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Mises’s Contribution to Understanding Business Cycles

[By Murray N. Rothbard. From Mises.org.]

September 29, 2014 is the 133rd anniversary of Ludwig von Mises’s birth. From The Essential von Mises:

Included in The Theory of Money and Credit were at least the rudiments of another magnificent accomplishment of Ludwig von Mises: the long-sought explanation for that mysterious and troubling economic phenomenon — the business cycle. Ever since the development of industry and the advanced market economy in the late eighteenth century, observers had noted that the market economy is subject to a seemingly endless series of alternating booms and busts, expansions, sometimes escalating into runaway inflation or severe panics and depressions. Economists had attempted many explanations, but even the best of them suffered from one fundamental flaw: none of them attempted to integrate the explanation of the business cycle with the general analysis of the economic system, with the “micro” theory of prices and production. In fact, it was difficult to do so, because general economic analysis shows the market economy to be tending toward “equilibrium,” with full employment, minimal errors of forecasting, etc. Whence, then, the continuing series of booms or busts?

Ludwig von Mises saw that, since the market economy could not itself lead to a continuing round of booms and busts, the explanation must then lie outside the market: in some external intervention. He built his great business cycle theory on three previously unconnected elements.

1. One was the Ricardian demonstration of the way in which government and the banking system habitually expand money and credit, driving prices up (the boom) and causing an outflow of gold and a subsequent contraction of money and prices (the bust). Mises realized that this was an excellent preliminary model, but that it did not explain how the production system was deeply affected by the boom or why a depression should then be made inevitable.

2. Another element was the Böhm-Bawerk analysis of capital and the structure of production.

3. A third was the Swedish “Austrian” Knut Wicksell’s demonstration of the importance to the productive system and the prices of a gap between the “natural” rate of interest (the rate of interest without the interference of bank credit expansion) and the rate as actually affected by bank loans.

From these three important but scattered theories, Mises constructed his great theory of the business cycle. Into the smoothly functioning and harmonious market economy comes the expansion of bank credit and bank money, encouraged and promoted by the government and its central bank. As the banks expand the supply of money (notes or deposits) and lend the new money to business, they push the rate of interest below the “natural” or time preference rate, i.e., the free-market rate which reflects the voluntary proportions of consumption and investment by the public. As the interest rate is artificially lowered, the businesses take the new money and expand the structure of production, adding to capital investment, especially in the “remote” processes of production: in lengthy projects, machinery, industrial raw materials, and so on. The new money is used to bid up wages and other costs and to transfer resources into these earlier or “higher” orders of investment. Then, when the workers and other producers receive the new money, their time preferences having remained unchanged, they spend it in the old proportions. But this means that the public will not be saving enough to purchase the new high-order investments, and a collapse of those businesses and investments becomes inevitable. The recession or depression is then seen as an inevitable re-adjustment of the production system, by which the market liquidates the unsound “over-investments” of the inflationary boom and returns to the consumption/investment proportion preferred by the consumers.

Mises thus for the first time integrated the explanation of the business cycle with general “micro-economic” analysis. The inflationary expansion of money by the governmentally run banking system creates over-investment in the capital goods industries and under-investment in consumer goods, and the “recession” or “depression” is the necessary process by which the market liquidates the distortions of the boom and returns to the free-market system of production organized to serve the consumers. Recovery arrives when this adjustment process is completed.

The policy conclusions implied by the Misesian theory are the diametric opposite of the current fashion, whether “Keynesian” or “post-Keynesian.” If the government and its banking system are inflating credit, the Misesian prescription is (a) to stop inflating posthaste, and (b) not to interfere with the recession-adjustment, not prop up wage rates, prices, consumption or unsound investments, so as to allow the necessary liquidating process to do its work as quickly and smoothly as possible. The prescription is precisely the same if the economy is already in a recession.

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Ludwig von Mises: Interventionism

This article was published at Mises.org in November 2012.

[Economic Policy: Thoughts for Today and Tomorrow (1979), Lecture 3 (1958)]

A famous, very often quoted phrase says, “That government is best, which governs least.” I do not believe this to be a correct description of the functions of a good government. Government ought to do all the things for which it is needed and for which it was established. Government ought to protect the individuals within the country against the violent and fraudulent attacks of gangsters, and it should defend the country against foreign enemies. These are the functions of government within a free system, within the system of the market economy.

Under socialism, of course, the government is totalitarian, and there is nothing outside its sphere and its jurisdiction. But in the market economy the main task of the government is to protect the smooth functioning of the market economy against fraud or violence from within and from outside the country.

People who do not agree with this definition of the functions of government may say, “This man hates the government.” Nothing could be farther from the truth. If I should say that gasoline is a very useful liquid, useful for many purposes, but that I would nevertheless not drink gasoline because I think that would not be the right use for it, I am not an enemy of gasoline, and I do not hate gasoline. I only say that gasoline is very useful for certain purposes, but not fit for other purposes. If I say it is the government’s duty to arrest murderers and other criminals, but not its duty to run the railroads or to spend money for useless things, then I do not hate the government by declaring that it is fit to do certain things but not fit to do other things.

It has been said that under present-day conditions we no longer have a free-market economy. Under present-day conditions we have something called the “mixed economy.” And for evidence of our “mixed economy,” people point to the many enterprises which are operated and owned by the government. The economy is mixed, people say, because there are, in many countries, certain institutions — like the telephone, telegraph, and railroads — which are owned and operated by the government.

That some of these institutions and enterprises are operated by the government is certainly true. But this fact alone does not change the character of our economic system. It does not even mean there is a “little socialism” within the otherwise nonsocialist, free-market economy. For the government, in operating these enterprises, is subject to the supremacy of the market, which means it is subject to the supremacy of the consumers. The government — if it operates, let us say, post offices or railroads — has to hire people who have to work in these enterprises. It also has to buy the raw materials and other things that are needed for the conduct of these enterprises. And on the other hand, it “sells” these services or commodities to the public. Yet, even though it operates these institutions using the methods of the free economic system, the result, as a rule, is a deficit. The government, however, is in a position to finance such a deficit — at least the members of the government and of the ruling party believe so.

It is certainly different for an individual. The individual’s power to operate something with a deficit is very limited. If the deficit is not very soon eliminated, and if the enterprise does not become profitable (or at least show that no further deficit losses are being incurred), the individual goes bankrupt and the enterprise must come to an end.

But for the government, conditions are different. The government can run at a deficit, because it has the power to tax people. And if the taxpayers are prepared to pay higher taxes in order to make it possible for the government to operate an enterprise at a loss — that is, in a less efficient way than it would be done by a private institution — and if the public will accept this loss, then of course the enterprise will continue.

In recent years, governments have increased the number of nationalized institutions and enterprises in most countries to such an extent that the deficits have grown far beyond the amount that could be collected in taxes from the citizens. What happens then is not the subject of today’s lecture. It is inflation, and I shall deal with that tomorrow. I mentioned this only because the mixed economy must not be confused with the problem of interventionism, about which I want to talk tonight.

What is interventionism? Interventionism means that the government does not restrict its activity to the preservation of order, or — as people used to say a hundred years ago — to “the production of security.” Interventionism means that the government wants to do more. It wants to interfere with market phenomena.

If one objects and says the government should not interfere with business, people very often answer, “But the government necessarily always interferes. If there are policemen on the street, the government interferes. It interferes with a robber looting a shop or it prevents a man from stealing a car.” But when dealing with interventionism and defining what is meant by interventionism, we are speaking about government interference with the market. (That the government and the police are expected to protect the citizens, which includes businessmen, and of course their employees, against attacks on the part of domestic or foreign gangsters, is in fact a normal, necessary expectation of any government. Such protection is not an intervention, for the government’s only legitimate function is, precisely, to produce security.)

What we have in mind when we talk about interventionism is the government’s desire to do more than prevent assaults and fraud. Interventionism means that the government not only fails to protect the smooth functioning of the market economy but that it interferes with the various market phenomena; it interferes with prices, with wage rates, interest rates, and profits.

The government wants to interfere in order to force businessmen to conduct their affairs in a different way than they would have chosen if they had obeyed only the consumers. Thus, all the measures of interventionism by the government are directed toward restricting the supremacy of consumers. The government wants to arrogate to itself the power, or at least a part of the power, which, in the free-market economy, is in the hands of the consumers.

Let us consider one example of interventionism, very popular in many countries and tried again and again by many governments, especially in times of inflation. I refer to price control.

Governments usually resort to price control when they have inflated the money supply and people have begun to complain about the resulting rise in prices. There are many famous historical examples of price control methods that failed, but I shall refer to only two of them because, in both these cases, the governments were really very energetic in enforcing or trying to enforce their price controls.

The first famous example is the case of the Roman Emperor Diocletian, very well-known as the last of those Roman emperors who persecuted the Christians. The Roman emperor in the second part of the 3rd century had only one financial method, and this was currency debasement. In those primitive ages, before the invention of the printing press, even inflation was, let us say, primitive. It involved debasement of the coinage, especially the silver. The government mixed more and more copper into the silver until the color of the silver coins was changed and the weight was reduced considerably. The result of this coinage debasement and the associated increase in the quantity of money was an increase in prices, followed by an edict to control prices. And Roman emperors were not very mild when they enforced a law; they did not consider death too mild a punishment for a man who had asked for a higher price. They enforced price control, but they failed to maintain the society. The result was the disintegration of the Roman Empire and the system of the division of labor.

Then, 1,500 years later, the same currency debasement took place during the French Revolution. But this time a different method was used. The technology for producing money was considerably improved. It was no longer necessary for the French to resort to debasement of the coinage: they had the printing press. And the printing press was very efficient. Again, the result was an unprecedented rise in prices. But in the French Revolution maximum prices were not enforced by the same method of capital punishment which the Emperor Diocletian had used. There had also been an improvement in the technique of killing citizens. You all remember the famous Doctor J. I. Guillotin (1738–1814), who advocated the use of the guillotine. Despite the guillotine the French also failed with their laws of maximum prices. When Robespierre himself was carted off to the guillotine the people shouted, “There goes the dirty Maximum.”

I wanted to mention this, because people often say, “What is needed in order to make price control effective and efficient is merely more brutality and more energy.” Now certainly, Diocletian was very brutal, and so was the French Revolution. Nevertheless, price control measures in both ages failed entirely.

Now let us analyze the reasons for this failure. The government hears people complain that the price of milk has gone up. And milk is certainly very important, especially for the rising generation, for children. Consequently, the government declares a maximum price for milk, a maximum price that is lower than the potential market price would be. Now the government says, “Certainly we have done everything needed in order to make it possible for poor parents to buy as much milk as they need to feed their children.”

But what happens? On the one hand, the lower price of milk increases the demand for milk; people who could not afford to buy milk at a higher price are now able to buy it at the lower price which the government has decreed. And on the other hand some of the producers, those producers of milk who are producing at the highest cost — that is, the marginal producers — are now suffering losses, because the price which the government has decreed is lower than their costs. This is the important point in the market economy. The private entrepreneur, the private producer, cannot take losses in the long run. And as he cannot take losses in milk, he restricts the production of milk for the market. He may sell some of his cows for the slaughter house, or instead of milk he may sell some products made out of milk, for instance sour cream, butter or cheese.

Thus the government’s interference with the price of milk will result in less milk than there was before, and at the same time there will be a greater demand. Some people who are prepared to pay the government-decreed price cannot buy it. Another result will be that anxious people will hurry to be first at the shops. They have to wait outside. The long lines of people waiting at shops always appear as a familiar phenomenon in a city in which the government has decreed maximum prices for commodities that the government considers as important. This has happened everywhere when the price of milk was controlled. This was always prognosticated by economists. Of course, only by sound economists, and their number is not very great.

But what is the result of the government’s price control? The government is disappointed. It wanted to increase the satisfaction of the milk drinkers. But actually it has dissatisfied them. Before the government interfered, milk was expensive, but people could buy it. Now there is only an insufficient quantity of milk available. Therefore, the total consumption of milk drops. The children are getting less milk, not more. The next measure to which the government now resorts is rationing. But rationing only means that certain people are privileged and are getting milk while other people are not getting any at all. Who gets milk and who does not, of course, is always very arbitrarily determined. One order may determine, for example, that children under four years old should get milk, and that children over four years, or between the age of four and six, should get only half the ration which children under four years receive.

Whatever the government does, the fact remains, there is only a smaller amount of milk available. Thus people are still more dissatisfied than they were before. Now the government asks the milk producers (because the government does not have enough imagination to find out for itself), “Why do you not produce the same amount of milk you produced before?” The government gets the answer: “We cannot do it, since the costs of production are higher than the maximum price which the government has established.” Now the government studies the costs of the various items of production, and it discovers one of the items is fodder.

“Oh,” says the government, “the same control we applied to milk we will now apply to fodder. We will determine a maximum price for fodder, and then you will be able to feed your cows at a lower price, at a lower expenditure. Then everything will be all right; you will be able to produce more milk and you will sell more milk.”

But what happens now? The same story repeats itself with fodder, and as you can understand, for the same reasons. The production of fodder drops and the government is again faced with a dilemma. So the government arranges new hearings, to find out what is wrong with fodder production. And it gets an explanation from the producers of fodder precisely like the one it got from the milk producers. So the government must go a step farther, since it does not want to abandon the principle of price control. It determines maximum prices for producers’ goods which are necessary for the production of fodder. And the same story happens again.

The government at the same time starts controlling not only milk, but also eggs, meat, and other necessities. And every time the government gets the same result, everywhere the consequence is the same. Once the government fixes a maximum price for consumer goods, it has to go farther back to producers’ goods, and limit the prices of the producers’ goods required for the production of the price-controlled consumer goods. And so the government, having started with only a few price controls, goes farther and farther back in the process of production, fixing maximum prices for all kinds of producers’ goods, including of course the price of labor, because without wage control, the government’s “cost control” would be meaningless.

Moreover, the government cannot limit its interference into the market to only those things which it views as vital necessities, like milk, butter, eggs, and meat. It must necessarily include luxury goods, because if it did not limit their prices, capital and labor would abandon the production of vital necessities and would turn to producing those things which the government considers unnecessary luxury goods. Thus, the isolated interference with one or a few prices of consumer goods always brings about effects — and this is important to realize — which are even less satisfactory than the conditions that prevailed before.

Before the government interfered, milk and eggs were expensive; after the government interfered they began to disappear from the market. The government considered those items to be so important that it interfered; it wanted to increase the quantity and improve the supply. The result was the opposite: the isolated interference brought about a condition which — from the point of view of the government — is even more undesirable than the previous state of affairs which the government wanted to alter. And as the government goes farther and farther, it will finally arrive at a point where all prices, all wage rates, all interest rates, in short everything in the whole economic system, is determined by the government. And this, clearly, is socialism.

What I have told you here, this schematic and theoretical explanation, is precisely what happened in those countries which tried to enforce a maximum price control, where governments were stubborn enough to go step by step until they came to the end. This happened in the First World War in Germany and England.

Let us analyze the situation in both countries. Both countries experienced inflation. Prices went up, and the two governments imposed price controls. Starting with a few prices, starting with only milk and eggs, they had to go farther and farther. The longer the war went on, the more inflation was generated. And after three years of war, the Germans — systematically as always — elaborated a great plan. They called it the Hindenburg Plan: everything in Germany considered to be good by the government at that time was named after Hindenburg.

The Hindenburg Plan meant that the whole German economic system should be controlled by the government: prices, wages, profits — everything. And the bureaucracy immediately began to put this into effect. But before they had finished, the debacle came: the German empire broke down, the entire bureaucratic apparatus disappeared, the revolution brought its bloody results — things came to an end.

In England they started in the same way, but after a time, in the spring of 1917, the United States entered the war and supplied the British with sufficient quantities of everything. Therefore the road to socialism, the road to serfdom, was interrupted.

Continue reading at Mises.org.

Joseph Keckeissen: What Would Mises Say?

[Published at Mises.org on March 25, 2009.]

Far from being prosperous, our America is now being buffeted by the worst financial tsunami in generations. All of us want to know what happened. What really caused this unbelievable turbulence?

To answer this, why not turn to the teachings of my late professor, Ludwig von Mises, the greatest economic analyst of the past century?

In the early 1920s, Mises predicted that the newly organized Soviet Union had set up an unviable economic system that would not be able to survive. Mises based his death verdict (made in his book, Socialism, shortly after the Russian Revolution) on the principle that a society cannot rely on political committees to set market prices as the commissars were trying to do; only the freely demonstrated choices of the market can produce functioning prices. All artificial prices are unworkable; they cannot tell the central planners which goods are expensive and which are cheap, so it would be impossible for them to organize production in an efficient way.

Without real prices, there could be no economization. Mises was derided for this analysis, even to the end of his life. But Mises was right, and history has approved his verdict, although he passed away without receiving due accolades. Even posthumously — when the Russian monster collapsed in 1989 — recognition of his genius was scant.

For this reason I consider myself justified in naming him as the greatest analyst ever.

Continue reading at Mises.org.

The Hidden Costs of a Minimum Wage

By Art Carden

From Mises.org, July 23, 2009.

People in the market can compete on many different margins. They can compete by offering higher productivity, or they can compete by offering better products. Perhaps most importantly, people can compete by offering lower prices. In the case of laborers, this often means offering their services at a lower wage.

Anyone who has taken an introductory economics course is familiar with the idea that a minimum wage leads to a reduction in the demand for labor and an increase in the supply of labor in the relevant market — usually, the market for low-skill workers. The minimum wage removes the ability of some workers to compete by accepting lower wages and shuts them out of the labor force. As a result, it reduces job opportunities for these workers. A minimum wage breaks the hinges on the door of opportunity.

However, there are additional, hidden costs of these interventions, which are more difficult to detect but perhaps more insidious. For example, one effect of a minimum wage is to reduce the availability of on-the-job training, since more resources are required simply to hire and retain a workforce. And further interventions in the labor market (for example, safety regulations and payroll taxes) make it still more costly to employ labor. These burdens together reduce a firm’s willingness to hire laborers and — in the long run — must reduce the number of opportunities for those laborers to acquire valuable job skills. Far from increasing opportunities for the working poor, a minimum wage actually restricts their mobility.

In an attempt to compensate for the lack of skills and opportunities among the low-skilled, governments have created a lot of job training programs. However, whatever their intentions, these training programs circumvent the market processes that match skills with jobs. Every person has a unique set of skills, competencies, strengths, and weaknesses that will only be revealed through their activity in the market. Job training and skills assessments may be able to match people with suitable employment to some degree, but the search mechanism inherent in the labor market is a low-cost way of accomplishing the same result more efficiently.

Continue reading at Mises.org.

Platonic Competition

By George Reisman

[This article was published at Mises.org on December 20, 2005.]

The doctrine of “pure and perfect competition” is a central element both in contemporary economic theory and in the practice of the Anti-Trust Division of the Department of Justice. “Pure and perfect competition” is the standard by which contemporary economic theorists and Justice Department lawyers decide whether an industry is “competitive” or “monopolistic,” and what to do about it if they find that it is not “competitive.”

“Pure and perfect competition” is totally unlike anything one normally means by the term “competition.” Normally, one thinks of competition as denoting a rivalry among producers, in which each producer strives to match or exceed the performance of other producers. This is not what “pure and perfect competition” means. Indeed, the existence of rivalry, of competition as it is normally understood, is incompatible with “pure and perfect competition.” If that is difficult to believe, consider the following passage in a widely used economics textbook by Professor Richard Leftwich:

“By way of contrast, intense rivalry may exist between two automobile agencies or between two filling stations in the same city. One seller’s actions influence the market of the other; consequently, pure competition does not exist in this case.” (Richard H. Leftwich and Ross D. Eckert, The Price System and Resource Allocation, 9th ed., The Dryden Press, Chicago, 1985, p. 41.)

While competition as normally, and properly, understood rests on a base of individualism, the base of “pure and perfect competition” is collectivism. Competition, properly so-called, rests on the activity of separate, independent individuals owning and exchanging private property in the pursuit of their self-interest. It arises when two or more such individuals become rivals for the same trade. The concept of “pure and perfect competition,” however, proceeds from an ideology that obliterates the existence of individuals, of private property, and of exchange. It is the product of an approach to economics based on what Ayn Rand has characterized as the “tribal premise.” (Ayn Rand, Capitalism: The Unknown Ideal, The New American Library, New York, 1966, p. 7.)

Continue reading at Mises.org.

Philipp Bagus: Today’s Wealth Destruction Is Hidden by Government Debt

[This article was published at Mises.org on 21st November 2013.]

Still unnoticed by a large part of the population is that we have been living through a period of relative impoverishment. Money has been squandered in welfare spending, bailing out banks or even — as in Europe — of fellow governments. But many people still do not feel the pain.

However, malinvestments have destroyed an immense amount of real wealth. Government spending for welfare programs and military ventures has caused increasing public debts and deficits in the Western world. These debts will never be paid back in real terms.

The welfare-warfare state is the biggest malinvestment today. It does not satisfy the preferences of freely interacting individuals and would be liquidated immediately if it were not continuously propped up by taxpayer money collected under the threat of violence.

Another source of malinvestment has been the business cycle triggered by the credit expansion of the semi-public fractional reserve banking system. After the financial crisis of 2008, malinvestments were only partially liquidated. The investors that had financed the malinvestments such as overextended car producers and mortgage lenders were bailed out by governments; be it directly through capital infusions or indirectly through subsidies and public works. The bursting of the housing bubble caused losses for the banking system, but the banking system did not assume these losses in full because it was bailed out by governments worldwide. Consequently, bad debts were shifted from the private to the public sector, but they did not disappear. In time, new bad debts were created through an increase in public welfare spending such as unemployment benefits and a myriad of “stimulus” programs. Government debt exploded.

In other words, the losses resulting from the malinvestments of the past cycle have been shifted to an important degree onto the balance sheets of governments and their central banks. Neither the original investors, nor bank shareholders, nor bank creditors, nor holders of public debt have assumed these losses. Shifting bad debts around cannot recreate the lost wealth, however, and the debt remains.

To illustrate, let us consider Robinson Crusoe and the younger Friday on their island. Robinson works hard for decades and saves for retirement. He invests in bonds issued by Friday. Friday invests in a project. He starts constructing a fishing boat that will produce enough fish to feed both of them when Robinson retires and stops working.

At retirement Robinson wants to start consuming his capital. He wants to sell his bonds and buy goods (the fish) that Friday produces. But the plan will not work if the capital has been squandered in malinvestments. Friday may be unable to pay back the bonds in real terms, because he simply has consumed Robinson’s savings without working or because the investment project financed with Robinson’s savings has failed.

For instance, imagine that the boat is constructed badly and sinks; or that Friday never builds the boat because he prefers partying. The wealth that Robinson thought to own is simply not there. Of course, for some time Robinson may maintain the illusion that he is wealthy. In fact, he still owns the bonds.

Let us imagine that there is a government with its central bank on the island. To “fix” the situation, the island’s government buys and nationalizes Friday’s failed company (and the sunken boat). Or the government could bail Friday out by transferring money to him through the issuance of new government debt that is bought by the central bank. Friday may then pay back Robinson with newly printed money. Alternatively the central banks may also just print paper money to buy the bonds directly from Robinson. The bad assets (represented by the bonds) are shifted onto the balance sheet of the central bank or the government.

As a consequence, Robinson Crusoe may have the illusion that he is still rich because he owns government bonds, paper money, or the bonds issued by a nationalized or subsidized company. In a similar way, people feel rich today because they own savings accounts, government bonds, mutual funds, or a life insurance policy (with the banks, the funds, and the life insurance companies being heavily invested in government bonds). However, the wealth destruction (the sinking of the boat) cannot be undone. At the end of the day, Robinson cannot eat the bonds, paper, or other entitlements he owns. There is simply no real wealth backing them. No one is actually catching fish, so there will simply not be enough fishes to feed both Robinson and Friday.

Something similar is true today. Many people believe they own real wealth that does not exist. Their capital has been squandered by government malinvestments directly and indirectly. Governments have spent resources in welfare programs and have issued promises for public pension schemes; they have bailed out companies by creating artificial markets, through subsidies or capital injections. Government debt has exploded.

Many people believe the paper wealth they own in the form of government bonds, investment funds, insurance policies, bank deposits, and entitlements will provide them with nice sunset years. However, at retirement they will only be able to consume what is produced by the real economy. But the economy’s real production capacity has been severely distorted and reduced by government intervention. The paper wealth is backed to a great extent by hot air. The ongoing transfer of bad debts onto the balance sheets of governments and central banks cannot undo the destruction of wealth. Savers and pensioners will at some point find out that the real value of their wealth is much less than they expected. In which way, exactly, the illusion will be destroyed remains to be seen.

Philipp Bagus is an associate professor at Universidad Rey Juan Carlos. He is an associate scholar of the Ludwig von Mises Institute and was awarded the 2011 O.P. Alford III Prize in Libertarian Scholarship. He is the author of The Tragedy of the Euro and coauthor of Deep Freeze: Iceland’s Economic Collapse. The Tragedy of the Euro has so far been translated and published in GermanFrenchSlovakPolishItalianRomanian, FinnishSpanishPortugueseBritish EnglishDutchBrazilian PortugueseBulgarian, and Chinese. See his website. Send him mail. Follow him on Twitter @PhilippBagus See Philipp Bagus’s article archives.

Peter G. Klein: Coase and the Austrians

From Mises.org:

Ronald Coase passed away yesterday [2nd September] at the age of 102.  Coase is one of the most influential economists of the twentieth century, perhaps of all time. […] Coase was no Austrian, but was friendly with many Austrian economists, was deeply critical of modern positivism and instrumentalism, and was skeptical of most regulations. Austrians have generally rejected Coase’s approach to property rights, externalities, and liability (see Block, 1977Rothbard 1982, and Cordato, 1992, for examples of a large literature). However, Coase’s insight that legal entitlements are often traded, and that trading partners can often “contract around” legal and regulatory barriers, is important and useful, even if contemporary law-and-economics scholarship has drawn the mistaken implication that judges can somehow use this insight to determine the “optimal” allocation of property rights.

From Ronald H. Coase, Founding Scholar in Law and Economics, 1910-2013:

Ronald H. Coase helped create the field of law and economics, through groundbreaking scholarship that earned him the 1991 Nobel Memorial Prize in Economics and through his far-reaching influence as a journal editor.

Coase, who spent most of his academic career at the University of Chicago Law School, died at the age of 102 on Sept. 2 at St. Joseph’s Hospital in Chicago. He was the oldest living Nobel laureate, according to the Nobel Foundation.

Coase, the Clifton R. Musser Professor Emeritus of Economics, is best known for his 1937 paper, “The Nature of the Firm,” which offered groundbreaking insights about why firms exist and established the field of transaction cost economics, and “The Problem of Social Cost,” published in 1960, which is widely considered to be the seminal work in the field of law and economics. The latter set out what is now known as the Coase Theorem, which holds that under conditions of perfect competition, private and social costs are equal.

Biography of Ludwig von Mises (1881-1973)

From Mises.org.

One of the most notable economists and social philosophers of the twentieth century, Ludwig von Mises, in the course of a long and highly productive life, developed an integrated, deduct­ive science of economics based on the fundamental axiom that in­dividual human beings act purposively to achieve desired goals. Even though his economic analysis itself was “value-free” — in the sense of being irrelevant to values held by economists — Mises concluded that the only viable economic policy for the human race was a policy of unrestricted laissez-faire, of free markets and the unhampered exercise of the right of private property, with government strictly limited to the defense of person and property within its territorial area.

For Mises was able to demonstrate (a) that the expansion of free markets, the division of labor, and private capital investment is the only possible path to the prosperity and flourishing of the human race; (b) that socialism would be disastrous for a modern economy because the absence of private ownership of land and capital goods prevents any sort of rational pricing, or estimate of costs, and (c) that government intervention, in addition to hampering and crippling the market, would prove counter-productive and cumulative, leading inevitably to socialism unless the entire tissue of interventions was repealed.

Holding these views, and hewing to truth indomitably in the face of a century increasingly devoted to statism and collectivism, Mises became famous for his “intransigence” in insisting on a non-inflationary gold standard and on laissez-faire.

Effectively barred from any paid university post in Austria and later in the United States, Mises pursued his course gallantly. As the chief economic adviser to the Austrian government in the 1920s, Mises was single-handedly able to slow down Austrian inflation; and he developed his own “private seminar” which attracted the out­standing young economists, social scientists, and philosophers throughout Europe. As the founder of the “neo-Austrian School” of economics, Mises’s business cycle theory, which blamed inflation and depressions on inflationary bank credit encouraged by Central Banks, was adopted by most younger economists in England in the early 1930s as the best explanation of the Great Depression.

Having fled the Nazis to the United States, Mises did some of his most important work here. In over two decades of teaching, he inspired an emerging Austrian School in the United States. The year after Mises died in 1973, his most distinguished follower, F.A. Hayek, was awarded the Nobel Prize in economics for his work in elaborat­ing Mises’s business cycle theory during the later 1920s and 1930s.

Continue reading at Mises.org.

See also article on Mises by Jörg Guido Hülsmann.

Charles Plosser (FED): Keeping rates at zero for very long periods of time can distort decision making in various ways

Charles Plosser, president of Federal Reserve Bank of Philadelphia, said:

“We’re very conscious of the fact that keeping rates at zero for very long periods of time can distort decision making in various ways.”

(Via The Circle Bastiat.)

Resource for learning austrian economics online

Learn Austrian Economics online.

Books, articles, videos on the austrian economics: introduction, money, the business cycle, deflation, and much more.

Biography of Juan de Mariana: The Influence of the Spanish Scholastics (1536-1624)

An article by Jesus Huerta de Soto.

The prehistory the Austrian School of economics can be found in the works of the Spanish scholastics written in what is known as the “Spanish Golden Century,” which ran from the mid- sixteenth century through the seventeenth century.

Who were these Spanish intellectual forerunners of the Austrian School of economics? Most of them were scholastics teaching morals and theology at the University of Salamanca, in the medieval Spanish city located 150 miles northwest of Madrid, close to the border of Spain with Portugal. These scholastics, mainly Dominicans and Jesuits, articulated the subjectivist, dynamic, and libertarian tradition on which, two-hundred-and-fifty years later, Carl Menger and his followers would place so much importance. Perhaps the most libertarian of all the scholastics, particularly in his later works, was the Jesuit Father Juan de Mariana.

Mariana was born in the city of Talavera de la Reina, near Toledo. He appears to have been the illegitimate son of a canon of Talavera, and when he was sixteen, joined the Society of Jesus, which had just been created. At the age of twenty-four, he was summoned to Rome to teach theology, then transferred to the school the Jesuits ran in Sicily, and from there to the University of Paris. In 1574, he returned to Spain, living and studying in Toledo until his death at the age of eighty-seven.

Continue reading at Mises.org.

I Want to be a Consumer, a Poem by Patrick Barrington

Henry Hazlitt, in his Failure of the “New Economics”, quotes this poem, which can be viewed as a critique of Keynesian economics. Hazlitt writes (p. 146 in PDF file):

The natural consequences of the Keynesian economic philosophy were vividly portrayed by Patrick Barrington (two years before the particular rationalization that apeared in the General Theory) in his poem in Punch [Issue of April 25, 1934]:

I Want to be a Consumer

“And what do you mean to be?”
The kind old Bishop said
As he took the boy on his ample knee
And patted his curly head.
“We should all of us choose a calling
To help Society’s plan;
Then what do you mean to be, my boy,
When you grow to be a man?”

“I want to be a Consumer,”
The bright-haired lad replied
As he gazed up into the Bishop’s face
In innocence open-eyed.
“I’ve never had aims of a selfish sort,
For that, as I know, is wrong.
I want to be a Consumer, Sir,
And help the world along.

“I want to be a Consumer
And work both night and day,
For that is the thing that’s needed most,
I’ve heard Economists say,
I won’t just be a Producer,
Like Bobby and James and John;
I want to be a Consumer, Sir,
And help the nation on.”

“But what do you want to be?”
The Bishop said again,
“For we all of us have to work,” said he,
“As must, I think, be plain.
Are you thinking of studying medicine
Or taking a Bar exam?”
“Why, no!” the bright-haired lad replied
As he helped himself to jam.

“I want to be a Consumer
And live in a useful way;
For that is the thing that’s needed most,
I’ve heard Economists say.
There are too many people working
And too many things are made.
I want to be a Consumer, Sir,
And help to further Trade.

“I want to be a Consumer
And do my duty well;
For that is the thing that’s needed most,
I’ve heard Economists tell.
I’ve made up my mind,” the lad was heard,
As he lit a cigar, to say;
“I want to be a Consumer, Sir,
And I want to begin today.”

Value is subjective

“The value of an article does not depend on its essential nature but on the estimation of men, even if that estimation be foolish.”

— Diego de Covarrubias y Leiva (1512-1577), quoted in The School of Salamanca, by Marjorie Grice-Hutchinson.

Diego de Covarrubias y Leiva

Frank Shostak: What is Wrong With Econometrics?

[This article was published at Mises.org on April 17, 2002.]

A recent academic study by economists Karl Case, John Quigley, and Robert Shiller of consumer-spending behavior in the U.S. and 13 other developed nations indicates that the wealth effect from housing is twice as great on consumer spending as comparable changes in stock-market wealth. In the U.S., for example, they found that a 10-percent gain in housing prices would provoke an average 0.62-percent increase in consumption, while a similar jump in stock-market wealth only elicited about a 0.3-percent to 0.2-percent increase in spending (Barron’s, April 15, 2002).

What enabled these economists to derive these answers is econometric modeling.

In the natural sciences, a laboratory experiment can isolate various elements and their movements. There is no equivalent in the discipline of economics. The employment of econometrics and econometric model-building is an attempt to produce a laboratory where controlled experiments can be conducted.

The idea of having such a laboratory is very appealing to economists and politicians. Once the model is built and endorsed as a good replica of the economy, politicians can evaluate the outcomes of various policies. This, it is argued, enhances the efficiency of government policies and thus leads to a better and more prosperous economy. It is also suggested that the model can serve as a referee in assessing the validity of various economic ideas. The other purpose of a model is to provide an indication regarding the future.

By means of mathematical and statistical methods, an econometrician establishes functional relationships between various economic variables. For example, personal consumer outlays are related to personal disposable income and interest rates, while fixed capital spending is explained by the past stock of capital, interest rates, and economic activity. A collection of such various estimated relations—i.e., equations—constitutes an econometric model.

A comparison of the goodness of fit of the dynamic simulation versus the actual data is an important criterion in assessing the reliability of a model. (In a static simulation, the equations of the model are solved using actual lagged variables. In a dynamic simulation, the equations are solved by employing calculated from the model-lagged variables). The final test of the model is its response to a policy variable change, such as an increase in taxes or a rise in government outlays. By means of a qualitative assessment, a model builder decides whether the response is reasonable or not. Once the model is successfully constructed, it is ready to be used.

Despite the aura of importance and mysterious wisdom that econometric modeling projects, it is nevertheless an empty vessel. The econometric modeling procedure employs an untenable methodology: it tries to capture human behavior by means of mathematical and statistical methods.

Is the mathematical method valid in economics?

By applying mathematics, mainstream economics is attempting to follow in the footsteps of natural sciences. In the natural sciences, the employment of mathematics enables scientists to formulate the essential nature of objects. In short, by means of a mathematical formula, the response of objects to a particular stimulus in a given condition is captured. Consequently, within these given conditions, the same response will be obtained time and again.

The same approach, however, is not valid in economics. For economics is supposed to deal with human beings and not objects. According to Mises,

The experience with which the sciences of human action have to deal is always an experience of complex phenomena. No laboratory experiments can be performed with regard to human action.[1]

The main characteristic or nature of human beings is that they are rational animals. They use their minds to sustain their lives and well-being. The usage of the mind, however, is not set to follow some kind of automatic procedure, but rather every individual employs his mind in accordance with his own circumstances. This makes it impossible to capture human nature by means of mathematical formulae, as is done in the natural sciences.

In short, people have the freedom of choice to change their minds and pursue actions that are contrary to what was observed in the past. As a result of the unique nature of human beings, analyses in economics can only be qualitative.

Furthermore, to pursue quantitative analysis implies the possibility of the assignment of numbers, which can be subjected to all of the operations of arithmetic. To accomplish this, it is necessary to define an objective fixed unit. Such an objective unit, however, doesn’t exist in the realm of human valuations. On this Mises wrote, “There are, in the field of economics, no constant relations, and consequently no measurement is possible.”[2]

There are no constant standards for measuring the minds, the values, and the ideas of men. Valuation is the means by which a conscious purposeful individual assesses the given facts of reality. In other words once an individual establishes what the facts are, he then assesses which out of these established facts are the most suitable to attain his various ends.

Individual goals or ends set the standard for valuing the facts of reality. For instance, if the goal of an individual is to improve his health, then he would establish which goods will benefit his health and which will not. Among those that will benefit him, some will be more effective than others. There is no way, however, to quantify this effectiveness. All that one could do is rank these goods in accordance with perceived effectiveness.

The use of mathematics in economics poses another serious problem. The employment of mathematical functions implies that human actions are set in motion by various factors. However, this is an erroneous way of thinking. For instance, contrary to the mathematical way of thinking, individual outlays on goods are not “caused” by real income as such. In his own context, every individual decides how much of a given amount of income will be used for consumption and how much for savings. While it is true that people respond to changes in their incomes, the response is not automatic, and it cannot be captured by a mathematical formula. For instance, an increase in an individual’s income doesn’t automatically imply that his consumption expenditure will follow suit. In other words, every individual assesses the increase in income against the goals he wants to achieve. Thus he might decide that it is more beneficial for him to raise his savings rather than raise his consumption.

The validity of probability theory in economics

While mathematics is the key tool of econometric methods, the foundation of econometrics is probability theory. What is probability? The probability of an event is the proportion of times the event occurs out of a large number of trials. For instance, the probability of obtaining heads when a coin is tossed is 50 percent. This does not mean that when a coin is tossed 10 times, five heads are always obtained. However, if the experiment is repeated a large number of times, then it is likely that 50 percent will be obtained. The greater the number of throws, the nearer the approximation is likely to be.

Alternatively, say it has been established that in a particular area the probability of wooden houses catching fire is .01. This means that on the basis of experience, on average, 1 percent of wooden houses will catch fire. This does not mean that this year or the following year the percentage of houses catching fire will be exactly 1 percent. The percentage might be 1 percent each year or not. Over time, however, the average of these percentages will be 1 percent.

This information, in turn, can be converted into the cost of fire damages thereby establishing the case for insuring against the risk of fire. Owners of wooden houses might decide to pool their risk, i.e., spread the risk by setting up a fund. In other words, every owner of a wooden house will contribute according to a certain proportion to the total amount of money that is required in order to cover the damages of those owners whose houses will be damaged by the fire. Note that insurance against the fire risk can only take place because we know its probability distribution and because there are enough owners of wooden houses to spread the cost of fire damage among them so that the premium will not be excessive. In this regard, these owners of wooden houses are all members of a particular group or class that will be affected in a similar way by a fire. We know that, on average, 1 percent of the members of this group will be affected by fire. However, we don’t know exactly who it will be. The important thing for insurance is that members of a group must be homogeneous as far as a particular event is concerned.

In economics, however, we don’t deal with homogeneous cases. Each observation is a unique, nonrepeatable event caused by a particular individual response. Consequently, no probability distribution can be established. Again, probability distribution rests on the assumption that we are dealing with a nonparticular, and so repeatable, event. Let us take for instance entrepreneurial activities. If these activities were repeatable with known probability distributions, then we would not need entrepreneurs. After all, an entrepreneur is an individual who arranges his activities toward finding out consumers’ future requirements. People’s requirements, however, are never constant with respect to a particular good. The assumption that econometrics makes–that probability distribution exists and can be quantified–leads to absurd results. For it describes, not a world of human beings who exercise their minds in making choices, but machines.

Human activities, however, cannot be analyzed in the same way that one would analyze objects. To make sense of historical data, one must scrutinize them not by means of statistical methods but by means of trying to grasp and understand how they emerged.

Continue reading at Mises.org.

Gold vs. Paper

By Ludwig von Mises

[This article was published on Mises.org on 28th September 2009. It was originally published in the Freeman, July 13, 1953 (download PDF).]

Most people take it for granted that the world will never return to the gold standard. The gold standard, they say, is as obsolete as the horse and buggy. The system of government-issued fiat money provides the treasury with the funds required for an open-handed spending policy that benefits everybody; it forces prices and wages up and the rate of interest down and thereby creates prosperity. It is a system that is here to stay.

Now whatever virtues one may ascribe — undeservedly — to the modern variety of the greenback standard, there is one thing that it certainly cannot achieve. It can never become a permanent, lasting system of monetary management. It can work only as long as people are not aware of the fact that the government plans to keep it.

The Alleged Blessings of Inflation

The alleged advantages that the champions of fiat money expect from the operation of the system they advocate are temporary only. An injection of a definite quantity of new money into the nation’s economy starts a boom as it enhances prices. But once this new money has exhausted all its price-raising potentialities and all prices and wages are adjusted to the increased quantity of money in circulation, the stimulation it provided to business ceases.

Thus even if we neglect dealing with the undesired and undesirable consequences and social costs of such inflationary measures and, for the sake of argument, even if we accept all that the harbingers of “expansionism” advance in favor of inflation, we must realize that the alleged blessings of these policies are shortlived. If one wants to perpetuate them, it is necessary to go on and on increasing the quantity of money in circulation and expanding credit at an ever-accelerated pace. But even then the ideal of the expansionists and inflationists, viz., an everlasting boom not upset by any reverse, could not materialize.

A fiat-money inflation can be carried on only as long as the masses do not become aware of the fact that the government is committed to such a policy. Once the common man finds out that the quantity of circulating money will be increased more and more, and that consequently its purchasing power will continually drop and prices will rise to ever higher peaks, he begins to realize that the money in his pocket is melting away.

Then he adopts the conduct previously practiced only by those smeared as profiteers; he “flees into real values.” He buys commodities, not for the sake of enjoying them, but in order to avoid the losses involved in holding cash. The knell of the inflated monetary system sounds. We have only to recall the many historical precedents beginning with the Continental currency of the War of Independence.

Continue reading at Mises.org…

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