Tag: economics

In which SM asks me to respond to a post by Financial Times writer Martin Wolf:

I think we can say that conventional neo-classical equilibrium economics did a poor job in predicting the crisis and in suggesting what should be done in response. We can also say that neo-Keynesians pointed out some important precursors of the crisis, in particular, the destabilising role of huge private sector financial deficits in countries with large external deficits, such as the US, and the Keynesian view certainly played a big part in the post-crisis response, as did that of Milton Friedman.

Yet some would argue that economists working in the Austrian tradition were more nearly right than anybody else. In particular, they have argued that: inflation-targeting is inherently destabilising; that fractional reserve banking creates unmanageable credit booms; and that the resulting global “malinvestment” explains the subsequent financial crash. I have sympathy with this point of view. But Austrians also say – as their predecessors said in the 1930s – that the right response is to let everything rotten be liquidated, while continuing to balance the budget as the economy implodes. I find this unconvincing. Mass bankruptcy is extremely costly. Moreover, it is impossible to separate what is healthy from what is unhealthy during a general economic collapse triggered by an implosion of the financial system.

Anyway, what do readers think of the Austrian analysis? In particular, what does it imply about the future of the global monetary and global financial systems and about the right way to respond to financial crises when they occur?

1. Yes, Austrian economics does understand financial crises better than other schools of thought, even if one includes Hyman Minsky’s Financial Instability Hypothesis as a distinct economic school. The Austrian analysis is broadly correct because it a) provides a means of understanding one of the core components of modern economics that no other major economic school provides. None of the Neo-Classical, Marxian, Neo-Keynesian, or Monetarist theories of economics consider debt to be a primary aspect of economics and therefore their policy interpretations and prescriptions are all largely irrelevant with regards to modern economies with debt-based financial systems. Austrian school theory is also more robust and comprehensive, in my opinion, than the new empirical Post-Keynesianism which also attempts to account for debt and therefore is also vastly superior to the four major schools.

2. As I predicted both in 2002 and in my 2009 book, The Return of the Great Depression there is no future for the present global monetary and financial systems. The giant international banks are insolvent and the monetary systems are doomed to collapse. This means that in the interest of avoiding this collapse, the monetary systems will be unified, first on a regional and then eventually on a global basis when the regional moneys begin to break down. The correct response would be to let all of the “full faith and credit” moneys fail and be replaced by the gold standard or some other monetary standard less subject to the bank-driven inflate-and-collapse cycle that has been witnessed five times in the United States alone, but that is not going to happen at this point in time.

3. The right way to respond to financial crises is to let them play out. When a building is burning, it doesn’t matter how much damage is being inflicted by the fire, it is never the correct response to attempt extinguishing it by pouring something inflammable on it. Mass bankruptcy is certainly costly, but the only relevant point is that it is much less costly than the greater number of bankruptcies that will eventually follow combined with the immense costs of the futile atttempts to stave it off that will do little more than delay it for a time.

Moreover, it is ALWAYS impossible for a central authority to separate what is healthy from what is unhealthy, during a general economic collapse triggered by an implosion of the financial system or at any other time. Central economic planning does not work any more effectively or efficiently with regards to money and credit than it does with regards to goods and services.

Eilonwy asks about RGD:

I’m reading The Return of the Great Depression, which I bought at full-price at the Wall Street Borders. I’m only a quarter through it, since I have to call my securities-analyst brother once a day to make sure I understand the concepts. In short: it’s slow, but worthwhile, going for me.

One question I have for you, and maybe it’s answered later in RGD is: when? I get this sense from reading your blog and Mr. Denninger’s, that the center cannot hold much longer and that we are tottering on the brink of a Greek-style collapse. Then I read on Yahoo Finance that Social Security has moved permanently into the red and that the debt we will accrue paying SS benefits will hurt our AAA rating, moving us yet further into debt. As Ed Morrissey states, “the wheels have begun to fly off the entitlement bus.”

What I don’t quite understand is how the welfare states of Europe cruised along – functionally – for 60 years, with entitlement programs far more progressive than what we have here, before facing the crisis they find themselves in now. Whereas (at least when reading you and Mr. Denninger) it doesn’t seem our economy will be able to hold it together for five years, and we haven’t even socialized medicine yet!

I think my question is twofold: 1) are we really bordering collapse, or could we limp along a la Britain and France, with a soft-totalitarian welfare state, and remain semi-prosperous for a decade or three before all the bad decisions we’ve made and are making really come back and whallop us? and 2) if we are bordering collapse, why do we find ourselves here so quickly?

The main reason that Europe has been able to limp along with heavier social outlays is because the European nations have virtually no defense budget. Since 1962, U.S. defense spending plus defense-related interest on the debt has amounted to around $2,500 per year per capita. If you consider that full Social Security benefits at the average income amounts to around $12,576 per retiree, it’s not hard to see where Europe has been finding its additional social spending.

In answer to your first question, yes, we really are bordering upon collapse because our total debt level is over 500% of GDP when all of the unfunded, off-balance sheet debts are included, as they must be. This is completely unsustainable even if we ended all defense spending today. Which, of course, we’re not doing anyhow. In answer to your second question, this is a rather binary problem. You can get by one way or another right up to the moment that you can no longer do so. While some still think it’s possible to hyperinflate out of the problem – which is really just a means of buying stability a little time if you consider the eventual fate of most countries that hyperinflated – there is a very serious timing problem even if the peculiar U.S. debt-money system permits such rampant inflation.

Once the fleets of money helicopters are sent aloft, it’s game over for the global economy, for everyone with savings, and everyone holding debt. That’s assuming it even works; if it doesn’t work then it’s an instant game over for geopolitical stability. So, Washington and the Fed don’t dare to issue the order until the very last minute… which means that when the next default crisis hits, there is a very good chance that they will not react quickly enough and the financial system will collapse in a catastrophic manner beyond the ability of even hyperinflation to help it limp along.

Perhaps the financial wizards who created this situation can find a way out of it, but I do not see one nor have I read anything by anyone that offers what I consider to be an even remotely credible solution. And while it’s true that these events always take longer to develop than anyone ever thinks, when they finally come to pass they tend to unfold much faster than anyone expects.

LS emails a 2003 essay by R.B. Calco published in the American Conservative. Here’s an excerpt:

The Father of free trade was no globalist.

Adam Smith is commonly regarded as the father of modern economics. Free traders claim he is also the father of free trade and credit him with the first systematic attack on government regulation of trade ever written. This is true as far as it goes. This is not to say, however, that Adam Smith was a free trader in the same sense that the term is promoted today. Since David Ricardo and the Austrians took hold of it, the term has acquired a dimension and a purpose that was, to paraphrase Smith, no part of his intention. Or, in any event, it was no part of his definition. Smith’s argument for trade was rooted in what economists today refer to as “Absolute Advantage”; it was left to the crafty mind of David Ricardo half a century later to invent a justification for trade on the basis of the far more subjective “Comparative Advantage” that today the economists tell us we need to consider instead.

While the dull, pencil-headed, pocket calculator logic of Comparative Advantage works fine for the textbook laboratory example f two nations and two products, it falls apart entirely the minute real-world constraints or considerations are introduced. It becomes absurd when you attempt to factor “comparative advantage” across three nations and three products, let alone the hundreds of nations and millions of products of the real world. Try it – you will lose your mind.

All Comparative Advantage amounts to, reduced to its essential components, is a sophistic argument for international division of labor — for global economic union — without dealing with any issues of political union. It is the economic equivalent of living in sin, so to speak. For whatever intuitive sense it claims to have, this argument relies on a fundamental confusion between trade — economic activity between economic systems — and division of labor — economic activity between individuals in a single economic system.

At bottom, this argument is a bait-and-switch for a global system, not a plan for any one nation to become wealthy, least of all the United States, which, according to the law of equilibrium, would be forced under a free-trade regime to sustain massive losses of jobs and wealth to pull all other nations up in the new global wage and price structure.

There is little question that global free trade tends to raise the overall level of global wealth. But what consequence-blind Ricardians stubbornly refuse to understand is that Comparative Advantage simply does not work on a macroeconomic level. The falsity of their assumptions is easily determined both logically and empirically; in RGD, for example, I show how the historical trade statistics prove that the Smoot-Hawley tariff could not possibly have played a major role, let alone a causal one, in causing the Great Depression.

The important logical question that the Ricardians have to answer is this: Does the level of rising global wealth come at the benefit or the expense of the wealthiest nations? The important empirical question is this: What is the rate of increase in U.S. national wealth per capita compared to the rate of increase in global wealth per capita? Those who are intellectually honest enough to contemplate answering those straightforward questions of applied theory instead of retreating to the safety of the abstract will soon recognize that the Comparative Advantage is a fundamentally incorrect doctrine and the Ricardian case for free trade is strictly dependent upon circumstances that do not apply to many situations, presently including that of the United States.

Those who disagree are certainly welcome to answer those two questions so long as they provide an amount of reason and evidence in support of their answers. And it is worth keeping in mind, as Joseph Schumpeter pointed out, that David Ricardo was first and foremost a political creature and an ideologue, he was not an intellectual driven by a natural interest in the truth of the matter. This is not to argue that what is known as the Ricardian theory of Comparative Advantage is incorrect on an ad hominem basis, I am merely pointing out the historical fact that his case was a political one with a specific policy objective in mind. It is also worth noting that the this case was not even original to him, as the idea of Comparative Advantage was first introduced by Robert Torrens in An Essay on the External Corn Trade two years before Ricardo published On the Principles of Political Economy and Taxation.

Karl Denninger reaches a conclusion:

The Labor Department reported Thursday that productivity jumped at an annual rate of 6.9 percent in the fourth quarter, even better than an initial estimate of a 6.2 percent growth rate. Unit labor costs fell at a rate of 5.9 percent, a bigger drop than the 4.4 percent decline initially estimated.

In the real world this means:

Work harder and get more done. Get paid less. Suck it up, don’t complain, or you’re fired. That’s all.

And by the way, reduced pay per unit of work spells DEFLATION.

That’s not necessarily so. Inflation and an increase in the supply of labor can lead to reduced pay per unit of work; real weekly wages haven’t increased in the USA since 1973. But in general, declining labor costs do tend to point towards deflation, especially if they are nominal as well as real. Productivity up and costs down is a good thing for corporations; whether that is good for the smaller number of workers working and the reduced pay they are receiving may not turn out to be good for an economy already facing widespread defaults. Especially if those corporations happen to be foreign corporations sending those profits overseas.