Monday, November 12, 2018
Sunday, November 11, 2018
Friday, November 9, 2018
Wednesday, October 31, 2018
Saturday, September 22, 2018
Simple examples can be used to explain what seem at first glance to be complex economic principles. I'll use a hypothetical yet commonplace experience to explain how money may be used for only one of three purposes--it can be held/hoarded, saved/invested, or spent. Furthermore, my example will show that foregoing consumption--i.e., either holding or investing--is necessary for non-inflationary lending and that credit decisions must always be made by the entity taking the risk and especially not government. Here's the scenario:
Let's assume that my colleague and I go to McDonalds for lunch. When my colleague reaches for his wallet to pay for his five dollar Happy Meal, he finds that he left his wallet on his desk. I lend him the money and we have an enjoyable lunch. When we return to work, he repays the debt.
What economic lessons that can be learned from this simple story?
1. Expanding the money supply is NOT required in order to increase lending.
When I gave my colleague five dollars, total loans in the economy expanded yet the money supply remained unchanged. Upon returning to work, my colleague retrieved his wallet off his desk and repaid his loan. At that point loans in the economy fell by five dollars yet the money supply remained unchanged. Therefore it is a fallacy that expanding the money supply is necessary in order to increase lending.
2. A prior act of foregoing consumption IS required to expand loans.
Let's expand somewhat on our previous example. Where did I get the five dollars that I lent to my colleague? I had to have foregone previous consumption in order to have this amount available to lend to my colleague. Fortunately for my colleague I did not consume all that I could have.
3. The holder or hoarder of money does not harm the economy.
The act of carrying that extra five dollars in my wallet can be characterized as holding or hoarding. Hoarding is not the same as investing. Had I invested my money I would not have had the additional five dollars in my wallet. Instead the five dollars would have gone into some production process that would yield increased benefits later in time. Instead I desired the flexibility to spend the money for some unforeseen purpose. Lucky for my colleague that I didn't spend it on some frivolity or invest it in longer term production. Instead I hoarded five dollars and was able to lend it to him in order to purchase his lunch. Although the term hoarding is often used disparagingly, one can see that it serves a useful, economic and social purpose.
4. Money cannot be used at the same time for more than one of three purposes.
I had a choice of what to do with my unspent (unconsumed) five dollars. I could have carried it in my wallet, an act of holding or hoarding in order to take advantage of unforeseen circumstances. Or I could have invested in production, such as lend it to my son to buy gasoline for his summer lawn mowing business. Or I could have spent it on consumption, perhaps upgrading from a five dollar Happy Meal to a Big Mac, super sized fries, and a milk shake. Of course had I invested it or spent it, I would not have had money to lend to my colleague for lunch. The important point is that I could not do both hoard the money and invest it and/or spent it. Furthermore, we can see that there is no room in our simple example for a "multiplier effect" that emanates from the lending process, as is claimed by those who defend fractional reserve banking. I could lend the money only once.
5. The lender of money assumes the risk of non-repayment.
There was little possibility that my colleague would not repay his loan to me. However, I doubt that I would have lent my five dollars to just anyone who happened to be in McDonalds at the same time as we were. Let's assume that the person on front of me had been a stranger and not my colleague. I probably would not have lent him the money, despite the probability that he was a good credit risk. The important point is that I would not have known him. "Know your borrower" is rule number one in banking. The age old truism is still valid that good character is the best trait in a borrower. I would have known the character of my colleague but not that of a total stranger.
Yet much borrowing (and resultant defalcations) on loans today are made by giant firms based upon numerical credit scores. The lender never meets his borrower. The loan production offices that generate the loans applications do not know their applicants. Many of these loans are then sold to a government owned entity, such as Fannie Mae or Freddie Mac.
Furthermore, lending also has become a tinder box of political risk. For example, the infamous Community Reinvestment Act requires banks to make loans that do not meet their lending criteria. If the borrower and his property reside in an arbitrarily and ill-defined underserved area, the bank must lower its credit standards. The result is higher loan losses. We would not desire a government mandate that I be allowed to loan my colleague five dollars to pay for his lunch at McDonalds only if I also lend five dollars to complete strangers.
We must look askance also at outright loans by government or government loan guarantees to politically connected borrowers. We taxpayers are the true holders of the loan and will suffer if the loan is not repaid. The Export-Import Bank is a prime example. We taxpayers are on the hook for non-payment of government loans to foreigners so that they can buy the products of politically connected groups. It's simple corruption disguised as a legitimate banking function. It would be absurd for the government to design a program to lend money only to people who desired to buy lunch at McDonalds in order to help the world's largest fast food chain maintain its sales in a highly competitive environment. It is no different just because the program helps foreigners buy American products. In both cases the real lender is the American taxpayer.
Simple examples from everyday life help us clarify our thinking about what at first appear to be highly complex economic problems.
Tuesday, August 14, 2018
Saturday, June 23, 2018
In a recent post I explained that China's manipulations of its own currency hurt only herself and not her trading partners and, therefore, retaliatory tariffs were not warranted and would be self-defeating anyway. China harms herself by causing her own money supply to expand, which destroys capital through malinvestment and causes prices to rise domestically. Retaliatory tariffs cause American goods to rise in price, resulting in a recession and general lower standard of living. Few economists claim otherwise.
It seems that everyone is in favor of free trade, as long as it is the other guy who must compete with foreign products. When it comes to their own products, the most typical response from American manufacturers begins with the caveat that "although free trade is beneficial most of the time, it causes harm under certain circumstances." There follows a convoluted chain of cause-and-effect purporting to prove that lower priced foreign goods would hollow out America's key manufacturing industries and turn America into a second class nation.
The purpose of this brief response is to counter these claims and explain why understanding economic theory is vital to the argument in favor of free trade.
There are two books which address the fact that we cannot experiment with an economy the way that physical scientists do. We must use logic to form irrefutable conclusions of what MUST happen, even if we cannot see it! The first is Frederic Bastiat's early nineteenth century classic That Which Is Seen, and That Which Is Not Seen. Henry Hazlitt's updated the book a hundred years later in order to appeal to modern readers. His Economics in One Lesson employs a series of short stories to illustrate that one must always consider the economic effects of an intervention on all and not just a few actors, plus, that one must look to the long term effects of an intervention and not just the short term effects.
So, let's use logic to consider the effects of China's economic interventions on itself and its trading partners who do nothing to retaliate against China in any way.
1. China uses its capital in an inefficient way. Outright subsidies to any industry must be paid by someone. The very fact that China believes that it cannot compete in certain industries to its own satisfaction without subsidies is an admission that these industries are inefficient. Therefore, Chinese internal subsidies are transfers of capital from more efficient industries to less efficient industries. Put another way, if the targeted industries already were very efficient, more capital would flow to these industries and subsidies wouldn't be necessary.
2. Monetary expansion to fund an industry causes overall higher prices and malinvestment. This is the classic Austrian Business Cycle Theory. China may very well expand its steel industry, for example, with monetary expansion, but such action will disrupt the time structure of production and result in a higher price level and a recession. Other factors of production that feed the Chinese steel industry will rise in price, necessitating another round of currency expansion, which will lead to even higher prices and another recession. It's a vicious cycle that can end only with an end to currency expansion.
3. China's overall economy will be less developed, weakening the impact of subsidies to targeted industries. Because capital is stripped from more efficient industries, China's ancillary industries will be less developed, harming the targeted steel industry indirectly. Public infrastructure may be less than it would be otherwise, for example. The many business-to-business goods and services that feed the steel industry will lack the capital to expand. The workforce may lack adequate education. The list is endless. China's economy will lack coordinated growth, as was so apparent in the moribund economies of the old Soviet bloc. The point is that something must be sacrificed to aid the targeted industry. Of course, this is a classic Bastiat "Not Seen" scenario.
4. American products get cheaper and gain market share. It may be true to some small extent that the steel industry, for example, may not be able to expand and may even contract in the face of equal quality Chinese steel that can be purchased at lower prices. But all the many American manufacturing firms that USE steel will have a lower cost of production and, therefore, will be able to expand their markets. Again, something has to give; i.e., the Chinese may be able to sell more steel to American manufacturers, but these manufacturers can sell more finished goods into the world market.
5. American industries benefit from the general expansion of all levels of production. This is a corollary to number three above but opposite. Because the companies that use cheaper Chinese steel reduce their costs, passing along the savings to customers in the form of lower prices, passing along the increased profits in the form of dividends to shareholder, increased investment in their own firms, or a combination of above. The reason for this beneficial prospect is that America becomes more capital intensive, and that capital came in the form of a gift from China.
6. Chinese subsidies actually become subsidies to Americans' standard of living. The purpose of production is consumption. Although we may give lip service to how much we love our jobs, what we really mean is that we are satisfied with the life style that we can obtain through meaningful labor. I truly doubt that many of us would work if we were not paid. Chinese subsidies allow us the option to work less for the same standard of living or work as long yet enjoy a higher standard of living because our pay goes further. We workers have more options. For example, as we become richer through Chinese subsidies, mothers may opt for part time work instead of a full time job, or they may leave the workforce altogether. Fathers may decide to pursue lower paid but less stressful careers. Let us not forget that leisure is a valuable good in and of itself.
Finally, the idea that all subsidies can be eliminated worldwide and businesses can compete on a level playing field is a foolish idea. What is the definition of a subsidy? Is it government provided healthcare? How about a state or municipality forgiving business taxes in order to entice industries to expand or relocate? If the government builds a super highway near a plant, is this a subsidy? Likewise, industries in many developed economies decry the fact that undeveloped countries have lower environmental standards, worker safety requirements, and worker rights. Periodically one reads that the European Union is threatening a member for having taxes that are too low and, thus, provide an indirect subsidy.
Capitalists must accept all of these interventions by foreign governments as part of the unknown and uncontrollable factors of conducting business and not lobby their own governments to take self defeating economic reprisals. Unilateral free trade is the best and only real option.