Patterico's Pontifications

9/8/2015

“Human Action” and Robert Murphy’s “Choice,” Part 12: Mises’s Approach to Money and Banking

Filed under: Economics,General,Human Action and Choice — Patterico @ 12:01 am

This is Part 12 of a 17-part series of posts summarizing Bob Murphy’s indispensable book Choice: Cooperation, Enterprise, and Human Action. Murphy’s book is itself is a summary of Ludwig von Mises’s classic treatise “Human Action.” Like previous posts, this post is a summary of a summary.

The purpose of these posts is to popularize and spread the word about Austrian economics and educate the public. Rather than list all the previous parts, I have created a category for all these posts, called “Human Action and Choice,” so that all these posts can be read (in reverse order) with a single click. Note well: any errors in these summaries are mine and not Murphy’s.

Murphy says of chapter 12: “The material in this chapter is the most technical of the present book.” But it will make the explanation of the business cycle in post 14 more understandable, so it’s worth it.

We begin with some definitions. We have already discussed commodity money (such as gold, for example) and how it emerged on the market. A money substitute is a trusted alternate form of money that can be redeemed for the commodity money on demand. “Money in the broader sense” encompasses both the substitute and the commodity money (“money in the narrower sense”). When the issuer suspends redemption for the commodity, but people believe the suspension is temporary, the medium of exchange is credit money. Once the suspension is understood to be permanent, we have fiat money. (Recall from past chapters that Mises believed all fiat money necessarily originated with a commodity money — and logically had to emerge in that manner, or its purchasing power could never be determined.)

Commodity money allows new producers to produce money, while fiat money must of necessity be issued by a monopoly (a government). No single firm (such as a private mint) can monopolize commodity money, because the firm is not creating money, it is ensuring the authenticity of existing money.

As noted, in addition to money (whether it be commodity money or fiat money), there are also money substitutes, which fall into two broad categories. One is a money certificate, in which the issuer has set aside the money to back it. Another is fiduciary media, in which the issuer does not retain the commodity in reserve. In fractional reserve banking, a guy named Eugene might deposit $1000 of actual money — dollar bills — into an account. The bank might loan $900 of Eugene’s money, but still allow Eugene to withdraw the full $1000. Eugene’s bank balance consists of $100 of money certificates and $900 of fiduciary media. Fiduciary media in a gold standard setting could also include token money — coins that don’t have the requisite amount of gold, for which the government did not retain a 100% reserve of gold to back up the nominal face value.

To sum up, money in the narrower sense could include commodity money, credit money, or fiat money. Money substitutes could include money certificates or fiduciary media (uncovered bank deposits or token money). Money in the broader sense encompasses money in the narrower sense plus money substitutes.

A sneak peek of the relevance of all this: as banks create new money by creating fiduciary media (uncovered bank deposits created when loans are made), the quantity of money in the broader sense increases. As we saw in post 11, an increase in the money supply will tend to lead to a drop in money’s purchasing power or value, through the basic law of supply and demand (due to the lower marginal utility of extra units of money out of the total stock). Such a credit expansion (accomplished through the creation of new fiduciary media) tends to force banks to lower interest rates to encourage borrowing.

In other words: credit expansion tends to lead to higher prices and lower interest rates, while credit contraction leads to the opposite.

At this point Murphy pauses to delineate the two distinct functions of banks: 1) to serve as a safe place to keep money, and 2) to serve as a credit intermediary. Murphy explains that a bank can serve the latter role, even while keeping 100% reserves on demand deposits (deposits that can be withdrawn immediately at any time) — by lending out only funds obtained from depositors who purchase certificates of deposit, or make time deposits. (In either situation, the bank customer has made a deposit in which the customer’s right of withdrawal is limited by contract.) While lending and 100% reserves for demand deposits are not mutually exclusive, many Austrian economists differ on whether fractional reserve banking is desirable or legitimate.

Murphy next turns to Mises’s view of free banking: banking without government regulation. Mises believed that only free banking could prevent dangerous credit expansion, because banks that overissue fiduciary media would be forced to settle accounts with other banks, and the expanding bank would see its reserves dwindle. To avoid insolvency, the expanding bank would have to contract credit to strengthen its reserves. This is all a function of the interbank check clearing process. When customers of bank A write checks to customers of bank B, bank B comes to bank A and demands the money. Bank A must hand over the cash, or it will lose its reputation for being a sound bank. If bank A has overexpanded its issuance of fiduciary media, bank B (and bank C, and bank D, and so on) will come knocking, asking for their cash, at some point. So when each bank has only a small percentage of the population as its clients, “any attempt to expand credit will lead to a quick drain on its reserves.”

By contrast, government intervention allows all the banks to expand credit together. When the inflation takes place in all banks, you don’t see cash reserves accumulating in conservative banks and leaving inflationary banks. Having a central bank allows cartelization, which in turn allows a general expansion of the money supply . . . which governments love.

This is why governments want to have a central bank. Not to protect people. To have a mechanism to allow endless inflation.

Next, we’ll look at capital, time preference, and the theory of interest.

145 Responses to ““Human Action” and Robert Murphy’s “Choice,” Part 12: Mises’s Approach to Money and Banking”

  1. “credit expansion tends to lead to higher prices and lower interest rates”
    As decades of monetary policy demonstrate, this is simply not the case. Japan has been expanding credit rapidly for more than a decade, with deflation remaining stubbornly.
    We of course need to look at the other side of the equation: demand for money. If demand for money is high enough AND credit is expanded rapidly enough, prices will rise.
    More important, perhaps, inflation will then push interest rates UP, not DOWN.
    The problem with Austrian economics is that it’s driven by social ideology rather than math.

    El Razon (f3b4d0)

  2. Please present your control group to show what happened in Japan absent the credit expansion. Thanks!

    Patterico (3cc0c1)

  3. I should note also that I am not certain whether Murphy and Austrians like him would consider QE to be “credit expansion” as described in this chapter. As I understand it, QE results in the increase of reserves in a bank’s vault, and that certainly seems to have been the main effect of QE in the U.S., which is the form of QE concerning which I have read the most. Increased reserves create the potential for the issuance of new fiduciary media in a fractional reserve system, but that does not necessarily mean the bank will issue new fiduciary media (perhaps due to a lack of demand as you posit).

    Whether the reserves deposited at member banks through the actions of the central bank are fiduciary media, I can’t declare with certainty, but based on Murphy’s description I think those reserves are not fiduciary media.

    So in summary, I don’t know whether your example of Japan falsifies the theories here, not just because you lack a control group, but also because I’m not sure that a credit expansion of the sort described by Murphy has taken place.

    Patterico (31088f)

  4. I have the day off so I will return to read after errands but for now an interesting backstory:

    http://www.zerohedge.com/news/2015-09-08/mystery-buyer-us-treasurys-revealed

    ‘Interesting’ does not really do the present justice.

    DNF (c70dac)

  5. Historical note which neither affirms nor contradicts Mises’s ideas.

    19th century America had more than one episode in which the majority of banks were inflationary. Eventually there was a crash. Ironically, the most important crash, in the 1830s, resulted in part from Jackson’s struggle with the Bank of the United States and his attempts to curb credit expansion…it was the government which was against the central bank and government action which curbed credit expansion.

    kishnevi (86e9bc)

  6. I still get it. Barely.

    DRJ (521990)

  7. Very interesting link. Belgium has always been the world’s bank, DNF, but they used to use their own money.

    DRJ (521990)

  8. @El Razon
    By your logic the statement “If you drive a more fuel-efficient car, it will use less fuel” is inaccurate because you could drive enough extra miles to cancel out the stated effect.

    One of the first things my Econ prof told our class is that every statement ever made in Econ has the implicit coda “(all other things remaining equal)”. Of course, if you change other things too, you’ll get a different result.

    The Monster (0ab45d)

  9. “One of the first things my Econ prof told our class is that every statement ever made in Econ has the implicit coda ‘(all other things remaining equal)’”.

    Same here.

    felipe (b5e0f4)

  10. Mine didn’t. But only because he used the fancy Latin phrase that means “all else remaing equal”

    ceteribus paribus

    kishnevi (d764f4)

  11. Excuse me.

    Ceteris paribus

    That econ class was some thirty five years ago, and my Latin needs a lot of WD40.

    kishnevi (d764f4)

  12. If the money supply doesn’t expand with economic growth, either the economy stops growing or individuals or banks will inflate the currency to meet demand. That’s what has always happened when it has been allowed to. Such as in the United States until 1863; before then Americans were free to use any currency and there was a lot of free banking going on.

    There’s three things you can’t have together at the same time:

    No state control of the money supply
    No inflation
    Economic growth

    If the state doesn’t regulate what is and is not money, then people are free to bring in other kinds of money when the money supply gets low to support economic growth, which is inflation by definition, and they have always done this historically.

    If the economy grows with no increase in the money supply, deflation will slow and stop the growth as money becomes more expensive. The money will be more valuable as a commodity than as a medium of exchange, and so there will be fewer exchanges.

    Here math and history are trying to tell us the same thing. If Mises wants to argue that economies should be forced to grow at a rate no higher than the growth in the supply of various commodities we use as money, that we’ll really all be better off if we’re made to do it that way (by whom? since historically the market has never gone along with it), I really think that needs to be fleshed out in detail and not hand-waved over.

    Gabriel Hanna (64d4e1)

  13. Gabriel,

    Whether deflation causes problems for the economy depends upon the reasons for the deflation. When economic growth results in more goods and services being available, while the money supply remains constant, this results in money gaining in purchasing power. This is a good thing for the economy. Try reading Joseph Salerno’s paper An Austrian Taxonomy of Deflation—With Applications to the U.S. (.pdf), which discusses this in some detail. Salerno asserts that economic growth can accompany, and has accompanied, deflation at points in history.

    Patterico (3cc0c1)

  14. I have said this before and had the Joseph Ds of the world come down on me, but the point remains valid: under the theories we constantly hear about deflation, everyone delays purchases and the economy slows down when goods become less expensive over time. And yet . . . computers improve over time, and get cheaper (same with iPhones and other sorts of electronics) . . . and yet people don’t delay purchases forever, and those industries do quite well. What has happened? Economic growth and improvement within the industry. There is no reason this can’t be true for an entire economy: as it grows and more good and services become available, everyone’s real purchasing power increases and everyone wins.

    Patterico (3cc0c1)

  15. 12,13. Possibly pertinent to your discussion we’ve experienced since 2009 a huge growth in global money supply with a decline in personal purchasing power. Consumers can no longer support economic growth being completely tapped out.

    The upshot is another round of boosts to the money supply risks uncaging inflation but cannot possibly spur an increase in goods and services,

    DNF (c70dac)

  16. If Mises wants to argue that economies should be forced to grow at a rate no higher than the growth in the supply of various commodities we use as money

    But of course you know he doesn’t “want” to argue that, and you know he doesn’t argue that — because you have been reading the series and you know that Mises argued that any quantity of money can perform the monetary function for any size economy.

    You are of course free to disagree, but I know you do not want to distort what he is trying to argue. So maybe it would be worthwhile to revisit the previous posts, so you don’t inadvertently misrepresent his arguments as you just did.

    Patterico (36e2c3)

  17. @Patterico:under the theories we constantly hear about deflation, everyone delays purchases

    Not every possible purchase obviously. Things that require large amounts of capital that need to be borrowed get delayed. People still of course have to buy food when they get hungry. But with deflation you get a real rate of return (in terms of other commodities, again) for doing nothing with your money, and so lenders have a strong motive to do that. Lenders are going to demand a real return at least higher than the deflation rate–otherwise they’d have to pay you take the loan (math again).

    the economy slows down when goods become less expensive over time

    But with deflation goods are NOT necessarily becoming “less expensive” over time. You are confusing the nominal price with the real price. Money is getting more expensive with respect to other commodities. If gold is getting more and more expensive with respect to other commodities, than the easiest return for your money is to do nothing with it. Your labor or profits can still be worth the same, or less, in terms of all the other commodities. Since gold under deflation is profitable, without risk, without doing anything–in terms of what people can buy with it–people will tend not to use it as a medium of exchange because what you can get for it by sitting on it and waiting might well be higher than what you can get for trading it. And if anyone is free to use anything they like as money, other commodities will step in as a medium of exchange because they will be cheaper to acquire and returns on trading are higher than returns on sitting and waiting. And adding more commodities as money counts as inflation by definition.

    computers improve over time, and get cheaper (same with iPhones and other sorts of electronics)

    They got cheaper in real terms AND in nominal terms even with inflation. They did not get “cheaper” because of deflation.

    you know that Mises argued that any quantity of money can perform the monetary function for any size economy.

    And I maintain that this argument does not mean what you think it does. We could, in principle, represent an entire economy with 10 kg of gold as well as with 10,000,000 kg–aside from problems of how to manipulate tiny quantities etc. This is not disputed.

    The problem of deflation is that money gets more expensive over time, not what the amount of money is at any particular time. As one commodity gets more valuable as a commodity than as a medium of exchange, cheaper commodities are going to step in as they always have because a “medium of exchange” is just as much an economic good as any other.

    An analogy: we find a person at one time in his life weighing 120 pounds. At another time we find him weighing 180 pounds. We find healthy adults at both weights. If this change in weight happens over 50 years it probably doesn’t mean anything, but if it happens in a month something is wrong, and the kind of thing that is wrong is going to depend on which order those things happen in.

    Gabriel Hanna (e2539b)

  18. #4: DNF, very interesting link. Do you think the Treasury’s reports of foreign ownership are accurate? This suggests otherwise, and I’ve heard estimates as high as $4T for China’s portfolio (which I think is way too high.)

    bobathome (c93b3f)

  19. Salerno’s paper is a good antidote to Gabriel’s algebra. I’m only part way thru it, but it has answered many historical questions. It would be interesting to see a similar study encompassing the QE era.

    bobathome (c93b3f)

  20. @bobathome:Salerno’s paper is a good antidote to Gabriel’s algebra. I’m only part way thru it, but it has answered many historical questions.

    Marxists can also write narratives retrospectively “explaining” history in terms of their discipline, and do. At any rate, I am not starting with the assumptions that Salerno attacks, so little he says applies to me. I’m not a Keynesian or an anything-ian. I’m a person who professionally uses math to solve problems and who has passed actuarial exams as well as holding a Ph. D. in a quantitative discipline.

    The only thing I am saying here–the only thing–is that commodity money does not immunize you from inflation except at the expense of economic growth, and that this will happen when whatever commodities are used for money do not grow at the rate of the economy as a whole. There will be two choices: some form of inflation and continued growth, or deflation and contraction. The math is basically compound interest.

    I am not saying that inflation is desirable and deflation is bad. I am not even saying commodity money is bad. I am saying that incompatible claims are being made regarding these things, and I am not even blaming Austrians or Mises for these incompatibilities.

    Here is the thing, though, about using non-mainstream economic theories to advocate a complete overhaul of our current system while simultaneously disavowing math applied to economics (I know not all Austrians do) and any historical evidence whatever. The current system, though far from perfect, has been compatible with enormous, real economic growth. Even letting government control the coinage of metal was compatible with centuries of real economic growth. Maybe Austrian economics could have done better, but to throw out systems that have delivered, even perhaps in spite of themselves, in favor of something that has not been tried and which its proponents argue, can never be judged fairly to have succeeded or failed unless all conditions are exactly as they dictate–well, Marxists might be shamed by that special pleading at that level, if Marxists could feel any shame.

    Gabriel Hanna (e2539b)

  21. Gabriel, I think I understand what your concerns are, and I must say I shared them back in the day. What I find interesting in our current readings are explanations that make some sense of what we see going on around us. Salerno, for example, points out that wage laws, either minimum wages or union contracts (that are often deeply embedded in government contracts) prevent wage adjustments that would mitigate the effects of cash building (hoarding) deflation (page 86):

    Nevertheless, if there is interference with the free exchange of property titles on the labor market that renders the money price of labor downwardly inflexible, such as minimum wage laws or laws that grant unions exclusive privileges as bargaining agents in particular firms or industries, then unemployment and a decline in economic activity will result. However, the consequent recession or depression does not result from cash-building deflation per se, but from the coercive political attempt to impede the exchanges of property titles that lead to the increase in the value of money demanded by consumers.

    If I take your last paragraph correctly, you would say that to have our wonderful economy, we’ve got to be realistic and take a little vinegar in our milk. So we have minimum wage laws, so unions have a strangle hold on government projects (roads, etc.), this is no big deal. I disagree, and I’m enjoying these discussions and the reading as it crystalizes some of my thoughts on the subject.

    bobathome (c93b3f)

  22. @Patterico: Let’s try a worked example that will make it easy to keep straight what we’re talking about.

    Case 1: Suppose we’re in an economy where the money is gold and the inflation is zero. This could happen if there is no growth, or if the gold supply is keeping up–I know you think that those conditions are not necessarily connected, but you do agree that inflation would be zero if the supply of money relative to the rest of the economy is not changing.

    I need to borrow 5000 g of gold to purchase a house. The bank (let’s suppose) needs a minimum of a 3% real annual return on investment, and I’m a good enough risk that they lend at that price. Now “real return” would mean that regardless of what the gold is doing, they need to make 3% in terms of the goods and services available in the economy. The easiest one to look at is a house: they need to make 3% real return on the value of the house every year, no matter what commodities we chose to measure that value in, and we can measure it in houses if we wish.

    So I borrow 5000 g at 3% for 30 years. My monthly payment is 21.08 g of gold, which is 0.4216% of the value of the house, measured in any combination of commodities, and that ratio (by assumption) does not change over the lifetime of the loan, because the price of gold is not changing relative to other commodities.

    My monthly payment represents, let’s say, 10% of my monthly income. My income could be measured in gold, and it is, but I make that money by in someway adding value to something, either to my own business or my employer’s, and my monthly payment is 10% of my added value.

    Case 2: Suppose everything the same but inflation is 5%. Perhaps large new sources of gold are being tapped, or whatever, and that the rest of the commodities are staying the same relative to each other. Gold is getting 5% cheaper, in terms of stuff, every year.

    The bank now needs an 8.15% interest rate to get a 3% real return, again, “real return” meaning “measured in stuff that’s not gold”. My monthly payments are much larger: 37.12 g of gold, 17.5% of my added value, 0.742% of the value of the house.

    At the end of the mortgage my house is now priced at 21,610 g of gold–but it’s still represents the same value in terms of stuff that’s not gold. My monthly payment is the same, 37.12 g of gold, but it only represents 0.172% of the value of the house. But what happened to my income in that time? If I can still produce the same real added value, again as measured by stuff that’s not gold, my income probably did more or less keep up, and so my monthly payment probably now represents about 4% of my real monthly income.

    The bank had a motive to lend because inflation was eating the value of its 5000 g of gold, as measured by other commodities. I had a motive to borrow, besides wanting the house, because the real value of the fixed payment got cheaper as time went on. As the price of the house in gold increases, the bank has less to worry about in getting its 5000 g back if things go wrong.

    And all this time the real value of nothing else but the gold changed.

    Case 3: 5% deflation

    Suppose everything the same as Case 1 but the supply of gold is now smaller than the economy. If the total amount of goods and services is increasing 5% every year, and the other commodities are keeping the same value relative to each other, then gold is more expensive, by 5%, in terms of other commodities.

    But now the bank will not be satisfied with a 3% real return, as measured by commodities and things like houses. They get 5% in terms of commodities that are not gold by doing absolutely nothing. If I want their money I have to offer more than a 5% real rate of return, but the banker is my cousin and I get the loan at a nominal interest rate of 0%, which is a 5% real return for the bank.

    My monthly payment is now 13.89 g of gold, 6.6% of my monthly income, 0.278% of the value of the house. Yay deflation! But what happens over time?

    Unless my real income is also increasing at 5%–meaning the added value I contribute to my or my employer’s business in terms of other commodities–my income cannot keep up. The payment takes up a larger and larger share of my real income over time. At the end of the loan, my house is the same value as it was, but its price in gold is 1073.19 g and my monthly payment represents 1.294% of the real value of the house, which we assumed did not change.

    In the meantime if something goes wrong the bank cannot recover the 5000 g, because the house doesn’t bring in that price. In fact, I should never have take taken the loan at all: if I expect deflation to continue, I should have put that 13.89 g away and in 14-15 years I could have paid cash for the house, because its price would have decreased by that much. And if I don’t expect it to continue I could wait until the conditions are more favorable for borrowing money.

    Case 4: We have 5% gold deflation, but some bright young lad or lass at the bank suggests that I pay for my house in silver, which did not change its values with regard to other commodities. I have to get a lot more grams of silver, but now in terms of real values I’m back at Case 1 where I am paying the bank 3% real return–but I am at least getting my house now, and the bank of course has a better motive to lend silver than to lend gold. Gold gets more valuable by sitting, but silver makes money lent out instead of sitting. Both of us desire to use the cheaper money.

    This state will not long persist. Other bright lads and lasses at the bank have had the same thought, and the price of silver will go up while gold goes down a bit, it being not quite as in such high demand. More money chasing the same goods will be: inflation. If silver doesn’t keep up with growth, copper or paper will step in, until the money supply has at least grown to match the demand for money occasioned by economic growth.

    Gabriel Hanna (e2539b)

  23. @bpbathome:If I take your last paragraph correctly, you would say that to have our wonderful economy, we’ve got to be realistic and take a little vinegar in our milk. So we have minimum wage laws, so unions have a strangle hold on government projects (roads, etc.), this is no big deal.

    Absolutely the opposite of what I am saying. I am actually saying this:

    Here is what we have now, fiat money, central banking, business cycles, etc. We have had it for over fifty years. In that time the real value of the world economy has doubled several times, and we have the highest standard of living in history. A lot of the stuff we did–like the examples you gave–probably kept us from getting all we could have had. But it is very hard to tell what is baby and what is bathwater, and however flawed this system is we did very well out of it.

    Now here are some people who say that if we do things very very differently, we can do even better. In fact they say that the things that are responsible are the things they said to do, and the things are not responsible are things that they said not to do but we didn’t listen and we did it anyway, and we’d have been even better off if we’d done it ALL their way.

    Some of these people are Austrians and some are Marxists, but what they do is mainly say we’re doing it wrong, and they don’t (in the case of Marxists) admit that anyone gave their ideas a fair shake, and in the case of (some) Austrians they argue that evidence is not even necessary.

    I am by temperament reluctant to smash up things I don’t fully understand but that are working tolerably well most of the time, especially when not offered compelling evidence backed by compelling logic. The economy we have had since 2008 isn’t so hot but Obama didn’t invent fiat money and some of the times before this were really good, and they created lasting gains, even if it’s been one step forward, 0.8 steps back.

    Gabriel Hanna (e2539b)

  24. Gabriel, doesn’t it bother you that the purpose of QE was to generate a nice little bout of inflation with the idea that this would reduce unemployment? And if you say that unemployment is now just 5.2% then I will question your analytical skills, since we have the lowest participation rate (say 62% of the potential labor force) since the mid-70s. A growing, healthy economy would have a 67% participation rate, which means that about 4% of those who should be employed aren’t even counted, and this affects both the numerator and the denominator in the unemployment rate.

    I believe that most economists are little more than cargo cultists. They observe that inflation often occurs when the economy is booming (or perhaps bubbling) and conclude that inflation was the cause.

    I prefer to think of this as a magnificent puzzle, and I’d like to understand it better. I know that the welfare state is not the answer. Politicians can buy off a lot people and their votes with promises of security, freedom from fear(????), and happiness using other people’s money. But these people will not find their lives fulfilling or satisfying, which will provide the politicians with yet another opportunity to promise them even more. And these professional welfare clients fall for it, again, and again, and again. We’re now witnessing the removal of civil police in places like Baltimore because the demagogues who run the city have convinced the population that all policemen are a threat. This defies all logic, and it will end badly. However, it does fit into the welfare client role of being a victim which is engendered by those who have embraced welfare too long. And in the end they will be right, they will be victims, but they’ll be victims of their own cupidity.

    bobathome (c93b3f)

  25. 17. “The problem of deflation..” Is that outstanding debt grows, at first geometrically, then exponentially.

    Consumers may have walked away from zero percent down mortgages and car loans but they have not delvered since 2008.

    China has only begun devaluing and may unpeg to the dollar completemente. In two years time monetization of government debt thru sovereign purchase by the Fed, the JoB, ECB and RBS will no longer be possible and the only resort to QE will be ‘helicopter money’.

    Classic economics under this regime is treacherous.

    DNF (c70dac)

  26. 18. I don’t have an indepedent opinion on Treasury’s accuracy. Currently foreign governments maintain $7.5 Trillion in forex reserves, mostly UST, to manage their own currencies. But surplus petrodollar holdings of assets denominated in dollars may exceed that amount by 50%.

    That all of these sources are to be spent in the next few years is plausible in all out foreign exchange wars but shocks to interest rates may only be short term. The need for loan collateral in the now illiquid UST market should cap swings.

    DNF (c70dac)

  27. But with deflation goods are NOT necessarily becoming “less expensive” over time. You are confusing the nominal price with the real price. Money is getting more expensive with respect to other commodities.

    Or, put another way, other commodities are getting less expensive as compared to money.

    Patterico (3cc0c1)

  28. no it was to get money circulating into the system, the rise in basic staples was just an oversight,

    narciso (ee1f88)

  29. If gold is getting more and more expensive with respect to other commodities, than the easiest return for your money is to do nothing with it.

    Maybe the easiest, but not necessarily the best. People will still demand credit. Savers can still make money by extending credit (directly, or more commonly using banks as intermediaries.) When consumers sock away real savings, money becomes available for credit without having to create that money with waves of a magic wand. In such a free market, where the savings rate determines the amount of available credit and thus the interest rate, then the interest rate (which reflects time preference) can coordinate the lines of production to be in sync with consumers’ time preferences. When government distorts the price of credit, as the Fed does by manipulating the money supply, it sends false signals to entrepreneurs about consumers’ time preferences, which causes malinvestment and a discoordination between lines of production and consumers’ time preferences.

    That is the nub of the Austrian business cycle theory, right there.

    Patterico (3cc0c1)

  30. Here is the thing, though, about using non-mainstream economic theories to advocate a complete overhaul of our current system while simultaneously disavowing math applied to economics (I know not all Austrians do) and any historical evidence whatever.

    That, again, is a false characterization of the view of Austrian economics. As I have said repeatedly, Mises, Hayek, and Rothbard were intensely interested in economic history, and how the principles they articulated were reflected in that history. I am as well. (I am not interested in repeating the defense of the a priori nature of the principles, as I have already written on that extensively and tire of arguing in circles.)

    You make a good point when you note that living standards have increased dramatically even under a mixed economy with elements of command control mooshed in with the free market. The challenge, of course, is how to make it better, and that requires a diagnosis of what elements of our economy have made the growth of living standards possible, and what elements have held us back. I think you and I probably agree that it is the free-market elements that have made our lives better, and the command-and-control parts that make it worse. Austrian economics simply helps provide a logical foundation for that belief.

    The issue is not simply whether we carry on as always, or upend the entire system for a new and scary and unproved one. The analysis affects the way we handle real problems on an ongoing basis, all the time. People with different philosophies are led to react to events in very different ways. Do we react to a sudden downturn in financial markets with a huge bailout and a giant stimulus, or do we let things shake out on their own? Do we give government a guiding hand in how we finance every aspect of caring for our health, or do we return the issue to the market, removing the distortions of the tax code and other regulations? These are very real problems, and different economic philosophies lead to very different conclusions, all with real-world effects. That’s why this is all important.

    Patterico (3cc0c1)

  31. Gabriel,

    Some observations regarding your “Case 3″:

    1. “Unless my real income is also increasing at 5%–meaning the added value I contribute to my or my employer’s business in terms of other commodities–my income cannot keep up. The payment takes up a larger and larger share of my real income over time.” If financial entities expect regular deflation every year, they can structure payments to respond to that, much as they structure loans nowadays to address their expectation of some inflation every year.

    Meanwhile, the beauty of “growth deflation” is that you can get paid the same amount every year and yet your real income (ability to purchase goods and services) will go up, naturally.

    2. “In fact, I should never have take taken the loan at all: if I expect deflation to continue, I should have put that 13.89 g away and in 14-15 years I could have paid cash for the house, because its price would have decreased by that much.” I suppose, but you would have to have lived somewhere during that time. This goes back to the point that people can’t delay purchases forever because they have some ongoing desires (and needs) that can be satisfied only by consumption in the present. If your point is that maybe you would rent while you save the money to buy the house, that does not sound like the end of the world.

    Patterico (3cc0c1)

  32. Maybe the easiest, but not necessarily the best. People will still demand credit …

    But credit will be more expensive so fewer loans will be made. If the government taxed loans people would still make loans but fewer of them.

    More generally conservatives consider inflation an unjust tax on people holding money. Similarly deflation seems like an unearned benefit. Why should you be rewarded for keeping money out of circulation?

    James B. Shearer (68fa41)

  33. 13. I started reading Salerno’s paper and got stuck when he says:

    … Thus when economists, business forecasters and Alan Greenspan scrutinize indexes of input prices such as the PPI or indexes of raw commodity prices, they do so because they incorrectly believe that changes in these indexes are harbingers of future changes in general consumer prices, as if input prices determined product prices rather than the other way around.

    So when the price of crude oil collapses it is incorrect to believe that this will soon be reflected in the price of gasoline? I am going to have to side with Alan Greenspan et al on this point.

    James B. Shearer (68fa41)

  34. @Patterico:Maybe the easiest, but not necessarily the best. People will still demand credit.

    Yes, as I showed in my example above. They demand credit in a different form of money, one that has real returns from being exchanged. They sit on forms of money that have real returns from NOT being exchanged.

    In my inflation case, the bank has a powerful motive to lend gold, they lose money by sitting on it. They have much less motive to lend the silver, but they’ll still get a real 3% return on it. They prefer to save the more expensive money and lend the cheaper money, and the cheaper money (the inflating gold) is what I will spend on the house.

    In my deflation case, the bank has a powerful motive to NOT lend the gold and I have a powerful motive to NOT borrow it. Instead, the bank wants to lend me silver, which makes nothing by being saved (as in the previous case), and I want to borrow it–and I can even fund the borrowing using my deflating stock of gold that is worth ever more silver the longer I sit on it.

    In each case, the cheaper money is what get lent and spent. That’s inflation right there.

    What’s interesting about the two cases is that it makes more economic sense for me to borrow gold at 8% with 5% inflation, than it does for me to borrow gold at 0% interest with 5% inflation.

    If financial entities expect regular deflation every year, they can structure payments to respond to that

    Another way to say this is “set payments in a commodity other than gold”, which I addressed. Instead of having fixed gold payments, they’d have varying gold payments that were equivalent to fixed payments in something other than gold such as silver. Silver would become money and thus inflation. Likewise for copper and paper when the price of silver starts to go up.

    In the deflation case I outlined the bank should save its gold, earning risk-free 5%, and lend its silver earning 3% at some risk. It should only lend its gold to some outrageous rate of return, which of course will have higher risk–but it will always make more sense to just lend the silver instead if it has any.

    Eventually of course the market will bring these two rates into some kind of equilibrium, but if the combined growth rate of the combined gold and silver supply doesn’t keep up with economic growth, then some other commodity will step in and inflate the supply some more.

    If all commodities end up getting used as money, you are effectively now back to barter; eventually your transaction costs go up to where it doesn’t help you to involve more commodities and then you are going to get a contraction if the supply of money STILL can’t keep up.

    much as they structure loans nowadays to address their expectation of some inflation every year.

    They do that by charging higher interest, as I worked out above in the case of inflation, what nominal rate they need to charge to get their desired real rate of return.

    Meanwhile, the beauty of “growth deflation” is that you can get paid the same amount every year and yet your real income (ability to purchase goods and services) will go up, naturally.

    Only if your own personal economic production also increases, as I proved above. Suppose in my examples my business is building houses. If the price of gold is increasing with respect to the other commodities, and everything else is staying the same, in order to keep growing my real income at 5% to keep up with deflation, I have to build 5% more houses every year. Now since I postulated that the economy is growing by 5% maybe I can do that, and maybe I can’t.

    But where it differs from the inflation case is that with inflation all I have to do is keep up the same level of real output. I’m always getting higher prices in gold for my houses; I’m not having to build houses at an ever-increasing rate to because my houses are getting lower prices in gold. After 14 years of inflation I have to be building twice as many houses as before just to keep up with the same fixed payment.

    This goes back to the point that people can’t delay purchases forever because they have some ongoing desires (and needs) that can be satisfied only by consumption in the present.

    I already said this. OF COURSE THEY DO. They have to eat.

    But any purchase that CAN be delayed will, ESPECIALLY if it involves using someone else’s money. Lenders have a powerful motive to not lend. Consumers have a powerful motive to not spend. Saving is not always bad. Not lending is not always bad. But a large incentive to not spend and not lend is going to result in less economic growth. And perhaps less growth is not always bad either, but we don’t want to go one for a long period of time.

    If your point is that maybe you would rent while you save the money to buy the house, that does not sound like the end of the world.

    No one was saying deflation was “the end of the world”. I was saying that deflation implies either a) contraction because saving money has a higher return than exchanging it for goods and services, b) inflation when cheaper money steps into the gap and allows the growth to continue.

    In my own real life I lived in a tiny apartment while I got my family into position to buy a house. Under the deflationary scenario I would have delayed the purchase even longer until it made economic sense, and so I would have in my little way slowed economic growth.

    Again, my one and only point is, commodity money is not immune to inflation if you want to allow economic growth. Growth against a fixed supply of commodity money is deflation, by definition. Deflation produces either a) contraction, because saving money has a guaranteed real return but lending or spending the money does not; or b) inflation when a cheaper commodity begins to circulate to maintain the growth.

    Gabriel Hanna (64d4e1)

  35. @bobathome:Gabriel, doesn’t it bother you that the purpose of QE was to generate a nice little bout of inflation…

    No, because I was not consulted on today’s economic policy and I am not defending it.

    I am only examining the implications of using commodity money. You cannot avoid inflation and deflation this way, and you cannot get deflation without contraction or compensating inflation using commodity money. And since the US has not been using commodity money for a very long time now, I am not obligated by my arguments here to defend anything that the US government has been doing. I have no idea, nor do I care, if QE “worked” or not, I was not asked for my consent or approval and it has nothing to do with what would happen if we were using commodity money.

    And if you say that unemployment is now just 5.2% then I will question your analytical skills

    Why on earth would you assume I would say this? I’m talking about what happens when you use gold and silver as money, that deflation implies contraction or compensating inflation, and this has nothing to do with that. Again, no one in the government got my advice or consent on whatever fool thing they tried.

    Something you missed in the many scattered posts that I have been making is that to me, free markets, including those in money, are a MORAL question. Except in rare and clearly defined cases, I believe that I am morally obligated to oppose efforts to interfere in free trade, just as I am morally obligated to oppose the killing or imprisonment of people without clearly defined and compelling reasons. There is no one inn government making economic policy right now who believes what I do so why are you telling me I have to defend them–and impugning my analytical skills based on things I didn’t say and that I am opposed to anyway?

    Gabriel Hanna (64d4e1)

  36. Gabriel, my apologies. It seems to me that the thrust of your comments regarding Murray’s book, and Misesian economics in general, is that it doesn’t comport with current practices, and you are reluctant to think about alternatives because things have gone so well in the last 60 years. If this is wrong, again, my apologies.

    I think Patterico is challenging us to consider an entirely new way of thinking about economics, and this requires that we examine our assumptions very carefully. One simple example. It is assumed that inflation is growth enhancing because debtors escape from their obligation and have more income to spend or invest as they pay off old obligations with discounted dollars. This is an attractive argument since most of us, and the U. S. government, are debtors. We naturally assume this is a good thing. But we should also ask what about the lenders, the individuals who accumulated the capital that allowed those loans to be made before inflation played havoc with their investment. Is it correct to say that these were foolish investments to begin with, and so disregard the consequences to the lenders? Or should we be asking what will happen now, given that lenders got hammered. Will they be so willing to make fixed rate loans, or will everything be tied to some measure of inflation. And given that these lenders were often banks lending amounts that were based on fractional reserve requirements, what will happen to this source of capital? It’s all about the question of what happens in response to a situation. You have to put yourself in the position of someone who looks at the problem from a contrarian standpoint, and see what opportunities arise if you cast off all assumed constraints.

    Sort of like our current president and the concept of constitutionally constrained government. If you cast off these constraints, how much can you get away with given a cowardly and obsequious opposition.

    bobathome (279337)

  37. More generally conservatives consider inflation an unjust tax on people holding money. Similarly deflation seems like an unearned benefit. Why should you be rewarded for keeping money out of circulation?

    Well, first of all, Mises makes the point that while people refer loosely to money being “in circulation,” in theory all money is held by someone at a particular point in time.

    But what I think you are also missing is that people who hold money tend not to do so in their mattresses. They tend to save that money in a bank, making it available for lending by the bank, or invest it. So greater savings actually makes more credit available.

    Patterico (3cc0c1)

  38. So when the price of crude oil collapses it is incorrect to believe that this will soon be reflected in the price of gasoline? I am going to have to side with Alan Greenspan et al on this point.

    There is often a correlation, but as it turns out, it’s not as clear as you have portrayed it, James B. Shearer. For example:

    Over the 10 years from 1980 – 1990 even though oil prices fell lower and lower gas prices remained relatively flat.

    Even in those cases where they track each other, you are assuming causation flowing one way, when it may flow the other way. If demand for a particular consumer good collapses, that may cause demand for the inputs to collapse.

    Patterico (3cc0c1)

  39. Over the 10 years from 1980 – 1990 even though oil prices fell lower and lower gas prices remained relatively flat.

    Gasoline prices at the beginning of this period were artificially low because of 1970s price controls which were not totally removed until Reagan took office in 1981. And there were 5 cent per gallon increases in the federal gas tax in 1983 and 1990.

    Over the entire period covered by the chart there is a clear relation which has continued to the present. No one is claiming crude oil prices are the only influence on retail gasoline prices but they are obviously important.

    Even in those cases where they track each other, you are assuming causation flowing one way, when it may flow the other way. If demand for a particular consumer good collapses, that may cause demand for the inputs to collapse.

    No one is denying that this can happen. But it is also the case that if the supply of an input explodes this will normally cause the price to drop and that this will normally eventually flow through to products using that input. The recent drop is gasoline prices was primarily caused by an increase in the supply of crude oil.

    Prices are determined by the interaction of supply and demand not by demand alone.

    James B. Shearer (e8cef7)

  40. Prices are determined by the interaction of supply and demand not by demand alone.

    Depends on what you mean. You can give the world any supply of crap nobody wants, and whether that supply is high or low won’t matter if nobody wants it. But yes, as I have been at pains to explain in this series, supply has an effect on the marginal value of additional units of a good.

    Patterico (3cc0c1)

  41. No one is claiming crude oil prices are the only influence on retail gasoline prices but they are obviously important.

    Yes, but someone (you) certainly seemed to imply that crude oil prices would soon change the price of gasoline: “So when the price of crude oil collapses it is incorrect to believe that this will soon be reflected in the price of gasoline? I am going to have to side with Alan Greenspan et al on this point.” And I showed you that was not true. The fact that you were able to come up with a theory as to why this was so, does not transform your incorrect statement into a correct one.

    Patterico (3cc0c1)

  42. the supply of Jeb is very high right now

    but the demand is very very low

    so what then is the marginal value of more Jeb?

    it’s super small!

    this is obvious to anyone who is willing to do the analysis

    happyfeet (831175)

  43. Re: The Price of Gas, etc. The world’s oceans are awash with tankers acting as mobile crude oil reservoirs. If anyone had a use for this oil, or the refined products of this oil, it would be a matter of a few weeks before the increased supply would satisfy this new demand. Perhaps it would be more appropriate to ask why there is little or no demand for this oil, even at a low price. And don’t use the EPA dominated U. S. market as an example of the inelasticity of the price. Our gas has so many variants depending upon EPA regulations that relatively few refineries service any given market. This reduces competition as one might imagine. And many oil companies are vertically integrated. The losses they are suffering on the exploration and production side are being covered by profits earned on the refining side. Union 76, Conoco Phillips, whatever, recently separated these two functions, and the history of COP and PSX exemplify this problem.

    Let’s see, why might someone be reluctant to invest in the future prosperity of the world. Cuba is a bright spot with the influx of new U. S. dollars, surely there are ample investment opportunities there? New chrome fenders for 1958 Cadillacs, new valves for 60 year old V8s capable of tolerating modern fuels, advanced GPS tracking systems that can be sewn into the shirt collars of suspected dissidents, microscopic drones that can be used to spy on high ranking subordinates. The list is endless, as are the potential for profits, as long as you can find a buyer for the sugar cane. Iran may not be able to earn anything from its oil at these prices even with the collapse of western sanctions, but there are a lot of fat chickens waiting to be plucked in almost every direction. The opportunities for providing them with antiaircraft systems, centrifuges, advanced trigger mechanisms for nuclear warheads, ICBM gear of every sort, ground attack aircraft, ultra sonic cruise missiles, and state of the art torture devices, including biological agents, must signal large profits for those who have foreseen this development and paved the way for the administration’s capitulation. Russia is also hurt by the drop in oil prices, but they are placing their bet on Assad, and Assad has taken the measure of the U. S. and laughs at us. And Russia has yet to play their next move in the Ukraine adventure, and the Baltic states look ripe and inviting. Venezuela has descended into vigilante justice and suffers from shortages of almost every staple. Surely there are wondrous opportunities for trade and profit there. The U. S. has repeatedly proclaimed that climate change is its number one priority. Surely preventing the world from incineration by SUV has the admiration of every thinking dictator, let alone the ISIL Caliphate. Europe is being invaded by millions of young jihadists, and the European elite think the way to peace and prosperity is to let these savages assume control of economically blighted areas, presumably because they believe Sharia Law will provide the impetus for beneficial social change. And we haven’t even begun to analyze the opportunities in the China, and the surrounding states nor the crumbling nation-states along the northern periphery of Africa. Yes, if tyrants, dictators, jihadists and quislings are your customers, this is the best of all possible worlds!

    So why doesn’t someone come up with an idea that would benefit from really cheap energy???

    bobathome (279337)

  44. … And I showed you that was not true. …

    You perhaps showed that I was a little imprecise and should have included some language like most of the time or other things being equal. Do you believe the statement of Salerno that I objected to is true? It was:

    … Thus when economists, business forecasters and Alan Greenspan scrutinize indexes of input prices such as the PPI or indexes of raw commodity prices, they do so because they incorrectly believe that changes in these indexes are harbingers of future changes in general consumer prices, as if input prices determined product prices rather than the other way around.

    Salerno appears to be saying supply never matters which is nonsense.

    James B. Shearer (e8cef7)

  45. … Assad has taken the measure of the U. S. …

    Assad is betting that given a choice between him and ISIL the US will back him. This would in fact be sensible but there is little evidence that US policy is determined by a realistic appraisal of the available options.

    James B. Shearer (e8cef7)

  46. Assad doesn’t give a $#it what the U. S. says or thinks. He’s figured it out. The Russians have his back, and they can help each other. We aren’t even in the arena.

    The administration is going to live out its wet dream for the next 16 months, and the only problem Assad has is figuring whether he needs to act now, or whether this 16 months will be followed by 48 more.

    France collapsed to the Nazi’s in six weeks of all out war. Sixteen months is plenty of time if you are Putin, or a prospective Caliph, or Iran. The trick is to pick a strategically defensible objective that doesn’t involve nuking more than a few U. S. cities, and those preferably in red state flyover country. Something that can be held with minimum cost for a few years while the western elite figure out a way of rationalizing your conquest and offering reparations for past indignities.

    bobathome (279337)

  47. Salerno appears to be saying supply never matters which is nonsense.

    I think he was talking about prices and not supply.

    You asked, do I agree with this?

    Thus when economists, business forecasters and Alan Greenspan scrutinize indexes of input prices such as the PPI or indexes of raw commodity prices, they do so because they incorrectly believe that changes in these indexes are harbingers of future changes in general consumer prices, as if input prices determined product prices rather than the other way around.

    Yes, as I explained in a previous post, I agree with the Austrian view that the prices of inputs are determined according to entrepreneurs’ view of what the end products will bring them, which requires their appraisement of the revenue that the inputs will bring them:

    Murphy notes that entrepreneurs choose to buy inputs according to anticipated marginal productivity — similar to the way consumers buy consumer goods according to the marginal utility they expect to receive from successive units of those goods in the production process. The only difference is the inclusion of the factor of the entrepreneur’s appraisement. The entrepreneur appraises how much extra revenue a producer good will bring in, and purchases (and thus appraises the value of) those producer goods accordingly.

    It’s not that the prices of inputs don’t matter, of course, but the labor theory of value is generally rejected even by mainstream economists these days, and the same reasoning that leads one to reject that theory leads one to reject the theory that input prices mechanically determine the prices of consumer goods. Again: the subjective value a consumer places on a good is what imbues it with value. As I have discussed upthread and in previous posts, supply affects marginal utility decisions often. But (again): supply of a good nobody wants is irrelevant, because nobody wants it and therefore it has no value.

    Patterico (3cc0c1)

  48. I think he was talking about prices and not supply.

    When supply increases prices normally decrease. The recent drop in the price of crude oil was caused by an increase in supply.

    Yes, as I explained in a previous post, I agree with the Austrian view that the prices of inputs are determined according to entrepreneurs’ view of what the end products will bring them, which requires their appraisement of the revenue that the inputs will bring them:

    But this assessment (to the extent it is actually made) can be wrong. The shale oil producers in the United States did not correctly anticipate the drop in prices increased production (much of it from them) would bring about. As a result many of them are in financial trouble and some are going bankrupt.

    … As I have discussed upthread and in previous posts, supply affects marginal utility decisions often. But (again): supply of a good nobody wants is irrelevant, because nobody wants it and therefore it has no value.

    It is usually the case that consumers don’t want unlimited quantities of a good. I use about 500 gallons of gasoline a year and have little reason to buy more (especially in the short run) no matter how low the price drops. So a slight over supply of crude oil can cause a significant drop in price as happened recently (similarly a slight under supply can cause a significant increase in price as has occurred in the past).

    James B. Shearer (fe81ca)

  49. But this assessment (to the extent it is actually made) can be wrong. The shale oil producers in the United States did not correctly anticipate the drop in prices increased production (much of it from them) would bring about. As a result many of them are in financial trouble and some are going bankrupt.

    Indeed. Thank you for reinforcing a point that I make here constantly: entrepreneurs with bad foresight lose money. As they fail, the resources from their failed businesses are freed up, to be used for more productive uses that actually satisfy consumer needs. This was called “creative destruction” by economist Joseph Schumpeter, and is a key feature of capitalism. That’s why government can’t interfere with businesses failing.

    It is usually the case that consumers don’t want unlimited quantities of a good. I use about 500 gallons of gasoline a year and have little reason to buy more (especially in the short run) no matter how low the price drops. So a slight over supply of crude oil can cause a significant drop in price as happened recently (similarly a slight under supply can cause a significant increase in price as has occurred in the past).

    Indeed. Again, you are reinforcing a point I have made in different words, concerning marginal utility. It’s nice that we find ourselves in agreement on both of these topics.

    Patterico (3cc0c1)

  50. … It’s nice that we find ourselves in agreement on both of these topics.

    What we are in agreement about is classical economics. What we disagree about is topics where Mises (and the Austrian school in general) differ from classical economics. Salerno claims that (contrary to the beliefs of classical economists like Greenspan) that drops in input prices aren’t predictive of drops in output prices. This seems both contrary to common sense and real world experience to an extent that makes it hard for me to take anything Salerno says seriously.

    James B. Shearer (fe81ca)

  51. Salerno claims that (contrary to the beliefs of classical economists like Greenspan) that drops in input prices aren’t predictive of drops in output prices. This seems both contrary to common sense and real world experience to an extent that makes it hard for me to take anything Salerno says seriously.

    Huh, that’s odd, because all he is doing is referencing the subjective theory of value, which was rejected when first proposed, but now is accepted by virtually all mainstream economists. You seem to be having a hard time understanding it, but there are many resources out there if you want to read more.

    For the rest of the crowd, it’s enough to say that the theory James B. Shearer is rejecting is one of the most widely accepted economic principles currently known to man.

    Patterico (3cc0c1)

  52. 52 For the rest of the crowd, it’s enough to say that the theory James B. Shearer is rejecting is one of the most widely accepted economic principles currently known to man.

    Widely accepted by everybody except ” … economists, business forecasters and Alan Greenspan … “?

    James B. Shearer (fe81ca)

  53. The subjective theory of value seems to say that given a choice between A and B (say a Coke or a Pepsi) some people will pick A and some people will pick B and there is no objective way to say one choice is right and one choice is wrong. This seems hard to argue with but it is unclear what this has to do with the price of A or B or with the Salerno quote I am objecting to.

    James B. Shearer (fe81ca)

  54. The subjective theory of value seems to say that given a choice between A and B (say a Coke or a Pepsi) some people will pick A and some people will pick B and there is no objective way to say one choice is right and one choice is wrong.

    That may be what it seems to say to you, but that’s not what it says. You might profit by re-reading my post 3 in this series, where I summarized Murphy’s views on it this way:

    Other than learning the building blocks of Austrian economics, one of the main concepts you might learn from this post (if you are unfamiliar with the concept, which many people are) is the concept of “subjective value theory.” The idea here is that the market price of any good, or service (or stock, or bond) does not depend upon anything objective. The price simply reflects the subjective perspective of consumers in the market. This is not a uniquely Austrian insight, as far as I know; I believe it is universally accepted by all honest economists these days.

    I offered you a link in my previous comment in which I saved you the trouble of Googling the term yourself. If you’re interested in doing some deep reading from Menger, the fellow at the forefront of this now commonly accepted theorem, you couldn’t do any better than Principles of Economics (.pdf). But even Wikipedia has a good general definition, available in the handy link above:

    The subjective theory of value is a theory of value which advances the idea that the value of a good is not determined by any inherent property of the good, nor by the amount of labor required to produce the good, but instead value is determined by the importance an acting individual places on a good for the achievement of his desired ends.

    Now, regarding Salerno’s quote, which I will set forth again here:

    Thus when economists, business forecasters and Alan Greenspan scrutinize indexes of input prices such as the PPI or indexes of raw commodity prices, they do so because they incorrectly believe that changes in these indexes are harbingers of future changes in general consumer prices, as if input prices determined product prices rather than the other way around.

    I will grant you this: this wording is a bit overly simplistic, in my view, because it suggests that product prices determine input prices, without mentioning the role of the entrepreneur. And yet, as I have pointed out in this series, Mises considered the role of the entrepreneur to be absolutely central. I explained this in post 10, which you also might gain some insight by re-reading. Here is a key passage bearing on this question:

    For a single actor, the subject of valuation of a higher-order good depends on his own subjective valuation of the consumer good it helps produce. In a market economy, by contrast, the prices of higher-order producer goods are ultimately determined both by consumer preferences and by entrepreneurs — who appraise the prices of producer and consumer goods using economic calculation. Mises’s concern is that we always keep in mind the key role of the entrepreneur in allocating resources to produce consumer goods. This is a task that entrepreneurs do using economic calculation, which works only in a free market economy with accurate price signals.

    The point is that the value of a consumer good (and ultimately the price of a consumer good) is not a mechanical function of adding up input prices and slapping a markup on them. The value of a consumer good is determined by the subjective value a consumer places on an item. Again, this is not to say that supply is irrelevant. As I have said many times, it is not — because scarcity affects a consumer’s evaluation of marginal utility of additional units of goods, as noted in post 4:

    [A]s the supply of a good increases, the marginal utility of the good decreases, and vice versa. You pay less for water than diamonds because there is plenty of water (currently) to satisfy our most critical desires, like satisfying thirst. If there were so little water that you had to pay $10,000 (more than you’d pay for a small diamond), just to get a drink and not die of thirst, you’d pay it (if you had the money).

    But everything comes back to the marginal utility of goods to consumers. If they desire a good badly, the good will have value to them. If they do not, it won’t.

    Thanks for the chance to tie some of these concepts from various posts together in one place.

    Patterico (3cc0c1)

  55. … The idea here is that the market price of any good, or service (or stock, or bond) does not depend upon anything objective. The price simply reflects the subjective perspective of consumers in the market. …

    This is simply wrong. Prices don’t just depend on what consumers are willing to pay for something but also on what producers are willing to sell it for. When technology improves so that it is cheaper to make something producers are willing to manufacture and sell it for less. This will normally cause the price to fall even if the subjective preference of consumers in the market have not changed at all.

    The cost of producing something (which depends on objective factors) is normally a floor on its market price as producers will not usually manufacture goods for sale unless they expect to sell them for more than what it cost to make them. Of course producers sometimes miscalculate and end up selling goods at a loss but this is a relatively rare occurrence (else nobody would be willing to take the risk of manufacturing goods for market).

    Market transactions depend on a meeting of the minds. Just as you can’t force someone to buy something you can’t force someone to make and sell it. So prices don’t just reflect the subjective values consumers place on goods they also reflect what producers have chosen to manufacture for sale. There may be great consumer demand for some product but if producers don’t realize this it won’t be available to buy.

    James B. Shearer (fe81ca)

  56. Put another way, it is true that the prices of inputs can seem to have an effect on the prices of ultimate consumer goods — but ultimately, this is always a function of marginal utility of the ultimate consumer good to the consumer. Before the concept of marginal utility was developed, it was a mystery why diamonds seemed to be more valuable than water. The resolution of the paradox was provided by marginal utility analysis. The issue is not that “diamonds are more valuable than water” in the abstract. The issue is that, once units of water have been put to use for more critical human needs, the value of extra units of water on the margin may be lower in an individual’s preference rank than a unit of diamonds. Obviously, the supply of water is critical to this analysis, because if the supply decreases to the point where there is not enough water to satisfy more critical needs that are higher in one’s preference rank, then the value of those units of water that will satisfy the critical needs of the individual becomes much greater to the individual.

    But all of this can be explained in terms of marginal utility to the consumer. Again (and here I am repeating myself for at least the third time), if a good does not satisfy any desire of a consumer, it will be of no value regardless of its supply.

    James B. Shearer, I believe you are sufficiently set in your ways of thinking that everything I am saying in these comments is wasted on you. However, I do not write the comments for your benefit. I write them for the benefit of onlookers who might be reading the comments who might have an open mind — either because they are younger and do not have their mindset closed off, or (more likely) because their mindset allows them to consider the principles I am discussing, but they simply were previously unfamiliar with the specific concepts I am describing.

    So don’t feel the need to leave a comment showing that you disagree with my analysis. I already know that. From long experience, I know your mind is closed. Please understand that my failure to persuade you is already known, and I do not consider my comments to be a failure simply because the anticipated outcome occurs.

    Patterico (3cc0c1)

  57. Much of what you’re saying is not very different from what I’m saying, except that you quite clearly fail to understand that everything comes back to the marginal utility of goods and services to the consumer. I am not saying that supply, or the cost of producing goods, are irrelevant. I am saying that they are relevant only to the extent that they affect the concept of marginal utility — which is, again, a widely accepted concept, but one that you clearly have no interest in understanding.

    Patterico (3cc0c1)

  58. I am not an economics expert, James B. Shearer, but I know enough to know this: you would benefit by doing more reading concerning the concepts of marginal utility and subjective value theory. These are not easy concepts, and I don’t mean to suggest that they are. But there is a wide body of knowledge out there that you are seemingly making no effort to grasp on a fundamental level. Rather than trying to pick isolated phrases here and there, and attempting to discredit subjective value theory based on a myopic fixation on those isolated phrases, I recommend more reading, and a deeper understanding of these concepts, as your optimal first step.

    Patterico (3cc0c1)

  59. @Patterico:They tend to save that money in a bank, making it available for lending by the bank, or invest it. So greater savings actually makes more credit available.

    I just went through a worked example, crunching the numbers, why that does that does not happen the way you say it here.

    I showed that the return on investment on deflation discouraged trading done in a deflating currency and encourages trading in alternative currencies, which increases the money supply and thus causes inflation as a reaction.

    Did you find something wrong with the math? If so, let me know so I can correct it, or show why it’s right after all.

    Gabriel Hanna (e2539b)

  60. @Patterico:So greater savings actually makes more credit available.

    If deflation is on, saving makes credit unavailable. If all you have is a deflating currency, then no one wants to lend it or invest it, because the returns from deflation are risk free. Only very rates of return are going to be attractive, and this will slow growth.

    If other currencies are freely available, it will make far more sense to invest and lend those currencies and hoard the deflating one, no matter what the rate of return on the investment is. This is going to keep growth up and will bring more of the alternative currencies into the market, which will be inflation. And that inflation will continue until the currencies have reached some kind of equilibrium.

    Please show me in my worked examples where I made the mistake, if there is one. If there isn’t a mistake, you could at least acknowledge that you don’t yet have an explanation for why you should not accept what I’ve said.

    Gabriel Hanna (e2539b)

  61. Gabriel,

    In a free market where government does not control the money, there is a potential for anything to serve as a medium of exchange. I do not believe that one can reduce humanity’s willingness to move to an alternate medium of exchange to mathematical equations. To the extent you believe one can do that, I reject the premise. There are far too many variables to make such shifts predictable.

    By the way: In truth, as I have said, I don’t advocate a gold standard per se so much as I favor removing the governmental restrictions on gold being used as money (taxing its sale, e.g.) and allowing all possible currencies to compete. We have always gravitated towards gold in the past, but perhaps in the future we would settle on something else. The idea is not to fixate on one particular yellow metal, but rather to seek the freedom that is possible only when government has released its control over the money supply, and fulfills a limited role of serving to enforce contracts (and defending us against violence, both internal and external).

    Patterico (3cc0c1)

  62. @bobathome: It seems to me that the thrust of your comments regarding Murray’s book, and Misesian economics in general, is that it doesn’t comport with current practices, and you are reluctant to think about alternatives because things have gone so well in the last 60 years. If this is wrong, again, my apologies.

    Wrong again, but I’m not offended so don’t apologize. I’m perfectly happy to think through alternatives. That’s what I’m doing here.

    What I’m arguing about specifically is that blithe, vague, and optimistic statements are being made about commodity money, and I am using math to show that all of these statements cannot possibly be true.

    Math intensely clarifies discussions. Without it, the logical quantifiers available to you are “all”,”none”,”some”. “All” and “none” are virtually worthless when talking about human motives and actions, so now all everyone has to work with is “some”. Math lets you say how much “some” represents.

    Gabriel Hanna (e2539b)

  63. @PAtterico:In a free market where government does not control the money, there is a potential for anything to serve as a medium of exchange.

    We agree on this.

    I do not believe that one can reduce humanity’s willingness to move to an alternate medium of exchange to mathematical equations.

    I did not write equations that “reduce humanity’s willingness to move to an alternate medium of exchange”. I said nothing of the sort.

    In fact what I showed is exactly how those alternatives would have to work. Using math. The math of investment and finance, which I don’t think you actually dispute. If you accept compound interest, that’s basically all the math I used.

    The idea is not to fixate on one particular yellow metal, but rather to seek the freedom that is possible only when government has released its control over the money supply, and fulfills a limited role of serving to enforce contracts (and defending us against violence, both internal and external).

    I agree with you; we had that freedom in the first 50 or so years since independence.

    The specific thing I am saying is that a fixed supply of money opposes economic growth. Growth causes deflation, and deflation provokes contraction (if no other money is available to step in) or inflation (because other money steps in and fills the demand). I never said people won’t switch to other money: I explicitly assumed other money is available and showed that they will spend, lend and invest the cheaper money in preference to the expensive money, which is in fact inflation.

    Now that you’ve seen the math and followed it I am not going to allow you to go back on handwaving statements about how deflations going to make everything cheaper without challenging you. Because you’ve been shown otherwise.

    Gabriel Hanna (e2539b)

  64. If deflation is on, saving makes credit unavailable. If all you have is a deflating currency, then no one wants to lend it or invest it, because the returns from deflation are risk free.

    My, that’s quite the blanket statement. So if I have two avenues available to me, and one is riskier than another, but the potential rewards are greater for the riskier course, your contention is that a human will always choose the less risky course?

    Patterico (3cc0c1)

  65. @Patterico:your contention is that a human will always choose the less risky course?

    See my point to bobathome about the value of “all” and “none”. It only depends on what most people would do.

    There are people who light cigarettes with $100 bills but it’s not something you can draw conclusions from unless most people think it’s a reasonable thing to do.

    Rates of return have to be modified by risk. That’s the basics of financial math.

    I offer you three investment alternatives for your 100 g of gold:

    1) Do nothing, at the end of the year it will be worth what 105 g is now because of deflation.
    2) Invest with my Option A, which has an 80% chance of success, and I will give you 105 g at the end of the year.
    3) Invest in my option B, which has a 1% chance of success (the prospectus starts with “Hold my beer and watch this”), and I will give you 150 g at the end of the year.

    Which do you choose? Obviously anyone can be found to invest in any of them, but you have your retirement at stake and not your beer money. Which one will most sober investment professionals choose? Which ones will the mutual fund managers choose? (Actually a combination of all three but they are going to put much less into 3) than into 1).)

    Gabriel Hanna (e2539b)

  66. @Patterico:your contention is that a human will always choose the less risky course?

    Same three options as before but now there is 5% inflation:

    1) Do nothing, at the end of the year it will be worth what 95 g is now because of deflation.
    2) Invest with my Option A, which has an 80% chance of success, and I will give you 105 g at the end of the year.
    3) Invest in my option B, which has a 1% chance of success (the prospectus starts with “Hold my beer and watch this”), and I will give you 150 g at the end of the year.

    Under inflation option 2) now has a much higher expected value than option 1) and even 3) has increased a little with respect to what it was.

    So inflation vs deflation does in fact change the likelihood of money-under-the-mattress saving vs investment and lending.

    Gabriel Hanna (e2539b)

  67. By the way: In truth, as I have said, I don’t advocate a gold standard per se so much as I favor removing the governmental restrictions on gold being used as money (taxing its sale, e.g.) and allowing all possible currencies to compete. …

    What does this mean? There is no federal sales tax on gold (as far as I know). Are you talking about capital gains taxes? How would you figure income tax with many currencies in use? This seems unavoidably complicated.

    James B. Shearer (fe81ca)

  68. @James B. Shearer:How would you figure income tax with many currencies in use? This seems unavoidably complicated.

    I don’t think this is so hard in principle. You know how you can buy an index fund which represents the value of a collection of stocks? Somebody will certainly put out a reference index commodity fund and your income for tax purposes could be calculated in terms of it. The capability could easily be incorporated into tax software.

    But there’s lots of ways to collect taxes and income taxes are a very recent invention compared to commodity money; something like VAT would certainly be easier and bring in comparable amounts of revenue.

    Before anyone jumps on me, no I’m not advocating VAT. Just saying there’s lots of ways to collect taxes. I would prefer a system that is as far as possible user fees.

    I live in a state with no income tax and a big government (18% of state GDP). They find ways to get the money: licenses and fees, sales tax, property tax, and the Business and Occupation tax which I think only Washington has. Wage-earners like me pay only licenses, fees, sales and property tax (explicitly: of course business taxes are passed on to consumers).

    I think now you could write a contract to be paid in anything you like, though. It’s just that they’ll look at you funny at the bank if you try to negotiate your mortgage in gold. The transaction costs are very high because we have an alternative available, the fiat currency that has a privileged status.

    And the fiat currency is clever in that its value is essentially only as a medium of exchange; its commodity value is practically zero, unless President Sanders nationalizes toilet paper and then we’ll see… It’s not worth much to hold on to, compared to trading it for something, so it tends to circulate.

    Gabriel Hanna (e2539b)

  69. I offer you three investment alternatives for your 100 g of gold:

    Please provide your proof that these options mirror what would be available in the real world.

    Patterico (5f0ab0)

  70. @Patterico:Please provide your proof that these options mirror what would be available in the real world.

    There are any number of investments options that could work in these ways. Problems like these are pretty standard in finance and are studied by actuaries, who have to put them into practice to make money for insurance companies. Any investment you can think of, someone has offered somewhere at some time.

    So is it that you really can’t choose a preference under the two situations, or is that that you just don’t want to answer? I mean the “cite please” thing is a getting to be a bit of a double standard, don’t you think? You are advocating many changes to the current system of economics that have never been practiced in reality, aren’t you?

    I will be happy to work an example for you and then if you see I’m doing the math wrong, holler, I won’t be offended. I’m not doing anything that requires any math harder than compound interest and probability, and every bank, insurance company, and investment group is making millions of real-world decisions every second based on these considerations.

    So again, in the deflationary case which investment has the highest expected rate of return and which investment has in the inflationary case? And which do you expect sober professionals to turn most of their attention to in the three cases?

    Gabriel Hanna (2ca835)

  71. 69. I don’t think this is so hard in principle. …

    Let me elaborate. Patterico wants to allow different currencies to compete on an equal footing. But a problem with this is that the US government expects all gains and losses to be computed in terms of dollars. So for example if I am paid in gold and I spend the gold a week later the government wants any change in the value (in terms of dollars) of that gold during that week to be reported as a capital gain or loss on my income tax return. In contrast if I am paid in dollars and spend dollars the government doesn’t care about any increase or decrease in the value of those dollars (in terms of gold or anything else) during the week that I held them. As a result conducting your business in dollars will make doing your taxes much simpler seriously discouraging the use of alternative currencies.

    But what is the alternative? Allowing tax payers to compute and pay their taxes in whatever currency they feel like? I doubt this is practical.

    James B. Shearer (fe81ca)

  72. 59.I am not an economics expert, James B. Shearer, but I know enough to know this: you would benefit by doing more reading concerning the concepts of marginal utility and subjective value theory. These are not easy concepts, and I don’t mean to suggest that they are. But there is a wide body of knowledge out there that you are seemingly making no effort to grasp on a fundamental level. Rather than trying to pick isolated phrases here and there, and attempting to discredit subjective value theory based on a myopic fixation on those isolated phrases, I recommend more reading, and a deeper understanding of these concepts, as your optimal first step.

    You seem to believe Rothbard and Mises are right about everything despite the fact that most professional economists disagree. Why should I accept your opinion over that of people like Bryan Caplan who although initially sympathetic to Austrian economics is unwilling to treat it as infallible? Caplan’s essay explaining why he no longer considers himself an Austrian economist can be found here. I won’t say I agree with (or even understand) all of his points but many of them seem reasonable. If some of Rothbard’s ideas are generally rejected by the economics profession as a whole perhaps that is because Rothbard was sometimes wrong.

    James B. Shearer (fe81ca)

  73. @Shearer: So for example if I am paid in gold and I spend the gold a week later the government wants any change in the value (in terms of dollars) of that gold during that week to be reported as a capital gain or loss on my income tax return. In contrast if I am paid in dollars and spend dollars the government doesn’t care about any increase or decrease in the value of those dollars (in terms of gold or anything else) during the week that I held them. As a result conducting your business in dollars will make doing your taxes much simpler seriously discouraging the use of alternative currencies.

    The whole premise is that the government is going to accept things other than dollars as currency, not just as commodities, and all sorts of wonderful benefits will flow which Patterico will happy provide real-life examples of to illustrate. It will take him some time to assemble them, so in the meantime I will propose something that could work. I don’t actually oppose the idea of commodity money, I just demand that it be quantitatively thought through and not hand-waved.

    In the happy days before income tax there actually was commodity money in this country. People used all sorts of circulating metal, Spanish and Mexican were favored as well as American. (The Spanish real is the origin of our expression “two bits” for an quarter of a dollar since it was a silver coin designed to be cut into eight wedges.) Anyone who dealt with money had to figure out what kind of money it was and price it appropriately; old worn money from far away versus shiny new money from nearer by, for example.

    Now we have income tax, but we also have computers and index funds.

    So an index fund translates the values of a different stocks into one number which represents a price of them considered collectively. Under the Hanna Administration the government would simply have you account all of your commodity money transactions using a commodity money index fund for tax purposes. So if you were paid 854 gold ducats and 13,758 silver florins in wages, your company payroll fund would report that they had paid you the equivalent of 218,542 units of the Patterico Commodity Metal Index. No doubt there would be more than one index fund, and the Hanna Administration would allow you use the one most favorable to you of a group of two or three that the government regularly audits, but my esteemed opponent will favor a policy of requiring you to use the least favorable one because he thinks you’re a fatcat and you’re not paying your fair share.

    So, I think I’ve shown that it’s possible in principle to pay income taxes in this way. The idea is that dollars won’t be privileged. They won’t have to be.

    Of course if it was really hard to do that they could collect taxes in literally hundreds of other ways, I don’t think they’ll do without.

    Gabriel Hanna (2ca835)

  74. … So if you were paid 854 gold ducats and 13,758 silver florins in wages, your company payroll fund would report that they had paid you the equivalent of 218,542 units of the Patterico Commodity Metal Index. …

    So I take my gold ducats and exchange some of them for silver florins and then I exchange some of my silver florins for gold ducats and eventually (because I’m smart and/or lucky) I end up with 1000 gold ducats and 15000 silver florins. Is my trading gain taxable income and if it is how is the amount computed?

    James B. Shearer (fe81ca)

  75. Shearer:

    I have spent a lot of time reading Caplan’s article as well as numerous rebuttals to it. You’re just dragging it out as an appeal to authority, and I’d bet any sum of money you haven’t read it and don’t understand anything Caplan is saying or why it’s wrong.

    Here’s my appeal to authority: economists accept marginal utility theory and subjective value theory.

    Patterico (3cc0c1)

  76. @Shearer: Is my trading gain taxable income and if it is how is the amount computed?

    Under current tax law, ask your accountant. Under the system I suggested, you’d convert your initial and final balance into an accepted commodity index fund. If the law says that’s capital gains it’s easy to calculate how much the gain was, and if the law says it’s income it’s still easy to compute how much the gain was.

    Of course a government that allows commodity money is not necessarily going to have the US tax code, so the objection you are making is really dependent on a specific set of tax laws, and not what would happen if we had commodity money.

    Gabriel Hanna (2ca835)

  77. @Patterico:Here’s my appeal to authority: economists accept marginal utility theory and subjective value theory.

    They do. And they also accept that deflation causes contraction by making money-under-the-mattress saving more attractive than lending or investment. And so do you, because you accept how financial calculations are done and you didn’t find anything wrong with mine.

    Gabriel Hanna (2ca835)

  78. 77 … Under the system I suggested, you’d convert your initial and final balance into an accepted commodity index fund. …

    This might work if you solely traded between gold and silver (although it would eliminate the distinction between realized and unrealized capital gains that exists in current law) but it would be more complicated if you used a little of the gold and silver to buy food along the way.

    Of course a government that allows commodity money is not necessarily going to have the US tax code, so the objection you are making is really dependent on a specific set of tax laws, and not what would happen if we had commodity money.

    Sure but one objection to Patterico’s proposals is that he doesn’t provide a realistic way to get from where we are now to where he wants to be. It would be helpful if this could be done by a series of small changes (each of which improved things slightly). Of course it is possible no such path exists (even if Patterico is right about the end state being better) but people are understandably reluctant to make drastic changes to implement a theory that has never been tested in practice particularly since as you pointed out the current system works pretty well.

    I thought Patterico had in mind some such small change regarding allowing competitors to the US dollar within the US and I was trying to ask exactly what he was proposing and how it would interact with current tax laws.

    If reaching his ultimate goal requires changing both the tax laws and the currency it might make more sense to try to change the tax laws first. It seems likely to me that the current tax code is imposing more unnecessary costs on the economy then our currency system.

    James B. Shearer (e8e729)

  79. 76 … I’d bet any sum of money you haven’t read it and don’t understand anything Caplan is saying or why it’s wrong.

    I did in fact read it before posting the link. If you wish to post links to rebuttals I will read those too. I stated I didn’t understand everything Caplan was saying. For example Caplan claims that:

    … This is why neoclassicals say that the utility function is uniquely defined up to a monotonic transformation. You can rescale any utility function however you like, so long as you re-scale it monotonically.[9]

    However the utility function I am familiar with ( von Neumann-Morgenstern ) can only be rescaled by linear transformations. Possibilly Caplan means a different utility function but if so it would have been helpful if he had explicitly distinguished it from von Neumann-Morgenstern utility functions to avoid confusion.

    Here’s my appeal to authority: economists accept marginal utility theory and subjective value theory.

    Do they also accept the assumption of continuity which (according to Caplan) Rothbard rejects even as an approximation?

    James B. Shearer (e8e729)

  80. James, I’m enjoying thinking about the problem of complying with income tax laws with a commodity-based money. What a joy. Every coin (or commodity backed certificate) you receive would need to be marked (if not otherwise uniquely identified) and dated. This could be done with an app on your cell phone. It would read the certificate serial number and add the new certificate/coin to the database with the date (and time.) Next, as you use the money to pay for something, you read it into the app and it is logged out of the database. Come April 15th, collect all transactions, computing capital gains and losses based on a standardized table maintained by the IRS, and shazam!!, one more line on the 1040 is completed. The entire issue of FIFO/LIFO/??FO would occupy accountants for years on end. This is akin to problems you have if you invest in oil trusts which feature depletion allowances and aggressive state tax collectors. But with the trusts you have only a few transactions in a year, whereas every time you buy something these capital gains issues would come into play. But this is getting pretty far afield from an a priori analysis of economics.

    The Morgan Dollar was created to facilitate trade with China. I’ve seen pictures of Morgan dollars that were used in the trade, and each Chinese merchant would stamp it with his icon verifying that he found it authentic. I don’t know what this has to do with capital gains on money used in a transaction, but I found it interesting. Perhaps it is just something to keep in mind if status quo suffers a Richter 9 shakeup. Like, say, Janet Yellen deciding to let the market set interest rates.

    bobathome (a52abe)

  81. I’m disappointed with the direction these comment threads have taken and I believe it’s my fault. As the blog owner I set the tone, and the tone should not be combative or adversarial but cooperative. I am going to work on doing better.

    Patterico (3cc0c1)

  82. Gabriel,

    Can I ask why you are putting risk (80% chance of getting x amount of gold) into your examples? Are you just trying to justify why the return is higher?

    The answer to your question is very complex, I think. I have done some more reading on the basic concepts, which I have found very interesting.

    First, I’ll cut to the chase: I don’t think it’s possible or fruitful to answer your question: “Which do you choose?” But I want to do my best to understand the point you are making, and accurately address your concerns in the manner that I believe the Austrians would answer them.

    This may turn into a post, but I’m not there yet. I want to talk out loud. Are you around right now? I’d love to have a relatively active conversation if you have time at the moment. Obviously anyone else who wants to chime in, please do.

    Patterico (3cc0c1)

  83. My basic understanding is this — and it incorporates some of the concepts I have already discussed in these posts.

    First: the central idea when we talk about interest rates (as I think we are) is that they are a reflection of people’s time preference. I have mentioned this before but let me spin it out a bit.

    Time preference is basically a human’s preference for having goods now, as opposed to having (obviously a greater number or amount of) goods in the future. Those with greater time preference have a greater desire for goods NOW and will give up more future goods to get more present goods.

    People have different time preferences, and you can put them on preference ranks as we did with ice cream. Without making it overly complicated, you might prefer 105g of gold in one year (a future good) to 100g of gold today (a present good). I might prefer 100g of gold today to 105g of gold in one year. If these are your preference ranks, you would be willing to lend 100g to me today, provided I promise to give you 105g of gold in one year, and you believe I will actually do it.

    So far, so good.

    Now, different people’s preference ranks are different. I might have a preference rank like this:

    1) 106g of future gold (when I say “future gold,” assume I mean gold in one year, consistent with the above)
    2) 100g of present gold
    3) 105g of future gold

    while James’s might look like this:

    1) 100g of present gold
    2) 106g of future gold
    3) 105g of future gold

    If you’re deciding which one of us to lend to, it’s probably going to be James, if you figure out that you can get him to pay you 106g in one year, while I am willing to give you only 105g.

    James and I have different time preferences from each other, and each of us has a different time preference from you. This is true of everyone in society. As you add up all these time preferences, they get you to an equilibrium rate of interest, which is derived through our old friends the supply and demand curves.

    You can draw out these curves on a piece of paper, which is beyond my capacity right now, so I have grabbed this from Murray Rothbard’s Man, Economy, and State. Note a few things:

    * Demand for present goods correlates with supply of future goods.

    * Supply of present goods correlates with demand for future goods.

    As the interest rate goes up, two things happen:

    1) Demand for present goods / supply of future goods decreases. (This makes sense. When you borrow (i.e. when you demand a loan), you are demanding something right now — a present good, like money. When interest rates are high, demand for loans decreases. Similarly, you are less willing to supply a future good — an IOU that will give the lender future money — and thus the supply decreases.)

    2) Supply of present goods / demand for future goods increases. (Again, this makes sense. When you lend, you are supplying a present good, like money, and demanding a future good: an IOU that you can redeem for future money. Lenders want to lend more money, i.e. supply a present good, when the interest rate is higher. Similarly, your demand for that IOU, a future good, increases, because it will be worth more in the future when the interest rate is higher.)

    The supply and the demand curves slope in opposite directions and meet at the equilibrium rate of interest (the point labeled A in the linked chart).

    So: higher interest rates in the aggregate mean greater savings. All other things being equal, higher interest rates mean a greater supply of loanable funds (make possible by greater savings) but a lower demand for loans.

    All of this is a reflection of the aggregate of individuals’ time preferences.

    That’s enough for one comment; let’s take a breath. But it’s what comes next that is truly interesting.

    Patterico (3cc0c1)

  84. Now, different people’s preference ranks are different. I might have a preference rank like this:

    1) 106g of future gold (when I say “future gold,” assume I mean gold in one year, consistent with the above)
    2) 100g of present gold
    3) 105g of future gold

    I have a question here. What happens if we vary the amount of future gold from 106g down to 105g? One might think there is some amount of future gold like 105.4g such that you would prefer any amount more than 105.4g of future gold to 100g of present gold, you are indifferent between 105.4g of future gold and 100g of present gold and you prefer 100g of present gold to any amount of future gold less than 105.4g. But according to Caplan Austrian economists don’t like to vary things continuously (as from 106g to 105g) and don’t accept that people can be indifferent between two alternatives. Is this accurate?

    James B. Shearer (e8e729)

  85. Here is the key insight, which I referred to in a previous post, but am fleshing out here in greater detail. The intricacies of the loan market I just described are only a small part of the time market.

    An even greater part of it comes with the renting (or even purchase) of various factors of production. As I said in a previous post, capitalists and landlords alike ultimately are receiving interest income.

    Let’s use an assumption called the ERE, the Evenly Rotating Economy. That is an economy where demand levels are constant and unchanging. Tastes do not change; new technologies do not develop; the supply of resources remains constant; people are not born and they do not die. If there is aggregate demand for 10 widgets this month, there will be next month as well. This is, of course, an impossible situation — but it simplifies the example so that we can remove the role of the entrepreneur, whose job it is to foresee changes in preferences, supply levels of factors of production, etc.

    I made the point in an earlier post that even in such an economy, there is still a markup that the producer of goods must charge, because it takes him time to create a good. If all producers knew exactly what people wanted, knew exactly what the value of the final product was, you would tend towards a world where profits disappear (because the role of the entrepreneur disappears), but the role of the capitalist remains, and his ability to earn interest remains. What would happen is that the capitalist would sell his money (a present good) to people who owned factors of production (like, say, a tractor), and in exchange for that money, they would rent or sell it to the capitalist for his use. The same is true for the land where he conducted his operation, or the labor he put to use in assembling consumer goods; all of this, he would hire, with the idea that it would help him increase his output. The capitalist would rent the tractor because it would increase his output. He would hire workers for the same reason. He would rent land for the same reason.

    Once he spent all the money he needed to spend for land, labor, and factors of production, he would still be able to charge a markup over and above what he spent, because of time preference — which allows him to earn interest when he finishes producing the good and sells it. If it takes him a year to create the product, he will earn a year’s worth of interest.

    This means that the time market operates throughout the economy — not just in the loan industry, but throughout all production processes. Meaning interest is a concept that applies to all production processes. And individuals’ time preferences pervade all of it, and are reflected in the equilibrium rate of interest. And the loan industry is actually a small part of the time market, since the time market pervades the entire economy.

    This leads us to an insight that many people don’t understand: when one expects inflation or deflation, entrepreneurs factor those expectations into the prices of inputs, and the rate of interest remains unchanged. As I explained in this comment in April with respect to the deflationary environment:

    When the population increases, productivity tends to rise. With a fixed supply of money, this may cause prices to fall, but that does not mean there will be a depression. If the real costs of production are lower (because productivity has increased) then businessmen will be able to purchase inputs for less, and can still make a profit even if prices are steadily falling with the expansion in population in productivity. People can even settle for lower wages if they can still purchase the same goods (or more and better ones!) with the lower amount of money.

    Profit margins are not absolute; they are relative, to the inputs needed and what can be bought with the profits.

    I have placed in bold the parts I think are important. My argument was intended as a response to those who argue that businesses necessarily lose money in a deflationary environment, because the prices of what they sell are constantly falling. I wanted to show that the prices of the factors of production also fall in a deflationary environment, and businesses can still make money. Here, I want to make the point that, because there is a time market involved here, expected deflation (such as the steady deflation that accompanies increased production with a constant stock of money) does not affect the rate of interest (defined as the return a capitalist earns by advancing the money for the labor, land, and factors of production used in creating goods). The inputs are offered at lower prices in such an environment, making the rate of return constant.

    Similarly, anticipated inflation does not affect the rate of interest. If entrepreneurs expect inflation to push up their rate of return, they will bid up the prices of inputs correspondingly. Only unanticipated inflation affects interest rates.

    This stuff is hard. And some of the things that seem to make intuitive sense (like the assertion that deflation or inflation necessarily change the rate of interest) turn out not to be true upon a closer analysis. Like the Monty Hall problem in statistics, the intuitive answer is not always correct.

    Patterico (3cc0c1)

  86. By the way, Gabriel, when people “save” I think it’s very rare for them to stuff money in their mattresses. They tend to prefer the security of a bank. That means that when they save, more money becomes available for lending. This is all consistent with the in-depth analysis of my 7:58 comment.

    Patterico (3cc0c1)

  87. 84

    First: the central idea when we talk about interest rates (as I think we are) is that they are a reflection of people’s time preference …

    This seems to assume people only borrow because they want to trade future consumption for present consumption. But people also borrow because they believe they can earn a greater return on the money than the interest rate. For example they borrow 100g of gold (promising to pay back 105g of gold in a year) intending to buy say 100 shares of XYZ stock which they expect to be worth more than 105g of gold in a year at which time they can sell the stock and collect the extra gold.

    This is important because this means interest rates don’t just reflect people’s relative preferences between present and future consumption but also their view of the outlook for the economy as a whole.

    James B. Shearer (e8e729)

  88. James B. Shearer,

    It’s interesting that you should bring up Caplan because his article was the subject of a Tom Woods podcast last week. Tom has intermittently run a series of podcasts addressing and refuting different aspects of Caplan’s article. The one from Friday addressed Caplan’s criticism of Rothbard’s welfare economics analysis, while a previous podcast (linked in the show notes to Friday’s podcast) addressed some related issues (including your question about continuous preferences). I don’t think I can do as good a job as Jeff Herbener in summarizing these issues, so I really do commend the podcasts to you, but the one observation that I think connects all of it is the Austrian emphasis on demonstrated preference — preferences that are demonstrated in action. The idea is that, to be of any use in economic analysis, a human’s subjective thoughts can’t profitably be accounted for until they are manifested in some action.

    For example, in the welfare economics podcast, they talk about the possibility that an exchange may not be Pareto optimal — because even if the exchange benefits both sides of the transaction (I sell you my company for $100 million, making you happy because you prefer the company to the $100 million, and making me happy because I prefer the $100 million to the company), there may be some third party like Gabriel who is envious and thus is worse off. The Austrian view is that the envy is not something that can be analyzed because it does not manifest itself in action.

    This only scratches the surface, but these podcasts really are at a very high level of quality for someone interested in these issues. It’s not easy stuff.

    Patterico (3cc0c1)

  89. This seems to assume people only borrow because they want to trade future consumption for present consumption. But people also borrow because they believe they can earn a greater return on the money than the interest rate. For example they borrow 100g of gold (promising to pay back 105g of gold in a year) intending to buy say 100 shares of XYZ stock which they expect to be worth more than 105g of gold in a year at which time they can sell the stock and collect the extra gold.

    This is important because this means interest rates don’t just reflect people’s relative preferences between present and future consumption but also their view of the outlook for the economy as a whole.

    One’s time preference can be affected by one’s belief in the potential of whatever they intend to do with the money; if you think you have a great opportunity, that may make your time preference greater. But whatever factors drive the time preference, it is time preference that determines the rate of interest. Thus, I think it’s inaccurate to say: “interest rates don’t just reflect people’s relative preferences between present and future consumption but also their view of the outlook for the economy as a whole.” I think it would be more accurate to say: “interest rates reflect people’s relative preferences between present and future goods, and this time preference itself can be affected by many factors, including but not limited to humans’ view of the outlook for the economy as a whole.” See the difference?

    Patterico (3cc0c1)

  90. Believing as I do in the soundness of these principles, it is horrifying to watch policymakers try to spur consumer spending and deliberately tamp down interest rates — when higher interest rates are what encourage saving and investment in the production process, which makes the economy more productive. The feeling is as if you traveled back in time and watched people dying from the Black Plague, and various Dr. Krugmans were running around warning doctors against washing their hands.

    Patterico (3cc0c1)

  91. 84 Time preference is basically a human’s preference for having goods now, as opposed to having (obviously a greater number or amount of) goods in the future. Those with greater time preference have a greater desire for goods NOW and will give up more future goods to get more present goods.

    I don’t think the “obviously greater number or amount of” is correct. Suppose I have the choice of 100 units of goods this year and 0 units of goods next year or 45 units of goods this year and 45 units of goods next year. Assuming 45 units of goods over a year allows me to live reasonably well I will choose the second choice trading 55 units of goods this year for 45 units next year when I will need goods more. This comes up in retirement situations if you have a million dollars and no prospects for earning more you will defer some of your consumption even if this means unavoidably losing some value to inflation.

    This is also true for society as a whole, it may make sense to store some grain from a bumper harvest even if you know rats will eat some of it because you may need it more in the future.

    James B. Shearer (e8e729)

  92. 90

    One’s time preference can be affected by one’s belief in the potential of whatever they intend to do with the money; if you think you have a great opportunity, that may make your time preference greater. But whatever factors drive the time preference, it is time preference that determines the rate of interest. Thus, I think it’s inaccurate to say: “interest rates don’t just reflect people’s relative preferences between present and future consumption but also their view of the outlook for the economy as a whole.” I think it would be more accurate to say: “interest rates reflect people’s relative preferences between present and future consumption, and this time preference itself can be affected by many factors, including but not limited to humans’ view of the outlook for the economy as a whole.” See the difference?

    I think where we disagree is I think interest rates reflect time preferences for money not for consumption. This isn’t the same thing because borrowed money isn’t always used for immediate consumption as in my example.

    James B. Shearer (e8e729)

  93. I think where we disagree is I think interest rates reflect time preferences for money not for consumption. This isn’t the same thing because borrowed money isn’t always used for immediate consumption as in my example.

    I did not express it very well because it’s very hard to express, but my giant comments above are intended to dispel exactly that idea. In a nutshell, the idea is that, wholly apart from the loan market, capitalists advance money for the factors of production, and thus surrender time. The time they surrender is the time between when they advance the money for the factors of production, and the time that they are able to sell the finished goods that are produced. They were without that money during that period of time, and the extra money they get at the end is interest, which compensates them for giving up that money during that period of time.

    The Austrian insight is that this is part of the time market, and is properly classified as interest — and the amount capitalists are able to earn this way is a function of people’s time preference. So interest rates reflect time preference for present goods over future goods — money being only one of a world of such goods.

    You’re the one who first used the term “present consumption,” in comment 88, and I mistakenly adopted the term. I have corrected it in my comment to “present goods” and not present consumption. If one takes a loan and uses it for an investment, one is still taking present goods (the money) and putting it to a use. You are correct that it need not be present consumption but it is present goods.

    Rothbard treats borrowing to obtain producer goods as a special case (although I believe one that follows the same general principles) and I have not had the time to read his full analysis on the topic.

    Patterico (3cc0c1)

  94. It’s very important to understand the concept of the time market (and interest rates) as pervading the entire economy and not just the loan market. I have been reading Chapter 6 of Rothbard’s “Man, Economy, and State” on the topic. You can too, if you’re interested. It’s free; you can get it here in .pdf or epub formats.

    Patterico (3cc0c1)

  95. I don’t think the “obviously greater number or amount of” is correct. Suppose I have the choice of 100 units of goods this year and 0 units of goods next year or 45 units of goods this year and 45 units of goods next year. Assuming 45 units of goods over a year allows me to live reasonably well I will choose the second choice trading 55 units of goods this year for 45 units next year when I will need goods more. This comes up in retirement situations if you have a million dollars and no prospects for earning more you will defer some of your consumption even if this means unavoidably losing some value to inflation.

    I’m not sure I follow this. If we are talking about goods depreciating or spoiling, the calculus may change because simply holding onto the good will not be equivalent to getting a new version of the same good in the future. But if the good is not depreciating or spoiling, why would you trade 55 units of the good today for 55 units, or 45 units, of the same good in the future? I feel like I must be missing something or misunderstanding.

    Patterico (3cc0c1)

  96. @Patterico: You keep almost agreeing with me, and then taking it back. I think because a lot of what I’m saying is new to you (and what you’re saying is new to me).

    Here’s an example:They tend to prefer the security of a bank. That means that when they save, more money becomes available for lending.

    But in the deflationary scenarios I outlined in this thread, the bank doesn’t want to lend. The consumers are putting their money in the bank, and the bank is stuffing the money in the mattress (okay its vault). Because their gold is yielding a higher expected return by doing nothing.

    Another example:Here, I want to make the point that, because there is a time market involved here, expected deflation (such as the steady deflation that accompanies increased production with a constant stock of money) does not affect the rate of interest (defined as the return a capitalist earns by advancing the money for the labor, land, and factors of production used in creating goods).

    I see what you mean about real vs nominal rates and I actually was saying that and computing those things. But you are not accounting for risk. Expected deflation is a riskless return and if you are going to lend money or invest there is a risk, so the real rate of return demanded on loans and investment will necessarily increase.

    You quibbled about my three investment scenarios, like I was trying to palm a card. I used examples instead of variables because I thought it would be easier. I see that was a mistake which I will rectify below.

    I get what you are saying about interest rates reflecting average time preference and what not. It doesn’t affect anything I’m saying. People want a real positive rate of return on investment: real, not nominal; positive, not negative. Whatever reason they have for wanting it, time preferences or wherever it comes from, whatever value they prefer, they want a) real and b) positive. And that’s why deflation and inflation aren’t a wash when it comes to lending, spending, and investment.

    So let’s say there’s a bank and the equilibrium real interest rate for money is r. The bank of course would love to make more than r but that’s the equilibrium. However it got set.

    The bank is asked for a loan for an investment, they put in P grams of gold and at the end of the year they will be paid (1 + r) P. And that’s the real rate of return they want, so they lend. Except: we didn’t account for risk.

    So the Poindexters at the bank think there a probability p that the investment will fail and the bank will (let’s say) get the real value of P back but make no return. There’s a probability (100% – p) that the investment will succeed and the bank will get paid its return.

    So what rate are they going to demand? The bank makes many loans, some succeed and some fail. They need to have an average expected real return to be a profitable bank and that average rate for lending is r. So the risk has to be accounted for:

    (1 + r) P = p * P + (100% -p) P (1 + r’)

    The bank has a p % chance of getting the real value of P back and a (100% – p) chance of getting r’, the interest rate they are going to ask for, and they choose r’ so that their expected real rate of return is r.

    So it’s easy to figure out: r’ = ((1 + r) – p)/ (100% – p) – 1

    So I didn’t palm a card. Put in any numbers you think are reasonable. If r = 3%, and p = 1%, then r’ = 3.03% (just about, not exactly). If r = 5%, and p = 20%, then r’ = 6.25%.

    If risk is involved you ask for a higher real rate of return than you do if risk is not involved.

    So these are all real rates. When you account for inflation and deflation, the money has a different value at the beginning of the year than at the end, and the calculation looks like this, where i is the inflation rate:

    (1 + r) P = p * P + (100% – p) P (1 + r’) / (1 + i)

    The p * P term assumes that the bank recovers only the real value of P in a failure of the investment, I think this is sufficiently generous. And so the rate r’ the bank has to charge is

    r’ = (1 + r – p) (1 + i) / (100% – p) – 1

    Again, put in any values you think are reasonable, I am not trying to palm cards. If you like r = 3%, p = 1%, i = 2%, then r’ = 5.1%. If there’s deflation of 2% then i = -2% and r’ = 1%. (In both cases r’ is a nominal interest rate, it’s what’s used to calculate the payments.)

    These can be worked backward and applied to the three options I offered you under inflation and deflation, and I’ll do that below.

    So when the money supply is fixed and the economy is growing, your bank is getting a riskless real rate of return by doing nothing–the money buys more at the end of the year than it does now. So your bank is going to ask for at least higher real rates of interest (but lower nominal rates) than the deflation rate. This is going to make borrowing money more expensive and make it harder for people to invest and buy things like houses. Corporations that don’t have money and want it are going to have to offer higher rates on their bonds. Not only is the money more expensive to acquire, in terms of producing goods and services, it is also more expensive to rent.

    Again, this is on average. There will still be gamblers, fools, people who know better than the market, and people looking for arbitrage and what-not. So it’s not like economic activity is going to cease but people are going to either a) try to use cheaper money if it’s available or b) not do as much lending and investing as they are saving because they will find it harder to get the money.

    However, suppose the money supply is increasing but the economy isn’t (a lot of gold is coming on the market that wasn’t). Now your bank has a real negative rate of return on keeping the money in the vault. They are going to ask for higher (nominal) interest rates than they would for deflation, but lower real rates, because the money is losing value over time, but they want any excuse to get that money out of the vault, it does them no good there.

    So two effects can happen out of that: a) the amount of lending and investing and spending goes up, which is growth, or b) the bank starts saving money that is not losing its value and tries to lend out money that is, and that’s deflation.

    Under both inflation and deflation, the cheaper money is going to be what is circulating more. In practice, both effects are going to happen in some proportion to whatever degree they are allowed to.

    Deflation provokes economic contraction coupled with inflation until equilibrium is restored. Inflation provokes economic expansion coupled with deflation until equilibrium is restored. The new equilibrium might be lower or it might be higher, in terms of size of the economy and size of the money supply.

    But it seems to me very straightforward that a free market in commodity money is going to provoke a reaction that opposes whatever the economy is trying to do. I’m not saying that’s necessarily bad, could be a feature instead of a bug. The idea nowadays seems to be that we should always have economic growth and that we can get it by always having a little inflation. I really don’t know if that is better, in the long run, but so far it has “worked” in the sense of not being perfect but certainly we have had real, sustained economic growth for a very long time. We might have had it better using commodity money, I don’t know.

    I think that besides the math of interest and probability, history also supports this. There have been times in history where money was a commodity, not within nations necessarily but always between them. (You are a 17th century Dutch merchant and you are selling Indonesian spices in Venice. You bought them in silver guilders and you are getting paid in gold ducats but you are going to take that money home to Amsterdam, what are you going to get for it? Depends on the condition and purity of the currency and your bank in Amsterdam knows how to figure it out because they get money from all over the world. How Dutch banking works features heavily in Wealth of Nations.) The experience of Spain and Portugal with importing enormous amounts of gold and silver that kept them poor is pretty compelling, coupled with endless agitations and workarounds for cheap money in England and France.

    Anyway, my investment scenarios I offered to you can be worked with the same math I outlined above. In this case we are solving for r instead of r’.

    So, one equation:

    r = p / (1 + i) + (100% – p) (1 + r’) / (1 + i) – 1

    In the deflation case:

    1) Do nothing, at the end of the year it will be worth what 105 g is now because of deflation.

    p = 0%, r’ = 0%, i = -5%, r = 5.3%

    2) Invest with my Option A, which has an 80% chance of success, and I will give you 105 g at the end of the year.

    p = 20%, r’ = 5%, i = -5%, r = 4.2%

    3) Invest in my option B, which has a 1% chance of success (the prospectus starts with “Hold my beer and watch this”), and I will give you 150 g at the end of the year.

    p = 99%, r’ = 50%, i = -5%, r = 0.05%

    Option 1 has the highest rate of return of the three I presented, and option 3 is for people who are very optimistic. But try your own values and see how little risk and how much interest is required to do better than deflation.

    In the inflation case:

    1) Do nothing, at the end of the year it will be worth what 95 g is now because of deflation.

    p = 0%, r’ = 0%, i = 5%, r = -4.76%

    2) Invest with my Option A, which has an 80% chance of success, and I will give you 105 g at the end of the year.

    p = 20%, r’ = 5%, i = -5%, r = -3.8%

    3) Invest in my option B, which has a 1% chance of success (the prospectus starts with “Hold my beer and watch this”), and I will give you 150 g at the end of the year.

    p = 99%, r’ = 50%, i = -5%, r = -0.048%

    In this case option 3) almost breaks even. High enough inflation can make “hold my beer and watch this” pretty reasonable, compared with sitting on the money or doing something much more sensible like option 2). Of course this is a telling point against encouraging inflation, the penalty for wise behaviors may high enough that stupid behaviors are encouraged. (Had I really been trying to stack the deck I would not have picked the numbers this way, I would have made option two come out best). But you can pick any numbers you want: an investment or loan can be quite risky and still wiser than sitting on money. And you can see why people who think growth is good and contraction is bad are going to want to encourage a little inflation. Whether they are right that growth is good I do not know, having never lived under any system but the one we know now.

    Gabriel Hanna (2ca835)

  97. @Patterico:r = p / (1 + i) + (100% – p) (1 + r’) / (1 + i) – 1

    There’s a typo in this one, should be

    r = p + (100%-p) (1 + r’) (1 + i) – 1

    and that’s what I used to generate all the numbers for real returns under inflation and deflation. The other equations all look right.

    Gabriel Hanna (2ca835)

  98. I’m running a bit short on time but two things:

    1. There is no question but that the rate of interest must be more than zero because I think you and I agree that nobody will give up present dollars for the same number of future dollars. (James seems to quibble with this, but I don’t yet understand his reasoning and I think the principle is sound.)

    2. Before we concentrate on the loan market example, do you follow my (admittedly difficult to grasp) dissertations above on how the time market pervades the whole economy, and how in the production process expected inflation and deflation do not affect the interest rate because of the changing price of inputs? I’d like to start there because I think the principles are important and the effect of that market is much greater, although I do want to get back to the loan market example when I have more time.

    Patterico (3cc0c1)

  99. The very short answer to the loan market example is that I think you’re assuming that the person’s ease of acquiring the funds is the same in the deflationary scenario as it is in the inflationary scenario; in other words, your starting point is assuming that the person already has the money. But that ignores how the person got the money, and how much it cost him to get it. The issue is always the spread, not the absolute amount. That’s terse and I can elaborate later if it’s too terse.

    Patterico (3cc0c1)

  100. In other words, don’t start with the person having the money. Also do the math on what it took him to acquire it, in an inflationary and deflationary scenario, and then compare that to what he can get when he puts it to use. That gives you a fuller picture.

    Patterico (3cc0c1)

  101. Gabriel has raised some interesting points, but I think he goes wrong right at the start. The deflation that he describes is a symptom brought about by other actions within the economy. Without considering what those are, you really can’t make headway. As an example, imagine that aliens have landed on earth and they have revolutionized every single production process, every where. In this case, everything that anyone does now yields 5% more goods. And to carry this out a few years, all consistent with Gabriel’s unstated assumptions, this improvement will be a steady 5% every year. This sounds like heaven, yes???? Well, no not really. Who needs 5% more broccoli, every year, forever. In fact, the clean green waste barrels in Seattle will soon be overflowing with broccoli. My point is that once real people see what’s happening, a few of them, smarter than me for sure, will see new opportunities. So until we understand why there is deflation, meaning the same amount of money chasing an increasing amount of goods in Gabriel’s analysis, we can’t make projections about what makes for a sensible loan by a bank.

    bobathome (a52abe)

  102. 96 I’m not sure I follow this. If we are talking about goods depreciating or spoiling, the calculus may change because simply holding onto the good will not be equivalent to getting a new version of the same good in the future. But if the good is not depreciating or spoiling, why would you trade 55 units of the good today for 55 units, or 45 units, of the same good in the future? I feel like I must be missing something or misunderstanding.

    Suppose you retired at 65 with a lump sum amount like $1000000 which you need to live on for the rest of your life. Of course one problem is that you don’t know how long you are going to live but let’s simplify things by saying everyone in your family lives to 85 in good health and then abruptly dies. So you have to cover your needs for 20 years. With a real interest rate of zero you could just budget $50000 per year to spread your consumption evenly (or of course if you prefer you could move some consumption forward by budgeting $60000 the first year decreasing to $40000 the last year or whatever depending on your time preferences).

    But suppose the real interest rate is slightly negative (there is inflation and no safe investments that keep up). What do you do then? You could say well I will just buy everything I will need for the next 20 years now before my money loses value. But if you think about it this is totally impractical. You can’t buy and store services like haircuts or restaurant meals or taxi rides etc. And many tangible goods are either awkward to store (consider trying to buy and store all the gasoline you will need for 20 years) or will lose value (fresh fruit for example). And there is an additional problem. Who knows in advance everything they will want or need for the next 20 years? You may get a flat tire or drop a dish or your taste in clothes may change etc. Many people are in this position today. They keep money in the bank slowly losing value because it is better to accept some loss in value than to try to buy everything in advance.

    Of course inflation were severe you would try to spend your money before it lost all value but you might prefer to buy some money substitute like gold coins or cigarettes or whatever you think you will be able to exchange for future consumption instead of providing for future consumption directly. But such money substitutes are not perfect and you might rationally prefer to just hold dollars and accept a slow erosion in their value.

    James B. Shearer (0d77ca)

  103. well there is inflation on staples, and no safe investment, but quantitative easing has furthered this path, so what happens when the bubble pops,

    narciso (ee1f88)

  104. @Patterico:I think you and I agree that nobody will give up present dollars for the same number of future dollars.

    If there is any riskless alternative that offers a positive real rate of return, then no one will give up present money for the same amount of future money.

    Before we concentrate on the loan market example, do you follow my (admittedly difficult to grasp) dissertations above on how the time market pervades the whole economy,

    Yep.

    how in the production process expected inflation and deflation do not affect the interest rate because of the changing price of inputs?

    Here we disagree. The people who lend the money have choices and one is stuff the money in the vault and wait. Expected deflation is a real riskless return and any possible alternative will have to beat the deflation rate once risk is accounted for.

    Also do the math on what it took him to acquire it, in an inflationary and deflationary scenario, and then compare that to what he can get when he puts it to use.

    Already did all that in the my previous comments…

    Gabriel Hanna (64d4e1)

  105. @bobathome:The deflation that he describes is a symptom brought about by other actions within the economy. Without considering what those are, you really can’t make headway.

    I did more than once explain that I was describing a fixed supply of commodity money with a growing economy–all other goods and services remaining fixed relative to each other, i. e., everything but the amount of gold used as money is increasing by 5%. In that case, everything that I have worked out follows. For inflation I am discussing the converse, the commodity supply is increasing but the economy isn’t.

    There are a lot of things that can be called “inflation/deflation”, but I am talking specifically about commodity money and careful distinguishing real from nominal quantities.

    Gabriel Hanna (64d4e1)

  106. 102 102.Gabriel has raised some interesting points, but I think he goes wrong right at the start. …

    To some extent this is a side issue because slow steady anticipated deflation isn’t what people mainly worry about. However it seems true that the rate of inflation (or deflation) constrains what the real interest rate can be. If the deflation rate is 3% a year then the real interest rate must be at least 3% (else potential lenders will just hold on to their money). But if the inflation rate is 3% a year then the real interest rate only must be greater than -3% a year (as potential lenders will lose 3% a year sitting on their money). Of course in both cases the real interest rate will be higher to account for the overhead and expenses involved in lending money.

    So the question is could the deflation rate ever be high enough that this constraint on the real interest rate damages the economy? It appears growth in China has averaged 10% a year for the last 25 years. If China were using a fixed money supply this would seem to imply a deflation rate of 10% a year and hence real interest rates in excess of 10%. It appears the actual real rates were substantially less than this. So it seems plausible China would not have done as well with a fixed money supply. Of course China is not exactly a model free market economy and who knows how reliable the statistics are but still it is not obvious that a fixed money supply never imposes any unnecessary costs on an economy.

    James B. Shearer (0d77ca)

  107. @Shearer:To some extent this is a side issue because slow steady anticipated deflation isn’t what people mainly worry about.

    I think because it’s quite rare! Either it chokes out growth or it stimulates cheaper money alternatives.

    It appears growth in China has averaged 10% a year for the last 25 years. If China were using a fixed money supply this would seem to imply a deflation rate of 10% a year and hence real interest rates in excess of 10%.

    I think this sort of growth could only happen, using gold (say), if China could either mine enough gold or attract enough gold to keep the gold supply growing at 10% along with it. If there are ten things being used as commodity money, then the aggregated amounts of those currencies would have to grow at 10%. Of course the different commodities could grow at different rates as long as the aggregate grows, and people will shift between currencies as advantageous to them–as I already addressed in my worked examples. (Which implicitly excluded trade as a source of gold and silver, I was assuming a world economy since the total potential supply of gold in the world is pretty nearly accounted for and mostly in use already.)

    Gabriel Hanna (64d4e1)

  108. Gabriel, as I tried to illustrate with my broccoli production example, not everything can grow at a perfectly even rate. There’s only so much broccoli you can eat. And remember everything else is growing (in your example) at 5%, so it isn’t just broccoli, it’s also Kimchi and pickled herring in cream sauce. This will create opportunities for entrepeneurs to create new products and services that would be profitable irrespective of deflation or inflation. You’ve thrown the baby out with the bathwater.

    bobathome (279337)

  109. @bobathome:Gabriel, as I tried to illustrate with my broccoli production example, not everything can grow at a perfectly even rate.

    Not forever, no, and I never said it would. I only used a time frame long enough to make loans over. Obviously nothing grows or decays at the same rate forever, and I never said it had to be EXACTLY even growth either. It’s an “all else being equal” argument.

    You’ve thrown the baby out with the bathwater.

    I am simply demonstrating how loans would have to work using a set of assumptions. I’m not drawing grand conclusions about how no new inventions or productivity gains are possible. I’m holding everything else constant to look at changes in one thing. I didn’t account for self-driving cars, fusion technology, alien invasions, or time travel either. That’s no reason to declare anything I’ve worked out to be illegitimate on that ground.

    I’m saying that inflation or deflation, for commodity money only, is when the economy and the money grow at different rates, and that the mismatch in growth rates provokes behaviors that counteract the mismatch.

    I’m serving a can of cranberry sauce, and only cranberry sauce, at dinner. You don’t like my cranberry sauce, and you are complaining that it doesn’t go with the turkey, which isn’t even on the table. You’re doing that because you assume I must have a whole Thanksgiving dinner stashed somewhere. But I don’t. It’s only cranberry sauce. You can’t conjecture a whole Thanksgiving dinner out of your imagination and then blame me for it.

    Gabriel Hanna (64d4e1)

  110. I agree that you are demonstrating how loans work using a set of assumptions. My point is that your assumptions throw the baby out with the bathwater. The universe you have created can’t exist.

    bobathome (279337)

  111. @bobathome: The universe you have created can’t exist.

    I didn’t create a universe. I used a set of assumptions that are valid, not forever, and not always, but for some limited period of time and all else being equal, using very very basic financial math to explore the consequences. For some reason you’ve decided to insist that I am creating this whole universe out of it but I’m not; I’m afraid it’s because you can’t find anything wrong with my math and you want to deny the conclusion, so all you can do is reject the premise.

    But I’m not doing anything Mises or Patterico is not doing. If you reject mine you should reject theirs for the same reasons.

    Gabriel Hanna (2ca835)

  112. Gabriel, their (Mises or Patterico) analysis is generally focused on instantaneous transactions that benefit both parties. Time, and the idea of interest rates, are added to explain second order transactions, or more generally, transactions that are based on expectations. Your universe is filled with broccoli and all sorts of stuff that few people would buy more of, toothpaste for one, than they do today, even if 5% more of it was displayed on their local grocery store’s shelves. Which brings to mind the question of how your universe is going to accommodate 5% more of everything. Much of what we see around us is the result of past investments. My 250 gallon propane tank for example. It is only filled to 80% of its nominal capacity because of real world considerations. If I am supposed to consume 5% more propane in your universe, I will need a bigger tank. Just as grocery stores will need more shelves. And my house will be heated to unbearable levels. This doesn’t seem Pareto optimal or even marginal superior. Baby and bathwater, both over the transom.

    bobathome (279337)

  113. Gabriel, your math is not my problem, believe me.

    bobathome (279337)

  114. But suppose the real interest rate is slightly negative (there is inflation and no safe investments that keep up).

    The Austrian view is that there is never any such thing as a pure interest rate that is negative. If a bank charges a so-called “negative interest rate” (as I believe has happened in Europe), I am confident Austrians would deem that (as I would) a depositor paying the bank a fee for ensuring the safety of their money. Money stored in a bank is generally thought to be safer than storing it “under the mattress,” and that is arguably worth something. But if you felt that your money was every bit as safe from theft or fire or other disaster under your mattress as it is in the bank, there is no reason you would allow a bank to charge you a “negative interest rate” and promise to give you fewer future dollars in exchange for more present dollars.

    Patterico (3cc0c1)

  115. 115

    I am talking about the real interest rate (the rate after accounting for inflation) not the nominal interest rate. For example for the last 5 years (2010-2014) inflation has averaged about 1.7% a year. However short term interest rates have been less than .7% a year for this period. This means the real short term rate has been negative, less than -1% a year. Each year you hold money in such accounts it loses at least 1% of its value. But this is better than holding it as cash as you are still earning a small amount of interest which is better than nothing. So lots of people (including me) are accepting this slight loss of value because there is nothing we really want to buy right now and we might need the money in future (if we lose our job or our house burns down or some other urgent need arises).

    Every so often you see a story about some former professional athlete who is broke despite earning some large sum of money (like $100 million) during their career. These athletes are generally considered foolish for failing to set aside some of their earnings for future consumption. I would agree that this is foolish and I think it remains foolish even if the money set aside was expected to lose a small amount of value.

    James B. Shearer (0d77ca)

  116. If I have said something that made it seem as if I was denying the desire of people to hold cash balances, then I have spoken imprecisely or there has been a misunderstanding.

    Patterico (3cc0c1)

  117. 89

    For example, in the welfare economics podcast, they talk about the possibility that an exchange may not be Pareto optimal — because even if the exchange benefits both sides of the transaction (I sell you my company for $100 million, making you happy because you prefer the company to the $100 million, and making me happy because I prefer the $100 million to the company), there may be some third party like Gabriel who is envious and thus is worse off. The Austrian view is that the envy is not something that can be analyzed because it does not manifest itself in action.

    I find this example a bit confusing as envy often does manifest itself in action like voting for Bernie Sanders.

    In any case the harm to third parties is often more tangible than envy. Suppose A hires B to add a second story to his house which blocks the view of C. C has been damaged in a tangible way even if A has a property right to build the second story which means C can’t do anything about it. So this exchange has not produced Pareto improvement (because somebody is worse off).

    James B. Shearer (0d77ca)

  118. I agree with that, James. But the Austrian is not a utilitarian in any event. In your example, I believe the Austrian would say that the property rights of C have been harmed.

    Patterico (3cc0c1)

  119. 117.If I have said something that made it seem as if I was denying the desire of people to hold cash balances, then I have spoken imprecisely or there has been a misunderstanding.

    Okay, do you accept that this desire can be strong enough that people may want to hold cash balances even if they know their purchasing power is slowly decreasing? And isn’t that the equivalent of a time preference for future consumption rather than present consumption? More precisely a preference to marginally decrease present consumption in order to marginally increase future consumption.

    James B. Shearer (0d77ca)

  120. 119.I agree with that, James. But the Austrian is not a utilitarian in any event. In your example, I believe the Austrian would say that the property rights of C have been harmed.

    Well A and C can’t simultaneously have conflicting property rights. Either A has a property right to build (as I specified) or C has a property right to his view. Local law will generally specify default rules (unless modified by mutual agreement) about what A can do by right on his property even if the neighbors object. It will sometimes be the case that C’s view is protected but that is certainly not universal.

    James B. Shearer (0d77ca)

  121. 111.I agree that you are demonstrating how loans work using a set of assumptions. My point is that your assumptions throw the baby out with the bathwater. The universe you have created can’t exist.

    The point at issue is whether a fixed supply of money can cause problems in a rapidly growing economy. China has apparently grown at an average annual rate of 10% for the last 25 years. And that is while being run by a bunch of commies, presumably growth would been even faster had it been run by Austrian economists. But doesn’t this imply an annual deflation rate of 10% or more? And doesn’t this mean real interest rates (after accounting for deflation) of at least 10%? And isn’t it possible that such rates are higher than the real rates would have been if the money supply had been managed to grow at the same rate as the economy? And doesn’t such a difference in real rates mean the amount of money available matters?

    James B. Shearer (0d77ca)

  122. Okay, do you accept that this desire can be strong enough that people may want to hold cash balances even if they know their purchasing power is slowly decreasing? And isn’t that the equivalent of a time preference for future consumption rather than present consumption? More precisely a preference to marginally decrease present consumption in order to marginally increase future consumption.

    The Austrian view is that holding a cash balance performs a function for the holder at the time he holds it: of addressing uncertainty. He is holding it for future spending, but does not know when that spending will take place, or what he will spend it on. The cash balance provides him a benefit now as a bulwark against uncertainty. Read Rothbard Chapter 6 (page 1987 of the free book I linked above) for a further discussion.

    Patterico (3cc0c1)

  123. @bobathome:Your universe is filled with broccoli and all sorts of stuff that few people would buy more of, toothpaste for one, than they do today, even if 5% more of it was displayed on their local grocery store’s shelves.

    Except that I also have 5% more labor, so maybe I have 5% more people available who’ll eat and produce the broccoli.

    You’re really arguing against the elasticity of demand to impugn something that is not essential to my argument. I wanted to make the effects of deflation easier to see without endless “but what about …” So it’s a catch-22. If I neglect second-order effects you’re going to tell me that they are too important to be neglected and if I include them you’re going to argue about any number of them, hoping that by impeaching one you somehow impeach the whole.

    None of it has any bearing on the time value of money, which is what I’m talking about. IF we can’t talk about one thing at a time no discussion of economics is even possible.

    Gabriel Hanna (64d4e1)

  124. @Patterico:The Austrian view is that holding a cash balance performs a function for the holder at the time he holds it: of addressing uncertainty.

    I don’t think this is very controversial. There are other reasons to hold a cash balance though; liquidity is one (you are certain to make many frequent cash transactions that go through in a short time). Another is that cash itself is worthwhile to invest in, which sometimes happens.

    Gabriel Hanna (64d4e1)

  125. @Shearer: Thinking more about your challenge for handling commodity money. Remember I alluded to Dutch banking, which Smith talks about in “Wealth of Nations.”

    Dutch banks were getting commodity money from all over the world. The big bank in Amsterdam would calculate the value of deposits in a standard way and then issue an account balance to the customer. Then all the people who had deposits, when they traded with each other, would do it in what Smith calls “bank money” but he really means that the bank is doing the accounting for them on paper in terms of their paper balances.

    And “bank money” was very, very good and it traded in preference to actual commodity money. Of course you could withdraw your deposit, but there were fees you had to pay periodically. Smith says no one ever could figure out if the bank really had enough gold and silver to back all the balances and the issue never came up; most people were more than happy to have the balance instead of the actual gold and silver, and the bank was well and transparently managed, and the city of Amsterdam was on the hook for its performance. So “bank money” was in a way analogous to fiat money; it was a quasi-government entity whose balances were worth whatever they said they were, and it was worth a lot as a medium of exchange, and that was largely because people were confident that the bank would continue to be well-run and continue to be valuable.

    Even gold and silver are at times of little value, of course. (Lifeboats. Zombie apocalypse.)

    Gabriel Hanna (64d4e1)

  126. The Austrian view is that holding a cash balance performs a function for the holder at the time he holds it: of addressing uncertainty. He is holding it for future spending, but does not know when that spending will take place, or what he will spend it on. The cash balance provides him a benefit now as a bulwark against uncertainty. Read Rothbard Chapter 6 (page 1987 of the free book I linked above) for a further discussion.

    Certainly uncertainty is one reason to hold cash, if for example your dishwasher breaks you can just buy a new one. But as Hanna says it is not the only reason.

    Consider school teachers who only work 9 months a year. In some cases they are paid on a 9 month basis (that is they are not paid during the summer). In such cases they are wise to put aside some of their earnings during the school year to get them through the summer. This is true even if they lose a little purchasing value by doing so. They are decreasing their consumption during the school year in order to increase it during the following summer when on the margin it is more valuable to them. There is no great uncertainty involved here, you know you are going to want to eat during the summer.

    Money represents a claim against society’s resources. For a long time we have lived in a generally growing economy which makes it easier for society to satisfy a claim (for a fixed value) in the future then at the present. So we don’t expect to be charged for deferring consumption but do expect to be charged for accelerating consumption.

    But if we lived in a generally contracting economy future claims would be more difficult for society to fulfill than present claims so we would expect to pay a price for deferring consumption rather than for accelerating it. Even so there would still be people who wished to defer consumption enough that they would pay to do so.

    James B. Shearer (32f75a)

  127. 89 … while a previous podcast (linked in the show notes to Friday’s podcast) addressed some related issues (including your question about continuous preferences). …

    I listened to this podcast. Herbener criticized classical models on the grounds that everything derives from human actions and humans aren’t capable of making fine distinctions or weighing millions of alternatives. So models involving continuous variables (and hence calculus) are deprecated. I didn’t find this terribly convincing but there is another problem.

    A significant (and increasing) number of decisions (which lead to actions) in today’s economy are not being made by humans, they are being made by computer algorithms. Apparently over half the trading volume on the NYSE is initiated by computer algorithms. Companies like Amazon set their prices with computer algorithms. There are new start up companies which offer investment advice using computer algorithms, if you let these companies manage your money all the investment decisions are made by computers. There are numerous additional examples and the trend seems clearly towards even more computerization in the future.

    So if the entire structure of Austrian economics is based on how humans behave, isn’t it becoming increasingly irrelevant?

    James B. Shearer (32f75a)

  128. @Shearer:In such cases they are wise to put aside some of their earnings during the school year to get them through the summer.

    I worked for a university that did that and nearly all the faculty complained about how tight their finances got in the summer. Some of them would says the university should do the withholding for them. I was amazed at how many holders of PhDs simply did not cope with it themselves, as I did. (I had 25% each paycheck direct deposited into saving.)

    Gabriel Hanna (64d4e1)

  129. @Shearer: Herbener criticized classical models on the grounds that everything derives from human actions and humans aren’t capable of making fine distinctions or weighing millions of alternatives.

    Maybe he should speak for himself; but humans are as you point out capable of building technology to do this for them. A lot of physicists have gone into quantitative finance. (I assume the ones who can cope with prorating their paychecks to cover the summer.)

    Gabriel Hanna (64d4e1)

  130. 129 I worked for a university that did that and nearly all the faculty complained about how tight their finances got in the summer. Some of them would says the university should do the withholding for them. I was amazed at how many holders of PhDs simply did not cope with it themselves, as I did. (I had 25% each paycheck direct deposited into saving.)

    Yeah, I was going to mention that. I think most public schools pay on a 12-month basis simply because experience has shown many teachers can’t handle even simple financial planning.

    Income tax withholding has the same rational, many people just can’t manage sensibly on their own.

    Which makes me doubtful of conservative proposals to allow people to provide for their own retirements. Many people just won’t.

    James B. Shearer (32f75a)

  131. #118: James, your blocking view issue was played out very nicely about 20 years ago in Seattle.

    Existing house: 3620 56th Ave SW, nice view of Puget Sound.

    Vacant lot across street, and down the hill, was developed, blocking view of 3620: 5636 SW Manning St. The new house was 2 stories, and tall trees were planted.

    Owner of 3620 56th Ave SW bought vacant lot down hill of 5636 SW Manning St. and built as high and as close as zoning permitted: 5614 SW Manning St.

    The satellite view tells the story. But the street view is also illuminating.

    bobathome (a52abe)

  132. Consider school teachers who only work 9 months a year. In some cases they are paid on a 9 month basis (that is they are not paid during the summer). In such cases they are wise to put aside some of their earnings during the school year to get them through the summer. This is true even if they lose a little purchasing value by doing so. They are decreasing their consumption during the school year in order to increase it during the following summer when on the margin it is more valuable to them. There is no great uncertainty involved here, you know you are going to want to eat during the summer.

    Again: nothing I have said is designed to imply that people do not save or hold cash balances, for all kinds of different reasons. If one anticipates a period in the future when one will have lower income, it obviously makes sense to save (and if possible invest) such that one has available the income at the time that it is expected to provide the greatest marginal utility. Nothing about the principle that, all other things being equal, a person prefers his desires to be fulfilled now instead of in the future, means that he cannot have a lower time preference because future goods will provide greater marginal utility in the future. Nothing in the Austrian theory says one must spend all of one’s money once one receives it. If anything I have said seems to imply that, then we have a serious failure of communication.

    Patterico (fecd9b)

  133. Yeah, I was going to mention that. I think most public schools pay on a 12-month basis simply because experience has shown many teachers can’t handle even simple financial planning.

    Income tax withholding has the same rational, many people just can’t manage sensibly on their own.

    Which makes me doubtful of conservative proposals to allow people to provide for their own retirements. Many people just won’t.

    Everything in life is a trade-off. There is always some human who will live their life in a manner other than the manner that other people would prefer them to live. You can create a state that forces people to live in the manner deemed proper by those who consider themselves wise, but you will remove a lot of freedom when you do so.

    For example, not everyone buys life insurance. So far, I have seen no national movement that says the government must provide universal life insurance, because if it doesn’t, some people just won’t buy it, and will leave their relatives without the necessary financial means. Your argument, carried to its logical conclusion, would seem to require that you be “doubtful” about this woeful governmental oversight.

    I’m sure I could come up with many other examples where people conduct their lives in a way that you don’t consider wise. Where do you draw the line, such that you no longer support laws by which the government tells them they must live a certain way, at the risk of having armed men show up at their house to point guns at them and put them in cages if they don’t comply? Surely it’s not just a matter of defending whatever the status quo happens to be. What is the rational principle that distinguishes forced purchase of life insurance from forced savings for retirement? Or do you even see one? Would you support forced purchase of life insurance?

    Patterico (fecd9b)

  134. I listened to this podcast. Herbener criticized classical models on the grounds that everything derives from human actions and humans aren’t capable of making fine distinctions or weighing millions of alternatives.

    I mentioned more than one. Which one did you listen to? The most recent, or one of the older ones? (Herbener was in more than one of them.)

    Patterico (fecd9b)

  135. I worked for a university that did that and nearly all the faculty complained about how tight their finances got in the summer. Some of them would says the university should do the withholding for them. I was amazed at how many holders of PhDs simply did not cope with it themselves, as I did. (I had 25% each paycheck direct deposited into saving.)

    And yet I think it would be immoral for the government to force them to withhold for themselves. But I guess my pining for a day when people were free — free to choose, take risks, and even fail — is old-fashioned and out of date. Gabriel, you might even share my view in this area — but if you do, then we are fighting a losing battle, it seems.

    Patterico (fecd9b)

  136. This is capitalist theory, right? With savings and investments and banks. Not money jingling in the pocket and under mattresses. Most of all banks. So that $1,200.00 teacher’s paycheck, or that $1,200.00 ounce of gold would go to a bank, and a debit card and/or check book with some pocket money in currency would solve (as they already do) both Gabriel’s concern about “enough money” and James’s about non-periodic payments. I can tell you that as a sole practitioner my income was never the same month to month, BTW.

    nk (dbc370)

  137. Of course, if your main concern is the welfare of the workers, then you want them to have a steady income that if it ever varies it is only to increase. Right, comrades?

    nk (dbc370)

  138. @Patterico: I think it would be immoral for the government to force them to withhold for themselves.

    Are you kidding? The government has Top Men who can manage our affairs much better than we can. It would be immoral for the government to let us fall short of our potential by failing to live according to principles supported by the best possible science and the most competent implementation. If we knew everything they did we’d fall all over ourselves to live the way they say we should, so why should we let people endanger themselves by making choices?

    True freedom can’t be experienced by blindly suffering consequences of choices made in ignorance. True freedom is the full expression of one’s potential developed under the best possibly managed conditions, freedom to experience the best that one can be. No one person can figure it out for themselves, that’s why we have experts who can help us make the wisest decisions, and make them for the benighted souls who don’t have the sense to listen and do what the Top Men suggest.

    Poe’s Law implies I should stop here, before someone accuses me of believing what I have just said.

    Gabriel Hanna (2ca835)

  139. … so why should we let people endanger themselves by making choices?

    Comrade, exactly right! We can let them cast a vote, but it is best for everyone that we count it.

    bobathome (d43973)

  140. 135 I mentioned more than one. Which one did you listen to? The most recent, or one of the older ones? (Herbener was in more than one of them.)

    I believe it was number 403 discussing utility functions among other things. My statement was my understanding of what Herbener said. I didn’t check this against the transcript because the transcripts aren’t free.

    James B. Shearer (de6a3b)

  141. I listened to this podcast. Herbener criticized classical models on the grounds that everything derives from human actions and humans aren’t capable of making fine distinctions or weighing millions of alternatives. So models involving continuous variables (and hence calculus) are deprecated. I didn’t find this terribly convincing but there is another problem.

    A significant (and increasing) number of decisions (which lead to actions) in today’s economy are not being made by humans, they are being made by computer algorithms. Apparently over half the trading volume on the NYSE is initiated by computer algorithms. Companies like Amazon set their prices with computer algorithms. There are new start up companies which offer investment advice using computer algorithms, if you let these companies manage your money all the investment decisions are made by computers. There are numerous additional examples and the trend seems clearly towards even more computerization in the future.

    So if the entire structure of Austrian economics is based on how humans behave, isn’t it becoming increasingly irrelevant?

    The transcripts are free to me because I support Tom Woods. Here is the relevant passage on utility functions:

    HERBENER: Utility functions are constructed as an
    arbitrary arrangement of utility or value that is embedded in fictitious agents. So all
    the neoclassical approaches to explaining the real world of economics begin with
    agents that are assumed to have particular ways of valuing things. And so it isn’t the
    association of means and ends — particular things that we’re using as human beings to
    obtain particular ends — but the neoclassical economist assumes that there are these
    economic agents that are able to place a value on all of the different combinations of
    things that exist in the world. And so the assumption is that these agents are able to
    make comparisons between the value that they would place upon all sorts of different
    combinations of goods, whether or not these combinations of goods are associated
    with particular actions that particular people would be taking.

    It’s a little bit hard to wrap your head around this distinction, but perhaps we can use
    a concrete illustration. With the Austrian approach, we would look at a human person
    who is in particular circumstances and then chooses an end. He’s hungry, and so he
    wants to eat lunch, and so he chooses a chicken wrap for lunch. And the means that
    he chooses, the chicken wrap, he values with respect to the end that it attains. So
    there’s this connection that the human person creates between the ends and the
    means. The agent, though, of the models of the neoclassical school would value the
    chicken wrap within a bundle of all the other goods that exist. This agent has the
    ability to value all the different combinations of different amounts of the good. Like
    half of a chicken wrap, with a bag of apples, with an automobile, with a house that
    the person owns, and so on and so forth. And then minutely changing each of these
    amounts — so two chicken wraps, and two bags of apples, and six cars, and so on and
    so forth. And then decide whether or not each of the bundles of goods has more or less
    value than any other bundle. So fundamentally, these are two entirely different
    approaches to the whole question of valuing and choosing and acting.

    WOODS: This is probably my Austrian prejudice coming in, but the value scale
    approach seems so much more commonsensical and seems to be more understandable
    from the point of view of ordinary life.

    HERBENER: Right, that’s an excellent point. Why go through all this rigmarole? And the
    answer to this, I think, is that it harkens back to what Milton Friedman claimed about
    mathematical logic: if we can put, he thought, economic arguments in mathematical
    language, then it’s possible to give strict, demonstrable proof of conclusions that flow
    within the mathematical structure of the model. And this is superior to merely verbal
    reasoning, where there are all sorts of difficulties and fallacies, and so on and so
    forth, that he thinks don’t enter into mathematical logic. Now, whatever one might
    say about that kind of a claim, it still leaves open the question, as you suggest, of
    what all this mathematical treatment has to do with explaining real human action and
    real economies.

    WOODS: Let’s talk about what Caplan is saying with regard to Rothbard’s criticism of
    utility functions and Rothbard’s preference for value scales. So value scales are high on
    Rothbard’s value scale, apparently. So he’s saying that Rothbard is critical of utility
    functions, because he believes that economists using them are conceiving of utility in
    a cardinal sense, as there being units of utility; whereas Rothbard claims that utility is
    ordinal –- you can’t say how much more, in terms of some fixed unit, you value an ice
    cream cone to a bottle of wine or something, but you can simply say that you prefer
    one to the other. And Caplan says this is a complete misunderstanding; there is no
    cardinal utility being used in these utility functions. So who’s right?

    HERBENER: Well, it might be that Caplan has a point here. But again, if we accept his
    view, which is the standard neoclassical position, that you can use mathematical
    techniques, called representation theorems, to show a mathematical function that
    does in fact have cardinal elements to it as merely a representation of an ordinal
    ranking system –- if you accept this claim, then Caplan is correct. Now whether or not
    one should accept this claim in a broader sense — whether this is just kind of a narrow
    mathematical proof or whether it’s acceptable philosophically — well that, I think, is a
    different matter.

    So Rothbard, I think here, is just taking the commonsensical view that if you say that
    we have utility functions, and utility is the dependent variable in the function, then it
    has to have cardinal numbers. Otherwise, the whole functional analysis is rather
    pointless. So from a kind of commonsensical view — and again, from various
    philosophical positions one might take — this seems to be a legitimate criticism.
    Now, if we accept Caplan’s argument that representation theorems sort of get around
    this problem by showing that, if I ordinally rank things, I can from that construct a
    mathematical function that preserve the ordinal ranks, and therefore I can use the
    mathematical function in analysis — if one accepts all that, which again I don’t think
    one has to — then one still has this problem that I alluded to earlier, that there has to
    be, in order for this to work, a complete and continuous ordering of preferences
    behind the mathematical function, so that when you construct the mathematical
    function, it’s completely and utterly continuous. And you need this kind of continuity
    in order to do calculus and other mathematical operations on these functions.
    So that then becomes the telling point against this approach. Is it really reasonable
    that we can model human beings by agents who not only can rank every conceivable
    bundle of goods that they might possess, but can do so in infinitesimally small,
    changing amounts across all of the goods that they own or potentially could own? This
    seems, again, quite remotely connected to real human beings.

    I agree. The fact that you might come up with an “increasing” (incredibly tiny) number of decisions made by computer algorithms (written by humans btw) does not change the point that the vast, overwhelming majority of economic decisions made by humans are, and will continue to be in our lifetimes and for generations to come (until we ourselves become robots), made by humans and not by machines.

    Patterico (fecd9b)

  142. 133

    Again: nothing I have said is designed to imply that people do not save or hold cash balances, for all kinds of different reasons. If one anticipates a period in the future when one will have lower income, it obviously makes sense to save (and if possible invest) such that one has available the income at the time that it is expected to provide the greatest marginal utility. Nothing about the principle that, all other things being equal, a person prefers his desires to be fulfilled now instead of in the future, means that he cannot have a lower time preference because future goods will provide greater marginal utility in the future. Nothing in the Austrian theory says one must spend all of one’s money once one receives it. If anything I have said seems to imply that, then we have a serious failure of communication.

    If you are going make economics purely deductive like Euclidean geometry then it is necessary to be precise about exactly what you are assuming. It is remains unclear to me exactly on that is. If goods didn’t deteriorate and could be stored free of cost then I guess you could say people will always prefer to receive a fixed quantity of goods now rather than at some point in the future. But any result deduced from this will only apply to a world consisting solely of such goods.

    You later said in 99:

    1. There is no question but that the rate of interest must be more than zero because I think you and I agree that nobody will give up present dollars for the same number of future dollars. (James seems to quibble with this, but I don’t yet understand his reasoning and I think the principle is sound.)

    Again this is not obvious to me. Suppose your currency was based on a commodity that slowly disappears (a radioactive isotope for example). Then one could quite rationally give up a certain number of present dollars for the same number of future dollars. Putting this aside, in our world people give up present dollars for the same number of future dollars all the time. The teacher who asks to be paid on a 12 month basis rather than on a 9 month basis is doing this. As is the taxpayer who arranges to be deliberately over withheld (so as to receive a refund).

    These objections might seem like pointless nitpicking but again if you are trying to make economics a matter of axioms and proofs then the proofs need to be valid. In mathematics it sometimes appears that assumptions A, B and C obviously imply X but then when you try to prove X you eventually realize you need assumptions D and E also because of weird counterexamples where D or E are not assumed.

    James B. Shearer (de6a3b)

  143. 134

    I’m sure I could come up with many other examples where people conduct their lives in a way that you don’t consider wise. Where do you draw the line, such that you no longer support laws by which the government tells them they must live a certain way, at the risk of having armed men show up at their house to point guns at them and put them in cages if they don’t comply? Surely it’s not just a matter of defending whatever the status quo happens to be. What is the rational principle that distinguishes forced purchase of life insurance from forced savings for retirement? Or do you even see one? Would you support forced purchase of life insurance?

    My general rule is that society should be arranged so that sensible people (such as I consider myself) are inconvenienced as little as possible by poor decisions made by people who aren’t sensible. In some cases this means discouraging people from making poor decisions rather than allowing them to make poor decisions and than attempting to deal (or not deal) with the results.
    The optimal degree of coercion will depend on the specific instance. Less coercion is indicated in the case of life insurance than the case of retirement savings as the cost of just dealing with the results is less (as failure to buy life insurance is usually harmless while failure to save for retirement usually isn’t).

    James B. Shearer (de6a3b)

  144. 142 I agree. The fact that you might come up with an “increasing” (incredibly tiny) number of decisions made by computer algorithms (written by humans btw) does not change the point that the vast, overwhelming majority of economic decisions made by humans are, and will continue to be in our lifetimes and for generations to come (until we ourselves become robots), made by humans and not by machines.

    First the fact that machines are programmed by people does not mean they make decisions in the same way as humans do. Chess playing computers don’t think like people. Also most of the algorithms making economic decisions were written by people who don’t believe in Austrian economics and hence are not based on Austrian economic principles.

    Second I don’t think the number of important economic decisions currently made by computer programs (or humans aided by computer programs) is “incredibly tiny”. Stock trading, options trading, futures and foreign exchange trading etc. are all heavily influenced by such programs. The Black Scholes option price formula (and similar mathematically complex models which I assume Austrian economists reject) are pervasive in modern finance.

    James B. Shearer (de6a3b)


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