Economics has often been called a "dismal science". Looking at the current discourse on the economic crisis it is probably the only conclusion that any normal person could draw. Real intellectual thought is indeed near extinction in the economics profession. After all that algebra, all those graphs and all those fancy econometric models they were taught in college, economists these days are completely lost(well they're okayish in microeconomics, but macro is horrible).
If you ask a non-economist about the causes of the economic crisis, the answer will probably be as insightful as if you asked an economist. They'll say it's "inherent in capitalism", a result of "deregulation" or maybe they'll confess and simply say that they don't know. The reasons are many, but the solutions are the same without fail: more state intervention in the economy.
"Economics is not a dry subject. It is not a dismal subject. It is not about statistics. It is about human life. It is about the ideas that motivate human beings. It is about how men act from birth to death. It is about the most important and interesting drama of all — human action." ~Leonard P. Liggio
In a market economy the most successful entrepreneurs make profits and can thus expand their business. Bad players are automatically weeded out through the profit-and-loss mechanism. Even good entrepreneurs make mistakes, but when almost everyone makes mistakes(often the same kind of mistakes to boot) at the same time, shouldn't there be an explanation for this? Isn't this a question worth asking?
I am not quite satisfied with the usual suspects, whether it be greed, irrational exuberance or just the good old animal spirits. If collective insanity was really the explanation, why does it take so long for the mistakes to be revealed? Why is the economy so completely out of whack when the bust hits? How could there suddenly be such a lack of capital?
A castaway is on an island by himself. To sustain himself he decides to catch fish. He doesn't have any capital(any equipment other than his own body) so he does it with his bare hands and is able to catch only 3 fish each day. After a week or so he decides to make a net, but he knows he'll need a whole day to complete it. But he also needs to eat, so what does he do?
He'll need to eat only 2 fish per day(he'll need to underconsume) for three days to save 3 fish for the day on which he constructs the net. He saves because he thinks those savings will enable greater enjoyment later(remember time preference?). Those savings are his subsistence fund, the net will be his new capital equipment and this way of production is called a more roundabout method of production. It takes a longer time to construct the net and use it than to just keep catching fish with your bare hands, but it is also a more productive method and if it wasn't then there would be no point in doing it. If two methods of production are equally productive, then the one that takes longer will always be rejected.
As we underconsume we release resources into the economy to be used by others. Banks then allocate these funds in various ways and everyone is happy. Savers are paid interest for their sacrifice and borrowers use these savings to fund different activities. As we've already seen, a fall in time preference(less present, more future consumption) lowers the rate of interest. But when the rate of interest falls, what kinds of effect does that have on the structure of production?
Long-term debt is interest rate sensitive. When comparing to short-term debt, the demand for long-term debt changes much more with changes in the rate of interest. This is not surprising, as we always try to use the shortest and most productive processes of production. If there is more to invest and the shorter (less roundabout) processes are already in use, how else could the savings be allocated than to fund more roundabout production processes?
By saving we've indicated that we want to consume less in the present. This obviously lowers the demand for the production of lower-order goods(close to the consumer: warehousing, retailing etc) and releases these resources to be used in the production of higher-order goods(far away from the consumer: research and development, mining etc).
Everything is still in perfect harmony. We save more, we release resources to be used for a lenghtened structure of production and we wish to consume more in the future(this greater consumption in the future is enabled precisely by the lenghtened structure of production).
"The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions." ~Ludwig von Mises
Central banks create new money all the time. By doing so they push the rate of interest down. New money is also created through fractional-reserve banking. Now if banks have more to lend, they'll obviously charge a lower rate of interest for it. So everything goes as I described, except that there's one big difference: there are no additional savings. There is certainly additional credit, because the banks create it out of nothing, but no one has underconsumed and the society's subsistence fund hasn't changed.
Entrepreneurs will react to a change in the rate of interest and start more roundabout methods of production. They will start bidding resources away from the rest of the economy. But as these funds trickle back to people through wages, interest, rents and dividends, people will go and spend this money according to their old consumption/saving patterns(maybe they'll save even less; the rate of interest is lower after all). The lower-order stages of production see this demand and a tug o' war with higher-order stages begins, as both sides try to outbid each other. This leads to a rise in the price of capital and the rate of interest is pushed higher.
A modern society has a subsistence fund that isn't composed of just current savings, but also of past savings that have already been "used" to fund projects. The increasing costs of capital may for example lead to a decision that a machine isn't replaced with a new one even though it was supposed to be. In this way the machine(funded by past savings) is acting as a buffer to deal with the diminishing subsistence fund. This is one of the reasons why the boom can go on for so long.
As the price of higher-order goods rises much faster(they also collapse much more severely during the bust) during the boom, illusory profits appear. This creates an illusion of greater wealth while capital is being actually consumed. This perception of wealth can lead to a change in people's consumption/saving patterns, as they will feel richer. This is why the boom can(does not always happen) spread from higher-order goods to consumption.
The central bank can try to fight the rise in the rate of interest by injecting more credit into the economy, but this can only postpone the day of reckoning. At some point the choice will be between hyperinflation or letting the rate of interest rise.
As the rate of interest rises, the mistakes reveal themselves. Profitable ventures become unprofitable and the lack of real savings becomes apparent. There were no additional savings to begin with, but on top of that a lot of the existing savings were mishandled during the boom. The whole thing was unsustainable from the beginning.
Ludwig von Mises, in his book Human Action uses the example of a master builder who is building a house. This master builder thinks that he has 20% more bricks than he actually has at his disposal. If he thinks he has more bricks then he'll obviously build a completely different or at least a larger house than if he knew the real amount of bricks.
While the master builder is contructing the house everything is going well: people are employed, capital is being used, wages are paid and the house is being built. But would it be better for the master builder to realize his error sooner or later? When someone says that we need to inject more credit into the economy, he's basically suggesting that we get the master builder completely drunk, so maybe he won't notice the dwindling supply of bricks. This doesn't change the fact that the master builder is building a house that cannot be completed and he is wasting his time and resources.
The sooner the boom comes to an end, the better. The boom is the problem; it's during the boom that all the mistakes are made. Of course the best policy would be to never start the artificial boom to begin with, but this would require the abolition of central banks and fractional-reserve banking(JFYI: I'd like to abolish them).
The rate of interest should be left alone.
2010-05-25
2010-05-11
Minimum Wages
Almost everyone agrees that fixing prices is a bad idea. It causes shortages or surpluses, unless it happens to be fixed exactly where demand and supply would require it to be. Prices are obviously constantly changing and central planners cannot imitate the market, which means a fixed price can be at its equilibrium level only for a very short period and only by accident.
Almost everyone has exceptions to this rule, though. In times of crisis, such as natural disaster, people are willing to give up on economic rationality and will favor price-fixing schemes in order to help people. Obviously these actions hurt those they are intended to help. When the prices of water and food rise after a devastating hurricane for example, that is a good thing. It makes it profitable to actually get the food and water where they are needed and it also restrains people from using these scarce resources in less important things. Having food and water at a higher price is better than having no food or water at all.
There are some price-fixing schemes that many favor even in normal times. Most notably some wages and interest rates(in a way interest rates are the price of renting money). Interest rates are to be decided by central banks, while (minimum) wages should be the responsibility of the people's representatives.
"'Wages aren't just prices!"
Well actually they kind of are. Wages are the price of labour, and economic theory should always consider them as such. It is of course difficult for people to grasp this simple concept, because many of us earn wages. It is easy to simply think that higher wages lead to greater prosperity, regardless of how these higher wages are achieved. After all we individually enjoy greater prosperity if our wages are raised, so why isn't this the same for society as a whole?
Wages are a function of productivity, so if wages rise because we are more productive, there's no problem. But if wages are raised due to politicial pressure, we will simply end up with the predictable outcome of a surplus in labour. That means unemployment.
If a person brings X amount of money to a company's bottom line, then obviously they would be willing to pay this person up to X amount of money in wages. Of course it's not that simple in practice, since it's hard to evaluate how much additional wealth a single person would create for the company and all kinds of other factors need to be taken into account.
But why doesn't the company pay 0,1X in wages? I mean that would mean an additional 0,9X in profits. The reason is competition: If the company pays only 0,1X, then another company might bid this labour away by offering 0,2X. Then someone offers 0,3X and so on, until equilibrium is reached. In real life wages, just like other prices, never reach their equilibrium level, but are nonetheless constantly moving towards it.
"Politics relies on ignorance."
So let's take the minimum wage. What kind of labour has the lowest productivity? Those with no education and/or practical skills and those with a high risk premium(ex-cons, recovering drug addicts etc). A minimum wage hurts precisely these people, because they can no longer be employed economically. Our interventionist friends are obviously telling us that the minimum wage would help precisely these people. They forget that even though we have a right to work, we do not have a right to a job.
Most industrialized countries have either explicit or implicit minimum wages. There aren't any economic reasons for this, so what are the political implications of a min. wage? In political entrepreneurship the first question should be cui bono: Who benefits?
Politicians obviously benefit, both directly and indirectly. Directly they benefit by gaining popularity among voters. Those hurt most by a hike in the minimum wage aren't exactly the most active voters(poor, uneducated etc) in society, so we end up with a situation where politicians make the middle class feel good about themselves while they proceed to make labour of lower productivity unemployable.
"The rich get welfare too."
If we can get a job done by hiring one skilled worker(16€/hour) or three unskilled workers(5€/hour each), then we'd obviously hire the unskilled ones. We'd end up saving 1€/hour. Suppose we have the same situation with a minimum wage of 6€/hour...
The skilled worker benefits, because the minimum wage makes it harder for unskilled labour to compete. This is why labour unions, Wal-Mart and other organizations that are in no way affected by the minimum wage champion it. They directly benefit from it. Politicians on the other hand now benefit indirectly, because these organizations go and lobby for hikes in the minimum wage.
There is an unlimited amount of work to do, so doesn't it seem weird that getting a job is so hard? Especially young people have had a ton of job opportunities die out due to the minimum wage. What about a recovering drug addict who hasn't worked in ten years? Why can't he offer his labour services at a discount? The longer you are unemployed, the less employable you become.
It must be noted that even countries with extensive welfare programs for the poor have minimum wages. If you already have guarantees against poverty in the form of wealth redistribution, why on earth would you need a minimum wage on top of that?
The minimum wage makes it illegal for some people to work at a certain wage. That's all it does. If we actually had a shortcut to prosperity, then why don't we set the minimum wage at 100€/hour? Because if those favoring the minimum wage were right, this would be the logical conclusion of their arguments.
To get an idea of what would happen, look at what the United States did to American Samoa:
http://www.youtube.com/watch?v=_LaPGIIAyk4
The minimum wage is a political tool with no ethical or economic justification. It should be completely abolished and replaced with nothing.
Almost everyone has exceptions to this rule, though. In times of crisis, such as natural disaster, people are willing to give up on economic rationality and will favor price-fixing schemes in order to help people. Obviously these actions hurt those they are intended to help. When the prices of water and food rise after a devastating hurricane for example, that is a good thing. It makes it profitable to actually get the food and water where they are needed and it also restrains people from using these scarce resources in less important things. Having food and water at a higher price is better than having no food or water at all.
There are some price-fixing schemes that many favor even in normal times. Most notably some wages and interest rates(in a way interest rates are the price of renting money). Interest rates are to be decided by central banks, while (minimum) wages should be the responsibility of the people's representatives.
"'Wages aren't just prices!"
Well actually they kind of are. Wages are the price of labour, and economic theory should always consider them as such. It is of course difficult for people to grasp this simple concept, because many of us earn wages. It is easy to simply think that higher wages lead to greater prosperity, regardless of how these higher wages are achieved. After all we individually enjoy greater prosperity if our wages are raised, so why isn't this the same for society as a whole?
Wages are a function of productivity, so if wages rise because we are more productive, there's no problem. But if wages are raised due to politicial pressure, we will simply end up with the predictable outcome of a surplus in labour. That means unemployment.
If a person brings X amount of money to a company's bottom line, then obviously they would be willing to pay this person up to X amount of money in wages. Of course it's not that simple in practice, since it's hard to evaluate how much additional wealth a single person would create for the company and all kinds of other factors need to be taken into account.
But why doesn't the company pay 0,1X in wages? I mean that would mean an additional 0,9X in profits. The reason is competition: If the company pays only 0,1X, then another company might bid this labour away by offering 0,2X. Then someone offers 0,3X and so on, until equilibrium is reached. In real life wages, just like other prices, never reach their equilibrium level, but are nonetheless constantly moving towards it.
"Politics relies on ignorance."
So let's take the minimum wage. What kind of labour has the lowest productivity? Those with no education and/or practical skills and those with a high risk premium(ex-cons, recovering drug addicts etc). A minimum wage hurts precisely these people, because they can no longer be employed economically. Our interventionist friends are obviously telling us that the minimum wage would help precisely these people. They forget that even though we have a right to work, we do not have a right to a job.
Most industrialized countries have either explicit or implicit minimum wages. There aren't any economic reasons for this, so what are the political implications of a min. wage? In political entrepreneurship the first question should be cui bono: Who benefits?
Politicians obviously benefit, both directly and indirectly. Directly they benefit by gaining popularity among voters. Those hurt most by a hike in the minimum wage aren't exactly the most active voters(poor, uneducated etc) in society, so we end up with a situation where politicians make the middle class feel good about themselves while they proceed to make labour of lower productivity unemployable.
"The rich get welfare too."
If we can get a job done by hiring one skilled worker(16€/hour) or three unskilled workers(5€/hour each), then we'd obviously hire the unskilled ones. We'd end up saving 1€/hour. Suppose we have the same situation with a minimum wage of 6€/hour...
The skilled worker benefits, because the minimum wage makes it harder for unskilled labour to compete. This is why labour unions, Wal-Mart and other organizations that are in no way affected by the minimum wage champion it. They directly benefit from it. Politicians on the other hand now benefit indirectly, because these organizations go and lobby for hikes in the minimum wage.
There is an unlimited amount of work to do, so doesn't it seem weird that getting a job is so hard? Especially young people have had a ton of job opportunities die out due to the minimum wage. What about a recovering drug addict who hasn't worked in ten years? Why can't he offer his labour services at a discount? The longer you are unemployed, the less employable you become.
It must be noted that even countries with extensive welfare programs for the poor have minimum wages. If you already have guarantees against poverty in the form of wealth redistribution, why on earth would you need a minimum wage on top of that?
The minimum wage makes it illegal for some people to work at a certain wage. That's all it does. If we actually had a shortcut to prosperity, then why don't we set the minimum wage at 100€/hour? Because if those favoring the minimum wage were right, this would be the logical conclusion of their arguments.
To get an idea of what would happen, look at what the United States did to American Samoa:
http://www.youtube.com/watch?v=_LaPGIIAyk4
The minimum wage is a political tool with no ethical or economic justification. It should be completely abolished and replaced with nothing.
2010-05-04
The Rate of Interest
Everyone knows that most borrowing isn't free. Lenders ask you to pay back more than you initially borrow. How much more is normally expressed in percentage points and calculated from the amount owed. These percents are what we usually call the rate of interest.
Obviously there are many rates of interest in the economy, because there are many different credit transactions taking place. Borrowing from your friend to buy a beer will probably have a different interest rate than when you go and take out a mortgage to buy a house.
But why do we usually pay back more than we borrow?
"Inflation causes the value of money to go down over time."
Yes and no. Inflation certainly affects the interest rate of the credit transaction, but it is not the fundamental reason for interest. What if we completely forgot about money? What if we loaned 10 000 apples for 30 years(we're going to assume that the enjoyment we get from apples will stay the same, even though this is quite improbable)? Would you simply accept 10 000 apples back 30 years later? I'd say it's very unlikely that anyone would accept that kind of deal.
"Lenders need to make a profit."
Yes and no again. The amount of profit lenders aim to make certainly affects the interest rate. If we take our previous example and assume we don't want to make a profit; would we now make that deal? It still seems that something is off.
"Debtors might not pay back, so we need interest to make up for the risk the lender takes."
Yes and no again. Especially with banks, who have many customers, it is very likely that some will not pay back. The perceived risk indeed affects the interest rate. If we build on our example and assume that the debt is now guaranteed by all the governments in the world, would interest become meaningless? After all we don't need to make a profit, we're not worried about inflation and the debt is certainly going to be paid back.
It would not.
"We prefer present goods over future goods."
Or to be more precise, we prefer current enjoyment more than the same amount of enjoyment later. For example someone during the winter might say that he'd rather wait for summer before having some ice cream. The only reason for this is that he thinks he'll enjoy it more during summer. If he didn't, he'd eat the ice cream during winter already.
Actually we're not even comparing the same good, because ice cream in the winter is not the same as ice cream in the summer. Just like an orange in Spain is a different good from an orange in Finland. People in Finland are ready to pay more for an orange in Finland than for a claim to an orange in Spain(for obvious reasons).
Physical properties are meaningless; what matters is the subjective valuations of consumers. For example a physicist might say that out of two bottles of water the other one has 0,007l less water in it. The consumer wouldn't even notice or care, so if those two bottles are next to each other in a supermarket, they would (from the point of view of economic theory) be considered the same.
An orange in Finland and a diamond are also different. But a diamond is obviously "more different" than an orange in Spain. This is because the oranges are different units of the same good. If we magically swapped the oranges with each other, the consumer wouldn't notice a thing. But if we swapped either orange for a diamond, it would be quite obvious to the consumer that he has a completely different good now.
It is interesting to note that if we didn't prefer the present more, we'd never do anything. After all we show our preferences through our actions, which means that every time we act, we are proving that we prefer to do so now instead of later. I prefer to write this right now and I do not need to answer a poll or gallup(the usual ways with which people's preferences are measured) to know this. I know it because I'm writing this.
What I've described is called time preference.
The natural rate of interest(how much we prefer present vs. future goods or that rate which exactly balances the demand for loan capital and the supply of savings) is not what we observe in the economy, because the rate of interest is tightly linked to money, and the monetary system is controlled by central banks and the banking system. In fact central banks often manipulate the money supply in accordance with what they think the proper rate of interest should be, not the other way around.
Not to mention the interest charged by lenders, as was discussed earlier, is affected by other factors as well(value of money over time, profits and risk).
"Excuse me, what?"
If we want to consume more in the present, the rate of interest goes up. If we want to consume less in the present, the rate of interest goes down. Another way to look at it is that when we save more, the banks have more to lend(we usually save by depositing our money in a bank), so they'll ask less for it when they lend it to someone(=lower interest rates). If we consume more(i.e. save less), then the opposite obviously happens.
You might think that this beautiful harmony is screwed up big time when a central bank arbitrarily sets interest rates somewhere where they no longer reflect society's time preference. Well, that's exactly what it does. I'll cover that when I talk about the Austrian Theory of the Business Cycle.
Obviously there are many rates of interest in the economy, because there are many different credit transactions taking place. Borrowing from your friend to buy a beer will probably have a different interest rate than when you go and take out a mortgage to buy a house.
But why do we usually pay back more than we borrow?
"Inflation causes the value of money to go down over time."
Yes and no. Inflation certainly affects the interest rate of the credit transaction, but it is not the fundamental reason for interest. What if we completely forgot about money? What if we loaned 10 000 apples for 30 years(we're going to assume that the enjoyment we get from apples will stay the same, even though this is quite improbable)? Would you simply accept 10 000 apples back 30 years later? I'd say it's very unlikely that anyone would accept that kind of deal.
"Lenders need to make a profit."
Yes and no again. The amount of profit lenders aim to make certainly affects the interest rate. If we take our previous example and assume we don't want to make a profit; would we now make that deal? It still seems that something is off.
"Debtors might not pay back, so we need interest to make up for the risk the lender takes."
Yes and no again. Especially with banks, who have many customers, it is very likely that some will not pay back. The perceived risk indeed affects the interest rate. If we build on our example and assume that the debt is now guaranteed by all the governments in the world, would interest become meaningless? After all we don't need to make a profit, we're not worried about inflation and the debt is certainly going to be paid back.
It would not.
"We prefer present goods over future goods."
Or to be more precise, we prefer current enjoyment more than the same amount of enjoyment later. For example someone during the winter might say that he'd rather wait for summer before having some ice cream. The only reason for this is that he thinks he'll enjoy it more during summer. If he didn't, he'd eat the ice cream during winter already.
Actually we're not even comparing the same good, because ice cream in the winter is not the same as ice cream in the summer. Just like an orange in Spain is a different good from an orange in Finland. People in Finland are ready to pay more for an orange in Finland than for a claim to an orange in Spain(for obvious reasons).
Physical properties are meaningless; what matters is the subjective valuations of consumers. For example a physicist might say that out of two bottles of water the other one has 0,007l less water in it. The consumer wouldn't even notice or care, so if those two bottles are next to each other in a supermarket, they would (from the point of view of economic theory) be considered the same.
An orange in Finland and a diamond are also different. But a diamond is obviously "more different" than an orange in Spain. This is because the oranges are different units of the same good. If we magically swapped the oranges with each other, the consumer wouldn't notice a thing. But if we swapped either orange for a diamond, it would be quite obvious to the consumer that he has a completely different good now.
It is interesting to note that if we didn't prefer the present more, we'd never do anything. After all we show our preferences through our actions, which means that every time we act, we are proving that we prefer to do so now instead of later. I prefer to write this right now and I do not need to answer a poll or gallup(the usual ways with which people's preferences are measured) to know this. I know it because I'm writing this.
What I've described is called time preference.
The natural rate of interest(how much we prefer present vs. future goods or that rate which exactly balances the demand for loan capital and the supply of savings) is not what we observe in the economy, because the rate of interest is tightly linked to money, and the monetary system is controlled by central banks and the banking system. In fact central banks often manipulate the money supply in accordance with what they think the proper rate of interest should be, not the other way around.
Not to mention the interest charged by lenders, as was discussed earlier, is affected by other factors as well(value of money over time, profits and risk).
"Excuse me, what?"
If we want to consume more in the present, the rate of interest goes up. If we want to consume less in the present, the rate of interest goes down. Another way to look at it is that when we save more, the banks have more to lend(we usually save by depositing our money in a bank), so they'll ask less for it when they lend it to someone(=lower interest rates). If we consume more(i.e. save less), then the opposite obviously happens.
You might think that this beautiful harmony is screwed up big time when a central bank arbitrarily sets interest rates somewhere where they no longer reflect society's time preference. Well, that's exactly what it does. I'll cover that when I talk about the Austrian Theory of the Business Cycle.
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