money

The meaning of Hayek’s main views on monetary theory

Federico Sosa Valle Economics , , , , , ,

The one who is set to determine what Friedrich Hayek’s monetary theory consisted of will discover that his was a labyrinthic exploration conducted to dead-ends, which taught him what paths not to follow.

In his first years of research, Hayek was focused on the business cycle theory and on the monetary effects on the business cycles, his main objective being the pursuit of a neutral currency. This means, a monetary system that does not interfere in the price system, i.e., that the variations in relative prices express only the variations in the relative scarcity of goods, without any monetary disturbances. In this first stage, Hayek concentrated on the study of what he called “Cantillon effects,” in which the variations in the money supply did not affect prices simultaneously but were transmitted from capital goods firstly to consumer goods later, generating thus an intertemporal distortion or falsification in relative prices.

This distortion in the intertemporal value of goods is expressed in the distortion in the interest rate. It is worth clarifying about this last aspect, that for the Austrian School of Economics, which was where Hayek came from, time preference is the predominant element in the interest rate and that the monetary element represents, precisely, a disturbance in said time preference scale.

The monetary disturbances on the interest rate had two main consequences for Hayek: the first, the generation of cycles of boom and recession; the second, a process of continuous decapitalization of the economy.

In turn, in this first stage of Hayekian economic thought, stability in the purchasing power of money would not necessarily mean a neutral monetary system: that the money supply accompanies an increase in money demand, for example, could lead to a cycle of boom and recession with an initial stage of stability in the general level of prices, since the increase in the money supply would first be channeled into the capital goods market, generating an effect similar to an initial drop in the interest rate, which would then rise when the increase in the money supply reached the market for consumer goods.

In this last stage, the demand for consumer goods would increase, but the supply of such would not be able to satisfy it, since the resources -induced by the initial drop in the interest rate- had previously been redirected to the production of capital goods.

For Hayek, therefore, crises were not generated by underconsumption, but quite the opposite, by pressure on the demand for consumer goods. If this additional demand for consumer goods was not validated by further increases in the money supply, adjustment and recession would ensue. It is what was called The Concertina Effect -which later received severe critics from Hayek’s former disciple and translator Nicholas Kaldor.

But if indeed the monetary authority validated the expectations of consumers permanently, in order to avoid the slump, this would induce a gradual substitution in the production of consumer goods for capital goods. A process of a sort that John Maynard Keynes had already mentioned in his “A Tract on Monetary Reform” -to which Hayek adhered: The phenomenon of capital consumption that caused high inflation. Such a process of erosion of the capital structure of an inflationary economy would be the central theme of Hayek’s studies on the Ricardo Effect, which John Hicks proposed to rename the Ricardo-Hayek effect. This theme of his youth will accompany him both in the works of his adulthood and in his old age, as exposed in his essays “The Ricardo Effect” (1942) and “Three Elucidations of the Ricardo Effect” (1969).

To summarize, Hayek’s initial concern on monetary theory was not focused on the stability of the price level but rather on the attainment of the neutrality of money. His most relevant conclusions on this subject could be found in his short note titled “On Neutral Money” (originally published as “Über ‘neutrale Geld’” in 1933), in which he stated what follows:

“Hence the relationship between the theoretical concept of neutrality of the money supply and the ideal of monetary policy is that the degree to which the latter approximates to the former provides one, probably the most important though not the sole, criterion for assessing the maxims of monetary policy. It is perfectly conceivable that monetary influences would always give rise to a ‘falsification’ of relative prices and a misdirection of production unless certain conditions were fulfilled, e.g., (1) the flow of money remained constant, and (2) all prices were perfectly flexible, and (3) in the conclusion of long-term contracts in terms of money, the future movement of prices was approximately correctly predicted. But the implication is, then, that if (2) and (3) are not given, the ideal cannot be attained by any kind of monetary policy at all.”

In turn, in 1943, he rehearses the proposal of “A Commodity Reserve Currency“, with the purpose of giving a functional meaning to the phenomenon of hoarding: an increase in the purchasing power of money caused by a monetary demand for a reserve of value would translate into in a greater demand for primary goods by the monetary authority, which would curb the fall in prices and the monetary disturbances on the level of activity. Correlatively, a rise in spending would be offset by the sale of raw materials by the monetary authority and the concomitant sterilization of means of payment, thereby decompressing inflationary pressures. The big problem with such a proposal was the instrumentation itself: having a reserve system for a basket of raw materials is laborious and costly; in the same way that the choice of goods that make up said basket of goods is not exempt from controversy.

That is way Hayek’s attitude towards the inevitability of monetary shocks to the real economy is one of apparent resignation. When it comes to describing the incidence of the money multiplier by the banking system, Hayek points out that not much can be done about it, other than to understand that this is how capitalist economies work.

However, in 1976 – 1977, Hayek returned to contribute to monetary theory from his proposal of competition of currencies in “Denationalisation of Money”, where he questioned whether the monopoly of money was a necessary attribute of the nation state -something that dates back to the times of Jean Bodin- and proposed that the different countries that made up the then European Economic Community, instead of issuing a common currency, compete with each other in a selection process of currencies by the public.

Although Hayek is credited with having outlined inflation targeting in that book and is regarded as an inspiration to the private and crypto currencies, his main contribution remains yet to be assessed: The competition of currencies is not the best monetary system but the best procedure to discover a better one.

Previously, in his essay of 1968, “Competition as a Discover Procedure”, Hayek had stated that: “Competition is a procedure for discovering facts, which, if the procedure did not exist, would remain unknown or would not be used.” Thus, we will never define by ourselves, speculatively, how it would work the perfect monetary system, but the competition of currencies would enable us with a more powerful tool to discover which monetary system would better adapt to the changing conditions of the economic environment. The denationalization of money is not a monetary system by itself, but a device to improve the existing ones.

Some Monday Links: Mostly Econ, again

Michalis Trepas Links , , , , , , , , ,

The worldly turn (Aeon)

The chocolate route (Aeon)

For the Woke warriors, culture and economics are two sides of the same coin – just ask Mollie-Mae (CapX)

Optional.: Knowing who Mollie-Mae actually is.

Measuring the Essence of the Good Life (Finance & Development)

Nightcap: Development with Dignity (NOL)

Great Stories and Weak Economics (Regulation)

Digital currencies and the soul of money (BIS)

To close this, a couple of neat graphs from the European Central Bank. The first one shows a measure of central bank messages’ clarity , the lower the number, the better. The second graph demonstrates the frequency (a proxy for significance) of some buzzwords. As old Korean masters comment when comparing various strands of their art, the major central banks are “same, same, a little different“.

Source
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Elective Affinities in Institutional Design, 1951

Brandon Christensen Economics, History , , , , , , ,

[Note: this is a piece by Michalis Trepas, who you might recognize from the now-defunct NOL experiment “Be Our Guest.” Michalis is a newly-minted Notewriter, and this is the first of many more such pieces to come. -BC]

The Treasury and the Federal Reserve System have reached full accord with respect to debt-management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government’s requirements and, at the same time, to minimize monetization of the public debt.

– Joint announcement by the Secretary of the Treasury and the Chairman of the Board of Governors, and of the Federal Open Market Committee, of the Federal Reserve System, issued for release on Mar. 4, 1951

The Allied High Commission appreciates that these responsibilities [for the central bank] could not, without serious inconvenience, be given up so long as no legislation has been enacted establishing a competent Federal authority to assume them.

– Letter from the Allied High Commission to Chancellor Adenauer, Dated Mar. 6, 1951

A Financial Fable by Carl Barks, a short story starring Donald Duck and his duck-relatives, was published in Mar. 1951. It featured concepts like supply/ demand, money shocks, inflation and the ethics of productive labor, from a rather neoclassical perspective. Read today, it seems out of synch with the postwar paradigm of a subordinated monetary policy to the activist state and, more generally, with what came to be known as the Golden Age. As you have already probably noticed, this March also marks the 70th anniversary of two more instances against the currents of the time. It was back then that two main traditions of central bank independence – based on political consensus and judicial (“Chevron”) deference in the case of US, based on written law and judicial review in the case of Eurozone (read: Germany) – were (re)rooted. In the following lines, I offer an outline focused on institutional interplay, instead of then usual dramatis personae. 

The first instance is the well-known Treasury – FED Accord. Its importance warrants a mention in nearly every institutional discussion of modern central bank independence. The FED implemented an interest rates peg – kind of capping the yield curve – in 1942, to accommodate public debt management during World War II. The details were complicated, but we can still think of it as a convenient arrangement for the Executive. The policy continued into the early 50s, with the inflationary backdrop of the Korean War leading to tensions between a demanding Executive and an increasingly resistant central bank. Shortly after the dispute became more pronounced, reaching the media, the two institutions achieved a compromise. The austere paragraph cited above ended the interest rates peg and prompted a shift of thinking within – and without – the central bank, on monetary policy and its independence of fiscal needs.

The second one is definitely more obscure, and as such deserves a little more detail. The Bank deutscher Länder (BdL) was established in 1948, in the Allied territory of occupied Germany. It integrated central banking institutions, old and new, in a decentralized fashion á la US FED. Its creation underpinned the – generally successful – double reform of that year (a currency conversion with a simultaneous abolition of price controls), which reignited free market forces (and also initiated the de facto separation of the country). The Allied Banking Commission (ABC) supervised the BdL and retained the sole right to issue direct instructions, a choice more practical than doctrinal or ideological. As the ABC gradually allowed a greater leeway to the central bank, while fending off even indirect German political interventions, the resulting institutional setting provided for a relatively independent BdL. 

In late 1950, the Occupational Authority wanted out and an orderly transfer of powers required legislation from the Federal Government. Things deadlocked around the draft of the central bank law, the degrees of centralization and independence being the thorniest issues. The letter cited above, arriving after a few months of inertia, was the catalyst for action. The renewed negotiations concluded with the “Interim Law” of 10 Aug. 1951. The reformed BdL was made independent of instructions from the Federal Government, while at the same time assuming an obligation to support government’s general economic policy – without prejudice to its monetary duties. 

This institutional arrangement was akin to what the BdL itself had pushed for, a de jure formalization of its already de facto status. Keep in mind that the central bank enjoyed a head start in terms of reputation and experience versus the Federal Government, after all. But it can also be traced to the position articulated by the free market-oriented majority in the German quasi-governmental bodies back in 1948, a unique blend of explicit independence from/ cooperation with the government. The 1951 law effectively set the blueprint for the final central bank law, the Bundesbank Act of 1957. The underlying liberal creed echoed in the written report of the Chairman of the Committee for Money and Credit of the parliament:

The security of the currency… is the highest precondition for the retention of a market economy, and hence in the final analysis that of a free constitution for society and the state… [T]he note-issuing bank must be independent of these [political bodies] and subject only to the law.

The Financial Fable was the only story featuring Disney’s characters that made it to an important history of comics book, published in 1971. Around that time, the postwar consensus on macroeconomic stabilization policy was reaching its peak. A rethinking was already underway on the tools and goals of monetary policy, taking it away from the still garbled understanding of the period. It took another decade or so for both sides of the Atlantic to recalibrate their respective monetary policies. The accompanying modern central bank independence, with its foundations set in 1951, became a more salient – and popular – aspect a bit later.

Nightcap

Brandon Christensen Links , , ,
  1. Why we fight over fiction Robin Hanson, Overcoming Bias
  2. Why money matters Scott Sumner, MoneyIllusion
  3. Stand up with Aristotle Irfan Khawaja, Policy of Truth
  4. Never reason from a fatality change Nick Cowen, NOL

Davies’ “Extreme Economies” – Part 2: Failure

Joakim Book Books, Economics, Liberty , , , , ,

In the previous part of this three-part review, I looked at Davies’ first subsection (“Survival”) where he ventured to some of the most secluded and extreme places of the world – a maximum security prison, a refugee camp, a tsunami disaster – and found thriving markets. Not in that pejorative and predatory way markets are usually denounced by their opponents, but in a cooperative, resilient and fascinating way.

In this second part, subtitled “The Economics of Lost Potential”, Davies brings us on a journey of extreme places where markets did not deliver this desirable escape from exceptionally restrictive circumstances.

There might be many reasons for why Extreme Economies has become a widely read and praised book. Beyond the vivid characters and fascinating environments described by Davies, this swinging between opposing perspectives is certainly one. Whether your priors are to oppose markets or to favour them, there is something here for you. Davies isn’t “judgy” or “preachy” and the story comes off as more balanced because of it.

If the previous section showed how markets flourish and solve problems even under the most strained conditions, this section shows how they don’t.

Darien, Panama

We first venture to the Darien Gap, the 160-kilometre dense rainforest that separates the northern and southern sections of the Pan-American Highway – an otherwise unbroken road from Alaska to the southern tip of Argentina.

To a student of financial history, “Darien” brings up William Paterson’s miserable Company of Scotland scheme in the 1690s; trying to make Scotland great (again?), the scheme raised a large share of scarce Scottish capital and spectacularly squandered it on trying to build a colony halfway around the world. In the first chapter of subsection ‘Failure’, Davies skilfully recounts the Darien Disaster, “Scotland’s greatest economic catastrophe” (p. 114).

Judging from Davies’ ventures into the jungle bordering Panama and Colombia, it wouldn’t be a far cry to call the present state of affairs a similar economic catastrophe. Rather than failed colonies, the failed potential of Darien lies elsewhere: its environmental challenges coupled with the trade and markets that failed to emerge despite readily available mutual gains for trade.

A stunning landscape of mile after mile filled with rainforests and rivers and the occasional lush farmland, the people of the Gap make a living through extracting what the land provides. If you’re deep into environmentalism, you might even say unsustainably so. Davies’ point is to illustrate a more well-known economic problem: when unowned or communally owned resources suffer from the tragedy of the commons – the tendency is for such resources to be overexploited and ultimately destroyed.

Whether through logging companies exceeding their quotas or locals chopping trees out of desperation to survive, the story in Darien is altogether conventional. At the edge of the Gap, “the people of Yaviza do what they can. [T]he environment is an asset, and for many people living in Yaviza getting by is only possible by chipping a bit off a selling it” (p. 120).

What’s striking here is that in times of need (as Davies himself showed in the chapter on Aceh) that’s exactly what we want assets to do! We can show this in down-to-earth, real-world examples like Acehnese women drawing on their jewellery as emergency savings, or in formal economic models such as the C-CAPM, the Consumption Capital Asset Pricing Model, familiar to every business and finance student.

On a much cruder level: if the mere survival of some of the poorest people on earth depend on chopping down precious trees – well, precious to far-away Westerners, anyway – accusing those people of destroying our shared environment is mind-blowingly daft. To rationalise that equation, you have to put a very large value on turtles and trees, and a very small value on human life.

Elinor Ostrom, whose Nobel Prize in economics was awarded to her work on common pool resources, emphasised three ways to solve tragedies of the commons: clear boundaries (i.e. individual property rights); regular communal meetings such that members can voice opinions and amicably resolve conflicts; a stable population so that reputation matters and we can socially police deviant behaviour (p. 125).

The Darien Gap has none of those. Property rights are routinely ignored; the forest includes many different populations (indigenous tribes, farmers, ex-FARC fugitives, illegal immigrants); and those populations fluctuate a lot, meaning that most interactions are one-shot games where reputation becomes useless. End result: extensive, illegal, unsustainable logging mixed with armed strangers.

What I can’t quite wrap my head around is that almost all (market and non-market) interactions that all of us have daily are with strangers: the barista, the people we walk past on the street, the new client you just met or the customer support agent you just talked to. All of them are strangers. A large share of interactions with other humans in the last few centuries of human societies have been one-offs, yet very few of them have spiral into the lawlessness that Davies describes in Darien. Be it the Leviathan, secure property rights, the doux commerce thesis or some wider institutional or cultural reason, but the failure of Darien to establish well-functioning formal and informal markets of the kind we saw in the book’s first part are intriguing.

While a fascinating chapter, it might also be Davies’ worst chapter, factually speaking. He claims, mistakenly, that “globally, deforestation continues apace with 2016 the worst year on record for tree loss”. On the contrary, we’re approaching global zero net deforestation. More specifically, Davies claims that Colombia and Panama are particularly at risk here, with rates deforestation “increased sharply”. A quick look through UN’s Global Forest Resource Assessment report (latest figures from 2015), these two countries are indeed chopping down their forests – but by less than any other time period on record.  Moreover, the Colombian net deforestation rate of 0.05% per year is easily exceeded by a number of countries; not even Panama’s dismal 0.3%/year (worse than the Brazilian Amazon) is particularly high in a global or historical perspective.

To make matters worse, the figure on p. 158 titled “The World’s Disappearing Tropics” might win an award for the most misleading graph of the year: by making the bars cumulative and downplaying the annual deforestation, it suggests that the forests are rapidly disappearing. The only comparison to relevant numbers (remember, Rosling teaches us to Always Be Comparing Our Numbers) is the tired “football pitches”. That’s hugely misleading. A vast amount of football pitches cleared in the Amazon this year still only amounted to 0.2% of the Brazilian Amazon; in other words, Brazilians could keep chopping down trees for a few good decades without making much of a dent to that vast rainforest.

davies

Moreover, the only reference point we’re given is that over a period of almost twenty years, an area the size of France has been deforested – but that’s equivalent to no more than one-tenth of only the Amazon forest, and the tropics have many more forested areas than that. The graph aims to intimidate us with ever-rising bars signalling the loss of forests; with some proper numbers and further examination it doesn’t seem very bad at all. On the contrary, locals (and yes, international logging companies) use the assets that nature has endowed them with – what’s so wrong with that?

Finally, the “missing market” that Davies observes in the Gap involves countless of illegal immigrants from around the world that trek through the jungles in search of a better life in the U.S. We have cash-rich Indians, willing to pay people to guide them through unknown and dangerous terrain, and local tribes and farmers and ex-FARC members with such knowledge looking for income; setting up a trade between them ought to be elementary.

Instead, it’s not: “in this place of flux,” writes Davies, “reputation does not matter, interactions are one-offs” (p. 137). Overturning the market quip that “trading is cheaper than raiding”, in the Darien Gap raiding is cheaper than trading. One might of course object that the failures of rich countries to offer more liberal immigration rules for people willing to go this far to get there illegally is hardly a market failure – but a failure of government regulation and incompetent bureaucracies.

Kinshasa, Democratic Republic of the Congo (DRC)

A 12-million people city sprawled on the banks of the Congo river, so unknown to Westerners that most of us couldn’t place it on a map. Democratic Republic of the Congo, the country with more people in extreme poverty than any other, is frequently described as “rich”. Or, with Davies’ euphemism “unrivalled potential” (p. 143).

Congo, the argument goes, has “diamonds, tin and other rare metals, the world’s second-largest rainforest and a river whose flow is second only to the Amazon. [it] shares a time zone with Paris [and the] population is young and growing”. It is one of the poorest countries but “should be one of the richest” (p. 143).

No, no and no. Before any other consideration of the remarkable day-to-day trading and corruption that Davies’ interview subjects describe, this mistaken idea about wealth must be straightened out. Wealth isn’t what could be if this or that major obstacle wasn’t in the way (Am I secretly a great singer, if I could only overcome the pesky fact that I have a voice unsuited for singing and lack practice?). This is almost tautological; what we mean by a country being poor is that it cannot overcome obstacles to wealth.

All wealth has to be created; humanity’s default position is extreme poverty.

And natural resources do not equate to wealth – there is even more support suggesting the opposite – in which case Japan and Singapore ought to be poor and Venezuela and DRC rich. My own sassy musings are still largely correct:

As Mises taught us half a century ago – and Julian Simon more recently – wealth (or even ‘goods’ or ‘commodities’ or ‘services’) are not the physical existence of those objects somewhere in the ground, but the satisfaction and valuation derived by the human mind. The object itself is only a means to whatever end the actor has in mind. Therefore, a “resource” is not the physical oil in the ground or the tons of iron ore in the Australian outback, but the ability of Human Imagination and Ingenuity to use those for his or her goals. After all, before humans learned to harnish the beautiful power of oil into heat, combustion engines and industrial production, it was nothing but a slimy, goe-y liquid in the ground, annoying our farmers. Nothing about its physical appearance changed over the centuries, but the mental abilities and industrial knowledge of human beings to use it for our purposes did.

Still, “modern Kinshasa is a disaster everyone should know about” (p. 172). No country has done worse in terms of GDP/capita since the 1960s. And we don’t have to go far to figure out at least part of the reason: the first rule of Kinshasa, says one of Davies’ interviewees, is corruption (p. 145). Everyone “steals a little for themselves as the funds pass through their hands, and if you pay in at the bottom of the pyramid there are hundreds of low-level tax officials competing to claim your cash.” (p. 185). Mobutu, the country’s long-time dictator, apparently said “if you want to steal, steal a little in a nice way” (p. 159).

Whether small stallholders at gigantic market or supermarket-owning tycoons, workers or university professors, pop-up sellers or police officers, everyone in Kinshasa uses every opportunity they can to extract a little rent for themselves – out of desperation more than malice. And everyone hates it: “The Kinoise”, writes Davies, “understand that these things should not happen, but recognize that their city’s economy demands a more flexible moral code.” (p. 168).

Interestingly enough, DMC is not a country whose state capacity is insufficient; it’s not a “failed state”, an “absent or passive” government whose cities are filled with “decaying official buildings and unfilled civil-service positions.” (p. 148). On the contrary:

The government thrives, with boulevards lined with the offices of countless ministries thronged by thousands of functionaries at knocking-off time. The Congolese state is active but parasitic, a corruption superstructure that often works directly against the interests of its people.

Poorly-paid police officers set up arbitrary roadblocks and extract bribes. Teachers demand a little something before allowing their pupils to pass. Restaurant owners serve their best food to their civil service regulators, free of charge, to even stay in business. Consequently, despite an incredibly resilient and innovative populace, “these innovative strategies are ultimately economic distortion reflecting time spent inventing ways to avoid tax collectors, rather than driving passengers or selling to customers” (p. 162).

But, like the ingenious monetary system of Louisiana prisons, the most fascinating aspect of Kinshasa’s economy is its use of money. Arbitrage traders head across the river to Brazaville in neighbouring Republic of the Congo equipped with dollars which they swap for CFA – the currency of six central African countries, successfully pegged to the euro. With ‘cefa’ they buy goods at Brazaville prices, goods they bring back over the river and undercut exorbitant Kinshasa prices. Selling in volatile and unstable Congolese francs carries risk, so Kinshasa’s streets are littered with currency traders offering dollars – at bid-ask spreads of less than 2%, comparing favourably with well-established Western currency markets. Before most transactions, Kinoise stop by an exchange trader sitting outside restaurants or malls, to acquire some Congolese francs with which to pay. Almost, almost dollarisation.

In Kinshasa, people rely on illegal trading as a safety net when personal disaster strikes or the state’s required bribes become too extortionary. Davies’ point is a convincing one, that “a town, city or country can get stuck in a rut and stay there” (p. 174).

Judging from his venture into Kinshasa, it’s difficult to blame markets for that. I don’t believe I’m invoking a No True Scotsman fallacies by saying that a market whose participants spent half their time avoiding public officials and the other half bribing them to avoid arbitrarily made-up rules, is pretty far from a free market.

Believing the opposite is also silly – that markets and mutual gains from trade can overcome any obstacles placed before them. Governments, culture or institutions have power to completely eradicate the beneficial outcomes of markets – Kinshasa’s extreme poverty attests to that.

Glasgow, the last part of ‘Failure’, is discussed in a separate post.

Davies’ “Extreme Economies” – Part 1: Survival

Joakim Book Books, Economics, Liberty , , , , , ,

Late to the party, I relied on the quality-control of the masses before I plunged into Richard Davies’ much-hyped book Extreme Economies: Survival, Failure and Future – Lessons from the World’s Limits (see reviews by Diane Coyle and Philip Aldrick). I first heard about it on some Summer Reading List – or perhaps Financial Times’ shortlist for best books of 2019. What really prompted me to read it, however, was an unlikely source: The Guardian’s long-read in late-August. Davies adopted his Louisiana Prison chapter and described the intricate ways prisoners and guards in maximum-security prison Louisiana State Penitentiary (“Angola”) exchange value using the top-up debit card Green Dot and single-use MoneyPak cards. I was hooked.

Davies’ captivating and personal writing in that 4000-word piece made me want to read the full thing. Once I got around to it, I couldn’t put it down – which is the best compliment an author can get. At little over 400 pages of easy non-jargon prose, it doesn’t take too long to get through – and the nine case-study chapters can easily be read on their own. Further attesting to the brilliance of the book are the many questions it raised with me, insights to investigate further.

The book’s structure is simple to follow: three themes ‘Survival’ (“The Economics of Resilience”), ‘Failure’ (“The Economics of Lost Potential”) and ‘Future’ (“The Economics of Tomorrow”), each containing three fascinating places, wrapped between an introductory and a concluding chapter.

The motivation for the book is a mixture of John Maynard Keynes and a Scottish 19th century civil engineer named David Kirkaldy. The latter’s big idea was studying “why materials buckled and bent under pressure” (p. 31); to fully grasp the potential for something, we need to examine why they fall apart. From Keynes Davies took the idea that the future is already partly here:

“We can get a glimpse of the future today, if we know where to look. The trick was to identify a sustained trend – a path most people are following – and look at the lives of those experiencing the extremes of that trend. […] to zoom forward in time, he said, we need to find those whose lives are like this already.” (p. 31)

Davies ventures to nine places of the world, all extreme in some aspect, and investigates the everyday economic challenges that people face and the ingenious ways in which they do – or do not – solve them. By carefully looking at the present, he posits to gauge something about the future.

In this first part – ‘Survival’ – I look at Davies’ three selections (Aceh, Indonesia; Zaatari, Jordan; and Louisiana, U.S.). The next part contains the case studies of ‘Failure’ (Darien, Panama; Kinshasa, DRC; Glasgow, Scotland) and the concluding part looks at ‘Future’ (Akita, Japan; Tallinn, Estonia; and Santiago, Chile). As I have personal experience of living in two of these places while knowing virtually nothing about many of the others, I reserve some complementary reflections on Glasgow and Santiago when appropriate.

Aceh, Indonesia

On Dec 26, 2004, an Indian Ocean earthquake created a tsunami that devastated coastlines from Thailand to Madagascar. Two-thirds of the 230,000 human lives lost were in Indonesia, mostly in the Aceh province on the northern tip of Sumatra, closest to the earthquake’s epicentre. Pictures taken before and after show how complete the destruction was; except for a few sturdy mosques, nothing was left standing.

A few years later, the busy streets and crowded beaches were pretty much back to normal. How?

Davies’ story does not emphasise aid flows or new investment by outsiders, but “informal systems of trade, exchange and even currency” (p. 49), an aspect that generally “goes unmeasured an unassessed” (p. 65). Aceh’s catastrophe is a story of human resilience and of intangibles.

The people Davies interviewed told him how the ancient Aceh practice of keeping savings in wearable and portable gold – necklace, rings, bangles – provided survivors who had lost everything with a source of funds to draw on. Importantly, a gold dealer told him, as the market price of gold is set internationally, the massive sell orders coming in simultaneously did not affect prices very much. Additionally, the dealer’s knowledge of market prices and contacts in Jakarta allowed him to quickly set up his business again. Buying Acehnese’s gold during those crucial months, way before foreign aid or government could effectively respond, provided people with funds to rebuild their lives. Traditional practices “insulated Aceh and provided its entrepreneurs with rapid access to cash” (p. 49).

Another insightful observation is the role played by intangibles – the knowledge of how and where and when that most of our economies depend on. Sanusi, 52-year-old coffee trader, lost everything: his shop, his equipment, his family. Amid his devastation he realized that one thing that the tsunami had not destroyed was his knowledge of the coffee business – where to source the best beans, how to make it, where and when to sell the coffee. He patched together some spare planks, used his business contacts to provide him with trade credit and had his rudimentary coffee business set-up in time for the arrival of coffee-drinking construction and aid-agency workers.

Davies also gives us a very balanced GDP discussion here, as the years after the December 2004 disaster saw huge GDP growth. Most economists would reflexively object and invoke Bastiat’s Broken Window Fallacy. Yes, Davies is well aware, but he’s getting at something more subtle:

“GDP aims to capture what a country’s residents are doing now, rather than what they have done previously. [It is] all about current human activities – spending, wages, income, producing goods – rather than the value embodied in physical assets such as building and factories. Far from being a mean or cold measure, economists’ favourite yardstick is a fundamentally human one.” (p. 53, 65)

To GDP, what you produced in the past is of no consequence. Clearly, when the tsunami devastated the coastline of Aceh, killing hundreds of thousands of people in the process and wiping away houses, factories and equipment, that made everyone poorer – their assets and savings and capital were literally washed away. Considering the massive construction boom that followed, only partly financed by outside aid and government money, it is not incorrect to say that GDP boomed; it is only incorrect to believe that people were made better off because of the disaster. Bastiat teaches us that they were not.

I think of this as the difference between your total savings (in cash, stocks, bank accounts, houses, jewelry) and your monthly income, a difference between “stock” and “flow”. If, like many Acehnese that Davies interviewed, your earnings-potential depend on your knowledge of your industry, your most valuable assets remain untouched even after a complete disaster. Your savings – your capital, your stuff – are completely eradicated, but the basis for your future income remains intact. With some minor equipment – a trade credit, some furniture, a shop patched together with flotsam – you can quickly approach the production and income you had before. GDP attempts to measure that income – not the current value of total assets.

“The people here,” Davies concludes, “lost every physical asset but the tsunami survivors retained skills and knowledge from before the disaster, and rebuilt quickly as a result.” (p. 66).

Zaatari, Jordan

Following the Syrian civil war and its exodus of refugees, camps were set up in many neighbouring countries. Often run by the UN, these camps ensure minimum survivability and life-support for refugees and are rather centrally-planned; the UNHCR hands out blankets, assigns tents and provides in-kind goods and services (food, medicine etc).

In April 2013, the Zaatari camp in the northern Jordan desert had grown to over 200,000 inhabitants, with daily inflows of up to 4,000 refugees. It was too much – and the UNHCR “ran out of manpower” (p. 70). They rationalised operations, focused on their core tasks – and left individuals alone to trade, construct and flourish on their own. It became a lesson in anarchic cooperation and of the essentiality of markets – and, like the Louisiana prison economy below, an ingenious monetary system.  It “did not happen by design, but by accident”, Davies writes, and constitutes “an economic puzzle worth unpicking” (p. 72) only if you doubt the beneficial consequences of markets and free people. If you don’t, the result is predictable.

Every month, the Zaatari camp administrators load up payment cards for the refugees with 20 dinars (£23) per person, spendable only in the two camp supermarkets. Designed to be a cashless economy, the money flowed directly from donors to the supermarkets: “refugees cannot transfer cash between wallets, so aid money designated for food cannot be spent on clothes, and the winter clothing allowance cannot be spent on food” (p. 79).

This extreme and artificial economy teaches us something universal about markets; imposed orders, out of touch with market participants’ demands, malfunctions and create huge wastes. Complete monetary control by outsiders, Davies writes, “fails the basic test of any well-functioning market – to be a place where demand meets supply” (pp. 80-81). Supermarkets lacked the things refugees wanted, and they stocked up on things that reflected kickbacks to donor countries (Italian spaghetti or Brazilian coffee), entirely out of sync with Syrian cuisine and preferences. And the unorganic, artificially-set prices were entirely detached from the outside world.

Yet, the refugee city of Zaatari is a flourishing economy where people build, make and trade all kinds of things. How did this happen? Innovative Syrians found a way around their monetary restrictions: the economy of Zaatari “rests on the conversion of homes to business and flipping aid credit, via smuggling, into hard cash” (p. 88). Informal and free markets, at their best.

Along most of the camp’s boundaries, there are no fences, only roads – and the huge number of children playing ball games on the concrete roads or running in and out of the camp, makes identifying who’s a refugee and who’s a teenage smuggler next to impossible. What the refugees did was:

  • buy some item in the supermarket using the e-card credits provided by UNHCR
  • sell it to smugglers for less than their outside market value and obtain hard cash in return
  • smugglers slip out of the camp and sell the goods to Jordanians and other driving past, taking a cut for themselves.

Bottom line: refugees turned 20 dinars of illiquid and restricted e-credit into hard cash, spendable on anything anywhere in the camp. The productive powers of 200,000 refugees was unleashed. In Zaatari, the presence of smugglers allowed large-scale interactions with the outside world – and so the artificially-created closed-loop payment system did not remain closed. Instead, it was connected to the outside Jordanian economy through smuggling!

The take-away point is to cherish market activities, even informal ones, since they “matter to everyone and are fundamentally human” (p. 102). Governments plan and creates problems; markets solve them.

Louisiana State Prison

Analogous to the Zaatari refugees, prisoners in Louisiana’s maximum-security prison (“Angola”) find themselves in a similar economic squeeze: unsatisfied demand and large shortage of goods, artificial constraints on what prisoners can and cannot own. Prisons are places where official prices don’t work: paltry “incomes” through mandatory work stand in no relation to the officially-mandated prices of goods that prisoners can buy at commissary. Accusations of modern slavery comes to mind. The “official price system,” Davies writes, “has been intentionally broken” (p. 119).

To escape their formal and restricted economy, prisoners have long relied on smuggling. Radford’s famous article about cigarettes becoming money in a WWII Prisoners-of-War camp applied – until Angola officials decided to ban tobacco from the premises. Cash too risky to hold; age-old money banned. What now? Fintech to the rescue!

Louisiana prisons “have a remarkable new currency innovation, something far better than tobacco or cans of mackerel”. Physical dollar bills are not handled, bank accounts that leave digital traces are not linked to individuals: “people pay each other with dots”, says an ex-convict that Davies interviewed (p. 132).

Contrary to the belief that smuggling into prisons happen through corrupt prison guards only, prisoners have some power; they can stage riots or make guards’ everyday-life very hard by misbehaving in every imaginable way. That power gives prisoners and guards alike incentives to trade with another – but prisoners don’t have anything to offer, apart from occasional or indivisible services like car repairs or (like Andy Dufresne in the movie Shawshank Redemption) accounting services. And paying guards in commissary products is not gonna cut it.

Here’s how Angola prisoners solved their monetary constraints, obtaining means of payment to smuggle in items their economy’s participants demanded:

  • set up an account with Green Dot, providing a pre-paid debit card without requirements of ID or proof of address.
  • buy a second card, a single-use scratch card called MoneyPak, used to load the first card with anywhere between $20 and $500. These cards are usable anywhere that accepts VISA and Mastercards, and easily bought/cashed out at Walmarts or pharmacies.
  • Scratch away MoneyPak’s 14-digit number (“the dots”), and transfer those digits to somebody else, be it another prisoner or guard.
  • that person goes online, logs into their Green Dot account, enters the combination and credit is added to their debit card.

The dots, Davies describes, “are a currency close to cash: an instant, simple and safe transfer of value over long distance” (p. 134). Even prison economies, argues Davies, “show that the human urge to trade and exchange information is impossible to repress” (p. 136).

The Economics of Resilience

The power of informal economies are great – and essential to people cut off from regular economic processes. Through natural disasters, in refugee camps or in prisons, innovative people find ways around their imposed-upon constraints and “establish a trading system if theirs is damaged, destroyed or limited in some way”. (p. 135)

Aceh, Zaatari and the Angola prison show “three places where markets, currencies, trade and exchange exist despite all odds.” (p. 139).

Nightcap

Brandon Christensen Links , , ,
  1. Antisemitism was anti-capitalist and anti-communist Colin Schindler, History Today
  2. The invention of money John Lanchester, New Yorker
  3. Why do we look to Science as a guide for living? Ronald Dworkin, Law & Liberty
  4. Salman Rushdie’s hyperloquacity Matt Hill, Literary Review

A Short Note on Fraudulent Banking

Joakim Book Economics, History, Liberty , , ,

In my piece over at American Institute for Economic Research the other week, I discussed the phenomenon of selling property that one does not (yet) own. I mentioned a left-wing and a right-wing version, but focused my efforts mostly on the right-wing “Fractional-Reserve-Banking-is-Fraud” idea.

My main point was to, by analogy, point to other fiduciary relationship – specifically insurance and airline overbooking – that fulfil the same criteria of double-ownership that is so crucial for the right-wing view. Insofar as this analogy holds, rejecting fractional reserve banking as fraudulent and illegal requires one to similarly reject insurance policies and airlines’ practice of overbooking. Regardless of where one comes down on the legal relationship between a depositor and a bank, I thought the theme interesting to explore.

Unknown to me, in one of Hoppe-Hülsmann-Block’s (HHB) early articles they devoted about two pages to addressing my main points. To HHB, there’s a “fundamental distinction” between property and property titles that render these and other analogies “mistaken”: future vs present goods. Money titles such as fractionally issued bank notes are designated present goods whereas insurance policies, parking permits or flight tickets are considered future goods. Money is the “present good par excellence“ to use Rothbard’s words.

HHB claims that one can legally oversell future goods, but when overselling present goods, one is committing fraud. A narrow distinction, admittedly, and we’ll see that it doesn’t fare so well. Discussing the example of airline overbooking, this distinction does momentarily save HHB from condemning airlines; yes, the airline is selling a flight at a future date, which seems meaningfully different from the instantly-available present goods bank notes ought to be. But the thing about the future is that it inevitably and predictably becomes the present. Once that future arrives, HHB explicitly admits that having more passengers at the gate than they have seats on the plane does amount to fraud. Strangely, however, HHB exonerate airlines since they are “prepared to pay every excess ticket holder off”.

Oh, and fractional reserve banks aren’t?

At this point their already weak defense falls apart. Every instance of historical bank runs include management, shareholders and governments doing precisely that: slowing down the run by paying employees, friends or relatives to deposit funds; acquiring new funding (either debt or equity) to pay off skittish depositors who want their present goods right away; or my own personal favorite, as a good student of Scottish financial history: the Option Clause!

HHB say that airlines are not committing fraud since once at the gate – on the verge of having their oversold future goods transform into present goods – they stand ready to

“repurchase [the passenger’s] ticket at a price (by exchange of another good) that the holder considers more valuable than his present airline seat.”(HHB 1998: 47)

Let’s see what the financially innovative Scots did. Their notes were subject to a legal clause, allowing management to ‘mark’ particular notes when offered up for redemption. That meant deferring the redemption claim for six months, effectively transforming the present good (the money title) into a future good (money title in six months), at the maximum legal rate of interest of 5%. That sounds like a good “the holder considers more valuable”, especially considering that these notes were effortlessly accepted in trade – i.e., the holder could instantly turn around and buy things with this note, its value gradually appreciating as the six-month date arrived.  In practice, this deterrent was only used infrequently, and then almost exclusively against English currency speculators.

Indeed, extrapolating this point, as I do in a forthcoming piece on maturity-mismatch (and have flaunted in Austrian conferences), illustrate how little practical and economic difference there would be between the opposing and deeply-entrenched Fractional-Reserve-Banking camps.

Regardless, it seems the airline-insurance-parking permit analogy still stands.

Monetary Progression and the Bitcoiner’s History of Money

Joakim Book Economics, History , , , , , , ,

In the world of cryptocurrencies there’s a hype for a certain kind of monetary history that inevitably leads to bitcoin, thereby informing its users and zealots about the immense value of their endeavor. Don’t get me wrong – I laud most of what they do, and I’m much looking forward to see where it’s all going. But their (mis)use of monetary history is quite appalling for somebody who studies these things, especially since this particular story is so crucial and fundamental to what bitcoiners see themselves advancing.

Let me sketch out some problems. Their history of money (see also Nick Szabo’s lengthy piece for a more eloquent example) goes something like this:

  • In the beginning, there was self-sufficiency and the little trade that occurred place took place through barter.
  • In a Mengerian process of increased saleability (Menger’s word is generally translated as ‘saleableness’, rather than ‘saleability’), some objects became better and more convenient for trade than others, and those objects emerged as early primative money. Normally cherry-pick some of the most salient examples here, like hide, cowrie shells, wampum or Rai stones.
  • Throughout time, precious metals won out as the best objects to use as money, initially silver and gradually, as economies grew richer, large-scale payments using gold overtook silver.
  • In the early twentieth century, evil governments monopolized the production of money and through increasingly global schemes eventually cut the ties to hard money and put the world on a paper money fiat standard, ensuring steady (and sometimes not-so-steady) inflation.
  • Rising up against this modern Goliath are the technologically savvy bitcoiners, thwarting the evil money producing empires and launching their own revolutionary and unstoppable money; the only thing that stands in its way to worldwide success are crooked bankers backed by their evil governments and propaganda as to how useless and inapt bitcoin is.

This progressively upward story is pretty compelling: better money overtake worse money until one major player unfairly took over gold – the then-best money – replacing it with something inferior that the Davids of the crypto world now intents to reverse. I’m sure it’ll make a good movie one day. Too bad that it’s not true.

Virtually every step of this monetary account is mistaken.

First, governments have almost always defined – or at least seriously impacted – decisions over what money individuals have chosen to use. From the early Mesopotamian civilizations to the late-19th century Gold Standard that bitcoin is often compared to, various rulers were pretty much always involved. Angela Redish writes in her 1993 article ‘Anchors Aweigh’ that

under commodity standards – in practice – the [monetary] anchor was put in place not by fundamental natural forces but by decisions of human monetary authorities. (p. 778)

Governments ensured the push to gold in the 18th and 19th centuries, not a spontaneous order-decentralized Mengerian process: Newton’s infamous underpricing of silver in 1717, initiating what’s known as the silver shortage; Gold standard laws passed by states; large-scale network effects in play in trading with merchants in those countries.

Secondly, Bills of Exchange – ie privately issued debt – rather than precious metals were the dominant international money, say 1500-1900. Aha! says the bitcoiner, but they were denominated in gold or at least backed by gold and so the precious metal were in fact the real outside money. Nope. Most bills of exchange were denominated in the major unit of account of the dominant financial centre at the time (from the 15th to the 20th century progressively Bruges, Antwerp, Amsterdam and London), quite often using a ghost money, in reference to the purchasing power of a centuries-old coins or social convention.

Thirdly, monetary history is, contrary to what bitcoiners might believe, not a steady upward race towards harder and harder money. Monetary functions such as the medium of exchange and the unit of account were seldomly even united into one asset such as we tend to think about money today (one asset, serving 2, 3 or 4 functions). Rather, many different currencies and units of accounts co-emerged, evolved, overtook one another in response to shifting market prices or government interventions, declined, disappeared or re-appeared as ghost money. My favorite – albeit biased – example is early modern Sweden with its copper-based trimetallism (copper, silver, gold), varying units of account, seven strictly separated coins and notes (for instance, both Stockholms Banco and what would later develop into Sveriges Riksbank, had to keep accounts in all seven currencies, repaying deposits in the same currency as deposited), as well as governmental price controls for exports of copper, partly counteracting effects of Gresham’s Law.

The two major mistakes I believe bitcoiners make in their selective reading of monetary theory and history are:

1) they don’t seem to understand that money supply is not the only dimension that money users value. The hardness of money – ie, the difficulty to increase supply – as an anchoring of price levels or stability in purchasing power is one dimension of money’s quality – far from the only. Reliability, user experience (not you tech nerds, but normal people), storage and transaction costs, default-risk as well as network effects might be valued higher from the consumers’ point of view.

2) Network effects: paradoxically, bitcoiners in quibbling with proponents of other coins (Ethereum, ripple, dash etc) seem very well aware of the network effects operating in money (see ‘winner-takes-it-all’ arguments). Unfortunately, they seem to opportunistically ignore the switching costs involved for both individuals and the monetary system as a whole. Even if bitcoin were a better money that could service one or more of the function of money better than our current monetary system, that would not be enough in the presence of pretty large switching costs. Bitcoin as money has to be sufficiently superior to warrant a switch.

Bitcoiners love to invoke history of money and its progression from inferior to superior money – a story in which bitcoin seems like the natural next progression. Unfortunately, most of their accounts are lacking in theory, and definitely in history. The monetary economist and early Nobel Laureate John Hicks used to say that monetary theory “belongs to monetary history, in a way that economic theory does not always belong to economic history.”

Current disputes over bitcoin and central banking epitomize that completely.

Economists vs. The Public

Joakim Book Economics , , , , , , ,

Economics is the dismal science, as Thomas Carlyle infamously said, reprising John Stuart Mill for defending the abolishment of slavery in the British Empire. But if being a “dismal science” includes respecting individual rights and standing up for early ideas of subjective, revealed, preferences – sign me up! Indeed, British economist Diane Coyle wisely pointed out that we should probably wear the charge as a badge of honor.

Non-economists, quite wrongly, attack economics for considering itself the “Queen of the Social Science”, firing up slurs, insults and contours: Economism, economic imperialism, heartless money-grabbers. Instead, I posit, one of our great contributions to mankind lies in clarity and, quoting Joseph Persky “an acute sensitivity to budget constraints and opportunity costs.”

Now, clarity requires one to be specific. To clearly define the terms of use, and refrain from the vague generality of unmeasurable and undefinable concepts so common among the subjects over whom economics is the queen. When economists do their best to be specific, they sometimes use terms that also have a colloquial meaning, seriously confusing the layman while remaining perfectly clear for those of us who “speak the language”. I realize the irony here, and therefore attempt my best to straighten out some of these things, giving the examples of 1) money and 2) investments.

An age-old way to see this mismatch is measuring the beliefs held by the vast majority of economists and the general public (Browsing the Chicago IGM surveys gives some examples of this). Bryan Caplan illustrates this very well in his 2006 book The Myth of the Rational Voter:

Noneconomists and economists appear to systematically disagree on an array of topics. The SAEE [“Survey of Americans and Economists on the Economy”] shows that they do. Economists appear to base their beliefs on logic and evidence. The SAEE rules out the competing theories that economists primarily rationalize their self-interest or political ideology. Economists appear to know more about economics than the public. (p. 83)

Harvard Professor Greg Mankiw lists some well-known positions where the beliefs of economists and laymen diverge significantly (rent control, tariffs, agricultural subsidies and minimum wages). The case I, Mankiw, Caplan and pretty much any economist would make is one of appeal to authority: if people who spent their lives studying something overwelmingly agree on the consequences of a certain position within their area of expertise (tariffs, minimum wage, subsidies etc) and in stark opposition to people who at best read a few newspapers now and again, you may wanna go with the learned folk. Just sayin’.

Caplan even humorously compared the ‘appeal to authority’ of other professions to economists:

In principle, experts could be mistaken instead of the public. But if mathematicians, logicians, or statisticians say the public is wrong, who would dream of “blaming the experts”? Economists get a lot less respect. (p. 53)

Money, Wealth, Income

The average public confusingly uses all of these terms interchangeably. A rich person has ‘money’, and being rich is either a reference to income or to wealth, or sometimes both – sometimes even in the same sentence. Economists, being specialists, should naturally have a more precise and clear meaning attached to these words. For us Income refers to a flow of purchasing power over a certain period (=wage, interest payments), whereas Wealth is a stock of assets or “fixed” purchasing power; my monthly salary is income whereas the ownership of my house is wealth (the confusion here may be attributable to the fact that prices of wealth – shares, house prices etc – can and often do change over short periods of time, and that people who specialize in trading assets can thereby create income for themselves).

‘Money’, which to the average public means either wealth or income, is to the economist simply the metric we use, the medium of exchange, the physical/digital object we pass forth and back in order to clear transactions; representing the unit of account, the thing in which we calculate money (=dollars). That little green-ish piece of paper we instantly think of as ‘money’. To illustrate the difference: As a poor student, I may currently have very little income and even negative wealth, but I still possess money with which I pay my rent and groceries. In the same way, Bill Gates with massive amounts of wealth can lack ‘money’, simply meaning that he would need to stop by the ATM.

Investment

A lot like money, the practice of calling everything an ‘investment’ is annoying to most economists: the misuse drives us nuts! We’re commonly told that some durable consumption good was an investment, simply because I use it often; I’ve had major disagreements friends over the investment or consumption status of a) cars, b) houses, c) clothes, and d) every other object under the sun. Much like ‘money’, ‘investment’ to the general public seem to mean anything that gives you some form of benefit or pleasure. Or it may more narrowly mean buying financial assets (stocks, shares, derivatives…). For economists, it means something much more specific. Investopedia brilliantly explains it: The definition has two components; first, it generates an income (or is hoped to appreciate in value); secondly, it is not consumed today but used to create wealth:

An investment is an asset or item that is purchased with the hope that it will generate income or will appreciate in the future. In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth.

This definition clearly shows why clothes, yoga mats and cars are not investments; they are clearly consumption goods that, although giving us lots of joy and benefits, generates zero income, won’t appreciate and is gradually worn out (i.e. consumed). Almost as clearly, houses (bought to live in) aren’t investments (newsflash a decade after the financial crisis); they generate no income for the occupants (but lots of costs!) and deteriorates over time as they are consumed. The only confusing element here is the appreciation in value, which is an abnormal feature of the last say four decades: the general trend in history has been that housing prices move with price inflation, i.e. don’t lose value other than through deterioration. In fact, Adam Smith said the very same thing about housing as an investment:

A dwelling-house, as such, contributed nothing to the revenue of its inhabitant; and though it is no doubt extremely useful to him, it is as his cloaths and household furniture are useful to him, which however make a part of his expence, and not his revenue. (AS, Wealth of Nations, II.1.12)

Cars are even worse, depreciating significantly the minute you leave the parking lot of the dealership. Where the Investopedia definition above comes up short is for business investments; when my local bakery purchases a new oven, it passes the first criteria (generates incomes, in terms of bread I can sell), but not the second, since it is generally consumed today. Some other tricky example are cases where political interests attempt to capture the persuasive language of economists for their own purposes: that we need to invest in our future, either meaning non-fossil fuel energy production, health care or some form of publicly-funded education. It is much less clear that these are investments, since they seldom generate an income and are more like extremely durable consumption goods (if they do classify on some kind of societal level, they seem like very bad ones).

In summary, economists think of investments as something yielding monetary returns in one way or another. Either directly like interest paid on bonds or deposits (or dividends on stocks) or like companies transforming inputs into revenue-generating output. It is, however, clear that most things the public refer to as investments (cars, clothes, houses) are very far from the economists’ understanding.

Economists and the general public often don’t see eye-to-eye. But improving the communication between the two should hopefully allow them to – indeed, the clarity with which we do so is our claim to fame in the first place.

Revised version of blog post originally published in Nov 2016 on Life of an Econ Student as a reflection on Establishment-General Public Divide.

On Scottish Free Banking (a Canadian Perspective)

Vincent Geloso Economics, Liberty , , , ,

Yesterday, George Selgin responded on Alt-M to a series of (relatively) recent paper that posit the impossibility of private money. While Selgin does criticize the theoretical reasoning of the papers, the majority of his case is based on the historical experience of private money – notably the Scottish experience with free banking.

I wanted to write something on this, but Selgin got there faster. Indeed, the historical evidence of free banking in Canada, Scotland, Sweden and the limited experiences observed in France and elsewhere provide a strong backing for soundness of private money. Selgin is right to emphasize this.

However, I can provide a small piece of evidence to support his case. It is not only scholars like Selgin who believe that the historical experience of Scotland was positive. As far back as 1835 and as far away as Canada, the robustness of the Scottish free banking experience was lauded. Consider the following quote from a report to the House of Assembly of Upper Canada (modern day Ontario):

“In Scotland, private banking has long existed and fewer failures have occurred there than in any other part of the world; their Joint Stock Banking Companies embrace some of the following principles by which the public are quite secured and the institutions useful as Banks of Deposit and circulation, while the stock is above par, and proved to be a good investment”

This report was actually presented in Canada arguing that Scottish free banking was a solution to a longstanding problem in the colony : dearth of small denominations. The “big problem of small change” was a real issue in the colony and created important frictions. The problem was most likely created by the fixing of exchange rates between the different currencies at levels dissonant with the actual value of different currencies so that “bad money drove out good money” (see Angela Redish’s work). The report recommended legislative actions to encourage the formation of banks that would issue private notes to solve this problem. Newspapers in the neighboring colony of Lower Canada also praised (in the early 1830s) the role that banks played in easing the problem of “poor money”.

I have made an initial foray on this with Mathieu Bédard of Aix-Marseille School of Economics (and we plan to make another few) and  showed that the role of free banking in improving economic growth was considerable exactly because of the issue of private money. While Canada is a small, it provides some additional support to the claim that private money can indeed exist, survive and be superior to state money.

Source:  House of Assembly of Upper Canada. 1835. Report of the Select Committee to which was referred the subject of The Currency. Toronto : M.Reynolds Printer.

P.S. Below there is a picture of a half-penny issued by the Quebec Bank in 1837 showing that there was even private coinage in Canada.

IMG_6955

NGO v. NGDP: In reply to Nunes and Sumner

Vincent Geloso Economics, Liberty , , , , , , , , , , ,

A week ago, I initiated a discussion on using another indicator of nominal spending instead of NGDP when the time comes to set monetary policy. My claim was that NGDP includes only final goods and as a result, it misses numerous business-to-business transactions. This means that NGDP would not be the best indicator. I propose a shift to a measure that would capture some intermediate transactions.

The result was a response by Nick Rowe (to which I did respond), Matt Rognlie, Marcus Nunes and Scott Sumner (to whom I am responding now). Nunes and Sumner are particularly skeptical of my claim. I am providing a first response here (and I am attempting to expand it for a working paper).

The case against NGDP

GDP has important shortcomings. First of all, thanks to the work of Prescott and McGrattan (2012 : 115-154), we know that a sizable part of capital goods acquisition fails to be included inside GDP. That sizable part is “intangible capital” which Prescott and McGrattan define as the “accumulated know-how from investing in research and development, brands, and organizations which is the most part expensed rather than capitalized” (p.116).  Yet, investments in research and development are – in pure theoretical terms – like the acquisition of capital goods. However, national accounts exclude those. Once they’re included in papers like those of Prescott and McGrattan and those of Corrado, Hulten and Sichel (2009), increases in productivity were faster prior to 2008 and that the collapse after 2008 was much more pronounced.  In addition, this form of capital is increasing much faster than tangible so that its share of the total capital stock increases. Thus, the error of not capturing this form of capital good investment is actually growing over time causing us to miss both the level and the trend.

A second shortcoming of importance is the role of time in production. Now, just the utterance of these words makes me sound like an Austrian. Yet, this point is very neoclassical since it relies on the time to build approach. In the time-to-build model of the real business cycle approach, production occurs over many periods. Thus changes in monetary policy may have some persistence.  The time-to-build model proposes that firms undertake long projects and consume more inputs. In terms of overall transactions, this will mean more and more business to business (B2B) transactions.  Hence if an easy monetary policy is inciting individuals to expand their number of projects that have more distant maturities, then a focus on GDP won’t capture the distortionary effects of that policy through. Similarly, if monetary policy tightens (either directly as a fall of the money supply or through an uncompensated change in velocity), the drop in economic activity as projects are closed down will not equally well captured. While this point was initially advanced by Kyland and Prescott (1982), some Austrians economists have taken up the issue (Montgomery 1995a; 1995b; 2006; Wainhouse 1984; Mulligan 2010), several neoclassicals have also taken it up (Kühn 2007; Kalouptsidi 2014; Kyland, Rupert, Sustek, 2014).

Why shift to another measure

My contention is that NGO (Nominal Gross Output) allows us to solve a part of that problem. First of all, NGO is more likely to capture a large share of the intangible capital part since, as a statistic, it does not concern itself with double counting. Hence, most of the intangible capital expenses are captured. Secondly, it also captures the time-to-build problem by virtue of capturing inputs being reallocated to the production of projects with longer maturities.

Thus, NGO is a better option because it it tries to capture the structure of production. The intangible capital problem and the time to build problem are both problems of intermediate goods. By capturing those, we get a better approximate idea of the demand for money.

Let me argue my case based on the Yeager-esque assumption that any monetary disequilibrium is a discrepancy between actual and desired money holdings at a given price level. Let me also state the importance of the Cantillon effects whereby the point of entry of money is important.

If an injection of money is made through a given sector that leads him to expand his output, the reliability of NGDP will be best if the entry-point predominantly affects final goods industry. If it enters through a sector which desires to spend more on intangible investments or undertake long-term projects, then the effects of that change will not appear as they will merely go unmeasured. They will nonetheless exist. Eventually firms will realize that they took credit for these projects for which the increased output did not meet any demand. The result is that they have to contract their output by a sizable margin. In that case, they will abandon those activities (imagine unfinished skyscrapers or jettisoned research projects).

In such situations, GO (or even a wider measure of gross domestic expenditures) are superior to GDP. And in cases where the effects would start in final-goods industry, then they have the same efficiency as GO (or the wider measure of gross domestic expenditures.

The empirical case

The recurring criticism in most posts is that NGO is volatile over the period when the data is available (2005Q1-today). True, the average growth rate of NGO is the same as NGDP over the same period, but the standard deviation is nearly twice that of NGDP. However if you exclude the initial shock of the recession, the standard deviations converge. In a way, all the difference in volatility between the two series is driven by the shock of the recession. Another way to see it is to recompute two graphs. One is an imitation of the graphs by Nunes where NGDP growth in period T is compared with growth in the period T minus 1, but we add NGO. The second is the ratio of NGO to NGDP.

As one can see from the first figure, NGO and NGDP show the same relation except for a cluster of points at the bottom for NGO. All of those lower points are related to the drop from the initial recession. All concentrated at the bottom. This suggests that the recession had a much deeper effect than otherwise believed. The second graph allows us to see it.

Nunes

The ratio of NGO to NGDP shows that the two evolved roughly the same way over the period before the recession. However, when the recession hit, the drop was more important and the ratio never recovered!  This suggest a much deeper deviation from the long-term trend of nominal spending which is not seen at the final level but would be seen rather in the undertaking of long-term projects and the formation of intangible capital (the areas that NGDP cannot easily capture).

Ratio.png

The case for NGO over NGDP is solid. It does not alter the validity of the case for nominal spending stability. However since the case for nominal spending stability hinges on total transactions of inputs and outputs more than it does on the final goods sold, NGO is a better option.

 

Quick comment in response to Rognlie 
In his reply to Nick Rowe, Matt Rognlie states that the more important fall of NGO is explained by changes in relative prices. Although his transformation shows this, the BEA disagrees. Here is the explanation provided by the BEA:
For example, value added for durable-goods manufacturing dropped 15 percent in 2009, while gross output dropped 19 percent.  The decline in gross output is much more pronounced than the decline in value added because it includes each of the successive declines in the intermediate inputs supply chain required to manufacture the durable goods.

 

NGDP, NGO and total expenditures

Vincent Geloso Economics, Liberty , , , , , , , , , , , ,

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

A Tale of Free Banking

Warren Gibson Economics , , , , , , ,

Herewith we visit an imaginary future where free banking prevails. Government regulation of banks is a thing of the past. Banks have the freedom and the responsibility that they lacked under government regulation. In particular, private banks are free to print money, either literally, in the form of paper banknotes for the shrinking number of customers who want them, but in electronic form for most.

Print money? Horrors, you say! Fraud! Runaway inflation!

Not so fast. Come with me on a fantasy visit to the local branch of my bank, a future incarnation of Wells Fargo to be specific.

The first thing we notice is a display case showing a number of gold coins and a placard that says, “available here for 1,000 Wells Fargo Dollars each, now and forever.” I have in my wallet a number of Wells Fargo banknotes in various denominations. I could walk up to a teller and plunk down 1,000 of them and the smiling young lady would hand over one of these coins. More likely I would whip out my smartphone and hold it up to the near-field reader, validate my thumbprint, and complete the transaction without paper.

I have a few of these beautiful gold coins socked away at home but I don’t want any more today nor do I want to carry them around. Electronic money is ever so much safer and more convenient. Still, I am reassured by the knowledge that I could get the gold any time I wanted it. That is the basis for my confidence in this bank, not the FDIC sticker we used to see in the bank’s window.

Confidence? What about inflation? Wells Fargo can create as many of these dollars as they want, out of thin air. Without government regulation, who will stop them from creating and spending as many dollars as they want?

The market will stop them, that’s who.

In my scenario, Consumer Reports and a number of lesser known organizations track Wells Fargo and other banks. These organizations post daily figures online showing the number of Wells Fargo dollars (WF$) outstanding and the amount of gold holdings that the bank keeps in reserve to back these dollars. Premium subscribers, I imagine, can get an email alert any time a bank’s reserves fall below some specified levels. Large depositors will notify Wells Fargo of their intention to begin withdrawing deposits and/or demanding physical gold. Small depositors piggyback on the vigilance efforts of big depositors. They know it is not necessary for them to pester the bank when the big guys are doing it for everybody.

Wells Fargo practices fractional reserve banking. They cannot redeem all their banknote liabilities and demand deposit liabilities at the stated rate of one ounce of gold per thousand WF$. This situation is clearly outlined in the contract that depositors sign and is printed on their banknotes.

Let’s assume Wells Fargo backs just 40% of its banknotes and deposits with physical gold. How is this figure arrived at? By trial and error. Managers believe that if they let the reserve ratio slip much below 40% they will start getting flak from the monitoring websites and their big depositors. If they let it rise much above that figure their stockholders will begin complaining about missed profit opportunities.

Under fractional reserve banking, bank runs are possible. A bank run is a situation where a few depositors lose confidence in a bank and demand redemption of their deposits in gold or in notes of another bank. Seeing this, other depositors line up to get their money out, and if left unchecked, the bank is wiped out along with the depositors who were last in line. Bank runs are not a pretty sight.

Wells Fargo has a number of strategies for heading off a bank run. They have an agreement with the private clearing house of which they are a member that allows the bank to draw on a line of credit under certain circumstances. There is a clause, clearly indicated in the agreement with their depositors, allowing them to delay gold redemption for up to 60 days under special circumstances. They can reduce the supply of WF$ by calling in loans as permitted by loan agreements. Most important, though, is Wells Fargo’s reputation. Not once in their long history has Wells Fargo been subject to a bank run. Management is keenly aware of the value of their reputation and will move heaven and earth to preserve it.

To sum up, Wells Fargo’s ability to create unbacked money is limited by the public’s willingness to hold that money. The bank can respond to changes in the demand to hold WF$ whether those changes are seasonal in nature or secular.  They have strategies in place to head off runs should one appear imminent or actually begin.

What about competing banks, you may ask. Does Bank of America issue its own money? If so, there must be chaos with several different brands of money in the market. Are there floating exchange rates? Is a BofA$ worth WF$1.05 one day and WF$0.95 the next? What else but government regulation could put an end to such chaos?

The market, that’s what else.

Competing suppliers of all sorts of products have an incentive to adhere to standards even as they compete vigorously. If we were in a classroom right now I would point to the fluorescent lights overhead. The tubes are all four feet long and 1.5 inches in diameter, with standard connectors. They run on 110 volt 60 Hz AC current. Suppliers all adhere to this standard while competing vigorously with one another. If they don’t adhere to the standards people won’t buy their light bulbs.

So it is that competing banks in my fantasy world have all converged on a gold standard. They all adhere to the standard one ounce of gold per thousand dollars. (I trust it’s obvious that I just made up this number. Any number would do.)

Why gold? Gold has physical properties that have endeared it to people over the ages—durability, divisibility, scarcity to name a few. But other standards might have evolved such as a basket of commodities—gold, silver, copper, whatever.

You may raise another objection. All this gold sitting in vaults detracts from the supply available for jewelry, electronics, etc. That’s a real cost to these industries and their customers.

Yes, it is. It’s called the “resource cost” of commodity-backed money. To get a handle on this cost we must recognize that gold sitting in vaults is not really idle, but is actively providing a service. It is ensuring a stable monetary system immune from political meddling. How valuable is that? The market will balance the benefits of stability against the resource costs of a gold standard.

Furthermore we can expect resource costs to decline slowly as confidence in the banking system increases and people are comfortable with declining reserve ratios. Wells Fargo may find that a 30% reserve ratio rather 40% will be enough to maintain confidence. Other things equal, this development would boost profits temporarily, but those profits would soon be competed away, to the benefit of depositors and the economy as a whole.

Let’s go back to bank runs. Aren’t they something horrible, to be avoided at all costs?

Actually an occasional bank run is something to be celebrated. Not for those involved, of course, but to remind depositors and bank managers alike that they need to be careful. The same is true of the recent Radio Shack bankruptcy. Bad news for stockholders, suppliers and employees but an opportunity for competitors to learn from this bankruptcy.

Under my free banking scenario, depositors must take some responsibility for their actions. That doesn’t mean they have to become professional examiners. They just have to take some care to check with Consumer Reports or other rating organizations before signing on with a bank.

Have I sketched out a perfect situation? There’s no such thing as perfection in human affairs but I submit that this situation would be vastly superior to what we have now, where the Federal Reserve’s policy of printing money to finance government deficits will end badly. Furthermore, relatively free banking has existed in the past and worked well. To learn more, start with Larry White’s “Free Banking in Britain.”

Part Two of Capitalism for the Intelligent Ignorant: the Actors

Jacques Delacroix Economics, History , ,

FACTS MATTER

This is a little complicated. Part One of this series listed the main constraints on pure capitalism. Then, I took a detour – which was NOT Part Two – on the subject of money which is a quite specialized topic. Below is Part Two of Capitalism for the Intelligent and Ignorant. It describes the main actors of capitalism, of real capitalism, of capitalism such as it exists. with an emphasis on the American instance.

As have stated forcefully in Part One the government is a the biggest economic actor in all developed countries. Although it’s nowhere constitutionally required, at any one time, the government has most or almost most of the money in its hands. This fact alone requires it to do some investing. It’s also the biggest buyer of many things because of the sheer size of government agencies, including the armed forces. It’s also a major seller of…

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