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Loans and Savings

February 19, 2014 1 comment

The next installment of my organic credit model, following on from these previous posts.

I.  Commodity Money

II.  Banks and Credit

III. Credit Expansion

Remember, this is intended to describe a decentralized free-market economy with free-market (commodity) money.  The connections between this and our current economy are not entirely straightforward.

Loans and Savings

When most people think about banks, they think of an entity whose function is to allocate capital by borrowing from people who wish to put off consumption until some point in the future and lending to people who would prefer to consume or invest today and pay for it with future goods.  And of course banks do perform this function.  However the function described above serves a different purpose.  In our model so far the purpose of the bank is purely to provide liquidity by allowing people to use bank credit as a medium of exchange in place of hard currency.  It is my assertion that this is the primary function of banks as it is the function which distinguishes them from other institutions which also serve to allocate capital such as stock markets, corporate bonds, mutual funds, venture capital firms, etc.  But since these two functions are bound up together, we must take a moment to distinguish between them and see how they interact. Read more…

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“Added to the Economy”

March 24, 2011 Leave a comment

I keep seeing this commercial for natural gas where they say that natural gas “added…..dollars to the economy.”  There is a profound confusion underlying this notion of adding to the economy and it demonstrates how the current central bank economic paradigm distorts our understanding of economics and even our morality. 

You observe a firm.  It has costs of $1000 and revenue of $1200.  How much did it “add to the economy?”  The correct answer is $200.  The cost of $1000 represents the value of the goods that they used up to create whatever their output is.  The benefit to society generated by this firm is the excess of the value of what they create over what they use up, or in other words their profit.    But nobody who says “added to the economy” is ever talking about the amount of profit a firm generates.  On the contrary, whenever you see a politician or a pundit speak of profits it is always with scorn.  After all, profits are the elixir of the greedy corporations.  It shouldn’t be about how much you profit from something, it should be about how much you add to the economy.  That’s how much your endeavor benefits other people…right?

So usually when people talk of “adding to the economy” they are talking about the $1000 of costs (sometimes they are talking about revenue, I don’t know what the natural gas people mean but both are incorrect).  They act like the money spent on inputs is created out of thin air the moment it is spent on something that gets used up.  Come to think of it, this is the same way they talk about consumption isn’t it?  You add to the economy by using things up.  This is one of the oldest fallacies in economics.  Any clear thinking microeconomist will see through it and point out that in fact, if someone doesn’t spend money on one thing, that money won’t just disappear, it will be spent on something else and the resources which could have been used in producing that thing will be used for something else.

So who is right?  Well, in a natural economy the latter theory would be completely correct.  The problem is that we don’t have such an economy.  In fact, when people spend money it actually is (to some extent) created out of thin air.  It is created by borrowing.  The key to preventing an economic meltdown is to maintain a high enough level of money and consequently of debt.  In this environment it is more important to prevent the monetary contraction than to efficiently allocate resources.  This means that anything that causes people to borrow more money and spend it on something is beneficial.  Buying up resources and using them to produce something of lower value is good because it increases the money supply and drives up the prices of those resources.  It’s actually better if they are not employed too efficiently because if they do it will drive the price of whatever they are producing down.

This is how the government can take a firm that has $1000 in costs and produces $800 worth of output, give it a $300 subsidy and then claim that the firm is adding $1100 to the economy when in fact it is wasting $200 worth of goods.  They are not talking about adding goods to the economy, they are talking about adding money.  This has driven us to the point where we worship waste and disdain profit.  This has even led Lou Dobbs–no progressive–to remark recently that the disaster in Japan would actually benefit the global economy because they would have to buy a bunch of stuff to rebuild.  You don’t have to think very hard to realize stuff they use to rebuild is stuff we could have been using to produce something else, which means we have less goods because of it.  But think of all the money that they will create by borrowing to buy that stuff….

Death Panels

December 28, 2010 2 comments

Death panels are in the news again.  Here is the story.  Basically, they tried to include end of life planning in the healthcare bill but the public didn’t like it so they took it out and now they are doing it through the bureaucracy over the weekend…..on Christmas…… oh and they advised Democratic congressmen not to brag about it too much.  So having the government pay for end of live planning isn’t really such a bad thing (at least it’s not any worse than when they pay for other things).  But there are two important things to take away from this.

First, this is how things get done now, not through congress but through the bureaucracy.  All the attention is on what congress passes but regardless of what they pass, the bureaucracy does whatever it has to do in order to advance their progressive agenda.  We mistake these bills for a battle over how powerful the government will be but for the most part, the battle is already over and we have lost.  We have let the executive branch gradually gain the power to do practically whatever it wants so now they have a big debate and the public weighs in and then they do whatever they want regardless of public opinion and the outcome of congressional proceedings.  We have to realize that our problems are deep and systemic.  They won’t be fixed by just electing Republicans or repealing the healthcare bill.

Second, and more importantly, even though what they are creating now are not death panels, death panels are the inevitable result of their philosophy.  The progressive moral code says that “healthcare is a human right.”  This is not like the right to life, liberty and the pursuit of happiness.  Let’s examine the difference.

Negative rights:  This means you cannot be prevented from doing something.  These are the rights of which the founders spoke.  The right to life does not mean that you are guaranteed to never die.  It means that you cannot be prevented from trying to remain alive.  There are certain negative rights with which everyone is “endowed by their creator.”  These are part of the laws of nature.  There is a liberty inherent in man simply as a result of being man.  This cannot be taken away by the government, the government can only change the options between which he is at liberty to choose.

Positive rights: This is the right to get something no matter what.  This is the right to healthcare.  It is entirely different from a negative right.  If “right” is understood to mean a negative right, then we had a right to healthcare when the country was founded.  That is, you had a right to get whatever healthcare you could buy or get someone to willingly buy for you.  But this is not what they mean.  They mean, you should get healthcare no matter what, even if nobody is willing to provide it for you.  There are no positive rights inherent in nature.  Every creature is born with the freedom to try to survive but no creature is born with the guarantee that it will survive no matter what it does.

I have said before that progressives are people who don’t believe in scarcity.  This is the case here.  They say “I believe everyone has a right to healthcare.”  But if they believe this then they are simply factually incorrect.  There is no natural right to healthcare.  What they mean to say is “I wish there were a right to healthcare.”  Well that’s all well and good but the fact is that there isn’t and in the presence of that fact the question which confronts us is whether to embrace the rights we do have or to sacrifice them grasping for an imaginary one we wish we had.

This may sound like hyperbole but it must be understood that creating a positive right always infringes upon someone else’s negative rights.  If someone is to be guaranteed healthcare that means that someone else must be compelled to provide it for them.  This means the second person’s right not to provide it is sacrificed.  Sometimes it’s more subtle than this.  For instance if you are healthier than I am and the government gives me the “right” to buy health insurance for the same price as you, what it is really doing is preventing you and the insurance company from engaging in a mutually beneficial trade (insurance for some amount of money less than the amount for which it would be willing to sell it to me).  In other words, they are taking away your negative right to healthcare.

So what does this have to do with death panels?  Once you acknowledge that scarcity is not caused by greedy capitalists, it is a fact of nature, you have to acknowledge that goods must be rationed.  The question then is how to ration them.  Here are two ways.

1.  Everyone has the right to their own property and labor and the right to trade it with whomever at whatever prices they want.  This means that you have a right to whatever healthcare you are willing and able to pay for.  You make the decision about how much of it is worth buying just like any other good.  You can negotiate an insurance contract with an insurance company and buy as much or as little as you think is worth buying on terms that are beneficial to both parties. 

2.  Everyone has a right to healthcare.  Healthcare must be provided to anyone who wants it potentially at someone else’s expense.  This already violates the moral premise of private property but it doesn’t even address the issue of rationing.  Rhetorically this solves the problem of rationing by assuming scarcity away.  But the problem is still there and eventually it must be dealt with.  You can’t actually give everyone all the healthcare they want because there isn’t an unlimited supply of it. 

What’s more, people will now make decisions which are inefficient since they are no longer trading their own stuff for healthcare, they are just demanding it and someone else is paying for it.  So naturally they will want as much as they can get. Under the first rationing scheme a person might find themself toward the end of their life and be faced with the opportunity to undergo an expensive procedure which is expected to prolong their life for a few months.  They may decide that it would be better to pass the money on to their children or donate it to the local orphanage or what have you.  Or they may not, since it’s their money they could decide the best way to use it.

On the other hand if a person finds themself in a similar situation under the second scheme, naturally they will want as much healthcare as possible because the benefits will be disassociated with the costs.  The costs will be bourne by others but the check will be signed by the government, quite likely a government that had promised to reduce healthcare costs.  So who will decide whether or not it is worth it to get the procedure? 

The free market is a mechanism for rationing scarce goods.  It happens to be the only mechanism compatible with individual liberty and property rights and it also turns out to be pretty efficient most of the time.  But the free market doesn’t guarantee that everyone will be “equal.”  If you go on a quest to make them “equal,” you will have to destroy the free market.  If you destroy the market and the price mechanism, you must have another way of rationing (one that is not compatible with individual liberty and property rights). 

I’m not saying that they have created this system already I am saying that it is a logical necessity of the system they are creating.  Of course they aren’t going to tell you that they are creating a system where the government has to decide what you can and can’t get.  They are just going to tell you that you can have whatever you want. But scarcity is a law of nature you can’t just wish it away.  Eventually this system will cause a “crisis” by which they will pretend to be totally surprised.  They will have no choice but to ration care.  But don’t worry because the structure to do this will already be in place.  We will just have the bureaucracy tweak the rules a little bit, no congressional approval required.

Scarcity in a Macro Model

September 8, 2010 Leave a comment

I made a bit of a breakthrough over the weekend that I eventually want to talk about.  First, though, I want to back up and discuss the philosophical foundations of macro theory to provide some context for what I will be discussing.

My main beef with all forms of Keynesian economics is that it assumes there is no such thing as scarcity.  Since economics is the study of the production and allocation of scarce goods, I consider this a highly undesirable characteristic of an economic model.  I have quoted Keynes on this subject in the past and I won’t rehash that here.  Instead I will highlight what I mean with a simple example using the IS/LM model.  In this model, if the government increases taxes and increases spending by the same amount, this causes an increase in output.  This is because output is assumed to be whatever demand happens to be and investment demand is assumed to be independent of savings.  This causes a spending multiplier

The reason for this is that saving is substituting for scarcity in this model.  The only thing holding down output and consumption is people’s stubborn tendency to save part of their income.  If everyone would just spend it all, output would be infinite and we would live in a socialist scarcity-free utopia.  When the government takes part of your income and spends it, that keeps you from saving some of it and this causes an increase in output. 

The obvious question that rarely gets asked is: where does that increased output come from?  The model doesn’t really answer this it just assumes that it will appear if it is demanded.  Frankly this is complete nonsense.  It may be true that increasing government spending increases output but if we get this result from a model with no concept of scarcity we haven’t really explained anything.  What’s more, we don’t know if this is desirable or not since we cannot have any concept of efficiency in a model with no scarcity.  More is always better and you always get more by increasing government spending or lowering interest rates. 

Similarly, this model assumes that if you lower interest rates, this increases investment demand.  Since investment demand is assumed to be independent of savings (and therefore independent of consumption), where does this increased investment come from?  The answer of course is that it just appears.  It must appear because we have assumed that it can’t come from anywhere except an increase in output.  For those who believe that some consumption must be foregone in order to invest, this model will seem very unintuitive. 

Now to go a bit farther, one might argue that adding aggregate supply introduces scarcity.  However, this is not the case because it still does not model any tradeoff between one good and another.  Because of this Keynesians believe in the concept of a natural level of output which prevents increases in government spending from having a long-term effect on output but anything that increases the natural level of output can only be considered beneficial.  What’s more, there is no reason within the model to interpret a temporary increase in output as undesirable and there is nothing preventing a series of progressive increases in government spending and/or the money supply (decreases in interest rates) from constantly distorting output above its natural level (sound familiar?).

In order to construct a theory with scarcity we must be very careful to focus on real goods or real wealth.  Our model must obey the following simple rule.  At any given point in time, there is a fixed quantity of real goods in existence.  This means that we have to consider carefully what we mean by real goods.  This must include all valuable resources in the economy.  For instance, it includes gold in a vault but not money in a checking account.  It includes a stand of trees that is sitting idle in the wilderness.  It includes minerals in the ground that are not yet dug up (although it may be appropriate to exclude these if they are unknown), and perhaps most importantly, it includes a quantity of that one important asset for which every person has an endowment just as rigidly fixed by nature — time.

When we think of wealth in this way, the idea of output takes on a different character.  The question is no longer about how much we have but how effectively we are maximizing the value of what we have.  The question is not how much will be created.  Instead it is into what form will the endowment we have be transformed.  To understand this consider the case of labor.  A typical view is to look at an increase in employment and a corresponding increase in “output” and say that we got more stuff so we are better off.  This is not precisely correct.  We did in fact get more stuff but we gave up some other goods to get it.  We transformed some amount of labor which could have been used for leisure or some other production, along with some other inputs most likely, into another form.  It is quite likely that this resulting form will be of higher value than the inputs, in which case it may be a Pareto improvement but when we lose track of the inputs we lose the ability to even consider this question.  The problem with unemployment from our standpoint is not that it causes us to have less but that it represents a situation where we are for some reason unable to transform the wealth we have into its most valuable form. 

In this context we can still talk about production and output but if we are to construct our model on markets that are in equilibrium on a micro level, then we will have to make the amount of output at any given time dependent on decisions made at previous points in time.  This is because any wealth which is capable of changing form instantly will naturally change to its most valuable form at that point in time.  Therefore, we may (and typically will) take these decisions for granted.  The important issue for our purposes will be how we arrived at that level of wealth, or to state it another way, how will we make decisions that affect the value of the wealth (output) in the future. 

What this boils down to is a distinction between consumption and investment, that is between using the wealth in existence at a given point of time to satisfy consumption at that point in time or to produce wealth at some point in the future.  For our purposes, we will assume that if wealth is consumed, it will be consumed in its most valuable form and typically that if it is invested it will be invested in its most valuable form.  This latter assumption marks the point of departure from Austrian business cycle theory, although it may at times be worth considering the possibility of “malinvestment.”  This would not be a significant change in approach so long as agents think that the chosen investment forms are of highest value at the time they are made.  Naturally, since there is some amount of time between the decision and the realization of the results, this belief could end up being incorrect, and if this happened in a systematic way it could constitute a valid theory of the business cycle.  Once we develop a model of a frictionless economy where markets clear, we can consider the effects of various market imperfections such as sticky prices or price controls.

With this approach in mind, we can consider the question which has been confounding me for some time until now.   If the decision between consumption and investment depends on the real interest rate, what happens if the Fed sets the nominal interest rate below the natural rate and manages inflation expectations in such a way that people actually perceive the real interest rate to be lower than the market clearing  rate?  This question is difficult because this describes a shortage of real investment.  In other words, lower interest rates should cause an increase in the quantity  of investment demanded but it should also cause an increase in the quantity of consumption demanded (decrease in quantity of savings supplied).  If more investment is demanded than supplied, how can this market clear without inflation expectations or interest rates changing?  Or in other words, when both consumers and investors are pulling harder on a fixed quantity of wealth, who wins?  Stay tuned for the answer.

Update: It’s worth noting that this approach is essentially that embodied in neoclassical growth theory so I don’t mean to make it sound that profound, just to contrast it with the approach taken by Keynesians.

Prices, Monopoly and the Law

September 1, 2010 5 comments

This is going to be a long one.  I want to take two ideas I have been meaning to write about and weave them together because the connection between them is very important and not very obvious.  So if you’re looking for a quick read, skip this one.  If you’re ready to understand the real problems we face and where we went off the rails, then pour yourself a cup of coffee and settle in.  We begin with this story (and here is part 2).  Everything is illegal.  Everyone is a criminal.  The first terrifying revelation that comes from this is that if someone wanted to put you in prison, the chances are that they would be able to find a way, even if it’s a way you don’t even know exists.  That’s not what I want to talk about though, there are more subtle economic implications of this paradigm.

Lately I have been talking about a stereotype of the left which I will, from now on, refer to as the “lunatic left.”  If you missed it here is the video I have chosen to represent their views.  The lunatic left believes that employment is slavery, and that the need to have a job is a construct of an oppressive capitalist system.  Again, while this is about 90% nonsense, there is a kernel of truth here.  To find it, first consider how a man would live in a society with no trade.  He would have to produce everything he owned/consumed himself.  This would certainly not be a socialist paradise where you didn’t have to work and you just laid around looking at art all day.  However, it would also be a situation where you wouldn’t be at the mercy of an employer for your survival. 

In a free market, the reason people take jobs is because someone offers to pay them more than they could produce on their own.  In other words the job makes them better off.  This is possible because it is more efficient for labor to be specialized and coordinated.  This is not slavery.  Anyone who wanted to could choose not to take a job and try to survive on their own.  Indeed many people would be able to produce a great deal on their own without working for anyone else.  These are the people we now call entrepreneurs.

But now we live in a society where large numbers of people are unemployed for years at a time and are seemingly unable to support themselves and therefore must petition the government for their sustenance.  I suspect that most of them wouldn’t be unemployed that long if we weren’t paying them for it but many apparently don’t agree with me so let’s imagine they are correct.  We have to ask ourselves how that could be the case.  How have we found ourselves in a situation where we can’t support ourselves without someone “giving” us a job?   All you have to do is get up in the morning and do something of value to someone.  Are we to believe that these people haven’t been able to create anything of value for two years? 

To see the problem, we have to consider what would happen if you got up one morning with no job and tried to create something valuable.  Let’s say you know a little bit about carpentry (how much could you learn about carpentry in two years?) and you start making furniture — nobody hires you to make furniture, you just start doing it one day because it’s something of value you are capable of creating.  First, you will probably have to get a business license if you intend to sell any of it.  Ok, that’s not that big a deal.  You might not be able to sell it out of your house because it’s probably not zoned correctly.  You could sell it on the street somewhere but then you would need a permit for that.  To get the business license you would probably have to get insurance incase a chair you made spontaneously combusted and caught someone’s house on fire.  If there is a carpenters’ guild, you will have to pay them a hefty fee and possibly wait on a list before you are allowed to sell anything.  Your garage will have to be OSHO compliant.  And if you’re neighbor is also unemployed and you think you could make your operation run more efficiently by bringing him in to do some of the work, you will have a whole new set of fees and regulations you will have to follow.  And if there are price controls on your product then you may as well just forget it.

I used to be a business major and I changed to economics because I rarely learned anything useful in a business class but one thing I do remember learning is that the moment you start a business you have to hire two people, a lawyer, and an accountant (he also said you need a banker but that’s a different story…).  The reason for this is obvious.  It takes at least two people with probably 11 combined years of college education just to be compliant with all the laws and regulations which govern even the most simple activities.  If you aren’t careful you could easily end up bankrupt and in prison because you thought you could produce on your own by selling orchids or inventing a new motor.  If you can’t produce enough value to sustain yourself and a lawyer and an accountant, and pay all the taxes and fees to government, then you aren’t allowed to produce. 

All of this makes it very difficult for a typical person to get up in the morning and take care of himself.  By taking away their outside option, we create a population of people who know no other way to live but to beg for a job or beg for a government handout.  Where the lunatic left goes wrong is in thinking that work is slavery.  Every creature has to work to survive.  But it is true that our government has gone to great lengths to create an economy in which you need a job in order to work.  So let’s talk about how that happened.

Most people are scared of freedom.  We have been told our entire lives that if people (often “capitalists”) are left to their own devices, even when confined by a proper system of laws which protect property rights, that they will find ways to screw us over somehow.  When trying to convince people that “laissez-fair” capitalism is a good idea, it is usually necessary to meticulously break down a litany of arguments, poor though they may be, to this effect.  And the last stand of the frightened interventionist is almost always the monopoly argument.

The monopoly argument goes like this.  If firms are allowed to get a monopoly on some market, they will be able to increase profit by restricting output and raising prices.  This is essentially an economic fact.  However, the real issue is how do you get a monopoly?  If you had a monopoly and you were making monopoly profits, other firms would be able to gain by entering the market and competing with you at a lower price.  If you could get all of your competitors to cooperate, then you could all gain from higher prices but each member would have an incentive to cheat, and even if they didn’t others could enter and undercut the cartel.  These issues have proven to be very steep obstacles to the capitalist in his endless quest to fleece the public.  But he has found a way.

Now read this excellent short (short by history book standards, long by blog standards) history of the robber barons. (I’m serious you have to read this one)

The only reliable way to get monopoly power is to have it enforced by the government.  The problem with a cartel is that if people cheat, you have no power to punish them.  But if you can get control of the government, then you can punish them for doing things like lowering the price or producing too much.  This is where we went wrong.  It was not greedy fat-cat capitalists running wild with no government oversight screwing the common man.  It was greedy fat-cat “capitalists” discovering that they could use the government to screw the common man and in doing this they screwed the real capitalists. 

The folly of this is most readily highlighted by noticing that the whole justification for all these policies was based on the fear that companies who had been continuously providing more and more goods at lower and lower prices would somehow, someday end up screwing the consumer by restricting output and raising prices even though this had never happened. 

To really solidify their hold on the economy, it was necessary to convince the public that high prices are actually good and low prices are bad.  This sounds ridiculous until you notice that that is exactly what Keynesian economics does.  Every problem is caused by prices falling.  Every solution is some attempt to prop them up.  It is now so pervasive that we constantly see things like this.   In this clip the host of a show on Fox Business asks if what we need to bring a market that is characterized by a surplus into equilibrium is for prices to rise.  Now this might be an indication that she has no idea how even the basics of economics work or it might be a slip of the tongue, but even if we give her the benefit of the doubt, the housing market analyst from Moody’s answers the question with a slightly less incompetent but still profoundly confused response saying that the reason prices are falling is that there is too much supply compared to demand.  This is correct (assuming that what she meant by supply is quantity supplied at the current price and by demand she meant quantity demanded at the current price) but then she says that what we need is for demand to increase.  What we really need is for prices to fall!  The thing that we need is the thing that the market is desperately trying to accomplish but we have it so engrained in us that falling prices is a catastrophe that we want to do anything we can to fight it. 

[As a side note, let me point out that people who’s wealth was “tied up in their house” would be largely unaffected by falling housing prices, the people who are hurt are the people who don’t have their wealth tied up in their house but are instead have their house highly leveraged.]

During the great depressing the fear of falling prices was used to increase wages while people were unemployed, throw dry cleaners in jail for charging too low a price and destroy crops while people were going hungry.  This is the reason that the depression lasted for a decade and a half.  The beneficiaries of these policies were not “the public” they were the powerful businesses and unions who had the ability to manipulate the government.  These policies are designed to keep the little guy from competing with them.  The same thing is true of recent legislation such as healthcare and financial regulation.

Where we went wrong was in allowing the government to meddle in the economy.  Out of the fear of a monopoly which had never existed we empowered the government to create and enforce monopolies.  Once we allowed the government to be a giant grab bag of subsidies and a thug for hire to attack competing companies, we created a system where success is determined largely by one’s ability to control the government and lobbying the government is an activity characterized by significant economies of scale.  Is it any wonder that in this environment small business is finding it difficult to compete?

I Found One!

August 24, 2010 Leave a comment

Actually Sumner found him.  Here is Narayana Kocherlakota, president of the Minneapolis Federal Reserve acknowledging what I have been saying for a while now, albeit in a dismissive aside.

As I said, the FOMC meets eight times a year. Its decisions are always influenced by fairly recent economic data. But, at the same time, its decision-making has to be shaped by long-run considerations. In that vein, let me close by offering some thoughts about long-run inflation—or really, long-run deflation. I mentioned earlier that inflation has been near 1 percent recently. These data have led some observers to worry about the possibility of a multiyear period of falling prices—that is, persistent deflation. I don’t see this possibility as likely. It would require the FOMC to make the surprising mistake of ignoring the long run in its desire to fix the short run.

Here’s what I mean. It is conventional for central banks to attribute deflationary outcomes to temporary shortfalls in aggregate demand. Given that interpretation, central banks then respond to deflation by easing monetary policy in order to generate extra demand. Unfortunately, this conventional response leads to problems if followed for too long. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

Another interesting quote from the speech is this.

If one digs deeper into the data, the situation seems even more troubling. Since December 2000, the Bureau of Labor Statistics has been keeping data on the job openings rate, which is defined as the number of job openings divided by the sum of job openings and employment. Not surprisingly, when job openings rise, the unemployed can find jobs more readily, and the unemployment rate typically falls. The inverse relationship between unemployment and job openings was extremely stable throughout the 2000-01 recession, the subsequent recovery, and on through the early part of this recession.

Beginning in June 2008, this stable relationship began to break down, as the unemployment rate fell much faster than could be rationalized by the fall in the job openings rate. Over the past year, the relationship has completely shattered. The job openings rate has risen by about 20 percent between July 2009 and June 2010. Under this scenario, we would expect unemployment to fall because people find it easier to get jobs. However, the unemployment rate actually went up slightly over this period…..

….Given the structural problems in the labor market, I do not expect unemployment to decline rapidly. My own prediction is that unemployment will remain above 8 percent into 2012. Persistently high unemployment of this kind will impose considerable losses on many of our citizens. Good public policy requires that we help mitigate their losses via a well-designed unemployment insurance program. Recent economic research, including some done at the Federal Reserve Bank of Minneapolis, shows that such a program will not feature the termination of benefits after 26, 52, or 99 weeks. Instead, a good insurance program should offer constant benefits over the entire duration of an unemployment spell, however long. It should provide incentives only through the level of those benefits, not through their timing.

In other words, we have high unemployment despite having a lot of job openings.  This has occurred as we have been continuously extending unemployment benefits with seemingly no end in sight.  His solution is to continue paying people to be unemployed with no end in sight.  Sometimes it amazes me how economists can completely ignore the most obvious explanation for some phenomenon.  I have a feeling most microeconomists would see the issue differently….just saying.  This highlights an interesting aspect of an altruist-collectivist society.  If you struggle alone you better find a way to fix it yourself.  If enough other people are struggling with you, don’t worry the government will come to the rescue.

The Compartmentalization of Economics

August 18, 2010 Leave a comment

Alright, before I begin I want to acknowledge that the field has been working on these issues for a while and has made significant progress.  So to some extent I’m arguing with a historical phenomenon here.  But I think this is still important for a couple of reasons.  First, we still teach econ majors the version of economics that suffers from this deficiency, and our policy makers seem to rely largely on the same models.  Second, from a historical perspective I think it is important to ponder how things like this happen.

As you may know by now, I have been trying to develop the idea on this blog that our monetary system is of such a nature that lowering the interest rate causes inflation in the “medium run” and then deflation in the long run.  The argument for this is amazingly straight forward.  All you have to do is look at the Fisher equation and believe that in the long run, the real interest rate is determined by real factors (which I suspect most economists would concede).  And yet I have never heard another economist make this observation (of course that doesn’t mean it has never happened, but if it was common it seems like I would have noticed).  How can this be?

My opinion that Keynesianism marked a radical departure from sound economic reasoning is well documented but how was this able to happen and persist for all these years?  There are several reasons I think.  Part of it is that it has enjoyed some degree of empirical success (though with much help from progressives manipulating the economy into something that doesn’t make much sense).  This brings up the old rationalism vs. empiricism debate which I don’t intend to have here.  Another (big) reason is that the theory is convenient to politicians and other “powers that be” who enjoy having an intellectual justification for a lot of interventionist policies and Keynesian economics suits that purpose nicely (see the above parenthetical comment).  But I think another important component in this formula is the compartmentalization of the discipline.

What I mean by that is dividing the subject into multiple “schools” which peacefully coexist and yet are logically incompatible.  I am talking of course, about the neoclassical synthesis in which  economics was divided into microeconomics and macroeconomics.  This allowed the sound reasoning which had come to dominate all of economics up to the time of Keynesianism to be cordoned off and kept away from the Keynesian paradigm which was to become the accepted mainstream approach to macro.  Before this, economists were not macroeconomists or microeconomists they were just economists.  Their theories had various implications and often these extended to both of what we now call micro and macro. 

The problem with this is that if you really understand classical micro concepts, you can’t really understand Keynesian economics.  This is because Keynesian economics is hopelessly flawed.  It in fact takes a drastic step back in the area of economic understanding in the sense that it revives the old confusion between a supply relationship and a demand relationship as I pointed out in this post.  If you let capable microeconomists think about this long enough, certainly they would notice.  But certainly they couldn’t hope to overturn a century and a half of progress in the field.  They would have to find a way to let them keep that knowledge but also accept the new incompatible model.  The answer is natural.  Just create a new field. 

This has two important implications.  The first, and most obvious, is that most people don’t carefully study both micro and macro now.  You can ask an accomplished microeconomist about Keynesian economics and they will just shrug and say “I don’t know. I don’t think about that stuff.” and macroeconomists will say the same thing if you ask them about industrial organization.  But the second, and I think even more significant issue, is that the two fields, by their different natures, select certain kinds of people into them.  Specifically, people who have a strong intuition regarding things like market equilibrium and Pareto efficiency find micro fascinating.  Alternatively, people who like the idea of empirical knowledge and a giant machine called the economy that we can control by pulling the right levers at the right time gravitate toward macro.  These people (macroeconomists) tend to be the last people who want to discover that the economy can’t be controlled in a way that is good for society.  So can we be surprised when they don’t notice that a model which says all the things that get them excited is contradicted by the basic principles of another field which doesn’t really turn them on that much?

But it doesn’t stop there.  Macroeconomists know about the Fisher equation.  But they have actually further compartmentalized macroeconomics.  They did this by dividing it up into the short, medium, and long-run.  Again, newer models don’t do this but this is what we still teach in intermediate macro.  To see the importance of this, you must notice that what Keynesian economics says about the effect of increasing the money supply (lowering the interest rate) on the price level.  It says that in the short run, prices are fixed (again see previous parenthetical comment) so prices don’t change (or don’t change much) and then in the medium run expectations adjust and prices go up, and then in the long run blank out.  “Wait, what happens in the long run” you ask?  Well when we analyze the long run we use the Solow growth model.  It deals with saving and capital accumulation.  You: “but what happens in the long run when the money supply increases?” Smart professor: well, in the long run model there is no money supply, it’s all real variables…  You: hmph [rolling eyes] ok, so what’s going to be on the test….

Is it possible that the things we’re doing to save ourselves in the short run actually have long run implications?  Maybe a better question is: is it possible to answer the first question with this approach to economics?  And furthermore, is it surprising that we haven’t managed to stumble onto the answer to a question which doesn’t even exist in the framework on which we have built our knowledge? 

Ok, so in physics they had a theory of gravity that didn’t really work the same near earth as in space for a while but they fixed it.  Ok, so now they have a different theory for quantum physics than for astrophysics but at least they have the decency to be uneasy about that and realize that one or both must be wrong.  And when they find something that is logically consistent, they will stop teaching the one (or both) that’s wrong!