Quote of the Week

In the past, periods of monetary disturbances have always been periods of great progress in this branch of economics. The Italy of the sixteenth century has been called the country of the worst money and the best monetary theory.

— Friedrich Hayek, Prices & Production and Other Works (Auburn: Mises Institute, 2008), p. 198.

I Can’t Believe Economists Don’t Do X

You can exchange ‘economist’ for ‘scientist,’ in the title, and the point I’m about to make remains the same.

I saw, on Facebook, a comment relating to the apparent disinterest amongst economists for the philosophy of their science, on average. The person making the comment suggested that one should become familiar with the philosophy of the science, then the history, and then focus on “application of the discipline” (which, I assume, includes learning the discipline).

This approach should be met with suspicion, especially amongst economists. One way society becomes wealthier is through specialization, which is made possible by a growing division-of-labor. We focus on using a more specific set of skills, so that we can develop these skills and produce more. Further, by narrowing the skill set one needs to produce, you can focus on your greatest skills, and do away with those that hold you back. But, if we all continue to specialize, how does a single person still act in a way that jives with the division-of-labor in general?

To re-state the analogy in terms specific to the economics profession: if economists continue to specialize (e.g. spend more time learning and practicing labor economics, implying less time to learn and practice monetary economics), how does their work fit in with the rest of the discipline? If Joe the Labor Economist is conducting research that must fit in with the remainder of economic theory, how is he to accomplish this if increased specialization comes at the cost of general knowledge of your field?

Communication. In a division-of-labor, humans have developed — spontaneously or otherwise — methods of communicating useful knowledge, without having to actually spend a lot of time searching for it. The common example is the pricing process. Prices communicate certain pieces of information. If a steel buyer requires so much of that input for some project, but the only steel manufacturer suffers a fire in its factory, cutting the flow of output in half, prices can communicate this knowledge to the buyer. Similarly, humans use language to communicate, and use of language gradually becomes simpler and more direct — people want to economize their use of language. Norms, or rules and heuristics, serve a similar function: to allow us to operate in a socially beneficial way, without having to really be aware of the specifics of other cogs in the ‘machine,’ so to speak.

The same is true within the sciences. It is true that a loss of general knowledge comes at the cost of being cognizant of other parts of the science, which your own research has to be consistent with. However, it’s also true that the less you specialize, the less you can focus on your specific research. The more knowledge the field produces, the more we have to specialize, because — given decreasing marginal returns — we have to increase our productivity to produce something of equal value. This creates a strain, however, between specialization and the relevance of general knowledge (e.g. philosophy of science, or the science outside your narrow sub-field). Institutions have to arise to help us economize on that general knowledge.

We might lament the perceived lack of general knowledge amongst scientists. We might want to criticize an economist for not knowing much about economic history, for example. But, rather than seeing this as a weakness within the discipline, it’s better to interpret it as general progress. Economists are becoming more specialized, because improvements in the communication of general knowledge have made greater specialization possible.

One test as to whether I’m right is to think about how well the average piece of research fits into the overall puzzle of economic theory. If it’s true that the average economist does not know much about the philosophy, or history, of her science (I’m assuming it as true), and it’s true that greater specialization should lead to a loss of cohesion, then we’d expect the state of economics to worsen over time. We’d also predict that aforementioned loss of cohesion. But, that’s not what we’ve seen. Instead, economics is equally as unified as it used to be, and perhaps even more so — consider, for example, the ‘requirement’ of microfoundations. This despite the fact that modern economics can provide a much richer understanding of the real world than the discipline could 60 years ago, because specialization has continued to progress.

That the average economist might not know much about the history and/or philosophy of economics is not a problem. Instead, it’s evidence of the progress of the discipline. Methods of communicating ‘general knowledge’ have improved, allowing economists to focus on narrowing sub-fields. This, like specialization in any division-of-labor, allows for productivity increases. What this means for science is that specialization is an important cause of growth in scientific knowledge.

When is Transitivity Wrong?

Transitivity of preferences is an important assumption in the ‘orthodox’ theory of rational choice. Your preferences fulfill the assumption if you, for example, prefer x to y, y to z, and therefore x to z. Who wouldn’t have transitive preferences?

Failure to recognize relations of transitivity is characteristic of schizophrenics; those disposed to blatantly ignore transitivity are unintelligible to us; we cannot understand their pattern of actions as sensible ways to promote their values.

— Gerald Gaus, The Order of Public Reason (Cambridge: Cambridge University Press, 2011), p. 70.

Benefits to High Seas Piracy

While the study isn’t recent, I came across this news brief on a study on the relationship between piracy and the colonies,

Pirates mapped new territory, expanded trade routes, discovered good ports and opened doors with the native peoples, Acosta said. “They really helped European nations explore the Americas before Europeans could afford to explore them on their own,” he said.

By selling stolen silks, satins, spices and other merchandise in ports and spending their booty in the colonies, pirates created an economic boom, helping struggling settlements and making Port Royale in Jamaica and Charleston, S.C., huge mercantile centers, Acosta said. “They didn’t bury their treasure, they spent it, helping colonies survive that couldn’t get the money and supplies they needed from Europe,” he said.

Without the infusion of money into the New World from piracy, it is possible that Britain and France may not have been able to catch up with Spain, Acosta said.

Quote of the Week

But often rent seeking involves a real waste of resources that lowers the country’s productivity and well-being. It distorts resource allocations and makes the economy weaker. A byproduct of efforts directed toward getting a larger share of the pie is shrinkage of the pie.

— Joseph E. Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future (New York: Norton, 2012), p. 95.

Of course, it works both ways. Many programs that aim to increase the share of the pie accruing to labor will shrink the total size. But, I doubt that’s what Stiglitz had in mind.

Moral Authoritarianism

A moral order of free persons rejects appeal to the natural authority of some people’s private judgments over those of others. A social morality that allows the (self-appointed?) “enlightened” to make moral demands on others that as free and equal moral persons those others cannot see reason to acknowledge is authoritarian. Just as authoritarians in politics hold that they should rule over others who are too unenlightened or corrupt to see the wisdom of their laws, so too do these “enlightened” moralists hold up their “right reasoning” about morality as the standard that warrants their demands about how others should live, even when those others, exercising their rational moral autonomy, cannot endorse the imperatives to which they are subject.

— Gerald Gaus, The Order of Public Reason (Cambridge University Press: Cambridge, 2011), p. 16.

Haves and Have Nots

I received a chain email on “the America that works, and the America that doesn’t.” It quotes a diatribe launched by Bob Lonsberry — a “talk radio personality” — at Obama and the Democrats. It’s a response to the president’s recent speech on income inequality. Well, ‘response’ is misleading. Lonsberry takes the opportunity to rant about how inequality is caused by “inequality of effort,” and that the motivation behind social welfare is “envy” and “greed.” It’s too bad people take Lonsberry seriously, because he’s not only wrong, he’s ignorant. If that last sentence is off-putting, just humor me and keep reading.

The email distinguishes between an “America that contributes, and the America that doesn’t.” Between those that support themselves and those that don’t. Lonsberry says,

The president’s premise – that you reduce income inequality by debasing the successful – seeks to deny the successful the consequences of their choices and spare the unsuccessful the consequences of their choices.

And, if you support welfare you are advocating “a culture of dependence and entitlement, of victim-hood and anger instead of ability and hope.”

Only someone out-of-touch with reality could write that. Because, while there may very well be people who take advantage of the system, there are many more who have made the right choices, but were simply never presented the same opportunities as others. It’s not about working hard versus being lazy, it’s about having the fortune or misfortune of the environment you’re born into.

Lonsberry assumes that everyone has the same set of choices. Wrong. The average inner-city African-American does not have the same opportunities as the middle-class white boy living in the suburbs. Yes, African-Americans are less likely to graduate from high school and college, on average. But, it’s not about a lack of worth ethic. It’s about being born into an environment that makes school a lower priority; an environment that forces you to make choices that the middle-class white boy doesn’t have to face. Many people don’t have the option of earning a higher education, not because they’re lazy, but because their life path shut that door for them.

I’m a middle-class suburban white boy, but I was lucky enough to work a minimum wage job while I attended community college. I would be a fool to call any of my former colleagues lazy, because most of them were anything but. Some of them worked two, even three, jobs — those that could get them —; I guarantee that most of them work harder than Lonsberry does (it might behoove him to work harder to educate himself). My roommate works two jobs and attends school. Some days, he works over 12 hours, comes home and studies, then goes to sleep to start the process against the next day. Yet, he can barely afford the subsidized rent we offer him. He’s not lazy, he’s just unfortunate to have less options than many others do.

Our parents’ standard of living tells us a lot about what kind of standard of living we can expect as adults. In other words, the environment you’re born into is a heavy determinant of your success, all else (e.g. race, work ethic,…) equal. 33 percent of children born to a top 1 percent family will make $100,000 by age 30; comparatively, only four percent of children born into the bottom half of the income distribution will make that income at 30. About 40 percent of people born in the lower income quintiles will remain there. Likewise, about 40 percent of people born in the top income quintile will remain there. Clearly, Lonsberry’s charge that if only the poor were less lazy they would be more successful is false — there are factors that will weigh down on the poor, even if they work harder than anyone else.

Consider, for example, the kind of education the average poor person receives. Assume, to focus on what matters, that the student works at a 100 percent work rate — laziness is not an issue. Schools in poorer neighborhoods perform worse than schools in wealthier neighborhoods. They don’t have access to the same public funding — the taxable income of those neighborhoods’ families are very low. Many of these institutions don’t offer advanced placement (AP) courses, and classes of similar quality. Teachers in poorer schools will be less well educated than teachers in wealthier schools, on average. Schools in less well-off neighborhoods can’t offer their students the same level of support services. The educational options available to the poor are much worse than those available to the rich.

Kids born into poorer families have parents who work more, because they need to work more to make a decent income (income effect — the more you make, the more leisure time you will choose to have, on average). These are parents who simply can’t afford to provide their children with the same kind of learning environment as wealthier parents. Children in these environments will not be pushed to the same degree to read, write, and learn outside of school. Further, because low income parents usually grew up with the same disadvantages as their children, they are likely to be less educated than wealthier parents.

The typical path to a higher income is education. But, the poor, on average, will receive an education that is much worse than the one wealthy children get. They can’t compete on that margin — they don’t have that choice.

Wealthier children have the option to work less as they reach adulthood. Their parents can afford to support them, and send them off to school. The poor oftentimes don’t have that option. They start working when they’re 15 years old — this will impact their education, because it reduces the amount of time they can allocate towards that end. In the worst communities, employment can be hard to find. That’s why some kids turn to the black market, including the drug trade. It’s not always about making bad choices. It’s about making lemonade with the lemons life gave you.

Neither is social welfare about “envy” or “greed.” It’s about compassion. There are many, many well-off people who are cognizant of their luck — the arbitrariness of being born into a well-off family, for example —, and who choose to vote for social welfare. Yes, those that don’t have that same compassion, and aren’t willing to donate to the poor, are forced to pay into the welfare system, as well. But, the political system compensates the well-off: tax write-offs (which are often regressive — the higher your income, the more you benefit), public services, property rights protection (regressive, since poorer individuals will own less property, on average — often zero property, at that), and other forms of compensation.

Lonsberry wants to paint the rich-poor divide as an outcome determined by good and bad choices. This is fantasy. The real world is one where someone can make all the right choices, and still be poor. The real world is one where someone can work twice as hard as another, but still be poorer. We don’t all have the same choices offered to us.There is plenty of data available; many, many smart people have researched the subject and published their findings. This information is widely available. Lonsberry obviously hasn’t read it, which goes to show just how much you should trust his opinion. (To be perfectly clear: you shouldn’t trust his opinion.) Not everyone is “born with a silver spoon in hand,” and no matter how much the poor work, they are still less likely to one day be higher on the income ladder than those already born into wealth.

Cartels Against Legalization

Mary O’Hara reports,

“Is it hurting the cartels? Yes. The cartels are criminal organizations that were making as much as 35-40 percent of their income from marijuana,” Nelson said, “They aren’t able to move as much cannabis inside the US now.”

In 2012, a study by the Mexican Competitiveness Institute found that US state legalization would cut into cartel business and take over about 30 percent of their market.

Former DEA senior intelligence specialist Sean Dunagan told VICE News that, although it’s too early to verify the numbers: “Anything to establish a regulated legal market will necessarily cut into those profits. And it won’t be a viable business for the Mexican cartels — the same way bootleggers disappeared after prohibition fell.”

Read the rest of the article. O’Hara makes a good case, implicitly and explicitly, that the DEA’s anti-marijuana policy is not only wrong, but dangerous, and favors the cartels (whether intentionally or unintentionally).

Sound Money

What is “sound money?” The simple answer: a monetary system that best promotes coordination between market agents. Every economist advocates “sound money;” the disagreement is over what exactly constitutes a good monetary system. This is where the issue becomes much more difficult, because we enter the realm of monetary institutions. But, there are some who want you to believe that the problem is much simpler than it actually is. Some of these people are the same who advocate a return to a commodity money (e.g. gold, silver,…).

Will a return to commodity money end the business cycle? Would it end inflation? We can point to the period of U.S. history between, roughly, 1879–1893, and try to answer in the affirmative. After all, that was a period of strong growth and slight deflation (although, there were recurring banking crises). On the other hand, we could just as easily look at just about every other period of history and answer ‘no.’ The European “price revolution” (~1500–1650), for example, is thought to be caused by the large inflow of New World gold and silver. Likewise, it was common for monarchs to debase their currency, whether via clipping, or by replacing valuable content with less valuable metals. So, no, reverting back to commodities will not necessarily make our monetary system any more stable.

What makes, say, gold attractive as money, anyways? It has certain physical characteristics: it is physically scarce (relatively costly to produce), it is durable, and it is divisible, amongst other possible traits. Why do these characteristics matter? Because they help determine the rules that constrain the monetary system.

Suppose we are looking at two isolated societies, each with their own monetary standards. These systems are exactly the same, except for what they are using as money: one uses gold, the other bushels of wheat. We expect the former to outlive the latter. Why? First, wheat is relatively easy to grow, so it does not have that same production constraint as gold — the value of wheat, as money, is easy to drive towards zero. Two, wheat is not as durable. It can be stored, and modern storage methods have allowed us to keep it around for longer, but it doesn’t have the same durability as gold. If the value of wheat is low enough, it would also take a lot of it to buy certain products. These are all factors that determine the rules of the game, or monetary institutions.

What really makes one monetary system better than another, then, are the institutions that constrain it. This should re-frame the terms of the debate, because now we know that what really matters are these rules. And, we can’t just look at some rules over others; we have to consider these institutions in their totality, and how they interact. For example, if the currency is in some way controlled by an extractive government, even if this currency is gold, we can expect a sub-optimal monetary system. Yes, even with commodity money, certain institutions can ruin the game, so to speak.

Another bad rule that could fit with a gold standard — or commodity money, more generally — is full reserve banking. Forcing banks to keep gold in their vaults that they would otherwise somehow get rid of is sub-optimal; that society is forgoing a better use of that gold. Similarly, by constraining a banking system’s ability to expand their liabilities when the demand for money increases, we forgo the opportunity of inter-mediating between a certain group of savers and a certain group of spenders (whether investors or through consumer credit). Finally, a banking system that cannot respond to changes in the demand for money will cause macroeconomic instability.

Despite all the benefits to using certain commodities as money, these benefits alone do not guarantee that they will be “sound money.” You also need good man-made institutions, or additional rules that constrain the monetary system. These rules evolve over time, and in different directions.

One direction is central banking. The Federal Reserve arose to re-write some of the rules that constrain the banking system. Primarily, it serves as the most important clearinghouse, with the ability to expand and contract its liabilities to service its member banks. During times of crisis, a central bank also acts a lender of last resort — a role private clearinghouses also fulfilled. Those who believe that, without a central bank, an economy can be stuck in monetary disequilibrium for long periods of time also advocate for central banking, because it allows for an elastic money supply even in the worst macroeconomic conditions. Of course, central banks — and their rules — evolve over time. One example of this is the general preference for independent central banks, because this weakens the ability of the few to manipulate the money supply at the expense of the many.

Another direction is “free banking,” which refers to financial institutions that arise through a decentralized process of change. This is not all theory; we have seen episodes that come fairly close to completely free banking. This monetary system is still regulated — it is still constrained by rules —, but these rules arise through a decentralized process. Competing systems might have competing rules, and good rules replace bad rules through, for instance, profit and loss. More concretely, if clearinghouses develop sets of rules that they enforce over member banks, separate clearinghouses and their bank networks will compete against each other. Good rules promote a healthier industry, which usually means greater gains, at least over some period of time (a bank that commits fraud might make a high profit at first, but they will certainly lose customers as people catch on). Bad rules promote losses, creating an incentive to replace bad with good.

What’s important here is that what improves the monetary system are rules. Some of these are innate to the type of money being used. But, these institutions might not be strong enough as the market becomes more complex, money is inter-mediated, the pricing process becomes more complicated, et cetera. This is why man-made monetary institutions are ubiquitous: they are experiments to improve monetary systems. In other words, the quest for  “sound money” is really a process of developing sound monetary institutions.

Where does this leave commodity money? Many free bankers do advocate commodity money, along with inside money of a form dictated by the market — classically, we usually think of paper money when we think of “inside money,” but it could just as well be “e-money.” But, we should be open to the idea that maybe commodity money is no longer optimal, because of the other institutions that regulate the monetary system. It could very well be that a modern banking system would prefer alternative safe assets as “outside money,” and that gold is antiquated. In any case, when answering “what is sound money,” gold, or silver, or commodity money are not right answers — what matters are institutions, and monetary rules have developed since the 19th century, so returning to a 19th century monetary system is retrogressive.

Quote of the Week

Whether Rousseau or (as Hill 2005 shows) Rawls, Marx or Marcuse, Sinclair or Steinbeck, Habermas or Horkheimer, Fourier or Foucault; whether liberal or communitarian theorists, street activists or social scientists, mass movements or intellectuals, scholars or novelists or journalists — it is simply not true that the left can be characterized as yearning for “order” — i.e., the conscious direction of men (by men!). Rather, the left yearns for freedom and an end to the exploitation of man by man.

—    Jeffrey Friedman, “Popper, Weber, and Hayek: The Epistemology and Politics of Ignorance,” Critical Review 17, 1–2 (2005), pp. 39–40.