An Overview of the "Audit the Fed" Debate

The debate over H.R. 1207 and S. 604 is achieving quite a bit of publicity. I would like to compile some of the questions and resources surrounding it. To be clear - the audit gives the Government Accountability Office (GAO) additional power to examine

• The Fed’s discount window operations
  
• Funding facilities
  
• Open market operations
  
• Agreements with foreign banks and governments

With that said, lets take a look at the arguments for, and against, auditing the Fed.

Why should we audit the Fed?

In The Case Against The Fed, Murray Rothbard argues that the Fed enjoys a greater secrecy and independence than even the CIA.

The CIA and other intelligence operations are
under control of the Congress. They are accountable: a Congressional committee supervises these operations, controls their budgets, and is informed of their covert activities. It is true that the committee hearings and activities are closed to
the public; but at least the people's representatives in Congress insure some accountability for these secret agencies.

...

The FederalReserve System is accountable to no one; it has no budget; it is subject to no audit; and no Congressional committee knows of, or can truly supervise, its operations. The Federal Reserve, virtually in total control of the nation's vital monetary system, is accountable to nobody—and this strange situation, if acknowledged at all, is invariably trumpeted as a virtue.

...

So: if the chronic inflation undergone by Americans, and in almost every other country, is caused by the continuing creation of new money, and if in each country its governmental "Central Bank" (in the United States, the Federal Reserve)
is the sole monopoly source and creator of all money, who then is responsible for the blight of inflation? Who except the very institution that is solely empowered to create money, that is, the Fed (and the Bank of England, and the Bank ofItaly, and other central banks) itself?

Rothbard's first chapter is excellent, and highly relevant to this post. I would strongly recommend reading it in its entirety.

Ron Paul articulates:

Claims are made that auditing the Fed would compromise its independence. However, by independence, they really mean secrecy. The Fed clearly cherishes its vast power to create and spend trillions of dollars, diluting the value of every other dollar in circulation, making deals with other central banks, and bailing out cronies, all to the detriment of the taxpayer, and to the enrichment of themselves. I am happy to challenge this type of “independence.”

They claim the Fed is endowed with special intellectual abilities with which to control the market and that central bankers magically know what the market needs. We should just trust them. This is patently ridiculous. The market is a complex and intricate thing. No one knows what the market needs other than the market itself. It sends signals, such as prices, that should be reacted to and respected, not thwarted and controlled. Bankers are not all-knowing and cannot ignore the rules of supply and demand. They might act as if they are, but their manipulation of the market just ends up throwing it wildly off balance, which gives us the boom and bust cycles.

They claim the Fed must remain apolitical. No organization is apolitical that relies on the President to appoint the Chairman. In fact, it is subject to the worst sort of politics – power to create trillions of dollars and affect the value of every dollar in the country without the accountability of direct elections or meaningful oversight! The Fed typically enacts monetary policy that is favorable to particular administrations close to elections, to the detriment of long-term considerations. They do this partly because of the political appointee process for the Chairmanship.

Ron Paul recently articulated the conflict between the people and the Central Bankers in this appearance on MSNBC:




Over at Campaign For Liberty, Peter Orvetti asks "What's the Establishment Got to Hide?"

A dollar today is worth less than one-twentieth what it was worth on the day the Federal Reserve was created 96 years ago. Yet over all that time, the unelected Fed has never had to face the full scrutiny of our elected representatives that other powerful agencies must. Even our intelligence agencies must report to Congress -- but not the Fed, which has helped rack up an $11 trillion national debt, and an additional $13 trillion in dubious loans and bailouts.

The Fed will not say where that money is going. Chairman Ben S. Bernanke has refused to tell Congress, and why should he? There is no means to compel him, and no way to find out what he’s been doing. The Federal Reserve Transparency Act would change that.

C-SPAN covers an excellent debate with Tom Woods and others (including Warren Coats, former IMF official) on the pros and cons of auditing and abolishing the Federal Reserve. The basic positions are:

• Audit and abolish the Fed and replace it with private commodity money and private banking.
• Strip the Fed down to the sole task of protecting the value of the dollar.
• It is too impractical to end the Fed without creating economic instability, so another plan is needed.

It is a very good video, if you have the time I recommend it.

The Smith Family Foundation hosts a very similar debate with George Selgin, Peter Schiff, Steven Axilrod (former member of the Federal Reserve's Board of Governors), and a political science professor from Columbia University:



I just want to point out that at minute 58 Axilrod exposes the political interests of the Fed and its Board of Governors.

Why shouldn't we audit the Fed?

Too Big To Bail makes the case that to audit the Fed is essentially to end it, and we should not forget that ultimately it was Congress that created the Federal Reserve system and as such they should be blamed for it. In other words, we are to blame for it, and blaming Bernanke and the Fed for our woes is misplaced anger. As he states,

Don’t get me wrong. I think the idea of a Fed and fiat currency, are bad ideas. I just think we should stop the classic congressional game where we create a problem and then complain about the Fed as if they are to blame. We created the beast and now are not happy with it. We can pull the plug whenever we want. But doing so would be an admission that we screwed up, not the Fed. The issues everyone has seems to be with the institution per se. And we created the institution.

So within the very framework that we set up, the Fed’s argument in favor of independence seems to make perfect sense. Of course, I question the whole framework, but given the situation, it does make sense.

Fed Chairman Ben Bernanke speaks on the issue, and claims that the audit would nullify Fed independence -




And from his article in the WSJ:

The Congress, however, purposefully--and for good reason--excluded from the scope of potential GAO reviews some highly sensitive areas, notably monetary policy deliberations and operations, including open market and discount window operations. In doing so, the Congress carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining an appropriate degree of independence for the central bank in the making and execution of monetary policy. Financial markets, in particular, likely would see a grant of review authority in these areas to the GAO as a serious weakening of monetary policy independence. Because GAO reviews may be initiated at the request of members of Congress, reviews or the threat of reviews in these areas could be seen as efforts to try to influence monetary policy decisions. A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability. We will continue to work with the Congress to provide the information it needs to oversee our activities effectively, yet in a way that does not compromise monetary policy independence.

The Washington Post also thinks auditing the Fed is dangerous:

Though the bill has attracted 276 co-sponsors in the House and 17 in the Senate, it is wrongheaded in the extreme. By opening up the Fed's most sensitive interest rate and credit policies to public second-guessing, the bill would create a risk -- real and perceived -- of monetary policy bent to suit congressional overseers. This would destroy financial markets' faith in the Fed and, by extension, the value of the U.S. dollar, just as surely as a political "audit" of the Supreme Court's deliberations would undercut public faith in the justice system. ... The Federal Reserve Transparency Act is an unserious answer to a serious question.

If I may, the serious question is the existence of the Federal Reserve itself. As I find more sources I will update this post and continue to compile them. I hope this is a good start for you, though.

Unintented Consequences with Walter Williams

An excellent video series exploring the negative effects of state legislation on black people. The same legislation that was supposedly proposed to help blacks.







These videos do a great job exploring the themes of Henry Hazlitt's "Economics in One Lesson". The barrier to entry that is minimum wage, unintended consequences of government intervention in markets, and the deleterious effects of welfarism on the human spirit.

Two Images - Two Countries - Two Governments

Two Bureaucracies.

Who owns the Fed?

You would think this question would have an easy answer. Is it public or is it private? If it is public, we the people own it. If it is private, well, the shareholders own it. So who owns the Federal Reserve? Let me google that for you.

Here's what the Fed has to say about the matter:

"The Federal Reserve System is not "owned" by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects."

Maybe it is just me but that is confusing. Why is "owned" in quotations? So it is not a profit-making institution, but an independent entity within the government. If that is the case, why did a Federal District Court in California rule that the Federal Reserve is a private corporation? See here:

"Plaintiff, who was injured by vehicle owned and operated by a federal reserve bank, brought action alleging jurisdiction under the Federal Tort Claims Act. The United States District Court for the Central District of California, David W. Williams, J., dismissed holding that federal reserve bank was not a federal agency within meaning of Act and that the court therefore lacked subject-matter jurisdiction. Appeal was taken. The Court of Appeals, Poole, Circuit Judge, held that federal reserve banks are not federal instrumentalities for purposes of the Act, but are independent, privately owned and locally controlled corporations."

And further,

"Each Federal Reserve Bank is a separate corporation owned by commercial banks in its region. The stockholding commercial banks elect two thirds of each Bank's nine member board of directors. The remaining three directors are appointed by the Federal Reserve Board."

And,

"Examining the organization and function of the Federal Reserve Banks, and applying the relevant factors, we conclude that the Reserve Banks are not federal instrumentalities for purpose of the FTCA (Federal Tort Claims Act), but are independent, privately owned and locally controlled corporations."

It is worthwhile to read the ruling in its entirety, but "independent, privately owned and locally controlled corporations" doesn't seem to jive with "an independent entity within the government". Maybe the District Judge was confused. I certainly am. Lets see if this handy chart from the Richmond, VA Fed can help us...



So the member banks (commercial banks like Citi, JP Morgan, etc.) are the shareholders in the local Federal Reserve banks, and they appoint two-thirds of the board of directors which manage the local banks. Each banks' board of directors appoints a president, five of whom in turn sit on the Federal Open Market Committee. Stop me when I hit public ownership land, by the way. The Federal Open Market Committee is comprised of five presidents from regional banks, and seven members of the Board of Governors. The Board of Governors is appointed by the President and confirmed by the Senate. The Board of Governors appoints the other third of the board of directors at local Federal Reserve banks, and is advised by a Federal Advisory Council comprised of a representative from each of the twelve regional banks.

Aside from all the confusion, I don't see any public ownership in there at all. There is some public representation - the Board of Governors and their appointment of 1/3 of each banks' board of directors. That is not much. Anyway, who owns the Fed?

Here is an excerpt from an article written by former N.Y. Attorney General Eliot Spitzer on the cozy relationship between the N.Y. Fed and Wall St: (italics mine)

"Given the power of the N.Y. Fed, it is time to ask some very hard questions about its recent performance. The first question to ask is: Who is the New York Fed? Who exactly has been running the show? Yes, we all know that Tim Geithner was the president and CEO of the N.Y. Fed from 2003 until his ascension as treasury secretary. But who chose him for that position, and to whom did he report? The N.Y. Fed president reports to, and is chosen by, the Fed board of directors.

So who selected Geithner back in 2003? Well, the Fed board created a select committee to pick the CEO. This committee included none other than Hank Greenberg, then the chairman of AIG; John Whitehead, a former chairman of Goldman Sachs; Walter Shipley, a former chairman of Chase Manhattan Bank, now JPMorgan Chase; and Pete Peterson, a former chairman of Lehman Bros. It was not a group of typical depositors worried about the security of their savings accounts but rather one whose interest was in preserving a capital structure and way of doing business that cried out for—but did not receive—harsh examination from the N.Y. Fed."

Spitzer appears to be suggesting that Geithner works more for Wall St. than he does for the Fed. This quasi-conspiracy theory about Geithner is also advanced by former Assistant Treasury Secretary Paul Craig Roberts (@ 2:50) :

The Federal Reserve system has all the pomp and veneer of a government institution:

• The name implies a Federal agency
• The public face, Chairman of the Board of Governors, is appointed by the President
• It was created in name of the "public interest", to protect the value of the dollar and provide economic stability
  
• Has regulatory power over other private corporations
• Non-profit organization
• Has a special .gov web address
  

Despite these embellishments, the District Court of California found it to be a private corporation, and we don't know who the major shareholders currently are. So who owns the Fed? We don't really know. It sure isn't the American people. It appears to me that the Federal Reserve banks are by and large owned by member banks, possibly other foreign central banks, and are "directed" mostly by people who have ties to the banking industry. Can you see why conspiracy theories begin to emerge? Until we can have a proper audit of the Fed, we won't know who owns it.

Support Ron Paul's bill to audit the Fed. Why? 'Cause he pwns the Fed!

Does Capitalism Work?

Here is a map depicting how each states' GDP compares to other countries around the world:

















What system can generate such a circumstance? How can comparatively small states like New Jersey can produce more than the geographical area of Russia? Is it merely that New Jersey has more natural resources than all of Russia? Or that the people of New Jersey are smarter than the people of Russia? Or is it related to each states' respective proximity to the natural state of liberty?

From the index of economic and political freedom:

"State involvement in economic activity remains considerable, and institutional constraints on economic freedom are severe. Non-tariff barriers add significantly to the cost of trade. Inflation is high, and prices are heavily controlled and influenced by the government. Virtually all foreign investment faces official and unofficial hurdles, including bureaucratic inconsistency, corruption, and outright restrictions in lucrative sectors like energy. Corruption weakens the rule of law and increases the fragility of property rights and the arbitrariness of law enforcement."

The answer is quite simple - the government acts as an obstacle to natural market activity. Price controls and excessive bureaucracy prevent individuals from disposing of their property how they see fit. A weakened rule of law and barriers to trade stifle risk taking and entrepreneurship. All of these things lower productivity. The truth becomes clear - it does not matter how many natural resources a country has, nor how intelligent the population is. If government will not allow people to trade freely with each other, guarantee the security of property and establish the rule of law, productivity and quality of life will suffer.

Thomas Jefferson, George Washington, and the rest of the founders took a different approach. They recognized both the economic and personal woes that emerge from a bloated State. The United States was founded on the principles of individual liberty and the rule of law, precisely what is lacking in Russia. Capitalism works, and one need to look no further than to compare New Jersey to Russia.

* It should be noted that New Jersey outproduces Russia despite being one of the most heavily taxed and regulated State's in the Union.

I, Pencil

Cafe Hayek directed me to this essay, which I enjoyed thoroughly. It is the story of how a pencil is made, which seems boring at first, but the perspective taken illuminates the wonder of free markets beautifully.

Here are some excerpts:

You may wonder why I should write a genealogy. Well, to begin with, my story is interesting. And, next, I am a mystery—more so than a tree or a sunset or even a flash of lightning. But, sadly, I am taken for granted by those who use me, as if I were a mere incident and without background. This supercilious attitude relegates me to the level of the commonplace. This is a species of the grievous error in which mankind cannot too long persist without peril. For, the wise G. K. Chesterton observed, "We are perishing for want of wonder, not for want of wonders."

Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others. Now, you may say that I go too far in relating the picker of a coffee berry in far off Brazil and food growers elsewhere to my creation; that this is an extreme position. I shall stand by my claim. There isn't a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infinitesimal bit of know-how. From the standpoint of know-how the only difference between the miner of graphite in Ceylon and the logger in Oregon is in the type of know-how. Neither the miner nor the logger can be dispensed with, any more than can the chemist at the factory or the worker in the oil field—paraffin being a by-product of petroleum.

I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the configuration of creative human energies—millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire and in the absence of any human master-minding! Since only God can make a tree, I insist that only God could make me. Man can no more direct these millions of know-hows to bring me into being than he can put molecules together to create a tree.

Don Boudreaux adds,

Whenever I hear or read someone proclaim that "the market doesn't work," I try (if the situation permits) to ask him or her how is it that an ordinary pencil exists. Its production requires the cooperation of literally millions of people from around the world. Not one in one-thousand of these people know each other. Many of them, were they to meet, would positively hate each other. And yet, pencils exist in appropriate abundance, and can be acquired almost free of charge. (If you're in the United States, go up to strangers on the street, in shopping malls, or at your school or workplace and ask for a pencil. You'll not wait long before someone gives you one without expecting it to be returned. I do this experiment frequently; it works.)

To be fair, lets not forget to consider the statist take on this whole process:

But, but you need a government person to supervise the transaction. So first we must pass laws, and then create the departments of pencils. Then when someone's pencil tip breaks, they will call their senator and demand government do something about breaking pencil tips. A new set of regulations will appear, with the promise that this time it will fix the problem. The cost of pencils go up, sales go down, and the pencil lobby descends on Washington to add pens to the regulations. The department of pencils gets bigger, but pencil tips keep breaking and wearing out.

I will let someone else finish the story, as it never ends. (from comments @ Cafe Hayek)

I think there is a product out there for each person that will make the idea of "I, Pencil" clear to them. For me it is the existence of the grocery store. The myriad of products, some at incredibly cheap prices, oftentimes appear miraculous to me. The cost of a plastic bag at Wegmans, I am told by the cashier, is 25 cents. The cost of a can of corn, on sale, is 39 cents. That a can of corn - with all the division of labor that went into growing and harvesting the corn, the canning process, designing the label, and being shipped throughout the country - costs marginally more than a plastic bag is in my mind a great wonder in the world.

Jaguar Inflation

Found this over at Economics Junkie. A very clear illustration of how foolish and hopeless bubble blowing can be.

Written by Robert Prechter:

Jaguar Inflation

I am tired of hearing people insist that the Fed can expand credit all it wants. Sometimes an analogy clarifies a subject so let’s try one.

It may sond crazy, but suppose the government were to decide that the health of the nation depends upon producing Jaguar automobiles and providing them to as many people as possible. To facilitate that goal, it begins operating Jaguar plants all over the country, subsidizing it with tax money. To everyone’s delight , it offers these luxury cars for sale at 50 percent off the old price. People flock to the showrooms and buy. Later, sales slow down, so the government cuts the price in half again. More people rush in and buy. Sales again slow, so it lowers the price to $900 each. People return to the stores and buy two or three, or half a dozen. Why not? Look how cheap they are! Buyers give Jaguars to their kids and park an extra one on the lawn. Finally, the country is awash in Jaguars. Alas, sales slow again, and the government panics. It must move more Jaguars, or, according to its theory - ironically now made fact - the economy will recede. People are working three days a week just to pay their taxes so the government can keep producing more Jaguars. If Jaguars stop moving the economy will stop. So the government begins giving Jaguars away. A few more cars move out of the showrooms, but then it ends. Nobody wants any more Jaguars. They don’t care if they’re free. They can’t find a use for them. Production of Jaguars ceases. It takes years to work through the overhanging supply of Jaguars. Tax collections collapse, the factories close, and unemployment soars. The economy is wrecked. People can’t afford to buy gasoline , so many of the Jaguars rust away to worthlessness. The number of Jaguars - at best - returns to the level it was before the program began.

The same thing can happen with credit.
It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing credit and providing it to as many people as possible. To facilitate that goal, it begins operating credit production plants all over the country, called Federal Reserve Banks. To everyone’s delight , the banks offer the credit for sale at below market rates. People flock to the banks and buy. Later, sales slow down, so the banks cut the price again. More people rush in and buy. Sales again slow, so it lowers the price to 1 percent. People return to the banks and buy even more credit. Why not? Look how cheap it is! Borrowers use credit to buy houses, boats and an extra Jaguar to park out on the lawn. Finally, the country is awash in credit. Alas, sales slow again, and the banks panic. They must move more credit, or, according to its theory - ironically now made fact - the economy will recede. People are working three days a week just to pay the interest on their debt so the banks can keep offering more credit. If credit stops moving the economy will stop. So they start giving credit away at zero percent interest. A few more loans move through the tellers’ windows, but then it ends. Nobody wants any more credit. They don’t care if they’re free. They can’t find a use for it. Production of credit ceases. It takes years to work through the overhanging supply of credit. Interest payments collapse, banks close, and unemployment soars. The economy is wrecked. People can’t afford to pay interest on their debts , so many bonds deteriorate away to worthlessness. The value of credit - at best - returns to the level it was before the program began.

Keynes on Inflation

This is somewhat of a cross-post from Cafe Hayek, but I'd like to expound on it. John Maynard Keynes is an economist whose ideas have shaped government policy since the early 20th century. His ideas are the heart and soul of stimulus plans all over the world. Stimulus is supposed to be the antidote to massive deflation and the paradox of thrift. The government prints or borrows money for spending now, to "stimulate" the economy and improve private consumption rates. This policy is inherently inflationary, and it must be so. The only way to combat deflation is through inflation.

That being said, it is important to take a look at what Keynes himself said about the consequences of inflation:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls . . . become 'profiteers', who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished not less than the proletariat. As the inflation proceeds . . . all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless. (from pages 220-233 of The Economic Consequences of the Peace (1919))

Some will point out that he begins by stating that a "continuing process of inflation", and that perhaps a one time stimulus would be good. Let's look at the value of the dollar after we completely abandoned commodity money in 1971. (chart from here)



Look at what happened to the cost of living when the USA went off the gold standard. We are clearly in a "continuing process of inflation". Let's look at the lower part of the graph for some interesting events in US history.

• 1860-1865: Funding the civil war creates massive inflation.
• 1913-1920: The Fed is created, an agricultural depression occurs.
• 1930-1940: The Great Depression.
• 1940-1945: Funding WWII.
• 1970-1980: End of Bretton-Woods
• 1980-present: Stable 2-3% inflation

There is a divergence in the two graphs, as inflation appears to be stable at 2-3%, the cost of living skyrockets. If inflation is low and constant why would the cost of living grow so rapidly? What is the cause? Not allowing a deflationary force to manifest is to create an inflationary force. Before 1940 we had alternating periods of deflation and inflation, which gave us stable average prices over time. There basically has been no net deflation since 1940, only varying degrees of inflation. That is why the cost of living has gone up year after year. You can thank these guys.

To your left you'll see a table charting the declining value of the dollar since the creation of the Federal Reserve in 1913. The dollar lost 50% of its value (you need twice as many dollars for the same purchasing power) between 1913-1920, 1920-1970, 1970-1980, 1980-2000. From 1913-2008 the dollar has lost ~95% of its value.

Now that continuing process of inflation is clear, lets revisit some of the consequences that Keynes' spoke of:

• Governments can, in a hidden way, arbitrarily confiscate the wealth of their citizens.
  
• Typically the poor and middle class lose money while foreign and domestic banks and other financial institutions profit from inflation.
  
• When the poor and middle class see this arbitrary rearrangement of riches, it is blamed on capitalism.
• Eventually the relationship between creditors and debtors is so distorted that the debtors will never possibly be able to pay back what they owe, and so the two terms become essentially meaningless.

Keynes is saying that inflation can be dangerous. Not in the mere sense that people will lose value of their money, but that it undermines the entire system of capitalism! Nowadays, deflation is a dirty word. In the not so distant future inflation will be the dirty word. The truth is that there are no dirty words in economics, but in politics. This is what is happening in the USA. Furthermore, the politicians are acting on the assumption that we are not in a "continuing process of inflation" and thus a one time "stimulus" would possibly work. Keynes implies that is an exceedingly dangerous assumption.

Happy birthday John Maynard Keynes
June 5, 1883 - April 21 1946

Fresh produce + what lies ahead 5.31.09

1. Germany may amend its constitution to ban budget deficits.

2. Russian perspective on American Marxism in 2009.

3. Bond vigilantes. Excerpt:

“There’s becoming an embedded inflationary premium in the bond market that wasn’t there six months ago,” Gross said yesterday in an interview at a conference in Chicago.

The US government is stuck in a very dangerous situation. They have chosen to prop up existing financial institutions with trillions of dollars, yet there are only three ways to get that money: raise taxes, borrow it, or print it. After decades of deficit spending the USA is now unable to raise taxes without strangling growth, borrow money without investors demanding higher interest rates, or print money without risking severe inflation.

The simplest solution is to face the reality that there is no money left for entitlements. The people and the government are to blame for attempting to live beyond their means for so many decades. Germany is cutting spending massively - Obama is spending $634 billion as a down payment on universal health care entitlements. It does not appear to me that the US government is even considering facing the reality that there is no money left for entitlements.

4. The government took on $6.8 trillion in new obligations in 2008, pushing the total owed to a record $63.8 trillion.

Someone will have to pay for this. Maybe this generation, maybe the next generation, but reality will eventually make its presence felt. Unfortunately in this case it will not be gentle.

What is seen and what is unseen for May 21, 2009

In keeping with the general theme of this web log, I would like to illustrate the principle that Frederic Bastiat so keenly illustrated in his parable of the broken window. A good economist will take into account the effects of an action or policy on all groups, across all time scales. With that in mind, let's take a look at a new policy proposed by Rep. Alan Grayson (D) from Florida.

The Paid Vacation Act will:

"...require companies with more than 100 employees to offer a week of paid vacation for both full-time and part-time employees after they’ve put in a year on the job. Three years after the effective date of the law, those same companies would be required to provide two weeks of paid vacation, and companies with 50 or more employees would have to provide one week."

Sweet! Who doesn't like vacation, right? The idea here is that more vacation days increase worker productivity and happiness, and result in people using less unnecessary sick days. These developments are claimed to stimulate the economy. They certainly sound good. What worker wouldn't want more paid vacation time? These workers would most probably be happier and may be more productive as a result.

Here is what we'll see if the bill is passed: more people on vacation and a boom in the travel industry. Will overall productivity increase? Let's look at what is unseen:

• Requiring businesses to provide paid vacation raises the costs for business because workers are being paid not to be productive. If the cost of business increases, it becomes more difficult for employers to hire new workers. Some workers might even have to be fired for the business to continue running at a profit. We don't see the workers retained or barred from entry.
  
• Employees are currently producing during what would become paid vacation. The money they earn from their production may not go to the travel industry, but it would go somewhere - and the community will be richer for it. For example, the workers in a TV manufacturing plant will have produced 100 televisions and have money in their pockets to spend on home improvements. Now the community has more TVs and job growth in the home building sector. We wouldn't see either of them.

Just for kicks, lets examine unintended consequences as well. Mandatory paid vacation time effectively subsidizes an unproductive activity, and doesn't remove the incentive for people to use sick days. This is what happens when subsidies are introduced into the marketplace: demand goes up because the good is perceived as "free". Once workers get a taste of paid vacation time they are likely to demand more of it. Thus a more likely scenario is that people will begin to use both paid vacation and sick days, and in time demand an increase in the number of paid vacation days. The article cited unwittingly points out the truth of this.

"France currently requires employers to provide 30 days of paid leave."

The Paid Vacation Act will restrict employment capacity, lower productivity, and restrict the community's ability to accumulate wealth. At least we'll see more Americans taking vacations during these tough times.

Elihu Root and the Federal Reserve

Senator Elihu Root (1845 – 1937) in his prescient understanding of central banking and easy credit:

“Little by little, business is enlarged with easy money. With the exhaustless reservoir of the Government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community. . . . Bankers are not free from it. They are human. The members of the Federal Reserve board will not be free of it. They are human. . . . Everyone is making money. Everyone is growing rich. It goes up and up, the margin between costs and sales continually growing smaller as a result of the operation of inevitable laws, until finally someone whose judgment was bad, someone whose capacity for business was small, breaks; and as he falls he hits the next brick in the row, and then another, and then another, and down comes the whole structure.”

Who knows if he had heard of the Austrian Business Cycle Theory, but for someone speaking during the creation of the current US central bank, he had a clear vision of what would happen in 2008. This reference was made known to me by a good speech from Thomas Woods.

What is seen and what is unseen for May 18th, 2009

Borrowing from Fredric Bastiat, here is today's edition.

Take a look at this map illustrating where stimulus dollars are planned to go for highway reconstruction and infrastructure. Billions of dollars are allocated in this map, for the purpose of "jumpstarting the economy". Kind of like stimulus checks, only made of asphalt. Stimulus asphalt.

When these projects are completed, this is what you will see. Smooth new highways and bridges, and we'll all thank the government for it. What we will never see, however, is where the billions would have gone otherwise. You'll never see a new first home being bought, the new small business, the new investments in technology and medicine, or any other choice of the marketplace. Maybe those businesses and investments would have failed, but we will never know.

What is money? (Part II)

Last time we demonstrated that wealth is only created through production. That eliminated the possibility of money as wealth, but did not shed any further light on what the nature of money is. To continue our investigation we have to consider a new scenario.

The original scenario analyzed the economy of a single man isolated from others. What dynamic emerges when we introduce more people into the picture? There are two possibilites: either each man fends for himself and is responsible for producing all of his needs, from housing to food to health, or there is a division of labor. As society transitions from a single man to a village, each productive citizen specializes in a particular good or service. One man may become a fisherman, another may harvest wheat berries, still another may tailor clothes. This division of labor improves the quality and variety of goods for everyone.

Yet there still exists a logistical problem. How does the fisherman acquire his new trousers (because back then they didn't wear pants they only wore trousers)? He trades his fish directly to the tailor. This is known as barter exchange. This will solve the problem for some cases of exchange, but it soon becomes apparent that not everyone wants what the other party is offering. If the tailor has no taste for fish, then the fisherman will be pressed to find a new commodity that does suit the tailor's taste. So the fisherman finds out that the tailor wants butter, trades some of his fish with the dairy farmer for butter, returns to the tailor and exchanges his butter for the new threads. Problem solved. This process is called indirect exchange and in this case the butter is the medium of exchange.

Notice how the medium of exchange in this case was itself a useful commodity. This is an important point to remember.

An interesting question can be raised at this point. Are all mediums of exchange created equal? Is there any significant difference between the various possible mediums? In his book "What Has Government Done to Our Money?", Murray Rothbard says the answer is no. He explains that the commodities that are chosen as the medium of exchange are more marketable than other commodities. In other words, they are readily sold. He lists several categories that make one commodity more marketable than another: Divisibility, durability, and transportability.

In the example above, butter is used as a medium of exchange with excellent divisibility, poor durability, and fair transportability. A cow might be considered to have poor divisibility, but strong durability and transportability. It is clear that over time certain commodities will rise to the top, and those will be the ones with the greatest marketability. Rothbard argues that gold and other precious metals eventually become the most widely used commodity as a medium of exchange. Gold and other precious metals wind up becoming money. The truth is that all of these various commodities are money, but not all monies are created equal, because they are not all equally marketable.

To illustrate the properties of money lets examine one more scenario. Assume we live in a society where gold is the preferred medium of exchange. Lets say that a new technology emerges which confers a tremendous social benefit but must use gold. If the net effect of this new technology sufficiently damaged the marketability of gold, a different commodity would inevitably take its place. Perhaps platinum, or maybe tungsten carbide. In other words, the marketplace would choose a new medium of exchange to compete with gold. History does bear this out with the emergence of silver and copper coins.

To summarize: Money is always a commodity in itself, and the commodity that finds itself in greatest favor for use as the medium of exchange is one that is most marketable at that time. Money is not confined to one commodity, the marketplace will use whatever varieties of money necessary to expedite trade.

This is a satisfying account of the origin of money, but there are still questions. What is our money? How do we make the leap from commodity money to paper money? Lastly, we still haven't gotten any closer to understanding John Adams' statement. We will look further into these questions next time.

Interview with Israel Kirzner at Mises.org

Thank you Jake for helping me find this. The interview makes some very solid points about Austrian economics and its relation to other schools of economic thought.

On Keynesian economics:

I have never really seen myself as a macroeconomist. Of course I've taught macro for many years, yet I felt I never understood Keynesian economics. It assumes that decision making doesn't matter. All that matters are the relationships between totals. While I often pointed out what seemed to me gaping holes, I had no great desire to counter this with a separate macroeconomic theory of some sort.

On the Austrian Business Cycle Theory:

...it's one thing to develop a theory which could explain a downturn. It's quite another to claim that historically every downturn is to be attributed to that particular theory. That does not necessarily follow. If one were asked, does this theory necessarily explain each and every cycle, I would say no.

On human action:

The fundamental Misesian insight into human action is that it involves a tendency to be right rather than to be wrong. People have an interest in being right. They do not have an interest in being wrong. This definitely, distinctively weights the tendency of human action in the direction of being right.

Each of these points is incredibly interesting in its own right. I think they speak for themselves, but I would like to add to the third point.

If people generally have more of an interest in being right, or getting something right, then in the long run we will all be better off economically. In trading it is often said that when you're losing money the market is trying to tell you that you're wrong. Every person has a different threshold of pain, but once that point is reached people adjust and strive to be right.

Do we live in a capitalist country?

And can we blame the recent fallout on "market failure"? Well, first we should define capitalism. The answer according to this well (and vehemently) argued case, is no:

"Nobody's abandoning capitalism here."

True. Capitalism was abandoned -- destroyed, actually -- long ago, beginning around 1913, when the last of free banking was destroyed with the creation of the Federal Reserve and the imposition of a fiat money supply controlled by that Fed.

Since that point in time, what has existed in the United States is a "mixed economy", with continuously-diminishing elements of freedom mixed with continuously-growing elements of statism in the form of fascist controls and regulations on business and economic activity as well as socialist welfare-state looting and redistribution-of-income schemes.

It is true that a whole host of non-government entities and players have helped urge on this destruction of freedom. Lots of big businesses have lobbied for regulations to strangle their competitors -- labor unions of all sorts have lobbied for regulations that permit them to coerce higher-than-market wages. "Special interest group warfare" -- as Ayn Rand called it -- is an inevitable result of government having the power to regualate the economy and dispose of the citizen's money, against their will.

But the main point is that what exists in the U.S. at this time is not capitalism. Capitalism does not feature, among other things:

1) Capitalism does not feature fiat money.

2) Capitalism does not feature a central bank -- the Fed -- with total control over that money, with power to expand it or contract it at will -- with the power to dictate interest rates and enforce capital requirements for fractional-reserve banking that leverages commercial banks at 20-to-1, investment banks at 50-to-1, and government-sponsored entities at 1000-to-1.

3) Capitalism does not feature bank regulators that enforce legislation like the Community Reinvestment Act, the Fair Housing Act, the Equal Credit Opportunity Act, the Community Development and Regulatory Improvement Act and the American Dream Down Payment Act, regulations which banking regulators can and did use to pressure lenders to make billions in loans to people who, under capitalism, would not have qualified for those loans.

3) Capitalism does not feature government-sponsored entities, like Freddie and Fannie and Ginny Mae, that create secondary markets to help encourage nervous lenders to continue making shaky loans. Nor does it feature federal agencies like the Federal Department of Housing and Urban Development (HUD), the Federal Housing Authority (FHA), the, the Federal Housing Enterprise Oversight Office and the Federal Home Loan Bank -- all of which were created because those selfish, stingy lenders wouldn’t give money to people they suspected would not pay it back.

4)Capitalism does not feature a government-controlled cartel of investment rating agencies, which all issuers of securities are required by law to use -- and which are still in business, and whose "services" are still being forced on the investment community, even after these ratings agencies disastrously rated securities containing sub-prime loans as "AAA".

5) Capitalism does not feature “bailouts” of failed companies in the form of taxpayer-financed loans or loan guarantees -- bailouts that insure the incompetent remain in business to further waste capital and further bleed the taxpayers..

6) Capitalism does not feature government-takeovers of failed companies, with government intervening to head off bankruptcy.

7) Capitalism does not feature massive labor regulations such as the Equal Employment Opportunity Act and the agency that enforces it -- the EEOC; or the Americans with Disabilities Act; or the Occupational Safety and Health Act; or the Family Medical Leave Act; or the state laws mandating Workman’s Compensation Insurance; or the state laws mandating Unemployment Compensation Insurance.

11) Capitalism does not feature corporate welfare programs, like the billions of dollars given to farmers who are paid not to produce or who are guaranteed prices -- all paid for by taxpayers who don’t have, and cannot afford, the lobbying power that such corporations or interests can bring to bear.

12) Capitalism does not feature an income tax and welfare system that rewards the lazy, the incompetent, the shiftless, the foolish, the ignorant and the just-plain-no-good by providing them free economic goods and services, paid for by seizing the earnings of the most rational, most productive, most responsible, most creative and most entrepreneurial members...

13) Capitalism does not feature a “code of Federal Regulations” -- now 75,000 pages in length -- that dictates the details of virtually every aspect of our financial and economic life -- a set of regulations that has steadily increased under every president and which, at present, would stretch for over 1.5 miles if its pages were laid end to end -- 1.5 miles of double-columned, small print, both-sides-of -page regulations.

14) Capitalism does not feature a government with departments designed to interfere, intervene and overrule the market in housing, transportation, healthcare, education, energy, mining, agriculture, labor, and commerce.

15) Capitalism does not feature a government in which the actions of the aforementioned departments are amplified by more than one hundred federal agencies and commissions, the most well-known of which include, besides the IRS, the FRB and FDIC, the FBI and CIA, the EPA, FDA, SEC, CFTC, NLRB, FTC, FCC, FERC, FEMA, FAA, CAA, INS, OHSA, CPSC, NHTSA, EEOC, BATF, DEA, NIH, and NASA.

As this quick overview of our current system shows, whatever else one may argue about, the claim that what exists in the U.S. today is capitalism is ludicrous beyond belief -- fully as ludicrous as the corollary claim that said non-existent capitalism is to blame for this “financial crises”.

Capitalism is dead -- long dead. What you are witnessing is the self-destruction and failure of the fascistic regulatory/welfare state that killed it -- a fascistic regulatory/welfare state that, in its death throes, is being vastly expanded in one last desperate attempt to loot whatever else can be looted from the remaining productive American taxpayers.

Martin wrote:

"We're not abandoning capitalism, because capitalism is all about protectionism and bailouts. It always has been. Capitalists don't want free markets."

That’s nonsense, Martin. The meaning of the term “capitalism” does not change because those participating in what’s left of the system are advocating destroying still more of it.

If the police and judges stopped enforcing the law -- and instead began advocating allowing more and more criminals to go free, that would not mean that the term “law enforcement” now means, “not enforcing the law”. “Law enforcement” is a term which, like “capitalism”, has a specific meaning that is not a function of what those participating in the system happen to advocate at any one time.

Posted by: Michael Smith | May 12, 2009 6:58:06 PM

From Cafe Hayek. I tried to throw some funny links in there. This was edited for brevity's sake. However, he does make a compelling case for the extent of generalized intervention in normal market processes. Just click on each one of those links for Federal agencies. It's staggering. Maybe we should begin to start blaming our troubles on a "mixed economy" instead of "capitalism"... Kinda like the first step in AA, you know? Admit that you have a condition, and it's not what you thought it was.

What is money? (Part I)

"All the perplexities, confusion and distress in America arise, not from defects in their Constitution or Confederation, not from want of honor or virtue, so much as from the downright ignorance of the nature of coin, credit and circulation." -- John Adams

What is so mysterious about money? We trade pieces of paper, transfer digital money back and forth and to the average person this system seems to work quite well. We can go into any number of stores and take out some paper which they will gladly accept in return for something useful. What was John Adams talking about? Why do we need to know what money is if we can just know that it works? In order to answer these questions we have to go back to the beginning. Way back.


Consider the case of a shipwrecked man on a desert island. While searching the wreckage for useful items, he finds a suitcase half buried in the sand. Upon opening the suitcase he discovers $1,000,000 in pristine, freshly minted Federal Reserve Notes. He's rich! Now if he could just locate that desert island supermarket, he'd be set for life... Well, he died so lets consider the case of a shipwrecked man on a different desert island. This time, when he opens the suitcase he sees 1000 oz. of neatly stacked pure gold bars. Rockefeller! ... He died too. Some years later a third man gets shipwrecked on this desert island, but when he scours the wreckage he finds a suitcase filled with tools. Hammers, chisels, saws, the works! With these tools and a little labor he was able to start production of a sturdy shelter. Soon afterward he produces buckets to catch rainwater and spears to fish with. After weeks and months of production, he was rich! He had a steady supply of fish to eat, a shelter over his head, a fire pit to keep him warm at night, clean drinking water, and even wooden planks for engraving - to express his artistic sense.


What makes us rich? Is it money? Clearly not. The third man was wealthy due to one thing only - his production. To be even clearer: the source of his wealth lay in his tools, the means of production, also known as capital. If he had no capital, he could have no production. If he had no production, he would be no different than the first two men. He would be dead. Once again, wealth is created through production, which is facilitated by capital.

While we can now see that capital is the source of our wealth and not money, we still have not begun to understand what money itself is. Seeing as how the lone man on a desert island has no use for it, we're left to ask: what is money useful for? When does it acquire value? Perhaps money is more mysterious than we originally thought. Next time we'll dive into "the nature of coin, credit, and circulation" more deeply. If for no other reason than to understand what John Adams' was getting at!

How can we approach economics?

Economics can appear to be an esoteric area of study for those unfamiliar with it. It can even be intimidating, or boring. Yet the news is rife with reports on the state of the economy. We are told that we have a "bad" economy, or that "our economy is fundamentally sound". What do these statements really mean? How do we begin to understand such platitudes?

Henry Hazlitt outlines his approach to economics in his book, Economics in One Lesson:

"...the whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence. The art of economics consists in looking not merely at the immediate but the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups." (17)

If we are to be "good" economists, then, we should strive to see as many consequences of actions or policies on as many groups as possible. We would be "bad" economists to the extent in which we fail to envision the consequences of our actions on all groups. This idea is elegant in its simplicity and carries a greater power to explain our world than one might initially think.

I'd like to highlight that Hazlitt characterizes economics as an art. It is a method of thinking more than an exact science. To many in modern academia this is a critical mistake, but his "one lesson" is successfully applied to many areas of life. Oftentimes when we apply this method of thinking we learn that what we intuitively assumed to be truth is revealed to be fantasy. This is where economics ceases to be boring and becomes fascinating - it provides a methodology that illuminates our minds and explains our world, solving many problems that have plagued humanity for thousands of years. Economics is another area where we generally find ourselves looking into Ozymandias' mirror.