Radio Free Market

Dear Sirs:
Mr. Mark Zandi says the following in his latest OpEd titled “Ways to help a generation in economic distress”:

“Most obviously, we need to focus on raising educational attainment.”  He goes on to say that tax money should be redirected in ways that will not boost tuition, although it is far from clear how his spending choices would not cause the same problems that he wishes to alleviate.  Aside from the observation that “businesses could have more input into college curricula”, Mr. Zandi offers nothing that would make hiring young people a more attractive option for businesses.  What about reducing the regulatory costs of employment, from minimum wages to mandatory insurance to mandatory family leave, not to mention the minefield of discrimination and environmental laws?

Here’s a little known truism–there is always more work to be done than people to do it.  Labor is the only truly limiting factor in the ability of an economy to progress, because only increased specialization of labor can bring about a lower cost of living.  (Think how a family living in a wilderness cannot become prosperous, because its members must be jacks of all trades and masters of none.)  Fewer workers mean less specialization, lower productivity, and a lower standard of living.

Our very large country has so much unemployment, because government interferes in the natural cooperation between labor and capital.  Let them come together to produce increased standards of living for all.  Patrick Barron

Re: This is the Common Market Europe Needs, by Iain Martin

Dan Hannan will present the draft statement of a proposed “pan-European Free Trade area open to all states on the European continent.”

Wonderful!  But why limit the free trade area to European states? Why not expand it to the entire world?  Just declare unilateral free trade and go home.  You cannot force anyone to trade with you, and those who refuse to trade harm only themselves.  This is so simple only politicians cannot see it.  Patrick Barron

From today’s Open Europe news summary:

European banks face a €280bn capital shortfall in 2014, PricewaterhouseCoopers (PwC) has warned. In its report labelled “De-leverage take 2”, it notes that this is because banks’ capital reserves will face three pressures next year: the Basel III capital ratio requirements, leverage ratio requirements, and the European Central Bank’s (ECB’s) Comprehensive Assessment. CNBC City AM

The ECB believes that the banks’ capital problems can be solved by injections of more capital.  What this simplistic solution ignores is a serious assessment of why the banks’ capital became inadequate in the first place.  If you have a hole in your bucket, constantly refilling the bucket with water solves nothing.  Patrick Barron

From today’s Open Europe news summary:

In its latest financial stability report, released yesterday, the ECB warned of potential volatility and stress on global financial markets from the US Federal Reserve’s decision to taper. The ECB also warned that banks’ provisioning against potential losses has “barely kept pace with the deterioration in asset quality” and further “additional reserves” will likely be needed. FT City AM

With this report the European Central Bank as much as admits that its own policies have failed.  Bailouts, monetary stimulus, Long Term Repurchasing Operations (LTRO), etc. have done nothing to prevent the further deterioration of bank assets.  The increased capital injections amount to nothing more than money down the proverbial rat hole.  This will continue to be the case, even if Basel III is implemented, because the ECB and the Basel regulators do not understand the source of the problem; i.e.,the socialization of money and banking in the EU.  All socialist enterprises, which perfectly describes the European Monetary Union, end in capital destruction, poverty, and social chaos.  Further political and economic integration will merely ensure that this process continues…but at a faster pace.  Angela Merkel foolishly believes that her so-called “contracts” with deficit nations will work.  But the deficit nations are sovereign entities answerable only to their own citizens.  If they try to implement Merkel’s policies, the Germans will be blamed for the necessary hardships that must accompany the restructuring of their economies.  At that point the deficit nations will dishonor their so-called “contracts”.  New governments will disown the actions of previous governments, and the EU will have done nothing to cure its inherently unsustainable, unworkable, and unjust continent-wide social experiment.  Patrick Barron

Merkel’s CDU/CSU and SPD seal Grand Coalition agreement Following two months of negotiations, the CDU/CSU and SPD signed off on a coalition agreement early this morning. The Europe chapter of the agreement has not changed from the draft agreement of which Open Europe was the first to provide an English translation on its blog and in yesterday’s press summary.
European Parliament President Martin Schulz, part of the SPD’s negotiating team, confirmed that the parties had agreed that the ESM bailout fund could be used to directly recapitalise struggling eurozone banks if other measures such as bail-ins and state guarantees are not sufficient. The deal also includes introducing a national statutory minimum wage of €8.50 per hour from 2015 – a major victory for the SPD. The coalition has also committed to implementing the controversial EU Data Retention Directive, which had been blocked by the FDP.
Open Europe’s Nina Schick appeared on CNBC this morning discussing the coalition agreement. Open Europe’s blog translating the draft German coalition agreement has been cited by Gazeta Wyborcza, Forex Live and Central Banking. Open Europe blog Handelsblatt EUobserver El País El Mundo Le Monde FAZ FAZ 2 Süddeutsche Süddeutsche 2 Süddeutsche 3 Süddeutsche: Denkler FT WSJ Euractiv Telegraph Central Banking Gazeta Wyborcza Forex Live

The deal to seal the Grand Coalition between Germany’s Christian Democrats and Social Democrats is a bad deal for Germany, a bad deal for Europe, and a bad deal for the world.  Germany gets a minimum wage of over $11, ensuring higher unemployment among its young and less skilled citizens.  The German taxpayer gets to pay higher social welfare costs to support the increase in unemployed workers and to fund the European Stability Mechanism (ESM), which WILL be tapped by the banks in deficit countries.  Nothing could be more certain, for the political class in these countries will oppose bail-ins and will have no budgetary room for bailouts.  All Europe will suffer from more socialization of banking, which will postpone even further the necessary restructuring of the European economies.  Even the citizens of the countries receiving ESM funds will suffer, as they need real jobs not more welfare.  Only their own politicians can solve their problems by being forced to face the reality that no one will lend them more money.  And the world will suffer as German capital is wasted on more international welfare.  The only beneficiaries will be the predatory German political class, led by the Christian Democrats’ Angela Merckel and the Social Democrats’ Martin Schulz, who will bask in the false glow of being good European neighbors for sacrificing the wealth and future of the common German citizen.

Re: Today’s Open Europe news summary:

On Monday 2 December, Open Europe will host an event entitled, “Greece after the ‘double crisis’ – Can the feedback loop between sovereigns and banks be broken and can the economy return to sustainable economic growth?” Speakers will include Professor John Mourmouras, Chief Economic Adviser to the Prime Minister of Greece, and Hugo Dixon, Editor-at-large at Reuters. Spaces are limited but if you would like to attend please send an e-mail to sophie@openeurope.org.uk. Open Europe events

Dear Pieter, There really never can be an end to the “feedback loop” of capital destruction as long as government controls money and banking.  End bailouts.  End depositor guarantees.  Return money and banking to the private sector, where market forces are all that are needed.  Then weak banks will find their funding drying up without causing systemic problems that must be placed on the backs of taxpayers.  Market forces will cause funding costs to rise when the public believes that a bank is overextended.  It will be up to the individual banks to reassure their customers that its funds are safe.  If it hides bad news from the public, its officers and directors should be subject to both civil and criminal sanctions.

I imagine that this event will attract lots of ideas that really are nothing but band-aids or calls for more government regulations and/or coercive measures that just will not work, because they do not address the real problem:  moral hazard.

Patrick Barron

Re: Draghi says ECB needs “safety net” against deflation, by Ambrose Evans-Pritchard

Ambrose Evans-Pritchard is worth reading not because he understands economics but because he does a good job of parroting the misinformed opinions of Europe’s monetary authorities.  AEP’s latest column contains all the old, discredited worries about “deflation”; i.e., falling prices.  Supposedly, once the monetary authorities have inflated a giant credit bubble, market forces to deflate the bubble in order to restore equilibrium must be fought with every coercive monetary tool available.  Yes, countries that went on a borrowing spree, funded by the ECB’s interventions to drive down the interest rate, will find it difficult to pay back their debts in money of equal purchasing power. But their policy errors should not be justification for robbing all citizens using the euro via monetary debasement.  This reminds me of the old Brezhnev Doctrine, that any country could become communist and fall under the orbit of the Soviet Union, but no country could throw off the communist yoke.  Any attempt to do so would result in an invasion by Russia.  Gee, I wonder what happened to that doctrine?  Patrick Barron

Our monetary czars lecture us to be unconcerned about their unprecedented expansions in base money and the money supply, since there has been little sign of inflation in the economy.  For the purposes of this essay, we will assume that there has been no inflation, although John Williams at www.shadowstats.com and anyone who tries to make ends meet on the same money income will tell you a different story.  Our purpose is to explain the theory behind the price level and how theory can explain the so-called miracle/mystery of an increase in monetary aggregates with little or no inflation.

There is no miracle or mystery as to why prices have not gone significantly higher.  Our monetary authorities have not found the magic formula that allows the government to engage in noninflationary spending sprees, funded neither by an increase in taxes nor an increase in interest rates.  Our monetary masters remind me of the story of the man who jumps off the Empire State Building.  As he is passing a floor on the way down, an office worker leans out a window and asks him how he’s doing.  He replies: so far, so good!

What determines the price level

On page 505 of his magnum opus, Capitalism: A Treatise on Economics, George Reisman defines the price level as a formula: P = Dc/Sc.  P is the price level.  The numerator Dc represents demand for goods as manifested in a definite total expenditure of money.  The denominator Sc represents the supply of goods as manifested in a definite total quantity of goods produced and sold.  Notice the importance not of the total supply of money but of that portion of the supply actually spent.  A Scrooge McDuck swimming in his supply of money in his basement does not affect the price level until he actually spends some of his money.  Similarly, if the money supply increases but remains

unspent, it will have no effect on the price level.  In fact, if the demand to hold money exceeds the growth of the money supply, prices actually will fall.  Likewise, notice the importance of the supply of goods as that portion of production actually sold.  For example, inventory accumulation does not affect the price level.  The goods must be both offered on the market and sold at some market clearing price for them to affect the price level.

Therefore, two events, or a combination thereof, can cause prices to rise–an increase in sales expressed in money terms, independent of whether or not the supply of money has increased, or a decrease in supply sold on the market, even if increased production goes into inventory accumulation.  The opposite of these two events, of course, will cause prices to fall.

We easily see from this simple yet powerful explanation that a falling price level need not be of concern, if it is the result of an increase in the supply of goods offered on the market.  As John Stuart Mill explained over two hundred years ago, the purpose of production is consumption.  Goods are produced to satisfy human wants.  The Keynesian view that digging holes and filling them up again adds to the general welfare of an economy is nonsense.  Jean Baptist Say explained that increased production becomes the means by which increased sales are realized.  Again, man produces for the purpose of consumption, and his production becomes the means by which he consumes via market exchange expressed in money terms.  Digging and refilling holes does not represent anything that would be valued on the market.  Neither would printing money and giving it to welfare recipients to spend.

OK, but what would cause an increase in the demand to hold money that would suppress the price level?  And is this increase in money demand something that we can rely upon to hold down the price level forever?

Mises’ Three Phases of Inflation that Lead to Money Destruction

Ludwig von Mises explained that there are three phases to monetary destruction.  Murray N. Rothbard summarizes Mises’ explanation in his Mystery of Banking, Chapter V  (The Demand for Money), pages 68 through 72.

In phase one the monetary authorities inflate the currency, but the public expects that prices will not rise or may actually fall, so they withhold their spending, which is the same thing as saying that they increase their demand to hold money.  Prices may actually drop during this period of monetary inflation, which seems paradoxical but actually is explained by proper theory.  The demand to hold money rises faster than the supply printed by the monetary authorities.  The people believe that whatever crisis causes an increase in money will end and prices will fall to pre-crisis levels or even lower.  They are long accustomed to lower prices or even a gently falling price level.  Therefore, their firmly held belief in lower prices becomes self-fulfilling, at least for awhile, because their increase in demand to hold money brings about this very situation.

Phase one may last a long time, but eventually the demand to hold money abates and prices start to rise, gently at first but more robustly as time progresses.  In this second phase the people come to believe that prices are not going to fall and that they actually will continue to rise.  Therefore, they begin spending more to purchase goods before the inevitable increase in prices.  In this phase, even if the monetary authorities shrink the money supply, prices still can rise, because the people’s demand to hold money is falling too fast.  Again, the people’s belief that prices will continue to rise becomes self-fulfilling.  Price increases in phase two come faster and faster, as more and more people accelerate their spending to thwart the falling purchasing power of their money.

Phase two morphs into phase three, when people lose all confidence in the future purchasing power of their money and demand to hold money goes to zero.  In this final phase the monetary authorities are unsuccessful in stopping the loss of monetary confidence even if they take drastic action to curb monetary inflation.  People wish to exchange their money for any vendible commodity.  The panic feeds on itself.  This is what Mises calls the “crackup boom”, because there is a flurry of buying as everyone tries to exchange his money for whatever he can.

The Cantillon Effect and Boom/Bust Business Cycle

Not only do our monetary masters fail to understand the real danger of monetary destruction that they have unleashed with their zero interest rate and quantitative easing policies, they do not understand the true nature of money as part and parcel of the market.  For example, they fail to understand that money is not neutral.  Its expansion does not fall upon the economy equally, perhaps raising the price level but not disturbing its underlying structure.  In his eighteenth century book, An Essay on Economic Theory, Richard Cantillon first observed that money enters the economy in certain places, enriching the early receivers of new money at the expense of later receivers.  Money expansion transfers wealth within society, benefiting the politically connected and harming the true engines of progress, the savers.  This is the Cantillon Effect of the non-neutrality of money.  In his first great book, The Theory of Money and Credit, Ludwig von Mises went even further and corrected a major deficiency of the classical economists by integrating money into general economic theory that governs all economic processes.  For example, money is just as much subject to the law of diminishing marginal utility as all other goods and services.  Our monetary masters admit as much when they muse that more recent quantitative easing measures have had less effect on their favored monetary metrics than earlier ones.  What they do not understand is that the economy was not helped by increases in money.  Quite the contrary.

At the conclusion of The Theory of Money and Credit, Mises introduced another great contribution to economic theory: that bank credit expansion is the source of the boom/bust business cycle.  Money and GDP aggregates fail to identify the capital destruction set in motion by monetary interventions.  GDP may indeed increase but only due only to the Keynesian fascination with monetary aggregates.  The capital structure of production is set in disequilibrium, sending too much capital to the earlier, long term stages of production which eventually cannot be completed due to the fact that there never were enough resources in the economy for their profitable completion.  Mises termed such misallocation “malinvestment”.

No one can predict when people will begin to lose confidence in the purchasing power of the dollar.  Each new dollar that the Fed creates is like one more strand of straw laid on a mountain of straw.  The real question is “Is this next strand of straw going to be the one that breaks the camel’s back?”  Patrick Barron

Re: Steag starts coal-fired power plant

I thought that Germany was going to lead the world to a new era of electricity generated by wind mills and solar panels instead of dirty old coal.  What happened?

Of course, we know what happened.  Reality intervened.  Coal is cheaper, for one thing, and neither wind nor solar can ever produce enough power to meet the needs of a modern, industrial economy.  Furthermore, I doubt that the Germans would allow a new coal fired power plant to begin operations if it didn’t meet the already stringent environmental standards.  Patrick Barron