NGDP, NGO and total expenditures

I did not think that my post on NGO versus NGDP would gather attention, but it did (so, I am happy). Nick Rowe of Carleton University and the (always relevant) blog Worthwhile Canadian Initiative responded to my post with the following post (I was very happy to see a comment by Matt Rognlie in there).

Like Mr. Rowe, I prefer to speak about trade cycles as well. I do not know how the shift from “transactions” to “output” occurred, but I do know that as semantic as some may see it, it is crucial. While a transaction is about selling a unit of output, the way we measure output does not mean that we focus on all transactions.  I became aware of this when reading Leland Yeager (just after reading about the adventures on Lucas’ Islands). However, Nick (if I may use first names) expresses this a thousand times better than I did in my initial post. When there is a shift of the demand for money, this will affect all transactions, not only those on final goods. Thus, my first point: gross domestic product is not necessarily the best for monetary transaction.

In fact, as an economist who decided to spend his life doing economic history, I do not like gross domestic product for measuring living standards as well (I’ll do a post on this when I get my ideas on secular stagnation better organized). Its just the “least terrible tool”. However, is it the “least terrible” for monetary policy guidance?

My answer is “no” and thus my proposition to shift to gross output or a measure of “total spending”. Now, for the purposes of discussion, let’s see what the “ideal” statistic for “total spending” would be. To illustrate this, let’s take the case of a change in the supply of money (I would prefer using a case with the demand for money, but for blogging purposes, its easier to go with supply)

Now unless there is a helicopter drop*, changes in the money supply generate changes in relative prices and thus the pattern (and level) of production changes too. Where this occurs depends on the entry point of the increased stock of money. The entry point could be in sectors producing intermediary goods or it could closer to the final point of sale. The closer it is to the point of sale, the better NGDP becomes as a measure of total spending. The further it is, the more NGDP wavers in its efficiency at any given time. This is because, in the long-run, NGDP should follow the same trend at any measure of total spending but it would not do so in the very short-run. If monetary policy (or sometimes regulatory changes affecting bank behavior “cough Dodd-Frank cough”) causes an increase in the production of intermediary goods, the movements the perfect measure of total spending would be temporarily divorced from the movements of NGDP. As a result, we need something that captures all transaction. And in a way, we do have such a statistic: input-output tables. Developed by the vastly underrated (and still misunderstood in my opinion) Wassily Leontief, input-output tables are the basis of any measurement of national income you will see out there. Basically, they are matrixes of all “trades” (inputs and outputs) between industries. What this means is that input-output tables are tables of all transactions. That would be the ideal measure of total spending.  Sadly, these tables are not produced regularly (in Canada, I believe there are produced every five years). Their utility would be amazing: not only would we capture all spending (which is the goal of a NGDP target), but we could capture the transmission mechanism of monetary policy and see how certain monetary decisions could be affecting relative prices.** If input-output tables could be produced on a quarterly-basis, it would be the amazing (but mind-bogglingly complex for statistical agencies).

The closest thing, at present, to this ideal measure is gross output. It is the only quarterly statistic of gross output (one way to calculate total spending) that exists out there. The closest things are annual datasets. Yet, even gross output is incomplete as a measure of total spending. It does not include wholesale distributors (well, only a part of their activities through value-added). This post from the Cobden Centre in England details an example of this. Mark Skousen in the Journal of Private Enterprise published a piece detailing other statistics that could serve as proxies for “total spending”. One of those is Gross Domestic Expenditures and it is the closest thing to the ideal we would get. Basically, he adds wholesale and retail sales together.  He also looks at business receipts from the IRS to see if it conforms (the intuition being that all sales should imitate receipts claimed by businesses). His measure of domestic expenditure is somewhat incomplete for my eyes and further research would be needed. But there is something to be said for Skousen’s point: total nominal spending did drop massively during the recession (see the fall of wholesale, gross output and retail) while NGDP barely moved while, before the recession, total nominal spending did increase much faster than NGDP.

NGONGDP1

In all cases, I think that it is fair to divide my claim into three parts: a) business cycles are about the deviation from trends in total volume of trades/transactions, thus the core variable of interest is nominal expenditures b) NGDP is not a measure of total nominal spending whose targeting the market monetarist crowd aims to follow; c) since we care about total nominal spending, what we should have is an IO table … every month and d) the imperfect statistics for total spending show that the case made that central banks fueled spending above trend and then failed to compensate in 2008-2009 seems plausible.

Overall, I think that the case for A, B and C are strong, but D is weak…

* I dislike the helicopter drop analogy. Money is never introduced in an equal fashion leading to a uniform price increase. It is always introduced through a certain number of entry points which distort relative prices and then the pattern of trade (which is why there is a positive short-term relation between real output and money supply). The helicopter drop analogy is only useful for explaining the nominal/real dichotomy for introductory macro classes.
** Funny observation here: if I am correct, this means that Hayek’s comments about the structure of production would have been answered by using Leontief’s input-output table. Indeed, the Austrians and Neoclassicals of the RBC school after them have long held that monetary policy’s real effects are seen through changes in the structure of production (in the Austrian jargon) or by inciting more long-term projects to be undertaken creating the “time to build” problem (in the RBC jargon). Regardless of which one you end up believing (I confess to a mixed bag of RBC/Austrian views with a slight penchant to walk towards Rochester), both can be answered by using input-output tables. The irony is that Hayek actually debated “planning” in the 1970s and castigated Leontief for his planning views. Although I am partial (totally) to Hayek’s view on planning, it is funny that the best tool (in my opinion) in support of Hayek is produced by an intellectual adversary

Blaming Finance, Ignoring Real Causes

The fall 2014 Cato Journal has an article, ‘The Financial Crisis: Why the Conventional Wisdom Has It All Wrong,” [pdf] by Richard Kovacevich, Chairman Emeritus of Wells Fargo. The author is correct in saying that the conventional wisdom is wrong in blaming the slow recovery on the “uniqueness of a financially led economic recession.” The US economy recovered from the severe 1980 recession within two years, while now the economy is creeping like a turtle.

The economic cause of recovery and growth is simple. Economic investment – the production of capital goods – drives the business cycle. Recessions are caused by a sharp fall in investment. Then, as the prices of raw materials fall, and as land rent drops, a depression reduces these costs of production, therefore increasing profits, so investment recovers. Government can boost the recovery by further reducing the costs of production, by decreasing the taxes and regulations it imposed previously. This is the “supply side” policy of increasing investment and production by reducing the costs of regulations and taxes.

But this time around, the federal government did the opposite. Costly regulations have magnified, with an anti-supply-side effect. Every year, there are thousands more regulations that hamper enterprise, and finally, regulations plus taxes have achieved the tipping point of making it too costly for enterprise to invest and hire labor.

After the Crash of 2008, the federal government had two basic policy options: it could help the economy recover with market-enhancing supply-side policies, or else the government could enact the welfare-state agenda of greatly increased governmental medical services. The government chose the latter option, which imposed even greater costs on enterprise and labor.

When the recession hit the economy in 2008, one of the responses was TARP, the Troubled Asset Relief Program. As the article states, one of the problems with TARP was that it did not focus on the troubled banks, but imposed the policy on all banks. The banks that were not troubled had to obtain the funds and then pay interest on them. TARP imposed the impression that all banks were in trouble, which destroyed confidence, and then Congress responded to the turmoil by imposing 25,000 pages of Dodd-Frank regulations.

None of the financial regulations, going back to the Great Depression, confront the causes of the boom and bust. The fundamental cause is massive subsidies to land values. The Cato article focused on the financial industry, but the more fundamental issue is government policy regarding real estate. The problems of the financial industry originate in their financing of real estate.

The history of the Americas has been that of grabbing land and enslaving labor. In the American colonies, the British government promoted European settlement to control land and to profit from trade. After the defeat of the French in 1763, the United Kingdom changed policy to avoid conflict with the people of Quebec and with the Indians, by restricting western speculation and migration. That annoyed the landed interests enough to declare independence, and to establish a constitution that would better extend and protect land speculation. Huge grants of land were given to railroads, veterans, colleges, and speculators.

After the public domain was disposed of, the government continued the subsidy of the large landed interests with implicit policies that are invisible to the public and to most economists. The provision of public works, welfare to the poor and elderly, and artificially cheap credit, all generate greater land rent and land value. This amounts to a vast redistribution of wealth from workers, tenants, and enterprise owners, to landowners, especially the concentrated owners of commercial and farm land.

With a fixed supply of land, much of the gains from an economic expansion is captured by higher land rent and land value, which then attracts speculation that carries real estate prices to unsustainable heights. When land values crash, they bring down with them the financial system that provided the loans. None of the financial regulations touch this basic cause, and land-value seeking is so deeply ingrained in American culture that people favor it even at the price of high taxes, high unemployment, and the destruction of liberty.

Ask a typical American, “Would you favor a tax reform that eliminates taxes on your wages, on interest from your financial assets, and on buildings, replaced by a tax only on land values?” The answer is, “No! I would rather suffer unemployment, insecurity, crime, poverty, and loss of liberty, than have my precious land taxed!”

“OK, then, would you favor the complete replacement of government’s public goods with private, contractual, provision that eliminates the subsidy to land values?” “No! We need government to provide these things!”

Then you ask, “So why do you want the word ‘liberty’ put on our coins?” The answer is, “I want liberty so long as it is not put into practice!”

And that is why government deals with the superficial financial appearances, and not the implicit reality that causes the booms and busts.

Where the World’s Unsold Cars Go To Die [Zerohedge]

I don’t have time to comment a ton on this (Life has just been absurd lately) but wanted to make sure more people saw this.

The guys over at Zerohedge noticed a surprising sight on google maps in the city of Sheerness, United Kingdom. West coast, below the River Thames and next to River Medway. Left of A249, Brielle Way. A car lot full of unsold, brand new cars. Zerohedge claims these are all new cars that cannot fit on overcapacity dealer lots. If true this would be a prime example of malinvestment spurred on by government bailout and subsidies. Quite literally a textbook case of the Austrian Business Cycle.

Further research is needed since I do not know whether these lots are standard practice or a new feature of our post-2008 crash world. It is possible that these are merely staging grounds for cars before they ship to dealers but at first glance I tend to agree with Zerohedge’s conclusion that “There is proof that the worlds recession is still biting and wont let go. All around the world there are huge stockpiles of unsold cars and they are being added to every day. They have run out of space to park all of these brand new unsold cars and are having to buy acres and acres of land to store them.”  

Something to keep an eye on regardless.

Is China running out of cash?

Is China running out of cash?

China Halts Bank Cash Transfers

“The People’s Bank of China, the central bank, has just ordered commercial banks to halt cash transfers.”

Could we be seeing the start of total economic collapse? The answer, ceteris paribus, is yes and the Austrian Business Cycle Theory (ABCT) explains why.

To quote Ludwig Von Mises’ explanation of the final act of the ABCT:

Ludwig von Mises stated that the “crisis” (or “credit crunch“) arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates.[12][

This means that when consumers finally realize that the money they have invested has actually been malinvested in the economy they then seek to acquire as much of their money as possibly from said investments. Most of which take the form of bank deposits.

The linked article reminds us that this is the numerous such time that China has adopted this policy saying:

“So what’s really going on?  This crunch follows similar incidents in June and December of last year.  In June, for instance, the central bank used the excuseof a “system upgrade” to allow banks to shut down their ATMs and online banking platforms.  As a result, they conserved cash and thereby avoided a nationwide meltdown.”

Other instances, such as this one in England where “[s]ome HSBC customers have been prevented from withdrawing large amounts of cash because they could not provide evidence of why they wanted it,” show that this problem may not be contained to China and may be spreading to the international market.

What does Murray Rothbard say will happen when this “credit crunch” inevitably occurs?

Wasteful projects, as we have said, must either be abandoned or used as best they can be. Inefficient firms, buoyed up by the artificial boom, must be liquidated or have their debts scaled down or be turned over to their creditors. Prices of producers’ goods must fall, particularly in the higher orders of production—this includes capital goods, lands, and wage rates […]

this means a fall in the prices of the higher-order goods relative to prices in the consumer goods industries. Not only prices of particular machines must fall, but also the prices of whole aggregates of capital, e.g., stock market and real estate values. In fact, these values must fall more than the earnings from the assets, through reflecting the general rise in the rate of interest return […]

“Since factors must shift from the higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary […]

Another common secondary feature of depressions is an increase in the demand for money. This “scramble for liquidity” is the result of several factors: (1) people expect falling prices, due to the depression and deflation, and will therefore hold more money and spend less on goods, awaiting the price fall; (2) borrowers will try to pay off their debts, now being called by banks and by business creditors, by liquidating other assets in exchange for money; (3) the rash of business losses and bankruptcies makes businessmen cautious about investing until the liquidation process is over.

With the supply of money falling, and the demand for money increasing, generally falling prices are a consequent feature of most depressions. A general price fall, however, is caused by the secondary, rather than by the inherent, features of depressions.

So is the massive failure of all economies imminent? Well not necessarily because the government can take some steps to prevent the immediate failure.

According to Mises:  

“Continually expanding bank credit can keep the borrowers one step ahead of consumer retribution (with the help of successively lower interest rates from the central bank). In the theory, this postpones the “day of reckoning” and defers the collapse of unsustainably inflated asset prices.[12][14] It can also be temporarily put off by price deflation or exogenous events such as the “cheap” or free acquisition of marketable resources by market participants and the banks funding the borrowing (such as the acquisition of land from local governments, or in extreme cases, the acquisition of foreign land through the waging of war).[15]

The “false” monetary boom ends when bank credit expansion finally stops – when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates”

These steps only “kick the can down the road” and delay the inevitable since “the longer the “false” monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures and depression readjustment.”

We may be seeing the beginning of the next great depression here but only time will tell.  One thing is certain though, a massive economic readjustment is coming and the central banks of the world have only been aggravating the problem.  When it will hit is anyone’s guess but in this author’s opinion we are either looking at a repeat of the early 30’s or a repeat of the early 40’s and I can only hope we can avoid going through both.

Around the Web

  1. A university in Malaysia has awarded an economics doctorate to North Korea’s communist dictator
  2. Ian Bremmer asks, in the pages of the National Interest, if China is in the middle of a big bubble
  3. The Diffusion of Responsibility: a short piece on government employees, the rest of us, and some implications of the drug war
  4. How laissez-faire made Sweden rich by Johan Norberg
  5. Why do banks keep going bankrupt? Kirby Cundiff answers this question in the pages of the Freeman
  6. Mud People and Super Farmers: Creatively adapting to the lack of land rights in Africa

Another Housing Bubble?

Last year I wandered down the street to an open house for sale. Even though I announced myself as a looky-loo, the agent welcomed me. We sat around talking and eating cookies for an hour; no prospects showed up.

It was a nice day today and I decided to walk to another open house thinking I’d again look around and chat with the agent. Hardly – the place was mobbed! It looks great in this picture but the reality is it’s stuck way up on a hill with a steep driveway and no garage. It’s 80 years old and although it’s been fixed up cosmetically it’s nothing to write home about; not in my book anyway. Nevertheless, I’m betting they’ll have multiple offers before this first day on the market is over.

This is the San Francisco Peninsula which is by no means representative of the whole country but I hear that Las Vegas has turned around too, as have tony places in New York. Why? Although I can’t prove it, I believe a good part the gusher of money that the Fed has been printing is now making its way into housing. The stock market has stalled, the bond market is in retreat, gold has plummeted, and that pretty much leaves housing.

So although the basic premise of monetary stimulus is plausible, it just doesn’t work. The new money seems to go careening around the economy in search of the Next Big Thing. Bubbles form and collapse, malinvestments are revealed and the cycle starts anew. What’s different this time is that it’s been such a short time since the collapse of the previous housing bubble to what looks like the start of another.

If these wasteful cycles of boom and bust are to end, the Fed must cease its stimulus programs. But it can’t. When the Fed dropped just a hint last week that it might start “tapering” off its bond-buying (money-printing) program, the bond market panicked. Why should we care about the bond market? For one thing, the average maturity of the federal debt is just a couple of years. Maturing debt must be rolled over into new debt, and if the new debt carries higher interest rate, the total annual interest payment could quickly swell from a “mere” $345 billion for the current fiscal year toward a trillion dollars per year, swamping any efforts to contain spending, like the $80 billion sequester that just took effect. We could end up needing a bailout from China.

The Fed will very likely continue or even accelerate its bond buying, depending on who occupies Bernanke’s seat come January. We should expect continuing cycles of bubbles and busts and the real possibility of some very nasty fiscal consequences.

Moral Markets and Immoral “Capitalism”

The question, “Is capitalism moral?” was raised by Steven Pearlstein in a 15 March 2013 article in the Washington Post. He is a professor of public and international affairs at George Mason University and a column writer for the Washington Post.

Pearlstein writes that we in the US are engaged in a “historic debate over free-market capitalism.” Maybe so, but “free-market capitalism” is a contradiction in terms. There are two reasons why the economic system is called “capital”ism rather than “laborism” or “landism.” First is that capital dominates labor. The second reason to call the system “capitalism” is to hide the role of land, so that people focus only on the conflict between workers and capitalists. The chiefs of finance and real estate are able to dominate because of their political clout. They obtain privileges from government in subsidies, limits on competition, and periodic bail outs. In contrast, in a free market, there is no domination, with neither subsidies nor imposed costs.

Pearlstein then says that if “markets” were providing prosperity for most folks, there would be no need for governmental intervention. But we don’t have pure markets. We have a mixed economy, with intervention into markets, so one has to first analyze whether it is markets or else interventions that cause high inequality, instability, poverty, and unemployment. Since pure markets are not given an opportunity to work, how can they be responsible for economic woes?

He then asserts that for the past 30 years, the world has been moving towards a greater role for markets. That is so for China and the countries previously dominated by the USSR, and these economies have indeed experienced greater growth and prosperity.

But, contrary to Pearlstein’s assertion, the US has been moving away from a market economy. Frequent governmental crises – the fiscal cliff, budget deadlines, ever changing tax rates – threaten the stability of financial, industrial, and labor markets. The subsidies to real estate and its financial allies have never been greater. The domination of the Federal Reserve over money, banking, and interest rates has reached historic heights. The tax reforms of the 1980s have been reversed by Congress, which has made income taxes ever more complex. Costly regulations continue to pour out of Washington DC by the thousands each year. And now the government will dominate medical provision like never before.

The decline in the role of markets can be measured by an index of economic freedom. According to the Fraser Index of Economic Freedom, U.S. market freedom peaked out in the year 2000 at a rating of 8.5 out of 10, and then declined to 7.69 in 2010 as intervention grew. The US freedom ranking among countries dropped from third place in 2000 to 18th out of 144 in 2010, and most probably has continued sinking since then.

Critics of markets have asserted that stagnant household incomes and financial crises are the fault of a greater role for markets, when in fact, in the US and Europe, massive subsidies to real estate caused the recession, excessive government borrowing has caused the fiscal crises, and a governmental redistribution of wealth from workers to landowners has stagnated net wages.

I agree with Pearlstein that we should welcome the debate on economic morality. But we should use words that have real economic meaning, rather than propaganda terms. Any person who refers to “capitalism” other than with critical quotation marks contributes to the confusion. The critics of markets opportunistically use the term “free market” to refer to the mixed economy, and then use the term “capitalism” also for the concept of a pure free market. Hence they argue that “capitalism,” as the mixed economy, suffers from economic woes, and then jump to the false conclusion that “capitalism,” meaning the pure market, causes the problems.

A real debate should also unmask the role of land that hides under the label “capital”ism. Critics who speak of the “market’s” unequal distributions overlook the massive redistribution of income from workers to landowners, as taxes on wages pay for public goods that pump up rent and land values. Their call for higher taxes on the rich disregards the distinction between earned income from entrepreneurship and unearned income from governmental subsidies.

Pearlstein admits that “many of the arguments have been a bit flabby, with both sides taking refuge in easy moralizing.” That is true. An honest and robust debate should avoid the deceitful switching of meanings for “capitalism”, and indeed avoids using the flabby term altogether. Instead, use the clear and honest words “pure market,” “intervention,” and “mixed economy.” If we say that the mixed economy has economic woes, one cannot then conclude that the pure market has caused them, because the mix also includes intervention. Clear thinking about economic morality cannot begin until we have clear terms that reflect the full-spectrum of economic reality.

Free Banking Explained

Free Banking is free-market banking. In pure free banking, the money supply and interest rates are handled by private enterprise, there is no restriction on peaceful and honest banking services, and there is no tax on interest, dividends, wages, goods, and entrepreneurial profits. Free banking provides a stable and flexible supply of money, and allows the natural rate of interest to do its job of allocating funds among consumption and investment, thereby preventing inflation, recessions, and financial panics.

To understand free banking, we first need to understand the relationship between capital goods and interest rates. Capital goods, having been produced but not yet consumed, have a time structure. Think of it as a stack of pancakes. The bottom pancake is circulating capital goods, which turnover in a few days, such as perishable inventory in a store. The higher levels take ever longer to turn over. The highest pancake level consists of capital goods with a period of production of many years, the most important type being real estate construction.

Lower interest rates make the pancake stack taller, while higher interest rates make it flatter. Think of trees that take 20 years to mature. Suppose the trees are growing in value at a rate of three percent per year. If bonds pay a real interest rate of four percent, and the interest rate is not expected to change, then the trees will not be planted, since savers will put their funds into bonds instead. But if bonds pay a rate of two percent, then the trees get planted. So the lower interest rate induces an investment in long-lived trees and steepen the capital-goods pancake stack. Continue reading

Credit Booms Gone Wrong

Recent research by economists Moritz Schularick and Alan M. Taylor have confirmed the theory that economic booms are fueled by an excessive growth of credit. They have written a paper titled “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870–2008“, published by the National Bureau of Economic Research.

A major cause of the Great Depression was a credit boom, as analyzed by Barry Eichengreen and Kris Mitchener in their paper, “The Great Depression as a credit boom gone wrong” (BIS Working Paper No. 137). Eichengreen and Mitchener cite Henry George’s Progress and Poverty as providing an early theory of booms and busts based on land speculation. They also credit the Austrian school of economic thought, which in the works of Friedrich Hayek and Ludwig von Mises, had developed a theory of the business cycle in which credit booms play a central role. Henry George’s theory of the business cycle is complementary to the Austrian theory, as George identified the rise in land values as the key role in causing depressions.

An expansion of money and credit reduces interest rates and induces a greater production and purchase of long-duration capital goods and land. The most important investment and speculation affected is real estate. Much of investment consists of buildings and the durable goods that go into buildings as well as the infrastructure that services real estate. Much of the gains from an economic expansion go to higher land rent and land value, so speculators jump in to profit from leveraged speculation. This creates an unsustainable rise in land value that makes real estate too expensive for actual uses, so as interest rates and real estate costs rise, investment slows down and then declines. The subsequent fall in land values and investment reduces total output, generates unemployment, and then crashes the financial system.

We can ask whether this theory is consistent with historical evidence. One strand of evidence is the history of the real estate cycle, which has been investigated by the works of Homer Hoyt, Fred Harrison, and my own writings. Another strand is the history of credit booms, as shown by Schularick and Taylor, who assembled a large data set on money and credit for 12 developed economies 1870 to 2008. They show how credit expansions have been related to money expansions, and how financial innovations have greatly increased credit. Because economic booms are fueled by credit expansion, Schularick and Taylor note that credit booms can be used to forecast the coming downturn.

Followers of Henry George have focused on the real estate aspect of the boom and bust, while the Austrian school has focused on credit, interest rates, and capital goods. A complete explanation requires a synthesis of the theories of both schools, but these recent works on credit booms have not recognized the geo-Austrian synthesis. In order to eliminate the boom-bust cycle, both the real side (real estate) and the financial side (money and credit) need to be confronted.

Current Austrian-school economists such as Larry White and George Selgin have investigated the theory and history of free banking, the truly free-market policy of abolishing the central bank as well as restrictions on banking such as limiting branches and controlling interest rates. In pure free banking, there would be a base of real money such as gold or a fixed amount of government currency. Banks would issue their own private notes convertible into base money at a fixed rate. The convertibility and the competitive banking structure would provide a flexible supply of money along with price stability. The banks would associate to provide one another with loans when a bank faces a temporary need for more base money, or a lender of last resort.

Both the members of the Austrian school and the economists who have studied credit booms have not understood the need to prevent the land-value bubble by taxing most of the value of land. That would stop land speculation and eliminate the demand for credit by land buyers.

But the credit-bubble theorists have not understood that financial regulation and rules for central banks cannot solve the financial side of credit bubbles. Credit booms always go wrong. As the Austrians have pointed out, there is no scientific way to know the correct amount of money or the optimal rates of interest. Only the market can discover the rate of interest that balances savings and borrowing, and only the market can balance money supply with money demand.

Thus the remedy for the boom-bust cycle is both land value taxation and free banking. Land speculation would not be as bad without a credit boom, but will still take place as land values capture economic gains and land speculators suck credit away from productive uses. But also, a credit boom with land-value taxation will still result in excessive construction and the waste of resources in fixed capital goods, reducing the circulating capital need to generate output and employment, as Mason Gaffney has written about.

Economic bliss requires both the public collection of rent and a free market in money.

[Editor’s note: this essay first appeared on Dr. Foldvary’s blog, the Foldvarium, on April 4 2010]

Boombustology: A Review

These days commentators near and far are announcing booms and bubbles in Treasury securities, gold, China – perhaps even a bubbles. Vikram Mansharamani is in the China camp, but his arguments stand out from the others. If you can get past the title of his book – Boombustology – you will be rewarded with a thorough, well-documented, yet mercifully brief and readable exposition of a theory of booms and busts applied to past events and China’s future.

Most macroeconomists see the boom-bust cycle as an unsolved problem. Like physicists in search of a Grand Unified Theory, they long for a model that accounts for all the major aspects of the business cycle. Perhaps they are hampered by looking through the wrong end of a telescope. Mansharamani uses not just one but five “lenses” to examine the subject. In addition to micro- and macroeconomics, they include psychology, politics, and biology. He is not the first economist to invade these fields. Rather his accomplishment lies in assembling ideas from each of those areas, applying them to past boom-bust cycles, and putting his ideas on the line by issuing a brave prediction of a forthcoming Chinese economic train wreck.

Austrian Business Cycle Theory

The author’s macro lens includes Austrian business cycle theory. That theory says inflation of the money supply causes a drop in interest rates, which is misinterpreted as an increased aggregate preference for saving over consumption, leading to investments in more roundabout means of production. When it becomes clear that there has been no such preference shift, these undertakings are seen to be at least partial mistakes, requiring write-offs and retrenchment – a bust. The boom is the problem, not the bust, which is the market’s attempt to realign itself to the realities of time preference. Austrian business cycle theory has great merit but leaves some things unexplained.

Mansharamani’s micro lens includes the concept of reflexivity. Market participants don’t just observe prices but also influence them. Reflexive dynamics occasionally give rise to instabilities in which rising prices lead to increased demand.  A simpler term would be a “bandwagon effect.” I recall an office party in 1980 where one of the secretaries asked about buying gold – precisely at the peak, as it turned out. All she knew about gold was that it was way up and therefore must be going higher. I should have realized that when you see financially unsophisticated people like her climbing on a bandwagon, you can be pretty sure there’s no one left to sell to and nowhere for prices to go but down, which is where gold and silver prices went in 1980, and in a big hurry.

From psychology Dr. M. borrows ideas and data about cognitive biases. For example, subjects asked to guess some bland statistic, like the number of African countries that belong to the UN, are influenced by the spin of a wheel of fortune: When the wheel lands on a high number, they guess higher. He translates this and a dozen other cognitive biases into irrational market behavior that can foster booms and busts.

He introduces his biology lens with an analogy to the spread of an infectious disease. When the prevalence of a disease reaches a high level, the infection rate necessarily slows and the disease begins to wane, just like the 1980 gold market.  But it is devilishly difficult to “inoculate” oneself against infectious ideas. Individual investors who can do so have a decent chance to beat the market averages over time, I believe. (Those who would pursue these ideas in greater depth would do well to find James Dines’s quirky and expensive but worthwhile book, Mass Psychology.) Continue reading