Austrians vs. Keynesians: A Case Study

The Keynesian model and the Austrian economic philosophy continue to lock horns. Similar ideas have gone toe to toe for three centuries now trying to explain the business cycle. Thomas Malthus and Jean-Baptiste Say made their case in the 19th century, John Maynard Keynes and Friedrich Hayek in the 20th century, and the largely Keynesian-dominated public policy of today against the increasingly louder Austrian rebuttal. Keynesians believe the cause of recession is a general glut of goods and insufficient demand for those goods. They tend to use John Mayard Keynes’ ideas as an excuse for government to spend, claiming that we can spend (borrow and print) our way out of recession and a lack of aggregate demand. This has been the thinking behind Bush and Obama’s policies to avoid depression and a double dip recession. Paul Krugman contends that the stimulus bill would have worked wonders had we only spent more, floating a $2 trillion figure. But then again, Krugman also advised Alan Greenspan in a 2002 Times editorial to offset the bursted stock market bubble with a housing bubble. Said Krugman:

To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

That is some killer advice. Thanks Paul. It is commentary like this that makes Krugman the least favorite economist of my colleague Andrew.

Meanwhile, Austrians like Peter Schiff and Ron Paul predicted the 2008 crash in remarkably specific terms. Many YouTube videos of Peter Schiff commenting on the state of the economy have gone viral. Who can forget Schiff absolutely eviscerating Art Laffer on CNBC? Andrew posted a collection of Schiff commentary here, including the Laffer segment. Ron Paul predicted the housing bubble and warned of the perverse involvement of Fannie and Freddie in the housing market as early as 2002 on the House floor:

Mr. Speaker, I rise to introduce the Free Housing Market Enhancement Act. This legislation restores a free market in housing by repealing special privileges for housing-related government sponsored enterprises (GSEs). These entities are the Federal National Mortgage Association (Fannie), the Federal Home Loan Mortgage Corporation (Freddie), and the National Home Loan Bank Board (HLBB). According to the Congressional Budget Office, the housing-related GSEs received $13.6 billion worth of indirect federal subsidies in fiscal year 2000 alone.
 
One of the major government privileges granted these GSEs is a line of credit to the United States Treasury. According to some estimates, the line of credit may be worth over $2 billion. This explicit promise by the Treasury to bail out these GSEs in times of economic difficulty helps them attract investors who are willing to settle for lower yields than they would demand in the absence of the subsidy. Thus, the line of credit distorts the allocation of capital. More importantly, the line of credit is a promise on behalf of the government to engage in a massive unconstitutional and immoral income transfer from working Americans to holders of GSE debt.
 
The Free Housing Market Enhancement Act also repeals the explicit grant of legal authority given to the Federal Reserve to purchase the debt of housing-related GSEs. GSEs are the only institutions besides the United States Treasury granted explicit statutory authority to monetize their debt through the Federal Reserve. This provision gives the GSEs a source of liquidity unavailable to their competitors.
 
Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market. This is because the special privileges of Fannie, Freddie, and HLBB have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.
 
However, despite the long-term damage to the economy inflicted by the government’s interference in the housing market, the government’s policies of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.
 
Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.
 
No less an authority than Federal Reserve Chairman Alan Greenspan has expressed concern that government subsidies provided to the GSEs make investors underestimate the risk of investing in Fannie Mae and Freddie Mac.
 
Mr. Speaker, it is time for Congress to act to remove taxpayer support from the housing GSEs before the bubble bursts and taxpayers are once again forced to bail out investors misled by foolish government interference in the market. I therefore hope my colleagues will stand up for American taxpayers and investors by cosponsoring the Free Housing Market Enhancement Act.

You know who else called the housing bubble and GSE nightmare? Henry Hazlitt, in 1946.

Then, of course, there is the fudging of history to support your viewpoint and confirm your bias. Keynesians like to point to New Deal policies saying that the government action propelled us out of the Great Depression. They also say that World War II got us out of the Depression, which is one of the most repugnant fallacies spewed today. Recently Krugman argued that fiscal austerity would make our economic crisis worse:

Even if we manage to avoid immediate catastrophe, the deals being struck on both sides of the Atlantic are almost guaranteed to make the broader economic slump worse…if the negotiations succeed, we will be set to replay the great mistake of 1937: the premature turn to fiscal contraction that derailed economic recovery …

Unfortunately, Paul doesn’t quite have his facts straight. Total government spending never decreased in the 1930s. Total government spending actually went up:

After seven years of New Deal spending, then-Secretary of Treasury Henry Morgenthau said in 1939, “We have tried spending money. We have spent more than we have ever spent before and it does not work.” It is possible that things would have been worse without government spending. That generally unknowable counter-factual is a favorite argument of Keynesians. So does government spending help if the rest of the economy is deleveraging and deferring a portion of their consumption? Krugman’s platform, The New York Times, recently pointed out that many studies show fiscal cuts actually lead to greater economic growth; even during the short-term when Keynesian spending tries to limit the pain of a recession:

Recent studies, however, have found the opposite: Countries that rely primarily on spending cuts tend to experience less economic pain in the short term. Moreover, in some cases, the cuts seem to spur faster growth.
 
The monetary fund study reported that a 1 percent fiscal consolidation achieved primarily through tax increases reduced economic activity by 1.3 percent over two years, while an identical consolidation driven primarily by spending cuts reduced activity by 0.3 percent.

Austrians believe one’s productivity drives their purchasing power, and that only savings (deferred consumption) can be invested to produce real economic growth. As Peter Schiff says, paper wealth of stocks and real estate can be driven up by malinvestment caused by Federal Reserve and government policies. Naturally, that paper wealth eventually crashes back down to Earth after the bubble bursts. Inflating one bubble after another and driving capital to areas of the economy it doesn’t belong is not a coherent economic policy. In fact, the greater the malinvestment, the harder the fall. The more you prop up the malinvestment, the worse you make it. Debt-financed “growth” is not growth, particularly as it erodes the purchasing power of the dollar.

I’ll leave you with a debate between friends in a bar, or should I say pub as Keynes gets to host. Three of the most influential economists ever, whose ideas shape our monetary and government policy, decide who understands the business cycle best. Without further ado, Milton Friedman, Friedrich Hayek, and John Maynard Keynes walk into a pub, courtesy of Nick Hubble:

Friedman asks Hayek; ‘So what should be done then?’ Keynes chimes in; ‘Yeah, doing nothing would mean a terrible depression.’
 
Hayek sighs.
 
No. Doing nothing would have avoided the problem in the first place. You are right that over indebtedness causes a depression. People, businesses and governments all realise they cannot afford the debt. They invested the money in things that do not justify the cost of the debt by providing revenue that exceeds the debt. Now they have to liquidate that debt by paying it off or defaulting. And that causes the deflationary contagion that Fisher fears.
 
But why is there so much debt in the first place? And why was it so poorly invested? None of you seem to explain that. And don’t tell me it’s just a cycle. People make mistakes, but they only do it as a group at the same time when there is a reason for it – a cause.
 
Remembering that debt and money are synonymous in the monetary system we live in, it should become obvious. Who controls the price and quantity of money? The government and/or the central bank do. Along with the private banks that can create money out of thin air, as Fisher often laments.
 
Just as price controls, rationing and fraud wreak havoc in any industry they are employed in by government and monopolists, so they wreak havoc in the banking industry – the industry of money. And money is half of every transaction.
 
If government keeps interest rates too low and creates too much money, which is then multiplied by the banks, there is too much debt. Eventually this will lead to the over indebtedness that causes a depression. The money and debt vanishes because it was never real. It only existed as bookkeeping entries on the central banks and private banks balance sheets.
 
Profitable investments are financed by real savings – deferred consumption – not imaginary money created out of nothing. Entrepreneurs are fooled by this sleight of hand on the part of their bankers. They think they are investing real savings, with the consumption that was deferred becoming their demand in the future. But, as the savings weren’t real, the consumption wasn’t deferred and so never materialises. Thus, the malinvestments are exposed.
 
‘That may or may not be true, but you haven’t answered my question,’ Friedman points out. ‘Now that we are in debt, what should we do?’
 
Hayek smiles. ‘Buy gold.’

Photo Credit (Preview): KAZVorpal
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The Meaning of Inflation Changes

The word “inflation” is thrown around quite a bit, but it’s meaning has changed over time. It used to refer to an increase in money circulating in the economy. When this happens, more dollars begin chasing the same amount of goods and services. What happened to prices afterward was dealt with separately. This is why Milton Friedman memorably contended that “inflation is always and everywhere a monetary phenomenon.” This meant not only a change in the money supply, but changes in money demand. Inflation can arise if consumers begin to spend their money at a faster rate.

Today, even most economists use the word inflation to describe something different: a general and sustained rise in the average price level. The media takes it a step further and will often describe the price of one asset or one sector as “inflating”. Turn on CNBC and you’ll hear about things like energy inflation, simply meaning that energy prices are rising relative to other goods and services. The price increases in a single sector like energy only represent that the demand for energy resources is increasing faster than the supply of energy resources. The fact the price went up only reflects underlying real changes in the economy.

Discussing inflation like CNBC in a single commodity, asset, or sector is nonsensical. Prices are the result of real inputs into supply and demand. If the price of one good rises, it can’t create a ripple effect through the entire economy causing the average level of all prices to rise. Everyone only has so much money to spend. If you use more dollars to fill up your car’s gas tank and heat your home, you have fewer to use on other things. The demand for some other good will fall, as will the price, all thing’s being equal.

So the old meaning of inflation referred to changes in circulating money while the new meaning refers to a sustained rise in the average price levels of a select basket of goods and services. The technical term to describe the old inflation is demand-pull inflation. The government needs to pay for things it can’t afford and prints extra money. This causes demand for goods and services to go up with the extra money circulating. Voilà, prices increase.

We should be asking why prices are going up (or down). If it’s due to real resource constraints, consumer demand, and consumer preferences in saving, so be it. But if it’s due to changes in monetary policy, that is sure to create distortions in the economy. If all of the sudden more people are coming to your burrito stand, is that because your burrito’s are more popular or there is just more money circulating in the economy? Amidst monetary inflation, a business owner might mistakenly decide that their burrito’s are more popular, and expand their business to meet the demand. That is a distortion, which can be taken away when the money supply contracts. Once the burrito stand owner realizes the real demand for his burrito, he’ll be forced to cut back his production.

The Fed has expanded its balance sheet to an unprecedented $2.492 trillion. Much of that money has not began circulating in the economy, instead being hoarded by the banks. When and if it does make it out there, we’ll see demand-pull inflation.

Money and prices are a veil, but they also have real effects which distort our view of the economy. We should look through the veil to the real underlying factors. Prices are not what we care about. We care about our command over goods and services, or the purchasing power of our money. Milton Friedman argued for small, constant growth of the money supply. I personally don’t fear deflation in all cases, so I’m not necessarily on board with him on such a fixed policy. However, a low, consistent increase in the money supply is better than erratic monetary policy because people can set their expectations accordingly. Unfortunately, inflation in the old sense doesn’t equal growth or a higher standard of living. When the next nominal GDP figures are released, ask yourself how much of that is real growth and how much of it is demand-pull inflation (or debt which must be repaid with interest later). Real growth requires improvements in human capital (our education system is killer), productivity, labor productivity, entrepreneurship, and technology. That’s where our focus should be; not on deficit spending, defense spending, and increasing the amount of money circulating.

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Why Gold is the Go-To Asset to Store Value

Mobile computing machine...AND currency hedge. Think about it.

Many people wonder what makes gold so special as a store of value. When inflation fears set in, people flock to gold. One answer is that the dollar used to be backed by gold. An even better answer I will leave to Judy Shelton, an economist and director of the National Endowment for Democracy:

“From the mid-14th century until now, you can draw a relative straight line in the purchasing power of gold, and every central banker in their heart knows that. Gold is universally recognized as a store of value. That’s important because it denotes price stability.”

While fiat currencies come and go, gold was the standard currency used for international trade for centuries. Despite price fluctuations of gold, its purchasing power has pretty much remained the same; and a currency is only as good as its ability to buy goods and services.

Snowflake, the Ultimate Shadow Cost

Photographer rendering of Snowflake

The science of economics transcends dollars and cents. If economics is the distribution of scarce resources, the most simplified unit of every “scarce resource”, is happiness. Do you remember converting velocity measurements in math class? There was the classic furlongs to meters conversion, and even more amusing, meters to kilometers. Similarly, every action can be converted into a happiness unit. Everything an economic agent does is for the purpose of maximizing their happiness.

Plenty of us have jobs we can’t stand; a decision that doesn’t sound like a happiness maximizer at work, but actually is. The job may be putrid, like the mystery items you clean up as a part of your job description, but food and shelter are glorious things. For most people, the happiness gained from the money they earn, whose purchasing power pays for meals and a roof, far outweigh their loathing of a dreadful job.

In classical economic models, the economic person is said to act with “rational expectations.” This is probably the weakest assumption made by these models. People are rational…oh sure.

People are said to achieve rational expectations by using all information available to them, in the most optimal way possible, while (here’s the kicker) learning from their past mistakes. Did these economists look around during the holidays at their family members? Did they interact with humans in day-to-day life? Evidently not or they might have noticed few red flags.

One past mistake worth learning from is the curious case of Snowflake; a 1999 white Nissan Pathfinder, recently acquired by one cost-cutting 24-year-old on the secondary car market. This beauty carried 103,000 miles at the point of purchase, was in immaculate condition inside and out, and by the acumen of an expert mechanic, ran perfectly.

What came before Snowflake may put her into better perspective. Our 24-year-old car owner, let’s call him J.C., used to get from point A to point B in a 1987 Toyota Camry. And there’s nothing wrong with that. But the Camry had some mechanical issues; issues that the aforementioned expert mechanic couldn’t even put his finger on. When it rained, which happens occasionally in the great Northwest, the Camry often puttered out on the road. Sometimes, even beautiful, sunny weather would disagree with it. Getting from first to second gear in the Camry sometimes meant the engine would die, and you’d be rolling amongst traffic, with zero ability to accelerate. If this wasn’t enough to swallow, car thieves had quite an affinity for the Camry. In its seven-year history as J.C.’s loyal confidante, the Camry was stolen four times. Stereos were pilfered, direct iPod hook-ups taken and I’m sure other fun was had in the Camry that J.C. will never fully appreciate (I like to imagine stickups and high speed chases, but to each their own). For the record, let it be known that the Camry was totaled before J.C. called it his own, thus it had a salvaged title. As any benevolent person could understand, J.C. was eager to get another car. Insert Snowflake.

After J.C. bought Snowflake from an owner in Washington State, he began salivating at the thought of finally selling the Camry, for the grand total of $400. He wanted that cash inflow to help pay for some of the expenses he would incur driving and insuring Snowflake. A concerned humanitarian warned J.C. that selling the Camry to another human being would mean a lifetime of bad karma. “It’s a karma play,” the friend warned with trepidation. “Don’t sell your soul for $400.”

Maybe J.C.'s stolen Camry was released into the wild

The decision of selling the Camry was taken care of, for J.C., after the fourth and final grand theft auto occurred, and this time, the Camry was never found. Like many of the robberies before, it happened in broad daylight, around noon and this time at a prominent university’s football stadium, surrounded by many other parked cars and people. The Camry always knew how to charm. Let’s all take a moment of silence.

For all the times the Camry was stolen, the thieves never decided to keep it. Even they ditched J.C.’s clunker of a car.

The euphoria of driving a highly respectable car was immense; J.C. was on a high. In some ways, he felt like he had arrived. There was still the business of changing the Washington license plate to an Oregon plate and notifying insurance of the car change, all costs the $400 from the Camry would have eased.

A friend of J.C.’s had a solution; the same friend who nicknamed J.C.’s new Pathfinder with the effeminate name, Snowflake.

“How about this? I will pay for the new Oregon plate if we get the custom “Cultural Trust” style and the license plate number, SNW FLK.”

It just so happens the “Cultural Trust” plate is pink. His friend refrained from sharing his other plan, regardless of J.C.’s answer, to put snowflake stickers all over the tinted windows.

The cost of a standard Oregon plate is $34. A custom plate will run you $54.

What transpired from there was a true economic phenomenon. The curious case of Snowflake was instantly transformed into the ultimate shadow cost. J.C. was seriously thinking this proposition was a great deal.

In J.C.’s quest to save the almighty dollar, he forgot about the non-monetary ramifications of a 24-year-old guy, son of a mechanic known as Outlaw Pete, driving a white SUV with a pink “SNW FLK” license plate. Worse would be his explanation to every girl, family member and human he ever interacted with: “My friend said he’d pay for the plate and I wanted to avoid a $34 expense.” The social ridicule would be off the charts. J.C.’s friend was willing to pay $54 for a good 5-10 year run of dishing out mockery and for the comfort of knowing J.C. was squirming at almost any moment in his social interactions. Conversely, J.C. was willing to forego spending $34 to drive a white Pathfinder with a pink “SNW FLK” license plate.

When we chase the almighty dollar to get by financially, it’s easy to forget about the full costs.

A shadow cost is the cost of the most valuable alternative given up. Also known as opportunity cost, indecisive people tussle with shadow costs…or they just can’t come up with any ideas to begin with. The happiness unit any action can be converted into, in its simplest form, economists call utility. Money can play a role in increasing an outcome’s utility, but not necessarily. If a person sleeps in he or she relinquishes the opportunity to see the sun rise. The sun rise is the opportunity cost of sleeping in, the most valuable alternative given up at 5:45 in the morning.

Each person has a different utility function or set of personal characteristics that drive their happiness.

Virtually anything a person does has the opportunity cost of earning a salary or wage. Rather then sleep, a person could work a graveyard shift at a gym. A person could work full time instead of training in dentistry school. The full cost of any decision is not only the time or money outlay, but also the happiness given up from the best alternative foregone. From an economic perspective, nothing’s free in this world.

This would make for a good first date

And nothing would have been “free” about getting a free license plate for J.C. His friend watched in amazement, as J.C. strongly entertained the deal for a good 5-10 minutes; an expanse of time that seemed like days. The more J.C. thought about it, though, the more he realized he was getting the short end of the stick. He thought about taking girls out on dates, for all intents and purposes, in a snowplow. He thought about telling his proud father, Outlaw Pete, his rationale for saving $34. He thought about driving to the grocery store and being laughed at, by high schoolers waiting at the bus stop. Ultimately, the cost/benefit analysis, in utility, wasn’t even close to a winning proposition.

What could have been the ultimate shadow cost, Snowflake will drive the streets with a standard plate. But in the hearts and minds of some, it will always be pink.

Lessons from ‘Raising Arizona’

Leonard Smalls knows what the market will bear

The following selection is from the 1987 Coen brothers comedy ‘Raising Arizona.’

Nathan Arizona’s son, Nathan Jr., has been kidnapped. His furniture mogul father places a $25,000 reward for him. Hilarity and economic wit ensues when a manhunter named Leonard Smalls comes and visits Nathan Sr. at his unpainted furniture store:

Nathan Arizona, Sr.: Mister…I got the cops, state troopers, Federal BI, already lookin’ for my boy. Now if you got information…

Leonard Smalls: The cops won’t find your boy. A cop couldn’t find his butt if he had a bell on it. You wanna find an outlaw, you call an outlaw. You wanna find a Dunkin’ Donuts, call a cop.

Nathan Arizona, Sr.: Smalls, first off, get your damn feet off my furniture. Second off, it’s widely known I posted a twenty-five grand reward for my boy. Now if you can find him, claim it. Short of that, what have we got to talk about?

Leonard Smalls: Price. Fair price. That’s not what you say it is. That’s what the market will bear. Simple economics. Now there are people – and, mind you, I know ’em – that’ll pay a lot more than $25,000 for a healthy baby.

Nathan Arizona, Sr.: What are you after?

Leonard Smalls: I’ll give you an idea. As a pup, I myself fetched $30,000 on the black market. And that was in 1954 dollars. Now, for fifty grand, I’ll track him and I’ll find him. And the people that took him…I’ll kick their butts. No extra charge.

Nathan Arizona, Sr.: And if I don’t pay?

Leonard Smalls: I’ll get the boy regardless. And if you don’t pay, the market will.

Supply and demand fetching what the market will bear and inflation all rolled into one movie quote. Doesn’t get much better than that. Even bounty hunters benefit from knowing a little economics!