Much Ado About Nothing

Earlier this week Charles Plosser, the relatively new president (August 2006) of the Federal Reserve Bank of Philadelphia, took issue with his chairman, Ben Bernanke, and other members of the Federal Reserve Board when he stated that the Fed should set an inflationary target and then manage monetary affairs to meet it. At this point most readers of this column may be tempted to stop reading and turn to something that is more intellectually stimulating, such as the chances of the Phillies winning the pennant. Believe it or not, I agree with them. It is statements such as these by Mr. Plosser that drive an Austrian school economist to drink, as if any of us needed an excuse.

At first blush Mr. Plosser sounds reasonable. He recommends a slightly different monetary strategy from the one currently employed by the Fed. Under the tenure of Alan Greenspan, the Fed targeted inflation but kept its target a secret. Under Ben Bernanke the Fed has released its target but with the caveat that it feels free to deviate from it depending upon circumstances. Mr. Plosser heroically states that the Fed should meet its target regardless of circumstances. In most monetary circles this is considered a great and courageous stance.

For the Fed Inflation Means an Increase in Prices

But what does the Fed mean by the term “inflation”? And can the Fed actually do anything to manage inflation in real time; that is, before the economy has already internalized the price increases and nothing can be done? For the Fed and the public in general, the term “inflation” refers to price increases. When prices rise, we have inflation. When prices fall, we have deflation. (What’s the matter with you, Barron? Been spending too much time reading von Mises?) The Fed tries to control inflation by managing the money supply through open market operations; that is, it buys and sells treasury debt, thusly, expanding or contracting the money supply respectively. How does it know how much treasury debt to buy or sell? It really doesn’t, so it manipulates the Fed Funds rate, the cost of interbank overnight borrowing—raising it to contract the money supply and lowering it to expand it. This all sounds wonderfully scientific, doesn’t it? Well, it’s about as scientific as the pronouncements of Punxsutawney Phil.

Price Increases Are But a Symptom of an Increase in Money

The flaw in the whole system is the very definition of inflation itself as a general rise or fall in prices. But price changes are merely the symptoms of expanding or contracting the money supply, not a cause thereof. Any expansion of the money supply must cause prices to rise more than they would without the expansion. Furthermore, targeting prices assumes that all prices rise and fall in unison and by the same relative amounts. This is not the case at all. The first recipients of new money–created out of thin air, by the way—experience no inflation at all. Think of a counterfeiter, who passes his worthless paper as the genuine article. He buys at prices prevailing in the marketplace. Only later do prices rise as the increased supply works it way irregularly throughout the economy. The same is true of money supply increases generated by the Fed. The first recipients buy at prices prevalent at the time the money is introduced. Who might these first recipients be? Social Security beneficiaries, bank borrowers, U.S. government contractors, their employees and subcontractors, to name the most obvious.

The CPI Is a Poor Measure of Inflation

Since prices do not affect the entire economy all at once or in regular ways, how can the Fed determine the inflation rate? Here’s the short answer—it can’t. Oh, it may try. We all read about the Consumer Price Index (CPI) and Producer Price Index (PPI), but these are very poor models of our vast, dynamic economy.

A further complication is that many other factors affect the price of goods, not just the quantity of money. Remember that all valuations are subjective, not objective. There is no objective price of anything, only what people are willing to pay right now. Yesterday’s price means nothing and today’s price will change tomorrow. Here’s an example. Suppose that the CPI were composed only of prices of consumer electronic goods, which have been dropping for about two decades. Would we say that the U.S. economy experiences no inflation, in fact that it has experienced deflation and the Fed should pump up the money supply accordingly in order to keep the price of electronic goods from dropping? Of course not. OK, then should the CPI be composed only of the price of oil? This commodity has experienced huge price fluctuations over the last twenty years. Have all of these fluctuations been caused by the money supply? Of course not. So how can the Fed build a “market basket of goods and services”, measure their price fluctuations, and claim that it knows anything about inflation, and has the ability to control it?

Inflation is Any Increase in the Quantity of Money

Austrian school economists are not impressed by all these haughty pronouncements and ivory tower tempests in teapots. We know that ANY increase in the supply of money is inflationary. Since the Fed’s only tool is controlling the money supply, it alone has the power to control inflation in today’s fiat monetary system. But rather than do the one and only job it is capable of doing, the Fed injects money into the economy and removes money from the economy based upon information that is hardly more reliable than one would obtain from reading tea leaves. But I sure bet Messrs. Plosser and Bernanke revel in the solemnity bordering on adoration with which the financial press and the world markets greet their latest intellectual spat about nothing.

Two Views of the World

The world’s philosophers hold two competing views of mankind. The Hobbeseans view man as a grasping, violent, superstitious brute. Thomas Hobbes (1588-1679), author of Leviathan, said, “The condition of man…is the condition of war of everyone against everyone.” He famously said that “the life of man (is) solitary, poor, nasty, brutish, and short.” The Miseans hold the opposite view. Ludwig von Mises (1883-1973), author of Human Action, said “What distinguishes man from animals is the insight into the advantages that can be derived from cooperation under the division of labor.” This view was no mere opinion as to how best to grasp the riches of life. Mises understood that cooperation was essential for civilization to exist. In Liberalism he wrote that “Modern civilization will not perish unless it does so by its own act of self-destruction…It can come to an end only if the ideas of liberalism are supplanted by an antiliberal ideology hostile to social cooperation.”

Joe Murray and I may enjoy our recent repartee in these pages (I do!) and flatter ourselves that The Bulletin’s readers follow our points and counterpoints favoring protectionism (Murray) and free trade (Barron) respectively. But the issue is a very serious one being argued throughout the world, and a victory by the protectionists will have grave implications for our personal welfare and freedom. This is no academic controversy. It has real impact on average folk. The victor will decide the kind of world in which we live, a Hobbesean world of poverty and fear or a Misean world of plenty and peace.

Trade Benefits Both Parties

The foundation of these two, opposing views, is one of economic understanding. Both Joe Murray and I desire the best for America, yet we stand at opposite ends of the free trade issue. The protectionists see trade as necessarily harmful to one side and beneficial to another. Mr. Murray thinks that the U.S. has been harmed by free trade and attributes just about every social pathology to it, from a supposed deterioration in middle class living standards (not true!) to arming our enemies (mainly the Chinese) with our own money. On the other hand, I see free trade as benefiting each participant. International free trade holds the same benefits as free trade within our own borders. Each side expects to gain or one side would not participate. Peaceful neighbors engage in trade, exchanging those goods which each produces most efficiently for the benefit of both parties. Fearful neighbors produce guns. Would Mr. Murray rather employ the Chinese in producing consumer goods for the world market or tanks, ships, and planes? This is the source of the dictum that when goods fail to cross borders armies will. A billion Chinese workers will produce something—which shall it be?

The Korean Case

Mr. Murray dismisses the case of the Koreas, describing the Stalinist North as a backward country. But this begs the question—why is the North backward and the South prosperous? At one time the Korean peninsula was united. North and South started from the same regrettable position at the end of the Korean War. Now the South is prosperous and at peace and the North is destitute and at war with the entire world. How did the South become so peaceful and prosperous and the North so dangerous and backward? The North embraced the Hobbesean view of the world and structured its economic policies accordingly. The South embraced the Misean view and is now one of the most prosperous and free nations on earth. It is the foundational view of the world that has made all the difference in just half a century. South Korea has done everything imaginable to prevent war with the North, yet the North will have none of it. If war comes to the Korean peninsula once again, it will not be because of the Misean free trade policies of the South.

Free Trade—Essential But Not Sufficient

Free trade is an essential, but, unfortunately, not sufficient, requirement for peace. Furthermore, it is an essential, but not sufficient, requirement for prosperity. Taxes and regulations can hobble a free trade nation, but most free trade nations have few regulations and low taxes. At the end of World War Two Hong Kong and Singapore were grubby outposts of the fading English Empire. Given self-rule, both became wealthy, safe and (especially Singapore) clean city-states. Occupying little physical territory, they are the top two trading centers of the world. Contrary to Mr. Murray’s revisionist interpretation of the rise of English power, Great Britain was the first truly free trade nation of the modern era and rode its advantage therefrom to world dominance for a hundred years. There is no other explanation to account for the rise to power and prosperity of this tiny island nation on the edge of Europe than that it embraced the concepts of the Scottish Enlightenment and, fortunately for us, exported them to its colonies in the New World. The much greater Spanish Empire exported its Mercantilist ideology to its colonies in Latin and South America. The relatively backward experience of our southern neighbors vindicates von Mises’ assertion that ideas rule the world. So, which idea shall we embrace?

The Distraction of the Balance of Payments

On Tuesday, February 27th The Bulletin’s Joe Murray reported on lobbying efforts to end the president’s “Fast Track” trade authority. Organizations such as the United States Business and Industry Council (USBIC) are leading the charge to end the worldwide free trade effort that has characterized international relations since the end of World War II. These organizations claim that free trade has harmed America’s “Main Street”, a euphemism adopted by the USBIC. In calling for an end to free trade (just Google the USBIC and read the laundry list of desired government interventions from sixty percent tariffs on any country that manipulates is currency to scaling back on LEGAL (!) emigration) the USBIC points to the large U.S. balance of payments deficit as an indicator of the damage to our economy from free trade. I doubt that anyone at the USBIC understands much about international balance of payments except that it can be useful in manipulating public opinion into adopting policies beneficial to its members’ interests even if adverse to those of the rest of us.

Let me first address the issue of linking a nation’s trade deficit (or surplus) with the idea that the former is bad and the latter good. First of all, it is impossible for ALL nations to hold trade surpluses, since this could happen only if the nations of the world traded with Martians or if international trade were banned altogether. Secondly, it is not true that a trade deficit always or even primarily means that a nation is buying more than it sells abroad. The trade deficit is a statistical construct encompassing flows of goods, services, capital, and debt, among other financial data. It is not the same as an individual, a firm, or our government going into debt. A country’s economic health is independent of its balance of payments. A nation can go into recession when it has a positive balance of payments and when it has a negative balance of payments. A nation’s economic health is measured primarily by whether or not its citizens can acquire the goods and services that they desire at the lowest cost in the market.

The Barrons Suffer a Balance of Payments Deficit

It can be said that the Barron household has a trade deficit with just about everyone in our hometown. We buy haircuts, groceries, cleaning services, restaurant meals, videos, gasoline…you name it…and none of these establishments buy anything from us. At one time, when the Barron household was young, it had a huge balance of payments surplus with the world at large, because it had borrowed money for the purchase of our home–the mortgage lender bought our debt. Was this a good thing for the Barron household or a bad thing? Well, it was neither good nor bad. The home mortgage lender made a judgment, correctly as it turns out, that the Barrons were likely to pay back the debt, which we did. The lender’s action of buying our debt gave us a temporary balance of payments surplus. But as we paid it back over time, we experienced a gradual balance of payments deficit. If we had failed to pay back the loan, we would not have suffered a gradual negative balance of payments vis a vis our home mortgage lender. But that does not mean that it would have been a good thing, because we would have had a hard time getting credit anywhere else for quite awhile.

The same is true of international balance of payments, which is nothing more than a statistical construct of millions, perhaps billions, or private transactions among the private citizens of many nations of the world with one another. The private parties to it evaluate each transaction. They may evaluate correctly or incorrectly. But each party expects to gain from the transaction, which just happens to involve parties from different countries. It makes no difference that the transaction crosses international borders, state borders, county borders, or with a next door neighbor.

A Nation Cannot Gain by Manipulating Its Currency

Next let me address the claim that the Chinese benefit by holding their currency at roughly a third of its free exchange value. It is clear that the Chinese are doing this, but is it a good thing for the Chinese or a bad thing? If it helps the Chinese, as the USBIC claims, then why don’t we hold our currency at half its free market value? Then maybe the Chinese will go one up and hold their currency at three-fourths the free market value! Then we can make our currency free! The answer is obvious. No nation can become wealthy by manipulating its own currency. All it can do is cause some special interest groups within its monopolized currency area to gain at the expense of all others within its monopolized currency area. In the case of China, the owners and employees of export oriented manufacturers (who just happen to be Red Army and Communist Party bigwigs) gain at the expense of the rest of the teeming Chinese masses. By holding its currency cheap, the Chinese are causing inflation inside China, the burden of this inflation being shouldered by those who have little or no political power. There is nothing that we can do about this. It is a problem caused by the Chinese and only internal pressure from the Chinese themselves will correct it. If the U.S. adopted such a policy–which, by the way, we have done in the past when the Fed injected excessive reserves into the economy, driving down the interest rate–inflation eventually emerges. Export oriented businesses gained at the expense of the rest of us, because their goods became more competitive internationally. But the increase in the supply of money eventually worked its way through our economy in irregular ways, causing the prices of goods to increase. Those of us who were not involved in these export-oriented industries suffered, and most people had no idea what had happened except that their dollars didn’t go as far as in the past.

Fortunately the average U.S. citizen has more political power than the average Chinaman, so eventually the political elite is forced to put an end to this inflation, at least temporarily. But the lure of an inflationary boom still beckons, despite the damage that it does.

The Japanese Lesson

The USBIC claims that U.S. businesses are harmed by these currency interventions and, I must admit, in an indirect way they are harmed. Currency manipulations by any major international trading nation cause capital to be malinvested. (The U.S. is as big a culprit as any nation.) Export oriented industries are harmed in the sense that they fail to make sales that they would have made in a free market environment. But retaliatory actions would harm all of the U.S. while failing to help the industries suffering from cheap imports. China’s Mercantilist policies will not work and eventually the Chinese will be forced to abandon them, just as the Japanese did. In fact Japan is an example of the failure of the policies now followed by China. For decades Japan followed policies that aided export manufacturers at the expense of the rest of the Japanese economy. It appeared to work for a long time. But the Japanese economy has been stagnating for almost two decades, all a result of malinvestment that cannot be undone.

Subsidizing a Lawn Mowing Service

A few years ago my friend’s son wanted to get into the lawn mowing business. He went to his father, who made him a gift of a large, industrial-sized mower plus a trailer to transport it from job to job. My friend’s son solicited the business of friends and acquaintances and offered to perform lawn-mowing services below the price currently charged by those in the business. He got lots of customers. At the end of the second year, the mower was worn out. The young man went to his father and asked him to buy him a new mower. The father asked him why he had not saved enough to replace the first one, which he received as a gift. Of course, the young man had not charged enough to produce enough savings to buy a new machine. That was the end of his lawn mowing business. Now, my original mowing service was harmed indirectly when I switched my patronage to my friend’s son. Its revenue went down. Perhaps the owner was forced to lay off men. I don’t know. But I am back with them now. In the meantime, I enjoyed savings from cheaper lawn mowing services, made possible by my friend, who gave his son the mower and trailer.

I doubt that the USBIC and the manufacturers of America will be encouraged by this example of a slow market correction, but it is the only peaceful means available. I suppose my old lawn-mowing firm could have gone to my township government and asked them make it unlawful for me to hire anyone else, perhaps pointing out the “illegal subsidy” of my friend’s mower to his son. In that case, I would have been at the mercy of whatever prices my lawn mowing service wanted to charge. Or my township could have gone to my friend and asked him to refrain from subsidizing his son’s new business, but it is as unlikely that my friend would so oblige my township government as that the Chinese will oblige U.S. diplomats’ entreaties to refrain from intervening in their own currency markets. I’m sure my friend would tell my township government to mind its own business, just as the Chinese are telling U.S. diplomats the same thing in much more polite language. We can only be reassured that internal pressures from both sources drove these market interventions in the first place and only internal pressures will end them.

Get Our Own House in Order

The balance of payments position of any nation is not an accurate indicator of the health of an economy. Intervention to restrict international trade will have little effect on this statistical construct and will only cause damage to the nations so affected. Those who decry the lack of competitiveness of American industry must look internally for its causes. Excessive regulation, high taxes, legal barriers to market entry, restrictive labor laws, unnecessary licensing, plus the burden of government reporting adds unnecessary cost to American products. It may be true that countries manipulate their currency to benefit export industries, but there is nothing that we can do about it and eventually those countries will recognize the error of their ways. Obsessing on our trading partners’ internal policies is a waste of time and detracts us from taking our own positive steps to free our economy so that our companies can better compete in the world.