Paul A. Samuelson (1915-2009)

Paul A. Samuelson passed away on Sunday, December 13, 2009. Along side Milton Friedman, John Maynard Keynes and Irving Fisher, he was one of the most significant influences on modern, mainstream economics. His influence is even felt at Mount Olive College. His textbook placed Macroeconomics before Microeconomics, and as a result, our MOC principles of economics classes are ECO 211 Macroeconomics and ECO 212 Microeconomics.

As an Austrian Economist, I think that his popularization of Keynes's theories led the economics profession down the wrong path, that his mathematization of theory was overreaching and in error, that his separating Macroeconomics from Microeconomics is unjustifiable (and Microeconomics should come first), and that his insistence of the superiority Soviet Union's economy over the U.S.'s was just plain wrong. However, he was a brilliant economist and he deserves his due. The official Press Release from MIT is here and an obituary from Robert Higgs is here.

Humpty Dumpty Health Care

“And all the King’s Horses and all the King’s men couldn’t put Humpty together again.”

This children’s nursery rhyme makes a fitting warning. Sometimes, after a sequence of events, there is no going back. Such is the situation with the passage of governmental health care. When the government passes the so-called “public option,” there will be no going back. Why? In economics, we say that we have fallen into a transitional gains trap. A transitional gains trap is one in which it would be better if we had entirely avoided it, but once we are in the trap, there are so many vested interests, there is no escape.

When governmental health care becomes available, new incentives will be created and economic actors (consumers, suppliers, politicians, bureaucrats, special interest groups, etc.) will respond to them. Let’s take a look at each group in turn.

Consumers

Consumers are always comparing benefits and costs at the margin, and we usually don’t even know that we are doing it. When we go to a store was look for deals and specials and decide whether the purchase is “worth it.” By making this appraisement, we are not only signaling our wants and desires, we are also placing a limit on how much of which items we are willing to purchase for these prices. Suppliers react to this information and search for the least cost methods to provide these items and thereby make money.

In a world, where there is a third-party payer, these checks-and-balances disappear. The consumer is no longer constrained by the amount of purchasing power available to himself. He is no longer “writing the check.” Someone else is paying. So the discernment over price, quality and quantity vanishes. The result is a dramatic overconsumption of health care and skyrocketing prices. Once someone else is paying the bill, a resistance to even the idea of paying for these services yourself builds until no one can even remember what it was like to not have a third-party payer. This group is now stuck in the trap.

Suppliers
Suppliers are constantly striving to earn profits. They do so by raising their revenues and by cutting their costs. Raising a company’s revenue is not the easiest thing to do. A company can certainly raise prices, but the consequence to this choice is the reaction made by customers. They will make fewer purchases as the price goes up. There is a limit to the height of prices before revenues diminish. Economists call this relationship “the price elasticity of demand.”

The alternative choice that companies can make is to cut costs. The cutting of costs is a difficult and sometimes painful process. It may require the purchasing of machines that displace workers. Trying to increase internal efficiencies and cutting internal costs requires tenacious dedication and penny pinching. The virtue that comes from this is that resources are seldom wasted. When waste does occur, there is an incentive to correct it and raise profit levels.

When the government enters into the picture, they are not subject to market conditions. Companies are allowed charge “cost-plus-mark-up.” We see this approach in many highly regulated sectors of the economy like water and electric utilities. Under a single payer system, companies that supply medical care will always be able to cover their costs. The incentive to vigilantly cut waste evaporates. In fact, the reverse occurs. There is now an incentive to pad one’s costs. The result is that the financial burden of the health care market multiplies. The companies like not having to compete and hold down costs. They are now stuck in the trap.

Politicians

Economics differs from other fields such as political science when it comes to the basic assumption about the motivation of individuals. Political scientists traditionally ask about “the good, “the just” or “equity” and then assume that the actor in their scenario pursues these goals. The economist assumes that individuals are rationally self-interested. They set their own goals and pursue them in the way that maximizes benefits and minimizes costs. The economist applies this outlook to politicians. We suppose that politicians are no different than the rest of us and pursue their own personal goals. Chief among these goals is the goal of staying in power. I do not think that this is an unreasonable assumption to make about politicians.

The politician stays in power by getting people to vote for him or, at least, by voting against the other guy. If a governmental take over of health care occurs, the politicians in favor of the system will campaign on the platform of expanded the benefits to all who vote for him. At the same time, he will demonize his rival by stating that his opponent will “take away your health care.” The implication of this campaign is that only those who are in favor of a governmentally run system are compassionate and just, while those who are against it want to see people dying in the street. Thus, the political class will have an incentive to maintain and expand the system—even those who were initially opposed to it.

Bureaucrats
A large bureaucracy will be needed to run governmental health care. Those employed by the government obviously have an interest in perpetuating the system, but the incentives are much worse. Bureaucrats are paid by the seriousness of the problem. The larger the problem they are tasked to solve, the more money and resources they command. That translates into nicer offices, more lavish conference locations, etc. They even have a disincentive to actually solve the problem. We see this occurring in the public school system. Failing businesses are liquidated and resources are transferred to more efficient users. In contrast, failing schools get larger budgets and more resources to “fix the problem.”

On a departmental level, we know that budgets are assigned by “need.” “Need” in a bureaucracy is determined by how much it spent the previous year. Thus, there is a strong incentive to spend all of the money in the budget as rapidly as possible so as to increase the future budget. As a result, health care costs spiral and service declines. The bureaucrats are strongly entrenched in the trap.

Special Interest Groups
There is currently an army of special interest groups on Capitol Hill and there is nothing that indicates that the situation will change with the passage of governmental health care. In fact with more power and more money flowing through Washington, we should expect to see an increase in lobbying efforts. We should not be surprised to see lobbying efforts to expand Program X and efforts to include Group A and efforts to cut the out of pocket expenses for Group B. New special interest groups will spring up. And why not? When it is easier to gain by the majority vote of 535 people than by any other means, people will follow the path of least resistance and lobby 535 people. These special interest groups will raise money for those politicians that support them. They will increase the costs to the system. They will actively help perpetuate the trap.

After Humpty Dumpty Falls

The transitional gaps trap is a nasty place to be. There is no easy way out. Once we are in it, the combination of these groups, acting in their own self-interest—basically responding to the incentives before them, diminishes the whole. Unfortunately, the direct cost of getting out of the trap is higher and so we will sink further and further into the trap until the entire system implodes.

It is for these reasons that we must fight as hard as we can to stay out of the trap, because once Humpty Dumpty falls, no one will be able to put him back together again.

The True Meaning of Thanksgiving

This month I was going to write about why Thanksgiving is one of my favorite holidays. Why? It's simple. It is because Thanksgiving represents the triumph of Capitalism over Socialism.

Beating me to the punch this year, is my former Hillsdale College economics professor, Richard Ebeling. He now teaches at Northwood University in Michigan and here is his post.

Enjoy!

The Proper Role of Macroeconomists

Last week Mount Olive College hosted a lecture by an economist from the Federal Reserve District Bank of Charlotte. While he presented several interesting facts, his explanation of why the economy was in a recession was unimpressive. He said that it was as if the economy was riding on a bicycle and it was hit by a car. Since the car has sped away the only thing left to do was attend to the victim. There is no sense leaving that poor guy on the side of the road, because he could die if nothing was done.

Maybe I am reading too much into a single analogy, but I think that this story is very telling about the sort of theory that he is operating under. That is, there is no theory. Where did the car come from? Why did it hit us? Are there other cars? Will they also hit us? Macroeconomists call events such as these “Real Stochastic Shocks.” In other words, these mainstream macroeconomists are saying, “We really have no idea when these shocks will happen or how big they will be. These shocks could be anything: a change in the oil market (think early 1970s), the popping of the dot.com bubble, the bursting of the real estate market bubble, etc. It’s rarely the same thing twice and we really can’t prepare for it. It’s just a part of the world we live in. It’s sort of like a car hitting you from out of the blue. One thing is certain, the shock wasn’t caused by anything that The Fed did or any policy that Congress and the President have been following. They have no culpability in the existence of the business cycle and thank goodness that they are there with the tools to save us from ourselves.”

This modern macroeconomic story is a blending of the Real Business Cycle and the New Keynesian theories. Unfortunately, neither one of these theories is that; they are not theories! Theories are explanations of how the pieces fit together. The fundamental question of what caused the business cycle is, “Is the cause either a random or a non-random occurrence?” If there is a pattern that can be detected, then the causes of the business cycle are not random. Economics is about finding the patterns in human society.

Fortunately there is a pattern that business cycles follow, but it is not one that the politicians and Fed bureaucrats would like to acknowledge. The pattern is this: the central bank of the US (The Fed) artificially lowers interest rates below the rate that a free market would produce. Whenever the price of something is below its equilibrium price a shortage is created. Normally, a capital shortage would be the result, but since the Fed has the power to create money out of a black hole of nothingness, it is able to “paper over the shortage.” Thus, individuals are reducing their savings (lower interest rates encourage consumption spending) and there is an increase in investment spending. This phase is the artificial boom. The problem is that there simply aren’t enough resources to go around. There is a crisis that manifests itself as either a credit crunch or a real resource crunch. The recession is a liquidation process that is a painful but necessary process to clear out all of the built up malinvestments that were launched during the artificial boom. (I have made an analogy where I assigned my students a big paper that is due tomorrow morning at 8am. They then get hyped up on caffeine (boom) and crash (bust) the next morning.)

The bottom line is this: the economy was not hit by a car. It was not some random event that just happens to us. It was not some unavoidable occurrence that happens in a free market economy. No, the blame is to be placed squarely on the shoulders of the central bank and the rest of the Federal Government. They created the bubble. They say that Wall Street was drunk with greed. Fine, but it was the Fed that was supplying the alcohol. Greed is checked by fear—the fear that you’ll lose your shirt. With the bailouts, that fear has dissipated and it will be worse next time.

The culpability of the Fed also means that their “doing more of the same but larger” measures are not only not going to help the economy, but it is making a bad situation worse. The government is claiming that there is a lack of Aggregate Demand in the economy; that there is not enough spending, but we are spending ourselves into a huge hole. The national debt is nearly $12 trillion. The whole US GDP is only $14 trillion! The average credit card debt is around $10,000. How much more deficit spending can we handle? All of this debt is being supported by a massive increase in newly created dollars. The high wire act that the Fed is claiming to be able to pull off is that as the economy improves, they will be able to pull that money back into the big black pit of nothingness before we see prices skyrocket.

The good economist walks a tough road during a recession. He is blamed for the problem and when asked for advice, the good economist basically tells the policy setters to stop what they are doing and don’t do it again. It is a policy of non-interference, and it is a terrible policy for a central bank and government to take, however it is better than its alternatives. It should be remembered that the hardship endured under a non-interference policy does not stem from the policy itself, but from the fact that the economy is in a recession caused by prior economic interventions. When malinvestments are built up during previous expansionary monetary policies, recessions are the necessary consequence. Going to the dentist due to a cavity is not a pleasant experience, but it is a necessary one for the overall health of the individual. Recessions are terrible economic events, but are necessary for the overall health of the economy.

The best means to transform malinvestments into viable economic activities is by increasing savings. This means that one of the government’s most effective policies is to cut taxes on savers. Those who are savers are usually labeled as “the rich.” Unfortunately, the prescriptions of “get government out of the market” or a “tax cut for the rich” tend not to be politically popular. Regardless, it is the duty of the economist to present the truth. The economist cannot state that the government should do nothing. Such a policy was tested in the early 1930s and failed. The modern economist needs to present the case that the government caused the recession and only by removing the government from the equation can the economy truly recover.

Distress Index

The Foundation for Economic Education has asked me to put together a Distress Index. So I quickly threw together five variables to create the index.

There is more detail at the FEE webpage (and a better picture too).

Methodology:
The idea was to keep the index simple, so that no more than a handful of statistics are used, and it was also important that those statistics be relatively uncontroversial. So we relied solely on numbers provided by the Federal Government.

Included Statistics:

Unemployment: Clearly, no “misery” index would be very relevant without considering unemployment. This is pretty self evident.

Consumer Price Index: Like the original “misery” index, we included inflation, even though we are actually in a deflationary period at the moment.

Gross Domestic Product: GDP is the market value of all final goods and services in a particular geographic area over a period of time. It is the most widely recognized measure of the "health" of economy.

Total Capacity Utilization (TCU): This is a measure of the utilization of the all available capital goods. We use the inverse of this number, since higher utilization is generally a good thing. So for instance, if TCU is at 70 percent, we would add 30 percent to our index as a measure of the idle capacity.

Household Financial Obligations as a percent of Disposable Personal Income (HFO/DPI): This measure is intended to gauge the ability of individuals to participate in the consumer economy.

It is important to emphasize that no statistic will ever fully articulate what is happening in the real economy. The real economy is made up of living, breathing, planning, acting individuals. Statistics are simply an abstraction and, as such, imperfect. Nevertheless, we feel this index has substantial value for two reasons.

First, it gives us a tool to help interpret what the media and government are telling us about the economy. Second, we hope it will give voice to the taxpayer and the frustrating conditions he or she is enduring these days. We hope the index will keep pressure on policy makers and opinion leaders to make decisions that improve the economy rather than distressing it further.

After a cursory historical analysis on the index, we can see that the results were pretty impressive. The chart below shows the Distress Index since 1967 with economic recession periods highlighted. There seems to be at least a superficial correlation between the index breaking 45.0 and the economy falling into recession. (Note we have not tested the strength of this correlation). In most cases the index appears to lead the recession’s beginning and end, which would seem to indicate that the index is actually useful in telling us where we are headed, not just where we’ve been.

THE CURRENT DISTRESS INDEX IS 61.0.

Unemployment: 9.7%

CPI: -1.5%

Real GDP: 3.897% (as a % change y-t-y × -1)

TCU: 30.4% (100% - TCU = an Idleness Index)

HFO/DPI: 18.5%

Please feel free to comment and improve this index.

Covering Insurance

A podcast with FEE on this topic is found here.

If you have a television or have listened to talk radio you cannot help but notice the large controversy surrounding the role of government in our health care system. Recently I heard one talk radio caller make the following comment: “I can see that doctors and nurses provide a service, but what does an insurance company add?” The implication was that since insurance companies are not adding anything “real,” they are simply parasitical and could be easily replaced with a government agency.

Today there is a general lack of understanding when it comes to insurance. The word “insurance” has been misused for decades. We have Social Security Insurance, Unemployment Insurance, Medicare Insurance, but none of these programs are actually insurance programs. Many people look at insurance as a Club Membership Discount Card. The thinking is “Once I get the card, I will get health care for less or even for free!” However, this is not what insurance is.

Insurance is about the mitigation and elimination of risk.

It begins with the idea of class risk. Class risk means that we know the statistical probability of an event happening to an individual in a group but we don’t know who in particular it will happen to. So we could know that a certain percentage of MOC students will get into a car accident or get cancer or have their house burn down, but we couldn’t point to someone and say that it would happen to a particular person.

If an individual can influence the probability of the event, then they change their risk class. So if you are a careless driver, then you are a higher risk. And this is why we do not pay insurance claims to arsonists who burn down their own houses.

Insurance is when we all put a small amount of money into a common pot. The winner of the pot is the one who suffers the tragedy. So the guy who gets into a car accident is the winner and gets to pull the money out of the pot. The guy who gets cancer is the winner and the winner is also the guy whose house burns down. The losers are those who are fine. They are not in car accidents nor have any other tragedy befall them. The money the “losers” put into the pot goes to the “winners.” The risk of not being able to pay for the catastrophic event is reduced or eliminated because of the existence of this pool of money.

Suppose that you and your friends have no insurance and there is no social safety net. As a result, you are exposed to risk. If something happens, you are fully liable for the full cost of whatever that has befallen you. Suppose that you are most worried about broken bones. You and your friends are a fairly safe group and the class risk for this group is that one person in the group will break a bone over the course of the year. We don’t know who will break their bone this year but we can predict that it will be one person. So if you and your friends come together and each put a small amount into a fund, then the winner, the person who breaks a bone, gets to pull the money out of the pot to pay the doctor. The small amount that each person puts in is the premium.

Now suppose that another group, a bunch of rugby and lacrosse players, want to join your insurance club. They are of a much higher risk class. They are much more likely to break more bones than anyone in your group.

If they are able to join and pay the same amount as you and your friends, then they will be subsidized by the “losers” of the club. The rugby players will pull money out of the pot at a much faster rate than before. So either the rate they pay will have to go up (because they are in a different risk class), or everyone’s rates will go up (thus transferring more wealth from the losers to the winners), or once the money in the fund is used up, that’s it, and no one can pull money from the pot.

We have moved away from using insurance according to the first choice. Instead, we have been raising rates across the board or have started to ration health care. A few years ago, Massachusetts created a law that requires all people to have medical insurance. Today 95% of the state’s population is covered. The result is that health care gets overused and healthcare gets rationed. The average wait time in the top 15 metro markets for a specialist is 20.5 days. However in Boston it is 49.6 days. (The next highest is Philadelphia with 27.0 days.) This result is even more surprising when it is discovered that Massachusetts has the highest number of doctors per capita in the nation. Rationing means longer waiting times. The waiting times in Canada and the U.K. have become ridiculous.

We have come to look at medical insurance as a discount card or entitlement. It is not surprising that people will use more health care services if they are not directly paying for it. If the funds come from a third-party payer, then why not run that extra test just to be sure or go to the emergency room and see the most expensive doctor? If someone else is footing the bill, then why should I be concerned with how much it costs? And if I do care, can I even find out?

If we decouple insurance from the idea of a free give away or entitlement and return to the idea of risk mitigation, the health care landscape would change for the better. Individuals would be able to buy insurance according to their own needs. If I am worried about broken bones and car accidents but not sickle-cell anemia, then I could get an insurance plan that covers me the way I desire.

Regular doctors visits are not something that insurance should cover because there is no risk to mitigate. As a result the responsibility of buying health services is placed back on to the customer. Consumers are better with spending their money than any bureaucracy. There is no grocery store insurance or clothing insurance and we see that these prices are competitive. And there is a diversity in the markets. On one end of the spectrum there are stores such as Whole Foods and Nordstrom and on the other there are Food Lion and Walmart. And just because you occasionally shop at Nordstrom doesn’t mean you can’t pick up some socks from Walmart.

Today if one has a preexisting condition, he cannot get insurance. Or if he can, it is extremely expensive. Why? It is because we do not have a free market in health care. There is blanket coverage in policies that are organized through employers. (Using employees of a firm doesn’t even make any sense normally. Why would a single firm’s employees all belong to the same risk class for broken bones, etc.? Yet they are all under the same plan!)

Imagine a person who has won the fight against breast cancer. It’s true that the risk of cancer returning is higher than the risk to another person (thus a higher premium for cancer insurance), but why shouldn’t this safety conscious person be able to buy health insurance for broken bones at the same rate as those in your club? Obviously we live in a very skewed system.

A truly free market for health care would have a great diversity in options for all. With consumers spending their own dollars, costs would come down just as they are in the relatively free markets of cosmetic and lasik surgeries.

Insurance companies in a truly free market reduce and eliminate risk; the risk that you will be unable to cover the costs of a medical event. The losers are those that pay in and nothing happens to them. And while the insurance winners are those are able to collect from the pool of funds, in a truly free market for health insurance we are the winners with falling costs and increasing quality. If we turn away from the market and adopt a system that is controlled by bureaucrats and politicians we will all be losers.

A podcast with FEE is found here.

The Market Will Find A Way

Writing a blog each month is more difficult during the summer because we are out of our normal routines. At least those of us in academia are out of our normal routines. This summer, as I have mentioned, I have been travelling up to the Foundation for Economic Education in New York. The largest headache is going through New York’s airport. The one I travel through is LaGuardia. I have learned that if you plan to go through LaGuardia, go early. If one minor hiccup occurs, that airport will get delayed and backed up quickly.

In addition to worrying about the weather and possible delays it might cause, there is also the bottleneck at security. Flying through the Raleigh-Durham airport isn’t so bad because it’s smaller and has fewer travelers. However, LaGuardia, JFK, Boston, Atlanta, Washington, Denver, etc. have significantly more travelers and were designed before the 9/11 attacks. This makes getting through security at each of these locations a potential nightmare. Everyone is sick of having to take off one’s shoes and of putting your liquids into a quart-sized plastic bag that has to be separated when going through security. The lines tend to be long and move slowly. It is nerve wracking because the plane is on a tight schedule. As a result, you either barely make it to the plane or you get there so early you wait and wait at the airport.

An entrepreneur might look at this frustration and say that there has got to be a better way. People might be willing to pay money to not have to go through the hassle of standing and waiting in the security checkpoint line. The market finds a way. Clear Registered Traveler is a company that negotiated with 20 airports to set up separate security lines. Members would pay a fee and enroll into the company. The company would verify who you are by taking a photo of you, taking your fingerprint and scanning your iris. Thus, when you go to the airport you would go up to a Clear Lane, and zip through to the front of the security line.

Do you think that this sounds like a good idea? Is this worth the use of resources? Luckily there is what is called a market test. This company asks, “What’s Your Time Worth?” If consumers find that it is worth paying the fee to by-pass the line, then the resources are wisely used and will be continued. However, if travelers do not find the service worth it; if they think that the price is too high for the amount of time standing in the “free” line, then the company is wasting resources. When companies waste resources, they are shut down by going out of business. The resources that they use are transferred to other companies and are then used in other combinations so that customers will get more value than the cost paid.

So what has the market test revealed? Clear Lanes are no longer available. As of June 22, 2009, they ran out of money and suspended operations. The resources that they were using were not organized in a preferred arrangement. Consumers did not find the service “worth it.” Instead of bailing out such a company, those resources need to be allocated to other organizations that do satisfy the public. Bankruptcy is an absolutely necessary function of a prosperous society. Without it, we would get stuck in unproductive ventures. It is the ability of entrepreneurs to try, fail and try again that makes the capitalist society the most dynamic and versatile.

We have to remember that the function of an economic system is not about creating jobs. It is about increasing the standard of living for all. We do this by allocating resources to their most highly valued uses. Profits and losses are the signals by which these decisions are made. We like to think of the entrepreneur recognizing consumers’ frustrations. Then by individual effort create a company that satisfies those needs and as a result wealth and riches flow. Sometimes that is exactly how it happens, but we cannot forget that the other side, the losses and bankruptcies that occur from the unproductive arrangements of capital structures, are also necessary. While we should not celebrate the loss of a person’s job and company, we should be thankful that we have a system that self-corrects and transfers resources to their most highly valued use.

Hmmmm… Economic Harmony

This summer I have been fortunate enough to be asked to lecture at the Foundation for Economic Education (FEE) for several of their summer secessions. During my prep work, a lingering idea hit me with more force this year.

The word “equilibrium” is a terrible, horrible word to use in economics. It does not convey what economists mean. The word equilibrium is borrowed from the natural sciences—physics. It means a state of rest. Imagine a ball rolling down a hill into a valley. It swings up one side and then back down; up the other and then down, etc. until it comes to a state of rest. It stops. It will stay at rest until another outside force acts upon it. The ball is in equilibrium.

Now here is what an economist is looking at…There are millions of individuals making choices. Each one has an independent subjective point of view on life. Each buyer decides if a good or service is or is not worth the price asked. Each seller is attempting to get customers to buy their products and make as much money as they can, while constrained by competitors and fickle consumers. Economists describe these actions and behaviors through the use of supply and demand models. When the price is too high there is a surplus of goods that go unsold. When the price is too low, there is a shortage and group of frustrated buyers. However when the price is just right, the amount of goods wanted and offered match perfectly. The market clears and no one goes home frustrated, at least with respect to the market. One can always find something to be frustrated about.

It is this balance between supply and demand that economists use the word “equilibrium.” However, economists do not mean a state of rest where nothing is going on. There is definitely something happening. People are happily trading and no one is angry about not getting enough or having too much.

I think that the 19th century French economist Frederic Bastiat may have gotten it right when he called his book on the overall economy Economic Harmonies.

“Harmony” is a much better word to use than “equilibrium.” Harmony means the complementary actions of many weaving together a greater whole. Think of a symphony. The strings, the brass, the woodwinds, all coming together that create a larger work of art. In the same way, the economy is a process of harmonization. The economy is many people working together, comprehending, complementing, completing projects, tasks, ideas so that others will be served. If customers are not served, the business closes.

The economy is truly a marvelous, beautiful work of art.

Circling the Drain*

Prices are amazing things. They communicate the relative scarcity of goods and services to all who wish to look at them. The importance of this information is that it allows producers and consumers to engage in economic calculation. In other words, in an instant you can look at the price of something and determine if it’s worth buying. When everybody makes such lightning quick calculations, the result is an efficient allocation of resources and a minimization of waste.

Market prices are created by the interaction of all those that consume the good (demand) and all those that produce the good (supply). When there is more demand or less supply, the price increases, signaling to all to conserve the resource and look for substitutes. Additionally, the extent to which the price has gone up (3% or 300%) signals how much of a change in behavior is necessary. Even if consumers and producers do not even know or understand why the good is more scarce; they all know to conserve it.

Unfortunately, this very important function of prices only works in a market. When a price is arbitrarily set and imposed on consumers, there is no information of relative scarcity. There is no real information for anyone to make a correct economic calculation.

Sadly, the City Council of Raleigh has been completely thwarting the formation of market prices for water. They arrogantly believe that they know more about the scarcity of water than do all of the users and providers combined. Raleigh’s City Council voted 6-2 last Monday (4/27) to raise the price of water by 23% by the end of the year. I ask why this amount? Why not 4% or 40%? Why should there even be an increase? There is no economic answer to these questions since there is no market for water.

North Carolina has been struggling with drought conditions for the past several years. If we had a market for water, prices would have risen. An increase in price has two effects: people cut back on how much they consume and producers produce more. Unfortunately, local governments claim ownership over water. There is no market. The local governments simply pick prices that they think are politically viable.

During the past drought, Raleigh and the State of North Carolina convinced people to use less water, by buying rain barrels, for example. The marketing campaign worked and the amount of water consumed dropped dramatically. As a result, the revenue from water has dropped off. In a budget crisis, the city council wants more revenue and so they are raising rates. Despite their lip service, this increase is not for economic or environmental reasons.

The Cold War has been over for almost 20 years. It is time to stop letting councils or politburos set prices. Water is too precious a commodity to let politicians play politics with it.

Now is the time for the City of Raleigh to get out of the water business. Cities across this country have been selling the water business or at least contracting out the water production services to the lowest bidder. The results are lower costs and higher quality. Other cities such as Atlanta, Jersey City and Indianapolis, have experimented with privatizing water services and the lessons learned will be enormously beneficial to the Raleigh City Council when it follows this path.

Some cities have had problems in the past because they simply have not gone far enough. They think that since they were a monopoly provider that only a monopoly should take their place. There is no reason for this. The market needs to be thrown open to all companies that think that they can produce and provide water to the metro-Raleigh area. Many services that were once thought of as monopoly-only markets are radically different today because the market was thrown open. Think telephones. As a general rule, the more companies that produce a service, the lower the price to consumers will be.

If there are several companies competing for your customer dollars, you will see a dramatic change in the way people buy water. Right now, I have no idea how much water I am using and how much I am being charged. However, today I can go online and look up how many minutes I have used on my cell phone plan. How can people accurately conserve water if they don’t know how much they are using?

Most importantly, if a market for water is created, market prices will emerge. They will shift and change to supply and demand conditions. If we are hit with another drought, prices will rise and consumers will know exactly how much their activities are costing them: $15 to water the lawn; $8 to wash the car; $1.50 to take a shower; etc. Then individuals can be free to choose how to live their own lives. No more draconian water police sweeping through neighborhoods, issuing citations of violation and fines. People with established lawns can make their own decisions on how to cut back and people with new lawns won’t have to beg at the feet of the bureaucrats and politicians.


Markets are economically efficient and are the best path to ensure liberty. By allowing politicians to control something as important as water, our livelihoods, our standard of living and our liberties are certainly circling the drain.

*This is an expanded version of the Op-Ed in The Garner Citizen News and Times, May 13, 2009.

Bitter Medicine

Yesterday, I experienced an event that no parent wants to go through. My 23-month old daughter was playing, fell over a railing and landed forehead first on a 2-inch rock. Just to alleviate any anxiety, she is fine (or technically, after the bruises, cuts, etc. heal, she will be fine). She was watching her brother run past, leaned over a railing to see better and then fell from a height of about 3.5 feet. After the blood was cleaned up and gunk put upon the wounds, my wife called her father. He’s a medical doctor, but unfortunately he lives in California and not in North Carolina where we live. He recommended that we have a professional to take a look and get a CT scan.

Unfortunately, since it was Sunday and the regular pediatrician’s office was closed, we took her to an urgent care facility. Sadly, they only treat patients 2-years and older. With a 23-month old, we had to go elsewhere. After going to one 24/7 facility–oddly closed–and another place that did not have a working X-ray machine, we ended up going to the Children’s Emergency Room.

The people at the hospital were very friendly and competent. I am very pleased about how we were treated. While we were in the waiting room, it seemed as though there was a whole lot less “emergency” going on than one might expect at the Emergency Room. Someone was there because their child had a fever for about a week. Another was there because the boy was having bowel trouble. His mother stated in a rather non-chalant manner that it was probably something that should be looked at. I agree, but is the emergency room the best place for such an examination?

Now, I can think of several scenarios where these situations could seem much more serious than I inferred. However, the emergency room has limited resources. I think that it should only be used for–surprise, surprise–emergencies! Since the emergency room is not allowed to turn people away, the result is a long line and a lot of waiting. There are obviously priorities, e.g., when trauma patients need immediate attention, but overall, the entire service is clogged by people inappropriately using the emergency room when urgent care or even a regular doctor visit would be more appropriate.

Why are these people doing this? Is it because nothing else is open? Possibly, I don’t know. Is it because some of these parents do not have a primary care pediatrician? Possibly, I don’t know. Is it because they don’t have insurance and the hospital will write-off and/or charge the tax-payer, thus making the cost of the trip to the recipient the price of their time? Again, I don’t know.

However, I do know this: when a good or service is underpriced it will be overused. When a good or service is overused and the price can’t reflect the increased scarcity, non-economic methods of rationing will occur. The most typical form is waiting in line. Other rationing methods are by need, by force, by merit, by some lottery, etc. Each of these ignores the supply-side incentives. As a result, there is little economizing; there is little reason to expand output or production; there is little reason to try harder and take that extra step.

Behold, waiting in line is the future of medical care: it is called socialized medicine and universal coverage. Everywhere it is tried, it is a complete failure. Socialized medicine is characterized as being too expensive and having too few services. Patients in Canada are coming to the US for heart operations. Patients in Europe are flying to Singapore and India for treatment. It has even been reported that the UK has a 10-month wait for its maternity list. The only rational alternative to the “one size fits all,” “sit in a waiting room and hope someone will see you,” government health care is the personalized care one gets from a market.

I fear that too many people are not going to heed the words of economists; and through some combination of false charity, ignorance and greed, we are going to end up with socialized medicine. As H. L. Mencken once said, “Democracy is the theory that the common people know what they want, and deserve to get it good and hard.” And that would be some bitter medicine.

Twist and Shout

On March 18th, the Federal Reserve announced it will keep the Fed Funds rate between 0 and 0.25%, buy $750 billion in mortgage backed securities, and buy $100 billion in agency debt. While injecting $850 billion into the economy is problematic, the almost unnoticed announcement is that the Fed plans to buy $300 billion in long-term Treasury securities.

The last time the government tried to manipulate long-term interest rates was in 1961, during the Kennedy Administration. The goal of a project called “Operation Twist” was to flatten the yield curve by raising short-term rates while maintaining long-term rates. Legislators thought that higher short-term rates would reduce the flow of capital from the US, while lower long-term rates would encourage domestic investment. Operation Twist was a disaster because the result was the opposite of what the Fed intended.

Unfortunately, our economy is in a recession – the downside of the business cycle. The business cycle works something like the following. Suppose that a student is assigned a research paper that is due tomorrow at 8am. Since the student hasn’t started the paper, she is in for a long night. By 11pm, the student is getting tired but hasn’t finished the paper. What does the student do? Quite naturally, she reaches for some coffee, a sugary soda, or whatever else that has a lot of caffeine. The jolt of caffeine gets her moving again; but, around 3am, she’s slowing down. What does she do? Grab more caffeine! However, now to get the same jolt, she needs a bigger dose. Each artificial jolt cannot last, and the next jolt requires an even larger dose. Eventually, 8am arrives and the student hands in the paper. Then, she crashes! A long sleep is necessary to flush the junk out of her system and restore her to a normal state.

Our economy has been on an artificial all-nighter for the past several years. It is now time to clear the “junk” out of the system. The junk that needs to be cleared out consists of malinvestments, which were built up during the artificial boom of the last several years of expansionist monetary policy. Now, the time has come to hand in the paper and flush these malinvestments from our economy.

The only way that we can get back to a solid foundation for economic growth is by increasing saving. Savings provide the wherewithal for investment. Investment allows for capital accumulation. Capital includes better tools, better machines, and better equipment, which are necessary for workers to become more productive and raise the standard of living. This is the “Magic Formula” for economic growth; but it’s really not magic. The formula has been known and followed since the beginning of the 1800s. Following this magic formula transformed the US from a bunch of backwater colonies into the largest economy in history.

The opposite approach, the one we are currently taking, is to encourage consumption, except that method doesn’t work. We cannot consume our way to prosperity. A basic tenant of economics is that our wants and desires are unlimited; however, supply is the limiting factor. Stimulating demand alone will not increase the amount of stuff that is being produced.

Furthermore, the Fed is engaging in a policy that allows the entrepreneurs who malinvested capital to persist unnaturally. Unfortunately, those businesses must fail for the economy to recover. When they go out of business, other entrepreneurs can buy their assets for pennies on the dollar. This process allows new firms to use those very same resources (and perhaps the very same employees) with a much lower cost structure. Lower costs are good for firms and very good for consumers, especially those without jobs.

The Fed policy is propping up failing firms while attempting to keep prices high. This policy is backwards. The Fed’s action of pumping money into the economy today will force prices to be much, much higher in the future. The last thing those who have lost their jobs or suffered wage cuts need is for prices to remain high.

Every delay in the painful liquidation phase of the business cycle makes the future reckoning worse. It’s like not going to the dentist when you have a cavity. The drilling will be bad, but if we let it fester, it will become much worse.

We need to shout to the Fed, “Stop drinking those heavily caffeinated, sugary sodas! Stop flooding the market with all of this artificial credit! And let the economy wash out the malinvestments!” Perhaps the song “Twist and Shout” will always be in style; unfortunately Operation Twist is a policy that should have remained in the past.

The Real Bills Doctrine of 2009

In the late 1920s and early 1930s the Federal Reserve System followed a theory called “The Real Bills Doctrine.” While the theory has been totally discredited, it nevertheless emerges in the news and in political circles from time to time. The real bills doctrine makes a distinction between the financial sector of the economy and the “real” economy.

In the late 1920s, the central bank was worried about the amount of money flowing into Wall Street. Many claimed that there was too much speculation, which was creating a false stock market boom. As a result, the central bank stated that it would only loan money to banks and corresponding projects that were “productive.” In others words, the central bank would only loan money to projects that were to be used to produce real goods and services. With the production of real goods and services, the loans would not be inflationary. Or so the theory goes. The reality is that all monetary creation is inflationary regardless of what it is used for.

Today, we are suffering from the real bills doctrine again. It is just dressed up a little differently. The politicians are calling for more economic stimuli to “jump start” the economy. Some politicians are objecting to the direction that Washington is taking not because the theory of increasing government spending to create an economic recovery is flawed (which it is); but rather politicians are objecting to the idea that the money isn’t going toward “real stimulus” projects. They claim that instead of using the money for balancing state budgets, the federal monies should go to “shovel ready” projects. It is in this distinction that the real bills doctrine emerges. When it comes to inflationary pressures, there is no difference between balancing state budgets, shovel ready projects, road construction, stock market speculation, and so on. The more dollars put into the economy devalue each and every dollar, regardless of how it gets into the system.

Furthermore, spending federal dollars will not restart economic growth. The source of economic growth ultimately comes from savings and capital accumulation. Capital accumulation means the production of better tools, better machines, and better equipment. More capital is necessary because it allows each worker to become more productive and raise the standard of living for everyone. This formula has been known and followed by the US since our revolutionary days. Following it has transformed the US from a bunch of small, backwater colonies into the largest economy in human history.

The current stimulus package cannot be funded by using today’s tax receipts. The government will try to get the money to cover these expenditures through borrowing, which will result in the largest deficit ever. Unfortunately, there is simply not enough money to borrow to cover all of the spending. The balance will have to come from money creation. Regardless of what is done with this money, it will cause prices to rise in the near future. Furthermore, since our banks adhere to a fractional reserve system, it means that the newly created base money will be loaned, deposited and reloaned, over and over. This credit creation process will multiply the money supply throughout the economy by a factor of about nine.

We are standing at the edge of a very nasty inflationary period. We can turn back or we can make things worse. If we follow the path of monetary expansion, it will come at a very high cost. Not today, but not too far into the future. It will be at that point when the real bills will have to be paid.

Stop! In the name of the LAW!

Ask any lawyer or police officer and they will tell you that ignorance of the law will not get you off the hook. The same is true when it comes to economic laws and their consequences. Regardless of the intentions behind the legislation, the consequences of economic policies have impacts that follow economic laws.

Today’s government’s strategy is to try to stimulate the economy by increasing aggregate demand by spending more than three-quarters of a trillion dollars on anything and everything. To help put this into perspective, the stimulus package, all by itself, would be the 15th largest economy in the world. So we need to ask, “Where is all of this money going to come from?”

Governments, all governments, have only three options open to them when it comes to raising money: taxation, borrowing, and money creation. Each method not only counteracts the intention of the spending (sustained economic growth), but creates a situation that is ultimately economically worse.

It does not matter whether the law places a new tax on either the consumers or the producers; the burden of the tax is identical. The side that is less price-sensitive will end up carrying the heavier burden of the tax. Furthermore, taxes create what economists call dead-weight losses. These are burdens to all of society because some buyers are willing to buy and some sellers are willing to sell, but because the tax has increased the selling price and lowered the revenue from the sale, they walk away from the exchange undone and frustrated. The bottom line when it comes to taxes is this, it takes before it gives. If the government is hoping that its spending will create “economic stimulus,” it must first take away that economic energy out of the economy if it taxes. The net result is a wealth transfer, but not sustainable economic growth.

The second method of borrowing the money to pay for the spending package has a similar result. The government is not constrained by market forces when it comes to offering interest rates on their securities. Thus to get people to borrow from it, it can keep raising interest rates in order to get the saved dollars. When the government behaves this way, it “Crowds Out” private sector investment. Investors are looking to put their money into a vehicle that will give them a strong return. When the government starts bidding up interest rates, private companies cannot compete and they end up going without. The best possible effect of this crowding-out is a simple wealth transfer, but this is not really the case. The market is looking to put dollars into areas that send resources to their highest valued uses. However, the government does not spend money according to market signals, and as a result, it spends money in areas that do not have the highest valued uses. The net result is that instead of recovery, the economy slows further.

The third method financing the spending is through money creation. Where does the Federal Reserve get this money from? The answer is nowhere. Money is literally created out of nothingness. When this new money is put into the economy it has several effects. The first is that it changes the relationship between debtors and creditors in favor of the debtors. The second implication is that it adds static to the price signal that entrepreneurs follow. Suppose that you are an entrepreneur and you see the prices of your goods are rising by 5%. Is this because there is an increased demand for your goods? Or is it because of inflation? Or is it some combination between the two? What could that ratio be? It makes the already difficult job of the entrepreneur that much harder, thus slowing down the economy.

The most insidious implication that results from monetary expansion is the wealth transfer that occurs. Money is not neutral. When people think of inflation, they think of a price level rising. They think of the water level rising evenly across the surface of a pool. This thinking is, unfortunately, completely wrong. Money affects prices in ways that has real effects on prices and wealth.

Money is never injected into an economy equally across the entire economy. It is injected at specific points. Some people and businesses get the new money first. When they get this new money, they use it. They purchase consumer goods and services and make investments. By making these transactions, they are applying upward pressures to the prices of the items they are buying. They are literally out bidding others to attract goods and services to themselves. The specific pattern of which prices rise and by how much completely depends on who gets the new money first and what their tastes and preferences happen to be at that moment.

There is another group who are witnessing the prices rising, but they have not yet received the new money; it has not filtered to them. An example is those on fixed-incomes. As they see prices rise, their real wealth falls because their incomes have not changed. Thus, there is a real wealth transfer from those that get the new money last to those that get the new money first. The people whose real wealth is declining use their savings to maintain themselves during a recession. Savings are the key to economic growth and recovery, and inflation causes it to dry up. The result is that the economy moves two steps backwards.

Who are the people and businesses that are getting the bail-outs and the government spending? It is those companies that are inefficient and losing money. We are transferring wealth from the healthy part of the economy to the part that is inefficient and needs to be liquidated.

To all of these misguided economic policies, we need to say, “Stop! In the name of the LAW!”

A “Magic Formula” for Eastern NC

With unemployment at 9.9% in Rocky Mount and 7.5% in Greenville (according to the Bureau of Labor Statistics), there is a strong desire for a political solution to a deteriorating economy. The cry of "Do Something; Anything" is what leads to the wasting of taxpayers' money like with the Randy Parton Theater fiasco, or with giveaways to special interest groups like Hollywood production companies to film in Wilmington.

What eastern NC needs is real growth and not some ad hoc, temporary political solution. Those have been tried and still the average annual income in eastern NC is 15% less than the rest of the state. Eastern NC needs widespread, systemic growth, but growth cannot be forced. Farmers know that you can't force crops to grow. You can only set the right conditions: prepare the soil; provide water; control pests; augment the soil; etc., but you certainly cannot force growth.

The same can be said for economic growth—you can't force it. It has to occur naturally and spontaneously. It can be encouraged by setting the right conditions. Luckily those conditions can be discovered and have been discovered by economic science. There is a pattern to economic growth. This pattern has many names, which I tell my students is a magic formula. It seems like magic because without anyone issuing orders, without a central planning board, with individuals acting in their own interests as they best see it, we have achieved, in a very short period of time, living standards that had never been seen in the preceding 5,000 years of recorded human civilization. Fortunately, the magic formula for economic growth is not a secret formula (we're allowed to talk about it), but unfortunately it is seldom heard over the demagogic political voices.

The goal of an economy is not balanced trade, universal health care, or even jobs. Jobs are easy to create. Stalin and Mao created many jobs. The key is to have jobs that create goods and services that people want and desire. The true sovereigns in the economy, the consumers, set the goal of the economy, which is an increase in the standard of living for all. The means by which this is achieved is through the production of more goods and services. But how can more be produced using the same amount of resources? The answer is that it must come through an increase in productivity. Increasing productivity comes from newer and better machines. Economists call this "Capital Accumulation." Capital accumulation comes about through investment, and investment funds come from savings. Thus the magic formula for economic growth is this: savings leads to investment, which leads to capital accumulation, which leads to higher levels of productivity and creates higher living standards. Notice that the magic formula follows the age old wisdom of the pre-20th century American: saving is good; invest and in time it will bear fruit; and you can't get rich by eating the seed corn. By following this formula, America has created a higher standard of living for more people in barely two centuries.

Governments do not make wise choices with investment dollars, just look at the DOT, Randy Parton Theater, or the giveaways to large corporations in the vain hope that they will create jobs. Government has no guiding star by which it knows where to put resources. The current practice of catering to the loudest special interest group is not good enough.

In a market economy, it is the entrepreneurs who make investment decisions. They are self-directed but others-focused. Entrepreneurs follow market signals and direct resources to their highest-valued uses, maybe not perfectly, but better than the governmental alternative.

Eastern NC has great potential for growth, but it will not occur overnight and it cannot be done by some get-rich-quick political scheme. The economic ground has to be prepared. Savings and capital accumulation are currently discouraged. A return to the magic formula is necessary. As such, we must resist the calls for political bail-outs, corporate welfare, business incentives, and the creation of new projects to “jump start” growth. We need to unleash the entrepreneurs. We need to make starting and keeping a business easier. Often the best thing to do is not a government hand-up or hand-out, rather it is to just step out of the way.