Archive for September, 2009

Average Prices are Signals that Dictate Economic Traffic Or, What if a one way street signs were randomly posted in the wrong direction?

Friday, September 25th, 2009

During the 1990’s and into the 2000’s, many developing economies increased their ability to export cheap consumer goods to the US and other industrialized markets. All things being equal, this placed deflationary pressure on consumer prices in the US. In absence of activist monetary policy, we would have seen deflation as measured by the consumer price index. What we had instead was a Federal Reserve increasing the money supply to prevent deflation.

What we need to understand is three fold. Firstly, what signs was deflation trying to give the US economy? Secondly, what signs did the Fed give the economy instead? Thirdly, what were the consequences of getting our signals crossed?

  1. Pretend that we held money supply constant while cheap consumer goods flooded the US market. We would have the same amount of money chasing more goods, i.e. deflation in the short term and a reduction in real GDP in the long term. In the short term deflation causes consumers to cut back on consumption. Why buy today if stuff is cheaper tomorrow? Thus, the market’s natural response to an increased trade deficit would have been an increase in domestic savings and a reduction in said trade deficit.

  1. Being overly scared of deflation, the Fed kept their foot pressed down on increasing the money supply to generate a positive rate of inflation. In so doing they took interest rates to historically low levels. These low interest rates acted as signals to consumers, businesses, and the government that borrowing was unusually cheap. The result was an unprecedented increase in consumer, business, and government borrowing. This borrowing increased the current demand for foreign goods driving up the US trade deficit and destabilizing the international economic system.

  1. When the proper response was to increase savings rates, the Fed put up street signs that said borrow as fast as you can. In so doing the Federal Reserve aided the creation of asset bubbles and sowed the seeds of the global financial meltdown. Had the Fed allowed the market to naturally read the deflationary signs, the global meltdown could have been converted.

The moral of the story is that average prices are just as much signals to the macro economy as individual prices are to the micro economy. To think that the government or a central bank has more information than the economy on what the “right” prices are is preposterous. The recent financial meltdown’s causes can be traced right back to the doorstep of the Federal Reserve. Capitalism works best when prices are set by markets, not central planners.

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What good is a compass if you don’t know how to read it; Or, Prices, even average ones, are signals

Friday, September 18th, 2009

Should price stability be a legitimate goal for the Federal Reserve (or any central bank)? To answer this, let’s take a step back. Should the government be in charge of creating price stability for automobiles? When the price of autos increase, should the government increase the supply of autos? When the price of autos falls, should the government buy up automobiles on the open market? After all, the government (i.e. taxpayers) owns a car company (GM) and could manipulate the equilibrium price of automobiles.

Why might the government like price stability in cars? You could argue that producers could better plan production if they knew in advance what their cars would sell for. Consumers might be able to better plan their car purchases as well. So what’s the problem? By masking real prices, the government covers up information from market actors. Prices aren’t arbitrary or meaningless. The price of every product is a little piece of information telling the market how to efficiently allocate resources.

Does the government know better than the market how to allocate resources in the car (or for that matter any other) industry? History tells us that centrally planned economies fail in part because planners lack information. Hayek’s “man on the street” is the guy with information, and he uses this information he sees from prices to make decisions to maximize his own self interest. An ill informed central planner sets prices only to cause surpluses and shortages of products they mis-price.

If there is no individual price the government can set better than markets, why do we believe that a central bank can set average prices better than the market? There is an aggregation problem here that monetary policy activists need to come to terms with. Setting one price is bad; setting two prices is bad; setting three prices is bad; setting all prices is good? You have to go back to the 1700’s to find economists believing that inflation/deflation doesn’t affect relative prices.

What could possibly go wrong when a central bank uses activist monetary policy to achieve price stability at the cost of ignoring market signals? Tune in to next week’s post.

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Homeostasis and Economic Equilibrium: Steroids and Economic Stimulus

Monday, September 14th, 2009

For a long time, I have been fascinated by the parallels in the study of equilibrium across academic disciplines. Biology, chemistry, and physics represent a short list of disciplines where the study of equilibrium can benefit our understanding of equilibrium in economics. Given economists general interest in baseball, I’ll make my first “equilibrium” post have to do with steroids.

A properly functioning human body engages in homeostasis. Homeostasis is the ability or tendency of an organism or cell to maintain internal equilibrium by adjusting its physiological processes. Organisms routinely face exogenous shocks which require they use their natural self-correcting mechanisms to return to equilibrium.

Now, let’s say that a pro athlete isn’t content with his body’s equilibrium home run production. By taking anabolic steroids, testosterone levels can be raised above their natural state which in turn can improve home run production. One of the many downsides of anabolic steroid use, however, is that the human body in an effort to balance the exogenous shock either lowers or completely stops natural testosterone production. In the short term, then, the athlete becomes dependent upon anabolic steroids to maintain the needed testosterone to perform at their expected level. Normal testosterone production may return to steroid users after a lengthy abstinence from steroid use.

Now let’s say that politicians aren’t content with the current equilibrium employment. Their solution is to create employment by creating new government jobs. One of the many downsides of government job creation, however, is that economic actors (either existing or potential) in an effort to balance this exogenous shock either lower or completely stop natural job creation. Normal job production may return to the economy after a lengthy abstinence from stimulus use.

Every government job has to be funded from somewhere. If it is funded through increased taxation on current economic activity, then producers won’t be able to afford to hire as many non government workers. The existence of tax wedges (dead weight loss) insure that the money collected for the government jobs is less than the money lost from private employers. So if the government tries to pay for their new jobs, net job loss results. This is why economic stimulus packages are funded by long term debt.

Long term steroid use carries with it serious physical consequences, but any short term reduction in steroid use will lead to a period of time with depressed hormone production until the body retools to restart hormone production. At least most athletes have an off season.

Once the economic actors get used to government job creation replacing private sector job creation, they become dependent upon the government stimulus. Here is where economic actors get caught in the same catch 22 as do doping athletes. Increased long term borrowing brings on slower long term economic growth, but to withdraw economic stimulus in the short term will cause employment to fall until the self-correcting mechanisms of the economy restart private job creation.

The moral of the story: Sammy Sosa entertained some people in the short run, but will never get into the MLB Hall of Fame.

Prediction: Posterity won’t look kindly on “government job creators”

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A Czar of your own Castle

Tuesday, September 8th, 2009

Since when did we fall in love with czars? Manufacturing policy czars, drug czars, green jobs czars, car czars, the list goes on and on and on…. I think that it is time for politicians of both parties to do a little reading.

Why was Adam Smith a revolutionary? He showed that you don’t need czars, kings, dictators, bureaus of economic planning, or any such nonsense to organize an economy. Economies run best when you let individuals pursue their enlightened self interest.

Does the US car czar know what kind of car will make me happy? No. Does the manufacturing czar know what the US is supposed to be producing? No. Does the drug czar know how to win the “war on drugs”? No.

Czars bring nothing but poverty and a loss of freedom. Read history. They always have and they always will. How about we let people be kings/ czars of their own castle? As Mel Brooks said, “It’s good to be king”.

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