Categories
Economics

Statistical Surveys and Non-Response Errors

Survey Non-Response

The purpose of this post is to address the concepts and issues behind non-responses in the survey. When economists or any researchers are collecting data for an academic or statistical study, non-response is becoming a more prevalent issue. Hence data collection needs to adapt to societal changes to maintain a level of academic rigor.

There are two types of non-response

  1. Unit non-response
  2. Item non-response

Either one can be selective non-response, which is a systematic difference. Systematic non-response is a severe statistical problem because of a group of responders can effectively invalidate a study. Below I give a hypothetical scenario that shows some of the reasons for non-response comes about in research.

Surveys have statistical issues

An illustration of Non-Response – Nutritional Adequacy of Low-Income Earners in the Rural US

To illustrate better the reasons for non-response, consider a survey that involves low-income earners in rural America. For example, if a researcher is studying the nutritional adequacy of low-income households, and when the household head tends to be female, there is a higher occurrence of non-response compared to other demographic categories. This means results for female lead households could be radically different from two-parent households simply because of sampling error. Therefore, with fewer female lead household responders, the data might not be as statistically rigorous for this category, and therefore, the study as a whole. Let us look at why there might be non-response in this category more than other categories.

With a male at home, many rural Americans grow their own food.

A Hypothetical case study from Rural America

Safety concerns of interviewee might result in non-response

In the case of one parent female lead households, women have safety concerns to identify themselves as the only adult at home, in rural areas. Therefore, single-parent females might not reply. The result is a systematic non-response. However, the nutritional profile, in reality, is different in a household when a male is present.

Additionally, this data skewing might be exacerbated in the following case. In the USA, many low-income rural households grow food and hunt and fishing for food, themselves when the male is present. (This was similar to the situation when in Poland during communism, people in the countryside often had land or domesticated animals, and this contributed to nutritional adequacy people in the city might not have access to through the standard economic system).

Therefore in the Rural US, even though incomes are low, they have moderate to high-level nutritional adequacy because of self-sufficiency coming from the land. This is even encouraged as Supplemental Nutrition Assistance Program (SNAP) benefits for food can be used to purchase seeds, plants, and trees for a backyard food plot.

People in the rural US like Appalachia, Texas, the Deep South, and the Mountain regions, have cultural values of self-sufficiency. Homesteads grow corn, have a garden, have an orchard, hunt, farm catfish, raise a chicken, pigs, or have a cow for milk, cheese, and yogurt. (Author’s note: I live in a rural area, and I personally have a sugar cane field, potato field, a garden, and a fig orchard.) 

However, single mothers do not have the time or opportunity to engage in non-income producing primary sector activities, and they and their families have lower nutritional adequacy because of their dependence on a traditional monetary economy. Because of family responsibilities, the opportunity cost of agricultural self-sufficiency is too high to take on themselves. Therefore, they do not have the same access to food as rural households with a male present (the same could be the case with male single-family households).

The result is more inadequate nutrition for household lead by single parents. Specifically, government low-income nutritional programs for families and mothers like the Special Supplemental Nutrition Program for Women, Infants, and Children (USDA WIC) specify household food purchases on this program must be the cheapest quality food because of the program’s budget restrictions. For example, milk must be the lowest price and low-fat (which is not optimal because of the need for growing children and nursing mothers to have fat for their brain development). Also, produce needs to be inorganic as does the bread. Therefore, low-income mothers are living on hormone-treated milk, white bread, and canned produce grown in soil lacking micronutrients such as chromium or selenium. These diets might be sufficient in macronutrients like protein and carbohydrates but lacking in micronutrients, which are a catalyst for health.

However, the issue here as it relates to the researcher and study is, the female head of households will not reply in a survey as mentioned above for safety reasons or feelings of self-esteem. There is also distrust/belief in the government system, which can take their children away and put them in a foster home if the state feels the family can not provide for the children, as can be the case in the United States.

Therefore, the study will show that the overall level of nutrition for low-income earners is adequate if you polled the composition and nutritional components of a family’s daily diet of low-income earners. This is because it might underrepresent the female head of households because of non-response.

That is, the case is because female lead single-parent homes are not statistically represented in an academically rigorous way, because of non-response. However, they are arguably the most important category of the study as there is a disproportional number of single parents in poverty. Statisticians and surveyors/data collectors, therefore, must overcome or account for this non-response to make it a meaningful study.

Rural single mothers have a large non-response

How can non-response be mitigated in this case

Ways to overcome this non-response might be a simple as hiring local trusted and known female surveyors that can go door to do. If interviewers are known in the community and mirror the demographic, in this case, female to female and a single mother themselves, the response rate tends to be higher. Also, assure the single mothers this is anonymous, and the survey is not to be used by Child Services to determine parental adequacy. Alternatively, give monetary incentives. 

Another way to mitigate is simply over-sample. By over-sampling when statisticians collate the data, there, adjustments could be made if done correctly.

It can be noted there is also Non-selective non-response but no reason that there is a difference between respondents and non-response. 

Why non-response errors are impactful

Non-response errors affect sample size and outcomes. Sample different than the entire population. It does not represent the population in a meaningful way. Needs to represent the population and non-response sampling errors can alter this.

  1. Reduction in sample size – Statistical issues, as noted above, larger sample sizes are associated with measures closer to the whole population.
  2. Unwilling participants can skew the results. The answers from the pool of responders can be different than the pool of non-responders. Each group has a different reason. Non-response bias, a particular group, is underrepresented or not represented. 
  3. Item non-response – In some cases, a particular group or demographic might respond; however, on specific questions, they might non-respond. Not replying to specific items can create an under response, which can also distort the result.

Reasons why there are non-response errors

The reasons for non-response ultimately is based on the psychology of the individual. That is their perception of the survey in the context of their defined situation.

  1.  Formal social categories (age, gender, race, political parties, religion, education level, race)
  2. Limiting social factors ( crime, extreme poverty, health, cognitive or technology deficiencies)
  3. Survey settings (meeting in person, personal appearance, subconscious signals).
  4. Survey privacy is an issue (concerns if the survey is anonymous, and the researcher protects personal data and any connection to the individual).
  5. Lack of clarity in the question can result in less response (ambiguity can lead to non-response).
  6. The mode of data collection is significant when constructing the survey. The researcher must be cognizant that the objective is accuracy, not just convenience (technology fluent individuals compared to less tech-savvy, or door to door, for example, some people might not open their door or answer their phones as a rule).
  7. Could be seen as invasive or offensive questions
  8. Psychological reasons

How to reduce non-response

  1. Try to understand the reasons for non-response in one’s particular case
  2. The chosen interviewer could mirror the demographics of the interviewee. For example, if part of the study looks at older Hispanic Males, the interviewer could be an older Hispanic male. In contrast, younger Caucasian females might not be relatable to the interviewee.
  3. Include visual graphics to explain and simplify the purpose and questions.
  4. Oversampling
  5. Dress professional can and a congenial, professional attitude
  6. Economic incentives (such as a chance to win a Starbucks gift card if you reply).
  7. Follow up.
  8. Have a clear privacy policy, and ensures data is anonymous.
  9. Have the timing of the call or interview respondent centered rather than researcher convenient.
  10. Before the use of the questionnaire, do a user testing for clarity before the release. This way, you have feedback on how to improve the sample questionnaire for higher response. This allows researchers to improve on their mode and format and clarity of the questions.
  11. Give respondents multiple ways to respond, such as email or post.
  12. Give a clear summary of the importance of the research. That is why the study will be beneficial to society as a whole.
Categories
Economics

Can Money be Neutral?

Central banks pursue a policy of money neutrality. Except when they are seeking a monetary policy to steer the economy. Money neutrality means money has no impact on the workings of supply and demand in the real sector. That is, money is just a veil or a cloak. Money’s influence and function are to serve as a medium of exchange to calculate and facilitate natural market prices and forces.

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The way central banks pursue their stated goal of money neutrality is to harmonize the Fed Fund’s rate with the Natural rate of interest. Let us say for simplicity the Natural Rate is the rate of interest, which brings savings and investment in equilibrium ex-ante (it is always in balance ex-post).

However, it is not that simple. When you are referring to a large aggregate macroeconomy, it is not simply setting the market rate equal to the natural rate of interest. Here is why.

Money cannot be Neutral

The following are a summary of arguments of why money can not be neutral. To date there is no central banker or academic that can refute this in its totality. The reason we have a central bank is political rather than having a positive effect on the macro economy.


1. How you define the natural Rate of interest

Definitions of the natural rate vary and how you define it will change your model. For example, in natura marginal productivity on real mobile capital, price stability, I=S ex-ante also modern interpretations such as Woodford’s past, present and future flexible prices in contrast to the world of rigidities, Austrian time preference theory of interest. If you can not define it how can you target it?

Three posts on the natural rate of interest:

2. Empirical estimates are problematic

There exists multiple models and estimates, Holston-Laubach-Williams, and other competing models. Each one has a claim to a number, what the rate is at a point in time. How can they all be right? If you steer a ship and you are off a few degrees you will end up somewhere else dending on your model’s output.

However, more important a neutral rate of interest is paradoxically impossibility because of money’s influence is ubiquitous., on par with traveling faster than the speed of light.

Money is about real markets and real market prices than empirics. Money and real factors are intertwined so you can not have money neutrality or estimate this empirically. The natural rate is in a very real sense and fairy-tale. Therefore, estimates are not meaningful.

Econometrically it is challenging to estimate the natural rate of interest. It is beyond the scope of this post. However, Central banks believe that with the right formula’s and complicated equations, R-Star is a reasonably accurate measure of the natural rate of interest. I am skeptical for reasons laid out here: R-Star.

Therefore they target something that does not exist, except for at universities on backboards and books that win awards . However, and equilibrium rate of interest is not something in the world of real markets.

3. Multiple rates of interest

However, even if Central banks could estimate the natural rate of interest, there is the problem of the existence of multiple natural rates of interest. Again that is not within the scope of this discussion. (Pierro Straffa, 1932). Here is a further discussion on:

4. Interventions create a feedback loop

Each intervention creates an imbalance in a dynamic economy. Money/purchasing power enters the macro-economy in a specific path, which distorts the market and creates feedback.

Frequently interventions create a more complicated situation with estimating a neutral rate of interest. Even if they could pinpoint a rate that brings neutrality, they still have to maintain it and it is a moving target.

Interest is not neutral buoyancy like a bubble in a quiet pool of water but rather in a dynamic economy that has forces that go up or down simultaneously and instantly and simply trying to move the water influences the bubbles path. This is not neutrality.

Money is not injected to everyone equality

When money is pumped through the system it is not injected equality. Rather, there are first and last receivers.

Therefore, the point that I want to focus on is that money cannot be neutral because when the central bank decides it needs to expand or contract money or purchasing power in the economy, it does not do this by dropping money on people’s doorsteps by helicopters, or in modern speak drones.

Instead, monetary expansion occurs via the banking system. The central bank in the United States pumps money by lowing the Fed Funds rate (hypothetically in relation to the natural rate of interest).

The Fed Funds interest rate which banks lend reserve balances to each other overnight. This seems like a convoluted way to control the supply of purchasing power, however, it effectively increases or decreases the amount of purchasing power in circulation.

The issue here is the opportunity cost of holding money is different for those who are rich and those who are poor. The rich benefit first, as well as those closer to the money expansion process.

Time preference theory of interest

The time preference theory of interest states that the opportunity cost of saving money is lower for the wealthy. This is because they can make their monthly payments easier than those living on a minimal income. To save money for a poorer person is a much more difficult task.

Therefore, first receivers have more money and their time preference will be lower.

The last receivers or no receivers become poorer. The opportunity cost for them is higher.

This is a transfer of wealth, a wealth redistribution. This is not a neutral policy.

Therefore, if you inject money there will be winners and losers. This again is not a neutral rate policy.

If rates go up the first recipients will lose money and there will be a business cycle.

Any policy is not neutral as it involves a redistribution of wealth.
Therefore, the only way you can have a neutral money policy is if you have free markets.

Historical context of money neutrality

The conversation in modern thought originates with David Hume, but became predominate after Knut Wicksell’s work Interest and Price (1898), and Mises’s Money and Credit (1912) development of his theories. Hayek and Keynes discussed and further popularized the economic concept. Robert Lucas also had a discussion but within the context of the Phillips curve. Michael Woodford, does not discuss it in his 800 page book on Interest and Prices (2003) but rather he assumes it with his flexible price equilibrium. The Federal Reserve combines this with their FRB/US econometric model and the Taylor rule .

It is only the Austrian economists of today that directly and repeatedly challenge this concept, such as Murry Rothbard, Frank Shostak, Robert Murphy, William Butos, Steven Horowitz or Lawrence White.

Free banking is the only money neutrality

That is free banking where supply and demand for purchasing power are determined by the market rather than by a central authority. Here is a discussion on:

Can money be neutral? Not with the existence of the Federal Reserve. Central banks exacerbate the trade cycle by ensuring the money is not neutral in the short or long run. In contrast, a free market combined with free banking which allows for the organic nature of money to evolve and operate can be neutral. A classic gold standard is a close proxy also but free banking is almost synonymous with neutral money. With this, the economy would have a high growth path, lessen the Gini coefficient and have a money macro equilibrium path.

Categories
Economics

Multiple Natural Rates of Interest – Pierro Straffa

The natural rate of interest is a rate of interest that exists in , that if there were no use of money. The Wicksellian marginal productivity on capital in a barter economy.

This posts looks at the significance of multiple natural rates and offers one avenue to pursue for a solution.

R-Star the singular empirical natural rate of Interest

Why this is important? The Federal Reserve Bank targets R-star an empirical proxy for this rate to try to create equilibrium in the economy. That is, if the observable market rate, (the fed funds rate) equals the natural rate, (R-star for the central bank), then money should be neutral. This means prices will neither go up or down for monetary reasons and the economy should avoid a business cycles for monetary reasons.

These are generalizations and there are many contributors to this theory, however, you can find these ideas in Knut Wicksell, Friedrich Hayek, and Michael Woodford.

Therefore, if the natural rate of interest equals the market rate of interest the Federal Reserve generally postulates we will have money macro equilibrium. This point is debatable. However, it is a mainline Federal Reserve opinion and operational policy. It is important because it is core theory the central banks operate on.

For a more detailed discussion of R-star directly from the Federal Reserve you can find it here: R-Star the empirical Natural Rate of Interest.

However, despite the intricate models and mathematical proofs, there is a theoretical problem that has not been addressed. Specifically, there are multiple natural rates of interest.

In other words, instead of one wholly empirically derived rate of interest, there exists multiple natural rates of interest for each commodity. Each good, particularly capital goods has its own rate of interest.

This means that the central bank targeting one interest rate is an incorrect policy. What might be good for one capital good is not good for another. Therefore, at some point there will be a distortion in the entrepreneurial use of capital that can create a business cycle. The result is the natural rate of interest as a theoretical construct and its representative in the empirical world R-Star is on unsure footing to use for policy. Central banks around the world like the US Fed and the ECB do just that.

Multiple natural rates of interest issue for theory

This objection of multiple rates of interest was raised by Piero Sraffa (1932) specifically in response to Hayek’s Austrian business cycle theory (ABCT) developed from Mises (Theory of Money and Credit 1912).

The idea of multiple natural rates of interest by Sraffa was so devastating to ABCT theoretically it was never directly addressed. It was circumvented by both the Austrians and the Federal Reserve and notably when Michael Woodford (Interest and Prices 2003) resuscitated the Wicksellian idea.

Woodford does discuss multiple rates on interest is his paper on Financial Intermediation in 2010, but this is not the Sraffa’s multiple rates of interest. Rather this is simple a spread rate to account for frictions. Woodford focuses on rigidities and frictions into his model. However, his model is still based on an equilibrium rate of interest which has theoretical issues, such as multiple rates. Therefore, the model which the central bank bases policy has a weakness. Specifically articulated by Pierro Straffa in 1932.

It is not addressed by mainstream economists or Austrian Economists.

Is Straffa’s natural rate a Wicksellian rate?

The own rate of interest– the rate at which something exchanges for itself. A commodity rate of interest.

Straffa’s own rate is not a natural rate of interest as understood by Wicksell. However, for the critique of the theory the same argument would hold if it was a Wicksellian natural rate or an Straffa own rate.

That is, shoes, are not a form of capital that is generally used in the production process. Better are potatoes seeds. Potato seed would be something I see as mobile capital that could approximate a natural rate as understood by Wicksell. It is homogeneous but also functions as a commodity and capital for the production process.

Straffa on Multiple natural rates:

An essential confusion, is the belief that the divergence of rates is characteristic of a money economy […] If money did not exist, and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium, but there might be at any one moment as many “natural” rates of interest as there are commodities, though they would not be “equilibrium” rates. […] if loans were made in wheat and farmers […] “arbitrarily changed” the quantity of wheat produced, the actual rate of interest on loans in terms of wheat would diverge from the rate on other commodities and there would be no single equilibrium rate.

(Sraffa 1932 p.49)

This divergence and the existence of multiple rates was a common phenomenon in a barter economy. Sraffa’s sees the divergence of the money rate and the natural rate as the divergence between the spot rate and the forward rate. However, in this case, it is still observed in a monetary economy. Money is still ubiquitous and flowing in every part of this economy. Even though he is analyzing essential commodities like cotton or wheat, it feels like a natural rate. But it is not, it is still in a world where all we see is money prices.

  • Sraffa does understand the dynamic nature of the economy that, changes in the production of a particular commodity can at least temporarily create changes in the natural rate between, so there are multiple natural rates.
  • Sraffa did see a convergence of commodity rates of interest when the economy was in equilibrium, in which all commodity rates were equal as well as the money rate.
  • Sraffa critiques Hayek by stating that the multiple naturals rates are not equilibrium, only when unified as one rate.

This is my first pass at an understanding of the multiple natural rate problem. A more in-depth article I might review latter is by Robert P. Murphy. Murphy has a suggested solution.

Multiple Interest Rates and Austrian Business Cycle Theory

Categories
Economics

Free Banking as an Alternative to the Federal Reserve

Free banking compared to Central Banking

Free banking is money that is issued by free-market private banks with minimal regulation and clear market rules in a competitive environment.

Free banking has worked throughout history, yet for ideologically derived and fiscal expansion reasons it is jettisoned for government-controlled money. The idea is a few intellectuals know better than the free market. We should trust the few intellectuals over our own wisdom.

Free Banking is the only method available for the prevention of the inherit expansion of credit.

Ludwig Von Mises, Human Action, p.440

Free banking in history

Banks historically back their currency with gold or silver. In this manor confidence in the currency was established. If you could transact in fiat backed by ‘thin air’ or a gold note what would you have more confidence in?

Not just confidence generally but that the note would retain its value. If something retains value and is known to be quality, people use it more and it functions better.

Trust is the currency of this game.

Jeff Probst Survivor

Similarly economics is a social science and experiment. You can not legislate trust it has to be earned. Econometricians forget that individual social aspect of economics is the micro-foundations for macroeconomics.

To attract deposits banks tried hard to establish credibility and trust. Think about your visa or master card. You feel confident that your card will stand by you if there is fraudulent activity. Or Amazon, it does out of its way to establish credibility. Google with search, puts trust at their priority, that the integrity of the results is optimized for user satisfaction.

Similarly, banks under free banking did everything they could to establish and keep their reputation.

Again think of your visa card and all the relationships this company has and agreements of trust. Similarly, banks made agreements so make sure people trusted the value of their currency. This was all before Google reviews and the nearly instantaneous transmission of information.

Therefore, banks became interchangeable much like visa cards today. Retailers will accept visa cards from Bank of America or your credit union as there is backing or trust and the profit motive. Banks could not hold inadequate reserves or take on risky strategies or risk-averse investors would quickly lose confidence in the currency. Therefore, this was not done historically.

  • Without this risky behavior, there would be no need for bailouts.

A government issuer can devalue and manipulate the vale of its currency for political ends or a deemed social engineering objective. Free banking could not do that or it would lose trust.

Example of the Federal Reserve’s performance

  • 1 US dollar in 1787 was worth $1.06.
  • In 1913 the Federal Reserve Bank was established and $1 dollar in 1913 is today worth .04 cents.

How can you argue with that? Not to mention something called the Great Depression.

Think of anything you buy. If you buy something of lower quality, that falls apart people do not want to continue to buy it or it does not function as it is supposed to well. I would rather buy and use something of quality. So it is with money. You want to hold and use the money of quality. People today do not have a choice the government stronghold on the money supply.

It is like under communism you had to buy your goods from the one state-owned store. In our society, it is all people know, so like under communism people have been economically conditioned to believe this is the reality. It took a generation in the post-communist countries to change their mentality.

  • The issue here is people do not have a choice in these most important commodity in the market.

The Federal Reserve has a monopoly on money. With any monopoly, the price is generally distorted. Even if the monopoly is well-intentioned and benevolent.

Money is no exception that the free market results in the most efficient outcome based on individual choices. This is in contrast to the Central Banks around the world printing money out of thin air to pay the governments spending and promises. Look at our debt today.

The Theoretical support for Free Banking

Resources on the Free Banking debate versus Central Bank

This is academic theory, not some battle cry to abolish the Fed. Respected non-conspiracy theorists advocate the return to free banking and sound money.

The following is an outline of the basic logic.

Definitions of concepts in monetary economics

Prices are inter-temporal information points. That is they coordinated demanders and suppliers of a good while also are considering the future. How much they want to consume of that good in time weighing all the possibilities now and in the future.

The information is about the supplier willingness to supply and demanders willingness to hold or use.

This coordination is done at a microeconomics individual level. For example, each person decided for themselves how much of that particular good they want to consume. Each person has a different utility preference to consume, for example, ice cream. However, in aggregate we can derive a demand curve.

Money is a commodity, which functions as a medium of exchange, store of value and a unit of account. It is the second half of every transaction. You barter something for money in every transaction.

Credit is a derivative of money and in a modern economy functions as the medium for purchasing power, what Mises called fiduciary media. Purchasing power is what expands and contracts and influences economic decisions.

Interest is the price of credit. That is an inter-temporal information point that tells us how much credit people want to consume now based on a future looking time horizon. This purchasing power can be for consumer or capital goods.

Capital are tools which enhance the production process. The wise use of capital will result in greater profitability. Entrepreneurs perform economic calculations based on market estimates and based their capital deepening on these economic calculations.

Therefore, if the price of money/credit is wrongly estimated by a central bank, even a smidgeon, it will cause market distortion. Especially in the capital markets where entrepreneurs are formulating long term plans.

This theory has roots with Carl Menger’s organic understanding of money, in the Knut Wicksell with a cumulative process of price movements and Ludwig Von Mises and Friedrich Hayek with distortions in the capital structure that cause a business cycle.

What do we mean by the wrong price of credit?

We mean specifically the interest rate, that is the rate controlled by the central bank for practical purpose the Fed funds rate does not coordinate the ex-ante investors and savers. I=S ex-post by definition. We are concerned with the ex-ante process of coordination. This forward-looking process that all humans have because of inflated frontal lobes.

If this price on credit is wrongly estimated we have a market distortion, much like rent controls or the government setting the price of gas at the pump. If there is too little of a supplied good, then there are shortages. There could be non-price rationing, like lines at the pump, and loss of consumer surplus. Similar and excess supply of good causes of waste in that market.

However, since money is the second half of every transaction, the way money works out its disequilibrium, is not in an individual market but in every market. Every market is a market for money.

Therefore, if the Federal Reserve sets the Interest rate too high or too low, the price of credit, then there is a severe issue that affects every individual.

In contrast, in free banking, the market sets the price of credit. In fact, for different risk profiles and lengths of the loans and asset compositions, there should be multiple rates of interest not just one rate of interest. The idea of one rate is that entrepreneurs will arbitrate all markets to this singular rate. In the Hayek Staffa debates on the 20th century, this point was brought out.

How does the Central Bank set the price of money?

The Central Bank uses a wholly empirically derived estimate called R-star, a proxy for the theoretical concept of the natural rate of interest. It is an economic estimate of the price of money that would bring money neutrality to all markets.

The historical evidence is the Federal Reserve has failed to do its job.

It is beyond the scope of this discussion to explain the econometric reasons why, but historically the based on the Great Depression to the Crisis of ’08 the central bank has not done a good job.

What about Free banking or even its cousin the Gold standard?

Prices were stable and the US reached its gilded age. This was in a time of great historical upheaval and the industrial revolution and when the information was arguably less perfect than it is today.

The historical date of growth, stability and the Gini coefficient argues the Federal Reserve has not done as good of a job as free banking or the classic gold standard.

Why do we have a Central Bank? The political reason, so we can finance endless overseas military acts (these are not wars as Congress did not declare war) which we do not win or other programs. Who pays for it? The working and middle class. Who benefits, the people who have access to credit and work on Wall Street. The fat cats on Wall Street have they earned their money in the same way as hard working entrepreneurs? The irony is this is not Marxist speak, rather, free-market ideas.

Could we eliminate the Federal Reserve and return to free banking? Yes if there the paradigm is overturned. Paradigms are overturned all the time. It would translate for the US a return to the free market and free choice.

Categories
Economics

The Real Meaning of Laissez-Faire

Laissez-faire is an economic philosophy that literally translates to ‘let do’ or ‘let go.’ It generally means ‘leave it alone’ in reference to economic policy. Laissez-faire is an import word from the French because the genesis of modern economic thought connected to these ideas was physiocrats in the 18th-century. However, these ideas go back to ancient times.

Specifically, Laissez-faire economics defined takes the view that the relationship between economic agents and the government should be left unhindered. Free market trade and commerce, if unregulated, results in a more efficient outcome, and higher general prosperity than interventionist policies. It also results in greater individual happiness or at least self-actualization through unrestricted social interaction in the economic arena. This interaction tempered by moral choice and social awareness.

A laissez-faire economic philosophy relates to local regulation as well as macroeconomic financial and monetary policy. In the area of political debate, topics include trade, taxation, regulation, property rights, central banking and choice, and human action. It does not include moral issues that deprive others of life, liberty and the pursuit of happiness. Libertarians, classical economists, and laissez-faire economists are not anarchists; this is an important point. On the contrary, their goal is to improve human cooperation and peace as these ideas facilitates economics freedom.

However, the critical point often missed by too many of my students at first glance is, Laissez-faire economics is a spectrum rather than an either/or. You do not have to embrace one idea or the other. Even within the community of free-market economists, there are those that are extreme Laissez-faire and others that see government as ‘the night watchman.’

Therefore, it is essential to reserve judgment until one develops an economic philosophy that tests assumptions of any idea on the spectrum logically and if need be with empirical research.

Why there is confusion about Laissez-faire economics

The confusion is people often mixed with human normative statements about what ‘should be’ based on personal views on ‘justice’ with economics. They extrapolate and project the ends onto the means.

We can acknowledged that justice is the ultimate good. However, our conception of what justice is varies as does the way to achieve it. I recommend the book Six Great Ideas by Mortimer J. Adler for a clarification of this topic and why justice is the summon .

Yes, most people have compassion and sincere intentions to better humanity and a desire for justice; however, how we define and achieve this is the issue.

Some people subscribe to the classical liberal philosophy in economics, and others follow the derivatives of Karl Marx, e.g. socialism and communism.

Austrian economists like Mises, Hayek, Rothbard, and Robert P. Murphy want to make the world a better place for us to live by emphasizing choice and individual human action as the drivers for improvement.

Similarly on another group of economists like John Maynard Keynes, Michael Woodford, and Paul Krugman also want to make the world a better place, by developing theories about how political entities (central governments and central banks) should engineer people’s economic activity because of perceived market failures.

How can both of these educated, intelligent, knowledgeable economist vary so radically in their ideas is their ultimate aim is a more just society?

Adding to this confusion is the current trend in economic research. That is the desire to empirically test ideas, even if they are on an aggregate macro level. This empirical approach stems from the belief that economics is science closer to physics than social science. It is a science with laws and generalizations that are universal and humans are the particles.

The problem with this is individuals and their actions, and most important, purposeful intentions are not abstractions. Their dreams and desires that are changeable and uniquely human. It is not like if I drop an object on a planet with a specific gravity it will fall. Rather, humans are complex and even transcendent.

To abstract into seeing humans as objects and data points to be steered into a model’s constructs with the end goal of the model being a statistical average based on an economic index is an academic loss of objectivity. Words like output gap and average income, the natural rate or CPI are the targets of these models (despite their conflicting definitions) and do not represent individual choice.

Therefore at the core, an understanding about laissez-faire economics are not about which group of economists care more about humanity or can build a better model, rather it is about which group of economists understand some fundamental philosophical ideas.

Recommended thinkers in laissez-faire political economy

Adam Smith’s Wealth of Nations in 1776 and the Theory of Moral Sentiment are two works which detail this discussion.

However, it was Ludwig von Mises who in his book Human Action in 1949 helped clarify these issues.

A modern discussion is a book by Robert P. Murphy titled Choice Cooperation, Enterprise, and Human Action clarifies this further for the modern reader.

The underlying premise of the above mentioned political economists is, that when people are left to their ‘enlighted self-interest’ then society as a whole benefits through innovation and cooperation, even if the arena of economics is competitive. It is this free human expression that allows for society to prosper and individuals to be happy.

Conversely, the restriction of liberties stagnates society and has a significant social welfare cost. There is a loss of consumer and producer surplus. This loss of productive and allocative efficiency often exacerbates microeconomic loss and transmutes into large scales cycles, such as the Great Depression or Great Recession (caused by monetary mismanagement) or the collapse of the Soviet Union (caused by central planning of human goals and desires).

Plans by the many or plans by the few

Keynes versus Hayek

Subjectivity theory of value

A major contribution for Austrian Economics is taking Carl Menger’s subjectivity of value theory and understanding this applied to price. Price being the an inter-temporal information point. Price conveys information to individuals in society about how to satisfy others people in the market place. In contrast, if you take an objective theory of value such as Marxism which is tied to cost, specifically labor, then you see humans acting contrary to individual and societal happiness.

This can also be applied to monetary theory and the price of money/loan-able funds, that is the interest rate. However, that is another topic.

Selfishness or Service

Arguments that laissez-faire economics is governed by selfishness paints humans or society as innately evil. Further, it implies there are a few elite, ‘the good ones’, government bureaucrats and politicians or Ivory tower PhDs that are untainted by this malaise of humanity, so we surrender our individual rights to allow them to steer us for the ‘greater good’.

Whether it be Marxism, Socialism or Keynesianism, the market interventionist philosophy misunderstands the subtle point that there is a difference between pathological self-absorption and enlighted self-interest. This self-interest, which is aware of the whole of humanity, acts, to satisfy the wants of desires of others. This is manifest formally in the supply and demand construct but generally, in countries, higher on the freedom index are more prosperous.

Consider this, that generally, people are not robbing ATMs but rather, people are making Youtube channels and search engines and growing local organic produce for the farmer’s markets, finding cures for pollution like bacteria that eats plastic waste. This is why Malthusian predictions of the apocalypse caused by economic demand outstripping supply have not come to fruition, except in restricted economies like modern-day Venezuela or North Korea. The innovation brought about by creativity (almost by definition free-thinking), combined with enlighted self-interest is what makes laissez-faire economics not something to be ackknoweldged but rather understood.

We are always searching for ways we can serve one another. Laissez-faire capitalism and is not evil, but rather merely another word for human freedom and the belief that most people are innately good.

Categories
Economics

What are the Causes of Inflation?

Inflation is a monetary phenomenon. Inflation can be defined as an aggregate increase in the prices or a decrease in the purchasing power of money. A price level change can be sustained or temporary. Inflation is sustained. Increases in the price level from exogenous shocks do not continue to increase prices generally.

In contrast, when monetary policy incorrect, there can be a sustained increase in the price level. The question is what is a monetary policy that creates inflation? There is a second question, how is inflation manifest. There is a third question, is a stable CPI synonymous with money macro equilibrium.

Monetary policy is bank action. There are two primary types of monetary policy that cause inflation or deflation.

  1. The central bank increases or decreases the quantity of money.
  2. The central bank increases or decreases the interest rate.

Quantity Theory of Money

The quantity of money is the oldest explanation for changes in the price level. Simply stated ceteris paribus for the velocity of money and the real output, the price level will increase if you increase the money supply. The equation is: P = VM/Y

This theory is an old theory, known in Roman times and before because of it is intuitive. If you increase the amount of money in circulation you will see a rise in the price level. The modern economists, John Stuart Mill and David Hume articulated this.

The Federal Reserve Bank in the US and the European Central Bank has kept a fairly steady increase in the money supply. Hyperinflation in developing countries or the interwar experience of reminded modern central banks of the welfare cost of irresponsible monetary policy connected to changes in the quantity of money.

Definitions of the Money Supply

The most relevant definition of the money supply today is M2. M2 is cash and near cash plus bank reserves. Most people think money is cash, but relevant for monetary stability is M2.

Modest increases in M2 in a growing economy does not cause inflation.

Milton Friedman resurrected the quantity theory of money and advocated rule based monetary policy with the quantity money being the target.

Why the Quantity theory of Money is abandoned?

The theory is correct in the long-run and especially in cases of hyperinflation. However, for the intermediate term a better theory emerged.

Despite modern-day commentaries, we are not simply “printing money”. However, we are doing it metaphorically. This can be understood with a interest rate theory of inflation.

Knut Wicksell the founder of Modern Monetary Theory

Wicksell’s book Interest and Prices in 1898 explained a more relevant theory of price level movements. . The idea is there was an observable bank rate of interest, that is the rate you might see at the bank. This was known as the market rate of interest. However, there was also another rate of interest that this market rate was to be measured against. That was the natural rate of interest.

A level of interest is too low or too high relative to the natural rate. A nominal rate tells us little about the appropriate level or the target for the interest rate. However, the nominal rate is relevant when compared to the natural rate. This is not to be confused with the Fisher rate real rate of interest which is simply, the nominal rate minus the inflation rate.

Money Macro Equilibrium

The natural rate is the marginal productivity of capital if barter ratios were used and when harmonized with the market rate should bring money neutrality, that is no monetary inflation or deflation.

There still may be a change in the price level, even a persistent change but that would be caused by other factors, such as technological improvement.

Why are interest rates important for the prices?

Interest rates are a price. Specifically the price for loan-able funds. Purchasing power that can be used to fund the capital formation process. It is a price that is also inter-temporal. That is purchasing power used today versus the future.

A price – any price including an interest rate, conveys information about time and subjective valuation

Wicksell’s theory shifted the emphasis from a simple relationship between money and capital formation and expansion to purchasing power or credit. We are really talking about what level of credit should be in the market to fund entrepreneurial capital expansion or capital lengthening (Mises, 1912, The Theory of Money and Credit)?

Credit is more relevant in a modern economy because this is what entrepreneurs use, they certainly are not paying in cash, rather money is done in a bank giro system, money transfers and credit.

Therefore if interest is what governs the supply and demand for credit, the central bank tries to bring money to a neutral or equilibrium rate.

The natural rate of interest as a monetary policy target

After the central banks jettison targeting monetary aggregates, interest rate targets are the primary way that central banks achieve their mandated policy objective of price stability.

Misunderstanding of what the natural rate is has lead central banks to misestimate the natural rate or not consider there might be multiple natural of interest. It might be low because rates are low, and this a feedback mechanism.

The Fed uses an interest rate target called R star, this is an empirical estimation of the natural rate of interest. This theory is largely based on economists as Michael 2003, Interest and Prices. They believe like Wicksell, that if the natural rate of interest is equal to the market rate, in this , the Fed Funds rate, money would be neutral and price moments would be worked out in the real sector by supply and demand.

What is wrong with interest rate targeting?

The issue is, these estimates are wholly empirically based. The illusion that they have anything close to the natural rate estimate is manifest everything time a chief economist proclaims “this time is different’. Lets look at the theoretical basis for this central bank theoretical error.

In one rendition of the natural rate of interest Wicksell wrote:

This is necessarily the same rate of interest which wold be determined by the supply and demand if no use were made of money and all lending were effected in the form of real capital

Interest and Price, p.188

This is a monumental error by the Federal Reserve. It is an assumption. The assumption is in an economy where is ubiquitous, can you make an estimate of the rate of interest in ? That is a rate of interest is barter ratios are used. How can you have a natural rate of interest, a is hypothetical in a barter economy, if money is everywhere? It is a theoretical paradox with realworld implications.

If you are wrong, you will start a boom and bust cycle as articulated by F.A. Hayek. If money is not neutral and the price of credit is miss-priced than like every other price you will have a loss in surplus. Since there is no market for money unto itself, monetary disequilibrium is worked out through all prices across all markets.

I explain Austrian business cycle here in a natural rate framework. That is how a misunderstanding of the natural rate and how it coordinates investors and savers ex ante causes capital distortions which can be coupled with price distortions.

This is manifest giving wrong signals to entrepreneurs, like traffic lights that do not work.

Rates are too low to harmonize investors and savers ex ante. This is distorting the capital structure.

The result is an equilibrium that is less than optimal. It might seem like everything is functioning as should in the economy, especially with a stable price level defined as the CPI, but it is not.

The economy is in a disequilibrium that cannot be perceived at first glance because the natural rate of interest is at the wrong level. Only after the crisis has started or is this reality manifest.

How inflation is manifest

Typically there is not a traditional rise in the CPI like in old style theories and economies. This is because productivity gains associated with technological innovation has decreased the overall cost of production. Rather inflation is seen in asset bubbles like real estate and the stock market.

Asset bubbles – the new inflation

Business cycles and inflation are connected. Not in the old school Keynesian Phillips curve but with meteoric rise in the stock market. This is fueled by credit and debt brought about by a market rate of interest that is too low.

The cause of inflation, whether it is old style CPI inflation or manifest in asset bubble like the market the Federal Reserve bank’s non-market solution to the money supply. Creating empirical models which are based on wrong assumptions.

Productivity gains results in cost efficiency and a lower CPI.

Why is health care and college so expensive while the CPI does not manifest this? Because everything we observe is in aggregate. Because productivity gains in consumer goods have decreased their relative price, prices with social welfare in places like education and health have inflated.

The bottom line in the Federal Reserve causes price disequilibrium even if inflation is not manifest. This inflation is manifest in a estimate of the natural rate of interest.

Categories
Economics

Keynesian vs. Austrian Business Cycle Theory – Explained

I often ask my class to compare the Keynesian explanation for the business cycle compared to a monetary or Austrian explanation of a business cycle. I am primarily looking for the theory, rather than policy recommendations. I am looking for objectivity and positive economic analysis.

Here are my class notes summarized in pdf. If you need to study for an exam or just want to the ideas quickly you can download them here. This simple list of economic keywords. It is only a summary table.

Download Keynesian and Austrian Business Cycle Theory in PDF:

For a verbal discussion on the subject read the post below.

Funny answers my students give me in the Keynes versus Hayek debate

I often read and hear “Yeah man, Keynes was for big government and Hayek believed the government should stay out”. Then they apply some normative statement connected to what they think is right based on opinion. “Dude, Keynes man, he was bad”.

That is basically correct, however, I am really looking for the theory behind this. Why did the economists of the Keynesian school of thought and the Austrian school of thought come to come to different theoretical conclusions? It is the economic theory that brings you to a conclusion and even an economic ideology. Therefore, I am concerned with an objective non-basis statement of the theory as they understand it. In fact, sometimes I disallow students to use the word ‘government’. It is a too general cliche word. Better would be to go into fiscal or monetary policy.

Depending on which hat I wear that day, I would argue either the Keynesian or Austrian ideas, and sometime even suggest a synthesis. However, a synthesis as understood in today’s terms is really a Keynesian model. Full disclose, I come from a more Austrian perspective.

Regardless, I want my students and my readers to be able develop critical thinking. At the end, I want people to weight the evidence and perhaps draw some conclusions based on which theory is more logically rigorous and what the empirical evidence suggests. Being objective and impartial needs to be the stance from the start so even when you have a conclusion you can better defend it as you understand both sides.

Lucky, I find politics boring, this is why I prefer the theory over the prescription.

Lets get right into it.

How Keynes explained the business cycle

Y=C=I+G

Keynesian economics is an under-consumption model and explanation for the business cycle based on under-consumption. In the Y=C+I+G equation, C or consumption is the biggest component. Many people think G or government is, however, it is C. G is the most stable and I, Investment is the driver behind business initiatives and sensitive to interest rates.The reason C fell or falls is because Keynesian economics is an under-consumption model and explanation for the business cycle based on under-consumption. In the Y=C+I+G equation, C or consumption is the biggest component. Many people think G or government is, however, it is C. G is the most stable and I, Investment is the driver behind business initiatives and sensitive to interest rates.

Say’s law

Keynesians believe if C is the largest component, the lifeblood of the economy there is where the focus of the theory is. In contrast to Say’s law, Keynes believed demand creates its own supply. If people demand something business will respond and bring it to market. If consumer demand falls then business will have to cut back. Objectively this makes sense.

Aggregate Demand and Aggregate Supply model

If you look at the AD and AS model this would be seen in shifts in the AD curve. The long-run AS curve being vertical and AD moving to the left or right depending on decreasing or increasing consumer demand.

How Animal Spirits leads to unemployment

‘Animal Spirits a version of consumer confidence, is a primary in the fluctuations in GDP. The AD curve will fluctuate. What happens next is a domino effect. Whether you see it as a negative multiplier or the paradox of thrift, that is people are allocating money from spending to savings the end result is spending falls. Firms feel the in demand, and adjust their production. This ultimately is equated to unemployment. Profit-maximizing firms need to lay off workers because of lagging sales and fixed cost.

They could reduce workers wages , which is a cost of labor price adjustment. However, workers tend not to accept wage reductions either because of explicate contracts such as labor unions or implicate contracts or an general understanding.

Think about it, if your boss told you, sales were down a little, we will cut your salary by 20% would you agree? You personally have non-discretionary payments like your mortgage and car payments that you could not make. The usually scenario is a simply layoff.

When you are unemployed you personally will be spending less. For example, you will order less on Amazon and perhaps opt for a Netflix night watching Portlandia instead of a weekend trip to Portland. This means you are spending less and the economy as a whole starts to experience an inverse multiplier effect. That is, you spend less and business make less and have to lay off more people. The unemployed have less money and people again spend less and the result is business spending and employment is depressed. You have a recession or a depression.

The stickiness of wages and slow price adjustments cause the economy be to stuck outside equilibrium or in a less than optimal equilibrium. In other words, information and coordination lags affect price adjustments back to equilibrium.

Money in Keynesian theory

Money in the original Keynesian models played a relatively subsidiary role. It was connected to the liquidity preference and hoarding of money. Keynes introduced the idea of a liquidity trap, which no matter what the rate of interest people preferred to hold money rather than spend it.

Money’s role in the economy was essentially about spending and again, the C component in the Y=C=I+G equation. The problem was because of market failures money and spending was not flowing, not in a circular way or any way.

GDP in aggregate falls

The end result is you have an aggregate fall in GDP. Again this is aggregate. Aggregate is not be equated with individual people and markets. Just because the aggregate is down does not mean individuals are not prospering and making money. People who can adjust and adapt are the agents that bring markets back to equilibrium.

The Keynesian Solution

The ultimate solution is to increase G and this will create a money multiplier. Whether it is digging ditches, war, or paying the glass man to fix broken windows. If the engine has stalled you need to give it push.

Alternatively Keynesians do not mind monetary stimulus, low interest rates. It does not not matter just get spending flowing. It does not matter debt or deficits or Federal Reserve stimulus. When the economy is down turn the dials and micro manage the free market that has failed.

All you have to do is spend. The paradox of thrift needs to be eradicated, now get out there and spend money, it does not matter how.

How the Austrians explained the business cycle

The Austrian business cycle or ABCT is a monetary theory of the business cycle. disequilibrium in the money disequilibrium in the real sector. It is the boom that is the cause. A boom by a monetary policy that expands credit inappropriately for the level of real savings. Credit expansion should correspond to a real savings level. Instead, in a it is related to the Federal Reserve the interest rate and ‘creating money out of thin air’. This creates a distortion of the capital lengthening and formation process.

Do not worry about what that means now, it will become apparent latter.

Lets look at money and the real world then why and how their interrelationship is the basis of the Austrian Business Cycle theory.

Money

Money has been something that has evolved as a tool to satisfy the double coincidence of wants. A barter economy simply could not achieve the same level of efficiency in satisfy wants. Therefore, people started to spontaneously and organically use commodities that functioned as a medium of exchange and most efficiently satisfied the double coincidence of wants. Initially it was such things as shells or salt (hence the word ‘salary’) and eventually it evolved into metals such as silver and ultimately gold.

The important point is, it is not that gold was chosen, rather, people just started to use it as it worked the best. Money evolved to be what people use as a medium of exchange.

Economics of supply and demand

Basic economics is about the supply and demand for a particular good. For example, the price of potatoes is determined by the market forces of supply and demand.

If I bring potatoes I grow in my backyard to market for price of 3 (dollars or Euros) a basket, the market will tell me what if the price of 3 is correct. If I sell everyone and I am happy, with the price, this is a natural equilibrium.

If I sell my potatoes for 1 penny and I sell all I have, this would most likely not cover my cost.

If I sell my potatoes for 100 dollars I will not sell them.

My point is I find a market clearing price. The market clearing price ex post will be the equilibrium price.

The point being supply and demand work out disequilibrium quickly though the price mechanism.

There is no market for money

Every commodity, including capital goods works out disequilibrium through an adjustment in prices. However, money has no market, so it works out its equilibrium across all markets. This is because money is the second half of every transaction. Adjustments to equilibrium for money is seen across every market.

These adjustments can come in the form of adjustment to price, the price level such as monetary inflation or deflation. It also can come in the form of a business cycle, that is fluctuation from GDP away from the optimal, that is an output gap.

Therefore, a monetary theory and policy that is money neutral is important for an economy to achieve a high growth path and optimal equilibrium.

Interest rates an Monetary Theory

The old theory of money was the quantity theory of money for example David Hume, and its resurrection by Milton Friedman.

Austrian monetary theory starts with Wicksell’s understand of the relative interest rates. That is the quantity theory is true in the long-run but in the intermediate term and relevant for money macro equilibrium are interest rates.

Wicksell’s interest rate was:

determined by the supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.

Knut Wicksell Interest and Prices, 1898

That is why it is called the natural rate. That is in natura means something that is raw in nature and untouched. It could be called the rate of interest.

If the central bank brings the market rate of interest, in modern terms the Federal Reserve Funds rate with the hypothetical natural rate, this would replicate a world without money, a money neutrality where all prices and quantities and investor dections are based on real factors rather than monetary arbitrage. Intertemoporal descions would be coordinated optimally for investment plans.

Wicksell and the Keynesians of today (For example Michel Woodford) would equate th8is with money macro equilibrium. It would be observational through a stable price level.

The issue is the natural rate of interest is a theoretical construct and by its definition unobserved. You cannot observe a natural rate, that is a rate of interest if only barter ratios were used because money is the second half of every transaction. It is embedded so deeply in the economy that any wholly empirical estimate like the Federal Reserves R* would be nothing short of a fairy-tale. See the Fed fairy-tale here: Natural Rate of Interest.

The Interest Rate is a Price

Prices coordinated inter-temporal decision making processes. For the entrepreneur it is part of the discovery process and allows the entrepreneur to make decisions about future plans for investment. Specifically, how to length and to what extent the entrepreneur takes on long term projects. Ludwig Von Mises in 1912 in the Theory of Money and Credit outlines this.

If the price of money, or more exactly the price of loanable funds is mispriced then wrong signals are sent through the market and you have a market miscoordination.

This is so profound because money is the second half of every translation. It is everywhere so money’s non-neutral effect on the economy is like a domino that starts a process.

Federal Reserve estimates of the natural rate of interest called R-star through the FED/US model and mirrored by the DSGE model and supported by the theory of Micheal Woodford in his book Interest and Prices are rule based better than discretionary policy. However, it would be the third best way to achieve money neutrality since these estimates will consistently create bubble no matter who good the math becomes. Why? Because money is the second half of every transaction and therefore the money neutral rate is unobserved.

Market prices do something, they communicate information, they are not just some arbitrary number.

Robert Murphy

Cluster of business mistakes

If you were to wake up one morning and you heard there were 500 fender benders on U.S. Route 1 you could assume either there was temporary insanity en masse or something more likely, the traffic lights all went green. When rates are low relative to the natural rate, all lights are green.

The economy is giving false signals to the proper level of savings and investment. This results in a . You have a cluster of business failures. That is a business cycle. It is a distortion of the capital structure from people getting wrong signals, in this case the interest rate controlled by the Federal Reserve.

If you centrally macro manage the interest rate, you will mislead people and they will make wrong decisions.

Malinvestment – Capital Theory

A detailed discussion on the malinvestment, caused by entrepreneurs getting wrong signals is beyond the scope of this article. However, idea is understandable. When the Fed sets rates too low, relative to a money neutral level because it can not estimate correctly or there are multiple natural rate, then ex ante investment and savings is coordinated in a distorted way ex post. It is saving that there is more savings then there really is when rates are low in relation to the natural rate.

The level of investment during the boom is not supported by real savings.

Whether it is the dot com bubble or the crisis of ’08 and the expansion of real estate or the next crisis, perhaps the stock market and debt expansion crash, there is a distortion. The interest rate is giving wrong singles about how the capital lengthening process is optimal for profit.

Investing does not have anything to do with frugality and savings and real value and wealth creation, but rather a credit fueled high. This cannot be sustained as it is artificial.

Money pumping exacerbates inequality

The policy of discretionary and non-discretionary money pumping is often tied to political and business incentives and potentially exacerbates the Gini coefficient because the money flows top down to the banks and to people who have preferred.access to credit.

Austrian school of economic solutions

Let the markets work. Let saving and investment and investment coordination be determined by real market prices. This includes the elimination of the Fed and it replaced by a market standard, rather than a standard. That is people, free people make choices about saving and investment and interest rate based on real rates and prices, rather than a planning the interest rate.

Keynes versus Hayek the next round

In the Keynes versus Hayek debate, new economists have entered the field.

Old Keynesians: John Maynard Keynes, John Hicks, Franco Modigliani, Paul Samuelson

New Keynesians: Michael Woodford, Paul Krugman.

Old Austrians: Ludwig von Mises, F.A. Hayek

New Austrians: George Selgin, Steven Horwitz, Robert Murphy, William , Lawrence H. White

Although I would like to go into more detail, it is a good review. It is more a sketch of two schools of thought and if you have questions or please leave them in the comments below.

Categories
Economics

Wicksell expectational business cycle model

Knut Wicksell developed a model for understanding price movements based on the divergence of the observed bank rate of interest and marginal productivity of capital or let us say the profit rate. variations of this idea were developed by the Austrian school of economics to explain business cycles. That is disequilibrium in the monetary markets create disequilibrium in the real sector, a business cycle.

A simplified version of Wicksell’s theory of price changes

Although Wicksell was more concerned about explaining changes in prices caused by the divergence of the general profit rate, the rate of return of an entrepreneurial activity in relation to the bank rate of interest or the charge for business credit, I look at it as a very good explanation for why an economy experiences a boom and bust cycle of recession. His economic theory was a framework for modern business cycle theory.

If I were to choose one explanation for why we are in a great recession, I would nominate, the monetary shocks cause disequilibrium in the real sector. That is the Federal reserve lowing the rate of interest so low, that the economy bubbled and burst. When the Fed and Fiscal action tried to inflate the balloon again, with similar measures, it would not inflate because there was a hole in the balloon.

The basic idea of why markets go crazy and why ‘in the day’ we were all winners and borrowed even after signs of weakness in the economy; not because we were irrational about our choices, but simply the expected profit was greater than the cost of borrowing.

Enter Wicksell’s theory with rational expectations. If you extend Wicksell’s theory of prices to expectations of the marginal productivity of capital, that is the expected profit rate, rather than an observed profit rate, then entrepreneurs do not want to expand based on the uncertainty of profit in the future. The more uncertainty there is it has a dampening effect on profit.

For example in simplified terms, if there is a current 10% profit on capital, and interest rates are 5%  you would think there might be growth. You could borrow at 5% and earn 10%. Yet investors are leery and do not go to the bank to take a loan.  Why?

This is because the term of a loan lets say 30 years and expected profit over the life of the loan is only 6%, yet the variance caused by uncertainty might be 3% to 8% and since investors are risk-averse (statistically),  business owners would rather not take the risk. So it is not the profit rate today that counts but the expected profit rate, but also factored for uncertainty.

Ways to prevent trade cycles

  • The only way for a market to achieve long term growth is by letting the markets work. This could include the elimination of the central bank and free money.
  • If the government really must monopolize the money supply a gold standard would provide expectational stability and lessen the chance of a monetary shock.
  • Business cycles would come about even if the monetary world of interest and prices were in equilibrium because economic research shows statistically there are most likely a number of causes to business cycles. However, I would nominate monetary disequilibrium with an expectational component as the primary cause.

What Wicksell really said about business cycles before the Austrians expended his price theory

Wicksell’s theory of business cycles was based on real factors and was somewhat Malthusian. Wicksell explained recessions and recoveries a function of shocks and variances in technology, discoveries, population, and the capital stock. Remember the economic theory of Knut Wicksell was concerned with Wicksellian ideas like the natural rate of interest, the cumulative process, the neutrality of money, in the short and the long run and a pure credit economy were discussed to explain problems of deflation. It was Gunnar Myrdal and Erik Lindahl that developed the idea of monetary equilibrium. It was Misses and Hayek that extended this.

Categories
Economics

Cost based pricing vs. Value based pricing – How naive are you about economic justice?

I believe the heart of the misunderstandings about economic justice and fairness is a misunderstanding about what a price is. Many people on all sides of the political spectrum have passionate views about economic justice and what this represents? It determines who to vote for and how the economy should develop. The central question is what is a fair price? And this includes the price of you are paid at work or your wage.

Cost of construction is almost the same for homes on the beach in contrast to a few miles away in the country but the price is several times more. People put up little cheap houses on the beach and yet demand a great price. This is because of the subjective theory of value.

Example of how naive people are with economics

There is a real estate agent in my office who sells high-end homes on the side. I am looking to buy a home and said I would work with her if she goes for the best possible price. Her reply was “I do not want to insult the seller by offering too low a price”. I was surprised at such a naive answer.

I questioned her as to why she has such a view. She explained how foreigners were coming in and low balling the prices and driving them down. She continues to explain that the price was a function of the cost to the owners, which was in tern a function of the cost to the real estate developer. The price should be fair. It is unjust if someone pays 400,000 dollars for a home and someone buys it for 200,000. My Initial reaction was what century is this lady living in. It certainly was not the 21st century.

  • St. Thomas Aquinas believed in something called a ‘just price’ based on cost and a just profit. This was in the 13th century. I am Catholic and, one of my favorite thinkers but he did not have a clear understanding of supply and demand.
  • Karl Marx believed there was an objective measure of value, such as the cost of labor put into the object. This was in the 19th century. Started a revolution in thinking that cost the human race 100 million lives not to mention economic poverty for Eastern Europe.

What do I care what some bloke paid for something? All that matters is what value is it to me. He could have paid 1 penny for it, but if I find it of value I might pay 100 dollars. This is economics.

Finding gold example

For example, if I find a gold nugget in a river, should I sell it for what it cost me to pick up and then a 10% margin? Value is always determined subjectively, that is by the price a customer will pay for something. Value is subjective. Value is determined by supply and demand not cost. Not even a little.

Crude artistic example

Another example, if some person, offers to tattoo your chest with a dadaist images of an upside-down toilet with a flower in it, but it will cost me 100,000 dollars because of his artistic skill and the cost that went into obtaining that, would you do it? Of course not. I would not do it for 1 penny. In fact, I find both objectionable. Price is determined by what a person will pay for something, nothing more.

Even if marginal cost equals marginal product is the microeconomics understanding of price, it still comes down to a subjective understanding of value.

Rules to remember about price

  1. Buyers do not care about your cost – I bought some stock and the price is down, when I sell it in the market, the largest auction block in the world, the stock market, no one cares about my personal acquisition cost.
  2. Cost-based pricing impedes your ability to differentiate based on satisfaction, the customer suffers. For example, I like ballet, when I go, I pay for cheap seats because that is what I can afford. Yet richer folks pay for better seats. Now the cost of the seat is the same for the builder, but and owner, but the price is different based on the view. Similarly in Real Estate the cost of a home in a cornfield in Nebraska or Detroit, Michigan is different than in Florida on the Ocean even though the cost to build in Florida might be cheaper, as it does not have to be prepared for winter.
  3. Profits are limited as is innovation with cost-based pricing. – Imagine someone develops a way to make a smart phone thinner, lighter and more user-friendly than the older model, but the same production cost, as an old-style cell phone. Are you telling me I can not charge more, to the consumer who wants a clearer picture and more fun with communication? Where is the incentive to innovate?

Cost pricing is something stuck in the heads of accountants but in the real world, you are paid what someone thinks you are worth and you purchase something based on the same idea. The idea of justice and economics come into play as there is not a fair price for work or goods. Fair is something in a game or gentlemen sport. But economics, says nothing about fairness one the price level.

Where the ideas of economic justice do come into play are giving people the chance to develop their potentials in life and providing a safety net for those disenfranchised in life. I believe this is both a private sector with charities and government initiative and on an international scale.

  • But the price, no, there is no such thing as an unfair price or wage. It is a free county. If you do not want to pay for it and if you are paid to little quit your job.
Categories
Economics

Mitt Romney’s economic plan

Do not read journalist’s critiques of Mitt Romney’s economic plan by papers like the New York Times or the Huffington Post. They will only give you partial gobbledygook. Read my critique of he economics of Mitt Romney.

  • In one clear, crisp concise statement ‘Romney is free market but uses economic incentives to encourage productivity and keep a safety net for the disenfranchised in our society’. If you like that view of political Economy than Romney is your man. Please read on for more interesting elaboration.

Romney does support economic common sense, and not give aways to the fat cats on Wall Street, contrary to what his opponents try to represent.

Mitt Romney’s economic plan is free market but not to the end. The purpose of this post is to look in a summary form at the pros and cons of Romney’s economic vision for the USA. Since I was a kid, I remember the neighbor fathers talk about we need a businessman to be President of the United States. Well at this juncture, it looks like it is going to happen. So it is important to get a clear understanding of his economic ideas, right from his book, not the media or political ads.

I might seem critical of Romney,  but on a whole, I think he is a good man and his economic ideas would help the USA more than Obama’s. Romney is generally free market and has positioned himself as someone who can appeal to Democrats economically because he is not about ripping apart safety nets but rather encouraging jobs in the free market and yet retaining a safety net for the poor and displaced.

Endeavor t0 provide the dignity of work in every safety-net program where that is possible, evn if it costs the government more money to do so.

Mitt Romney’s economic – political ideas

Romney like Obama sincerely wants to help the lower and middle class American.  I have never doubted their sincerity, just their understanding of markets. I will use Mitt Romney’s book No Apology as a guide to understanding Mitt Romney’s view of economics and quote from it. It is not economic theory but more the ideas of a politician who understand economics to some extend.

Productivity

An economy  is a function of the number of people in the workforce and the productivity of that workforce.

Romney’s view is focus on productivity as the central idea for generating wealth in the USA. This comes from his business background. That is if you have ever worked in an office you know a lot is about increasing efficiency and productivity. It is about showing efficiency gains on a micro unit level that gets you as a middle manager your bonus.

For example, lets imagine a micro nation, has one hundred people raising the food, while 100 built houses. Then one day, an innovation like the plow comes a long. Wow this is a breakthrough and now this micro nation only needs 50 people to raise food. Would fifty people be unemployed?  Romney’s answer is not really. They would use their talents and brainpower in other ways to increase the well-being of society instead of manual labor intensive processes. Some of these displaced workers will be better off and some will be worse off, but no one would argue for the return to agriculture before the plow. Life for all would be harder.  Productivity gains are almost synonymous with economic progress.

Romney is correct that productivity is an important component of economic growth.

Two books discuss similar issues if you wan to examine this in more detail and different points of view are:

  • The Power of Productivity: Wealth, Poverty, and the Threat to Global Stability – William W. Lewis
  • Cities and the Wealth of Nations by Jane Jacobs
  • I think it Romney needs to make his message clearer, that economic freedom accelerates innovation, not that innovation gives us prosperity and hence economic freedom. Further, not government economic plans or recovery initiative to jump-start the economy.  The economy is not an engine that starts and stops, it is me and you taking individual action. Romney needs to champion this point even more if he understands it.

Innovation is the engine of productivity gains

In the 1980s it took ten hours to produce a ton of steel, today only one hour. This was because of innovation in the process of production. It is not that people are working harder, maybe they are, but it is more about technology and the process. It is not just some earth shattering breakthrough in science but also process improvement and work flow.

A key component of getting the economy to function better as well as the government sector is free markets so innovation can lead the growth. This includes outsourcing government functions to the private sector.

It has been my experience that almost always government is far less productive than enterprises in the private sector. That’s why private companies build roads for governments and make equipment for the military. It’s also the reason why FedEx and UPS can make a profit shipping and delving packages while the U.S. Postal service loses money, even with its inherent competitive advantages.

  • We can conclude Mitt Romney is free market in the general sense. So where does he fail in his economic understanding?
  1. Increasing the military – the biggest waste in the world.  This is an economic issue. We have been fighting wars since I was a kid in the 1960s and that is not going to change. Romney argues for an increase in soldiers (he says we need at least 100,000 more) in the military because the percent of GDP is not that large. I tend to disagree, I will not go in detail on this but let you do your own research. However, I personally know a lot of military and ex military guys doing nothing in the USA, nor can I see them ever integrating into the economy in a meaningful way. I think the military has a profound psychological impact on the most productive years of your life and many times hurts those young people from finding their way in a complex post industrial economy (in contrast to the post WWII economy which was easier).  Remember we are not defending US soil but playing a political chess game and using brave Americans as pawns in Middle Eastern politics. Most people know this by now. I say a smaller military for home defense not micro managing the Middle East. The impact of having a bloated military is huge. For example, did you know the cost of the wars in the Middle East exceeds the revenue collected in individual income taxes. Yep, the income tax is not where the US government gets the majority of its income. We could have eliminated the income tax instead of fighting those Middle Eastern wars with the grande army. So why does Romney want to increase military spending and overseas influence?
  2. Quasi free market but not really Supported the bail out of the auto industry with managing restructuring. This is better than Obama’s cash infusion method. I would say the auto industry could have fallen and restructured without the cost to US tax payers. Maybe I am wrong on this, but I have always said let the markets work or the cost is higher prices, less innovation and lower consumer satisfaction.  I still think cars are expensive as anything and thanks to your tax payer dollars it looks like it will stay that way. Supported the bank bailouts. Banks now sit on a huge inventory of foreclosed homes and the prices are still high in my opinion. If you want affordable housing, let the reckless banks fall and deflation correct the market, then you would see the haves loose and have nots gain because the market would work naturally. Supported the Federal reserves anti-deflation monetization. Big mistake, we should let he markets work.
  3. Barack Romney or Mitt Obama – they are more similar than different, despite the political noise. Obama focuses on social programs and Romney military build up, but besides that basically the same. Ron Paul would like to eliminate the income tax and the Federal reserve and balance the budget by cutting real spending not growth like Romney’s cut the rate of increase. Now that is free market and that is different. Mitt Romney is more a bit free market and a better choice economically than Barack Obama, I guess, however, I would have to see more  understanding of money and markets to be totally impressed. I think at this point I will vote for him, maybe. Obama did the opposite of what should have been done in many cases because accident economists advised him wrong and he did not have the understanding to go against them.
  4. Mitt still thinks in a corporate way, that the economy is a big machine

Having grown up in Detroit, I tend to think in automotive terms. If we imagine that the economy is an engine, then capital is its fuel.  – Romney

The economy is not an engine. It is you and I. It is not fueled just by balance sheet capital but by intellectual capital like the people who started Microsoft or Google.  They are usually innovative individuals, not large companies to start. Romney supports a decrease in corporate taxes to increase company balance sheet retained earnings for research and development and innovation. I guess, but don’t you think a lot of that will be just paid out to someone instead of allocated to R&D? It is trickle down economics.  What about eliminating the income tax so people, who are the ones who often create the best innovation in the basements (I have known many people who start companies in their garage that have done brilliant things like one of my former employers SS&C, an Investment Accounting software company, it was started by Bill Stone in his garage). So Romney is good, but thinking in terms of his experience in the corporate world. In contrast, I tend to think from an ideological standpoint of maximizes individual liberties, including economic and markets in aggregate will take off. This is Adam Smith.

Romney on minor economic issues

Romney supports a moderate minimum wage (some people argue this hurts small business not large). And Romney supports unemployment insurance as a safety net (some people say this prolongs unemployment). I have no major problems with either of these ideas because they do not have a huge economic impact. I think both have a libertarian solution but this is not the source of our massive economic problems.

What is the real source of the economic problems?

The Federal reserve creates business cycles with easy credit and excess spending with Keynesian fiscal policy. This  displaces productive people from the private sector to the sluggish,  wasteful government sector. Not just a trade-off between one sector and another. Remember the post Keynesian model C+I+G=GDP? Wrong. Spending is a not an accounting equation, but one of crowding out and opportunity cost that is usually over looked.

For example, when someone is getting your income via taxes by being employed by the military in the desert as an artilleryman, does he have a job? Yes, but what if that young fertile brain was in the private sector using his 20s to create something innovative. A major displacement of intellectual capital.

Other economic quotes by Romney

The best way forward is not to erect trade barriers but instead to facilitate innovation and productivity that will sustain our global manufacturing competitiveness.

I agree. Trade protection will make every consumer good higher priced, I will not be afford a lot. Focus on innovation.

Our Standard of living are the highest of any other major economy

Questionable but I am glad I live in the USA.

In his capacity as chairman of the Federal Reserve, Alan Greenspan made a decision to hold down interest rates for an extended period that didn’t help either. He was motivated by a desire to avoid deflation – and in that respect it worked.

Did not help? That was the  root cause not a helper in all this. And deflation, nothing wrong with it, it is the market working. To not have deflation if needed is asking for long-term slow growth and deprives the have-nots the chance to have. People point to the deflation of the great depression, but that was a symptom of a deflating bubble created by the central bank.

The fact that both parties have come to accept deficits and ever-higher levels of public debt is deeply troubling.

Agreed, Romney is much more fiscally responsible than Obama. But why not just way number one probity is a balanced budget amendment?

Increase our investment in science and basic research

Not libertarian but I like it. I was talking to a military guy at the park the other day when our kids were in the playground. He told me every new immigrant should be required to serve in the military, even in combat zones before they come to the USA. Yeah right, we would turn away brilliant minds in research and science and replace then with jarheads. We should focus on intellectual strengths not old world ideas of blood and iron like Bismark believed. We do not need more industrial factories but high-tech centers offering solutions. I think investment in science can be encouraged with government and private business, although I think the latter does a better job. US innovation is on of our saving graces, we need to make sure it stays that way.

Romney on economics and the USA

  1. A Strong Economy
  2. A strong Military
  3. A free and Strong people

Mark Biernat on economics and the USA

  1. A free economy – only way to achieve a strong economy and real stability is maximizes economic freedom like delete the Federal reserve and let the markets work. People criticize free markets, do not realize we have not tried it yet.
  2. Military for defending America – To illustrate the waste, what if we spend 1/3 to 1/2 of our budget on helping childhood diseases or making our cities safe instead of being the British empire of the 19th century; we would have a safer America.
  3. A free people –  You achieve this largely by a free economy, but not just.

In summary economics and the election

Here is Mitt Romney’s economic plan in detail.

Will I vote for Romney in a Obama Vs Romney election in 2012? I have to think about it, but I suppose. Maybe I will vote libertarian as Obama and Romney are pretty similar despite all the noise. The bottom line both candidates want to cut the rate of growth, not the baseline. Both support a Federal reserve and income taxes with adjustments here and there. Both support bailouts, although Romney tends to be more free market with managed bailouts. But for me they are more similar economically, than different. He is more moderate and will appeal to cross party voters, therefore, have a good chance of winning in 2012. However, Romney does have a radically better of understanding economics than Barack Obama and can appeal to both parties.

Despite my affiliation with the Republican party, I don’t think of myself as highly partisan – Mitt Romney

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Romney will get the Neo-con vote anyway, as what choice do they have, they will not vote for Obama. in the 2012 presidential election. So he would be wise to tone down the strong international military stance during the election. The election will be about a battle for the middle voters, not the extreme. What are your thoughts on Mitt Romney’s economic plan.