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!”