Reviving Say's law

In an old piece for the Freeman, Steve Horwitz writes about 'Say's Law', named after the classical French economist Jean-Baptiste Say who coined it. Say's law is commonly — and, says Steve, wrongly — thought of as stating that 'supply creates its own demand'. That's a little nonsensical. In fact, what he said was that the source of demand is production: unless you have something to offer on a market, you aren't really 'demanding' anything else:

Hutt states this as: “All power to demand is derived from production and supply. . . . The process of supplying—i.e., the production and appropriate pricing of services or assets for replacement or growth—keeps the flow of demands flowing steadily or expanding.” Later, Hutt was to be somewhat more precise with his definition: “the demand for any commodity is a function of the supply of noncompeting commodities.” The addition of the modifier noncompeting is important. If I sell my services as a computer technician, it is presumed that my resulting demands will be for goods and for services other than those of a computer technician (or something similar). The goods or services competing with those that I sell can always be obtained by applying my labor directly, so I am unlikely to demand them. The demand for my services as a computer technician is a result of the supplying activities of everyone but computer technicians.

Read the whole thing.

The ratings agencies are quasi-governmental institutions, not market players

On the New Statesman blog today, David Skelton of Policy Exchange argues that “We must free ourselves from the tyranny of the credit rating agencies”. Citing the failure of the big three ratings agencies (Standard and Poors, Moody’s and Fitch) to anticipate the subprime mortgage crisis, he says that the agencies now “hold enormous power over democratically elected governments … often enough to force a government turn away from the democratic mandate on which they were elected.” Because they’ve been so badly wrong before, we should “stop thinking that their declarations should be decisive”.

I think Skelton has missed the most important point. He asks whether the "anonymous, powerful experts deserved the credibility and the exalted position they are given by the media and politicians?", apparently unaware of the fact that the ratings agencies owe their position not to media (or even politicians') trust, but to a complex thicket of US financial regulation.

As Professor Lawrence J. White of Stern Business School has written, it was “the regulatory structure that propelled these companies to the center of the U.S. bond markets”, and what has stopped them from going down following their colossal failure in 2008.

In 1936, financial regulators eager to impose discipline on the banking sector introduced rules that banned banks from holding bonds rated below BBB standard by one of the “recognized ratings manuals” – S&P, Moody’s or Fitch. In White’s words, “the creditworthiness judgments of these third-party raters had attained the force of law.”

Over the following decades, insurance regulators followed suit, so that eventually all fifty US states had rules requiring insurance companies to hold amounts of capital commensurate to the riskiness of their bond holdings as judged by the ratings agencies. Federal pensions regulators did the same in the 1970s.

Finally, in 1975, the Securities Exchange Commission (SEC) created a category of “nationally recognized statistical rating organizations” (NRSRO) to risk-rate the bonds that the SEC now required broker-dealers to hold. According to White: “The other financial regulators soon adopted the SEC's NRSRO category and the rating agencies within it as the relevant sources of the ratings that were required for evaluations of the bond portfolios of their regulated financial institutions.” The SEC only granted NRSRO status to four more organizations over the next 25 years, but by 2000 these had merged with the original three, once again leaving only three agencies on the market.

Whether through error or design, the NRSRO application process was remarkably opaque, with no formal application or review processes. As White argues, these regulations created (and continue to create) an enormous barrier to entry for any new ratings agency: “Without the NRSRO designation, any would-be bond rater would likely be ignored by most financial institutions; and, since the financial institutions would ignore the would-be bond rater, so would bond issuers.”

With the ratings agencies as insulated from competition as this, it is hardly surprising that they all made the same errors in the run-up to 2008. Nor is it a surprise that their market dominance has continued, despite that massive failure. It was only in 2006 that the SEC’s barriers to entry were reformed at all, and even then the reforms were limited, at best.

These facts are not well known. Jeffrey Friedman has argued that widespread ignorance of the ratings agencies’ status was a significant contributory factor in the subprime mortgage bubble – bankers were unaware that the ratings they were getting were not the product of a competitive marketplace (where risk-taking that turned out to be correct would be rewarded) but of a quasi-governmental oligopoly.

I may disagree with Skelton more broadly – when he accuses bond markets of holding governments to ransom, he is really just attacking them for being wary about who they lend to. And only governments relying on borrowing to fund spending could be forced to change policy to satisfy bond markets. But his assessment of the ratings agencies appears to miss the most important fact of all: that these agencies are creatures of regulation, not competition.

Milton Friedman on big business and big government

Thanks to Peter Twigg for bringing this excellent clip on the double threat to the people of big business allying itself with big government to my attention.

Tax facts

Those who think that all our problems can be solved by taxing the rich more would do well to study this year's tax facts mentioned by City AM editor, Allister Heath, in Tuesday's edition.

1.  The top 1% of earners earn 10.8% of all income, but will pay 24.2% of all income tax.

2.  The top 10% earn 33.2% of all income but will pay 55.3% of all income tax.

3.  The top 31,000 individuals (earning £0.5m+) will pay £14.8bn, which is more than the £13.9bn paid by the bottom 13,600,000 people earning below £20,000 pa.

4.  Those earning £0.5m+ per year pay 43-44% in income tax, plus National Insurance plus indirect taxes.  The very top 2,000 earners pay on average £2m each in income tax alone.

These facts are sobering, but a real injustice comes from the fact that those earning the minimum wage (for a typical working week) have income tax and National Insurance taken out of that minimum wage.  Those on minimum wages would earn a 'living wage' were it not for the money taken from them by government.  It seems wrong that people struggling to get by on the minimum wage should lose some of that meagre sum to government.

Inflation: the ultimate corruption

The ultimate corruption is the single, most cynical, abuse of the people by the State (your government), in perpetrating the myth that inflation is an economic disease that government cannot stop. The truth is that government perpetuates inflation and that it remains in the government's interest to maintain a level of inflation. The truth is that government makes itself out to be the victim of inflation when in fact it benefits from inflation.

"With the exception only of the 200-year period of the gold standard (1714 to 1914 in Britain), practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people." FA Hayek, Choice in Currency

The truth is that government spends a lot of time and resources continuing the facade that they too are the hapless victims of this scourge called inflation. This illusion is maintained by social science academics having created a whole ‘science’ around the myth of inflation.

“We have indeed at the moment little cause for pride: as a profession we have made a mess of things”. ~ FA Hayek

Inflation has a street definition which is ‘rising prices’ and even academics now pander to this definition. Rising prices in fact, are the effect of increases in money supply which is determined by government and its agencies. It suits government to have this skewed view of this 'intractable problem'.

The great danger of inflationary policies is that there exists a tipping point at which the loss of purchasing power and confidence begins to accelerate out of control.  Since psychology and perception play a large role in determining that point, it is impossible to know where it lays ahead of time.  And once started, the rapid erosion of a currency’s value is very difficult to halt. ~ Henry Hazlitt

Inflation is caused by governments continually expanding the nation's money supply for which it holds a monopoly. The heart of the inflation engine is the credit creation process that banks are licensed to engage. The rewards for that process are immense in that banks are the first to receive the benefits of increases in money supply.

Inflation generates a sense of false prosperity and is the basis of booms and busts occurring in the economy. As Hayek indicated in his book, 'The Political Order of a Free People':

"Government would be deprived not only of the main means of damaging the economy and subjecting individuals to restrictions of their freedom but also of one of the chief causes of its constant expansion."

Inflation keeps people trapped on a perpetually moving hamster wheel and you cannot get off. Inflation constantly erodes the value of your savings and creates the illusion that you are getting wealthier because the money value of your assets is getting higher. This is illusion. If you sell your asset, your cash proceeds are soon depreciated away. It forces you to keep purchasing - to not purchase means your money loses purchasing power. This causes people to make wrong purchasing decisions, just as business people make wrong investment decisions because false pricing, including interest rates, create a distorted sense of an economy's prospects. Whether it's an investment property, or some consumer good, the hidden need drives you to divest your money because it has no store of value. Ironically this is good for economic growth. Buying things you don't really need is wasteful for you when your resources are better employed in some other way.

Inflation encourages debt. If you know something is going to cost more in the future because inflation will drive up the price of your purchase then, it makes sense to buy it now. If you need a little credit to help you with your purchase, that’s ok! Inflation helps by eroding the value of the money owing on your credit contract and IF your earnings keep pace with inflation, you are the winner.

You see, this is how governments benefit. They borrow massive amounts of money to pay for schemes and promises, made by politicians to win your vote and ensure your loyalty. They pay interest on the loans they take out on your behalf and inflation erodes the value of the debt over the life of the debt. But you are the one that ultimately pays the price and this is why inflation is the ultimate corruption and abuse of the people. As I said, the government gives nothing that it does not take from you first.

For government this has been such a good scheme. Left unchecked, government has made many promises and borrowed more and more to meet those promises so that now we have reached the stage where the jig is up! Examine the UK debt situation below. You can see government has a problem which means you have problem. After all you are the one that will be left to pay.

“Government is the great fiction, through which everybody endeavors to live at the expense of everybody else”. ~Frederic Bastiat

We are not too many steps away from the situation where government defaults on its obligations to you. Unthinkable before - a realistic proposition now! Not only in the UK, but European countries, USA, China. We have all passed the point of no return.

Inflation also contributes to unhappiness and lack of wellbeing. Being trapped on the hamster wheel and having your standard of living perpetually eroding does not build confidence for the future nor does it build future, real prosperity. The sense is - enjoy the party now! At best it creates manipulated booms, doomed to failure. And the numbers don’t lie when they say ‘the jig is up!’

Inflation promotes corruption by showing people that they too can game the system. It becomes a feeding frenzy of ‘grab what you can’ whether you are in business or receiving benefits. Rent-seeking, subsidies, moral hazard, market distortion, lobbying, regulation, government license and unintended consequences are the behaviors of people playing the government game.

"Corruptissima republica plurimae leges. (The more numerous the laws, the more corrupt the state.)" ~Tacitus, the Annals ca. AD 69

What would it mean if we could end inflation?

Ending inflation would allow people to accumulate real wealth and they could aspire to an affordable quality of life based on real savings and investments and real equality of income based on their money having constant purchasing power. In other words £1 today would purchase £1 of equal value in one or twenty year’s time. Social and economic dislocation and disparity would be much diminished.

Ending inflation would mean that people could begin to save for their retirement without worrying that their savings will shrink as inflation chomps away. For people already retired, it would mean they no longer have to worry about how they will make ends meet.

Ending inflation also means that the national savings pool could begin to grow again so that the economy would have a sustainable basis for solid economic growth without the boom-bust fluctuations we have become accustomed to. Investors and entrepreneurs could feel secure in their decision making once again.

Ending inflation would mean affordable housing and real prices for goods and services. Inflation has caused property prices to soar over the last 20 years creating a gap between nominal house prices and real property prices. When the property price bubble burst in 2007-2009, nominal prices quickly fell. Ending inflation would allow real and nominal property prices to come together over time making housing affordable for more people.

Ending inflation also means governments would have to find another way of doing things rather than continuing to cheat the people.

“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists”. ~Ernest Hemingway

What can we do?

We can send a signal to our politicians - enough is enough! In fact this is what voters did in 2010 when the general election returned a vote with no clear majority to govern. But that is not enough. They need to know that you do not want their meddling in your lives. Ignoring the promises of your politicians is another step. Remember, anything government offers you is firstly taken from you.

We need choice for consumers by allowing people with savings to hold their money in the form of cash, gold or silver. Allow banks to offer gold and silver savings accounts. Give people the choice about the kind of money they want to hold. It’s time to end the paper money farce and make money the store of value it could be.

The international monetary system has undergone change roughly every 40 years for the last 150 years. It's due for a change now. It’s likely the new system will introduce a store of value because the old is technically bankrupt. Many central banks around the world are already purchasing gold bullion because they see the writing on the wall. It’s not enough to wait for the change because that may worsen the catastrophe. We need to effect change now, even if it is too late.

Peter Twigg is CEO and Futurist for Pointmen Pte Limited and runs http://emergingevents.com, a website offering scientifically based prediction services for navigating the future. 

What a Bank Governor should understand

I had a letter published in the Business section of Monday's Telegraph.  It had to be abbreviated for lack of space, but I think the full text is worth repeating here because it explains what it is that the incoming Governor should understand.
_____

Dear Sir,

Next month a new Governor of the Bank of England will be appointed to replace Sir Mervyn King.  A suitable candidate must not only possess rare qualities, but should also understand the causes of the financial crisis in order that they might make a recurrence unlikely.  They should understand that the low interest rate policy pursued by governments and central banks to smooth the down side of the business cycle produced cheap money and easy credit that fuelled a housing bubble.  This was intensified by implicit government guarantees in the US to support loans to borrowers with a high default risk. 

This was exacerbated by rules that required banks to take more mortgage debt, done in the name of prudence, but in fact compounding regulatory error.  Added to this was the fact that the artificially low interest rates drove fund managers into riskier investments because of the low returns on the safer ones.

If the person to be chosen as Governor understands this, they are unlikely to countenance future intervention designed to secure a politically acceptable outcome rather than an economically wise one.  They will be unlikely, too, to punish by a regulatory stranglehold a financial sector that was far less culpable than the politicians who tried to make it serve their interests.

Yours etc.

Madsen Pirie

____

Anyone who thought it was all down to greedy bankers taking reckless risks and thinks that tighter regulation is the answer is lacking in the insight and understanding we are entitled to expect from the next Governor.

Inflation: the ultimate corruption

Inflation, says Peter Twigg, is the ultimate corruption: the trick used by politicians to conceal vast spending and wastefulness. It is nothing less than a full-scale robbery of the people by the state, and it's high time that more of us realized how pernicious it really is.

The ultimate corruption is the single, most cynical, abuse of the people by the State (your government), in perpetrating the myth that inflation is an economic disease that government cannot stop. The truth is that government perpetuates inflation and that it remains in the government's interest to maintain a level of inflation. The truth is that government makes itself out to be the victim of inflation when in fact it benefits from inflation.

"With the exception only of the 200-year period of the gold standard (1714 to 1914 in Britain), practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people." FA Hayek, Choice in Currency

The truth is that government spends a lot of time and resources continuing the facade that they too are the hapless victims of this scourge called inflation. This illusion is maintained by social science academics having created a whole ‘science’ around the myth of inflation.

Read this article.

Beyond fiat currencies

There's a new way to by-pass fiat currencies that governments can debase.  From Euro Pacific Bank come two new cards, one gold and one silver.  Instead of drawing from your cash reserves held in sterling or dollars or whatever, or of spending on credit and paying the bills in such currencies, these cards draw on bullion.  You own gold and silver in a vault, and what you spend is converted into bullion and drawn from your stock:

Now you can actually own precious metals and convert the amount you choose into cash at an instant. Spend cash from your metals backed card at more than 30 million locations and 1.4 million ATM’s worldwide.

With the gold card you spend gold, and with the silver one you draw from your stock of silver bullion.  This solves one of the problems of a commodity-backed currency, namely the ease with which it can be traded in small amounts.  These cards subtract coins and notes from the equation, replacing them by electronic transfers of bullion.

It's an intriguing idea.  If it catches on in a big way, it could give hard-pressed savers some respite from the ravages inflicted upon them by governments through inflation and artificially low interest rates.

On economic ignorance

Madsen takes a poke today on his site at people who don't allow their ignorance of economics to stop them from making illiterate proposals.  In language considerably more temperate that Tim Worstall uses, Madsen suggests that some people think they can bring about a new economic reality simply by wishing it into existence, without the slightest idea of the complexities they are dealing with, or of the unintended consequences that their proposals might bring about:

This tendency seems nowhere more true than in economics.  The average ignoramus hesitates to propose how theoretical nuclear physics should proceed, but feels quite at easy making economic proposals that seem plainly daft to anyone who has the slightest knowledge of the subject.  If anything, economics could well be more complex than theoretical nuclear physics because it deals with objects that are profoundly dissimilar in more respects. Yet some people think they can make a new economic reality simply by wishing it so.

Madsen is right.  Open your newspaper, watch television or read Hansard, and there you'll find scores of them, maybe hundreds. Economic illiteracy has never had it so good.

Good drugs and supporting markets

Good drugs lead to support for the market system. Umm, no, not that sort of recreational pharmaceutical, that's not what I mean. Rather, that the system which produces good pharmaceuticals is an example of how and why a market based system is superior to a planned one. Take this from Corante, discussing Nassim Taleb's view of finance:

Well, those of you out there who've heard the talk I've been giving in various venues (and in slightly different versions) the last few months may recognize that point, because I have a slide that basically says that drug research is the inverse of Wall Street. In finance, you try to lay off risk, hedge against it, amortize it, and go for the steady payoff strategies that (nonetheless) once in a while blow up spectacularly and terribly. Whereas in drug research, risk is the entire point of our business (a fact that makes some of the business-trained people very uncomfortable). We fail most of the time, but once in a while have a spectacular result in a good direction. Wall Street goes short risk; we have to go long.

A planned system, whether it be an economy, a business or a sector of either, is always trying to reduce the risks of whatever it is that is being done. Most importantly, to reduce the risks  of failure. A market system allows any and everyone to chase their wildest dreams, lunatic or not. That is, a planned economy is short risk and a market one long. 

And the thing is, in order to get the sort of transformations of the entire economy that we need in order to keep this wealth creating juggernaut on the road we need to be long that risk. As William Baumol has pointed out, as Paul Krugman has noted, planned economies have extreme difficulty in increasing total factor productivity. Market ones seem to manage it, as least they have for the past couple of centuries, at a fairly steady clip 2% a year or so decade after decade. This is the very result of such economies being long on risk. People just doing their own thing, without central plannning and risk reduction. Most fail- the vast majority fail- but that's what being long risk means. We explore the possible technological space, find that most of it's not worth anything but are able to quickly seize upon those parts that are.

It's unconstrained exploration that makes market economies work: exactly the very thing that planning abhors and abjures.