Notes – “Economics: The User’s Guide”

Economics: The User’s Guide

by Ha-Joon Chang, published 2014

Who is Ha-Joon Chang?

Born in South Korea in 1963, Ha-Joon Chang is currently a professor of economics at the UK’s University of Cambridge. He gained his PhD after successfully completing a thesis on “industrial policy” under British Marxist Robert Rowthorn, which advocated a “middle way” between central planning and free markets.

In a section on his personal website entitled “Economists Who Have Influenced Me“, Ha-Joon Chang states,

Many people find it difficult to place me in the intellectual universe of economics. This is not surprising, given that I have been influenced by many different economists, from Karl Marx on the left to Friedrich von Hayek on the right.

Of Austrian economist FA Hayek, Chang further states,

Hayek is very different from the Neoclassical school, even though many Neoclassical economists mention him in the same breath as Milton Friedman, on the basis that he was one of the most influential advocates of the free market. Unlike Neoclassical economists, however, Hayek does not take the socio-political order underlying the market relationship as given and emphasizes the ultimately political nature of our economic life. This is a big contrast to the Neoclassical view, which thinks that economics and politics can be, and should be, separated. Indeed, if you read Hayek’s book, Individualism and Economic Order, you will see that he is very critical –sometimes even abusive – of Neoclassical economics.

And with regard to Marx, Ha-Joon Chang claims,

With the collapse of communism, people have come to dismiss Marx as an irrelevance, but this is wrong. I don’t have much time for Marx’s utopian vision of socialism nor his labour theory of value, but his understanding of capitalism was superior in many ways to those of the self-appointed advocates of capitalism. For example, when free-market economists were mostly against limited liability companies, Marx saw it as an institution that will take capitalism on to another plane (to take it eventually to socialism, in his mistaken view). In my view, 150 years after he wrote it, his analysis of the evolution of labour regulation in Britain in Capital vol. 1 still remains one of the best on the subject. Marx also understood the centrality of the interaction between technologies (or what he called the forces of production) and institutions (or what he called the relations of production), which other economic schools have only recently started to grapple with.

On the dreaded Keynes, Chang admits,

Despite having been educated and taught in Cambridge, I have not been very ‘Keynesian’ in my approach to economics. This is not because I disagree with Keynesian thinking, but because I have mainly done my research on ‘micro’ issues, such as trade and industrial policy. However, I have come to be drawn more into ‘macro’ issues in the process of thinking about the recent financial crises, especially the 1997 Asian crisis and the 2008 world crisis. In thinking about these issues, John Maynard Keynes, Hyman Minsky, and Charles Kindleberger have been big influences.

According to biographical information in his book “Bad Samaritans”, Chang grew up in relative poverty as the son of a South Korean finance minister. He has written a number of books on the subject of economics, specifically with regard to economic history, global economic development and global trade patterns. Henceforth in my book blogs I will refer to him as “HJC” to save myself time.

Because of HJC’s intellectual background, pre-eminent social and intellectual position and large and established bibliography of thought, his ideas are worth studying and critiquing as a representative of a popular strand of “economic” thinking supported across countries and institutions.

Introduction

My purpose in this book blog is to apply my own understanding of economics (informed, to date, by a mainstream US college education in the subject as well as intense and ongoing self-study in a variety of alternative theories) to the methods and arguments provided by HJC in this introductory economic work of his and in so doing arrive at conclusions about the soundness of his thought. In particular, because HJC represents a strain of “new thinking within the mainstream” and my personal convictions lie with what is known as the “Austrian school”, I want to empathetically highlight the areas where the two schools are in agreement, as well as try to explain wherein the differences lie.

Let’s get started!

“Why Are People Not Very Interested In Economics?”

HJC wonders why economics is an unpopular subject:

95 per cent of economics is common sense – made to look difficult, with the use of jargons and mathematics.

This is actually a point the Austrians make– that good economics involves simple logical deductions within the grasp of any reasonably intelligent person and that the introduction of jargon and higher math is used to keep laypeople out and make the discipline unintelligible to the uninitiated. HJC says that economics doesn’t appear to be relevant to most people’s lives and that the issues that they believe economics deal with, such as international currency movements, government budgets and foreign aid debates, are not things people believe they can comment on or think about competently without economic training.

On the other hand, HJC laments the “megalomania” of many economists who would just as soon argue that economics is the most relevant intellectual discipline in that it seems to explain everything, and more. HJC critically cites the success of titles like “Freakonomics” and the humblebrag quality of many economic book titles that purport to show how economics is behind anything that can be imagined.

HJC sees a more limited role for economics in human thought, though still an important and useful one, which raises two specific issues: is economics a science and, to the extent it is, what is economics actually about?

Is economics a science?

HJC is pretty clear on the matter:

economics can never be a science in the sense that physics or chemistry is [because] human beings have their own free will, unlike chemical molecules or physical objects.

He also adds that,

people have been led to believe that, like physics or chemistry, economics is a ‘science’, in which there is only one correct answer to everything

Instead, HJC argues that

What is needed is to learn economics in such a way that one becomes aware of different types of economic arguments and develops the critical faculty to judge which argument makes most sense in a given economic circumstance and in light of which moral values and political goals (note that I am not saying ‘which argument is correct’).

Let’s consider these claims one by one.

The first claim, that economics can never be an (empirical) science like physics or chemistry is something that Austrians would again agree with. The Austrian view of the epistemology of economic science strictly prohibits the use of inductive logic derived from empirical observation and research. The reason for this is that in “hard” sciences like physics, the effect is known but the cause is unknown. Physics, as an example, is a study of effects in search of causes. Various factors deemed to be the significant causal agent dictating a particular result can be tried in a series of controlled experiments and then conclusions can be arrived at by the experimenter based on the manipulation of the variable factor and the observed changes in the experimental data.

Economics, by contrast, is a science whose causes are known (human action) but whose effects are often mysterious, because multiple causal factors can occur simultaneously in the lead up to an observed result. For example, the price of two pounds of chuck roast at the supermarket involves a negotiation between a group of suppliers of chuck roast and a group of buyers of chuck roast and these suppliers and buyers are unique and uniquely motivated at a given time and location. The method of the economic sciences, then, must be the “gedanken experiment” (thought experiment) in which a conceptual reality is held in mind and the logical implications of changes in one factor at a time are deductively explored. This is impossible when studying human action, that is, economic activity, because it is never that one thing only changes and it is never guaranteed that the same reaction will occur by the people observed because of the nature of free will.

It is in fact curious that HJC makes this specific point because later on he seems to contradict himself when he says,

we need to look at history because we have the moral duty to avoid ‘live experiments’ with people as much as possible.

The questionable moral claim of having a duty to avoid human experimentation in economic matters “as much as possible” aside, this quote suggests that HJC believes economic theory can be derived from historical (experimental, empirical) data and observations despite earlier claims to the contrary. This is one of many confusions and muddled writing/thinking that the book suffers from. It also begs the question, well-known to Austrians, of what interpretations of the significance of various historical data could tell us on their own without any kind of intermediating and pre-selected theory applied to them.

History, as a discipline, is a process of careful selection of particular facts for a particular purpose. The past provides us with a nearly infinite quantity and quality of data to choose from. It is the task of the historian to pick from this quantity only the data that is relevant to examining a particular historical question. To do this, the historian must already be versed in valid theories from the applicable branches of science to which his question belongs. For example, a historian studying the incidence, severity and consequences of disease would need to understand human biology and epidemiology. Or a historian studying the history of money in France circa 1750-1850 would need to already understand monetary theory (a branch of economics) as well as other theoretical knowledge pertaining to the historical episode (for example, a theory of the State in general and a theory of post-Medieval French statism in particular).

We can not validate an economic theory by looking at the historical record. All we’d manage to do is to assume that which we’re trying to prove and thereby fool ourselves.

This gets us to the second claim. To reiterate, while it is true that economics is not a science “like” physics or chemistry (pertaining to the necessary differences in methodology), it is NOT true that economics is not a science in that it offers one right answer to a given question. If economics can not offer objective truths about universal causal relationships, then it would not be a science, it would be a canon of opinion and not worth studying any more than studying people’s opinions on the superiority of vanilla versus chocolate ice cream is worth studying. It would not be productive to write books about economics, it would be pointless to try to explain economics to other people and ultimately, any arguments or claims about one economic phenomenon or another would be arbitrary. This would be the position of philosophical nihilism in the realm of economics.

It’s hard to believe that this is what HJC personally believes or is advocating because it would then make most of the rest of what he has to say about economics empty of content and meaning. It would also make puzzling comments such as “95% of economics is common sense” as nihilism in any realm is typically not the common sense position, not to mention that the concept of “making sense” implies rationalizeable facts about reality. Yet, this is what this man, who is an economics PhD and responsible for instructing others in the philosophy, claims is the “state of the art.”

And thus we arrive at the third claim about economics which is almost the most puzzling of all. We’re admittedly early on in the book so I hope HJC is going to spend some time explaining the meta-epistemology of how one can know which circumstances call for the application of which economic arguments but it is already seeming like a muddled concept because we’ve rejected the idea that we can look at history as a source of theory about economics, and we’ve rejected the idea that economics is devoid of any content and meaning whatsoever and thus “non-scientific.” This would only leave one alternative to mind, that of logical deduction from axiomatic assumptions to arrive at conclusions which must be true.

It’s worth noting at this time that the Austrian school provides a special comment to this concept that economic arguments must be chosen and applied based on a specific moral or value-based perspective. The Austrians argue that to be scientific (“objective”), economics must be wertfrei, or value-free. That is, the knowledge of economics is not dependent upon the economist’s class, creed, race, nationality, personal preferences or other personal identifications. It is dependent upon logic which universally belongs to all mature human beings and is necessarily embedded in the biological structure of the mind.

Economics is not a tool for furthering a particular interest group’s agenda. It describes causal relationships between specific phenomena, ie, “If X, then Y” and it comments on whether specific ends aimed at can be achieved with specific means employed– NOT whether the ends aimed at are “good”, “right”, “holy”, “moral”, “desirable”, “valuable,” etc. For example, economics can help us understand the consequences of certain actions undertaken by human beings, but it can not tell us if those consequences are good, bad, etc. It simply tells us, “If you do this action, it will lead to this consequence, all else equal.”

I think this is a very different position than the one taken by HJC in the text and I look forward to exploring this idea and its implications in contrast to HJC’s claims further on as it seems inevitable he’s going to have to come back and explain this more eventually.

So what is economics?

From HJC’s comments so far, it’s unclear if he believes economics is a science. But because the book doesn’t end here, we’ll operate from the assumption for now that he believes it is a science. The question then becomes, what is the proper scope of economics as a science?

Here HJC levels his criticism mostly at popular, mainstream and “neoliberal” economists following what is termed neoclassical economics. Citing a contemporary (and former critic) of Keynes, Lionel Robbins, HJC says,

Robbins defined economics as ‘the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses’

He claims that most economists

define their subject in terms of its theoretical approach, rather than its subject matter

based off of Robbins’ logic. In other words, economics is a study of “rational choice” and focuses on the calculations entertained by people choosing between specific means to achieve specific goals in a variety of circumstances (choosing a spouse, choosing what to eat, choosing where to work, choosing what to invest in).

In contrast, HJC offers his definition of economics:

My belief is that economics should be defined not in terms of its methodology, or theoretical approach, but in terms of its subject matter, as is the case with all other disciplines. The subject matter of economics should be the economy – which involves money, work, technology, international trade, taxes and other things that have to do with the ways in which we produce goods and services, distribute the incomes generated in the process and consume the things thus produced – rather than ‘Life, the Universe and Everything’ (or ‘almost everything’), as many economists think.

In other words,

what we want from economics is the best possible explanation of various economic phenomena

It’s hard to argue with the idea that economics should be defined by its subject matter like any other science. Of course, the preceding paragraphs in the book up to this point are a litany of potential subject matter according to HJC versus those he criticizes in the neoclassical mainstream, which seems to beg the question.

And HJC even makes a point about subject matter that Austrians would sympathize with, namely that

The economics profession, and the rest of us whose views of the economy are informed by it, need to pay far more attention to production than currently [because] production is the ultimate foundation of any economy

This is a criticism leveled by Austrians at Keynesians with regards to macroeconomics, namely that there is an undue focus on consumption patterns and an incorrect emphasis on consumption (“aggregate demand”) as the driving energy of an economy without study or consideration of the productive activity necessary to enable it.

As a matter of comparison, it’s worth considering the thoughts of Austrian economics patriarch Ludwig von Mises on the questions of whether economics is a science and, if so, how to define it. The following passages are from Mises’ 1949 “Human Action“:

Economics is the youngest of all sciences. In the last two hundred years, it is true, many new sciences have emerged from the disciplines familiar to the ancient Greeks. However, what happened here was merely that parts of knowledge which had already found their place in the complex of the old system of learning now became autonomous. The field of study was more nicely subdivided and treated with new methods; hitherto unnoticed provinces were discovered in it, and people began to see things from aspects different from those of their precursors. The field itself was not expanded. But economics opened to human science a domain previously inaccessible and never thought of. The discovery of a regularity in the sequence and interdependence of market phenomena went beyond the limits of the traditional system of learning. It conveyed knowledge which could be regarded neither as logic, mathematics, psychology, physics, nor biology.

Thoughts so far– economics is a science, it is the youngest of sciences, it revealed new knowledge about observed market phenomena and this knowledge was separate and distinct from existing sciences (that is, economics is not a branch of a then-existing science, such as psychology). Mises continues,

Philosophers had long since been eager to ascertain the ends which God or Nature was trying to realize in the course of human history. They searched for the law of mankind’s destiny and evolution. But even those thinkers whose inquiry was free from any theological tendency failed utterly in these endeavors because they were committed to a faulty method. They dealt with humanity as a whole or with other holistic concepts like nation, race, or church. They set up quite arbitrarily the ends to which the behavior of such wholes is bound to lead. But they could not satisfactorily answer the question regarding what factors compelled the various acting individuals to behave in such a way that the goal aimed at by the whole’s inexorable evolution was attained.

Whether or not we define economics by its methodology, it is clear that in Mises’ mind, the discovery of a valid method for economics was one of the critical pillars of its emergence as a science. Prior observers witnessed mass phenomena, but had no method for explaining how component behavior led to the mass phenomena. Again, Mises continues,

Other philosophers were more realistic. They did not try to guess the designs of Nature or God. They looked at human things from the viewpoint of government. They were intent upon establishing rules of political action, a technique, as it were, of government and statesmanship. Speculative minds drew ambitious plans for a thorough reform and reconstruction of society. The more modest were satisfied with a collection and systematization of the data of historical experience. But all were fully convinced that there was in the course of social events no such regularity and invariance of phenomena as had already been found in the operation of human reasoning and in the sequence of natural phenomena. They did not search for the laws of social cooperation because they thought that man could organize society as he pleased.

If there are no “regularities in the sequence and interdependence of market phenomena”, that is, no universal scientific laws of cause and effect, then any social schemer’s vision for reforming society should be possible. The only thing that could get in the way of such a scheme would be purposeful obstruction or moral flaws in the individuals in society with whom the scheme is concerned. Instead, says Mises,

The discovery of the inescapable interdependence of market phenomena overthrew this opinion. Bewildered, people had to face a new view of society. They learned with stupefaction that there is another aspect from which human action might be viewed than that of good and bad, of fair and unfair, of just and unjust. In the course of social events there prevails a regularity of phenomena to which man must adjust his actions if he wishes to succeed. It is futile to approach social facts with the attitude of a censor who approves or disapproves from the point of view of quite arbitrary standards and subjective judgments of value. One must study the laws of human action and social cooperation as the physicist studies the laws of nature. Human action and social cooperation seen as the object of a science of given relations, no longer as a normative discipline of things that ought to be–this was a revolution of tremendous consequences for knowledge and philosophy as well as for social action.

Now we’re getting into the juicy part of the epistemological differences of the Austrians and an economist like HJC. First, Mises is describing the history of philosophy here. He is talking about the historical emergence of economics as a scientific discipline a couple hundred years ago (writing in 1949, he would be relating events that took place from approximately 1749 onward, and he is purposefully glossing over the proto-economic thought of groups like the Spanish scholastics as well as various contributions made by those in the Eastern philosophical traditions) and the impact on social thought and social events that followed. Consider, for example, HJC’s reference to Adam Smith’s “The Wealth of Nations”, which put forth one of the first serious philosophical challenges to the then predominant “mercantilist” thought of contemporary political economy, a “technique of government and statesmanship” as Mises termed it.

Second, consider how radical this emergence was then, and how radical it is in the face of what HJC is saying now. As we will see very shortly, HJC provides a revisionist “history of capitalism” and spends most of his effort trying to make the claim that much or most of what is historically appreciated as the capitalist industrial development of the Western world did not occur via free markets and free trade, but rather through a series of calculated tariff and other regulatory structures, “techniques of government and statesmanship.” The Misesian/Austrian argument, then, is not that Western capitalism was developed through state intervention but that the remarkable economic development of the West took place in spite of these “techniques of government and statesmanship” which were implemented in ignorance or disregard for the existence of “regularities in the sequence and interdependence of market phenomena”.

Finally, then, note that Mises is directly supporting the claim that economics is a science with discoverable, constant laws of cause and effect (like physics) and therefore “one truth” in answer to a given question, but that the methodology of economics is not based on empirical experimentation (unlike physics) and that it was the radical departure from “ought” and the new focus on “is” that allowed economics to emerge as an objective and true science. This is somewhere close to the polar opposite claim HJC is making when he argues that economics involves learning to figure out which of many competing intellectual school’s claims should be applied as an explanation to a given set of observed economic phenomena based on their pre-existing moral or value systems (“oughts”).

And Mises does HJC one better:

For a long time men failed to realize that the transition from the classical theory of value to the subjective theory of value was much more than the substitution of a more satisfactory theory of market exchange for a less satisfactory one. The general theory of choice and preference goes far beyond the horizon which encompassed the scope of economic problems as circumscribed by the economists from Cantillon, Hume, and Adam Smith down to John Stuart Mill. It is much more than merely a theory of the “economic side” of human endeavors and of man’s striving for commodities and an improvement in his material well-being. It is the science of every kind of human action. Choosing determines all human decisions. In making his choice man chooses not only between various material things and services. All human values are offered for option. All ends and all means, both material and ideal issues, the sublime and the base, the noble and the ignoble, are ranged in a single row and subjected to a decision which picks out one thing and sets aside another. Nothing that men aim at or want to avoid remains outside of this arrangement into a unique scale of gradation and preference. The modern theory of value widens the scientific horizon and enlarges the field of economic studies. Out of the political economy of the classical school emerges the general theory of human action,praxeology. The economic or catallactic problems are embedded in a more general science, and can no longer be severed from this connection. No treatment of economic problems proper can avoid starting from acts of choice; economics becomes a part, although the hitherto best elaborated part, of a more universal science, praxeology.

Now this is powerful stuff and, based on HJC’s lampooning earlier in the chapter of “Economics: A User’s Guide”, the author would likely find this perspective quite challenging at first. As HJC laments, economists seem to think that economics explains “life, the universe and everything.” To this point, Mises replies, “No, economics does not explain this– but praxeology comes close.”

Now is probably a good time to refer to my notes from “Lecture 1” of the 2014 Rothbard Graduate Seminar. For Austrians, praxeology is the broader science studying all human choice (“rational choice” from earlier?), of which economics is a dependent part and probably best developed. Political economy would also be a branch of praxeology, or as Austrians refer to it, the theory of violent intervention in the market (although it’s questionable whether war is a subset of praxeology, or of violent intervention in the market). And within economics, the area best developed and most relevant for the purposes of most people on planet earth, yesterday, today and tomorrow (sorry, Zeitgeisters/Singularityists/Post-Scarcity Societyists) is the branch of economics known as catallactics, or the theory of exchange and especially money exchange.

In future book blogs, these particular issues of methodology and epistemology will undoubtedly be returned to as they form the core disagreement between most economic schools of thought, including HJC, neoclassicalism and the Austrian school. In the next installment, we’ll move on to HJC’s revisionist treatment of the “history of capitalism.”

Crude Economic Analysis: Government Student Aid Edition

This is a funny headline from the WSJ.com:

College Tuition Hikes Slow, but Aid Falls
The rate of tuition increases at colleges has slowed for the second year in a row, but government aid has fallen, continuing a cycle of rising costs and debt for students.

There seems to be a correlation in the data here. As government aid lessens, rate of tuition increase lessens.

But it would be crude to jump from here to the conclusion that there is a necessary causation in the data. Right?

“But” implies there is no causation and that the status of aid availability is a separate problem.

“And” or “As” would imply causation. Interesting how the WSJ editors chose their words on this one.

Can You Tell The Difference Between Economics And Politics?

These days, it is trendy to practice political punditry under the guise of a thoughtful economist handing out enlightened “economic policy” suggestions.

A recent case in point is the interview with Harvard’s Ed Glaeser with EconTalk’s Russ Roberts, wherein Glaeser shared the following ideas about reforming city governance with respect to “historic preservation districts”:

In the case of the city historic preservation districts I would probably replace the ever-increasing swatch of territories–15% of the land area in Manhattan south, in the bottom half of Manhattan excluding Central Park as an historic preservation district right now–and areas go into historic preservation districts but they rarely come out of them. So, it seems like it’s going to be an ever-increasing swath of the city. I don’t much like the idea of cities being museum pieces. There are a few which are appropriate, like Bruges, but I think it’s good that cities change and that they develop new space, combination of new activities and people. So, I would in terms of preservation–my father was an architectural historian so I do really believe in the value of preserving some old, beautiful buildings–but I would have a fixed number of the total number of buildings that they are able to set aside as being preserved rather than allow them to just keep on getting new areas for preservation districts.

Here is what an economist would say:

Land and property use should be conditioned on “most highly valued use”, as evidenced by voluntary exchanges agreed to by participants in the property market. For some, purchasing historic properties for the purposes of preserving them, perhaps for commercial exploitation as a tourist attraction or simply to be kept out of the hands of the public or those who might privately redevelop them, might be the “most highly valued use” for which a person would exchange their wealth to control these properties. For others, tearing the historic buildings down or otherwise modifying them from their original, historic state, may be the “most highly valued use”, perhaps for the purpose of providing new housing or areas of commerce and industry.

There is no moral reason why future generations should be beholden to the land-use decisions of ancient generations, and even if there was, it is not an economist’s place to discuss such topics.

Notice– Glaeser said none of this, and in fact violated the statement at the end while complementing it all with a bit of arbitrary personal psychological projection, the idea that because his father was an architectural historian he has some kind of special need or special knowledge into the value of preserving historic properties that necessitate the violence of the State to protect such value impositions.

In fact, the closest Glaeser came to say anything “economic” about the subject was his attempt to calculate a “fixed number of total buildings” which would be available for historic preservation. But even here, his theorizing falls flat on its face, for Glaeser does not explain how his arbitrary calculus would be superior to the outcomes of voluntary exchanges between market participants.

How many is a “fixed number”? What constitutes a “building” for purposes of this policy? Which “buildings” shall be a part of this “fixed number” and which shall remain outside it, and how are such decisions evaluated in an objective way?

Such policies are an invitation for gross, arbitrary and wild government intervention and special interest group politicking that Glaeser claims earlier in the interview he is strongly against. Yet, he opens the intellectual door to them in moments like these when he places his economist costume over his political self and attempts to perpetrate a theoretical deception.

More Banking Confusion: Liquidity Versus Solvency

Here is a choice quote from the recent EconTalk podcast with Anat Admati of Stanford University:

Well, they have fancy ways to talk about banks, and we try to unpack those. They talk about maturity transformation, liquidity transformation. What that means is really that the depositor, the people who lend to the banks, often time want their money quickly, especially demand deposits. But when they invest it, they kind of invest it longer term and in less liquid things. So there is a sort of imbalance between the money that they use to fund and their investment in the sense of the length of time until something has to happen and also the speed with which they have to pay versus get paid. And so that mismatch creates fragility by itself, which also means for example if all of us run to the bank at the same time then the bank may not be able to cover all of that. Even if it technically would be solvent, it has everything, that’s kind of an inefficient run that you could have, in principle. So basically the banks tend to run a little bit more than other people into liquidity problems. You could say that, just, I have the money but I didn’t go to the ATM kind of thing–I can pay you back but we’re going to have to find a liquidity solution, sort of a rolling back my debt. Their funding is kind of fragile almost by definition because of the way it comes and the way people can come back for their money on short notice or any time they want. So that’s part of the funding. And the investments are not as liquid or longer term than that. (emphasis added)

This is an utter confusion. This is not a “liquidity problem”, it’s a solvency problem.

Money-in-an-ATM is not the same economic good as money-in-my-hand. That is, money-five-minutes-from-now is not the same as money-right-now.

They are separate economic goods due to the time value of money. What Admati has done is create an arbitrary distinction between a future money good and a present money good, by projecting her preference/judgment onto an exchange involving two other parties of which she is not one.

If party A demanding “liquidity” from the bank B truly saw no difference between money-right-now and money-a-few-days-from-now, for example, then a bank run would never happen and these items would trade at the same price, which they do not.

This is a fundamental error of economic reasoning. I expect a professor of finance and economics to understand something like this and as a result I find myself disappointed to see that she does not.

Economists and politicians only let banks get away with this. If anyone else were to be so arbitrary and haughty toward contracts they’d be thrown in prison, but for banks insolvency never comes so long as you can contort logic to the point that you convince yourself that all that’s missing is a bit of liquidity.

This is more free lunch thinking.

Observations On Expectations

A story of expectations met and unmet, in two parts.

Part the first. I spoke in front of a group of students at a local continuation high school this morning. The original topic was my career (what do I do? what do I like/dislike about it? etc.) and my career path (what’s my background? education? how’d I get to where I am?) but I never quite got there. I mostly ended up talking about economics as I was speaking to an economics class, nominally, and the program coordinator kept prompting me on that subject.

I introduced two economic concepts to the assembled: TNSTAAFL/opportunity cost, and subjective value theory. I tried to apply them to “real life” to make them tangible and interesting to the audience. I talked about how everyone got suckered into the Housing Bubble, which cost a lot of people their homes, their personal finances, their jobs and sometimes more. I suggested that a person who understood that TNSTAAFL wouldn’t have gotten suckered in because he would’ve recognized the bubble for what it was and played it safe as he could. Subjective value theory I used to explain why we have an economy and why people work jobs, to serve each other’s subjective needs. I encouraged the class to think about their own values and to pursue them, and recognize that when people tell them what to do they’re simply telling them they should follow subjective values other than their own. I tried to highlight the role opportunity cost plays in pursuing subjective values, for example, people often get into traps such as pursuing money to provide for their families in such a way that they don’t get to spend time with their families. This opportunity cost is forgotten or ignored.

I also covered time value of money and the function of credit during a brief tangent, prompted by the program coordinator emphasizing the importance of personal finance principles.

The instructor goaded the students into applauding me before I had even spoke, as some kind of polite welcome for someone who had taken the time to stand before them and pontificate on a subject they cared little about. I said, “We’ll see if you still feel like applauding me at the end” and then began my talk. At the end of it, as the students rose to leave at the sound of the Pavlovian bell, one of the young men closest to me in the front of the room turned to his classmate and said in a quite intentionally audible way, “Thank GOD that is over!”

The morning’s events completely met my expectations and as a result, I was satisfied with myself when I myself left. I had entered a prison, whose inmates were being held against their will, by force of law, who had been assembled before me because they had no other choice save punishment and who had little to no interest in the subjects I had been invited to speak about before them. You certainly can’t blame a person in such circumstances for being disengaged, melodramatic and at times downright hostile.

If you put me in a cage I’d be uncomfortable and not in a friendly mood, either.

I didn’t expect to touch anyone, change a life or spark a fire or interest in anyone for the subjects I spoke about (economics, careers, my career, me) and if I happened to do that despite my intentions, that’s fine. I expected to go in there, treat the poor beasts with respect and maybe a bit of sympathy, having once been caged in a similar manner myself, and deliver my thoughts as articulately and coherently as I could. I expected to get practice speaking before an audience and trying, not necessarily succeeding, at making a foreign subject engaging or relatable for them.

In this, I met my expectations and so I believe I succeeded and thus I felt satisfied.

Part the second. For some time now I have watched in despair as a previously favorite blog of mine has gone into seemingly terminal decline. What was once a source of original thinking, unique coverage and respectable ideological consistency has in time become a haven for hacks and simpletons, its content hollowed-out and refocused on a few topics I just don’t have much interest in. The purveyor of the site has taken numerous opportunities, on his blog and his new webcast radio show, to demonstrate qualities of his personality I’ve found surprising, disappointing and at times reprehensible.

My distress with this reached a fever pitch early this week when a long-awaited debate on the subject of “intellectual property” was joined by the purveyor and another popular blogger on the subject. While the purveyor’s behavior leading up to the discussion gave me no reason to believe it’d be an intelligent, objective attempt at sussing out the truth by the two parties, but rather much evidence that it would be a battle of wills and ego characterized by willful blindness of reason and savage emotional assaults on each respective victim, the final product was so shockingly extreme in terms of all the undesirable qualities I suspected it would contain that I almost couldn’t believe these two adults had allowed themselves to be recorded, their outrage to be shared in front of a public audience of strangers.

I found myself so disappointed with the whole thing. It was anti-intellectual and truly uncivilized, the kind of stuff blood feuds at made of (gusto about sacred honor and the like that can never be satiated by way of reasonable argument). I knew both men were capable of a bit of underhandedness, but at least in the past the underhandedness seemed to have some kind of productive point. This time, after I finished sitting through two and a half hours of two middle-aged men calling each other names and screaming at one another, waiting for a point, I realized too late that there was none beyond sharing pure hate and distrust.

Who was to blame for my dissatisfaction in this instance? Initially, I found myself disgusted with these two people for subjecting me to this idiocy. “How dare they!” Then I thought about it some more. They are who they are. Their current skills and capabilities with regards to interpersonal communication and intellectual reasoning are aspects of their identity that exist as they do, whether I find them appealing or satisfying or not. I expected them to work hard to please me in their debating efforts (despite, I should add, much evidence that they were capable of no such thing) and when they didn’t live up to my expectations, I was disappointed.

Not by them, but by myself. For expecting people to live to serve my intellectual and emotional needs.

In the first part, I participated in something that could easily be seen as a disastrous waste of everybody’s time. Yet, I walked away from it in a positive state of mind. In the second part, I witnessed a true social tragedy and felt depressed and upset. Both circumstances were undesirable, but my reaction was different each time because my expectations were different.

Expectations can glorify our existence or cast the light of our lives down a dark abyss. I hope to remind myself of this fact more often.

The Best Interview On Gold, The Gold Market And Investment Implications I’ve Ever Read

In “What is the key for the price formation of gold?” at GoldSwitzerland.com, SF-based software developer Robert Blumen covers a lot of fascinating and, to my eyes, original ground in an interview with the site’s host.

This has got to be the best interview on the subject of gold in general, the functioning of the gold market and the implications for investors that I’ve ever come across. Blumen not only covers these specific subjects related to gold, but also discusses the Chinese economy, the US economy and the state of monetary and fiscal affairs and even the attitudes of value investors, demonstrating thoughtful familiarity with all he touches. Blumen is well-versed in Austrian economic philosophy and applies this theory to the various practical considerations resulting in surprising new perspectives on common themes.

It’s a long interview and it will only fully reward those determined to dive all the way in. Here’s an excerpt:

There are two different kinds of commodities and we need to understand the price formation process differently for each one. The first one I’m going to call, a consumption commodity and the other type I’m going to call an asset.

A consumption commodity is something that in order to derive the economic value from it, it must be destroyed. This is a case not only for industrial commodities, but also for consumer products. Wheat and cattle, you eat; coal, you burn; and so on. Metals are not destroyed but they’re buried or chemically bonded with other elements making it more difficult to bring them back to the market. Once you turn copper into a pipe and you incorporate it hull of a ship, it’s very costly to bring it back to the market.

People produce these things in order to consume them. For consumption goods, stockpiles are not large. There are, I know, some stockpiles copper and oil, but measured in terms of consumption rates, they consist of days, weeks or a few months.

Now for one moment I ask you to forget about the stockpiles. Then, the only supply that could come to the market would be recent production. And that would be sold to buyers who want to destroy it. Without stockpiles, supply is exactly production and demand is exactly consumption. Under those conditions, the market price regulates the flow of production into consumption.

Now, let’s add the stockpiles back to the picture. With stockpiles, it is possible for consumption to exceed production, for a short time, by drawing down stock piles. Due to the small size of the stocks, this situation is necessarily temporary because stocks will be depleted, or, before that happens, people will see that the stocks are being drawn down and would start to bid the price back up to bring consumption back in line with production.

Now let’s look at assets. An asset is a good that people buy it in order to hold on to it. The value from an asset comes from holding it, not from destroying it. The simplest asset market is one in which there is a fixed quantity that never changes. But it can still be an asset even when there is some production and some consumption. They key to differentiating between consumption and asset is to look at the stock to production ratio. If stocks are quite large in relation to production, then that shows that most of the supply is held. If stocks are small, then supply is consumed.

Let me give you some examples: corporate shares, land, real property. Gold is primarily an asset. It is true that a small amount of gold is produced and a very small amount of gold is destroyed in industrial uses. But the stock to annual production ratio is in the 50 to 100:1 range. Nearly all the gold in the world that has ever been produced since the beginning of time is held in some form.

Even in the case of jewelry, which people purchase for ornamental reasons, gold is still held. It could come back to the market. Every year people sell jewelry off and it gets melted and turned into a different piece of jewelry or coins or bars, depending on where the demand is. James Turk has also pointed out that a lot of what is called jewelry is an investment because in some parts of the world there’s a cultural preference for people to hold savings in coins or bars but in other areas by custom people prefer to hold their portable wealth as bracelets or necklaces. Investment grade jewelry differs from ornamental jewelry in that it has a very small artistic value-added on top of the bullion value of the item.

So, now that I’ve laid out this background, the price of a good in a consumption market goes where it needs to go in order to bring consumption in line with production. In an asset market, consumption and production do not constrain the price. The bidding process is about who has the greatest economic motivation to hold each unit of the good. The pricing process is primarily an auction over the existing stocks of the asset. Whoever values the asset the most will end up owning it, and those who value it less will own something else instead. And that, in in my view, is the way to understand gold price formation.

Many of the people who follow and write about this market look at it as if it were a consumption market and they look at mine supply and industrial fabrication as the drivers of the price as if it were tin, or coal, or wheat. People who look at gold as if it were a consumption market are looking at it the wrong way. But now you can see where the error comes from. In many financial firms gold is in the commodities department, so a commodities analyst gets assigned to write the gold report. If the same guy wrote the report about tin and copper, he might think that gold is just the same as tin and copper. And he starts by looking at mine supply and industrial off-take.

I wonder if more equity analysts or bond analysts were active in the gold area, if they would be more likely to look at it the same way they look at those assets.

Kleptocracy Via Inflation Is The Global Model, Not Just Chinese

Australian hedge fund manager John Hempton is out with a new piece on his blog about “The Macroeconomics of Chinese kleptocracy“, the main takeaway of which is:

But ultimately the Chinese establishment like inflation – it is what enables their thievery to be financed.

The more serious threat is deflation – or even inflation at rates of 1-3 percent. If inflation is too low then the SOEs – the center of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 percent. A positive real funding rate – well that is a completely different story.

[…]

The Chinese establishment has a vested interest in getting the inflation rate up in China. Because if they don’t all hell will break loose.

Unless the Chinese can get the inflation rate up expect a revolution.

I know John (who appears to be a well-intentioned but generally naive political conservative) would likely strongly disagree with the following characterization but…

This is the kleptocratic model prevalent in all major developed and developing world economies– inflation is the keystone piece of these systems and it is why CB presidents from Bernanke to Draghi to Shirakawa are all intent on creating and maintaining it.

If the inflationary engine fails to turn over, the loot-truck stops making its rounds. If the loot-truck stops making its rounds, the elite and their scumbag offspring don’t get paid and all the world’s peasants (you don’t have to work a farm to be an economic peasant) suddenly wake up to just how desperately poor they are after being continually ripped off for decade upon decade.

But, I’m a cynic, so of course I’d see the world that way. More reasonable men, like Mr. Hempton, are more prevalent in the world than I, so everyone is spared my dark view of things and can instead bask in the glory of knowing that, while our systems may not be perfect, at least they’re not as bad and out in the open as China’s.