The Curiosity Seekers: Modern Economics Is Irrelevant to Life

When I was an economics undergraduate in the 1980s, I learned an astonishing “joke” among economists: “Torture the data and nature will repent.” My professor, a Chicago School economist who studied under Milton Friedman, used the joke to illustrate how a clever economist armed with the tools of statistics can “torture” the data to reach any conclusion he wished. My professor was an “empiricist” economist.

The other type of economists I encountered taught my classes in Keynesian macroeconomic theory. They spun intricate, mathematical theories divorced from the real world. They were the “theorists.”

Both approaches resulted in “conclusions” that, if they had anything to do with reality, it was only by smuggling in a better approach. Otherwise, the questions asked and answered by these economists were as relevant to human life as the questions debated by a group of peasants standing around a well in the Middle Ages or by a group of scholastic monks peering down at them from their monastery up the hill.

Now we have an article entitled “International bright young things” (The Economist, 12/30/08), which highlights the best and brightest new economists, as selected by their mentors.

One who calls herself a “randomista” uses randomized trials to answer economic questions. She recently demonstrated that “mothers in the Indian state of Rajasthan are three times as likely to have their children vaccinated if they are rewarded with a kilogram of [lentil beans].” The article wonderingly asks, “[who knew] such a modest incentive (worth less than 50 cents) [would] make such a big difference?”

Another has “proven” that regressive inheritance subsidies [that means subsidies for those who receive inheritances] would “take the edge off…the uncertainty” that results from the “biggest roll of the dice in life [which is] the family you are born into.”

Yet another “shows” that government must provide enough unemployment benefits so that “[t]he unemployed decide that an unhurried job search is worth the extra cost of depleting [their additional funds].”

Armed with rigorous tools of statistics and mathematics, and powerful computers, these economists are spinning their wheels answering questions about… nothing.

But they are missing the most powerful tool, the one that will give them the proper method and purpose for their efforts. Without that tool, these practitioners of a vital science have become seekers of unimportant curiosities at best and diminutive statist nostrums at worst.

That tool is a rational philosophy. Every scientist is guided by a philosophy that tells him what is the proper subject of study and how that knowledge can be gained. Today's economists are sorely in need of a rational philosophy, one that will point them to subjects that are more than a handful of lentil beans in importance, and to research methods that are more effective at discovering enduring principles than the randomista's spin of the wheel.

A philosophy like that exists. See Ayn Rand and her philosophy of reason called Objectivism.

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I originally posted a version of this piece on the Harry Binswanger List forum.

Money Unmoored by Gold

A stockbroker friend of mine sent me this chart showing the ratio between the Dow Jones Industrial Average (and its equivalent predecessor index) and the price of gold. Notice the greater amplitude of variation in this ratio after Congress established the Federal Reserve Bank in 1913 and severed the connection between gold and money. After 1913, money could be created in arbitrary fashion by the Federal Reserve Bank. Further sundering the connection between gold and money in the 1930s, FDR's New Deal Congress outlawed the private ownership of gold, and clauses in private contracts that called for payment in gold. Finally, Richard Nixon's Congress severed the last vestige of the gold standard in the late 1960s and early 1970s by suspending the U.S. government's promise to pay in gold to settle international claims.

These moves to unmoor the dollar from gold coincided with the stock market swinging to higher highs and lower lows relative to gold. I interpret the chart as showing the effect of monetary inflation in the 1920s, 1960s, and 1990s, and then the impact of recession/Depression in the 1930s and price inflation combined with recession in the 1970s.

When the stock market was relatively high and gold low, in the 1920s, 1960s, and 1990s, the economy genuinely boomed, but that boom was artificially enhanced by easy money. That is why the ratio soared to higher highs than existed in the pre-1913 gold standard era. The result of that monetary inflation was an economic bust, as the dislocations caused by that monetary inflation harmed the economy. Inevitably, the excess money showed up in price inflation, especially evident during the 1970s "stagflation" when both recession and inflation cursed the nation.

Does this chart tell us anything about the future? The author of the chart would have us believe that we are headed for a 1930s or 1970s style economic catastrophe, as shown by the "Target Zone" marked on the chart. Certainly, the precursors for such a catastrophe have been established, and we are seeing the first signs of economic malaise of the 1970s variety. We had monetary inflation in the 1990s and 2000s, which is now manifesting itself in price inflation and incipient recession.

What is your interpretation of the historical meaning of the graph? What do the highs and lows of the various eras mean? Do you agree with my interpretation? What is your thought of the future? Are we headed to a low Dow/high gold ratio that we last saw in the 1930s and 1970s, or will such an economic disaster be averted? In other words, will our economy muddle along for awhile, or must we endure a true economic disaster before the economy improves?

I will offer my opinion later in the comments section.

Helicopter Ben

"Helicopter Ben" is the nickname Federal Reserve Chairman Ben Bernanke reportedly got for a comment he once made regarding how the government should aggressively use monetary policy to prevent a recession. Emphasizing that the key point is to inflate quickly to avert a crisis, he said the government could simply drop money from a helicopter to stimulate the economy.

Federal Reserve chairmen like to fly around in helicopters. Maybe that's their problem. By attempting to manage the money supply from their helicopter vantage, the Federal Reserve fails to see the real action of the economy on the ground. As a result, they make bad decisions. They add too much money or too little. They act too early or too late. The result is an exacerbation of booms and busts in the economy. The booms become unreal, and the busts too severe.

In 2003, the Federal Reserve lowered the interest rate at which it facilitates bank loans to an unprecedented low of 1%. In those years, we saw tremendous investment in real estate and a boom in real estate prices. The excess investment was stoked by cheap credit for mortgages available from banks. Variable interest and interest-only loans keyed to the artificially low federal funds rate enabled homebuyers to bid ever more for larger houses. Easy 100% or more financing enabled those who hadn't saved for a down payment to buy houses on the bank's credit.

Artificially cheap money had led to a flood of financial capital becoming available for mortgage lending by the banks. Lend they did, at terms that did not reflect the true financial risk they were undertaking. Such artificially supplied cheap money is inflation. When the Fed realized that its inflation of the money supply led to inflated asset prices, it tried to limit the damage by tightening credit, eventually raising the bank interest rate to a recent high of 5 1/4%. Now, the reverse process is happening. Over-extended borrowers are defaulting, credit is tightening, and the economy is poised for a slow-down.

All of this is the result of managing monetary policy from way up high in helicopters. How do we bring monetary policy down to earth? The only way to do this is to privatize money. Instead of the Federal Reserve, a sole, legal monopoly issuer of money and credit, all money should be issued by private banks. Private banks do not operate in helicopters. They operate on the ground. They understand the specific financing needs of particular borrowers. They assess their ability to extend credit based on the creditworthiness of the borrower, and on their own availability of funds.

The supply and demand conditions of money and credit that the banks respond to are the real economy. If a new technology creates promising new business opportunities, the banks lend to those businesses. If a regional downturn reduces creditworthiness, they extend less credit. All the time, the banks lend with a view to protecting their own balance sheets and maximizing their own profit. This grounded action by private banks will result in the most efficient deployment of financial capital possible.

Does it mean the end of booms and busts? That is a question I am not sure of, but I think it may not. Nevertheless, the booms and busts that will occur will be shorter in duration and less severe. More importantly, they will reflect real economic events, not artificial changes of the money supply by the helicopter money monopolists.

The Businessman's Hall of Fame

The New York Times, without intending it, has published the businessman's hall of fame. By ranking these great business figures in order of the wealth they created, the NYT has allowed us to honor the greatest businessmen of the past 200 years, ranked by the measure of their achievement.

Wealth is the measure of the businessman, for what is wealth than the measure of the value of the products he has made? Wealth comes from profit, which is the difference between value received for a product less the cost of manufacturing it. If consumers everywhere pay more for the personal computer or the Model T Ford then it cost to make it, that difference is an objective measure of the value created. If the product is so popular that millions of PC's and Model T's are sold, then millions of customers have benefited from the entrepreneurial ingenuity of the businessmen.

I honor the wealthiest businessmen. They are those who have created the most beneficial, useful, enjoyable products that all of us enjoy. Hats off to Bill Gates (the 5th wealthiest) and Warren Buffett (the 16th wealthiest), for making the software for the fabulously useful personal computer on which I am writing this, and for providing capital to America's most efficient companies, respectively. Hats off to John D. Rockefeller, the leader of the Hall of Fame, who created the modern oil industry, the seminal industry that continues to fuel our industrial economy.

Hats off to all of the Hall of Famers. In a future world, we will see sculptures of your figures in a real world Hall of Fame. Schoolchildren will learn your stories, and emulate you, and some of them will add themselves to your august glory.

[Hat tip to NoodleFood for the link to the New York Times article.]

The One Minute Case for Unrestrained Profit

PROFIT IS THE ENGINE OF PRODUCTION

Restraining profit by taxing it or limiting it has the effect of limiting production. Restraining profit means an economy will produce fewer goods, of less variety, and at higher price. Innovation suffers. As a result, to the extent profits are restrained, all consumers suffer. Profit drives production in several ways:

PROFIT IS THE INCENTIVE FOR PRODUCTION

The profit motive is the supreme motivator of productive business activity. The creativity of scientists, the entrepreneurship of businessmen, and the resourcefulness of financiers are all motivated, in whole or part, by the pursuit of profits.

PROFIT PROVIDES THE MEANS OF PRODUCTION

Profits and savings are the ultimate source of the investment capital (money) that finances construction of factories, research laboratories, distribution centers, ships, warehouses, and all of the equipment that is used to invent, produce and distribute the goods that we consume. To restrict profits is to deny a source of capital necessary for production.

PROFIT DIRECTS CAPITAL TO THE PRODUCTION OF GOODS MOST URGENTLY WANTED

The highest profits are earned by the businessmen who can supply the goods most wanted by customers. iPods, portable generators after a hurricane, personal computers, fashionable clothes, and all of the goods consumers want most, are made by those who make the greatest profits. The profitability of an enterprise is the ultimate measuring stick of how well it has satisfied its customers. A money losing business is either making products consumers do not want or charging too much for them.

PROFITS RESULT IN EVERYONE'S GAIN

Profits do not come from the net loss of anyone. On the contrary, profit results from the creation of goods that people voluntarily buy in the marketplace. A businessman who makes a huge profit makes things that are good enough that many people want them and willingly buy them from him.

PROFIT IS PROPERTY

Profits are the property of the shareholders and other investor/owners of the business. Restricting or taxing profits is not just impractical, but is theft.

HONEST PROFITS ARE AN ESSENTIAL FEATURE OF CAPITALISM

A profit honestly earned in a capitalist society is beneficial and good for all. Profits must be distinguished from the money a businessman might get because of special governmental favors, such as tariffs, regulations or subsidies. These interventions are contrary to capitalism and allow some businessmen to gain at other people’s expense. Their gain is not profits, but a form of theft.

Further reading

• Capitalism: The Unknown Ideal by Ayn Rand
• Atlas Shrugged by Ayn Rand
• “Profit and Loss” by Ludwig von Mises

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I published this on an interesting new web-site called The One Minute Case. It has a clever premise. State a case on various topics succinctly, and provide suggestions for further reading. I liken it to a Wikipedia for busy capitalists. I wish it success, with many new entries and readers.

Comments on the Electric Utility “Deregulation” Mess

Recently, I received the following (edited) question regarding the choice of electricity supplier in the state of New Jersey. The question is applicable for anyone who has a “choice” in any of the states that “deregulated” their electric utilities in the 1990s. These include California, Connecticut, Illinois, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island and Texas. The details of the deregulation plans vary by state, but all of them, to varying degrees, offer or did offer customers a choice of electricity supplier. Most of these states also mandated that utilities in their state had to divest all or a portion of their power plants. My answer is applicable to all of these states and, in important respects, to the entire country. PSEG is Public Service Enterprise Group, which provides electricity to parts of New Jersey.

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Hi GB,

I hope this email finds you well. I've lately become consumed with what I pay PSEG so I requested alternative electric energy supplier options (they pretty much have a monopoly on distribution).

Of the list of 19, just 2 offer residential service to my zip code. My question to you is: does the residential customer really have any choices? It seems all of the options are for businesses. (With the amount of research I've done on this topic today, this may turn out to be an article in the newsletter I publish! But I need to check my facts with you first.)

To their credit, PSEG does offer many comprehensive programs, tips, and arrangements to "help pay", lower, and generally help make paying them less of a burden, however, I can't help feeling like I'm just not getting the choices I'm supposed to get in a dereg'd marketplace.

Any thoughts you can share with me on this will help alleviate my frustrations... thanks!

A Reader

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My answer:

Dear Reader,

As for the question in your email, residential customers don’t really get much of a choice much of the time. I suspect that any deal you are offered probably doesn’t present much savings over PSEG.

As for why, it is quite complicated to answer. The simplest answer is that the electric industry was never really deregulated, so deregulation can’t be blamed for what you are observing with regard to residential choice of electricity supplier.

Consider that “deregulation” in the case of utilities involved something good (allowing entities other than utilities to build more power plants) and quite a lot that was not good and “re-regulatory” in nature. The good thing, allowing others to build power plants, should lower prices over time because newer and more efficient plants will get built. However, that is true only if both utilities and non-utilities are truly free to build plants. Being truly free would mean that they can: (1) charge whatever they want for power produced from those plants, (2) locate them in the best locations, wherever they can buy land, and (3) build the plants using whatever they think is the best technology.

None of those things are true today. I’ll briefly address each of them:

(1) Price Maximums = Expensive Power. Price maximums are set by federal and regional regulators in the wholesale power market. Capped prices mean capped profits and a reduced desire for companies to build power plants. If fewer new power plants get built, prices will remain high because electricity continues to be made with old, inefficient plants.

(2) You Can’t Build It Here. Local zoning rules, land use restrictions, environmental rules, and the “NIMBY” reaction of local politicians to a power plant in their local area make it extremely difficult to locate new plants in the areas where they are most urgently needed, such as near urban areas where the customers are. “NIMBY” stands for “Not In My Back Yard.”

(3) Using the Best Technology Is Forbidden. The cheapest technology for a new “base-load” power plant, i.e., one that is designed to run 24/7, 365 days a year, is nuclear. Base load plants are the work-horse plants on the grid. They supply most of the electricity that you use. Unfortunately, nuclear energy in America has been made prohibitively expensive through unnecessary safety rules imposed after Three Mile Island. No one has died from exposure to nuclear radiation in that accident or any other accident anywhere in the modern, Western industrialized world (which the Communist government responsible for Chernobyl was not; no Western engineer would have built a nuclear power plant without a containment vessel, which the Soviets did). Despite nuclear energy's exemplary safety record, arbitrary safety regulations have made nuclear energy almost prohibitively expensive.

So, faced with the rules & regulations embodied in points 1-3, the electric industry remains very highly regulated in a manner that results in high electricity prices.

The other part of the answer is the re-regulation that was part of “deregulation”. Sound confusing? What makes it confusing is that when the “deregulators” thought they were deregulating, they were actually re-regulating the industry by imposing an artificial industrial structure on the utilities. The “deregulators” developed the mistaken belief that they knew better than the utilities what business structure they should have. So, they broke apart the utilities, much in the same way AT&T was broken up by deregulators in 1984 (that action was also a mixed bag of “re-regulation” and partial deregulation, but that is another discussion). They forced the utilities to sell their power plants, and then they forced the utilities to allow others to use their distribution wires to deliver electricity to customers. That is why someone other than PSEG can “sell” you power even though they do not own the wire that delivers it to your house. Instead, PSEG owns the wire and you pay PSEG to have that other company’s power delivered over PSEG’s wire to your house. It is similar to how competing long distance companies would use Verizon’s local phone lines to provide you with long distance service.

The result of the artificial manipulation of the utilities’ corporate structures and business practices is that they operate in a manner less friendly to customers. Until the pseudo-deregulation of the 1990s, utilities were vertically integrated. They owned their power plants. That enabled them to offer power at predictable prices. However, by artificially separating utilities from their power plants, they were forced to buy power partially or completely in the wholesale power markets. In itself, that might have worked out okay, but regulators also forced the utilities to buy power under relatively short-term contracts. As a result, short-term price fluctuations get transmitted to customers.

To summarize the point about re-regulation, the artificially broken-up structure of utilities makes them less economically efficient, with the result that power prices are both higher and more volatile to customers.

Sound complicated? It is. Is it deregulation? No. Is it an unholy mess? Indeed, it is.

I will give a hint of what a proper government policy toward utilities should be: hands-off or laissez faire. In particular, utilities should get no legal monopoly protection, which they still have. Anyone should be free to start up a business selling electricity to customers. If this were permitted, we would likely see a lot of technological and business structural innovation, such that utilities would look a lot different than they do today. For example, real estate developers may build “mini-utilities” with small power plants to provide power to residential sub-divisions. Large commercial buildings may find it is economical to self-generate using gas-fired generators in their basement. It is even conceivable that individual homes may be powered by micro-generators the size of air conditioners. Large utilities are likely to still exist, but they will compete with each other, with the customer benefiting from lower rates. Or, large utilities may function largely as back-up sources of power to whom electricity customers would pay a fee for that service.

All of this innovation (and other types that remain to be conceived by a future entrepreneur) could happen if utilities were truly deregulated and politicians stayed away from the business of providing electricity. None of it will happen under the current structure, which mixes a few, tentative measures of market freedom with a whole lot of contradictory government control. Utilities today are arguably the most regulated private industry in the country, with a welter of overlapping local, state and federal authorities all having a hand in how they are run. With that many cooks in the kitchen, is it any wonder that the pies they make taste so awful and cost so much?

Bottom line for you personally: without knowing the details of the offers from other electricity suppliers, I suspect you are better off, in terms of hassle and probably even money, by staying with PSEG!

Bottom line for the country: we all pay too much for power and will continue to do so until true deregulation occurs. But, before that can happen, people need to draw true conclusions about the ersatz-deregulation that has been attempted already.

Sincerely yours,
GB

P.S. – There are other aspects to this complicated problem. One of them (to be discussed) is the price and profit controls on electric transmission lines that prevent enough new transmission lines from being built. The result is that the electric grid is ossified and subject to blackouts, and power is too expensive.

Private vs. Public

7 World Trade Center, destroyed on 9/11/01. Today it is a shining tower that is 80% leased. Top rents are $80 per square foot, well above the $50 per square foot its critics said it would never get.

Nos. 1-6 World Trade Center, destroyed on 9/11/01. Today it is… a pit.

What is the difference? The former is owned and operated by a private developer, Silverstein Properties. The latter is owned by the Port Authority of New York and New Jersey. Although leased to Silverstein Properties, all major decisions regarding its rebuilding have to be approved by its government owners.

What is the lesson? Draw your own conclusions.

Source: New York Post, "Moody's Takes More", 2/27/07

The American Samoa Exemption

The new legislation to increase the minimum wage reportedly will maintain the "American Samoa Exemption", a policy that has permitted employers on the U.S. island chain to pay workers far below the U.S. mainland minimum wage.

The Exemption reveals the immorality and impracticality of the minimum wage.

The exemption of American Samoa from the minimum wage is an acknowledgement that the minimum wage forces some people to endure a wage of zero, i.e., far below the "minimum". No one can legislate productivity, and if productivity means some worker's labor is worth less than a minimum wage, that worker will not be hired. His job will essentially be outlawed.

Productivity in that part of the world is much lower than in the mainland United States, and therefore prevailing wages are much lower. If the U.S. minimum were enforced there, it would cause not just a little unemployment, like it does in the mainland U.S., but widespread unemployment. In fact, it would be completely unenforceable.

The existence of the American Samoa exemption is an unpleasant reminder to everyone who votes for the minimum wage -- Democrats, Republicans and President Bush -- that it destroys jobs, and that the higher it is set, the more jobs it destroys. Furthermore, the people who suffer the most from the minimum wage are those who are young and beginning their working years, and those with the least education and skills. These are precisely the people the Democrats pontificate about wanting to help.

The wider issue is that the Democrats don't want to help the poor; they want the poor. In fact, they want as many people as possible to be poor, because it creates a dependent class of modern-day serfs who believe that the Democrats are their salvation. By keeping a large class of people poor, unemployed and dependent on government hand-outs, Democrats corral their votes. It is an ugly form of "vote-buying" that trades on human misery. The minimum wage is part of that.

As for the hapless Republicans who vote for the minimum wage, they "just don't get it". They think that by placating their opposition, the Democrats, they will somehow keep their grip on political power. In fact, their policy does nothing but strengthen the opposition by endorsing their moral premises, and enacting their laws.

UPDATE 1/16/07: A cruel experiment in economics may be about to happen. The Democrats have agreed to extend the mainland minimum wage to American Samoa and the Marianas Islands. Tuna workers are now paid an average of $3.60 there. Workers in nearby tuna-processing countries such as Thailand and the Philippines are paid $0.67 per hour.

With the new minimum wage slated to rise to $7.25 per hour in two years, it is highly likely that many of the U.S. island workers will lose their jobs, and the industries they work in will contract. A rump group of workers will get paid the higher wage. Watch some economist cite those workers in a future study when he claims the minimum wage is working in American Samoa.