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Where We Went Wrong

March 31, 2010 Leave a comment

The real genius of progressivism is that it is progressive.  The effect of this approach is that over generations, people completely lose touch with what a reasonable alternative to progressivism looks like.  At each step we are forced to choose between the existing progressive system which we know to be flawed and an alternative, even more progressive system which we don’t yet realize is even more flawed.  This leaves those of us who would advocate for true freedom the difficult task of explaining what a real free market would look like to people who have never seen anything like it.  This I will attempt here. 

The only way to break the cycle is to take a historical perspective and ask questions like “what could we have done instead at some point in time and what would likely be the effect?”  These questions are not very appealing to academic economists because it involves analyzing a system that either hasn’t existed in generations or hasn’t existed ever, so it may not seem to be of much practical importance to the American Economic Review.  It should, however, be considered of the utmost importance to people who have any hope of returning to a system which relies on personal liberty.

There is a common blueprint for basically all progressive schemes.  First, you take an individual problem and turn it into a collective problem.  Then you take it for granted that it is a collective problem and use this as justification for using the government to “fix” it and claim you are doing so in defense of freedom and liberty.  As congress prepares sweeping new financial regulation, I will identify where and how we first caused the problems we now have with the financial system (at least some of the problems) and go through a thought experiment regarding what might have happened had we embraced individual instead of collective responsibility.

As usual with this stuff, we go back to the early days of progressivism.  In this case it was 1913 when the Federal Reserve System was created.  The main reason for the Fed was to stave off bank panics.  A bank panic happens because banks lend out more money than they keep on hand and the contract depositors make with banks (theoretically) allows them to withdraw it at any time.  If you put $100 in the bank, they are contractually obligated to give you $100 at any time if you come in and demand it.  But if they don’t expect you to come ask for it in the near future, they may not want to have that money just sitting around doing nothing.  If they loan it out, they can make some interest on it.  So they will keep some on hand to deal with the people who do happen to come demand their money and lend the rest out.  Currently they are required by the Fed to keep 10% on hand.   

Now the problem is that, while the bank may have assets of greater value than its liabilities at any given time,  it does not have sufficient liquidity to settle all the demand which could be made on it.  If the bank remains financially sound and everyone believes it is financially sound, this is not likely to cause a problem.  The problem comes if something happens which makes people concerned about the long-run health of the bank.  Imagine that you have your money in such a bank and you know that it has loaned a large amount of money to a property manager constructing a large resort casino and halfway through construction, the building burns down and the owner has no insurance.  He will certainly default on the loan.  And imagine that this is such a large part of the portfolio of the bank that the loss causes the actual value of their assets to be less than their liabilities.  One of their liabilities is to you.  And your contract with them requires them to pay you in full on the moment that you present yourself at their bank and ask for your money.  You also know that every other depositor has the same contract and eventually someone is going to have to bear the loss incurred by the bank from the fire.  What do you do?  Of course, you run down to the bank and try to get your money out so you won’t be left holding the bag.  Naturally everyone else does the same thing and the bank doesn’t have enough money to pay everyone because they loaned most of it out.  This causes additional losses due to the manner in which the bank collapses.  It also may cause an otherwise healthy bank to fail if people “panic” for some reason which is unfounded.

Before investigating the possible solutions to this situation, we must consider the purposes which the banking system serves.  The first is the safe storage (and sometimes transport) of money.  Originally, banks were nothing more than places where you could put your gold or other valuables and be more comfortable about their security than if you had them under your mattress.  There are two important things to point out about this.  First is that the risk of losing your valuable assets is a reality of nature that exists with or without banks.  The purpose of this sort of bank is that it reduces that risk.  Second is that in exchange for this reduction in risk you would pay them

The second purpose of a bank is to be a middleman between investors and borrowers.  If you had a certain amount of money that you wanted to invest in a productive activity and you had to find such a thing yourself, there would be some difficulties.  First would be that you would have to find a project of a size and risk level which was suitable for you and every borrower would have to find lenders in a similar way.  This requires every investor and borrower to spend a lot of resources engaging in activities which they don’t necessarily have a comparative advantage in.  Banks act as a specialist in this area.  Also, if you invested all your savings in one project and it failed you would lose everything.  Since people seem to be risk averse, this is probably not ideal.  By borrowing from many investors and then lending to many borrowers, a middleman can spread the risk in a way which is more beneficial.

A bank engages in a pure form of this function when it issues a certificate of deposit in some amount to be paid on a specified date.  The important difference here is that you cannot just walk in and demand your money whenever you want.  This allows the bank to plan and manage the inflow and outflow of cash.  The risk of loss still exists but there is no incentive for a bank run.  This risk may likely be increased compared to storing your money under your mattress and even if it is not it requires you to give up some liquidity.  Because of this, the bank pays you

Now the bank run is a symptom of banks pretending that they can provide the best of both worlds.  If the deposit banker who had promised to keep your gold in a safe place where you could get it whenever you want decides “hey, I have all this money lying around. I may as well lend it to someone and make a little extra profit, but I won’t tell anyone because it might scare them to know that I couldn’t really pay back everyone who deposited here if they all wanted their money,” this would be considered fraud.  The complicating issue is that by the early 1900s banks were all doing this and had been doing it for a long time, depositors knew it was happening, and the price of bank deposits had been competed down to a level which reflected this behavior (that is, the bank was paying the depositor rather than the other way around). 

The progressives solved the problem of bank runs by federalizing the banking system.  The basic argument is that bank runs are irrational (which they may or may not be) and that by ensuring people that they will get their money, they can be avoided.  This allows banks to continue engaging in fractional reserve banking without having to pay a rate of interest which compensates people for the risk.  The risk still exists but it is assumed by the government.  This is the check that came due in 2008  and it is why the “health” of the financial system is now a collective problem.

Murry Rothbard, who deserves credit for much of the explanation above, argues in The Case Against the Fed that the way to eliminate bank runs is to eliminate fractional reserve banking.  I take a somewhat more moderate (though even more liberty-minded) approach which is to say that fractional reserve banking is not necessarily a bad thing, the bank runs of the 19th and early 20th century were the result of a failure by individuals to recognize flaws in a contractual relationship.  The flaw was that they failed to recognize that there is a real risk associated with depositing money in a fractional reserve bank which is greater than that of depositing money in a safe deposit box and they failed to anticipate this and provide for it in the contract.  This could be easily fixed without any government intervention.

Consider a contract between a depositor and a bank similar to the following:  Depositor deposits Y dollars in the bank and the bank pays r% interest as long as the money remains in the bank.  The bank will maintain a minimum reserve ratio of X% of all deposits on hand for withdrawals and will pay withdrawals up to the full amount of a depositor’s account upon demand so long as their reserve ratio exceeds X%.  The current reserve ratio will be disclosed at all times to the public.  If the reserve ratio falls below X%, or if the manager of the bank anticipates that it will fall below X%, then the bank will be considered insolvent and will freeze all withdrawals for a period of Z days/weeks/months during which time the assets of the bank will be liquidated at the most favorable terms possible.  At the end of this period, the remaining assets of the bank will be distributed among depositors in some specific way. 

The only difference between this contract and the one that existed between banks and depositors is that it recognizes the existence of a real risk and provides for dealing with it in a specific way which would eliminate the incentive for a bank run.  Once people observe that bank runs are a potential problem, this is how thoughtful people could be expected to deal with it in a country of individual freedom, property rights, and rule of law.  The only “problem” with this is that it prevents people from pretending that the risk doesn’t exist.  You would have to acknowledge that you might not be able to get your money under certain circumstances.  This means you would likely demand a higher rate of interest to induce you to deposit there.  It also means banks would compete on both r (the interest rate) and X (the deposit ratio).  If you didn’t want to bear any risk you could deposit it in a “traditional” bank which does no lending (as Rothbard wanted) but then you would have to pay them.  If you wanted maximum profit and weren’t concerned with liquidity you would get a CD.  If you wanted some intermediate combination of risk, liquidity and return, then you would choose a bank with the appropriate X and r for your taste. 

The only thing preventing this was the delusion that we deserve maximum liquidity, with no risk and the bank should pay us.  In a free market, people who continue to cling to this mistaken belief would continue to get burned by bank runs and people who realized it was mistaken would form and seek out banks which offered more realistic agreements and would not get burned by bank runs.  In this case it would not be a collective problem.  Only people who were too ignorant to recognize that just because a risk isn’t provided for in a contract does not mean that it doesn’t exist would be susceptible to it.  In this case, it probably wouldn’t take long for everyone to come around because it wouldn’t be in their interest to continue to deny the reality of the situation.

Instead of allowing this to happen, we decided to institutionalize the delusion.  The government said that if we just let them take over the banking industry we could continue to have the maximum liquidity with no risk and a high rate of return that we had mistakenly believed was possible.  It wasn’t particularly in anyone’s interest to figure out the flaw in this plan so nobody did (or if they did they were a sufficiently small portion of the population that they couldn’t stop it) so we went forward with this solution.  Because of this, there is an inherent moral hazard problem in the banking system since banks don’t bear the risk of insolvency.  This means the Feds have to regulate them.  Also it turns what was an individual problem into a collective problem, so that they can eventually regulate anything even relating to it (but don’t worry not much is related to the financial system).  And, perhaps most importantly, it removes the incentive for anyone to figure out a free market way to fix the problem.  This means that generations later, we just take it for granted that this is a reasonable thing for government to be doing and we can’t even imagine what a free market would look like.

Categories: Uncategorized

Link

March 30, 2010 2 comments

Sumner is doing a very good job over on Money Illusion of moderating a debate among some prominent economists regarding the impact of healthcare reform on the deficit.  His conclusion is similar to mine.  Although, he’s apparently not as concerned about it as I am.

Categories: Uncategorized

Atlas Now?

March 23, 2010 1 comment

 “You did not care to compete in terms of intelligence–you are now competing in terms of brutality.  You did not care to allow rewards to be won by successful production–you are now running a race in which rewards are won by successful plunder.  You called it selfish and cruel that men should trade value for value–you have now established an unselfish society where they trade extortion for extortion.  Your system is a legal civil war, where men gang up on one another and struggle for possession of the law, which they use as a club over rivals,  til another gang wrests it from their clutch and clubs them with it in their turn, all of them clamoring protestations of service to an unnamed public’s unspecified good.  You had said that you saw no difference between economic and political power, between the power of money and the power of guns–no difference between reward and punishment, no difference between purchase and plunder, no difference between pleasure and fear, no difference between life and death.  You are learning the difference now.”

Ayn Rand, “Atlas Shrugged” (1957)

Categories: Atlas Now?

Quick Fix: Senate

March 23, 2010 2 comments

When the founders set up the federal government, they created two legislative bodies.  The idea was that one body would represent the people and the other would represent the state governments.  Since state governments were considered sovereign, they had to have a voice in the making of federal law, otherwise the federal government could erode that sovereignty over time. 

In 1913, after a long campaign by progressives such as Robert La Follette and William Randolph Hearst, congress passed the 17th amendment to the constitution which made senators elected by the public instead of by the state governments.  Once this happened, the senate was just another house of representatives with longer terms.  This means that the state governments have no say in what the federal government does. 

Now look at what the federal government does.  They pass massive unfunded entitlements for “the people” and then impose them on state governments who have to find a way to pay for them.  Naturally this leads to states going bankrupt which we are now seeing.  And the Feds. are heaping more and more on them while they’re already struggling.  It’s almost as if they want states to be in trouble…  The healthcare bill which passed the house yesterday apparently forces millions into Medicaid which is funded by states.  This is largely responsible for the “deficit reduction” that is claimed to result from the bill.  But how are states going to pay for it?  Well if you read my previous post in this category you know the answer.  The federal government will give them back some of the money that they take from their citizens.  But notice that we are crossing an important line here.  This federal money is about to go from being something that states would really like to have, to being something that they need in order to survive.  Once this happens, can we really convince ourselves that states are sovereign?

State governments need to be able to keep the federal government from doing this to them and the way to make that happen is to have them elect their senators again.  If we could get this done along with getting rid of direct taxation and the top down flow of money, then we would have a system that could work long-term.  That’s about all we need actually.  If I know me though, I will probably keep thinking of things and posting them.  Actually I’m thinking of a minor amendment to the constitution right now that would help a lot….

Categories: Quick Fix

What Glenn Beck Understands About the Economy that Paul Krugman Doesn’t

March 20, 2010 2 comments

Keynes once referred to economists as “the trustees not of civilization, but of the possibility of civilization.”  We live in a highly specialized world and economists specialize in figuring out how it all works.  This means that all the people who specialize in other things trust economists, to some degree, to keep the economy running smoothly, or at least to sound an alarm if there is a potential problem coming up.  This makes perfect sense except for the fact that mainstream economists have pretty much never sounded an alarm before any major economic problem (Austrians tend to do this but they’re basically sounding an alarm all the time…).  I get the feeling that right now people in general are relatively at ease (more so than they would be otherwise) because mainstream economists seem to be at ease. To explain why it may not be wise to trust mainstream economists to forsee a catastrophe and help us avoid it I will have to explain a little bit about how economics works.

Economics is the study of how resources get allocated in a world of scarcity.  The fundamental problem of economics is that people’s wants are seemingly endless but the amount of available resources is not.  This means we have to choose between competing uses.  To understand the effects of these choices economists use models.  A model is a mathematical representation of a decision by one or more economic agents.  Typically these models consist of an objective function which agents are trying to maximize and a set of constraints.  The objective function is a way of quantifying their desires and the constraints are a way of quantifying the scarcity which they face.  Then you use math to figure out how these things interact given the way you chose to quantify them to begin with.

As a simple example, take a model of consumer optimization.  A consumer has a utility function which represents his desire for goods.  He tries to get the most utility he can by buying goods.  If you stop here you have a very uninteresting model because, assuming he always gets more utility from more consumption, he will consume infinite quantities of every good.  An economic model that says that everyone has as much as they want of everything isn’t very useful since in the real world we seem to observe that goods are scarce.  We need to add scarcity into the model somehow.  The way we do it is with a budget constraint.  This says that the consumer can only buy bundles of goods that he can afford.  The scarcity he faces is then quantified by his income and the prices of the goods.  Imposing this condition on the model means you cannot get a solution where the consumer consumes more than he can afford.

Now, more to the point, essentially every macro model used by mainstream economists has what is called a no ponzi game constraint.  Without getting into the mathematics of this thing, which is a little tricky, it basically imposes the condition that the government cannot constantly spend more money than they have.  This is necessary for a macro model because if you didn’t have it you wouldn’t have scarcity.  The optimal solution would always be that government borrows and spends infinitely and everyone gets as much as they want of everything.  The important thing to understand here, though, is that this condition is a constraint.  It is not a result.  This means that the model is incapable of considering any state in which this is not the case.  Every result coming from these models assumes that any budget deficits are temporary and will be paid back at some point in the future.  The model cannot be used to answer the question “what happens if we just keep running deficits forever?”

The real important question facing us right now is “do we believe that the government is going to pay off its debts someday?”  This is a question that the economists aren’t going to answer for us.  I don’t think we need them though.  Let’s play a little game where you pretend to be a lender and I pretend to be a guy asking for money.  I will tell you some facts about myself and then you decide whether you think I’m a good credit risk.

“I am 234 years old.”

“I was in debt when I was born.”

“I had 0 debt for about a year 175 years ago.”

“So far this year my income has been $2.1 trillion and I have borrowd about $1.4 trillion.”

“I only borrow in the bad times. When times are good I pay it down.  Since 1931, there have been eleven years when I ran a surplus.  Including four years in the 90’s when I was experiencing one of the greatest technological booms in history along with a massive real estate bubble.  During those years I paid back about 1% of what I owed (this is debatable, and I am being liberal).  The total of the surpluses for those eleven years, adjusted for inflation, is only slightly less (about 1/3) than the amount I borrowed last year.”

“In addition to the $12.6 trillion I owe to lenders, I have also accumulated an estimated $108 trillion in liabilities that I don’t count as debt because I don’t like to think about it.”

“You don’t have to worry because I have an entire country that I can tax at will to pay you back.  The total assets of the country amount to about $72 trillion, which is only about $49 trillion less than the amount I owe…. Oh and the people who own those assets only owe $16.6 trillion to other people.”

“I am restrained by law from borrowing too much.  Although I can change the law whenever I want.  Last year I raised the limit….this year also.”

“I did recently make a law that every time I wanted something new I would pay for it without borrowing… except for spending associated with the $108 trillion of liabilities mentioned above.  I had a rule like this in 1990 and it lasted all the way till 2002.  Then I brought it back in 2007.  I went almost a year before breaking the law and passing the alternative minimum tax, the stimulus bill of 2008, and a farm subsidy bill.  Then I made this sort of thing legal by adding an “emergency” exemption.  Since then I’ve hardly done anything that did comply with this rule.  Last month when congress tried to extend unemployment benefits, out of 535 legislators 1 man suggested that we should pay for it somehow.  He was promptly shouted down.”

“I have a vast portfolio of failing businesses including banks and car companies and I have the ability to acquire all sorts of other entities so long as they are failing.”

“Oh and since this loan will be in nominal terms and I control the money supply, I have the ability to reduce the value of my liability to you at any time to whatever degree I want.”

Would you loan money to me?!  You probably are…

Here is what Moody’s has to say about our credit rating, as quoted in a NYT article

“Growth alone will not resolve an increasingly complicated debt equation,” Moody’s said. “Preserving debt affordability” — the ratio of interest payments to government revenue — “at levels consistent with Aaa ratings will invariably require fiscal adjustments of a magnitude that, in some cases, will test social cohesion.”

Translation: “You can’t go on the way you have been.  You have to give some things up!  And we are getting a little nervous because we can imagine the things you will have to give up and we can imagine the political fallout and it won’t be pretty.”  Meanwhile our government is passing another gigantic entitlement.  So we have to start asking: “is it even conceivable that the government will suddenly wake up and cut what they would need to cut in order to start paying off this debt?”  Personally I can’t see that happening.  Maybe you can but it’s important to keep in mind that it’s not the kind of thing that economic models can predict, it’s a political issue. Furthermore, economic models don’t give us much information about what will happen if the real-world government decides not to obey the constraint that is required to make the model work.  The only thing we are pretty confident about is that it wouldn’t work….

debt clock

Categories: Uncategorized

Atlas Now?

March 19, 2010 Leave a comment

“The only proper purpose of a government is to protect man’s rights, which means: to protect him from physical violence.  A proper government is only a policeman, acting as an agent of man’s self-defense, and, as such, may resort to force only against those who start the use of force.  The only proper functions of a government are: the police, to protect you from criminals; the army, to protect you from foreign invaders; and the courts, to protect your property and contracts from breach or fraud by others, to settle disputes by rational rules, according to objective law.  But a government that initiates the employment of force against men who had forced no one, the employment of armed compulsion against disarmed victims, is a nightmare infernal machine designed to annihilate morality: such a government reverses its only moral purpose and switches from the policeman to the role of a criminal vested with the right to the wielding of violence against victims deprived of the right of self-defense.  Such a government substitutes for morality the following rule of social conduct: you may do whatever you please to your neighbor, provided your gang is bigger than his.”

Ayn Rand, “Atlas Shrugged” (1957)

Categories: Atlas Now?

Quick Fix: Dual Federalism

March 17, 2010 2 comments

The government of the United States was designed around the principle of  dual federalism.  According to wikipedia, this system places the following limits on federal authority.

1. National government rules by rules only.

2. National government has a limited set of constitutional purposes.

3. Each governmental unit—state and federal—is sovereign within its sphere of operations.

4. Relationship between nation and states is best summed up as tension rather than cooperation.

Now consider the story of the National Minimum Drinking Age Act.  In 1984 the government wanted to make it illegal for anyone under the age of 21 to drink.  The only problem with this was that keeping people from drinking didn’t fall within the “limited set of constitutional purposes” assigned to the federal government.  That’s why they had to change the constitution when they tried to keep people from drinking the first time.  This time, however, they decided to take a different approach.  They simply passed a law saying that if a state chose not to raise its drinking age to 21, the feds would cut that state’s annual federal highway appointment by ten percent.  In other words the feds said to the states “you don’t have to do what we want, but if you don’t, we will keep taxing your citizens and giving their money to other states but we will stop giving it back to you.”  Of course, every state fell in line, the constitution wasn’t changed and the government got a new power. 

More recently, if you watch MSNBC (especially Rachel Maddow) you have probably witnessed a long steady lambasting of republican lawmakers who voted against the stimulus bill and then later took credit for bringing stimulus money back to their districts.  Frequently a question like this will be proposed (although I’ve never seen it addressed to someone who could actually answer).  “If the stimulus was so bad, shouldn’t you have refused the money?”  Now these republicans are politicians so their principles are probably highly impeachable in many cases.  It is not my intention to defend republicans in general but rather to point out how ridiculous this question is.  Imagine Nancy Pelosi calls up your congressman and says the following:  “We want to spend a lot of money.  We’re going to give it out to states and then later we will have to tax them to pay for it.”  Now your congressman may think it’s a bad idea and vote against it but once it has been passed, the question is no longer whether he thinks it is a good idea or not.  At that point Nancy Pelosi comes to your congressman with a sack full of money, he doesn’t have the option to say “no I don’t want the money because it’s not worth the money that it will cost my state in the future. ”  His state is going to have to pay for it anyway!  The question is simply “do I want to get my state’s fair share of the wasteful spending or do I just want to subsidize wasteful spending in other states?”    Certainly most of them will choose the former and we can hardly blame them.

This brings me to the next key for fixing our system.  It is essentially a corollary to the previous entry in this category.  The flow of money between state governments and the federal government should be one way only.  That is, the federal government should be disallowed from giving money to state governments for any purpose.  Why is the federal government giving money to states to build roads?  Forget about setting a drinking age, where in the constitution is the federal government given the authority to build roads?  Shouldn’t that fall within the state’s sphere of operations?  Does it really work better when the federal government takes your money and then decides how much of it to give back to your state to build roads or do you think your state could handle that itself?  Could it be that the federal government only does this so that they will have leverage over the states to make them do little things that the feds want and if so is this “ruling by rules only?”  The only other reason I can think of is that they just like transferring wealth from one state to another, which I’m not a big fan of either.

For a hundred years the federal government has been finding ways to get the things they want done in spite of their limited set of constitutional purposes.  The most effective way they have found to do this is by creating a humongous grab bag of cash in Washington D.C. funded by individual taxes and then hand this money out in exchange for whatever they want.  Mary Landrieu doesn’t want healthcare?  I bet there’s some money for Louisiana in here.  Who’s next, Ben Nelson?  Let’s see what we have for Nebraska… There’s no reason for the federal government to be doing this.

If we were to abolish the IRS and make the federal government take their taxes directly from state governments, we would still have the problem that the Feds. would take way too much and then dangle it in front of states to “convince” them to cooperate (see limit on federal authority number 4).  This is much like the relationship they have with you and me right now.  When they “cut taxes” they don’t actually cut taxes they just give you a credit for doing something they like.  This gives you more money but it doesn’t give you more liberty.  In order to restore any degree of liberty to state governments the federal government must be prohibited from giving them money.

Categories: Quick Fix