Monday, December 27, 2010

Economics: Productive vs Destructive

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Too often our citizens call for the government to create jobs, but there's fallacy in this thinking, because the government does not create jobs, it destroys them.

If we can understand the purpose of government and of law then we can better find the balance of taxation, and how little taxes we truly need in order to create an atmosphere of innovation and productivity. *I* believe the purpose of government is to provide liberty & protection of private property, NOT to provide prosperity, the latter is on our own heads to produce. In trying to postpone political dialogue for another day (it'll be a long discussion of theory and history) I'll focus on the economic side of why government spending is destructive and economically unwise. (Side note: *some* things government spends on is necessary to provide for liberty, but it would still economically fall in the category of unproductivity.)

The open market is used for buying and selling of goods & services. If someone creates a business that doesn't provide a valuable good or service then the market chooses to not allocate any resources to that business, therefore it fails. This is essentially what's known as the "profit motive", to provide something of value so that you may attain more resources for yourself and in turn provide even more things of value to the market so that you can attain even more resources. Thus there's motivation to be productive.

What happens when government spends? In my open letter to my congressman I brought up the wasted resources of the IRS, but let's be more concrete and discuss building a bridge. If a governor decides that his citizens need work perhaps he'll decide to have a bridge built or rebuilt, so he sets in motion some taxes that allows him to buy the materials and hire the workers to build a bridge. Hooray, there's a boom in employment for a select few citizens, they're able to provide food for their families and earn an honest day's wages.

This is where Henry Hazlitt has originated the thought process of identifying the "seen" versus the "unseen". What we do see is that there's now a bridge where perhaps there wasn't one. However, what we do NOT see is the jobs that were lost because of this project. We don't see where the taxes were extracted from the private sector, where businesses had to forgo finances that would've been used to expand their operation, perhaps they had to lay off a worker, or perhaps they did NOT get to hire a worker. We don't see where the physical resources were taken from, the concrete and steel that may have been used for another building or warehouse. You see, when the government buys it takes away resources from the open market and drives prices up, the law of supply & demand at work, so now we also have supplies that are more expensive to the private sector. Yet, despite having this thing that can be "seen", all we have is a bridge that the market apparently did not need; we have people who are now unemployed again, actually we have even more people unemployed because resources were taken from the private sector.

The government saw a problem, and only made it worse. Government spending seems to always be destructive, when the military goes to war it kills citizens (workers/resources), it builds bombs and literally destroys resources in the bomb itself and if a miracle happens and it manages to hit a building it destroys even more resources. "Ah", you say, "but a building destroyed is now a new project that can provide employment!" Never mind that we just covered that, instead let me introduce you to Frederic Bastiat's "Broken Window Fallacy".

Bastiat is a Frenchman from the 1800s who wrote some seething satirical articles and highly enlightened books about economics and philosophy. One of his most renowned analogies is that of the "Broken Window Fallacy". Suppose a boy picked up a rock and smashed out a baker's window, well under the false thinking then the boy is now responsible for the glass maker's new-found job, he's a hero! This would seem obviously false, if it were true then we would break all windows, bomb all cities and pray for natural disasters. Instead, imagine had the boy not broken the window and the baker had used the money to buy a new suit, now we have a window AND a new suit. Two things instead of one.

Government has the unfortunate capacity that it never has to worry about a profit motive, because when it needs money it simply increases taxation (or in our modern times it simply prints the money, a different form of taxation, a hidden tax). This is one of the reasons why it's a good idea for the government to stick to its core reasons for being and not infiltrate on the private sector, or become friends with it. With competing in the private sector it can offer wages that private businesses cannot compete with, so it taxes us to pay even more to have XYZ (mail, Amtrak, whatever) done in an inefficient manner. Realistically, 1 Federal government job costs us 2 in the private sector. And those 2 jobs are a real cost to productivity, something that would've gone towards a real good or service instead of a job building a bomb that is only meant for destruction. Sometimes, the "bomb" is simply IRS agents, TSA screeners, or actual bombs destroying lives in countries afar which result in the government asking for more bombs to kill the lives that weren't happy with the destruction of the first set of lives, but that's a topic I've covered already.

So, what happens when the government makes friends in the private sector? This is "Crony Capitalism", it's what we have now, and it's up for discussion next.
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A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive

Monday, December 13, 2010

Economics: Bubbles pt 3 - The Bust is a Good Thing

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Too often the boom is praised and the bust is hated, when in reality the only healthy part of the cycle IS the bust. Think of the bust like a shower, you scrub off the dirt and dead tissue so that you're only left with the healthiest and cleanest parts. For me, showers are also a good time of contemplation, a time where reflection spawns creative thought.

I'm not saying that we should rejoice that people are losing jobs, but if we understand *why* a business needs to fail then we'll also understand that new jobs will soon be created, because the market has automatically become more efficient in this cleansing process making available resources that were being wasted with inefficient businesses.

If Wes-E-B is giving away goods due to my awesome idea of expanding credit to my customers then when I go out of business there will now be many things that can happen. The supplies that were going to my store can now go to other stores that are more efficient and they can expand their business to serve more people. Someone can also take over the building I was using, maybe starting a new store or perhaps an entirely different business (like a warehouse for shipping FedEx, or whatever), they'll likely get a great deal since I have to auction off the only usable parts of my business (buildings, inventory, equipment), while removing from the market those bad things (my empty line of credit), this is an automatic increase in efficiency over what I had originally started with. The employees are released, but there will likely be new businesses that will need employees as well, and since these other businesses are more efficient they'll likely have a more stable job. Not to say that any of those things are guaranteed, it's a highly random example so there's a lot of room for variables, but we *can* say that there's a rush of new resources available to the market.

So it is when a bubble bursts, there needs to be a liquidation of malinvestment (a term I believe that was created by the Austrian School that stands for failing businesses/bad assets). Through the liquidation the market now can see which businesses are efficient and can be trusted, the usable assets can now be reallocated by an efficient business.

Ah, but you say that the Financial Bubble has burst, so why hasn't there been a recovery? To which I remind you that it *hasn't* burst yet! Remember Bush & Obama's bailouts? Remember Bernanke's Federal Reserve bailouts? No, rather than let the bad assets fail they've merely been propped up, further exacerbating the issue. That isn't to say that no businesses were helped, but if you loan ME a billion bucks I'm sure I could make something out of it too, the point is that the market didn't determine that those businesses *earned* anything else, politicians did! The fact that they propped up these illiquid assets is why we have NOT had a full recovery yet, just further kicking the ball down the road.

I often hear that we're making things worse for the next generation, but I'm here to tell you that you should not be concerned with your grandchildren and probably not even your children, because WE are the ones that will likely face the fallout of a century of bad economic policy. However, if we allow it to take place and let the market make its determinations then we can get back on fertile ground, where only good businesses thrive and survive.

First, we have to undergo the treatment to the disease, not merely continue treating the symptoms. Believe me, the treatment will freaking hurt.
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A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive

Monday, December 6, 2010

Economics: Bubbles pt 2 - Pure Credit Expansion

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How extremely fortuitous that last night Federal Reserve President Ben Bernanke was on 60 Minutes, because today we're talking about how pure credit expansion creates booms and busts. In his interview he said a few interesting things, "One myth that's out there is that what we're doing is printing money, we're not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way. What we're doing is lowering interest rates by buying Treasury securities, and by lowering interest rates we hope to stimulate the economy to grow faster. So the trick is to find the appropriate moment when to begin to unwind this policy. And that's what we're gonna do."

I'll unpack that statement in a moment, but let's jump ahead to another profound statement that pretty much sums up everything you need to know about Central Banking and Central Economic Planning:

In response to being asked if he had any regrets, he said: "Well, I wish I'd been omniscient and seen the crisis coming....I didn't."

And there you have it, if you really want to sum up why planned economies fail it's because the people running it are not God, they aren't omniscient, in fact they're only people, well not people like us, they're dumber people. Sure they've got degrees and have studied lots of economic theory, but that's as useful as me gaining a degree on why the moon is made of cheese, *if it's wrong then I'm well-studied in something that's WRONG*, and no matter how many degrees you get in bad economics the theories are still _fundamentally_ wrong. Let's address the fundamentals while dispelling why his first statement I quoted is either a lie or a semantic game (or both).

Imagine I own a grocery store, let's call it Wes-E-B. Here at Wes-E-B the sales have only been okay, but I'm ready for some serious growth, so I decide to let all my customers open an account for $1,000 so they can buy as much as they desire. It works! Everyone is buying everything off the shelves and business is amazing!! My numbers are looking massive! Well, the next day I go to re-supply and it turns out that my suppliers don't take Wes-E-B credit and I can't pay to re-stock my shelves, my business goes belly-up and what looked like great gain turned out to be a short lived "bubble". My credit meant nothing to the rest of the world, so I actually gained nothing, in fact the things that I had were gone as well, I actually gave them away!

That's a very non-systemic bubble. "Systemic" is when everything is intertwined with each other, kind of like the planks in a ship, if one of those planks pops a hole then it dooms the rest, they're linked. So let's expand the scenario a bit further to make it more systemic.

Wes-E-B's line of credit was a success, and to help their sales all my suppliers decide to let me have their goods on credit as well, because once I get paid by my customers (who now owe me $1,000 plus interest) then they'll reap a tidy extra profit too. That game has to work alllll the way down to the farmers and the manufacturers and even to their raw suppliers, miners and whatnot. If the farmers decide they don't want our credit since that won't pay their electricity then the fuse is lit for the entire chain to go up in smoke, because the manufacturer of cereal can't get any corn, Lays can't get potatoes, which means Wes-E-B can't get any inventory and now there's several businesses that are in trouble instead of only mine. My suppliers can't get supplies, I can't put anything in my store, we all fold because we created *new* money through expanding credit.

The turnaround isn't normally that fast, if it only took a few months for the resources to be called upon (and not found) then we'd likely already have abandoned this flawed thinking. Instead, it takes years to find out that the resources aren't there, because the process is far more convoluted and complex, but results are the same.

Here you should note: nearly the entire globe is systemically involved in Wes-E-B's line of credit, it's called the dollar and it's the reserve currency of the world. No one wants to see it go up in flames, because the fallout will be massive if it does.

You see, money is supposed to represent a product or a service rendered. When people see money they believe that they can buy something with it, if you looked at money and said "That won't buy anything because that particular dollar was never earned!" then you'd be insane, because you can't differentiate the two. Money is merely a placeholder for a transaction, $2 I earned by selling shoes is a placeholder for the milk I bought for $2. I traded shoes for milk, that's what currency is for, to allow complex forms of exchange.

However, when you initiate the creation of money by loaning it into existence (which sounds EXACTLY LIKE PRINTING MONEY OUT OF NOWHERE YOU SON OF A B---, ahem) then people suddenly have the ability to purchase items, OR invest it into projects. This is why the rate of interest is so important, a lower interest rate means you can take out a lot of money for longer term projects. If you had a 15% interest rate, would you want to have that rate for 10 years? Probably not, so you're projects would be shorter term so that you could pay back the loan faster and focus only on the most immediately profitable projects. However, if you had access to a loan at 3% interest then you can focus on Research & Development and work on projects that take years to develop and find that next new invention/product that the 'kids' are wild about. Interest rates are VITAL to a healthy economy, it sends all the signals to business about whether it should be producing for now or researching for later.

The market, if left alone, will set these rates automatically. When times are tight then the interest rates should be sky high, because there's so little money to loan out that it can only be allocated to the most profitable projects! Think of it this way, if you only had $100 in your account to last you for the next 45 days, would you loan $90 of it out to someone starting a business? Not if you want to live semi-comfortably! So, the only way you'd lend that $90 out is if you KNEW that 1.) you could get $150 in repayment (which means this person you're lending it to has A++ credibility) and that 2.) you'll get it back before you starve.

If, however, you had $10,000 in your account then you'd be much more willing to loan it out at lower rates of return and be riskier as well in the hopes that you hit a home-run rather than a base-hit.

Where "Helicopter Ben" comes in, is that though he has verbally acknowledged that he's not omniscient, he somehow still thinks he can manipulate the market by setting the interest rates, which leads to an *expansion of credit* that the market never, in reality, ever had. It signals the market to take out loans and create new projects, build houses (financial bubble), build businesses (Dot Com bubble), INVEST (1929 bubble that led to the Great Depression).

If you simply hand out money that nobody ever earned/produced, then it'll be spent on things leading to a boom, but when those things look to get "re-stocked" then it will crash, because those extra 'things' were never there to begin with. If Wes-E-B simply had extra inventory then I'd lower the prices in order to sell more, leading to more real world sales, aka a bigger share of the money that's already out there that I can now use to re-stock, using the excess to fund a new store down the street leading to actual economic growth.

When money grows while the number of products don't, then prices increase, this isn't growth! Growth is when there are products created. You can't replicate growth by increasing the amount of currency! It only leads to the depletion of goods through the boom and bust cycle.

In a post from March, I noted how it's "tricky" for the Fed to "unwind" their inflation. Ben admits it isn't easy, oddly he also simultaneously says that the money supply doesn't increase and that it DOES increase but not in any significant way. Eh? Can up also be down? It's semantics, he's saying the "currency in circulation" doesn't change even though he does increase the money supply. "Currency in circulation" = what we use when we shop; "money supply" = what the banks have access to, essentially. So, if the banks begin loaning out the money he wants to raise rates to keep all of the money from flowing out too quickly, Goldilocks' "just right". However, knowing where that "just right" spot requires some otherworldly knowledge (if it were in fact a good idea anyway, which it isn't).

Bernanke is either "Lord, liar or lunatic", and he admits he isn't Lord.
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A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive