Category Archives: Economics

Kirzner, Mises, the Entrepreneur, and the Market Process

Daniel Kuehn has a string of interesting posts on Israel Kirzner and they have pulled me from my slumber.1 I want to defend Kirzner, but at the same time I agree with Daniel that maybe Austrians have ignored “mainstream” contributions to market process economics. While I can’t claim to be superbly well read on Kirzner, I do feel comfortable making the claim that maybe Kirzner’s (main) contribution was much more narrow than many Austrians suspect the entrepreneur’s role in the market process, rather than the market process in general.

First things first, I suspect one of the following happened: (a) Daniel misunderstood Kirzner; (b) Kirzner did not communicate his argument well. (I’ve already commented on this on Daniel’s blog, but hopefully he won’t mind if I repeat myself here.) Daniel claims that Kirzner made an elementary mistake is confusing value for prices. If that’s true, I agree with Daniel. But, then I think that Kirzner articulated his point poorly.

If I interpreted Competition and Entrepreneurship correctly, Kirzner cares about prices not values. Specifically, and following Mises, he argues that the entrepreneur’s role is to notice disequilibria between factor and final good markets. To illustrate this line of reasoning in terms of equilibrium, suppose that the final goods market is producing at qc(uantity) < qc*, and let’s assume that this implies that the the price for factors of production is pf < pf*, such that if the entrepreneur buys at pf he’ll be able to sell at a price that corresponds to qc*, but at a cost that corresponds to qc. Kirzner is explaining pure profits, not surplus value.

It is, I think, more-or-less the same point that Frank Knight makes in “Profit and Entrepreneurial Functions,”

In the theory of competition, all adjustments “tend” to be made correctly, through the correction of errors on the basis of experience, and pure profit accordingly tends to be temporary. While it exists, in a positive form, it may obviously be regarded as a phenomenon of monopoly, and some distinction, which can never be clear, must be made between temporary profit and permanent monopoly revenue.

— p. 128.

(Kirzner, however, would disagree with the notion that profits are a monopoly phenomenon.)

What of the claim that the “mainstream” ignores the market process? I can’t agree with this argument, because I think there is a large “mainstream” literature out there that talks exactly about the market process, although perhaps not in a way that Austrians can readily identify. In fact, I think that there are several theories out there which go beyond Kirzner and, actually, explore many areas that Kirzner maybe didn’t recognize.

Consider the debate between Ludwig Lachmann and Kirzner. Both agreed that there are equilibrium and disequilibrium “forces” at work; they disagreed on what the net outcome has to be. Kirzner believed that markets ultimately equilibrate, while Lachmann held the much more ambiguous position that we can’t know for certain, at least in an a priori sense. Doesn’t the literature on job market search frictions and monopsonistically competitive labor markets prove Lachmann right? Things like employee loyalty to their firm, or imperfect knowledge of labor markets, other forms of transaction costs (e.g. transportation costs), suggest that maybe there comes a point where markets won’t equilibrate further (given a set of institutions). Finally, don’t these results contribute to our understanding of the market process?

Speaking of institutions, doesn’t Akerlof’s “Market for Lemons” paper, when properly interpreted, give us quite a bit of insight on the market process and institutional change? Coming back to the Lachmann-Kirzner debate, Akerlof’s insight actually seems to back Kirzner if markets don’t equilibrate [the way we want them to] under one set of institutions, we’ll develop new institutions to get them there. Moreover, to posit that agents will introduce new rules (e.g. reputation, guarantees, et cetera) seems to implicitly assume that there are agents willing to capitalize on new profit opportunities.

Likewise, I interpret New Trade Theory as belonging to the study of the market process. Paul Krugman, and others, provided insight on how markets respond to changes in population size and, more fundamentally, how markets can form at all, if we assume that there are no comparative advantages at t0. This is a dynamic theory at heart, so it must say something about the market process (something that many Austrians have been quick to dismiss). Perhaps New Trade Theory has a more narrow focus than, say, Mises’ discussion of profit and loss, but that doesn’t mean that it doesn’t offer any process theory insight at all.

Sure, maybe these theories are framed in terms of equilibrium not unlike Kirzner’s theory, mind you , but they’re suggestive of the fact that maybe the “mainstream” thinks more about the market process than Austrians give them credit for. So, in this regard, I completely agree with Daniel. In fact, I could go as far as to claim that, rather than Austrian contributions being underestimated by the “mainstream,” perhaps the Austrians have underestimated “mainstream” contributions. Or, maybe there’s a little bit of both going on.

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1. This site has been loading very slowly. The servers I contract through aren’t working out, but hopefully I’ll be able to move the site to new servers soon.

Fractional Reserve Banking Made Simple

I’m about to kick a dead horse, but every once in a while you see the horse’s ghost gallop about the internet. The notion that fractional reserve banking is “fraudulent” and “unstable” is a “brain worm” that deserves to be extinguished.

Part of what a bank does is intermediate between savers and borrowers. When you put your money into a savings account, the bank will lend it out. Fractional reserve banking works the same way, but deals with relatively liquid type of deposits. There’s nothing fraudulent about it.

I’m relatively young and I don’t make a big income, so I keep a good amount of money in a demand deposit. If I ever unexpectedly need it, it’s there. Most of the time, it just sits there. Anything not being presently consumed is being saved for future consumption, so those dollars are savings — just like a savings deposit, but (given regulatory rules) with no interest and greater liquidity. The bank will lend these savings out.

Are there two claims on the same money? In a sense, yes, but that’s true with just about any savings vehicle. The money you’re lending is yours, you’re just not currently spending it, so it can be lent out. You might argue that the problem with fractional reserves is when depositors go to the bank to withdraw their money. This isn’t an issue unique to deposit banking. It’s called a maturity mismatch and it can happen with any kind of asset. In fact, it’s something that is inherent to banking: banks borrow short and lend long.

The “trick” is to manage these different assets and rely on the law of large numbers to make sure you always have the sufficient liquidity to pay-off short-term liabilities. That’s what successful banks accomplish. Without the ability to juggle assets of different term lengths, the intermediation industry is going to be very inefficient.

What’s the relationship between fractional reserves and economic crises? Some see that many financial crises are preceded by bank runs, so they conclude that it must have been the maturity mismatch that was at fault. It’s strange, actually, that some Austrians would believe this, because they’re the ones always stressing about their peers mistaking the symptoms (the crash) for the cause (credit expansion). Business cycles are caused by excess supplies of money, which change the distribution of profits. When money supply growth begins to slow down this distribution changes — thus, the sudden loss in profitability for large swaths of industry.

Just because too much sugar is bad for you doesn’t mean all sugar is bad. There’s nothing inherently destabilizing with fractional reserve banking as long as excess money is minimized. What’s the difference between “excess money” and lending on fractional reserves?

Like with any other economic good, there is a point at which demand and supply are equal. Unlike many other economic goods, money has to clear in multiple markets. When the demand for money increases, ignoring for a minute the ability to increase supply, the prices of other goods that exchange for money have to decrease in order to clear against the higher relative value of the currency. If prices don’t clear and exchange suffers, we call that a shortage of money. On the other hand, if there’s more money than people are willing to hold, this is called excess money. It will continue to circulate (the “hot potato” effect) until it returns for redemption or the price level increases, the relative value of money falls, and demand and supply are again equal to each other.

That a bank lends on fractional reserves doesn’t really say anything about whether there is excess money. When the demand for money increases, the volume of deposits might swell (the amount of liabilities returning to the bank for redemption will fall) and it will allow the bank to issue credit. In this case, the banking system is increasing the supply of money to meet the heightened demand. That’s why, if you’re worried about the business cycle, blaming fractional reserve banking is the wrong way to go. What you should really be worried about is surplus money.

How do we accomplish limiting the ability of banks to create liabilities, without enforcing full reserves? Through coordinating monetary institutions (rules or constraints), which may include:

  • In a competitive banking system, banks holding other banks’ liabilities will send them in for redemption, draining on the issuing bank’s assets. If a bank over-issues money, it will suffer from illiquidity. If a bank under-issues money, they will be foregoing the revenue they could have earned had they maximized the use of their assets.
  • If banks could pay competitive interest on demand deposits, they’d have to raise this rate to attract new deposits to fund their lending. But, as the supply of loanable funds increases, the rate of interest on these loans will fall. If the latter rate (on loans) falls below the former (on deposits), the bank is making a loss.

That’s why it pains me when I read Austrians cheering for recent IMF studies and old Chicago research papers supporting 100 percent reserves. They’re worrying too much about the symptom and they don’t realize that they’re supporting the cause: bad monetary institutions (after all, it’s not like these IMF and old Chicago School economists are advocating for free banking).

Techno Economics

The Electric Daily Carnival is a major music festival that takes place every year in a number of cities, originally in the U.S. but not spread to U.K. and Mexico. You may remember an article of mine on EDC, which I wrote back in 2011.There I discussed some qualitative aspects, with my mind on prohibition in particular. I discussed how the market helps mitigate some of the adverse consequences of drug use, while the government tends to do the opposite of help.

Dancing Astronaut has an interesting infographic on with hard data on EDC’s economic impact on Las Vegas. They find that total spending amongst attendees was $158 million, and broken up into more specific categories the distribution of that income looks as follows:

  • $52.2 million → Food and beverage
  • $29 → Hotel rooms
  • $25.6 → Transportation
  • $22. 7 → Gaming
  • $15.2 → Entertainment
  • $13.7 → Retail spending

$20 million eventually became tax revenue. According to the infographic, $131.9 million represents “increased labor income,” which I’m assuming means wages/salary. To put that figure into context, that’s 83.5 percent of total cash flow.

To me this says something about the “labor v. capital” inequality question. Sure, EDC, hospitality, and most of these other industries are labor-intensive. Other sectors of the economy, particularly manufacturing, might see distributions of income between the two factors that are different. But, aren’t we see seeing a structural shift towards the service sector? Aren’t we moving back to a labor-intensive dominant economy? In Capital, Thomas Piketty ascribes human capital to labor. It seems to me, when comparing margins, the return to human capital is quickly growing relative to the return to much of the physical capital the growing service industry uses.

Ancient Athens’ Economic Freedom Ranking

The abstract:

We use the Economic Freedom Index to characterize the institutions of the Athenian city-state in the fourth century BCE. It has been shown that ancient Greece witnessed improved living conditions for an extended period of time. Athens in the fourth century appears to have fared particularly well. We find that economic freedom in ancient Athens is on level with the highest ranked modern economies such as Hong Kong and Singapore. With the exception of the position of women and slaves, Athens scores high in almost every dimension of economic freedom. Trade is probably highly important even by current standards. As studies of contemporary societies suggest that institutional quality is probably an important determinant of economic growth, it may also have been one factor in the relative material success of the Athenians.

— Andreas Bergh and Hampus Lyttkens, “Measuring Institutional Quality in Ancient Athens.”

I Welcome the Terminator

Before I start with anything else, I apologize for the lack of writing. I work at a marketing agency and I just have not had much time for anything else recently. In fact, I haven’t been thinking much about economics at all. I’m stimulated when I read, and I haven’t found the opportunity to finish what I’m currently working through (The Order of Public Reason), so I’ve felt uninspired lately — I totally get where Nick Rowe is coming from, although my mean is well below his. Not being able to think or read about econ totally sucks, by the way!

I did, however, enjoy a “nice” economics discussion during last weekend’s Shabbat dinner. Someone asked me if I thought robots could ever completely replace workers. I said ‘no.’ I should have added the caveat that if it turns out the answer is ‘yes,’ we should all be quite happy about it. I, for one, am looking forward to the day that I no longer have to work, because we live in a world of superabundance. Of course, in order to imagine a world where robots replace the human labor force we have to assume superabundance, because as long as there’s something else to produce there’s always work to be done (and an income to make).

Bastiat put the case more-or-less like this. Does the home worker complain about replacing hand washing laundry with a washing machine? No, because that person now has time to do something else — the robot helped to complete two tasks within the same amount of time; it makes the home worker better off. The benefits of capital don’t stop at washing machines. The reason we employ machines is to increase our productivity and make us better off. The more we can produce, the more we can consume.

What about “labor saving capital?” Remember, there is a difference between partial and general equilibrium. McDonalds might have a touch-screen computer replace its cashiers, to reduce its payroll, but that doesn’t mean that there is nothing else that cashier can do. That person can find work as a construction worker, or a bus driver, or a graphic designer, or whatever that person can find a demand for. Maybe one day someone will create a program to auto-write premium website content, which allows marketing agencies to let go of all of their content writers. While writing no longer be a skill in demand, there are still many other types of jobs content writers can do — “worst case,” they can bag groceries.

The day humans no longer have work to do is the day we live in superabundance. What does superabundance mean? I believe human wants are limitless, but let’s say that there is a point of comprehensive satiation, defined as Y. As long as capital, or robots if you’d like, produce less than Y, say X, there are YX goods that still need to be produced. That’s the stuff that humans can produce. Suppose X is a very large number which is actually not that far off from Y. To make it clearer, what if capital produced 95 percent of economics goods and humans only the other five? We can all agree that it would be pretty awesome if we had machines doing most of the work for us, so that we can enjoy the combined fruits of “our” (robots don’t need to consume, after all — Bender aside). At the point where capital produces Y, we have reached superabundance; there is nothing else we want. It’s what Nirvana would be if the Buddhists were materialists.

I’m all for robots taking our jobs. It makes us better off, because it allows us to consume more than we previously could (we can consume more for the same amount of labor we expend). What’s unfortunate is that we’re still a long way off from being completely replaced by robots in the labor force. Although, I did overhear my company talking about replacing its content writers with content generators (is there a content generator that writes as well as a trained copywriter?). What I find surprising, in any case, is that only one person at the Shabbat table agreed with me on this.

Tenure as a Division of Power

A California judge recently declared tenure unconstitutional. A lot of people are rejoicing, because they think this means that bad teachers will no longer be excessively protected from being fired. While the public school system needs a remake, to put it lightly, people might be jumping the gun on tenure. It may have costs, but tenure also has benefits. The problem with public schooling isn’t tenure, anyways; the problem runs down to the roots, school administrations.

Tenure limits administration’s power on teachers. It can give teachers the independence to choose their own approach to educating their students. Sometimes it turns out badly. More often, it stops the administration from dictating the curriculum. It puts a limit on pressure placed on the teacher to change their curriculum for the worse. This element of the debate reminds me of the argument in favor of independent central banking. Some people noticed the Federal Reserve’s poor response to the recession and called for an end to central bank independence. The problem with that is a central bank directly controlled by government is one in a position to help that government at the expense of the people — such as when government uses its central bank to finance its spending. The benefits may outweigh the costs.

School administrations can be very political. I have first-hand experience through my dad, who is a high school teacher. Yes, I did let him know what most libertarians think about public schools. If it wasn’t for tenure, my dad would have probably been fired a long time ago. You might be thinking, “He probably deserved it because he was a horrible teacher.” You would be wrong. The administration pressures him to raise the grades of students who don’t do their homework, who don’t study, who fool around in class, and who generally just don’t care about their education. The administration wants to look good in front of the parents and they want their statistics to shine. These create perverse incentives. My dad is an AP Spanish teacher and to punish him they took away his AP Spanish Literature class. AP test scores in that class plummeted. The administration doesn’t always punish instructors for good reasons, they do it for very bad reasons.

Few people look at the administration. Maybe this might catch your attention: Sweetwater Union High School District, in San Diego country, was recently rocked by a corruption scandal. Top school administrators were caught siphoning “gifts” received for preferring certain contractors over others. That shows how much they care about the kids.

Oftentimes schools push sports rather than academics, because that’s what some parents want — some parents couldn’t care less about their children’s education, or they think that there isn’t a trade-off when they push for funding elsewhere. Yes, many parents are negligent; you see this a lot in lower income schools (see also “Have and Have Nots“). The administration wants to look good, and this creates perverse incentives. Removing an institution that limits their ability to control  teachers risks making our schools worse off.

I am not saying teachers are saints. I oppose teacher unions. I told my dad it was ridiculous that he was protesting the reduction in his salary after the economy collapsed. He doesn’t seem to understand that if there’s less money to pay him, he might have to take a salary reduction or else risk losing a job (actually, he has seniority — tenure aside —, so it would just be a hypothetical future hire who is now unemployed). I also disagreed with his decision to oppose a recent reduction in healthcare benefits. I thought, “Great for the taxpayer.” But, actually, no. As is turns out, most of the money saved from reduced healthcare benefit was just allocated somewhere else — and definitely not towards improving the quality of the schooling, because the teachers had to fight to reduce things like classroom size, as well.

Finally, it’s worth mentioning that tenure, strictly speaking, doesn’t protect teachers from teaching poorly. Bad teachers can be fired. It might be more difficult, but that’s because the reasons for firing the teacher have to be legitimate and well documented. The thing is, the administration is so bad at doing its job that it’s negligent at the time of monitoring and documenting bad teaching. School administrations are a libertarian’s worst nightmare: extremely inefficient bureaucracies. Bad teaching is more common than it should be not because the administration has its hands tied, but because the administration is inept.

By the way, libertarians should be receptive to the notion that tenure is an institution that establishes some degree of “teacher independence.” In many cases, your favorite libertarian thinker is able to publish a constant stream of libertarian-oriented literature only because he or she has tenure. Otherwise, that person would be writing on some other topic — some topic that would keep that person employed —, at the expense of the libertarian movement. But, tenure doesn’t necessarily cause these professors to reduce the quality of their teaching. (Sometimes the worst teachers are the most liked by the administration, because they’re the ones who focus too much on their research and too little on their students. Publishing in top journals makes the school look good, though.) Oftentimes, tenure creates a positive effect on education, like the ability for a tenured professor to teach the students more on Friedrich Hayek or Robert Nozick than the curriculum normally allows for.

Blaming teachers is the easy thing to do. But, sometimes the easy way is the wrong way. Maybe the problem with public schooling runs deeper. We need to focus more on the machinery of the system, a machinery prone to corruption and waste.