In Man, Economy and State, Rothbard says that producers have vertical supply curves for their inventory:

In the first place, the stock of newly produced goods in the hands of the producers is also fixed for any given point in time Say that for the month of December the producers of copper de­cide to produce 5,000 tons of copper. At the end of that month their stock of newly produced copper is 5,000 tons. They might regret their decision and believe that if they could have made it again, they would have produced, say, 1,000 tons. But they have their stock, and they must use it as best they can. The distinguish­ing feature of the original producers is that, as a result of special­ization, the direct use-value of their product to them is likely to be almost nonexistent. The further specialization proceeds, the less possible use-value the product can have for its producer. Picture, for example, how much copper a copper manufacturer could consume in his personal use, or the direct use-value of the huge number of produced automobiles to the Ford family. Therefore, in the supply sched­ule of the producers, the direct-­use element in their reservation demand disappears. The only reason for a producer to reserve, to hold on to, any of his stock is speculative—in anticipation of a higher price for the good in the future. (In direct exchange, there is also the possibility of exchange for a third good—say cows instead of fish, in our example.)

If, for the moment, we make the restrictive assumptions that there are no class (b) sellers on the market and that the producers have no present or accumulated past reservation demand, then the market supply-demand schedules can be represented as SS, DD in Figure 29. Thus, with no reservation demand, the supply curve will be a vertical straight line (SS) at the level of the new stock.

Rothbard believes that supply curves are vertical for inventories of produced goods because the seller has no use for the good, other than to sell it. There is no reservation demand on the part of grocers, he would say, for bananas.

I have never been satisfied with this explanation. The problem I have with it is that it does not make clear over what time frame a business firm plans to sell. In an auction with one (or more) goods, multiple buyers, and an auctioneer who takes bids, the supply curve is clearly vertical, the price is set by the buyers, and all goods are sold when the bidding stops. But this is not a good description of a retail store.

While it is true that producers have little or no direct use for their inventory, does that mean they try to clear their inventories in a moment, a day, a week, a month, or even longer? Most businesses have some inventories of unsold goods most of the time, suggesting that they are not trying to instantaneously clear their markets. A significant share of the costs incurred by business firms are costs resulting from carrying inventory. If Rothbard is correct, why don’t firms price their inventories to sell out immediately, and by doing so reduce their costs?

While Reading W. H. Hutt’s The Theory of Idle Resources, I found a better explanation of the supply curve for producer inventories. According to Hutt, even for producer stocks of goods, reservation, demand plays a role in price formation. Hutt identified two reasons that business firms may have a reservation demand for their inventories. One is that the buyer of tomorrow may be willing to pay a higher price than the buyer of today. Setting the asking price for a good at a price that would clear the market in one day will probably result in less total revenue than pricing it to sell over a longer period of time.

Yet producers some times price their goods high enough that unsold perishable goods spoil. For durable goods, selling out the entire inventory can usually be done, though it may take some time. Blueberries spoil within a few days while cars do not. But even cars lose some of their value if they are not sold in the current model year. Grocers frequently throw out some of their inventory, spoiled, and car dealers occasionally find themselves with unsold inventory from the previous model year.

Does unsold inventory indicate an error by the seller? Did the seller err in setting his asking price too high? Not necessarily, according to Hutt. Hutt (p. 29), explains that sellers set the asking prices on their inventories in order to sell them over a period of time, and, to intentionally avoid entirely running out of stock.

Consumers’ goods, for instance, are clearly being distributed over time in accordance with consumers’ demand. … we can make use of the same principle through the rule that the balance of a “surplus” of consumers’ goods … is in a state of “pseudo-idleness” when its rate of liquidation is being determined by expectation of the future demand and supply position as modified by the costs of holding. The most important case of this is that of stocks which are in the nature of a “reserve” to meet the vagaries of day-to-day or week-to-week demand. Consider consumers’ goods held in the course of the marketing process, e.g., the stocks kept in a retail shop. The consumer pays for their availability. The mere presence of the goods in that place is the performance of a productive function, sometimes called by writers on marketing “the function of assembly.” Thus, those who occasionally wear silk hats will actually purchase them on unpredictable occasions. Yet they will expect them to be available in the shop when they chance to require them.

Customers expect business firms to have inventories and are willing to pay higher prices if they can be reasonably sure that the stores or suppliers they use will not be out of stock most of the time. Think about how annoyed you were the last time an item you planned to order at a restaurant was out for the day. The cost of being out of stock, measured in terms of lost goodwill, must be balanced against the costs of unsold inventory.

Edward Chancellor in The Financial Times (requires free registration) after a few paragraphs on the perversities of the current international monetary system, asks “What’s to be done?”. Replying:

Some yearn for a return to the strict discipline of the gold standard. But there is not enough of the precious metal and it would be absurd to restrict global growth to the rate of future gold extraction. There are no clear alternatives to the dollar.The euro is not a candidate since it is a “currency without a state”, in Mr Eichengreen’s words. China hopes to challenge US financial supremacy, but its capital account remains closed and the banking system is state-controlled.

That an economy needs an increasing quantity of money in order grow is widely believed, yet false. In this article, Chancellor makes an even strong claim: that the rate of growth of the economy must be equal to the rate of money growth (which is the rate of gold extraction under a gold standard). In the financial media, where this belief is regarded as fact, I have never seen a reason given by anyone for thinking so. And, even if there were money growth and restricted economic growth, what reason is there to think that the rates should be identical?

Austrian economics gives us reasons for thinking the opposite. Economic growth, defined as an increase in the quantity of goods produced per capita, requires the capital to labor ratio increases in favor of more capital per unit of labor. Capital accumulation must be funded by real investment. However, while nominal investment depends on the quantity of money, real investment does not. Any amount of real investment can take place with any amount of money because prices adjust not only to the quantity of goods but the quantity of money.

Economic history also suggests the contrary: during the 19th century, the economy grew faster than the rate of gold mining. Prices remained constant or slowly fell over time.

As reported by ABC News, what started out as a program to hold unclaimed property, such as the contents of safety deposit boxes owned by people who have moved away without a forwarding address, has gone wildly out of control. The program is now using the flimsiest of excuses to drill safe deposit boxes and sell the contents, often for below-market value, the proceeds going to the state’s general revenue.

In a case reminiscent of the Monty Python organ donor skit (or perhaps the movie Repo Men), a San Francisco woman’s jewelry appraised at over $80,000 was sold even though she lived a few blocks from her bank, had not moved, and was current on all of her box rental feeds. In another case, a man’s retirement savings consisting of $4 million of stock certificates were sold; and “A Sacramento family lost out on railroad land rights their ancestors had owned for generations”.

The program began life as a place to hold unclaimed property for up to 5 years while the state made attempts to locate the owner. Both the holding period and the efforts to locate the owner have diminished over time. ABC news indicates that there have been internal debates within the state on these changes, with an internal memo objecting to efforts to to find the owners on the grounds that “It could well result in additional claims of monies that would otherwise flow into the general fund.”

What surprises me about these seizures is the scale and how under-reported it is. This is the first article that I have seen on this topic, compared to dozens of pieces and several books on civil asset forfeiture. This phenomenon is probably at least as large as CAF — Jarret Wollstein cites a number in the low single-digit billions for asset forfeiture (which may be an annual number) compared to the $32 billion (which may be a multi-year aggregate) appearing in the ABC news story. In comparison, looting of safe deposit boxes requires even less due process than asset forfeiture, which at least requires that the property be accused of a crime, and can be fought in court.

In my earlier post Chinese Ghost Town, part 2, I criticized financial strategist for his naive faith in the ability of Chinese socialist central planners. After some thought I believe that I missed the core point of why he is wrong.

Central planners – who rely on direct orders — can tell banks or other businesses, exactly what to do. “Lend $1000 to this guy at this rate of interest”, or “Sell this widget to that guy for $45″. What they cannot do is to produce particular outcomes at a macro level.

Griffiths talks about China as a whole moving in the right or wrong direction, which without being too specific probably means something like too much inflation, too much credit growth, over-reliance on exports to the US, or some other macro-economic outcome.

I don’t believe that an economic system as such has macro-scopic goals. An economy is a framework within which individuals pursue goals. But suppose that, for the momenty, we go along wiht the idea that the planners want less credit growth, or more output, or less inflation — and it doesn’t matter for the purpose of this point which of these. Then which banks exactly should call in which loans or raise interest rates? Which credit-sensitive borrowers should be allowed to default? Which prospective borrowers should be funded, and at what rates of interest?

The point of Mises economic calculation argument is that the central planner has no way of connecting exactly which direct orders to give with any kind of macroscopic outcome. The planner has no way of translating generic goals to specific commands because the specifics of resource allocation depend on a price system.

Modern classical music is primarily a project of the classical music industry’s managerial elites which has no basis in consumer demand. Despite decades of evidence that audiences do not like this music, the managerial elites continue to push this agenda. When challenged, their response is to blame the classical music audience for not liking the music.

Much of my thinking about the arts has been informed by Mises faculty Paul Cantor’s ten-part lecture series on Commerce and Culture. The main theme of his lectures is that high culture has its roots in popular culture and that popular culture has always been a commercial product. While there are some instances of great art that have not been commercially successful, there is no systemic conflict between great art and commercial success. By this standard, the modernist classical agenda is a failure because it has failed the market test.

Two articles illustrating the “the consumer is wrong” crossed my web browsing path this week – Why do we hate modern classical music? by Alex Ross writing in the Guardian, and a response, Why does contemporary music spurn melody? by Michael Fedo in the Christian Science Monitor.

Fedo provides evidence of the lack of popular acceptance of the modernist agenda. New commissions hardly ever “get legs” and receive a second performance because…well…no one wants to hear them again. Actually, no one wanted to hear them the first time either.

[his father, a French horn player in the Duluth symphony] said that during his tenure Duluth conductors scheduled at least one modern unconventional score each season. “During all those years, the orchestra repeated Beethoven, Mozart, Tchaikovsky – most of the classical canon – many times,” he said. “But we never again replayed a modern composition.”

While I say that “no one” likes this stuff, that is clearly wrong. As evidenced from Ross’s piece, hardly anyone likes this stuff. A typical concert program provides the following clues to the real demand for modernist music: 1) a gnarly modernist work is always programmed with Beethoven or some other popular work (disparagingly know as a “warhorse” or a “chestnut”) and 2) the popular work is always programmed after the intermission because, well, it would be very embarrassing if everyone left after the intermission and most people will not deliberately arrive late. (I am the exception to this, timing my arrival for the second half of these programs if it is something that I want to see.)

Fedo relates the following story illustrating the “blame the listener” reflex that is so common among the managerial class:

In 1986, when he became music director of the Minnesota Orchestra, Edo de Waart was an advocate of contemporary composers. On a radio talk show, a caller asked him, “Why do we have to listen to music that sounds like bus crashes?” To which the maestro replied, “Sir, you’re living in the wrong century.” In other words, get used to the dissonance.

Ross — a tireless advocate of the audience-blaming agenda — admits that “modern classical music remains an unattractive proposition for many concertgoers” and in the next paragraph refers to it as a “problem” (Ross later uses the word “unappreciative” to describe concert-goers who do not like the new music). Mr. Ross, why is it a “problem” if people don’t like something? This happens all the time in markets – consumers do not like something; a product is not commercially successful. This is, from the point of view of the producer of the product a problem if he takes a loss, but it is not a systemic problem for the industry as such. It is a market signal indicating that the classical music industry is producing poor quality music.

Ross — taking the agenda of the managerial elites as a given and the preferences of listeners as changeable — argues that classical music is an acquired taste and that it is the audiences who should, well, just go about acquiring it, as distasteful as that might be.

Ross analyzes number of theories, such as the rejection of novelty, the idolization of the past, and poor marketing that seek to explain why listeners do not like modernist classical music. This effort only serves to illustrate his view of the fixity of modernism, to which audience tastes must eventually yield. The only question that remains is whether it is the classical elites who should try harder to foist this music on us, or whether we as listeners must try harder to digest this distasteful menu.

But why should it be so? Why not some public apologies on the part of the classical music elites for their poor judgment in funding composers? Why does the classical-managerial class after a century of its failed agenda not admit that they were wrong and start trying to fund music that people might like? In what other industry would entrepreneurs continue to pour funding into a failed business model?

That compositional talent still exists is proven by the film industry, which produces several great classical-sounding scores every decade. Yet Ross, predictably, draws exactly the wrong conclusion from this data:

Indeed, it’s striking that film-makers have made lavish use of the same dissonances that concertgoers have found so alienating. Stanley Kubrick’s 2001: A Space Odyssey, with its hallucinatory György Ligeti soundtrack, mesmerised millions in the late 1960s. Martin Scorsese’s Shutter Island, which deploys music by Cage, Morton Feldman, Giacinto Scelsi, and Ligeti again, was a recent box-office hit. Michael Giacchino’s score for the TV series Lost is an encyclopedia of avant garde techniques. If the human ear were instinctively hostile to dissonance, these and 1,000 other Hollywood productions would have failed.

When I think of the score of 2001, I think of the music of the younger and the older Strauss, not of dissonances. Setting that aside, I would point out that movie-goers also like action movies with car crashes that sound like car crashes. Would Ross take that as evidence that the human ear is not hostile to dissonance? Maybe people like these films in spite of the score, or maybe we have different tastes for musical scores that act as a sort of enhanced sound effect track but are not perceived as music.

The classical-sounding film scores that have taken off commercially in their own right, such as John Williams’ brilliant Star Wars efforts and Howard Shore’s Lord of the Rings all have recognizable melodies that any movie-goer could hum after a single hearing.

The human race has not lost the ability to write good — and popular — music. It is only that the managerial elite who run symphonies and granting agencies controlling the funding of composition have placed themselves in opposition to the tastes of classical music, and justify this by blaming the audience for their tastes.

Ross and the classical-managerial elites should question their assumption that modernism is a permanent feature of musical composition that may or may not be accepted by audiences one day. But there is nothing so permanent about modernism. The classical-managerial elites have put the modernist program on welfare to shield it from a market test. A big part of the welfare program has been the constant drum-beat of propaganda suggesting that audience should like this music, and that the problem — if they do not — is with the listener, not the music.

Even after a century, the public does not accept the a-melodic, dissonant, car-crash, sound-effect-driven compositional output of the modernist school as music. It is ultimately audience acceptance that drives composition, not the other way around. While we have been on a bit of a detour for the last 100 years, that should be long enough to declare the modernist agenda a failure and move on to something that people do like.

The classical music audience wants melody. What needs to change is not public tastes, but musical composition. It’s time to give the nascent John Williams and Howard Shores of the world the the new commissions instead of pouring more money and symphony programming space a dark hole in the ground. C’mon Alex Ross, give melody a chance.

In a recent article, The Case Against Gold David Berman interviews a Canadian fund manager who is bearish for all of the wrong reasons.  As do the vast majority of analysts and writers, he totally misunderstands how the gold price is formed.  

While Berman is correct that “gold must obey the law of supply and demand”, his explanation of how the law works is fatally flawed.   The supply and demand numbers presented in the article are meaningless and tell us nothing about the future direction of the gold price.   


The key to understanding the gold price is that gold is in demand as an asset, not as a commodity.   A commodity is a good that is purchased in order to be permanently removed from the market (usually destroyed), while an asset is a good that is purchased because the buyer values it more as a holding than for its direct use.  The most important consequence being held rather than destroyed is that the accumulated stockpiles of exceed annual production by a large margin.   In the case of gold the ratio is between 50:1 and 100:1 while for most (consumed) commodities it is less than 1:1, (i.e. less than one year’s total production is held in above-ground stockpiles). 


For a commodity, everything that is produced is sold; everything that is sold is purchased; and everything that is purchased is consumed. The act of consumption removes the supply from the market permanently.  For the moment, let’s idealize the situation a bit by assuming that there are no above-ground stockpiles of a commodity at all.   Subject to this simplifying assumption the following is true: the amount traded is the same as the amount produced which is the same as the amount consumed.


This mathematical identity is not true for an asset.   Because so much of the asset already exists and so little is produced, most of the trading takes place among buyers and sellers who are only shifting the existing stock piles among themselves.  The equality of the quantities produced, supplied, demanded, and consumed does not hold.   Small amounts of gold are consumed for industrial uses but the quantity permanently consumed can be considered effectively zero because most gold is either held in investable form (bars and coins) or as jewelry. The quantities bought and sold are by definition equal, but the quantities produced and consumed are not equal, nor does the quantity produced necessarily equal the quantity bought and sold. The quantity bought and sold can exceed quantity produced by an enormous ratio because there is no limit on how much existing stockpiles of the asset may be traded during a one-year period.    

The different relationship between the quantities produced, consumed, and traded between a commodity and an asset is the source of much of the confusion about gold. 
For a commodity, increases or decreases in the quantity produced can have a dramatic effect on the price because the quantity consumed must move either up or down along with the quantity produced.  Because there are no stockpiles to buffer the difference between production and consumption, the only way for them to come into balance is through price.   But for an asset, things work differently. For an asset, most trading consists of the change of ownership of existing stocks.   The gold that gets produced will certainly be sold, but trading volumes during a year will far exceed new mine production because of the large volume of trade of existing holdings.

To quantify the impact of mine supply on the market I have (elsewhere) estimated the trading volume on the London Bullion Market Association (LBMA).  The LBMA can absorb an entire year’s mine output in about twelve trading days.  And consider that the LBMA is only one of several investor bar markets worldwide, and that the investment market as a whole includes the coin market as well.   While I do not have a precise number, I estimate that an entire year’s worth of mine production turns over in the physical market in several days. 

Because mine supply is small compared to existing holdings and because the volume traded exceeds mine supply by a large ratio, mine supply is quickly absorbed into the market and has little impact on the gold price.   Far more important is the price at which existing sellers are willing to part with their ounces.  

With this in mind, let’s return to the article. 
Berman states ”the underlying fundamentals are now looking distinctly negative for the metal’s long-term prospects.” As we will see reaches this conclusion by looking at the market only on an annual production basis: 

“According to GFMS, the London-based precious metals consultancy, global jewellery purchases plunged to 1,759 tonnes last year from more than 3,000 tonnes at the start of the decade, as the rising price of gold turned off consumers and jewellery makers cut back on gold content.”

As explained above, looking only at annual production ignores most of the gold market. The entire gold market is a single integrated market with one price. There is not one market with one price for gold produced this year and another market selling at a different price where existing stockpiles of gold are traded. Looking at gold on an annual basis gives the appearance that the supply – and therefore the demand – are highly variable. If the supply goes from 1759 to 3000 over a few years – almost a 100% increase — then demand must also nearly double, otherwise the price would plunge, right? Well, no. The supply of gold is not 1759 or 3000 tonnes, it is about 165,000 tonnes – the total all mined gold in history that has not been lost or destroyed. And what about demand? The demand is also 165,000 tonnes, exactly equal to the supply. And the supply has not doubled over the last few years, it has grown modestly by about 1-2% each year for a cumulative increase of less than 20%.

What does it mean to say that the demand for an asset is equal to the supply? For a commodity, the demand consists of off-take from the market for destruction. An asset, on the other hand, is not destroyed; it is acquired in order to be held. The demand for an asset consists of what economists call reservation demand, meaning that investors demand an asset by holding it off the market while the price is below their selling price. Demand for gold has not and does not need to double to keep pace with mine supply. As the supply grows by about 1% each year, reservation demand must only grow by the same amount in order to keep the market in balance.

Here is where we get into the meat of Berman’s case for the bearish gold supply fundamentals:

“At the same time as demand is falling, gold supply is rising. Most central banks, for instance, are jettisoning their gold holdings. According to the World Gold Council, total gold holdings were about 30,600 tonnes in December, down nearly 2,900 tonnes since the start of the decade – and these overall declines take into account an increase in gold holdings by China’s central bank

Adding to supply is ramped-up production from mines. This rose to a four-year high of 2,572 tonnes in 2009. In addition, consumers are now happily mailing in their “scrap” gold jewellery to the host of gold-dealing companies that have sprouted up in recent years. Add in this recycled gold and total world supply hit 4,034 tonnes last year, the highest level in at least a decade.”

Correction, Mr. Berman: a seller selling gold is not an increase in supply. It is only a transfer of existing supply from one owner to another. It does not matter whether this seller is a central bank or someone melting scrap. And moreover, is central bank selling a huge bearish indicator? 3,000 tonnes per year is about annual mine supply. This is, as noted above, a few trading days’ volume. If there are no buyers near the market price, then it could be bearish, but not nearly as bearish as it sounds when you consider that the total supply of gold is 165,000 tonnes – 50 to 100 years annual production. The real influence on the price is not possible to quantify. Once the gold changes hands, the price depends on the reservation price of the new buyers, which could be higher than that of the recent seller.

Berman also misunderstands the relationship between investment products and jewelry:

“Unlike most commodities, gold isn’t consumed in high quantities. Industrial uses account for only about 10 per cent of total demand, which is why jewellery makers have traditionally provided most of the market for the metal.
However, global demand for gold jewellery has been in steady decline, replaced only by demand from fickle investors – a shift that could have a disastrous impact on the price of gold if those buyers turn squeamish.”

And:

 “Of course, gold is still in high demand. But the source of this demand is now investors, who have become gold’s biggest buyers for the first time in about 30 years. These buyers have no uses for gold, other than the hope of selling it to someone else at a higher price somewhere down the road.”

 
In reality, investment and jewelry are not so different. They are two different ways of holding gold. In either form, the gold is not destroyed. The boundary between them is somewhat fluid based on the relative intensity of investment demand versus jewelry demand. As gold becomes more in demand by investors demanding bars and coins, the opportunity cost of using it for jewelry increases. At the margin, more people will sell back unwanted jewelry as scrap and (also at the margin) more buyers will substitute silver or other metals for gold. If the investment demand fell, then at the margin people would hold onto more of their family jewelry and use more gold in new jewelry fabrication.  What Berman describes as a fall in demand is only a natural shift between different ways of holding gold as an investor and consumer valuations change.

The intentions of the jewelry buyer and the investment buyer may be different. Investment buyers hold gold as a store of value, while jewelry buyers may use it for ornamental purposes. But the gold is still held and most jewelry can and does eventually return to the market as melt. And furthermore, in some parts of the world a lot of jewelry is purchased as a store of value – a wearable investment. In the West investors prefer to hold gold as bars or coins while in Asia and the Near East, some jewelry purchases are investments rather than ornamental. Bullion jewelry has a low workmanship value-added compared to ornamental jewelry which sells for substantially more than its gold melt value.

Berman also makes the common error of quantifying gold demand by counting trading volume. As explained above, for a commodity the quantity traded is equal to both production and consumption, but not for an asset. For an asset, the supply and the demand are both equal to the total quantity stockpiled. There is no obvious relationship between production and trading. High market volume in the gold market means a high level of demand and an equally high level of supply. This does not provide a clear indicator of the price direction in the market, though this does not stop many analysts from pointing to high trading volume as evidence of either a lot of demand (if they are bullish) or a lot of supply reaching the market (if they are bearish). We cannot use the trading volume as a measure of supply and demand because the price at which the existing supply changes hands does not depend on the trading volume: the price can rise, fall, or go sideways on increasing, or decreasing volume.

An example that I like to use to illustrate this point is if an analyst studying a particular stock (corporate equity) wrote “demand for the shares of corporation XYZ were 30M shares…but we expect demand for the shares to increase next year to 40M shares, which is very bullish”, then anyone reading this would have to scratch their head a bit in trying to understand what the analyst meant. In fact, the statement is meaningless — the analyst would be spouting gibberish. The deep confusion exhibited by writers and analysts on this issue contributes to the lack of understanding by investors and the continuing stream of articles such as Mr. Berman’s piece.

One of the best indicators that the an analyst is in a state of deeply misguided thinking is that he provides two different numbers for supply and demand. The numbers result from adding up some fraction of the total gold trades on each side of the market and calling those numbers “supply” and “demand”. As noted above, trading volumes do not measure supply differently than demand. If the supply and demand number are not equal, then the analyst has counted some trades as supply only and others as demand only. These numbers do not mean what these analysts say they do and they tell you nothing about the direction of the gold price.

When reading interviews and articles by prominent gold analysts – such as Jon Nadler and Jeffrey Christian – providing price forecasts based on quantitative figures for supply and demand, keep in mind that these numbers are meaningless and so then are their interpretations of the numbers. Whenever I listen to or read a Jeffrey Christian interview I feel the urge to grab him by the shoulders, shake him, and shout “Stop talking nonsense, man!”.

In the end, the gold price is not analyzable by quantitative measure of supply and comparing it to a quantitative measure of demand. Supply and demand are identical and both are equal to the total stock of gold. The price depends on the reservation price of the owners of existing stockpiles as compared to the buy price of existing holders of fiat money. This cannot be measured other than by the gold price itself.

How then do we forecast the price of gold? Personally I am sympathetic to methodologies that compare the purchasing power of an ounce of gold over time to other assets such as a man’s suit or the DOW index. Another approach that makes some sense to me is looking at historical trends in gold’s total “capitalization” compared to that of other financial assets. But it’s hard to point to an arbitrage that would bring the price of gold in line with historical values of these metrics.

Today’s New York Times Magazine features an inspirational article on India’s New Generation of Caste Busters telling the story of how private sector entrepreneurs are providing affordable educational services to help the poorest people develop skills for the global economy.

The article is centered around Ravindra Misal, a man from a poor family who became the founder of a school for roller skating, event management, and English language skills.

There are several passages from the article that surprised me and provoked further thought:

“Electricity is essential to ambition,” an energetic young man named Ravindra Misal explained to me, “because I need it to do my homework, I need it to listen to music if I am a dancer, I need it to listen to tapes of great speakers, I need it to surf the Internet. But I cannot, so people get angry.”

and

In Misal’s world, television was seen, even by parents, as a force of liberation. “TV is the very hi-fi form of everything,” Misal said. “It’s the extreme level of ideas, where they show you everything at top level, so that certainly gives you motivation. On TV you see the things of world-class standard. When you see some person on Discovery catching anaconda, you are looking at the best person in the world for catching anaconda. On TV we never see the strugglers or something like that; we see the people who have achieved what they wanted to be.”

In the developed world we are gradually losing ground to Algorism, an ideology wrapped around an attack on energy consumption. Private sector media, especially television, is one of the favorite targets of anti-market cultural criticism.

The poignancy of Misal’s comments comes from the direct connection he observes between energy consumption, the media, and the path from poverty to prosperity for the people who in spite of being very poor are highly motivated and intelligent.

Another potentially useful research tool from Google – ngrams shows the occurrence of words or phrases (for example Mises,Hayek,Rothbard) charted over time based on the scanned books in Google books. Note the spike in Hayek mentions around the time of his Nobel.

This week on King World News financial strategist Robin Griffiths is interviewed on a range of macro topics. Around 13:00 into the MP3 file Griffiths says (approximately transcribed):

I do think that being a command economy and not a democracy is an advantage for China at the moment, because if it finds that it’s moving in the wrong direction, as it recently did, it can just suddenly say to the banks “right now I want you to do these different things and cool it,” and it instantly starts to happen…but It’s a very efficient form of government at the moment to keep their show on the road

Just after (the new Year) we will get a new five-year plan from China. And I understand that will amount to a massive plan to stimulate the domestic economy and switch the emphasis away from selling exports to America through Walmart. As long as they do tend to deliver on their five year plans…having a five year plan out there will encourage people to invest and keep the show on the road.

Some questions for Griffiths:

• How would the central planners know what is the “wrong direction” for the economy?
• Without prices and a profit/loss system how would the planners know what instructions to give to banks (or any other firms) in order to get the results they want?
• How can central planners monitor whether banks are carrying out their instructions?
• Without prices and a profit/loss how can central planners have any idea of what to plan?
• Why does consumption need to be “stimulated”? Why is it necessary to plan consumption? Doesn’t everyone want to consume goods?
• How will the central plan ensure that the that what gets produced are the goods that people want to consume?

I have been a skeptic of the Chinese growth miracle for some time. Last year, I blogged about a Chinese ghost town built by central planners but never inhabited. Via a friend I received amazing satellite and ground photos of Chinese ghost cities. These mind-blowing photos show multiple cities, some of which have a few dozen cars owned by central planners parked around government offices, others totally vacant. In my view these empty cities are more indicative of the results of central economic planning than the fantasy world that Griffiths lives, in which central planners snap their fingers and the results they want arrive.

In a response to my blog post on the Fekete Real Bills Doctrine Rudy Fritsch raises the issue of seasonal variations in money demand, which he suggests is a death blow argument against the 100% reserve banking system.

The problem with equilibrium theory is simple, and is clear to anyone who took the trouble to listen to Professor Fekete; the demand for product is not steady… the ‘equilibrating’ process is impossible, as there is no fixed ‘target’ toward which the economy could ‘equilibrate’! In fact, as Professor Fekete has stated, a 100% Gold Standard would fail at the first Christmas shopping season.

The reason is perfectly clear; much more merchandise is sold in high season, therefore much more cash would be needed to support the clearing function… and where would this cash come from? Then, as the shopping season winds down, demand for cash drops… and there would be an excess of cash on hand. What to do with this excess cash?

[...] The flexibility needed to accommodate swings in demand is provided by Real Bills in circulation.

Fritsch’s article repeats the persistent fallacy that a 100% reserve banking system rules out the use of a clearing mechanism. This is simply false. Murry Rothbard, the greatest advocate of 100% reserve banking, devotes an entire section of his opus to clearing systems. What it does rule out is monetization of the clearing claims by banks. But there is no problem with clearing alongside 100% reserve banking.

However, this is really a side issue. As I will show a fully cash settled system with 100% reserve banks can accommodate the Christmas shopping season.

The problem that Fritsch is alluding to is a dramatic and unanticipated shift in money demand. For example, If there were to be a sudden increase in money demand, then prices would also have to adjust rapidly downwards. If no one had anticipated this, then firms would be in a position where they would have to sell their inventories below their cost.

The first problem with this scenario is that it treats money demand as if that were something separate from prices. The way that individuals and firms increase their money demand is by lowering their asking prices so as to increase their volume of money incomes and by lowering their bid prices for goods so as to decrease their money expenditures. The adjustment of the price system and a change in money demand are one and the same thing.

A bigger problem with the Christmas scenario as a killer argument is that Christmas does not entail a huge unanticipated variation in money demand. Assume a 100% reserve banking system. Consumers who plan to purchase gifts during the November-December time frame increase their money demand during the January-October months so that they will have the funds available for year-end shopping; or they may borrow money during the shopping season (which under 100% reserves requires other individuals to reduce their money holdings by lending).

Retailers who anticipate making a large volume of sales during the year end period reduce their money demand during the months leading up to the shopping season as they purchase inventory that they plan to sell.

To summarize, during the months outside of the year-end shopping seasons, consumers increase their money demand while retailers decrease theirs. During the shopping season, the reverse happens: consumers decrease their money demand as they exchange their accumulated cash balances for gifts, while retailers increase their money demand as they exchange inventories for cash. As long as the process is reasonably well-anticipated, the money demand does not change much.

It is possible that Fritsch has confused money demand with currency demand. Money is broader than currency. In a 100% reserve system, money consists of currency plus demand deposits held by money warehouses. Under 100% reserves there is no problem with an increase in the demand for currency because it is exactly offset by an identical decrease in the quantity of demand deposits. Overall money supply remains the same as money moves between demand deposits and currency.

Under fractional reserves, however, the story is quite different because base money upon which fractional reserves are multiplied includes vault currency, and any demands for currency above and beyond what banks hold in vaults must be met by a liquidation of some portion of the bank’s assets. Therefore a large increase in currency demand shrinks the monetary base of the banking system and causes a contraction of the money supply.

Gonzalo Lira on zero hedge has published an article Gonzalo Lira On The Identity Of The False Religion Behind The Mask Of Economic “Science” about the generally poor record of macro-economic forecasting. Lira’s view is that macro-economic forecasting is a false religion masquerading as a science. Along the way he takes a few shots at the Austrian school. After reading the article it is pretty clear that he didn’t bother to inform himself even at a basic level about Austrian economics.

Consider the following:

Very few people have been asking why economics has failed so spectacularly at predicting the Global Financial Crisis, and very few people have asked why economics cannot seem to solve the Global Depression we are currently experiencing.

While Lira is correct that the mainstream of economics has largely failed to inquire into its failure to see the collapse, a large fraction of the very few people who have been asking exactly that question write for this web site or otherwise use the Austrian macro-economic framework in their thinking.

As for whether “economics” cannot solve the current depression, it is not fair to blame the Austrian school when the Austrian recommendations have not been tried. Whether cutting taxes and spending, raising interest rates (or allowing the market to set interest rates), standing aside as insolvent banks fail, not bailing out over-indebted firms, and putting the banking system on a 100% gold reserve system would work better than what we are doing is a counter-factual proposition and one that Austrians can advance arguments in favor of; but no one can reasonably assert that these things have been tried.

Next, let’s move on to the following:

What does [macro] economics do, as a discipline?

The answer is obvious: [macro] Economics tries to predict the future.

I agree with Lira on the following points: that prediction as such cannot be science, at least not in the same way that economics is a science; and, that we have seen a lot of really inaccurate forecasting leading up to the crash and that most of the post-mortem analysis hasn’t been very useful either.

But is forecasting the defining property of Austrian macro-economics as a discipline? I don’t believe that Austrians would accept that. For Austrians economics is a single unified theory. The theory aims to provide an understanding of the laws of cause and effect in the domain of production and exchange.

Economic science can provide us with true statements about the qualitative relationship between a single cause and its effects. While we can use economics to make predictions, predictions will not be accurate all of the time because predictions have as their domain the real world, in which there are multiple past causes and multiple unknown future causes that will occur within the time frame of the prediction.

Whenever there are multiple causes, combining their influence is a matter of judgment because economics as such does not provide us with any tools for quantifying the effects of each cause. The forecaster must bring into play his own experience and opinions about which causes are most important in any given historical situation. This task falls under Mises’ term thymology.

Neither micro nor macro-economics for Austrians is about forecasting; macro is that part of the theory which deals with the entire economic system. Yet while Lira rips economists for their failure to forecast the collapse, in the several years before 2008, Austrians were above-average at seeing the train heading down the tunnel. See for example Mark Thorton’s article Who Predicted the Bubble? Who Predicted the Crash? in which he provides evidence that a disproportionate number of the economists and financial analysts who did see something coming were using Austrian concepts to reach their conclusion.

I will finish with Lira’s most ludicrous and blatantly inaccurate slur against Austrians:

Austrians argue that the government should cut spending and raise taxes, so as to balance the budget—and magically, the economy will improve, with no loss of GDP.

I challenge Lira to find even a single example of an Austrian economist who has advocated raising taxes as a solution to the bust or to anything else. I did a google search of the Mises.org site on the keyword “taxes” and opened the first page of links. Every one of the had a negative view of taxes or reported on a tax without comment. On top of that, most Austrians don’t like GDP as a measure of economic output. Even the form of the prediction – if spending is cut and taxes are raised then GDP will not fall is a quantitative prediction of the type that Austrian economics cannot make.

While I agree with a lot of the points that Lira makes against mainstream economics, it is clear that he didn’t bother to learn some basic things about the Austrian school before making false and innaccurate criticisms of it.

Rudy Fritsch of the Gold Standard Institute has responded to my earlier post. While Fritsch raises a number of points including seasonal variation in money demand, and the inability of the price system to adapt to changes in supply, demand, and consumer preferences, I am going to be selective in what I respond to because for me there is one major issue that he and Fekete are grossly mistaken about: in the Miltonic example that I cited, Fekete has argued that there are not enough savings to support an increase in production and that real bills can in essence substitute for actual savings. I am going to limit my response to that issue because I don’t want to dilute my response by delving into other areas.

Misunderstanding of Savings

The real bills advocates consistently demonstrate a mis-understanding of actual savings. While money is used to effect saving, we not save money and saving is not a monetary process. The stream of final goods reaching the market is available for savings. Saving is the consumption of some final goods to fund the production of capital goods. In a monetary economy, we use money to save but to understand saving is a real process. Out of the final goods reaching the market some are “destructively consumed” and some are “reproductively consumed”. The total supply of saving is the latter category. In a monetary economy, these decisions are carried out using money but it is only the stream of goods made available for “reproductive consumption” that is available to fund investment.

James Mill has a very good description of the real meaning of saving:

The two senses of the word consumption are not a little remarkable. We say, that a manufacturer consumes the wine which is laid up in his cellar, when he drinks it; we say too, that he has consumed the cotton, or the wool in his warehouse, when his workmen have wrought it up: he consumes part of his money in paying the wages of his footmen; he consumes another part of it in paying the wages of the workmen in his manufactory. It is very evident, however, that consumption, in the case of the wine and the livery servants, means something very different from what it means in the case of the wool or cotton, and the manufacturing servants. In the first case, it is plain, that consumption means extinction, actual annihilation of property; in the second case, it means more properly renovation, and increase of property. The cotton or wool is consumed only that it may appear in a more valuable form; the wages of the workmen only that they may be repaid, with a profit, in the produce of their labor. In this manner too, a land proprietor may consume a thousand quarters of corn a year, in the maintenance of dogs, of horses for pleasure, and of livery servants; or he may consume the same quantity of corn in the maintenance of agricultural horses, and of agricultural servants. In this instance too, the consumption of the corn, in the first case, is an absolute destruction of it. In the second case, the consumption is a renovation and increase.

Fritsch states “Money that could be used as savings under Real Bills would by necessity have to be used to support the clearing function”. In the same passage Fritsch states that:

Furthermore, all other things being equal, if more of the total stock of money is available for investment, aka savings, then interest rates experience downward pressure. If less cash (relative to the total stock) is available, because it is used for clearing, interest rates tend to rise.

The essential problem with this view is to look at savings and investment in terms of the money stock. This approach leads to the fallacy that conserving money is the same economizing real resources. What limits production of final goods is the total quantity of real resources available for investment. The total stream of final goods reaching the market is divided into consumed goods and saved goods. This division is carried out using money but it is not the money that is saved, it is the final goods. Reducing the monetary cost of some activity only makes more resources available for saving if the real cost is reduced. The clearing process does not conserve any real resources, it only enables the system as a whole to operate with lower money demand.

Interest rates are not, as Fritsch says “driven by the ratio of savings to cash”, they are driven by the consumption:saving ratio. This ratio can remain unchanged as money demand moves up and down.

If the same set of transactions can be carried out with less total cash flow, that does not mean that they consume fewer real resources. To know whether or not a process consumes fewer real resources, we need to know the prices and quantities of the goods. For Fritch’s point to be valid, it would have to be the case that when firms adopted clearing to reduce their money demand, that all the same resources were available to them at the old low prices.

As an individual if I could find a way to reduce the money expenditures on one activity then that would leave funds available for other activities. However, to extend this reasoning to the entire economy is a fallacy of composition. Changes in systemic money demand due to clearing do not make more real resources available for production because there are offsetting price changes to a system reduction. The error in analysis comes from a failure to take into account the seen and the unseen effects. What Fritsch misses here is that there are offsetting adjustments to the reduction in money demand elsewhere in the system – the prices of goods, generally increase. Real costs of production for the clearing firms would only be reduced if there were no offsetting effects in the price system to the adoption of clearing.

While it is true that the economy is not in an equilibrium, arbitrage opportunities to appear the price system responds to them. In particular, the price changes initiated by the introduction of clearing into a non-clearing economy would be arbitraged away. If some sector of the economy or subset of firms began using clearing to lower their money demand, even if initially the changes in prices appeared initially in the goods that these firms traded, if they to continued to use clearing, the resulting changes in relative prices between the clearing firms and the non-clearing firms would open up arbitrage opportunities between the clearing and the non-clearing part of the economy. There is no reason to think that these price changes would permanent and not arbitraged away.

If some technological innovation reduces the real cost of production then real resources become available for some other use. For example, suppose that a car could be produced with half as much steel – then the steel would be available for some other use in the economy. But reducing the monetary flow through a production process — as clearing does — is not the same as reducing the real cost or production. Reducing the money flow through a process does not make any real resources available for another other use. The changes in money demand are offset by changes in the price system and real costs are not changed.

Suppose that there are a several production functions for a car, of the form X tons of steel, Y pounds of rubber, Z hours of labor, use of K robots,…. There is always some ability to substitute among different factors of production and to substitute capital for labor or vice versa. The only way that the real cost of producing a car could change with clearing is if there was a way to substitute a real bill for X pounds of steel to produce a car made out of real bills.

I believe that there is an unstated assumption in Fekete and Fritsch’s work that, when the quantity of money or near-money is increased (through bills) that quantities of goods somehow adjust upwards rather than prices adjusting upwards. If I am right about this it raises a huge set of issues around how these goods can be produced without additional real factors of production. He may be thinking that the real bills themselves serve as a factor of production that can substitute for real labor and capital. This is consistent with Fekete’s statement that savings alone are not sufficient to fund production but that real bills can.

Low Interest Rates

From Fritsch:

Low, steady interest rates are clearly conducive to production; projects that would be sub marginal at higher rates of interest become profitable if rates are low and steady. Real Bills thus free Gold for longer term investment. Real Bills circulation is essential to a workable Gold Standard.

“Low steady interest rates are clearly conducive to production” as Fritsch says only if those interest rates reflect the scarcity of actual saving. A monetary system which achieves the objective of lowering interest rates to stimulate investment through monetary means do not in reality make sub-marginal production projects marginal because there is not sufficient real savings to complete them; such projects only appear to be viable so for a time. I won’t provide an explication here of the Austrian Business Cycle Theory (ABCT) but there is plenty of literature on-line for those who wish to investigate.

Update 2010-11-7In my original post I had incorrectly identified the author of the response as Michael Fritsch. The author’s corrected name is Rudy Fritsch. I have updated the title of the post as well to reflect my error.

One of the key empirical findings supporting Milton Freidman’s attack on the Keynesian system was a wealth of data from various countries showing that money demand tends to be stable.

There are situations where money demand changes suddenly. The most obvious example is during the contraction phase of the business cycle, where people become more risk averse and prefer to hold cash rather than assets. If you accept the Austrian theory of the Business Cycle, the boom and bust is a feature of fractional reserve banking and therefore not a problem for a 100% reserve system.

Via Antony Müller of the Mises Institute, Brazil, the Frankfurter Allgemeine Zeitung has published an article on the influence of Austrian economics in America with a sidebar about the history of the Austrian school. I do not read German but through Google translate I was able to verify that the article mentions Guido Hülsmann’s biograpy of Mises. There is also an embed of the Hayek-Keynes rap video.

After having written several pieces (1 2 3 4 5 6) on Antal Fekete’s neo-Real Bills Doctrine (RBD) I had not intended to address the issue again. (I endorse Sean Corrigan’s critiques of Fekete 1 2 3 4 5.) While Fekete has accused me of being impolite by calling him a monetary crank (guilty) and has invoked the argument from the authority of Adam Smith (a thinker whom many Austrians do not like), but I have not seen anything from him amounting to a substantive response addressing the issues.

Yet seven years later this continues to be a hot topic, or at least a lukewarm one. I receive a steady trickle of emails about this. After getting into several lengthy email discussions with defenders of Fekete, I believe that in my published articles I may not have expressed my criticism in the simplest possible way. At this time I feel that I have gained some understanding of how to more clearly explain the main problem with Fekete’s doctrines.

Real Bills and the Neo-RBD

Real Bills are short-term credit instruments secured by a claim on partially finished or finished goods. These securities can be used as near-money (not so dissimilar to shares in a money market mutual fund that invests in commercial paper). Because the bills mature at some time in the future, they trade at any given day at a discount to their principal value reflecting the prevailing rate of interest over the remaining maturity of the bill. I will refer to this as the Real Bills System (RBS).

Fekete’s neo-RDB can be summarized simply as RBS + fractional reserve banking. While Fekete is mostly concerned with reviving the Real Bills Doctrine (neo-RBD), most of his important economic propositions do not depend on the neo-RBD, only on the RBS. The egregious errors in his understanding are based on the RBS, not the neo-RBD.

One of Fekete’s errors is that if he can demonstrate the validity of certain points relating to the RBS, that proves the correctness of the neo-RBD. While I am critical of fractional reserving banking, I will not address the neo-RBD in this post because if the RBS falls, then so does the neo-RBD.

Fekete’s Propositions Concerning the RBS

It is difficult to really pin down what Fekete’s propositions in an analytical way because his discussion take the form of story-telling. It is also important to understand that not everything Fekete says is wrong. A lot of what he says is not controversial. The key error on which he builds a large pile nonsense can be seen in the following direct quotes from this article:

On savings

1. “it is not possible to finance all of society’s circulating capital out of savings. It would put inordinate demand on savings that simply could not be met.
2. Moving goods to market should not require “invad[ing] the pool of circulating gold coins and [tying] up savings for 30 days”
3. “Let me suggest it to you that no conceivable economy can generate savings so prodigiously as to move all the indispensable items to the consumer. “

On clearing

1. “Clearing has been put to work making it entirely unnecessary to invade the pool of circulating gold coins and divert savings, to finance the movement of consumer goods through an ever more refined and roundabout process, provided only that those goods be demanded by the consumer urgently enough.”

“There is no way of telling how much trade a given amount of monetary gold can support at any given price level. The volume of trade depends, not on the stock of monetary gold, but on the clearing system which can be improved to meet the challenge. ”

Fekete’s propositions concerning the RBS can be reduced to these three:

1. Real Bills function as a clearing system (true, not controversial)
2. Clearing systems reduce the demand for money (true, not controversial)
3. Holding the quantity of savings constant, more production can occur in an economic system when money demand is reduced by the use of clearing than if all transactions were cash settled

Fekete’s First and Second Propositions

One of Fekete’s errors is to take attacks on his views as attacks on clearing and netting systems. This is not so. Fekete’s first and second propositions are both true and non-controversial. Rothbard devotes a portion of a chapter in Man Economy and State to a discussion of clearing systems. There is no problem with clearing and netting systems. Really.

Fekete mistakenly attacks the advocates of 100% reserve banking for opposing clearing systems. The adoption of one hundred percent reserve banking does not depend on whether clearing systems are used or not. The two issues have nothing to do with each other. Fractional reserves can exist with or without clearing systems as can 100% reserves.

Clearing and netting systems (like other financial innovations that reduce the demand for cash such as credit cards) reduce money demand, which increases the price level. This is a market-based form of price inflation. It is a one-time effect and once the system equilibrates to the new, lower level of money demand, there is no further rise in prices.

When there is ongoing trade between two or more parties that is not necessarily in balance every month, it would make sense to adopt netting rather than paying for every transaction in cash, but only for the convenience of not moving the cash back and forth. It also makes sense to adopt some kind of accounting process where unsettled cash balances could be turned into short-term credits that either reversed the next month or got rolled forward. In the modern world, cash settlement can be done with checks or electronic transfer, which reduces the need to physically ship stacks of paper money around.

Fekete’s Third Proposition

The core of Fekete’s neo-RBD doctrine is expressed in his third proposition. I gained a deeper understanding of this point during a lengthy email discussion I had with an advocate of Fekete’s position who argued that, if too money was spent on moving goods to market then there would not be enough left over for capital investment. Fekete’s basic error is that clearing and netting systems do not augment the production process in the way that he says they do. The net effect of clearing and netting systems is approximately zero.

Clearing and Money Demand

The nominal supply of money doesn’t matter in terms of production. To explain this suppose that we had 10x as much money as we do now. We could do all of the same transactions and produce all of the same goods but every transaction would have an extra zero on the end. If money supply was 1/10th as much we could conduct the same transactions, produce the same goods, but there would be one less zero on the end.

Changes in money demand works in almost the same way as changes in money supply. An increase in money demand is a lot like a decrease in the money supply: the price level falls but the same transactions can take place and the same production of goods. A decrease money demand is similar to an increase in money supply: the price level goes up but overall production doesn’t change much other than redistribution effects.

There are transition effects when the money supply or money demand changes. These transition effects change the distribution of wealth to the extent that they are anticipated by some people better than by others. But once the system equilibrates to a new level of money demand, the transition effects are done.

Now to address clearing to clearing, all that clearing does is to decrease money demand because fewer transactions are required to be settled in cash. After the system equilibrates to the new level of money demand, the same transactions can occur, the same production, and the same amount of final goods.

Fekete’s error is to suppose that that clearing and netting systems enable more transactions to take place and more final goods to be produced than a cash settled system. This is not the case. With or without clearing, all of the same transactions could take place, only without clearing the price level would have to be lower because the demand for cash would be higher. What clearing and netting systems to is enable more transactions to take place without the price level having to fall as much as it otherwise would in a pure cash-settled system.

Fekete’s exposition assumes that the effect of Real Bills would be limited to the production of goods in process. He proposes that the use of bills avoids “invading” cash balances for the production of goods-in-process so that cash can be used for other purposes. Not so. As explained above, the the use of clearing instruments reduces money demand, which will increase the general price level. The prices of goods-in-process are not segregated from all other prices in the economy. An decrease in money demand show up as an increase in the prices of all goods: capital goods, partially finished goods, goods-in-transit, and final goods. At this new higher systemic price level the same production processes will occur as would happen without real bills. The bills only enable the same processes to occur at higher nominal prices.

In a recent piece, Fekete claims the adopt of Real Bills explains the growth of international trade in the 19th century. This is nonsense. Ultimately goods are traded for goods whether final goods or capital goods. It was the production of more good that enables the international trade of more goods. Whether people found ways to lower money demand by avoiding cash settlement of every transaction really has nothing to do with the volume of goods that get produced. All that bills did is to decrease money demand. All of the same trade could have been accomplished with entirely cash-settled transactions at a lower price level.

Clearing and Savings

Fekete’s proposition is that clearing systems enable savings to be used more efficiently because when real bills are used to finance the movement of goods, then precious can be conserved for other uses.

Fekete’s has completely confused cash transactions with savings. Every cash transaction, in his mind, uses up real savings. Economizing on cash, then, is the same as economizing on savings. In his “Miltonic” example, he computes the volume of cash transactions, which totals $4995, and then compares this to quantity of savings. From this he reaches the conclusion that there would not be enough savings to produce the Miltonic.

Accumulated cash balances are not savings and cash transactions do not use up an equivalent amount of savings. Savings and cash transactions are not the same thing and are not directly comparable. The act of saving is a decision by to consume some final goods to fund the production of new capital goods. Savings is usually accomplished in a monetary economy by the transfer of money. A cash transaction then can be used to accomplish an increase in savings, for example, when a business purchases a new capital good out of retained earnings. The relationship between cash transactions and savings depends on what is being purchased.

Accumulated cash balances are not accumulated savings. Accumulated savings consist of the entire stock of existing capital goods and partially finished goods. We might also add stockpiled partially consumed final goods such as houses and cars as savings. Production processes cause use up some capital goods and cause capital goods to wear out, which is the consumption of savings.

The consumption of savings is a real process. Savings are consumed as stockpiles are used up, energy is burned, and capital goods wear out. These processes are not directly comparable to quantities of cash used in transactions. Because the production of capital goods and the movement of goods to market uses up real resources, these processes can only be funded by savings.

Fekete’s repeated assertions of the insufficiency of savings can now be understood. When he says that there are insufficient savings to accomplish necessary transactions, what he means is that there are insufficient cash balances to perform these transactions or that the money supply could not grow fast enough to perform the increasing number of transactions that occur as the economy grows. This is not a problem in the real world because any volume of transactions can be performed with any quantity of money at some price level. Everything that Fekete says on this topic is false once you realize that the price system is capable of adjusting to any supply of money. If the economy grows faster than the supply of money, prices of both capital goods and final goods will have to fall in order for the larger volume of transactions to be accommodated, a point brilliantly explained by Hayek in his essay The Paradox of Savings

Conclusion

While Fekete piles a lot of other nonsense on top of his rotting foundation, the error that I have addressed int his post is the key to understanding everything that that is wrong with his neo-RBD.

Econtalk host Russ Roberts interviews author Daniel Pink on the topic Drive, Motivation and Incentives in last week’s podcast. Pink’s message is that a substantial body of empirical evidence shows that people are only motivated to a limited extent by money to increase their production in a work situation. Once employees are paid “enough”, other motivators take over, such as “autonomy, mastery and a sense of purpose.”

Some thoughts I had while listening to this.

As I understood Pink’s synthesis of the research, a given individual may not increase their work production by the incentive of more money beyond a level they are satisfied with. What I think that this shows is that offering the same set of employees marginally more money may not improve output. However, the way I suspect that the labor market works is that different individuals who produce a higher level of output find their wages bid up as they move around the labor market.

Around 19:00, Pink raises the question of whether a large bonus for producing a new idea that succeeds in the market would produce more and better products. Roberts points out “Dan, that is the way our economy actually works”. Roberts points out that this is how entrepreneurial competition works. The market rewards entrepreneurs who produce a great new product with a large “bonus”, known as “profit”. The prospect of this reward stimulates many entrepreneurs to try new ideas, some of which fail. Thank you Russ Roberts for not letting that point get by.

However, the point Roberts makes is slightly different than what I think the research shows. For a company, holding the set of employees constant, the research questions whether offering a bonus to those employees will result in more innovation. It might or might not; maybe the employees of that company are not very entrepreneurial or are highly risk-averse. But what the market for new products and new firms does is to select those individuals — employed or otherwise — who are motivated by the possibility of earning profits.

Pink is not convinced, citing the example of people who have accumulated a large amount of wealth from profits on one company who start another company because the marginal value of the additional money is insignificant to that person. He interprets this to mean that entrepreneurs are not primarily motivated by money. I believe that Pink is correct, that we are all motivated by many things including, but not limited to money. But I don’t think that his example proves the point: successful entrepreneurs may still be motivated by earning money.

[Warning: spoilers but you have nothing to worry about if you are current through the end of season 3.]

I have been enjoying the cable TV series Mad Men, now in its fourth season on the AMC network. New York, the 1960′s, and the fictitious Manhattan ad agency of Sterling Cooper provide the setting of the series. The firm’s talented creative director Don Draper, brilliantly depicted by John Hamm, leads a talented ensemble cast. Smart dialogue, great acting, and loyal attention to the design of the era make this show a difficult habit to break.

While I do not entirely disagree with Jeff Tucker (who has written that in its depiction of social customs and mores lies an endorsement of the subsequent expansion of the nanny state) I believe that there is another dimension to the show that has not been much discussed: the show is in the minority of products from the entertainment industry that take business seriously.

Most movies which depict business executives in one of two ways: either they motivated entirely by pure malevolence toward humanity in general; or, they are driven by an over-arching greed that transcends any other motives.

As Alex Tabarrok writes in the Wall Street Journal,

In the movies, capitalists are almost invariably cast as villains. Has someone been murdered? Are the residents of a small town dying of cancer? Is an environment being despoiled? Look no further than the CEO of some large corporation. Quick, name as many movies as you can that feature capitalists as heroes. “Batman Forever” and “Iron Man” do not count. There are a few (“The Edge,” “You’ve Got Mail”), but it’s a short list. Now name as many movies as you can that feature mass-murdering corporations and corporate villains? That one is easy: “The Fugitive,” “Syriana,” “Mission Impossible II,” “Erin Brockovich,” “The China Syndrome” and “Avatar,” to name only a few.

Even when a corporation is not the primary villain, Hollywood lets its dislike of commerce be known.

The show is nearly alone in looking at the reality of business as a complex and challenging undertaking of imperfect, but not malevolent human beings. The show is clearly not anti-business in the way that Tabarrok illustrates. The advertising industry is one of the prime targets of anti-market ideology. The series does not condemn advertising. Instead it takes a respectful and interested stance toward the industry and the people in it. That is in itself a political statement.

The story lines bounce back and forth between the office and the private lives of the characters. On the business side, several economic themes emerge – consumer preference, competition, constant change, innovation, skill, and the division of labor.

As Tucker noted, the 60′s itself is one of the main characters in the show. The camera often lingers over a piece of furniture, a clock, a carpet, a car, a meal, or a costume. Typewriters are ubiquitous. The arrival of a photocopier at the firm causes considerable consternation: where to put it? What will clients think when they see it? After laughing at products that were new in the 60′s but now strike us as outmoded, I realized that the the innovation in production and constant change in consumer preference is a theme in the show. While we are not so far removed from that era, the range of products we have available today has changed considerably.

Consumer preference is the driving force behind advertising. Don Draper frequently is shown meeting with clients to discuss the needs of their business. The executives discuss their success or failure in terms of their own customers.

A theme of the show is success and failure of products and industries. In some cases a business that has been stable for many years is going into decline; for example a bathing suit company that refuses to shift its production to what the company’s management considers risqué bikinis is losing market share as bathing dress becomes more revealing. Many of the prominent brands featured in the show no longer exist.

Responding to technological change is another important theme. Television emerged and overtook print media as a platform for advertising during this period. Harry Crane, an account manager, invents his own job by requesting to be appointed director of television for the firm, which prior to him, did not have one. Not realizing the importance of this position, senior partner Roger Sterling agrees to appoint him to this position. Over time the television department grows as a share of the firms’ revenues, and Crane advances in his career, adding subordinates to his department.

In other cases, a new firm is attempting to gain market share from the industry leaders. A young entrepreneur (whose wealth was inherited from a successful father) jai-alai launches an expensive ad campaign based on his belief that the sport will become as popular as baseball. We know from the perspective of the present that this will never happen, and that the ad campaign will be a failure.

The writers do not shy away from addressing the issue of personal success and failure. Draper is depicted as a creative director of extraordinary talent. His ability to connect on an emotional level with the consumers is one of the main themes of the show. His success is achieved through his deep and intuitive insight into the imagination of consumers and his ability to see connections between the product and the consumer’s desires. His ability is exemplified in a scene where he presents the advertising strategy for a new invention – the slide projector. Draper presents a slide show of family pictures and then explains,

Nostalgia – it’s delicate, but potent. Teddy told me that in Greek, “nostalgia” literally means “the pain from an old wound.” It’s a twinge in your heart far more powerful than memory alone. This device isn’t a spaceship, it’s a time machine. It goes backwards, and forwards… it takes us to a place where we ache to go again. It’s not called the wheel, it’s called the carousel. It let’s us travel the way a child travels – around and around, and back home again, to a place where we know are loved.

An example of how the show addresses failure is a scene where the father of the jai-alai entrepreneur explains that his son grew up in an atmosphere of success (“my success”, he adds) and that only when his son has lost his inherited wealth will he face the reality and possibly do something valuable to someone other than himself.

Division of labor is a theme of the show. Don Draper is fond of pointing out that the advertising industry exists because its customers – the producers of products — do not have the creative skills found within the ad agencies. At the firm, many skills are present, and as we see over the course of a season, necessary: graphic art, account management, copy writing, and secretarial. After he loses an account with the Hilton Hotel chain, Draper admits that he is not an “account man”. When Draper leaves to form his own agency, the co-founders invite the business manager Lane Price to come along as their CFO because none of them knows how to manage budgets.

Competition between firms is another theme of the shows. Sterling Cooper is a mid-tier firm that has a few of the premium brands and some lesser-knowns. In one episode, the firm has the chance to get an account with a major airline (Pan Am – another brand that no longer exists). A serious miscalculation, which results in Sterling Cooper losing one of their best existing customers and failing to win the new account. A dialogue follows between Draper and partner Roger Sterling about their nature of risk taking.

I am so familiar with the anti-business bias of most entertainment products that for the first season I was expecting every scene about a business topic to be framed with the post-modern irony quotes that have become so indispensable to express the writer/viewer’s smug position of superiority. Somewhere in to the second season I began to trust that the writers were really trying to depict business in a more realistic way – as a complex and challenging pursuit that people do imperfectly, incorporating both success and failure.

I have been a skeptic of the Chinese growth miracle for some time. This excellent piece by Edward Chancellor, titled China’s Red Flags makes raises several objections to the bullish story.

Chancellor points out the similarities to the similar mania around Japan in the 80s when it was argued that their economic growth was due to their central planners’ ability to pick winners and direct investment into those sectors.

A prominent British investor recently announced that he was coming out of retirement to run a China fund. Among his reasons for being bullish was the “effectiveness of central planning.”

On Jeff Tucker’s blog post last week about Senator Schumer’s directive to Steve Jobs to fix the iPhone 4 antenna problem, the best response I have seen is by song writer Jonathan Mann in his iPhone 4 Antenna Song. Mann makes the point of consumer sovereignty in a humorous way. As Brian Maupin’s tinywatchproductions points out, there are other phones with similar features on the market..

Disclousure: I own an iPhone 4. I haven’t taken it back.

Host Scott Horton interviews human rights lawyer Scott Horton for the Antiwar.com podcast. Around 20:00 the latter Scott Horton has a few kind words for Austrian economics and discusses the influence of the Austrian school on post-Soviet Eastern Europe. I’ve been listening to the two the one Scott interview the other Scott for a while but I had no idea that the latter was sympathetic to the Austrian school.

Economics is Hard. Don’t Let Bloggers Tell You Otherwise by Katrik Athreya, a research economist at the Fed can be summarized “Kids, don’t try this at home. Economics requires adult supervision.”

The following is a letter to open-minded consumers of the economics blogosphere. In the wake of the recent financial crisis, bloggers seem unable to resist commentating routinely about economic events. It may always have been thus, but in recent times, the manifold dimensions of the financial crisis and associated recession have given fillip to something bigger than a cottage industry. Examples include Matt Yglesias, John Stossel, Robert Samuelson, and Robert Reich. In what follows I will argue that it is exceedingly unlikely that these authors have anything interesting to say about economic policy

The reason for this is that economics is hard, or, to quote Athreya, “not, by any reasonable measure, simple”, “very complicated”, “far, far, more complicated than most commentators seem to recognize”", “takes enormous effort”.

Athreya’s critique of non-professional bloggers is primarily the field is so complex and subtle that no one without specialized Ph.D.-level training from “a decent economics department” is likely to even understand the terms of debate correctly, not even to make a contribution to it. In contrast to bloggers who have no external checks on what they write, the self-identified scientific community of economists rigorously enforces high internal standards through peer review:

The punchline to all this is that when a professional research economist thinks or talks about
social insurance, unemployment, taxes, budget deficits, or sovereign debt, among other things, they almost always have a very precisely articulated model that has been vetted repeatedly for internal coherence. Critically, it is one whose constituent assumptions and parts are visible to all present, and can be fought over. And what I certainly know is that to even begin to talk about the effects of unemployment, debt, deficits, or taxes, one has to think very hard about many, many things. .. Comparing, even momentarily, [the careful work of certain economists] its explicit, careful reasoning, its ever-mindful approach to the accounting for feedback effects, and its transparent reproducibility, with the sophomoric musings of auto-didact or non-didact bloggers or writers is instructive.

What Athreya is saying is not so different from the view of Murray Rothbard , who said, “It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a “dismal science.” But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.” People who write about economics should first become educated about the subject matter.

Many of the writers and bloggers on this site have a Ph.D. in economics (although I’m not sure whether the institutions where they studied would qualify under Athreya’s standard to enter the select who can “meaningfully advance the discussion on economic policy.”). But I can cite numerous examples of writers in the Austrian camp who do not have economics doctorates who have meaningfully advanced the discussion: Henry Hazlitt; Lew Rockwell; Thomas Woods (a historian). Some other non-Ph.D.-accredited economic writers in the financial sector that I follow are David Tice and Doug Noland, Sean Corrigan, Doug French, Fred Sheehan, James Grant, and Gary North (a Ph.D. historian). I like Stossel as well.

Athreya is probably right to the extent that he is saying that the models taught at most university economics departments are so complex and specialized that anyone who has not taken the coursework probably does not understand them. But where I think that he goes wrong is to identify the study of university macro with learning economics. Economics, as we see it, is the understanding of human action under conditions of scarcity. Many of us in the Austrian camp believe that the field of economics, macro in particular, went off the rails in the mid-30′s under the influence of Keynes. By Keynesian thinking I mean the meta-model underlying most modern macro models: the focus on very high levels of aggregation, the focus on consumption, the lack of capital theory, the lack of an explicit model of inter-temporal coordination through the interest rate, and the obsession with sticky prices. Athreya defines a meaningful advance in the discussion of economics in terms of the models that are taught at university economics departments, which for the most part inherit the problems with the Keynesian meta-model.

Those of us who have been influenced (to a greater or lesser extent) by the original thinkers of the Austrian school need a place on the net to discuss what is going on in the world according to our view of how things work. The general lack of availability of university training in Austrian economics ensures that most of the commentary in this area is going to come from non-university trained writers. Some of the time we may take on the mainstream, but other times we only want to have our own internal discussion among people who share the same starting point for analysis.

I have no reason to doubt that he is correct the self-appointed priesthood of macro enforce high standards when it comes to a discussion within their own frameworks. Writing at length, as Athreya does, about how difficult it is to master those models, does not address the point that the intellectual framework underlying those models may be fatally flawed for reasons that are not nearly so difficult to understand as the models themselves.

I also would fault Athreya for not making a clear distinction between pure economics and policy analysis. Mises wrote“There never lived at the same time more than a score of men whose work contributed anything essential to economics.” Mises would no doubt agree with Athreya that making an advance in fundamental economics is hard. But many of us who blog as not trying to make make an original contribution to the field. We are trying to apply the thinking of Mises and the other great original thinkers of the Austrian tradition to current events. But most bloggers are not trying to make fundamental advances in economics (at least not in our blog posts); we are usually observing the world around us and attempting to explain some features of it using our understanding of economics.

Update (Jul 5 2:46 pm)It occurred to me after I wrote this that one reason many people have opinions about economics, compared to other specialized fields such as cancer research and geology is that the economic thinking is very influential in the choice of economic policies, and economic policies affect us all. Geology, while it may affect us all, is not influenced by policies and cancer research affects a relatively small number of people. Mises wrote that everyone has a share of responsibility for the direction of society.