Monday, September 14, 2009

The Truth About the “Dismal Science”

I begin teaching a civics/economics class to local home school students this evening. The article below will be required reading:

Everything You Always Wanted To Know About Economists

by Art Carden and Steven Horwitz, 09.12.09

In a recent article for the Huffington Post, Pulitzer Prize winner Jane Smiley questions the wisdom and integrity of economists--as well as the value of economics. Unfortunately, she misunderstands what economics is and what economists do.

Smiley points out that English majors know a lot more about human nature and motivation than economists. True--so do theologians, psychologists, sociologists, anthropologists, philosophers, artists, historians, garbage collectors, short-order cooks, accountants, nurses, baristas and many others.

But that is missing the point. The strength of economics is not in explaining human preferences but in explaining the effects of changing incentives given those preferences. We assume people are "rational," but we don't mean they are omniscient or wise or even quick learners. We mean people want to make themselves as well-off as possible; people try to shape the world according to their values, whatever those may be. Free-market economists also assume that people are ignorant, and we show that markets teach them how to use resources wisely.

Smiley claims that economists' enthusiasm for markets stems from a belief that people are basically good. This isn't the case. Economists from Adam Smith to F.A. Hayek saw our intrinsic moral limitations. They believed individuals were generally self-regarding and would put their particular interests--including family and friends--first.

Yet they did not see this as a reason to reject competitive markets. They understood that markets make it more difficult for the knaves among us to wield power because markets decentralize power among numerous private property owners. Firms' "power" comes from customers who buy their products, and it can be taken away just as easily (ask the U.S. automobile manufacturers). Free-market economists do not have to trust individuals; they trust that good institutions minimize the damage done by knaves.

Some notable exceptions notwithstanding, it is--as Smiley writes--"human nature to cheat, monopolize and buy off others." But we see this as a reason to distrust politics rather than markets. Political incentives exacerbate knavery. Centralizing power in the hands of the state, which is Smiley's implied alternative to free markets, will not make things better. It will put more power in the hands of the sorts of people Smiley fears.

The examples Smiley uses to call the economist who supports free markets a "fool," "monster" or "at least an ignoramus" are cases in which there aren't formal markets for the goods in question. No free-market economist believes that children should be bought and sold. They recognize you can't have a market without respecting rights. Markets presuppose that people have control over their own bodies and property. Hence, owning other human beings is antithetical to the free market.

Smiley next claims that capitalism keeps wages low because capital moves to low-wage regions in a "race to the bottom." Again, this is wrong. The law of comparative advantage shows how trade creates wealth and raises living standards, as Paul Krugman discusses in his essay "Ricardo's Difficult Idea."

Smiley argues that the international economy works to shove capital upon people with progressively lower wages, leaving those who produce without an ability to purchase what they're producing. This theoretical framework has been dead for 30 years and hasn't a shred of empirical support. In fact, economies that have gone more toward capitalism in the last few decades do better along measures of GDP per capita, education, life expectancy and democracy.

Smiley claims that economists "have always resisted calculating the costs of raw materials by calling them 'externals.'" We haven't. Raw materials are factors of production, and there's a lot of literature on how these factors should be priced. And we don't call the costs "externals." We talk about "externalities," which are costs and benefits from our actions that spill over onto non-consenting third parties, and there are hundreds upon hundreds of papers about externalities and "market failure." Indeed, one of the quickest routes to professional success as an economist is to find a new kind of market failure that might require government intervention.

Smiley also describes an example in which a country wages war for oil. This is an example of rent-seeking, which is trying to use government power to increase private wealth or power, and it is part of a well-developed tradition in economics. Free-market economists aren't sucking up to tyrants; we're the ones decrying institutional arrangements in which licking tyrants' boots is standard operating procedure. [emphasis added]

Smiley, like so many others, confuses "capitalism" with "corporatism." Being in favor of capitalism, in the sense of free markets, does not mean we support whatever is in capitalists' interests. We support competitive markets, which often work against the interests of capitalists who would generally prefer cozy monopolistic relationships with the state, such as those likely to result if the state gets more power. [emphasis added]

Murray Rothbard once said that "it is no crime to be ignorant of economics," but that it is "totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance." It is tempting, therefore, to dismiss Smiley's article as little more than sound and fury. Yet it does signify something profound and troubling: economists' failure to communicate the essential insights of our discipline. Jane Smiley's contemptuous and uninformed dismissal shows that we really need to redouble our efforts.

Art Carden is an assistant professor of economics and business at Rhodes College in Memphis, Tenn., and an adjunct fellow with the Oakland, Calif.-based Independent Institute. He is a regular contributor to, and Division of Labour.

Steven Horwitz is Charles A. Dana Professor of Economics at St. Lawrence University in Canton, N.Y. and an Affiliated Senior Scholar at the Mercatus Center in Arlington, Va. He writes for Liberty and Power and The Austrian Economists.

Wednesday, September 2, 2009

But Will They Listen?

This afternoon I will present a talk (Lord willing) at the Advanced Appraisal Seminar in Greensboro, NC. My topic will be the economic theory of real estate bubbles. I will borrow heavily from the work of Auburn University’s Roger Garrison, who has created a handy macroeconomic overview of how speculative bubbles arise.

At the core of the theory is the action of the Federal Reserve. In my talk I will point out that, between 2001 and 2004, the Fed lowered its federal funds rate (the rate at which banks can borrow from other banks to meet their reserve requirement) from 5.5% to 1%. The Fed also purchased bonds from commercial banks, which injected reserves into the banking system. The net effect was to increase the money supply and the amount of loanable funds. Borrowing from Neil Young, I call this phenomenon “the needle and the damage done,” because the resultant reduction in interest rates was not the natural, market result of consumer savings. In fact, as Fed policy artificially lowered rates, consumers actually saved less of their incomes, and began demanding immediately consumable goods. A great disconnect occurred in the economy: consumers’ time preferences rose (consume in the present) while investors’ time preferences fell (divert production to more roundabout, future-oriented enterprises).

By the end of 2007 most American consumers were so over-leveraged (using their home equity accounts as virtual ATM’s) they hit the proverbial wall. By mid-2008 it became manifest that investors had over-extended themselves in real estate projects, many which had to be abandoned. Those are the very basics dynamics of a “recession” (depression) – the natural and inevitable correction following a central bank induced “boom.”

Even as I sit in my office I can look out the window and see five construction cranes over the Charlotte skyline. Far from being harbingers of future growth, they represent to this appraiser future vacancy – the continued effect of malinvestment in real estate projects.

When you see retail shops close and the space going “dark” (as we say), don’t think, “business failure.” Rather, see it for what it is: overcapacity. Our economy has been on a heroine rush for years. The time for cold turkey has come, but the manipulative State, through the agency of the Fed, is continuing to pump liquidity into the blown economy. Those cranes, and the derelict skyscrapers they are raising, are the sobering evidence.

Sort of like pumping air into a blown tire.

The question is, will my fellow appraisers receive this theory? They ought to, seeing that the values they have placed on an untold number of properties have been exposed as inflated.

In the meantime, a public service announcement: contact your representatives and insist that they support a stand-alone version of H.R. 1207, the bill that will require an audit of the Federal Reserve. This represents a key first step toward exposing the Fed and, hopefully, bringing it down.