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Atlas Now?

April 24, 2011 2 comments

If Ayn Rand wrote dialogue like this, you know her detractors would call it ridiculous and unrealistic.

This was one of nearly a dozen “clawback” orders signed in two months under the state’s new Republican governor, John Kasich. There will be more, says his job-creation director, Mark Kvamme: “We need every single dollar we can get our hands on.”

YUSA’s view: “Give me a break,” says Chris Fairchild, the auto-parts firm’s controller. “For crying out loud, we’re doing our darnedest. While other local businesses have gone bankrupt or gone to Mexico or other states, we’re right here. You’d think there would be a little respect for that.”

The budget vise squeezing states and cities is changing the economic-development game. Governments are attaching more strings to their offers of tax breaks, cheap rents and bond deals designed to lure business, and are getting tougher on past recipients who didn’t come through.

Here’s the full story.

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Categories: Atlas Now? Tags: , ,

The Anatomy of a Bubble

April 14, 2011 2 comments

 Keynesians and progressives (along with Marxists) hold some combination of the beliefs that interest is immoral and lower interest is better for the economy because it increases investment.  Recall the words of Keynes.

Interest to-day rewards no genuine sacrifice, any more than does the rent of land.  the owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce.  but whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant….

The justification for a moderately high rate of interest has been found hitherto in the necessity of providing a sufficient inducement to save.  But we have shown that the extent of effective saving is necessarily determined by the scale of investment and that the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment.

This highlights a key difference between them and us.  A classical economist would tend to observe a positive price for something (like the lending of capital) and take this to indicate that there must be some “genuine sacrifice which could only be called forth by the offer of a reward.”  Keynes, on the other hand, assumes that there is no such sacrifice and therefore that it would be beneficial to create a giant quasi-governmental organization with the power to manipulate the entire economy in order to eradicate this seemingly inexplicable phenomenon.  Of course he is confusing capital with money.  It’s true that it is possible to print money until the money rate of interest is zero.  The problem for Keynesians is that this does not necessarily cause the rate of interest on capital to become zero. 

This is because creating money does not create more capital, it creates a higher demand for capital at a given price.  To see what I mean imagine you own a business and you borrow money to invest in producing some good.  You will do this until the marginal return on investment is equal to the interest rate (both in money terms).   This means that when interest rates are lower, you will invest more because there will be some projects that are productive enough to pay the lower rate of interest but not the higher one as long as you hold all other things equal.  So the Keynesians would like to “stimulate” investment by lowering the interest rate.  The problem is that all other things do not remain equal.

When you see the lower interest rate, you borrow more money (the money supply increases) and you use it to invest in your business.  But the “capital” that you invest consists of real goods which you buy with the money you borrow.  And these real goods have alternate uses.  The reduction in nominal interest rates doesn’t make anyone else any more willing to forego the other uses of those real goods (if it did, this would lower the real interest rate) so when you use this borrowed money to purchase capital it drives the price of these real goods up.  Furthermore, if you actually expanded investment you would produce more in the future and if everyone produced more in the future, the price of your output would be lower.  In other words, you would see short-run inflation, then long-run deflation and if everyone predicted this accurately, the equilibrium amount of deflation would bring the Fisher equation into balance with the new lower nominal rate and the same real rate as before.  Because, the real rate wouldn’t change, investment wouldn’t change, and this policy would have no effect on production (although the bankers would end up with some wealth that they didn’t have to begin with).  This is the same phenomenon I have been trying to describe for a while now.

So if they are going to “stimulate” investment, they have to do something to drive the expected real interest rate down, not just the nominal rate.  The way they go about this is quite simple: they just come out and tell us that they will keep prices steadily rising.  “Trust us, we know what we’re doing” they say.  Now you’re a producer and you believe that inflation will be 2% and you are looking at a nominal interest rate of 2% and you say “wow I can borrow at a real rate of 0%, Keynes’ dream has finally been realized, we’ve overthrown the rentier class at last.”  So you undertake all projects that you expect to yield a positive real return.  In your rush to borrow more and increase investment you drive prices up for a while which fulfills the Fed’s promise of inflation.

After a little while, though, the loans come due and you have to find some money to pay them back.  Your plan was to sell the resulting produce of your investment to get this money but lots of other people borrowed back then to invest and produce goods and their loans are now coming due as well so there are a lot of goods out there chasing that money and prices are in danger of falling.  If this were to happen you would not be able to pay back your loan and a wave of defaults would sweep the economy.  But have no fear, the Fed will prevent this from happening by lowering the interest rate some more which will cause more borrowing, investment, and inflation keeping prices high enough for you to carry on.  Let’s say they lower it to 1%.

So as interest rates keep going down prices keep going up and everyone manages to pay off their loans and life is good.  But wait a minute!  Now nominal interest rates are 1% and you are expecting 2% inflation…. This means that you don’t even have to produce anything to make money.  You can take out a loan and just buy something and hold on to it, then sell it when the loan becomes due and you will have some money left over because its price will increase at a greater rate than the rate you have to pay on the loan.  All you need to do is find a durable good and someone to give you a loan.  So what could you buy…?  I know, how about stocks?  Or you could buy real estate, there are lots of government programs to help you get a loan for that.  And there’s always gold….

So did you ever wonder what was going on at the Fed in 1928-29?  Well according to Milton Friedman’s authoritative account:

The stock market boom produced severe disagreement within the System on policy, generally oversimplified as a difference between the Federal Reserve Board and the Federal Reserve Bank of New york.  The question at issue between the Board and the New york Bank in 1928-29 had provoked controversy as far back as late 1919, when the Bord, at the Treasury’s behest, refused to sanction increases in the discount rate and instead urged the Banks to use “direct pressure–in the language of the 1929 and later annual reports–to prevent overborrowing by member banks.  The question arose again in October 1925, when Walter W. Stewart, surprisingly in view of his presumed authorship of the Tenth Annual Report (for 1923), seems to have recommended direct pressure.  Governor Strong disagreed, pointing out that direct pressure could not succeed in New York unless the Federal Reserve Bank refused to discount for banks carrying speculative loans, and that it would mean rationing of credit, “which would be disastrous.”  in May 1928, Adolph Miller, the economist on the Board, demanded that the presidents of the large New York banks be assembled and warned that speculative activity must be reduced, although a few months later, he was no longer in favor of such a warning.

Both the Board and the Federal Reserve Bank of New York agreed that security speculation was cause for concern.  The difference was about the desirability of “qualitative” techniques of control designed to induce banks to discriminate against loans for speculative purposes.  The Tenth Annual Report section on “guides to credit policy” had emphasized the impossibility of controlling the ultimate use of Reserve credit, and other reports had repeatedly noted the same point.  Nevertheless, the view attributed to the board was that direct pressure was a feasible means of restricting the availability of credit for speculative purposes without unduly restricting its availability for productive purposes, whereas rises in discount rates or open market sales sufficiently severe to curb speculation would be too severe for business in general.  The Board’s unwillingness to approve a rise in discount rates was partly, no doubt, a reaction to the severe criticism the System had suffered for the 1920-21 deflation.  The board’s view prevailed until August 1929, when it finally permitted the New York Bank to raise its discount rate.  Bu then the New York Bank believed the time might have passed for such action.

The collapse of 1920 (remember the Fed was created in 1913) was caused largely by a commodity bubble.  They knew the same thing was happening again in the stock market.  Their problem was that the obvious solution to this (raising rates) would have burst the bubble so they were trying to use the approach that progressives always turn to once their distortion of a market starts to cause unintended consequences: “direct pressure.”  They tried to ration credit by arbitrarily deciding who could get loans and who could not (death panels anyone?) 

So of course, this bubble can’t go on forever because, just as before, eventually the loans that people used to drive the prices of these goods up have to be paid back.  At that point, the borrowers have to liquidate their positions and the prices collapse.  In 1920 the bubble was in commodities, it was the stock market in 1929 and again in 2001.  In 2008 it was housing and here are quotes from two different stories in the Wall Street Journal on April 11, 2011

The task has become even more daunting recently because companies and individuals [in China] have been hoarding commodities of all types–from cotton and copper to cooking oil–betting that prices will rise.  With little insight into the stockpiles, analysts tend to overestimate China’s real strength of consumption.In China’s three dozen largest cities, prices have shot up by about 50% over the past two years, according to Dragonomics Research, a Beijing consulting firm.  Ordinary Chinese have become real-estate speculators, figuring that real-estate prices can only go up.  State-owned industries are also big speculators, using loans they received from state-owned banks in late 2008 to fight the global recession to invest in urban real estate.

Here is what gold has been doing over the last 5 years.

Oh, if only there were some way that we could set the interest rates to simultaneously prevent unwanted speculation and also coordinate saving and investing in such a way as to achieve the efficient amount of each and not blow up these inflationary bubbles that eventually burst and harm the poor working class……

History shows again and again how markets point out the folly of men.  Godzilla!

Scylla and Charybdis

Ok now I want to explain why a couple of statements that you hear frequently are misguided.  This should help in understanding the claim I made earlier about the potential for inflation or deflation (and the respective economic ailments associated therewith) being entirely at the whims of a handful of politicians and bankers.

Fallacy number 1:  “At some point, people will stop buying our debt and we will be faced with a European-style debt crisis.” 

I’m actually guilty of making this claim int he past.  However, the Federal Reserve is a borrower of unlimited capacity.  When everyone else stops buying our debt, the Fed can just buy it all.  How do I know this is true?  It’s already happened.  The Fed now buys 70% of new government debt, despite previous assurances that they would never “monetize the debt” (more on this later).  If the government wants to run bigger and bigger deficits and nobody thinks they are good for it, the fed can just print up more money and loan it to them.  There is nothing preventing them from doing this forever causing larger and larger deficits until the end of time.  If China decides to sell their debt the Fed can just print up dollars and buy it from them.  The only downside to all of this is that it could cause inflation.  But remember that all that money they print goes back with interest so we have to be careful about assuming just because they are printing money like crazy that a severe inflation is coming.  It could be that this amount of printing is required just to make up for the long-run contraction inherent in this system.  In fact, as I have been saying, this is the reason (I believe) that we have such a big debt because it is necessary to counteract this deflationary tendency.

Fallacy number 2: “The government can just inflate the debt away.”

This is wrong because the government does not control the printing presses.  The Fed does.  This means that in order to cause inflation (or avoid deflation) the Fed must get somebody to borrow.  If private people and foreign governments are willing to borrow enough at positive interest rates, then it is possible to cause some inflation and reduce the debt.  However, this is not generally the case, at least not for very long due to the contractionary long-run effects of monetary expansion.  This means that if they want to cause prolonged inflation they need the government to borrow.  This means that causing inflation causes the government deficit to grow not shrink. 

The big Picture

So to sum up, the Fed and the government need each other to cause inflation and this requires expanding public debt.  So should you fear inflation or deflation?  I don’t know.  And that’s the big picture.  The Fed (a group of private bankers with a government granted monopoly on printing money) and the federal government have the power to drive the economy in either direction they wish (so long as they work together).  The Keynesian line is to trust them to carefully steer a middle course between these two dangers.  Personally I have no confidence in their ability to do this.  But the more important question is this: is it responsible to put the fate of the entire economy in the hands of a few elite bankers and politicians even if we do think it’s possible for them to manage it in a benign way?  Is it that inconceivable that they might use this position to increase their own wealth and power at the expense of the rest of us?  I’m looking at you “liberals.” 

This economy, while not being centrally planned, is certainly centrally manipulable.  Supporters of this arrangement (which seems to be most people) seem to make the argument that for some reason we can’t trust an economy where every individual owns his own property and is free to trade and contract as they wish and accept the gains or losses of their own actions.  You see in that scenario the greedy fat-cats and bankers will surely trick the poor working man out of all of his money.  Therefore we have to create a body with the power to control the money supply by printing as much as they want at any time and setting the interest rate for the whole economy at whatever level they wish.  Also they must confiscate the gold of all the citizens and we will require everyone by law to use their notes.  And who are we going to give this power to?  Obviously the rich fat-cat bankers….who else?  But don’t worry, we will make a big deal about them being “independent” from the government so that nobody will have any real oversight over what they are doing.  After all we wouldn’t want those two bodies who we are trusting to jointly steer us between Scylla and Charybdis to be able to coordinate their efforts too well.  If they could, they might use the power to screw us by debasing the currency…..Come on America, does this make any sense?

The New Public-Private Partnership

When you read this story, recall this post.  Also, if you haven’t seen John Stossel’s program on freeloaders, it is excellent.  Notice the lady saying that the free market doesn’t know anything unless we all collect our interests and tell them what is of value to us collectively.  This is complete nonsense that could only be spewed by someone who has never considered how markets actually function.  It’s also the real divide between freedom lovers and statists.