Monday, March 21, 2011

Say's Revenge: Living in Keynes' Long-Run

I gave a talk at the John Locke Foundation today, which I thought went rather well.  It is called, "Say's Revenge: Living in Keynes' Long Run."  Here is a clip from the talk:

For the full video please go here:
or here:

Thursday, March 17, 2011

A Gold Currency for North Carolina?

In a recent N&O article (found here), it is reported that a state legislator, Glen Bradley-R Youngsville, has introduced a bill to create a State currency backed by gold and silver.  The reporter is perplexed by such an odd bill, and he basically ridicules the sponsor.  In the article, he talked to an economist at the State University, the Democratic State Treasurer and a Democratic State Legislator.  (I guess that's "Fair and Balanced.")

While I know that this bill is going nowhere today, it is worth thinking about.  What would happen if a state decided to go on the gold standard without the rest of the nation?  (I know that the bill says gold and silver, but bimetalism is a whole different set of problems, so let's just focus on the gold standard.)

The advantages of a gold standard, at least nationally, is that it forces the government to live within its means and is a brake on hyperinflation.  Additionally, it reduces the ability of the Federal Government to grow the Welfare/Warfare state.  While it might not eliminate the business cycle, it does help reduce the artificial bubble (boom) the preceeds the painful, but necessary, liquidation process.

Why should a State like North Carolina consider it?  The benefit of owning a currency that is not depreciating is obvious to the guy who has the gold coins in his pocket.  In fact, I'd rather be paid in such a currency.  Furthermore, the adoption of a sound currency would mean a big positive jump in investment into the NC economy.  If the people of the state adopt the gold currency, then it would attract businesses the world over who are afraid of doing business in a coming hyperinflation.  (While those in power cannot forsee a collapse of the US dollar, does not mean that such a thing is all that far off.  I doubt the Germans in 1922 forsaw the inflation awaiting them in the next year.)  And finally, since the State already has a balanced budget rule, the impact on the budgetary process would be small. 

The problem of going it alone, when we have legal tender issues, is that of Gresham's Law.  The law says that with legal tender laws, bad money drives out good money.  (It also says, but is less commonly known, that good money drives out bad money in a competitive market.)

So, unfortunately, Gresham's Law will fully apply to North Carolina.  Why?  Suppose that Bradley is correct on the dollar's purchasing power falling through the floor.  Now to pay my taxes I have the choice of choosing between using a state gold coin or a depreciated dollar.  I will always choose to pay in the least valuable currency.  So I will hoard the state gold coins and spend the increasingly devalued fiat dollars. 


The only way that the Gresham's Law will work to the advantage of the state gold coins is if it is allowed to compete with the US paper dollar.  If the paper dollar and state gold coins value are fixed, then the paper money will drive out the gold.  However, if value of the state gold coin was allowed to float against the paper dollar, then it would, indeed, drive out the use of the paper money.  Not entirely, of course, but to the extent that residents of North Carolina can demand payment in gold coins, it would. 

And that is the catch.  The paper dollar says that it is good for all debts public and private.  So that means you have to accept it.  If the buyer can force the seller to accept the paper, then there is no chance of its success.

Tuesday, March 15, 2011

Getting Back to Breakeven: ASC 2011 paper

This past weekend, I attended the Austrian Scholars Conference at the Mises Institute in Auburn, AL.  There were many papers presented and I plan on commenting (later) on several of them on this blog.

Many have asked for a copy of the paper I presented with Harry Veryser.  The link to it is here or you can find it here:

Monday, March 7, 2011

Failure is a Necessary Option

An often repeated and overused phrase is, "Failure is not an option."  How ridiculous!  In fact, the reverse is not only true, but it is a necessity.

One major problem with the public school system is that failing schools do not close.  In fact, a failing school usually gets more funding the next year in order to "turn it around."  Ask yourself if this policy really makes long-term sense.  What sort of incentives are being created when failing schools are given expanded budgets?  An axiom in economics is that people respond to incentives.  If we pay people more for failing schools is it any wonder that we get failing schools?

In the private sector, the customer is sovereign.  The customer chooses what to buy (or not buy) and no one can force such a decision on another.  An entrepreneur who is able to please his customers receives continued business as his reward.  Hopefully, with proper management, profits also accrue to the entrepreneur.  However, if the company does not please the customer, regardless of reason, the business suffers.  Maybe there was rudeness, maybe the product was shoddy, or maybe the price was too high, the reason doesn't matter because the end result is the same: the loss of business.  When the customer is not pleased with the entrepreneur, he takes his business elsewhere.  The entrepreneur had better shape up quickly or the venture will close its doors and the resources will be transferred to others who are better at satisfying customers. 

The continuous process of pleasing customers continually shifts resources to those who are the most efficient users and most effective satisfiers.  This phenomenon is relatively new; it has only been around for the last couple of hundred years.  During this short period of history, we have achieved higher living standards for more people than at any other point in recorded human history.

When we step away from the market and into the world of public provision of goods and services, we see that it operates by a whole different set of rules.  In the public sector, the government collects the revenue to operate the institution.  However, it can't simply hand someone billions of dollars and say, "Go educate some kids."  Along with the dollars come the rules and regulations.  These reorient the focus of the employees and managers away from "customer" and toward the rulebook.  Additionally the same system strips away all vestiges of competition between providers of education.  The children are assigned schools; the parents are not allowed to choose.  Imagine if such were the case with phone and Internet providers.  (Actually I can imagine it, because it was the law of the land for decades.  What was the result?  Poor quality, high costs, lack of convenience, ugly phones, and attaching an answering machine was considered illegal because it was "installing a foreign device.")

Our public education problems are far too complex to simply say that the answer is competition between our schools, but don't discount that simple phrase too quickly.  Imagine the impact the following three changes would have on our public schools:

  1. allow parents to choose which school to send their child to;
  2. attach the dollars to the child so that a school's budget is based upon the number of students that enroll at their location; and
  3. allow schools that cannot cover its costs to close and be sold.
Such a proposal will cause the teachers' and administrators' unions to howl, but I am not concerned with protecting their jobs any more than I am concerned about protecting McDonald's workers' jobs when I go to Burger King.  In fact, our university system has this feature and it seems that we have a large and diverse set of higher educational institutions.

Competition will weed out the bad teachers and they should lose their jobs.  Competition will weed out the bad administrators and they should lose their jobs.  Competition will weed out the unnecessary overhead and reward quality.  It will reward good schools, good teachers and good administrators.  

Many think that competition is scary because some producers are winners and some are losers.  Unfortunately, too many people think this way.  I say "unfortunately," because this thinking is backwards.  There is too much focus on the providers and too little attention paid to the customers, the children.  When there is competition, the customers are the big winners.  And, paradoxically, the only way that we can guarantee a successful school system is if we make failure not only an option, but a necessity.

Friday, March 4, 2011

Austrian Economics Forum Spring 2011 #3--Non-Neutral Money

This session we had three readings: “The Non-Neutrality of Money” by Ludwig von Mises (1938 [1990]), “Neutrality of Money” by Don Patinkin (1987/1989) and “The Problem of Monetary Equilibrium,” by J.G. Koopmans (1936).  We started with Mises’ article and, sadly, ran out of time before we could really get into the Koopmans piece.  The Koopmans piece is a lecture that he gave at the LSE on June 15, 1936.  The copy we used comes from Professor Richard Ebeling.  He hopes that it will be soon published as a journal article.  We shall see.

The idea of money's non-neutrality seems to be fairly straight forward, while the idea of neutral money is the idea that seems to be alien.  Nevertheless if we examine the economics profession, the idea of non-neutral money is almost summarily rejected or, on a good day, it is given some lip service--and then tossed aside.  So what is neutral money and where does the idea come from?

In the mid-1700s, David Hume (Scottish philosopher and teacher of Adam Smith) was arguing against mercantilism.  Mercantilism was the political economic doctrine that held that a nation is richer if it has more gold and silver.  These riches could then be transformed into military power and then ultimately into national supremacy.  Hume argued that the wealth of a nation could not be simply measured by counting the amount of money (gold and silver) that existed in the economy.  He said that ultimately wealth was found in the goods and services in a country and not the amount of money.  For example, suppose that an economy doubles its money supply overnight.  Is it doubly as rich?  The obvious answer is, "No, all that changes is prices."

So far the neutral and the non-neutral money theorists agree.  The next step is where the two groups part company.

The neutral money theorist says that if the money supply doubles, then all prices will double.  The modern version of this position is that the "Price Level" doubles.  In other words, on average, prices will double. 

The non-neutral money theorist says that this analysis is drawing conclusions with assumed facts.  The neutral money supporter is implicitly assuming his conclusions: increasing the money supply has no effects on anything real. 

So let's get into the details of the debate.

First of all, the Austrian asks what is meant by the "Price Level"?  Mises explicitly rejects the metaphorical use of the term "level."  It conjures up an image of a pool of water in which water is added or withdrawn.  The height of the water in the pool then reflects the change in the injections--i.e., a doubling of the amount of water, doubles the height of the pool's level.  Money is not diffused into an economy so quickly.  Hayek has said that instead of water, we might envision the pouring of honey.  Mises argues that positing all prices and wages simultaneously rising or falling to the same extent simply cannot be assumed. 

Patinkin, on the other hand, argues that nothing other than exactly that can occur.  He sets up a general equilibrium model of an economy and then increases the money supply by "k."  He then shows, mathematically, that in order for all the equations to reequilibrate, all prices and wages must increase by exactly "k."  The assumption is made at the moment when we assume unique general equilibrium conditions.  If there is only one solution for general equilibrium, then of course the only solution is to change prices by "k."  However, that is a huge assumption that is never (rarely?) justified.  In his defense, Patinkin does admit that in the short-run there may be some non-neutral effects, however, his argument is that the long-run patterns must reemerge.

But, let's take Patinkin at face value.  The entire focus of Austrian analysis is on the short-run effects of monetary injections and their distortionary effects.  So, why should the Austrian even take the bait and argue the implications of a hypothetical long-run, which will never emerge?  Furthermore, as we will see below, the role of heterogeneous capital will make returning to an original hypothetical long-run equilibrium impossible.

So then what is the Austrian position and why is it so important?

The Austrians do not view money as some mystical numeraire that simply measures the height of purchasing power.  Instead, money is a good that is also subject to the same laws of diminishing marginal utility (demand) and increasing opportunity costs (supply) that govern all other goods and services.  Since the valuation of money is governed by marginal appraisals and the goods and services purchased are also governed by marginal appraisals, then the concepts such as "Price Level" and "velocity" must be viewed with extreme suspicion.  Indeed, Mises outrightly rejects the use of either.  Mises states,

Monetary problems are economic problems and have to be dealt with in the same way as all other economic problems.  The monetary economist does not have to deal with universal entities like volume of trade meaning total volume of trade or quantity of money meaning all the money current in the whole economic system.  Still less can he make use of the nebulous metaphor "velocity of circulation."  He has to realize that the demand for money arises from the preferences of individuals. ... Money is never simply in the economic system, ..., money is never simply circulating. ... The decisions of individuals regarding the magnitude of their cash holdings constitute the ultimate factor in the formulation of purchasing power.

As a result, it makes no sense to aggregate all of the money into a graph containing Money Supply and Money Demand to determine the "Purchasing Power" of money.  Furthermore, the Austrians reject the "equation of exchange," MV = PQ. 

So without such mechanisms for analysis, what is the proper method for examining macroeconomic and monetary problems?

The Austrians use a stepwise approach.  Austrians argue that money is injected into specific points into the economy and that these injection effects have specific impacts and implications.  Suppose that the central bank creates and injects new money into the economy.  Economists agree that this money creation favors debtors and harms creditors.  Additionally, economists agree that a signal extraction problem might emerge; that it is a hidden tax and can distort the incidence of the tax code; and that it can blossum into hyperinflation, which can be very difficult to reverse.  However, the Austrians focus on the emergence of the Cantillon Effects. 

If the central bank creates $100, it is injected into the economy and not scattered evenly throughout it.  As a result the first person (firm, institution, etc.) to get the new money has an advantage over everyone else.  He is able to obtain $100 worth of goods and services at today's prices without first contributing to the general welfare.  The buyer who uses this new money competes against everyone else in the economy.  The effect of his purchases is an increase in the demands for those specific goods, resulting in the prices for those goods inching up.  Now those who have the new money are able to buy goods and services with only some prices slightly higher.  The effect ripples through the economy.  As the new money passes from person-to-person, prices inch up as a real goods and services are exchanged. 

While this process continues there are those people who do not yet have the new money.  Nevertheless, the prices that they face are rising.  Their real wealth falls.  Thus, there is a real wealth transfer from those who get the new money last to those who got the new money first. 

The next step is to add heterogeneous capital to the analysis.  To the degree that capital has specificity, these distortionary effects create illiquid malinvestments.  As these malinvestments are built up in the economy, their removal becomes more difficult.  This idea is the underlying framework for Austrian Business Cycle Theory.

None of these issues emerge if money is assumed to be neutral.  Indeed, many economic problems become difficult to analyze when neutral money is assumed.  This is probably why Mises concludes his article with this important observation:

I wish to emphasize that in a living and changing world, in a world of action, there is no room left for a neutral money.  Money is non-neutral or it does not exist.