Macroeconomic Disequilibrium

Posted by PITHOCRATES - September 24th, 2012

Economics 101

In the Barter System we Traded our Goods and Services for the Goods and Services of Others

Money.  It’s not what most people think it is.  It’s not what most politicians think it is.  Or their Keynesian economists.  They think it’s wealth.  That it has value.  But it doesn’t.  It is a temporary storage of value.  A medium of exchange.  And that alone.  Something that we created to make economic trades easier and more efficient.  And it’s those things we trade that have value.  The things that actually make wealth.  Not the money we trade for these things.

In our first economic exchanges there was no money.  Yet there were economic exchanges.  Of goods and services.  That’s right, there was economic activity before money.  People with talent (i.e., human capital) made things, grew things or did things.  They traded this talent with the talent of other people.  Other people with human capital.  Who made things, grew things or did things.  Who sought each other out.  To trade their goods and services for the goods and services of others.  Which you could only do if you had talent yourself.

This is the barter system.  Trading goods and services for goods and services.  Without using money.  Which meant you only had what you could do for yourself.  And the things you could trade for.  If you could find people that wanted what you had.  Which was the great drawback of the barter system.  The search costs.  The time and effort it took to find the people who had what you wanted.  And who wanted what you had.  It proved to be such an inefficient way to make economic transactions that they needed to come up with a better way.  And they did.

The Larger the Wheat Crop the Greater the Inflation and the Higher the Prices paid in Wheat

They found something to temporarily hold the value of their goods and services.  Money.  Something that held value long enough for people to trade their goods and services for it.  Which they then traded for the goods and services they wanted.  Greatly decreasing search costs.  Because you didn’t have to find someone who had what you wanted while having what they wanted.  You just had to take a sack of wheat (or something else that was valuable that other people would want) to market.  When you found what you wanted you simply paid an amount of wheat for what you wanted to buy.  Saving valuable time that you could put to better use.  Producing the goods or services your particular talent provided.

Using wheat for money is an example of commodity money.  Something that has intrinsic value.  You could use it as money and trade it for other goods and services.  Or you could use it to make bread.  Which is what gives it intrinsic value.  Everyone needs to eat.  And bread being the staple of life wheat was very, very valuable.  For back then famine was a real thing.  While living through the winter was not a sure thing.  So the value of wheat was life itself.  The more you had the less likely you would starve to death.  Especially after a bad growing season.  When those with wheat could trade it for a lot of other stuff.  But if it was a year with a bumper crop, well, that was another story.

If farmers flood the market with wheat because of an exceptional growing season then the value for each sack of wheat isn’t worth as much as it used to be.  Because there is just so much of it around.  Losing some of its intrinsic value.  Meaning that it won’t trade for as much as it once did.  The price of wheat falls.  As well as the value of money.  In other words, the bumper crop of wheat depreciated the value of wheat.  That is, the inflation of the wheat supply depreciated the value of the commodity money (wheat).  If the wheat crop was twice as large it would lose half of its value.  Such that it would take two sacks of wheat to buy what one sack once bought.  So the larger the wheat crop the greater the inflation and the higher the prices (except for wheat, of course).  On the other hand if a fire wipes out a civilization’s granary it will contract the wheat supply.  Making it more valuable (because there is less of it around).  Causing prices to fall (except for wheat, of course).  The greater the contraction (or deflation) of the wheat supply the greater the appreciation of the commodity money (wheat).  And the greater prices fall.  Because a little of it can buy a lot more than it once did.

Keynesian Expansionary Monetary Policy has only Disrupted Normal Market Forces

Creating a bumper crop of wheat is not easy.  Unlike printing fiat money.  It takes a lot of work to plow the additional acreage.  It takes additional seed.  Sowing.  Weeding.  Etc.  Which is why commodity money works so well.  Whether it’s growing wheat.  Or mining a precious metal like gold.  It is not easy or cheap to inflate.  Unlike printing fiat money.  Which is why people were so willing to accept it for payment.  For it was a relative constant.  They could accept it without fear of having to spend it quickly before it lost its value.  This brought stability to the markets.  And let the automatic price system match supply to the demand of goods and services.  If things were in high demand they would command a high price.  That high price would encourage others to bring more of those things to market.  If things were not in high demand their prices would fall.  And fewer people would bring them to market.  When supply equaled demand the market was in equilibrium.

Prices provide market signals.  They tell suppliers what the market wants more of.  And what the market wants less of.  That is, if there is a stable money supply.  Because this automatic price system doesn’t work so well during times of inflation.  Why?  Because during inflation prices rise.  Providing a signal to suppliers.  Only it’s a false signal.  For it’s not demand raising prices.  It’s a depreciated currency raising prices.  Causing some suppliers to increase production even though there is no increase in demand.  So they will expand production.  Hire more people.  And put more goods into the market place.  That no one will buy.  While inflation raises prices everywhere in the market.  Increasing the cost of doing business.  Which raises prices throughout the economy.  Because consumers are paying higher prices they cannot buy as much as they once did.  So all that new production ends up sitting in wholesale inventories.  As inventories swell the wholesalers cut back their orders.  And their suppliers, faced with falling orders, have to cut back.  Laying off employees.  And shuttering facilities.  All because inflation sent false signals and disrupted market equilibrium.

This is something the Keynesians don’t understand.  Or refuse to understand.  They believe they can control the economy simply by continuously inflating the money supply.  By just printing more fiat dollars.  As if the value was in the money.  And not the things (or services) of value we create with our human capital.  Economic activity is not about buying things with money.  It’s about using money to efficiently trade the things we make or do with our talent.  Inflating the money supply doesn’t create new value.  It just raises the price (in dollars) of our talents.  Which is why Keynesian expansionary monetary policy has been such a failure.  For their macroeconomic policies only disrupt normal market forces.  Which result in a macroeconomic disequilibrium.  Such as raising production in the face of falling demand.  Because of false price signals caused by inflation.  Which will only bring on an even more severe recession to restore that market equilibrium.  And the longer they try to prevent this correction through inflationary actions the longer and more severe the recession will be.



The Invisible Hand

Posted by PITHOCRATES - April 16th, 2012

Economics 101

A Command Economy Reduces the Overall Economic Output because those Managing the Economy don’t Understand It

Command economy?  Or free market capitalism?  Which works better?  Well, let’s find out with a little experiment.  Let’s go back in time.  Say ancient Mesopotamia.  Just after they developed mass farming.  And produced some of the first food surpluses.  Allowing the rise of a middle class of artisans.  Now let’s look at what could have been the first two of these artisans.  A potter.  And a winemaker.  Who probably weren’t the first two artisans.  But will suffice for our little experiment.

The winemaker needs some pottery vessels to store and sell his wine in.  And the potter enjoys drinking wine.  They each have something the other wants.  And because we’re so far back in time there is no money yet.  We’re still only bartering at this time.  Trading the goods we make with each other.  But in our experiment the high priest of the civilization is also the economic planner.  This priest communicates to the civilization’s gods.  And guides the civilization in pleasing their gods.  Which he is very good at.  For he knows all of the old teachings and rituals.  But he doesn’t know a thing about pottery or winemaking.  But he looks at an empty pottery vessel and a pottery vessel full of wine and sees that the vessel volume equals the volume of wine.  And deems the price of one pottery vessel is the amount of wine one pottery vessel holds.

Well, the potter is quite happy with this price.  Because he is skilled.  And can dig up some clay.  Throw it on the potter’s wheel and knock out vessel after vessel.  Glaze them and fire them in the kiln.  Even working by himself he can achieve some economies of scale.  By repeating this process every day.  Something the winemaker isn’t quite able to.  For he makes wine by the batch.  Because each step in the process takes a lot of time.  Maintaining his grape vines.  Then picking the grapes.  Carrying them back to his winery.  Putting them into his winepress.  Squeezing the juice out of the grapes.  Putting the grape juice in large vats to ferment.  Monitoring the process.  When he determines the process is complete he fills the small pottery vessels with wine.  When it was finally ready for ‘sale’ and consumption.  Considering all the work it took him to make one vessel of wine the winemaker was not at all happy with the price the high priest set.  And instead builds his own potter’s wheel and kiln to make his own vessels.  Greatly increasing his workload.  And reducing his winemaking output.  While the potter loses a potentially large customer.  Thus reducing the amount pottery he makes.  Reducing overall economic output in the command economy.

The Invisible Hand makes sure we use our Limited Resources Efficiently to Make the Things People want Most

In this command economy the civilization suffered a deadweight loss.  Economic resources went unused.  They could have created more economic benefits with the available resources.  They could have made more pottery.  And made more wine.  Perhaps even creating some jobs to help with the economic output of efficiently using the available resources.  But they didn’t.  Because of the fixed prices economic resources went unused.  Thus creating a market equilibrium lower than where it could be.  Hence the deadweight loss.  Now let’s look at the same example with only one difference.  The high priest does NOT set prices.

In a barter economy people agree to trade the goods they make.  And now the potter and the winemaker are free to determine what they think is a fair trade.  That is, they set the price of pottery in wine.  And the price they agree on is one they find mutually acceptable.  Where the potter agrees to trade an amount of his pottery for an amount of wine.  And the winemaker agrees to trade an amount of his wine for an amount of pottery.  Everyone wins.  For the potter gets an amount of wine he values more than the pottery he traded for the wine.  The winemaker gets an amount of pottery he values more than the wine he traded for the pottery.  And the civilization wins because at this mutually agreed upon price both the potter and the winemaker increase their production.  Providing the civilization with more of their goods.  The potter and the winemaker may even hire people to help them produce more goods to meet this higher demand.  Thus increasing the level of happiness in the civilization.  By increasing the amount of economic activity.  Moving the market equilibrium to a higher level of economic output.  And thus reducing the deadweight loss.  By using the available resources in the most efficient manner.  As determined by these mutually agreed upon prices.

This is the Invisible Hand in action.  An economic concept put forth by Scottish economist Adam Smith (1723-1790) in his The Wealth of Nations (1776).  In a competitive market place where traders set the price for their economic trade (not a command economy) two things happen.  First, resources flow to where we demand them most.  That is, to the buyers willing to pay the highest price.  Second, because of the competitive market place only those companies that sell at the low prices the market demands stay in business.  Which means that they have to use those resources as efficiently as possible.  Especially when they’re paying the highest prices for them.  And all of this happens because of the Invisible Hand. 

History has Proven that no Government Bureaucrat can do a Better Job than the Invisible Hand

Those who favor a command economy (or more government intervention into market forces) say the economy is too complex for us to leave it to its own devices.  That without a smart government bureaucrat managing this complex thing we cannot reach a market equilibrium that maximizes economic output.  Whereas Adam Smith says it is because the economy is so complex that no one is smart enough to manage it.  Just as a high priest doesn’t understand pottery or winemaking a smart government bureaucrat cannot hope to understand all the intricacies of a complex economy.  Nor can they ever hope to understand what millions upon millions of consumers want to buy most.  But the beautiful thing is we don’t have to.

The multitudes make individual decisions just like our potter and winemaker.  Where everyone is looking to maximize their own value.  And when they agree on a mutual acceptable price all parties in the trade win.  While making sure our resources flow to where they are demanded most.  And that we use these valuable and limited resources most efficiently.  Thus maximizing overall happiness in our country.  Reducing deadweight losses to a minimum.  And obtaining a market equilibrium that maximizes economic activity.  All of which happens with no one in charge.  As if an Invisible Hand guides us in the market place to make all the right decisions to maximize this economic output.  And our happiness.

So which is better?  Command economy or free market capitalism.  Well, if you’re being honest you have to choose Adam Smith’s Invisible Hand and free market capitalism.  For history has proven that no government bureaucrat can do a better job than the Invisible Hand.  Not the Soviets.  Not the Chinese Communist (under Chairman Mao).  Not the Cubans.  Not the North Koreans.  Even the Americans failed when their government actively intervened in the private economy.  Something that President Jimmy ‘one-term’ Carter knows only too well.  So based on our hypothetical Mesopotamian example, and history in general, free market capitalism is, and always has been, and always will be, better than a command economy.

