallacy that exporting is better than importing and that the object of economic policy should therefore be to secure a favourable balance of trade ... of course, all countries cannot achieve a trade surplus simultaneously, so the pursuit of these policies involved continuing trade wars between the leading European powers.”
But what is wrong with trade wars? “The mercantilists believed that state activity and spending could galvanize the growth of national wealth. War was an investment decision by the state: the state needed sufficient revenue to conquer foreign markets.” Why rely on peaceful exchange when you can take what you want by force?
In addition, war has another benefit: it reduces inequality. “Recently, discussion of distribution has centred on the fact, and meaning, of the sharp rise in inequality since the 1970s, particularly in the United States and Britain. The most notable contributions here are Thomas Piketty’s Capital in the Twenty-First Century (2013) ... and Walter Scheidel’s The Great Leveler (2017). ... Both attribute the great compression of wealth and incomes in the middle years of the last century to the effects of the two world wars and Great Depression.”
Skidelsky is not content to urge the merits of power over market. He wishes to challenge advocates of the free market on their own ground. They take as their standard the welfare of consumers and on that basis argue for voluntary exchange. The fundamental argument of his book is that, in doing so, they fail to realize the disruptive effect of money. In a barter economy, Say’s Law, which Skidelsky wrongly states as “the infamous ... Law that supply creates its own demand” holds true. As W.H. Hutt pointed out in his major study A Rehabilitation of Say’s Law, the law is better stated as “all power to demand is derived from production and supply.” Another way to state the law is “the supply of a good on the market is demand for other goods.” There can be no overproduction that covers all of the economy.
Once money enters the scene, the situation alters. Instead of spending their money on consumption or investment goods, people can hoard money. “Speculators, too, have always known that in disturbed times they can profit from being liquid. Increased propensity to hoard, what Keynes called the ‘speculative demand for money’, thus arises from increased uncertainty. It slows down the economy by slowing down the spending of money on currently produced goods and diverting it into financial operations. Thus money earned in producing goods may be unavailable for spending on those goods, causing unemployment.”
As Skidelsky tells the tale, neoclassical economists who favored the free market attempted to solve this problem through the quantity theory of money. By varying the quantity of money, the monetary authorities could keep the value of money stable. In that way, the fears of speculators would be calmed and hoarding averted or countermanded. Milton Friedman’s monetarism is the best known example of this view, but Knut Wicksell, and even Keynes before the General Theory, supported it. As Keynes came to realize, though Friedman did not, monetarism does not work. The central monetary authority is unable to control the money supply in the way this theory supposes.
Although Skidelsky mentions Austrian economics several times, he never confronts the Austrian criticism of his entire line of reasoning. In the Austrian view, he has gotten wrong both the alleged problem posed by hoarding and the alleged “cure” that the proponents of the free market suggest for it.
As Murray Rothbard has pointed out in Man, Economy, and State, allocation of resources between consumption and investment depends on the rate of time preference. The demand to hold money creates no special problem for this allocation. In assuming otherwise, Keynes and his followers wrongly took the loan rate of interest to be primary, when in fact it is subordinate to the primary determinant of the rate of interest, the aforementioned rate of time preference.
Rothbard explained the basis of the Austrian account of the interest rate in this way: “People, therefore, allocate their money, among consumption, investment, and hoarding. The proportion between consumption and investment reflects individual time preferences. To think of the rate of interest as ‘inducing’ more or less saving or hoarding is to misunderstand the problem completely. ... One grave and fundamental Keynesian error is to persist in regarding the interest rate as a contract rate on loans, instead of the price spreads between stages of production.” In contrast to the Keynesian fear that expectations of falling consumption demand will lead to a cycle of further price falls and lowered expectations, Rothbard says, “The expectation of falling factor prices speeds up the movement toward equilibrium and hence toward the pure interest rate as determined by time preference.”
Moreover, the speculative bubbles that Keynes feared stem not from sudden and mysterious collapses of the “animal spirits” of investors but rather from injections of bank credit in fractional reserve banking, a system unsustainable without state control of the money supply. Skidelsky is well aware of this theory but has little to say about it, perhaps because he does not like its consequences for policy: “The causes of the crash of 1929 have been much disputed. Friedrich Hayek claimed that it was a result of excessive credit creation in the United States. In his account, the price stability of the mid-1920s, so much praised by the monetary reformers, was an indication of inflation, not of equilibrium, since productivity gains would have naturally produced a falling price level. ... ‘Excessive credit creation’ became the standard ‘Austrian’ explanation of the 1929 collapse. It resurfaced to explain the crash in 2008. ... On the Austrian analysis, recessions give a chance to reallocate ‘mal-invested’ productive factors to efficient uses. They should therefore be allowed to run unhindered until they have done their work. Economists whose common sense had not been completely destroyed by their theories rejected the drastic cure of destroying the existing economy in order to rebuild it in the correct proportions.” Skidelsky is sure that allowing prices to fall in a depression would ruin the economy, but as James Grant shows in his outstanding The Forgotten Depression, the US government did exactly that in coping with the downturn in 1920–1921, and the result was a speedy recovery. Skidelsky cites Grant’s book in his bibliography but ignores its relevance to his complaint against the “drastic cure.”
Further, Austrians reject the quantity theory of money. Mises in The Theory of Money and Credit said about it: “There is no justification whatever for the widespread belief that variations in the quantity of money must lead to inversely proportionate variations in the objective exchange value of money, so that, for example, a doubling of the quantity of money must lead to a halving of the purchasingpower of money.” Austrians thus oppose endeavors by the state to stabilize the value of money based on this theory. It is ironic that Skidelsky takes the failure of monetarism, a form of state intervention, to show the defects of the unhampered market economy. It is ironic that Skidelsky takes the failure of monetarism, a form of state intervention, to show the defects of the unhampered market economy.
Our account of Skidelsky’s book now takes a surprising turn. Although he opposes the free market, he is not prepared to dismiss entirely the views of the Austrians. To the contrary, he considers Hayek a great thinker and recognizes that his warnings against government intervention have merit. “Liberalism, or social democracy, unraveled with stagflation and ungovernability in the 1970s. ... Keynesian/social democratic policymakers succumbed to hubris, an intellectual corruption that convinced them they possessed the knowledge and the tools to manage and control the economy and society from the top. This was the malady against which Hayek had inveighed in his classic The Road to Serfdom (1944).”
Skidelsky recognizes that the Keynesians had no adequate answer to the “stagflation” of the 1970s. He also recognizes the force of the “public choice” analysis of government though he by no means commits himself fully to it. “Its main thrust was to emphasize the importance of the private incentives facing politicians and bureaucrats. The Keynesian-social democratic state was modelled as a private interest masquerading as guardian of the public interest. This was back to Adam Smith.” Skidelsky errs, though, when he says that “Public choice theory is simply rational expectations theory applied to government. It takes from REH [rational expectations hypothesis] the methodology of modelling public policies as the solution to individual maximization problems.” This is not correct. The basis of the theory is that politicians are self-interested actors, but this does not commit one to a particular model of how such actors behave.
Even readers who disagree with the thrust of the book will benefit from Skidelsky’s wide learning. The author sometimes makes mistakes. He says, “The French state, which emerged from the war [WWII] as the nation’s chief investor, did not have to learn its statism from Keynes; Colbert had pointed the way in the eighteenth century.” That was a neat trick for Colbert, who died in 1683. He calls the well-known businessman and New Deal financial expert Beardsley Ruml “Rummel.” But the slips are few and minor.
Just as in his earlier book How Much Is Enough? (2012), Skidelsky manifests an inordinate distaste for money and “greed.” Far better in his eyes is the pursuit of power by the State, even at the cost of wars and massive public debt. Some of us will not agree.
Pundits are hoping that instead of a crisis, we just get a "global economic slowdown." Given the damage done by central banks, a sustained slowdown would be a best-case scenario.
Original Article: "It's Not a Recession, It's a 'Global Economic Slowdown'".
Our great friend Daniel Lacalle, author of Escape from the Central Bank Trap, joins the show to discuss the perilous condition facing central banks after a decade of their own malfeasance.
Daniel and Jeff discuss absurd reactions to the Fed's tiny interest rate hikes, the fragility of central bank policy in the face of enormous sovereign, corporate, and household debt, why expansionary monetary policy always hurts poor people, and what the Fed and ECB might do– realistically– under current conditions. This is a must-listen interview with one of the best and most visible central bank critics.
Former Dallas Fed official Danielle DiMartino Booth joins the show just as Chairman Jay Powell faces his first major challenge: will he keep raising rates as promised now that autos, housing, employment, and even tech stocks look soft? And if not, will he effectively signal that the US economy is in big trouble?
DiMartino Booth and Jeff Deist discuss Powell's performance to date, the credulity of the financial press, the ugly ticking time bomb of US corporate debt, and whether Austrians and permabears overestimate the Fed's influence on the economy.
What's the biggest and most dangerous financial bubble? Sovereign debt issued by profligate governments. And unlike stocks or corporate debt, government bond bubbles harm millions of ordinary people when they burst.
Economist Daniel Lacalle joins Jeff Deist to figure out the bizarro world of the bond bubble: negative interest rates, anemic rate spreads between government bonds and "high yield" bonds, and central banks as the unseemly buyers of last resort. They discuss the Fed's interest rate hikes, Jerome Powell's focus on data, the US housing market, and why all of us have a stake in seeing central bank balance sheets shrink.
Related article: Daniel Lacalle on the Bond Bubble
Presented at the Mises Institute's 2018 Supporters Summit in Auburn, Alabama. Recorded on September 27, 2018.
Even many libertarians dismiss gold and precious metals as irrelevant in the global monetary system. Ben Bernanke famously told Ron Paul that gold is a commodity, not money. So why do central banks still hold so much of it, Ron asked? Good question.
Ronni Stöferle from Incrementum AG joins Jeff Deist to talk about everything related to gold: why it's still money, how it might react to rising interest rates, why the IMF still worries about it, and why so much of it seems to be flowing from West to East. You won't want to miss his analysis of why gold and precious metals are complementary assets with respect to cryptocurrencies, and his call for both camps to join forces and promote Hayek's goal of denationalizing money.
Related: Ron Paul on the Dollar Dilemma.
Caitlin Long recently joined us in San Francisco for an inside look at how blockchain technology might blow up the financial service and banking industries. This is a presentation you won't want to miss from someone at the cutting edge of both blockchain technology and the legal landscape surrounding it.
Nomi Prins previews her talk at our event in Ft. Worth this weekend, based on her new book Collusion: How Central Bankers Rigged the World—a damning indictment of how the Federal Reserve bullied other central banks and bailed out Wall Street in the wake of the 2008 financial crisis.
Join us in Texas this Saturday to meet Ms. Prins and receive an autographed copy of Collusion!
Patrick Byrne on how blockchain technology is a revolutionary force that will democratize stock markets and help secure property titles for un-banked people around the world.
Caitlin Long discusses the blockchain's disruptive influence on our existing notions of money and wealth. Recorded in San Francisco, California, on 19 May 2018.
Jeff Deist joins his friend John O'Donnell on Power Trading Radio to talk about everything from money to Marx to whether "unilateral" free trade is a good idea.
Hosted by the Mises Institute in Nashville, Tennessee, on 14 April 2018. Special thanks to an Anonymous Donor for making this event possible.
Hosted by the Mises Institute in Nashville, Tennessee, on 14 April 2018. Includes an introduction by Jeff Deist. Special thanks to an Anonymous Donor for making this event possible.
The Ludwig von Mises Memorial Lecture, sponsored by Yousif Almoayyed. Presented at the Austrian Economics Research Conference at the Mises Institute in Auburn, Alabama, on 24 March 2018.
Quarterly Journal of Austrian Economics 20, no. 1 (Spring 2017)
ABSTRACT: The aim of this article is to demonstrate how monetary disorder spawns asset price inflation. This is re-interpreted here according to modern usage as meaning an empowerment of irrational forces in asset markets. The author blends insights from behavioral finance research and from Austrian business cycle theory to develop a hypothesis about how mental flaws of investors become inflamed by monetary influences and how these contribute to episodes of widespread mal-investment. Identifying two types of asset price inflation—boom type and depression type—this article draws on the last century of history to illustrate both through several stages, accompanied by a variable intensity of inflation symptoms in the goods markets.
KEYWORDS: asset price inflation, Austrian business cycle theory, carry trade, hunt for yield, irrational exuberanceJEL CLASSIFICATION: B53, E14, E31, E32, E42, E43, E44, E58, F45, G02, G12, N12, N14
How can liberty-minded Americans move toward more freedom in our lifetime? This panel discussion features Nomi Prins, Albert Lu, and Chris Casey. Recorded in San Diego, California, on 25 February 2017.
We've all heard about negative interest rates, but we may not really understand them-- either conceptually or in terms of bond markets. Here to explain is our returning guest Dr. Patrick Barron, a longtime professor in the graduate school of banking at the University of Wisconsin.
How and why would interest rates ever be negative, when everyone prefers current consumption to future consumption? Can the "natural" or market rate of interest ever be negative? What going on in Europe that would make negative-rate government and corporate bonds attractive to investors? Will the ECB be forced to raise rates back into positive territory if Janet Yellen continues to raise the Fed Funds Rate here in the US? And will Congress resist steady rate hikes that could radically spike its annual budget outlay for debt service?
Our guest this weekend is Nomi Prins, a prolific writer and speaker on the subjects of central banking, financial markets, and Wall Street cronyism. She is a former managing director at Goldman Sachs and Bear Stearns, but left investment banking to speak out against what she perceives as global financial malfeasance by commercial, investment, and central banks. Nomi is a dedicated progressive who supported Bernie Sanders, but she's also a harsh critic of the Fed and sympathetic to Austrian depictions of malinvestment and artificially-created bubbles.
Nomi and Jeff discuss the role of central banks in creating an unworthy financial elite, the revolving door between the Treasury Department, the Fed, and banks like Goldman Sachs, how the Fed is necessarily and unavoidably political, how central banks historically have financed interventionist wars, and how the Fed could be the great populist issue that further unravels the Left/Right paradigm.
Learn more about Nomi at NomiPrins.com.
Thirty-five years ago, Ron Paul and Lewis Lehrman published The Case for Gold, their minority report from Reagan's gold commission. Today, Jim Rickards has written The New Case for Gold, an uncompromising call for using gold as money and reestablishing a gold standard for central banks.
In this wide-ranging interview, Jeff Deist and Jim Rickards discuss gold in the context of current geopolitics and enduring myths about monetary growth. While the "anti-gold reflex" is strong among older generation monetary economists in the west, a new gold-friendly order is emerging in Asia. Jeff and Jim even discuss whether Hillary will be indicted, leading to a Joe Biden/Elizabeth Warren ticket. This is a fascinating interview that you won't want to miss.
Our guest this week is James Grant, founder and editor of Grant's Interest Rate Observer. Jeff and Jim discuss Jim's recent cover article in Time magazine, and the reaction it received from Krugman and others on the left.
They also discuss comments recently made by Ben Bernanke, who argued in favor of the Fed looking into helicopter money. When did fiscal and monetary sanity become a radical position in America?
There are numerous well-known definitions of economics, but the one that best captures what economics is about is James Buchanan's definition, namely: "Economics is the science of markets or exchange institutions."
A guest panel featuring Daniel McAdams, Larry Beane, Sandra Klein, Andrew Widener, and Bill Haynes. Recorded at the Mises Circle in Houston, Texas, on 30 January 2016.
Special thanks to Christopher Condon, TJ and Ida Goss, Terence Murphree, and an Anonymous Donor for making this event possible.
Our guest this weekend is Dr. Mark Thornton, a senior fellow here at the Mises Institute, and our topic is booms and busts. Falling stock prices are in the news lately, so Mark and Jeff talk about how and why central bankers don't understand deflation, whether they are really Keynesians or some variant thereof, what a "crack-up boom" might look like, and what the Skyscraper Index and other symptoms of irrational spending might tell us about the future of the global economy.
On Tuesday, Vermont Senator Bernie Sanders stood up on the stage of a Democratic Party presidential debate and proudly proclaimed himself a “democratic socialist” to an adoring crowd. Spurred on by myths about the success of socialism in countries like Sweden and Norway, the horrors of a centrally planned economy have never been more popular in American politics. As Mises President Jeff Deist highlighted in Thursday’s Mises Daily:
These ideas, and the people who hold them, are not outliers in America. There are millions … who believe exactly as Bernie believes. They may prefer to vote for Hillary Clinton purely as a tactical matter because they are unsure the country is “ready” for full socialism … but average progressives and Democrats agree with Bernie Sanders across the board …
Ninety-five years after Ludwig von Mises published his indispensable essay Economic Calculation in the Socialist Commonwealth, it is as critical to stand up to the tyranny of statism — on any scale — now as ever before.
The devastating consequences of government intervention into healthcare markets is the topic of this week’s episode of Mises Weekends. Charles Hugh Smith joins Jeff to discuss how Washington’s desire to eliminate markets from medicine has led to the industry being captured both by incompetent government regulators and insurance lobbyists.
In case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Charles Murray's Tepid Radicalism by David GordonWhat "Progressive" Corporate Welfare Looks Like by Andrew SyriosThe Dirty Business of Government Trash Collection by Allen MendenhallSanders and His Followers Are Not Outliers by Jeff DeistHow Modern Sweden Profits from the Success of Its Free-Market History by Yonathan AmselemGeorge Akerlof, Meet Oliver Williamson by Peter KleinAngus Deaton and Modern Economics by Peter KleinThe Mistake of Only Comparing US Murder Rates to "Developed" Countries by Ryan McMakenThe Fed’s Quadral Mandate and Impossible Balancing Act by Jonathan NewmanRothbard on Economic Ignorance by Matt McCaffreyTrue Money Supply: August Money Supply Growth Remains Way Down from 2012 Levels by Ryan McMakenDonald's Remarks on the Bubble and the Fed Are on the Money by Joseph SalernoNo way, Norway! by Carmen Elena Dorobăț
There appears to be a mistaken belief on the Left that any government action is either done in the interest of “the people” or in the interest of corporations and rich oligarchs. So the naked corporate welfare to Archer Daniels Midlands is called out, as are the sports stadiums being paid for by taxpayers and of course the banker bailouts as well. (Although, it should be noted that congressional Democrats voted in support of TARP by a rate of three to one whereas a slight majority of Republicans opposed it.)
In general, however, the Left seems to see tax cuts as corporate welfare while ignoring or outright supporting corporate welfare in many of its guises. The reason is because corporate welfare is rarely sold to the public as a way to help millionaires become billionaires at the taxpayer’s expense. It’s much more insidious than that. Usually this cronyism comes wrapped in a bill of goods that makes it much easier to swallow.
ObamacareWhile the Right yells about how the so-called Obamacare is socialized medicine, it would actually best be described as a corporatist scheme. Or in other words, it’s corporate welfare.
Indeed, if it were some socialist scheme to destroy private enterprise, one would suspect that these companies’ stock prices would plummet before the passing of the bill (March 23, 2010). Here’s what actually happened in the year prior to the bill’s passing for the five largest health insurance companies (the Dow Jones is in red):
Chart from Finance.Yahoo.com (WLP = Anthem; CI = Cigna; HUM = Humana; AET = Aetna; UNH = United Healthcare)The average return for these five companies over the year was 72.85 percent, almost twice that of the Dow Jones Industrial average. Cigna lead the group with a 98.5 percent increase. Now, it’s important to understand how stock prices are valued. They are not derived from the value of the assets a company holds or even what the company has done recently. Instead they are valued by how much a company is expected to make in the future and how much those future cash flows are worth today.
In other words, investors seemed to be uniformly of the opinion that Obamacare was good for business. And they were right. Here are those same companies last five year’s performance:
It shouldn’t be hard to see why an individual mandate and billions in subsidies for people to buy insurance from these companies could increase profits. This is especially true given all of the rate increases. The law’s poor conception has pushed health insurance companies to seek rate increases of 20 to 40 percent for 2016 because the “new customers … turned out to be sicker than expected.”
How about the pharmaceutical companies? In March of 2009, Billy Tauzin, head of PhARMA (the main lobbying group for the pharmaceutical industry) was asked whether investors should be worried about the upcoming healthcare reform. He responded as follows,
Think about what this plan does: This plan talks about providing comprehensive health insurance to people who don’t have it. That means to patients who can’t take our medicines because they can’t afford it: $650 billion spent to better insure Americans for the products we make. That ought to be a very optimistic and positive message for everyone [who] is interested in our sector of the economy.
They continued,
Mike Huckman: “… if there is some kind of universal healthcare plan where prescription drugs are more broadly available and they’re available at a cheaper price, [is it possible] that your sector may make up in a higher prescription volume and sales what it might lose on price?”
Billy Tauzin: “Absolutely, think about this: almost half of the prescriptions that get written today go unfilled … primarily because people don’t have adequate insurance.”
The LA Times reported that “Tauzin has morphed into the president’s partner. He has been invited to the White House half a dozen times in recent months.” Tim Carney lists some of the blatant corporate welfare in the bill,
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Complex drugs known as biologics will receive a 12 year monopoly patent instead of the standard 5 years.
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The individual mandate will require everyone to buy prescription drug insurance.
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$196 billion in annual subsidies will be given to poor and middle class Americans to buy health insurance.
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It preserves the 2003 Medicare Part D stipulation that prohibits Medicare from negotiating down prices for drugs it subsidizes.
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It continues to prevent re-importation of drugs from Canada.
Given this, it’s not surprising that the drug industry paid $150 million to support Obamacare with things such as this delightful ad.
Cap and TradeEarly in Obama’s presidency (and John McCain’s platform) he pushed for “cap and trade”; a market-driven method to fight global warming. Or more accurately, a corporate welfare laden plan that wouldn’t do much of anything.
Paul Krugman accused opponents of the bill of committing “treason against the planet” and most of the left seemed to agree. But to give credit where credit is due; Dennis Kucinich actually hit the nail on the head,
[H.R. 2454, the cap-and-trade bill] is regressive. Free allocations doled out with the intent of blunting the effects on those of modest means will pale in comparison to the allocations that go to polluters and special interests. The financial benefits of offsets and unlimited banking also tend to accrue to large corporations. And of course, the trillion dollar carbon derivatives market will help Wall Street investors. Much of the benefits designed to assist consumers are passed through coal companies and other large corporations, on whom we will rely to pass on the savings.
Indeed, Al Gore makes an interesting observation in some of the bonus material to his documentary An Inconvenient Truth,
A lot of business leaders are changing their positions. New businesses and CEO’s and corporations every week are now joining this new bandwagon saying “we want to be part of the solution and not part of the problem.”
Or perhaps they just saw gobs of money available to be made by getting in line with the government. After all, there was the Solyndra scandal and then GE reduced its tax burden to zero primarily with green energy tax credits. Al Gore has even gotten in on the government dole for green technology and made a fortune. And then of course there was Ken Lay.
In 1997, then-Enron CEO Ken Lay wrote an op-ed entitled “For Prevention’s Sake: Focus on Climate Solutions.” In it he strongly advocated the Kyoto Protocol, which would cap carbon emissions worldwide. On August 4, 1997, Ken Lay met with Bill Clinton, Al Gore, and others at the White House to discuss Kyoto. Ken Lay was an enthusiastic supporter. In 2001, Lay sent an emissary to the Bush administration to lobby for Kyoto. Surprisingly, his old friend turned him down (other interests to appease perhaps?). And of course, the reason Enron wanted cap and trade was the same as Goldman Sachs: to create a new energy market for them to trade in.
Cigarette CronyismInterestingly enough, the government actually makes more money off of tobacco than the tobacco industry (about $48 billion to $35 billion). And oddly (and morbidly) smoking probably saves the government money as it just means people die when they’re 50 or 60 instead of when they are 70 or 80 (and thus collect less Social Security and Medicare).
Cigarettes are still the most preventable cause of death around. So many would think the 1998 government lawsuit that lead to the Master Settlement Agreement would be a good thing. Not so fast. Here’s how Tim Carney describes it,
In exchange for settling all the state lawsuits filed in the 1990’s, the companies promised huge annual payments to state governments. To safeguard the new revenue stream, the states passed laws protecting Big Tobacco [the four largest retailers] from smaller competitors. Critics have called the MSA, “one of the most effective and destructive cartels in the history of the Nation.”
Many states are now extremely reliant on this tobacco money making, the government and tobacco industry are two peas in a pod.
What the Master Settlement Agreement did was simply cartelize the market. The settlement banned most advertising, which of course favored the big companies with well-known brands. But it also made sure “… that tobacco companies that were never sued, were never accused of wrongdoing, and in some cases didn’t exist when the alleged deception and wrongdoing occurred, and certainly never participated in the settlement would pay the same damages as the Big Tobacco companies…” The economies of scale for larger companies make these costs easier to swallow.
Small companies could get out of these payments if they “… joined the settlement within 90 days of its completion. …” But of course, there was a catch, “… small companies signing on to the MSA were not allowed to grow by more than 25 percent.”
Indeed, it’s hard to think of a better way to cartelize a market.
ConclusionBig government is not a hedge against big corporations. Generally speaking, they work together against the consumer. While government intervention in healthcare reform, greenhouse emissions, and tobacco could be attempted in a way that didn’t line the pockets of big corporations, it rarely turns out that way. Entrenched interests are the ones with influence after all. The best way to reduce the power and influence of corporations is to reduce the power and influence of government. Such a reduction would force firms to compete without special favors on the free market. Price and quality would be what set companies apart, not their ability to influence politicians.
International trade grabbed headlines this week with Monday’s announcement that twelve governments have reached agreement on the Trans-Pacific Partnership. While it should be of no surprise to see the news celebrated in the editorial pages of the Wall Street Journal or the Council of Foreign Relations blog, it is unfortunate even libertarian organizations are praising the agreement.
Of course, this is not the first time alleged defenders of lassiez-faire have endorsed intergovernmental agreements that enhance the power of the state. Ferghane Azihari and Louis Rouanet put TPP in historical context in Wednesday’s Mises Daily:
Murray Rothbard opposed NAFTA and showed that what the Orwellians were calling a “free trade” agreement was in reality a means to cartelize and increase government control over the economy. Several clues lead us to the conclusion that protectionist policies often hide behind free trade agreements, for as Rothbard said, “genuine free trade doesn’t require a treaty.”
Dr. Ed Stringham takes on the notion that government is necessary at all for markets and trade to thrive in his new book Private Governance. He joined Jeff Deist to discuss his work on the latest episode of Mises Weekends. Listen as Jeff and Ed destroy the argument that markets rely on government to protect property rights, mediate contracts, and numerous other excuses interventionists make in defense of the state.
In case you missed any of them, here are articles from this past week’s Mises Daily and Mises Wire:
The TPP and the Trade Rhetoric by Carmen Elena DorobățTPP: The Latest Assault on Free Trade by Ryan McMakenRothbard: Gun Regulation Explained by Murray RothbardIn Policy Debates, Can Economics Trump Ethics? by Matt McCaffreyThe Future Is Decentralized by Patrick ByrneNo More "Free Trade" Treaties: It's Time for Genuine Free Trade by Ferghane Azihari and Louis RouanetThe Menace of Egalitarianism by Lew RockwellFashionable Prohibition for Modern Lawmakers by Ryan McMakenIn Brazil, Free-Market Ideas Rise as the Economy Falls by Antony P. MuellerMissed last Saturday’s Mises Circle? Watch Jeff Deist, Tom DiLorenzo, Tom Woods and Lew Rockwell tackle the threat of political correctness.
The costs of centralizing information are higher than people understand. Until they have worked in actual organizations that have missions like fighting a war or making a profit, people tend to underestimate just how expensive it can be to centralize information.
If our mental picture of the world is like the pointy-haired manager in the Dilbert cartoons, we’ll tend to favor institutions where knowledge comes from the knowledge frontier, and is then moved to the central office where the managers sit and cogitate. The managers then push stupid orders back to the frontier.
And that pretty much describes the way collectivists want to organize the world. They don’t want there to be peer-to-peer consent because they think they can save a bunch of time and cost if everything can be centralized.
Hayek understood this well, especially in his 1945 article “The Use of Knowledge in Society.” This article influenced Thomas Sowell’s work in his books A Conflict of Visions and Knowledge and Decisions. And all of these works influenced me.
Thanks to the works of Hayek and Sowell, I’ve come to appreciate that whether we’re talking about business or social matters, life is all about avoiding the costs of centralizing information to some higher power that then spits orders out.
How To Build Enduring Organizations that Use Decentralized InformationI know the last thing I want to be is the Dilbert manager who sits in the corner and thinks he has all the answers. I know the smart people are on the front lines; the smart people with the ideas; the smart people who understand the marketplace and customer. So my job is building institutions that let that distributed intelligence express itself. So, in my businesses, I have built various mechanisms that let innovation come from the front lines, from customer agents, from people in marketing.
I want an institution that can let the knowledge of 2,000 colleagues form the new ideas, and their colleagues can work together to decide how to use the knowledge.
I want a system to crowdsource innovation. The wisdom of crowds is smarter, and more consistently intelligent, than any single person.
As owner I must sometimes say “I think you got that wrong, I have to veto you.” And by its nature, sometimes, employees, for legal reasons, can’t know everything about the company. But for the most part, I can let the company run, and by giving the employees what they need, they just get smarter and smarter, and do more and more.
There’s a field that evolved in the last seven years called Enterprise 2.0. The idea is to use online technology to keep organizations flat and to avoid hierarchy — and people collaborate through technology. A very simple example of this model is Wikipedia, and closely related to this is a field called “idea management.” Think of it as a super-sophisticated suggestion box in which people are making suggestions and other people are seeing their suggestions. People then vote others’ suggestions up and down. For example, suppose 200 ideas get proposed over a two-month period. Using idea management, we then have the crowd decide the best ten. And then we have the crowd rank them and decide which are best and which we should put capital into.
Here’s another example: at the end of last year, I knew I wanted to give my employees a $4 million raise. They had many suggestions including changes to the 401k, an addition of day care services, or just a simple pay raise. I gave their ideas to the accounting department to figure out what each one would cost. We put a price tag on each one, and I gave the list back to the 2,000 employees. They ranked each, and we ended up with a ranking, and we went down from the top, until we got to $4 million.
So more and more decisions are being made in our company, not by me, but by our people in general. The philosophy underlying this all comes from Hayek and Mises — the true knowledge among our colleagues is all out there.
I’ve got the staff that can figure out what each option will cost. But the truth is I don’t know which one is going to work, but I have found that when I turn that over to the group, the result is more intelligent than the executive group can do or what I can do by myself.
Why We Have Centralized Government InstitutionsNaturally, this has applications far beyond some private companies. When we look at government in Washington, or what’s happening on Wall Street, we see so much centralization. But really, our goals should be to eliminate and overcome these central institutions.
And in recent years we have gained powerful new tools to do this, and most significant among those is the block chain, which is the software behind Bitcoin. But it’s so much bigger than just Bitcoin.
I’m not sure that even in our pro-freedom movement, that people are understanding the significance of the block chain. I discussed the topic at length in Wired, but even more important was a recent article in Politico in which my work with the block chain was featured, as was the central problem of consensual exchange in the marketplace.
This is where the block chain is most useful and revolutionary. It helps us to overcome the problem of mutual trust in exchange, which will in turn make many of our modern central institutions unnecessary.
So what is this problem of trust in mutual exchange? Well, if I have a camel and you’re going to give me a gold coin in exchange for it, I have to trust that you did not debase this coin.
Certain groups will then attempt to develop a business model that can address this problem. For example, an organization (i.e., a monarch) that has a monopoly on violence in some area can monetize this monopoly by saying “I will mint gold coins and put my face on them, and if anyone tries to debase those coins, I’ll kill him.”
That’s just a business model, and we happen to call that business model “government.”
So the question is: can we just have consensual exchange, or do we have to pick some central institution that we can trust, so we don’t have to trust each other?
There are, of course, many other examples of the usefulness of central institutions in exchange. If we want to buy and sell land, and we don’t trust each other, we can use a central institution called a land title office, which will ensure that the sellers actually own the land they’re selling. Governments all across the world are involved in this every day. And as Hernando de Soto discussed in his book The Mystery of Capital, it is difficult to have capital formation when you don’t know for sure who owns what.
So, throughout human history, we have relied on these central institutions to help us overcome this problem of trust in exchange.
But, as we know, there are problems that arise from these systems, as well.
Decentralizing Wall StreetNot all of these central institutions are what we call government. Yes, many of these institutions are run by guys in two-piece suits in Washington. And some are run by guys in black robes. Some are done by people with badges and guns. But many of them are done by guys in three-piece suits on Wall Street.
Wall Street, however, is not immune to fraud and abuse, and this problem is often made worse by centralization. But most people don’t know how these central institutions work.
When you watch a movie, for example, you know there are things going on behind the scenes, and you probably assume the same is true for Wall Street. But on Wall Street, that behind-the-scenes stuff works a lot differently than you think it does.
Unbeknownst to many, Wall Street now relies on central institutions that were created in the 1970s all allegedly with the purpose of accomplishing what’s called “settlement” which is the process through which securities actually change hands in exchange for payment.
These central institutions were created to replace the old “stock-jobbers” who carried around sacks of stock certificates in the old days, but who couldn’t keep up with the tripling of trading volume that occurred during the 1960s.
So we now have these central institutions that handle the problem of settlement by controlling the flow of information and the stocks themselves. But new problems have arisen as a result. As of 2008, for example, it was quite possible that Merrill Lynch was sending you a statement at the end of the month saying you own 100 shares of IBM, and other people saying the same thing. But back at Merrill Lynch, they only had 100 shares. They were telling five different people they had 100 shares.
On most days that won’t make a difference. But deep down that’s a game that looks a lot like fractional reserve banking.
And as a result, the system was being looted, and just like if someone practiced fractional reserve banking and wasn’t telling anyone, someone could loot that vault and take advantage of investors for a long time before anyone noticed.
And just in general, this is what happens when you have centralized institutions.
Getting Rid of CentralizationThe key to overcoming the problems in these central institutions is the block chain. Because, with the block chain, for the first time, we no longer need these central institutions for settlement, or for guaranteeing the value of coins, or for land titling. All of these functions can be replaced by a transparent public ledger that is safe from tampering, and which can make value and ownership clear and open for everyone. This is information that is decentralized, and is not controlled by any central organization. We don’t need central institutions to control or protect this information anymore. Using the block chain, we can disrupt all these systems — and much more, too — and the institutions behind them. In turn, this spreads decision-making and the use of knowledge to a much larger number of people and institutions. The advantages of decentralization that are already being employed in private companies can then be felt society-wide.
In other words, with the block chain, we liberals — those of us who have been fighting authoritarianism, whether it’s socialism or fascism or “social justice-ism,” for 500 years — just got “the bomb” in this fight. It’s something new.
And this is why the block chain and I got so much attention in response to that recent Politico article. I was told that the article was being talked about all over Washington. And they were talking about it because these institutions that are threatened by the block chain have finally figured out that they’re in trouble.
The CEO of JPMorgan, Jamie Dimon, for example, wrote a letter to shareholders in April that basically freaked out over the block chain. He told shareholders that “Silicon Valley is coming to eat Wall Street’s lunch.” Since he did that, everybody on Wall Street in the last three months — it seems every day, there is a new announcement coming from another corporation — whether UBS, Credit Suisse, Morgan Stanley, saying “we have to study this and get involved.”
But it’s too late for them. A year and a half ago, we started on this, and we’ve been very aggressive about developing new systems that can challenge these old central institutions.
I’m not doing this because I want to create a new monopoly. On the contrary, I want to create a bomb to blow up these central institutions.
Whether it’s a single company, or a stock exchange, or an entire society, we know — thanks to Hayek — that information is best used when it’s not centralized and when it’s not being monopolized by some central institution. We know that flat and non-hierarchical systems use information best. I’ve tried to do that with my own company because it works better that way. And society at large will work better as well, if we can get rid of these old institutions and hierarchies. New innovations like the block chain can make this possible.
We knew when the internet was being created, that it was going to cause profound changes. But this new invention and the crypto revolution is going to be more significant than the internet itself.
Bill Bonner, founder of Agora Financial, joins the show to discuss the hysteria preceding Janet Yellen's announcement last week that the Fed would not raise interest rates. We also consider various ugly endgames for the US dollar, and whether federal debt will all come crashing down with a bang or a whimper.
The image of a dead three-year-old Syrian refugee washed up on a Greek shore sparked renewed international focus on the waves of Middle Eastern and North African immigrants fleeing their war torn homelands. The issue has been presented by politicians and the media almost exclusively through a statist lens: a choice between government-imposed integration as proposed by open borders advocates, or government-enforced exclusion advocated by nationalists who wish to wall off their nation from foreigners. But we must never lose sight of fundamental issues, namely property rights and the freedom of voluntary association.
For this reason, we felt it was important to bring back an article written in 2005 by Dr. Per Bylund addressing the complexity of the immigration issue. Dr. Bylund reminds us:
With the state as it is today, should we as libertarians champion open borders or enforced property rights (with citizens’ claims on “state property”)? Both views are equally troublesome when applied within the framework of the state, but they do not contradict each other; they are not opposites.
To dive deeper in this important topic, Dr. Bylund joined Jeff Deist for this week’s episode of Mises Weekends.
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Real Wealth Weaker than GDP Stats Show by Frank ShostakAn Unhappy Union: Marriage and the State by Andrew SyriosWhy the Greeks Should Repudiate Their Government’s Debt by Simon WilsonAfter the Greek Crisis, Euro Elites Dream of a Unified Euro State by Ryan McMaken"Mathiness" vs. the Logic of Action by Jonathan NewmanWithout Government, Who Would Force a Men's Barbershop to Cut Women's Hair? by Ryan McMakenNext WeekAll eyes will be on the Federal Reserve as the FOMC meets to consider raising interest rates for the first time since 2006.
Jeff Deist and James Rickards discussed what the Fed will do on this episode of Mises Weekends.
Monday, September 14th, is the 66th anniversary of the first edition of Human Action.
Our guest this weekend is Jim Rickards, the author of the New York Times bestseller The Death of Money and a well-known expert in geopolitics and global capital.
Jim and Jeff discuss the unfolding drama at the Fed, which can't decide when—if ever—QE will come to an end. They also discuss possible endgame scenarios for liquidating unprecedented amounts of sovereign, commercial, and household debt; whether coming monetary shocks will present the IMF with an opportunity to demand a global currency reset, and who wins and loses when the game of musical chairs stops. This is a must-hear interview for anyone interested in currency wars, central banks, and the unholy politics behind it all.
See Jim Rickards' Strategic Intelligence newsletter.
See the transcript of this interview.
Last Monday's mini-crash in equity markets reminded many people of the dark days following the Crash of 2008. The 400 richest people in the world collectively lost $124 billion—at least on paper—in a single day. And the average investor may get tired of seeing his or her net worth take a nosedive every 7 or 8 years.
Here to make sense of market crashes is our own Dr. Joe Salerno. Why does the financial press fail to see monetary inflation as the cause of stock bubbles? Why is deflation portrayed as an enemy to be defeated, rather than a sign of a more productive economy? Why do even seasoned financial experts fail at timing the market? And are deflationary crashes actually the cure for a sick economy?
Patrick and Jeff discuss European integration, which pits creditor nations like Germany against hapless debtors like Greece under the yoke of the Eurozone. With the Euro operating as a political project rather than a real currency, spendthrifts like Greece chronically find themselves unable to service debt. Greece, says Patrick, represents an example of Say's Law in action and a clear refutation of Keynes's belief that creating artificial demand via cheap credit stimulates production.
Think Greece can't happen here? Look no further than California, with its public pension crisis and huge debts.
If you're looking for a sober and hard-hitting analysis of what's really at issue in Greece, stay tuned for a great discussion with Patrick Barron.
In a world of private property rights, where the contracts that derive from those rights must be honored, there would be no controversy about the rights of corporate “stakeholders.” Owners of capital resources pool them and delegate day-to-day control to corporate management as their agents. The only stakeholders those delegated agents agree to represent are the owners of those resources (i.e., the shareholders).
However, stakeholder theory has made major inroads into firms’ fiduciary obligations to owners in recent decades. In consequence, shareholders have been increasingly demoted from owners with decision rights over their own assets to just one of many groups, all of whose desires must be incorporated into management decisions. That makes it worth revisiting the stakeholder approach to corporate management, as its growing influence increasingly insulates it from serious consideration.
Transaction Costs and Social CooperationOne of the great benefits of clearly defined property rights is that they specify who parties must reach agreement with — everyone whose legitimate property rights would otherwise be violated. The consent of other parties, who have no authority to say “no” to others’ arrangements, because that extends beyond the reach of their property rights, need not be acquired. The result is far lower transactions costs. That enables far more mutually beneficial specialization and exchange, and the massive increases in production and wealth that results.
One consequence of the clear definition of corporations as acting in the interests of those whose resources formed them — stockholders — is that it vastly increases their ability to raise large sums to benefit from economies of scale and scope. It also increases the liquidity of investments, decreasing the risks to owners involved, by making exchanging ownership claims far less costly. In contrast, if stakeholder theory was generally applied to corporations, it is hard to imagine efficiently conducting almost any large-scale or complex production process, involving vast numbers of contractual arrangements, as massive transactions costs would overwhelm the potential gains.
Shareholders’ Interests Take Other Legitimate Stakeholders into AccountFormer GE head Jack Welch once criticized the shareholder interest model of the firm as “the dumbest idea in the world.” He asserted that employees, customers, and product quality deserved priority over shareholders. But it is not a choice between employees, customers, and product quality versus advancing shareholders’ interests.
But attention to employees, customers, and quality in an unhampered market (as opposed to crony capitalism, from which GE benefited immensely), is the means to advancing shareholder interests. Share prices reflect gains from better utilizing and motivating employees’ skills and abilities, from better developing and serving customers, and from product improvements that users value more than they cost. All those stakeholders’ interests, derived from their property rights and the requirement of voluntary, mutually beneficial cooperation, are aligned with those of profit-seeking shareholders.
In other words, other valid stakeholders’ interests are reflected by shareholders’ interests, not trampled by them. Workers have to voluntarily agree to their terms of employment. So firms will consider everything that workers or potential workers care enough about to offer the potential for a beneficial alteration in the terms of employment. But no party is ever allowed to escape the constraint of the need for others’ voluntary cooperation.
Suppliers and venders are considered in a similar way. Any alteration that costs a firm less than it saves suppliers could receive mutual agreement. Consumer interests are also clearly taken into account, as they are the ultimate “enablers” of what is profitable and survivable, versus what is unprofitable and unsurvivable. Explicit, enforceable contracts spell out the terms some agree to. Powerful reputation and reliability mechanisms also put up what amounts to a bond to ensure reliability — the present values of future profits from ongoing “good” behavior, put at risk by poor present performance.
As a further example, consider how professional sports teams consider fans. Those teams are certainly interested in making higher profits. So they care about those who go or might go to games, and all the things that might swing their decisions. They care about those who buy or might buy team hats, jerseys, etc., in a similar way, as well as those who might or might not listen on radio or watch on television (through ad revenues, subscription services, or broadcast right sales, etc.). They even care about those who do none of those things, but talk about the team around their water coolers at work, which can influence others’ revenue-generating behavior. Such fans need no direct power over team decisions in order to have their desires reflected in those decisions.
Divergences Between Stakeholders’ Interests and Shareholder InterestsAs we have seen, many stakeholders’ interests are consistent with advancing shareholders’ interests, including workers, suppliers, customers, and even fans, are all incorporated in shareholders’ interests because they must be induced to cooperate on mutually agreed terms. If this was all stakeholder claims represented, stockholders would not object to stakeholder claims. But they often object strongly. What does that tell us? Those claims require imposing someone else’s decisions in place of owners’ decisions in an involuntary manner, which requires coercion against them. The coercion involved is also revealed by falling market capitalizations when campaigns for new “social responsibility” requirements target them. Further, even though “benefit corporations” can now be formed to advance specified stakeholder interests as well as stockholder interests, they have remained relatively uncommon, due to the difficulty of finding investors who agree both on their desires to advance the same stakeholder interests and the trade-offs they are willing to make between those ends and profits. That would not be the case if the stakeholder approach was generally superior in the eyes of those whose rights are involved.
The coercion necessary to impose stakeholder obligations in violation of stockholders’ property rights, in turn, explains why stakeholders turn to government actions or threats to advance their claims. It is also why stakeholder claims play greater roles in more heavily regulated industries. Stakeholders’ ability to exercise political clout over government decisions can then more effectively be used to extort firms (e.g., banking, where permission to open new branches or make other transactions can be subject to “community” support or opposition).
Ex Ante versus Ex PostStakeholder claims beyond those enabled by pre-existing property rights can often be best understood as ex post (after the fact) theft or piracy. They wait until something valuable has been created by others’ voluntary relationships, then try to deal themselves into leverage or power over subsequent choices, even when they had no appreciable role in causing its creation or growth. That makes their role as “benefactors,” because it is funded with other people’s resources, all benefit and no cost for them — self-defined social nobility for free. It is reminiscent of where people live in neighborhoods that “grew” in place of earlier citrus groves, but who then blockade others’ rights to do exactly the same thing with their land, in the name of protecting the community.
Stakeholder Claims Are AsymmetricalIt is important to note that stakeholder attempts to leverage new power are also asymmetrical. Those non-shareholders who claim they should be given a say in firm decisions do not propose granting outside stakeholders rights to similar influence over their actions.
If “community groups” are to be enabled to dictate firms’ choices because they are stakeholders, shouldn’t firms have similar powers over community decisions, because they are substantial stakeholders in the community? If a firm’s current workers should have decision-making power over it because of their stake in its policies, shouldn’t a firm have similar decision making power over those workers? After all, just as workers have a stake in not having their pay cut, the firm that employs them (and its customers) has a stake in workers’ pay not being jacked up.
The history of political power also shows that it is most commonly utilized to support the already politically powerful. A good illustration is plant-closing legislation, which represented the politically powerful interests of local workers who are outcompeted by others who are not politically influential, but would offer consumers better terms. Similarly, anti-takeover laws were widely enacted to protect rather than prevent inefficient management teams, by insulating them from the threat of losing their jobs due to takeovers whose profitability lay in increasing efficiency and benefits to customers.
The Stakeholder Approach Reduces the Accountability of ManagementAnother important problem of stakeholder theory is that it wipes out clear criteria — profitability — to evaluate managers, instead substituting ambiguous and often mutually inconsistent criteria, with no way of determining agreed-upon trade-offs. While this will serve stockholders poorly, it will often serve the interests of managers who would thereby see their constraints eased. That is a major reason why many managers support the stakeholder approach. It not only allows them to survive inefficiency and poor management, diametrically opposed to what stockholders hired them to do, but also gives them the ability to be seen as business statesmen and philanthropists in the process.
ConclusionShareholder control of corporations follows from private property rights and the requirement that delegated agents perform their contractual commitments. In other words, it derives from self-ownership and liberty in economic arrangements. Firms, as agents for shareholders, have to live up to their voluntarily agreed contractual obligations to customers, suppliers, employees, and owners. As a result, they all benefit from those arrangements. Beyond that, a firm’s sole obligation to others is, in Walter Block’s words, “the one we all have to each other: to refrain from threatening or engaging in initiatory violence against them and their rightfully owned property.”
That is why Block described stakeholder claims as “the entering wedge of yet another attack on private property rights.” Given the immense wealth enabled by that arrangement, the costs of undermining it on behalf of self-determined stakeholders are similarly immense. And the process of determining who will qualify as a stakeholder and how large each stake shall be will entail the arbitrary and coercive substitution of politics over voluntary exchange.
James Grant, of Grant's Interest Rate Observer, recently joined us at our event in Stamford, Connecticut, to discuss his new book, The Forgotten Depression—1921: The Crash That Cured Itself.
If you've never heard of the Depression of 1921, it's because the federal government and the (then new) Federal Reserve did the opposite of what they did in 2008: federal spending was cut, the federal budget was balanced, and interest rates were allowed to rise. In other words, real austerity measures were implemented. The result? A short economic contraction that healed itself.
If you want to understand why TARP stimulus, too big to fail bank bailouts, and quantitative easing make our current economic crisis worse, there's nobody better than Jim Grant to explain.
David Stockman is our guest this week in the second of a two-part interview. Stockman was a congressman, Ronald Reagan’s budget director, and a private equity fund manager who saw the devastation brought to American companies by an economy built on cheap debt instead of real productivity. His book The Great Deformation is a tour de force exposé of crony capitalism, an indictment of Treasury Department and Federal Reserve bailouts following the crash of 2008, and one of the most important books on crony capitalism ever written. His Contra Corner website is a daily must-read for anyone interested in the truth about our rigged economy.
The William H. Peterson Lecture, sponsored by Robert L. Luddy. Recorded at the New York Area Mises Circle in Stamford, Connecticut, on 7 May 2015.
The F.A. Hayek Lecture, sponsored by Dr. Rafael Perez-Mera. Recorded at the New York Area Mises Circle in Stamford, Connecticut, on 7 May 2015.
The Murray N. Rothbard Lecture, sponsored by Caitlin Long. Recorded at the New York Area Mises Circle in Stamford, Connecticut, on 7 May 2015.
David Stockman is our guest this week in the first of a two-part interview. He is also speaking at our Mises Circle event in Stamford, Connecticut, next week, along with Jim Grant and Judge Andrew Napolitano (watch for free at Mises.org/Live). Stockman was a congressman, Ronald Reagan’s budget director, and a private equity fund manager who saw the devastation brought to American companies by an economy built on cheap debt instead of real productivity. His book The Great Deformation is a tour de force exposé of crony capitalism, an indictment of Treasury Department and Federal Reserve bailouts following the crash of 2008, and one of the most important books on crony capitalism ever written. His Contra Corner website is a daily must-read for anyone interested in the truth about our rigged economy.
Interviewed by host Phil Pepin, Mark Thornton discusses the fed's role in the 2007 crash, the fed's special treatment of banks, and the effect of the fed's hold on interest rates.
Our show this weekend features Patrick Byrne, the Chairman and CEO of Overstock.com. Patrick was here at our Auburn campus this past week presenting a keynote speech at our Austrian Economics Research Conference. His talk focuses on institutional design—how entrepreneurs ought to operate. Patrick also discusses Bitcoin technology and the entrepreneurial opportunities behind the Blockchain, itself. What Patrick is cooking-up could revolutionize the financial markets in the form of a peer-to-peer trading system that could actually replace Wall Street.
The F.A. Hayek Memorial Lecture, sponsored by Toby Baxendale. Recorded at the Austrian Economics Research Conference at the Mises Institute in Auburn, Alabama, on 13 March 2015. Includes an introduction by Joseph T. Salerno.
The Henry Hazlitt Memorial Lecture, sponsored by James M. Rodney. Recorded at the Austrian Economics Research Conference at the Mises Institute in Auburn, Alabama, on 12 March 2015. Includes an introduction by Joseph T. Salerno.
Recorded during the Authors' Forum at the 2015 Austrian Economics Research Conference, David Rapp discusses his recent book, Zur Sanierungs- und Reorganisationsentscheidung von Kreditinstituten [On Banks’ Decision for Restructuring] (Springer Gabler, 2014).
This weekend, we feature our own Senior Fellow Mark Thornton in an appearance on Paul Molloy’s "Freedom Works" radio show.
Mark is known for his work on the Skyscraper Index Model, which can help us understand why booms are followed by busts, why malinvestment is inevitable in an era of artificial interest rates, and how central banks cause so much harm.
Building booms—especially in the context of big city skyscrapers—can be clear signs of dangerous bubbles and hubris. It’s no coincidence that the Empire State Building was built on the cusp of the Great Depression, and Moscow’s empty new financial center is an eerie reminder that phony growth can end very quickly. With huge mega-towers planned for China, Korea, Saudi Arabia, among others, the “skyscraper curse” may strike again.
Jeff Deist and Jay Taylor, host of Taylor’s Hard Money Advisers, discuss the role of Austrian economics in understanding the market crash of 2008; and how some institutional investors used Austrian theory to get very rich shorting that crash. If you are interested in markets, business cycle theory, and what Austrian theory has to say about the even bigger bubble created by the Fed since 2008, you will enjoy this episode.
People accuse Austrian economics of being overly theoretical—but our guest John O’Donnell proves them wrong. He’s applied Austrian economics consistently over his long career both as a successful investment banker and the CEO of several public companies.
John met Murray Rothbard in the 1970s, and everything changed. He became a thorough Rothbardian and a dedicated libertarian—not to mention a close friend of hard money stalwarts like Doug Casey and Harry Browne.
You’ll enjoy hearing his memories of how Murray owned a room, how Murray’s incredible sense of humor was matched by his sheer endurance for late nights, how measuring investment returns in fiat currency is nonsensical, and how Wharton, Harvard, and the London School of Economics produce so many clueless Keynesian MBAs.
Volume 17, No. 4 (Winter 2014)KEYWORDS: John Maynard Keynes, marginal efficiency of capital, net present value, interest rates, central bankingJEL CLASSIFICATION: E12, E22, E52, In his recent article, Edward W. Fuller (2013) compared the Keynesian Marginal Efficiency of Capital approach with the Austrian Net Present Value approach. While his article has some important insights regarding the different treatments of investment projects in these two approaches, the result that the two approaches result in different rankings will only hold if factor prices are held constant. But, as the paper states, such an assumption is generally not true.
To briefly summarize Fuller’s main point: the net present value criterion demonstrates that there is a “switching” from one type of investment project to another as interest rates change. In particular, as interest rates rise, shorter projects will be preferred, while longer projects are preferred when interest rates are lower. In the marginal efficiency of capital approach, there is no such switching. Rather, there is an invariant list of projects with each listed by its rate of return (defined as that interest rate which sets the net present value equal to zero), and the going interest rate acts as a “hurdle” rate, determining how far down the list investors will go when funding projects.
All of this is true, if we hold the cost of starting the projects (and therefore the rate of return) constant. However, if we include the insight that “[c]ompetition between investors creates a tendency for the net present value of an investment project to equal zero” (Fuller, 2013, p. 381), then these results fail to hold. To show this, I will slightly modify Fuller’s examples.
Suppose that we have two projects that would utilize the same resources, so entrepreneurs with these two projects in mind are bidding against one another. The first project (“Project 1”) pays $1,000 of positive cash flow in each of the next three years (equivalent to Fuller’s “wooden bridge”) The second project (“Project 2”) pays $1,000 for each of 8 years, starting 3 years from now (equivalent to Fuller’s “steel bridge”). Fuller assumes that the first project will cost $2,000 to start, while the second costs $5,000. That is where the problem lies: if competitive bidding occurs, then the starting cost is not fixed. It will depend on the interest rate, and the Net Present Value (NPV) of the project with greater present value will be zero, while the less valuable project’s NPV will be negative. In short: while it is true that, “other things equal”, as the interest rate changes, the NPV will change as described by Fuller, Fuller has argued that when the interest rate changes, the startup cost of the project will change as well—and will change to keep the NPV at zero for any projects that get funded. To reexamine Fuller’s point, we calculate the Present Values (not the Net Present Values), under the assumption that the two projects are competing ways of using the same set of resources.
Table 1. Present Values
As long as the interest rate is below 28.18 percent, the longer project has a higher present value, so entrepreneurs pursuing Project 2 will get control of the resources and pursue that project. If interest rates are above 28.18 percent, then the shorter project will have a greater present value, so entrepreneurs that pursue Project 1 will win control of the resources and pursue that project.
On the whole, the story here is very similar to Fuller’s, simply because Fuller’s NPV was really just present value, but subtracting an arbitrary constant that he treated as the startup cost. However, the story changes if we allow for the startup cost to change and then look at the marginal efficiency of capital (MEC) criterion. To calculate the MEC, first I assume an interest rate. Then, I calculate the present value of the two projects. Then, I assume that the project’s startup cost is equal to the greater of the two present values. Then, I calculate the interest rate that would be required to make the Net Present Value of each project zero.
Table 2. Marginal Efficiencies of Capital
Once we correct for the changing cost of startup, the net present value and marginal efficiency criteria will give the same ordering—Project 2 is preferred if the interest rate is less than 28.18 percent, Project 1 is preferred if the interest rate is more than 28.18 percent. The reason is that the net present value of the “winning” project is zero, so the MEC of the winning project is equal to the going interest rate. The “losing” project has a negative NPV. To increase the NPV to zero, the MEC must be below the going interest rate used to calculate the original NPV.
But, what if we allow that the startup costs may be fixed? Does that suggest the rank ordering will be different for the two projects? Yes and no. Fuller has already laid out the reasons for a “yes” answer, so let me present the reasons for the “no.” If we apply the net present value criterion correctly, the decision we are making is not which of two (or more) projects to select—it is whether we should pursue a particular project at all. If the NPV is equal to or greater than zero, then investing in the project is wealth-enhancing. If the NPV is less than zero, then investing in the project is wealth-diminishing. In the following table, I assume that the startup cost is always $2,000, and bold those projects that should be undertaken. Then, I calculate the MEC for each project, assuming a $2,000 startup cost.
Table 3. Net Present Values (fixed startup cost of $2,000)
Under these assumptions, if the interest rate is less than 23.38 percent, then both Project 1 and Project 2 are undertaken according to the NPV criterion. If the interest rate is less than 26.48 percent, but greater than 23.38 percent, then Project 2 is undertaken, but Project 1 is not. If the interest rate is greater than 26.48 percent, then neither project is undertaken. By definition, the MEC of Project 1 is the interest rate that makes the NPV zero—so 23.38 percent. By definition, the MEC of Project 2 is 26.48 percent. So, using the marginal efficiencies of capital and comparing to a hurdle rate gives the same result as looking for a net present value greater than zero.
All of that said, Fuller raises an interesting point: Austrian theory is primarily about which investment projects get chosen, while Keynesian theory is driven by the question of how many projects get chosen. The goal of this comment is to add some clarification for two underlying reasons for those differences. The first reason is that Keynesian theory assumes idle resources. The second reason flows from that assumption: in Keynesian theory, prices of starting investment projects do not fully reflect expected, discounted present values of those projects—instead startup costs are “sticky.” Thus, Austrians, focusing on unsustainable malinvestments, see credit expansion as destructive while, for Keynesians, “[t]he conception of the interest rate as a hurdle rate naturally leads to a monetary policy of manipulating the interest rate.” (Fuller, 2013, p. 394)
Another year is under way, and we are in the midst of yet another central bank-induced credit bubble. This time, the culprit is shaping up to be the oil and gas industry. Hydraulic fracturing, or “fracking,” has seen a marked rise in usage in the United States over the last six years. It represented a new and innovative way to extract hydrocarbons from rock formations deep underground. Many may be tempted to say that the emergence of fracking, as well as the jobs it has created, is further evidence of the free market at work. However, as David Stockman makes clear in this excellent article, the fracking bubble would never have materialized if not for artificially low interest rates instituted by the Federal Reserve in the advent of the 2007–2009 financial crisis.
Oil and natural gas exploration and extraction via hydraulic fracturing is a highly capital-intensive venture. Given that the shelf life of a typical oil well is only two years, these firms need to establish new ones as maintaining existing wells proves too expensive. If not for the six years of Zero Interest Rate Policy (ZIRP) and several rounds of Quantitative Easing (QE) from the Federal Reserve, many of these upstart wildcatting firms would not be able to sustain the cost of exploration and extraction. Having record low borrowing costs has led to massive increases in production, and an influx of new jobs in the field due to economies of scale. In fact, a large percentage of the job gains we have seen since 2008 have been in the fracking industry.
The situation bears strong similarities to the inflating of the housing bubble from 2002–2007. Overproduction due to expectations of increasing demand because of the false impression of a strong economy, a large spike in job growth in the sector that will surely reverse as the bubble bursts, and companies (oil and gas wildcatters in place of homebuilders) issuing large sums of debt to fund their seemingly profitable ventures. However, just as in the case with the housing bubble, this boom was not induced by market fundamentals and an increased demand to feed this increase in supply. Firms, able to see energy as an indispensable sector just as housing, began directing their resources there and had no reason to believe oil prices would crash (sound familiar?).
Now companies and media outlets are scrambling to discover what the break-even oil prices are, because as the price continues to fall so does the collateral underpinning the large sums of bank debt. It is also worth mentioning that these oil and gas companies comprise approximately 17 percent of the overall high-yield debt market. This is a debt market for businesses with shorter track records of debt service and lower credit ratings, and offers slightly higher interest rates than standard investment-grade corporate bond markets in order to compensate the investor for heightened risk of default. A wave of defaults from these fracking companies would lead to ripples in the overall high-yield debt market, contributing to a market sell-off in the asset class that drives bond prices down sharply and inversely raises borrowing costs for other firms in the junk bond space.
Given the tentative strategy of the Federal Reserve in raising the benchmark interest rate, a sudden and unexpected increase in borrowing costs for businesses in the high-yield debt space is a serious cause for concern. The potential damage could be severe, as many of those bubble-created jobs would be in jeopardy. Whatever the result, the slowly unwinding fracking bubble should serve as a stark reminder about the importance of the Austrian business cycle theory. Years of QE and ZIRP have recreated an asset bubble in our economy with tremendous implications, and as the specific asset class may continue to change the same underlying problem of malinvestment and misallocation of resources will persist if central bankers do not change course.
Image source: iStockphoto.
The homeownership rate is now back where it was forty years ago. So what did all that federally-subsidized homebuying over the past decade accomplish? There was a lot of malinvestment, and a lot of politically-favored interest groups that got richer, writes Ryan McMaken.
This audio Mises Daily is narrated by Clay Barnett.
In 2014, the US homeownership rate fell below 65 percent, which means it’s back to where it was during the 1970s and much of the 1990s. Various federal agencies have long made homeownership a priority, and have introduced a bevy of government and quasi-government programs including the GSEs like Fannie Mae, FHA-insured loans, VA-insured loans, the Bush administration’s “American Dream Downpayment Initiative” and, of course central bank meddling to keep interest rates nice and low for the mortgage markets.
And for all their efforts, all the inflation, and all the taxpayer-funded subsidies poured into bailouts, we have a homeownership rate at where it was forty years ago. During the housing boom, though, homeownership rates climbed to unprecedented levels, cracking 70 percent or more in many parts of the country. When the boom in homeownership came to an end, it was not a painless matter of people selling their homes. It was a very costly readjustment process, and it was something that would have been completely unnecessary and would never have happened to the degree it did without the interference of Congress, the central bank, and the easy-money induced boom they engineered.
The American Dream = HomeownershipHomeownership rates have never been an indicator of economic prosperity. Switzerland, for example, has a homeownership rate half of the US rate. Nevertheless, raising the homeownership rate has long been a pet project of politicians in Washington.
The political obsession with raising homeownership rates dates back to the New Deal when Roosevelt began introducing a variety of homeownership programs designed to drive down the percentage of households that were renting their homes. Based on romantic ideas of frontier homesteading, it was assumed that owning a house was the only truly American way of living. It was during this time that the thirty-year mortgage — an artifact of government intervention — became a fixture of the mortgage landscape. And homeownership rates did indeed increase. And with it, debt loads increased as well.
By the 1990s, central-bank engineered low interest rates propelled mortgage debt loads to awe inspiring new levels, and houses kept getting bigger as families got smaller. Government-sponsored entities like Fannie Mae and Freddie Mac kept the liquidity flowing and home equity lines of credit turned houses into sources of income.
From 2002 to 2007, those of us who worked in or around the mortgage industry were amazed at just how easy it was to get a loan even with a very sketchy credit history and unreliable income. Only token down payments were necessary. Many of these less-than-impressive borrowers bought multiple houses. Behind all of it was the Federal government and the Fed forever repeating the mantra of more homeownership, lower interest rates, more mortgages, and rising home prices. The rising homeownership levels were for the populists. The rising home prices were for the bankers and the existing homeowners.
A Housing-Related Employment BubbleThe housing bubble became the gift that seemingly never stopped giving because with all this home buying came millions of new jobs in real estate, construction, and home mortgages. Seemingly everyone looked to real estate as a source of easy money. The bag boy at your local grocery store was selling condos on the side, and everyone seemed to be selling new home loans. Home builders couldn’t keep up with the orders and contractors had six-week waiting lists.
We know how that all ended. The foreclosure rate doubled from 2002 to 2010. Implied government backing of Fannie Mae and Freddie Mac became explicit government backing, and numerous too-big-to-fail banks which had invested in home mortgages were bailed out to the tune of hundreds of billions of taxpayer dollars. Some lenders like Countrywide and Indymac essentially went out of business, and all lenders (including many who were not bailed out) faced costs ranging from 20,000 to 40,000 per foreclosure in lost revenue, legal fees, and other costs. Foreclosures begat foreclosures as foreclosure-dense neighborhoods were most prone to price drops, leading to negative equity, which in turn led to even more foreclosures. Ironically, the most responsible borrowers — the ones who made sizable down payments and reliably made payments, and thus had more skin in the game — were the ones who suffered the most and who had the most to lose by simply walking away from their homes.
Real estate agents, loan industry professionals, construction workers, and others who relied on the home purchase industry lost their jobs and had to spend time and money on retraining in completely new industries. Or they were simply among the millions who collected unemployment checks and food stamps supplied by those who still had jobs.
Was the Bubble Worth It?And for what? The opportunity cost of it all was immense and during the bubble years, total workers in housing-related employment ballooned to 7.4 million, many of whom were fooled by the bubble into thinking the home-sales industry was a good long-term career. To get these jobs they spent many hours and thousands of dollars on certification, training, and job experience. After the bubble popped, three million of those jobs disappeared. From 2001 to 2006, employment in the mortgage industry increased by 119 percent, only to have most of those jobs disappear from 2006 to 2009.
Now, there will always be people who make bad career decisions, and there will always be frictional unemployment, but without the housing bubble and the myriad of federal programs and central bank pumping behind it, would millions of workers have flooded into these industries knowing that most of them would be unemployable in that same industry only a few years later? That seems unlikely.
Moreover, might we be better off today if those same people, many of whom were very talented, had invested their time and money into other fields and other endeavors? What businesses were never opened and what products were never made because so many flocked to the housing sector? We’ll never know.
Thanks to the government’s relentless drive for more homeownership and ever-increasing home prices, millions of workers concluded that real-estate jobs were the best bet in the modern economy. They thought this because investors chasing yield in a low-interest-rate environment were pouring their money into owner-occupant housing in response to government guarantees on single-family loans and easy money for mortgage lending.
The people were promised more homeownership, but after just a few years, it has become clear they didn’t get it. At the same time, Wall Street was promised high home prices, and when the prices faltered, it was offered bailouts instead. Wall Street got its bailouts.
The cost of the housing bubble is often calculated in dollar amounts that can easily be counted on Wall Street, but for those who aren’t politically well-connected — for ordinary workers, homeowners, construction firms, and many others — the cost in time and lost opportunities will forever remain among the many unseen costs of government intervention.
Image source: iStockphoto.
Martin Armstrong is one of the most famous economic forecasters alive, but you wouldn’t know it after the whitewashing job he’s suffered at the hands of the federal government and the mainstream financial press. The man who in the 1980s and 90s had central bankers and politicians calling him for advice is now scrubbed from the memory banks of sites like Bloomberg.com.
He’s famous—or infamous—for having predicted the October 1987 Black Monday crash to the very day. He also called the Nikkei stock market collapse in 1989 and the Russian financial collapse in 1998. And he hasn’t lost his touch, outfoxing hedge fund managers by predicting last week’s Swiss National Bank decision to abandon its peg to the euro.
Martin is not an Austrian by any stretch, relying on complex mathematical and historical models rather than economic theory. But he is strongly anti-state, anti-central bank, and quick to criticize Keynesian orthodoxy.
Martin spent more than a decade in a government cage after being prosecuted by the SEC, including seven years for the non-crime of contempt of court. His story—both as a forecaster and a stubborn thorn in the side of federal prosecutors—will be told in an upcoming documentary. It’s a story you won’t want to miss.
Legal recreational cannabis/marijuana/pot is almost one year old in Colorado. The Denver Business Journal recently published a retrospective containing several articles reviewing the experience. The general conclusion is that it has been a big success, not the tragedy some had predicted or claimed. The remarkable thing is that the report claims the biggest remaining problem for the industry is caused by the Federal Reserve!
Some of the big concerns prior to legalization have turned out to be trivial or failed to materialize at all. Expectations of overdose deaths, delinquency, and crime did not materialize to the extent that the newspaper barely reported on those issues. Crime in Denver actually declined in early reports.
Earlier this year, I examined the experience in Colorado and found that most reports were favorable to legalization. For example, the Business Insider reported that “Legalizing Weed in Colorado Is A Huge Success,” although they did report a “down side” as well. Jacob Sullum reported that such things as underage consumption and traffic fatalities declined, but not significantly within an already declining trend.
There was one early report that strongly called into question the legalization of marijuana in Colorado. It was put out by an outfit called the “Rocky Mountain High Intensity Drug Trafficking Area” program. It turns out that the program is part of the White House Office on Drug Policy, but that fact is not advertised in the report. Their lengthy report, “The Legalization of Marijuana in Colorado: The Impact,” appears to be very scientific and evidence based. However, I found it has more logical holes than a wheel of Swiss cheese gone wrong.
There certainly has been an increase in consumption and some diversion to minors. Colorado has historically been a high use and high abuse state, ranking above the national average in many categories. However, Colorado is close to the national average in the important category, the rate of drug overdose deaths, and the majority of deaths are the result of prescription painkillers, such as Vicodin and Oxycontin.
It is also true that there is anecdotal evidence of problems with legal weed in Colorado. There was the young man who consumed several times the recommended number of marijuana-infused cookies and jumped from a hotel to his death. There was a story of a dog that died after eating cookies left on the kitchen table. And there were several stories of children stealing cookies from their homes or their grandmothers and sharing them with their friends at school.
However, these events are still just newsworthy anecdotes, not trends or statewide calamities. They are also predictable. In transitioning from prohibition to legalization there are going to be such problems, but competition has its many ways of weeding out such problems over time. The marijuana dispensary industry has already been implementing new procedures and new ways of packaging edibles to improve their safe use.
Federal Regulations Prevent Financial Freedom in the IndustryThe one remaining problem is that people in the growing and retail businesses have been denied access to the banking system. Without bank accounts, and being a largely cash business, the firms are more at risk of robbery. Without bank accounts it is more difficult to pay vendors and employees, and paying fees and taxes to local governments has created headaches for all. Everyone agrees that the simple solution would be to allow the use of credit cards and bank accounts.
Local banking officials seem to be cooperating. The Colorado Division of Financial Services issued a charter for a credit union designed to serve the industry. However, efforts are being blocked by a holdup on obtaining deposit insurance and by none other than the Federal Reserve nixing efforts for the credit union to obtain a “master account” from the Federal Reserve.
A master account provides banks and financial services companies with a primary nine-digit routing number, which is the nine digit number on the bottom left of your bank checks. Without the routing number a bank cannot participate in the Fed’s check clearing system and this would make the use of checking accounts prohibitively inconvenient.
Trouble in the Federal Courts?An additional new hurdle for legal pot recently emerged when the states of Nebraska and Oklahoma sued Colorado over its legalization law in the US Supreme Court. Those states argued that Colorado's licensing of marijuana dispensary stores violates the US Constitution's Supremacy Clause. This clause says that when there is a conflict between federal and state law, the federal law trumps state law.
I am not a legal scholar, but it seems to me that Nebraska and Oklahoma have little or no “standing” in bringing such a lawsuit. I also believe that this Supreme Court can see the “writing on the wall” when it comes to things like legalizing pot and gay marriage. The writing on the wall comes from the people, and a large and growing majority of the people support medical and recreational marijuana legalization. Demographically, these majorities can be expected to grow into supermajorities in a fairly short time frame.
Colorado is only the cutting edge. Recreational marijuana has also passed in Washington, Alaska, Washington, DC, and in some local jurisdictions. More states are on their way to recreational marijuana and there are twenty states with legalized medical marijuana.
Including states that have decriminalized marijuana, the majority of Americans now cannot be put in jail for consuming small amounts of marijuana. Government officials have attempted to portray legalization as reckless and chaotic, but those who favor the limits on government should not attempt to derail these legalization efforts. Such efforts will only serve to enhance the cause of human liberty at the expense of political power in the long run.
Interviewed by host John O'Donnell, Peter Klein discusses the economics of sports business and the role that crony capitalism plays in professional and quasi-professional sports, plus what 2015 may hold for markets.
Looking back on our first year of Mises Weekends, we decided to check the numbers and run the program with the highest ratings as we close out 2014. So based on analytics from YouTube, iTunesU, and Stitcher, the #1 show of the year is none other than Patrick Barron in a two-part interview on the end of US dollar supremacy.
Recorded in October, Patrick and Jeff discuss how the dollar became the world’s reserve currency after Bretton Woods, the dollar’s evolution as a weapon of mass US imperialism, and how its inevitable decline will have horrific consequences for those nations—and individuals—not prepared for it.
We’d love to know what guests you’d like to hear—and what questions you’d like asked—on Mises Weekends in 2015. Let us know via twitter @mises_media, or by emailing weekends@mises.org.
Interviewed by Albert Lu, host of the Power & Market Report, Mark Thornton talks about the collapse in oil prices.
Jeff Deist addresses the topic of Austrian investing with Chris Casey, Managing Director of WindRock Wealth Management. If you are an investor and you are interested in Austrian Economics, you will enjoy this show.
Jeff Deist and Robert P. Murphy address the vital topic of Fed interference in financial markets. Are the global equity and bond markets a charade, engineered by monetary expansion and destined to collapse like a house of cards? Is the investing game basically rigged? How can Janet Yellen and financial elites keep markets from crashing without endless new rounds of quantitative easing? Why is understanding Austrian economics necessary, but not sufficient, to be a successful investor? And how would stock markets have a social function in a free society? Anyone interested in investing, personal finance, Austrian economics, and the wit and wisdom of Bob Murphy will enjoy this show.
There are strong indications that the remarkable run up of asset prices in the last few years is beginning to run out of steam and may be on the verge of collapse. We will leave aside the question of whether the asset inflation is symptomatic of a garden-variety inflationary boom or is a more virulent bubble phenomenon in which prices are rising today simply because buyers anticipate that they will rise tomorrow.
The Evidence
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The dizzying climb of London real estate prices since the financial crisis, noted in a recent post by Dave Howden, may be fizzling out. Survey data from real-estate agents indicate London housing prices in September fell 0.1 percent from August, their first decline since November 2012. Meanwhile, an index of U.K. housing prices declined for the first time in 17 months. In explaining the "pronounced slowdown" in the London real estate market, the research director of Hometrack Ltd. commented, “Buyer uncertainty is growing in the face of a possible interest-rate rise, a general election on the horizon and recent warnings of a house-price bubble,” which is playing out "against a backdrop of tougher mortgage affordability checks and limits on high loan-to-income lending."
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Just released data from the Dow Jones S&P/Case Schiller Composite Home Price Indices through July 2014 shows a marked deceleration of U.S. housing prices. 17 of the 20 cities included in the 20-City Composite Index experienced lower price increases in July than in the previous month. Both the 10- and 20-City Index recorded a 6.7 percent year-over-year rate of increase, down sharply from the post-crisis peak of almost 14 percent less than a year ago.
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More ominously, U.S. Total Household Net Worth (HNW), as recently reported by the Fed for the second quarter of 2014, reached a record high of $81.5 trillion, over $10 trillion higher than the level at the peak of the asset bubble in 2007. Furthermore, the 2014 figure was $20 trillion higher than the level of the post-crisis — and pre-QE — year of 2008, when asset prices and the real structure of production were just beginning to adjust to the massive capital consumption and malinvestment wreaked by the Great Asset Inflation of 1995-2005. The increase in household wealth has been driven mainly by the increase in prices of financial assets which was generated by the Fed's zero interest rate policy and its force feeding of additional bank reserves into the financial system via its quantitative easing programs. (See chart below). These policies falsify profit and wealth calculations and give rise to unsustainable investments and overconsumption. Once interest rates begin to adjust to their natural levels, however, asset prices are revealed to be grossly inflated and collapse. The asset inflation may be reversed even without an increase of interest rates, if people lose confidence in the narratives fabricated and propagated by government policymakers, economists, and the financial commentators to promote the continuation of the inflation in asset markets. Furthermore it is risible to believe that real wealth in the US in terms of the factories and other capital goods to which financial assets are merely ownership claims, has increased by over one-third since 2008, especially in light of the additional malinvestment and overconsumption caused by monetary and fiscal policy “stimulus” since then.
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If we look at HNW in historical perspective, we note that, in the chart below, the HNW/GDP (or wealth to income) ratio is now at an all-time high. From 1952 to the mid-1990s this ratio averaged a little more than 350 percent and never went above 400 percent until 1998 as the dot-com bubble was blowing up. It peaked at nearly 450 percent before the bubble collapsed causing the ratio to plummet to slightly below 400 percent, indicating the beginning of the purging of the illusory capital gains created during the asset inflation.
But just as the adjustment was beginning to take hold in 2002, the Greenspan Fed played the deflationphobia card, driving interest rates to postwar lows and pumping up the money supply (MZM) by $2 trillion from beginning of 2001 to the end of2005. During this second phase of the Great Asset Inflation, the HNW/GDP ratio again reached a new high before plunging below 400 percent during the financial crisis. And, tragically, the nascent readjustment of financial markets to the underlying reality of the economy’s shattered and shrunken production structure was yet again aborted by government intervention in the form of the heterodox monetary policies of Bernankeism combined with the outsized deficits of the Obama administration. These policies succeeded in driving the HNW/GDP ratio to yet another new high, but without having the expected stimulatory effect on consumption and investment spending.
Conclusion
In sum, I do not expect that the ratio will rise much above 500 percent — Americans have just not saved enough since 1995 to have increased their real wealth from 3.5 times to 5 times their annual income. Nor is there much reason to expect a plateau anywhere near the current level. Once interest rates begin to rise — and rise they must, whether as a result of Fed policy or not — the end of the asset price inflation will be at hand. The result will be another financial crisis and accompanying recession. The Fed and the Administration will no doubt attempt to bail and stimulate their way out but given the still dangerously enervated state of the financial system and the real economy, it will be like dosing a horse that has already been overdosed to death. Thus my forecast for the U.S. economy one year to two years out echoes that of Clubber Lang, the villain in the movie Rocky III. When questioned about his forecast for the forthcoming fight against Rocky, Lang replied, “Pain.”
Image source: iStockphoto.
A panel discussion at the 2014 Mises University addressed the question of whether Austrian economics can improve financial predictions.
We first want to distinguish between a colloquial meaning of prediction — improving the accuracy of one’s expectations — and the more rigorous sense of actually knowing the future. Austrians emphasize that the belief that one actually knows the future can be very dangerous, especially when central planners start to think their statistics and charts constitute crystal balls.
On the other hand, Austrian economists certainly predict in the more colloquial sense of improving accuracy of expectations. Indeed, Austrian economists even look both ways before crossing the street.
A secondary discussion has focused on the prediction failures of particular financial commentators who try to use an Austrian approach. This is a valid point; anybody who predicts for a living deserves to have their record examined. But in the process we want to be careful to assign blame correctly; was the theory to blame, or did the practitioner either misuse theory or combine that theory with bad data.
So, first, we want to be specific about what economic theory itself can and cannot do. Critics seem to think theory should be a map, when theory itself is more like a compass: a compass that tells you where to go, not how to get there. Just as there are good and bad compasses, there are good and bad theories.
In the real world, prediction is a spectrum: we might predict the sun will rise tomorrow, that winter will be colder than summer, that money-creation leads to inflation. All of these predictions are subject to outside factors, therefore they all run on different probabilities and different magnitudes.
Reading astronomy alone won't tell you if winter will be mild. And it certainly won't tell you if a given day will be cold. Similarly, economic theory will not give you precise magnitudes nor will it give you precise timing. For that we need to supplement the theory with data. This proposition, that theory alone does not give you all the answers, is a part of "radical uncertainty" in Austrian economics, a concept admirably popularized by Nassim Taleb's best-seller The Black Swan.
To actually predict using an economic theory — any theory — you need data. A good theory will tell you what data you need. If you choose well, that data informs your magnitudes, and it's the magnitudes that give you your best timing.
To see why, consider walking backward on an eastbound train. The train is pointed east, and you walk west. Which direction is your body moving? Well, are you walking fast? Is the train moving slow? Newtonian physics or human anatomy will only get you part-way. Closer than Aristotelian physics and octopus anatomy, to be sure. But you'll need to supplement the theory with data. The theory is necessary but insufficient.
The question becomes, then, whether Austrian economics is better theory. Does it give better answers about fundamental trends. After that, no matter what theory got you there, you'll have to plunge into the data.
One of my favorite examples is the role of consumption in economic growth. Consumption is taken by most non-Austrian economists as a positive indicator of economic health. Like a doctor's thermometer, consumption tells you the economy is "healthy" and likely to grow. Non-Austrians make this prediction largely via correlations: higher consumption is correlated with future growth.
An Austrian, on the other hand, starts with logical causation. And, logically, when an extra resource is consumed that means it was not invested and it was not saved. After all, you can only do three things with a resource — consume it, invest it, or set it aside for the future. So raise consumption of resources and you necessarily lower either physical investment or you run down the stock of saved resources.
So an Austrian doesn't naïvely celebrate consumption. Rather, our theory tells us which data to use next. Was the extra consumption siphoned out of investment? Or was it siphoned out of savings?
If it came out of savings, then consumption may well grow tomorrow's GDP, albeit "stolen" from the future by running down saved resources. If, on the other hand, it came from investment, then the mainstreamers are completely wrong — siphoning from investment to consumption will have no impact on current growth and will actually harm future growth. Simply because investment makes stuff in the future, while consumption does not.
The point here is that data alone doesn't tell you the whole story, which is a core proposition of the Austrian approach. Instead, you need to start with good theory that tells you which data you need and where to look next. Guiding that process is the fundamental proposition of Austrian prediction, and to ask for more is to fundamentally misunderstand what theory can do. Just as Newton alone won't tell you who's walking west on a train, Austrian theory alone won't do all the work in investing.
An earlier version of this article appeared at Realclearmarkets.com
Image source: iStockphoto
Not unlike governments, ponzi schemer Bernie Madoff used his victims' money to exhibit his "generosity" through charitable giving projects, writes Brandon Dutcher. This audio Mises Daily is narrated by Keith Hocker.
Interviewed by Merlin Rothfeld and John O'Donnell, Mark Thornton discusses the seven mega-trends facing our economy and what it means looking forward. Dr. Thornton also talks about the great classes available at Mises.org which will further improve your understanding of how our economic system functions.
Jeff Deist and Patrick Barron discuss what's going on in the EU, how Germany in particular suffers from being yoked to the other Eurozone nations, and what the comeback of the Deutsche Mark might mean for Europe — and for America.
Patrick Barron is a private consultant in the banking industry. He teaches in the Graduate School of Banking at the University of Wisconsin, Madison, and teaches Austrian economics at the University of Iowa.
There is a story about the great Catalan surrealist painter Salvador Dali. It is said that in the last years of his life, when he was already famous, he signed checks knowing that they would not be submitted to the bank for payment. Rather, after partying with his friends and consuming the most expensive items the restaurants had to offer, he would ask for the bill, pull out one of his checks, write the amount, and sign it. Before handing over the check, he quickly turned it around, made a drawing on the back and autographed it. Dali knew the owner of the restaurant would not cash the check but keep it,put it in a frame, and display it in the most prominent place in the restaurant: “An original Dali.”
It was a good deal for Dali: his checks never came back to the bank to be cashed, and he still enjoyed great banquets with all of his friends. Dali had a magic checkbook.
But what would have happened if one day art collectors concluded that Dali’s work really did not capture the essence of surrealism, and therefore that his art was not of great value? If that had happened, every autographed check would have come back to the bank (at least in theory), and Dali would have had to pay up. If Dali had not saved enough money, he would have had to find a job painting houses.
While the analogy is not perfect, we may find that something similar can happen with the Fed and the dollar. For now, The Fed has a magic checkbook that allows it to spend without paying the bill because it thinks the checks will never come back to be cashed.
Dali died long before people stopped valuing his art, but the US economy does not enjoy such a convenient escape. What if, as in the case of art collectors who might no longer see great value in Dali's work, the world loses faith in the quality of the dollar and stops using it for large international transactions? If that happens, in the same way Dali would have had to pay his bills, the US would also have to make good on the checks it signed. Would the US be able to pay its checks with more checks?
Since each country has its own currency, every central bank around the world has to print more of its national currency to buy the excess of dollars entering the country whenever the US expands its money supply. Thus, in the 1970s, in the wake of the Nixon Shock, members of OPEC accused the US of exporting inflation.
Recall that during the mid-1960s, the US central bank was financing a war in Vietnam and as well as funding Lyndon B. Johnson’s programs of “The Great Society”that supposedly would eliminate poverty. As the Fed was printing money, OPEC members had to inflate their currencies to buy the excess of dollars.
Central banks around the world have to buy excess of dollars entering their countries so their exports do not lose competitiveness. Thus, a double inflation is imposed on every country in the world, one created by its own domestic central bank, because all central banks inflate on their own, and another created by the US central bank. Hans-Hermann Hoppe wrote about the perils of monetary imperialism:
The dominating state will use its superior power to enforce a policy of internationally coordinated inflation. Its own central bank sets the pace in the process of counterfeiting, and the central banks of the dominated states are ordered to use its currency as their own reserves and inflate on top of them. Thus, along with the dominating state and as the earliest receivers of the counterfeit reserve currency, its associated banking and business establishment can engage in an almost costless expropriation of foreign property owners and income producers. A double layer of exploitation of a foreign state and a foreign elite on top of a national state and elite is imposed on the exploited class in the dominated territories, causing prolonged economic dependency on and relative economic stagnation in comparison with the dominant nation. It is this — very uncapitalist — situation that characterizes the status of the United States and the US dollar and that gives rise to the — correct — accusations concerning US economic exploitation and dollar imperialism.See Hans-Hermann Hoppe, “Marxist and Austrian Class Analysis.” Journal of Libertarian Studies 9, no. 2 (Fall 1990). www.mises.org/journals/jls/9_2/9_2_5.pdf
While it is true that in the 1970s the dollar enjoyed a worldwide hegemony — given that all European countries had their currencies separated, and given that China and Russia were outside the capitalist world — now the situation is different. Vladimir Putin recently stated that “The international monetary system itself depends a lot on the U.S. dollar, or, to be precise, on the monetary and financial policy of the U.S. authorities. The BRICS countries (Brazil, Russia, India, China and South Africa) want to change this.”See Vladimir “Putin, No plans for BRICS military, political alliance.” Russia: RT. Retrieved 16 July 2014. www.rt.com/politics/official-word/172768-putin-brics-economies-alliance
Salvador Dali had devised an ingenious method for not paying his bills. Similar stories are told about Pablo Picasso. But the Fed does not produce tangible items that people would rather hold on to, like an original Salvador Dali. The Fed does not produce work or items of value. The Salvador Dali effect, i.e., the ability to prevent checks from being cashed by creating something of real value, does not apply to the Fed. That is why it is good to remind the Fed, and the government, to be careful with the expenditures when partying, just in case the magic checkbook disappears.
Image source: Blue Wire Studio and Dante Bayona
This article is also available as an Audio Mises Daily
Everyone loves making a buck, including governments. Unfortunately, the reality of many “great deals,” especially in the history books, has today been inflated to mythical proportions.
While most countries throughout history expanded their frontiers through peaceful trade or the spoils of war, the United States purchased much of its land, mostly from foreign governments. Today several of these land purchases are immortalized as great financial coups for the country.
Of the great land purchases, the three most famous are: the purchase of Manhattan from the natives in 1626; the Louisiana Purchase from the French in 1803; and finally the Alaska Purchase from the Russians in 1867. Each of these transactions shares in common the fact that they were voluntarily agreed upon by the parties directly involved, and that the sums involved are paltry by today’s standards. (Historians debate whether the natives that “sold” Manhattan to the Dutchman Pieter Minuit understood the concept of private property in the same sense as European merchants. The surviving documents for the purchase of Manhattan show a completed contract with no ensuing bloodshed or hard feelings on either side.)
The problem with reckoning costs in historical terms is that it compares apples to oranges. A dollar today just doesn’t buy what a dollar bought in 1626, 1803, or even a decade ago.
Adjusting for the effects of inflation throughout American history is a little complicated. Up until 1914 America had been on some form of gold (or silver) standard. There were several bouts of deflation during this time to mute the effects of inflation, which in general was quite tame. Inflation averaged 0.4 percent per year prior to 1914. In 1914, the creation of the Federal Reserve System changed everything dramatically. With the ability to economize on bank reserves and to create fiat money at whim, the inflation rate surged. Since 1914 the inflation rate has averaged about 3.5 percent per year.
Adjusting the original purchase prices for inflation, they still look pretty good. In fact, the price Pieter Minuit paid for all of Manhattan would today buy about a half square meter of condo real estate on the island. Not bad. Likewise, sitting smack-dab in the middle of the Louisiana Purchase, farmland in eastern Nebraska today sells for around $7,000 an acre. The United States government bought roughly 53 million acres in 1803 for the same price as 100,000 acres of Nebraska farmland would cost today. Again, that looks like a shrewd investment.
But wait. When these tracts of land were initially purchased they were undeveloped. It would take some time before the pioneers, capitalists, entrepreneurs, and settlers arrived and started to make improvements to the land. Land in Nebraska or Manhattan is now more valuable because of the infrastructure improvements — highways, canals, utilities, and other services — that were made throughout the centuries. This allowed the land and people to be more productive.
Agriculture, such as dominates the eastern Nebraska landscape, has experienced productivity in leaps and bounds over just the past decades. Wheat yields which averaged less than 1,000 kg/Ha in the 1950s have increased to over 2,500 kg/Ha since the mid-1990s. Advances in mechanization, fertilizers, irrigation, herbicides, and methods of planting have all had the effect of increasing what we can harvest from this land. (In 1900, 38 percent of the US labor force was still employed in agriculture; today the figure is less than 1 percent.)
There was virtually no productivity on Manhattan island at the time it was purchased, and thus of less value. Today, 388 years later, and much work by hundreds of thousands of people, Manhattan has been transformed from a wilderness into a global financial center.
Adjusting the purchase prices for inflation for these three tracts of land is a good start, but it still compares apples with oranges. An acre of rocky, uncleared Nebraska land in 1803 is just not the same as a tilled, fertilized acre of farmland today.
To see if the prices paid centuries ago were reasonable, we need to determine what the same land is worth today; this will allow us to see what the return on the original investment has been. One way is to treat the current level of production in each region as a perpetuity to determine its present value. (We will discount these future cash flows at the long-run rate of nominal GDP growth of 5.5 percent.)
The greater metropolitan area of New York City generated $1.3 trillion in income in 2012, roughly 8 percent of the American total. The present value of a perpetuity paying $1.3 trillion per year (ignoring growth), discounted at 5.5 percent, is just shy of $24 trillion dollars.
The Louisiana Purchase is more complicated, as its boundaries do not correspond to actual states today. If we include states that have at least half of their area within what was the Louisiana Purchase: Montana, Wyoming, Colorado, Oklahoma, Louisiana, Arkansas, Kansas, Missouri, Iowa, Nebraska, South Dakota, North Dakota and Minnesota, we find that their combined output is roughly $1.7 trillion, or 12 percent of total American GDP. The present value of such a perpetuity (again, ignoring growth for simplicity) discounted at 5.5 percent is about $30 trillion.
Finally we get to Alaska. The total output of this state was around $60 billion last year in 2013, or about 3.5 percent of the total GDP of the United States. This perpetuity is worth around $1 trillion.
So how good were these original purchase prices viewed with the benefit of hindsight? We can answer this by comparing the present value of their current output with their original cost.
While historians often give credit for these purchases to the foresight of the governments of Thomas Jefferson and Ulysses S. Grant, in reality they haven’t paid off as well as one might expect. The Louisiana Purchase in particular has only “returned” about 7 percent once we adjust the figures for economic growth since 1803. The purchase of Manhattan hasn’t fared much better, and the figure would even be worse if we were to include only output produced within Manhattan, instead of the greater New York metropolitan area. All three purchases experienced fairly standard rates of return compared to what the general American economy has been able to generate.
By all appearances, instead of being wonder-investments they are just par-for-the-course. In comparison to many investors, like Warren Buffet for example, these returns are downright dismal.
To be fair, there are intangible benefits to each of these purchases not apparent in the objective numbers. Manhattan provided a trading foothold in the new world. The Louisiana Purchase secured the Mississippi River watershed, and with it, removed the ability of Napoleon and the French from halting the westward advance of Americans. Finally, Alaska has suffered from centuries of public ownership of its lands with heavy-handed regulations stopping entrepreneurs from developing its resources and putting them to good use.
This exercise demonstrates the dangers inherent in looking at historical transactions and thinking of them in modern terms. Not only is adjustment for inflation necessary, it may be insufficient as improvements to productivity still create a comparison of apples to oranges. The real value and relevancy comes by adjusting historical amounts by economic growth; only in this way can we grasp how profitable certain ventures have been.
Image source: iStockphoto
Robert Blumen, a software engineer with a background in financial applications, recently spoke with the Mises Institute about the Austrian School’s growing influence among investors.
Mises Institute: In recent years, we’ve seen more and more Austrian-tinged economic analysis coming from investors like Mark Spitznagel and Jim Rogers, to just name two. As someone personally involved in the investment world, have you yourself seen growth in Austrian ideas among investors and similar professionals?
Robert Blumen: There has been tremendous growth in interest in Austrian economics among financial professionals. I started an interest group for Austrians in Finance on LinkedIn which, in a few years, has grown to almost 2,000 members from the US, South America, East, Southern, and Central Asia, Africa, and Eastern and Western Europe. Peter Schiff appears regularly on financial shows. The Mises Institute drew hundreds of people from the investment world to an event in Manhattan.
Since 2002, a number of Austrian-themed books in financial economics have come out. Alongside titles from established writers such as James Grant, there is Detlev Schlichter’s Paper Money Collapse, and several books by Peter Schiff. There are many popular Austrian bloggers such as Grant Smith and Robert Wenzel. Over two million viewers watched a 2006 video in which a parade of condescending media hosts heap ridicule on Peter Schiff, who, to his credit, did not back down in the face of their smugness.
MI: Did the financial crisis of 2008 help increase the sympathy for Austrian economics?
RB: I have heard the same story from many people in finance. When the bust of 2000 (or 2008) happened, it did not fit what they had been taught in school, nor could it be explained within the belief systems of their colleagues in financial markets. Their next step was reading, searching for answers, and then, finding the writings of Mises, Hayek, or Rothbard that enabled them to make sense of what had happened.
To answer your question, yes, I think that the failure of the popular economic theories — evidenced by these inexplicable crises — has driven the search for superior ideas. The Mises Institute has been publishing for years, explaining these boom and bust cycles with Austrian economics. When people searched, many of them ended up at mises.org.
MI: In spite of lackluster growth on Main Street, Wall Street appears quite happy with growth over the past two years. For the casual observer, one might argue that the Fed has managed things well. What do you see as problematic with the current approach, and are there some in the finance world skeptical of the Fed’s current strategy?
RB: The Fed has a series of mistaken theories supporting their belief that higher stock prices indicate the success of their policies.
The first is the thinking that asset prices are actual wealth, when they are only the prices of the capital goods, which are a form of real wealth. Asset prices, in real terms, are the exchange ratios between consumption goods and capital goods. Artificially-boosted asset prices mean only that the owners of assets who bought them at lower prices have increased their consumption possibilities in relation to non-owners of assets. The owners of most assets, the so-called “1 percent” are the beneficiaries of Fed policies.
There is no systemic economic benefit to any particular value for stock prices. Young people saving for the future and entrepreneurs who are looking to pick up capital goods at bargain prices would find lower stock prices give them a better deal. This is the same as for any good.
Their second error is that higher stock prices create a “wealth effect,” in which people see their asset values rise, feel richer, and consequently save less and spend more. Their goal is to boost consumption through pumping up asset prices. As Keynesians, they are all in favor of this because they think that consumption drives production.
Sound economic thought has recognized, at least since the classical school, that production must precede consumption, and that production drives demand, not the other way around. The Fed understands none of this because they have no understanding of the purpose of capital goods in the production process, which is to increase the productivity of labor.
They believe this about home prices as well, which is arguably an even greater fallacy because homes are consumption goods. A rising standard of living means that we are able to buy consumption goods at lower real prices over time, not higher.
And finally, they see the stock market as a sort of public referendum on their policies. They point to the stock market and say, “see, the market approves of what we are doing.” But when you realize that through its monetary expansion, the Fed itself is responsible for the rising stock market, that calls into question whether we can use it as independent measure of public opinion, or instead, the Fed voting for itself with money that it prints.
Austrian-informed financial thinkers understand this. There are hundreds of Austrian-oriented blogs and commentary sites, as well as some excellent heterodox sites with a very Austrian-friendly perspective such as Zero Hedge, Jim Rickards, Marc Faber, and Fofoa.
MI: We’ve mostly been talking about the US so far, but speaking globally, do you see any areas that are of particular concern, such as China or the Euro zone?
RB: Credit allocation in China is not market-based. They import the Fed’s inflation through their currency peg, which diverts dollars into their sovereign wealth fund where it is “invested” by bureaucrats in various forms of dollar-zone assets. Their domestic savings go into their banking system, where it is wasted on politically-favored projects due to non-market allocation of bank credit. The entire system is experiencing a series of bubbles in real estate and other sectors.
Their rate of infrastructure spending for comparably developed economies is about twice as high as normal. This is because the communist party officials are under great pressure to hit GDP targets — as if prosperity could be spent into existence by hitting a number. Infrastructure such as roads and empty cities present an opportunity to spend a large amount of money, all in one place, on a lot of Very Big Stuff, which under market-based economic calculation would be revealed as wasteful.
The problems in Europe are a combination of the massive debts that can never be paid back, the unfunded entitlements, and the growth in the burden on producers, a theme that I addressed in my recent Mises Daily article on Say’s law. This burden consists of the totality of regulation, taxation, inflexible prices and labor markets, and the threat to the confiscation of wealth. If you project these trends into the near future, I’m not sure where the lines cross, but the system is clearly unsustainable in its present form because it relies on sustaining current levels of consumption as fewer and fewer people produce.
Image source: iStockphoto
This is a transcript of Jeff Deist’s interview with Andy Duncan on Mises Weekends.
Jeff Deist: Ladies and Gentleman, welcome to Mises Weekends. I’m your host, Jeff Deist, and I’m very happy to be joined by Andy Duncan. Andy, how are you this evening in the UK?
Andy Duncan: Well, it’s very nice to be with you again, Jeff.
JD: Andy, I’d like to get your impressions about UKIP. In the Western media, it seems to be portrayed a populist, nationalist, anti-immigration movement, but I’d like your thoughts.
AD: Well, the thing about UKIP, is it’s mostly a wing really of the Conservative Party. If you take the British Conservative Party from the 1970s, there was some very, what the media would call rightwing people in there, like Sir Keith Joseph and Margaret Thatcher and people like that. There’s also a big body of people behind them and they wanted to be independent with England. They wanted England to be like a free market, like a Singapore of the world, only a big Singapore, but the Conservative Party itself, the larger party, was much more kind of statist, socialist with a small “s,” so there is always this rump inside the Conservative Party and about 5-10 years ago, they just had enough, these people, and they just created the UK Independence Party because they didn’t believe the Conservative Party anymore, which has always been playing the rhetoric of we will leave Europe one day and they didn’t believe it anymore, so they decided to go it alone.
So, that’s how I see UKIP. It’s attracted a few people since then, as all political parties do once they grow power, they suck in intellectuals of various kinds, but the core to UKIP is a very what you might call, what the media in this country would call a rightwing Tory element. It’s very funny that today, a Conservative MP, Douglas Carswell, has actually defected from the Conservative Party and has joined UKIP. There might be about a dozen others in the Conservative Party in Parliament, who might defect as well. He’s standing against a Parliament in a few weeks’ time or a couple of months. If he wins, I suspect a lot of Conservative MPs will ditch the Conservative Party who were pro-EU and will get out and will join UKIP and that will hopefully wreck the Conservative Party.
JD: Andy, so just to clarify, there are no elected UKIP members in Parliament, i.e., in House of Commons.
AD: Well, Douglas Carswell is technically a UKIP MP now, but he has said that he will resign his seat immediately, on this declaration today and he will stand for reelection in what we call a local by-election, probably in a couple of months’ time. He has a very, very big majority at the moment, of something like 28% and he’s very, very popular in his constituency, so the chances are that he will win and that he will be the first UKIP member of Parliament. Nigel Farage is going to stand at the next election, you’ve probably heard of in the United States and he will probably win the seat that he chooses which I think is somewhere in Westminster and I’m hoping that, I don’t really follow politics that much, but when I do follow politics, I just follow the secessionary part of politics and I’m hoping that maybe 10, 15, 20 UKIP MPs will be elected at the next election and of course, being a Hoppean, I don’t vote.
JD: Well what seems odd about this system in UK is that UKIP sends many members to the European Parliament in Brussels, but it’s scarcely represented in Parliament.
AD: Well, the constituency elections are what we call here first-pass-the-post, so a town, say, like Redding, which I live near — I live in Henley on Thames — say, Reading will be divided into say, five constituencies and in each constituency there will be about 100,000 voters. Those 100,000 voters in each constituency will vote for one MP, so if say, everybody voted for one person, if everybody voted, if 51,000 people vote for one person, they become the MP, whereas with the European elections, it’s a big area and there’s party lists. So, Nigel Farage, I think, is an MEP for the Southeast of England, so they take, 15-20 million people and there’s usually very low turnouts in these elections and then depending on your votes across this huge area, I mean nobody knows who their MEP is. Nigel Farage might even be my MEP and I have no idea, very few people do. There’s a party list system that comes in play, so then they just go down the lists until you’ve used up your votes across this 15-20 million kind of area.
JD: Andy, Scotland has a proportionately high representation in Parliament, is that correct?
AD: Yeah, well actually that’s not the case in Scotland. Now this is an interesting thing. In Scotland, they have a lot smaller population, so as per MP, so out of about 600 MPs or so, about 40 of them are Scottish. Now if you were just to go on the population size, I’m not exactly sure of the exact numbers, but they would only get about 15 MPs. They have 40, whereas they should have 15. What this has done, is this has created this huge kind of political battering ram, the Scottish political vote in the House of Commons. If Scotland becomes independent, most of those MPs in the past have been Socialist MPs and so the Socialist Party in England, called the Labour Party, is going to lose a huge amount of power because they’re going to lose all the Scottish MPs and I think they only need about 30,000 people in each constituency in Scotland. And so almost the Labour Party will become unelectable, according to the current democratic setup in the UK and so the Labour Party is very, very keen on keeping the Union and stopping Scotland into going independent because if they let Scotland go independent, they’ll lose these 40 MPs, they’ll lose the balance of power and then the Conservative Party in England will be the dominant power for decades.
JD: Let me ask you this. Apart from the political aspects, is there any libertarian element to the UKIP revolution?
AD: There is a tiny libertarian element in the way that, for instance, the EU is just, on the first of September is going to ban vacuum cleaners of a certain wattage. This is obviously to give the eco intellectuals on the side, which all governments need the intellectual support. What this means is we’re all going to buy cheaper, nastier, less powerful vacuum cleaners and we’re going to spend longer in misery Hoovering our houses, just so that eco intellectuals can be happier with less powerful vacuum cleaners.
The EU has been doing this kind of thing for decades now and people just resent this interference of people they don’t know, people they’ve got no idea where these people got their power from, this kind of feudal setup of the EU and they’re just kind of a very primitive level, just anti- this monolith, altering the morale to making their lives worse all the time. They’ve banned decent light bulbs, for instance, and there’s now a black market in light bulbs. We all have to use these horrible mercury things, which are poisonous and difficult to get rid of and produce this white light that keeps you awake in the evening. I think the root of it, I think people genuinely know, deep down, that bigger government is worse for them and I think this is driving a lot of this secessionism and a lot of these failings and obviously as governments grow larger, more islands of socialism arise within the area that they control and then we get more chaos and we’ve seen with the EU, we’ve seen basically the destruction of Portugal and Spain and Greece and Ireland, by the EU, these islands of socialist chaos spreading in the EU.
JD: Andy, as I mentioned to you, I would love to discuss the upcoming Scottish Independence vote with you although I fear I’m going to get some angry emails. Here I am asking an Englishman about Scottish independence.
AD: Well, my name’s Andy Duncan and the first King of Scotland, according to some, in 734, was King Duncan I and my clan and the Duncan clan were at Bannockburn on the winning side, so I’m not entirely English. I’m kind of culturally half Scottish. So, I do have a little bit to say. The thing about the Scottish vote is, they’ll probably lose.
The Secessionists, unfortunately, will probably lose and the reason for that is because Scotland is being bought and paid for, I think as Robert Burns who said, we’re born and sold for English gold and a quarter of the adults in Scotland work for the British government, so they take a salary from the British government. There’s maybe a million pensioners are all receiving British government pensions and there’s all sorts of even private companies, a lot of their contracts are to the British government. So, Scotland is bought and paid for by the British government and I think people will vote with their wallets without any kind of morality about thinking this money is being stolen from others and then given to me, they won’t think that far. They’ll just think, who’s paying my salary? Who’s going to pay my pension? I’ll vote that way.
The general feeling in Scotland, though, is that people, even in 1707 when Scotland had this active union, it was only the elite that did that. They had this project called the Darien Project, you might have heard of, where when they were an independent country, they tried to form a colony in Panama and they basically took all the money in Scotland, this political elite, invested it in these ships to go to Panama. Everybody died of diseases and they created a legal monopoly for the company there that had a legal monopoly for all trade in the world with Scotland, just like monopolies and elites do. These people all went there and died of dysentery and whatever down there and the few that remained got killed by the Spanish, so the elites in Scotland were going to be poverty stricken, so they basically sold Scotland to the English in 1707 and all the people in Scotland were horrified by this. I mean, there had been Bannockburn, there’d been the Battle of Sterling Bridge, there had been an independent Scotland for 1,000 years and then it was just sold down the river by this elite in Edinburgh for English gold. Lots of the MPs in Scotland at the time of the political power elite, voted for the union. They were paid off by backdoor maneuvers. The treaty was rushed down to England and the armed guard, massive armed guard. It was totally hated, this thing in 1707 and ever since, the people of Scotland have had this general resentment about English interference in their lives and although many of them will vote to stay in the Union. There’s still a general feeling of antipathy towards England, even though many will go into the voting booth on September 18 and vote for the Union to remain.
JD: Andy, we were speaking off-mike earlier about how we as libertarians, tend to see secession and separatist movements as ever and always good things. Can you elaborate for us?
AD: Well, I think if you take an area, let’s say there is 2 million people and there’s a million people in one half and a million people in the other half, they’ll have a very powerful government, but if you split that area into two governments of one million people each, those two governments together are less powerful than the one big government alone and if you break that all the way down to the county, the town and the local area and then eventually the individual, every time you shrink a big government in half, you more than halve its power and so the elite in Westminster, in London, for instance, are terrified of losing Scotland because once we just become England here in England and not the United Kingdom, then all those people swanking around London in big cars and going to fancy foreign ministries and so on, will have less right to swank around like that. They’ll have less right to do these big foreign policy announcements. So, I always believe that the smaller that you can shrink them, the better because every time you do that, you more than shrink the power of the two governments which are left over.
JD: Can you give us your thoughts concerning how well the Scottish banking system and Scottish currency would operate without the backing of the Bank of England?
AD: Well, I mean, this is the great threat from the no campaign, which is “you must stay with the UK and hold aunty’s hand.” Scotland has a tremendous opportunity here, to become a kind of free-market Singapore of the North. I mean, many of our kind of free market Libertarian ideas come from Scotland, David Hume, and Adam Ferguson, and I won’t say Adam Smith because I know Murray Rothbard doesn’t like Adam Smith, but many of those great Libertarian ideas came from Scotland, and so it would be great if they did form this free marketplace and if they were booted out of the pound and then didn’t have a central bank and had to bring in a currency board to follow the pound or a currency board to follow the Euro, what they would lose is this ability to print money out of thin air, which would mean that the government would shrink massively. If they can’t print money out of thin air, they will just shrink and the welfare state will shrink and the state will shrink and they really will have a Singapore of the North and within 10, 15, 20 years, they would have this massively wealthy, dynamic enterprising society.
However, they don’t quite see it like that. The SNP, which is the driving force of Scottish independence, is a mostly socialist organization and how they’re couching it to the Scottish people is this. Yes, you will lose the English taxation for the welfare, but we will keep Scottish oil and you’ll get more welfare from the Scottish oil, none of whose revenues will go to England, than you will just being in the Union and receiving English taxation welfare, so that’s how they couch it is, you’ll have even more welfare than you’ve currently got whereas I would love to see them argue, you’ll be freer, you’ll be more independent, but unfortunately, most people are terrified of being freer and more independent and they just want a bigger nanny state, I think.
JD: Well, you bring up an interesting point. Independence seems to be a left wing phenomenon in Scotland and it seems to be portrayed as a right wing phenomenon in England.
AD: Well, it is a weird thing. I think in the Labour Party, this deep antipathy towards what Ayn Rand might have called the rugged individualist, best summed up in the kind of Anglo-Saxon free market thing. I mean, the Anglo-Saxons, when they were in Germany, fought off the Romans, defeated them in the Forest of Teutoburg and then faced away that bureaucratic threat and then eventually came to England and then were quite free and independent and had very strong freedom traditions. They took a lot of those traditions to the United States and to other parts of the world. So the Anglo-Saxon culture has always been seen I think by socialists as being something to be despised, you know, this treasuring of the individual and of liberty and so on.
So, Scottish independence, strangely, is seen as a way of throwing off the yoke of English right wing kind of thinking and being able to become even more socialist, so it’s the English who were seen or the English mentality of freedom and liberty, may be actually typified by Nigel Farage of UKIP, which is seen as being the problem, so it’s a great socialist thing to throw off the English yoke. Whereas in England, of course, the socialists in England, most of whom, there’s millions of them and lots of them read The Guardian newspaper, they love us to be in the EU because what that does is that’s a big blanket over the kind of English free spirit, so the EU is a way of moderating this Englishness, this kind of Anglo-Saxon thing. So, it kind of works if you see it like that. Scotland wants to get away from England to throw off the English yoke of freedom and English have been kept within the socialist yoke of the EU, to keep it in check.
JD: So perversely, it sounds like the rise of UKIP in England actually bolsters the yes independence vote in Scotland.
AD: Well, it is a weird thing. The UK Independence Party, led by Nigel Farage, as a kind of political statement, is actually against Scottish independence, which sounds a bit weird, doesn’t it? UK Independence Party is against Scottish independence. What Nigel Farage — he’s quite murky in what he says, but I’ve tried to interpret it and what I think he’s saying is this. If Scotland becomes independent, it’s not actually going to become more independent. It’s going to become more dependent on the EU because the first thing it will do, is it will join the EU promptly, maybe even adopt the Euro as the currency and instead of becoming more independent and having a free Singapore of the Northern Hemisphere, it will just become another area inside the Euro zone, so it will actually become less free than it currently is, joined to England.
JD: Andy, I’m sure you understand, as libertarians, it seems ludicrous that the Scots view Westminster as some kind of bastion of free market thought.
AD: Well, I mean, that’s the problem in the UK. I mean, I try to not be involved as much as possible, but we have three political parties here, three political elites and the Conservative Party, the Liberal Democrat Party and the Labour Party and the Conservative Party is supposed to be right wing and the Labour Party is supposed to be left wing and the Liberal Democrats are supposed to be somewhere in the middle, but they can all dance on the head of a pin. I mean, the leaders are indistinguishable. They read out indistinguishable speeches. They all believe in the same policies and when the horrible Gordon Brown, the Scottish Prime Minister was thrown out a few years ago in an election and David Cameron, the Conservative Prime Minister came in, I personally haven’t noticed a single difference in my life, absolutely nothing has changed.
So they just dance on the head of a pin. It’s all rhetoric. I think the British government spends something like 700 billion pounds a year, which is about 200 billion pounds a year more than they take in, in tax and they borrow the rest and the three main political parties argue about spending measures of around 10 billion pounds or 700 billion pounds would probably be about 1.2 trillion dollars. So, they argue, they get really vitriolic about these tiny, tiny, tiny changes in policy from each other, so I find it very weird that we even believe that there’s politics in this country. It’s just a group of people who just play musical chairs every four or five years.
JD: If the yes on independence vote somehow was to prevail in Scotland, do you think that that would inform other separatist movements that are currently percolating in Europe?
AD: Well, unfortunately, because of the bought and paid for nature of the Scottish electorates, don’t stay up late that night burning any candles or anything. It’s not going to be that exciting. The no vote will win and they won’t, I would bet a substantial sum of gold that the no vote will win. However, just like Robert the Bruce, I do believe that they will try, try, and try again and hopefully they will win eventually if they keep trying, but the problem is, is once they have this vote and the independence vote loses, it might be another decade or so before they get to have another go, but the spirit of Robert the Bruce will be there. I’m not historicist like the Marxists, but I do believe, though, that as we get these bigger and bigger governments, we do get these bigger and bigger islands of chaotic socialism within the areas that these governments control and that these islands of chaos eventually lead to people wanting to secede away from the chaos.
So, I actually personally think that we have a greater chance of secession somewhere more like Texas and that would be fabulous if Texas seceded, rather than Scotland. However, I think it is good that at least they’re trying and they’ll probably get 40, 42, 43% of the vote and the bigger the vote—if they got 48, 49, that would be fantastic because that would bring on the next secessionary vote to be a lot sooner, maybe within another 5, 6, 7 years. So, it does inform — there’s problems in the EU, it does inform us that people instinctively know that smaller government is better for them as an individual, but I see the future of secession as being in other parts of the world.
JD: Andy, do you think the urban versus rural mentality still plays a big role in the UK mentality?
AD: I don’t think it’s an urban-rural thing. I think it’s more of what some people in this country are called the chattering classes. These are the intellectuals, the political elites, the metrosexuals, the metropolitan people, and some of them have houses in the country and there’s lots of people in cities who are opposed to these people. They have this shared view, Sean Gabb who you might know, calls them the enemy class. I call them personally The Guardian-istas because the house newspaper is this terrible rag called The Guardian newspaper. It’s more of an intellectual elite versus everybody else, so this intellectual elite reads the Times, the Independent and the Guardian and they constantly bicker and chat about politics. They all are in favor of the EU, they’re all in favor of environmental measures. They’re all socialists with a small “s” even if they’re in the Conservative Party, their political positions are virtually identical in every possible way, bigger government, bigger government involvement, but the mass of people who are just doing daily jobs, you know, being plumbers, being truck drivers, delivering milk or whatever, they just don’t want any of this, but they’re too busy earning money and paying taxes to take much notice.
So, it’s not so much an urban versus rural thing. It’s a political intellectual elite with a small “s” socialist thing versus everybody else. So, in the last Euro election, which UKIP won, I mean UKIP actually won that election, all the newspapers were against UKIP, everyone was deriding them. Everyday, Nigel Farage had some story made up about him saying how he’d done this and he’d done that with this woman and he’d done this with this gambling, all prop fictional, but the people saw the message and they saw what he was saying and what he was saying is you’re better off without this massive superstructure of this elite and the costs associated with keeping them in the manner to which they have become accustomed.
JD: Andy, one last question in closing. Just give me your thoughts on the current state, if any, of the libertarian or Austrian movement in UK.
AD: Well, the problem with the libertarians in the UK I, it’s like cats in a bag. I mean, if you put 30 libertarians in a room, there will be 30 different positions. It’s quite frustrating at times. I mean, I go to the occasional conferences and I mean, people again, there will be vitriolic arguments with each other about the tiniest, tiniest thing, so this is why I always try and push secession because we all believe in secession, we all believe in coming down to the individual and I try to avoid conflict and there’s not many Austrians and if they are Austrian, they tend to be Hayekian Austrians. This is because of the link with Hayek and the London School of Economics and if you take a look at the most Austrian website in the UK, which is probably the Cobden Centre, which was founded by Steve Baker, MP, who is a Conservative MP who is very much a Misesian and it would be interesting if you got him on your program sometime to talk about his views, it’s still a bit Hayekian, this kind of — in the US, you’ve got George Mason University and you’ve got Auburn, I won’t go into the politics of that because I might get slapped by you, but there’s that distinct thing. We have the same thing in the UK.
We’ve got, most people that are Austrians are in London and they’re Hayekians and then there’s a few of us, not many, I probably know them all and I can probably count them all on one hand, that are kind of Misesian Austrians, but we are working on things. I mean, watch this space, a few of us Misesian, Hoppian, Rothbardian Austrians are thinking about doing something and you’ll be the first to know when or if we do that, but it’s very much a mixed bag in the UK. It’s very much a socialist country. Everybody believes in democracy. Most, except for a tiny, tiny handful of people believe in socialism of one form or another, i.e., statism and government intervention and government running the schools and government running the NHS, the National Health Service. I mean, you’re having a taste of that now with Obamacare and you’re seeing what that’s like.
Most people believe in the state in this country and even getting your haircut at a barber, I mean, I can hardly dare say anything because a barber almost threw me out of the shop, his barbershop recently with half a haircut because I dared say something that didn’t believe in the state and the whole of society is ridden with this belief that you are owed welfare and that the state has the right to do this and the state has the right to do that. I mean, just this year, children have now been compulsorily kept in education when 16 to 18, so I mean, I see state schools as basically day prisons and so there’s two more years of day prison being forced upon people and that pleases the teaching unions because they get to have more jobs and more work and more bureaucratic privileges and everyone’s just gone along with it. There hasn’t been a single murmur of complaints that I’ve seen anywhere in any of the press and these kinds of constant abrogations of people’s rights are just going on all the time. So, with the vacuum cleaner ban, of anything that’s too powerful, there’s a few murmurs of complaint, but hardly anybody really challenges the right of government to decide how powerful your vacuum cleaner can be, so libertarian movement in England, very small, not very strong. Everyone’s against each other, everyone holds different positions, but there are a few of us who are trying to work on making something stronger and basing it securely upon Misesian, Austrian economics.
JD: Andy, thank you so much for joining us. Thank you for a fascinating interview. Ladies and gentlemen, have a great weekend.
So far in August the differential between the yield on the 10-year Treasury note and the yield on the 3-month Treasury bill stands at 2.38 percent against 2.95 percent in December 2013.
Historically, the yield differential on average has led the yearly rate of growth of industrial production by fourteen months. This raises the likelihood that the growth momentum of industrial production will ease in the months ahead, all other things being equal.
It is generally held that the shape of the yield curve is set by investors’ expectations. According to this way of thinking — also labeled as the expectation theory (ET) — the key to the shape of the yield curve is the notion that long-term interest rates are the average of expected future short-term rates.
If today’s one-year rate is 4 percent and next year’s one-year rate is expected to be 5 percent, the two-year rate today should be 4.5 percent — since (4 percent + 5 percent)/2 = 4.5 percent.
It follows that expectations for increases in short-term rates will make the yield curve upward sloping, since long-term rates will be higher than short-term rates.
Conversely, expectations for a decline in short-term rates will result in a downward-sloping yield curve. If today’s one-year rate is 5 percent and next year’s one — year rate is expected to be 4 percent, the two-year rate today — (4 percent + 5 percent)/2 = 4.5 percent — is lower than today’s one year rate of 5 percent (i.e., a downward-sloping yield curve).
But is it possible to have a sustained downward-sloping yield curve on account of expectations? One can show that in a risk-free environment, neither an upward nor a downward-sloping yield curve can be sustainable.
An upward-sloping curve would provoke an arbitrage movement from short maturities to long maturities. This will lift short-term interest rates and lower long-term interest rates, i.e., leading toward a uniform interest rate throughout the term structure.
Arbitrage will also prevent the sustainability of an inverted yield curve by shifting funds from long maturities to short maturities thereby flattening the curve.
It must be appreciated that in a free, unhampered market economy the tendency toward the uniformity of rates will only take place on a risk-adjusted basis. Consequently, a yield curve that includes the risk factor is likely to have a gentle positive slope.
It is difficult to envisage a downward sloping curve in a free unhampered market economy — since this would imply that investors are assigning a higher risk to short-term maturities than long-term maturities, which doesn’t make sense.
The Fed and the Shape of the Yield CurveEven if one were to accept the rationale of the ET for the changes in the shape of the yield curve, these changes are likely to be of a very-short duration on account of arbitrage. Individuals will always try to make money regardless of the state of the economy.
Yet historically either an upward-sloping or a downward-sloping yield curve has held for quite prolonged periods of time.
We suggest an upward- or a downward-sloping yield curve develops on account of the Fed’s interest rate policies (there is an inverse correlation between the yield curve and the fed funds rate).
While the Fed can exercise a certain level of control over short-term interest rates via the federal funds rate, it has less control over long-term interest rates.
For instance, the artificial lowering of short-term interest rates gives rise to an upward-sloping yield curve. To prevent the flattening of the curve the Fed must persist with the easy interest rate stance. Should the Fed slow down on its monetary pumping the shape of the yield curve will tend to flatten. Whenever the Fed tightens its interest-rate stance this leads to the flattening or an inversion of the yield curve. In order to sustain the new shape of the curve the Fed must maintain its tighter stance. Should the Fed abandon the tighter stance the tendency for rates equalization will arrest the narrowing or the inversion in the yield curve.
The shape of the yield curve reflects the monetary stance of the Fed. Investors’ expectations can only reinforce the shape of the curve. For instance, relentless monetary expansion that keeps the upward slope of the curve intact ultimately fuels inflationary expectations, which tend to push long-term rates higher thereby reinforcing the positive slope of the yield curve.
Conversely, an emerging recession on account of a tighter stance lowers inflationary expectations and reinforces the inverted yield curve.
A loose Fed monetary policy (i.e., a positive sloping curve), sets in motion a false economic boom — it gives rise to various false activities. A tighter monetary policy, which manifests through an inversion of the yield curve, sets in motion the process of the liquidation of false activities (i.e., an economic bust ensues).
A situation could emerge however where the federal funds rate is around zero, as it is now, and then the shape of the yield curve will vary in response to the fluctuations in the long-term rate. (The fed funds rate has been around zero since December 2008.)
Once the Fed keeps the fed funds rate at close to zero level over a prolonged period of time it sets in motion a severe misallocation of resources — a severe consumption of capital.
An emergence of subdued economic activity puts downward pressure on long-term rates. On the basis of a near-zero fed funds rate this starts to invert the shape of the yield curve.
At present, we hold the downward-slopping yield curve has emerged on account of a decline in long-term rates whilst short-term interest rate policy remains intact.
We suggest this may be indicative of a severe weakening in the wealth generation process and points to stagnant economic growth ahead.
Note again the downward-sloping curve is on account of the Fed’s near-zero interest rate policy that has weakened the process of wealth formation.
Various criticisms have been raised against the Fed, not only from the side favoring the abolition of central banking, but also from the side of those who argue that the Federal Reserve is indispensable for stability. One of those arguments came from respected economist John Taylor, who is the author of the often mentioned “Taylor Rule” on how to conduct monetary policy, with two House Republicans recently proposing to impose this “rule” on the Fed.
Like Taylor, politicians who advocate for such a rule blame huge credit expansion for the Great Recession. Unfortunately such policymakers are usually not convinced by the Austrian arguments in favor of abolition of the Federal Reserve. Instead they are convinced by John Taylor’s statistical demonstrations. According to Taylor, the Fed set the interest rates too low in the beginning of this century, which led to an unsustainable real estate boom. He adds nonetheless: if only the central bank followed his rule of proper interest rate levels, then monetary policy would work very well.
For Taylor, the Federal Funds rate in recent years should have looked something like this:
The first thing to note about the Taylor Rule is that, strictly speaking, there is no such thing as one universal Taylor Rule. There are many possible Taylor Rules, depending on a variety of factors, on which there is no agreement. Any version of the rule crucially depends on the usage of mathematical variables and their coefficients in the used equation, which is used for calculating the “right” level of interest rates set by the central bank. Those main variables are price inflation and the so called “output gap,” a difference between “actual output” and “potential output.”
Depending on which variables we exactly pick and how we use them, we can have different rules, and therefore different interest rate policy recommendations. It is all well documented in the mainstream literature. Economists disagree how to measure “potential output” (should we use trends, econometric models, or “production function models”?) and there is no agreement how much importance should be assigned to it. There are discussions about the nature of the data that is being used — should it be the one registered currently, or real-time data, or should it be somehow adjusted, since every data set will sooner or later become revised data? Or perhaps since monetary policy takes time we should focus more on the predicted data, rather than just look at the immediate past? We can add to this the Austrian flavor: there are problems with proper price inflation measurements (various indices can differ significantly), and even the actual output measurements can be questioned as proper indicators of economic activity.
It is in fact the case that one can come up with several versions of the Taylor Rule. For example, we could come up with one that would recommend lower interest rates than what we had at the beginning of this century or we could come up with a version of the rule that would recommend higher interest rates. Or we could come up with one that suggests no change. Research does not give us any clear answer which version of the rule should be chosen.
One particular version which John Taylor is using for his criticism of Alan Greenspan, for example, serves as an ex post demonstration that interest rates should have been higher. Yet there is nothing really that special about this inference. After the fact, anyone can come up with an alternate version of any rule to demonstrate that interest rates should have been higher.
The crucial question to be answered is the following: can reliance on one particular version of the Taylor Rule pave the way for a bubble-proof economy? As described above, a Taylor Rule in any of its versions can at best target the balance between a chosen index for “price inflation” and a chosen way of measuring the invented concept of aggregate “potential output.”
The problem is that targeting either of those macroeconomic variables is not a recipe for intertemporal coordination understood in the Hayekian sense: as coordination between successive stages of production. In his major works Hayek proved that targeting one selected variable, such as price inflation, is not a proper formula for macroeconomic stability. Actually, stabilizing the index may ultimately cause macroeconomic destabilization. It is the same case with Taylor Rules, although in the rule the concept of “potential output” is hidden. Yet this potential output describes production in the aggregate, so it cannot capture the notion of intertemporal coordination among many acting individuals in countless industries.
Malinvestment bubbles are still possible when the central bank follows Taylor Rules, because by targeting potential output and price inflation the central bank triggers artificial credit expansions. For an example, we need only look to the dot-com bubble which happened even though the federal funds rates were actually significantly higher in the nineties than the most-used version of the Taylor Rule would recommend at that time.
The answer to the Taylor Rule is the Hayek Rule, which is the rule of balancing savings with investments in truly free financial markets. Meanwhile, we must endure the current situation of a market stimulated by the central bank with its pretense of knowledge about the “right” price for money and credit.
Jeff Deist and David Howden discuss the history of banking in America before 1913, the supposed justifications for the Federal Reserve Act, and why American economists all seem to be thrall to—and on the payroll of—the Fed. David also lays out the realities behind transitioning to a future without the Fed. Next, they discuss his book about the Icelandic banking crisis, and how that country's deposit insurance scheme created enormous moral hazards. David explains how Iceland, however, mostly had the good sense to allow its bad banks to fail and its foreign creditors to take a well-deserved haircut. The lessons to be learned, he tells us, are both cautionary and optimistic, at least for a homogeneous nation of 325,000 people.
The Free Market 32, no. 5 (May 2014)Mises Institute: In recent years, we’ve seen more and more Austrian-tinged economic analysis coming from investors like Mark Spitznagel and Jim Rogers, to just name two. As someone personally involved in the investment world, have you yourself seen growth in Austrian ideas among investors and similar professionals?
Robert Blumen: There has been tremendous growth in interest in Austrian economics among financial professionals. I started an interest group for Austrians in Finance on LinkedIn which, in a few years, has grown to almost 2,000 members from the US, South America, East, Southern, and Central Asia, Africa, and Eastern and Western Europe. Peter Schiff appears regularly on financial shows. The Mises Institute drew hundreds of people from the investment world to an event in Manhattan.
Since 2002, a number of Austrian-themed books in financial economics have come out. Alongside titles from established writers such as James Grant, there is Detlev Schlichter’s Paper Money Collapse, and several books by Peter Schiff. There are many popular Austrian bloggers such as Grant Smith and Robert Wenzel. Over two million viewers watched a 2006 video in which a parade of condescending media hosts heap ridicule on Peter Schiff, who, to his credit, did not back down in the face of their smugness.
MI: Did the financial crisis of 2008 help increase the sympathy for Austrian economics?
RB: I have heard the same story from many people in finance. When the bust of 2000 (or 2008) happened, it did not fit what they had been taught in school, nor could it be explained within the belief systems of their colleagues in financial markets. Their next step was reading, searching for answers, and then, finding the writings of Mises, Hayek, or Rothbard that enabled them to make sense of what had happened.
To answer your question, yes, I think that the failure of the popular economic theories — evidenced by these inexplicable crises — has driven the search for superior ideas. The Mises Institute has been publishing for years, explaining these boom and bust cycles with Austrian economics. When people searched, many of them ended up at mises.org.
MI: In spite of lackluster growth on Main Street, Wall Street appears quite happy with growth over the past two years. For the casual observer, one might argue that the Fed has managed things well. What do you see as problematic with the current approach, and are there some in the finance world skeptical of the Fed’s current strategy?
RB: The Fed has a series of mistaken theories supporting their belief that higher stock prices indicate the success of their policies.
The first is the thinking that asset prices are actual wealth, when they are only the prices of the capital goods, which are a form of real wealth. Asset prices, in real terms, are the exchange ratios between consumption goods and capital goods. Artificially-boosted asset prices mean only that the owners of assets who bought them at lower prices have increased their consumption possibilities in relation to nonowners of assets. The owners of most assets, the so-called “1 percent” are the beneficiaries of Fed policies.
There is no systemic economic benefit to any particular value for stock prices. Young people saving for the future and entrepreneurs who are looking to pick up capital goods at bargain prices would find lower stock prices give them a better deal. This is the same as for any good.
Their second error is that higher stock prices create a “wealth effect,” in which people see their asset values rise, feel richer, and consequently save less and spend more. Their goal is to boost consumption through pumping up asset prices. As Keynesians, they are all in favor of this because they think that consumption drives production.
Sound economic thought has recognized, at least since the classical school, that production must precede consumption, and that production drives demand, not the other way around. The Fed understands none of this because they have no understanding of the purpose of capital goods in the production process, which is to increase the productivity of labor.
They believe this about home prices as well, which is arguably an even greater fallacy because homes are consumption goods. A rising standard of living means that we are able to buy consumption goods at lower real prices over time, not higher.
And finally, they see the stock market as a sort of public referendum on their policies. They point to the stock market and say, “see, the market approves of what we are doing.” But when you realize that through its monetary expansion, the Fed itself is responsible for the rising stock market, that calls into question whether we can use it as independent measure of public opinion, or instead, the Fed voting for itself with money that it prints.
Austrian-informed financial thinkers understand this. There are hundreds of Austrian-oriented blogs and commentary sites, as well as some excellent heterodox sites with a very Austrian-friendly perspective such as Zero Hedge, Jim Rickards, Marc Faber, and Fofoa.
MI: We’ve mostly been talking about the US so far, but speaking globally, do you see any areas that are of particular concern, such as China or the Eurozone?
RB: Credit allocation in China is not market-based. They import the Fed’s inflation through their currency peg, which diverts dollars into their sovereign wealth fund where it is “invested” by bureaucrats in various forms of dollar-zone assets. Their domestic savings go into their banking system, where it is wasted on politically-favored projects due to non-market allocation of bank credit. The entire system is experiencing a series of bubbles in real estate and other sectors.
Their rate of infrastructure spending for comparably developed economies is about twice as high as normal. This is because the communist party officials are under great pressure to hit GDP targets — as if prosperity could be spent into existence by hitting a number. Infrastructure such as roads and empty cities present an opportunity to spend a large amount of money, all in one place, on a lot of Very Big Stuff, which under market-based economic calculation would be revealed as wasteful.
The problems in Europe are a combination of the massive debts that can never be paid back, the unfunded entitlements, and the growth in the burden on producers, a theme that I addressed in my recent Mises Daily article on Say’s law. This burden consists of the totality of regulation, taxation, inflexible prices and labor markets, and the threat to the confiscation of wealth. If you project these trends into the near future, I’m not sure where the lines cross, but the system is clearly unsustainable in its present form because it relies on sustaining current levels of consumption as fewer and fewer people produce.
Volume 17, No.1 (Spring 2014)ABSTRACT: Some economists of the Austrian School contend that business cycles are created when banks use the proceeds of short-term time deposits to create longer-term loans. These authors claim that while loan maturity mismatching of this kind does not create fiduciary media, it nevertheless artificially lowers the market rate of interest and causes forced saving and malinvestment. According to this view, Austrian business cycle theory, which hitherto has assumed forced saving occurs only in the quantity dimension as a result of fractional reserve banking, must also consider forced saving in the time dimension engendered by loan maturity mismatching. The present paper disputes this and argues that while loan maturity mismatching does affect the rate of interest and alters the production structure, it cannot independently cause forced saving or any systemic discoordination. Hence in the unhampered economy, it is not responsible for causing business cycles.
KEYWORDS: business cycles, interest rates, savings and investment, production structure, bankingJEL CLASSIFICATION: E32, E43, E44, E52I. INTRODUCTIONIn the last few years, there has been a debate among some Austrian economists concerning the economic effects of loan maturity mismatching by commercial banks. A positive yield curve—in which loans having a short term to maturity are associated with a lower interest rate than those with a longer duration—makes it profitable for banks to use the proceeds of their customers’ short-term time deposits to create longer-term loans that are issued to borrowers.It should be pointed out there is another kind of LMM possible—the inverse of that described above—where banks use longer-term deposits to create short-term loans. This form of LMM is not controversial and is not discussed in the present paper. Henceforth, the term LMM shall apply only to the case where banks create longer loans from shorter deposits. The term “borrowing short and lending long” or “BSLL” is not used here, as it is possible to confuse the borrowers with the lenders. For example, while the bank borrows from its depositors, and lends this money out, its depositors are also lenders, and those seeking loans from the bank are borrowers. For any given instance of this practice, even though the bank’s liabilities and assets have matching value, the durations of each are mismatched intertemporally, making it necessary for the bank to continue to find short-term depositors until the long loan is fully paid off. Thus for example, if depositor A lends bank B the sum of $100 for a period of one year, and B uses this amount to provide borrower C with a two-year $100 loan, then at the end of the first year, another depositor A’ must be found who is willing to provide a new one-year $100 loan in order that B can fulfill its obligation to A.
Barnett and Block (2009b) argue that while loan maturity mismatching (LMM) of this kind does not involve the creation of fiduciary media or expand the money supply, it nevertheless lowers the market rates of interest and is independently responsible for causing forced saving and malinvestment which generates business cycles. The purpose of the present paper is to demonstrate why this claim is erroneous, and to show that LMM’s macroeconomic effects, while not neutral, cannot by themselves cause systemic intertemporal discoordination. It should be noted that in order to determine whether or not LMM is an independent source of error, the scope of this discussion is limited to an examination of its effects when it is introduced into the unhampered economy. The question of whether or not LMM causes business cycles (or contributes to them) in an economy where violent intervention is established—i.e., where the government provides bail-out guarantees, or a central bank acts as a lender of last resort, or where fractional reserve banking is permitted—is not the focus here.For a discussion on the macroeconomic effect of LMM in an economy of violent intervention—i.e., one that is not free—see Bagus and Howden (2010). The term “violent intervention” is used, following Rothbard (2004), to describe any action that involves an initiation of aggression against a person or their property, i.e. an action that is coercive and contra the natural law. Government actions are thus “violent,” because they are non-voluntary and coercive. The position of the author is that fractional reserve banking is also a form of violent intervention, and contra the natural law, because it violates property rights. For opposing views on whether or not LMM itself violates the natural law, see Barnett & Block (2009a) and Bagus and Howden (2009).
In Austrian business cycle theory (ABCT), the rates of interest are artificially lowered when commercial banks create fiduciary media by using the proceeds of demand deposits to create loans. Lower interest rates on the producers’ loan market falsify the process of economic calculation for entrepreneurs, which, together with the increase in the supply of money, cause the production structure to be lengthened beyond that dictated by the social time preference. Gross investment increases without a corresponding increase in genuine saving, resulting in malinvestment and forced saving. Eventually, the more capital-intensive stages become unsustainable and the initial boom turns to recession. Barnett and Block (henceforth B&B) do not claim that LMM increases the quantity of fiduciary media. However, they do assert that it has the same effect in terms of creating the business cycle because, like fractional reserve banking (FRB), it both artificially lowers the market rates of interest and creates forced saving and malinvestment. Indeed, according to these authors, FRB should be viewed merely as a special case of the more general intertemporal carry trade described by LMM, in which the period of saving is artificially increased. In making this claim, they allege that saving and investment have both a quantity and a time dimension which “traditional” ABCT ignores. According to this notion, FRB increases the former while LMM increases only the latter, but in both circumstances an increase in forced saving and malinvestment is the result.
Barnett and Block (2009b) provide the following example of how they believe LMM causes forced saving: Suppose saver A deposits $100 with bank B for one year at 5 percent, and B lends this same money to borrower C for two years at 10 percent. In this scenario, saving is $100–1.0 years and investment is $100–2.0 years. According to B&B, it is clear that without B’s financial intermediation, the only way A and C could come to an agreement is if they were to meet somewhere in the middle, say with a loan of $100 for one-and-a-half years at 7.5 percent. In this case, total saving and investment would be equal to each other at $100–1.5 years. This means that B’s actions must increase investment by $100–0.5 years while reducing voluntary saving to the same degree. Because B creates a situation in which savings and investment are not equal to each other, this amount must be malinvestment accomplished through forced saving. In addition, interest rates have been lowered across the term structure, implying they are below those that would otherwise be dictated by time preference.
The crux of this argument is the unsupported claim that changes in the time dimension of saving and investment can be directly responsible for causing business cycles. It will be demonstrated, however, that the attributes of saving and investment, relevant to ABCT, are the rates of interest and the gross quantities of saving and investment, but not the period that individuals save or the length of loans. FRB affects production, resulting in cycles, because disequilibrating forces are set in motion by an artificially lower interest rate and by increases the quantity of money invested, without a corresponding increase in the quantity of money voluntarily saved. But changes to loan lengths induced by LMM cannot affect production in the same way. While LMM affects the market interest rate, and does affect the production structure, LMM alone cannot cause business cycles. Section II is a critique of the argument offered by B&B, in particular the notion that an extension of the time dimension of saving is relevant to causing business cycles in the market economy. Section III demonstrates why malinvestment and business cycles are not created by a mismatch of the durations of assets and liabilities. In section IV, an equilibrium construct is introduced to demonstrate how LMM affects the contractual rate of interest in the producers’ loan market. The macroeconomic effect of this change on the production structure is discussed in section V. Section VI concludes.
II. CRITICISM OF BARNETT AND BLOCK’S ARGUMENTB&B claim that LMM is directly responsible for causing business cycles. However, the example they provide between saver A, and borrower C, is not at all helpful in demonstrating this is true. First, ABCT presupposes a market economy where there is competitive exchange, so the mere fact that maturity mismatching gives rise to a certain outcome in a single example of isolated exchange is not evidence that LMM causes business cycles. One cannot jump to the conclusion that a particular example of malinvestment represents systematic error in a market economy by focusing on only one example of exchange or only one aspect of the economy.
Second, in ABCT the starting point for the analysis is an intertemporal equilibrium where the internal data—the quantities of gross saving and investment as well as the price ratios per unit of time—are fully resolved to the external datum of time preference. Time preference is assumed to be given, and not changed by the intervention. In “traditional” ABCT, this imagined state of affairs in the absence of FRB is necessary to show how the creation of fiduciary media causes the internal data to be at variance with the underlying time preference, and to determine through a process of logical deduction the effects of the intervention only and not those from other sources.All praxeological theorems rely for their proof on imaginary constructions. As Mises states, “The method of imaginary constructions is indispensable for praxeology; it is the only method of praxeological and economic inquiry. The main formula for designing of imaginary constructions is to abstract from the operation of some conditions present in actual action. Then we are in a position to grasp the hypothetical consequences of the absence of these conditions and to conceive the effects of their existence.” (Mises, 1998, p. 238) Without the equilibrium as the counterfactual state, it is not possible to demonstrate that the data that follow the event under consideration are cyclical in nature. If there is no reference point around which the data can oscillate, there can be no cycle.See Hayek (1931) pp. 34–35. Therefore, an intertemporal equilibrium is indispensable in any demonstration that LMM discoordinates the time structure of production and causes a business cycle.According to Garrison (1991) “The very meaning of disequilibrium in the context of business-cycle theory derives from its being compared to some relevant equilibrium. That is, adopting a suitable equilibrium concept establishes the initial conditions and facilitates the analysis of an ensuing disequilibrium caused, say, by the central bank’s cheap-credit policy.” “It is not necessary for the initial conditions to preclude all kinds of disequilibria but only to preclude systematic intertemporal disequilibrium—the kind of disequilibrium for which the theory itself accounts. This limited equilibrium construct complies fully with both the logic and the spirit of ABCT.”
Consider, however, the counterfactual circumstance when there is only one instance of saving and investment, as presented in B&B’s scenario. We are told that without B as the intermediary, A and C would agree on a loan of 1.5 years, which is less than the 2 years that arises under LMM. But what would happen after 1.5 years? Since we are given no further information, we can only conclude that the saving of A would fall to zero. Since C is not a saver, and since there are no other actors present, the time structure would cease to exist. The counterfactual equilibrium disappears. The problem is that when B enters the picture, he extends C’s loan beyond the time where there is any possible equilibrium, beyond where there would be any time structure at all. There is certainly malinvestment in this situation, which by virtue of the particular example given is systematic, but it cannot be called a business cycle. Introducing other savers into the scenario, so that the existence of an equilibrium position is no longer in doubt, eliminates this problem, but as will be discussed below, the issue then becomes one where the malinvestment is no longer systematic.
Third, in “traditional” theory, the variables that affect the time structure of production, upon which an exogenous disturbance must impinge if it is to upset the intertemporal equilibrium, are the interest rate and the quantity of gross saving and investment, as governed by the social time preference. The claim that LMM causes malinvestment by creating a disparity between saving and investment in the time dimension is sometimes true, but only in autarkic economies, or certain situations where the duration of gross saving and investment are assumed to be finite, and only indirectly, by effecting a change in quantity. It is not true in the genuine market economy, where gross saving and investment are continuous. In B&B’s example, because there is only one saver and one borrower engaged in only one exchange, the quantity of saving and investment are both destined to fall to zero, whether there is LMM or not. However, as a result of LMM, saving ends before investment, creating an inequality in their quantities, and hence malinvestment. The inequality is caused not by LMM affecting the quantity directly, as is the case when fiduciary media are created, but rather because the example chosen is one in which the period of saving and investment are finite, such that the duration of one can be extended relative to that of the other. The problem is that business cycles are market phenomena. And in the market economy, gross saving and investment do not end. Their time dimension extends indefinitely, and any difference between the period of individual saving and investment, caused by LMM, cannot create a disparity in either the duration or the quantity when the market is considered as a whole.
One possible response to this argument might be the following: Suppose consumers on average save for one year in order to buy TVs, but banks use these funds to create ten-year loans that are used by the manufacturers to produce TVs in ten years. At the end of the first year, is this not a situation in which there is a disparity between saving and investment? And is this not true even though time preference is unchanged? As with B&B’s example above, the problem with this scenario is that it considers only one group of savers at one particular point in time, and only one aspect of the economy in isolation, which is impermissible in the analysis of business cycles. We must ask, what happens at the end of the first year? Firstly, if these actors’ time preferences are truly constant, then, ceteris paribus, they must continue to save at the end of year one, for if they do not, then this indicates their time preferences have risen. But secondly, even if these particular savers decide not to renew their loans, then if the social time preference does not change—and this is what must be assumed before we can determine whether there is a business cycle—it is necessarily the case that other savers must step into the breach. In which case, ceteris paribus, gross saving continues to be constant and equal to gross investment. The issue here is that gross saving and investment and the interest rate—the variables of concern in business cycle analysis—are not directly tied to the quantity or length of individual saving and investment. Rather, in the social context, these variables are governed by the supply and demand schedules for present money in terms of future money. While changes in the period of individual saving or investment can sometimes mean a change in the social time preference, and thus a change in the supply and demand for present money, it is nevertheless the case that if the social time preference is constant, then this is manifested in supply and demand schedules that are unaltered; in which case the quantities of gross saving and investment must also be constant and equal. This is true irrespective of changes to the length of particular loans or investments.Even if the social time preference changes, as manifested in an altered supply or demand schedule for present money, the quantities of gross saving and investment must always be equal (even if not necessarily constant) assuming no fiduciary media are created, and this is the case no matter what individual savers and investors do. Put another way, markets always clear, ceteris paribus.
What of the time dimension of gross saving and investment? Even though individual time horizons can change, the period of gross investment cannot be extended relative to that of gross savings, unless the latter falls to zero, as in the earlier scenarios. But in a market economy where social time preference is assumed constant, gross saving is never zero. Since both are of indefinite duration, individual actors cannot create a disparity in the time dimension in this regard. There is still the question of whether mismatches in the durations of the assets and liabilities of individual banks cause malinvestment. However, as discussed below, any malinvestment that arises cannot be systematic. The following discussion will also serve as the basis of the equilibrium construct, used later, to show how LMM affects the interest rate and the structure of production without causing business cycles.
III. DO MISMATCHES IN THE DURATIONS OF ASSETS AND LIABILITIES CAUSE MALINVESTMENT?According to the pure time preference theory of interest, first elucidated by Fetter, time preference refers to the fact that all actors prefer a given satisfaction sooner rather than the same satisfaction later. The social time preference is manifested in the supply and demand schedules of present money in terms of future money—isolable only in Mises’s construction of the evenly rotating economy (ERE)—and expressed, on the one hand, by an underlying uniform pure rate of return that exists throughout the entire time structure of production, including all loan markets, and on the other hand, by the total quantity of present money (in terms of future money) supplied/demanded. Abstracting from consumer borrowing, this quantity represents gross saving and investment.
As Rothbard points out, it is important to stress that, with regard to time preference, the suppliers of present money include only those agents who save money by abstaining from consumption, and who then exchange it for either a promise of a greater amount to be delivered in the future—as in the case of credit transactions—or for productive assets that will yield a greater amount of money in the future.It does not include those engaged in plain saving (cash hoarding). Although it does include those who use previously hoarded cash for investment. To the extent these capitalists retain revenues within a firm, such that this money is reinvested and not received as personal income, these actors continue to be suppliers of present money, their value scales having determined that it not be used for consumption. But suppliers of present money do not include banks in their intermediary function, because they are not the original savers, or business leaders and managers unless they use their own funds or own an equity stake.
From the Rothbardian perspective, an individual is a demander of present money if he supplies factors of production—either original factors or capital goods—in which case the money is repaid at a later date from the product of the factor services, or if he borrows money for the purpose of consumption, in which case the money is repaid by the borrower himself. Since all capital goods are derived ultimately from land and labor, all demand in the productive sphere resolves into the demand from original factor owners. Banks in their intermediary function are not demanders of present money, because they neither supply factors of production nor borrow the funds for consumption, and borrowers on the producers’ loan market are not demanders, for they too are merely intermediaries. (Rothbard, 2004, p. 379)
Rothbard makes clear that the determination of who supplies and demands present money in this regard does not depend on the legal status of the borrower or the lender, or the type of financial instrument involved. Money can be channeled into production using a variety of methods, but the form of the financial instrument is unimportant from the point of view of fundamental analysis. As Rothbard states:
We must conclude that economically and even in basic law, there is no difference between shareholders and productive creditors; both are equally suppliers of capital, both receive interest return as determined on the general time market, both own their proportionate share of the company’s assets. The differences between the two are only technical and semantic. It is true that our discussion has so far applied only to the evenly rotating economy, but we shall see that the real world of uncertainty and entrepreneurship, while complicating matters, does not change the essentials of our analysis. (Rothbard, 2004, p. 439)
In short, analytically, there should be no distinction between savers who own equity, stock certificates, bonds, certificates of deposit, savings accounts, or any other kind of loans. They are all capitalists who save and then invest, either directly in production or indirectly through financial markets.This is not to say there are no differences from the perspective of individual investors as to the kind of financial instruments they use. To finance a project, one investor might prefer equity, another bonds, for example; each must consider the various risks and rewards. However, as Rothbard makes clear, from the perspective of fundamental analysis, any differentiation between the various types of instruments is not needed in order to deduce the relevant logical relations.
Consider, first, the general equilibrium construct of the ERE, where gross saving and investment are equal to each other and constant. Gross investment consists of the assets of all enterprises—i.e., all goods-in-process, durable capital goods, inventory, finished goods waiting to be shipped, etc. In the ERE, all assets, whatever their form, are renewed or replaced as they are used up in production. On the other side of the economy’s balance sheet, gross saving consists of the liabilities and equity of all enterprises, which, abstracting from intermediaries, is held ultimately by the suppliers of present money in the form of stocks, loans and other debt. Suppose an ERE has gross saving and investment that is maintained at $1000M. Savers in the aggregate continue to abstain from consumption insofar as what has already been saved, making no new additions or subtractions to this gross amount; all earnings, except for interest, are retained. Suppose, these savings are held as $500M of stocks and other equity, $250M of 1-year bonds, and $250M of 10-year bonds.All of these must bear the same interest or dividend rate in the ERE equal to the pure rate. Because the economy is evenly rotating, the stocks are held indefinitely, the 1-year bonds are renewed every year, and the 10-year bonds are renewed every ten years, so that $1000M of saving and investment continues to be provided over an extended time. In the ERE, the rotation of any dated securities is a necessary implication of the assumption that all preferences, including time preference, are constant. Since all production processes are repeated without end in the ERE, it is clear that the durations of the liabilities do not have to match those of the assets.
Consider, next, an economy where only the social time preference is assumed to be constant. The time preferences of individual actors can change, but gross saving is constant over time, as in the ERE. While the composition of the investment vehicles in which these savings are held need not remain the same, the renewal or replacement of those of finite duration with others of equal value—but not necessarily the same duration—must take place, this being the necessary implication of the quantity of gross saving being maintained. With regard to production, some processes are ongoing, others are newly initiated, and yet others are terminated, but gross saving and investment continue to equal each other in quantity—that is, in money value—as capitalist-entrepreneurs freely compete with one another to supply present money, and original factor owners freely compete to demand it.
Globally, the quantities and the forms of the equity, liabilities and assets can vary, but since time preference is constant, and because the gross money quantities on each side of the economy’s balance sheet are always equal and constant, the durations of the assets and liabilities do not have to match as a necessary condition of avoiding malinvestment. Intertemporal discoordination is not the inevitable outcome if the quantity ratios or maturity profiles change. Therefore, if banks use consecutive short-term deposits to sustain long-term loans, channeling the latter into production, this will not necessarily create malinvestment. If this activity increased the overall quantity of present money, as in the case of FRB, or if it prevented the liabilities from being renewed, then it would, but LMM does neither of these things. Provided the social time preference stays the same, the deposits continue to be made at the same interest rates, and LMM continues to operate unimpeded without causing intertemporal discoordination.
Consider, finally, an unhampered economy where no preferences are assumed to be constant, where the social time preference might rise. Suppose short-term interest rates become higher, such that a bank that previously lent long, when short rates were lower, finds its profits evaporate or becomes insolvent. This would represent malinvestment. However, it merely means the public’s value scales have changed, the equilibrium has shifted, and the bank has failed to anticipate it. It only demonstrates that banks are subject to the same kind of non-cyclical and non-systematic error as any other enterprise. It certainly does not give rise to a business cycle. In ABCT, a business cycle occurs because the intervention causes the internal data to diverge from the equilibrium, creating an initial boom, and the cycle is completed, as evidenced by a recession, as market actors attempt to reestablish the equilibrium. But if the social time preference changes, it is the equilibrium itself that shifts, a change that occurs as a result of unrelated exogenous events that are fully in accordance with actors’ value scales. There might be error in anticipating it, but this is always the case in the real world where the final equilibrium is never fully known or reached.
IV. THE EFFECT OF LMM ON THE MARKET RATES OF INTEREST, SAVING AND INVESTMENTIn the real world, where uncertainty is always present, the rate of return throughout the time market includes other components—either increments or decrements—that arise because the data are always changing. Rothbard refers to these real-world returns as natural rates, and uses the word “capitalist-entrepreneur,” instead of just capitalist or entrepreneur, to highlight the fact that the person who earns the natural return always earns the pure return in conjunction with these other components, the latter being determined through competition in a process that involves entrepreneurial understanding and judgment. The contractual rates in the producers’ loan market are a subset of the natural rates found in production and are therefore determined, firstly, by the pure rate of interest, as governed by all agents within the time structure who supply and demand present money, and, secondly, by the entrepreneurial premiums, arrived at through competition, by actors in the loan market. Since uncertainty regarding future price movements generally becomes greater the further into the future any given assessment lies, long-term contractual rates tend to have higher added premiums and therefore higher interest rates than shorter ones. Underlying all of them, however, is the uniform pure rate governed solely by social time preference.With regard to the loan market, there are three empirical observations related to yield curves. First, they are usually positively sloped; second, when interest rates rise and fall, rates across the whole term structure tend to move together; and third, long-term rates are relatively more stable than shorter-term ones. Various theories have been proposed to explain these phenomena (Cwik, 2005). However, praxeology cannot furnish definite answers as to their cause. All that can be said is that if actors have certain expectations and if they act upon them in a certain way, then a certain kind of yield curve will be the result, but it cannot be deduced a priori from the axiom of action that given a specific expectation, an actor will act in a specific way. Nor is it possible to deduce apodictic propositions that certain events lead to specific kinds of expectations. There may be good empirical evidence to argue in favor of certain causes, but such explanations lie outside the realm of praxeology.
In order to isolate the effects, if any, of LMM on interest rates, it is necessary to consider an imaginary economy, initially in equilibrium, in which market actors’ value scales with regard to time preference are assumed not to change. For a yield curve to exist, the judgments of the actors in the construct must differ between the alternative forms of saving, but these judgments are assumed to be given and constant over time. This latter element is necessary because it must be assumed that in the absence of LMM the yield curve does not change. Only then can it be said that ceteris paribus LMM causes X, Y, Z etc., or, in other words, that alterations to the endogenous data—i.e., quantities and prices (including interest rates)—follow as a result of LMM and not from some other cause.
Thus, according to the terms of this construct, the supply and demand schedules of present money in terms of future money, as dictated by the pure time preference of non-bank actors, are assumed not to change. The underlying pure rate is uniform. On the loan market, the non-bank actors’ supply and demand schedules with respect to individual financial instruments are also assumed to be invariant, for while they include, in addition, premiums arising from uncertainty, and while these components obviously differ depending on the type of security involved, the judgments of any given actor with regard to these uncertainties are assumed to be unchanging. The time market is assumed to be evenly rotating in that loans are renewed as they expire. This is not to say that once LMM is initiated the market interest rates or the quantities demanded of individual instruments are unchanging; indeed, variations in these data are precisely what needs to be examined. However, the other constraints ensure that changes in these rates and quantities arise only from LMM and not from some other exogenous cause.
With no creation of fiduciary media, LMM cannot increase the supply of present money and create an inequality between the quantities of gross saving and investment. And since time preference is assumed to be constant, these quantities are invariant. Therefore, if LMM alters the proportions of various types of loans, any increase in the quantity of one type is offset by a reduction in the quantity of another type. Any that remain continue to be renewed as their terms expire, ceteris paribus, this being the necessary implication of constant gross saving and investment.
Let the diagrammatic exposition in Figure 1 represent a simplified producers’ loan market, in which there are two kinds of loans, short-term and long-term.
The vertical axis represents the market interest rate, and the horizontal axis represents the quantity of money demanded/supplied in the particular instrument. The solid curves represent the supply and demand schedules of the non-bank public. As mentioned above, these schedules are assumed to be invariant over time. SS and SL reflect the supply schedules of capitalist-entrepreneurs who lend present money for productive purposes, the difference between SS and SL arising from the greater uncertainty-premiums attached to lending money when the duration of the loan is longer. DS and DL represent the demand schedules of those who borrow present money to invest in the production structure. While theirs is partly a derived demand—the time-preference aspect being ultimately determined by original factor owners—the borrowers’ schedules differ between short- and long-term loans as a result of their entrepreneurial function, and because uncertainty for borrowers is higher on shorter loans. As a result of the relative positions of the supply and demand curves, the long loans generally have a higher interest rate than the short ones; i.e., there is a positive yield curve. Without LMM—i.e., in the initial equilibrium—the quantity of savings demanded by the borrowing public is equal to the quantity supplied by the lending public with respect to any particular length of loan. For short-term loans, this quantity is B at an interest rate of D, and for long-term loans, the quantity is K at an interest rate of M.In practice, banks add a premium for their intermediation services—an agency fee—but since this is unrelated to LMM, it is not necessary to consider that here.
When banks engage in LMM, they increase the overall demand on the short-term market and increase the supply on the long-term market. The total demand and supply schedules that arise as a result of maturity mismatching are shown by the dashed curves, DMM and SMM. On the short market, the interest rate rises to E. At this rate, the quantity supplied by the public increases to C, and the quantity demanded by the public decreases to A, creating a difference of AC. This quantity is transferred by the banks to the long market, where the added supply gives rise to the total supply curve SMM. Here, the interest rate falls to N. At this rate, the quantity supplied by the public decreases to J, the quantity demanded by the public increases to L, and the difference JL equals AC.
Several observations can be made. First, in this new situation, in which banks establish LMM, the quantity JL must equal AC. This must be true because, unlike the case of fractional reserve lending, LMM alters only the duration of the new loans, but the money-amount of savings in the new loans in the aggregate is the same as that of the loans from which they are derived. Second, it is important to stress there can be no suggestion that LMM alters the social time preference in some way because, as with ABCT, the purpose of the analysis is to determine if LMM causes a situation that is at variance with the underlying time preference which is assumed to be static. And, as discussed previously, LMM must be assumed not to alter the public’s assessments of risk and other premiums associated with any given type of investment. Therefore, the loan market supply and demand schedules of the public remain unaltered. Third, even though the quantities supplied and demanded change, and even though their market interest rates change, the loans that remain are renewed when they expire. This is a necessary implication of time preference, and hence gross saving and investment, being constant, ceteris paribus. Fourth, the quantities AB, BC, JK and KL do not necessarily equal each other since the exact amounts depend on the shape of the supply and demand curves. However, AB + BC = JK + KL; i.e., the decrease of savings demanded in shorts plus the increase supplied in shorts equals the decrease supplied in longs plus the increase demanded in longs. Finally, as a result of LMM, the interest rate rises at the short end of the yield curve, and falls at the long end. The degree of this yield-curve flattening is determined by the propensity of the banks to engage in LMM. Any differences in the degree to which the market interest rates rise and fall at the opposite ends of the term structure are determined by the shape of the supply and demand curves.
Below is a summary of the effects of LMM on saving and investment and the interest rate.
The aggregate saving on the producers’ loan market is the total quantity of present money supplied by the lenders, both short and long term. Even though the quantity of savings supplied by the shorts increases, and the quantity of savings supplied by the longs decreases, there is no systematic increase or decrease overall. Shorts are being renewed as before, but with a greater amount, and longs are being rolled over as before, but with a lesser amount. The aggregate investment in the productive structure, originating from the producers’ loan market, is the total money-quantity of savings demanded by borrowers from both the shorts and the longs. Under LMM, there is no systematic increase in gross investment because, even though there is greater quantity demanded by borrowers in the long market and a lesser amount in shorts, all of these loans are being renewed, given the fact that the value scales of the public are assumed not to change. It is clear, therefore, that since both the aggregate savings and the aggregate investment are essentially unchanged, there is no excess of investment over saving and hence no forced saving.
Finally, the interest rate rises at the short end and falls at the long end. Because the amount of present money channeled into production by borrowers of short-term loans falls, while that channeled by borrowers of long-term loans rises, interest rates in the productive structure tend to be lower overall than they would be in the absence of LMM. However, this situation occurs without an increase in forced saving. For this reason, the effect of LMM on the productive structure is very different than that caused by FRB.
V. THE EFFECT ON THE STRUCTURE OF PRODUCTION
Before analyzing how a fall in interest rates, unaccompanied by an increase in present money, affects the production structure, a short digression into the shortcomings of the Hayekian triangle is necessary.While only one problematical aspect of the Hayekian triangle is addressed here, Barnett & Block (2006) provide an excellent and very comprehensive analysis of numerous other deficiencies. In Austrian capital theory, most authors consider only changes in the supply of present money, and disregard the potential for variations in demand when analyzing the effects of changes in time preference on the production structure. From this limited viewpoint, there are only two possibilities in the unhampered economy: Either the supply increases, which implies that consumption falls, gross saving rises, and the interest rate falls; or the supply decreases, which implies consumption rises, gross saving falls, and the interest rate rises. The pedagogical device most often used to explicate this state of affairs is the Hayekian triangle. One reason a triangle is reasonably successful in this regard is that when only changes in the supply of present money are considered, there is a correspondence between the logical relations governing consumption, gross saving, and interest, on the one hand, and the geometric properties of the right-angled triangle, on the other.
However, as described by Hülsmann (2008, 2011), a major defect of the triangle is that it cannot take into account the fact that the productive demand for present money can also change. It must be stressed here that Hülsmann is not alluding to changes in the demand to hold money or changes in the demand for fiduciary media, which some authors such as Selgin and White (1996) have cited, contrary to the arguments presented here, as a reason why credit expansion does not lead to business cycles. Rather, Hülsmann is referring to changes in the demand schedule for present money in terms of future money, which was alluded to earlier. Hülsmann cites several reasons why this demand might vary, such as a greater or lesser willingness to work, changes in immigration, and the discovery of new resources, etc. In the construct considered in the previous section, where both the demand and the supply of present money are assumed to be invariant, we abstract from these effects in addition to time preference. However, in the real world, because the demand can change, and do so independently of the supply, certain variations in gross saving and interest are possible in addition to those mentioned in the standard Austrian analysis of the capital structure. The possible variations are shown below:
With this insight, it can be seen that interest on the one hand, and gross saving and investment on the other, are not always inversely related in the unhampered economy. It is readily apparent that a triangle is incapable of graphically representing this kind of information. However, as discussed by Hülsmann, there is no such problem with a trapezoid. As with the triangle, the slope of the trapezoid represents the interest rate, the horizontal axis represents the stages of production,The interest rate is conceptual since in reality it consists of multiple different natural rates. The stages can be represented as existing simultaneously with respect to a stationary economy, or as proceeding in time. the major height represents the value of consumer goods, and the area approximates gross saving and investment.The area only approximates gross saving since, in praxeology, units are not infinitely divisible, and therefore not amenable to integration. Production is carried on discrete stages. Moreover, this presupposes a stationary economy. But in the trapezoid, the slope (interest) and the area (savings) are free to change independently, given that the horizontal distance (stages of production) is not tied to both of these variables. As a pedagogical device, the Hayekian triangle places limits on the relationship between the real-world variables it purportedly represents, which the trapezoid, though certainly not perfect, largely overcomes.It is no coincidence the trapezoid can represent this information. Hülsmann (2011) provides mathematical simulations of spending in various scenarios (as, for example, Huerta de Soto [2009] does for the triangle) to demonstrate that a trapezoid does indeed more faithfully represent the real-world relationship between interest, saving, and the length of the production structure.
Even though LMM causes a reduction in the market rates of interest, below those which would otherwise exist, it does so without a corresponding increase in forced saving or reduction in voluntary saving. Saving continues to correspond to the level of consumption, and saving and investment remain equal to each other. The rates of interest, while lower, arise not from any increase in the supply of present money, but rather from a reduction in the entrepreneurial risk premiums on a proportion of loans. The Hayekian triangle cannot depict the lower interest rate unless investment increases. Thus, if the triangle is used, a superficial analysis might conclude that the inevitable consequence of LMM is an unsustainable lengthening of the production structure and a business cycle. But these conclusions are unwarranted, for in the unhampered economy savings and investment can remain constant when interest rates fall, because the production structure shortens, as shown in Figure 2.
Overall, the production structure is altered, but since consumption, saving and investment remain aligned, there is none of the intertemporal discoordination or malinvestment that occurs under ABCT. Because gross investment is unchanged, and because the reduction in the number of stages is counteracted by a broadening of the earlier stages relative to the later ones, there is no growth or contraction overall. The following conclusions can be drawn:
Where LMM operates in an unhampered economy, it is certainly possible for the non-bank public to err in their assessments of risk and uncertainty, and be too conservative, such that the spread on interest rates in the loan market is wider than needed. If this is the case, then bank intermediation in the form of LMM can be seen as a correcting force, which flattens the yield curve to a level commensurate with the actual risk, the difference in premiums inuring to the banks as entrepreneurial profit. The proof, of course, is in the pudding. If the non-bank public is correct all along, then a bank could suffer losses. For example, if a bank underestimates the number of borrower defaults, or if short-term interest rates subsequently rise, such that they can no longer be used to finance existing longer-dated securities without a loss, then the bank could become insolvent. The danger of insolvency leads to an optimal level of LMM in the unhampered economy because, like any other business, banks that are consistently wrong must eventually cease to operate.
It should be noted that the constraints placed on banks in this situation, and the feedback mechanism that operates, are very different from those which occur under FRB. Under FRB, the lower interest rate is accompanied by an increase of fiduciary media, which gives rise to the illusion of profits and creates an initial boom. As a result, the ensuing malinvestment is manifested only after a delay. By increasing the supply of present money, FRB lowers the market rate as though time preference and the underlying pure rate are lower, when they are not. But this cannot persist, because the economy must return to the initial equilibrium that is dictated by the underlying time preference, whereupon systematic error is revealed. In contrast, LMM lowers the market rate by adjusting the entrepreneurial risk and uncertainty premiums. An individual bank can certainly err by being overly aggressive and by narrowing its spread too much. But this error is not systematic. In a similar vein—indeed one that is precisely analogous—an individual producer might underestimate the risks associated with its production processes, or take on too many short-term liabilities relative to its long-term assets, and find that its natural rate of return is not high enough. But in either case, there is no systematic malinvestment, no boom or bust and no cycle.
The main focus in this paper is on LMM’s macroeconomic effects in the unhampered economy. However, it must be mentioned that the situation is very different in an economy in which the risks associated with loan maturity mismatching are eliminated by some form of violent intervention. As Bagus (2010) and Bagus and Howden (2010) have rightly pointed out, the threat of insolvency for banks is considerably reduced when there is a central bank lender-of-last-resort, or when there are explicit bailout guarantees by the government. In these cases, the moral hazards created by these interventions permit banks to engage in what Bagus and Howden refer to as “excessive LMM,” a situation in which banks do not have to face any economic sanctions, at least for a while. Unlike in the unhampered economy, there can be no doubt this causes systemic malinvestment because it encourages banks to reduce interest rate spreads more than would otherwise be the case, and to do so in concert. Moreover, it causes rates overall to fall below the equilibrium rates that exist when LMM is conducted absent these interventions. When banks begin to fail en masse as a result of spreads that are too narrow, any subsequent expansion of the money supply deployed to keep them solvent creates a disparity between voluntary saving and investment, which, in conjunction with the below-equilibrium rates, extends and exacerbates the malinvestment and the cycle. However, none of this applies in the absence of the moral hazard or the monetary inflation that arises from the intervention. As this paper has made clear, LMM does not result in systematic error or cause business cycles in the unhampered economy.
VI. SUMMARY AND CONCLUSIONIf, hypothetically, the time structure of production involved only two participants—a saver and an investor—and only one exchange, then the period of saving would have to match the period of investment and production, lest there be discoordination. And if an intermediary created a mismatch in these durations, there would also be malinvestment. But a business cycle requires the presence of a market economy and competitive exchange. Moreover, to demonstrate praxeologically the existence of a cycle one must posit an intertemporal equilibrium into which LMM is introduced, and then show how the internal data oscillate. Time preference in this construct must be assumed to be given. Because LMM does not create fiduciary media, the quantity dimension of gross saving and investment in the construct is not affected. And since the social time preference is manifested in the supply and demand schedules of present money and is expressed only in the pure rate of interest and the quantity demanded of present money, the time dimension cannot change either. Because gross saving and investment are indefinite in time, no individual change in saving-investment maturities caused by LMM can logically have an effect in altering them.
The forms of the financial instruments used to channel individual savings into production, and their associated durations, are unimportant. Individuals might buy bonds with only limited durations, but at any given time it is the money-quantities of these, in the aggregate, in conjunction with the interest rate, that are relevant. In the unhampered economy, saving and investment continue to equal each other in quantity and there is no intertemporal discoordination. For any particular bank, the duration of its liabilities does not have to match the duration of its assets as a necessary condition of avoiding discoordination or malinvestment. If commercial banks create long-term loans from consecutive short-term deposits, and channels these into production, this practice does not create systemic malinvestment, ceteris paribus.
When banks initiate loan maturity mismatching, even though the quantity of savings in the form of long-term loans demanded by borrowers increases, the opposite is true with regard to short-term loans. And even though the quantity of savings in the form of short-term loans supplied by lenders increases, the opposite is again true with respect to long-term loans. All of which means there is no systematic increase or decrease in lending or borrowing, ceteris paribus; that is, no systematic increase in gross investment or necessarily implied reduction in voluntary saving; in short, no forced saving. Since short-term interest rates rise and long-term rates fall, borrowed money that is invested in production tends to have a lower interest rate overall than it would have in the absence of LMM. But unlike FRB, which increases the supply of present money and causes changes to the internal data as a result of the artificially lowered interest rates—as if this is all brought about by a reduced time preference—LMM lowers the market rate in response to risk and uncertainty components that are perceived as incorrect, and returns the data toward an equilibrium state. FRB deceives entrepreneurs by falsifying the data intertemporally, while LMM tends to correct entrepreneurial error by reducing the spreads, and at the same time lowering the overall rate to an appropriate level. In the unhampered economy, there is no reason to believe, as the Hayekian triangle might imply, that this lower interest rate represents malinvestment or engenders a business cycle.
If certain banks fail to predict future events and underestimate the risks associated with their loans by being overly aggressive with regard to LMM, they will be forced out of business in the free market, but this cannot cause a business cycle any more than when individual producers err in their forecasting predictions. While there are negative consequences for having an inadequate “understanding” of the future, there is no necessarily implied systematic error. Unlike the case of FRB, which causes business cycles with or without government intervention, LMM is benign when conducted in an unhampered economy. In the free market, LMM does not cause business cycles.
Volume 16, No. 1 (Spring 2013)ABSTRACT: Bank clearinghouse associations provided critical emergency services to their member banks during times of crisis. However, these associations, and the New York City Bank Clearinghouse Association (NYCHA) in particular, also provided critical intra-day liquidity to the security settlement process of exchanges such as the New York Stock Exchange (NYSE) through a process termed overcertification. Due to the risks involved, the NYCHA suspended overcertification during the Panic of 1873, forcing the NYSE to close for an unprecedented nine trading days. The NYCHA then began negotiations with NYSE officials concerning provision of liquidity, the NYSE’s clearing practices and who should bear the associated risks. Timberlake (1984) and Kroszner (1999) argue that bank clearinghouses evolved as private-sector solutions to serve as lenders-of-last-resort, and to constrain the risk taking of their members, particularly during crises. Our analysis shows that the NYCHA played a similar role in managing NYSE security settlement risks, and by encouraging the NYSE to adopt more efficient clearing processes.
KEYWORDS: bank clearinghouse, check certification, financial panics, New York Stock Exchange, stock trade financeJEL CLASSIFICATION: G21, N21Bernard McSherry and Berry K. WilsonBernard McSherry (bernardmcsherry@aol.com) is an assistant professor at New Jersey City University, and Berry K. Wilson (berrykwilson@gmail.com) is an associate professor at the Lubin School of Business, Pace University. The authors would like to thank Dr. Joseph Salerno for encouraging this topic, and an anonymous referee for helpful comments.
INTRODUCTIONTwo of the central banking roles of bank clearinghouse associations during the National Banking era are well documented (Timberlake, 1984; Calomiris and Gorton, 1991). Specifically, bank clearinghouse associations used suspension of convertibility and issuance of clearinghouse loan certificates to provide liquidity during times of crisis.During 1863–1914 there were four major instances of suspension of convertibility (1873, 1893, 1907, and 1914), and six instances of the use of clearinghouse loan certificates (1873, 1884, 1890, 1893, 1907, and 1914). In addition, bank clearinghouses played a central-bank-like regulatory role that included member audits, reserve requirements, deposit-rate ceilings, and disciplinary actions against violating members.
However, bank clearinghouse associations, such as the New York City Bank Clearinghouse Association (NYCHA), played an additional role of providing critical intra-day liquidity to the security settlement process of exchanges such as the New York Stock Exchange (NYSE). The NYSE required overnight settlement where trades were to be settled next day before 2:15 PMOvernight settlement was in force since the earliest days of the NYSE, but prior to 1857 most trades were settled by buyer’s and seller’s options (time contracts), which allowed negotiated delayed settlement. Time contracts allowed traders to trade in and out of positions before settlement was required. However, broker failures and time-contract defaults during the Panic of 1857 curtailed their use, and overnight settlement became preferred to limit settlement risk. To finance the NYSE’s daily trade volume, New York City banks allowed brokers to draft checks far in excess of their outstanding balance through a process termed overcertification.
A bank creates a certified check by escrowing funds from a check writer’s account, and then endorsing the check to certify that the funds are in escrow. Certification substitutes the bank’s creditworthiness for that of the check writer. With overcertification, the endorsement by the bank was often for an amount far in excess of the broker’s deposit. A broker used the certified check to settle NYSE trades, and then cover the overdrafted check through a loan collateralized by the acquired securities. Repeating this process throughout the trading day created the large amount of financing needed to settle trades. An 1882 Comptroller of the Currency study found that certification averaged 105.48% of bank capital for New York City (NYC) national banks and 312.14% of bank capital for nine NYC “broker banks” on a daily basis.
As with suspension of convertibility, the overcertification privilege could be suspended. Indeed, in 1873 the NYCHA suspended overcertification, forcing the NYSE to close for an unprecedented nine trading days. The NYCHA was concerned with the heightened counterparty risk from broker defaults during the 1873 panic. The NYCHA then began negotiations with NYSE officials concerning the NYSE’s clearing practices and their impact on the risk exposure from check certification by the clearing banks. The NYCHA’s influence limited these risks, since few bank losses or failures were linked to overcertification, but also influenced the NYSE to eventually create its first securities clearinghouse.
This paper explores correspondence between the NYCHA and the NYSE, drawn in part from the NYSE archives. The correspondence started shortly after the NYCHA suspended overcertification in 1873, and then traces a period of negotiations leading to the founding of the NYSE’s first securities clearinghouse. Timberlake (1984) and Kroszner (1999) argue that bank clearinghouses evolved as private-sector solutions to constrain the risk taking and risk exposures of their members, particularly during times of crisis. Our analysis shows that the NYCHA played a similar role in managing NYSE security settlement risks, and by encouraging the NYSE to adopt more efficient clearing processes.
THE COMPTROLLER AND THE MAGNITUDE OF THE OVERCERTIFICATION PRACTICELegislation was passed in March 1869 prohibiting national banks from overcertifying checks.Congressional investigation into the Gold Panic of 1869 found that overcertification provided leverage to speculators seeking to inflate asset prices. “With the great revenues of the Erie Railway Company at their command, and having converted the Tenth National Bank into a manufactory of certified checks to be used as cash at their pleasure, they (Jim Fisk and A.R. Corbin) terrified all opponents by the gigantic power of their combination, and amazed and dazzled the dissolute gamblers of Wall Street” (41st Congress, 2nd Session, House of Representatives Committee on Banking and Currency, 1870, p. 7)., Overcertification could be legally pursued by state banks and trust companies, and, although illegal, continued among national banks. This was similar to the legal limbo of the suspension of convertibility and the issuance of clearinghouse certificates., By 1868 it was estimated that three-fourths of the checks going through the New York Clearing House were certified checks issued in advance of deposits (Myers, 1931, p. 282). By 1879, the Comptroller of the Currency John Knox threatened prosecution of banks pursuing the practice. However, the practice continued. The risk involved was the default of brokers, which occurred particularly during market panics. As NYSE trading increased over time, the certified check volume became a larger fraction of the NYCHA volume.
The 1882 Annual Report of the Comptroller of the Currency presents data from selective daily audits performed by the Comptroller, as reproduced in Table I. As the table shows, the ratio of daily certified checks to bank capital level increased sharply from a ratio of 60.18% (141.47%) on 6/30/1875 to 265.86% (901.55%) on Oct. 3, 1882 for NYC (nine “brokers banks”) national banks. This large daily turnover of liquidity was critical to support NYSE settlement, but created a large credit exposure for the clearing banks. Because the checks were certified, the NYSE security settlement risk was concentrated among clearinghouse banks, rather than among brokers.
Table 1. Certified Check Activity at NYC National Banks 1875–1882
Despite the Comptroller’s concern for the risk exposure of national banks, few bank losses and failures were linked to the practice of overcertification. As well, despite the illegality of the activity, the Comptroller appeared to defer to the NYCHA to manage these risks, because of its critical role for the NYSE’s overnight settlement process.
The Wall Street view on anti-overcertification provisions was succinctly expressed by Frederick L. Talcott in the New York Times:Frederick L. Talcott was a 50-year veteran of Wall Street who wrote with some frequency for the New York Times. Apparently, he was also known as the “cotton king.”
The law is only another instance of the muddle into which politicians fall when the attempt to legislate in regard to the methods of financial transactions. The men who passed the banking law, or the great majority of them at least, know no more about the financial operations of this City than that apple woman in the corner…. In the 50 years that I have been in business I have known only one instance where a bank has suffered by certifying overdrawn checks, and a system which has been abused only once in 50 years is a pretty good system to stand by as things go in this world. Do you suppose that the shrewd men at the heads of our banks in this City do not know their customers? ...We don’t want a clearing-house. What we want is a repeal of that portion of the banking law which is stupid and which no financier would ever have inserted in the bill. We must open the eyes of Congress to the absurdity which has been committed in the framing and passage of this law, which operates as much to the disadvantage of merchants as of Wall-street. (New York Times Oct. 27, 1882)
THE ROLE OF THE NYCHA IN ESTABLISHING THE NYSE’S FIRST CLEARINGHOUSEThe NYCHA was acting in the interests of its member banks when check certification was suspended during the Panic of 1873 and the NYSE closed to trading for nine trading days from Sept. 20 to Sept. 30, 1873. Certification of brokers’ checks concentrated settlement risk among the NYCHA member banks. The NYSE was reluctant to internalize this risk itself and opposed creating a stock clearinghouse for various reasons.One was that NYSE members were reluctant to divulge confidential trading-position information to clearinghouse clerical staff. As well, there were concerns that contracts settled through netting might not satisfy a legal requirement that such transactions include an “intent to deliver” (Gibson, 1889, p. 118; Noyes, 1893, p. 266; Pratt, 1903, p. 131; Chamberlin, 1905, p. 425). The issue was how financing for settlement would be provided, and which organization would bear the settlement risk.
The NYSE took threats of suspension of overcertification seriously. An NYSE letter dated Sept. 24, 1873 acknowledged the counterparty fear among the associated banks, and the bank run threat, and requested that the coordinated actions of the NYCHA banks be used to allow certification to continue.
The great obstacle we have to deal with in resuming the operations of the Stock Exchange is the mode of settling our transactions. As long as the banks on whom checks are drawn are distrustful of each other, so long will a condition of unreasoning panic continue, and the demand on all sides will be for “greenbacks” rather than for “certified checks,” which may turn out worthless within twenty-four hours after they have been accepted in payment. To reopen the Stock Exchange under this condition of affairs would simply, therefore, be the inauguration of a run upon the banks for legal tenders, with what results you are better qualified to judge than ourselves. The true plan, in the present emergency, in our opinion, is that those banks who are content to make clearances with each other, should, to the extent of their associated capital, guarantee the payment of checks certified by the banks allowed to enter the clearing house. It is necessary to have the moral courage to sacrifice the weak members of your present association, rather than to have all the banks of New York suffer the disgrace of a suspension of payments. (Sprague, 1910, p. 39)
The NYCHA responded citing the risks posed by overcertification and refused to resume the practice:
“…the banks… could not be expected to voluntarily guarantee the payment of checks of each and every bank without reference to the amount, especially when they could have no control over the actions of tellers, who might carelessly or corruptly certify to millions more than the customers could respond to; particularly when the associated banks, not having it within their power to foresee such action, could never have security in hand to indemnify them for such gratuitous hazard of their stockholder’s funds.…
Respectfully submitted,
JOHN E. WILLIAMS,B.H. LOWRY,WM. L. JENKINS(New York Times, Sept. 28, 1873).
The NYSE reopened with limited trading on Sept. 30, 1873, and with the banks still refusing to overcertify broker checks. As monetary stringency eased, the banks resumed overcertification (Sprague, 1910, p. 40).
As the 1873 panic subsided, proposals were exchanged between the NYCHA and the NYSE. An Oct. 9, 1873 letter from the NYSE’s Committee on Clearances suggested creating a separate bank dedicated to clearing NYSE trades. The proposal acknowledges that the support of the NYCHA banks would be required.
The Committee on Clearances beg respectfully to report that to carry out a plan for clearing stocks in connection with a Bank where Brokers would be compelled by the New York Stock Exchange to keep an account, it would be absolutely necessary for the Bank to be represented in the Clearing House of the associated Banks of the City; for while the members of the Exchange could settle balances between themselves by checks on the Bank, parties carrying stocks would have to deposit large checks on the associated banks in the clearing house, on account of loans etc. and believing that a bank such as we propose would be cheerfully admitted to the Clearing House Association of the New York Banks we submit the following…. (NYSE archives).
In a Nov. 12, 1873 letter, the NYSE’s Committee on Clearances again suggested a separate clearing bank, in place of implementing a stock clearinghouse. Note that a stock clearinghouse would potentially involve the transfer of counterparty risk from the NYCHA banks to the NYSE itself.
The Committee on Clearances beg respectfully to report that in their opinion it is inexpedient to attempt the organization of a Clearing House at the present time; but are convinced that it is important to establish a Bank in accordance with the plan formerly presented by this Committee on October 9th, by which Money Clearances would be safely effected, and recommend that as soon as the capital can be obtained from the members of the Board for that purpose, the Bank be established and respectfully and earnestly urge upon your Committee to take all means within power to secure the necessary capital. The Committee urge this more particularly as the attempted arrangement by which approved certified checks on banks in the Clearing House would be received from depositors, as money without recourse has failed. The Committee respectfully asks to be discharged. (NYSE Archives)
The NYCHA banks continued to pressure for a stock clearinghouse, Indeed, the Philadelphia Exchange had implemented a stock clearinghouse earlier. In a letter written Oct. 28, 1879 W.H. Tevis, a Philadelphia Stock Exchange member, expressed his distaste for the Philadelphia Clearing House, but admitted that during times of stress it reduced the use of checks. “You may depend upon it that a ‘scrimmage’ in the market would lead to endless trouble that might provoke a panic… You may tell Mr Ives that a number of us try to get along without using the C.H. whenever we can but when it comes to the traders in millions of shares at hundreds of dollars differences they all rush to the C.H. as a happy delirium from plunking down bank due bills (which are our certified checks).” or the use of time options as an alternative to overnight settlement, as reflected in a Nov. 5, 1879 letter to NYSE President Brayton Ives from a special NYSE committee.
In accordance with your wishes that an informed conference would be held with certain bank presidents in relation to the subject of check certifications, with a view to ascertain whether anything was practicable in the methods of doing business at the Stock Exchange which would relieve the Banks as well as its own members of the necessity of using certifications of checks to the immense extent now requisite in the transaction of Stock business; the undersigned at your request met Presidents Fry of the Nat’l Bank of New York, Hays of the Union & Tappan of the Gallatin National Banks on the afternoon of the 31st of October.
Those gentlemen were quite seriously anxious in regard to the present aspect of the subject, while desiring to afford every reasonable facility for the transaction of the growing business of the Stock Exchange, the great increase in the number & amount of such checks was becoming a serious problem, especially as the National Banking Law prohibits certification beyond the balance at the credit of the dealer. They therefore had invited a conference with a view to elicit whether it was practicable for the Exchange to devise any system by which their business could be conducted without the use of the extraordinary numbers of certified checks now necessary.
A Clearing House for Stocks was freely discussed and fully considered. Your Committee represented that the Exchange had often, through Committee & otherwise, given serious thought and enquiry to that subject, but the practical difficulties in the way had prevented their coming to a satisfactory conclusion; the nearest approximation to such a system they had been able to agree upon was the adoption of a By Law authorizing dealings in Government Securities “For the Account.” This was done two years ago, but it had signally failed to secure the co-operation of the parties principally interested.
Your Committee are not prepared to pronounce that a satisfactory system for clearing stocks is impracticable, but they encounter such serious difficulties in considering the subject that they must reserve a conclusion upon it for the present.
They are however glad to invite the attention of the Exchange to a distinct proposition made by the President of the Continental National Bank to test the practicability of a Clearing house by trying it in respect to one or more active Stocks. We deem this proposition worthy of the serious considerations of the Stock Exchange.
There is a suggestion they will venture to make, which if adopted by members generally would result in largely diminishing the number of checks drawn & certified, under the present mode of doing business. The speculative transactions of the Stock Exchange are now largely conducted by borrowing & lending stocks from day to day, involving extraordinary numbers of certified checks. A return to the old fashion of dealing in buyers and sellers options, for short or long periods, would undoubtedly not only relieve members of many daily anxieties & troubles & perhaps have the effect, at some time, of averting serious embarrassments likely to occur to them out of the excitements often attending these daily settlements of stock loans. (NYSE Archives)
An additional proposal was to create a clearinghouse within the NYCHA, where the NYSE member brokers would jointly guarantee the checks used by brokers to clear trades, thus obviating the need for bank certification of such checks or the need for a separate stock clearinghouse.
I respectfully beg to offer the following suggestion as a substitution for the certification of checks—and the Stock Clearing House.
That the members of the Stock Exchange shall make an agreement with each other to guarantee the payment, through the New York Clearing House, of all checks issued by the several parties thereto- and authenticated under the said agreement…. This plan, a clearing house within a clearing house would not change the present routine of business, as a collective guarantee it would have the same value as Bank certification, and would be more economical than a Stock Clearing House.
(Nov. 1, 1882 letter from G. Ellis to the NYSE’s Governing Committee, NYSE Archives)
A related proposal was to create a safety fund within the NYSE that would insure the checks of member brokers.
The same committee published a series of goals for the new clearing plan, one of which was “Secrecy, safety and a minimum of labor, with the perfection of system to insure clearing in times of panic, and to place any liability or loss where it belongs…. To prevent any block or trouble in times of panic by reason of a default, a moderate sum can be deposited with the Treasurer of the Board by each member, making a Safety Fund from which the Superintendent of the Committee can temporarily pay any differences on stock sold out under the rule, such fund to be afterward reimbursed by the adjustment of the matter with the party having the contract with the defaulting member, this will seldom, if ever, occur, for if a member was solvent and settled all differences in the morning, he is not likely to fail to receive stock in the afternoon and the Clearing Department Fund will be augmented constantly by the profits of the Clearing Department, until it reaches a very large amount. No circumstances could arise when any serious loss could come to the department….
(Dec. 2, 1884 letter from the Joint committee to obtain and examine into plans for relief from the present system of settlement of stock contract, NYSE Archives)
The pressure for a stock clearinghouse continued, and the NYSE finally agreed to found its first stock clearinghouse, which began operations May 17, 1892. Francis L. Eames, founder of the NYSE Clearing House, reflected back on the pressure from the NYCHA banks:An additional pressure came from the Baring Panic of 1890 and from the NYSE’s competitor, the Consolidated Stock Exchange, whose clearinghouse had reduced financing needs and also lowered counterparty risk and broker defaults (Gibson, 1889, p. 115; Nelson, 1907, p. 49; Facciolo, 2005, p. 173). Emery (1896, p. 86) comments on this confluence of events: It was the borrowing panic of 1890 and 1891 that brought forcibly home to the Stock Exchange the impossibility of further continuing the cumbersome method of cash payments. This method necessitated a vast amount of borrowing and a cash settlement of all loans. When the stringency came at that time, many failures resulted from the impossibility of procuring the necessary loans. On the other hand, on the Consolidated Stock Exchange of New York, a young and less important exchange, the failures were comparatively few. This difference was ascribed by Bradstreet’s solely to the fact that one institution attempted to carry on its business by old fashioned methods, while the other was equipped with a modern clearing system. The explanation is easily accepted with the comparative ease with which the Stock Exchange has weathered similar troubles since the clearing house was adopted. It is not hard to imagine that the NYSE Governing Committee, concerned that its rival exchange might attract business due to its lower counterparty risk, decided to mimic much of the Consolidated Exchange’s successful system. The Consolidated Exchange’s clearing system had been introduced in June 1886, and the NYSE adopted a very similar system in May 1892 (Noyes, 1893, p. 259; Myers, 1931, p. 303).
Early in 1892, it became known that many of the banks were alarmed at the immense certifications necessary for stock brokers. It also became known that a resolution was to be introduced in the Clearing-House of the banks, to restrict the volume of certifications for brokers, and it was thought that the resolution would be carried. (NYSE archives)
Somewhat ironically, the stock clearinghouse established by the NYSE in 1892 was not a central counterparty. That is, it did not guarantee the settlement of trades of member brokers. Rather, the stock clearinghouse netted trades between brokers, which in the process greatly decreased the amount of certification required and thus eased pressure on NYCHA banks.
This outcome is reflected in Table 2, which shows the annual clearing results for the NYSE’s stock clearing corporation. For each year: 1892–1897, the stock clearinghouse was able to net over 90% of the NYSE’s trade volume, leaving a greatly reduced volume for clearing through the traditional (pre-clearinghouse) mechanism. Thus the banking sector continued to bear the risk of overcertification but at a greatly reduced level of certification.
Table 2. Stock Exchange Clearinghouse Transactions: 1892–1897
EPILOGUE CONCERNING THE STOCK CLEARING CORPORATIONOvercertification continued to grow as NYSE trade volume grew with economic growth, despite the netting of trades by the NYSE clearinghouse. On Nov. 3, 1913 the U.S. Supreme Court ruled that National City Bank and other banks were not entitled to redress losses incurred through overcertification of checks, related to the 1911 failure of brokerage firms: Lathrop, Haskins & Co. and J.M. Fiske & Co. As a result, the New York banks finally moved to end overcertification. The NYSE was able to forestall this action until an alternative plan could be formulated. After some deliberation, the Stock Clearing Corporation (SCC) was incorporated by the NYSE on Jan. 9, 1920 as a wholly owned subsidiary of the NYSE. The SCC began clearing all stocks on Sept. 15, 1922, and Rogers (1926, p.25) estimated that SCC operations reduced needed settlement funds from $139.911 billion to $21.429 billion over the period October 1922 to December 1926.
Losses due to overcertification continued to be very limited. S.F. Streit, Chairman of the Stock Clearing Corporation, in an April 10, 1918 letter to the Governing Committee estimated “the loss on the part of New York banks from certification in the past thirty-five years has been considerably less than $1,000,000.”
CONCLUSIONSThe NYCHA banks provided critical intraday liquidity to the NYSE’s overnight settlement of security trades through the overcertification of broker’s checks. Check certification transferred the settlement risk from the brokers to the banks. The NYCHA managed these risks among its members and thus suspended overcertification during the 1873 panic, which forced the NYSE to close its operations for an unprecedented nine trading days. The 1873 panic was the last time that the NYCHA suspended overcertification, but thereafter undertook a dialog with the NYSE concerning settlement and risk management practices. A review of documents in the NYSE archives and other sources shows that pressure from the NYCHA banks was instrumental in affecting changes in NYSE clearing practices, and with influencing the establishment of the NYSE’s first stock clearinghouse.
REFERENCESCalomiris, Charles W. and Gary Gorton. 1991. “The Origins of Banking Panics: Models, Facts, and Bank Regulation.” In R. G. Hubbard, ed., Financial Markets and Financial Crises. University of Chicago Press, Chicago, pp. 109–173.
Chamberlin, Emerson. 1905. “The Loan Market.” In E. C. Stedman, ed., The New York Stock Exchange. New York: Stock Exchange Historical Company.
Emery, Henry C. 1896. “Speculation on the Stock and Produce Exchanges of the United States.” Studies in History, Economics and Public Law 7, no. 2: 282–512.
Facciolo, Francis J. 2005. “A Broker’s Duty of Best Execution in the Nineteenth and Early Twentieth Centuries.” Pace Law Review 26, no. 1: 155–185.
Gibson, George R. 1889. The Stock Exchanges of London, Paris, and New York: A Comparison. New York: G.P. Putnam’s Sons.
Kroszner, Randall S. 1999. “Can the Financial Markets Privately Regulate Risk?: The Development of Derivatives Clearinghouses and Recent Over-the-Counter Innovations.” Journal of Money, Credit and Banking 31, no. 3, Part 2: 596–618.
Myers, Margaret G. 1931. The New York Money Market. New York: Columbia University Press.
Nelson, Samuel A. 1907. The Consolidated Stock Exchange of New York, Its History, Organization, Machinery and Methods. New York: A.B. Benesch Company.
Noyes, Alexander D. 1893. “Stock Exchange Clearing Houses.” Political Science Quarterly 8, no. 2: 252–267.
Pratt, Sereno S. 1903. The Work of Wall Street. New York: D. Appleton and Company.
Rogers, James H. 1926. “The Effect of Stock Speculation on the New York Money Market.” Quarterly Journal of Economics 40, no. 3: 435–462.
Sprague, Oliver M.W. 1910. A History of Crises Under the National Banking System. National Monetary Commission. Washington, D.C.: U.S. Government Printing Office.
Timberlake, Richard H. 1984. “The Central Banking Role of Clearinghouse Associations.” Journal of Money, Credit and Banking 16, no. 1: 1–15.
Volume 10, No. 4 (Winter 2007)
In contemporary economic theory, and especially in macroeconomics, expectations are being given a central place. There is virtually no economic model that does not examine how, within a dynamic perspective, the explicit account of individuals’ expectations qualifies the conclusions of the static analysis. To a certain extent this prominent place is well founded, for expectations of future events do motivate present actions and thereby influence social phenomena as they occur in reality. However, contemporary macroeconomists go a step further. They also maintain that a specific model of the formation of expectations is necessary in order to assess the role played by expectations, and ultimately to build economic theory itself.
Many still blame “deregulation” for the financial disaster that was caused by an intricate web of federal laws and regulations, writes Dale Steinreich. This audio Mises Daily is narrated by Robert Hale.
Volume 15, Number 1 (Spring 2012)ABSTRACT: The Efficient Markets Hypothesis (EMH) was dealt a fatal blow by the financial crisis of 2007-2009, out of which we have witnessed a revival of Keynesian conceptions of the financial markets. Exemplifying this trend is the rising influence of behavioral finance. But if EMH exaggerates the rational side of human nature, behavioral finance goes too far in reducing us to slaves of the emotions.
In search of a middle way, we explore the writings of L. Albert Hahn, a German banker and investor who made his name in the mid-20th century as a critic of Keynesian economics. Grounded on an Austrian understanding of the business cycle and uncertainty, Hahn depicts the stock market as being overwhelmingly inhabited by investors whose thinking is constrained by mass opinion. While this generates sustained irrational price movements, deviations from fair values are eventually corrected in a market process led by a few, independently minded investors. In Hahn’s view, financial markets are neither efficient nor animally spirited, but eventually adjusting.
KEYWORDS: efficient markets hypothesis, behavioral finance, stock market, business cycle, market rationality, HahnJEL CLASSIFICATION: B25, B26, B53, G02, G10, G14, E44, E58, N221. IntroductionUntil recently, the Efficient Markets Hypothesis (EMH) demonstrated an impressive resiliency in the face of discordant events. It emerged from the 1987 stock market crash only slightly bruised, though the Dow Jones Industrial Average fell a record 22.6 percent in a single day when the only news that might have possibly accounted for such a cataclysm was a disagreement among industrialized nations about currency and interest rate levels. Somehow, though it was left tottering, it managed to survive the denouement of the late-1990’s dot-com bubble. During this bubble, the NASDAQ Composite Index nearly quadrupled in an eighteen month period. Internet companies, such as eToys and TheGlobe.com, were accorded multi-billion valuations despite generating limited revenues and no profits. With the financial crisis of 2007–2009, however, it seems that the EMH has finally succumbed. Here was a situation, after all, in which a multitude of sophisticated analysts and investors, operating in the world’s leading financial institutions, grossly overvalued the mortgage backed securities at the heart of the crisis and systematically undervalued the risk in their portfolios, all the while relying on models quantitatively constructed on the assumptions of the EMH (Dowd and Hutchison, 2010).
Just as the crisis has revived Keynesian ideas in macroeconomics, so it has led observers to revisit the sections of The General Theory of Employment, Interest, and Money that address the behavior of securities markets. There, Keynes (1964) compares the stock market to a giant casino, describing investors as fundamentally driven by “animal spirits,” making decisions to buy and sell based on the estimated direction of crowd psychology as opposed to the intrinsic value of financial assets. Today, this Keynesian perspective is being taken up by Behavioral Finance (BF), a school of thought that began percolating at the margins of financial economics in the mid-1980’s and which has since dethroned the EMH of its monopoly status in the discipline to become a formidable alternative. Based on the work of Amos Tversky and Daniel Kahneman (1979, 1982), BF applies the findings of psychology to explain price formation on securities markets. Opposing the EMH presupposition of human beings as utility maximizing calculators, BF sees the mind as inextricably swayed by emotions, feelings, social influences, cognitive biases, and heuristics (Baker and Nofsinger, 2010; Ackert and Deaves, 2010; Schleifer, 2004).
No doubt, BF offers a useful corrective to the EMH. Yet common sense, in tandem with a bit of elementary logic, suggests that it cannot fully account for market phenomena. If everyday observation amply confirms that we are not cool logicians, it also reveals examples in which people manage to overcome their biases and control their passions. An investor is often enticed by greed to buy a penny stock touted on an Internet newsgroup only to be brought back to reason by the realization that the deal is too good to be true. What is more, markets surely do regain their senses after bouts of extreme pessimism and optimism. And while prices may not always be exactly right, it would be hard to deny that, on occasion at least, certain securities, if not stocks in general, are correctly valued. Yet if the human mind is the servant of sub-rational forces, as BF seems to claim, these moments of rationality are a puzzle. Describing BF’s position as one in which the human mind is said to be, “the servant of sub-rational forces” is no exaggeration. BF proponents often refer to the impact of cognitive biases as “systematic” rather than episodic or occasional (for example, see Barberis and Thaler, 2002, p. 11). The sheer number of biases and empirical deviations from the EMH put forward by BF advocates also suggest they view the influence of the irrational as being pervasive. BF advocates, too, resist the EMH description of the evidence mustered against market rationality as a collection of mere anomalies. Thus, Richard Thaler, a leading spokesman for BF, hopes for a future in which the discipline of finance will no longer be divided between the supporters and detractors of rational choice theory. “In their Enlightenment,” he says, “economists will routinely incorporate as much “behaviour” into their models as they observe in the real world.”(Thaler, cited by Bloomfield, 2010, p. 36). In other words, the irrational side of human nature will be acknowledged as a universal cause of human conduct. If it is such a challenge to impartially reason, how then do we manage to get things right from time to time?
This suggests we ought to explore the possibility of a middle way between the EMH and BF. In search of this, we return to the writings of Lucien Albert (L.A.) Hahn, a self-styled common-sense economist who first gained notice with his Economic Theory of Bank Credit (1921). In a career that traversed the worlds of academia and banking, Hahn attained his greatest level of fame with The Economics of Illusion (1949), a critique of Keynes, before laying out his own economic theory in Common Sense Economics (1956). Since then, Hahn’s work has been almost forgotten; only two articles on Hahn come to sight in the scholarly literature over the last twenty years (Selgin and Boudreaux, 1990; Leeson, 1997).
Hahn’s views on the stock market are set forth in the final part of Common Sense Economics. Embarking from an Austrian understanding of the business cycle and uncertainty, fleshed out with insights from psychology, Hahn argues that stock prices result from a combination of objective and subjective factors. On his account, the influence of mass opinion and mental inertia over most people’s psyches generates sustained divergences from intrinsic values. Sooner or later, Hahn observes, these distortions are corrected by the pull of the objective facts in a process led by a few alert, independently minded investors. In Hahn’s analysis — which this paper finds has stood the test of time — financial markets are neither perfectly efficient, nor animally spirited, but eventually adjusting.
- CURRENT THEORIES OF PRICE FORMATION IN FINANCIAL MARKETSAnyone putting himself forward as a common sense economist must have their views evaluated against not just the reigning academic theories, but also the way in which the relevant practitioners understand their own activity. Among stock market professionals, the myriad of investing and trading strategies followed all belong to either one, or a mix, of two approaches: fundamental analysis (FA) and technical analysis (TA). The first is the more predominant and respected of the two, though the second has gained adherents and stature over the last two decades with the development of faster computers and increased access to short-term trading opportunities. While most investors rely exclusively on either one of the two methodologies, more than a few combine them, typically by using FA to identify which stocks to purchase or sell and then turning to TA in deciding when precisely to execute a transaction.
FA insists that the best way to make investments decisions is to analyze the financial data pertaining to a security. It states, too, the necessity of accounting for industry macroeconomic conditions that impinge on a security’s value, the marketability of the firm’s goods and services, as well as the quality of management. Thus, practitioners of FA pore over a firm’s balance sheet, its cash flow statement, reported earnings and profit margins. They will evaluate how a company’s products stack up against the competition and whether its strategy is adequately framed to boost profitability. They will gauge the firm’s profit potential and risk exposures at different phases of the business cycle and ascertain whether it is part of an industry that is in a speculative, growth, maturity, or decline phase. All this is done with a view to determining the security’s intrinsic value. Some try to arrive at this number by projecting future cash flows and then discounting these to their present value. Most FA practitioners, though, apply a valuation metric of some kind, most commonly the price to earnings (P/E) ratio, against a group of comparable securities.Pablo Fernandez (2001, pp. 2–3) surveyed equity analysts at Morgan Stanley Dean Witter and found that more than 50 percent used and the P/E ratio, well above the slightly more than 30 percent applying the EV/EBITDA (Enterprise Value divided by Earnings before Interest, Taxes, Depreciation, and Amortization) metric. For a comprehensive treatment of share valuation can be found in Stowe, Robinson, Pinto and McLeavey (2007).
Clearly, FA assumes that financial markets are only sporadically efficient. According to the bible of FA, Graham and Dodd’s Security Analysis, “market prices, like a stopped clock, are a correct representation of value twice in an investor’s day” (Cottle, Murray, and Block, 1988, p. 26). However much information is now readily available to investors, FA proponents say, the fact remains that it is interpreted differently and that most observers fail to capture the more subtle and revealing bits of data within an evolving composite view. Not to mention that markets are subject to the oscillations of fashion, which bring different industry sectors in and out of favor alongside the waves of fear and greed that engulf the generality of stocks.
Diametrically opposed to FA, TA ignores all the financial, industry, and economic data (Edwards and Magee, 2001). Instead, TA focuses on the historical movement of prices and transactional volumes. This price and volume data is depicted on charts, which practitioners of TA examine for the presence of trends. Their modus operandi is to ride a trend until it shows signs of changing, at which point they reverse their market positions to exploit the new price move. To gauge these trends, TA refers to a set of patterns, such as the head and shoulders and pennant formations, in judging whether prices are consolidating within the prevailing trend or are at a critical turning point. Trend lines are drawn connecting significant high and low points, moving averages calculated, and indicators (i.e., stochastics, relative strength index, on balance volume) derived through a mathematical transformation of price and volume data into directional barometers. When asked to explain why charts are more instructive than financial statements, TA’s supporters aver that all fundamental information relevant to a security — whether it be financial, economic, strategic, or political — is already reflected in the price. Charts, too, are said to disclose the historical reality that markets often trend. Or, to put it in statistical terms, financial asset returns exhibit autocorrelation. Finally, TA claims that the psychological laws governing human nature mean that chart patterns inevitably repeat themselves (Murphy, 1986, pp. 2–4).
While the seeds of the EMH can be found as early as Louis Bechelier (2006) and Alfred Cowles (1933, 1944), the theory came into prominence with Eugene Fama (1970) and Paul Samuelson (1965) in the 1960’s and 1970’s. From the fact that investors compete to find the best investment prospects, the EMH deduces that this search must equilibrate with the elimination of all misvaluations. For if any such exist, investors will immediately exploit the arbitrage opportunity thereby presented until their actions move prices until market value and intrinsic value are equal. So long as information is readily accessible and the barriers to trading are minimal, this no-arbitrage equilibrium will be reached quickly in response to any changes in market conditions. Rather than being a goal to which market forces are drawn and only rarely achieved, as the Austrian economics tradition holds, equilibrium is seen by the EMH in neo-classical terms as the ordinary state of affairs (Boettke, 2010). As such, EMH asserts that stock prices reflect all available information. In the weak version of the EMH, this claim is restricted to information about historical prices, thereby rejecting TA. As for FA, the EMH questions this in its semi-strong version, according to which all publicly information about a company’s financial and economic situation is also encompassed in the stock price. There is also a strong version of the theory that states that all relevant information whatsoever, including that possessed by insiders, is assimilated into prices, though hardly any EMH advocate subscribes to it. So other than conceding an edge to insiders, the EMH claims that investors earn returns, not by buying undervalued securities and selling (or also shorting) overvalued ones, but by assuming non-diversifiable risk in their portfolios (Malkiel, pp. 180–215).
Despite its portrayal of investors as emotional and biased, BF admits this description does not apply to every single investor. A few are rational. Having made this exception, BF gives itself a means of solving the aforementioned puzzle of how to explain the periodic episodes of reasonable valuations when passion and bad judgment is so prevalent. Perhaps the elite corps of rational investors cancel the effects of their irrational brethren by exploiting the latter’s mistakes? Indeed, the EMH invokes such arbitrage trading to deal with the glaring fact that not everyone lives up to its assumption of utility maximizing behavior. BF, however, declines this tack, arguing instead that the rational face constraints on arbitrage. Once prices move away from correct levels, no guarantee exists that the deviation will not further widen and persist under the sway of irrational traders. Value arbitrageurs thus expose themselves to the danger of having to carry a losing position over a long period during which the intrinsic value of the security undergoes an adverse change or paper losses grow to the point of inducing financial stress. Recognizing this, rational investors will either resist the urge to trade against the irrational, or perhaps even try to join them for as long as they are in control of the price movement, thereby reinforcing the divergence from correct values. As Keynes originally put this BF claim: “Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries guess better than the crowd how the crowd will behave” (Keynes, 1964, p. 157).
Where BF goes beyond Keynes is in specifying the types of individual biases that combine to mislead the crowd. To cite the more notable findings, BF scholars conclude that investors, particularly male, overestimate their investment abilities (the overconfidence bias); they lag in updating their beliefs to new evidence (the conservatism bias); filter information that corroborates their existing beliefs (the confirmatory bias); surmise that runs within a series of events must soon reverse (gambler’s fallacy); deduce that a repeated occurrence of events portends a larger trend (clustering illusion); and overly rely on easily accessible memories or ideas in rendering probability judgments (the availability bias). So too, BF observes that investors are more sensitive to losses than to gains of the same amount of money, overweight small probabilities and underweight large ones, and change their decisions about the same probability scenarios when these are framed differently (Barberis and Thaler, 2002; Shefrin, 2000).
- HAHN’S CRITIQUE OF MARKET EFFICIENCYL.A. Hahn wades into the debate about financial markets because it illuminates the relationship between expectations and facts in economic life — that is, the extent to which human subjectivity affects the decisions that people make relative to the necessities imposed on individual choices by the objective realm. Entranced by the prospect of replicating the success of physics in the human realm, the dominant streams of economics over the last two centuries — whether classical or neo-classical — have tended to emphasize the determinative role of objective variables in accounting for economic phenomena. The mathematical techniques employed by orthodox economists, with all their equations depicting a given state of affairs as a function of various conditions, presuppose the priority of the objective over the subjective. But this epistemological preference, Hahn points out, falls afoul of the fact that businesspersons do not simply react to changes in the economic data taking place now, but must form some estimate of what shifts might occur in the future. This is because of the interval existing between the initial decision to deploy resources in the production of a good or service and the time it is ready for sale. Between these two points, input costs might change, as may consumer tastes and the competitive environment, either of which can significantly affect the profitability of one’s business projects. With businesspersons thus compelled to become forecasters, as the Austrian economists recognize (Mises, 1963, pp. 105–106), the subjective factor assumes an influential role, precisely insofar as the future is ultimately incomprehensible. From this it follows that the future cannot determine anything in the present and that the mind is liberated to conceive numerous scenarios in line with its psychological propensities.
That such expectations constitute the basic stuff of financial markets is obvious from even the most cursory observation of trading activity. When a company reports its earnings or the government releases the latest employment numbers, it is not so much what the data itself reveals that moves markets, but more so how the newly divulged information compares to expectations. Record profits may be announced and the unemployment rate fall dramatically, but stock prices may still drop if the good news does not accord with forecasts. In evaluating the efficiency of markets, the question thus becomes: do the expectations have a tendency to be on the mark? Prediction errors are inevitable, of course, but if these turn out to be normally distributed around realized levels then the argument for market rationality is greatly strengthened. It is precisely the contention of the EMH that the market’s forecasting mistakes are normally distributed. As such, the subjective element in expectations is rendered mathematically tractable by the application of statistical techniques. The result is that expectations are objectified, so to speak, by virtue of being construed as a mechanism reflecting the real probabilities of events. But if expectations err universally and systematically, then human subjectivity cannot be viewed simply as a mirror to the objective world, and must instead take on the character of a truly independent cause of market phenomena. This is exactly Hahn’s point.
He establishes it, first, by presenting a straightforward model of stock prices based on investor behavior. Noting that most individuals who buy shares do so with the aim of earning dividends in the future, Hahn infers the correct value of a stock as equal to the present value of that projected income. Since people value a dollar more today than a dollar to be had in the future, the present value of estimated dividends must be a discounted at a rate corresponding to the passage of time until their receipt. What Hahn thus arrives at is a discounted cash flow (DCF) model of stock prices:
(1)
Where S is the stock price, D is the dividend amount, n is the number of time periods over which dividends are being paid, while t refers to the nth time period, and r to the discount rate. Assuming the dividends are secure, this rate must equal the yield on long-term bonds, for otherwise investors would have an incentive to switch between bonds and stocks to whichever offered the higher return. Hahn does not spell out what happens if the dividend payments are not as certain as the bonds, but the obvious consequence is that the discount rate on the stock will then contain a risk premium.
One might counter that investors actually focus on earnings, rather than dividends, and that they often pin their hopes on selling at a higher price than where they bought. Even so, as Hahn observes, investors cannot really care about earnings per se, since they do not necessarily receive them as income, but only insofar as these signal the firm’s capacity to eventually issue dividends. Investors intent on capital gains must also concern themselves with dividends inasmuch as the stock price can only rise if the prospect of their payment and growth increase, as proxied by earnings (Hahn, 1956, p. 197). Given that financial markets are not populated solely by short-term traders, the latter will eventually have to deal with someone having a longer-term horizon. Such an investor will not purchase shares from the short-term trader, and help close the latter’s position at a profit, unless the outlook for dividends justifies the price (Hahn, 1956, p. 208).
Having put forward a DCF model, Hahn proceeded to test its predictions of intrinsic value against market prices. By proceeding in this fashion, Hahn anticipates the centerpiece of Robert Shiller’s (2000, pp. 184–190) brief against market efficiency. But unlike Shiller, a leading figure in the BF school, Hahn did not use the model to generate point estimates of the present value of future dividends, probably because of the difficulty of forecasting those numbers the further one goes out into the future. Another factor, arguably, is Hahn’s (1956) distrust of the mathematical methods that have come to dominate economics: “the mathematical language of modern economics has led many an economist to describe not so much what actually happens but what possibly could happen ... any resemblance of these descriptions and explanations to reality seems to me purely accidental” (p. xi). Consequently, Hahn only uses the model as a tool to interpret price movements.
The model thus tells us to expect stock prices to vary directly with dividends and to move inversely with bond yields. During the 1929–April 1956 period that Hahn investigated, the corporate bond yields that he used to represent the discount rate changed little from 1937 forward. Before then, stock prices accorded with changes in the bond yield, with equities declining between 1929 and 1932 as corporate bond yields rose, and equities increasing from 1933 to 1937 as yields fell. Afterwards, stock prices movements can only be accounted for on the basis of dividends. Here is how Hahn broke down the relationships amid the bull and bear markets that took place:
Table 1. Stock Prices vs. Dividends, 1929–April 1956
Three of the sub-periods, covering 12 of the 26¼ years in Hahn’s data set (almost half), show the stock market behaving irrationally. Once again foreshadowing Shiller’s analysis, Hahn goes further in discerning that, even when the two moved in the same direction, prices were noticeably more volatile than dividends. An objection might be raised here that this lack of correspondence exists because investors follow earnings instead of dividends. Yet, as Hahn notes, earnings and dividends generally move in tandem, just as one would expect from the former serving as a proxy for the latter. Earnings, indeed, are more volatile, since corporate boards prefer to keep dividend payouts steady knowing that profitability is subject to gyration from one year to the next. Stock prices, as a result, track earnings more closely.
Before we can affirm Hahn’s conclusion that markets are inefficient, we cannot forget that more than fifty years of additional data has become available since he wrote. Let us see, then, how his analysis has stood the test of time using his own interpretive method. To this end, we employ the Standard and Poor’s Composite Index (S&P 500) as our barometer of stock market performance, as well as the dividends and earnings per share of its constituent firms. We follow Hahn in adopting corporate bond yields as our proxy for the discount rate, and, more specifically, those rated AAA by Moody’s. Below are six charts depicting the S&P 500 index, dividends, earnings, and corporate bond yields over the 1956–1968, 1968–1982, and 1982–2010 time frames. This breakdown separates three broad trends that are discernible between 1956–2010. The 1956–1968 interval saw the continuation of the post-World War II bull market. From 1968 to 1982, the combination of inflation and slower economic growth led to a sideways range in stock prices. Between 1982 and 2010, the stock market experienced a historically unprecedented bull phase from which it has been correcting since 2000.
Figure 2. S&P 500 Index vs. Earnings and Dividends, 1956–1968
In Figure 2, it can be seen that dividends and stock prices broadly tracked each other, though the latter exhibited more volatility, just as it did in the 1929–1956 time frame that Hahn examined. This greater volatility seems due to the fact that investors were swayed by the vicissitudes of earnings.
Figure 3. S&P 500 Index vs. AAA Rated Corporate Bond Yields, 1956-1968
At odds with the market’s ascent is the steady rise in nominal yields from 1956-1968 depicted in Figure 3. It is not out of the question, of course, that the market’s upward movement was justified by the increase in dividends outweighing the higher discount rates. Still, the climb in nominal rates was both significant — doubling during the period — and persistent.
Figure 4. S&P 500 Index vs. Earnings and Dividends, 1968–1982
Figure 5. S&P 500 Index vs. AAA Rated Corporate Bond Yields, 1968-1982
Beginning in 1968, stock prices (Figure 4) finally succumbed to the increase in bond yields, as the longer term trend flattened with shorter-term moves exhibiting a zig-zag pattern. As Figure 5 shows, the ascent in yields continued into the early 1980s, helping account for the generally lackluster performance of stocks that characterized the period. Dividends trended higher during this period, even as the market was essentially flat, though the ascent was sharpest after 1975 as stocks began to show signs of re-establishing the secular uptrend. Once again, stock prices were more volatile than dividends, with earnings correlating more strongly with fluctuations in the S&P 500.
Figure 6. S&P 500 Index vs. Earnings and Dividends, 1982–2010
Figure 7. S&P 500 Index vs. AAA Rated Corporate Bond Yields, 1982-2010
With figures 6 and 7 we see that the bull market from 1982–2000 — interrupted by only three brief downturns in 1987, 1990, and 1998 — was directionally in accord with both rising dividends and falling nominal rates. Yet if the trend was justified, the slope of the price move was much steeper than that of dividends, especially from the early 1990s to the 2000 high when the fall in corporate bond yields had stabilized. Partly accounting for this, it is true, was the increasing prevalence during the 1980s and 1990s of firms using available cash to buy back shares in lieu of raising dividends. Even so, like dividends, these share repurchases are generally funded out of earnings, and the latter also rose at a slower pace relative to stock prices. Correcting for these divergences, stock prices fell sharply from the 2000 high even as dividends only gently declined. In 2007, the S&P index merely approached its 2000 peak, even as dividends were establishing all-time highs.
Imitating Hahn’s method, the table below offers a closer look of the 1956–2010 period, categorized by bull and bear markets. A bear market is defined as occurring upon a minimum fall of 20 percent in the daily closing price of the nominal S&P 500 index from an earlier peak. A bull market takes place upon a minimum 20 percent rise in that index from a low point. Yields are categorized as flat if there was a 50 basis point change or less during the bull or bear market in question. Dividends, in turn, are designated as flat whenever a nominal rise was canceled by inflation during the relevant period as measured by changes in the US consumer price index.
Table 8. Stock Prices vs. Dividends and Yields, 1956-2010
Compared to Hahn’s 1929–1956 analysis, fewer of the sub-periods — 7 of the 21 intervals representing just under 9 of the 55 total years — exhibit stock price movements in violation of the DCF model. In this instance as well, the inclusion of corporate yields generated 4 inconclusive findings, though these only constituted approximately 9 ⅔ years of the data set. Here, it should be kept in mind that during the longest of the inconclusive periods, Oct. 1974–Nov. 1980, dividends only slightly rose after factoring in inflation, while bond yields shot up. Dividends merely increased 1.9 percent in real terms over that entire 6 year interval as compared to the 5.9 percent equivalent figure that would have been expected had the average monthly growth rate of dividends from 1956–2010 prevailed. More importantly, the table above only takes the direction of the variables into account, not their respective fluctuations. To repeat, stock prices were significantly more volatile than the DCF model inputs, dividends in particular, throughout the entire 1956–2010 time frame. And, again, the upward slope in stock prices was noticeably more pronounced than that of dividends (or even earnings) in 1990–2000. On balance, therefore, Hahn’s conclusion of market inefficiency on the basis of the 1929–1956 experience is borne out by the subsequent data.
- THE INTERPLAY OF SUBJECTIVE AND OBJECTIVE FORCESAt the same time, it cannot be ignored that the market sometimes gets it right and that, even when it does stray from intrinsic value, it ultimately finds its way back. Hahn points out that the relationship between dividends and stocks becomes much closer once the oscillations created by bull and bear markets are diminished by smoothing prices through the calculation of a moving average. Figure 9 checks to see whether this is also the case for the 1956–2010 period using a 60 month moving average of the S&P 500 index.
Figure 9. 60 Month Moving Average of S&P 500 Index vs. Dividends, 1956–2010
The correlation is indeed tighter, except that the price average fails to track the dividend increases from 2003 to 2009. These reflect legislation passed by the Bush Administration in 2003 that lowered the taxation of dividends. While this change was subsequently extended to 2010, it was then set to expire in 2011 unless the U.S. government chose to renew the extension, which it subsequently did for another two years. In view of the uncertainty that surrounded the duration of this policy, the markets likely factored in the possibility of a return to the previous tax treatment of dividends. “It must be borne in mind,” as Hahn (1956) rightly says, “that if any future change is to lead to changes in the valuation of a share — or of all shares — it must be expected to be permanent” (p. 200).
Given how the DCF model looks against a long-term moving average of stock prices, Hahn concludes that objective reality ultimately acts as a magnet drawing markets back from the errors of its shorter and medium-term ways that continually recur because of the force of human subjectivity. Usually, Hahn posits, a complete market cycle proceeds as follows: bull markets emerge out of the depths of a bear market when dividend yields are high as a result of a pervasive gloom leading investors to expect further declines in earnings and dividends. That no bargain hunters enter the marketplace to take advantage of the high dividend yields, and thereby raise prices, only reinforces the negative sentiment. This is what Hahn calls the exaggeration phase of the bear market. The bull market commences as an adjustment phase of this overextended move as indications slowly materialize that the economy is on the mend and dividends are set to rise.
Then, the market enters a normal phase in which the investing public is neither exuberant nor disconsolate about the future. Share prices now merely obey the upward trajectory of dividends. But then another exaggeration stage ensues in which the very fact that dividends and earnings have been rising generates expectations that these will continue to rise. Accordingly, stock prices move ahead of dividends. As prices do not meet resistance from sellers, and short sellers shy away from exploiting the excessive valuations signaled by the low dividend yields, investors gain reassurance. Finally, a few alert investors notice that the market’s exalted levels are unsustainable. These sell and prices start to reverse. As the general optimism fades, the selling accelerates and we enter another adjustment phase that launches a bear market. This, too, subsequently goes into a normal stage during which prices decline in lockstep with dividends. With time, an exaggeration phase to the downside transpires and the cycle starts again. Throughout this entire sequence, Hahn adds, a mental inertia operates that renders investors incapable of changing their outlook until the evidence to the contrary becomes dramatically obvious. The exaggeration phases, especially, become resilient to incongruous news items as a result, helping explain how prices can diverge from intrinsic value for extended periods. A graphic representation of this cycle is given in Figure 10.
Figure 10. Hahn’s Depiction of the Stock Market Cycle
Embedded in this account of stock market cycles are a number of psychological claims that show Hahn foreshadowing elements of BF. By asserting that investors rely on recent trends in forming their expectations, and thus project the recent past onto the future, Hahn is alluding to what cognitive psychologists nowadays refer to as the recency effect, which itself is a variation of the availability bias so much talked about in the BF literature. The mental inertia, too, that Hahn invokes is equivalent to the conservatism bias. When he proceeds to outline the implications of his market theory to investing strategy, he cites a third psychological trait, namely the individual’s subjection to mass opinion. “It engulfs not only those who easily succumb to foreign influences but even those with normally detached views and sober judgment. An almost superhuman effort is needed to evade the influence of mass opinion” (ibid, p. 212). What this groupthink does, clearly, is to magnify the predominant trend that the Zeitgeist of the period happens to be buttressing. Continuing in this Tocquevillean vein, Hahn even suggests that the democratization of the stock market enhances this dynamic, insofar as the widespread dissemination of prices enables investors to quickly assess what the majority is thinking (Tocqueville, 1969, pp. 254–259). Were Hahn alive to see the Internet, and all the websites offering free quotes and news, he would surely have concluded that it has augmented the mental dominance of the crowd.
Why, fundamentally, do these subjective factors, these human thought processes, assume the role that they do in so often mispricing securities? Why is it, in other words, that investors are incapable of thinking about the markets in ways that avoid systematic errors? The very thing, it turns out, that opens up the economic realm to the play of subjective forces is that which conduces to market inefficiency: we cannot know the future. The freedom from present exigencies that this gives to act on the basis of our idiosyncratic predictions also dictates our getting those wrong often. As Hahn correctly notes, if the future could be known, then securities prices would immediately reflect that information — a point that would later be stressed by EMH advocates. The future would then effectively become the present and cease to exist as a distinct temporal category. At best, according to Hahn, we can make probability judgments about the near future. As to the distant future, “it lies, shrouded in a mist, beyond the horizon of time” (ibid, p. 203). Market practitioners acknowledge this, he insinuates, by restricting the discounting of future developments to twelve months — which surely does occur, if the predominance of one year earnings estimates among stock analysts over longer-term forecasts is any indication.
Even to the extent that an investor is able to make probability judgments, these are not of the kind described as rationally utility maximizing in the standard textbook treatments of finance. To be sure, Hahn concedes that a stock price can, in theory at least, be viewed as the summed value of various scenarios for the firm, each weighted by its probability. For example, if there is a 30 percent that company PQR will, over the next year, report earnings that correspond to a share price of $50, and a 70 percent chance its eventual income will be such as to correlate with a $40 per share figure, then PQR stock will trade at $43 (0.3 x times $50 + 0.7 x $40). In reality, the number of scenarios is greater than two and more complicated to delineate, so that the stock price ends up at the point where the chances of it going up or down seem to be equal, rather than whatever is dictated by the calculation of some complex equation.
More critically, however, the probabilities imputed are not mathematical in plotting the frequency of similar events in the past. In the world of investing, there is no equivalent of a billion throws of a die to consider, no large samples of essentially identical phenomena. As Hahn observes, a market event taking place in one cycle is always different, in some decisive respect, from an analogous occurrence in another cycle. An analyst might note, for example, that the stock market has experienced higher returns under Democratic presidents, as opposed to Republican ones, but one cannot simply infer from this that the pattern will recur. Not only were previous presidents of the same party often distinctive in their ideological mindsets and policy approaches, a multitude of other factors were driving stock prices — whose operation, for all we know, may subsequently combine to overwhelm the relevance of whether the White House is being occupied by a Democrat or a Republican. Besides the lack of homogeneity in the slices of history, the brute fact remains that too few of them are going to repeat themselves over an investor’s lifetime to enable him or her to depend upon the law of large numbers.
Consequently, though the playing of chances that investing entails means it can be likened to gambling at a craps table, no one can proceed in the buying and selling of securities the way a casino does in operating its games — that is, by continually playing across numerous locations according to the same rules on the expectation that, over time, the expected frequencies will assert themselves. Since his or her number of plays is much shorter than that of a casino, an investor’s risk is significantly higher — the variance of their potential outcomes is far greater — than what a historical sense of the probabilities might suggest. This offers an explanation as to why the risk models that Wall Street employed so spectacularly failed in the recent financial crisis. Instead of reflecting the mistaken specification of a normal distribution (Dowd and Hutchinson, 2010; Triana, 2009; Mandelbrot and Hudson, 2006), or the input of insufficient historical data, the problem lied in thinking that numerical probabilities could even be assigned at all.
Here is how Hahn (1956) aptly puts it:
The case is comparable not to that of the bank in Monte Carlo, which can and does rely on red and black turning up equally often in the long run, but rather to that of the individual player, who cannot know whether the ball will stop on red or on black. He has to take his chance. He may be playing red ten times in succession, although black may win ten times (pp. 204–205).What Hahn basically describes here is the distinction that Ludwig von Mises (1963, pp. 107–115) drew between class and case probability. Class probability refers to situations in which all the factors relevant to the production of numerous events sharing a set of characteristics are known. The probability that this set, or class, will occur can be mathematically calculated. Falling under this category are the chances of a seven arising from the throw of two dice. Case probability, by contrast, deals with circumstances in which some, but not all, of the causal variables are known and the event in question cannot be classified within a class. The event is unique and its probability is, therefore, not subject to a mathematical determination. Hahn, like Mises, places the game of investing under the heading of case probability.
Indeed, Hahn goes so far as to invoke David Hume’s (1978, pp. 127–130) contention that probability assessments are subjective mental acts. One simply feels inclined in favor of one outcome rather than another, with the level of intensity felt varying roughly with the preponderance of that outcome relative to other scenarios in one’s previous experience.
That brings us to the objective factors moving stock prices, by which Hahn means all market relevant phenomena operating externally to investor minds compelling their rational faculties towards similar evaluations. Despite the thoroughgoing value subjectivism of Austrian economics, Hahn nevertheless echoes that tradition in the objectivist side of his theory. As we have seen, he argues both that stock prices exhibit cyclical behavior and that, as per the DCF model, those prices are a function of expected dividends and prevailing interest rates. Now since dividends come out of profits, and these in turn fluctuate with the vicissitudes of the economy, it follows that the generality of stocks, though their long-term trajectory will follow secular trends, are nevertheless affected by the business cycles that have been a feature of capitalist economies since the 19th century. The upshot is that the question of what objectively drives the stock market is necessarily connected to the riddle of business cycles.
For Hahn, the puzzle here is figuring out why the demand for goods and services sometimes runs below production and other times above it. It is not that he thinks Say’s law is wrong. When the business cycle is viewed as a whole, demand and supply tend to balance. It is just that Say’s law does not prevail at all times. Finding underconsumption (Keynesian) and overconsumption accounts of the business cycle wanting, Hahn is brought to Knut Wicksell’s (1936) natural interest rate theory, which grounds the Austrian understanding of business cycles. According to Wicksell, the free play of supply and demand forces in the credit market work to establish the natural rate of interest or, if you will, the market rate. However, the central bank, with the commercial banks assisting, can exercise their monopoly power over currency issuance to drive interest rates away from the natural or market rate. Where the rate is higher than the market, fewer loans are sought to finance consumption and investment expenditures, thus lowering demand for goods and services. Prices fall and the economic activity declines. Where the rate is lower than the market, more loans are sought to finance consumption and investment, thus raising the demand for goods and services. Prices increase and economic activity rises. Accordingly, business cycles are the result of central bank policies.
It is very important to note, however, that Hahn supplements this essentially Austrian account with a psychological theory influenced by A.C. Pigou’s (1929) Industrial Fluctuations. Hahn does so to address an objection that would later be made by the rational expectations school, namely that the central bank cannot take the economy up and down, unless people err by not accounting for its actions. Who would invest in a new capital project well into an upswing, if they can see that the Federal Reserve is eventually going to raise interest rates to stop the economy from overheating? Who is going to shy away from a big investment amidst a slump if the central bank is committed to a very loose monetary policy? In Hahn’s view, such mistakes can only be explained by a pro-cyclical psychological dynamic in which people are carried by excitement in prosperous times and sunk by pessimism in recessionary periods. His analysis of the subjective forces operating in financial markets is meant to corroborate this point.
Beyond influencing the level of profits, and hence dividends, that stock prices incorporate, the central bank’s activities obviously impinge on the discount rate applied by investors to shares. Everything else remaining equal, an easing of monetary conditions, by lowering the discount rate, will raise stock prices and vice-versa. Hahn cites that easing which takes place during a recession to explain how bear markets manage to end even as everyone is pessimistic about the economy’s ability to generate profits and dividends. Once these begin to revive, the bull market gains momentum, especially as the central banks keeps interest rates from immediately jumping to ensure economic recovery. As this bull phase matures, rates do begin to rise, with the central bank less willing to accommodate increased credit demand, but the ascent in profits and dividends outweighs the higher discount rate. The bull market ends as interest rates continue to push higher, with the ensuing bear market strengthening in the wake of falling profits and dividends. All this, it must be said, is not much different from the story often told in Wall Street and the City. But, as Hahn (1956) says, “the world does not consist of economists who know and business men who err” (p. 166).
- CONCLUDING REMARKSUsing a DCF model of stock prices, Hahn maintains that the stock market is inefficient, doing so on the basis of 1929–1956 data. Updating his mode of analysis to the end of 2010, we substantiate his conclusion that dividends are only loosely correlated with stock prices, even after taking discount rates into account. In place of an efficient markets model, Hahn describes the stock market as subject to recurring cycles in which subjective and objective factors combine to set prices. Though the subjective forces of psychology, consisting of mental inertia and dependence on mass opinion, regularly take prices either above, or below, levels dictated by the objective facts, the latter do act as a magnet checking the movements of the former. The objective factors, insofar as these reflect business cycles, are decisively influenced by central bank practices of maintaining interest rates at non-market rates.
By arguing that financial markets are inefficient, Hahn ends up on the side of investment practitioners who subscribe to either FA or TA as well as the academic school, BF, most reflective of the conventional wisdom in the financial community. His more precise stance, though, with respect to these three approaches comes to sight in the personal investing counsel that he draws from his theory of the stock market. While agreeing with BF that psychological variables create divergences between stock prices and rational prices, and while sympathizing with FA that market values do not always equal intrinsic values, Hahn’s proposed strategy is surprisingly aligned with TA. Granted, Hahn does not refer to trend lines, moving average crossovers, head and shoulder formations, or any of the other constructs of TA. In the one instance he does allude to TA, he is dismissive. This happens when he briefly discusses the Dow theory, a century old concept that seeks to identify the market’s current trend by comparing movements in the Dow Jones Industrial Average to those of the Dow Transportation Average (Rhea, 1932). Hahn contends the Dow theory has proved to be of limited use and that its value is negligible in any case because it is widely known.
That said, Hahn figures that the optimal strategy is to buy shares at the intersection of the exaggeration phase of the bear market and the adjustment phase of the incoming bull market. Here, the wise investor must go against mass opinion, which is overwhelmingly pessimistic at this stage when the subjective forces of psychology are in control. From here, though, one must become willing to travel with mass opinion. For the wise investor is then supposed to hold on to their shares as the subjective element is brought back to objective reality. Furthermore, he or she is to maintain their position afterwards when the two diverge again as the bull market reaches its most enthusiastic phase. This is, of course, the moment in which one must again oppose mass opinion. Thus, the wise investor sells (or short sells), and stays out (or remains short) throughout the normal stage of the bear market when the objective and subjective orders are reunited once again, only re-entering (and covering) when these two diverge at the exaggeration phase of the bear market. “Thus it is as wrong always to oppose the prevailing tendency as it is always to follow it. In a nutshell, the right rule is: first against the tendency, then with it, and finally against it” (Hahn 1956, p. 214). Heeding this advice, one will spend quite a bit of time following the trend, precisely as TA counsels. Even Hahn speaks of the change in trend occurring over a “moment” (ibid.). Yet it must be conceded that Hahn does not think such changes can be scientifically predicted. To this extent, and only to this extent, is Hahn in accord with EMH.
Volume 6, No. 3 (Fall 2003)Unfortunately, Peter Bossaerts’ text, The Paradox of Asset Pricing, offers no relief from past use of flawed methodologies. Bossaerts is professor of finance and director of the Laboratory for Experimental Finance at the California Institute of Technology. His manuscript is aimed at the academic/professional market and is based on a collection of his lectures, working papers, and published research. Based on the title and preface, one may assume that Bossaerts is launching a full-scale attack on the use of positivism and econometric empiricism in past attempts to study asset pricing; this view is quickly extinguished by the time the reader gets to page xi of the Preface. In terms of general methodology, he utilizes the same techniques and measures that most Austrian economists reject.
Volume 15, No. 2 (Summer 2012)
The theory of monetary disequilibrium, as espoused by Selgin (1988), White (1989), Horwitz (2000), and others, has been used to justify the issuance of fiduciary media under a system of fractional reserve “free” banking. The present paper examines this monetary disequilibrium theory and concludes that it contains numerous errors and logical fallacies. The foundational economic argument in favor of fractional reserve banking is invalid.
Volume 14, No. 1 (Spring 2011)The winner’s curse was “discovered” in low rates of return on certain types of capital goods acquired in auctions or negotiated acquisitions. The inference was that companies were systematically bidding amounts in excess of their presumed “common investment worth.” In exploring this phenomenon, experimental auctions have uncritically relied on this exogenous ex ante standard of common capital worth. However, experiment auction are irrelevant to auctions of capital goods. Capital goods imply strategies for their employment. But an assumed common investment worth implies an absence of differentiated strategies. In fact, the prospective investment worth of a capital good inheres in strategically sought complementarities in the production of often distinctively differentiated goods and services. Hence, there is no likelihood that capital goods would ever have an appraised worth common to competing bidders. Bids can only be assessed ex post in the success or failure of an entrepreneurial strategy. This inquiry suggests a revised interpretation of the winner’s curse.
Volume 15, No. 2 (Summer 2012)
There are many methods for choosing common stocks for investment. These methods may or may not be consistent with a traditional Austrian view, depending on the processes involved and basic tenets of the analysis. Several Austrian authors display a positive affinity towards methods that fall into the category of fundamental analysis. This study explores fundamental analysis to determine its application as an Austrian approach to common stock selection. The thymologic method and the category of understanding are applied as frameworks for an Austrian approach and to evaluate fundamental analysis as a process for common stock selection. The analysis supports the conclusion that fundamental security analysis can be practiced in a manner consistent with traditional Austrian views and is suitable as a common stock selection method by those who wish to adhere to such views.
Volume 5, No. 1 (Spring 2002)The insider trading debate traditionally discusses the pros and cons of insider trading and draws a conclusion about the desirability or undesirability of public regulation of insider trading. One of the most important arguments against insider trading is that it generates agency problems that shareholders cannot resolve and that, therefore, insider trading should be publicly regulated. We have challenged this argument for failing to engage in comparative institutional analysis. We argued that when the negative aspects of insider trading, namely, the agency problems that it may create, are considered, it is necessary to engage in comparative institutional analysis and how these problems can be resolved under two different economic systems: the market economy and interventionism. We have been led to the conclusion that under a market economy, shareholders do have mechanisms to protect themselves against agency problems generated by insider trading and that these problems are reduced to a minimum. We have shown that interventionism hampers the functioning and reduces the disciplinary role of such mechanisms. Therefore, insiders have indeed more latitude to engage in these discretionary behaviors, pointed out by the supporters of the insider-trading-as-an-agency-problem argument, that harm shareholders. Finally, we have shown that the failures of government regulation reinforce this tendency of insiders’ behavior. We conclude that we cannot justify a public regulation of insider trading based on the insider-trading-as-agency-problem argument.
Volume 7, No.1 (Spring 2004)Complexity, Risk, and Financial Markets completes Peters’s trilogy by presenting the underlying philosophical case for chaos theory, which turns out to be grounded on distinctively Austrian views of information and market process. This book should be read by Austrians interested in, or already familiar with, fractal analysis or chaos theory, a statistical methodology developed extensively by Benoit Mandelbrot. In addition, this book should also be read by practitioners of fractal analysis and related statistical techniques, in order to receive an introduction to the Austrian School and deepen their understanding of their methodological paradigm’s justification, implications, and limitations.
Volume 4, No. 1 (Spring 2001)In this article, the prime concepts are based on the Mises-Hayek theory of the business cycle. Using this model as the general framework for analysis, additions and modifications are introduced reflecting theoretical advances and current problems. Free markets and a strict profit-and-loss system are the best ways to signal erroneous action and induce the constant process of corrective adaptation to bring forth efficiency in the allocation of capital.
Volume 2, No. 2 (Summer 1999)The popular media often see the technological advances of the last century as a frightening boost to the power and reach of the state. The box-office hit Enemy of the State, starring Will Smith, shows a government using high technology to persecute an innocent citizen. Likewise, Gattaca portrayed a society in which technology had almost erased personal privacy and enabled the state to suppress the most precious individual freedoms.In contrast, Richard Rahn’s view of the future of money and financial privacy is positive and exciting. If he is correct, totalitarians will suffer a massive cut in their power and reach in the next two decades. Technology has been used and abused by the state, but Rahn shows how it will be used by individuals for the enhancement of financial privacy and personal protection.Two key technologies give the impetus to Rahn’s encouraging predictions. Only in the last five years have they both come into common use, and Rahn believes that they now will force major reductions in the size and scope of civil government.The first development was public-key cryptography, which appeared in the mid-1970s. Public-key cryptography is now easy to use, and allows secure transmissions over telephone lines. Rahn, in a primer on public-key cryptography, shows that it is relatively simple to make a code that is practically unbreakable even by governments.The second development was the Internet (which Vice President Gore apparently intends us to believe was his brainchild). In combination with strong public-key cryptography, the Internet essentially allows any two modem-equipped computers in the world to trade information that is inaccessible by any government.Because of these complementary technologies, it is possible for digital money substitutes to be created (publicly or privately) and exchanged worldwide without the knowledge or consent of government regulators. Paper currency will become obsolete as privacy-seekers turn to secure, instantaneous digital transactions.International private exchange of money substitutes over the telephone allows businessmen to avoid some taxes and government regulations, which are typically geographically constrained. Many services, such as software development, architectural design, legal services, and banking services, can be provided from a distance over the Internet and service providers can move to free-market jurisdictions to avoid taxes. Writes Rahn,
Free trade in services increasingly will become a necessity, because governments will find they can neither regulate nor tax such transactions, because consumers will receive much of the “product” by way of the Internet in digitally encrypted form. Governments that fail to move to free trade in services will find they are faced with the digital equivalent of trying to sweep back the sea. (p. 30)
Rahn leaves little hope for tax collectors and financial regulators who wish to retain control. “The question is not whether we will have financial privacy—we will. The appropriate question is whether financial privacy will be legal, when, and at what price. The technological genie is out of the bottle. . . . [M]oney as we know it is going to disappear. At some point, all money and the information money conveys, will be electronic in digital form” (p. 65).Because financial privacy is absolutely essential to liberty, it is refreshing to see Rahn hopeful about the restoration of privacy to individuals worldwide. Governments have enjoyed the ability to monitor the slightest detail of electronic financial transactions, and in some places have legally required reporting of large cash transactions. The well-worn excuse that government snooping is necessary to suppress organized crime and money laundering is spurious, Rahn shows. Suppressing organized crime through money laundering statutes is ineffective, and any small benefit that may accrue is not worth the certain loss of privacy for non-criminals.Given the history of civil government, we cannot expect bureaucrats to use data about individual citizens only for the detection and prosecution of terrorism, theft, or fraud. Rahn discusses at some length the abuses of privilege by regulators, and shows how certain U.S. laws, such as the RICO statute (allowing federal agents to seize assets without proof of the owner’s guilt) and the Bank “Secrecy” Act, result in tragic losses of privacy and private property.Rahn opposes money laundering statutes and encryption controls of all sorts, declaring that, in any event, any attempt to limit financial privacy will soon become an absurdity. Comparing money laundering statutes to Prohibition, he writes,
When digitized money is encrypted. . . . it is unseen. . . . Alcohol is composed of atoms, it has to be contained in a bottle or a can and it is heavy, yet, during prohibition, only a small percentage of the bootleg product was ever seized or destroyed. The problem of trying to identify “bootleg” money is infinitely harder. When government officials tell you that they can control money laundering, when they cannot even stop tons (many, many atoms) of cocaine and marijuana from crossing the border, it does not pass the laugh test. (p. 71)
Rahn is careful to delineate his argument.
Advocating the abolition of laws and regulations that restrict financial privacy is not the same as condoning terrorism, drug dealing, or tax evasion. It is merely acknowledging that the new technology has made it impossible, at least in any reasonably cost-effective manner, to enforce such laws and restrictions and at the same time preserve civil liberties. (p. 20)
However, Rahn argues for the morality of tax evasion in some circumstances. “In Hitler’s Germany,” he states, “the moral person was the tax evader” (p. 169). Under the heading “When is Tax Evasion Morally Justified,” Rahn states,
An argument against financial privacy is that it will make the collection of some types of taxes more difficult for governments. This argument is indeed true, but that is not a justification for preventing financial privacy; in fact, it can be an argument for protecting financial privacy. When a government is unjust and corrupt, the people have both the right and the duty to oppose it. A form of opposition is the refusal to fund the government to the best of one’s ability, which can take the form of deliberate tax avoidance or evasion. (p. 169)
As long as Rahn is discussing the enhancement of privacy in the digital age, his arguments are credible and hopeful. However, Rahn’s economic understanding is deficient in some respects. Despite an attitude toward money that would be generally acceptable to Austrian economists, Rahn displays a few inconsistencies, and a little confusion about the nature of money. In the preface, Rahn emphasizes, “Money will disappear because a circulating medium of exchange is needed only when a time interval is required between the liquidation of an earning or useful asset and the acquisition of a new asset or service. In the digital age, such time intervals are no longer needed, hence there is no need for traditional money” (p. 8). Will money disappear, as the title, and this paragraph seem to indicate? Rahn flits back and forth from discussing “the end of money” and the “non-monetary economy” to mention of the “non-governmental money” of the future and “the world of digital money.” If only he were more clear. Rahn cannot mean the literal end of money, but rather the end of the use of physical currency in exchange and the end of government-issued fiat currency.Mises has pointed out that we cannot function in a world without money. “The whole structure of the calculations of the entrepreneur and the consumer rests on the process of valuing commodities in money. Money has thus become an aid that the human mind is no longer able to dispense with in making economic calculations” (Mises 1980, p. 62). Rahn’s digital money is really what Mises would refer to as a money substitute. Money substitutes, to Mises, are “those objects that are employed like money in commerce but consist in perfectly secure and immediately convertible claims to money” (p. 65). Whether these claims are printed or exist in a computer record seems to matter little in principle. Mises shows that what is important is not the physical characteristics of money and money substitutes, but the purposes they serve. In Human Action, Mises (1998, p. 444) writes, “Banknotes are not indispensable. All the economic achievements of capitalism would have been accomplished if they had never existed. Besides, deposit currency can do all the things banknotes do.”Rahn also still sees a role for a central bank, though he notes that it will be more disciplined by the market. In his view, government must still set a “unit of account,” but he speculates that the dollar may return to a commodity standard. To Rahn (pp. 53, 54), the commodity standard would not be gold or silver, but a basket of commodities, à la Irving Fisher, Benjamin Graham, and F.A. Hayek (1976). If Rahn were as well-read in Rothbard as in Hayek, he would be aware that Rothbard had launched a devastating critique of the commodity dollar at least fourteen years ago, which was based on Mises’s earlier work.
There are many deep-seated flaws in this approach. In the first place, such a market-basket currency has never emerged spontaneously from the workings of the market. It would have to be imposed. . . . as a “constructivist” scheme from the top, from government, to be inflicted upon the market. Second. . . . the government would be obviously in charge, since a market-basket currency does not, unlike the units of weight in exchange, arise from the free market itself. The government could and would, then, alter the ratios of weights and adjust the various fixed terms, and so forth. Third, the hankering for a fixed market basket is an outgrowth of a strong desire for the government to regulate the economy so as to keep the “price level” constant. As we have seen, the natural tendency of the free market is to lower prices over time, in accordance with growing productivity and increased supplies of goods. There is no good reason for the government to interfere. Indeed, if it does so, it can only create a boom-and-bust business cycle by expanding credit to keep prices artificially higher than they would be on the free market. (Rothbard 1977, p. 371; also Mises 1998, p. 422)
Rothbard also points out, with Mises, that there are fatal problems with the concept of “the price level.” In addition, Gresham’s Law would produce “perpetual shortages and surpluses of different commodities within the market basket” (Rothbard 1977, p. 372).Rahn believes that the new digital era will bring about not only a redefinition of the dollar, but a slew of private monies as well. “People can have a choice of monies, both government-issued and privately-issued monies, which will enable them to escape from unstable money.” Gold warehouses can now open and, without the knowledge or consent of government regulators, issue warehouse receipts that could, Rahn believes, circulate electronically as a viable alternative to fiat money.[1]Rothbard, however, warns that such a Hayekian plan for the denationalization of money would not work. “Americans have been used to using and reckoning in ‘dollars’ for two centuries, and they will cling to the dollar for the foreseeable future. They will simply not shift away from the dollar to the gold ounce or gram as a currency unit” (Rothbard 1977, p. 369). Even during runaway inflation, Rothbard points out, “people will cling doggedly to their customary names for currency.” In any case, as Rahn notes, the monetary system would still fall under the influence of the state, as people would “still be forced to use government money for the payment of taxes and for the receipt of payments from government” (ibid., p. 40). However, “for private transactions, people will increasingly move away from government money.”Rahn seems to conflate money and capital. He proposes that the “money” of the future will be instantaneously transferable securities—real working capital will be transferred instead of sterile gold or silver, so money will be interest-bearing. Rahn’s definition of money is somewhat vague, and should be clarified.Rahn’s definition of inflation is also problematic. Inflation, to Rahn, is “the situation in which there is too much money chasing too few goods” (p. 39). We obtain from Mises and others the idea that every money supply is optimal—there is no such thing as “too much” money. Properly understood, inflation is the increase of the money supply.[2]The best parts of Rahn’s book are those dealing with the enhancement of privacy in the digital age. These parts are realistic and encouraging. Yet when Rahn follows Hayek in his attempts to predict changes in the monetary system that could result from technological changes, he runs into trouble. Some academic economists may be aware of the Mises-Hayek debate on money, but the average businessman for whom this book is written is not so aware and is done a disservice by Rahn’s failure to note the controversy.Rahn also tends to ramble off-topic at times, and a sizable portion of the book is dedicated to a discussion of “what is wrong with the U.S.” rather than specific issues relating to digital money or even the monetary system in a broader sense. Most of what he says is consistent with a classical-liberal political position, but readers particularly interested in digital money would be better served to have the broader political issues left to another publication.The last chapter of Rahn’s book consists of a fictional tale of two countries as they might appear in 2013, after taking different paths in response to changing technology. Predictably, “Freelandia,” where government took a laissez-faire approach to private finances, is a virtual utopia; and “Malapense,” where government tried to squelch freedom, is a poverty-stricken nightmare. Cryptography and the Internet can be used for good or for evil. In the end, changing ideas is of far greater import than changing technology.
ReferencesHayek, F.A. 1976. The Denationalization of Money. London: Institute of Economic Affairs.Mises, Ludwig von. [1934] 1980. The Theory of Money and Credit. Indianapolis, Ind.: Liberty Fund.———. [1949] 1998. Human Action, Scholar’s Edition. Auburn, Ala.: Ludwig von Mises Institute.Rothbard, Murray N. 1997. “The Case for a Genuine Gold Dollar.” In The Logic of Action I: Method, Money, and the Austrian School. Cheltenham, U.K.: Edward Elgar.[1] The Gold and Silver Reserve has already set up a legal, Internet-based service (www.e-gold.com) that is a step toward the separation of money and state.[2] Some Austrians will also cringe at Rahn’s definition of public goods, included in a discussion of the functions of a limited government: “A public good is an indivisible benefit, like constitutional rights or national defense, that government atone can provide and can provide only to all citizens” (p. 176; emphasis mine).
Volume 3, No. 1 (Spring 2000)An entire generation of students has been taught to accept efficient market theory (EMT) as gospel. They have learned about investing in securities in an academic environment that rejects fundamental analysis. With the Austrian School of economics as his starting point, Frank Shostak has begun the process of reexamining EMT. Applying arbitrage and the historical record of Benjamin Graham and Warren Buffet to EMT would continue this process of critical examination.
Volume 22, Number 4 (Winter 2002)
Thomas C. Taylor is interviewed about the accounting profession, free markets, and Government intervention.
Any government intervention in the economy, such as, loan programs, regulations, and subsidies, creates malinvestments, writes Dayne Girard. This audio Mises Daily is narrated by Allan Davis.
Interviewed by host Redmond Weissenberger, Mark Thornton discusses markets, Keynes, Keynesians, and general economic craziness.
Mark Thornton discusses Martin Wolf's recent claim that "cautious savers no longer serve a useful economic purpose". Thornton is a Senior Fellow at the Mises Institute.
Interviewed by host John O’Donnell, Peter Klein discusses income inequality cause and effect, role of Fed intervention in capital markets, malinvestment in boom-bust cycles, and the 99% vs the 1% myth. Klein also discusses why boomers are working longer and the impact of youth joining the workplace.
Joe Salerno dismantles the Council of Economic Advisers' latest report touting the success of the 2009 stimulus, five years later. Dr. Salerno is the Mises Institute's Academic Vice President.
Mark Thornton explains what the latest government employment report really tells us. Thornton is a Senior Fellow at the Mises Institute.
Mark Thornton explains why the latest government GDP numbers are bogus. Thornton is a Senior Fellow at the Mises Institute.
Peter Klein answers a viewer's question, and discusses the growing evidence of asset price inflation. Submit a question via twitter @MisesView
Interviewed by host Redmond Weissenberger, Mark Thornton discusses the real estate and job markets.
Antifragile: Things that Gain from Disorder, Nassim Nicholas Taleb (New York: Random House, 2012).
No two buzzwords define the present crisis more than “contagion” and “robustness” in the world of economists and policy wonks. The current interrelated nature of the financial system has bred a fragile situation where the success of the greater economy supposedly hinges on its individual components, such as banks that are too big to fail. To combat this fragility, economists have increasingly sought to build robust institutions. Such institutions will remain strong in the face of adverse effects if an individual component of the economy fails — be it subprime mortgages, sovereign debt, deposit-taking institutions or investment banks. This approach to the crisis stresses that if we cannot battle contagion, we had better construct strong institutions to weather future storms.
Nassim Taleb takes great issue with this approach in his new book Antifragile. His view is that constructing such so-called robust institutions is not sufficient as they continually fight yesterday’s battles. Instead the focus should be in building “antifragile” institutions. Although often confused with robustness or resilience, an antifragile institution is not only unharmed by adverse events, but is actually strengthened by them. Building antifragile institutions will not only strengthen the global economic arena, but also have wide-ranging social applications.
Taleb’s latest work builds on two of his previous books, Fooled by Randomness (2001) and The Black Swan (2007). The common theme underlying all three is that there are events which are fundamentally unknowable — true uncertainties — in distinction to merely risky outcomes. Since we cannot know in advance what these events are, or what their effects will be, we should not exert too much effort in constructing contingency plans.
It is at this point that my first quibble with the book arises, and one I had with its predecessor The Black Swan. Taleb bifurcates between two definitions of uncertain events. On the one hand he invokes random or fundamentally unknowable events. Readers of this journal will be sympathetic to this definition of uncertainty, bearing close resemblance to Mises’s own use of “case probabilities”Mises, Ludwig von. 1949. Human Action: A Treatise on Economics. Auburn, Ala.: Mises Institute, 1998. (1949, pp. 110–113), or Shackle’s (1949) use of “non-seriable, non-divisible” events.Shackle, G. L. S. 1949. Expectations in Economics. Westport, Conn.: Gibson. On the other hand, it is also clear that Taleb also thinks of uncertain events as merely rare events. These are events located on the fat or long tails on a probability distribution. Even though he thinks that these represent true uncertainty, there is no doubt that he is referring to fundamentally probabilistic events.
This quibble aside, one can apply much of the remaining work cognizant that Taleb’s terminology differs from that of the Austrian economists, and also that the domain of his theory is slightly different than he thinks.
Something is “antifragile” if it gets stronger from a negative event. What are some examples? Taleb applies the prefix of his book liberally to outline what choices we should be pursuing. Indeed, the body of the book gives a long list of antifragile actions that, at least on one level, boil down to doing the exact opposite of what you think you should be doing.
Authors should be shocked to learn that there is almost no news that can harm a writer’s credibility, and that any publicity is good publicity (pp. 51–52). Corporations and governments that try to “reinstill confidence” should not be trusted because they would do so only if they were ultimately doomed (p. 53). Children shouldn’t be on antidepressants as this removes a source of learning from the life experience and thus make individuals less capable of dealing with unwanted events later in life (p. 61). The sinking of the Titanic was a positive disaster as it put shipbuilders on their toes, and possibly avoided an even larger accident later (p. 72). The general theme is that those who make errors are stronger than those who don’t — reliability, or antifragility — only comes when something is regularly tested by an unwanted event.
The theory has merit. Consider this lesson applied to central bank policies. In the wake of the dot-com bust a concerted effort by the world’s central banks flooded the global financial system with liquidity. The liquidation of assets that should have happened never did, and as a result lenders and borrowers didn’t learn their lesson on prudential money management. The seeds were sown for the larger crisis starting in 2007–2008 because a simple lesson was not learned when the financial system’s problems were still in relative infancy.
There is much to learn from this book and much to be wary of. At the end of the day, Taleb reckons the best test of an anti-fragile institution is Mother Nature mixed with a healthy dose of time. In chapter 21 he criticizes the prevailing orthodoxy of “neomania,” the mistaken belief that newer is better. Those institutions that have existed the longest are, in all likelihood, those that will continue to exist into the future. As an example, imagine that the year is 1988 and answer the following: which structure will last the longest, the Berlin Wall or the Great Pyramid of Giza.
In this test, as in much of the book, Taleb asks too much and too little. He asks too much because those institutions with the most longevity were once upon a time also the ones with the least. There must be a better test than longevity, as it only pushes the problem back in time to identify the source of antifragility. It cannot be turtles all the way down.
An applied example relevant to the present financial crisis would involve looking for those institutions that have been strengthened by current affairs. The crisis has taken its toll on many aspects of the financial services industry, but some general types of products have proven surprising resilient, or antifragile. Governments with prudent fiscal policies — e.g., Germany, Switzerland and Singapore — have fared well and indeed been strengthened as finances deteriorate in more profligate countries. Investment funds capitalizing on what were once unorthodox strategies, such as gold and other precious metal holdings, have out-performed more traditional investments as the financial crisis worsens. Readers of this journal will also notice that their stock in Austrian economics has increased in value over the past decade. Question begging and failed policies developed through more mainstream theories have led many former outsiders to the ranks of Austrian economists. An unwanted event caused an offsetting positive outcome in all these scenarios. That is what being antifragile is about.
Taleb asks too little by not exploring the true sources of antifragility. He comes close, alluding in many places that market-based institutions better combat the false security that planned institutions create. Explaining and elaborating on this link would do much to take the fundamental merits of antifragility to the next level. It would be, however, fodder for another book.
[The Dao of Capital: Austrian Investing in a Distorted World. By Mark Spitznagel. Wiley Press, 2013.]
The economy is extremely complex. As Leonard Read taught, no single individual in the world knows how to make something as simple as a pencil. The level of complexity has only increased over time with the expansion of knowledge, technology, transportation, and international trade. Our individual labor is increasingly focused on a narrower slice of the overall process of production.
Even the static picture, if it could be seen, is complicated by the fact that our world is a work in progress dating back thousands of years. Look around you and you will see the savings, investments, and work of individuals who are long dead. Previous generations made their choices, some of which have been maintained, repurposed, neglected, or destroyed. Ownership of all that capital is recognized in the form of stocks, bonds, titles, and deeds.
Austrian economics teaches that understanding the “economy” can only be undertaken with the aid of economic theory. There is no formula or equation for understanding the economy. It cannot be measured in any meaningful scientific way. Only the logical construction of cause and effect aid us. A simple example of this is when John trades his three apples to Mary for her three oranges because both John and Mary think they would be better off from doing so.
Mark Spitznagel, a hedge fund manager, tries to take economic theory, specifically Austrian economic theory, and breathe life into understanding how the economy works and why it sometimes doesn’t. In his book, The Dao of Capital: Austrian Investing in a Distorted World, he uses these insights to explain the process of investment that he uses.
The title refers to the paradoxical Chinese philosophy of Daoism. In this philosophy, in order to achieve your goal you must do the opposite, or Shi. For example: “turn right in order to go left.” This is used, ultimately, to underscore the roundaboutness of the market process, where production processes become increasingly more complex in order to become more productive. In investing, for Spitznagel, it means to step back and take small losses in preparation for making larger gains, a variation of “value investing,” where you must keep your vision of the future as one of a process that takes place over time.
As a young trader in the bond pit at the Chicago Board of Trade, the author was lucky enough to come across Hazlitt’s Economics in One Lesson and Mises’s Human Action. He found in these books a theoretical explanation for the otherwise perplexing world of primary markets at the Chicago Board of Trade. He later partnered with Nassim Taleb of Black Swan fame and later still opened his own firm to employ his concept of “Austrian Investing.”
Spitznagel begins with the metaphor of the forest and the trees. Briefly put, conifers cannot compete with hardwood trees on the fertile plains so they retreat to higher ground that is less fertile and more intemperate where they can outcompete the hardwoods. Here they thrive under harsh conditions, even battling glaciers of various ice ages. This is an illustration of competition and comparative advantage in nature.
Fire plays a role in the competition between conifers and hardwoods, serving to clear small areas with dense underbrush free for new competitions among seedlings. This ebb and flow between conifers and hardwoods shows how apparent losses from fire can lead to strength and an overall growth in productivity. In the economy, firms go bankrupt, products are displaced, and new production processes emerge over time.
In a similar manner, he shows how fire-suppression policies of the government are like government intervention in the economy. Fire-suppression policy aims to put out most forest fires as soon as possible. This can lead to too much underbrush so that fires can become catastrophic is scope. This is an illustration from nature of the havoc caused by government intervention meddling in nature’s competition. In the economy, the government’s central bank can try to suppress recessions and deflation, but this can result in catastrophic depressions, like the Great Depression. As Rothbard showed in his America’s Great Depression, President Hoover’s interventions to suppress deflation and depression only made things worse.
In chapter 3, “Shi: The Intertemporal Strategy,” the insights of the famous military philosophers Sun Tzu and Carl von Clausewitz are discussed in support of the Daoist concept of Shi. This is the concept of strategic advantage in war where you do not hurl your troops headlong directly at enemy positions for an immediate victory. Rather, you conserve your troops and resources and take advantage of points with defensive and strategic advantages in a more roundabout approach to final victory. Military history has confirmed the wisdom of this approach from the battlefields of the American Civil War to the more recent guerilla wars fought against the modern empires of the United States and the Soviet Union. As applied to investment, this discussion is meant to make the reader prepared and even eager to take small losses in order to achieve the ultimate goal of growing your wealth into the future.
Normally, I do not like examples from nature and war to serve as illustrations of the benefits of roundaboutness of production, preservation of capital, and competition, but I will admit that in this case they are effective.
The book takes us on a trip through time to explore the character, history, and contributions of the Austrian economists. He begins with Frédéric Bastiat (the seen and unseen), and moves onto J. B. Say (entrepreneurship), Carl Menger (marginal utility and price formation), Eugen Böhm-Bawerk (roundabout production and interest), and even Henry Ford (the assembly line as an example of roundabout production). This is followed by a fascinating discussion of the critical role of time preference in life before he turns his attention to Ludwig von Mises (monetary and business cycle theories and the market as a process). According to Spitznagel, Mises was “perhaps the greatest economist of all time.”
Since I am not an investment expert, I will not comment on the chapters on investing or the author’s tweaks of Austrian economics that try to bring Austrian economic theory closer to the understanding of reality for the non-economist. However, I applaud the book as a look into the thinking process of a great investor, especially one that has a clear and consistent understanding of the market process, the dangers of government intervention, and the benefits of Austrian economics.
In a recent appearance on RT, Mark Thornton discusses the economics of Bitcoin. Thornton is a Senior Fellow at the Mises Institute.
The US government and the European Commission (EC) recently slammed Germany for running large current account surpluses. Paul Krugman jumped in with this beauty of a quote:The problem is that Germany has continued to maintain highly competitive labor costs and run huge surpluses since the bubble burst — and that in a depressed world economy, this makes Germany a significant part of the problem.
Only in today’s surreal world of economic policy could being highly competitive be deemed detrimental. This criticism of Germany is not new, but we are no longer living in the 1950s. Germany does not have its own currency, and there is little that is “German” in a German export.
A BMW produced in Germany but sold in Spain contains parts coming from all over the world. Most, but not all, of the labor will be German, but technological innovations have reduced labor cost to about 10 percent of the price of a car. The return of capital will go to bond holders and shareholders who may be anywhere in the world. BMW may distribute a dividend to a Spanish shareholder who may use those euros to purchase Spanish goods. To say a BMW is a product of Germany alone is a stretch.
Germany is also part of a common currency. To talk about a current account surplus of a region within a common currency zone is like complaining about Florida’s current account surplus or, Jacksonville’s bilateral surplus with Miami.
We can bring this down to the individual level to make this argument crystal clear and highlight the silliness of the argument. We run a current account surplus with our employer and a current account deficit with our supermarket. Our employer buys more from us than we buy from him and the reverse is true about our relationship with our supermarket. However, we are not running to the supermarket and demanding that the manager buy more of our goods or services.
Furthermore, Germany’s current account surplus with other Europeans or euro zone members has been cut in half between 2007 and 2012, and Germany’s surplus with the rest of the world has more than tripled. This is what we would expect from the opening up of trade, gains from the division of labor, and specialization made possible by focusing on areas of comparative advantage. To criticize this trend is to criticize the stated reasons behind the European Union’s creation in the first place.
For reasons that are hard to understand, the European Commission has a rule that it must intervene if a member country has a current account surplus over 6 percent of output over a three year period. Germany’s was 7 percent last year, and it probably will record a similar number this year. If the free exchange of goods and services and free movement of capital leads to a 10 percent, 20 percent, or greater surplus, where is the problem? Why does this rule even exist? Why would the EC impose a constraint that limits the movement of goods and services or capital? Wasn’t the EU created to foster the elimination of unjustifiable constraints? The EU should not be surprised that countries want to leave when it imposes such illogical rules.
Underlying this criticism of Germany is mercantilism rearing its ugly head again. Within the mercantilist mindset, we must have a winner and a loser and not just winners resulting from mutually beneficial voluntary exchange. Germany is supposedly producing more than it’s consuming. Of course, this is playing on a common fallacy which some exploit for political gain. Every euro that is spent on a German car or other product will be received as income by someone who will spend that income. There is a direct link between production and expenditures. Say’s law tells us that (the right) supply creates its own demand. Consumption never needs encouragement: everything that is produced is consumed, either to produce other goods (investment) or for personal satisfaction (consumption).
Of course, the “solution” to this imagined problem is to have Germany boost government spending to spur growth in other EU countries. Never mind that Germany already has a debt to GDP ratio of 82 percent, well above the 60% that had previously been viewed as excessive. It is a standard Keynesian solution that constantly runs up against the logic of the “crowding out” effect. Every dollar that the government spends must be a dollar that would have been spent by someone else. The government can alter who gets a piece of the economic pie, but it cannot increase the size of the pie.
Even when Germany had its own currency this criticism never held water. Back then, a current account surplus would have meant an equivalent capital outflow, financing Italian or French government spending, or investments in plants and equipment in Spain, Italy, China or elsewhere. Again, words like surplus or deficit are remnants of our mercantilist past and have absolutely nothing to do with being good or bad.
If Germany has competitive labor costs and can build a better widget, where is the problem? Wasn’t the EU created to make Europe more competitive by allowing resources to move (e.g., labor to Germany) where they are most efficiently used? The criticisms by the EC and the IMF are even more out of line when you look at the reasons given for their existence.
The German Finance Minister Wolfgang Schäuble, a member of Chancellor Angela Merkel’s center-right Christian Democratic Union (CDU) was absolutely right when he said, “The German current account surplus offers no reason for concern for Germany, the euro zone or the world economy.” In reality, Germany should be praised not scolded. Its productive prowess is one of the few things moving the world economy forward.
Interviewed by host Angel Clark, Mark Thornton explains and discusses the Skyscraper Index and what it can tell us about the economy.
(Finance and the Good Society by Robert J. Shiller, Princeton and Oxford: Princeton University Press, 2012, 288 pp.)
What defines a “good society” and how can we use finance to achieve it? Robert Shiller takes the former question as settled, and dedicates his 2012 book Finance and the Good Society to the latter: what is wrong with modern finance, and how should it be restructured to reach this ideal?
What constitutes Shiller’s good society? He alleges this term has been used by philosophers, historians, and economists for centuries to signify the society we should aspire to live in, where everyone respects and appreciates one another. While everyone agrees we should respect one another, appreciation implies an obligation that is less universally accepted. Although this could be chalked up to a fairly unassuming statement, the definition, indeed the whole book, goes downhill from here. The good society is also an egalitarian one, according to Shiller, and finance should not be at odds with this goal.
Shiller never completely defines what he considers egalitarian to mean. In some places, it is synonymous with democratic participation, which generally results in wealth equality (p. 8). In other places, Shiller implies that a “good society” is also democratic financially — everyone has access to the same products and services (p. 44). In still other places, he uses the term to imply increasing regulation of the financial sector (pp. 183–185), while in others deregulation is necessary (p. 47). Perhaps most troubling is that he never bothers to inform the reader why egalitarianism is an ideal to attain. Indeed, like so many concepts in the book, he parades the idea around without much justification.
The first part of the book provides the reader with a rundown of the roles of the financial economy, and some problems Shiller has with them. Examples include CEOs apparently earning too much money, and taking on undue risks because they believe their firms are too big to fail (p. 23). The high returns on university endowments are examples of intellectual achievement and demonstrate the superiority of academic-led finance (p. 31). (Never mind the abysmal 30 and 29 percent losses on Harvard’s and Yale’s endowments in 2008–2009, or the collapse of Long-Term Capital Management, headed by two Nobel laureates.) Banks and bankers solve the critical moral hazard problem of investors not being able to monitor their own investments (p. 41). Housing is a fundamental need, and should be promoted through subsidies (p. 50). People do not die from lack of kidneys available to transplant each year because there is no legal market for them but because, according to Shiller, the government has not helped to design the market yet (p. 69). (Financial markets that do not exist yet, e.g., over-the-counter derivatives products, are encouraged to look to the government to support a market solution.) Private philanthropy can be “self-serving or motivated by ego” and can generate feelings of “resentment rather than gratitude” that result in a loss of dignity for the recipients (pp. 235–236).
So, what does he recommend we do with these problems?
The government should regulate executive pay, and perhaps defer compensation for an extended period, maybe as long as five years (p. 23). Better to put more financial activities in the hands of banks, and to increase regulatory requirements to stop other firms (shadow banks) from free-riding on their abilities (pp. 41, 43). Subsidizing home ownership through new government-sponsored enterprises that will not only make society better off, but will also allow us to learn from the mistakes of Fannie Mae, Freddie Mac, et al. (pp. 50, 56). Financial engineers are not looking at the correct problems to solve, and should look to the government for help, “Governments that do not encourage entrepreneurial enterprises that actively look for problems to solve won’t be very helpful” (p. 73). Regulators are mostly immune from regulatory capture (ch. 12), and policy makers are not just in charge of setting the rules of the game (as is their traditional role), but in stabilizing the economy (ch. 16). Central bankers, instead of playing a role in creating the crisis by easy monetary policies and extended periods of artificially low interest rates are praised by Shiller as “the first line of defense against economic instabilities” (p. 112).
The book’s second section looks at specific institutional improvements that we can make to the financial sector to rectify some of the misgivings he identifies in section one. Shiller starts by proclaiming strangely that we need to “reframe the wording of ‘universal human rights’ so that they represent the rights of all people to a fair compromise — to financial arrangements that share burdens and benefits effectively” (p. 150). This sentence sums up almost everything that is wrong with the book. When Shiller discusses “rights,” he really means “preferences”: his own preferences. It should come as no surprise that this reviewer finds almost every policy ideal prescribed to be in conflict with what he considers “good” for both society and finance.
One of Shiller’s proclamations is that society would be better with more democratic access to financial markets, but he also thinks that the American personal financial arena is inferior to that of China: the former has five credit cards per person, while the latter has thirty-three persons per card (p. 154). Stock ownership and the advent of limited liability allowed the masses to participate in financial capitalism for the first time by purchasing portions of businesses, but Shiller also thinks that Wall Street needs to return to a partnership model to exclude people from this realm (p. 176).
This is a dangerous book, not just because of what it says, but because of what it leaves out. By not providing background or justifications for the ideals proposed, Shiller leaves the reader with a feeling that the ends have been decided already. The only thing left is for us to find the best means to attain them.
Shiller and this reviewer can agree on some things. We both see financial capitalism as a means to obtain an end. It has a supportive role, mostly. We both view finance as not fundamentally about “making money,” although Shiller thinks that is what Western society has turned it into. This reviewer views financial capitalism, like all forms of capitalism, as being about rewarding success and punishing failure. If money is the way that success is rewarded — the common denominator to keep score — making money might not be such a bad thing.
The only full sentence I nodded my head in agreement with comes halfway through the book: “[A] good society has limited ability to make everyone’s dreams a reality — and finance is all about reality” (p. 120). Perhaps Shiller should pay heed to this lesson. Instead of creating a form of financial capitalism that furthers the good society, he should realize that finance, qua finance, is neither good nor bad; it just is. Utopian dreams might make for interesting reading for an undergraduate finance class, but they have repercussions in the real world. In finance, as the recent crisis attests, bad ideas reach far, and affect many.
Editor’s Note: This book review is adapted from a review in the Winter 2012 issue of The Quarterly Journal of Austrian Economics 15 no. 4.
Broadcast on RT's Prime Interest program, Mark Thornton talks to producer Bob English about Edward Snowden, the financial markets, and the Fed.
Stockman makes clear that the facile left-right distinction of US politics obscures a deeper crisis of capitalism that spans the breadth of the American economic and political landscape. While he admits he has little hope that America can now change course, in closing he does offer a few specific policy recommendations that might, just might, lay the foundation for a Great American Reformation, were they to be implemented in future.
David Stockman talks about his important new book, 'The Great Deformation', which has outraged the establishment. Recorded at the beautiful and historic Metropolitan Club in New York, NY, on 21 May 2013. Includes a Question and Answer period.
[Excerpted from The Economics of Liberty (1990), edited by Lew Rockwell] Astrologers, palmists, and crystal-ball gazers are scorned while professional economists are heralded for their scientific achievements. Yet the academics are no less mystical in trying to predict the direction of interest rates, economic growth, and the stock market.
Forty years ago, Thomas Dewey was defeated by Harry Truman, stunning the political experts and journalists who were certain Dewey was going to win. While questions about “scientific” polling techniques naturally arose, one journalist focused on the heart of the matter. In his November 22, 1948, column in Newsweek, Henry Hazlitt said the “upset” reflected the pitfalls of forecasting man’s future. As Hazlitt explained:
The economic future, like the political future, will be determined by future human behavior and decisions. That is why it is uncertain. And in spite of the enormous and constantly growing literature on business cycles, business forecasting will never, any more than opinion polls, become an exact science.
We know how well economists forecasted the eighties: from the 1982 recession and the employment boom to the Crash of 1987, no major forecasting firm came close to predicting these turns in the market. And following the Crash, virtually every professional forecaster revised his economic forecasts downward, all because the historical data suggested that the stock market was a reliable barometer of future economic activity. The economy then continued to expand and the stock market eventually reached new highs.
After President Eisenhower’s heart attack on September 24, 1955, the stock market experienced a massive drop. The stock market later recovered as the president recovered; like 1987, 1955 turned out to be one of the statistically best in economic history.
Despite the sorrowful record, most economists remain die-hard advocates of forecasting. Most have spent years in college and graduate school learning the tools of their trade, and can’t bring themselves to admit their own entrepreneurial errors. As one investment advisor put it: “No matter how many times they fail, their self-assurance never weakens. Their greatest (or only) talent is for speaking authoritatively.”
Of their errors, the forecasters contend that it’s only a matter of time before they master the techniques. Though that day will never arrive, economic forecasting remains an integral part of the economics mainstream. The original motto of the Econometric Society still holds sway: “Science is Prediction.”
Whether one uses a ruler to extend an economic trend into the future, or a sophisticated econometric model with dozens of equations, the problem is still the same: there are no constant relations in human affairs.
Economics, unlike the natural sciences, deals with human actions, plans, motivations, preferences, and so on, none of which can be quantified. Even if it were possible to quantify these things, changing tastes (and all the factors that affect tastes) would make the data almost instantaneously useless to the forecaster. And then there are the millions of “unimaginable” things, like Eisenhower’s heart attack, which constantly crop up, influencing people in unpredictable ways.
Economic statistics (i.e., history) do not imply anything about the future. Because data show the relation between price and supply to be one way for one period of time doesn’t mean that it cannot change. As Mises pointed out, “external phenomena affect different people in different ways” and “the reactions of the same people to the same external events vary.”
Some economic forecasters like to argue that economic forecasting is not unlike predicting the weather (and should also be equally difficult). Not only is the nature of these two problems entirely different, but one can reasonably expect that as scientific methods become more sophisticated, weather prediction could theoretically approach perfection. This is because there are constant relations among physical and chemical events. By experimenting in the laboratory, the natural scientist can know what these relations are with a high degree of precision. However, human society is not a controlled laboratory. This fact makes the forecaster’s job of accurately predicting future events impossible.
Forecasters try to get around this problem by linking events in historical chains, and randomly guessing that if one variable reoccurs, then the others will necessarily follow. But this is a sophisticated version of the logical fallacy, post hoc ergo propter hoc (after this, therefore, because of this). This has led major forecasters to seriously study astrological patterns and to build mathematical models that correlate weather patterns with business cycles. Once the forecaster throws out economic logic, anything could have caused anything else, and all variables in the universe are open to study. One mainstream forecasting theory for investors, for example, is based on the rate at which rabbits multiply.
Does this mean we can know nothing about the future? No, the best forecasters are successful businessmen, whose entrepreneurial judgment allows them to anticipate consumer tastes and market conditions. As Murray N. Rothbard points out:
The pretensions of econometricians and other “model-builders” that they can precisely forecast the economy will always flounder on the simple but devastating query: “If you can forecast so well, why are you not doing so on the stock market, where accurate forecasting reaps such rich rewards?”
Forecasting gurus, instead, tend to disdain successful entrepreneurs.
The myth that economists can predict the future is not just harmless quackery, however. Central planners use the same theories to direct the economy. Yet by setting production goals with the data collected by the planners themselves, they destroy the very process that directs free-market production.
Central planners try to overcome uncertainty by substituting formulas for entrepreneurial judgment. They believe that they can replace the price system with commands, but they miss the whole purpose of individual action on the free market. As Ludwig von Mises said, they make “not the slightest reference to the fact that the main task of action is to provide for the events of an uncertain future.” In that sense, central planners are no different from professional forecasters.
Don’t expect unemployment among forecasters, however. Many have cushy jobs with the Congress, the White House, and virtually every agency of the U.S. government, and will happily issue predictions to no end.
In the Austrian view, on the other hand, economists have three functions: to further our understanding of the free market, to identify possible consequences of government policies, and to counter economic myths.
Economic forecasting has nothing to do with these objectives. In fact, by presenting itself as the only scientific dimension of economics, forecasting has helped discredit the whole discipline, and fueled an exodus of economists from the more mundane academic world to the arena of state control and coercion, to the detriment of every American.
From the session on "New Frontiers in Austrian Economics," presented at the Austrian Economics Research Conference. Recorded 23 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
From the session on "New Frontiers in Austrian Economics," presented at the Austrian Economics Research Conference. Recorded 23 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
This lecture by Philipp Bagus was presented at the 2012 Mises University in Auburn, Alabama. Includes an introduction by Mark Thornton.
Recently, there has been an intense debate in Europe on the TARGET2 system (Trans-European Automated Real-time Gross Settlement Express Transfer System 2), which is the joint gross clearing system of the eurozone.The best short introduction and analysis of TARGET2 may be found in Stefan Homburg, "Anmerkungen zum Target-2-Streit," Wirtschaftsdienst, volume 91, numer 3 (2011): pp. 536–530. Our analysis and graphs follow Homburg's line of argumentation closely. The interpretation of this system and its balances has provoked divergent opinions. Some economists, most prominently Hans-Werner Sinn, have argued that TARGET2 amounts to a bailout system. Others have vehemently denied that. Jürgen Stark of the European Central Bank (ECB) even said that some commentators could lose their reputation as serious academics by claiming that TARGET2 functions as a bailout system.
Indeed, TARGET2 debits and credits have been built up since the beginning of the financial crisis. While peripheral countries accumulated TARGET2 debits, in April 2012 TARGET2 claims of the Bundesbank amounted to almost €644 billion. That is almost €8,000 per German.
But does TARGET2 really amount to an undercover bailout system for unsustainable living standards in the periphery? Let us start our analysis with a simple example of two individuals using a bank to clear their payments.
Person A sells a good or service to person B for €100. In international trade terms, A has a current account surplus while B has a current account deficit. A receives a claim or credit against the bank of €100 when the payment is made (the broken line in figure 1). B has a debt and owes the bank €100. The debt relationships are shown by solid arrows pointing in the direction of the debtor.
A now has some money saved in his bank that he may plan to use, for instance, for retirement. B has to produce something of value to be able to pay back his debt. A will finally be paid by B's production of real goods (that may maintain him at retirement).
For A it is important that the bank's loan to B is secured by a good guarantee or collateral such as a high-quality security or real estate. In the absence of collateral for B's loan, problems arise if B does not pay his debt because he dies or for other reasons. If the bank does not hold other property to make up for the bad loan, A will be left with a claim against a bankrupt bank.
Of course, if the bank has the privilege of printing (legal-tender) bank notes, the bank will not go bankrupt but can pay back A. But A will then be paid back merely in paper, a worthless claim in our scenario, because B has not produced anything and has died. So what should A buy with the newly printed paper? A's standard of living will fall at retirement as his wealth is based just on paper.
Let us now assume that A lives in Germany and B lives in Spain. Furthermore, we introduce Commerzbank as A's German bank, and Banco Santander as B's Spanish bank. In addition, we add the two national central banks and the ECB.
We again assume that A exports goods worth €100 to B. When the payment is made, A receives a claim against Commerzbank. A's bank account increases €100. B gets a €100 loan from Banco Santander (alternatively he could run down his deposit account at Banco Santander). Commerzbank gets a claim against the Bundesbank (or reduces its refinancing from it), while Banco Santander increases its refinancing with the Bank of Spain (or reduces its excess reserves).
On the level of central banks, the Bundesbank receives a credit against the ECB while the Bank of Spain gets a debit. Underlying this procedure is an import of goods to Spain that has been financed by Banco Santander creating new money in form of a loan to B. The money creation results in TARGET2 debits for the Bank of Spain and TARGET2 credits for the Bundesbank.
Let us compare the TARGET2 method with the financing of imports in a gold standard. In both systems, import surpluses may be financed by capital imports, i.e., A or Commerzbank buys a bond from B. If there is no private capital financing in a gold standard, the import must be paid by transferring gold. In contrast, in the Eurosystem, import surpluses can simply be financed by producing claims against the ECB. Instead of gold, the Bundesbank receives TARGET2 credits. While in a gold standard, the payment of imports (if not financed by private loans) is limited to the outflow of gold, there is no limit for TARGET2 credits, i.e., the import surpluses may be financed without any limit by the creation of Euro claims.
How do TARGET2 debits and credits disappear? The balances disappear if A imports from B or if B sells a bond to A or borrows from him on the private market. There is nothing to assert against financing the import surplus through private loans or bonds. TARGET2 debits, however, are not private loans but amount to public central-bank loans. Without TARGET2, someone in the Spanish economy would have had to find private investors to finance the trade deficit paying potentially high interest rates, especially if no high-quality collateral for such loans can be provided.
In this sense, the TARGET2 system indeed amounts to a bailout of an uncompetitive economy with too high prices. Thanks to this bailout mechanism, the country does not have to deregulate labor markets, and reduce government spending to adjust prices relatively but can continue its spending spree and maintain its uncompetitive internal structure.
But are the TARGET2 debits and credits really never settled? Surprisingly, there is indeed neither a limit for the TARGET2 bailouts, nor are the accounts ever settled. In contrast, in the Federal Reserve System debits are backed by gold certificates and each year balances are settled. If the Federal Reserve Bank of Richmond has a debit with the Federal Reserve Bank of New York, the former settles its account sending gold certificates to the latter.At least these rules appear in the Federal Reserve accounting manual. It seems, though, as if the Fed has suspended settlements ultimately. See Michiel Bijlsma and Jasper Lukkezen "Target-2 of the ECB vs. Interdistrict Settlement Account of the Federal Reserve" (2012).
The Eurosystem not only allows the financing of import surpluses via money creation; it also enables "capital flights." In the current situation, a default of the Greek government would bankrupt its banking system. In order to prevent losses, Greek depositors have sent and are sending their money from accounts at Greek banks to accounts of banks in Germany and other countries. Through this transfer, the Greek bank loses reserves while the German one increases its reserves. The Greek bank increases refinancing from its national central bank (i.e., receives newly created money) while the German bank can decrease it loans from the Bundesbank. The Bundesbank earns a TARGET2 credit, the Bank of Greece a TARGET2 debit. If the Greek government defaults, and the Bank of Greece default on its debits, losses mount for the ECB. Thus, the risk of a Greek default is now shared by German savers through the TARGET2 credit.
What Is the Essence of TARGET2 Balances?TARGET2 credits ultimately represent claims of savers, while TARGET2 debits represent debts of companies, governments, and individuals. TARGET2 accounts are just a consequence of an ongoing redistribution and of bailouts. For instance, TARGET2 accounts may mirror the tragedy of the euro, i.e., the monetization of government deficits. Take the following example. A Spanish bank creates new money to buy a Spanish government bond. This allows the Spanish government to maintain its government spending and to delay reforms of the labor market. It may increase public-sector wages and unemployment benefits. The competitiveness of the Spanish economy is hampered due to too high wages resulting in a trade deficit: a Spanish minister buys a German car. In the beginning, the trade deficit may be financed by private entities, for instance, by loans from German banks to Spanish banks. Yet after some time the Spanish banks will run out of good collateral. The increasing government debts and the overindebtedness of the private sector reduce the quality of Spanish debt as collateral. At some point, private investors do not want to continue to finance Spanish banks and the Spanish trade deficit because they do not have good collateral (we are already beyond this point). Yet thanks to TARGET2 the party can continue. Spanish banks can use bad collateral (Spanish government bonds) and refinance with the Bank of Spain, which accepts Spanish government bonds as collateral for new loans. As a result of this indirect monetization of government bonds, TARGET2 debits to the ECB increase. Bad risks (collateral) are shifted to the Eurosystem and socialized. TARGET2 thereby allows to finance the trade deficit through public central bank loans.
Not only public debts may be monetized through the Eurosystem and their risk socialized through TARGET2 but also private debts. This possibility augmented importantly in February 2012, when the ECB allowed national central bank on their own risk to determine eligible collateral for central-bank loans.Jens Weidmann criticized the change in collateral rules and demanded collateral for TARGET2 debits in March 2012. However, only central banks and governments could provide good collateral such as gold for TARGET2 debits. Most banks have no good collateral left. Otherwise they would have used it to refinance themselves on the private markets and not through the Eurosystem with its low collateral standards. Depending on the exact collateral rules, a Spanish bank may now loan to a Spanish company to import from Germany. The Spanish bank may take the loan to the importer as collateral for a new loan from the Bank of Spain (of course, applying a haircut). In this way, the private loan (in this case used for consumption), has been monetized. As an effect there will be also TARGET2 debits for the Bank of Spain and TARGET2 credits for the Bundesbank.
What Are the Risks Exactly for a TARGET2 Credit Country Such as Germany?If Greece leaves the euro, it most probably will not pay its debits to ECB with gold or hard assets. The ECB will suffer a loss, and through its capital contribution 27 percent of such a loss falls on the Bundesbank. If more countries leave the euro, the loss is correspondingly higher. In the opposite case of a German exit of the euro, the Bundesbank will suffer important losses if the new German currency appreciates as the Bundesbank's main assets are now TARGET2 credits denominated in euros. Moreover, the remaining eurozone countries might resist paying for the TARGET2 credits.
But is the liquidation of TARGET2 credits a real loss? If we take our initial example of the two individuals with a clearing bank, the conclusion is straightforward. If B defaults, the bank goes bankrupt and A loses his savings. The same happens in the case of the Eurosystem. If the peripheral governments default, their banks default, their national central banks default and the ECB goes bankrupt. The Bundesbank then has a TARGET2 claim on the bankrupt ECB and goes bust too. Commerzbank loses its claims on the Bundesbank (or is not refinanced anymore) and defaults as well. Then the German saver is left with nothing but empty hands. The purpose of the visible bailouts of peripheral countries such as Greece is to maintain the illusion that no losses are to be suffered for savers in Germany and other countries.
But can the ECB or the Bundesbank really go bankrupt? Can they not always pay, just by printing more money? It is true that the ECB can always pay its bills by producing money. However, creating money does not take away the fact that the wealth is gone when the periphery defaults. It is like B not paying with real goods because he dies. A may receive new paper money from his bank, but this will not feed him through retirement. Unfortunately, as long as the European periphery remains uncompetitive relative to Germany, nothing will be produced to settle the German TARGET2 credits. Most likely, their real value is gone forever. To think that they will represent real wealth is an illusion that will be ended in one of three possible ways. The first is the already-mentioned inflation when the ECB just prints money to keep the system afloat.
Second, in the case of a peripheral default, the quality of the assets of the ECB is impaired, its capital consumed. The ECB loses options to reduce the quantity of money in circulation and defend the value of the euro. The ECB simply has no good assets to sell; they have evaporated. There is the danger that the confidence in the currency evaporates also, first on international currency markets and later internally. The value of the currency may collapse and the wealth illusion of currency holders and savers ends.
Third, another alternative is to recapitalize the ECB by transferring high-quality assets to it. The ECB can then use these assets to maintain confidence in the currency and defend its value. The recapitalization, of course, requires also an expropriation of wealth holders in Germany and other countries. After default and inflation, fiscal expropriation means an alternative end to the wealth illusion.
TARGET2, Eurobonds, European Stability Mechanism: What Is the Difference?Eurobonds are jointly issued and guaranteed by all 17 eurozone members but have been very controversial. For instance, Eurobonds have been vehemently resisted by the German government until today. However, TARGET2 has not been resisted by the German government. TARGET2 is just the reflection of a substitute bailout. When governments issue bonds bought by their banks leading to a trade deficit, the result is a TARGET2 debit. The TARGET2 imbalances are just a sign of euros created in the periphery used to pay for goods from abroad.
The European Stability Mechanism (ESM) is another substitute for Eurobonds, as the ESM may grant loans to struggling governments issuing bonds guaranteed collectively. The difference between the three is merely of degree. There is more parliamentary control for Eurobonds or the ESM. In the ESM, creditor countries have more control over bailouts than with Eurobonds. Interest rates differences are also more pronounced with the ESM than with Eurobonds. The ECB wants to shift the bailout burden from TARGET2 to the ESM. Governments prefer to hide the losses on taxpayers as long as possible and prefer the ECB to aliment deficits. However, all three devices serve as bailout systems and form a transfer union.
In a lecture given at George Washington University on March 27, 2012, the chairman of the Fed said that the US central bank's aggressive response to the 2007–2009 financial crisis and recession helped prevent a worldwide catastrophe. Various economic indicators were showing ominous signs at the time. After closing at 3.1 percent in September 2007, the yearly rate of growth of industrial production fell to minus 14.8 percent by June 2009. The yearly rate of growth of housing starts fell from 20.5 percent in January 2005 to minus 54.8 percent in January 2009.Also, retail sales came under severe pressure — year on year, the rate of growth fell from 5.2 percent in November 2007 to minus 11.5 percent by August 2008. The unemployment rate jumped from 4.4 percent in March 2007 to 10 percent by October 2009. During this period, the number of unemployed people increased from 13.389 million to 15.421 million — an increase of 2.032 million.
In response to the collapse of the key economic data and a fear of a financial meltdown, the US central bank aggressively pumped money into the banking system. As a result, the Federal Reserve balance sheet jumped from $0.884 trillion in February 2008 to $2.247 trillion in December 2008. The yearly rate of growth of the balance sheet climbed from 1.5 percent in February 2008 to 152.8 percent by December of that year. Additionally the Fed aggressively lowered the federal-funds rate target from 5.25 percent in August 2007 to almost nil by December 2008.
Despite this pumping, the growth momentum of commercial-bank lending had been declining with the yearly rate of growth falling from 11.9 percent in January 2007 to minus 5.3 percent by November 2009. As a result of the fall in the growth momentum of lending, the growth momentum of the money supply would have followed suit if not for the Fed's aggressive pumping to the commercial paper market. This pushed the yearly rate of growth of our measure of US money supply from 1.5 percent in April 2008 to 14.3 percent by August 2009.
In his speech Bernanke blamed reckless lending in the housing market and financial engineering for the economic crisis. He also acknowledged that the supervision by the Fed was inadequate. According to Bernanke, once the crises emerged the Fed had to act aggressively in order to prevent the crisis from developing into a serious economic disaster. The Fed chairman holds that a highly accommodative monetary policy helps support economic recovery and employment.
We hold that various reckless activities in the housing market couldn't have emerged without the Fed's previous reckless policies. After closing at 6.5 percent in December 2000, the federal-funds rate target was lowered to 1 percent by May 2004. The yearly rate of growth of our monetary measure, AMS, jumped from minus 0.9 percent in December 2000 to 11.5 percent by December 2001. In short, the strong increase in the growth momentum of money supply coupled with an aggressive lowering of interest rates set the platform for various bubble activities, or an economic boom.
A reversal of the Fed's loose stance put an end to the false boom and put pressure on various bubble activities. The federal-funds-rate target was lifted from 1 percent in May 2004 to 5.25 percent by June 2006. The yearly rate of growth of AMS plunged from 11.5 percent in December 2001 to 0.6 percent in May 2007. As it happened, the effect of this tightening was felt in the housing market first before it spilled over to other bubble sectors. (A tighter monetary stance slowed down the diversion of real savings toward bubble activities from wealth-generating activities.)
Contrary to Bernanke, we suggest that his loose monetary policy of August 2007 didn't save the US economy but saved various bubble activities that had come under pressure from the previous tighter monetary stance.
Note the loose monetary stance has been aggressively diverting real funding from wealth generators towards bubble activities, thereby weakening the wealth-generation process. The only reason why loose monetary policy supposedly "revived" the economy is because there are still enough wealth generators to support the Fed's reckless policy. Also, note that all the gains from the previous tighter stance have now been wasted to support bubble activities.
As long as the pool of real savings is still growing, Fed policy makers can get away with the illusion that they have saved the US and the world economies. Once the pool of real savings starts stagnating, or worse, declining, the illusory nature of the Fed's policy will be revealed — note that the economy follows the state of the pool of real savings. Any aggressive monetary policy in this case is going to make things much worse.
The actions of Bernanke to revive the economy run contrary to the basic principles of running a company. For instance, in a company of 10 departments, 8 departments are making profits and the other 2 losses. A responsible CEO will shut down or restructure the 2 departments that make losses — failing to do so will divert funding from wealth generators toward loss-making departments, thus weakening the foundation of the entire company. Without the removal or restructuring of the loss-making departments, there is the risk that the entire company could eventually go belly up. So why then should a CEO who decides to support nonprofitable activities be regarded as a failure when Bernanke and his central-bank colleagues are seen as heroes who saved the economy?
Bernanke is of the view that by pumping money he has provided the necessary liquidity to keep the financial system going. We suggest that this is false. What permits the financial sector to push ahead is real savings. The financial sector does not have a life of its own; its only role is to facilitate the real wealth that was generated by the wealth producers. Remember that banks are just intermediaries; they facilitate real savings across the economy by means of money (the medium of exchange).
By flooding the banking system with money, one doesn't create more real savings but, on the contrary, depletes the pool of real funding. Most commentators are of the view that in some cases when there is a threat of serious damage to the financial system the central bank should intervene to prevent the calamity, and this is precisely what Bernanke's Fed did.
We suggest the severe threat here is to various bubble activities that must be removed in order to allow wealth generators to get on with the job of creating wealth. If a lot of bubbles must disappear, so be it. Any policy to support bubbles, be it large banks or other institutions, will only make things much worse. As we have seen, if the pool of real savings is not there, a central-bank policy to prop up bubbles will make things much worse. After all, the Fed cannot generate real wealth.
Bernanke's policy — which amounts to the protection of inefficiency, i.e., bubble activities — runs the risk of generating a prolonged slump with occasional rallies in the data. It could be something similar to the situation in Japan (which Bernanke has in the past criticized).
Summary and ConclusionWe can conclude that, contrary to Bernanke, his loose policies didn't save the US economy from a depression but have instead damaged the process of real wealth generation.
Bernanke's loose policies have provided support to bubble activities, thereby destabilizing the economy. So in this sense his policies have saved the bubbles, thus undermining wealth generators.
We suggest that the more forceful the Fed's response to various economic indicators is, the more damage this does to the pool of real savings. This runs the risk that at some stage the United States could end up having a stagnating or worse, declining, pool of real savings.
If this were to occur, then we could end up of having a severe economic slump. If anyone needs examples in this regard, have a look at countries such as Greece, Spain, and Portugal.
Over a prolonged period of time the policies of these countries (an ever-growing government and central-bank involvement in the economy) have severely damaged the heart of economic growth — the pool of real savings.
Again, if the pool of real savings is to become stagnant, or worse, starts declining, any attempt by the Fed to make things better is going to make things actually much worse by depleting the pool of real savings or funding further. If the pool of real funding is stagnating, then no matter how much pumping the Fed does, banks will not be able to lift lending. Remember: without expanding real funding any expansion in credit could lead to financial disaster.
Back at the height of the financial crisis, Steven Pearlstein of the Washington Post wrote a number of contradictory columns both praising the bank bailout known as TARP while issuing a scathing criticism on how the big banks were using taxpayer funds to pay shareholders and executive bonuses rather than lend credit. According to Pearlstein, those ignorant folks wary of Uncle Sam padding the balance sheets of reckless bankers (emboldened by the housing policies of the federal government, its mortgage-based GSEs, and the cheap money of Alan Greenspan's Federal Reserve) virtually free of charge just didn't "get it."
Apparently those who regard the virtue of private gains and losses as a fundamental necessity for markets to work efficiently are just too dense to comment on these matters. The world was imploding (or so we were assured by a banking class desperate to keep the party going, as well as its alumni occupying positions of authority within the Federal Reserve System and US Treasury) so there was no time for critical analysis. Taxpayers should have kept their claps shut and let their elected officials shove more squandered funds at an already-zombified banking system.
To really bolster the merit of his opinion, Pearlstein cited his own Pulitzer Prize in an online chat with Washington Post readers as proof of his superior knowledge on such a serious affair.
Nobody has been more critical of the practices of banks and Wall Street and brokers than I have, probably long before you were even focused on this issue, so I certainly don't owe you any apology on that one. If you want to check, you'll see I won a certain prize for that.
Who knew the Pulitzer Prize gave you free reign to declare any opinions contrary to yours null and void?
Recently, Pearlstein used his column to comment on Greg's Smith controversial New York Times editorial "Why I am Leaving Goldman Sachs." Smith's editorial caused quite a stir among the financial commentariat where everyone and their grandmother has weighed in on its significance and reasoning. While those knowledgeable on the mutually satisfying nature of a free economy were critical of Smith's attack of Goldman, many reveled on accusations of unfettered greed dominating the industry. Pearlstein falls in the latter camp, as he regards Smith's piece as wholly demonstrative of the evil exuberance of the infamous vampire squid.
The predictable response from Wall Street was to dismiss Smith as hopelessly hypocritical and naïve — hypocritical because he didn't resign from Goldman until after he had been passed over for promotion and after he received his 2011 bonus check, naïve for thinking that trading financial instruments with customers has ever been anything but a zero-sum game.
Such a dismissal would be more convincing, however, if it wasn't merely the latest piece of evidence of the ethical deterioration at Goldman in particular, and on Wall Street more generally.
As it happens, just as Greg Smith was reminding us of how Wall Street rips off its customers, Washington was moving to roll back regulations designed to protect investors from that kind of predation.
So begins Pearlstein's tirade on the opposition of banking regulations. The rationale for financial regulations falls back on the Marxist ideology that holds that capitalism is a system of exploitation where clueless consumers and workers fall prey to cash-rich producers. Because Joe Schmo happened to take out a loan he couldn't really afford to pay back, nanny-state bureaucrats have no other choice but to step in and protect him against his own choices. But of course no one forced Joe to take out a loan or patronize a bank; he does so on his own accord and believes himself better off in taking the money. Presuming anything else grants far too much insight to the observers who believe themselves all-knowing of any individual's unique preferences. It's sort of like the central banker who attempts to dictate the proper interest rate for millions in lieu of a rate determined solely by the time preferences and spending habits of all market actors.
If Smith's, as well as Pearlstein's, assertions were true and Goldman really was ripping off its customers en masse, then simple market forces would put it out of business fairly quickly. As John Tamny observed,
Indeed, what must be stressed here is that Goldman couldn't purposefully do badly by its clients even if it tried; the firmwide ethos of "putting clients first" the tautological mantra of any business — irrespective of sector — that wants to remain in business for the long haul. It couldn't because if it did, so great is the competition for its client list that it would soon find itself a hollow shadow of its former self.
For being a well-regarded business columnist, Pearlstein somehow misses the fact that only consumers believing themselves to be benefited by the services or goods offered by a company determine said company's success. Going off this naïve understanding, Pearlstein begins defending financial regulation.
What we also know from painful experience — from the mortgage and credit bubble, from Enron, Worldcom and the tech and telecom bubble, from the savings-and-loan crisis and the junk bond scandal and generations of penny-stock scandals — is that financial markets are incapable of self-regulation.
This would actually be a very good passage if it were just tweaked a bit to include the real cause of all the crises listed. It should read like this:
What we also know from painful experience — from the mortgage and credit bubble, from Enron, Worldcom and the tech and telecom bubble, from the savings-and-loan crisis and the junk bond scandal, and generations of penny-stock scandals — is that the Federal Reserve's low-interest-rates policies perpetuate the continuance of asset bubbles.
Pearlstein's argument would hold up if the financial industry were indeed void of any government regulation. The fact is however that for almost a century, the Federal Reserve has been in charge of regulating the industry. Prior to the Fed's inception, regulation at the state level was prevalent. Contrary to Pearlstein's belief, the financial industry in the United States hasn't operated under laissez-faire conditions in well over 150 years.
Financial markets are hotbeds of asymmetric information, when one party in a transaction knows much more about the thing being traded than the other.
Again, for an expert business columnist, Pearlstein comes off as uniformed on how markets really work. There is hardly an industry out there where the same amount of information is held by all market participants. The essence of entrepreneurship is superior forecasting skills — that is, being more knowledgeable and in tune to consumer demands than competitors. If Pearlstein is going to charge the financial industry with being unfair in the lack of evenly dispersed market information, he has to be critical of all sectors of the economy to stay consistent.
Financial markets are magnets for moral hazard, where people can take risks knowing that they won't have to suffer the full consequences of those decisions because of government bailouts or insurance.
Thankfully Pearlstein recognizes the role of moral hazard in perpetuating risky behavior. But his recommended cure is just more of the same disease already distorting the checks on exuberance that would exist without government interference. With the existence of the Federal Reserve, the Federal Deposit Insurance Corporation, sanctioned fractional-reserve lending, and Congress's history of doing what it does best and throwing money at perceived emergencies, why wouldn't Wall Street overly leverage itself if its losses are expected to be socialized? Surprisingly, Pearlstein recognizes this dynamic:
And financial markets are highly conducive to herd behavior because bankers and money managers know that, no matter how disastrous their decisions turn out to be, they won't lose their jobs or their standing in the industry if they were making the same bad decisions as everyone else.
Despite all this, Pearlstein still sees further regulation as necessary to curb the excesses of Wall Street. This shortsightedness doesn't account for the role bureaucratic red tape plays in benefiting large firms such as Goldman Sachs by making it more costly for small startups to establish themselves and pose as any sort of competition. Pearlstein asks, "Have you ever met an executive who said he liked regulation?" Well, Steve, considering the Federal Reserve was the product of scheming bankers, one of the largest private health-insurance-industry lobbying firms (AHIP) endorsed Obamacare, and the CEO of Walmart, the country's biggest employer, called for raising the federal minimum wage just a few years ago, then yes, I have heard of the heads of big business actually liking regulation.
The real question to ask is if it's really that inconceivable that big business is more than willing to get behind regulation if it poses a financial burden on its competitors. Considering that the nature of the state is to grow in size and authority as it seizes ever more control over the private lives of its citizenry, any savvy businessman would see the advantage of co-opting such power for his own benefit.
Pearlstein ends by digging into the JOBS (Jumpstart Our Business Startups Act) bill that recently passed the House of Representatives. This bill would
exempt any firm with less than $1 billion in sales from many of the reforms enacted after Enron or the latest financial scandals.
Under the House-passed bill, these "small" companies would be exempted from rules requiring that they disclose the compensation of executives and other insiders or that they give shareholders the right to approve such compensation. They also would be exempted from having to hire outside auditors to assure that they have internal controls sufficient to prevent and uncover investor fraud.
Again, Pearlstein invokes the image of clueless investors incapable of making sound decisions on whom they place their money with. From a private-property-rights perspective, it should always be up to the owners of a company to disclose whatever relevant information they see fit. The same applies to government decrees forcing the hiring of outside auditors. Certainly these measures would improve the image of a company seeking private investment. But investors who choose to devote their scarce capital to a business venture do so because they anticipate that they will derive some benefit from it — either a monetary profit or some other desired end. If a small startup business lacks compensation disclosure or outside auditing, that is a risk any voluntary investor is free to take.
Despite all of his accolades, Steve Pearlstein fails to understand how a free market uninhibited by government regulation would function. He pokes fun at the laissez-faire views of those who don't see markets as zero-sum contests between exploiters and saps, while he also accuses firms like Goldman Sachs of conning their clients who voluntarily invest their own money and bear the inherent risk that exists when doing business with such firms. With opinions like this still permeating the editorial sections of the nation's most-read newspapers, it shouldn't come as a surprise that much of the public still believes them.
In their economic analyses economists utilize a range of statistical methods that vary from highly complex models to a simple display of historical data. It is generally held that by means of statistical correlations one can organize historical data into a useful body of information, which in turn can serve as the basis for assessments of the state of the economy. In short, it is held that through the application of statistical methods on historical data, one can extract the facts of reality regarding the state of the economy.Unfortunately, things are not as straightforward as they seem to be. For instance, it has been observed that declines in the unemployment rate are associated with a general rise in the prices of goods and services. Should we then conclude that declines in unemployment are a major trigger of price inflation? To confuse the issue further, it has also been observed that price inflation is well correlated with changes in money supply. Also, it has been established that changes in wages display a very high correlation with price inflation.
So what are we to make of all this? We are confronted here not with one but with three competing "theories" of inflation. How are we to decide which is the right theory? According to the popular way of thinking, the criterion for the selection of a theory should be its predictive power. On this Milton Friedman wrote,
The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed.Milton Friedman, Essays in Positive Economics (Chicago: University of Chicago Press, 1953).
So long as the model (theory) "works," it is regarded as a valid framework as far as the assessment of an economy is concerned. Once the model (theory) breaks down, we look for a new model (theory). For instance, an economist forms a view that consumer outlays on goods and services are determined by disposable income. Once this view is validated by means of statistical methods, it is employed as a tool in assessments of the future direction of consumer spending. If the model fails to produce accurate forecasts, it is either replaced or modified by adding some other explanatory variables.
The tentative nature of theories implies that our knowledge of the real world is elusive. Because it is not possible to establish "how things really work," it does not really matter what the underlying assumptions of a model are. In fact anything goes, as long as the model can yield good predictions. According to Friedman,
The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.Milton Friedman, ibid.
The popular view in economics that sets predictive capability as the criterion for accepting a model is absurd. Even the natural sciences, which mainstream economics tries to emulate, don't validate their models this way. For instance, a theory that is employed to build a rocket stipulates certain conditions that must prevail for its successful launch. One of the conditions is good weather. Would we then judge the quality of a rocket propulsion theory on the basis of whether it can accurately predict the date of the launch of the rocket?
The prediction that the launch will take place on a particular date in the future will only be realized if all the stipulated conditions hold. Whether this will be so cannot be known in advance. For instance, on the planned day of the launch it may be raining. All that the theory of rocket propulsion can tell us is that if all the necessary conditions hold, then the launch of the rocket will be successful. The quality of the theory, however, is not tainted by an inability to make an accurate prediction of the date of the launch.
The same logic also applies in economics. We can say confidently that, all other things being equal, an increase in the demand for bread will raise its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow, or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory as useless because it cannot predict the future price of bread? According to Mises,
Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only "qualitative."Ludwig von Mises, The Ultimate Foundation of Economic Science, p. 67.
Human Action Is CentralNow, without the knowledge that human actions are purposeful, it is not possible to make sense out of historical data. On this Rothbard wrote,
One example that Mises liked to use in his class to demonstrate the difference between two fundamental ways of approaching human behavior was in looking at Grand Central Station behavior during rush hour. The "objective" or "truly scientific" behaviorist, he pointed out, would observe the empirical events: e.g., people rushing back and forth, aimlessly at certain predictable times of day. And that is all he would know. But the true student of human action would start from the fact that all human behavior is purposive, and he would see the purpose is to get from home to the train to work in the morning, the opposite at night, etc. It is obvious which one would discover and know more about human behavior, and therefore which one would be the genuine "scientist."Murray N. Rothbard, preface in Theory and History by Ludwig von Mises.
The fact that people consciously pursue purposeful actions provides us with definite knowledge, which is always valid as far as human beings are concerned. This knowledge sets the base for a coherent framework that permits a meaningful assessment of the state of an economy.
To undertake the identification of data, one is required to reduce it to its ultimate driving force, which is purposeful human action. For instance, during an economic slump, a general fall in the demand for goods and services is observed. Are we then to conclude that the fall in the demand is the cause of an economic recession?
We know that people persistently strive to improve their lives and well-being. Their demands or goals are thus unlimited. The only way then for general demand to fall is via people's inability to support their demand. In short, problems on the production side — i.e., with means — are the likely causes of an observed general fall in demand.
Alternatively, consider the situation in which the central bank announces that increasing money supply growth while price inflation is low can lift real economic growth. To make sense of this proposition we must examine the essence of money. Money is the medium of exchange. Being the medium of exchange, money can only facilitate existing real wealth. It cannot create more wealth. Money cannot be used in production. It cannot be used in consumption. Hence we can conclude that printing money is not the right means to promote economic growth. In other words, the goal — of lifting real economic growth — cannot be achieved by means of printing money.
The fact that man pursues purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors. For instance, contrary to popular thinking, individual outlays on goods are not caused by real income as such.
In his own unique context, every individual decides how much of a given income will be used for consumption and how much for investments. While it is true that people will respond to changes in their incomes, the response is not automatic. Every individual assesses the increase in income against the particular set of goals he wants to achieve. He might decide that it is more beneficial for him to raise his investment in financial assets rather than to raise consumption.
In contrast, analyses that rely solely on statistical correlations are of limited help, because they are of a mechanical nature. Hence comments made by various experts who rely on such frameworks are arbitrary. All that these experts can do is repeat already-known data — they can tell us nothing about the essence of economic activity. In short, various statistical and mathematical methods are a particular way of describing but not explaining events; they do not improve on our knowledge of what causes the fluctuations in the data.
Summary and ConclusionsAccording to the popular way of thinking, the criterion for the selection of a theory should be its predictive power. So long as the model "works," it is regarded as a valid framework to assess the state of an economy. If the model fails to produce accurate forecasts, it is either replaced or modified. The tentative nature of theories implies that our knowledge of the real world is elusive. Contrary to the popular view, we hold that by means of a fundamental statement that human actions are conscious and purposeful we can derive the entire body of economics. Because the knowledge derived here is based on a fundamental, true statement, this knowledge is not tentative and elusive but absolutely definite. Consequently, we don't require various statistical methods here to validate the economic theory, which is derived from the fact that human actions are conscious and purposeful. Analysts who rely on statistical methods to ascertain the facts of reality are running the risk of producing erroneous analyses.
While Carl Menger and Léon Walras simultaneously discovered the principle of marginal utility, their ideas about the nature of market prices are very different. Walras was more interested in the final equilibrium prices arrived at by traders than the process by which these prices were formed. Therefore, he dramatically simplified the pricing process by imagining it as if it were governed by an auction mechanism capable of instantly calculating all prices in an economy.
For his part, Menger was fascinated with the actual process by which prices are formed. Rather than trying to abstract from the messy process of haggling by devising an artificial auction mechanism, Menger worked with a number of real-life pricing scenarios including isolated bargaining, monopoly, and competitive exchange.
As a result of these different approaches, prices in a Walrasian universe have different characteristics from prices in a Mengerian universe. Rather than registering at a single determinate equilibrium price, as is the case with Walrasian prices, Mengerian prices tend to be dispersed within an indeterminate range. In financial markets, we call this range the bid-ask spread.
Perhaps the best way to illustrate these two thinkers' differences on price is to use as our example the modern-day phenomenon of high-frequency traders (HFTs) and the digital tracks they leave as they operate in electronic equity markets.
High-Frequency Trading High-frequency trading is the use of computer algorithms to guide trading decisions in securities markets. HFTs will hold securities for no longer than a few seconds, and for as little as microseconds. It is estimated that they now account for anywhere from 50–70 percent of all equity trades in North America.
Nanex charts Nanex, a market data firm, provides a number of hauntingly strange charts showing the behavior of HFTs operating on the microsecond level. We provide a few of these charts below.
Figure 1
Click to enlarge.
This first chart represents price data for the ETF iShares S&P Target Date 2020 Index Fund (TZG). These quotes were submitted to the NYSE Arca exchange in a ten-second period just prior to the 9:30 a.m. market opening of September 23, 2010.
As in most securities markets, prices in equity markets are described by way of "bids" and "offers". The price at which a buyer is willing to purchase an equity is submitted to the relevant exchange as a bid. [1] In the chart above, the bid price is represented by the lower line. A number of bid orders may build up, with the "best bid" being the highest of the submitted bids. On the offer side, the price at which a seller is willing to offload an equity is submitted to the exchange as an offer. In the TZG chart above, this is the top line. Out of all submitted offers, the "best ask" (or "best offer") is the lowest one.
Between the "best bid" and "best ask" lies an empty channel called the bid-ask spread. In the chart of TZG, the bid-ask spread is the difference between the "best bid" in green and the "best offer" in red. This is a no-man's-land in which no market actor is, for the time being at least, willing to transact.
What is remarkable about the chart above is the steady cycling of the pattern of bids and offers and the microscopic space of time over which they occur. This is no human-created pattern, for no trader could submit this many quotes this fast, nor could they do so in such a remarkably consistent pattern. This is a pattern created by trading algorithms.
Or take this pattern:
Figure 2
Click to enlarge.
The price quotes submitted to NASDAQ in the above chart — which represents a fraction of a second (11:44:55) — shows a rapidly repeating pattern of changing bid prices between $20.77 and $20.80 in the PowerShares DWA Technical Leaders Portfolio ETF (PDP). Note that the ask price, represented by the top line, remains constant, and that the bid price represented is not the best bid, but some price below the best bid. The rate at which the bid price is changing is far too fast for human comprehension. This is an HFT at work.
Or check out the algorithm action on Blackstone Group (BX) on September 15, 2010:
Figure 3
Click to enlarge.
This chart represents three seconds of cycling bid and ask quotations submitted to the BATS exchange by an HFT, or group of HFTs.
There are a number of other charts at Nanex's website including the fascinating but very complicated one below. [2] See if you can figure out what is going on. Suffice it to say, battling algorithms on a number of different exchanges are competing to provide offer prices for Casey's General Store (CASY) over a period of around one second.
Figure 4
Click to enlarge.
Back to Menger Competing algorithms manipulating the bid-ask spread on equity exchanges perfectly illustrates a thoroughly Mengerian idea: that of Preiskampf, or "price duel."
In determining how prices are formed in such duels, Menger imagines isolated individuals coming together in a bargaining process. [3] He begins by considering a grain producer and a wine producer. The grain producer is prepared to exchange at most 100 units of his grain for 40 units of wine, and would be especially happy if he could give less units of grain for a unit of wine, say 99 units of grain for 40 units of wine. The wine producer is prepared to exchange 40 units of her wine for only 80 units of grain, and would be happy to receive more units of grain for the wine, say 81 units of grain for 40 units of wine. Neither side knows the other's strategy and price-marks. But if a trade is to occur, it will happen somewhere between the 80 units of grain the wine producer is willing to accept and the 100 units the grain producer is willing to pay.
At which exact price will the transaction occur? This depends on each producer's relative talents in bargaining. The wine producer will begin by submitting her first offer — say 110 units of grain. The grain producer will submit his best bid for the wine — say 70 units. The size of the bid-ask spread in the wine market is therefore 40 units of grain. Neither is willing to transact at these prices, so they will begin to bargain, slowly narrowing the bid-ask spread. The wine producer reduces her offer from 110 to 100, while the grain producer raises his from 70 to 80. The spread is now just 20 units (80 to 100), and both the price offered by the wine producer and the price bid by the grain producer are sufficient for the other side to transact. The grain producer may immediately consummate the trade at 100 units of grain for the wine, or the wine producer may be more eager and accept the price of 80 units of grain for her wine.
But if both sides in the price war think they can extract a bit more from the other, then the bargaining will continue. Like the HFTs in the charts above, they will try and read each other's intentions so as to determine their respective desperation or lack thereof, and with this information update their bargaining strategy. Says Menger,
Each of them will direct his efforts to turning as large a share as possible of the economic gain to himself. The result is the phenomenon which, in ordinary life, we call bargaining. Each of the two bargainers will attempt to acquire as large a portion as possible of the economic gain that can be derived from the exploitation of the exchange opportunity, and even if he were to try to obtain but a fair share of the gain, he will be inclined to demand higher prices the less he knows of the economic condition of the other bargainer and the less he knows the extreme limit to which the other is prepared to go. (Menger, Principles of Economics, p. 195)
The location in the bid-ask spread at which the trade is consummated depends
upon their various individualities and upon their greater or smaller knowledge of business life and, in each case, of the situation of the other bargainer … there is no reason for assuming that one or the other of the two bargainers will have an overwhelming economic talent … therefore, I venture to state, as a general rule, that the efforts of the two bargainers to obtain the maximum possible gain will be mutually paralyzing. (p. 195–196)
Now let's bring this back to the HFTs in Nanex's charts. The odd patterns exhibited by trading algorithms are little more than graphical representations of Mengerian price duels. In these duels, the final price at which stock is transacted depends on each algorithm's respective talent and the "greater or smaller knowledge" of all duelers involved. Bidding algorithms may make quick feints up into the spread by issuing a sudden stream of new bid quotes, either hoping to goad other buying algorithms into following them, or to instigate algorithms on the sell side to respond. Algorithms providing offer quotes hope to do the same by making quick plunges down into the spread. These submitted quotations are meant to provide false information to other algorithms so as to confuse them, or to gather information from reacting algorithms so as to take advantage of them. By gleaning tidbits about their competitors, or providing them with false knowledge, algorithms and those who deploy them hope to gain for themselves a favorable spot in the bid-ask spread. [4]
And Walras In imagining the structure in which transactions are facilitated, Walras begins from a different starting point than Menger. Whereas Menger begins with bilateral exchange among isolated individuals and then worked through monopoly and competitive exchange, Walras begins with a fully formed and centralized auction market:
The markets which are best organized from the competitive standpoint are those in which purchase and sales are made by auction, through the instrumentality of stockbrokers, commercial brokers or criers acting as agents who centralize transactions in such a way that the terms of every exchange are openly announced and an opportunity is given to sellers to lower their prices and to buyers to raise their bids. (Walras, Elements of Pure Economics, p. 84)
Walras's centralized market is coordinated by an all-knowing auctioneer. Prior to the market opening for trade, the auctioneer cries out at random the price ratios of various goods and all participants in the market place submit to the auctioneer the quantities they will demand at that price. If there is an imbalance between supply and demand for stocks at the announced prices, the auctioneer will quickly adjust prices until the demand and supplies of all stocks in the market balance. The auctioneer then informs each individual the prices at which they will transact, and with whom. The market opens and trade occurs. It then closes again for the next auction.
Walras's auctioneer precludes the sort of market phenomena that Menger found so interesting. In particular, in a Walrasian market there are no bid-ask spreads, and therefore no reason for HFTs and their warring algorithms to exist.
Spreads arise, in part, because HFTs and other market actors do not know when or if they will be able to resell a stock — after all, there is no auctioneer who guarantees a sale come the next market period. Therefore, the spread represents the price that must be paid to a buyer or seller to compensate them for enduring the possibility of future illiquidity. Knowing that an auctioneer will always facilitate a future trade means that there is no threat of illiquidity, and therefore no reason to demand a spread so as to compensate.
Spreads also arise because market actors have different levels of knowledge about the securities being traded. The less informed therefore demand a price spread to compensate them for enduring the possibility of unintentionally buying bad securities from savvy traders, or selling good ones to them. In a Walrasian setup, the auctioneer informs all participants about the nature of goods available on the market. This levels the informational playing field and precludes any motivation for the emergence of a spread.
[product:0] While infinite liquidity and information remove the psychological motivations for the emergence of a spread, the Walrasian setup also physically prevents the emergence of spreads. Because an auctioneer monopolizes the price-setting process by soliciting the amounts demanded from all actors at various prices prior to the market opening for trade, HFTs are effectively barred from fiddling themselves with various bid and offer prices so as to get valuable information prior to exchange. Secondly, all final prices and quantities are given to actors by the auctioneer. Because every trader is literally forced to accept the same price when the market opens, no HFT can transact in a way so as to obtain a better price. The market machinery, so to say, is out of HFT's hands in a Walrasian setup.
Conclusion In a Walrasian market, HFTs simply have nothing to do. Walrasian prices don't hover in an indeterminate range bounded by bids and offers, as they do in a Mengerian market, but are singular and given. There is no reason for price duels, because the auctioneer removes both the psychological motivation for their emergence and the physical capacity for any sort of spread to arise. In short, Walrasian pricing can't explain the wondrous patterns that Nanex has isolated, but Mengerian pricing can.
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Notes [1] There are dozens of equity exchanges in the United States. Traders submit bids and offers for a given equity to whichever exchange they desire. The exchanges consolidate these quotes into the "consolidated tape" — the combined range of bids and offers over all exchanges for a given equity. The "best bid" and "best offer" is that bid or offer that is the best across all exchanges. The more prevalent exchanges (and their Nanex codes) include the NASDAQ (NSDQ), the BATS Exchange (BATS), the Boston Stock Exchange or NASDAQ OMX BX (BOST), Direct Edge (EDGE), and the Pacific Exchange or NYSE ARCA (PACF).
[2] "Crop Circle of the Day," Nanex.
[3] The example begins on page 177 of Principles of Economics.
[4] According to Hülsmann, Mises: Last Knight of Liberalism (2007), Menger's early experience as a journalist writing market surveys at the Wiener Zeitung, a government controlled newspaper that reported on business and stock markets, influenced the content of the Principles of Economics. No wonder Menger's thought applies so well to modern stock markets.
In his Outside the Box e-letter, February 13, 2012, respected economic commentator John Mauldin presents an interview with Dr. Lacy Hunt, a highly regarded US financial economist. According to Hunt the key factor behind the current world economic crisis — in Europe and the United States in particular — is a very high level of debt relative to gross domestic product (GDP). For instance in the United States, as a percentage of GDP, both public- and private-sector debt is currently at around 400 percent, while in the eurozone it is 450 percent.
This way of thinking follows in the footsteps of the famous American economist Irving Fisher who held that a very high level of debt relative to GDP runs the risk of setting in motion deflation and in turn a severe economic slump. Irving Fisher, Boom and Depressions, London: George Allen, p. 39. According to Fisher the high level of debt sets in motion the following sequence of events that culminate in a severe economic slump:
The debt liquidation process is set in motion because of some random shock, for instance, a sudden large fall in the stock market. The act of debt liquidation forces individuals into distressed selling of assets.
As a result of the debt liquidation the money stock starts shrinking, and this in turn slows down the velocity of money.
A fall in money leads to a decline in the price level.
The value of people's assets falls while the value of their liabilities remains intact. This results in a fall in the net worth, which precipitates bankruptcies.
Profits start to decline, and losses emerge.
Production, trade, and employment are curtailed.
All this leads to growing pessimism and a loss of confidence.
This in turn leads to the hoarding of money and a further slowing in the velocity of money.
Nominal interest rates fall, however; but because of a fall in prices, real interest rates rise.
Note that the critical stage in this story is the stage 2, that is, debt liquidation results in a decline in the money stock. But why should debt liquidation cause a decline in the money stock?
Take a producer of consumer goods who consumes part of his produce and saves the rest. In the market economy our producer can exchange the saved goods for money. The money that he receives can be seen as a receipt as it were for the goods he produced and saved. The money is his claim on these goods.
He can then make a decision to lend his money to another producer through the mediation of a bank. By lending his money, the original saver — i.e., lender — transfers his claims on real savings to the borrower. The borrower can now exercise the money — i.e., the claims — and secure consumer goods that will support him while he is engaged in the production of other goods, let us say the production of tools and machinery.
Observe that once a lender lends his money he relinquishes his claims on real goods for the duration of the loan. Can the liquidation of credit, which is fully backed by savings, cause a decline in the money stock? Once the contract expires on the date of maturity the borrower returns the money to the original lender. As one can see, the repayment of the debt, or debt liquidation, doesn't have any effect on the stock of money.
Things are, however, different when a bank uses some of the deposited money and lends it out. Remember that the owner of deposited money continues to exercise demand for money — he didn't relinquish his claims on real savings in favor of a borrower. Therefore, when a bank uses some of the deposited money, the bank effectively creates another claim on real savings. This claim is just empty stuff. While in the case of fully backed credit the borrower, so to speak, secures goods that were produced and saved for him.
This is however, not so with respect to unbacked credit. No goods were produced and saved here. Consequently, once the borrower exercises the unbacked claims, this must be at the expense of the holders of fully backed claims. The bank here creates money "out of thin air." On the date of maturity of the loan, once the money is repaid to the bank, this type of money must disappear, because it never existed as such and never had a proper owner.
The Money Supply and the Pool of FundingThe point that must be emphasized here is that the fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary policies of the central bank and not the liquidation of debt. It is loose monetary policy that provides support for the creation of unbacked credit. (Without this support, banks would have difficulty practicing fractional-reserve lending.) The unbacked credit in turn leads to the reshuffling of real funding from wealth generators to non–wealth generators. This in turn weakens the ability to grow the pool of real funding and in turn weakens the economic growth. Note that the heart of the economic growth is the pool of real funding, or the pool of real savings, or the "subsistence fund."
According to Böhm-Bawerk,
The entire wealth of the economical community serves as a subsistence fund, or advances fund, from this, society draws its subsistence during the period of production customary in the community.Eugen von Böhm-Bawerk, The Positive Theory of Capital, book 6, chapter 5, Macmillan and Co., 1891.
Similarly von Strigl wrote,
Let us assume that in some country production must be completely rebuilt. The only factors of production available to the population besides labourers are those factors of production provided by nature. Now, if production is to be carried out by a roundabout method, let us assume of one year's duration, then it is self-evident that production can only begin if, in addition to these originary factors of production, a subsistence fund is available to the population which will secure their nourishment and any other needs for a period of one year.… The greater this fund, the longer is the roundabout factor of production that can be undertaken, and the greater the output will be. It is clear that under these conditions the "correct" length of the roundabout method of production is determined by the size of the subsistence fund or the period of time for which this fund suffices.Richard von Strigl, Capital & Production, Mises Institute, p. 7.
Because of prolonged and aggressive loose monetary and fiscal policies, a situation can emerge in which the pool of real funding starts shrinking. In short, there are now more activities that consume real wealth than activities that produce real wealth. Once the pool of funding starts falling then anything can trigger the so-called economic collapse.
Obviously, when things are starting to fall apart, banks try to get their money back. Once banks get their money (credit that was created out of thin air) and don't renew loans, the stock of money must fall. Note however that the consequent price deflation and the fall in the economy is not caused by the liquidation of debt as such, nor by the fall of the money supply, but by the fall in the pool of real funding on account of previous loose monetary and fiscal policies.
The Size of the Debt and the Severity of the Economic SlumpIn his writings, Fisher argued that the size of the debt determines the severity of an economic slump. He observed that the deflation following the stock market crash of October 1929 had a greater effect on real spending than the deflation of 1921 had because nominal debt was much greater in 1929.
We, however, maintain that it is not the size of the debt as such that determines the severity of a recession but rather the state of the pool of real funding. Again, it is not the debt but loose monetary and fiscal policies that cause the misallocation of real funding. (The level of debt is just a symptom, as it were; it doesn't cause damage as such.)
By putting the blame on debt as the cause of economic recessions, one in fact absolves the Fed and the banking system it maintains from any responsibility for setting the whole thing in motion. Additionally, once it is accepted that debt can set in motion a monetary implosion and in turn an economic depression, it appears to justify the idea that the Fed must step in and lift monetary pumping in order to offset the disappearing money supply.
However, rather than countering the emerging depression, what monetary pumping in fact does here is to further weaken the pool of real funding and thereby deepen the economic crisis. (Note that many commentators are of the view that, because of price deflation, the debt burden intensifies. Consequently, it is held that, by means of monetary printing, this burden can be eased, thereby arresting the economic plunge. Again we suggest that pumping more money only dilutes the pool of real funding and makes things much worse.) Additionally, the emergence of monetary deflation is a positive development for wealth generators, because it slows down the diversion of real funding toward nonproductive activities.
The Fallacy of Insufficient Aggregate DemandNow, both Keynes and Friedman felt that the Great Depression was due to an insufficiency of aggregate demand, and so the way to fix the problem was to boost the aggregate demand. For Keynes, this was to be done by having the federal government borrow more money and spend it when the private sector wouldn't. Friedman advocated that the Federal Reserve pump more money to revive the demand. Fisher, while agreeing that the problem was with insufficient demand, held that insufficiency of aggregate demand was a symptom of excessive indebtedness. Therefore, what was needed to contain a major debt depression was to prevent it ahead of time. You have to prevent the buildup of debt.
Again we suggest that Fisher deals here with symptoms and not the true cause, which is the declining pool of real funding that results from loose fiscal and monetary policies. Additionally, there is never such a thing as insufficient aggregate demand, as such.
We suggest that an individual's effective demand is constrained by his ability to produce goods. Demand cannot stand by itself and be independent — it is limited by production. Hence what drives the economy is not demand as such but the production of goods and services. The more goods an individual produces, the more of other goods he can secure for himself.
In short, an individual's effective demand is constrained by his production of goods. Demand, therefore, cannot stand by itself and be an independent driving force.
According to James Mill,
When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation's power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation.… Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.James Mill, "On the Overproduction and Underconsumption Fallacies." Edited by George Reisman, a publication of the Jefferson School of Philosophy, Economics, and Psychology, 2000.
If a population of five individuals produces ten potatoes and five tomatoes — this is all that they can demand and consume. No government or central-bank tricks can make it possible to increase effective demand. The only way to raise the ability to consume more is to raise the ability to produce more.
The dependence of demand on the production of goods cannot be removed by means of loose-interest-rate policy, monetary pumping, or government spending.
On the contrary, loose fiscal and monetary policies will only impoverish real wealth generators and weaken their ability to produce goods and services. It will weaken effective demand.
What is required to revive the economy is not boosting aggregate demand but sealing off all the loopholes for the creation of money out of thin air and curbing government spending. This will enable true wealth generators to revive the economy by allowing them to move ahead with the business of wealth generation.
ConclusionsContrary to the popular way of thinking, the threat to the US economy is not the high level of debt as such but loose fiscal and monetary policies that undermine the pool of real funding. Also, the fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary and fiscal policies and not the liquidation of debt as such. Also, once the pool of funding becomes stagnant or begins to shrink, economic growth follows suit and the myth that government and central-bank policies can grow the economy is shattered.
According to Mises,
An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.Ludwig von Mises, Human Action, chapter 36, "The Crisis of Interventionism."
Wall Street traders, like high-stakes poker players, are a different breed. The constant pressure, the appetite for risk, the ability to think and react in split seconds, all the while calculating odds in their heads that most can't do with an HP12C.
"These guys are a pretty weird bunch," Dr. Paul Zak says. "They're very rational and very competitive." Zak is a neuroeconomist at Claremont Graduate University who is studying the brains of traders to find out if this personality type has a certain genetic signature.
In his "Head Case" column in the Wall Street Journal, Jonah Lehrer writes that Dr. Zak and fellow Claremont neuroeconomist Steve Sapra have analyzed the genes of 60 professional traders working at five major Wall Street firms. Zak and Sapra focused on the genes known to affect the activity of dopamine.
Dopamine is a neurotransmitter in the brain that "helps to regulate decisions involving risk and reward," Lehrer writes, "allowing us to experience both the thrill of getting what we want and the pain of losing it all."
Traders who manage to last on Wall Street for a long time, "tended to hit a sweet spot of dopamine activity: their genes kept them from experiencing either very high or very low levels of the molecule," explains Lehrer. "These prosperous professionals were much more likely to have so-called Goldilocks genes, placing them solidly in the middle of the dopamine distribution."
Goldilocks is not what comes to mind as we watch the frantic activity on any trading floor. In fact, it's just the opposite, with people yelling, screaming and gesturing wildly. As Jared Dillian says in this video clip promoting his book Street Freak: Money and Madness at Lehman Brothers, "For someone who has bipolar disorder, being on the trading floor is the absolute worst place to be, because no one's going to notice that anything's wrong, because everybody is crazy." If Dillian had been working at Starbucks, his mercurial behavior might have called attention to his disorder. As is was, at Lehman, being manic, yelling and screaming, was "considered functional behavior on the trading floor."
Dillian tells his story in a fast-paced style that sweeps the reader up into the author's two worlds: the bare-knuckle world of price discovery on the trading floor, along with his descent into depression and the constant coping with his nearly debilitating obsessive-compulsive behavior. All of this makes the book hard to put down.
Street Freak is a great American success story — with a twist. A young man gets out of the Coast Guard and dreams of having a Wall Street career, working in the center of capitalism — the World Trade Center. But he doesn't have the top-tier college pedigree that paves the way to the brass ring. The competition is fierce in the Lehman Brothers training class. He has a slim chance of earning a position.
His training is rudely interrupted by 9/11 and the author must live with the memory of watching the second plane ram into the second tower right above him. Training resumes across the Hudson and would eventually include performing security-guard duties. But while his classmates don't take the menial job seriously, Dillian does, and it serves him well.
He's granted an interview and tells of reading Burton Malkiel's A Random Walk Down Wall Street, a book extolling the virtues of efficient-market theory. "I read the book," Dillian tells the interviewer, "decided it was loathsome, nihilistic, academic bullshit, and set out to spend the rest of my career proving it wrong."
Dillian gets his start in index arbitrage, only watching at first, then calculating his mentor's P&L, and finally was allowed to trade. When the firm moves back to New York, and the head man Dick Fuld abolishes business casual, the author goes on a cheap suit shopping spree at Men's Warehouse, spending for five suits what his coworkers pay for one. But his frugality put him on the wrong side of the "Lehman Handshake." (You'll have to read the book.)
The author has a gift for math, while knowing little about finance when he began. As he writes, "I just wanted to create money out of speed and pure intimidation." He says he had no idea what the market was doing, but tick by tick Dillian developed an extraordinary sense for the direction of the beast that is the futures market.
Street Freak is chalk full of market jargon and trading lingo and, occasionally, Dillian stops to explain a trade that tells you all you need to know about modern finance.
I was expressing a view, not just on interest rates but also on forward interest rates, through a cash-settled future. Furthermore, I was doing so in a nonlinear fashion, using options on futures. I'd used a derivative of a derivative to express a view on an imaginary concept. It was downright magical.
While Dr. Zak calls traders very rational, Dillian writes that to get anything done on Wall Street you have to not only act irrationally but also be insane: "Only insane people do exactly the opposite of what common sense tells you to do."
Very little of Dillian's recount of trading resembles deliberate rational thought. But perhaps there is no distinction between rational and otherwise. Ludwig von Mises wrote that there is only purposeful behavior or human action. "Praxeology does not employ the term rational," Mises wrote in Money, Method, and the Market Process, explaining that the "opposite of action is not irrational behavior, but a reactive response to stimuli on the part of the bodily organs and of instincts, which cannot be controlled by volition."
In Mises's view, economics doesn't deal with homo economicus at all, but with homo agens: man "as he really is, often weak, stupid, inconsiderate, and badly instructed."
Dillian's weaknesses overtake him. He attempts suicide unsuccessfully and later on exits the trading floor suddenly, checking himself into a psychiatric hospital. He emerges medicated but healthier, bolstered by the insight that he can write.
However, the Lithium wrecks his concentration (and sex drive) and the patterns and flows that he once saw so naturally are fuzzy and incomprehensible. He must learn to trade all over again.
As impregnable as its employees thought it was, Lehman Brothers was allowed to fail for its overexposure to real estate. While its trading floor was making millions, Lehman brothers amassed a real-estate portfolio that was, in Dillian's words "absolutely pornographic."
According to rumor, Dick Fuld refused an offer of $40 a share for Lehman from Korean Development Bank in its dying days. But unlike his traders, Fuld allowed his pride to get in the way of making the best trade possible.
When capitalism is allowed to work, liquidation creates new beginnings. This was the case for Lehman. The New York trading operation was bought by Barclays, and Nomura Securities purchased the overseas operations. Most everyone kept their jobs.
As for Jared Dillian, he's created the financial newsletter the Daily Dirtnap and is doing what he enjoys most.
The financial-market crisis is not over but has grown into a vicious sovereign-debt crisis. Nevertheless, monetary policy makers of the major economies go on to practice the same sort of policy that has led to the crisis. Following the model of inflation targeting, they continue to disregard the quantity of money and the amount and kind of credit creation. As they did before, central bankers cut interest rates as low as they can. Few seem to remember that the monetary-policy concept of inflation targeting was adopted with the promise that low and stable inflation rates would produce financial and economic stability. Reality has not confirmed this assurance. On the contrary, inflation targeting was instrumental in bringing about the current financial crisis.
What Is Inflation Targeting?A central bank that pursues an inflation-targeting monetary policy model would raise the policy interest rate (which in the case of the United States is the federal-funds rate) when the current price-inflation rate tends to move beyond the target and to reduce the policy interest rate when the rate tends to fall below the range. Operationally, the inflation rate is the target variable of this approach while the policy interest rate serves as the instrument variable. Different from monetarism, the monetary aggregates play only a secondary or no role at all in the inflation-targeting model.
The monetary policy model of inflation targeting can be expanded into the so-called Taylor rule to include the output gap and thus to encompass economic policy goals such as economic growth and employment. The Rules-Discretion Cycle In Monetary and Fiscal Policy Unlike the original Taylor rule, monetary policy of inflation targeting in practice has ignored the growth of money and credit and uniquely selected the current official price-inflation rate as its foremost standard. Particularly in phases when the unemployment rate was found to be above the acceptable level, low rates of the consumer price index have served as a justification to bring down interest rates to excessively low levels. In many parts of the world where monetary policy employs an inflation-targeting framework, it has become a rule to ignore the expansion of monetary aggregates and to install extremely low interest rates. Inflation targeting has led monetary authorities to ignore not only money and credit growth but also asset prices along with other variables such as the exchange rate. By the rationale of inflation targeting, monetary policy has become blunt and ignorant by design, and in this respect a repetition of an earlier failure has occurred just at a time when the future head of the Federal Reserve felt sure that he could promise that "we won't do it again" and let the US economy fall into depression. Not different from other areas of policies, in monetary policy, too, the only lessons that are learned from history are the wrong lessons.
As was revealed by the recent release of the transcripts of the meetings of the Fed in 2006, central banking is a fraudulent institution where the men at the top act like deliberate ignoramuses. As the transcripts flagrantly show, it was not lack of information that made the authorities ignore reality but a deficiency of comprehension and an almost childish faith in model constructions.
An Earlier Episode of Inflation TargetingInflation targeting is not new. Its basic idea was conceived by the American economist Irving Fisher (1867–1947). The Fed implemented a rudimentary form of inflation targeting shortly after it became operative in 1914 and explicitly practiced a policy of "stabilizing the price level" in the 1920s, in the decade before the inception of the Great Depression.
The 1920s marked a period of rapid accumulation of debt that until 1929 was accompanied by a rise of wealth due to a stock-market and housing boom. The collapse of the market ushered the economy into the Great Depression, which lasted over a decade.
During the 1920s the US monetary authorities seemed little concerned with credit expansion because the main focus was the "price level" — a statistical construct that Fisher also had promoted. Noticing that the price level was "stable," the Federal Reserve felt no need to change course or to become preoccupied with what was going on. The Roaring Twenties were in fact exuberant times — albeit not for agriculture. It was industry that celebrated the new era and most of all this decade was one more heyday for Wall Street after the financial bonanza that World War I had delivered as the great enrichment of the financial sector.
The focus on price inflation had induced the monetary authorities to ignore credit growth and the expansion of money as well as to disregard the productivity gains of the US economy in this period. The Fed felt vindicated for letting the monetary aggregates expand as long as the price level remained relatively stable. No consideration was given to the notion that with productivity advances the price level should decline as had been the case when the United States was still on a full gold standard, and thus the quantity of money was relatively constant. In the 1920s, fixed on the price level, the monetary authorities did not hold the quantity of money constant, which would have meant deflation, but instead allowed an expansion of the money supply, because there seemed to be no reason to be concerned as long as the price level stayed stable.
What had happened in the 1920s was a wrong reaction of monetary policy makers to the widening divergence between the agricultural and industrial sector of the US economy. While agriculture fell into depression already shortly after World War I, US industry experienced a monetary-induced boom. On average, the price level appeared steady, although its stability was the result of a leveling out due to the combination of a deflationary depression of the agriculture sector and an inflationary boom of the industrial sector.
The Current CrisisThe latest episode of a megaboom occurred in the 1990s when, as in the 1920s, there was a stock-market bubble in combination with a massive increase of indebtedness of consumers for housing and other items. Central bankers did not pay much attention to the money supply and remained sanguine throughout the period that led up to the current crisis. The mantra of monetary policy was that, as long as the price level was relatively stable and only moderate price inflation rates were registered, interest rates could fall as low as they can drop, and the money supply could grow without restraint and get as large as demand of money seemed to warrant.
There were a series of severe shocks in the 1990s as well as in the decade before and after. Yet up to the outbreak of the last crisis, all of the preceding calamities could be overcome, so it seemed, with the simple tool of bailing out the creditors and by an expansion of the money supply. Inflation targeting consequently entailed a pervasive policy of bailouts and thus laid the basis of a financial culture of moral hazard.
In 2007 financial markets suddenly began to freeze, the flow of money in the interbank market came to a sudden standstill. It was as if a cardiac infarction had hit the heart of the financial markets. Albeit shocked, monetary policy makers demonstrated full confidence that a proper amount of liquidity injection would make the markets move again and soon; thus, they believed in their naïve conviction, the economy would recover to full bloom again. Yet doom set in when the old recipe didn't work anymore. Despite massive injections of liquidity, markets only slightly recovered, and in 2008 a wave of defaults of financial institutions occurred. In August 2011, the United States came close to bankruptcy when Congress was reluctant to raise the statutory debt limit. Shortly thereafter the global financial crisis deteriorated into the European sovereign-debt crisis. Greece came close to bankruptcy and contagion hit Spain, Portugal, and Italy.
By early 2012, monetary policy has reached a stage where it is almost completely paralyzed. With interest rates close to zero in the major economies of the world, it is only through gargantuan amounts of liquidity injections that the financial system is propped up. By practicing a "zero interest rate policy" (ZIRP), by buying assets of dubious quality from financial institutions through its Troubled Assets Relief Program (TARP) and by trying to pump ever more liquidity into the market through its policy of "quantitative easing" (QE), an expansion of unprecedented proportions of the Federal Reserve's balance sheet has occurred. The real or imagined assumption that the financial system is on the verge of complete collapse has brought about massive government bailouts and stimulus programs that have resulted in rising fiscal deficits and unsustainable public-debt burdens. Deflation has become the ultimate scare of governments and the dreadful nightmare of central bankers.
Fear of DeflationIt is largely forgotten that the spectacular economic rise of Britain, of parts of the European continent, and of the United States in the period of almost a century until the outbreak of World War I was characterized by moderate deflation, particularly since the beginning of the latter half of the 19th century when productivity increases began to accelerate. The price level did fall in the expanding economy because the money supply was linked to the gold stock and the gold stock was relatively constant. The deflationary period was marked by the ascendancy of prosperity brought about by a financial environment of stable interest rates, moderate long-term declining prices, and rising real wages. Letting good deflation happen put a break on excessive economic growth. A fixed stock of base money prevented the excess on the upside, and thus it automatically provided a safeguard against the excess on the downside. A stable stock of base money did not imply a strictly fixed amount of liquidity, because an adaptable velocity of money does provide a range of flexibility.
The outbreak of World War I marks the end of the deflationary period and the beginning of the inflationary age. When the last obstacle against a full discretionary hold on money was instituted and the Federal Reserve gained unrestricted power to produce as much money as it wanted, a new chapter in monetary history began. With the abandonment of the last remnants of the gold standard with the Smithsonian Agreement, monetary policy no longer had any anchor other than some kind of a policy concept. By slashing what was left of a monetary anchor in 1971, the monetary base of the US dollar began to rise and has swelled into an avalanche of money.
Now, the escalation of government debt to exorbitant heights practically prohibits central banks from raising interest rates if inflation should emerge more prominently. As of now, the additional liquidity that the major central banks have created serves mainly for the banking sector to refinance itself. Monetary policy has become a vehicle for the bailout of a whole sector of the economy. By coming to the rescue of the financial sector, central banks have delivered even more monetary dynamite. The world is at a crossroads. The chance to get out of the fix without great pain is much smaller than of having either a hyperinflation to be followed by economic depression or of crashing right away into the abyss of a deflationary depression. Monetary policy has reached the dead end. Once again a magic formula of an interventionist monetary policy has hit the wall.
ConclusionInasmuch as central banks dominate the discourse about monetary policy, there is almost no debate going on about the thesis that inflation targeting is not only defective in guaranteeing monetary stability but that it also provided the conditions for the current financial crisis to happen. The episode that was praised as the great moderation was a great delusion, which has become the nightmare of a long stagnation. There is a vital need to establish a sound monetary system. Its consequence would be moderate deflation and the avoidance of extreme booms and busts. The main barrier against sound money is neither intellectual nor practical but political. The resistance comes from the public sector because the chief casualty of an institutional change to sound money would be the modern inflated government along with its warmongers, debt pushers, and all the rest of the spin doctors of deceitful promises who form part of this kingdom.
Jon Corzine told the House Agriculture Committee, "I simply do not know where the money is, or why the accounts have not been reconciled to date." The public is outraged that the former CEO of bankrupt global financial-derivatives broker and prime dealer in US Treasury securities MF Global doesn't know where the missing $1.2 billion in client funds went.
Corzine is the member a few exclusive clubs: he is a Goldman Sachs alum, former US senator, and former New Jersey governor. After the incumbent Corzine was beat by Chris Christie in the 2009 New Jersey gubernatorial race, the MF board probably rejoiced, believing the guy to fix their problems was suddenly available. Now he's in the club of taking a mere 20 months to create the eighth largest bankruptcy in history.
As a stand-alone entity, MF Global was born in 2007 when it was spun off from UK hedge-fund giant, Man Group. MF booked revenues of $4 billion that year from interest earned by using its customers' funds, an operation that sounds like fractionized banking: short-term embezzlement used to make profits.
For banks, the practice was sealed in English common law in 1811 in the court case of Carr vs. Carr, where Master of the Rolls Sir William Grant ruled that debts mentioned in a will included bank accounts since the money had been deposited into the bank and wasn't earmarked in a sealed bag. The deposit was thus a loan rather than a bailment.
The same Judge Grant ruled the same way five years later in Devaynes vs. Noble, despite an attorney's argument that "a banker is rather a bailee of his customer's funds than his debtor … because the money in … [his] hands is rather a deposit than a debt, and may therefore be instantly demanded and taken up."
In 1848, in Foley vs. Hill and Others, Lord Cottenham ruled,
Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it.… The money placed in the custody of a banker to do with it as he pleases.
It's been clear sailing for bankers ever since. No questions asked.
At the same time, people are surprised that a commodity brokerage firm would misplace client assets. As Christopher Elias explains for Thomson Reuters,
MF Global's bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF's dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients' funds to finance an enormous $6.2 billion Eurozone repo bet.
Free bankers are always insisting that fractional-reserve banking is A-OK, as long as bankers inform depositors up front that the bank will be using their customers' money to make loans and investments.
That is exactly the case with MF Global. The company's customer agreements included the following clause:
- Consent To Loan Or Pledge You hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate, loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.
Back in 2007, customer funds held by MF as collateral against commodities trades could be invested in two-year Treasuries earning north of 4.5 percent. But in the wake of the '08 meltdown, the Bernanke Fed has flattened yields to be counted in basis points. With these low rates MF Global revenues fell to $517 million in 2010.
The old bond trader Corzine thought he could juice up MF's earnings with a little financial razzle-dazzle. Thinking outside the box (and off the balance sheet), Corzine moved $16.5 billion in assets into repos. A repo involves putting up assets as collateral, assets to be repurchased later, and borrowing money against those assets. MF used an off-balance-sheet repo called a "repo-to-maturity" where the loan and the collateral in the transaction have the same maturity. US accounting rules consider the transaction a sale and the assets can be moved off the balance sheet.
Most of these assets were bonds from Italy, Spain, Belgium, Portugal, and Ireland, all paying healthy coupon rates that would easily cover the repo interest rate and provide a nice profit. MF Global would have virtually no skin in the game (their customers provided it) and be earning a nice interest-rate spread.
Although things have been rocky in euroland, the collateral value of the short-term bonds appeared safe with the guarantee provided by the European Financial Stability Facility (EFSF).
With the $16.5 billion in assets moved off its balance sheet, MF Global then ramped up a net-long sovereign-debt position of $6.2 billion on its balance sheet, exposure that was five times the company's net worth.
While the EFSF guarantee would insure against the default of the sovereign debt if the bonds were held to maturity, MF was still at risk to make margin calls, if the bonds dropped in price day-to-day. Elias writes,
Like Wall Street cocaine, leveraging amplifies the ups and downs of an investment; increasing the returns but also amplifying the costs. With MF Global's leverage reaching 40 to 1 by the time of its collapse, it didn't need a Eurozone default to trigger its downfall — all it needed was for these amplified costs to outstrip its asset base.
So while MF Global's eurozone bets had not defaulted, the company's liquidity was drained making margin calls and trying to meet short-term-debt obligations as the euro-crisis news flow out of Europe vacillated.
MF Global was able to leverage up its euroland bets by way of the rehypothecation of their clients' collateral. Hypothecation is pledging collateral for a loan. Like the mortgage on your house.
Customers of MF posted cash, gold, or securities as collateral to backstop their commodity futures and derivatives trading. MF would then take those customer assets to back its own trades and borrowing. Mr. Elias explains, "The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds."
Under US rules, a prime broker is allowed to rehypothecate assets to the value of 140 percent of the client's liability to the broker. The rules are more liberal in the United Kingdom, where there is no limit and in many cases UK brokers rehypothecate 100 percent of collateral value placed in their custody.
Elias writes that by 2007, rehypothecation was half the shadow banking system.
Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as "churn"), the original collateral being used may have been as little as $1 trillion — a quarter of the financial footprint created through re-hypothecation.
All of this churning has created rivers of liquidity, much of it with no asset backing. And what assets do provide backing aren't the quality they used to be. The repo rules were liberalized in the Clinton era. So instead of AAA government paper being required, AA sovereign debt works just fine, after all, as James B. Stewart writes for the New York Times:
The law also allows commodities firms like MF Global to use segregated customer funds as a source of low-cost financing for their own operations, but they are required to replace any customer assets taken from segregated accounts with supposedly ultrasafe collateral of the same value, typically United States Treasuries, municipal obligations and obligations whose payments of principal and interest are guaranteed by the government. (emphasis added)
Of course all this rehypothecating creates mountains of counterparty risk, all dependent on dubious collateral that has been pledged multiple times. The equivalent of having four mortgages on a house, each having been sold to other parties who have been told their mortgage is in first position. When the property value starts dropping or the borrower doesn't pay, only one lender will get there first and legal fistfights ensue.
This rehypothecation activity may be the biggest credit bubble of all time, according to Elias. J.P. Morgan alone has rehypothecated over half a trillion dollars in 2011, Morgan Stanley $410 billion, Goldman Sachs $28 billion, and the list goes on.
Americans have been told US banks have little exposure to European sovereign debt, but according to the Bank for International Settlements (BIS), US banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal, and Spain. And while Germany is considered the belle of the Continental ball, Grant's Interest Rate Observer reports that Deutsche Bank is levered at 43:1 and the Bundesbank has doubled its leverage since 2007 when it was geared at 75:1 — these days the central bank is levered at 153:1.
Extreme leverage is a problem if the slightest thing goes wrong — anywhere. When the cost of swapping euros for dollars soared at the end of last month, a coordinated central-bank cavalry charged out of nowhere, cutting swap rates and establishing temporary bilateral-liquidity swap arrangements. Nobody but financial news junkies seemed to know or care.
The truth about the financial crash wasn't known until Bloomberg chased its request for information all the way to the Supreme Court to obtain documents that shed light on how much dough the Federal Reserve really provided the banks during the 2008 meltdown.
For instance, it turns out Wachovia shareholders got lucky as the bank was floated a secret loan from the Fed of $50 billion to keep the doors open while a sale could be arranged with Wells Fargo for $7 a share rather than shareholders having to take the buck-a-share offer from the wounded Citibank.
"This deal enables us to keep Wachovia intact and preserve the value of an integrated company, without government support," Wachovia's chief executive Robert Steel said at the time.
Right, no government support at all.
Instead of being among the bailed out, Corzine and MF Global are now joining Lehman, IndyMac, Colonial, and all the small-fry banks lacking the friends in high places needed to keep them afloat. In the fractional-reserve world, markets don't decide the winners and losers; government does.
Stewart writes for the NYT, "SIPC will replace up to $500,000 of securities and cash (but not futures contracts) missing from customer accounts at member firms," and the notion of even covering futures accounts has been floated on CNBC by Senator Debbie Stabenow, just as the FDIC replaces deposits up to $250,000. But covering the losses of clients and depositors is hardly the reflection of sound capitalism and the honoring of property rights.
[product:10434]
"If no business firm can be insured," Murray Rothbard wrote,
then an industry consisting of hundreds of insolvent firms is surely the last institution about which anyone can mention "insurance" with a straight face. "Deposit insurance" is simply a fraudulent racket, and a cruel one at that, since it may plunder the life savings and the money stock of the entire public.
So it's unlikely Jon Corzine knows where the $1.2 billion in customer money went any more than the president of a failed bank would know exactly where the customer deposits went.
The bigger issue is that, day by day, Mr. Corzine looks to be merely a canary in the fractional-reserve coal mine.
"While flash trading can lead to sudden dips in the market, the market has proven to be quick in correcting itself."It's fascinating to watch footage of a trading floor on Wall Street. Here men and women spend hours with their eyes glued to computer monitors while furiously calculating trades that often yield small profits or minimal losses. In the case of Swiss bank UBS trader Kweku Adoboli, it can result in a $2 billion loss and an unfortunate incarceration. The risks run high as trading requires a sizeable amount of dexterity and concentration to be successful in a network of like-minded profit seekers. Still, there is an underlying beauty to the process, as thousands (perhaps millions) of individuals coordinate their knowledge on the allocation of limited resources throughout the world.
Nobel laureate Friedrich Hayek dedicated much of life's work (brilliantly summed up in his classic essay "The Use of Knowledge in Society") showing us how knowledge and expertise are widely dispersed throughout society and can never reside in a single mind. That is to say, while individuals may use their own expertise and labor to create, they will never be in full possession of all available knowledge to account for the nuances of market and societal demands. The same concept applies to a government composed of fallible men — much to the dismay of statist ideologues such as Elizabeth Warren.
The limit of individual knowledge is what provided the initial need for social cooperation. Primitive man banded together with others, not under the auspices of creating one great state, but as a desire to utilize more resources and raise their own standard of living. Out of this grew the division of labor and increased sharing of knowledge and information. As Mises said, "one must never forget that the characteristic feature of human society is purposeful cooperation; society is an outcome of human action."
When it comes to the disbursement of information, nothing is more controversial than high-speed "flash" trading. A recent New York Times article documented the trend:
Regulators in the United States and overseas are cracking down on computerized high-speed trading that crowds today's stock exchanges, worried that as it spreads around the globe it is making market swings worse.
The cost of these high-frequency traders, critics say, is the confidence of ordinary investors in the markets, and ultimately their belief in the fairness of the financial system.
"There is something unholy about them," said Guy P. Wyser-Pratte, a prominent longtime Wall Street trader and investor. "That is what caused this tremendous volatility. They make a fortune whereas the public gets so whipsawed by this trading."
The public gets whipsawed by this trading? Funny how those on Wall Street no longer classify as the "public" in the eyes of populism.
What this demonization of flash trading really comes down to is the inability of regulators to monitor and control such a phenomenon. What the state can't control, it exerts more power and authority to tame. Like a vampire to blood, the state never gets its fill of supremacy.
The justification for regulating flash trading comes down to a brief market crash back on May 6, 2010. In the course of just 16 minutes, the Dow Jones Industrial Average dropped 1,000 points, only to rebound to its original level. It was the largest intraday decline in the history of the Dow Jones. Despite the market's quick correction to the crash, a joint panel was created and headed by the chairmen of the Security and Exchange Commission and Commodity Futures Trading Commission to investigate the matter. Their report, which was released back in February, recommended that new rules and regulations be adopted to address flash trading. Considering how successful the SEC and CFTC were at recognizing the housing bubble, it's a wonder anyone still takes their recommendations seriously.
While flash trading can lead to sudden dips in the market, the market has proven to be quick in correcting itself. The rapid disbursement of information that encompasses the stock market becomes its own self-correcting mechanism.
As society and technology progress, the instantaneous sharing of knowledge and information is not something to fear but to celebrate. In a world where, to borrow a phrase from John Tamny, "capital moves at the speed of light," flash trading ensures that resources will continue to meet more deserving hands and be put to more efficient use.
Clamping down on such a practice doesn't just limit capital flow; it limits the market's mechanism by which to progress. Like all government regulation, it will put the brakes on productivity and the achieving of a better standard of living. Attempting to level the field in the name of "fairness" is nothing but a government power grab destined to bring about destructive consequences. As Hayek pointed out in his Nobel acceptance speech, The Pretense of Knowledge,
In the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process … will hardly ever be fully known or measurable.
Knowledge is best utilized when it reaches as many people as possible. Hayek's lesson must not be forgotten as it not only shows the fallacy of central planning but the incredible benefits derived from social cooperation through instantaneous communication.
[Introduction to Rothbard's America's Great Depression, December 1999]
The Great Depression was a failure not of capitalism but of the hyperactive state."The Wall Street collapse of September–October 1929 and the Great Depression which followed it were among the most important events of the 20th century. They made the Second World War possible, though not inevitable, and by undermining confidence in the efficacy of the market and the capitalist system, they helped to explain why the absurdly inefficient and murderous system of Soviet communism survived for so long. Indeed it could be argued that the ultimate emotional and intellectual consequences of the Great Depression were not finally erased from the mind of humanity until the end of 1980s, when the Soviet collectivist alternative to capitalism crumbled in hopeless ruin and the entire world accepted there was no substitute for the market.
Granted the importance of these events, then, the failure of historians to explain either their magnitude or duration is one of the great mysteries of modern historiography. The Wall Street plunge itself was not remarkable, at any rate to begin with. The United States economy had expanded rapidly since the last downturn in 1920, latterly with the inflationary assistance of the bankers and the federal government. So a correction was due, indeed overdue. The economy in fact ceased to expand in June, and it was inevitable that this change in the real economy would be reflected in the stock market.
The bull market effectively came to an end on September 3, 1929, immediately the shrewder operators returned from vacation and looked hard at the underlying figures. Later rises were merely hiccups in a steady downward trend. On Monday October 9, for the first time, the ticker tape could not keep pace with the news of falls and never caught up. Margin calls had begun to go out by telegram the Saturday before, and by the beginning of the week speculators began to realize they might lose their savings and even their homes. On Thursday, October 12, shares dropped vertically with no one buying and speculators were sold out as they failed to respond to margin calls. Then came Black Tuesday, October 19, and the first selling of sound stocks to raise desperately needed liquidity.
So far all was explicable and might easily have been predicted. This particular stock-market corrective was bound to be severe because of the unprecedented amount of speculation which Wall Street rules then permitted. In 1929 1,548,707 customers had accounts with America's 29 stock exchanges. In a population of 120 million, nearly 30 million families had an active association with the market, and a million investors could be called speculators. Moreover, of these nearly two-thirds, or 600,000, were trading on margin, that is on funds they either did not possess or could not easily produce.
The danger of this growth in margin trading was compounded by the mushrooming of investment trusts which marked the last phase of the bull market. Traditionally stocks were valued at about ten times earnings. With high margin trading, earnings on shares, only 1 or 2 percent, were far less than the 8 to 10 percent interest on loans used to buy them. This meant that any profits were in capital gains alone. Thus, Radio Corporation of America, which had never paid a dividend at all, went from 85 to 410 points in 1928. By 1929 some stocks were selling at 50 times earnings.
"The 1920 recession had adjusted itself within a year. There was no reason why the 1929 recession should have taken longer, for the American economy was fundamentally sound."A market boom based entirely on capital gains is merely a form of pyramid selling. By the end of 1928 the new investment trusts were coming onto the market at the rate of one a day and virtually all were archetype inverted pyramids. They had "high leverage" — a new term in 1929 — through their own supposedly shrewd investments, and secured phenomenal stock-exchange growth on the basis of a very small plinth of real growth. United Founders Corporation, for instance, had been created by a bankrupt with an investment of $500, and by 1929 its nominal resources, which determined its share price, were listed as $686,165,000. Another investment trust had a market value of over a billion dollars but its chief asset was an electric company which in 1921 had been worth only $6 million. These crazy trusts, whose assets were almost entirely dubious paper, gave the boom an additional superstructure of pure speculation, and once the market broke the "high leverage" worked in reverse.
Hence awakening from the pipe dream was bound to be painful and it is not surprising that by the end of the day on October 24, eleven men well-known on Wall Street had committed suicide. The immediate panic subsided on November 13, at which point the index had fallen from 452 to 224. That was indeed a severe correction but it has to be remembered that in December 1928 the index had been 245, only 21 points higher. Business and stock-exchange downturns serve essential economic purposes. They have to be sharp. But they need not be long because they are self-adjusting. All they require on the part of the government, the business community, and the public is patience. The 1920 recession had adjusted itself within a year. There was no reason why the 1929 recession should have taken longer, for the American economy was fundamentally sound. If the recession had been allowed to adjust itself, as it would have done by the end of 1930 on any earlier analogy, confidence would have returned and the world slump need never have occurred.
Instead the stock market became an engine of doom, carrying to destruction the entire nation and, in its wake, the world. By July 8, 1932, New York Times industrials had fallen from 224 at the end of the initial panic to 58. US Steel, the world's biggest and most efficient steel maker, which had been 262 points before the market broke in 1929, was now only 22. General Motors, already one of the best-run and most successful manufacturing groups in the world, had fallen from 73 to 8. These calamitous falls were gradually reflected in the real economy. Industrial production, which had been 114 in August 1929, was 54 by March 1933, a fall of more than half, while manufactured durables fell by 77 percent, nearly four-fifths. Business construction fell from $8.7 billion in 1929 to only $1.4 billion in 1933.
Unemployment rose over the same period from a mere 3.2 percent to 24.9 percent in 1933 and 26.7 percent the following year. At one point 34 million men, women, and children were without any income at all, and this figure excluded farm families who were also desperately hit. City revenues collapsed, schools and universities shut or went bankrupt, and malnutrition leapt to 20 percent, something that had never happened before in United States history even in the harsh early days of settlement.
"If the recession had been allowed to adjust itself, as it would have done by the end of 1930 on any earlier analogy, confidence would have returned and the world slump need never have occurred."This pattern was repeated all over the industrial world. It was the worst slump in history, and the most protracted. Indeed there was no natural recovery. France, for instance, did not get back to its 1929 level of industrial production until the mid-1950s. The world economy, in so far as it was saved at all, was saved by war, or its preparations. The first major economy to revitalize itself was Germany's, which with the advent of Hitler's Nazi regime in January 1933 embarked on an immediate rearmament program. Within a year Germany had full employment. None of the others fared so well. Britain began to rearm in 1937 and thereafter unemployment fell gradually, though it was still at historically high levels when war broke out on September 3, 1939. That was the date on which Wall Street, anticipating lucrative arms sales and eventually US participation in the war, at last returned to 1929 prices.
It is a dismal story and I do not feel that any historian has satisfactorily explained it. Why so deep? Why so long? We do not really know, to this day. But the writer who, in my judgment, has come closest to providing a satisfactory analysis is Murray N. Rothbard in America's Great Depression. For half a century, the conventional, orthodox explanation, provided by John Maynard Keynes and his followers, was that capitalism was incapable of saving itself, and that government did too little to rescue an intellectually bankrupt market system from the consequences of its own folly. This analysis seemed less and less convincing as the years went by, especially as Keynesianism itself became discredited.
In the meantime, Rothbard had produced, in 1963, his own explanation, which turned the conventional one on its head. The severity of the Wall Street crash, he argued, was not due to the unrestrained license of a freebooting capitalist system but to government insistence on keeping a boom going artificially by pumping in inflationary credit. The slide in stocks continued, and the real economy went into free fall not because government interfered too little but because it interfered too much. Rothbard was the first to make the point, in this context, that the spirit of the times in the 1920s, and still more so in the 1930s, was for government to plan, to meddle, to order and to exhort. It was a hangover from the First World War, and President Hoover, who had risen to worldwide prominence in the war by managing relief schemes, and had then held high economic office throughout the '20s before moving into the White House itself in 1929, was a born planner, meddler, orderer, and exhorter.
Hoover's was the only department of the US federal government which had expanded steadily in numbers and power during the 1920s, and he had constantly urged Presidents Harding and Coolidge to take a more active role in managing the economy. Coolidge, a genuine minimalist in government, had complained: "For six years that man has given me unsolicited advice — all of it bad." When Hoover finally took over the White House, be followed his own advice, and made it an engine of interference, first pumping more credit into an already overheated economy then, when the bubble burst, doing everything in his power to organize government rescue operations.
We now see, thanks to Rothbard's insights, that the Hoover-Roosevelt period was really a continuum, that most of the "innovations" of the New Deal were in fact expansions or intensifications of Hoover solutions — or pseudosolutions — and that Franklin Delano Roosevelt's administration differed from Herbert Hoover's in only two important respects: it was infinitely more successful in managing its public relations, and it spent rather more taxpayers' money. And, in Rothbard's argument, the net effect of the Hoover-Roosevelt continuum of policy was to make the slump more severe and to prolong it virtually to the end of the 1930s. The Great Depression was a failure not of capitalism but of the hyperactive state.
I will not spoil the reader's pleasure by entering more deeply into Rothbard's arguments. His book is an intellectual tour de force, in that it consists, from start to finish, of a sustained thesis, presented with relentless logic, abundant illustration, and great eloquence. I know of few books which bring the world of economic history so vividly to life, and which contain so many cogent lessons, still valid in our own day. It is also a rich mine of interesting and arcane knowledge, and I urge readers to explore its footnotes, which contain many delicious quotations from the great and the foolish of those days, three-quarters of a century ago. It is not surprising that the book is going into yet another edition. It has stood the test of time with success, even with panache, and I feel honored to be invited to introduce it to a new generation of readers.
This introduction to Rothbard's America's Great Depression originally appeared in Mises Daily on May 15, 2000.
On Monday, August 8, the S&P 500 stock-price index fell 6.7 percent to close at 1,119.46. The index fell 13.4 percent from July, and this was the fourth consecutive monthly decline. It has fallen 17.9 percent from its high of 1,363.61 in April this year.
Also, the index's growth momentum has fallen visibly. Year on year, the rate of growth declined to 6.7 percent from 17.3 percent in July.
The trigger for the plunge in stocks was Standard & Poor's lowering of the US Treasuries' rating from AAA to AA+. But while the trigger may have been this downgrade, the key factor that set in motion the plunge in stocks is the sharp deterioration in the state of the pool of real savings as a result of loose monetary and fiscal policies.
Normally, what matters for the stock market is the state of monetary liquidity.
As economic activity slows down, the demand for the services of the medium of exchange that money provides in the real economy declines. Therefore, a surplus of money or an increase in monetary liquidity emerges. As a rule this surplus is put to work in financial markets, including the stock market. Consequently, the prices of financial assets and stocks are pushed higher. (Remember, the price of an item is the amount of dollars paid for the item. Likewise the price of a stock is the amount of dollars paid per stock.)
For instance, the yearly rate of growth of industrial production fell from 3.5 percent in January 1974 to negative 12.4 percent in May 1975. The yearly rate of growth of the CPI fell from 12.3 percent in December 1974 to 9.4 percent in June the following year. Changes in the industrial production and the CPI can be seen as a proxy for changes in the demand for money.
As a result, the yearly rate of growth of surplus money climbed from negative 7.7 percent in March 1974 to positive 7.6 percent in May 1975. In response to the increase in liquidity, the S&P 500 climbed from 68.6 in December 1974 to 95.2 by June 1975 — an increase of 38.8 percent.
Historically, fluctuations in liquidity precede fluctuations in the S&P 500 stock-price index (see chart below).
For July this year, the growth momentum of liquidity displays a visible uptrend — the yearly rate of growth stood at 4.5 percent against 3 percent in June. So from a liquidity perspective the S&P 500 appears to be well supported. What's more, there is a growing likelihood that the Fed will embark on more money pumping.
So why then has the stock market declined despite a strengthening in the growth momentum of monetary liquidity? Most experts believe the reason is the S&P downgrade of US government debt and a weakening in some key economic data. The yearly rate of growth of real personal-consumption outlays fell to 1.8 percent in June from 2 percent in May. The ISM manufacturing index fell to 50.9 in July from 55.3 in June, while the ISM services index eased to 52.7 in July from 53.3 in the previous month.
The growth momentum of real AMS (the Austrian money supplyFrank Shostak, "The Mystery of the Money Supply Definition," Quarterly Journal of Austrian Economics 3, no. 4 (Winter 2000): 69–76. ) has been in an uptrend since April last year. After closing at 0.8 percent in April last year, the yearly rate of growth of real AMS jumped to 7.8 percent in July this year. (In June the rate of growth stood at 6.4 percent.) The increase in the growth momentum of real AMS should provide good support ahead for the ISM manufacturing and services indexes (see charts below). All other things being equal, an uptrend in the growth momentum of monetary liquidity coupled with a likely bounce in the yearly rate of growth of key economic data should be good news for stocks.
If the pool of real savings is in trouble, then various key economic data will have difficulty performing well. If the pool of real savings is falling, then an increase in liquidity is not likely to be employed in the stock market. The state of the pool of real savings dictates the economy's ability to generate wealth — that is, economic growth.
For instance, the yearly rate of growth of industrial production fell from 15.3 percent in January 1929 to negative 24.6 percent in October 1930. The growth momentum of the consumer-price index (CPI) also had a large fall during this period. The yearly rate of growth fell from negative 1.2 percent in January 1929 to negative 6.4 percent in December 1930.
In response to these large falls, the yearly rate of growth of surplus money increased from negative 16.6 percent in May 1929 to a positive figure of 25.5 percent by November 1930. Despite this strong increase in liquidity, the S&P 500 fell from 24.15 in October 1929 to 15.34 by December 1930 — a fall of 36.5 percent. The index in fact continued to slide falling to 4.4 by June 1932 — a fall of 81.8 percent from October 1929.
The inability of the increase in liquidity to affect the stock market from May 1929 to December 1930 was because of a fall in the pool of real savings. The ensuing depression and massive unemployment pushed people to stay out of any form of risky investment for safety reasons.
We maintain that, regardless of the downgrade by Standard & Poor's, if currently the percentage of wealth-generating activities out of all activities is still above 50 percent, then it is likely that the pool of real savings or the pool of funding is still growing. Consequently, real economic growth should follow suit. In this situation, the Fed could perpetuate the illusion that monetary pumping can grow the economy. Indeed, in this situation an increase in the money supply's rate of growth is likely to be associated with a rebound in various key economic data and with a strengthening in the stock market.
If, however, less than 50 percent of all activities are wealth generators, then more pumping will only make things much worse. (Loose policies will only further weaken the pool of real funding, deepen the economic slump, and deepen further the slide in stocks.)
Although we cannot quantify whether the pool of real savings is currently expanding or stagnating, we can definitely say that the loose policies of the Fed and the US government have weakened the pool. The fact that, despite the aggressive pumping by the Fed (QE1 and QE2), the economy remains depressed raises the possibility that perhaps the pool of real funding is stagnant or worse. Obviously in this case, given the fact that the Fed and the government will try to "revive" the economy, the downtrend in the stock market could last much longer. (Such policies will only undermine the pool of real funding further and delay meaningful economic recovery.)
But what about the fact that corporate earnings are doing very well? More than 75 percent of corporations in the S&P 500 index have exceeded earnings estimates of Wall Street analysts for the second quarter. Furthermore, most experts are of the view that corporate earnings will rise by 18 percent in 2011 and 14 percent in 2012.
We suggest that, irrespective of how supposedly well various companies are doing, if the pool of real funding begins to slide the performance of so-called good companies will follow suit.
ConclusionWhile Standard & Poor's downgrade of US government debt has triggered the plunge in the stock market, the underlying cause behind the stock market's sharp decline is loose monetary and fiscal policies that have badly damaged the ability of the US economy to generate wealth. Historically, fluctuations in monetary liquidity have preceded fluctuations in the S&P 500 stock-price index. The recent visible strengthening in the growth momentum of monetary liquidity will be of little help to the stock market if the pool of real savings is stagnating or, worse, declining.
If the word "ironic" doesn't apply to bond-investing gurus, then it applies to no one. Former George Soros protégé Stanley Druckenmiller and Doubleline Capital founder Jeffrey Gundlach have warned that US government spending is unsustainable at current levels and that the ballooning deficit increases the likelihood of default.
Bill Gross, manager of the world's largest bond fund — PIMCO's $243 billion Total Return Fund— famously announced back in March that he had sold all US Treasury holdings, and then he raised the alarm, and a few eyebrows, with his declaration that default on Treasury debt wasn't outside the realm of possibility. But default is apparently outside the realm of probability: Gross, unable to withstand the allure of rallying US Treasury prices, added US Treasury debt to PIMCO's holdings in May.
As for the irony, where do the government-bond-investing gurus think government gets the money to run up astronomical deficits? The government gets it from government-bond investors.
If it were not for US Treasury debt there would be no US fiscal deficit, nor would there be unsustainable growth in Social Security, Medicare, and Medicaid spending, nor any unsustainable growth in military spending. Taxes and inflation can rise only so high before citizens bristle. Yes, the Federal Reserve could fully fund the Treasury, but that would be a highly inflationary scam. Debt is the most surreptitious, and therefore the most sinister, of expropriations.
Private buyers of government debt are the real villains. They give profligacy legitimacy, so any finger wagging and reproach from the bond-investing darlings should be met with eye rolls, not media fawning. The hypocrisy is too obvious.
The excuses for purchasing government debt are easily conjured up, but without conviction: The securities have low credit risk, and therefore they are invaluable to risk-averse investors. Government-debt securities are imperfectly correlated with other assets, so, again, they are risk-reducing.
A government-debt investor could riposte that not all government spending is ruinous; to the contrary, much government spending is investment and benefits posterity. After all, that highway built today will last at least a generation or two. So, instead of placing the entire burden of capital investment that would also benefit future generations on the present generation, let future generations bear their "fair" share of the cost.
There is a certain soothing logic to the argument, until you realize it's based on the disdainful doctrine of the dead controlling the living and the living controlling the nonexistent.
Worse, government "capital investment" is a fiction, a duplicitous euphemism. A bond purchased from a private issuer enables the issuer to buy equipment with which to increase output for products and services the market desires (signaled by a willingness to engage in free exchange). The interest paid to the bond holder is generated from the increased production made possible by the loan.
Government, in contrast, spends — that's all it can do. Government investment generates no return — and mostly losses when opportunity costs are considered. How is interest paid? Not from profits, but from taxes, to which the bond holder contributes a share — a share increased by the cost of servicing the bond. In effect, the bond holder is paying himself. That's no investment.
"We owe the debt to ourselves" is the more fatuous solipsism. It's not that simple or even accurate. Over $4.4 trillion in US Treasury debt is owned by foreigners, and $2 trillion of it is owned by the governments of China and Japan. Yes, interest payments will flow to foreign holders, who buy US Treasury debt not as a favor to the United States but as a tool to manipulate their own currency in order to play the long-discredited mercantilist game. Nevertheless, those payments will flow back to the issuing country through investment in or consumption of domestic production.
That said, we could never owe it to ourselves anyway, even if all US Treasury debt were owned by US citizens. The United States isn't a thing or person who can move money from one pocket to the other.
Both purchasers — domestic and foreign — weaken property rights in the sovereign country issuing the debt. When "C" — a citizen — purchases debt from "G" — the government — G slaps a claim on C's and every other citizen's property in order to repay C. The property claim is no different if "F" — the foreigner — purchases the debt: C and his compatriots are on the hook. Both claims on the debt weaken property rights by allowing government to further encumber private property with its own lien. Claims are claims, whether they be taxes or borrowing. It is your liability.
The opportunity cost — what the United States and other debtor nations have foregone in wealth and prosperity — is the greater waste, and the greater tragedy. Government debt has attracted funds from private investment that would have produced goods and services actually demanded by the market, not goods and services pimped and pumped into existence by pliable politicians with support of their sycophantic economists and rent-seeking constituents.
Trading in government debt is worse than zero-sum. Most money managers trade government debt to wager on the direction of inflation, with the expectation that interest rates will rise or fall with their inflation prognostication. If you expect inflation to rise, you'll short government bonds; if you expect the opposite, you'll go long. (Most money managers are unfamiliar with the Austrian focus on time preference.) Money that would have improved society had it been lent — after thorough analysis — to private firms is funneled into the government-bond market to wager on whether QEII is sufficiently inflationary. Simultaneously, this money is "invested" to subsidize grandpa''s Lipitor habit, the kids' atrocious education, a windmill manufacturer's R&D, and armaments to perpetuate a pointless confrontation.
With their portfolios replete with government bonds, financial institutions and bond gurus are understandably nervous. They should be, and they deserve to be. They are, in effect, the junior partner of the government treasury. Self-interest compels compliance. A precipitous price drop in government debt would shake the large endowments, foreign governments, and the world's financial centers to their core. So be it; no one owes anyone a putative no-default security.
For those unencumbered with government holdings, default — even if it's a remote possibility — would be a catharsis: a forced purging of a lot of government rot. Even if a default isn't forthcoming, we should welcome the good news that there are few private buyers of US government debt. No buyers would be even better news.
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Scott Patterson, reporter for the Wall Street Journal and author of The Quants (2010), tells the story of
traders and financial engineers who used brain-twisting math and superpowered computers to pluck billions in fleeting dollars out of the market. Instead of looking at individual companies and their performance, management and competitors, they use math formulas to make bets on which stocks were going up or down. By the early 2000s, such tech-savvy investors had come to dominate Wall Street, helped by theoretical breakthroughs in the application of mathematics to financial markets, advances that had earned their discoverers several shelves of Nobel Prizes.[1]
The fall of the quants in 2007 was even more precipitous than their rise. Patterson tells of the experience of one outfit in particular, Morgan Stanley's Process Driven Trading, during the week of August 6.
PDT, one of the most secretive quant funds around, was now a global powerhouse, with offices in London and Tokyo and about $6 billion in assets (the amount could change daily depending on how much money Morgan funneled its way). It was a well-oiled machine that did little but print money, day after day.
That week, however, PDT wouldn't print money — it would destroy it like an industrial shredder.
The unusual behavior of stocks that PDT tracked had begun sometime in mid-July and had gotten worse in the first days of August. The previous Friday, about half a dozen of the biggest gainers on the Nasdaq were stocks that PDT had sold short, expecting them to decline, and several of the biggest losers were stocks PDT had bought, expecting them to rise. It was Bizarro World for quants. Up was down, down was up. The models were operating in reverse.
The market moves PDT and other quant funds started to see early that week defied logic. The fine-tuned models, the bell curves and random walks, the calibrated correlations — all the math and science that had propelled the quants to the pinnacle of Wall Street — couldn't capture what was happening.[2]
The quants were among the first of many victims of the bursting of that decade's economic bubble. Patterson would have us believe that they were also among the chief causes of the financial crisis that ensued. But the bubble and its bursting were made virtually inevitable by the prior actions of the Federal Reserve, as anyone who adheres to the Austrian business-cycle theory will tell you.[3] However, exactly who is involved the most in the inflating of the bubble, and exactly who suffers the most when it bursts, depends on the actions of the market participants in question. And undoubtedly the quants were foremost among their own gravediggers.
The ultimate test of market strategies should always be profit and loss, and therefore it is worse than useless to regulate such investment strategies as President Obama has tried to do.[4] But if Ludwig von Mises were alive today, he probably would not have been in the least surprised that the quants' methods ultimately bore such bitter fruit. Their models "couldn't capture what was happening" for two fundamental reasons:
They did not integrate an accurate understanding the business cycle.
They treated a matter of case probability as if it were a matter of class probability.
Mises's distinction between these two kinds of probability is the cornerstone of his theory of uncertainty, which in turn hinges on his theory of "the specific understanding." In this article, I will endeavor to explain both of these little-understood areas of Mises's thought.
Class Probability and Case ProbabilityAccording to Mises, there are two approaches that the human mind can take concerning incomplete knowledge of real affairs: class probability and case probability.
The most important thing to note about this distinction is that class probability has to do with frequency, and case probability does not. Another important thing to note is that class probability has to do with causality and nature, while case probability has to do with teleology and human choice.[5]
Mises defines the two kinds of probability in Human Action.
Class probability means: We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.[6]
Case probability means: We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.[7]
Here are some examples Mises gives of each type.
Class ProbabilityCase ProbabilityGambling (Lottery Tickets, Roulette, etc.)Betting (Sports Wagers, Political Bets, etc.)Engineering Margins and Medical PrognosesHistorical ScholarshipBusiness-Inventory VicissitudesEntrepreneurial SpeculationPurchasing Insurance To take the example of a lottery, a prospective ticket buyer may know everything about the class "Tickets for the MegaMillions Lottery Ending May 31." He may know exactly how many tickets there are, and exactly how many will be winning tickets. He would thus have complete knowledge concerning the "winning frequency" about the class in question. However, as he looks at four tickets hanging on the wall behind the drugstore counter, he would know absolutely nothing about the cases in question (the particular tickets he is considering) except that they are members of the MegaMillions-Tickets class. He has relevant (and, in this situation, complete) class knowledge, but no relevant case knowledge. Placing a stake according to class probability is Mises's definition of a gamble.[8]
Now, the state of affairs would be very different if one were placing a stake on human action. For example, let us say an ancient Roman named Quintus is placing a wager on whether Caesar will lead his army across the River Rubicon toward Rome, an act that will commit the Roman commander to war against the forces of Pompey and the Roman Senate, thus plunging Rome into a civil war.
Unlike the situation with the lottery ticket, Quintus has no relevant class knowledge concerning Caesar. Quintus can classify Caesar according to any number of class distinctions (or "real types," as discussed further below) his mind can conceive of: "Roman consul," "Roman of patrician rank," "human born on 13 July." But any survey he makes of members of such classes would be useless to him for predicting his choice. That is because, as Mises says,
the distinctive mark of what we call the human sphere or history or, better, the realm of human action is the absence of … a universally prevailing regularity. Under identical conditions stones always react to the same stimuli in the same way; we can learn something about these regular patterns of reacting, and we can make use of this knowledge in directing our actions toward definite goals. Our classification of natural objects and our assigning names to these classes is an outcome of this cognition. A stone is a thing that reacts in a definite way. Men react to the same stimuli in different ways, and the same man at different instants of time may react in ways different from his previous or later conduct. It is impossible to group men into classes whose members always react in the same way.[9]
So when we are dealing with uncertainty concerning any event determined by human choice, we are
grappling with an individual, unique, and nonrepeatable case. The case is characterized by its unique merits, it is a class by itself. All the marks which make it permissible to subsume it under any class are irrelevant for the problem in question.[10]
Therefore Quintus's wager on whether Caesar will cross the Rubicon is not a matter of class probability.
Now, while the prospective lottery ticket buyer has no case knowledge about particular tickets, is it possible to have case knowledge about the particular man Caesar? Is it possible to have insight into the individual, unique, and nonrepeatable cases we call human beings?
Case Probability, the Specific Understanding, and ThymologyYes, case knowledge is undeniably possible. In our daily lives, we all have experience in achieving psychological insight into the emotions, motivations, ideas, judgments of value, and volitions of unique individuals. Mises calls such knowledge "thymology," and he calls the mental process that results in such knowledge "the specific understanding" (or, in German, "verstehen").[11]
Because it is possible to achieve psychological insight into the emotions, motivations, ideas, judgments of value, and volitions of the individual named Caesar, Quintus can have case knowledge: That is, as Mises defined it, knowledge of, with regard to a particular event (the crossing or noncrossing of the Rubicon), some of the factors which determine its outcome. Placing a bet based on case probability is Mises's definition of a bet.[12]
The specific understanding, as well as the thymological knowledge which it produces,
is applied by everybody in daily intercourse with all his fellows. It is a technique employed in all interhuman relations. It is practiced by children in the nursery and kindergarten, by businessmen in trade, by politicians and statesmen in affairs of state. All are eager to get information about other people's valuations and plans and to appraise them correctly.[13]
Thymology is the insight that people refer to when they speak of a biographer's insight into the "psychology" of his subject or an advertiser's insight into the "psychology" of the potential consumers of his product. However, to avoid confusion, Mises used the term "thymology" instead of "psychology" because the latter term had already, by his time, come to be associated with naturalistic disciplines like psychopathology and neuropathology, which deal with physiological states and outward behaviors, but not the "inner life" of ideas and values.
It must be understood that the specific understanding is not some kind of magical inspiration. In producing thymological knowledge, the specific understanding does depend on experience — just not on controlled experiments or quantitative data.
Thymology is on the one hand an offshoot of introspection and on the other a precipitate of historical experience. It is what everybody learns from intercourse with his fellows. It is what a man knows about the way in which people value different conditions, about their wishes and desires and their plans to realize these wishes and desires.[14]
For example, for Quintus to understand anything about Caesar, or anybody else, requires some introspection. Our direct experience of our own emotions, ideas, values, and volitions is the root of our understanding of what it means to have emotions, ideas, values, and volitions in the first place. Furthermore, through introspection, we can empathize with, and thus better understand, the mental states of other individuals. But introspection by itself is not enough. Understanding also requires experience. This experience can be personal conversation with Caesar himself, or it can be hearing from others about the character and actions of Caesar.
Maybe Quintus judges based on these sources that Caesar has longed to be a dictator, either out of lust for power or a desire to reconstitute the republic. And maybe he judges that if Caesar does not cross the Rubicon, and instead relinquishes control of his army, that he will never be able to enter Rome again without being prosecuted. And perhaps Quintus judges that Caesar himself is fully aware of that. These factors may contribute toward the likelihood of Caesar crossing the Rubicon.
But then there may be counterfactors. Quintus may expect Caesar to abhor the prospect of the bloodletting among his fellow Romans that would ensue in a civil war, and to be concerned particularly for his loved ones.
There may be dozens of such factors that Quintus may think will weigh on Caesar's mind in making the decision. Quintus must try to estimate as best as possible, using his own judgments concerning the importance of each factor for Caesar, which factors will ultimately hold sway.
As illustrated above, the specific understanding has two tasks in constructing thymological knowledge for use in forecasting human choice:
It must establish the factors (goals, judgments of value, ideas, etc) that may influence the choice.
It must establish the relative importance of each factor.
But of course this is all necessarily educated guesswork. Quintus may be wrong about what factors exist, or (and this is the trickiest issue) about the importance of each factor, or both.
Understanding is always based on incomplete knowledge. We may believe we know the motives of the acting men, the ends they are aiming at, and the means they plan to apply for the attainment of these ends. We have a definite opinion with regard to the effects to be expected from the operation of these factors. But this knowledge is defective. We cannot exclude beforehand the possibility that we have erred in the appraisal of their influence or have failed to take into consideration some factors whose interference we did not foresee at all, or not in a correct way.[15]
$40 $20
For this reason, the operation of the specific understanding always deals with probabilities, and not certainties.
Thymology … can never predict in the way the natural sciences can. It can never know in advance with what weight the various factors will be operative in a definite future event.[16]
Because choice factors and their relative importance are unquantifiable, the probability dealt with by the specific understanding (case probability) is also necessarily unquantifiable, and therefore it can have nothing to do with quantitative frequency.
The term "probability" in philosophical discourse used to include such nonquantitative uncertainties, but, according to the quantophrenetic[17] trend of modern thought, the term now often is given an exclusively mathematical connotation. Due to this, Mises also suggested referring to "case probability" as a "likelihood" instead, if that helps avoid confusion.[18]
In dealing with case probability, people may speak of one human event having a "greater" or "lesser" likelihood of occurring than another human event. But just as there is no way of measuring how much "greater" is one's valuation of apples over oranges,[19] there is no way of even crudely measuring such "differences" in likelihood.
Also, in dealing with uncertainty in human affairs, people may verbally assign quantitative probabilities to their judgments of likelihood. But this does not mean class probability has any bearing on human affairs. Mises gives the example of someone, on the eve of the 1944 US presidential election saying that they estimate the chances of Franklin Roosevelt winning to be 9 to 1.
This is a proposition about the expected outcome couched in arithmetical terms. It certainly does not mean that, out of ten cases of the same type, nine are favorable for Roosevelt and one unfavorable. It cannot have any reference to class probability. But what else can it mean?
It is a metaphorical expression. Most of the metaphors used in daily speech imaginatively identify an abstract object with another object that can be apprehended directly by the senses. This is not a necessary feature of metaphorical language, but merely a consequence of the fact that the concrete is as a rule more familiar to us than the abstract. As metaphors aim at an explanation of something that is less well known by comparing it with something better known, they consist for the most part in identifying something abstract with a better-known concrete. The specific mark of our case is that it is an attempt to elucidate a complicated state of affairs by resorting to an analogy borrowed from a branch of higher mathematics, the calculus of probability. As it happens, this mathematical discipline is more popular than the analysis of the epistemological nature of understanding.
There is no use in applying the yardstick of logic to a critique of metaphorical language. Analogies and metaphors are always defective and logically unsatisfactory. It is usual to search for the underlying tertium comparationis. But even this is not permissible with regard to the metaphor we are dealing with, for the comparison is based on a conception that is in itself faulty in the very frame of the calculus of probability, namely the gambler's fallacy. In asserting that Roosevelt's chances are 9:1, the idea is that Roosevelt is in regard to the impending election in the position of a man who owns 90 percent of all tickets of a lottery in regard to the first prize. It is implied that this ratio 9:1 tells us something substantial about the outcome of the unique case in which we are interested. There is no need to repeat that this is a mistaken idea.[20]
Ideal TypesThere are other sources besides personal experience with, and hearsay about, Caesar that Quintus could draw from to try to forecast his choice. Quintus could also draw from his experience with human nature, Roman civilization, patrician culture, or, "the military man."
Now, this may seem to run contrary to what was said above about the irrelevance of class concepts with regard to understanding and predicting human action. However, such terms are not "class concepts," but instead they are what Mises called "ideal types."
Mises distinguished the ideal types used in contemplating human action from the class concepts used in contemplating natural phenomena.
The natural sciences classify the things of the external world according to their reaction to stimuli. Since copper is something that reacts in a definite way, the name copper is denied to a thing that reacts in a different way. In establishing the fact that a thing is copper, we make a forecast about its future behavior. What is copper cannot be iron or oxygen.[21]
Individual humans, on the other hand, do not react in definite, fixed ways to given stimuli, and so men, ideas, customs, institutions, and artifacts cannot be classified according to stimulus reaction. Instead, they can only be grouped according to human meaning.
Some human things can be grouped according to human meaning into rigidly definable class concepts. Mises calls such class concepts in human affairs "real types."
In acting-in their daily routine, as well as in technology and therapeutics, and also in history-people employ "real types," that is, class concepts distinguishing people or institutions according to neatly definable traits. Such classification can be based on concepts of praxeology and economics, of jurisprudence, of technology, and of the natural sciences. It may refer to Italians, for example, either as the inhabitants of a definite area, or as people endowed with a special legal characteristic, viz., Italian nationality, or as a definite linguistic group. This kind of classification is independent of specific understanding. It points toward something that is common to all members of the class.[22]
But as discussed above, class concepts constructed concerning human affairs (real types) are useless with regard to dealing with uncertainty in human affairs.
Ideal types are distinct from real types in that
The characteristic mark of an "ideal type," on the other hand, is that it implies some proposition concerning valuing and acting. If an ideal type refers to people, it implies that in some respect these men are valuing and acting in a uniform or similar way. When it refers to institutions, it implies that these institutions are products of uniform or similar ways of valuing and acting or that they influence valuing and acting in a uniform or similar way.[23]
Ways in which people concretely value and act are often noticeably similar, but their marks of similarity are not such that they can be abstracted in order to construct neatly definable class concepts (real types). The specific understanding, however, can perceive such resemblances and make judgments concerning their importance. Based on such perceptions and judgments, the specific understanding can recognize affinity between various instances in human affairs, and construct an enumeration of connected traits based on this "meaning affinity." Such a construction is an "ideal type."
An ideal type is not a class concept, because its description does not indicate the marks whose presence definitely and unambiguously determines class membership. An ideal type cannot be defined: it must be characterized by an enumeration of those features whose presence by and large decides whether in a concrete instance we are or are not faced with a specimen belonging to the ideal type in question. It is peculiar to the ideal type that not all its characteristics need to be present in any one example. Whether or not the absence of some characteristics prevents the inclusion of a concrete specimen in the ideal type in question depends on a relevance judgment by understanding. The ideal type itself is an outcome of an understanding of the motives, ideas, and aims of the acting individuals and of the means they apply.[24]
For example Quintus may consider Caesar to possibly be a "demagogue/striver" — an ideal type constructed in his mind characterized by these traits:
Love of powerLove of prestigeHigh self-esteemRestlessnessDaringOpportunismUnscrupulousnessAbility to sway the masses (rank-and-file soldiers as well as city mobs)Quintus may have constructed this ideal type in his mind when reading about Pisistratus, an ancient Greek who never ceased his dramatic machinations until he was tyrant of Athens.[25] He may see much of the character of Pisistratus and other Greek tyrants in the character of Caesar. Again, "demagogue/striver" is not a class concept with a rigid definition. Quintus may even consider some of the enumerated traits to be wholly inapplicable to Caesar. For example, Quintus may consider Caesar not to be unscrupulous, unlike Pisistratus. But he may consider Caesar to fit the type well enough for it to be applicable to him.
Also, Quintus may not be able to judge from personal experience or hearsay whether some of the enumerated traits apply to Caesar or not: for example, whether Caesar is personally daring. But he may infer from how Caesar fits the type in other regards that he likely fits the type in that regard as well.
What thymology achieves is the elaboration of a catalogue of human traits. It can moreover establish the fact that certain traits appeared in the past as a rule in connection with certain other traits.[26]
This may seem like a prejudicial simplification on the part of Quintus, and it is. But such simplifications are pragmatic necessities in our daily task of carving meaning out of the bewildering profusion of data in human affairs.
In referring to ideal types the historian of the past as well as the historian of the future, i.e., acting man, must never forget that there is a fundamental difference between the reactions of the objects of the natural sciences and those of men. Ideal types are expedients to simplify the treatment of the puzzling multiplicity and variety of human affairs. In employing them one must always be aware of the deficiencies of any kind of simplification.[27]
According to Mises, ideal types, unlike class concepts (including real types), can be used to forecast the future in human affairs.[28] How can this be? Well, the use of an ideal type may help us infer a trait that we could not discover through personal experience or hearsay. For example, as discussed above, the use of the ideal type "demagogue/striver" may lead Quintus to conclude that Caesar was a daring person. And considering Caesar to be a daring person might lead Quintus to expect the former to cross the Rubicon.
It must always be noted that ideal types are highly tentative tools for the highly tentative sciences of history and human forecasting, and that the usefulness of an ideal type depends on the insight and judgment used in formulating and applying it.
The service a definite ideal type renders to the acting man in his endeavors to anticipate future events and to the historian in his analysis of the past is dependent on the specific understanding that led to its construction. To question the usefulness of an ideal type for explaining a definite problem, one must criticize the mode of understanding involved.[29]
More on Class Probability and Case ProbabilityIt is not only bet-placers who deal with case probability. Everybody does in dealing with his fellow man. For example, Pompey himself was most likely vitally concerned with whether Caesar would cross the Rubicon or not, and thus would have had to use his imperfect specific understanding to try to glean incomplete thymological knowledge from introspection and experience about Caesar's ideas and aims in order to prepare as best he could.
And it is not only forecasters that deal with case probability. Historians do too. A historian may be virtually certain, based on documentary evidence, that Caesar did indeed cross the Rubicon. But to glean why he crossed the Rubicon, the historian must use his specific understanding to try to glean from introspection and experience (including experience with the documentary evidence) thymological knowledge about Caesar's desires and beliefs in order to judge what motivated him. Of course, such conclusions can only ever be probabilities, and never certainties. And, as with anticipations of future human action, such probabilities can have nothing to do with quantitative frequency.
Economics is immensely concerned with one kind of forecaster of human action in particular: the entrepreneur. The entrepreneur tries to forecast the patterns in which future consumers will buy and abstain from buying (consumer demand). Based on these uncertain forecasts, he seeks to buy and sell on the market so as to attain profits and avoid losses.
The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers.[30]
This kind of speculation too is a matter of case probability. The entrepreneur must use his specific understanding to glean thymological knowledge about the desires and values of consumers. Again, such conclusions can only ever be probabilities, and never certainties. And, again, such probabilities can have nothing to do with quantitative frequency.
However, not all incomplete knowledge in business affairs is a matter of case probability. Mises characterizes the vicissitudes of inventory management as a matter of class probability.
Every businessman includes in his normal cost accounting the compensation for losses which regularly occur in the conduct of affairs. "Regularly" means in this context: The amount of these losses is known as far as the whole class of the various items is concerned. The fruit dealer may know, for instance, that one of every fifty apples will rot in this stock; but he does not know to which individual apple this will happen. He deals with such losses as with any other item in the bill of costs.[31]
Uncertainty in the realm of human action (case probability) is, by definition, in the province of the entrepreneurial function. Uncertainty in the realm of natural events (class probability) is not.
One must not confuse entrepreneurial profit and loss with other factors affecting the entrepreneur's proceeds.
The fact that the bursting of bottles reduces the output of champagne does not affect entrepreneurial profit and loss. It is merely one of the factors determining the cost of production and the price of champagne.
Accidents affecting the process of production, the means of production, or the products while they are still in the hands of the entrepreneur are an item in the bill of production costs. Experience, which conveys to the businessman all other technological knowledge, provides him also with information about the average reduction in the quantity of physical output which such accidents are likely to bring about. By opening contingency reserves, he converts their effects into regular costs of production. With regard to contingencies the expected incidence of which is too rare and too irregular to be dealt with in this way by individual firms of normal size, concerted action on the part of sufficiently large groups of firms take care of the matter. The individual firms cooperate under the principle of insurance against damage caused by fire, flood, or other similar contingencies. Then an insurance premium is substituted for an appropriation to a contingency reserve. At any rate, the risks incurred by accidents do not introduce uncertainty into the conduct of the technological processes. If an entrepreneur neglects to deal with them duly, he gives proof of his technical insufficiency. The losses thus incurred are to be debited to bad techniques applied, not to his entrepreneurial function.[32]
Implicit in the above are these conclusions:
Insofar as the businessman is dealing with forecasts of consumer choices (which are human events, and therefore are a matter of case probability) he is an entrepreneur, and those parts of his net returns that are dependent on the success of such forecasts are his profit/loss.
Insofar as the businessman is dealing with forecasts of natural events (which are a matter of class probability), he is a technician (a kind of laborer), and those parts of his net returns that are dependent on the success of such forecasts are wages.
The businessmen confronting class probability with regard to rotting apples and bursting bottles brings up another important point: class probability does not require the certainty and precision concerning frequency that you find in the case of a lottery or a dice throw. The apple businessman above may not know with certainty that exactly one of every fifty apples will certainly rot. But because the rotting of apples is a process of nature, in which universal regularity does prevail, class concepts can provide relevant knowledge concerning frequency, even if technical knowledge of the natural phenomenon in question is not yet sufficient for perfect knowledge concerning frequency to be had. For this reason, the margins of error of the engineer and the prognoses of the physician are also matters of class probability, as are even the rough judgments laymen make every day: for example, a fellow judging the chance of rain, and whether he should bring his umbrella, based on nothing but eyeballing the sky. Class probability forecasts concerning natural events,
are based either on statistical information or simply on the rough estimate of the frequency derived from nonstatistical experience.[33]
As Donald Rumsfeld might put it, class probability is not only a matter of "known unknowns," but also a matter of "unknown unknowns."
Of course, human actions and natural phenomena both occur in the same universe, and affect each other. So acting men often have to deal with both class probability and case probability concerning the same choice, as Mises points out:
The outcome of horse racing depends both on human action — on the part of the owner of the horse, the trainer, and the jockey — and on nonhuman factors — the qualities of the horse. Most of those risking money on the turf are simply gamblers. But the experts believe they know something by understanding the people involved; as far as this factor influences their decision they are betters.[34]
And, again, gambling is a matter of class probability and betting is a matter of case probability.
Furthermore, as discussed above, business forecasting can involve both class probability (as in the case of forecasting inventory vicissitudes) and case probability (as in the case of forecasting consumer demand). And sometimes a single business decision may depend on both kinds of forecasts. For example, in deciding how much to invest in the rice market, an investor may try to forecast the natural events that affect the rice market (future rainfall, etc.) as well as human factors (consumer tastes, institutional factors such as tariffs, etc.).
Nonetheless, in all such cases, the natural factors can only be dealt with successfully by the human mind as matters of class probability. And the human factors can only be dealt with successfully as matters of case probability. The ultimate choice may be a simple "do" or "do not," but the deliberation leading up to the choice may be a composite of different modes of reasoning.
ConclusionClass probability and case probability are similar in that they both deal with incomplete knowledge. In all other regards, they are worlds apart, and thus require different approaches ("methodological dualism"). Until mainstream scholars take such differences seriously, and give due regard to the distinct methodological challenges of the sciences of human action, they will always be at best, stymied, or at worst, lost.
Businessmen too would benefit by paying due regard to such distinctions. By dealing only in class "patterns" and ignoring the specific characteristics of
the "individual companies and their performance, management and competitors" within those classes,
the consumers those companies served,
and the institutional factors which constrained those companies,
$20 $16
the Wall Street quants completely abjured case probability, the specific understanding, and thymology. And entrepreneurship is at bottom all about the application of these tools, even if the entrepreneur himself is wholly ignorant of the distinct nature of the cognitive tools he is using, or of the Misesian terms for them.
But even now the enthusiasm for heavily class-probability-reliant approaches seems little abated among many investment strategists. For some, the lesson of the financial crisis is the need to prepare for low-frequency "black swan" market catastrophes with statistical "tail-risk hedging."[35] Again, the proof in the market pudding is in the eating of profit and loss, so the SEC has no business sticking its nose in the matter. But buyer beware of class-probability gamblers posing as case-probability entrepreneurs.
Notes[1] Scott Patterson, "The Minds Behind the Meltdown" The Wall Street Journal, January 22, 2010.
[2] Ibid.
[3] See Ersan Bocutoglu and Aykut Ekinci, "Austrian Business Cycle Theory and Global Crisis."
[4] For more on this point, see Robert P. Murphy, "Anne Hathaway and Automatic Trading."
[5] Ludwig von Mises, Human Action (HA), Chapter 6, Section 2.
[6] HA, Chapter 6, Section 3.
[7] HA, Chapter 6, Section 4.
[8] HA, Chapter 6, Section 6.
[9] Ludwig von Mises, Theory and History (TH), Introduction.
[10] HA, Chapter 6, Section 4.
[11] By Mises's time, the concept of verstehen already had a long tradition in German epistemology.
[12] HA, Chapter 6, Section 6.
[13] TH, Chapter 12.
[14] Ibid.
[15] HA, Chapter 6, Section 4.
[16] TH, Chapter 12.
[17] Inappropriately relying on statistics and mathematical results for their own sake.
[18] TH, Chapter 14.
[19] Robert P. Murphy, Subjective Value and Market Prices
[20] Mises, HA, Ch. 6, Sec. 5.
[21] Ibid.
[22] Ibid.
[23] Ibid.
[24] HA, Chapter 2, Section 9.
[25] According to Herodotus (The Histories, Book 1), Pisistratus even went so far as ride into Athens in a golden chariot, accompanied by an unusually tall woman impersonating the goddess Athena, so that the Athenians would believe she favored him.
[26] TH, Chapter 12.
[27] TH, Chapter 14.
[28] Ibid. "Ideal types are constructed and employed on the basis of a definite mode of understanding the course of events, whether in order to forecast the future or to analyze the past."
[29] Ibid.
[30] HA, Chapter 15, Section 8.
[31] HA, Chapter 6, Section 3.
[32] HA, Chapter 15, Section 8.
[33] HA, Chapter 6, Section 4.
[34] HA, Chapter 6, Section 6.
[35] "Fat-tail Attraction," The Economist, March 24, 2011.
A major piece of financial news last week was billionaire Raj Rajaratnam's conviction on 14 counts of securities fraud and conspiracy. Rajaratnam, founder of the hedge fund Galleon Group, was worth an estimated $1.8 billion in 2009. His conviction has pleased those who want the feds to crack down on "insider trading" and show the fat cats on Wall Street that they aren't above the rules.Although the public generally loves the fall of a ruthless and greedy financial titan — this, of course, is what made Oliver Stone's original Wall Street such a hit — economists have argued for decades that the practice of "insider trading" can actually be beneficial. In practice, the government can use the amorphous "crime" to go after any successful trader it wants. In a free society, there would be no such thing as laws against so-called insider trading.
The Facts of the CaseTo argue that "insider trading" is a bogus offense, and that laws against it only give the government the power to interfere with economically beneficial activity, is not to suggest that Rajaratnam was an innocent babe in the woods. Indeed, some of the episodes being used to shock the general public would probably also be criminal in a genuinely free market.
For example, in 2008, Rajat Gupta, a board member at Goldman Sachs, apparently told Rajaratnam that Warren Buffet was about to invest $5 billion in Goldman. Rajaratnam bought millions of dollars worth of the stock before the market closed, and then he profited handsomely when the news broke and the stock jumped the next day. Later in the year, after a board meeting, Gupta apparently told Rajaratnam that Goldman would report earnings well below expectations. Rajaratnam dumped the stock, getting out before the earnings news became public and pushed down Goldman's share price.
Now this type of activity — let alone the breaking and entering that Charlie Sheen's character performed for Gordon Gekko in the movie Wall Street — would probably be criminal even in a purely laissez-faire world. Specifically, when the shareholders of a corporation appointed board members, they would presumably have standard confidentiality clauses in the contracts prohibiting this type of behavior. The same thing would hold for a law firm; it's not good business if clients know that their lawyers can phone tips to their buddies on Wall Street while working on a sensitive case, and so a major law firm would insist that its employees sign contracts prohibiting such things.
We Want People Trading on Unique KnowledgeTo understand the social benefits of insider trading, we have to first realize that stock prices mean something. They reflect real facts about the world, such as the assets and liabilities of a particular corporation and how effectively its current management is using resources to satisfy customers.
If a computer glitch suddenly swapped the prices randomly on all corporate stocks, the result would be disastrous, and it would affect "Main Street" as much as Wall Street. For an exaggerated example, if the share price of Microsoft fell from its current level of around $25 down to $1, a "corporate raider" might find it very profitable to borrow money, buy a controlling share in the company, and sell off all company assets to the highest bidders. The high price of $25 per share fends off such efforts to break up the successful company. The assets currently owned by the Microsoft Corporation are best deployed by Microsoft, rather than being integrated into different organizations around the world.In general, speculators perform a useful social service when they are profitable. By buying low and selling high (or by short-selling high and covering low), stock speculators actually speed up price adjustments and make stock prices less volatile than they otherwise would be.
In this context, we can see the absurdity of the general view of "insider trading." There is a whole literature on the economic analysis of the subject, and economist Alex Padilla's 2003 dissertation defended the practice from a specifically Austrian angle. In a nutshell, insider trading is beneficial because it moves market prices closer to where they ought to be. Those profiting from "inside knowledge" actually share that knowledge with the rest of the world through their buying and selling.
Insider Trading: Who Is the Victim?Above, we acknowledged the fact that obtaining information in illegal ways obviously had actual victims. But the mystique behind "insider trading" suggests that somehow if a person financially profits from special knowledge, that he or she is bilking the general public.
In general, this analysis doesn't hold up, as Murray Rothbard has pointed out. For example, suppose a Wall Street trader is at the bar and overhears an executive on his cell phone discussing some good news for the Acme Corporation. The trader then rushes to buy 1,000 shares of the stock, which is currently selling for $10. When the news becomes public, the stock jumps to $15, and the trader closes out his position for a handsome gain of $5,000. Who is the supposed victim in all of this? From whom was this $5,000 profit taken?
"In a free society, there would be no such thing as laws against so-called insider trading."The $5,000 wasn't taken from the people who sold the shares to the trader. They were trying to sell anyway, and would have sold it to somebody else had the trader not entered the market. In fact, by snatching the 1,000 shares at the current price of $10, the trader's demand may have held the price higher than it otherwise would have been. In other words, had the trader not entered the market, the people trying to sell 1,000 shares may have had to settle for, say, $9.75 per share rather than the $10.00 they actually received. So we see that the people dumping their stock either were not hurt or actually benefited from the action of the trader.
The people who held the stock beforehand, and retained it throughout the trader's speculative activities, were not directly affected either. Once the news became public, the stock went to its new level. Their wealth wasn't influenced by the inside trader.
In fact, the only people who demonstrably lost out were those who were trying to buy shares of the stock just when the trader did so, before the news became public. By entering the market and acquiring 1,000 shares (temporarily), the trader either reduced the number of Acme shares other potential buyers acquired, or he forced them to pay a higher price than they otherwise would have. When the news then hit and the share prices jumped, this meant that this select group (who also acquired new shares of Acme in the short interval in question) made less total profit than they otherwise would have.
Once we cast things in this light, it's not so obvious that our trader has committed a horrible deed. He didn't bilk "the public"; he merely used his superior knowledge to wrest some of the potential gains that otherwise would have accrued as dumb luck to a small group of other investors.
To repeat, stock-market speculation is not a zero-sum activity. Even though we can look at any particular transaction and tally up the "winners" and "losers," the presence of speculators enhances the overall functioning of the stock market. For example, the market for any particular security is more liquid when there are rich speculators who will quickly pounce on a perceived mistake in pricing. If an institutional investor (such as a firm managing pensions) suddenly has a cash crunch and needs to dump its holdings, speculators will swoop in and put a floor under the fire-sale price. This is good for the beleaguered pension fund, and for the stock market in general.
Laws against Insider Trading Give the Government Arbitrary PowerCrackdowns on insider trading are harmful because they chill the cultivation of superior knowledge and speculative correction of market prices. Beyond this loss of general economic efficiency, insider-trading laws are insidious because of the arbitrary power they give to government officials.
In the specific case of Rajaratnam, prosecutors for the first time relied extensively on wiretaps to prove their allegations of insider trading. Legal experts predict that the government will expand its eavesdropping on the financial community in light of this courtroom "success."
More generally, Murray Rothbard argued that every firm on Wall Street is technically engaging in "insider trading." If they literally relied only on information that was available to the public, how could they make any money? Thus, the government has the statutory authority to harass or even shut down anybody in the financial sector who doesn't play ball. In Making Economic Sense, Rothbard declared,There is another critical aspect to the current Reign of Terror over Wall Street. Freedom of speech, and the right of privacy, particularly cherished possessions of man, have disappeared. Wall Streeters are literally afraid to talk to one another, because muttering over a martini that "Hey, Jim, it looks like XYZ will merge," or even, "Arbus is coming out soon with a hot new product," might well mean indictment, heavy fines, and jail terms. And where are the intrepid guardians of the First Amendment in all this?
But of course, it is literally impossible to stamp out insider trading, or Wall Streeters talking to another, just as even the Soviet Union, with all its awesome powers of enforcement, has been unable to stamp out dissent or "black (free) market" currency trading. But what the outlawry of insider trading (or of "currency smuggling," the latest investment banker offense to be indicted) does is to give the federal government a hunting license to go after any person or firm who may be out of power in the financial-political struggles among our power elites. (Just as outlawing food would give a hunting license to get after people out of power who are caught eating.) It is surely no accident that the indictments have been centered in groups of investment bankers who are now out of power.
To drive home just how arbitrary and non-criminal "insider trading" really is, consider this scenario: Suppose someone had been planning on buying shares of Acme, but just before doing so, he caught wind of a bad earnings report. In light of the new information (which was not yet public), the person refrained from his intended purchase. Should this person be prosecuted for insider non-trading?
ConclusionRaj Rajaratnam and (even more likely) some of his collaborators may indeed have violated genuine contractual obligations and fiduciary duties to their clients. To the extent that is true, some of their activity might have been illegal even in a truly free-market society.
In general, however, the practice of "insider trading" would not be a criminal offense, because it is impossible to define the concept in a way that wouldn't bar legitimate speculative research and trading. In practice, these laws give the government a very blunt club with which to knock down any profitable firm it wishes.
A recent discussion regarding commodity prices on CNBC consisted virtually of sentence-by-sentence errors with respect to macroeconomic theory. Most of the misstatements involve either accidentally or intentionally — I don't know which — attributing economic and financial market events to various incorrect or misleading cause-and-effect scenarios, when the real explanation is simply the government's creation of money and credit.
Regrettably, these errors are not restricted to the CNBC commentators and guests in the segment in question, but in fact are characteristic of economic misunderstanding generally. Therefore, I offer the following as a step-by-step clarification of these issues, so that readers can gain a clearer understanding of both the truth and the misconceptions.
Will the Fed Raise Rates?The discussion began with CNBC's in-house economist Steve Liesman discussing whether the Fed should raise rates in response to reports of soaring wholesale inflation numbers. He explains that the Fed "has so far concluded that it would be the wrong medicine right now for the problem."
That alone brings us the first concern: It is difficult to imagine that the Fed has actively decided not to raise rates, when the fact is that — as things stand — it could not raise rates even if it wanted to (and it might want to). It can raise treasury rates by ceasing to buy treasuries, but it can't raise the federal-funds rate.
The Fed raises the federal-funds rate via open-market operations that withdraw money from the federal-funds market, making money more expensive. But given the massive amount of excess reserves that the banks hold at the Fed, it is virtually impossible for the Fed to withdraw all the reserves it has created without causing massive economic damage. Therefore, it is the excess money on the market that is keeping rates near zero. Thus, the banks — not the Fed — are in charge of interest rates. As the Economist stated:
The Fed could announce a federal funds target of 3% but the tsunami of excess reserves now out there swamps any conceivable demand, so the Fed funds rate would be guaranteed to remain stuck at zero. The target would be meaningless.[1]
It is because the Fed can't raise rates due to the excess reserves (along with the much-discussed concern that all those excess reserves will lead to inflation) that the notion of the Fed having "painted itself into a corner" in terms of trying to "unwind" all of the positions it took from failed Wall Street firms is so widespread.
Now, it would be possible for the Fed to raise the federal-funds rate by way of paying the banks significantly higher rates on their reserves than the current 0.25 percent. But such an action would cause banks to cease lending to the public, which would create a recession. Therefore, the Fed cannot raise rates without causing a recession.
Why the Fed Is Leaving Rates AloneNonetheless, Liesman explained the reasons the Fed has decided to leave rates unchanged. He first noted that the argument some put forth is that the Fed should raise interest rates in order to cool rapidly rising commodities prices that are leading to wholesale price inflation. But he then said that the Fed has stated it is not going to react to commodity prices, because those price increases are coming from economic growth in emerging markets, not from the Fed. (And, of course, the Fed is not going to publicly admit that due to its recent attempts to address the problems of its own prior actions, it can do nothing about rising prices now.)
What's wrong with this argument is the idea that commodities prices or inflation can arise from strong economic growth. What the Fed is referring to regarding emerging markets growth is the Keynesian notion that after a period of strong economic growth, inflation can arise from too much demand chasing too few goods. This "too much demand" is usually said to be caused by workers/consumers via increased spending resulting from increased employment. In this way, more employment would cause inflation. This increased employment and spending that leads to prices rising faster than goods is what Keynesians call demand-pull inflation. They admit that inflation causes prices to rise — though they claim that many, many other factors do as well — but only when the economy is operating at full capacity.
The main problem with this theory is that Keynesians claim that additional demand comes from additional production and employment instead of from the central bank. "Demand" consists of the desire plus the ability to purchase something. People can only demand and purchase something by paying for it. They pay for it by exchanging other goods that have been produced; money is simply the medium of exchange. Thus, production is the source of true demand. But when the medium of exchange — money — is increased, the price of the product being purchased will rise. Such a rise is not an increase in real demand; it is an increase in the prices of products being produced. Real demand can increase only by way of an increase in production, which in fact lowers prices.[2] In reality, the increased demand that the Keynesians refer to (but do not name) is increased monetary demand, not real demand. Increased monetary demand comes only from an increase in the quantity of money pushing up prices.
It is quite incorrect to argue that producing more goods will result in prices rising instead of falling. It is also incorrect to say that an economy can overheat as a consequence of (real) demand exceeding supply, since increased real demand comes from increased production, which itself results in a greater supply. An increase in demand — which is in fact an increase in supply — cannot cause prices to rise. Prices can rise only if the monetary unit is being devalued as more money is being added to the economy. Thus, the only thing "overheating" is the government's printing presses.
A Closer Look at Emerging-Markets Growth and CommoditiesTherefore, by definition, if emerging markets are truly growing quickly, they are creating new goods and services at a very fast rate; they are producing more commodities and other goods. Their demand for purchasing commodities is being enabled (i.e., paid for) by those other recently produced goods that are given in exchange for commodities, and whose creation lowers both domestic and international prices. And if the United States (and other Western economies) were truly growing as well, it, too, would be producing more goods, causing prices to decline. All of this increased production would cause all goods — including commodities — to fall in price, not to rise.
Indeed, unlikely as it is, there could — theoretically — just happen to occur simultaneously a slower supply growth rate of all of the hundreds of commodities produced in the world relative to the hundreds of thousands of other goods produced in the world, causing all of the various commodities to rise in value relative to other goods. But in the absence of more money being created, an increasing monetary demand for and an increasing price of commodities would be offset by a corresponding decrease in the monetary demand for and prices of other goods. Additionally, as the price of commodities rose, demand would fall.
But the demand for commodities and the prices of other goods have not been falling. Why? Because what is driving up commodity prices — while the prices of all other goods are rising at the same time — is simply an increase in the quantity of money. Market participants are bidding up the price of commodities, along with consumer goods and stock and bond prices (and, formerly, real-estate prices) with the additional money they are receiving from the central bank.
Rising asset prices are the manifestation of inflation. The prices of financial instruments and commodities are rising more rapidly than consumer prices because they are traded on exchanges, where banks, insurance companies, hedge funds, and the like insert funds newly borrowed at cheap rates from the world's central banks. Further, foreign central banks themselves redirect reserves earned from the US trade deficit into the financial markets. Therefore, new money flows disproportionately into the asset markets relative to the real economy.
For Federal Reserve officials to claim that the large amount of new money they have created in the last few years is not contributing to pushing up the price of commodities markets, and to (implicitly) assume that all of that money has instead flowed everywhere else in the economy except to commodities markets is indefensible. (And even if they were correct, the fact that other prices besides commodities are rising shows that the Fed must be responsible for those price rises).
But let's even say that they're right. In that scenario, because neither the money the Fed is creating nor emerging markets growth is responsible for pushing up commodity prices, then it must be new money being created in emerging markets or developed markets outside of the US that is responsible for rising commodity prices (but not for aggregate American prices).
But even in this case, the Fed still plays an indirect role. This is so because many countries in the world create new money only as a means to keep their currency in line with, or lower than, the US dollar, in order to support their mercantilist trade policies; when the Fed expands the money supply, lowering the value of the dollar, foreign central banks create money to respond to this event (by way of creating new local currency to match the excess dollars they receive through trade surpluses they have with the US). But what's certain is that either some or all of the central banks are the only entities responsible for rising commodity prices (but only the Federal Reserve can be responsible for aggregate American prices).
Transmission MechanismsIt is important to point out that the mechanism of transmission of monetary policy to the economy or financial markets discussed by mainstream economists concerns the interest-rate effect, not the money-supply effect. Most economists hold that lower interest rates spur economic activity by way of lower borrowing costs, which bring about additional investment spending and in turn consumer spending.
This additional production and consumer spending causes increased "demand" that stimulates the economy — sometimes to the point of inflation, as we saw above. But also as noted above, "demand" is usually implicitly seen to be some amorphous type of "strong economic activity"; the money-supply component of this monetary policy is rarely made explicit.
While lower interest rates indeed cause businesses to borrow and invest more, what is usually being borrowed, invested, and spent is new money, not previously existing money. Interest rates are lowered by increasing the money supply. It is this new and additional money that causes increased corporate revenues and profits, GDP, and asset prices. It is the new and additional money that is the sole cause of rising prices of any kind, anywhere (given that most other prices are rising simultaneously).
Similarly, it is usually said that the lower dollar causes commodities prices to rise because, since commodities are priced in dollars, as the dollar falls, commodities become cheaper in foreign-currency terms. Thus, demand, and therefore, prices, increase. This much is true. But rarely mentioned is the other side of this effect, which is the "money effect." The value of the dollar (of each dollar existing) falls because more dollars are created. It is those additional dollars that bid up commodity prices (new dollars flow disproportionately into commodities markets).
To the extent that the demand for dollar-priced commodities is from overseas (such as the commonly referred to "demand from China"), though the demand usually originates as real demand — i.e., production and real economic growth — the only "demand" that actually pushes up prices is additional monetary demand in the form of additional foreign currency being created overseas (which can be used to buy dollars with which to purchase commodities).
Wall Street Chimes InAnother discussant on the CNBC show was Milton Ezrati, senior economist and market strategist for Lord Abbett mutual funds. He agreed that the Fed has no control over commodity prices, and he said that raising rates might not be in accordance with the Fed's "long-term goals." Though he didn't say what those goals were, they are pretty clear: to keep an abundance of money flowing into the economy so that "demand" does not fall off and so that (artificial and contrived) employment does not fall; and to keep money flowing as well into the financial markets, so that there is the appearance of a "strong economy," because most people (falsely) believe that the financial markets rise because the economy is growing. Most importantly, the Fed's primary goal is to keep the money-supply growth positive, so that a monetary contraction will not take place and cause banks to become insolvent.
Ezrati is therefore correct in saying that changing monetary policy now could harm the Fed's "goals"; if the Fed slowed or reversed the rate of money pumping, both GDP and the financial markets would fall. Though it's not clear whether all economists understand the specific cause-and-effect relationships, the result would be a recession, unemployment, and bank and business losses. It would then be even harder to pump the economy back up again with artificial credit.
But, of course, Ezrati was incorrect in agreeing that the Fed has no control over commodities prices. Not only that, he went on to make another incorrect claim: he also mentioned that a major factor causing the dollar to fall is America's fiscal situation, which, he says, the Fed can't control. But this is completely sophistic. Without the Fed buying the government's bonds, the government could not have much of a fiscal deficit, since it would have to rely solely on taxes and real savings from individuals. But when the Fed purchases these bonds, it does so by creating money, which lowers the value of the dollar. The Fed is therefore the sole entity responsible for lowering the dollar.
Jim O'Sullivan, chief economist at MF Global, appeared on the program too. He said outright that it is too risky to raise rates because the bond and stock market might fall; he is thereby acknowledging that the Fed affects asset prices. Granted, he was likely thinking in terms of higher rates causing slower economic growth, resulting in less economic activity and thus lower asset prices (which supposedly reflect that activity). Still, even if he was not recognizing the more realistic transmission effect of more Fed-created money directly pushing up prices, his comments show that the Fed's policies affect asset prices — even if they don't (as I would argue) wholly drive them — in one way or another.
Curtailing the Rise in Commodities PricesLiesman then states that "some Fed officials suggest they could lower commodities prices only by tightening policy and reducing economic growth." For Fed officials to say that they can lower commodities prices by tightening policy is tantamount to contradicting their previous statement claiming that they are not driving commodities prices (unless it was different specific officials making each statement). The Fed officials are saying that if they raise interest rates and/or reduce money supply growth, the economy will slow. They are therefore saying that the economy is being driven — or at least pushed along — by low rates and by money and credit "being available" (as they would say). Therefore, the growing economy, in their view, causes a "demand" for commodities. They don't say that it is a monetary demand — just a general "demand."But they also acknowledge that if this demand were reduced with "monetary policy tools," demand for commodities would fall. Thus, they are simultaneously saying that their policies are not driving commodities prices higher, but that if they undo their policies, commodities prices will fall. The fact is that it is their money pumping that is driving both GDP growth and commodities prices — but not the real economy.
Falling Prices and WagesInterestingly, Liesman said that if the Fed did in fact tighten monetary policy and slow economic growth, that wages and prices would fall. In this case, he asserted, inflation-adjusted prices would not be changed at all. He said that "prices [would be] coming down, even though … wages are coming down too, and the actual affordability of the thing that's coming down hasn't changed … at all … so there's an asymmetry out there."
Now, if Liesman is referring to a sudden monetary-contraction-induced deflation that would come about from shutting off the money valves, he is right that prices and wages would both fall. But the way to prevent such a deflation is to not print money in the first place, as deflation of the money supply can come about only from having previously expanded the money supply. Additionally, falling prices and wages resulting from a contractionary deflation would be a temporary, not ongoing, occurrence.[3]
But if Liesman is — as appears to be the case — referring to falling prices that would come about from not expanding the money supply to begin with, he is dead wrong. Absent money printing, when prices fall, they fall due to an increase in the supply of goods. Wages, however, do not fall, because the supply of workers does not increase as the supply of goods increases.
Even if the number of workers did increase, the supply of goods would increase in proportion to the increased supply of workers (i.e., each new worker will produce additional goods). No matter how many workers are working, as their productivity increases, the supply of goods per worker increases. Thus, the prices of goods fall faster than the prices of labor. And if the labor supply does not increase, wages will never fall at all. In fact, this phenomenon of the prices of goods falling relative to the price of wages happens even when there is inflation of the money supply, because new money pushes up wages much faster than it pushes up the prices of goods, because goods are expanding faster than are people. That is how real wages rise whether prices are rising or falling.
So Liesman's idea that prices and wages would fall at the same pace fails to understand what an economy really is and how standards of living really improve. Further, it is insulting to say that people will be in the same shape in real terms, even if prices and wages do move together. This is because the mere act of printing money in order to make prices rise destroys savings, destroys capital, and therefore causes economic and financial crises. All of these things lower standards of living and make people worse off.
Consider just the savings effect of printing money. People have to save for their retirement because they have to have money to live on when they're no longer working. Their current savings will not support them in the future, so they must save more, especially because prices will be higher. Suppose that today it costs a 40-year-old $45,000 a year to live. With inflation of 3 percent per year, it will cost her over $94,000 a year to live when she retires at age 65. Thus, she must save heavily in order to have an amount of savings large enough to live off each year, and still have it grow for future years of retirement (say, into her 90s, given current life expectancies) at a rate faster than she is drawing down on it. A very high growth rate is needed, especially considering that she will be taxed on all her gains.
But consider an alternative scenario in which no money was printed, and that the rate of production increased at 3 percent per year. In this case, upon retirement, the living that used to cost the woman $45,000 would now cost just over $21,000. And by age 95, it would cost less than $8,500 per year — in real terms, and with nothing taxed! In that case, not only would workers not have to race against the inflation clock before and during retirement, but whatever savings they had would buy more each year.
So indeed, in today's world, because of the government's printing of money, even if wages keep up with inflation, people have to save more and consume less than they would otherwise, and once wages aren't earned anymore, most people usually begin falling behind immediately. Clearly, society would be in better shape with greater savings, a stronger economy, and with prices falling in both nominal and real terms on a monthly basis, as would be the case absent money creation and rising prices.
Nevertheless, Liesman goes on to express his outright surprise at Bank of Japan surveys that consistently show that people like falling prices more than rising prices (seriously, he was actually surprised). Even though this expert economist doesn't understand how people are any better off without credit expansion and inflation, actual people who face the consequences in their everyday lives do understand quite clearly.
Another problem with the statement regarding falling wages and prices is that, even if prices and wages did fall at the same rate, and even under monetary deflation, if there were no printing of money, commodities prices would fall at a much faster rate (because they have been rising at a much faster rate), causing people to more easily afford commodity-based products such as gasoline, food, and airline trips. In other words, in the absence of printing money, some prices would not, as now, rise so disproportionately faster than others; a better balance would be maintained.
For circumstantial proof that commodities prices would fall significantly if the Fed quit creating inflation, consider Figure 1, which shows the 2008 collapse in commodities prices — as measured by the Powershares DB Commodities Index — that resulted from the reduction in the rate of money-supply growth during 2005–07, and the subsequent reduction in credit growth and velocity of circulation (particularly in the financial markets) in 2007-08. As we all know, derivative prices, such as food and oil prices, also fell dramatically in 2008.
Figure 1The money-supply driven boom and bust of commodities prices during 2007–2008(Chart time frame is 2006–2011. Click to enlarge figure 1.)The Wage-Price-Spiral FallacyLiesman then states that one of the Fed's "tests" for inflation involves looking for a "wage-price spiral." The idea of the wage-price spiral — another construct of Keynesianism accepted by most economists and taught in virtually every economics program — is that workers demand higher prices in order to keep up with inflation, and that the higher wages in turn cause more inflation, prompting workers to once again push wages higher. Once this vicious circle process gets started, inflation can explode uncontrolled.
The fallaciousness of this argument once again brings us back to the quantity of money. Without additional money added to the economy, neither workers nor businesses could ever raise aggregate wages or prices for the reason that, given a fixed quantity of money, it is mathematically impossible for aggregate prices to rise. For a detailed proof of this, please refer to my last article (middle section).
As far as whether workers could raise individual prices, let's do a mental experiment. Consider an economy with $100 of demand, or, money and spending ("demand" and "spending" both consider velocity as well) with 100 workers that produce 100 units of goods. In this scenario, each worker is paid $1 and each good sells for $1.
Now suppose that workers somehow forced up wages by 33 percent, to the level of $1.33 per worker. With the same $100 of money and spending with which to pay salaries, only 75 people could be employed ($100 in spending for labor divided by $1.33 per worker = 75 people). Then, 75 people would receive $1.33 each. Every time workers forced wages higher, more workers would become unemployed.[4]
Similarly, suppose prices were somehow driven up 11 percent from $1.00 per unit to $1.11. The number of units sold would fall by 10 percent to 90 units sold ($100 in spending for goods divided by $1.11 per good = 90 goods sold). With production falling 10 percent, approximately 10 percent fewer workers would be needed, and unemployment would rise by 10 percent. Every time prices rose, the number of goods in the economy would decline, and more workers would be unemployed. Thus, workers would not keep driving up prices.
But in today's world, as wages and prices rise by the year at even a "slow" rate, unemployment levels do not rise, and the number of goods produced and sold does not fall. This is because the central bank is continually providing the economy with more money, so that wages can be bid higher without causing unemployment. When the increased dollar amount of wages is spent in the economy, resulting in increasing demand for goods, prices increase. Thus, if there is any semblance of a wage-price spiral, it is an artificial one caused by the Fed itself. So when the Fed says it is looking for a wage-price spiral, it is really looking for the results of its own money pumping in the form of price inflation. (And while it wants to restrain price inflation, it actively seeks and promotes asset-price inflation in the form of stocks and bonds.)
Another indicator that Liesman said the Federal Reserve uses to test for inflation is that of rising "inflation expectations." It is widely believed that the mere expectations of inflation can actually bring on inflation. For example, in a 2007 speech, Fed Chairman Ben Bernanke relayed that it's possible for "people [to] set prices and wages with reference to the rate of inflation they expect in the long run."[5]
Supposedly, according to this argument, workers expect inflation and, therefore, start demanding higher wages, or consumers begin paying higher prices for goods, even in the absence of businesses and consumers having received additional monetary purchasing power with which to bid up wages and prices. Thus, this unrealistic argument does not take into consideration that there would be no additional money in the economy with which to pay higher wages or higher consumer prices.
Indeed, there could be expectations of inflation, but expectations of future inflation are brought about only by the existence of previous inflation, or by observing that more money is being added to the economy, and knowing that the additional money will eventually raise prices. But the actual existence of inflation can come only from an increase in the quantity of money (and velocity, or the amount of times each dollar is spent, is driven mostly by the supply of money.)[6]
ConclusionThe CNBC program is an example of typical misunderstandings about macroeconomics. In order to understand the global economy correctly, one must have the correct economic lens through which to view it. While mainstream economists without a doubt are very bright people, they have learned — and they stick with — theories that cannot possibly be correct when thoroughly scrutinized.
Why do they not consider alternative explanations that explain and forecast their world better than their own theories? Depending on the case in question, they might not consider other theories due to one or more of the following reasons: they refuse to believe that they have incorrect theories, even if theirs don't often pan out; they truly haven't been exposed to other theories that could be plausible; they would have to make a large investment to learn a new theory; they would betray the ideology that they want to stick with no matter what; they prefer to speak the most common economic "language"; or, they benefit in various ways in their careers by supporting theories that even they know do not fully add up. Whatever the reason, we must remember that just because they say something doesn't mean it's true.
Notes[1] "The Truth About All Those Excess Reserves," (December 30th, 2009).
[2] And not by a supposed multiplier effect from monetary spending.
[3] And there is absolutely no need for or benefit from an increased supply of money (see last section of this article).
[4] This example is based on the example George Reisman uses.
[5] Federal Reserve Chairman Ben Bernanke, "Inflation Expectations and Inflation Forecasting" (speech).
[6] Since a lot of people ask me about this, I will refer anyone interested in learning more about the relationship of velocity to the money supply to George Reisman's Capitalism, p. 517 section 3, and p. 915 section 7, and to doing a text search on Mises.org for discussions on velocity by Henry Hazlitt, and by Frank Shostak.
During the first-ever Federal Reserve press conference, Fed chair Ben Bernanke said the number of jobs in America was still 7 million behind the number of people employed when the recession began. When asked whether the Fed could do anything about long-term unemployment, Bernanke said the central bank has been fighting it with an aggressive monetary policy. But he admitted his crew operating out of the Eccles Building doesn't have any tools to make the long-term unemployed employable again.
A day later the news came that first-time unemployment claims rose to 429,000 — up from the week before and surprising economists, who had guessed the number would be 40,000 less. Wells Fargo economic analyst Tim Quinlan stated that "this is a major disappointment because it's another move in the wrong direction."
A generation born at the tail end of the baby boom did what mom and dad told them they should: Get off the farm, don't be a barber, forget about being a mechanic. Go to college and then go be a doctor or lawyer or such. However, high barriers to entry and lack of mental horsepower kept most out of medical or law school. But a business degree means you will still be able to wear a shirt and tie to work, not get dirty, and push paper for a living. An MBA will make you unstoppable.
What's known as the FIRE economy ("Finance, Insurance, and Real Estate") fired up in 1980 and headed for the sky until 2006. Now there are 50-years-olds who may never work again. In an April 25 cover story, Newsweek described these out-of-work boomers as "Dead Suits Walking."
Capitalism has always been cruel to its castoffs, but those blessed with a college degree and blue-chip résumé have traditionally escaped the worst of it. In recessions past, they've kept their jobs or found new ones as easily as they might hail a cab or board the 5:15 to White Plains. But not this time.
A post on the professional-finance blog Calculated Risk says that if college-educated workers 45 or older lose their jobs, "they are toast." That sounds harsh, but the point is that even in the financial capital of the world, New York, "men in the 35-to-54 kill zone have lost jobs faster than any other group, including teenage girls, according to new data from the Fiscal Policy Institute," write Newsweek's Rick Marin and Tony Dokoupil.
According to the official FIRE-economy website, the sector is composed of
Commercial Banks, Savings & Loans, Credit Unions, Finance / Credit Companies, Securities & Investment, Venture Capital, Hedge Funds, Private Equity & Investment Firms, Insurance, Real Estate, Mortgage Bankers & Brokers Accountants.
These industries are the sweet spot of loose monetary policies that have led to a series of booms and busts, bubbles and crashes, in ever-greater frequency, since the money supply was completely unshackled from the slightest gold constraint in 1971. Capital has been funneled into higher-order goods, and thousands went to college believing that lending money, landing a hot sales position, or penciling real-estate deals would last forever.
Now the vacant shopping centers are being foreclosed upon, and those who made a living analyzing the numbers or drawing the plans are at home with the kids while mom keeps the family boat afloat.
"Through the first quarter of 2011," write Marin and Dokoupil,
nearly 600,000 college-educated white men ages 35 to 64 were unemployed, according to previously unpublished Labor Department stats. That's more than 5 percent jobless — double the group's pre-recession rate.
Newsweek's "Beached White Males" aren't interested in taking a job they feel is beneath them, despite most realizing that, after months of being unemployed, they will never obtain their previous level of work again. Besides being in denial, they are tired and depressed. This was portrayed smartly by Ben Affleck in the recent movie The Company Men.
Affleck's Bobby had made all the right moves and was a big-company sales manager at 37, making $120,000 a year plus bonus, driving a Porsche, living in a big house, with a country-club membership, a boy, a girl, and a size-zero wife, Patriots season tickets, and all the associated debt and obligations that go with it.
Bobby swaggers in and brags to his sales staff about shooting 86 that morning at his country club, but a minute later he is "86ed" by the head of human resources.
Elisabeth Kübler-Ross's five stages of grief then proceed.
Denial: Bobby thinks he'll get a job right away. No reason for belt tightening.
Anger: Bobby believes the company screwed him after 13 years of loyal service and he was betrayed by higher ups.
Bargaining: OK, Bobby resigns himself to cutting back and goes to work for his smug brother-in-law (Kevin Costner) in construction.
Depression: Bobby loses interest in the bedroom and tells his wife he's sorry he let her down.
Acceptance: Bobby and wife Maggie (Rosemarie DeWitt) spend more time with each other and the kids, while Bobby starts to actually enjoy his construction job.
Career coach Judith Gerberg explains that these men may be able to get it up and down from trouble on the links, but are at a complete loss in a situation like this one. She tells Newsweek,
If you went to the college of your choice, married the woman of your choice, and bought the house of your choice, you've never dealt with rejection. You've never had to develop fortitude.
And it's not just the FIRE sectors that have thinned the ranks: 90,000 architects and engineers have been let go. Jobs considered professional are going the way of farmers since the financial crash, while, according to Marin and Dokoupil,
The rolls of all unemployed white professional men have more than doubled, to a million (not including sales jobs, which add another 300,000). Wall Street and the broader world of business culled the most, laying off more than 300,000 from their trading desks and cubicle farms.
Also dimming employment prospects for white males older than 50 is states' rigorous enforcement of age-discrimination laws. Employers steer away from employees likely to pull the age card and sue. There were a record number of Equal Employment Opportunity Commission (EEOC) claims in 2010 and the Age Discrimination in Employment Act (ADEA) prohibits discrimination in employment on the basis of age against anyone (regardless of race) over the age of 40.
Perversely, while the market tries to clear away malinvestments and the jobs that supported them, colleges continue to turn out more business majors than any other discipline. In 2007 and 2008 there were more than 335,000 business degrees granted — 100,000 more than a decade before, according to the National Center for Education Statistics.
No wonder statistics show that it's a struggle for fresh college graduates to find work. "College graduates have fared worse than other labor market participants, similar to what took place in the 2001 recession," according to a Federal Reserve Bank of San Francisco report.
The Federal Reserve's zero-interest-rate policy attempts to resuscitate jobs that are considered "professional" but are really just a mirage, much like the redundant shopping centers, housing tracts, and casinos built during the boom. In a bubble, there is a market for hail-fellows-well-met who look good in a suit and have connections from their frat days at State U.
Propping up Wall Street and the FIRE economy only fuels denial. Murray Rothbard wrote in Economic Depressions: Their Cause and Cure that government must never bail out businesses in trouble or prop up wages. "It will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries."
The Bernanke Fed must accept that it can't fix the mess it created in the first place. For a generation of people to find meaningful work, the government must embrace the Misesian prescription of a strict "hands-off" policy — rather than staying on the Keynesian drug.
I have a confession to make. I am a geek. I have been for years. I love reading articles on all the latest gadgets and gizmos, the new apps and software, all the hacks, and all the technological breakthroughs that happen daily. I can't get enough of it, but I often come to find that when a tech author is reporting on certain events, he lacks a proper understanding of economic theory.
This is understandable in a world where specialization is necessary; but in a world with government, a lack of knowledge in the field of economics often leads to people advocating government action that will make us all worse off rather than better. This applies especially to geeks. Geeks need to know that advocating certain government policies meant to help the advancement of technology will in fact hinder it or cause it to retrogress.
AT&T and T-Mobile: Microsoft All Over Again? When on March 20, 2011, Deutsche Telekom AG agreed to sell T-Mobile USA to AT&T Inc. for $25 billion in cash and $14 billion in AT&T stock, giving Deutsche Telekom an 8 percent share in AT&T and a representative on AT&T's board of directors, it was huge for the tech market. It was like hearing that Ford and GM were going into a merger. Immediately, the geek pundits began crying, "Monopoly!"
In blogpost after blogpost, statistics were thrown up about how acquiring T-Mobile would make AT&T the "biggest" wireless provider in the United States. One article on Engadget uses such scary nouns as "behemoth" and such ominous claims as "we don't have to wait that long to start discussing life with only three major US carriers."
AT&T rightly saw this kind of hysteria coming, and the company mentions in its own press release,
The U.S. wireless industry is one of the most fiercely competitive markets in the world and will remain so after this deal. The U.S. is one of the few countries in the world where a large majority of consumers can choose from five or more wireless providers in their local market. For example, in 18 of the top 20 U.S. local markets, there are five or more providers. Local market competition is escalating among larger carriers, low-cost carriers and several regional wireless players with nationwide service plans. This intense competition is only increasing with the build-out of new 4G networks and the emergence of new market entrants.
AT&T also felt the need to point out its progressive track record by mentioning that it is "the only major U.S. wireless company with a union workforce, offering leading wages, benefits, training and development for employees."
The most astounding part of this story is that only a week after the deal was announced, Sprint openly declared its opposition to the deal.
The transaction, which requires the approval of the Department of Justice and the Federal Communications Commission, and will likely spark a host of hearings in the U.S. Congress, would reverse nearly three decades of actions by the U.S. government and the courts that modernized and opened U.S. communications markets to competition. The wireless industry has sparked unprecedented levels of competition, innovation, job creation and investment for the American economy, all of which could be undone by this transaction. … "Sprint urges the United States government to block this anti-competitive acquisition," said Vonya McCann, senior vice president, Government Affairs. … "So on behalf of our customers, our industry and our country, Sprint will fight this attempt by AT&T to undo the progress of the past 25 years and create a new Ma Bell duopoly."
Contrast this with Verizon's much earlier response to the deal. Verizon's CEO, Daniel Mead, announced that his company is neither opposed to nor worried about AT&T acquiring T-Mobile. Attempting to use the government to squash their competition would distract the company from being "the most profitable wireless carrier in the country." When asked if Verizon would seek to acquire Sprint in response, Mead said, "We're not interested in Sprint. We don't need them." Zing!
Thankfully, in addition to Verizon's Daniel Mead, there are a few cooler heads in the geek realm. Brian Osborne, writing for the appropriately named geek.com, shows that there is little to be alarmed about when you compare the US telecom market to other markets.
Looking at the Japanese picture, post-merger AT&T's new market share with T-Mobile would still be about 10% less than what Japan's leading wireless carrier, NTT DoCoMo, currently enjoys. While it is safe to say that any acquisition by Verizon Wireless, AT&T or Sprint bringing a single carrier closer to 50% market share would be more criticized by federal regulators, an argument can be made that AT&T's new market share won't be as dominant as NTT DoCoMo's in Japan. …
If we look at the average market share enjoyed by leading operators in Europe and compare that once again to the expected market share AT&T would enjoy if an acquisition of T-Mobile is approved, the result would be that AT&T's market share would only have a variance of above 1%.
While Sprint's CEO (Dan Hesse) brings up the statistic that AT&T and Verizon Wireless would together hold 79% of the U.S. market, the reality is that it is not uncommon for the #1 and #2 wireless carrier in international markets to hold around 70% or more of their perspective markets. AT&T's new market share also wouldn't be significantly more than the average market share of leading operators in Europe and it would be significantly less than the leading operator in Japan. In the end, Hesse will have to make his case not based on big picture numbers alone, but on specific markets where there will be limited competition as a result of AT&T's acquisition of T-Mobile.
Background: The Rise of the Verizon iPhone Yes, AT&T will indeed become the largest wireless provider in the United States (provided that the market shares of both AT&T and T-Mobile do not drastically fall between now and when the deal is completed) but a big company does not a monopoly make. Nor does that "bigness" in any way preclude any sort of success on the part of AT&T after it becomes the largest provider. Even among those who are not panicking over T-Mobile coming under new ownership, there seems to be little understanding as to why this might be a good thing for the two companies and consumers as a whole. To really understand why this is taking place, we need to look back a little ways and see the journeys that these two companies took to reach this point.
The current uproar notwithstanding, AT&T has been having a bit of an image problem among consumers. The problem is that AT&T is not seen as a great cell-phone service provider. In a 2008 consumer report, one year after the release of the first iPhone, AT&T was ranked second to last in terms of customer satisfaction, with Verizon on top. In 2009, AT&T was dead last, and Verizon held on to its lead.
The primary reason for dissatisfaction cited among AT&T's customers is the high rate of dropped calls. While there are several reasons why any one call may be dropped, the most common reason is when one enters a "dead zone," an area out of range of any nearby cell-phone towers. Lack of cell-tower coverage is precisely what has been AT&T's problem, a fact Verizon pointed out in its infamous "There's a map for that" ad.
With such low customer satisfaction, you might think that customers would simply stop using AT&T. Perhaps they would have, were it not for the fact that in order to get your new iPhone for the $200 price you had to sign on to a two-year, $60-per-month service contract with AT&T. While the flame wars rage on over whether iOS or Android is the better operating system, in terms of hardware the iPhone is considered the very best. (Besides, hacking makes these arguments moot.) If you wanted the best, and you didn't want to pay the extra $300 or more for a contract-free iPhone, you were stuck with AT&T.
The Mises Wiki
It wasn't long until the masses started to get vocal. Owners of the best cell phone wanted the best service provider to go with it. They wanted Verizon. Soon rumor mills were buzzing about a Verizon iPhone. By the spring of 2010, things were getting a little out of hand. Comedy superstar Jon Stewart (warning: strong language) even publicly criticized Apple and AT&T on his own show.
The final nail in the coffin came that summer, during Apple's 2010 Worldwide Developers Conference. While on stage in front of several thousand people, Steve Jobs began to experience some technical difficulties. When he asked, "Any suggestions?" there was a very audible response of "Verizon!" The audience laughed and applauded, as did the Internet. Another consumer report at the end of the year, yet again, had Verizon at number one and AT&T dead last.
In January of 2011, the Verizon iPhone was officially announced, along with a new commercial from Verizon. In the commercial there is a series of ticking clocks with a voice saying, "To our millions of customers, who never stopped believing this day would come, thank you." It was the first of its kind. It wasn't just an ordinary commercial advertising a new product; it was a visual thank-you letter to a movement that was also the first of its kind. Consumers literally, audibly, demanded a particular product into existence.
Now that iPhone users have the option to choose Verizon, AT&T is at risk of losing a major portion of its current market share. A recent study by ChangeWave Research showed prospective iPhone buyers wanting Verizon over AT&T 46 percent to 27 percent. While current owners of both iPhones seem fairly satisfied, Verizon beating AT&T at just 82 percent versus 80 percent, AT&T still has the highest dropped call rate; and data actually shows that AT&T's dropped call rate was increasing between September of 2008 and September of 2010, whereas Verizon's was steadily decreasing.
AT&T seems set to lose big to Verizon this summer when the new iPhone 5 comes out. By the summer of 2012, even more two-year AT&T contracts will be expiring. Regardless of any improvements in AT&T's service from here on out, the damage has been done, and it will take some time before AT&T can recover its image.
T-Mobile's Push into the 4G Market Meanwhile, T-Mobile USA had its own goals. It needed to upgrade its network from 3G (3rd Generation) to 4G. There were two different ways it could go about this. It could continue using its High Speed Packet Access (HSPA) method, or it could convert over to the Long Term Evolution (LTE) standard used by AT&T and Verizon. To the surprise of many, T-Mobile announced in December of 2010 that it would do both.
The first part of this project involved a partnership with Nokia Siemens Networks. The two companies would develop new antennas to upgrade their existing cell-phone-tower infrastructure. This would allow T-Mobile to provide 4G that is comparable to, or even faster than, AT&T and Verizon's LTE 4G. HSPA 4G also gives T-Mobile a great cost advantage over its competitors, because it won't have to build a whole new cell-phone-tower infrastructure to support it as AT&T and Verizon must do with their LTE network. However, T-Mobile still wants to develop LTE technology for the future.
This is where AT&T comes in. Joining with AT&T gives T-Mobile access to all the research and development that AT&T has done over the past several years. It also gives T-Mobile access to AT&T's much-larger portion of licensed spectrum. (T-Mobile has a much smaller spectrum than either AT&T or Verizon, which is why it developed HSPA to begin with. HSPA makes use of the electromagnetic spectrum much more efficiently than LTE.) AT&T in return gains access to T-Mobile's technology as well as its vast network of upgraded towers. This essentially fixes AT&T's coverage problem without the time and money needed to build new towers.
How the Free Market Works For any geek still concerned about a possible reemergence of the old Ma Bell monopoly, it is important to remember that it was government that created the monopoly in the first place. This knowledge is so common and undisputed, you would think that someone would have brought it up by now. A simple Google search could clear that fact up for anyone, but actually acknowledging this fact in any discussion would require a radical paradigm shift from what one is taught in government schools.
The primary factor in what causes any particular market to become monopolized is neither the number of companies providing the service nor the size of those companies but rather freedom of entry into that market. So long as there is at least a threat of competition from new entrants into the telecommunications market, there will be a pressure on all wireless providers to keep increasing their efficiency and decreasing their prices.
If any conclusion can be drawn from all this, it is not that AT&T is on the verge of achieving total control over the telecommunications market. If anything, this ought to be interpreted as a sign of AT&T's imminent decline. AT&T has consistently provided poor service relative to other wireless providers, and it is now beginning to pay the price. Now that AT&T is no longer exclusively subsidized by iPhone sales, it is possible that AT&T's projected four percent size advantage over Verizon will disappear within the next year.
Firms that provide their customers with superior service are rewarded, while those that provide inferior service are not. We don't need the government to forcibly keep AT&T as only the second-largest wireless-service provider. Rather, it seems perfectly capable of doing that itself.
$20 $18
The merger with T-Mobile is AT&T's attempt to get back on its feet. It will allow AT&T to provide faster service with wider coverage and fewer dropped calls at a more competitive price. Will AT&T succeed in winning back the hearts of iPhone users? It's a possibility, but nothing is for certain. All an FCC blocking of the acquisition will do is stop AT&T from even trying to please its customers.
The amount of choice and variety in the wireless market is not shrinking but increasing exponentially. While government forces us to choose between the lesser of two evils, the market allows us to freely choose from a massive spectrum of goods. Those who think there is too much variety are free to not even bother. This is how the market works, and I can't help but geek out over it.
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A humorous financial story making the rounds concerns the apparent relationship between media mentions of the actress Anne Hathaway and jumps in the stock price of shares of Warren Buffett's Berkshire Hathaway.
The presumed culprits are algorithmic trading programs, which raises the question, What does Austrian economics have to say about computers buying and selling shares of stock?
The Hathaway EffectDan Mirvish at the Huffington Post broke the story, in an article cleverly titled, "The Hathaway Effect: How Anne Gives Warren Buffett a Rise." Mirvish documents the apparently irrational correlation:
Whatever you may think of how Anne Hathaway and her co-host James Franco did as hosts of the newer, younger, hipper Oscars, one thing appears to be certain: When Anne Hathaway makes headlines, the stock for Warren Buffett's Berkshire-Hathaway goes up. Think of Berkshire-Hathaway shares (BRK.A) as a really expensive version of the IMDb's StarMeter (which actually is designed to go up and down as actors make the news). But a bedrock member of the New York Stock Exchange? The evidence would indicate as much.
On the Friday before the Oscars, Berkshire shares rose a whopping 2.02%. And on the Monday just after the Academy Awards, they rose again, this time 2.94%. But it's not just an Oscar bounce, or something Warren Buffett may have said in the newspaper, or even necessarily something the company itself is doing (i.e. rumors afoot to buy Costco). Just look back at some other landmark dates in Anne Hathaway's still young career:
Oct. 3, 2008 — Rachel Getting Married opens: BRK.A up .44%
Jan. 5, 2009 — Bride Wars opens: BRK.A up 2.61%
Feb. 8, 2010 — Valentine's Day opens: BRK.A up 1.01%
March 5, 2010 — Alice in Wonderland opens: BRK.A up .74%
Nov. 24, 2010 — Love and Other Drugs opens: BRK.A up 1.62%
Nov. 29, 2010 — Anne announced as co-host of the Oscars: BRK.A up .25%
My guess is that all those automated, robotic trading programming are picking up the same chatter on the internet about "Hathaway" as the IMDb's StarMeter, and they're applying it to the stock market.
Although it's always risky to try to explain particular changes in stock prices, Mirvish's analysis seems plausible. Presumably there are computer programs guiding lightning-fast stock purchases and sales, which scour news sources in order to make "momentum trades." In other words, if a particular stock is being discussed in the media, then (other things equal) at least some of these programs buy shares, because it's "hot" and is likely to continue rising as more slow-footed investors read the buzz and want to get a piece of the action.
Of course, the downside of automated stock-trading programs is that they have no common sense (which isn't to say that human traders necessarily do, either). In order to beat their competitors to the punch, they can't engage in careful analysis of the news items; they simply look for "Hathaway" and take it as a bullish signal for Berkshire Hathaway A-shares. (I wonder if Mirvish could do another story on the fortunes of the Rand Capital Corporation as the new Atlas Shrugged movie premieres?)
Do Automated Trading Programs Have Any Benefit?After stories such as these — and certainly after the huge financial collapse in 2008 — many cynics understandably dismiss all the newfangled derivatives markets and financial strategies as a casino for egomaniacs with above-average math skills. Yet there is a danger here in throwing out the baby with the bathwater.
It's true that economics — as conceived by Ludwig von Mises and his followers — is a logically deductive science. Mises didn't believe that economists should ape the physicists and develop empirical hypotheses that are then "tested" by the data. Rather, Mises believed careful introspection on the nature of human action could yield a core of economic principles or laws. It was this framework that allowed the economist to then interpret the mass of available data on commodity prices, unemployment rates, and so forth.
For example, Mises wouldn't "start with a blank slate" and look at the historical statistics to try to develop theories about the business cycle. Rather, he would first reflect on the operation of the capital structure in a market economy, think through the function of market prices and interest rates, and only then be able to start explaining the connection between credit expansion and unsustainable booms. Mises didn't reject the use of historical data — in fact he helped Hayek found an institute to study the business cycle — but he didn't fall for the positivist illusion that one could develop economic theories by "letting the facts speak for themselves."
Having said all that, Austrian economics doesn't forbid stock traders from using such techniques in their quest for profits. For example, suppose an analyst at a hedge fund starts cranking out regressions on "randomly" selected data. He discovers a startling correlation between the phases of the moon and the NASDAQ index. He shows the other analysts, and they confirm his results. They can only offer the most ad hoc "explanations" to their boss, but the relationship is nonetheless staring them in the face.
Suppose the hedge fund begins trading on the newly discovered relationship, and earns money. Over time, as the formula continues to perform, the hedge fund wagers more and more heavily upon it, and is never let down. At the bar the analysts' buddies ask, "Why are you guys up 84 percent this quarter?" but the analysts smile and say, "Ancient Chinese secret."
The question is, are these profits "real" or illusory? Is our hypothetical hedge fund actually doing something useful?
The social function of stock speculators is that they speed up price adjustments. The goal of the speculator is to "buy low, sell high" (or "short sell high, cover low" for an overpriced stock). In this respect, so long as the hedge fund's moon strategy is profitable, then that is prima facie evidence that it is performing a service to others in the market economy. Specifically, the hedge fund buys into the NASDAQ when its price is about to rise, and it sells when the NASDAQ is about to fall. In this limited yet important sense, the successful trading strategy is a time machine, giving the rest of the world advance access to future information.
In this grand sense, results are what matter. The fact that the hedge fund personnel can't really explain the correlation is irrelevant. By the same token, the workers at a utility company can't really explain the laws of physics; they just know that if they repeat certain actions every day, then consumers are able to turn on their lights and run their refrigerators. As David Hume famously pointed out, just because something has happened in the past doesn't mean it will happen in the future, but in many contexts we benefit from making just such an invalid leap.
What About Bubbles?The arguments above might make some readers uncomfortable. After all, didn't the fancy quants on Wall Street look like hot stuff for a few years during the housing boom — until everything blew up in their faces?
Yes, but that is entirely consistent with the position we've laid out. Austrian economists do not naïvely endorse the most extreme versions of the "efficient-markets" approach of the Chicago School. Austrians know that investors can make colossal mistakes and that the going market price can be horribly wrong.
If a trading strategy yields profits for a few years, but will eventually bankrupt the company when a "black swan" comes along, then it is an unprofitable strategy — barring government bailouts. For this very reason, our hypothetical hedge fund managers had better be very careful with their uncanny moon-trading strategy. They have no business being shocked if and when the strategy completely backfires on them, and they had better position themselves accordingly rather than shooting the moon (if you'll forgive the pun) with each new trade.
To correctly assess the value of any entrepreneurial venture, we need some idea of the underlying uncertainty involved. (Note that Mises made a distinction between quantifiable risk and amorphous uncertainty.) To switch away from financial markets to something more concrete, suppose in January a t-shirt manufacturer sunk $1 million into producing shirts saying, "The VCU Miracle of 2011." After the VCU basketball team made the Final Four against all odds, the manufacturer was able to recover his investment as well as a tidy profit.
Now how should an Austrian interpret this event? Did the entrepreneur see beyond what others saw, and allocate resources more effectively to serve consumers? Or did he take a big chance but "get lucky"? At this point the question is almost philosophical rather than economic, but the scenario sheds light on automated trading programs yielding short-term profits.
ConclusionFaced with such apparently nonsensical results as the Anne Hathaway effect, automatic trading programs look silly. On the other hand, this is true of any task to which humans put computers; it doesn't mean computers are useless.
The ultimate criterion for whether automated trading is socially useful is the profit-and-loss test.
If the financial institutions relying on these programs blow up in the long run, we'll have our answer — if only the government and Fed would stay out of it.
Steve Landsburg is an economics professor at the University of Rochester, and author of some great books on free-market thinking. However, in a recent blog post he gave a misleading explanation of option pricing. It's worth going over the episode because it beautifully illustrates the tendency of economists to overlook the assumptions they sneak into their arguments, particularly when it comes to discussions of the financial markets.
Landsburg, Jeter, and Option PricingA call option on a stock is a derivative contract that gives the owner the right, but not the obligation, to buy the stock at a certain price (the "strike price"). Some call options can only be exercised on a particular date in the future, whereas others can be exercised anytime up to and including the date. Call options are an important part of a modern market economy and serve a definite social function, as I explain here.
There is a whole literature in the field of mathematical finance on various methods of pricing options. The most famous is the Black-Scholes formula. In his recent post, Landsburg gave the intuition behind these common formulas.
Because he's a clear writer — and because my overall point is that Landsburg doesn't show us how the rabbit got into his option-pricing-formula hat — it's worthwhile to quote him extensively. Keep in mind that for brevity's sake, I'm editing out all of his caveats. The problem (as we'll see) with Landsburg's argument isn't that it's unrealistic; the main problem is that he unintentionally misleads the reader:
Imagine a stock that sells for $10 today. A year from now it will be worth either $20 or $5. … What would you pay for an option that allows you to buy the stock next year at today's $10 price?
You might think you'd need a whole lot more information to answer that question. You might expect, for example, that the answer depends on the probability that the stock price will go up to $20 rather than down to $5. You might expect the answer to depend on how much traders are willing to pay for a given dollop of risk avoidance.
But the amazing fact is that none of that matters. The only extra bit of information you need is the interest rate.
Let's assume, for example, that the interest rate happens to be 25%. …
Now let's price the option. The key is to focus on my imaginary cousin Jeter, who never buys stock options. Jeter happened to wake up with $12 in his pocket today. Then he went out, borrowed $8, and used his $20 to buy 2 shares of stock.
A year from now, one of two things will happen. Either Jeter will get lucky, sell his 2 shares for $40, use $10 to repay his debt ($8 plus $2 interest), and pocket $30. Or he'll get unlucky, sell his 2 shares for $10, use that $10 to repay his debt, and pocket $0. …
I, on the other hand, bought 3 stock options today. A year from now, one of two things will happen. Either I will get lucky and use my 3 options to buy 3 shares of $20 stock at a price of $10 each, pocketing a $30 profit. Or I will get unlucky and the stock price will [plummet], in which case I will throw my option away and pocket $0.
In other words, Jeter and I are guaranteed exactly the same outcome next year. Either the stock price goes up, and we each pocket $30, or it goes down and we each pocket $0. In that strong sense, Jeter's strategy and mine are perfectly interchangeable.
Jeter's strategy costs him $12 out of pocket. Therefore my strategy must also cost $12 out of pocket — otherwise, nobody would ever pursue the pricier strategy. Since buying 3 stock options costs $12, the price of a single option must be $4. Problem solved.
As I said above, Landsburg's thought experiment is a simplified version of the general approach to option pricing used in mathematical finance. Newcomers to this field are often stunned to learn that the price of a call option apparently has nothing to do with the likelihood (or "probability" if we are using a formal model) that the underlying asset will attain a very high price by the time the option expires. (Instead, the price of the call option — according to the standard formulas — varies according to the volatility of the underlying stock price.) This is so counterintuitive that option theory is the quantum mechanics of finance.
Before continuing with my critique of Landsburg's demonstration, I should be clear: I am not rejecting the conventional approach to option pricing as useless. It is an important baseline result, and every batch of MBAs (let alone people with PhDs in finance) should understand the formulas and the logic behind their derivation.
What I am saying is that Landsburg is simply wrong when he claims the "amazing fact" that the probabilities of the stock price's future values, and the risk tolerance of the investors, don't matter. They do matter, just as our intuition suggests.Although the context isn't exactly the same, Emanuel Derman and Nassim "Black Swan" Taleb have a fascinating journal article on option pricing theory that defends a simple expected-discounted-value approach. The reason Landsburg apparently gets the "correct" price for the stock option using just the interest rate is that he relies on other assumptions about the efficiency of the stock market.
Tweaking the NumbersThe easiest way for me to illustrate the problem with Landsburg's magic trick is to change just one of the original numbers. What would Landsburg think about the following argument?
Imagine a stock that sells for $10 today. A year from now it will be worth either $5 or $9. What would you pay for an option that allows you to buy the stock next year at today's $10 price?
You might think that the "correct" price of the option is $0. Even though you don't know the probability of the stock being $5 or $9 next year, you are certain that it will be less than $10. Under no circumstances, therefore, will the option have any value to you. What good is it to own the right to buy a stock for $10, when at best it will be worth $9 at the time of exercise?
But the amazing fact is that this reasoning is wrong, as I can prove to you once you tell me the interest rate.
Let's assume, for example, that the interest rate happens to be 25%. …
I hope the reader will agree that it would be fruitless to go down this path. Using our "intuition" about pricing options works just fine in an extreme case where the strike price is higher than we think the stock can possibly go.
Now in fairness to Landsburg, I actually can't replicate the remainder of his argument using my tweaked number. The reason is that cousin Jeter will lose different amounts of money depending on the stock price, but you (the option buyer) will lose the same amount in either case, namely what you paid for the option. So there's no way to make your strategy equivalent to Jeter's, and so Landsburg could understandably argue that my scenario doesn't really affect the validity of his demonstration.
After this warm-up, let's really go to the heart of the problem with Landsburg's discussion.
Landsburg Assumes "Correct Price" Is the Same as "Arbitrage-Free Price"Let's return to Landsburg's original numbers. Recall that there is a stock that will be worth either $5 or $20 in one year, and that the interest rate is 25 percent. Landsburg asked, "What would you pay" for a call option on that stock?
Just for the sake of argument, suppose we do have the extra information about probabilities and risk tolerance. Specifically, assume that the probability of the stock being $5 is 100 percent, and the probability of it being $20 is 0 percent. (If you think that's cheating, set the probability of the stock being $5 to 99.999 percent, and the probability of it being $20 at 0.0001 percent, and further assume the investor is risk-neutral.) Clearly, I shouldn't pay anything for that option.
However, unlike our previous tweaking, in this case Landsburg's argument still "works." He never said anything about the respective probabilities of the two outcomes — remember, that was the "amazing fact," that his answer didn't depend on it. So there's no reason it breaks down when the probabilities are 100 percent and 0 percent (or just shy of 100 percent and just above 0 percent, if you prefer).
Specifically, what's going on is that the stock is clearly overvalued right now in the market, when it's selling for $10 even though it is guaranteed to be $5 next year. Cousin Jeter (using the strategy Landsburg outlined) is guaranteed to lose his $12. Therefore, because your buying 3 call options is an equivalent strategy, it must be the case that the options cost $4 each. If they only cost, say, $3, then it would be cheaper to use that route — you'd only be throwing away $9 for sure, instead of throwing away $12 for sure.
Since Landsburg is assuming that arbitrage has eliminated such discrepancies, the only way the current stock price can be held up at the (overvalued) price of $10, is if call options (with a strike price of $10) are held up at the overvalued price of $4. But by no means can we conclude that "you would pay" $4 for an option that you are certain will expire worthless.
We now see how much power was tucked into Landsburg's innocent statements: "Jeter's strategy costs him $12 out of pocket. Therefore my strategy must also cost $12 out of pocket — otherwise, nobody would ever pursue the pricier strategy."
What Landsburg has really shown is that if the stock price is "correct," given investors' beliefs about the probabilities of the future stock price and investor appetite for risk, then we don't need to know those probabilities, or risk appetite, to calculate how much "you would be willing to pay" for a call option.
ConclusionLandsburg's discussion of option pricing is fine, interpreted correctly. But whether he realizes it or not, his "lesson" is very misleading. All he has done is show that certain prices must bear a particular relationship to each other, lest arbitrageurs exploit a pure-profit opportunity.
The problem arises when people read too deeply into the significance of these results. For example, one could use an analogous argument to show that "all we need" to price stocks is to look up the interest rate and the price of a call option. We might erroneously conclude that no investor ever needs to worry about what the stock will actually do in the future.
Yet that is absurd; of course investors and speculators in the real world need to form expectations about the future levels of stock prices. It is the seductive elegance of the entire "Efficient Markets" approach that led Landsburg to suggest otherwise.
For those readers who are still unconvinced, let me try the following approach. Landsburg's argument for the pricing of call options is equivalent to this one: "Suppose there is a stock currently selling for $10. You know that next year, it will either be $5 or $20. How much should you pay right now for the stock? You might think the probabilities of the outcomes matter, but they don't. If your cousin Jeter wants to buy the stock, he has to pay $10 for it. That would give him the same outcome as if you bought the stock, and so you should pay $10 too. Problem solved."
If Landsburg had offered the above analysis, the fallacy involved would have been crystal clear. But because of the complicated steps in the linkage to a call option, the fallacy was buried. The whole episode is another illustration of the dangers in reasoning from equilibrium.
It was a modern thriving economy one day, and then, suddenly, the food disappeared from the shelves, the banks closed, and the ships stopped arriving. Iceland in 2008 experienced an unprecedented economic meltdown that struck fear in the hearts of people all over the world. If it could happen here, it could happen anywhere.
The economic crisis led to a political crisis, with resignations galore. The whining and wailing about the disaster continues to this day, with most commentators blaming deregulation and the free market.
In Deep Freeze, economists Philipp Bagus and David Howden demonstrate that the real cause of the calamity was bad central bank policy. Rates were way too low, banks were too big to fail, housing was implicitly guaranteed, and banks were borrowing short term from abroad to finance long term bonds.
The authors discuss the implications of this maturity mismatching and zero in on the central bank policies that encouraged unsound practices. They demonstrate the cause and effect without a shadow of a doubt, using vast amounts of data and a detailed sector-by-sector look at the economy of Iceland.
What they find is another instance of the Austrian Theory of the Business Cycle, working itself out in a way that is customized for a time and place.
Toby Baxendale writes the introducton to this story that reads like a great novel. It serves as a reminder that central banking policies aren't just about monetary arcana. They affect our lives in profound and sometimes catastrophic ways.
The Iceland Freeze is one of the great historical cases that makes Mises’s point. Let it always serve as a reminder of what happens when the laws of the market are papered over by politicians and central bankers.
This account is likely to remain the definitive one for many years.
[This article was adapted from a talk delivered at the Mises Circle in Houston, Texas, January 22, 2011.]
The stock market has been on a tear and it's all about mergers and acquisitions (M&A).
Last year ended up being a blockbuster for global mergers and acquisitions, with the total number of deals and values both rising by over 20 percent for 2010, hitting $2.4 trillion. Private equity buyouts meanwhile rose 7.2 percent, marking the strongest year for buyouts since 2007. Activity in M&A more than doubled in Australia; the Asia-Pacific region saw M&A deal value reach its highest value on record; and M&A deals also jumped 37 percent in Europe.
But of all regions, it was the emerging markets (EM) that posted the most impressive year. In 2010, the EM group saw 2,763 deals, worth approximately $557 billion. That marked a 20 percent increase in deal volume and a nearly 60 percent jump in total deal value.
But it wasn't exactly deals, deals, deals here in the States. The total value of American M&A only rose 3 percent year-over-year. But now M&A talk is really heating up in the United States.
The Fast Money Traders on CNBC say M&A is a major market theme — in tech, retail, mining, even deals in the financial services and real estate. "We would be remiss if we didn't disclose that we are somewhat surprised by the speed at which M&A transaction multiples have improved toward the sellers' favor," Keefe, Bruyette & Woods said in a research note concerning bank mergers. "We believe the market may be signaling that the buyers are being overly generous in sharing the economics with the sellers this early in the cycle."
Byron Wien, vice chairman of Blackstone Advisory Partners, listed as one of his "Ten Surprises for 2011," "Merger and acquisition activity becomes intense and the market reaches a blow-off euphoria."
With the announcement of AOL buying Huffington Post for $315 million, February 7 was referred to as Merger Monday. Danaher also announced it was buying Beckman Coulter for $6.8 billion, while oil driller Ensco Plc said it would buy Pride International Inc. for $7.3 billion.
But every Monday in 2011 has seemed liked "Merger Monday."
Jack Ablin, who is chief investment officer with Harris Private Bank in Chicago, says that "investors are coming in with the attitude, if these business leaders are confident enough to buy other companies, then I'm confident enough to buy stocks."
So what's driving M&A other than CEO ego?
First of all, it's cheap money. Wall Street began to fall apart in the summer of 2007 with the M2 money supply standing at $7.3 trillion. The Fed has hit the monetary gas — we've had TARP, TALP, and who knows what all, and by November of 2010, M2 was just short of $8.8 trillion, a more than 20 percent increase.
The prime lending rate was 8.25 percent back in the summer of 2007; now it's 3.25 percent. Six-month Libor (the London interbank offered rate) was 5.37 percent in July 2007; last month it was 45 basis points. No wonder someone on CNBC said recently that at these low interest rates, all of these "deals" (mergers and acquisitions) will be accretive to earnings.
A lot of deals will work on paper with rates this low.
Second, firms have lots of cash on their balance sheet and it's not earning anything. US treasuries with less than a year term are kicking off 13 to 27 basis points. Bank CD rates are somewhere around 1 percent for 12 months.
Rates are not low because people are delaying consumption and keeping high cash balances. It is the central bank that is keeping rates low, thinking businesses will begin borrowing and then start hiring. So rates are low, and everyone with cash from corporate CEOs to retirees wants to earn something besides 1/2 percent.
CEOs especially have money burning a hole in the pockets of their corporate balance sheets. They could pay the money out to current shareholders in the form of dividends, but they must figure, "what would the shareholders do with the money?"
The CEOs could hire more people and produce more goods and services, but, no matter what the Business Cycle Dating Committee of the National Bureau of Economic Research says, it's still a recession. Demand isn't that good. People are expensive to hire and especially to fire (if you can fire them at all).
Finally, there is increased government interference. Professor Peter Klein has found that firms make acquisitions when faced with increased uncertainty, citing regulatory interference and tax changes as major causes of uncertainty. When faced with increased regulatory interference, firms respond by experimenting, making riskier acquisitions — and consequently more mistakes.
Klein found that unprofitable acquisitions tend to come in industry clusters and that these clusters are likely to arise from intensified regulation. So, while money's cheap and government keeps getting more intrusive, CEOs figure, "Let's roll the dice and buy another business."
But according to Max Landsberg and Dr. Thomas Kell at the consulting firm Heidrick & Struggles, 74 percent of mergers fail. "Two-thirds of the newly formed companies perform well below the industry average," according to the Harvard Management Update. Although "up to 70 percent [of mergers] failed to create value, it seems clear that the end is not yet in sight," claims Financial Executive. And the Journal of Property Management says "60 percent to 80 percent of all business combinations undergo a slow, painful demise."
While CEOs think that when they do a deal two plus two will equal five, the fact is it often turns out that two plus two ends up equaling three.
Leadership consulting types claim a large company needs more effective leadership than a smaller one, and companies must consider their leadership capacity when confronted by change or contemplating an acquisition.
Human resources consultants say these mergers don't work because most executives manage the business integration but do not manage the human integration. Eager for the gains anticipated, they treat the acquisition like a series of financial reports, instead of organizations comprised of human beings.
Companies call these things "mergers," "acquisitions," "buyouts," and "takeovers," but what are they really doing? Buying stocks and typically at a premium to what the stocks had been trading for — forget volume discounts. These guys aren't just buying a cow or two but the whole ranch and paying a premium to the market price to boot.
Why is that? Unfortunately, government regulations cause this anomaly. Companies acquiring large blocks of stock in other companies must register their intentions with the government, thus alerting the market to those intentions. The government protects targeted firms from hostile takeovers and raises the price of buyouts.
And where do acquirers come up with the numbers that they pay for these acquisitions?
A former director of Coopers & Lybrand told author Mark Sirower, "Lotus is the culprit in failed acquisitions. It is too easy to assume anything you want in perpetuity without any understanding of the economics of an industry, and package it in a beautiful report."
In his book The Synergy Trap, Sirower says valuation models turn on three things: free-cash-flow forecasts, residual value, and a discount rate.
The cost of capital is integral to making these assumptions. The lower the assumed interest rate or cost of capital, the higher the price for the acquisition that the models will justify.
And if anyone is assuming today's Fed-induced microscopic interests rates will last forever, well, now would be the time to be selling instead of buying. Once interest rates go up, these valuation models will be blown up along with the government-employee pension-plan assumptions.
It's hard to make something work out economically if you overpay in the first place. And that is most often what happens. Companies overpay for the firms they acquire.
Or, as Warren Buffett put it in the Berkshire Hathaway 1982 annual report,
The Market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do…. A too high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.
Although he isn't writing about a stock-market boom driven by M&A, Ludwig von Mises could have been when he wrote that
the moderated interest rate is intended to stimulate production and not to cause a stock market boom. However, stock prices increase first of all. At the outset, commodity prices are not caught up in the boom. There are stock exchange booms and stock exchange profits. Yet, the "producer" is dissatisfied. He envies the "speculator" his "easy profit." Those in power are not willing to accept this situation. They believe that production is being deprived of money which is flowing into the stock market. Besides, it is precisely in the stock market boom that the serious threat of a crisis lies hidden.
Many mergers have been spectacular failures. Daimler Benz's had the great idea to buy Chrysler for $37 billion. The companies merged in 1998, and by 2007, Daimler Benz was selling Chrysler for just $7 billion.
Mattel bought the Learning Company for $3.5 billion in 1999. Less than a year later, the Learning Company lost $206 million, taking down Mattel's profit with it. The Learning Company was sold by the end of 2000.
"When faced with increased regulatory interference, firms respond by experimenting, making riskier acquisitions — and consequently more mistakes."Hedge-fund king Eddie Lampert bought Sears and Kmart in 2005 and merged them to create Sears Holdings. However, by 2007, Lampert was named the America's Worst CEO because the combination was floundering.
Quaker Oats purchased Snapple in 1994, for $1.7 billion. After just 27 months, the food giant sold Snapple for $300 million, losing $1.6 million for each day that the company owned the drink company.
Who can forget the AOL/Time Warner merger? In 2001, old-school media giant Time Warner consolidated with American Online (AOL), the Internet and email provider of the people, for a whopping $111 billion.
In May 2009, the CEO of Time Warner, Jeff Bewkes, announced that the marriage of AOL and Time Warner was dissolved. And now AOL is buying the Huffington Post for reportedly five times revenues. But we don't know the multiple to profits. If there are any at all.
With upwards of three-quarters of all mergers destined to fail, just what is the problem? Personnel and business culture-clash issues or just plain overpaying?
The Austrian School has determined that there are limits to the size of a firm. As much as those on the Left wring their hands about giant corporations taking over the world, it doesn't work out that way.
Mises famously determined that socialism can't function because there are no market prices in a socialist economy to distinguish more- or less-valuable uses of social resources.
But Peter Klein points out in his book The Capitalist and the Entrepreneur that Mises wasn't just talking about socialism. Mises was addressing the role of prices for capital goods. Entrepreneurs make guesses about future prices and allocate resources accordingly to satisfy customer wants and turn a profit while doing it.
If there is no market for capital goods, resources won't be allocated efficiently whether it's a socialist economy or otherwise. The market economy requires well-functioning asset markets. Without these prices, decision making is destroyed.
If one can't calculate and compare the benefits and costs of production using the structure of monetary prices determined at each moment on the market, as Joe Salerno points out,
the human mind is only capable of surveying, evaluating, and directing production processes whose scope is drastically restricted to the compass of the primitive household economy.
Mises explained that
one cannot play speculation and investment. The speculators and investors expose their own wealth, their own destiny. This fact makes them responsible to the consumers, the ultimate bosses of the capitalist economy.
Murray Rothbard extended Mises's analyses to considering the size of firms, and the problem of resource allocation under socialism to the context of vertical integration and the size of an organization. He wrote that the
ultimate limits are set on the relative size of the firm by the necessity of markets to exist in every factor, in order to make it possible for the firm to calculate its profits and losses.
To make implicit estimates, there must be an explicit market. "When an entrepreneur receives income, in other words, he receives a complex of various functional incomes," Rothbard wrote. "To isolate them by calculation, there must be in existence an external market to which the entrepreneur can refer."
As firms get too big, economic calculation gets muddied because firms do not receive the profit-and-loss signals for their internal transactions. Managers are lost as to how to allocate land and labor to provide maximum profits or to serve customers best.
As these firms grow (especially by acquisition), one part of the company is often the provider and another part of the company is the customer, yet there are no market prices to allocate resources efficiently.
Rothbard wrote,
Economic calculation becomes ever more important as the market economy develops and progresses, as the stages and the complexities of type and variety of capital goods increase. Ever more important for the maintenance of an advanced economy, then, is the preservation of markets for all the capital and other producers' goods.
Professor Klein makes the point that
as soon as the firm expands to the point where at least one external market has disappeared, however, the calculation problem exists. The difficulties become worse and worse as more and more external markets disappear, as [quoting Rothbard] "islands of noncalculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc, become greater."
When firms expand, company overhead expands. And there is difficultly in allocating overhead or any fixed cost for that matter amongst various divisions of a firm. "If an input is essentially indivisible (or nonexcludable), then there is no way to compute the opportunity cost of just the portion of the input used by a particular division," explains Klein. "Firms with high overhead costs should thus be at a disadvantage relative to firms able to allocate costs more precisely between business units."
You know what overhead looks like. It's what Scott Adams describes as organizations "riddled with hamster-brained sociopaths in leadership roles," sitting around having meetings and looking at Powerpoint presentations. M&Ms kill productivity — not the candy: managers and meetings.
Too much management is required when firms get too big. If managers knew how to manage, there wouldn't be dozens of new management books constantly for sale — like Who Moved My Cheese? Who Made My Cheese?, Who Moved My Secret?, Who Moved My Soap?, and Who Moved My Church?.
People trying to manage are so desperate they look to Rudy Giuliani, Attila the Hun, and George W. Bush for management secrets.
The results of CEO buying sprees spurred by cheap Fed-produced money and credit are not new jobs and new products that make our lives better. These corporate shopping extravaganzas are just wasteful malinvestments that destroy capital.
Federal Reserve monetary policy over the last couple decades has not produced real economic growth but instead bubble after bubble — with each bubble (or each group of contemporaneous bubbles) being bigger in aggregate and more damaging than the one that preceded it.
As economist Kevin Dowd explains, these bubbles destroy part of the capital stock by diverting capital into economically unjustified uses. The central bank's artificially low interest rates make investments appear more profitable than they really are, and this is especially so for investments with long-term horizons, i.e., in Austrian terms, there is an artificial lengthening of the investment horizon.
And there is nothing more long term than buying a company, which is not just a group of employees and the current inventory of products or services but a package of previously made, long-term capital investments.
These distortions and resulting losses are magnified further once a bubble takes hold and inflicts its damage too: the end result is a lot of ruined investors and 'bubble blight' — massive overcapacity in the sectors affected," Dowd explains. "This has happened again and again, in one sector after another: tech, real estate, Treasuries, and now financial stocks, junk bonds, and commodities — and the same policy also helps to spawn bubbles overseas, mostly notably in emerging markets right now."The Fed's printing press is destroying the capital base of the American economy in so many ways that most don't realize.
Savers are punished and encouraged to risk capital on ventures that don't make economic sense. And CEOs, fooled by the faulty assumptions buried in their valuation models, see cheap money as the path to building empires.
However, these empires inevitably crumble and destroy precious capital in the process.
This article was adapted from a talk delivered at the Mises Circle in Houston, Texas, January 22, 2011.
[Chapter 17, Out of Step (1962). An MP3 audio file of this article, read by Steven Ng, is available for download. The reader might consider the further merits of Chodorov's argument, given the existing federal debt of $12 trillion.]
In 1800, the United States Treasury owed $83 million. The population was then three million. Every baby born that year was loaded down with a debt burden of about $28; if the interest rate was 6 percent, the newborn citizen could look forward to paying a service charge on the national debt of $1.68 per year. Today the debt load of the nation comes to well over $290 billion, and the population is, in round figures, 180 million. Thus, while the population has increased by 60 times, the national debt has increased by 3,600 times; and figuring the interest rate at 4 percent, the cost of handling this debt is, roughly, $68 per citizen per year. The child is now loaded down at birth with a debt load of $1,700. These figures might be adjusted to the increased production per citizen, and to the decreased value of the dollar. Even so, the fact sticks out that posterity does not pay off anything of the national debt, that each administration adds to the debt left to it, and that the promise of liquidation implied in every bond issue is a false promise.
The bulk of the rise in the national debt has occurred since 1933, when Franklin D. Roosevelt abolished the gold standard and thus made money redeemable in — money. When money was redeemable in gold, the inherent profligacy of government was somewhat restrained; for, if the citizen lost faith in his money, or his bond, he could demand gold in exchange, and since the government did not have enough gold on hand to meet the demand, it had to curtail its spending proclivity accordingly. But, Mr. Roosevelt removed this shackle and thus opened the floodgates. The only limit to the inclination of every politician to spend money, in order to acquire power, is the refusal of the public to lend its money to the government. Of course, the government can then resort to printing money, to make money out of nothing, but at least the people will not be compounding the swindle. Therefore, I offer the following gratuitous advice:
Don't buy bonds.The advice is based on purely moral, not fiscal, grounds. I could point out that when the government issues a bond it is diluting the value of all the money in existence. Every bond is, in effect, money: the fact that the indenture bears the seal and imprint of the government makes it so, even though it may not enter the market place as money; it does not become monetized for some time. That is, every bond issued by the government is inflationary, and thus robs the savers of the value of their savings. That, of course, is a swindle and is immoral. But, the immorality of bonds runs much deeper.
In the first place, when the State spends more money than it receives in taxes — a fact indelibly written into the bond — it is deliberately committing an act of bankruptcy. If your neighbor should do that you would promptly put him down as a dishonest person. Is the dishonesty transmuted into its opposite when committed by a legal entity? By what multiplier can robbery be made a virtue? The act of borrowing against imaginary income is a fraud, no matter who does it, and when you make a loan to that borrower you aid and abet a fraud.
The State's excuse for borrowing is that it invests the proceeds of its bonds for the benefit of posterity. Instead of putting the entire burden of meeting the cost of its beneficial acts on the living, it proposes to demand of unborn children their share of the cost. Quite plausible! But is this not the impossible doctrine of control of the living by the dead? What would you think of a prospective father who deliberately put a debt load on his expected offspring? That is exactly what you do when you cooperate with the State's borrowing program. You are loading on your children and your children's children an obligation to pay for something they had no voice in, and for which they may not care at all. Your "investment for posterity" may earn you nothing but the curses of posterity.
The use of the word investment in connection with a bond issued by the State is a treacherous euphemism. When you buy an industrial bond you lend your money to a corporation so that it can buy a machine with which to increase its output of things wanted by the market. The interest paid you is part of the increased production made possible by your loan. That is an investment. The State, however, does not put your money into production. The State spends it — that is all the State is capable of doing — and your savings disappear. The interest you get comes out of the tax fund, to which you contribute your share, and your share is increased by the cost of servicing your bond. In effect, you are paying yourself. Is that an investment?
"The use of the word investment in connection with a bond issued by the State is a treacherous euphemism."When you depart from this earth you pass on to your heirs both the tax-collecting bond and the tax-paying obligation it represents. Or, as is usually the case — for the history of bonds is that ownership tends to concentrate in a few hands — if you sold your bond, the new owner in due time passes on to his heirs a claim on the production of your offspring. Your great-grandchildren are called upon to labor for his great-grandchildren. The bond thus becomes a legacy of slavery.
The fact is that posterity never pays off its ancestral debts — or not in the way you are led to believe by the bond-selling State. The present generation is posterity to all the generations that have gone before. Are we paying off any of the debts incurred by our forebears? Hardly. We have spending of our own to do and must leave to our posterity some new debts as well as those we inherited. They, in truth, will do likewise.
Whether or not there is any obligation on the living to liquidate the debt left by an arbitrary ancestry, the political machine prevents its being done. Actual liquidation would necessitate increased taxation, on the one hand, and a curtailment of State spending on the other. Increased taxation the State always welcomes, for any increase in taxes means an increase in State power, and the politicians are always for that; it can never spare a sou for the reduction of the national debt. No State — absolutist or constitutional — has ever put aside its ambitions to make good on its promissory notes. The "posterity should pay" argument, in the light of this historic fact, becomes the equipment of a confidence game.
What, then, becomes of the national debt? It grows and grows until, like a balloon, it bursts. But, though this is inevitable, thanks to the money-making monopoly of the State, it takes a long time before the balloon does burst, and certain conditions must prevail to cause the explosion.
When the promissory paper of a small nation is held by a powerful one, some semblance of financial rectitude is maintained by means of the marines; the economy of the defaulting State is impounded until the debt is liquidated, and sometimes for a longer period. Internal debts, on the other hand, are never liquidated. When the burden of meeting the service charges becomes economically unbearable, and the State's credit is gone, repudiation or inflation is resorted to.
Of these two methods, repudiation is by far the more honest. It is a straightforward statement of fact: the State declares its inability to pay. The wiping out of the debt, furthermore, can have a salutary effect on the economy of the country, since the lessening of the tax burden leaves the citizenry more to do with. The market place becomes to that extent healthier and more vigorous. The losers in this operation are the few who hold the bonds, but since they too are members of society they must in the long run benefit by the improvement of the general economy; they lose as tax collectors, they gain as producers.
"Were confiscatory taxation the only means of carrying on the war its popularity might wane; the war would have to be called off."Repudiation commends itself also because it weakens faith in the State. Until the act is forgotten by subsequent generations, the State's promises find few believers; its credit is shattered. Never since the Russian repudiation of 1917 has the regime attempted to float a bond issue abroad, while its import operations have been largely on a cash basis. Internally, Russia does its "borrowing" from its own nationals as a highwayman does.
Anyhow, since honesty and politics are contradictory terms, the State's standard method of meeting its debt obligations is inflation. It pays off with engraved paper. To be sure, even as it issues its new IOUs to pay off its defaulted ones, the inflationary process is on, for every bond is in fact money; like money, it is a claim on production. The bond you buy increases the circulatory medium, thus depressing its value, and you are really exchanging good money for bad. You are cheating yourself. That is demonstrable by comparing the purchasing power of the dollar at the time you bought the bond with its purchasing power at maturity.
As Germany did in the 1920s, the State can make inflation and repudiation synonymous; it can inflate for the purpose of repudiation. This is what is called "uncontrolled" inflation, another impostor term. There is really no such thing as "uncontrolled" or "runaway" inflation, because the printing presses do not run themselves; somebody must start and keep them going until the desired end, the wiping out of the national debt, is accomplished. The disadvantage of this process, as against outright repudiations, is that in wiping out the debt it also wipes out the values which the citizenry have laboriously built up; it wipes out savings. However, no nation has ever resorted to "uncontrolled" inflation until its economy has been destroyed by war, until production was unable to meet the expenses of the political establishment, to say nothing of the debt piled up by its predecessors.
But, how about the natural pull of patriotism? In the face of national danger, is it not right that we put our all into the common defense? Of course it is right; and people being what they are, the pooling of interests is spontaneous when community life is threatened, as in the case of a flood, an earthquake or a conflagration, or when the Indians attacked the stockade. In such catastrophes we give; we do not lend. Patriotism weighted with profit is of a dubious kind. Bonds do not fight wars. The instruments and materials of war are forged by living labor using the existing stock of capital; the expense must be met with current production. The bonds are issued because laborers and capitalists are reluctant to give their output for the common cause; they put a greater value on their property than on victory. Were confiscatory taxation the only means of carrying on the war its popularity might wane; the war would have to be called off.
This specious resort to spurious patriotism reaches its ultimate in the textbook justification for the public debt. It runs something like this: citizens who have a financial stake in the State, by way of bonds, take a livelier interest in its doings. Thus, love of country is made contingent on the probability of returns, both as to capital and to booty. This smacks of the kind of patriotism that motivated the money brokers of the Middle Ages; once they invested in their king's ventures they could not afford to become lukewarm in their fealty.
"It is not patriotism that is engendered by the borrowing State. It is subservience."It is not patriotism that is engendered by the borrowing State. It is subservience. With its portfolio chock-full of bonds, the financial institution becomes in effect a junior partner whose self-interest compels compliance. An allotment of bonds to a bank carries force because its current large holdings might lose value if doubt were thrown on the credit of the State. A precipitate drop in the prices of federal issues would shake Wall Street out of its boots; hence new issues must be taken up to protect old issues. The concern of heavily endowed universities in their holdings of bonds is such that professorial doubt of their moral content could hardly be tolerated. Even the pacifist minister of a rich church would have to be circumspect in voicing his opinion of the public debt. That is, the self-interest of the tax-collecting bondholders, not patriotism, impels support of the State.
Taken all in all, the bond is a thoroughly immoral institution. I would not be caught dead with one of these papers on me.
This article is chapter 17 in Frank Chodorov's Out of Step: The Autobiography of an Individualist (1962). An MP3 audio file of this article, read by Steven Ng, is available for download.
This paper investigates whether the government regulation of insider trading or insider trading laws can be effective.
Volume 22, Number 1 (2011)
With gold selling for around $1,400 per ounce, it seems like everyone has jumped on the yellow-metal bandwagon. Resource-investment guru Rick Rule said about gold investing recently, "we're no longer lonely in the gold trade. You couldn't describe this as a contrarian activity, and you couldn't describe this as a low-risk activity."
But while Rule and the likes of David Einhorn aren't alone keeping some, or a lot of, money in gold, the Wall Street Journal ran a profile of a more typical investment guide who claims, "There's no utility of gold." Investment advisor Tim Medley says people only trade their dollars for gold when they're afraid, and they won't be afraid much longer.
Medley is old enough to remember overflow crowds at financial conferences in the early 1980s listening to presentations about gold, only to have the metal's price plunge and go nowhere for two decades. He's figuring the same will happen again. "Given a choice between first-rate common stocks and gold over the next five to ten years, I feel strongly that stocks will do much better," says Medley.
Unless his clients specifically tell him to buy some gold or gold stocks for their accounts, Medley won't touch the stuff. "There's no organic growth" in gold, he says.
For sure, gold coins and bars silently gather dust. Gold has no staff, makes no product, earns no profit, and incurs no loss. The yellow metal owes no one, but at the same time it collects no interest either.
However, to say gold has no utility? Time and history would say otherwise. Murray Rothbard listed seven necessary qualities for money during a History of Economic Thought lecture at UNLV back in the fall of 1990. For a substance to be used as money it must be (1) generally marketable, (2) divisible, (3) durable, (4) recognizable, (5) homogeneous, and have a (6) high value per unit weight and (7) fairly stable supply.
Gold happens to meet the test of all seven attributes. However, investment advisor Medley seems to be equating the macroeconomic landscape today with that of 1980, when gold hit $850 per ounce, thinking that it's all downhill from here for the price of the yellow metal, just as it was 30 years ago.
But he turns a blind eye to the fact that M2 was just short of $1.5 trillion in January 1980, while this past October it was $8.7 trillion. Gross debt in 1980 was $909 billion, on November 2 of this year, $13.7 trillion. As a percentage of GDP, the debt was 33.4 percent in 1980; today it's 93.2 percent.
On February 15, 1980, the discount rate was goosed up to 13 percent and federal funds were yielding 14.5 percent to 15 percent (on the way to 20 percent a year later) Today, the discount rate is all of 75 basis points and federal funds fetch a yield of zero to a quarter percent.
And while Volcker's policies spurred widespread protests due to the effects of the high interest rates on the construction and farming sectors, causing irate, bankrupt farmers to drive their tractors onto C Street NW, blockading the Eccles Building, Ben Bernanke invited 60 Minutes into the Fed's chambers to go on camera assuring people he will keep rates near zero for as long as it takes.
Bernanke assured the national audience that the Fed was not printing money; however, he didn't explain where the Fed was going to get the funds to buy $600 billion worth of treasuries.
Rick Rule already knows the answer; and it's not just the Fed that's creating money out of nowhere to buy government bonds. "The decision by the European Central Bank to emulate their American peers to print money to buy existent European bonds is tantamount to government counterfeiting," says Rule.
And while central-bank bureaucrats come up with fancy names for this counterfeiting, like "quantitative easing," the owner of Global Resource Investments differs with that characterization. He says, "I disagree; I think it's a form of fraud. I think they are printing money to buy bonds that they couldn't otherwise sell."
Tim Medley believes stocks are selling at good prices and have the potential to reward investors with significant gains, while he believes the gains in gold prices are likely short-lived. Rule also remembers the late 1970s gold bull market, and he contends this market hasn't yet become the "echo market" that that one was:
In an echo market, the market might be kicked off by fear buying like we're seeing in gold now, and the momentum established by the fear buyers attracts the greed buyers. The momentum associated with the greed buyers sparks more fear buying and backwards and forwards.
Based on what Bernanke said on 60 Minutes, it is hard to imagine that it's really too late to be afraid.
Philipp Bagus, professor of economics at Universidad Rey Juan Carlos in Madrid, is a young scholar with a large influence, having forecast all the problems with the Euro and having persuaded many economists on the Continent that this currency is no better than any fiat currency. In some ways it is much worse because it has cartelized the management of European monetary regimes and created a terrible moral hazard.
We often hear analysis of the workings of the Fed. Discussion of the European Central Bank is more rare. Bagus compares the two institutions to show a fundamental difference. Member states of the ECB can run deficits and expect them to be financed by the ECB. This is not true with the Fed. So Europe has a tragedy of the commons at work with its monetary policy that sets up very dangerous incentives for member states. For this reason, the system is unworkable.
With this book, Professor Bagus brings his scholarship to English readers, explaining the background to the idea of European unity and its heritage of sound money. He explains that the Euro is not what the older classical liberals had hoped for but instead is a politically managed money that is destined for failure.
He writes with a keen sense for economic analytics and empirical detail, offering one of the most accessible and yet rigorous accounts of the emergence of the Euro. He predicts its downfall due to political pressures, bad banking practices, and exploding public-sector liabilities.
The analogies with the dollar are indeed close, but with welfare states at a more advanced stage, it will be a race to see which paper currency will crumble first.
Professor Bagus brings theoretical power to investigating one of the most important topics in economics today. His arguments and evidence convinced even Jesus Huerta de Soto to withdraw support for the Euro. For this reason, de Soto has written the introduction to this important work.
Perhaps I lead a sheltered life, but I found The Tragedy of the Euro to read like a great adventure novel. Here we have heroes (mostly post war German bankers, resisting inflation) and villains (mostly post war Frenchmen, allied with post war German politicians, determined to keep the common German citizen paying and paying). The villains believe, falsely, that they can secure for all time their special privileges over the German citizenry—which is not the same as the German elite, who often collude with the French elite for their own privileges. But this is their great error, which Professor Bagus explains so clearly. They want to ignore the laws of economics by building coercive pan-European bureaucracies to enforce their will. But this will not work. How long it will last is the question. The European financial crisis proceeds from day to day. This wonderful book will help everyone understand what is really happening and, we hope, provide a lesson for others. —Patrick Barron
Over the last two years, I have gotten perhaps dozens of requests to "deal with" the deflationist approach of Mike "Mish" Shedlock. On his popular financial blog, Mish has been repeatedly patting himself on the back for correctly calling all the major trends in contrast to those economists (like Gary North and I) who naively think Bernanke has the power to raise prices if he so chooses.
In the present article, I want to explain why I have not been persuaded by Mish's alternate framework. To be clear, I'm not arguing that Mish's fans should abandon their hero. Rather, I will simply point out that Mish's "calls" have not been nearly as prescient as he so often claims. Furthermore, I still believe that the Federal Reserve has the power to destroy the dollar next Thursday if it really wanted to.
Mish's Framework: Credit, Deflation, and GoldA good summary of Mish's views comes from a September 2010 blog post — it was this one that spurred me to write the current article, egged on by a reader who enjoys both Mish and my own work. Mish writes,
Day in and day out I hear it from readers who insist that we are not in deflation and will not be in deflation because prices are rising and continue to rise. …
Such comments come from those who are not thinking clearly about what's important. Here's why:
In a fiat credit-based financial system, when credit is plunging businesses are not hiring. There are currently 14.9 million unemployed who want a job but do not have a job because businesses are not hiring. … This is all related to the ongoing credit contraction.
When credit is plunging so do yields on treasuries and in turn yields on savings accounts. …
When business earnings are under pressure or when business owners face uncertainty over consumer spending trends, businesses cut back on benefits, especially health care. Those with health care benefits are asked to chip in more of the costs. This too is a function of deflation.
When profits are weak and business uncertainty high, stock prices do not act well (at least in the long run). Those with 401Ks or personal investments are affected.
With credit falling and wages stagnant or falling, anyone in debt is likely to have a harder time paying back that debt. Foreclosures rise so do bankruptcies and divorces. Entire families have gone homeless. …
Expanding credit (inflation) created an enormous housing bubble, a commercial real estate boom, a rising stock market, and an enormous number of jobs.
Contracting credit (deflation), burst the housing bubble, burst the commercial real estate bubble, burst the stock market bubble, resulting in millions of foreclosures and bankruptcies, millions of broken homes, millions on food stamps, 26.2 million unemployed or partially employed, and countless additional millions who are underemployed.
People notice food and energy prices because they tend to be somewhat sticky. Everyone has to eat, heat their homes, and take some form of transportation at times, but is that what's important?
No!
In the grand scheme of things, nominal increases in food and energy prices are but a few grains of salt in the world's largest salt-shaker compared to the massive effects of rising or falling credit conditions.
So we see that Mish takes great exception to those Austrians (especially Peter Schiff) who have been warning of inflation. Rather than focusing on statistics such as the monetary base (which has exploded since the crisis in the fall of 2008), Mish defines "inflation as a net expansion of money supply and credit, with credit marked-to-market. Deflation is a net contraction of money supply and credit, with credit marked-to-market."
The Rumors of Mish's Success Have Been Greatly ExaggeratedAlthough I am not a regular reader of Mish, I've skimmed enough of his posts to know that he frequently writes things like this (December 2008):
Those who think inflation is about prices alone were busy shorting treasuries, and looking the wrong direction for over a year. Only after the stock market fell 50 percent and gasoline prices crashed did the media start picking up on "deflation." Only those who knew what a destruction in credit would do to jobs, to lending, to retail sales, to the stock market, to corporate bond yields and to treasury yields got it right. (emphasis added)
As I say, Mish has been saying this repeatedly in the two years since TARP and the Fed's extraordinary interventions. And yet, if we don't simply take his word for it, and scour his archives, we'll find that he didn't "get it right" as much as he seems to think.
Before continuing, let me make a disclaimer: I am not arguing that Mish is a fool. If I spent two hours combing through the archives of any financial analyst who stuck his neck out making predictions, I would come up with all sorts of doozies. Mish knows this; he plays the game too. (Let me save Mish fans time and point you to my worst call, at the bottom of this article.) So the reason I am going through this exercise is to rebut the notion that Mish has guided his readers through the storm and gotten the major trends right, all along the way. That's simply not the case.
The Case of OilNow the "inflationistas" (Mish's derogatory term) will point to gold prices as proof that Bernanke is about to wreck the dollar. Yet Mish incorporates that into his deflationist framework by arguing that "gold is money." Okay, fair enough. Let's switch to oil prices then.
In the standard Mishian framework, oil prices should be crashing in a deflationary environment. And indeed, Mish points with pride (see the block quotation above) to the collapse in oil from the summer to the winter of 2008 as vindication.
But after crashing and bottoming out in December 2008, oil has steadily risen. Did Mish anticipate this? After all, if we were still in a deflationary environment, then the dollar should have continued to strengthen (or at least remain strong), and the real economy should have sputtered along. Both those forces together means falling (or at least stagnant) oil prices.
Although I had trouble finding explicit predictions, the few scattered remarks from that time frame confirm my interpretation. For example, on March 13, 2009, he wrote,
Many were of the belief that the trade deficit would widen as the US recession strengthened. The only way that could have happened is if oil prices stayed stubbornly high. While the price of oil may have bottomed, odds of it shooting up towards $100 again in the near future are slim.
So how did that (tentative) prediction play out? During the week he published that post, the average price of crude oil was $46 per barrel. Three months later it was $71. So does that 54 percent increase in price, in a mere three months, count as "shooting up towards $100 again in the near future"? I'll leave it to the reader to decide.
Incidentally, while we're on the subject of oil I have another Mish prediction, presumably the (partial) product of his deflationist worldview. On May 16, 2009, he wrote, "All things considered, oil prices are due for a pullback and gasoline prices at the pump are likely to follow."
Now the week that Mish wrote that, crude oil averaged $58 per barrel. From the time Mish made his "pullback" call, oil prices rose for the next four weeks to $71. (That's a 22 percent increase in under a month — not quite what I would call a pullback.)
And Mish's fans can't even say he got the longer-term trend right; to this day oil has never fallen back to its level in mid-May 2009. In other words, Mish's call on crude oil, quoted above, was exactly backward. Instead of pulling back, oil continued its steady march upward. Six months after making the pullback call, oil was trading at $78, for a 34 percent increase in half a year.
The Case of the DollarLet's do one more, and then move on to more theoretical issues. On July 16, 2010, Mish called for a "dollar bounce," primarily because his nemesis Peter Schiff was calling for the dollar to fall:
Politically I align with Peter Schiff. The financial sector bailouts were obscene, as are all of the stimulus efforts. There will be hell to pay for both.
However, investment-wise I cannot and do not agree with Schiff. His hyperinflationary rants are simply unfounded. The reason he cannot see the forest for the trees is he fails to consider the role of credit in a fiat-based credit world.
Credit dwarfs money supply. Much of that credit cannot and will not be paid back. Schiff got that part correct, in spades, predicting as many others did a collapse in housing. His mistake was in assuming the dollar would crash with it. …
Down the road, Schiff is correct that the problems facing the US dollar are enormous. However, investors must separate down-the-road conditions from what matters now.
What does matter now is the continued consumer credit implosion that dwarfs monetary printing and fiscal stimulus. That not only affects US stock prices but commodity prices as well, and in turn currency prices of commodity producing countries.
Factor that all in, and the possibility of the US dollar rising to 1.15 or even to parity vs. the Euro is not out of the question.
In the meantime, the US is back in deflation factoring in credit-marked-to market. Hyperinflation remains a pipe dream.
So let's go to the chart:
When Mish made his call on July 16 (indicated by the black vertical line), the price of a euro was $1.29. As the quote above reveals, Mish was predicting that the rising euro was just an aberration, and that the euro would continue its long slide against the dollar. In terms of the chart above, Mish predicted that the blue line would fall down to the bottom of the graph (i.e., a euro price of $1.15), or even down to $1.00 — which I can't even graph because it is literally "off the charts" compared to what actually happened.
To put it in other words, back in mid-July Mish was predicting that the euro would fall anywhere from 11 percent to 22 percent against the dollar. Instead, as of this writing the euro has risen 6 percent. Now it's true, because of the Irish debacle and the European debt crisis more generally, perhaps Mish's prediction will come true. But thus far, he has been wrong — the dollar has weakened (since Mish's call for it to strengthen) against the euro, and this is apparently due to the growing certainty that the Fed would engage in a second round of "quantitative easing." This is awkward for Mish, since he has been telling his readers that it is wrong to focus on the actions of the Fed when guessing which way currencies will move.
Vacuous or Wrong?The biggest problem I have with Mish's whole approach is that it is either vacuous or just plain wrong. On the first option, here's what I mean: Suppose a financial bubble bursts, meaning that asset prices start crashing, various businesses start losing money, and workers get laid off. In that environment, of course banks and other lenders are going to write down the market value of their outstanding loans. So you would of course see falling "credit marked-to-market" go hand in hand with those other trends. If that is all Mish means, then I've been converted.
But I think Mish is saying far more than that. I believe he's arguing that the shrinkage of credit causes those other things. After all, he has to be arguing that the change in credit is an independent variable in order for him to keep congratulating his predictive powers.
Yet Mish's story doesn't fit the basic facts. For example, in this post Mish uses the St. Louis Fed's data series "Total Bank Credit" to indicate whether we are having inflation or deflation. (As Mish says many times, credit dwarfs the money supply.) He wants to use this variable to explain the other trends, including the stock market. In fact, here's what Mish wrote on January 6, 2009:
Looking ahead in 2009 here are some things I see as likely.
Obama will pass a stimulus package of $850+− billion but $300 billion will be "tax relief" amounting to $19 a week at most. $19 a week per household is not going to stimulate much of anything but it will add to the budget deficit. People will use that money to pay down bills, which is exactly what they should be doing with it.
The first 3–5 months are going to be extremely weak on the jobs front with 400,000 or more jobs lost each month. Obama is going to need to create 2–3 million jobs just to counteract job losses in first half of the year. There is no way he is going to create jobs that fast given implosions in state budgets and retailers.
In 2009 consumers will continue to retrench, housing will continue to decline, and as many as 100 small or regional banks will implode over falling commercial real estate prices. The Fed may arrange shotgun marriages with these banks instead of letting them go under.
I am sticking with a thesis that says we are currently in a sucker rally in the stock market that will end soon after inauguration or moments after Obama signs a new stimulus package. My target is 600 on the S&P but 450 is not out of the question. However, it is better to think of this in ranges and that range would roughly be 450–700. (emphasis added)
When Mish wrote the above, the S&P 500 was 935. As the quote above tells us, at this time Mish was predicting that stocks would then fall down to 600 or maybe even 450. Instead, the "sucker rally" kept going, such that exactly one year later, the S&P 500 stood at 1137. To switch to percentages, this means that in early 2009, Mish was calling for stocks to drop anywhere from 35 percent to 52 percent. Instead, stocks steadily rose 22 percent. That's a phenomenally bad prediction.
But it gets worse for Mish. He can't even say that he misjudged which way credit would move. Look what happens if we superimpose the S&P 500 index on "Total Bank Credit":
Now if I understand Mish's model correctly, the movements in the S&P 500 index (red line) are supposed to follow movements in total credit (blue line). But if anything, they move in opposite directions: starting in the fall of 2008, the red and blue lines are pretty close to mirror images of each other.
Throughout 2006 and most of 2007, total bank credit rose in tandem with the stock market. So far, so good for Mish's framework. Yet the stock market crashed while total bank credit stagnated and then shot up. Then, as bank credit trickled down, the market bounced back.
Of course, Mish and his fans could explain the above chart by saying that the Fed intervened a few times to try to offset the deleveraging process. But my point is that Mish's basic story doesn't fit the facts; the variable he himself used in one of his posts — "Total Bank Credit" — doesn't move with the stock market the way Mish claims that it does.
And, as the block quotation above indicated, Mish was utterly wrong about what the stock market would do in 2009.
ConclusionI have had some harsh things to say about Mish's analysis in this article. In closing, I want to reiterate that I am not trying to "blow up" the viewpoint of the credit deflationists. I am merely pointing out that they have not called the major trends throughout the crisis, as they keep claiming. Moreover, it is still true that the major shifts in the stock market and the dollar can very plausibly be attributed to the various rounds of massive Fed intervention.
[Speech given at The Economic Recovery: Washington's Big Lie, the Supporters Summit for the Ludwig von Mises Institute, October 8, 2010.]
Ben Bernanke, the man who purports to be the savior of the economy today, was actually deeply involved in creating the housing bubble, encouraging people to invest in toxic assets, and orchestrating the cover-up after the bubble collapsed. Now he is bludgeoning the economy into depression. Just like his predecessor Greenspan, his statements are replete with misleading, convoluted, and inconsistent claims, all designed to disguise the role of the Fed in the economic calamity.
Ben Bernanke went to Harvard University, where he received his undergraduate degree in economics. He then went to graduate school at the Massachusetts Institute of Technology, MIT, where he received his PhD in economics. His thesis adviser was Stanley Fischer, and his committee consisted of Fischer, Rudiger Dornbusch, and Robert Solow, a Nobel Prize winner. (He also thanked Harvard University professors Dale Jorgenson and Peter Diamond [Nobel laureate 2010] in his dissertation.) It is safe to say that he had an elite education in mainstream economics.
Bernanke has taught at Stanford University, New York University, and Princeton University, where he served as chairman of the department from 1996 to 2002. Bernanke has authored major textbooks, has served as the National Bureau of Economic Research's director of monetary economics, and was an editor of the American Economic Review. He is still considered to be one of the top 20 authors of all time in academic economics journals despite having been out of academia for almost a decade.
Bernanke was appointed to be a member of the Federal Reserve Board of Governors in 2002. He was then appointed by President Bush to be Chairman of the President's Council of Economic Advisors in 2005. He was then appointed by Bush to be the chairman of the Federal Reserve in 2005 and subsequently renominated by President Obama in 2009. In 2009, Time magazine named Bernanke its "person of the year." Not a bad run-up in fame and influence for a boy from rural South Carolina.
Just to be clear, Bernanke received a top notch education in mainstream economics at Harvard and MIT under the direction of leading professors in the economics profession. He also taught at premier institutions and held key leadership roles in the profession. He is considered one of the most important researchers and publishers of his generation and is best known for his research on the Great Depression, where he added a distinction to the contributions of Milton Friedman and Anna Schwartz.
For Bernanke, the Great Depression was less about the Federal Reserve reducing the money supply (which is the Friedman and Schwartz hypothesis) and more about the bank failures that increased the cost of credit and decreased its availability, leading to a decline in aggregate demand and creating the Great Depression. For Bernanke, a downturn can lead to bank failures, which curtail credit. This can cause a further reduction in economic activity that spirals into a vicious cycle ending in economic depression. I will further address his distinction, because it is critical, in my closing remarks.
And Now for His RecordHere I will survey his record working for the Federal Reserve. In the interest of time, this survey is not comprehensive, but I feel almost certain that we could find problems in all of his testimony and speeches. In fact, I have become cynical enough to believe that every speech presented by the entire Board of Governors is designed to inject at least one untrue point into public discourse, mostly for purposes of maintaining "confidence."
Bernanke served as a member of the Board of Governors of the Federal Reserve System from 2002 to 2005. In one of his first speeches as a governor, entitled "Deflation: Making Sure It Doesn't Happen Here," he outlined what has been referred to as the Bernanke doctrine."Deflation: Making Sure 'It' Doesn't Happen Here," Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C. November 21, 2002. This doctrine holds that deflation, or a general decline in prices, is a highly destructive phenomenon, but one that is unlikely to occur in the United States. However, if it were to occur the Federal Reserve must resort to the printing press and several unconventional policy procedures if a zero-interest-rate policy fails to reverse the deflation. This would involve increasing the money supply, ensuring liquidity in financial markets, lowering the interest rate to zero, controlling the rates on private bonds and securities, devaluing the dollar, lowering the exchange-rate value of the dollar, and assisting the Treasury to buy equity stakes in private companies. He would do anything necessary to prevent the failure of major financial firms. At the time, it all seemed farfetched, but not anymore. According to Bernanke,
The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending — namely, recession, rising unemployment, and financial stress.
If all we know is that a collapse in aggregate demand is the source of deflation, then its cause remains a mystery because aggregate demand does not illuminate what sectors in the economy are collapsing or why they are collapsing. Only in a footnote does Bernanke suggest that an increase in aggregate supply (a good thing also known as economic growth) can cause deflation. "For the most part," Bernanke thinks that deflation is the cause of severe economic troubles.
Incidentally, Bernanke at times sounded Marxist with his statement that if the government controls the means of production in money production then it will have the ability to prevent deflation. You should also note that he was a big admirer of Franklin Delano Roosevelt, and this might be reflected in his use of acronyms for all his various "vehicles" (TARP, TAF, TSLF, PDCF, TALF, TDF, etc.).
The problem with Bernanke is that he is working with mainstream theory and ignoring history. He thinks deflation is bad, but unlikely to happen. If it does happen he will use weapons of mass economic destruction to stop it. In reality, deflation of prices is a normal aspect of the market economy as the production of goods outstrips the production of money resulting in higher real wages in a growing economy. The healthiest of economies will exhibit falling prices.
Historically, deflation was a common feature of the American economy, particularly before the establishment of the Federal Reserve. The one time that there was significant deflation and economic decline was the Great Depression.
Two economists published a study in the American Economic Review in 2004 that examined the association of deflation with depression. They looked at 17 countries and over 100 years of data and concluded that "beyond the Great Depression, the notion that deflation and depression are linked virtually disappears."Andrew Atkeson and Patrick Kehoe, "Deflation and Depression: Is there an Empirical Link?" American Economic Review: Papers and Proceedings, Vol. 94 (May 2004) pp. 99–103. Michael Bordo's work on this topic also suggests no clear linkage between deflation and depression. The only conclusion we can reach is that Bernanke, like his Princeton University colleague Paul Krugman, suffers from "apoplithorismosphobia," a term I coined (with the help of a Greek translator) to label the psychological and irrational fear of deflation.
In 2004, during the housing bubble, Bernanke addressed the phenomenon referred to as the "Great Moderation." It refers to the reduction in volatility in inflation and output that had occurred over the previous two decades. Bernanke found that improvements in monetary policy have not been given their due credit for bringing about this development.
The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. … This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.
I have put my case for better monetary policy rather forcefully today, because I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature."The Great Moderation," Remarks by Governor Ben S. Bernanke at the meetings of the Eastern Economic Association, Washington, DC, February 20, 2004
Obviously, changes in monetary policy could bring about less volatility in the economy. However, if those changes brought about less volatility from 1984 to 2004, then what about the increased volatility from 2006, when Bernanke took over as chairman of the Federal Reserve, until today? Was it the previous policies still in place that caused the increased volatility or was it changes in monetary policy brought about by Bernanke that caused the increased volatility? Which was it?
Possibly the worst of Bernanke's statements occurred in 2006, near the zenith of the housing bubble and at a time when all the exotic mortgage manipulations were in their "prime." This was the era of the subprime mortgage, the interest-only mortgage, the no-documentation loan, and the heyday of mortgage-backed securities. At the time, the new Fed chairman admitted the possibility of "slower growth in house prices," but confidently declared that if this did happen he would just lower interest rates.
Bernanke stated in 2006 that he believed that the mortgage market was more stable than in the past. He noted in particular that "our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real-estate appraisal practices have improved."Bernanke, Ben S. 2006a. Speech to the Independent Community Bankers of America National Convention and Techworld, Las Vegas, Nevada, March 8; Bernanke, Ben S. 2006b. "Reflections on the Yield Curve and Monetary Policy." Remarks before the Economic Club of New York, March 20. This is the equivalent of the Federal Reserve seal of approval being applied to mortgage lending at the pinnacle of the housing bubble.
Bernanke, the former economics professor from Princeton, gave an address to the annual meeting of the American Economic Association in January 2007."Central Banking and Bank Supervision in the United States." Speech given at the Allied Social Science Association Annual Meeting, Chicago, January 5, 2007. He is the first chairman of the Federal Reserve from academia to do so since Arthur Burns. It was Burns who helped take us off the gold standard. Who knows where Bernanke is taking us.
In addressing his fellow mainstream academic economists, Bernanke was unusually bold in describing the Fed's access and ability to use information and data concerning financial markets. This knowledge and expertise includes the market for derivatives and securitized assets. He described the Fed as a type of superhero for financial markets. In discussing the Fed's role as chief regulator of financial markets, he made powerful claims concerning the Fed's ability to identify risks, anticipate financial crises, and effectively respond to any financial challenge.
Many large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge obtained through its monetary-policy and payments activities, information gained through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions. …
In its capacity as a bank supervisor, the Fed can obtain detailed information from these institutions about their operations and risk-management practices and can take action as needed to address risks and deficiencies. The Fed is also either the direct or umbrella supervisor of several large commercial banks that are critical to the payments system through their clearing and settlement activities.
In other words, the Fed knows everything about financial markets. But it gets worse:
In my view, however, the greatest external benefits of the Fed's supervisory activities are those related to the institution's role in preventing and managing financial crises.
In other words, the Fed can prevent most crises and manage the ones that do occur.
Finally, the wide scope of the Fed's activities in financial markets — including not only bank supervision and its roles in the payments system but also the interaction with primary dealers and the monitoring of capital markets associated with the making of monetary policy — has given the Fed a uniquely broad expertise in evaluating and responding to emerging financial strains. (emphasis added)
In other words, the Fed is an experienced, forward-looking preventer of financial crises. This is a strong claim, given Bernanke's own abysmal record of forecasting near-term events.
Chairman Bernanke is infamous on the internet because of the YouTube video that chronicles his rosy view of the economy from 2005 to 2007. He denied there was a housing bubble in 2005, he denied that housing prices could decrease substantively in 2005 and that it would affect the real economy and employment in 2006, and he tried to calm fears about the subprime-mortgage market. He stated that he expected reasonable growth and strength in the economy in 2007, and that the problem in the subprime market (which had then become apparent) would not impact the overall mortgage market or the market in general.
In mid-2007 he declared the global economy strong and predicted a quick return to normal growth in the United States. How many times have we heard about green shoots over the last two years, when possibly as many as 40 percent of Americans families have experienced unemployment, bankruptcy, foreclosure, or are currently in jeopardy of foreclosure?
Remember, Austrians were writing about the housing bubble, its cause, and the probable outcomes as early as 2003. Bernanke and others have denied that you can predict bubbles and crises, and when prodded about the predictions of Austrian economists the familiar retort is the "broken-clock effect." That is, even a broken clock gets the time right twice a day. But not so fast, I have seen a list of about 40 people who made reasonably correct predictions about the housing bubble, and about three-fourths of them were from followers of Austrian economics. Given that Austrians make up a tiny percentage of all economists, it would seem that there is more to this than a broken clock.
ConclusionBernanke has the credentials of a mainstream economist of the highest rank, as well as the highest titles for economists working in government. His defining contribution in economics is the distinction he drew with regard to the Friedman and Schwartz analysis of the Great Depression. Where they found that the economy went into a "great" depression because of a decline in the money supply, Bernanke found the cause to be the collapse of the banking industry that resulted in restricted and higher-priced credit.
Both agree that there was a decline in aggregate demand that could have been averted by prompt action by the Federal Reserve and the government. However, the type of action required is different. Friedman and Schwartz argued that the Federal Reserve should have acted to increase the money supply or to have at least prevented it from falling. In contrast, Bernanke believes that the Federal Reserve should have acted to prevent the collapse of banks. The Friedman and Schwartz solution would have allowed some banks to fail, although presumably fewer than did fail due to the increase in the money supply and liquidity. Bernanke, in contrast, would have acted to bail out most banks from failing in order to maintain the availability of credit in the economy, but would have been less concerned with the overall money supply.
Whether either of these policies would have worked is dubious because, as Murray Rothbard wrote, other interventionist policies by the Hoover administration were also preventing the economy from correcting — a view that is gaining adherents even within mainstream economics. The relevant issue for today is that Bernanke essentially believes that it is the Federal Reserve's job to bail out financial institutions in order to maintain the channels of credit and to prevent other "nonmonetary" factors from negatively impacting aggregate demand. This explains Bernanke's swift acting to bail out financial firms like Bear Sterns and AIG, the nationalization of Fannie Mae and Freddie Mac, backstopping whole markets such as money-market mutual funds, and absorbing vast quantities of toxic assets onto the Federal Reserve's balance sheet.
In preparing for this lecture, I began to realize just how obvious a choice Bernanke was for chairman of the Fed. From the point of view of banks, corporations, and Wall Street — also known as the "corporatocracy," a government run for the interests of big corporations — who would be better than someone who literally wrote the book on bailing out the banks and Wall Street during a financial crisis?
Another example of Bernanke's suitability as Fed chairman is his willingness to drive down the value of the dollar. It means higher prices for you and me, but hey, it is great for exports, which again is largely the corporatocracy's gain. When you realize that the Fed is the major engine that enriches the corporatocracy at the expense of Main Street, you can fully understand the ongoing actions of the Fed and certainly of Bernanke.
A third example is Bernanke's use of forced low interest rates. Banks benefit. Corporations benefit. But how about Main Street, small business, and savers? Lowering interest rates hurts savers, retirees, and even small-town banks who cannot access the monetary pumping from the Fed and must rely on their depositors. According to the president of the Federal Reserve Bank of Dallas it would seem that the Fed is only helping the corporatocracy move overseas before the whole US economy crashes and burns.
In my darkest moments I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places. Far too many of the large corporations I survey that are committing to fixed investment report that the most effective way to deploy cheap money raised in the current bond markets or in the form of loans from banks, beyond buying in stock or expanding dividends, is to invest it abroad where taxes are lower and governments are more eager to please.Richard W. Fisher, "To Ease or Not to Ease? What Next for the Fed? (With Reference to Bill Frenzel, Alan Greenspan, Masaaki Shirakawa, Sherman Maisel and Raghuram Rajan)," Remarks before the Economic Club of Minnesota, Minneapolis, Minnesota, October 7, 2010.
As we enter the fourth year of this economic crisis, we should not be surprised to see additional moves from Bernanke. He admired FDR for his bold and innovative policy making and has replicated FDR's approach at the Fed, even down to the use of acronyms. So do not be surprised to see more "quantitative easing" with each successive downturn in the economy.
I end with a quotation from Murray Rothbard that captures my own conclusion about the coming consequences of Bernanke's rule at the Fed.
As we face the future, the prognosis for the dollar and for the international monetary system is grim indeed. Until and unless we return to the classical gold standard at a realistic gold price, the international money system is fated to shift back and forth between fixed and fluctuating exchange rates with each system posing unsolved problems, working badly, and finally disintegrating. And fueling this disintegration will be the continued inflation of the supply of dollars and hence of American prices which show no sign of abating. The prospect for the future is accelerating and eventually runaway inflation at home, accompanied by monetary breakdown and economic warfare abroad. This prognosis can only be changed by a drastic alteration of the American and world monetary system: by the return to a free market commodity money such as gold, and by removing government totally from the monetary scene.
This article is excerpted from the transcript of a speech given at The Economic Recovery: Washington's Big Lie, the Supporters Summit for the Ludwig von Mises Institute, October 8, 2010.
Recorded at the Ludwig von Mises Institute's Supporters Summit; Auburn, Alabama; 9 October 2010.
Recorded at the Ludwig von Mises Institute's Supporters Summit; Auburn, Alabama; 9 October 2010.
On Sunday the Troubled Asset Relief Program (TARP) officially expired, though its "legacy programs" could continue for years. Lately there has been a growing campaign to tout the success of TARP, Henry Paulson's extremely controversial plan to use (originally) $700 billion of taxpayer money to save the financial system. Despite this chorus of praise, the TARP bailout was a terrible idea that will cost taxpayers both directly and indirectly through its perverse incentives.
The Politics of TARPProbably more than any other issue, the pundits' handling of TARP has been extremely political. There were many right-wing analysts who were for the bailout when Bush Treasury Secretary Hank Paulson proposed it in September 2008, and yet these supporters mysteriously became some of the fiercest TARP critics after Obama was in the White House. (Glenn Beck is the most obvious example, but there were others.)
On the other hand, I can't help but think that at least some of the left-wing analysts who are currently singing the praises of TARP would be singing a different tune had John McCain won the election. We can't know what would have happened in that alternate timeline, but I'm guessing many of these progressive bloggers would have excoriated the Republican bailouts of their fat-cat banker friends. (In fairness, Matt Yglesias and Paul Krugman have been consistent — they were for TARP, with caveats, from the beginning!)
Say what you will about Austrian libertarians, we are a pretty consistent bunch, who heap scorn upon massive expansions of government power — whether in economic, social, or military arenas — regardless of the party in power. For example, on these very pages I described TARP way back when as "The Great Bank Robbery of 2008."
Did Taxpayers Make Money on TARP?In mid-September Matt Yglesias perfectly summed up the verdict being crystallized among interventionists in the blogosphere regarding TARP:
More opinion leaders really have an obligation to point out that TARP, the Troubled Asset Relief Program, looks set to go down in history as one of the most unfairly maligned policy initiatives of all time. The government took hundreds of billion dollars, gave it to banksters, and in exchange all we got was this lousy $7 billion in profit. Which is to say that even if TARP had no positive impact on the economy whatsoever, it had a negative cost to taxpayers. How many programs can you say that about? And how many of them are toxically unpopular?
The interesting thing here is that if you follow the link Yglesias himself provides, it is to a CNN Money article from last March with the headline, "Price Tag of TARP Bailout: $109 Billion." Now Austrian economists are famous for eschewing complex math, but even we can tell that $109 billion is larger than negative $7 billion.
If we dig into the article, we see where Yglesias came up with the claim that TARP "had a negative cost to taxpayers":
The government's unprecedented $700 billion economic bailout will actually cost taxpayers just 16% of that total, according to a Congressional Budget Office report released Wednesday.
The Treasury's losses on the Troubled Asset Relief Program (TARP) will total $109 billion over the program's lifetime, CBO latest estimates [made back in March 2010] show. …
TARP's two big moneysuckers are AIG and the auto industry.
AIG got TARP money in two forms: the government bought $40 billion in preferred stock and created a $30 billion line of credit for the company. CBO previously estimated the AIG bailout would cost the government $9 billion, but AIG hasn't paid the Treasury the quarterly dividends it owes. AIG's weak financial position prompted CBO to increase its loss projection to $36 billion — more than half of the AIG bailout cost.
Other major losses — a total of $34 billion — will come from TARP assistance to the automotive industry, CBO said. The government committed $85 billion to bailing out the automakers.
On the flip slide, the highly unpopular capital infusion for banks will actually net the government $7 billion, CBO expects — even including a $2 billion loss from CIT Group … which declared bankruptcy, and Pacific Coast National Bancorp, which was taken over by the Federal Deposit Insurance Corporation.
So let's be clear: When proponents say TARP "made money," they are narrowly referring to the infusion of funds into banks. The taxpayers have still lost money on the entire deal, because the slight profits on the bank investments have been dwarfed by the injections into AIG and the auto industry.
But even if we focus on the capital infusions into banks, it's hard to see how the Treasury made a good investment, or netted the taxpayers money.
First of all, the TARP plan was reconfigured almost the moment Paulson got his authorization. It was originally sold as a plan to buy troubled assets — hence the name of the plan. After Paulson got his $700 billion ransom payment, he instead decided to use the money not to buy mortgage-backed securities, but instead to acquire partial government ownership of major banks.
It's important to point out that at least some of these capital injections were offers that the executives couldn't refuse. We can never know exactly what went on in that room, but it seems likely that the strongest banks — which would look relatively healthy to markets if they had had the option to refuse a taxpayer bailout — were muscled into accepting packages by the Treasury Secretary.
This is an important difference. When TARP was first implemented, free-market economists were asking, "If these purchases of preferred bank stocks are such a good investment, why aren't people in the private sector putting up the money?" Yet private investors may not have had the option of acquiring some of the deals that Paulson was able to finesse with his privileged position.
Another important point is the risk involved. Just because an investment pays off in retrospect, doesn't mean it was a good idea all along. For example, if the United States Treasury offers loan guarantees to a shaky third-world government, in order to induce banks to accept its bonds, it may turn out not to "cost" the taxpayers anything. But it would be wrong to say such a loan guarantee had really been "costless," because in the event of a default, the taxpayers would have been on the hook.
A similar analysis holds for TARP. At least for the banks in the worst shape, they received generous terms from the Treasury. In other words, the Treasury infused capital into these banks at a risk of loss higher than private investors would have tolerated. The mere fact that this gamble didn't blow up in their faces doesn't prove it was a good idea.
The Role of the FedThe role of the Federal Reserve is even more important than the above points. Under Ben Bernanke's leadership, and in coordination with then–New York Fed President Timothy Geithner, the Fed expanded its balance sheet by more than a trillion dollars in late 2008, relieving the banks of their bad assets through various purchases and other deals on terms that no private hedge fund would have offered:
Federal Reserve Balance Sheet (source)So although the Treasury may have "made money" on a certain category of the TARP investments, this is hardly a boon to the taxpayer, because some (possibly all) of the major banks were propped up by the Fed's money creation. If this is success, then let's cut out the middleman. The Fed can simply print up $10,000 in new bills and mail them to every taxpayer. Woo hoo! We'd each make $10,000 on that deal, after subtracting out the Post Office's cut.
Dean Baker, a Keynesian economist who nonetheless can smell a rat, couldn't believe that the New York Times couldn't find any critics of TARP in its congratulatory write-up. Baker explained,
[If the NYT had found some critics], and they talked to them for their article on the end of the TARP, the critics likely would have told the NYT that the TARP preserved Wall Street as we know it. Had the market been allowed to do its magic, Citigroup, Goldman Sachs, Morgan Stanley, Bank of America, and many other fine institutions would have been bankrupt. This would have redistributed more than a trillion dollars of wealth from the shareowners, the creditors, and the top executives to the rest of the country.
By providing them with loans at below-market interest rates, the TARP and the much larger Fed and FDIC bailouts, allowed the banks to survive the crisis created by their own recklessness. This was like giving away food during a famine. The banks have repaid the food with interest now that the harvest has come in, but to pretend that we did not do them an enormous favor at enormous cost to taxpayers (we could have rescued others with these loans) is absurd.
Finally, even if we put aside all the above complications and concede that the TARP injections into the banks "made money," it was for the politicians, not the taxpayers. I certainly don't remember getting a dividend check in the mail for my share of the $7 billion profit that Yglesias trumpeted.
It is notoriously difficult to pin down money flows in Washington. But I have yet to be convinced that the government won't simply spend the incoming paybacks on other things.
Did TARP Prevent Another Depression?A crucial point in the case for TARP is that without it, we would have plunged back into another depression. For example, Simon Johnson wrote last week,
People who are opposed to bailouts of any kind like to argue that TARP was not really necessary. Banks could have been allowed to fail and the economic fallout around the world would not have been so dramatic.
This was, of course, the view taken by policy makers in 1929–31, after the Great Crash. Top people at the Federal Reserve and Treasury argued that the United States had experienced a financial mania (true), that a fall in asset prices was long overdue (quite likely, at least for stocks), and that the right approach was to stand back and — in the unforgettable words of Treasury Secretary Andrew Mellon, let the private sector "liquidate labor, liquidate stocks, liquidate the farms, liquidate real estate."
The result was the Great Depression. No responsible policy maker would want to run that risk again.
There is so much wrong in the above quotation that it would take a whole book to set the record straight. For now, let me mention two things: First, the only source we have for that infamous Mellon quote is from Herbert Hoover's memoirs, and his point in setting up Mellon's position is to then declare that Hoover didn't listen to Mellon's advice. There is no ambiguity here; Hoover repudiates the liquidationist plan in his memoirs immediately after laying it out.
Second, we don't have to trust Hoover's memoirs to know that he wasn't a liquidationist. To take just one example, we can go look up in Wikipedia to learn that the Reconstruction Finance Corporation was established in the Hoover Administration in 1932 and "gave $2 billion in aid to state and local governments and made loans to banks, railroads, farm mortgage associations, and other businesses." The article then adds, "The loans were nearly all repaid." See, the taxpayers made out like bandits back in the 1930s, too!
Did TARP Restore Business Lending?The primary reason that TARP allegedly averted another depression is that it fixed the credit markets. Here's Timothy Geithner praising his staff two weeks ago:
Two years ago the financial system was falling apart.
The banks and financial institutions that Americans rely on to protect their savings, help finance their children's education, and help pay their bills were at risk in ways few had ever experienced.
The institutions and the markets that businesses rely on to make payroll, build inventories, fund new investments, and create new jobs were threatened like at no time since the Great Depression.
Across the country, Americans were starting to question the safety of their money in our nation's banks, and a growing sense of panic was producing the classic signs of a generalized run. …
Now, TARP was not perfect. But it has delivered in ways few could ever have imagined.
It's not just that people are confident today that their money is safe in banks; it's not just that household wealth is much higher than when the President came into office; it's that the cost of borrowing for businesses and municipal governments has come down significantly; it's that families can again buy a new home or car at low rates and put their kids through college.
Geithner was wise to focus on interest rates, rather than the actual amount of loans going to businesses. Look at the chart:
Yes that's right, commercial and industrial loans at all commercial banks were at an all-time high … right when TARP was implemented. And then they fell like a stone. This doesn't prove that loans would have been higher in the absence of TARP, but it should make us pause when we hear how great the program was in getting credit to small businesses.
ConclusionThe TARP was crooked from the very start, using taxpayer funds to bail out some of the world's richest people from their own foolish investments. The claims that it made taxpayers money are unfounded. Even worse, TARP taught investment bankers an important lesson: During a boom, make as much money as you can, no matter how short-term the profits will be. When the bubble pops, the Treasury and Fed will be there with a taxpayer-funded pillow.
Robert Wenzel gave valuable suggestions for this article.