Author Archives: Jonathan Finegold

Conceptualizing Price Distortions

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If the real world is always in disequilibrium, meaning most (or, all) prices are never their equilibrium values, how can we give meaning to concept of price distortions? Specifically, how does the “transmission mechanism,” so to speak, of the Mises–Hayek theory of intertemporal discoordination work, if prices are always, in a sense, distorted? Mises and Hayek placed emphasis on the concept of relative prices, to draw attention to differences in the movement of prices of goods belonging to different stages of production (on aggregate, we can talk about the relative price of producers’ goods to consumers’ goods). To give meaning to their theory in a world of disequilibrium, we should also emphasize the concept of profit and loss. Indeed, what we typically refer to as a price distortion may be better termed a distortion of profit.

In equilibrium, prices perfectly reflect the goods’ opportunity costs, and the market process is irrelevant, because all goods are already perfectly allocated — this world is changeless, since change would change the equilibrium value of the goods in question. It follows that in the real world, where the market process is, by virtue of experience, always in a state of change, prices do not perfectly reflect goods’ opportunity cost. Does this imply that these prices are “distorted,” whether it be as a result of government intervention or an outcome of the kaleidoscopic market process? In the very narrow sense of disequilibrium, sure, but I don’t think what most people have in mind when they talk of price distortions.

In a world of non-equilibrium prices, how do economic agents coordinate? To explain this, economists of the inter-war era, including Ludwig von Mises and Frank H. Knight, looked to profit and loss. If we assume, for the sake of simplicity, that all equilibria are perfectly competitive, profit and loss can only exist in a world of disequilibrium. Profits are earned by exploiting price differentials, and losses accrue by poorly estimating price differentials. These two related phenomena make up one of the market process’ most important feedback mechanisms. Profits are signals for other entrepreneurs to allocate their capital towards the production of output where profits are relatively high, while losses are a signal of overinvestment. Losses and profits also force the redistribution of capital from entrepreneurs who preform poorly to those who do well, and this process of redistribution continues perpetually, meaning it’s receptive to the fact that entrepreneurial success, probably, has as much to do with luck as it does with skill.

Within the context of profit and loss, the way I conceptualize non-distorted market prices is to look at possible prices as a range. This range is bounded by profit and loss, such that a highly inaccurate price will bring either extreme profit or extreme loss, pushing the price in the opposite direction as entrepreneurs react. In The Market as an Economic Process, Ludwig Lachmann urges us to look at both sides of the coin when emphasizing that all coordinating forces can also cause discoordination, and vice versa. For example, an entrepreneur who is seeking to exploit the profitability of a certain market will throw off other entrepreneurs who seek the same end, if the degree of future competition in that market is not well predicted. This is how I look at, what we can call, market bounded prices, where prices in disequilibrium implies some degree of discoordination, but at the same time the profits and losses which stem from disequilibrated prices help coordinate market agents.

When thinking of the distortion necessary to bring about sustained intertemporal discoordination, it may be easier to think about it in terms of profit and loss — or, in terms of constrained price ranges.

Suppose that some hypothetical, advanced market economy enjoys a banking system where there is a single currency. Individual banks are not allowed to issue their own banknotes, but must acquire them from official mints, controlled either by some government or by a central bank. The lack of competitive currencies eliminates an important disciplining mechanism, which is the constraint private banknotes place on the banks themselves (where excess notes are ultimately returned to the bank for redemption, either for some metallic money or for some other backing asset). This lack of a disciplining mechanism makes fiduciary over-issue (the supply of inside money beyond the demand for it) not only more likely, but it also lifts the constraints on the extent of the over-issue, such that the supply of money can exceed the demand for it for a significantly longer period of time and at a much greater volume.

According to Austrian capital theory, since money is non-neutral, new money will impact some prices more and sooner than others, implying that the social distribution of new money is unequal. Consumer credit complicates our analysis a little, so for the sake of simplicity we’ll assume it to be irrelevant. Banks typically issue new money through the loanable funds market, implying that people borrow it — new money is created during the process of the intermediation of savings. If the increase in the supply of money is met by an increase in the demand for money, we can assume that all new loaned money represents social savings. In the case of a fiduciary over-issue, there is some fraction of total new money that does not correspond to savings, causing intertemporal discoordination. This is because money lent through the loanable funds market, on average, is invested, meaning it targets a specific set of goods: capital goods.

We can interpret Austrian capital theory as a theory of the optimal intertemporal distribution of capital goods (all goods which are not consumers’ goods; usually, original factors of production [land, labor, et cetera] are not included, but for simplicity’s sake I do). To help form of an idea of what Austrians have in mind, imagine production to take over a series of stages. The last stage, which provides the final consumers’ good, requires certain inputs, and the production of these inputs make up the second stage. To manufacture these inputs, in turn, these firms require other inputs, and the production of these makes up the third stage. This continues until the earliest stage, whose inputs are original factors of production. Reality is a bit more complicated, but this abstract model helps capture what Austrians have in mind. The length of the structure of production, that is the number of stages, is determined by social time preference, or the ratio between saving and consumption. The volume of production within a given structure, though, is determined by the capital stock (the greater the capital stock, the more you can produce).

Money is relevant to the intertemporal distribution of capital goods, because it’s money prices, and profit and loss, which guides the allocation of goods over time. Assume all new money is lent to entrepreneurs. A fall in consumption lowers the price of consumers’ goods, increasing the relative price of labor in those industries. As a result, these firms increase their demand for labor saving machinery, raising the prices of these capital goods. An increase in savings will allow entrepreneurs to borrow these and invest them in the production of this machinery, which in turn will increase the demand for the inputs required to produce this machinery, and this continues, theoretically, until the rate of profit in each stage is equalized. In a world of disequilibrium there will always be discoordination, but it should be randomly distributed, and profit signals will help constrain the degree of discoordination.

The problem of an excess supply of money, then, is that it will raise the profitability of manufacturing capital goods, and therefore alter the structure of production, without simultaneously increasing the stock of savings. A conflict between consumption and investment is created. Within the context of bounded market prices, what excess money creation does is change the range of possible market prices. As long as new credit increases at an accelerating rate (which fits with the data on credit creation preceding real world demand crises), these distortions of prices, and therefore profit and loss, will be sustained. In other words, the distribution of error is no longer non-random, but guided by distorted signals. This is why Austrians (borrowing from Murray Rothbard’s America’s Great Depression) call attention to the “cluster of errors,” rather than entrepreneurial error itself. The distinction between random and non-random error helps understand how Austrians interpret the phenomena of the demand-driven business cycle.

Illustrating this process with a Hayekian triangle and a production possibilities curve may help,

Output Combinations and the Hayekian Triangle

I ≡ investment; OC ≡ consumers’ goods; OP ≡ producers’ (capital) goods. In equilibrium, there is a specific point on the production possibilities curve (PPC) the economy will be in. Given how the axes are termed, the slope of the tangent of the equilibrium point will be equal to –PP/PC (the relative price of producers’ goods). We can see how an increase in savings and investment leads to a lengthening of the structure of production (represented by the triangle), as goods originally allocated in stages nearer the consumer are re-allocated towards earlier stages of production. This entails a movement down the PPC, as relative prices change. Therefore, an oversupply of money will cause this save movement, but without a change in social time preference, such that when relative prices re-adjust, a movement back to the original point must occur. This movement back to the original point is the depression (and recovery), and is aggravated because of the sudden collapse of demand — the distribution of profits and losses change, and those earning sustained profits during the boom are now subject to the losses that come with prices returning to the bounded range that better reflects the underlying opportunity costs of the goods in question.

Austrian business cycle theory — what I call the Mises–Hayek theory of intertemporal discoordination — is usually modeled with microeconomic tools which are built around the concept of equilibrium. This is done, because it’s easier. But, it’s fundamentally a disequilibrium process. It can only happen in a world where there exists profit and loss, and changes in prices. It entails a shift from a random distribution of losses to a non-random distribution of losses, caused by the distortion of prices that comes with an over-issue of money. Conceptualizing it in a world of disequilibrium only requires being creative with how we interpret the models used to illustrate the process.

Private Defense … on the High Seas!

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The Economist asks, “what happened to Somalia’s pirates,”

But the main reason for the drop in maritime hijackings seems to be that ships are now far better defended against attacks. Armed guards, now carried by more than 60% of vessels, have been essential in discouraging them. Pirates are playing it safe by first scouting for guards, whereas previously they opened fire to intimidate crews; seeing arms on board is a big deterrent. Higher cruising speeds in pirate-infested zones and rerouting also have helped, as have razor wire, high-pressure hoses and citadels—secure spaces on ships from which crews can call for reinforcements.

Also, The Economist links to a short blurb on mercenary naval forces, which shipping companies can hire to protect their convoys.

Quote of the Week

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Left Behind (Edwards)In a series of articles I used large data set and advanced statistical techniques to analyze the dynamics of economic growth in the emerging economies. This work focuses on the way in which severe shocks affect the deviation of economic growth from its long-term trend. My research indicates that a 10 percent improvement in terms of trade translates to approximately 1 percent acceleration in the rate of economic growth above its long-term trend. This means that all of Venezuela’s growth during the Chávez administration may be attributed to higher oil prices. Indeed, the data suggests that if it weren’t for the oil boom, Venezuela would have experienced a negative growth in income per capita during the years of the Bolivarian revolution.

Some have argued that there is a trade-off between encouraging economic growth and pursuing greater equality. According to this view, countries that want to improve social conditions for the poor and reduce inequality will grow more slowly than countries who economic policies focus exclusively on growth and ignore social goals. It is possible, then, that Venezuela’s mediocre record of growth could be justified by great improvements in the well-being of the poor. Unfortunately, there is little evidence that conditions for the poor have improved greatly. In an article published in Foreign Affairs, economist Francisco Rodríguez has argued that Chávez’s social policies record is mediocre — indeed, that it is arguably worse than the country’s economic growth record. Rodríguez’s article is noteworthy because he has not been particularly enthusiastic about the Washington Consensus; quite the contrary, for years he was an articulate critic of globalization. Using official statistics Rodríguez concluded: “Most health and human development indicators have shown no significant improvement beyond that which is normal in the midst of an oil boom. Indeed, some have deteriorated worryingly, and official estimates indicate that income inequality has increased. The ‘Chavez is good for the poor’ hypothesis is inconsistent with the facts.”

— Sebastian Edwards, Left Behind: Latin America and the False Promise of Populism (Chicago: University of Chicago Press, 2010), pp. 200–201.

N.B.: “Terms of trade” refers to a ratio between a price index for exports over a price index for import. An increase in the terms of trade, therefore, means that for each good exported, on average, you can purchase more imports.

Boycotting Bangladesh

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A fire at a Bangladeshi garment factory, which killed eight, has revived calls to boycott firms which take advantage of Bangladesh’s — and other countries with similar conditions — relatively low labor and safety standards. Matt Zwolinski, at Bleeding Heart Libertarians, has a few links you can follow. It’s becoming more acceptable to combat calls for boycotts, because more people are becoming aware of the fact that in poorer societies people will choose to work more dangerous jobs for a lesser wage, and that this state of affairs is better than having no wage at all. Despite the benefits of foreign direct investment, even where there are low labor standards, I’m not so sure we should discourage boycotts against firms that we perceive to be doing wrong.

There’s a common perception that the developing world is in a “race to the bottom.” The idea is that emerging markets, desperate to attract foreign direct investment and foreign capital, will undercut each other’s labor, environmental, and safety standards. The claim has been shown to be wrong. But, it’s not out of the benevolence of firms and foreign governments. Instead, firms often avoid countries with the lowest standards, because if it leads to bad publicity the loss in profit is greater than whatever gain in lower costs. In other words, public relations and the threat of consumer retaliation is one important factor which maintains a floor to global regulatory standards.

Universal labor standards are usually discouraged, because people are afraid that such standards will put relatively poorer emerging markets at a disadvantage. The concern is well founded. These countries tend to suffer from low capital accumulation, extractive institutions, a lack of local finance and the rule of law, which discourages local investment, et cetera. The value of these markets’ labor is comparably low. Any additional costs which effectively make for a price floor, above the optimal wage, will leave workers within shifting margins out of work. Thus, while Bengladeshi laborers may suffer from a high risk of injury and/or death at the factories they work at, this is undoubtedly better than the alternative of no work at all. It’s also worth mentioning that foreign direct investment also implies greater competition for labor, which leads to capital accumulation (to increase the productivity of labor) and, therefore, an increase in wages.

But, we can advocate consumer awareness and boycotts without, at the same time, advocating for universal standards. There has to be some means by which workers can bargain with their employers, whether directly or indirectly. Unionization, in these countries, is rarely an option, and free-market oriented economists typically dislike unionization anyways (well, as long as the unions are protected by government — which is the only way I see that they’ll actually be effective). The answer is to pressure firms to bargain with laborers, by threatening their profits. Firms will raise their costs if it means that by doing so they can maximize their profits. We shouldn’t be afraid of using the tools that come with public relations and consumer awareness.

What I have in mind is bargaining of time and place, where labor standards can change in the context of local conditions. A country with higher unemployment and less productive wages will be one where laborers have less room to bargain in, because the firm can minimally raise standards to appease consumers elsewhere and force laborers to accept them (or they’ll replace them with workers willing to accept whatever standards the firm has settled on). But, as productivity rises and competition for labor grows, the bargaining room expands with it. And, this type of process is pretty much what we want to see. We want laborers to be able to bargain for wage changes, even when these wages are put in terms of safety standards, healthcare, et cetera. Consumer awareness is an ally of labor movements, because they can help add pressure on the firm, where employees may not be able to.

The check on firms that good public relations creates is a good alternative, especially, when the nations in question are governed by extractive and broken political institutions. The connection between consumer awareness and firms’ relations with their employees is a good alternative to the political process. That is, it’s a private solution to what’s usually considered a public problem. I think that it forms part of the microeconomic dimension of spontaneous order, especially since all actions and decisions are based on local knowledge — there is no rational planning involved. It helps build the institutions — the rules of the game — which lead to what we today consider modern, advanced society. I think this is the best way to look at it. Instead of seeing it as a knee-jerk reaction to what we perceive as immoral corporate behavior, economists should accept it as part of the process of spontaneous order. Ultimately, these are the type of things which would exist in a hypothetical stateless environment, where the market process has to substitute for a lack of analogous political processes that aim for the same ends.

Keep in mind that this is just a thought I had, and I haven’t put in a lot of time to rigorously think about it. But, it’s something worth considering.

Am I the Only One…

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…that finds it shocking that the following was written in the “leading trade theory textbook,”

International Economics (Krugman)When they were first proposed, market failure arguments for protection seemed to undermine much of the case for free trade. After all, who would want to argue that the real economies we live in are free from market failures? In poorer nations, in particular, market imperfections seem to be legion. For example, unemployment and massive differences between rural and urban wage rates are present in may less-developed countries.

— p. 227.

To be clear, this is part of a single paragraph, and by no means represents the entire book. The book is very good, and if you’re looking for a textbook introduction to trade theory and international monetary policy, I definitely recommend it. And, no, it’s not anti-free trade, although not everything would be found in a hypothetical analogous textbook by Mises or Rothbard (e.g. optimal tariff theory, market failure arguments for tariffs, et cetera — and my intention isn’t to disparage the latter two authors, especially since I’d mostly agree with them).

However, in my opinion, that’s a shocking statement. There are market failures. The market often fails to coordinate. But, to blame poverty and mass unemployment in the developing world on market failure seems disingenuous, and I mean that word with all of its implications. Many of these problems are caused by failures of those countries’ political institutions, and this shouldn’t be controversial. Economists have blamed bad policy on poor economic performance since the birth of the discipline. More formal and more recent research on institutions has expanded on our intuitions.  Market failure probably explains very little of poverty in the developing world. What those economies need are freer markets.

Economicthought.net

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Believe it or not, after what will soon be a year and a half, I have something planned for economicthought.net. To some extent, it will act as a personal website — I will probably have my CV there. But, more than that, I’ve always wanted to have something like the Mises Daily system. At first, I might run a column once a week. If at some point I can interest others to write for the website, I’ll gradually work it up to an article per day (or more!). It would be mostly dedicated to economics, but other social sciences may be featured, as well: sociology, political science, philosophy, et cetera. Neither would it be restricted to a particular ideology or school of thought. I’m looking for some plurality in the points of view expressed in the articles (of course, for as long as I’m the only writer, the articles will reflect my own beliefs).

I’m not sure when the website will be up. I had a stroke of luck when my girlfriend just happened to have a degree in graphic design, with the added plus of plenty of webdesign experience. I’m having her design it for me. Then I have to negotiate with one of her co-workers, who does the actual coding, to see if I can get it done for an affordable price. I’m hoping that it will be done on the WordPress platform, as well, so that it’s easier for me to update then when I need to, and it’s easier to publish. At first, the website is going to be relatively basic: an article system and this blog. Even with only these two features, it might take some time to piece the whole thing together, given the shoestring budget. I originally thought of some kind of discussion forum, but those are always a pain to moderate, and there’s already one that seems to be taking off after the Mises.org forums were closed.

But, I’m glad I finally figured something out, because otherwise the economicthought.net page would probably indefinitely keep looking the way it does right now. At first, especially since this is my blog, the website is meant to sell me, in the sense that I can network through it. But, ultimately, I really want this to be a significant part of the Lachmannian “commerce of ideas.” And not one just restricted to academia, but one open to all and designed for all.