Tuesday, June 19, 2012

Very bad exchanges

An election in today’s welfare-fiat world is somewhat like gangs of people pushing on a big sow in different directions, trying to get it to move their way.  So who won the pushing contest Sunday in Greece?  The media tells us it’s the conservatives, who will stay the course and keep the sow on an austerity diet once they form a new government.  But the losers are not without influence, and they don’t like this frugality business, so maybe the new government will only mostly stay the course.  They will negotiate with creditors.  They will attempt to exchange their present deal for something more pleasing to the also-rans.

In the perpetual crisis of modern banking and sovereign states it may seem that economics is an arcane art beyond man’s comprehension.  Yet, its mystery is purely man-made.

In its broadest sense, economics can be thought of as the study of exchanges.  This is how it is defined by Robert Murphy, author of an unusual textbook called Lessons for the Young Economist.  It’s unusual in that it’s methodical without being tedious.  In fact, it’s downright fascinating.

The economists who were blindsided by the 2008 crisis were neck-deep in charts, aggregates, and bad theory they believe in to this day.  They tell us no one saw the train coming, so if everyone was blind, no one was blind.  The train wreck was just an unfortunate reminder that economics is hard stuff.  Better to leave it to the experts at the Fed and other places where high IQs run rampant.   

Problem is, economists of the Austrian school, such as Murphy, saw the train coming as soon as it left the station.  Every train that leaves the interventionist station has its fate written in economic law, as expounded in the works of Mises, Hayek, Rothbard, and others, including Ron Paul.  Everything that has happened in the past decade, and longer, has had all the suspense of a bad novel - for Austrians.

Did the Fed inflate pre-crisis?  Like mad.  Perhaps at Paul Krugman’s suggestion, Alan Greenspan created a monster housing bubble to replace the dot-com bubble.  Did it inflate in response to the bust?  Bernanke spiked the monetary base.  Are investors calling for even more monetary pumping?  The ones calling for QE3 are.  And there are countless nervous others hovering around the panic button ready to join them.  Will this pattern ever end?  Yes - and there’s an unspoken terror behind that thought. 

Murphy’s book, though geared to bright middle schoolers, provides the tools for understanding what the interventionist crowd seems unable to grasp, which is this: Unhampered markets have built-in regulatory mechanisms that keep the train on the tracks.  And the issue at stake could not be more critical.   As we read on page 9:
Unlike other scientific disciplines, the basic truths of economics must be taught to enough people in order to preserve society itself. It really doesn’t matter if the man on the street thinks quantum mechanics is a hoax; the physicists can go on with their research without the approval of the average Joe. But if most people believe that minimum wage laws help the poor, or that low interest rates cure a recession, then the trained economists are helpless to avert the damage that these policies will inflict on society.
The world’s policymakers as well as the people who suffer under them could benefit enormously from committing that passage to memory.  We have, in essence, exchanged sound economic principles for very bad ones - ancient fallacies framed in modern jargon - and are now wondering why the economic outlook is so threatening.

The idea of “exchange,” though, is not limited to the trading activities of individuals in which goods and services are traded for money or for other goods and services.  In every aspect of our lives we’re confronted with the possibility of exchanging the status quo for something else.  The exchange can be performed by an individual in isolation, such as the shipwrecked fictional character Robinson Crusoe who must build a one-man economy, or the change can be brought about by people acting together . . . as Greek voters did recently. 

Exchanging education for state indoctrination

In the early 19th century educational reformers began “exchanging” the Jeffersonian system of voluntary parental education for a more collectivist approach inspired by the despotic Prussian system.  Jefferson was a strong advocate of public schools for the poor, but an equally staunch opponent of compulsion in education.  Yet, by the end of the 19th century almost every state had compulsory public schools in which the “virtues” of obedience, equality, and uniformity were inculcated, sometimes violently, while independent thinking was discouraged or punished.

Given the educational system, should we be surprised that government inroads into the economy and our private lives take place without much resistance?

In 1913, we exchanged a high tariff for the income tax.  Then got the high tariff again later.

In 1917, we exchanged peace for war.  Then peace for war again a generation later.  And finally peace for perpetual war.

In 1933, we exchanged economic liberty for economic fascism.  It still bears the name of “free market capitalism,” though, which is useful for confusing people when the fascists in power screw things up.

After 2001, we exchanged freedom for security and are getting less of both.

But the biggest disaster has been the exchange of market money for political money, initiated in 1933 and completed in 1971.  Every American and dollar holder is now at the mercy of bureaucrats instead of Mother Nature.

In economics, all voluntary exchanges are win-win agreements at the time of the transaction.  Both sides to the trade believe they’re improving their lot, otherwise they wouldn’t agree to make it.  When politicians take to making exchanges for our benefit, however, we’re almost always on the losing side.  Someone must be winning, but in the end it’s not clear who. 

Thursday, June 7, 2012

Peter Schiff on avoiding the brick wall

Peter Schiff, who was famously ridiculed for calling the crisis of 2008, steps up as a prognosticator again in his new book, The Real Crash: America’s Coming Bankruptcy - How to Save Yourself and Your Country.  We had way too much government and cheap credit leading up to 2008, he says, and even more government and cheap credit since then, which is why the next crisis will be the real haymaker. 

His book is divided into two main sections.  Part I addresses the problems, while part II, which is by far the lion’s share of his discussion, presents solutions.  In a nutshell, the problem is government, and the solution is to take an ax to it - again and again.   Since this view is currently unacceptable to policymakers and the public at large, we can only hope reality will win out before calamity hits.

The Real Crash is encyclopedic in its coverage and highly readable in its presentation.  Is there a government agency that truly serves the interests of all Americans?  He finds few.  What about services people actually want, such as K-12 education: Could they be done better at the state or local levels?  Or better still by the free market?  In most cases the answer is a profound “Yes!” to both.

Living on Bubbles

Our problems stem from a love of bubbles and the flawed economic theory that blesses them.

During Alan Greenspan’s reign at the federal reserve we had a savings and loan bubble, followed by a tech bubble, followed by a housing bubble.   Now with Ben Bernanke at the Fed, we have a government bubble, meaning the Fed is creating money that the banks are then lending to the Treasury to expand government.  “If you keep replacing one bubble with another, you eventually run out of suds. The government bubble is the final bubble.”

When the dot-com and housing bubbles burst we at least had something to show for them - “a few good Internet companies and some pretty nice McMansions, [but] no such benefits will remain when the government bubble pops.”

The Fed, Schiff says, should let interest rates rise so people can start saving again.  The Fed’s low rates discourage savings, which are
the key to economic growth, as it finances capital investment, which leads to job creation and increased output of goods and services. A society that does not save cannot grow. It can fake it for a while, living off foreign savings and a printing press, but such “growth” is unsustainable— as we are only now in the process of finding out.
But for politicians and central bankers, rising interest rates are an abomination.  The cost to service the national debt would go through the roof, while the economic contraction that would likely result would raise the deficit.  The federal government would have to spend less, and many of the country’s biggest companies depend on government spending, through contracting, subsidies, or consumption.

But rising rates and the terrible pain it would cause is the good news; the bad news, if the Fed continues to hold rates low, is the economy will eventually go into hyperinflation.  “Rising interest rates will be productive pain— like medicine,” he writes, “while hyperinflation will be destructive pain.”  If we stay the course and pretend everything will somehow work out, we could be facing a crisis worse than the Great Depression.

Bernanke on the Great Depression

Chairman Bernanke, of course, is well-known as an “expert” on the Great Depression, and many people are betting the farm that he and his Keynesian staff have the skills to steer us back to sunny beaches and bikinis.  Bernanke’s approach is to keep asset values from falling by any and all means.  One of the reasons the depression of the 1930s became great, he believes, is because the Fed allowed the money supply to fall following the Crash.  With less money in the economy, prices nosedived.  People didn’t consume as much, consequently businesses didn’t profit as much, therefore employees got fired, and the economy headed south in a self-perpetuating spiral. 

“Sustained deflation can be highly destructive to a modern economy and should be strongly resisted,” Bernanke said in a 2002 speech that inspired his nickname.  And by deflation, he means “falling prices.”

Schiff explains what’s wrong with this analysis.

First, for 100 years prior to the 1929 Crash, bank deposits actually gained value each year.  In other words, we had a century of deflation, that much-feared condition that Bernanke has vowed to avoid at all costs.

Second, from mid-1921 to mid-1929, the Fed increased the money supply by 55 percent, giving rise to a real estate and stock bubble.  Most but not all economists missed the bubble and its inevitable consequences because rising productivity kept consumer prices fairly stable.  Even as stock prices were falling only days before the Crash, Irving Fisher said stocks had reached a “permanently high plateau,” and he expected to see “the stock market a good deal higher than it is today within a few months.”  In 1928, Ludwig von Mises had published a full critique of Fisher’s monetary theory, claiming that Fisher’s reliance on price indexes would bring about the Great Depression.  Nonetheless, Fisher’s stable price theory carried the day, and when the sky fell the Fed, along with Hoover, “did something,” as Schiff explains:
Hoover’s Fed actually boosted the money supply by 10 percent in the two weeks following the 1929 crash. Repeatedly throughout Hoover’s term, the Fed created more money. But the money supply fell because people began hoarding cash, and banks stopped lending out their money.
Deposits went down by 30 percent, but most of that was due to people pulling their money out.

In other words, the money supply shrank despite the Fed’s interventions, not because of its inactions.
Did a falling money supply promote massive unemployment?

Not by itself.  Hoover insisted on keeping wages high, and during his re-election bid in 1932 boasted that the wages of U.S. workers were “now the highest real wages in the world.”  They probably were, and by not allowing wages to fall along with other prices, unemployment soared.
Had Hoover simply allowed the free market to function, the recovery would have been so strong that he likely would have been elected to a second term, and Teddy would have been the last Roosevelt to occupy the White House. Instead he handed the Keynesian baton to Franklin Delano Roosevelt . . .
None of this, as we know, is even close to the standard view of the Depression.  Instead, we’re told
that government needs to play a bigger role in battling downturns, and the Fed needs to pump in cash to jump-start the economy. This bad lesson stays with us today, and beginning in the early 1990s, this way of thinking started the cycle of bubbles that put us where we are now.
End Keep the Fed

The one puzzling part of Peter Schiff’s masterpiece is his view that the federal reserve, as originally conceived, was a good idea.  He describes the Fed as “reckless,” the “biggest culprit in discouraging savings,” and insists “we never should have trusted the Fed to respect its boundaries.”  But he also says:
The original intention of the Fed was something I might have supported had I been around back then. In theory, it was an agent of stability that could also promote economic growth. . . .

The Fed would increase the money supply as the economy expanded, and then reduce the money supply as the economy contracted. . . .

In theory the Fed was a good idea. It’s just that in practice it did not work, because politicians quickly abused it.
He argues that before 1913, banks were issuing their own currencies backed  “by assets, such as gold, and by the banks’ loan portfolios.”  If “you traveled to California, your bank note from Connecticut might not be honored by other merchants or the California banks.”

Thus, he concludes, it was natural “for bankers to hatch an idea of a “banks’ bank.  Banks could deposit some of their assets— commercial paper or gold— with the Fed, and the Fed in return would issue its own bank notes to the individual bank.”

While this may sound plausible, questions arise as to (1) why the “banks’ bank” needed “guns and badges” (i.e., government cartelization) to make it work; (2) why loan portfolios or commercial paper can be assumed to be an acceptable substitute for gold coin; (3) why a central bank is needed to expand and contract the money supply - in other words, why assume the supply/demand relation of the free market fails when the good in question is commodity money; (4) why the historical record of central banks acting as an agent of stability and sustainable economic growth is short on examples; and (5) why did the Fed, at its creation, possess a massive inflationary structure if it was sold as a means to promote stability?

I believe central banking, by its nature, is a means of institutionalizing, centralizing, and cartelizing moral hazard.  It is my view that the Fed was never a good idea, but one of the absolute worst ever brought to fruition. 

These concerns notwithstanding, his critique of the Fed as it currently exists is emphatically on the money.  Though he doesn’t support its abolition he does say, “In an ideal world, there would be no Fed, and I think the nation would be better off if the Fed had never been created.”

How we can save ourselves

Readers of his book don’t have to be swept up in the impending disaster.  Unlike the crash of 2008 when investors flocked to the dollar as a safe haven, he believes the dollar and U.S. bonds will collapse before the U.S. economy goes under.  He devotes a chapter to crisis investing based on the observation that since Americans have been living beyond their means, many others have been living beneath their means. 
Elsewhere in the world there are more creditors than debtors, and there is pent-up demand and excess production. In the future, these economies will see a surge in demand, while ours will see demand fall. . . .

Bottom line: purchasing power is shifting. You should try to invest in companies that will benefit from this shift. These will primarily be foreign companies. Of course, many foreign companies sell to the United States. These aren’t the businesses I’m talking about.
He describes his investment strategy as
a stool with three solid legs: (1) quality dividend-paying foreign stocks in the right sectors; (2) liquidity, and less volatile investments, such as cash and foreign bonds; and (3) gold and gold mining stocks. 
Of particular interest to this reader was his section on the poor man’s investment strategy.  If consumer prices head for the moon the government will likely impose price controls, thereby creating shortages.  Solution: buy in bulk now and stock up.  One advantage is that
any returns are tax free. For example, if you buy a box of cornflakes today and eat it two years from now when the price of a new box is 40 percent higher, that’s a 40 percent tax-free return.
His writing is full of fresh and sometimes bold insights on long-standing issues.  Readers will find his discussions on drug prohibition, marriage, abortion, guns, health care, and prostitution especially engaging, I believe.  His detailed historical and legal discussion of the income tax is the best I’ve ever read, nor does he pull punches in describing it:
It’s hard to imagine a tax more destructive of productivity, more destructive of entrepreneurship, more destructive of our lives, more difficult and costly to comply with, more subject to gaming, or more absurd in its logical consequences. Congress should immediately, fully, and permanently abolish the income tax, and the Internal Revenue Service (IRS) along with it.
He would replace the tax with a revenue-raising tariff on imports.
Yes, tariffs suck. But they suck less than income tax. In fact, they might be preferable to a national sales tax.

Peter Schiff has written a riveting guide on what to do about our snowballing social, financial, and economic problems.  Inasmuch as he recommends freeing people from government, his solutions are far from pain-free and consequently will not be popular with the political class or their dependents.  Well, it’s time they got over it.  As Schiff writes in his introduction, it’s as if we’re headed down an icy hill with politicians in the driver’s seat accelerating toward the bottom. 
We need a grown-up to grab the wheel and steer us into the ditch on the side of the road. That won’t be pretty, but it’s better to go into the ditch at 80 miles an hour than crash into a brick wall at the bottom of the hill at 120.
The Real Crash is a must-read.

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