The Pin Factory Blog

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.

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.

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.

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.

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, 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.

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.

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.

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.

Peak Oil is the idea that one day there just won't be any oil left and civilisation will fall over. Or for the more discriminating but no less wrong, that one day we'll be producing less oil than the oil that is demanded and thus civilisation will fall over. The major problem with these and other flavours of the same prediction is that they ignore price. If demand for oil is greater than supply of it then the price will rise. Thus there never actually is a possible position where there is no oil and civilisation falls over. The newspaper home of this idea here in the UK has always been The Guardian. So it's something of a surprise to see that same paper saying this:

But the truly global implications of the International Energy Agency's flagship report for 2012 lie elsewhere, in the quietly devastating statement that no more than one-third of already proven reserves of fossil fuels can be burned by 2050 if the world is to prevent global warming exceeding the danger point of 2C. This means nothing less than leaving most of the world's coal, oil and gas in the ground or facing a destabilised climate, with its supercharged heatwaves, floods and storms. What follows from this is that the idea of peak oil has gone up in flames. We do not have too little fossil fuel, we have far too much. It also follows directly that the world's stock markets are sitting on toxic levels of subprime coal and gas, a giant carbon bubble ready to explode.

Still nutty of course. For it's still ignoring the role of price: in this case, the relative prices of using oil and having climate change or not using oil and not having climate change. Our whole and entire problem with the whole subject is that, as best we can guess, the no oil no climate change option would be more expensive than the oil and change one. Certainly it would be vastly more expensive if we tried to implement it today. Perhaps it won't be in 50 or 100 years. But that is actually our problem today: no oil today means billions die. This is indeed more expensive than having some climate change.

But there's something else much more interesting here. This idea that we must not, indeed cannot, use all of the fossil fuels we already know about. Fossil fuels that are embedded into the stock market values of a number of companies. If we all believed that these fuels would never be used then they would be valued at nothing (or perhaps a small option value). They're obviously not so we don't so believe.

However, there are those campaigning that we should leave them alone. And one would assume that they expect to be successful at saving the world. Which is something we can test of course, their own beliefs about how effective they are going to be. If they do believe that they'll keep those fuels in the ground then obviously all those energy companies will, in the future, be worth a lot less than they are now. Which is an arbitrage opportunity: they should be short those stocks. If they're not, they don't think they will be successful: if they are they do. So, Greenies, where are your pension funds?