Austrian Economics Forum Spring '12 #4--Kirzner & Cwik

For our fourth meeting, it was decided that we would discuss the paper that I presented at the Austrian Scholars' Conference in Auburn.  While I love to talk about myself, I decided to include a paper by Kirzner as well. 

The Kirzner paper is "The alert and creative entrepreneur: a clarification."  Basically, this is Kirzner responding to supporters and critics of Capitalism and Entrepreneurship, and then telling them that they are all wrong.

Kizner says that his work is not about how to become a successful entrepreneur.  Rather his work focuses on how the market process is set in motion be entrepreneurial decisions.

The interesting points he puts forward is an almost rewritting of his stance on Schumpeter.  He says that everyone knows of Schumpeter's creative-destroyer and so he did not want to dwell on that aspect of entrepreneurship.  He wanted to show how entrepreneurship coordinates the economy.

He then argues that many misinterpreted his writings to say that the entrepreneur was a passive noticer of opportunities.  He says that a false tension was created between the Schumpeterian "bold, disruptive, innovators or [the] passively alert, harmony-restoring responders to changes that have already occurred."  He then states,

[T]here must be scope for both a creative ("Schumpeterian") entrepreneur (one who generates pure profit) and a "passive," alert ("Kirznerian") entrepreneur (one who snuffs out given profit opportunities by promptly exploiting them.) p. 149 (italics in the original)

Cordato argued that his own work tends to connect the two positions.  He argued that we live in an "open-ended universe."  He means that there is no such thing as a final equilibrium to strive for.  In fact, as new information is added, the equilibrium point changes. 

It was based upon this point that we decided that the next week would center on Cordato's book, Efficiency and Externalities in an Open-Ended Universe.  And so we tabled further discussion on this point for the next week.

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Then the discussion turned to my paper, "Greed in Public and Private Institutions."

My paper, as is too often the case, was based upon frustration.  There is a general attitude that anything that happens in the private sector is due to greed, but when we switch to the nonprofit sector, motives are now made of pure light.  Indeed!

Of course people in every walk of life are greedy.  (As an aside, economists throw out the word "greed" because it cannot be precisely defined.  A typical definition of greed is the wanting of something too much.  However, what is "too much"?  Who decides?  As a result, economists use levels of self-interest.)  Self-interest is omnipresent and it propels Adam Smith's butcher, brewer and baker to serve others.  On the other hand, we have a separation of self-interest and the interest(s) of the overall organization.  It is a question of aligning incentives.  In other words, we are examining a principal-agent problem.  What if Bernie Madoff, Ken Lay or other suitable villain was in charge of the State Department or the US Treasury?  Would we even know what they would be up to?

My paper suggests that two questions arise: Can the institution efficiently allocate resources to satisfy the most intense wants and desires of consumers?  And can the principal-agent problem be overcome to ensure that the leadership will carry out its intended purpose or will the leadership use the entity as a means to a selfish (greedy) end?

In my paper, I looked at three institutional settings: for-profit companies, bureaucracies and nonprofits.  I conclude that the for-profit sector can answer both of the questions.  The bureaucracies cannot calculate efficiency, but it does issue rules, orders and regulations to control and guide the behavior of beaucrats.  It is in this way that bureaucracies have a chance of overcoming the principal-agent problem.  The nonprofit sector, on the other hand, is incapable of answering either question.

Overall, the discussion was friendly and supportive.  During the course of the discussion, Cordato asked a good question, "When it comes to bureaucracies, who are the principals?"  I did not have a ready answer for him.  When I wrote the paper, I had Mises' Bureaucracy in the back of my mind.  In it, he uses the model of a king that basically is in charge issuing orders.  And so in my mind, the king was the principal and the bureaucrat was the agent.  How that translates into a representative government is much more complex.  Although, the point that there is a potential solution remains.

Additionally, a student suggested that when it comes to the nonprofit organizations, we can split them into two groups.  The first group is primarily donation driven, while the second is endowment supported.  The first group "has its feet to the fire."  They must be very aware of what the donors expect, otherwise the funding disappears.  The second group is insulated from today's donors because an endowment has been built up.  (For example, think of colleges and universities that have large endowments.)  They are able to upset today's donors because they have the resources in place for tomorrow.  Of course, such an institution cannot upset significant donors forever, but they have a lot more room to be independent.  This insight certainly adds to the discussion that I make in separating the true-believers from the careerists.

US Debt Limit Analogy

Here is a short 3-min video making an analogy to the US Debt.  Just because we raised the limit last year, it does not mean that the problem has gone away.  If anything it has and will continue to get worse.

Enjoy.  For my thoughts on what to do to solve the debt problem, I have advocated partial repudiation of the national debt.  It is found here: http://tillmanspeaks.blogspot.com/2011/07/repudiation-should-we-repudiate.html

FEE TV

In the world of stranger things have happened, FEE has decided to post the following video of me.  In it I talk about the foundational difference between Austrian Economics and the mainstream.  I believe that they have done a good job (especially given what they had to work with!)

The Joys of Homeschooling

This year, we have been homeschooling my six-year old son.  Next year will probably be different, but after today I might just rethink it all.

Yesterday was Easter and so the story from the Last Supper through the Resurrection has figured prominently at our house.  And so at lunch, the boy was thinking about Judas' betrayal.  He asked, "Was Judas a tax-collector?"  I said that he wasn't.  And then the boy said, "But I thought he was a thief." 

Just when one thought it couldn't get better...

We were returning home after spending some time at the park and eating hot dogs.  He started telling me about his next entrepreneurial venture.  He wants to have a restaurant and live above it.  He will have a garden (where he grows the food for the restaurant), a park, a baseball field, play equipment, a pool, etc.  To me, it sounded like a chateau on an estate.  Anyway, we stopped at a red light where a guy with a sign was asking for money.  My son asked why he wanted money.  I asked my son didn't he also want money.  As he thought about it, I asked him how he could earn money.  He told me that when he gets older he could cut grass, fix things, build cars, etc.  (He's fairly entrepreneurial.)  I agreed with him by saying that if he wants money, he must think of how he could serve other people.  I explained that work is making things more useful (better) for others.

He then asked if he could make his own money.  I told him that he could, although no one else would want it.  He thought for a moment and said, "What if I make it out of gold?"  [Nice!]  I explained that he could as long as it was novelty money and not legal money.  Only the government is allowed to make "legal" money.  He then said that was completely wrong and that everyone should be allowed to make their own money!  YES!  A laissez-faire monetary system!  From the mouths of six-year olds! 

A Note on Price Gouging

Of course, there is no economic definition of "price gouging," but let's set that issue aside for a moment and focus on a particular objection in favor of price controls I recently came across.

Suppose that a storm knocks out water in the city and the price for water jumps from $1 to $10 for a single 16 oz. bottle.  If the government imposes price controls that limit the increase to 10% above the 30-day moving average, as many states do, then there will be a shortage. 

So the economist argues that the price spike is good because it reduces use of water and encourages suppliers to bring more in.

The objection runs like this, if you are a poor guy, you can't afford the $10 price and so you go without.  Alternatively, if we have to stand in line for rationed water, he has a chance to get some water.

This scenario is a false dichotomy.  Regardless of the method of distribution (by price, by 1st come/1st served, etc.), some people will be without water.  The reason is that a storm has knocked out the water supply. 

The correct question to ask is, "Which system gets water to the damaged area faster, so that the time is minimized for those who are without water?"

The correct answer is the price system.  High prices send a signal, to all, that water is needed in the area and rewards those who are there first with high revenues.  As the water comes "flooding" in (yes, a pun), the price falls and then even the "poor guy" will be able to get water.

Disasters are horrible situations to live through.  I remember the eye of a hurricane passing overhead.  It was an interesting experience.  The point is which system puts into place a system of incentives that gets the most relief to the most people in the shortest period of time.  And the best answer we have is the open and free market.

The South Sea Bubble

I recently finished reading a book on the South Sea Bubble. I was surprised at how fascinating it was. I have heard of the South Sea Bubble before, but I couldn’t really tell you much about it. I knew that it happened in the early 1700s and there was also something called a Mississippi Bubble. However, I couldn’t make a distinction between the two, until now.

The book is The South Sea Bubble: An economic history of its origins and consequences by Helen J. Paul (2011). She is an economic historian interested in Cliometric analysis (the application of statistical techniques to history). Using statistical analysis to analyze history is, from the Austrian point of view, entirely appropriate. In fact, it is really the only legitimate use of statistics.

Anyway, to the story…

Imagine a country that has been in and out of wars year after year. As a consequence, an enormous debt has accumulated and is difficult to pay off. (Stretches the imagination doesn’t it?) This was the situation that both England and France found themselves in the early 1700s. In England, some of the debt could be paid-off early, but not all of it and not without the permission of the creditor. Furthermore, this debt was between the King and the individual and could not be traded. In other words, if the King borrowed £1000 from you, he owed you. You could not sell that debt to another, and if the King died then the debt was cancelled. With all this debt hanging overhead, how does a King borrow more money to fight more wars? The solution came in three forms: the conversion of the King’s debt into the nation’s debt, the creation of paper money and with it the establishment of the Bank of England (as a central bank), and the chartering of a monopoly company.

The monopoly company was the South Sea Company. It offered equity shares in exchange for the previously untradeable debt. A creditor could exchange £1000 in government debt for shares in the company. These shares were tradable and the value would fluctuate on the open market. This allowed creditors to reduce their risk exposure to a government default or other inability to pay.

The company would collect the government debt from the creditors in exchange for shares. The company would then be the recipient of the government’s debt payments. As a result, the company was “guaranteed” a minimum amount of income each period. Furthermore, the South Sea Company was granted the exclusive right to trade in virtually all of South America. (Of course, other nations traded in South America so the grant of monopoly only stopped other English firms from competing with the company.) Additionally, the Spanish Asiento was granted to the company. The Asiento was a grant of monopoly to import African slaves into the Spanish colonies. (The agreement also allowed a limited number of “permission” ships to also trade in other goods.) So the South Sea Company would get the slaves from the Royal African Company, ship the slaves across the Atlantic under the full protection of the Royal Navy, and sell them in the Spanish Americas.

To try to put this into today’s terms, imagine if the US government sets up a company to buy up all the national debt. The company will have a positive cash flow as the US government pays the debt, and the company has a grant of monopoly to ship oil out of the Middle East, which is backed by the full power of the US Navy. The owners of the shares will collect the profits either through dividends or increased valuations of the stock. Many people thought that this arrangement was a good deal and sold their debt for shares.

But wait there’s more! The South Sea Company allowed owners of the stock to borrow money and use the stock as collateral. So, if I have £1000 in government debt, I could convert it into company stock and then borrow £1000 and use the stock as collateral. If the stock price falls, I could just walk away and let the company keep its stock while I pocket the cash.

But wait there’s even more! If you decide to purchase the stock, you could pay in installments. So if the price of the stock falls low enough, you could just stop paying the installments and forfeit the lower valued stock. Now combine this with the fact that you could borrow against the stock! You could purchase the stock and decide to pay in installments, borrow against it, and if the price falls, you could just walk away from it. What a deal!

No wonder there was a tremendous run up in the price of the South Sea Company! The result was a bubble that popped in September 1720. The French, under the direction of John Law, had a similar scheme. It was called the Mississippi Company. It, too, had a tremendous run up in price and also popped in the Spring of 1720.

For those history of economic thought buffs, you might recalled that John Law had a right-hand man that was able to get out of the Mississippi Company right before the collapse and walk away a rich man. He wrote a book about the experience and made other insights on the financial world and the economy in general. He was later murdered in London and his house set afire to cover up the treachery. His name was Richard Cantillon. Rothbard called him, “The Founding Father of Modern Economics.” Alas, that discussion is for another post.