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Economics

How time and uncertainty can make us “antifragile”

No two buzzwords define the present crisis more than “contagion” and “robustness” in the world of economists and policy wonks. The current interrelated nature of the financial system has bred a fragile situation where the success of the greater economy supposedly hinges on its individual components, such as banks that are too big to fail. To combat this fragility, economists have increasingly sought to build robust institutions. Such institutions will remain strong in the face of adverse effects if an individual component of the economy fails — be it subprime mortgages, sovereign debt, deposit-taking institutions or investment banks. This approach to the crisis stresses that if we cannot battle contagion, we had better construct strong institutions to weather future storms.

Nassim Taleb takes great issue with this approach in his new book Antifragile. His view is that constructing such so-called robust institutions is not sufficient as they continually fight yesterday’s battles. Instead the focus should be in building “antifragile” insti­tutions. Although often confused with robustness or resilience, an antifragile institution is not only unharmed by adverse events, but is actually strengthened by them. Building antifragile institutions will not only strengthen the global economic arena, but also have wide-ranging social applications.

Taleb’s latest work builds on two of his previous books, Fooled by Randomness(2001) and The Black Swan (2007). The common theme underlying all three is that there are events which are fundamentally unknowable — true uncertainties — in distinction to merely risky outcomes. Since we cannot know in advance what these events are, or what their effects will be, we should not exert too much effort in constructing contingency plans.

It is at this point that my first quibble with the book arises, and one I had with its predecessor The Black Swan. Taleb bifurcates between two definitions of uncertain events. On the one hand he invokes random or fundamentally unknowable events. Readers of this journal will be sympathetic to this definition of uncertainty, bearing close resemblance to Mises’s own use of “case probabilities”[1] (1949, pp. 110–113), or Shackle’s (1949) use of “non-seriable, non-divisible” events.[2] On the other hand, it is also clear that Taleb also thinks of uncertain events as merely rare events. These are events located on the fat or long tails on a probability distribution. Even though he thinks that these represent true uncertainty, there is no doubt that he is referring to funda­mentally probabilistic events.

This quibble aside, one can apply much of the remaining work cognizant that Taleb’s terminology differs from that of the Austrian economists, and also that the domain of his theory is slightly different than he thinks.

Something is “antifragile” if it gets stronger from a negative event. What are some examples? Taleb applies the prefix of his book liberally to outline what choices we should be pursuing. Indeed, the body of the book gives a long list of antifragile actions that, at least on one level, boil down to doing the exact opposite of what you think you should be doing.

Authors should be shocked to learn that there is almost no news that can harm a writer’s credibility, and that any publicity is good publicity (pp. 51–52). Corporations and governments that try to “reinstill confidence” should not be trusted because they would do so only if they were ultimately doomed (p. 53). Children shouldn’t be on antidepressants as this removes a source of learning from the life experience and thus make individuals less capable of dealing with unwanted events later in life (p. 61). The sinking of the Titanic was a positive disaster as it put shipbuilders on their toes, and possibly avoided an even larger accident later (p. 72). The general theme is that those who make errors are stronger than those who don’t — reliability, or antifragility — only comes when something is regularly tested by an unwanted event.

The theory has merit. Consider this lesson applied to central bank policies. In the wake of the dot-com bust a concerted effort by the world’s central banks flooded the global financial system with liquidity. The liquidation of assets that should have happened never did, and as a result lenders and borrowers didn’t learn their lesson on prudential money management. The seeds were sown for the larger crisis starting in 2007–2008 because a simple lesson was not learned when the financial system’s problems were still in relative infancy.

There is much to learn from this book and much to be wary of. At the end of the day, Taleb reckons the best test of an anti-fragile institution is Mother Nature mixed with a healthy dose of time. In chapter 21 he criticizes the prevailing orthodoxy of “neomania,” the mistaken belief that newer is better. Those institutions that have existed the longest are, in all likelihood, those that will continue to exist into the future. As an example, imagine that the year is 1988 and answer the following: which structure will last the longest, the Berlin Wall or the Great Pyramid of Giza.

In this test, as in much of the book, Taleb asks too much and too little. He asks too much because those institutions with the most longevity were once upon a time also the ones with the least. There must be a better test than longevity, as it only pushes the problem back in time to identify the source of antifragility. It cannot be turtles all the way down.

An applied example relevant to the present financial crisis would involve looking for those institutions that have been strengthened by current affairs. The crisis has taken its toll on many aspects of the financial services industry, but some general types of products have proven surprising resilient, or antifragile. Governments with prudent fiscal policies — e.g., Germany, Switzerland and Singapore — have fared well and indeed been strengthened as finances deteriorate in more profligate countries. Investment funds capitalizing on what were once unorthodox strategies, such as gold and other precious metal holdings, have out-performed more traditional investments as the financial crisis worsens. Readers of this journal will also notice that their stock in Austrian economics has increased in value over the past decade. Question begging and failed policies developed through more mainstream theories have led many former outsiders to the ranks of Austrian economists. An unwanted event caused an offsetting positive outcome in all these scenarios. That is what being antifragile is about.

Taleb asks too little by not exploring the true sources of antifragility. He comes close, alluding in many places that market-based institutions better combat the false security that planned institutions create. Explaining and elaborating on this link would do much to take the fundamental merits of antifragility to the next level. It would be, however, fodder for another book.

This article was previously published at Mises.org.

Peace

Remember

An article by Cobden Centre fellow David Howden for Mises.ca.

Today many of us are wearing a poppy on our lapels in a show of remembrance. What exactly are we remembering?

The Great War from 1914-18 saw many changes to the world. Many of them were bad, though as we shall see some good did come from one of, if not the worst war of all time.

Over 64,000 Canadians lost their lives fighting in Europe, almost 1% of her population. A further 150,000 were injured. The comparable statistics today, updated for population growth, would be nearly 315,000 dead soldiers and almost 700,000 wounded. Remember that these are just Canadian soldiers. The final global death toll was 17 million (including the civilian deaths in the neutral countries of Scandinavia) and over 21 million wounded.

In fact, in this regard one could argue that Canadians came away relatively unscathed. Romania lost 10% of its population, Serbia 16%, and the great Ottoman Empire almost 14%. This latter figure excludes the additional 100,000 Turks who died fighting the subsequent Turkish War of Independence following the signing of the Armistice in 1918.

The First World War was not only the first war to be waged on a truly global scale, it was the first to inflict the magnitude of destruction it did. Soldiers of previous battles were felled by disease more often than in direct combat. Advances in technology changed that, and even though the 1918 outbreak of Spanish influenza killed many more (current estimates place the deaths from the flu at 50-100 million), the Great War killed more people in four short years than most of the previous European wars combined.

In remembering the Great War it is easy to focus on the deaths of those who sacrificed their lives, but it is also important to reflect on what caused the War and what it achieved.

It’s true that advances in modern warfare and logistics made the War able to be fought on a wider scale than ever before. It is also true that a series of alliances – both formal and informal – agreed upon prior to the War brought belligerents into the melee with only tangential interest in it. Canada’s allegiance to Great Britain at the time might be thought of in this way, as could any number of the other Dominions and Colonies including Australia, India, New Zealand and Newfoundland.

Some simple economics also played an important role. Prior to the War most countries of the world had a monetary system linked to the gold standard. Government deficit spending was curtailed under this system as borrowing would be limited by the extent of a country’s gold reserves. The expression “to have a war chest” has its origins in the necessity of a sovereign to carry a chest of gold to war to pay soldiers. Wars under the gold standard were quite limited affairs, curtailed by the supply of gold available to keep soldiers paid (and motivated).

The War brought with it the breakdown of the gold standard as all belligerents resorted to monetary inflation to finance the growing expenses. This one simple fact goes far in explaining why the scope of the War and the resources driven into it were so great. The lack of a spending anchor under a fiat money regime allowed countries to print money and run deficits in order to finance the increasingly expensive battles, expensive both in money and lives. While governments could print money to paper over the cost of the War, soldiers were much less reproducible. As we shall see, the use of conscription was the counterpart to inflation and allowed the War to continue being waged once volunteers ran out.

The Great War was supposed to be the war to end all wars. Unfortunately the signing of the Treaty of Versailles to officially settle it proved to be the peace to end all peace.

A not well-known 36-year old economist by the name of John Maynard Keynes found fame penning his The Economic Consequences of the Peace in 1919. Keynes had two profound criticisms of the Treaty. First, that Europe could not survive and prosper without an integrated economic system, something that the Treaty precluded. Second, that the Treaty violated many terms of the Armistice signed 95 years ago on the eleventh hour of the eleventh day of the eleventh month of 1918. The armistice included terms relating to war reparations, territorial adjustments and general even-handedness in economic matters.

Keynes presciently predicted that the Treaty of Versailles would be the cause of a future war, and 20 years later he was proven correct. Poor economic conditions in Germany as a result of war reparations and the loss of culturally and economically important territories set in motion a series of events that brought Adolph Hitler to power and resulted in the invasion of Poland by both Fascist Germany and Communist Russia in September 1939.

Six years and 50-85 million additional deaths later the world had a new Great War. This one necessitated a numbering system to distinguish the first Great War from the Second.

All of this death and destruction could easily be pegged on one person. The Bosnian Serb student Gavrilo Princip may have fired the shot that killed the heir to the Austo-Hungarian throne, the young Archduke Franz Ferdinand of Austria on June 28th, 1914. But Princip was not alone in his distaste for the ruling class of that Empire.

Indeed, general unease concerning many sovereigns and governance structures were warming like kindling, ready to ignite Europe at any time. Secession problems in the Austro-Hungarian Empire and brewing revolutions in both the Russian and Ottoman Empires were slowly creating the conditions for civil wars.

The British Empire under the rule of King George V was also going through its own coming of age problems, though nothing severe enough to spark bloody revolution. Indeed, the Great War ushered in an era that saw Britain’s Colonies and Dominions reorganise into a peaceful and voluntary structure. In few places was this push more apparent than in Canada.

A bloody Battle of the Somme resulted in Prime Minster Robert Borden’s pledge to send 500,000 soldiers to Europe by the end of 1916, despite a population in Canada of only 8 million at the time. Conscription was enacted to offset the dwindling supply of volunteers to join the War cause.

Almost all French Canadians opposed conscription, feeling no allegiance or duty to aid either England or France. The Conscription Crisis of 1917 was primarily a backlash of Francophone Canadians against the forced military service imposed by Ottawa to aid his Majesty’s war. Uneasiness about being Catholic soldiers under predominantly Protestant commanding officers also fuelled the flames.

The Conscription Crisis exposed Ottawa to many difficult questions. One problem was that by forcing labour, the Canadian government had no knowledge who would be the best soldier, toolmaker or farmer. Someone had to stay back and supply those who went to fight, but the government lacked any rational way to make this decision. More importantly, there was the apparent rights issue. Canada had never before enacted conscription, and the idea of forcing someone to fight in a war against their wishes is morally repugnant. More to the point, fighting a war in a distant land to aid a government which one never voted for created its own problems. The problem lives on today for pacifists around the globe, as well as those who choose to refrain from political participation.

Indeed, in a bid to garner support for conscription the Military Service Act of January 1st 1918 included exemptions to remove oneself from the forced call of duty. By autumn of that year these exemptions were removed, in a move that offended not only the French but also English-speaking Canadians. This move by Robert Borden not only shut the Conservative Party out of Quebec for over 50 years, but also caused them to lose the next general election in 1921 to the Liberal’s of William Lyon Mackenzie King.

At the very least, the Conscription Crisis put in motion a debate as to what role and duty, if any, the Dominions and their citizens had in regards to the United Kingdom. The culmination of these debates was the Statute of Westminster, signed into law by the Parliament of the United Kingdom in 1931 and passed on to all realms within the Commonwealth for ratification shortly thereafter. Amongst other things, the Statute legislated equality and self-governance for the Dominions that ratified it. (Not all colonies did so: Newfoundland Colony did not ratify the Statute, and remained a Dominion of the British Empire until joining Canada in 1949.)

The Commonwealth of Nations today survives as an organisation of 53 countries, most of which were territories of the British Empire. It represents a quarter of the world’s land mass, almost a third of its population and 15% of the globe’s GDP. It is a voluntary group which exists due to some loosely shared values paired with some established statutes.

Racial equality is a requirement for inclusion, and this was tested with the withdrawal of South Africa under apartheid, as well as its eventual readmission after its end. Not all member states recognise the Queen as the head of State, though some (like Canada) do. We have a shared history, heritage and traditions (like wearing a poppy on Remembrance Day). Chief among these is obedience to the common law, one of the greatest forces of civilisation in history. A dedication to peace, liberty and free trade are all points for inclusion, secured by the values of the 1971 Singapore Declaration.

There are no formal laws dictating that member countries must trade or associate with one another, but they do. The voluntary nature of this institution is apparent in the immigrants that flow between Commonwealth nations as well as the fact that Commonwealth members trade up to 50% more with other Commonwealth members than with non-members.

Inclusion in the Commonwealth does not yet instil by law the free movement of goods, people or money across borders, but it would be wise to do so. Some countries give preferential treatment to immigrants or investors from other Commonwealth countries, and the benefits are clear. Economic prosperity reigns when people, goods and money go to where they are treated best. Informal preferences within the Commonwealth promote this.

There is discussion of making the Commonwealth into a broader free trade union, as is the case with the European Union. This should be welcomed as it would solidify into law those benefits which heretofore are only informally recognised.

A word of caution is in order.  Should the Commonwealth choose to formalise its union it must do so in its own way and according to its founding principles. Liberty and freedom are among these, and the voluntary nature of the union must also be upheld. (This in distinction to the mandatory nature of the European Union which now results in ill feelings of coercion or otherwise being forced to behave in ways undesired by many citizens of the member states.) Infringements to freedom and liberty, such as those occurring in South Africa under apartheid must be met swiftly and surely with exclusion from the union.

United we stand, but only if you want. Countries can choose to break the rules that have promoted peace and prosperity for so long, but must do so of their own accord and separately of Commonwealth benefits.

There is historical precedent for this. South Africa was forced to withdraw from the Commonwealth in 1961 under growing opposition from other members to legislated discrimination based on race. The Commonwealth reopened its arms at the fall of apartheid, and South Africa was readmitted in 1994 (less than one year after the fall of apartheid).  More recently Zimbabwe was suspended for its human rights violations, ignoring the rule of law and suspension of its constitution, and the country’s government decided to formally withdraw in 2003.

Zimbabwe – when your government gets its act together and restores the conditions for peace and prosperity so cherished by the rest of us we will be waiting with open arms.

The Commonwealth has no positive obligation to set straight those countries that pursue different policies than us; who are we to decide? But not playing by our rules will not be tolerated and will be costly for belligerent countries. This is established by the final article of the Singapore Declaration, which states:

These relationships we intend to foster and extend, for we believe that our multi-national association can expand human understanding and understanding among nations, assist in the elimination of discrimination based on differences of race, colour or creed, maintain and strengthen personal liberty, contribute to the enrichment of life for all, and provide a powerful influence for peace among nations.

Coercion is rejected as a policy tool to enforce these values. Even though the Millbrook Commonwealth Action Programme does set out that Commonwealth Nations must concern themselves with other members’ internal situations, it limits repercussions to sanctions, suspensions and expulsions from the group as punishments for persistent violations to its core values.

The continued voluntary nature of the Commonwealth sets it apart from other groups, such as the European Union, and goes far in explaining why this very large and diverse grouping of countries has stood together for almost 65 years. Countries have been free to leave in that period as well as apply for admission, but the core values shared by these member states – freedom and liberty – have not been altered. We are the better for it.

And so today we remember, not just the evils and injustices of 95 years ago but of the benefits that we have today as a result. The freedom and liberty that Canadians enjoy are in no small part the result of the injustices suffered during the Great War.

Canada’s Conscription Crisis in particular was a critical albeit costly coming of age moment. The Statute of Westminster that it resulted in freed Canada and the other Dominions from forced service to a Crown it never voted for. In its place was formed a voluntary Commonwealth of Nations, joined by certain principles and rights but not irrevocably so. Countries can choose to not adhere to these principles, but the Commonwealth will have nothing to do with them if they choose this path. Despite being a stalemate for many years the Great War did accomplish much. The formation of the voluntary union of the Commonwealth might not have been so without it.

And for this, in addition to the thoughts of those who perished and their families, we remember.

Economics

That savings glut vs. those low interest rates

Five years after the worst financial crisis since the Great Depression, economists are still starkly divided as to its causes. Perhaps this is not too surprising as we are now more than 80 years past the Great Depression with little end in sight to the debate surrounding the causes of that downturn.

Most economists fall into one of two camps when explaining where the imbalances originated that led up to the current crisis. Austrian School economists are in the unique position of being able to reconcile these two camps, even while favoring the first explanation to the second.

The first camp, which includes most Austrian School economists, looks at the imbalances caused by central bank interest rate policy being set “too low for too long.” In this view, artificially low interest rates allowed for erroneous capital investments following the dot-com bust of 2001, and continuing to the present time.

The Federal Reserve’s artificial reduction of interest rates (to use the U.S. as a proxy for the Western world) put in motion two shifts in the economy. The first was the decrease in savings by Americans, and a corresponding consumption-led boom (what Mises called “overconsumption”). The second was the overall decrease in investment and production in the lower stages of the capital structure, with a corresponding increase in investment and production in the higher stages. This shift is what Mises termed “malinvestment.” Note that this shift does not represent an “overinvestment” in capital, as is commonly and erroneously claimed by non-Austrian economists, but rather a temporal shifting of productive activity from stages closer to consumption to those further away.

Specifically, we see malinvestment in the large-scale shift of capital away from manufacturing in favor of higher-order research and development. Overconsumption, on the other hand, is illustrated by the rise of consumer culture embodied by big box stores and a plethora of shopping malls and outlet stores.

In the opposite camp are the economists favoring the “excess savings view” or the “global savings glut hypothesis.” These economists view the crisis as a result of current account surpluses, primarily in Asian countries, that led to financial imbalances in Western economies.

As consumers consumed more but the economy restructured itself away from producing consumer goods, an increase in imports was inevitable. As luck would have it, developing countries — and especially Asian countries — were in the reverse position of the U.S., and years of financial underdevelopment left many of them with immature financial markets. These Asian countries also proved to be low-cost producers of many products. As Americans increased their imports from these countries to feed their own unsustainable consumption-led boom, the net proceeds in these countries had no developed domestic financial markets to invest in.

In response, these funds were channeled back to U.S. financial markets, and in the views of those who favor the saving glut theory, it was this that set in motion the unsustainable boom. As time went on, the trade surpluses in Asia resulted in net capital outflows in search of a market to invest in. Western economies that were the recipients of these capital flows witnessed remarkably low interest rates and credit booms with a corresponding buildup of debt.

Thus, in the view of proponents of the savings glut theory, the Federal Reserve was not the cause of lower interest rates, but rather it was a passive observer as interest rates were lowered exogenously from these foreign sources.

Yet proponents of the global savings glut hypothesis must grapple with one unanswered question: what caused citizens of Asian countries to increase their savings rate and destabilize Western economies with their excess capital outflows? One could take the view that savings rates are exogenously determined — e.g., by animal spirits — yet this “explanation” only pushes the problem one step back. What determines these animal spirits?

To find a satisfying answer we must look at the role of monetary policy in determining saving rates.

There is no need to look to animal spirits or any ill-defined exogenous force to explain why developing countries increased their savings so much during the boom and funneled these savings into Western financial markets. The unsustainable boom propagated by Western central banks set this process in motion by creating a disconnect between the consumption demands with the domestic productive capacity of their economies.

Moreover, the current ire directed at the loss of manufacturing in the United States is not the result of “greedy outsourcers” or even “currency manipulators” in Asian countries. The loss of productive capacity in the U.S. is the outcome of a too-low interest rate policy by the Federal Reserve incentivizing entrepreneurs to move their investments to the higher stages of production — those furthest from final consumption — while simultaneously incentivizing consumers to increase their present consumption at the expense of savings.

This article was previously published at Mises.org.

Economics

2013 Toronto Austrian Scholars Conference

For readers across the pond, or those tempted to make the journey …

The annual Toronto Austrian Scholars Conference (TASC) of the Ludwig von Mises Institute of Canada will be held at the University of Toronto, November 2-3 (Saturday – Sunday).

TASC seeks papers that seek to improve the understanding of the role of markets in the economy. Submissions should seek to shed light on contemporary issues while being grounded in a praxeological reasoning. Papers are welcome from a variety of fields such as politics, sociology, and psychology, where ever they can bring relevance to economic and financial questions.

Scholars interested in presenting papers, serving as chairs/discussants, or proposing entire panels should submit proposals by Tuesday, October 1, 2013. With all submissions, please include the following information for each participant, including non-attending co-authors:

1. Name

2. Affiliation (title and institution)

3. E-mail address

4. Telephone number

5. Title of paper(s)

6. Abstract(s) of no more than 100 words

Please ensure that all attachments are either Adobe Acrobat (.pdf) or Word (.doc or .docx) format.

Please note that the conference organisers have to be free to place your paper or panel on any of the conference days. Organisers will entertain specific requests, however, if you prefer to present on either Saturday or Sunday, though no guarantees of such can be made in advance.

The registration fee for faculty members is $225, Independent Scholars $125, Observers $75, and Students $25.

Select papers from the conference will be published as Papers and Proceedings of the conference in the Journal of Prices & Markets, the flagship journal of the Ludwig von Mises Institute of Canada.

Please send your submissions by email only to David Howden at dhowden@slu.edu (with “TASC 2013” in the subject line of the e-mail).

Economics

Japan’s easy money tsunami

The Bank of Japan has embarked on one of the most inflationary policies ever undertaken. Pledging to inject $1.4 trillion dollars into the economy over the next two years, the policy is aimed at generating price inflation of 2% and further depreciating the Yen. The idea is to fight “deflation” and increase exports.

The end result of this policy will be an assuredly larger balance sheet at the Bank of Japan (projected to nearly double to $2.9 trillion). Despite being lower than it was 25 years ago, the Japanese Stock Index has increased by 70% since November of last year. However happy people have been about higher stock prices, eventually the economic effects will be harmful; indeed the recent stock price crashes foreshadow still more troubles to come.

In my own contribution to Guido Hülsmann’s recent edited book The Theory of Money and Fiduciary Media, I take a critical look at these exact policies — expansions of the money supply aimed at stimulating output by way of manipulating the exchange rate. At the 100-year anniversary of the publication of Ludwig von Mises’s The Theory of Money and Credit, we can see that Mises had already grappled with the issues of currency depreciation in a manner superior to modern monetary economics. Furthermore, with the refinement of his business cycle theory in his book Human Action, we find that Mises also outlined the detrimental effects of such expansionary monetary policies.

The exchange rate determines the price a foreigner will have to pay for a domestically produced good. Increases in the money supply will generate inflationary price pressures that will in turn increase prices. This leads to a higher exchange rate, which means it takes more domestic currency to purchase a unit of foreign currency. This makes it cheaper for foreigners to buy our goods so exports increase. Conclusion: countries can stimulate exports and increase the number of jobs in export industries by inflating their money supply.

Unfortunately, this is not the end of the story.

Depreciating your currency does make your export goods cheaper for foreigners to buy. However, it also makes it more expensive for you to buy imported goods. This helps to close a trade deficit and reduces foreign investment in your economy. However, if the goods you sell to foreigners are composed of many inputs that you have to purchase from foreigners the effect will be to drive up your cost of production.

Therefore, Japanese exporters will pay more for the inputs that they will need to import to construct the same goods they intend to sell to foreigners. This effect is especially noticeable in countries with large export markets, but only a small ability to supply the inputs for goods destined for export. No other large economy fits this description better than Japan.

Mises’ key insight was in looking at the long-term effects of such a policy, and in the process he examined the logic behind the short-term results as well.

The ineffectiveness of the policy in the long run is apparent when one understands how prices – both domestic and foreign – interact to determine exchange rates. Exports will be promoted in the short run, though the effect will be cancelled in the long run once prices adjust.

If the policy is ineffective in the long run, Mises demonstrated that the short-run gains are illusory. The same monetary policy aimed at depreciating the currency to promote international trade will reap domestic chaos.

Higher monetary inflation will reduce interest rates. One result of this policy will be greater consumption expenditures – what Mises coined “overconsumption” – as consumers save less and spend more. The other result of reduced real rates is what Mises referred to as malinvestment. Production plans must supply not only the amount of goods consumers want in the present, but also orient these production plans to produce goods in the future. The interest rate is what coordinates all these plans over time and is what entrepreneurs use to determine when to produce goods, and how long a production process should be employed. The negative effects of distorting the interest will only be revealed much later.

Upsetting the natural rate of interest through an inflationary monetary policy unbalances both consumption and production plans. The economy eventually succumbs to an Austrian business cycle as it tries to regain footing, and move to a more sustainable pattern.

The more things change, the more they stay the same. Ludwig von Mises was able to correctly identify the pitfalls of expansionary monetary policies over 100 years ago. Policy makers have yet to learn these important lessons, and consequently continue to plague their countries with the results of these failed measures.

This article was previously published at Mises.org.

Economics

France’s cul-de-sac

Over a year ago, in the midst of an ongoing economic crisis, François Hollande celebrated his victory over Nicolas Sarkozy in France’s presidential elections. Hollande became the leader of a country in economic turmoil. In the past year, he has had relatively free rein to carry out his economic agenda, since the Socialist Party he leads has a majority in the French Parliament.

France has a history of grandiose government spending, even among European countries. Public spending accounts for 57 percent of national output, and public debt accounts for over 90 percent of GDP. While austerity has been the buzzword in the rest of Europe since 2009, resulting in a modest decline in government spending as a percentage of GDP, France is not part of that trend.

The public sector now accounts for almost two-thirds of all direct economic activity, and more if indirect activity is counted. This large and growing dependence on government is disastrous because it is funded by ever higher taxes. These high taxes drain the private sector (while simultaneously giving the public sector an aura of impotence) and deficit spending obliges future generations of French citizens to pay off the largesse of today’s government.

Deep within the French psyche is the idea that cuts to the gargantuan public sector would cause undue harm to everyone. This inability to envision a French economy where the private sector picks up the slack when fewer public services are provided has reinforced the reluctance of politicians, and in particular, François Hollande, to use austerity measures to overcome the crisis. Instead, the current solution is to increase government spending and create more jobs in the public sector. For this reason, Hollande’s administration has pledged to increase the minimum wage for all employees, public and private, and create 60,000 new public teaching jobs.

In addition to the present increases in public expenditures, Hollande has committed to future increases in public spending. His decision to roll back Sarkozy’s initiative to raise the retirement age from 60 to 62 obliges taxpayers not only to support the burgeoning ranks of public employees “working” today, but the growing number of public retirees supported by generous social security payments.

In a bid to combat rising interest rates on its bonds, the French government has recently commenced a campaign to raise taxes to fund the country’s ballooning expenditures. Indeed, one of Hollande’s primary electoral promises was a top tax rate of 75 percent on the so-called riche (income earners above 1 million euros).

France has one of the highest corporate tax rates in the European Union, exceeding even the famous high rates of Sweden. While the European Union’s average tax rate has been decreasing (from about 50 percent in 2005 to about 44 percent in 2012), France’s tax rate has remained constantly high (over 65 percent from 2005 to 2012).

In addition to high tax rates, French businesses are faced with the highest social charges in the European Union, as well as oppressive government regulation. These factors make for an unattractive business environment. Recently several large companies closed their doors rather than deal with the difficult business conditions, resulting in thousands losing their jobs. New companies are slow to appear in such a climate.

In response to the threat of higher French taxes, British Prime Minister David Cameron, offered to “roll out the red carpet” for any high-income earning Frenchmen who wanted to avoid paying French taxes. Of course, we would be remiss to think that Cameron was motivated by anything other than to attract tax dollars into his own strained coffers. The result, however, was tax competition between states.

Before the advent of the European Monetary Union, highly indebted countries sought to cure their fiscal woes through inflationary policies. France removed this option from the table when it adopted the euro. Indeed, as Philipp Bagus demonstrates in his book The Tragedy of the Euro, it was the French who aggressively pushed for monetary integration within Europe. They must now adhere to the results of this decision.

The monetary union functions somewhat as a modern gold standard. Just as gold once kept states from running prolonged deficits, today the loss of an independent monetary policy constrains European member states in a similar way.

With no recourse to an inflationary monetary policy, the French government is at the mercy of the bond market. As lenders worry about the French government’s ability to repay their debts, now and in the future, interest rates will rise (as they have already). The French government will have to rein in its deficit spending either through spending cuts or tax increases as the cost of borrowing goes up. The private sector is already a heavily burdened minority, and given the current exodus of French companies and entrepreneurs to other countries, any further taxes would be coming from an already shrinking tax-paying base.

Like many of his counterparts, François Hollande realizes that the beleaguered French economy needs change. What he must do is focus on the areas that he can change. He must decrease public spending and lower taxes in order to increase employment. In addition, the private sector must be allowed to heal and recover, instead of treating it as a goose to be plucked. This is the only way the French government can continue to function, and more importantly, the only way to get France out of its economic cul-de-sac.

This article was co-authored with  and previously published at Mises.org.

Economics

Introducing The Journal of Prices & Markets

Ludwig von Mises once wrote that all of economics can be neatly summed up in one of two studies: either you are studying how prices come into being, or you are studying how markets allocate goods. All economic problems can be distilled into one of these two categories.

Prices and markets are innocuous concepts – they exist in various forms, and to paraphrase Adam Ferguson, “they are the work of human hands, but not of human design.” Both prices and markets are natural phenomena that have come into being as the result of our actions, and they serve no other purpose than facilitating our ends.

Yet from time to time, and the current time being a good case in point, prices and markets are viewed with much more sinister spectacles. Prices come to be seen as “right”, or more usually, “wrong”. They are too high or too low. Much sovereign debt is trading at a high price, too high if you believe some analysts. This is a function of its interest rate being low, too low as the case may be. The healthcare debacle in the United States is the consequence of a widespread belief that medical prices are too high, or more aptly that health insurance is too expensive.

Markets are those various places where prices come alive. Unsurprisingly, when prices seem “wrong” to people it must be that the markets that allow them to arise are themselves not functioning correctly. Main Street is in the midst of a recession, though Wall Street seems to be relishing record high stock prices. Might something be amiss in the financial markets? Millions of people are out of work, and yet the labour market seems woefully inept at getting jobs to them. 

The apparent mispricings and market failures lead to many calls for changes to rectify these perceived errors. What is missing is some real thought into why it is that these prices and markets do not coincide with what we perceive to be the “right” price, or “well functioning” markets. 

It is in response to these misgivings that I proudly announce The Journal of Prices & Markets, a scholarly peer-reviewed journal published bi-annually in collaboration with the Ludwig von Mises Institute of Canada.

The Journal’s goals are straightforward. 

First, it is an outlet for those interested not in the glossy superficial nature of events, but the real underlying phenomena shaping them. The journal is not concerned with overly elaborate constructivist plans to recreate the wheel. We don’t need to invent new prices or markets when the old ones no longer seem sufficient at serving their original purposes. What we need is critical analysis into why current events seem so dysfunctional.

Second, and perhaps more importantly, The Journal of Prices & Markets stresses the lost art of relevance. Economics is a beautiful science that should serve the purpose of enlightening us. Instead it has gotten to the state where it creates confusion. As the jokes go, economists predicted ten of the last five recessions, and if you want a second opinion on something, just call back the economist you originally asked. Economists cannot even seem to reach agreement amongst themselves on simple questions, and in a bid to convince each other of their correctness they seek ever more levels of complexity in their theories. Complexity is not necessarily a bad thing, but we should never lose sight of the original question.

Economics aimed at relevant issues is what the doctor ordered, not economics aimed at irrelevant problems created by economists through their ever-increasingly complex answers to simple questions.

With its world-class editorial board behind it, the Journal seeks to further these aims by serving up a healthy dose of theory and practice. 

Each issue will contain five editorials by specialists in their fields. These editorials will bring relevant and current problems to light, and enlighten the reader with analysis that is both elegant and simple. They will solve the age-old problem of economic analysis – how to give an obviously correct answer to a non-trivial question. 

For the learned reader looking to delve more deeply into the problems at hand, each issue of The Journal of Prices & Markets offers longer scholarly and peer-reviewed articles. Written by academics, these articles explore the finer details of price formation and market allocations. For the bookworms, the Journal even has reviews of the books you should be reading to understand the world, as well as what you should be looking for as you read them. 

Interested? Why not visit the website and put your name on the email list to receive updates when articles are published. If you are an academic, or know someone who is, and are interested in contributing to the Journal, please visit the submissions page for more details.

Economics

Regulating banks the Austrian way

Most people — from young to old and from all ends of the political spectrum — are united by a common bond. The idea that banks are deserving of taxpayer support is viewed as morally repugnant to them. Business owners see bank bailouts as an unfair advantage that is not extended to all businesses. Those typically on the political left see it as support for the establishment, and a slap in the faces of the little people. Those more at home on the political right see it as just another form of welfare: a wealth redistribution from the hard working segment of the population to the reckless gambling class of banksters.

Despite this common disdain for bankers, there is considerable disagreement on how to deal with them. One group sees less regulation as the solution — letting market forces work will allow the virtues of prudence and industry to prevail. This formulation sees these same market forces as limiting firm size naturally to evade the “too big to fail” issue, through many of the same incentives that foment competitive economic advancement.

Another group sees the solution as more regulation. The natural tendency in business, according to this group, is for large monopolies to form. As companies grow in size, they gain political influence as well as an aura of indispensability. The consequence is that not only will a company come to be seen as too big to fail, but it will also be politically influential enough to seek such recourse if troubles surface.

Like most answers, the truth lies somewhere in the middle.

The first group correctly notes that there are two specific drawbacks of increasing regulation. On the one hand, “one size fits all” regulatory policies (such as is commonly the case on the Federal level) are rarely capable of handling the intricacies and dynamics of business. They also have the effect of relaxing the attention individuals and businesses afford to their own behavior. Under the pretense that the state has enacted wise regulations, individuals see little need to actively monitor companies to make sure they behave in a responsible manner. Businesses too succumb to this mentality. By abiding by the existing regulatory regime, they take solace in knowing that any attack on their integrity can be brushed aside as an attack placed more appropriately on the failures of the regulating body.

On the other hand, increased regulation breeds the problem of what economists call “moral hazard.” An activity is morally hazardous when a party can reap the benefits of an action without incurring the costs. The financial industry is very obviously afflicted with moral hazard today.

Banks and other financial companies have largely abided by the law. I would venture a guess that there is no industry more heavily regulated than the financial services industry, and no industry that spends more time and resources making sure that it complies with this complex regulatory maze. Capital levels must be maintained, reporting must be prompt and transparent, and certain types of assets must be bought or not bought. Banks following these regulations get a sense that they will survive, if not flourish, provided they work within the confines of the law.

However, it is increasingly evident that the financial regulations put in place over the past decades are woefully inept at maintaining a healthy financial industry. In spite of (or perhaps because of) all these regulations, a great many companies are, shall we say, less than solvent. So, who is to blame? It would be easy to blame the companies themselves, except that they did everything that the regulators told them to do.

Why not at least consider relaxing regulations? Doing so would have a two-fold advantage.

On the one hand, businesses would be more obviously responsible for the instability they have now created. On the other hand, without regulations, more reckless or clumsily managed companies would have gone out of business already, lacking the benefit of a regulatory “parent” scolding them for their mistakes. The result would be fewer unstable businesses, and more attention to the dangers of one’s own actions.

I previously mentioned that both sides are correct to some degree, implying that those calling for more regulation had some merit to their arguments. And this is indeed true. However, to paraphrase Inigo Montoya, when they use the word “regulation,” I do not think it means what they think it means.

It is true that not all companies play on a level field. In the financial services industry, and particularly in the banking sector, this is especially apparent. Banks are granted a legal privilege of “fractional reserves.” The result is that banks behave in a way which is fundamentally different from any other type of business, and which is easy to misdiagnose as “inadequate regulation.”

A depositor places money in his bank. The result is a deposit, and the depositor has a claim to this sum of money at any moment. One would think that the bank would be obliged to keep the money on hand, much in the same way that other deposited goods — like grain in an elevator — must be kept on hand. The law begs to differ. Banks are obliged to keep only a portion, or fraction, of that deposit in their vaults and are free to use the remaining sum as they please. Canada and the United Kingdom are examples of countries where there is no legal requirement for a bank to hold any percentage of that original deposit in its vault. In the United States, if a bank has net transactions accounts (deposits and accounts receivable) of less than $12.4 million, the reserve ratio is also set at zero. This differs greatly from grain elevators, where the law strictly states that the elevator owner must keep 100 percent of the deposited grain in the silo.

There are two results of the practice of fractional reserve banking, neither of them positive for the average person.

First, banks grow larger because they have access to a funding source that would otherwise not be available if they conducted themselves by the same laws as other businesses. When commentators say “banks are different,” there is truth in the statement. They have a legal privilege that enables them to grow in scope beyond that which they could naturally. This also explains why many banks, and financial services companies, come to be viewed as too big to fail.

Second, banks become riskier. Every time a deposit is not backed 100 percent, the depositor is exposed to the possibility of not getting his deposit back in full. If a bank uses his deposit to fund a mortgage, and the borrower defaults and cannot repay the bank, there is a risk that the original depositor will lose some of his money. A more common case is a bank run, in which many depositors try to withdraw money at the same time. The result will be insufficient funds to simultaneously honor all redemption demands. This occurred with various banks in Iceland, Ireland, Britain, and Cyprus over the last four years.

Few people worry about this latter problem, however, because of the former one. Since banks have become too big to fail, we are assured that if one goes bankrupt, we as depositors do not stand to lose personally. The government has pledged implicitly, or even explicitly through deposit insurance, that it will step in and bail out the irresponsible actors.

The result is the confusing state of affairs that we have today with two sides both arguing for the same thing — banking stability — via two diametrically opposed means. The “more regulation” camp is pitted against the “less regulation” camp. 

A solution

These two camps are not mutually exclusive. We can solve the problems of moral hazard and “too big to fail” in one fell swoop by ending fractional reserve banking.

By ending this legal privilege, we eliminate the ability for banks to grow to such inordinate sizes. By abiding by the same legal principles (or “regulations,” if you will) as any other deposit-taking firm, banks are not unduly advantaged. If banks shrink in size, the “too big to fail” doctrine is eliminated, or at least greatly reduced. This means that depositors and bankers will realize that if a loss occurs to their bank, they personally stand to lose.

The risk of loss is a great force in removing moral hazard. Remember that it only arises when one person’s ability to gain is not constrained by the threat of a loss. Cognizant of ensuing losses, depositors will demand that their banks adhere to more prudent operating principles, and bankers will be forced to meet these demands.

The critics worried about “too big to fail” are right. We do need more “regulations,” in a sense. We need banks to be regulated by the same legal principles regarding fraud as every other business. The critics worried about moral hazard are also right. We need fewer of every other kind of regulation.

Repairing a broken financial system does not have to be hampered by irreconcilable political differences. Recognizing the true issues at stake — legal privilege and unconstrained risk taking — allows one to bring together advocates of widely differing solutions into one coherent group. Getting bankers to agree to all this is another story.

This article was previously published at Mises.org.

Economics

The pound’s slow demise

Once upon a time the pound sterling ruled the world of finance. Today it has been relegated to a less regal status, displaced by the U.S. dollar over the course of the twentieth century. Not only is very little international trade performed in sterling these days, but there are new doubts that it will remain the exclusive currency on the British mainland.

With the looming vote on Scottish independence comes the threat that an independent Scotland will introduce its own currency

Once upon a time, English as a language was a little known form of communication, largely isolated to the British Isles. Starting at about the same time as the spread of sterling as the universal money throughout the world, English set off on the route to global dominance. Today there are about 350 million native English speakers, but this number is dwarfed by the masses that use it as a lingua franca - their second or even third language.

Considering their common pedigree, one may ask why the currency is now a second-rate citizen in the world of international finance while the language is going stronger than ever.

Historians commonly attribute the rise of the English language to the rise of Pax Britannica throughout the 19th century. This period did see the English economy rise to great stature and expand its scope to the point where the sun never set on the British Empire. However, other great European economies also flourished and encompassed many foreign lands. The Spanish Empire at its pinnacle included more square miles than the British (though never as many people). Both France and Germany had sizable colonies. Even the Russians, it can be argued, held huge “colonies” in the form of the Soviet Bloc. 

Alternatively one could say that the rise of the United States (complete with its dominant media industry) assured the rise of the English language. Yet this too seems to put the cart before the horse. Much of America was settled by non-English speakers (Spaniards in the south-west, French in the South-east and Northern European Germans, Scandinavians and Dutch in the upper mid-west). English was emerging as the linguistic force to be reckoned with before the ascendance of the U.S. as a world super power, which really only happened after World War I. 

Instead, the rise of the English language can be largely explained by its decentralized nature. It is true that English grammar is quite simple relative to other languages, especially its Romance and Germanic brethren. Yet if anything this would normally incentivize Romance and German speakers to streamline their own grammatical rules to make adoption easier. In most languages this is not possible due to their extreme form of centralization. French and Spanish, as examples, require linguistic changes to be approved by the centralized governing body (L’Académie Française in France, and the Real Academia Española in Spain). Changes are almost impossible as they must go through the usual bureaucratic approval process as other changes to legislature.

It is no surprise that French and Spanish as languages are slow to adopt to changes, in much the same way as their legal systems are outdated and move only at a snail’s pace. Lacking any centralised authority, anyone was able to use English, but more importantly, they could change it as they saw fit. Changes and new words occurred spontaneously as a response to market demands, not to the pen of a bureaucrat. This form of crowd sourcing allowed the English language to be modified as it spread around the globe and incorporate the intricacies of daily life and the existing languages of its newfound locals.

By contrast, the British pound sterling has suffered from centuries of centralised mismanagement. Since the creation of the Bank of England in 1694, the venerable old lady has done what she can to diminish the pound sterling on an ongoing basis. While the First World War was devastating in many respects for Britain, one of the longest lasting effects was the decoupling of the pound from gold. This shift left the once proud currency open to continual and unabated inflation at the hands of the Bank of England, with the result that it is now worth a fraction of what it was just a century prior. 

In international finance people use the language that makes trade easiest, as well as the money that best facilitates its dealings. A decentralized language system has proven an overwhelming success as it is now the standard around the globe. The centralized monetary system has been mismanaged to the point where few outside of the country elect for sterling in their affairs. With the Scottish independence vote approaching it is questionable how many people within the United Kingdom want to continue using it.

If George Osborne stays up at night wondering what the future will be for the pounds his Treasury manages perhaps he would do best to take a lesson from British history. The English language became a world standard without the oversight of Parliament – perhaps it is time to recognise the same can be true for the pound sterling as well.

Economics

Who benefits from the Fed?

We recently looked at the Federal Reserve’s 2012 results. In particular, we pointed to some positive and negative developments. On a positive note, the Fed managed to shrink down the size of its balance sheet by approximately one-third of a percent. (Hey, it’s a start.) On a negative note, this decrease occurred because banks shifted their holdings of reserves into cash, thus forcing the Fed to sell off some of its assets. I explained that this is a potentially negative result, as the shift into cash brings with it inflationary pressure on prices.

In this article I want to point out who has benefited from the Fed’s operations over the past year.

There has been a lot of discussion about the large increase in reserves, and especially excess reserves, held by the banking system. Mostly this discussion is couched in terms of the increase in the money supply. While the increase in excess reserves—less than $2bn in August 2008 to almost $1.5 trillion at the end of 2012—does represent an increase in the money supply, some rule changes accompanying the crisis also signify that they are part of a bailout. One aspect of the Fed’s crisis response was to commence paying interest on required and excess reserve balances. (The required reserve is the amount of money banks must hold to meet the minimum reserve requirement on deposits, and excess reserves are any amount held in excess of this minimum.)

Interest on reserves is set at 0.25 percent, and is paid from the Fed’s operating revenues to its member banks. As we can see in Figure 1 below, the Fed has paid the banking system nearly $4bn each month for the last two years to hold on to their reserves.

Figure 1: Interest paid on reserve balances (monthly, $bn) Source: Federal Reserve Bank of St. Louis

One way to think of this payment is as a sort of bailout. Since the payments on reserves are paid out from the Fed’s operating revenues, it reduces its end of year profits by the same amount. Since these profits would normally be remitted to the Treasury, the policy of paying interest on reserves has been, in effect, a fiscal policy involving a transfer from the Treasury to the banking sector. Interest on reserves redirects taxpayer money to the banking system, over $45bn during 2012. This transfer from the Fed to the banking system is larger than any single year transfer from the Fed to the Treasury prior to 2009.

The Fed estimates that it will remit to the Treasury $88.9bn from its 2012 operations, a record-breaking year. As we can see in Figure 2, there has been a steady increase in the amounts of remittances to the Treasury over the past decade, and especially since 2009.

 
Figure 2: Federal Reserve annual remittances to U.S. Treasury ($bn)

The sharp increase after 2008 was the result of the quantitative easing policies. By increasing the money supply, the Fed had to purchase assets from the banking system. Some of these assets were U.S. Treasuries, some were riskier mortgage-backed securities, and some were guaranteed Federal agency debt. All of these newly purchased assets paid an interest rate, which contributed to the increase in Fed operating revenues and profits as it increased the money supply.

The $91bn of net income came almost wholly from interest earned on the securities the Fed holds ($80.5bn).

The U.S. Treasury issues bonds which are bought by the Federal Reserve. (We should note that the Fed doesn’t buy these bonds directly from the Treasury, but only on the secondary market from favored dealers.) Interest paid on these bonds accumulates at the Fed as income, and at the end of the year the Fed distributes it back to the Treasury, less its operating expenses. Since the Fed held, give or take, about $1.6 trillion of U.S. Treasury securities over 2012, the government was essentially able to get a free lunch—any interest paid on these securities was an accounting fiction, as it was remitted back at the end of the year (less expenses).

Normally the Fed only operates at the short end of the yield curve. This means that as a general rule the Fed only purchases short-term U.S. Treasury debt. Since short-term debt is also the lowest yielding, some might say that the Fed is not really providing much of a free lunch.

The big news during 2012 for Fed watchers was the expansion of its “Operation Twist.” With an increased focus on the long end of the yield curve, the Fed started purchasing bonds of longer maturity to keep long-term borrowing costs low. This was a savvy move that would help shield the Treasury from the effects of some of the Fed’s own policies. The Fed has the potential to increase inflationary pressures on prices through its monetary expansion. Since this inflation is not occurring now, but almost certainly will at some future date, only longer-dated securities will see their yields rise to account for their lost purchasing power. This would spell disaster for a Treasury that finances itself in part with longer-dated securities. By pledging to buy longer-term bonds, the Fed will artificially reduce their yields and thus mask the inflation premium building on their yields.

Jan. 1, 2012 Jan. 1, 2013 Change
Within 15 days 17,847 0 -17,847
16 to 90 days 25,506 5 -25,501
91 days to 1 year 87,285 16 -87,269
1 to 5 years 650,378 378,474 -271,904
5 to 10 years 660,486 862,403 201,917


Table 1: Maturity distribution of U.S. Treasury holdings of the Fed ($m)

While the Fed has slightly decreased the total amount of Treasuries held, Operation Twist has increased the average maturity of these holdings. The Fed currently holds almost no Treasuries with maturities under 1 year and has increased its holdings dated longer than 5 years by over $200bn. Even though the total amount of Treasury debt held has decreased, the total distribution to the Treasury has increased because of this maturity shift. By holding higher interest rate bonds of longer maturities, the Fed earns more interest, which results in more profit to remit to the Treasury at year end.

As we review the Fed’s operations in 2012 we see the usual outcomes. The banking sector has benefited from its operations (unusually so, thanks to the continued interest on reserve policy) and the government has received a free lunch by having a ready buyer for its ever-increasing debt, especially long-term debt, which might otherwise be susceptible to inflationary pressures increasing its interest yield. Let’s see what surprises the Fed has in store for us in 2013.