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!) 
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!
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.
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.
After a few years of attending the AEF, the third meeting was my first disappointment with this group. (I suppose it was bound to happen.) Yes, there was basketball that diverted some; and yes, there was severe weather; and so attendance was very low, but the real reason was that the topic really just did not fit our group. It was on Chapters 4-6 of Buchanan and Tullock's The Calculus of Consent (1962).
For me, the discussion went around and around in a large circle. The problem actually stems from the last sentences in Chapter 2.
It seems futile to discuss a "theory" of constitutions for free societies on any other assumptions than these. Unless the parties agree to participate in this way in the ultimate constitutional debate and to search for the required compromises needed to attain general agreement, no real constitution can be made. An imposed constitution that embodies the coerced agreement of some members of the social group is a wholly different institution from that which we propose to examine in this book. pp. 19-20. (emphasis added)Which political entity, then, could they be talking about? Even my Home Owners Association fails to fit this definition! Government is different than another human institution in this sense: it is the only institution that has the legal right to coerce and use force. Without this definition at the heart of the analysis, the rest is fluff.
At our second AEF meeting, we discussed the work of one of the NC State University's Graduate Students, Richard Hammer. He presented his work, "Life Grows Through Discovery of New Social Rules."
He argues that life is thermodynamic. If we start with some simple assumptions about basic life needs (rules to exist), he wants to know how far can we get with this line of analysis. Can it circle around to be useful for analyzing our own behavior?
He starts with single cell organisms (SCOs). They need food and water. If they lack enough food or water, they will die. If food and water are distributed homogenously, then we really do not get interesting results, because there is no reason to act--other than simply consume.
The interesting results begin when we assume that there are pockets of food and water that the SCOs have to go to. If the food and water are too far apart, the SCOs die. If they can travel back and forth, then they can survive.
A fundamental law in economics, The Law of Comparative Advantage (Mises called it The Law of Association), is based upon specialization and the division of labor. It says that when we trade, we can benefit. We have certain advantages over others. It might be that our skill set or natural talents are better than another's. It might be as simple as being closer to a natural resource than another. The point is that it is our differences that allow up to benefit.
So if we posit that food and water is irregularly distributed, then some SCOs will have a comparative advantage over others. Some SCOs will be closer to the food and the others will be closer to the water. This means that if they cooperate, both groups will be better off than if they opertated in autarky.
So far, so good. I agree, but I didn't really see much benefit to this line of analysis. However, others did. They asked, "Why do cells in our bodies perform particularized functions for the benefit of the overall body?" Their reasoning followed along these lines...
When SCOs start to cooperate, they are able to specialize. When they specialize, they give up other functions and become dependent upon other SCOs. Thus, we see the inklings of the transformation from SCOs to multi-cellular organisms. Additionally, a side discussion of meme theory took place.
All-in-all, it was an interesting disucssion, but I fail to see how such theories can circle back and inform economic theory. Why make an argument by analogy? Why not just make the argument?
I am reminded of a quote by Böhm-Bawerk, where he attacks arguing by analogy. It took place in his debates on Capital and Interest theory with John Bates Clark. He says,
There seems to dwell in the human heart an enervating proneness for playing the poet in matters of science, and for placing by the side of the common natural things and forces with which we have to do in the world of prose visionary doubles in the form of all sorts of mystical beings and powers, to which a semblance of reality is imparted by means of an ‘elegant’ abstraction. I hold this practice to be fraught with greatest danger to science. If one departs from the bare truths of nature by only a hair’s breadth, scientific accuracy of thought is irretrievably lost the sway of truth gives place to that of words and sounding phrases.Until next time...
We kicked off the latest round of the Austrian Economic Forum at North Carolina State University on January 27th, 2012. It was well attended and everyone seemed excited to get the semester under way. This semester is going to be a little different for us in that for each meeting a different Graduate Student will be either presenting his own work or a reading which interests him.
The first session's reading was selected by Alex Gill. He picked chapters 8 and 9 in Philipp Bagus' Tragedy of the Euro (2010).
The European Central Bank (ECB) has powers that are slightly different than those of the US Federal Reserve System. The difference we focused on was the ability of the ECB to expand the money supply.
The system works by the ECB loaning money to banks, which use national governments' bond as collateral. Suppose a national government (e.g., Greece) decides that it must spend more than it takes in from tax revenues; it has a budget deficit. (Hard to imagine I know, but hang in there.) The Greek Government cannot simply create new money to cover its budgetary shortfall. So it borrows the money by selling bonds. The bonds are (either directly or indirectly) purchased by banks. These banks then go to the ECB and ask for a loan. The ECB accepts the Greek government bonds as collateral and credits Euros to the banks' accounts. Where did this money come from? It comes from a big, black hole of nothingness. It is simply brought into existence by the recording of Euros in the banks' accounts.
Bagus also illustrated another difference. The Treaty of Maastricht said that no bail-outs are allowed. If a government overexpands and cannot meet its spending "obligations" then that's its own problem. The national governments were allowed deficits of no more than 3% of GDP and Total Debt to not be greater than 60% of GDP. Clearly, politicians care little about such restrictions.
Today's situation reminds me of the addage that if you borrow $1 million from your banker and cannot pay if back, you are in trouble. However, if you borrow $1 billion from your banker and cannot pay it back, then he is in trouble!
No one who agreed to the treaty should have been under any illusion that these clauses would have been tossed aside in the midst of a crisis. Austrian (or any decent economic) insight into the incentives of a crisis should have led one to this conclusion. Bagus takes a slightly different approach to this analysis.
Bagus argues that the Euro Zone is analagous to the Tragedy of the Commons. Since each country can run a deficit, and then monetize it, they will exploit the "common" value of the currency before others can. Some governments spend more than their revenue and cover the deficit spending with bonds. The governments that run deficits are able to exploit the "commons." The value of the common resource, the Euro, is diminished for the rest of the users of the Euro.
The analogy is a bit of a stretch. The problem with the commons analogy is that "the commons" are unowned resources. When a fisherman catches a fish, he is privatizing it for his own use. The "Tragedy" is that the resource is overused and depleted. The problem with this analogy is that all of the money is always owned by someone. There is not some unowned resource, a pool of value, that then gets exploited when the Greek government runs a deficit. I see what Bagus is trying to do, which is argue that the first to print new money is the winner. But if this is the case, why not just make the standard Austrian non-neutral money argument and be done with it? I think that making the argument on the grounds of non-neutral money is better because it is direct. However, perhaps, Bagus' approach opens Austrian insights and arguments to an audience that otherwise would reject the Austrians out-of-hand.
A conclusion that falls out of this analysis is that Greece will not reduce its deficit. It has no incentive t0 do so. It has been benefitting from the monetary might (stability) of other countries, such as Germany. As a result, the Germans are upset with the Greek. (See Chapter 9) Will it lead to the collapse of the common market, balkanization, or even war? Unfortunately, that is a question that cannot be answered.
***
There is another point on theory that I think needs to be addressed. I think that Bagus is conflating the property rights argument in money production with that of some right to a value of money. In Chapter 8, Bagus contends that money production has external effects, and that the costs and benefits to money production are skewed due to these external effects. So far so good.
However, now he states, "Private gold money with clearly defined property rights was replaced by public fiat money. This money monopoly itself implies a violation of property rights." (p. 79) Hmmm… The problem is that in one sense this is true, but there is a second sense where it is not true. In the first sense, when we switch to a fiat money system, I can no longer demand gold in exchange for my labor services. Thus, this law violates my ability to freely contract on my own terms. However, the negative externality of the loss of value of the gold-in-my-pocket due to demonetization is not a violation of property rights. Nor is it a violation of property rights when there is monetary expansion that leads to a loss in purchasing power for the dollars-in-my-pocket. As my friends who deny intellectual property rights are fond of pointing out, there is no right to the value of anything. All value is subjective.
I think that Bagus is leaning toward the second sense when he says, "By giving fiat money a privileged position and by monopolizing its production, property rights in money are not defended and the costs of money production are partially forced upon other actors." (p. 79)
It would have been better if Bagus stuck to the traditional Hoppean/Rothbardian property rights argument that says that fractional reserve banking assigns the right of the same dollar to two different individuals. but he doesn’t. Instead, Bagus goes after Selgin and White, in footnote #8, for missing the property rights argument. He states that they “do not see any property rights violation in the issuance of fiduciary media.” Then, in addition to citing Hoppe, Hülsmann and Block, he cites entirety of the nearly 900 page book Money, Bank Credit, and Economic Cycles by Jesús Huerta de Soto. Why relegate such an important, and unproven, assertion to a footnote? The way I see it, expanding the money supply, even if it is 100% pure fiat money, is not a violation of my property rights. To claim otherwise means that I have a right to the value of my money, which is simply untrue.
Regardless, I think that the property rights argument is weak and a better case against fiat money and a central bank can be made on pure economic grounds.
Next, I want to address Bagus’ discussion of the "quality" of money, pages 79-80. This line of reasoning makes sense when a country is on a pure commodity standard, but makes little sense when we are talking about fiat money, which is only exchange value. If he simply means seigniorage, then okay, why not just say that? But if he is making a larger assertion, he needs to come out and say what he means and then differentiate it from seigniorage. Especially puzzling are statements like, “In contrast to fiat paper situations, where an increase in the supply of money dilutes the quality of the currency, there is no dilution in the quality of the currency by gold mining.” (p. 80.) He is using “quality” to mean “purchasing power” the first time, but means “percentage of content” in the second. Puzzling and troubling, indeed.
Finally, Bagus misses the big reason there is a check on the overexpansion of the money supply (beyond extent of the money multiplier) in a free banking system. The threat of bankruptcy in a free banking system does not have to come from a bank trying to drive a competitor into the ground. (See pages 83-84.) As Rothbard demonstrates in The Mystery of Banking (Chapter 8, page 114+), we can suppose that all economic actors are fully wanting fractional reserve banking to expand as much as they can. The check on bank expansion comes from the fact that some people have deposits at different banks. Suppose that I bank at Bank A and you bank at Bank B. When I get a check from you, I will deposit that check in my bank so I can access the funds. When I do so, Bank A asks Bank B for the money. That's the check against infinite bank expansion. Bank B had better have the money available for my bank and me or it will go out-of-business. The check is not because a bank might be trying to drive its competitor out of business, instead the check comes from the fact that I want to access my money from my bank.
Overall, it was a good discussion and a good beginning to another semester of thoughtful Austrian Economic Analysis. The next session will cover the idea of using artificial intelligence as an analogue for economic theorizing. The session that follows that will cover The Calculus of Consent by Buchanan and Tullock.
