The current system of fractional reserve banking and central banking stands in stark opposition to a market economy monetary regime in which the market participants could decide themselves, without state pressure or coercion, what money they want to use, and in which it would not be possible for anyone to expand the money supply because they simply choose to do so.
The expansion of the money supply, made possible through central banks and fractional reserve banking, is in reality what allows inflation, and thus, declining income in real terms. In The Theory of Money and Credit Ludwig von Mises wrote:
The most important of the causes of a diminution in the value of money of which we have to take account is an increase in the stock of money while the demand for it remains the same, or falls off, or, if it increases, at least increases less than the stock. … A lower subjective valuation of money is then passed on from person to person because those who come into possession of an additional quantity of money are inclined to consent to pay higher prices than before.
When there are price increases caused by an expansion of the money supply, the prices of various goods and services do not rise to the same degree, and do not rise at the same time. Mises explains the effects:
While the process is under way, some people enjoy the benefit of higher prices for the goods or services they sell, while the prices of the things they buy have not yet risen or have not risen to the same extent. On the other hand, there are people who are in the unhappy situation of selling commodities and services whose prices have not yet risen or not in the same degree as the prices of the goods they must buy for their daily consumption.
Indeed, in the case of the price of a worker’s labor (i.e., his or her wages) increasing at a slower rate than the price of bread or rent, we see how this shift in the relationship between income and assets can impoverish many workers and consumers.
An inflationary money supply can cause impoverishment and income inequality in a variety of ways:
1. The Cantillon Effect
The uneven distribution of price inflation is known as the Cantillon effect. Those who receive the newly created money first (primarily the state and the banks, but also some large companies) are the beneficiaries of easy money. They can make purchases with the new money at goods prices that are still unchanged. Those who obtain the newly created money only later, or do not receive any of it, are harmed (wage-earners and salaried employees, retirees). They can only buy goods at prices which have, in the meantime, risen.
2. Asset Price Inflation
Investors with greater assets can better spread their investments and assets and are thus in a position to invest in tangible assets such as stocks, real estate, and precious metals. When the prices of those assets rise due to an expansion of the money supply, the holders of those assets may benefit as their assets gain in value. Those holding assets become more wealthy while people with fewer assets or no assets either profit little or cannot profit at all from the price increases.
3. The Credit Market Amplifies the Effects
The effects of asset price inflation can be amplified by the credit market. Those who have a higher income can carry higher credit in contrast to those with lower income, by acquiring real estate, for example, or other assets. If real estate prices rise due to an expansion of the money supply, they may profit from those price increases and the gap between rich and poor grows even faster.
4. Boom and Bust Cycles Create Unemployment
The direct cause of unemployment is the inflexibility of the labor market, caused by state interference and labor union pressures. An indirect cause of unemployment is the expansion of the paper money supply, which can lead to illusory economic booms that in turn lead to malinvestment. Especially in inflexible labor markets, when these malinvestments become evident in a down economy, it ultimately leads to higher and more lasting unemployment that is often most severely felt among the lowest-income households.
The State Continues to Expand
Once the gap in income distribution and asset distribution has been opened, the supporters and protectors of social justice will more and more speak out, not knowing (or not saying) that it is the state itself with its monopolistic monetary system that is responsible for the conditions described.
It’s a perfidious “business model” in which the state creates social inequality through its monopolistic monetary system, splits society into poor and rich, and makes people dependent on welfare. It then intervenes in a regulatory and distributive manner, in order to justify its existence. The economist Roland Baader observed:
The political caste must prove its right to exist, by doing something. However, because everything it does, it does much worse, it has to constantly carry out reforms, i.e., it has to do something, because it did something already. It would not have to do something, had it not already done something. If only one knew what one could do to stop it from doing things.
The state even exploits the uncertainty in the population about the true reasons for the growing gap in income and asset distribution. For example, The Fourth Poverty and Wealth Report of the German Federal Government states that since 2002, there has been a clear majority among the German people in favor of carrying out measures to reduce differences in income.
The reigning paper money system is at the center of the growing income inequality and expanding poverty rates we find in many countries today. Nevertheless, states continue to grow in power in the name of taming the market system that has supposedly caused the impoverishment actually caused by the state and its allies.
Related: How Government Hurts the Poor
Jason Brennan seems to think Mises considers action to be, by definition, “rational” in the sense of “guided by sound reason.” If he would read Mises more carefully, Jason would realize that Mises means “rational” in the sense of: guided by reason (human thinking regarding causation, relations, means, and ends, etc) at all, whether sound or faulty.
[Mises’ own view:]
“When applied to the means chosen for the attainment of ends, the terms rational and irrational imply a judgment about the expediency and adequacy of the procedure employed. The critic approves or disapproves of the method from the point of view of whether or not it is best suited to attain the end in question. It is a fact that human reason is not infallible and that man very often errs in selecting and applying means. An action unsuited to the end sought falls short of expectation. It is contrary to purpose, but it is rational, i.e., the outcome of a reasonable–although faulty–deliberation and an attempt–although an ineffectual attempt–to attain a definite goal. The doctors who a hundred years ago employed certain methods for the treatment of cancer which our contemporary doctors reject were–from the point of view of present-day pathology–badly instructed and therefore inefficient. But they did not act irrationally; they did their best. It is probable that in a hundred years more doctors will have more efficient methods at hand for the treatment of this disease. They will be more efficient but not more rational than our physicians.”
[Brennan then] gleans from his misinterpretation the conclusion that it is an open question whether markets and “actual human beings in the real world are better described by your a priori theory of human action or by behavioral economics.”
But the very questions virtually everyone of all schools of economic thought ask in economics involve such teleological notions as “prosperity,” “buy,” and “sell.” These notions presuppose that objects under consideration are acting, and therefore under Mises’s definition of the word, rational: using the human mind to guide action, however adeptly or ineptly.
He then scoffs at Austrian apriorists as characteristically the kind that contribute to journals that aren’t approved of by a certain massively state-sponsored and state-privileged establishment university in Washington, D.C., and which are therefore “fake.”
An important aim of the QE policies pursued in the United States, the United Kingdom, and Japan has been to encourage risk taking and to raise asset prices as the means to stimulate aggregate demand. The question that now needs to be asked is whether these policies may have given rise to excessive risk taking, overleveraging, and bubbles in asset and credit markets. In this context, one has to wonder whether historically low yields on junk bonds in the industrialized countries now understate the risk of owning those bonds… . One also has to wonder whether yields on sovereign bonds in the European periphery have become disassociated from those countries’ underlying economic fundamentals and whether global equity valuations have not become excessively rich.
Desmond Lachman, “Global Effects of Unorthodox Monetary Policies" (Lachman is formerly deputy director of the International Monetary Fund’s Policy Development and Review Department)
Adds Joe Salerno:
While the Austrian insight that super-accommodative Fed monetary policy may be causing a recurrence of asset bubbles is making headway in policy circles, it has not yet dawned on Janet Yellen. Nor is such an epiphany likely. Ms. Yellen wears the intellectual blinders of the mainstream macroeconomist which force her to focus narrowly on arbitrary and increasingly irrelevant statistical averages and aggregates like the CPI, the unemployment rate, and GDP and to ignore what is going on around her in real markets. This was clearly revealed in remarks prepared for her confirmation hearing released yesterday. Ms. Yellen noted that the rate of increase in the CPI index was less than the Fed target of 2.00 percent and that the labor market and the economy were performing far short of their potential (based on the meaningless concept of “potential GDP”). She thus reiterated her commitment to continuing monetary accommodation and “unconventional policies tools such as asset purchases.” It is true that in her testimony before the Senate committee today she did concede that it is “important for the Fed to attempt to detect asset bubbles when they are forming.” However, she blithely dismissed concerns that recent record highs in asset markets reflected “bubble-like conditions.” With Ms. Yellen’s confirmation highly likely, we can look forward to the Fed blindly fueling asset bubbles to a fare-thee-well. With the financial system still on shaky ground, this will lead to another financial meltdown and a U.S. government takeover of the financial system the like of which will make the last Wall Street bailout appear to be a minor intervention.
It’s important to understand the business cycle:
For centuries inflation has been considered a quick fix for economic problems. Create a lot of money, raise prices, and prosperity for all shall be assured in a short amount of time. …
Putting a lot of more money in people’s hands usually results in their attempting to spend it on the various goods and services they would like to have that money can buy. The greater spending tends to push up prices and increase sales.
The “magic” comes in due to the fact that workers’ wage contracts and resource price agreements tend to change more slowly, so they tend to lag behind the initial price rise of the finished consumer goods those workers and those resource suppliers help to produce. The rise in selling prices while labor and resource prices remain the same generates the extra profit margins that “stimulate” employers to try to expand output and hire more workers.
But the quick fix of inflation in creating “good times” and more jobs is short lived, is an illusion like many other “fixes” that provide an initial “high” but soon fade away. …
[T]he increased supply of money may push up the prices of consumer goods, while wages and resource prices remain more or less the same. But over time, the attempt to expand output by employers due to the initial higher profit margins will result in wages and resource prices being bid up as each employer competes against the others to attract workers and resource providers to work for them instead of their rivals.
At the same time, inflation-driven rising prices are reducing the real value, or buying power, of each dollar in people’s pockets. Over time, workers and others employed in industry will demand higher wages and resource prices to compensate for the lost purchasing power they have experienced at the old wages and resource prices.
Hence, over time, both selling prices as well as wages and resource prices will tend to go up by more or less the same amount, and the extra profits that served as the “stimulus” will disappear. The longer-run affect, therefore, will be all-round higher prices, with no lasting net increase in either jobs or production.
Of course, the government and its central bank could attempt to increase the money supply even more and at a faster rate than they had before. But this would merely set the economy on a vicious spiral of rising consumer prices followed by rising wages and resource prices bringing about nothing but the same process repeated again and again. The end result would be worsening price inflation and a potential destruction of the country’s currency.
In addition, the very fact that some prices rise before others, and to differing degrees while the inflation is running its course brings with it a whole host of problems that, in fact, represents the boom and bust of the business cycle.
America’s central bank, the Federal Reserve, increases the money supply by buying government securities and other assets with the new money first entering the economy through the banking system. Finding themselves, with extra money to lend, banks entice borrowers to borrow more by offering those funds at lower, more attractive interest rates.
The demands and prices for investment and construction projects (including home-building) start to rise, with workers and resource providers drawn into these parts of the economy. Their higher wages and resource earnings enable them to demand more of the goods they can now afford to buy. And the process continues, step-by-step, until more or less all prices and wages will be pushed up to higher levels than before.
But the entire structure of the economy – the demands for investment and construction, the jobs into which workers and others have been drawn through the inflationary spending – is now dependent on the monetary expansion continuing and keeping the patterns of demands and jobs artificially created by this process to continue to go on-and-on.
Once any attempt is made by the central bankers to slow down or stop the monetary expansion in the face of worsening price inflation, the entire house of cards begins to crumble. The boom turns into the bust, as investments undertaken and jobs created are discovered to be the misdirected outcome of money creation and the unsustainable patterns of demand and employments that could last only for as long as the inflationary spiral was kept going.
The “little bit” of inflation that some Harvard economists, Federal Reserve presidents and some in the business world are saying is not only nothing to worry about but is the panacea for all our economic ills, is a phony elixir to cure our national ailments. It will only set America on an even worse inflationary boom-bust rollercoaster than the one that current Federal Reserve monetary policy has been already setting us up for.
Until we learn from the past, we will continue to expose ourselves to devastating booms and busts. The Bernanke-led Fed has only exacerbated the problem, leading us to the brink of an even worse correction. … Without the meddling of central-bank intervention, the market — like any natural homeostatic system — can reestablish equilibrium on its own by allowing its natural entrepreneurial “governors” to work. Greater savings prompts longer-term production for future greater consumption (and the inverse). The natural order trumps intervention every time.
Until we learn from the past, we will continue to expose ourselves to devastating booms and busts. The Bernanke-led Fed has only exacerbated the problem, leading us to the brink of an even worse correction. …
Without the meddling of central-bank intervention, the market — like any natural homeostatic system — can reestablish equilibrium on its own by allowing its natural entrepreneurial “governors” to work. Greater savings prompts longer-term production for future greater consumption (and the inverse). The natural order trumps intervention every time.
— Mark Spitznagel, Interventionist Policies Cause Of, Not Cure For, Busts
The “war to save the economy” was unnecessary since it was a crisis wholly the result of previous actions by one of the supposed saviors of the economy. …
The financial crisis and the Great Recession were consequences of monetary central planning writ large that twice created bubbles, booms, and subsequent busts by turbocharging first the dot-com-driven productivity growth, and then simultaneously using an easy money and credit policy to impede necessary re-structuring of the economy. Following the dot-com bust, these policies led to an “unfinished recession” while new credit creation began a new round of misdirection of production igniting the housing bubble, general boom, and subsequent bust.
Back in the boom days, anyone who questioned double-digit growth in housing prices was viewed as an unenlightened Cassandra, lacking knowledge on how the new economy had fundamentally changed the law of scarcity. Austrian economists consistently warned that a boom built on foundation of easy money could only lead to a disaster. Today, most of the growth is coming from the interest rate-sensitive sectors of the economy, such as cars and housing. This should be ringing warning bells everywhere.
The conventional wisdom is that the Fed will begin to taper when growth picks up. This is a complete misreading of what is actually happening. The Fed made a monumental mistake, and does not really know how to get out of the trap it had set upon itself.
The Fed embarked on a “we know best” policy of QE3 in the fall, and induced a market bubble in the spring. The S&P 500 gained 12 percent from January to June 2013 while growth remained subdued. The Fed realized its mistake, and now wants to get out. The problem is that in economics, as with most things in life, it’s much easier to get into trouble than out of it. The FED wants to take away the punch bowl, but knows that interest rates will rise, the stock market will crash, and the economy will tank. The longer it waits, the greater will be the inevitable adjustment. …
We currently fear Fed tapering, as we should. Yet, we should be even more fearful that it doesn’t taper. Today, we really have a dreaded choice of losing an arm now or two arms and a leg tomorrow. Because the price distortions have been massive, the adjustment will be horrendous. Government policy makers and government economists simply do not understand the critical role of prices in helping discovery and coordination. …
When the Fed is finally forced to cut back, interest rates will rise, Wall Street will call for relief, and the economy will slump. This may be delayed with additional printing for a couple of months, but the adjustment will occur and it will be severe, probably much worse than in 2008. However, this time there are no arrows left in the government’s quiver to spend or print its way out of trouble.
Keynesian business cycle theories are based on the idea that cycles are caused by changes in aggregate demand. This theory, however, provides no purely economic cause for business cycles. The instigator or cause in Keynesian theory is a psychological factor that is driven by so-called “animal spirits.” Small changes in entrepreneurs’ optimism and pessimism affect their investment decisions and can spread and snowball out of control causing sharp increases and decreases in aggregate demand, profits, and employment.
The general solution for these problems within the Keynesian framework is for aggregate demand to be decreased or increased by the public sector as a substitute for the private sector. The primary means to increase public sector aggregate demand is to increase government spending financed by borrowing rather than taxes.
The problem with Keynesian business cycle theory is that cycles just happen or are brought about by random exogenous factors. With the Housing Bubble, people just went out and built too many houses and then realized they made a mistake. At that point, the animal spirits of depression took over the economy and in particular the housing and banking sectors went into a tailspin. The Keynesian explanation for the Housing Bubble crisis is correct in that expectations were psychologically impacted in a positive way during the bubble and in a negative manner after the crash and therefore do play a part in the narrative describing the cycle. …
It would be difficult to deny the psychological changes in people and markets that occur over the business cycle. In a true boom economy everyone is making money and they are often making more than they ever expected. Wealth, income, and wages grow at a very fast pace. Skyrocketing asset values encourage conspicuous consumption. Likewise, after boom turns to bust people first tend to deny that there has been any fundamental change in the economy.
However, these psychological experiences should be viewed as effects rather than causes.
It also would be difficult to deny that real changes and shocks occur over the business cycle, particularly during the boom. Most booms or bubbles are in fact linked to new technologies and specific industries and products. The Housing Bubble was linked to “subprime” and related financial innovations. The “tech” or dot.com bubble of the late 1990s, the Japanese Bubble of the 1980s, the Booming 60s and the Roaring 20s all expanded on the basis of new technologies in terms of products as well as production, distribution, and management processes. …
The Austrian business cycle (ABC) theory asks the question “why?” What is the ultimate cause of this cyclical process described by these approaches to understanding business cycles?
To answer this question, Austrians look at prices. The “price” that is most important at the macroeconomic level is the interest rate, whether it is the interest rate on loans, interest as the return to capital, or the natural interest rate based on time preferences in the overall economy. In a pure market economy the loan rate of interest would follow the natural rate of interest. Austrian economists have developed a theory of interest that explains the natural rate of interest as being based on social time preference.
The problem of the business cycle arises when the loan rate of interest diverges from the natural rate of interest. While this divergence could happen in a free banking system, the major divergence occurs under central bank regimes when large reductions of the interest rate are executed by injecting money into the banking system over a long period of time. A larger volume of loans is thereby made possible. The lower interest rate increases investment and consumption and reduces savings. These changes in the economy provide the conditions for a boom in the economy. If the new funds are funneled into a specific sector of the economy, a bubble could result.
So the central bank is the ultimate cause of the business cycle. Its actions first cause such things as heightened optimism and technological innovations during the boom that ultimately end up being malinvestments, damaged expectations, and depression in the bust. …
Back in 2004, I wrote an article that shows that by using the ABC theory, Austrian economists were able to observe the economy of the early 2000s and detect signs of the existence of a housing bubble where others could not. And Walter Block has showed that numerous Austrian economists and “Austrian” financial analysts published warnings of a housing bubble. The vast majority of mainstream and government economists saw no major problems in the economy at this time. In fact, as we came closer to the bubble collapsing, there were more denials of a housing bubble and more claims of the emergence of a new paradigm.
In fact, Austrian economists have a long record of spotting bubbles in the economy. For example, I pointed out here that Mises, Hayek, and other Austrian economists were aware that the 1920s were a period of unsustainable boom conditions and financial imbalances, whereas Irving Fisher had declared a permanently high plateau and continued to deny the problem throughout the stock market’s historic collapse. I also found that Hazlitt, Mises, and Rothbard were writing and speaking out against the U.S. government’s economic policy and the dangers to the dollar during the late 1960s, while Keynesian economists such as Arthur Okun, the chairman of the President’s Council of Advisors declared the business cycle had been defeated. What was ahead was the demise of Bretton Woods and the stagflation of the 1970s.
AEN: You’ve done some interesting work on that great diversion, the Phillips Curve.
HERBENER: A professor of mine used to say that the Phillips Curve is a fact in search of a theory. But he had it backwards. It never was a fact. The theory was that there was a trade-off between unemployment and inflation. But if you go back to the original article by Phillips, he never demonstrates that such a thing exists in the real world. He manipulated and maneuvered the data around to make it look as if there was one. Once his errors are swept away, and the data broken down, the Phillips Curve vanishes as any kind of long-run pattern. It didn’t take stagflation to teach us that. It was always untrue.
This raises a much more interesting question. How did the idea ever come to dominate the macroeconomic literature in the first place? Here’s my theory. Recall that Keynesian theory suggests there are no downsides to manipulating aggregate demand through fiscal and monetary policy. If you created full employment, it would stay there and we’d all live happily ever after. It seems paradoxical, then, that Keynesians would embrace a theory that suggests that creating full employment risks generating inflation. Keynes never said that, but people like Paul Samuelson did.
AEN: So the Phillips Curve gave them an out.
HERBENER: Exactly. It became fairly well recognized, even in the 1950s, that there could be such things as inflationary recessions. That put orthodox Keynesians in big trouble. In order to cover themselves, Samuelson and Solow adopted the Phillips Curve as a model. It served as the means to save themselves from the realization that Keynesianism was fundamentally flawed.
When inflation and unemployment increase, they don’t have to throw in the towel on Keynesian theory; they merely claim that the Phillips Curve has shifted outwards. They are saved–until of course the outward and inward shifts of the whole curve dominate movement along the curve. That means the supposed trade-off itself has disappeared. That’s exactly what happened. Many people see that the curve is now discredited. But in fact, it never did stand up. It was an escape hatch built by Keynesians that no longer allows them an escape.
AEN: Yet it continues to be the main lens through which most business reporters and even Federal Reserve officials view the world.
HERBENER: Just the other day, I read a piece by an economist at the American Enterprise Institute who was amazed at the mysterious fact that our economy has sustained high levels of growth while still not triggering inflation. This idea that growth “triggers” inflation is sheer Phillips-style analysis. It’s hard to believe educated people still talk that way.
On the other hand, it has a superficial plausibility. It’s true that if you pump money into the economy to create a boom, that can cause the unemployment rate to fall. The downside is that the new money–not the employment or growth as such–also risks creating inflation.
So here is an opening for Austrians. This phenomenon does have an explanation within the context of the Austrian business cycle theory. What’s occurring is not a mechanistic trade-off, but a credit-created boom in the capital goods sector followed by its inevitable consequences. Inflation expectations don’t kick in immediately, and neither is there a statistically predictable lag, as the Chicago School once claimed. Austrians can explain both the Phillips-type phenomenon, to the extent it appears, as well as its breakdown.
The beauty of the Austrian School is, fundamentally, this: It sees economics as an extension of human choice. There is nothing mechanical and predictable about it. But there are certain patterns that emerge just from the logic of human action itself.
— Jeffrey Tucker
For most economists, the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability. We suggest that by means of monetary policies that aim at stabilizing the price level the Fed actually undermines economic fundamentals.
— Frank Shostak, Stable Prices, Unstable Markets
Some key excerpts from the excellent essay by Robert Higgs:
In reality, the market system tends to foster an efficient allocation of resources—it constantly creates incentives for resource owners to direct their resources away from areas in which those resources have lesser value and toward areas in which they have greater value. Taxes, subsidies, and other government intrusions in the market process in effect falsify the price “signals” that guide market participants in their decisions about how much to buy, how much to sell, how to produce, where to produce, and exactly when to take various actions. If false prices should become established in a free-market system—if, for example, the price of gasoline in one town became greater than the price in a neighboring town by an amount greater than the cost of transporting a gallon of gasoline from one town to the other—entrepreneurs would have an incentive to move the product to the place at which it has a greater value.
In doing so, they would cause the lower price to become higher, and the higher price to become lower, and they would move the market toward an efficient allocation of resources. Those old enough to remember the so-called energy crises of the period from 1973 to 1981 in the United States will appreciate immediately how poorly the market system works when such price changes and resource reallocations are forbidden.
Government interference in the price system blunts or destroys the incentives that would otherwise lead entrepreneurs to reallocate resources more efficiently. Taxes destroy the incentive to produce more of certain goods that, without the tax, would be profitable to produce. Subsidies create the incentive to produce more of certain goods that, without the subsidy, would be unprofitable to produce. Taxes and subsides, and likewise regulations in various more complex ways, distort the true information inherent in the free market’s pricing process. By responding to the false prices of a government-distorted market system, entrepreneurs may enrich themselves, but only at the greater expense of the economy as a whole, not to mention the sacrifice of economic freedom inherent in the government’s coercive tax-and-subsidy system.
In this connection, we should recognize that interest rates are key relative prices, and hence government or central bank actions that push interest rates above or below their free–market levels are another way to suppress the truth about economic conditions. Artificially altered interest rates, indeed, are perhaps the most important form of falsification in economic life because they play a key role in inducing the malinvestments whose inevitable bankruptcy heralds the onset of economic busts, creating pervasive economic losses, unemployment of capital and labor, and human suffering that would not have occurred if only the government and the central bank had refrained from interfering in the market’s price-setting process. …
In both the realm of economic research and the realm of economic policy, freedom is an essential condition for the generation of truth and thus for the enhanced enjoyment of social life that depends on making use of true, rather than false, information.
The academic world of the show-off, pyrotechnic economists who dominate today’s mainstream profession would be impossible without the vast government subsidies that support these economists and the institutions in which they concoct their wizardry. Given a choice, consumers would not buy their glitzy but worthless research reports. The funds that support this superficially impressive intellectual showmanship must be extorted from taxpayers by threatening them with fines and imprisonment.
In similar fashion, the grossly distorted economy in which—to take but one example among thousands—ethanol producers and corn farmers are enriched at the expense of the direct and indirect consumers of corn throughout the world would be impossible without the huge subsidies and government mandates that have brought the biofuel industry to its present size and configuration. Without the various forms of taxes borne by producers today, many valuable goods and services would be supplied in enormously greater quantities. Work, saving, investment, and technological progress would be much greater and economic growth much faster in a world that relied on true information about relative exchange values, rather than on the false signals brought into being by the government’s coercive, politically inspired intrusions.
In economics, as in other areas of life, the pursuit and exploitation of truth depend on freedom. Every cognizant adult knows that virtually all politicians are habitual liars. Too few of us understand, however, that the free market itself is a grand generator of truth, and that, in general, government intrusion of any kind operates to substitute falsehood for this truth, with devastating consequences for the genuine flourishing of human beings in their social and economic lives.
President Obama is again turning his attention to the elusive economic recovery. His “pivot” will be for naught, however, as long as he continues to ignore two important points: first, government is a major squanderer of scarce resources, and second, its regulations are impediments to saving and investment.
We live in a world of scarcity. At any given time our ends outnumber the means to achieve them. Hence we economize so that we can achieve as many of our ends as possible. Resources, labor, and time devoted to one purpose can’t also be used for other purposes, and the alternative forgone is the true cost of any action. We individually choose among competing ends after assessing the trade-offs, because we don’t want inadvertently to give up something we prefer in exchange for something we don’t value as much.
The marketplace, when it’s free of government privilege and regulation, lets us accomplish this to a remarkable degree. In doing so, it raises our living standards and creates an orderly environment, thanks to the price system, which coordinates and facilitates our plans.
Government throws this process out of whack. When politicians forcibly extract resources from us (through taxation) and borrow, they leave us less with which we can improve our lives through entrepreneurship, business formation, and the like. But, you may ask, aren’t the politicians’ projects worthwhile? Actually, many government projects are of zero value or worse. The costly global empire is beyond useless: it endangers us. Other projects might be useful, but — and this is key — we can’t be sure, because they are not subject to the market test.
If a private entrepreneur acquires resources in a quest for profit, she must create value for consumers or she will fail. The market’s profit-and-loss test will see to that. That test is administered by countless millions of consumers who are free to take or leave what the entrepreneur offers. This test is relayed back to the investors who lend money to entrepreneurs for productive ventures. They know that if the entrepreneur fails, they will also suffer losses. So they must scrutinize projects in terms of their potential, ultimately, to please free consumers.
The upshot is that consumers’ uncoerced actions signal (through prices and profit/loss) what pleases them and what does not. Suppliers must pay heed or face bankruptcy. This explains why markets, when not burdened by government privileges and arbitrary rules, work so well to raise living standards.
Note how government projects differ essentially from market projects. Politicians and bureaucrats obtain their money through force, not consensual mutual exchange. (What happens if you tell the IRS you don’t want to purchase its “services”?) Even the money obtained through voluntary loans is expected to be repaid with the taxpayers’ money. It’s taxation all the way down.
Moreover, government “services” are not offered in a competitive market where consumers are free to take them or leave them. Since we’re forced to pay a monopoly provider regardless of whether we want the “services,” at the point of delivery they appear to be free. You can’t opt out of paying for “free public schools” even if you don’t want to use them. Everyone pays into Social Security, a (meager) pension plan, under threat of force. In other words, government services are not true services in the market sense because they face no market test from consumers free to withhold their money without penalty.
The market test assures that bad trade-offs are avoided, or at least quickly corrected if they are made. If steel is being used to make one product when consumers are demanding something else, the competitive entrepreneurial process sees to it that steel will be redirected.
No corresponding process exists in the political realm. It contains no incentives to look out for the consumers’ welfare. Instead, we have political theater and value destruction.
This would be bad enough, but it’s actually worse. What government does with the stolen resources typically makes it harder for us to use the remaining resources productively. Uncertainty about future taxation and regulation, for example, increases the risk of investment and hence reduces it.
According to most commentators, although not an easy task, experienced and wise policy makers should be able to navigate the US economy away from various bad side effects that come in response to a tighter Fed stance. We suggest that whenever the Fed raises the pace of monetary pumping in order to “revive” the economy it in fact creates a supportive platform for various non-productive bubble activities that divert real wealth from wealth generators. Whenever the US central bank curbs the monetary pumping this weakens the diversion of real wealth and undermines the existence of bubble activities—it generates an economic bust. We suggest that there is no way that the Fed can tighten its stance without setting in motion an economic bust. This would defy the law of cause and effect.