Hayek's Ghost Haunts the World
Did you ever have the feeling that we've been through this before?
Think of it. Those in charge have only recently sworn — yet again! — that if we keep interest rates at zero, keep battling the symptoms of recession and unemployment with spending and jobs programs, clobber the speculators with regulations, and otherwise keep trying to revive moribund industries, all will be well. Just don't cut government spending or let interest rates rise!
So where have we heard it all before? It was the 1930s, when the battle between F.A. Hayek and J.M. Keynes raged in the English-speaking world, not only in the academic journals but in the newspapers in London and the United States.
Hayek gave a series of lectures based on his previous works in German that tried to explain that the ruling elite and their theoretical apparatus had it all wrong.
In a thousand different ways he said the same thing: "To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about."
Further, "because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end."
The essays in which Hayek so prophetically explained the boom and bust are collected in the most convenient form possible: Prices and Production and Other Works. It is a 528-page book that explores every conceivable aspect of business cycles.
Because this book is in print, it is really inexcusable that the same errors should be revisited upon the world today, strangling growth and driving every major economy further into the depths.
Now, granted, many decades went by when these writings were hard to come by. Many people had only bound photocopies they would let others borrow. But since 2008, the Mises Institute has had them all gathered in a single book, with explanatory material and at the price of $25.
Wherever this book lands, and wherever it is read and studied, the answers to what to do and what not to do are clear as bottled water. Hayek could barely mask his frustration. This was hardly the first time that governments and central banks had tried to cure the bust with the very poison that had destabilized the economy in the first place.
He cites, for example, the expansionary policy of the Fed in 1927, which the Fed itself described as "the greatest and boldest operation ever undertaken by the Federal Reserve System." In Hayek's view, it was this very action that caused the explosion in stock prices that led to the bust that wouldn't seem to go away.
He concludes, already in 1932: "We must not forget that, for the last six or eight years, monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown."
Note the constant focus: the root of the problem is to be found in the boom, not the bust.
Hayek's frustration was not so intense as to prevent him from very patiently refuting every theory that imagined that the business cycle was caused by something other than monetary factors. He marched through the theories one by one until he concludes that only a distortion in monetary signaling can cause so many to be so wrong in their investment decisions.
Turning to positive theory, Hayek celebrates J.B. Say's view that, absent such interest rate and monetary manipulation, there can be no tendency for entrepreneurs to make such systematic errors that create economy-wide booms followed by busts.
And here we have the heart of the difference between Hayek and Keynes: one knew that markets work to give us the best of all possible worlds, while governments create and exacerbate malfunctions; the other imagined that governments were somehow capable of both perceiving and correcting malfunctions by means of the printing press, provided the right technocrats are in charge.
The fundamental differences are obvious in the 60-page critique that Hayek wrote of Keynes's own Treatise on Money (1930). The criticism came out in 1931, even as Keynes was working on his General Theory. Hayek — who, as Joseph Salerno points out in the introduction to the collection, was very young at the time but had the courage to correct the current giant of the English-speaking profession — corrects Keynes on point after point.
Hayek offers a polite but devastating demonstration that Keynes (a) was unfamiliar with any of the most sophisticated capital theory emerging from the Austrian tradition, (b) contradicted himself constantly, and (c) was so unclear in his writing and thought that he made serious correction almost impossible.
After this essay appeared, Keynes casually dismissed it with the comment that he no longer accepted the views put forward in that book. Keynes went one step further and wrote a petty attack on Hayek's own book! Hayek was so discouraged by this that he was loath to take up criticizing the General Theory with the same level of detail.
The experience of the 1930s and since underscores that Hayek's view, beautifully presented in this book, is the one that conforms to reality. Hayek is fastidious in crediting Ludwig von Mises for having been the first to link together all the theoretical parts that make up the Austrian business-cycle theory. Mises is "certainly to be regarded as the most respected and consistent exponent of the monetary theory of the trade cycle," he writes.
Hayek's argument is relentless but all the more praiseworthy given the times. Unlike today, where the dissent against the stimulus is intensifying, Hayek and Mises had very few colleagues whom they could count on to back up their arguments. For this reason, however, Hayek, writing in English, must have felt a special burden of proof. He wrote with vigor, scientific precision, and passionate intensity about the entire topic of boom and bust.
It's as if Hayek had an object in his hand, turning it slowly every which way and describing its shape, color, and size in every way he knew how.
It is also in these essays that Hayek first laid out the triangles that illustrate the relationship between time and the stages of production. This was a true innovation and one of his most lasting contributions to economics. The Hayekian triangle is brilliant in its simplicity, but it highlights a point that had been lost on economists at the time and has still not penetrated today: the capital structure is incredibly complex and embeds a vast range of time horizons within the plans of every actor.
Only a full comprehension of this point prepares a person to see how it is that the manipulation of interest rates by the central bank can cause such damage. But Hayek is also careful to note that reversing the course of monetary policy is probably not enough to end an economic bust.
Monetary policy might have caused the boom, but monetary factors alone are not enough to explain the fullness of the bust. There are other factors: taxes, which discourage savings and production; regulations, which block discovery and entrepreneurship; government spending, which draws resources out of the private sector; debt, crowds out investment, and more.
Hayek concludes by calling not only for an end to discretionary policy but also "a radical revision of public policy" in all areas. The same is precisely true today, which is why rereading Hayek's work from the late 1920s and 1930s is at once eerie and enlightening.
Many decades went by before English-speaking readers were made aware of a parallel series of writings that were taking place in Austria at the time. Mises himself wrote during the same period from 1928 to 1936 and on the same issues. His essays are collected in a book that is a kind of companion volume: The Causes of the Economic Crisis.
However, here we find a much clearer presentation: a different personality, a different audience, a different mode of writing and thinking. If anyone is left with a lack of clarity after reading Hayek, Mises provides the essence of the issue at hand in 1931:
Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on sand.
Economic Lessons from the Pawn Shop
Economic Lessons from the Pawn Shop
I enjoy watching TV shows like Pawn Stars and American Restoration, in part because I have an interest in history and antiques. There's something appealing about these cultural artifacts; they're rich in character, and every piece has a story. The other thing I appreciate about these History Channel shows is how each episode demonstrates a number of economic principles. Subjective-value theory, time preference, comparative advantage, and mutually beneficial exchange are all there.
Pawn Stars follows the daily operations of a Las Vegas pawnshop. Each episode features people bringing in historical items they wish to sell, and the subsequent negotiations between them and the store owners. During the haggling we learn the history of the item and what factors affect its value. Of course, each hopes to maximize their profits, and will only agree on a price if he believes it to be in his interest. Rick Harrison, one of the owners, must be careful to buy only the items he can sell at profit, taking care to avoid counterfeit items or something that will sit in the store for too long.
Each trade centers on one question: How much? The answer can be found at the intersection of the subjective value placed on the item by each party. This price then becomes the objective value of the item. Carl Menger developed a theory, explained here, wherein individuals assign value to something according to their preferences. This is easily observed when a buyer and seller negotiate a price. Harrison knows he can profit only by acquiring an item for a fraction of its appraised value. So for him, a particular item is only valuable if he can keep its price below this margin. Eventually he and the seller will come to an agreement. In most cases the seller could command a higher price elsewhere, but to do so would require more effort and time. Most sellers see a greater value in short-term profits than in larger future gains.
This willingness to accept less for an item than one could get at auction illustrates a high time preference. Occasionally a seller will decide to hold onto his item, hoping to find a buyer willing to pay more; this person has a low(er) time preference. These different preferences help to ensure that the capital structure is properly aligned. Though time preference is perhaps not as important in the case of classic cars or antique firearms, living standards can be raised when a low time preference is applied to savings. When those with lower preferences forgo their current consumption, the savings allows others to invest, thereby increasing productive capacity.
In American Restoration, Rick Dale and his crew restore classic pieces of Americana including vending machines, toys, and old cars. Often, collectors bring their own items for Dale to repair, knowing his reputation for quality work. Customers spend anywhere from several hundred to several thousand dollars to have antiques returned to their original luster. Additionally, Dale acquires items from pickers (people who earn a living buying and selling unrestored antiques), then repairs the goods and sells them to other collectors.
Dale's shop performs nearly all of the work, but he occasionally requires the expertise of another company. Here, the principle of comparative advantage can be seen. Though Dale could do all of the work, at times it's more efficient to subcontract some of the restoration. In one episode he was under a strict time limit from one customer, and in order to ensure that all of his clients were pleased, he hired a neighbor to do specialized work. Comparative advantage is a crucial part of the production process. When individuals and firms are able to produce particular goods more efficiently than others, and trade the surpluses, wealth is created.
Owners of antiques are sometimes reluctant to part with their money in the beginning, but upon seeing the completed work, they find increased satisfaction in their property. This is yet another enjoyable aspect of the show: Dale's primary focus is on creating a product that brings joy to its owner. Many of his clients bring childhood toys that are well worn, and the look on their faces when the toys are made to look new again is wonderful to see. Aside from the nostalgic value, another benefit of the work is that the items could fetch even higher prices if their owners decided to sell. So in a very real sense, wealth is generated in each exchange.
Both shows constantly focus on the concept of mutually beneficial exchange. Quite often, sellers on Pawn Stars walk away with as much or more than they hoped for. At times we see people accepting less, but they only do so willingly, showing they have gained something nevertheless. If neither party feels they are benefiting, the trade is off, and both leave peacefully. The same benefits of voluntary trade can be seen on American Restoration; no one is coerced, and no trade takes place where one feels he is being taken advantage of.
There are many great shows like these that feature the same basic economic principles. They entertain us, for sure, but they also demonstrate the benefits of trade, how prices are determined, and many other concepts that I am sure to have missed. When you examine the programs and see the concepts playing out in real time, you find that economics is more than a patchwork of disjointed theories. Each concept is neatly interwoven into ordinary life, as if to spontaneously regulate human activity in such a way as to maximize economic prosperity.
First in Line for New Money
First in Line for New Money
The world of high finance was still in full flight in February 2007. The cracks in the mortgage market had not yet begun to show and Stephen Schwarzman's Blackstone Group had just completed its $39 billion purchase of Equity Office Properties in what was the largest leveraged buyout ever.
There was plenty to celebrate, so Schwarzman threw himself a party for his 60th birthday, a 3 million dollar affair for 350 of the billionaire's closest friends, including Barbara Walters, CNBC money honey Maria Bartiromo, the Donald, Cardinal Edward Egan, and former New York governor George Pataki.
It was lobster, filet mignon, and baked Alaska for everyone, washed down with expensive vino, with comedian Martin Short as emcee. Composer-pianist Marvin Hamlisch played a number from A Chorus Line. Patti LaBelle sang a song written for the birthday boy, and Rod Stewart sang a medley of his hits, reportedly for a fee of a million dollars.
A year and half later, in September of 2008, it appeared the financial world was coming to an end. Lehman Brothers filed for bankruptcy, the once "bullish on America" Merrill Lynch fell into the arms of Bank of America, and AIG held out its tin cup in need of a quick $40 billion from the Federal Reserve.
The nation's M2 money supply was an unadjusted $7.8 trillion that month while Ben Bernanke, Tim Geithner, and Hank Paulson were working weekends to patch up their wounded Wall Street friends. Meanwhile, it didn't seem all that bad on Main Street with unemployment at 6.1 percent, despite the economy losing 605,000 jobs in the first eight months of the year. Home values had fallen 7.1 percent from the previous year, but few were underwater yet.
But the Fed chair was not interested in Main Street. On September 10, 2008, the Fed's balance sheet totaled $927 billion; by October 1 it had grown to $1.5 trillion; and on New Years Eve, the Fed rang in the New Year with $2.2 trillion in assets.
All this purportedly so that when normal folks used an ATM machine, their money would spit out on command. It all worked so well that Bernanke was TIME's Person of the Year for 2009, "providing creative leadership [that] helped ensure that 2009 was a period of weak recovery rather than catastrophic depression," Michael Grunwald wrote.
Two years on, one wonders if Grunwald realized that the weakness would continue indefinitely.
The M2 money supply has marched steadily higher to the $9.2 trillion mark last month. The monetary aggregates have gained traction, increasing at a 15.3 percent clip in the past three months.
Increases in money aren't sprinkled from the sky, floating indiscriminately into whoever's hands are in the right place at the right time. Money-supply increases occur through the commercial banking system and Federal Reserve. Those who receive the money first benefit at the expense of those receiving the money last.
"The fiat dollar is an 'elite' system," Jim Grant told the Wall Street Journal recently, "and Wall Street is its supporting 'interest group' — those nimble, market-savvy, plugged-in folks know how to shuffle assets and exploit cheap funding from the Fed to leverage up their profits and soften the downside."
After plunging to 666 on the S&P in March of 2009, the stock market has recovered up until the recent volatility, with that same index reaching over 1,350 earlier this year. Wall Street paid out $27.6 billion in bonuses in 2009 and $20.8 billion last year. Mergers and acquisitions have been all the rage and leveraged buyouts can't be too far behind. The demand for trophy office space has even heated up. But Craig Karmin, writing for the Wall Street Journal, worries the trophy-property bubble is already overdone.
An index of commercial-property values by Green Street Advisors, which is tilted toward high-end and trophy buildings, has risen more than 45% from its 2009 lows and is only 10% below its all-time highs. Although the index has been flat for the past two months, the run-up nevertheless raises questions about whether the surge in prices is getting ahead of sluggish economic fundamentals.
Bankers have been stingy toward lending to commercial businesses and private individuals, with total loans falling 3.4 percent from last year at the end of the first quarter. At the same time, bankers can't get enough of the government's paper, buying $500 billion in Treasury and agency securities during the past two years, reports Bud Conrad, economist for Casey Research. Bankers are returning the favor, "using their bailouts to help the government, albeit somewhat indirectly, using money from the Fed."
So while all this money has rushed into stocks, real estate, and especially government bonds, by the looks of it, none has found its way to Main Street except in the form of higher prices. John Williams at Shadowstats.com says prices are increasing at a 10+ percent clip. And while the Fed's QEs were supposed to stimulate hiring, unemployment soared in 2008 and '09 and hasn't recovered. According to Williams's numbers nearly one in four Americans is out of work.
While Williams says consumer prices are roaring upward, the government claims there has been no increase in the consumer price index from the third quarter of 2008 to the third quarter of 2010, so those receiving Social Security have seen no cost-of-living increase.
A record number of Americans now look to Uncle Sam to put food on the table. The US Department of Agriculture just announced that 46 million people — 15 percent of the population — are receiving government aid to buy their groceries.
And now the primary asset of the middle class, their home, has become a liability for 28 percent of homeowners according to real-estate-data provider Zillow. "We get tired of telling such a grim story, but unfortunately this is the story that needs to be told," the company's chief economist Stan Humphries told Bloomberg. It's likely more homeowners will be underwater if Robert Shiller is right. He believes home prices may fall another 5 to 10 percent.
Bernanke's crisis policy was called into question by Richard von Strigl in Capital & Production. Strigl pointed out that the creditworthy will not be interested in borrowing in a crisis. But those industries forced to liquidate during the crisis are all too eager to borrow.
However, satisfying this demand implies delaying the liquidation of the crisis, lengthening and strengthening it. For it is essential to this situation that a significant demand for credit by those who would like to work towards continuing the boom, that is an "unhealthy" demand for credit, exists along with a significantly reduced demand for new sound investments.
While times are tough for normal folks, Wall Street royalty had another birthday party to attend recently. Private equity billionaire Leon Black celebrated his 60th with a couple hundred folks at his oceanfront estate in Southampton. Elton John earned $1 million for an hour-and-a-half of serenading the likes of Vera Wang, Mayor Michael Bloomberg, Senator Chuck Schumer, Martha Stewart, and Howard Stern, who bellied up to a buffet featuring a seared-foie-gras station.
"While much of the nation's economy has struggled to recover from the financial crisis," Peter Lattman writes for the New York Times, "Mr. Black's firm — and the rest of the private equity industry — has snapped back."
Former Lehman Brothers partner and financial novelist Michael Thomas believes the party to be in bad taste. "This behavior suggests they are isolated from the rest of the world, living behind these great big hedges, and in a way they are."
Blackstone's Schwarzman attended the Black affair along with Goldman Sachs's Lloyd "we do God's work" Blankfein. "Your 60th got us into the financial crisis," Mr. Blankfein is said to have told Schwarzman. "Let's hope this party gets us out of it."
Not likely, Mr. Blankfein. The Fed's Wall Street band-aid looks to be peeling off. Another 60th-birthday blowout is signaling another financial blowup.
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