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Droughts, Famines, and Markets – Article by Steven Horwitz

Droughts, Famines, and Markets – Article by Steven Horwitz

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The New Renaissance Hat
Steven Horwitz
August 28, 2012
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As I write, many high school students all over the United States, my daughter included, are reading John Steinbeck’s The Grapes of Wrath, with its portrayal of the 1930s Dust Bowl, in preparation for literature courses in the fall.  Steinbeck’s fictional account vividly captures the suffering endured by many Americans due to the severe drought, poor farming techniques, and ensuing dust storms in Texas, Oklahoma, and other states.

With the U.S. Midwest stricken by drought this summer, it’s worth considering why the crop failures there have not led to food shortages and other serious problems.

It’s also worth considering why famines, which occurred with regularity for most of human history, have all but disappeared in the last 100 years or so.

The answer is: the market and globalization.  This combination, for reasons I explore below, enables humanity to be far less at the mercy of the weather and provides us with ways to ensure that food gets to where it needs to go.

Markets help us avoid famines in two ways.  First, the innovation made possible by the search for profit and the relative freedom of markets in the western world have increased agricultural productivity by an order of magnitude.  We feed a planet of almost 7 billion reasonably well–although not as well as we might like–and we do it with a decreasing number of people and acres of land.  The United States can feed its own population and still export grain to the rest of the world–even as farmers are forced to divert corn to boondoggles like ethanol.  We are at less risk for famines simply because we can produce more food with fewer resources, and even if one large crop fails, we have more large crops elsewhere to make up the loss.

Signals

The second way markets help is that price and profit signals inform producers where foodstuffs are in short supply and simultaneously provide incentives to get the food there.  Prices are an incentive wrapped in knowledge, enabling them to serve as traffic signals to ensure that no one goes without. True, food may be more expensive during a drought, but that is far better than no food at all, as was often the case in human history.

We see these processes at work right now.  The drought in the middle of America destroyed a good deal of the corn crop in Indiana and Iowa.  Meanwhile, farmers in places like Washington state and Virginia have largely escaped unscathed.  The short supply in the Midwest drives up prices and signals to producers elsewhere that profit opportunities exist in those places; the incentive associated with that signal leads farmers to get their crops to where the demand is.  Yes, the higher prices mean that folks will be a little worse off, but corn is in fact more scarce, so those higher prices are not the result of farmers exploiting the drought, but rather a reflection of genuinely shorter supply.

The price signals might also cause corn producers to divert some corn from other uses to food for humans. Such substitution is only possible because market prices provide the needed knowledge and incentives. In a world without markets, producers could not get information so easily and effectively; nor would they have the incentive to respond appropriately. More famines would result.

Globalization

Finally, globalization has nearly eradicated famines.  All the market processes I have identified are even more effective when the area of trade expands.  When commodity markets are global, countries facing droughts and bad harvests have a whole world from which they can attract new supplies.  The United States is not limited to tapping farmers in Washington and Virginia. It can attract corn from around the world.  In fact, Canadian farmers have had a much better year and are already seeing higher prices for their exports to the United States.  Canadians will pay a bit more for their grains as a result, but prices in the United States will be significantly lower than they would be without the Canadian imports.

As Pierre Desrochers and Hiroko Shimizu point out in their wonderful new book, The Locavore’s Dilemma, the belief that making food production and distribution more local and less global will increase “food security” has it exactly backward.  The most important thing we can do to ensure a secure food supply in the face of droughts and other threats to the harvest is to allow markets to work freely and extend that freedom globally.

We cannot control the weather, so the threat of drought is always present. But we can unleash the market and further globalize food production to avoid the human disaster of famines when harvests go bad.  The conquering of famine is one of the great human accomplishments of the last century.  That no one is starving because of the drought this summer is evidence of that victory.  Let’s not let the forces of locavorism reverse those gains.

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Why the Deflationists Are Wrong – Article by Gary North

Why the Deflationists Are Wrong – Article by Gary North

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Gary North
August 23, 2012
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An inflationist is someone who believes that price inflation is the result of two things: (1) monetary inflation and (2) central-bank policy.

A deflationist is someone who believes that deflation is inevitable, despite (1) monetary inflation and (2) central -bank policy.

No inflationist says that price inflation is inevitable. Every deflationist says that price deflation is inevitable.

Deflationists have been wrong ever since 1933.

Milton Friedman is most famous for his book A Monetary History of the United States (1963), which relies on facts collected by Anna Schwartz, who died recently.

It is for one argument: the Federal Reserve caused the Great Depression because it refused to inflate.

This argument, as quoted by mainstream economists, is factually wrong.

I often cite a study, where you can see that the monetary base grew under the Federal Reserve, 1931 to 1932. This graph is from a speech given by the vice president of the Federal Reserve Bank of St. Louis. You can access it here.

Figure 1
I posted this first in early 2010.

We can see that there was monetary deflation of the money supply, beginning in 1930. This continued in 1931 and 1932, despite a deliberate policy of inflation by the Fed, beginning in the second half of 1931 and continuing through 1932.

Depositors kept pulling currency out of banks and hoarding it. They did not redeposit it in other banks. This imploded the fractional-reserve-banking process for the banking system as a whole. M1 declined: monetary deflation.

The Fed could not control M1. It could only control the monetary base.

The argument of Friedman and Schwartz was picked up by mainstream economists. It is his most famous and widely accepted position. Bernanke praised him for it on Friedman’s 90th birthday in 2002.

Why was the argument wrong, as applied to 1931–33? I must tell the story one more time. Four letters tell it: FDIC. Well, nine: FDIC + FSLIC. They did not exist.

Franklin Roosevelt froze all bank deposits in early March 1933, immediately after his inauguration. This calmed the public when the banks reopened a few days later. He verbally promised people that the banks were now safe.

The US government created federal bank-depositor insurance in 1933. The Wikipedia article describes the Banking Act of 1933, which was signed into law in June:

  • Established the FDIC as a temporary government corporation
  • Gave the FDIC authority to provide deposit insurance to banks
  • Gave the FDIC the authority to regulate and supervise state non-member banks
  • Funded the FDIC with initial loans of $289 million through the U.S. Treasury

That stopped the bank runs. The money supply reversed. It went ballistic. So did the monetary base.

The key event was therefore the Banking Act of 1933. After that, the money supply never fell again. After that, prices never fell again by more than 1 percent. That was in 1955.

All it took for prices to reverse and rise was this: an expansion of the monetary base coupled with bank lending.

Yet deflationists ever since 1933 have predicted falling prices. They die predicting this. Then their successors die predicting this.

They never learn.

They do not understand monetary theory. They do not understand monetary history. They therefore do not learn. They do not correct their bad predictions, year after year, decade after decade, generation after generation.

They still find people who believe them, people who also do not understand monetary theory or monetary history.

I have personally been arguing against them for four decades.

Price deflation has nothing to do with the fall in the price of stocks.

There can be monetary deflation as a result of excess reserves held at the Fed by commercial banks. But this is Fed policy. The Fed pays banks interest on the deposits. Even if it didn’t, there would still be excess reserves. But by imposing a fee on excess reserves, the Fed could eliminate excess reserves overnight. Then the money multiplier would go positive, price inflation would reappear, and the Fed would get blamed. So, it maintains a policy of restricting the M1 multiplier.

Every inflationist says that monetary inflation will produce hyperinflation unless reversed by the central bank. There will be a return to low prices after what Ludwig von Mises called the crack-up boom. The classic example is Germany in 1934. That was a matter of policy. The central bank substituted a new currency and stopped inflating.

John Exter — an old friend of mine — argued in the 1970s and 1980s that monetary deflation has to come, despite Fed policy. There will be a collapse of prices through deleveraging.

He was wrong. Why? Because it is not possible for depositors to take sufficient money in paper-currency notes out of banks and keep these notes out, thereby reversing the fractional-reserve process, thereby deflating the money supply. That was what happened in the United States from 1930 to 1933. If hoarders spend the notes, businesses will redeposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.

Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is Fed policy to decrease prices. This was not true, 1930 to 1933.

Deflationists never respond to this argument by invoking either monetary theory or monetary history. You can and should ignore them until one of them does answer this, and all the others publicly say, “Yes. That’s it! We have waited since 1933 for this argument! I was blind, but now I see! I’m on board! I will sink or swim with this.”

Let me know when this happens. Until then, ignore the deflationists. All of them. (There are not many still standing.)

The fact that a new deflationist shows up is irrelevant. Anyone can predict inevitable price deflation. They keep doing this. Look for the refutation of the inflationists’ position. Look for a theory.

If you do not understand the case I have just made, you will not understand any refutation. In this case, just pay no attention to either side. If you cannot follow economic theory, the debate will confuse you. It’s not worth your time.

For background, see my book Mises on Money.

See also Murray Rothbard’s book What Has Government done to Our Money?

Gary North is the author of Mises on Money and Honest Money: The Biblical Blueprint for Money and Banking. He is also the author of a free 20-volume series, An Economic Commentary on the Bible. Visit his website: GaryNorth.com. Send him mail. See Gary North’s article archives.

This article originally appeared on GaryNorth.com.

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Copyright © 2012 by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Buy Team America? – Article by Gary M. Galles

Buy Team America? – Article by Gary M. Galles

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The New Renaissance Hat
Gary M. Galles
August 18, 2012
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Samuel Johnson once wrote that “patriotism is the last refuge of a scoundrel,” criticizing adverse policies and proposals falsely claimed to be based in patriotism. This has been most recently illustrated by the political furor over “made-in-China” Team USA uniforms. Many politicians asserted that it was un-American, with Senate Majority Leader Harry Reid saying those uniforms should be burned. Supposedly patriotic pressures to mandate “buying American” sprang up immediately, and Ralph Lauren quickly capitulated, promising to “go and sin no more.”

While some of the details of this flap are unusual, protectionism dressed up as patriotism follows a well-worn script.

Imports are found to cause some domestic harm. Given that those imports harm competing domestic producers, “Buy American” or some other version of protectionism is put forth as the patriotic response (with the producers seeking protection from superior competitors leading the patriotism bandwagon). The Team USA version simply exploits the Olympics’ peak in pro-American sentiment and symbolism to make the same case (though it makes no more sense than requiring that we grow our own coffee and bananas for our athletes).

The problem is that imports always harm competing domestic producers, so that the patriotism argument can always be used as political cover whenever any domestic producers get the government’s ear. And there are always politicians ready to listen.

One person who recognized the abuses and illogic of this approach was Leonard Read. In particular, his chapter “Buy American,” in Having My Way (1974), lays out a better way to approach the issue.

The admonition to “Buy American” has two diametrically opposed meanings. The first is its popular and mischievous meaning — shun goods produced in foreign countries. The second, and loftier meaning embodied in these words, is rarely mentioned or thought of — shun principles and practices alien to the American dream of limited government and personal freedom.

Producers who plead with consumers to “Buy American” are appealing to blind patriotism. Buy my product because it is made here; heed not its price or quality. This is sheer chauvinism. Suppose I were to urge your acceptance of my ideas, rather than those of Marx or Machiavelli, merely because of our differing nationalities. The absurdity of such an appeal is obvious: neither goods nor ideas are properly judged in this fashion; geographical origin has nothing to do with the matter.

Read points out that that the traditional use of “Buy American” is to justify some citizens beggaring their own neighbors, rather than something that advances any sensible interpretation of our general welfare. However, there is an interpretation that does advance our general welfare. Don’t buy (i.e., accept and make use of) actions that violate the American principle of freedom to choose your own productive associations, as long as you don’t violate the common, inalienable rights of others.

Read recognizes that whether a principle is true or not has nothing to do with where it comes from (i.e., ad hominem or “against-the-man” attacks do nothing to invalidate something that is true, although you wouldn’t know it from political rhetoric). As a result, he offers an excellent way to test whether some supposed general principle is valid — change “Buy USA” to “Buy Chinese” or “Buy Mexican,” and ask if Americans would accept the proposition as true based on their patriotism. If it is really a general principle, it is as valid for others in their dealings with us as their potential suppliers as it is for us in dealing with them as our potential suppliers, and the answer would not change. We would support others’ protectionism just as much as our own. But if it is really special pleading, rather than a general principle, people’s answers would change, as when people hypocritically attack other countries for their protectionism at the same time we defend ours as principled.

Read also recognized that the extent of protectionism is far vaster than most people recognize.

All obstacles to competition, be they foreign or domestic, are but variants of this theme.

The difference between a ban on buying a foreign country’s products and imposing tariffs, quotas, or any of a host of nontariff barriers is only one of degree. Whether it benefits or harms Americans does not change; only the degree of such benefit or harm. Similarly, change “Buy American” to “Buy Local,” as with locavore campaigns in agriculture, and the logic is equally invalid.

Such protectionism goes well beyond international trade, as well.

Change the wording to “Buy Union,” as with project labor agreements and prevailing (higher-than-competitive) wage laws, and the logic is the same. Union members are protected from the competition of other workers who would work for less. But that protection not only harms nonunion workers; it also harms customers, whose costs are increased.

Price controls are also protectionism. For example, a minimum wage protects other workers from competing with those who would be willing to work for less, but it harms both those denied their most productive employment and consumers.

The vast majority of antitrust cases are also forms of protectionism. They are not brought by consumers, who generally gain from the practices involved, but by outcompeted rivals who want to take away others’ advantages — advantages passed on to customers. Those outcompeted rivals don’t want potential customers to go elsewhere — and use antitrust to restrict consumers’ ability to access superior options.

A vast array of licensing schemes follows the same pattern. They hide behind masks of quality or safety but primarily keep new competitors out and keep those who would offer lower-quality–lower-price options some customers would prefer from doing so.

Leonard Read offers a powerful solution, powerfully illustrated by America’s own past.

Enough of this mischievous notion. Let us try instead to appreciate and “buy” the American ideal of freedom.

Ralph Waldo Emerson had this to say: “America is another name for opportunity. Our whole history appears like a last effort of divine Providence in behalf of the human race.”

As to the best in political economy, consider the Constitution of the United States. Regardless of its several flaws, no other nation’s charter has equaled it in an economic sense.

In what respect is this distinctively American? Here is the answer: “No state shall without the consent of the Congress, lay any imposts on imports and exports … “

In a nutshell, no tariffs, quotas, embargoes between the several states…the world has never known a free trade area as large as the U.S.A. when measured in value of goods and services produced and exchanged. Never perfectly free, but the nearest approximation to freedom!

In other words, the freedom to associate for productive purposes however and with whomever one chooses, because people were protected from many of the violations of that principle that governments have imposed throughout history, was the essence of the American miracle. And at its heart, as Thomas Jefferson wrote, was “the first principle of association, the guarantee to everyone the free exercise of his industry and the fruits acquired by it.”

Further, Read’s focus on America’s free internal trade offers a counterpoint to a frequent misinterpretation. Those who defend protectionism as a valid principle claim that it was the protectionism adopted by the United States in the form of tariffs that advanced our staggering early economic success. While it is true that import tariffs were imposed, and eventually dramatically raised (see the history of the “Tariff of Abominations” as an example), that was not the source of our success any more than hurdles — which slow running speeds — should be given credit for increasing running speeds because hurdlers are fast. The reality is that the positive impact of our massive internal free-trade zone and other constitutional restrictions on government interference far outweighed the negative impact of international-trade restrictions.

Read then addresses one particular common defense of protectionism: the “infant-industry” argument that free trade may be good in general, but that industries must be protected until they can grow to a scale where they can compete, which amounts to a claim that the benefits of freedom require restricting the freedom that generates them.

In reality, it is competition which protects “infant industries” — it protects them from stagnation and persuades them to grow.

In the absence of competition and freedom of transactions, producers stagnate. It is only when others are doing better that one attempts to overcome, to gain strength. Competition, combined with free exchange, makes strong giants out of weak infants — this is the password to economic opportunity and well-being — an American idea well worth buying.

Read recognized that from the perspective of consumers it is the competition that takes place without artificial assistance or restriction that expands their options the most. It does not matter whether competition leads to a foreign producer who offers better terms because of superior efficiencies or if that producer is American. So there is no reason to artificially nurture American infant industries (which often claim to be infants virtually forever), because it is the results of real superiority that benefit consumers, and artificially tilting the playing field only inhibits the process that best discovers and passes on the gains of such superiority.

Read next turns to another test that rejects the logic of protectionism. If we accepted protectionism in principle, we would be for it in all cases. But, as he notes, we are all free traders when it benefits us. In other words, we recognize that we gain from free trade, except when we are the one benefitted by special treatment — necessarily at others’ even greater costs — by those restrictions. We abandon our own revealed preference for freedom only when bribed by receiving some of what is essentially stolen from others.

Regardless of all the noisy arguments to the contrary, everyone known to me favors both competition and free trade. Name one who does not favor competition among those from whom he buys. Logically, then, how can one favor competition among millions of others and be against it for himself! This is irrationality, not disagreement.

Precisely the same can be said for free trade — domestic or foreign. Name one who would not welcome an order for his products from another country or county. Everyone favors exports. Imports? Favoring exports and objecting to imports is the same as favoring selling and objecting to being paid. This is an absurdity, not disagreement.

Leonard Read realized that the logic of protectionism is riddled with errors and that the practice of protectionism, in its myriad forms, is theft that impoverishes everyone except those bribed by the gains of their protected status and those whose political clout greases those transactions. It is a far cry from either liberty or justice for all. Read’s conclusion:

What then is meant by “Buy American” in its proper sense? Let willing exchange prevail among all people, locally and worldwide. Let each buyer or seller be guided by his own scale of values. Sell the American way and buy the American way — not as presently practiced, but as once prevailed and ought to be reinstituted. Keep ours the land of opportunity for everyone.

Gary M. Galles is a professor of economics at Pepperdine University. Send him mail. See Gary Galles’s article archives.

You can subscribe to future articles by Gary Galles via this RSS feed.

Copyright © 2012 by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Legalize Competing Currencies – Article by Ron Paul

Legalize Competing Currencies – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
August 16, 2012
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I recently held a hearing in my congressional subcommittee on the subject of competing currencies.  This is an issue of enormous importance, but unfortunately few Americans understand how the Federal Reserve and Treasury Department impose a strict monopoly on money in America.

This monopoly is maintained using federal counterfeiting laws, which is a bit rich.  If any organization is guilty of counterfeiting dollars, it is our own Treasury.  But those who dare to challenge federal legal tender laws by circulating competing currencies – at least physical currencies – risk going to prison.

Like all federally created monopolies, the federal monopoly on money results in substandard product in the form of our ever-depreciating dollars.

Yet governments have always sought to monopolize the issuance of money, either directly or through the creation of central banks. The expanding role of the Federal Reserve in the 20th century enabled our federal government to grow wildly larger than would have been possible otherwise.  Our Fed, like all central banks, encourages deficits by effectively monetizing Treasury debt.  But the price we pay is the terrible and ongoing debasement of our money.

Allowing individuals and business to use alternate currencies, especially currencies backed by gold and silver, would expose the whole rotten system because the marketplace would prefer such alternate currencies unless and until the Fed suddenly imposed radical discipline on its dollar inflation.

Sadly, Americans are far less free than many others around the world when it comes to protecting themselves against the rapidly depreciating US dollar.  Mexican workers can set up accounts denominated in ounces of silver and take tax-free delivery of that silver whenever they want.  In Singapore and other Asian countries, individuals can set up bank accounts denominated in gold and silver.  Debit cards can be linked to gold and silver accounts so that customers can use gold and silver to make point of sale transactions, a service which is only available to non-Americans.

The obvious solution is to legalize monetary freedom and allow the circulation of parallel and competing currencies.  There is no reason why Americans should not be able to transact, save, and invest using the currency of their choosing.  They should be free to use gold, silver, or other currencies with no legal restrictions or punitive taxation standing in the way.  Restoring the monetary system envisioned by the Constitution is the only way to ensure the economic security of the American people.

After all, if our monetary system is fundamentally sound– and the Federal Reserve indeed stabilizes the dollar as its apologists claim–then why fear competition?  Why do we accept that centralized, monopoly control over our money is compatible with a supposedly free-market economy?  In a free market, the government’s fiat dollar should compete with alternate currencies for the benefit of American consumers, savers, and investors.

As Austrian economist Ludwig von Mises explained, sound money is an instrument that protects our civil liberties against despotic government. Our current monetary system is indeed despotic, and the surest way to correct things simply is to legalize competing currencies.

Representative Ron Paul (R – TX), MD, is a Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Mass Production and the Emerging Cultural Differentiation – Article by G. Stolyarov II

Mass Production and the Emerging Cultural Differentiation – Article by G. Stolyarov II

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G. Stolyarov II
August 5, 2012
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I was recently asked: “But doesn’t mass society make even the atypical dress of [previous eras] unavailable to anyone?  Haven’t we had a kind of widespread proletarianization?“

The question presupposed a particular phase of mass production – one that has largely elapsed. When an extreme scarcity of resources still exists, as it did during the early Industrial era, only a few very basic products can be created, and the incentive for businesses is to make them in as high of a volume as possible, to market to as many people as possible without much concern for product differentiation, or esthetic considerations. (Think of the output of the early cotton mills, or the Ford Model T as examples of this.) The early industrial stage massively raises the living standards of most, simply because they can now have goods such as durable clothing, furniture, and (eventually) transportation and appliances – which were simply not available in any form to the majority of people previously. The same can be said of mass culture during the early days of recorded media. The complaint regarding the crudity and proletarization of mass media is not new. In fact, even Ludwig von Mises brought it up in 1954.

People of erudition and exquisite taste were the minority in every age – but what was new in the early 20th century was that, once the basic material sustenance of most in the Western world was achieved, the early mass-production stage became focused on culture (or “culture” – as you will) instead. At the same time, there came about a massively greater differentiation of physical products in the late 20th century, so that people can much more readily customize their living spaces, for instance. With the advent of electronic media, the prospects for cultural differentiation at relatively low cost have also become much more realistic. Consider that, back when I was a poor college student, the Internet enabled me to locate and afford numerous aspects of my quite extensive and unconventional attire.

We are just now coming into a new era of decentralized production of culture, aided by new electronic technologies that make creation much more convenient, as well as funding platforms (e.g., Kickstarter) that enable new forms of distributed patronage. As an example, I recently conducted a successful experiment where I was able to create a new musical composition and obtain some modest funding via Kickstarter, while releasing the work to my audience for free under a Creative Commons License. I am also technically able to create more such works for no compensation, so it is just a matter of having enough leisure time and inclination (of which I have more than a person in my economic situation would have had in earlier eras). I think many other people will increasingly come to be a in a similar position, triggering a new Renaissance of high culture.

The questioner also asked: “This [ability to use technology to compose more easily] is all true, of course, but do we have any Bachs or Mozarts? Is there anything even approaching late nineteenth-century Vienna, where there were multiple great composers within miles of each other?”

Perhaps such an era is soon to come – except the proximity of the composers will not need to be physical. The Internet and electronic composition programs will enable composers throughout the world to become aware of one another and to communicate and collaborate. The biggest barrier to such collaborations in recent years has been the copyright system and its draconian enforcement by American media/entertainment-industry interests. The advent of the Creative Commons License and similar alternatives to traditional copyright can largely solve this problem and create a far more refined culture that does not rely on the mass-distribution system of the large recording and film studios.

I hesitate to make any comparisons to Bach or Mozart – but there are certainly some promising composers out there. For just two examples, I refer you to the work of Maxwell Janis and Simone Stella. (Look for his original compositions, such as this one.)

Review of Mark Krikorian’s “The New Case Against Immigration: Both Legal and Illegal” – Article by Daniel Griswold

Review of Mark Krikorian’s “The New Case Against Immigration: Both Legal and Illegal” – Article by Daniel Griswold

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Daniel Griswold
August 3, 2012
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Published by: Sentinel • Year: 2008 • Price: $25.95 hardcover and e-book • Pages: 304
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In his new book Mark Krikorian of the Center for Immigration Studies argues that immigration may have been good for America a century ago but not today—not because the immigrants have changed but because our nation has changed.

That’s an interesting thesis, but as the book unfolds, the arguments sound more and more familiar. Krikorian argues that immigrants at current numbers can’t be assimilated and that “mass immigration” jeopardizes national sovereignty and security, our quality of life, our jobs, wages, and wallets.

Despite his avowed goodwill toward immigrants, Krikorian’s book is a polemic written to paint immigration in the worst possible light. The word immigration hardly ever appears without the modifier “mass” before it, even though the immigration rate today is far lower than a century ago. He dismisses efforts in Congress to legalize low-skilled immigration as “amnesty” legislation, even though the proposals would have imposed fines, probation, and security checks. He also ignores important findings in the immigration literature for the sake of advancing his argument.

Krikorian’s worries about assimilation are nothing new and carry no more weight today than similar worries about the Italians, Poles, Irish, and Germans in past eras. Government promotion of multiculturalism and bilingual education don’t help assimilation, but they are not the insurmountable hurdles that Krikorian paints: Studies show second- and third-generation immigrants are almost all fluent in English.

The book is at its xenophobic worst in the chapters on sovereignty and security. Krikorian warns that “Mexico City is moving to being, in effect, a second federal government that American mayors and governors must answer to . . . becoming a permanent participant in the day-to-day business of governance, [exercising] joint dominion” over American territory. As evidence for “this assault on American sovereignty” he mostly just musters quotes from Mexican officials urging the U.S. government to reform its immigration system.

That’s only the beginning. While just about everybody recognizes that radical Islam is the most likely source of future terrorist activity against the United States, Krikorian is eager to bring every immigrant group under equal suspicion. In a section titled “Future Wars,” the author manages to slander millions of normal, peaceful, hardworking immigrants from China, Korea, and Colombia. “Though the nearly 700,000 Korean immigrants here came from South Korea, there can be little doubt that the Communist regime in the north has a network of agents already in place among them,” he writes, casting unwarranted suspicion on the corner grocer in Brooklyn and the worshippers at the Korean Central Presbyterian Church down the road from where I live in northern Virginia. In the same vein, Krikorian writes, “War with China is by no means a certainty, but it is clearly possible, and the nearly 1.9 million Chinese immigrants throughout the United States, including a major presence in high-tech industries, represent a deep sea for Beijing’s fish to swim in.” Is this really a valid argument for turning away immigrants such as Taiwan-born Jerry Wang, cofounder of Yahoo!, or Beijing-born Liang Qiao, the Iowa-based coach of the American Olympic gymnast Shawn Johnson?

Turning to jobs and wages, Krikorian sounds like a class-warfare “liberal.” “Mass immigration affects society as a whole by swelling the ranks of the poor, thinning out the middle class, and transferring wealth to the already wealthy,” he asserts. The facts say otherwise. Studies show that immigration benefits the large majority of Americans, not just the wealthy. The middle class has not been thinning out but moving up: The shares of households earning below $35,000 a year and between $35,000 and $100,000 have both declined in the past 20 years as the share earning above $100,000 has grown. Fewer Americans were living under the poverty line in 2006 than in 1994, and the poverty rate has actually been trending down in the past 15 years—a time of robust immigration.

It is true that low-skilled immigrants consume more in government services than they pay in taxes, as Krikorian argues at length. But he dismisses the practicality of limiting access to welfare while glossing over the fact that the average immigrant and his or her descendents generate a sizeable net fiscal surplus for the government.

In the final chapter Krikorian advocates deep cuts in legal immigration and a sweeping crackdown on illegal immigration. Among his preferred coercive tools would be a national database of all U.S. workers, native and immigrant alike; uniform national ID documents; enlisting local law enforcement officers in pursuit of illegal immigrants; and even barring private property owners from renting to people without the right documents.

There are plenty of thoughtful questions to be considered when it comes to the role of immigration in a free, modern, and globally connected society. Unfortunately, this book brings nothing new to the discussion.

Daniel Griswold is director of the Center for Trade Policy Studies at the Cato Institute.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Audit the Fed Moves Forward! – Article by Ron Paul

Audit the Fed Moves Forward! – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
July 31, 2012
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Last week the House of Representatives overwhelmingly passed my legislation calling for a full and effective audit of the Federal Reserve.  Well over 300 of my Congressional colleagues supported the bill, each casting a landmark vote that marks the culmination of decades of work.  We have taken a big step toward bringing transparency to the most destructive financial institution in the world.

But in many ways our work is only beginning.  Despite the Senate Majority Leader’s past support for similar legislation, no vote has been scheduled on my bill this year in the Senate.  And only 29 Senators have cosponsored Senator Rand Paul’s version of my bill in the other body.  If your Senator is not listed at the link above, please contact them and ask for their support.  We need to push Senate leadership to hold a vote this year.

Understand that last week’s historic vote never would have taken place without the efforts of millions of Americans like you, ordinary citizens concerned about liberty and the integrity of our currency.  Political elites respond to political pressure, pure and simple.  They follow rather than lead.  If all 100 Senators feel enough grassroots pressure, they will respond and force Senate leadership to hold what will be a very popular vote.

In fact, “Audit the Fed” is so popular that 75% of all Americans support it according to this Rasmussen poll.  We are making progress.

Of course Fed apologists– including Mr. Bernanke– frequently insist that the Fed already is audited.  But this is true only in the sense that it produces annual financial statements.  It provides the public with its balance sheet as a fait accompli: we see only the net results of its financial transactions from the previous fiscal year in broad categories, and only after the fact.

We’re also told that the Dodd-Frank bill passed in 2010 mandates an audit.  But it provides for only a limited audit of certain Fed credit facilities surrounding the crisis period of 2008.  It is backward looking, which frankly is of limited benefit.

The Fed also claims it wants to be “independent” from Congress so that politics don’t interfere with monetary policy.  This is absurd for two reasons.

First, the Fed already is inherently and unavoidably political.  It made a political decision when it chose not to rescue Lehman Brothers in 2008, just as it made a political decision to provide liquidity for AIG in the same time period. These are just two obvious examples.  Also Fed member banks and the Treasury Department are full of former– and future– Goldman Sachs officials.  Are we really to believe that the interests of Goldman Sachs have absolutely no effect on Fed decisions? Clearly it’s naïve to think the Fed somehow is above political or financial influence.

Second, it’s important to remember that Congress created the Fed by statute.  Congress therefore has the full, inherent authority to regulate the Fed in any way– up to and including abolishing it altogether.

My bill provides for an ongoing, thorough audit of what the Fed really does in secret, which is make decisions about the money supply, interest rates, and bailouts of favored banks, financial firms, and companies.  In other words, I want the Government Accountability Office to examine the Fed’s actual monetary policy operations and make them public.

It is precisely this information that must be made public because it so profoundly affects everyone who holds, saves, or uses US dollars.

Representative Ron Paul (R – TX), MD, is a Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Sunk Costs: There’s No Crying Over Spilled Milk – Article by Steven Horwitz

Sunk Costs: There’s No Crying Over Spilled Milk – Article by Steven Horwitz

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The New Renaissance Hat
Steven Horwitz
July 29, 2012
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Nobel Prize-winning economist James Buchanan is fond of saying, “It takes varied reiterations to force alien concepts on unwilling minds.” That aphorism is surely true. Many basic ideas in economics require repeated attempts at explanation, and a variety of applications, before people fully grasp them and their importance. The one I want to focus on today is the concept of sunk costs and the related sunk-cost fallacy.

Understanding the concept of sunk costs first requires that one understand that, for economists, what matters for decision-making is what we call “action on the margin.” By “the margin” we simply mean the action we will take with respect to the concrete choice before us. When deciding whether a particular choice is worth making, the economic way of thinking tells us to compare the additional benefits that will come from that choice to the additional costs it will entail. This type of thinking then counsels: “Choose the option that delivers the greatest net additional benefits.”

Focusing on the additional benefits and costs that come from that specific action is what economists mean by acting on the margin. To forestall one objection, I will point out that what counts as a benefit or cost is of course subjective to the chooser. You and I could be in the identical situations but appraise the costs and benefits differently, and thereby end up making different choices. Economics says nothing about what should count as a benefit or cost, only that, whatever one chooses to count as benefits and costs, one should focus on the additional, or marginal, benefits and costs of a particular option and go with the one delivering the greatest net marginal benefits.

Irrelevant for Next Decision

An implication of this point is that costs that have already been incurred and that will not change with any of the specific choices now at the margin should be irrelevant to one’s decision. These are what we call sunk costs: The resources cannot be recovered, hence the costs are sunk. Such sunk costs should not matter for one’s next decision; only the costs now at the margin of choice count. No matter what we choose next, we can’t change the fact that we spent those resources in the past.

The idea of the irrelevance of sunk costs is all around us in folk wisdom and other places. For example, good poker players understand the idea when they say, “Don’t throw good money after bad.” Sometimes novice players will think, “Well, I’ve already bet five dollars on this hand, so I might as well see it through.” Good poker players know this is bad thinking: What matters is whether your hand is worth making the next bet. That you’ve bet five dollars already is beside the point. Bygones are bygones. You can’t put the toothpaste back in the tube. There’s no crying over spilled milk.

People who understand the sunk-cost fallacy know to beware when they hear people use phrases like, “You should get your money’s worth” or “You should finish what you started.” For example, suppose you pay a hundred dollars for a gym membership and never use it. Someone says to you, “You really should go to the gym and get something for your hundred dollars.” The problem, however, is that the money is gone whether you go to the gym or not. The relevant question is whether on any given day the benefits of exercising are worth the costs of going to the gym (or giving up your next best alternative). That’s action on the margin. The money spent is irrelevant.

Additional Costs Worth It?

The same is true of the argument that we should “finish what we started,” say, in Afghanistan or Iraq. We can’t change the past and undo the deaths and financial costs of those wars. The real question is whether the benefits of continued intervention are worth additional costs, regardless of what happened in the past. Are billions more spent and many more dead Americans and their victims worth it for the supposed additional gains of continuing those wars?

Sunk costs are sunk. Eventually, of course, in facing new decisions, we can rethink the old decision that sunk those costs in the first place (such as, should we renew the gym membership, or should we enter a new war?). But until then, the past is irrelevant because whatever we choose, we can’t change it. What matters for the economic way of thinking is decision-making on the margin: the additional benefits and costs of the options in front of us right now.

Understanding that choice is always on the margin and that sunk costs are sunk can help you make better decisions in your personal life and spot fallacious reasoning by politicians. This is just another illustration that good economics is the key to critical thinking and good citizenship.

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Let Unsound Money Wither Away – Article by Joseph T. Salerno

Let Unsound Money Wither Away – Article by Joseph T. Salerno

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The New Renaissance Hat
Joseph T. Salerno
July 29, 2012
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[This is a revised version of written testimony submitted to the the Subcommittee on Domestic Monetary Policy and Technology of the Committee on Financial Services, US House of Representatives “Fractional Reserve Banking and Central Banking as Sources of Economic Instability: The Sound Money Alternative,” June 28, 2012.]
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Chairman Paul and members of the subcommittee, I am deeply honored to appear before you to testify on the topic of fractional-reserve banking. Thank you for your invitation and attention.

In the short time I have, I will give a brief description of fractional reserve-banking, identify the problems it presents in the current institutional setting, and suggest a potential solution.

A bank is simply a business firm that issues claims to a fixed sum of money in receipt for a deposit of cash. These claims are payable on demand and without cost to the depositor. In today’s world these claims may take the form of checkable deposits, so called because they can be transferred to a third party by writing out a check payable to the party named on the check. They may also take the form of so-called “savings” deposits with limited or no checking privileges and that require withdrawal in person at one of the bank’s branches or at an ATM. In the United States, the cash for which the claim is redeemable are Federal Reserve notes — the “dollar bills” that we are all familiar with.

Fractional-reserve banking occurs when the bank lends or invests some of its depositors’ funds and retains only a fraction of the deposits in cash. This cash is the bank’s reserves. Hence the name fractional-reserve banking. All commercial banks and thrift institutions in the United States today engage in fractional–reserve banking.

Let me illustrate how fractional-reserve banking works with a simple example. Assume that a bank with deposits of $1 million makes $900,000 of loans and investments. If we ignore for simplicity the capital paid in by its owners, this bank is holding a cash reserve of 10 percent against its deposit liabilities. The deposits constitute the bank’s liabilities because the bank is contractually obligated to redeem them on demand. The assets of the bank are its reserves, loans, and investments. Bank reserves consist of the dollar bills in its vaults and ATMs and the bank’s deposits at the Federal Reserve, which can be cashed on demand for dollar bills printed by the Bureau of Engraving and Printing at the order of the Fed. The bank’s loans and securities are noncash assets that are titles to sums of cash payable only in the near or distant future. These assets include short-term business loans, credit-card loans, mortgage loans, and the securities issued by the US Treasury and foreign financial authorities.

Now the key to understanding the nature of fractional-reserve banking and the problems it creates is to recognize that a bank deposit is not itself money. It is rather a “money substitute,” that is, a claim to standard money — dollar bills — universally regarded as perfectly secure.

Bank deposits transferred by check or debit card will be routinely paid and received in exchange in lieu of money only as long as the public does not have the slightest doubt that the bank that creates these deposits is able and willing to redeem them without delay or expense.

Under these circumstances, bank deposits are eagerly accepted and held by businesses and households and regarded as indistinguishable from cash itself. They are therefore properly included as part of the money supply, that is, the total supply of dollars in the economy.

The very nature of fractional-reserve banking, however, presents an immediate problem. On the one hand, all of a bank’s deposit liabilities mature on a daily basis, because it has promised to cash them in on demand. On the other, only a small fraction of its assets is available at any given moment to meet these liabilities. For example, during normal times, US banks effectively hold much less than 10 percent of deposits in cash reserves. The rest of a bank’s liabilities will only mature after a number of months, years, or, in the case of mortgage loans, even decades. In the jargon of economics, fractional-reserve banking always involves “term-structure risk,” which arises from the mismatching of the maturity profile of its liabilities with that of its assets.

In layman’s terms, banks “borrow short and lend long.” The problem is revealed when demands for withdrawal of deposits exceeds a bank’s existing cash reserves. The bank is then compelled to hastily sell off some of its longer-term assets, many of which are not readily saleable. It will thus incur big losses. This will cause a panic among the rest of its depositors who will scramble to withdraw their deposits before they become worthless. A classic bank run will ensue. At this point the value of the bank’s remaining assets will no longer be sufficient to pay off all its fixed-dollar deposit liabilities and the bank will fail.

A fractional-reserve bank, therefore, can only remain solvent for as long as public confidence exists that its deposits really are riskless claims on cash. If for any reason — real or imagined — the faintest suspicion arises among its clients that a bank’s deposits are no longer payable on demand, the bank’s reputation as an issuer of money substitutes vanishes overnight. The bank’s brand of money substitutes is then instantly extinguished and people rush to withdraw their deposits in cash — cash that no fractional-reserve bank can provide on demand in sufficient quantity. Thus the threat of brand extinction and insolvency is always looming over fractional-reserve banks.

In other words, a fractional-reserve bank must develop what Ludwig von Mises called a “special kind of good will” in order to create a clientele who treats their deposits as money substitutes. On a free market this kind of good will is very difficult and costly to acquire and maintain. This reputational asset is what induces a bank’s clients to forebear from immediately cashing in their deposit claims and driving the bank into instant insolvency. Of course to remain profitable the bank must also build up conventional business good will, which depends upon convenient geographical location, outstanding customer service, attractive facilities, the reputation of its management team and so on. But unlike the common form of good will essential to all successful business ventures, the good will that is necessary for a particular bank’s brand of deposits to circulate as money substitutes is indivisible. In almost all other industries, customer good will can be gained or lost in marginal units and does not typically vanish all at once, destroying its product brand and plunging the firm into immediate insolvency.

Ludwig von Mises described the loss of confidence in a bank’s solvency and the related phenomenon of brand extinction in the following terms:

The confidence which a bank and the money-substitutes it has issued enjoy is indivisible. It is either present with all its clients or it vanishes entirely. If some of the clients lose confidence the rest of them lose it too.… One must not forget that every bank issuing fiduciary media is in a rather precarious position. Its most valuable asset is its reputation. It must go bankrupt as soon as doubts arise concerning its perfect trustworthiness and solvency. [1]

The issuing of deposits not fully backed by cash is therefore always a precarious business on the free market. The slightest doubt about the bank’s solvency among even some of its clients will instantly destroy the character of its deposits as money substitutes. Furthermore, the loss of confidence that causes this phenomenon of “brand extinction” is the cause and not the result of a run on the bank and cannot be deterred by a high ratio of reserves to deposits. For under fractional-reserve banking, by definition, reserves are always insufficient to pay off all the demand liabilities that the bank has incurred. In fact the level of cash reserves is not directly relevant to the stability of a bank. It is simply one of several factors that a bank’s clients take into account in forming their subjective judgment concerning whether a bank’s brand of notes and deposits are or are not money substitutes. For example in the 19th century the ratio of gold reserves to notes and deposits of the Bank of England are reported to have been as low as 3 percent, yet it was generally regarded as one of the most stable financial institutions in the world.

The peculiar and overriding importance of public confidence in sustaining fractional-reserve banking was particularly emphasized by Murray N. Rothbard:

But in what sense is a bank “sound” when one whisper of doom, one faltering of public confidence, should quickly bring the bank down? In what other industry does a mere rumor or hint of doubt bring down a mighty and seemingly solid firm? What is it about banking that public confidence should play such a decisive and overwhelmingly important role? The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding.[2]

Rothbard’s point about the extreme fragility of public confidence in issuers of fractionally-backed money substitutes is well illustrated by the stunning collapse of Washington Mutual (WaMu) in September 2008, the largest bank failure in United States history. WaMu had been in existence for 119 years and was the sixth-largest bank in the United States with assets of $307 billion. It had branches throughout the country and billed itself as the Walmart of banking. It was one of the top performers on Wall Street until shortly before its failure. Its depositors clearly had enormous confidence in its solidity, especially given that its deposits were insured by the federal government reinforced by the existence of the Fed’s “too-big-to-fail” policy. And yet, almost overnight the special good will that gave its deposits the quality of money substitutes vanished as panic-stricken depositors rushed to withdraw their funds. The unlikely event that triggered the sudden loss of confidence and subsequent brand extinction was the failure of Lehman Brothers, a venerable investment house. A week after Lehman failed, mighty WaMu was no more.

The highly publicized Lehman Brothers failure had shaken public confidence in the solvency not only of WaMu but of the entire banking system. Had the Fed and Treasury not acted aggressively to bail out the largest banks in the fall of 2008, there is no doubt that the entire system would have collapsed in short order. Indeed on a single day in December, the combined emergency lending by the Fed and the US Treasury had risen to a peak of $1.2 trillion. The recipients of these billions included some of the most trusted and reputable brand names in banking: Citibank, Bank of America, Morgan Stanley, as well as European banks like the Royal Bank of Scotland and UBS AG. Without this unprecedented bailout, these discredited brand names would have been relegated to the dustbin of business history

The ever-present threat of insolvency is a relatively minor problem with fractional-reserve banks, however. Its effects are restricted to the bank’s stockholders, creditors, and depositors who voluntarily assume the peculiar risks involved in this business.

The major problems with fractional-reserve banking are its harmful effects on the overall economy caused by the related phenomena of inflation and business cycles.

First, fractional-reserve banking is inherently inflationary. When a bank lends out its clients’ deposits, it inevitably expands the money supply. For example, when people deposit an additional $100,000 of cash in the bank, depositors now have an additional $100,000 in their checking accounts while the bank accumulates an additional $100,000 of cash (dollar bills) in its vaults. The total money supply, which includes both dollar bills in circulation among the public and dollar balances in bank deposits, has not changed. The depositors have reduced the amount of cash in circulation by $100,000, which is now stored in the bank’s vaults, but they have increased the total deposit balance that they may draw on by check or debit card by the exact same amount. Suppose now the loan officers of the bank lend out $90,000 of this added cash to businesses and consumers and maintain the remaining $10,000 on reserve against the $100,000 of new deposits. These loans increase the money supply by $90,000 because, while the original depositors have the extra $100,000 still available on deposit, the borrowers now have an extra $90,000 of the cash they did not have before.

The expansion of the money supply does not stop here however, for when the borrowers spend the borrowed cash to buy goods or to pay wages, the recipients of these dollars redeposit some or all of these dollars in their own banks, which in turn lend out a proportion of these new deposits. Through this process, bank-deposit dollars are created and multiplied far beyond the amount of the initial cash deposits. (Given the institutional conditions in the United States today, each dollar of currency deposited in a bank can increase the US money supply by a maximum of $10.00.) As the additional deposit dollars are spent, prices in the economy progressively rise, and the inevitable result is inflation, with all its associated deleterious effects on the economy.

Fractional-reserve banking inflicts another great harm on the economy. In order to induce businesses and consumers to borrow the additional dollars created, banks must reduce interest rates below the market-equilibrium level determined by the amount of voluntary savings in the economy. Businesses are misled by the artificially low interest rates into borrowing to expand their facilities or undertake new long-term investment projects of various kinds. But the prospective profitability of these undertakings depends on expectations that bank credit will remain cheap more or less indefinitely. Consumers, too, are deceived by the lower interest rates and rush to purchase larger residences or vacation homes. They take out second mortgages on their homes to buy big-ticket luxury items. A false economic boom begins that is doomed to turn into a bust as soon as interest rates begin to rise again.

As the inflationary boom progresses and prices rise, the demand for credit becomes more intense at the same time that more cash is withdrawn from bank deposits to finance the purchase of everyday goods. The banks react to these developments by sharply raising interest rates and contracting loans and deposits, causing a decline in the money supply. Indeed the money supply may very well collapse, as it did in the early 1930s, because the public loses confidence in the banks and demands it deposits back in cash. In this case, a series of bank runs ensue that pushes many fractional-reserve banks into insolvency and instantly extinguishes their money substitutes, which had previously circulated as part of the money supply. Recession and deflation results and the binge of bad investments and overconsumption is starkly revealed in the abandoned construction projects, empty commercial buildings, and foreclosed homes that litter the economic landscape. At the end of the recession it turns out that almost all households and business firms are made poorer by fractional-reserve bank-credit expansion, even those who may have initially gained from the inflation.

Inflation and the boom-bust cycles generated by fractional-reserve banking are enormously intensified by Federal Reserve and US-government interference with the banking industry. Indeed, this interference is justified by economists and policymaker precisely because of the instability of the fractional-reserve system. The most dangerous forms of such interference are the power of the Federal Reserve to create bank reserves out of thin air via open market operations, its use of these phony reserves to bail out failing banks in its role as a lender of last resort, and federal insurance of bank deposits. In the presence of such polices, the deposits of all banks are perceived and trusted by the public as one homogeneous brand of money substitute fully guaranteed by the Federal government and backed up by the Fed’s power to print up bank reserves at will and bail out insolvent banks. Under the current monetary regime, there is thus absolutely no check on the natural propensity of fractional-reserve banks to mismatch the maturity profiles of their assets and liabilities, to expand credit and deposits, and to artificially depress interest rates. Without fundamental change in the US monetary system, the growth of bubbles in various sectors of the economy and subsequent financial crises will continue unabated.

The solution is to treat banking as any other business and permit it to operate on the free market — a market completely free of government guarantees of bank deposits and of the possibility of Fed bailouts. In order to achieve the latter, federal deposit insurance must be phased out and the Fed would have to be permanently and credibly deprived of its legal power to create bank reserves out of nothing. The best way to do this is to establish a genuine gold standard in which gold coins would circulate as cash and serve as bank reserves; at the same time the Fed must be stripped of its authority to issue notes and conduct open-market operations. Also, banks would once again be legally enabled to issue their own brands of notes, as they were in the 19th and early 20th century.

Once this mighty rollback of government intervention in banking is accomplished, each fractional-reserve bank would be rigidly constrained by public confidence when issuing money substitutes. One false step — one questionable loan, one imprudent emission of unbacked notes and deposits — would cause instant brand extinction of its money substitutes, a bank run, and insolvency.

In fact on the banking market as I have described it, I foresee the ever-present threat of insolvency compelling banks to refrain from further lending of their deposits payable on demand. This means that if a bank wished to make loans of shorter or longer maturity, they would do so by issuing credit instruments whose maturities matched the loans. Thus for short-term business lending they would issue certificates of deposits with maturities of three or six months. To finance car loans they might issue three-year or four-year short bonds. Mortgage lending would be financed by five- or ten-year bonds. Without government institutions like Fannie Mae and Freddie Mac — backed by the Fed’s money-creating power — implicitly guaranteeing mortgages, mortgage loans would probably be transformed into shorter five- or ten-year balloon loans, as they were until the 1930s. The bank may retain an option to roll over a mortgage loan when it comes due pending a reevaluation of the mortgagor’s current financial situation and recent credit history as well as the general economic environment. In short, on a free market, fractional-reserve banking with all its inherent problems would slowly wither away.

Notes

[1] Ludwig von Mises, Human Action: A Treatise on Economics. Scholar’s Ed. (Auburn, AL: Ludwig von Mises Institute, 1998), pp. 442, 444.

[2] Murray N. Rothbard, Making Economic Sense, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2006), p. 326.

Joseph Salerno is academic vice president of the Mises Institute, professor of economics at Pace University, and editor of the Quarterly Journal of Austrian Economics. He has been interviewed in the Austrian Economics Newsletter and on Mises.org. Send him mail. See Joseph T. Salerno’s article archives.

This is a revised version of written testimony submitted to the the Subcommittee on Domestic Monetary Policy and Technology of the Committee on Financial Services, US House of Representatives “Fractional Reserve Banking and Central Banking as Sources of Economic Instability: The Sound Money Alternative,” June 28, 2012.

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Copyright © 2012 by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Ice and Economics – Article by David J. Hebert

Ice and Economics – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
July 21, 2012
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What can ice teach us about economics? We’ll see, but let’s begin with some fundamentals.

Prices, property rights, and profit (and loss) lead to information, incentives, and innovation. This simple statement contains nearly every lesson necessary for a free and prosperous society. But what do these words mean?

Prices convey information about relative scarcities and communicate to us the relative value of competing uses of a resource. They also economize on the acquisition of knowledge. When we see the price of a resource rise, market actors understand the need to use less of the resource. What they don’t know, however, is whether this rise is due to a disaster that destroyed some of the stock of that resource (an inward supply shift) or if a new, more valuable use for that resource has been discovered (an outward demand shift). These facts are irrelevant for a person who is currently using the resource, but from a societal level, her using less is necessary. If there is a disaster, we would want people to use less of it so that everyone else can still use some. If there is a new, more valuable use discovered, we would want the original users to use less so that more could be allocated towards this new use.

The Right to Exclude

Property rights refers not only to the right to use a resource, but also to the right to exclude others from its use. In this sense property rights provide the incentive to allocate the use of a resource efficiently across time, for example, to conserve it for later. With firmly established and enforced property rights, not only does the owner not have to worry about someone else taking his things but he also doesn’t have to rush out to gather the resources as quickly as he can. A situation where there are no property rights is susceptible to what is called the “tragedy of the commons,” where the resource gets depleted too quickly and never has a chance to replenish.

Profit (and loss) leads to innovation. Earning a profit is akin to being rewarded for doing something good. Suffering a loss is the opposite, a punishment for doing something wrong. In this case, the deed being done is the attempt to allocate scarce resources to where their will earn their highest return. People who successfully do this are rewarded with monetary gain, which we call “profit.” People who fail to do this experience what we call “loss.” In doing so, economic actors learn what works and what does not. Reducing the profitability of an activity through taxes or legislation or sheltering people from losses, therefore, acts to retard this learning process and stifles innovation.

This lesson is exemplified in early nineteenth-century Boston with the rise of the American natural ice trade. In 1806 Frederic Tudor sailed a ship full of ice from Boston to the Bahamas. Two years earlier Tudor had begun experimenting with insulation with the goal of bringing ice to the Bahamas.  When he was ready to set sail, he found that the ship captains refused to carry his cargo for fear of damaging their vessels. So he bought his own brig, the Favorite, and set sail February 10, 1806. He arrived in Martinique with a large quantity of ice still intact and began selling. The Bahamians loved the ice, which they had never seen before. Yet that first year Tudor lost a substantial sum of money, although he proved that ice could be shipped to the Bahamas. Now the objective became doing it at a profit.  Convinced his idea would be wildly successful, he continued his attempts to drive down costs and increase demand.

Higher Return

Meanwhile, as the price of the ice on the ponds rose, the people of Boston gained the information that the ice would bring a higher return in the Bahamas, thus they used less themselves and sold the ice to the Bahamians. In 1840 the ponds in the Boston area were explicitly divided, giving each person on the lake the right to exclude everyone else from harvesting any ice that wasn’t theirs. This allowed Tudor, for example, to invest in his ice and let it freeze longer so that it could better survive the long journey from Boston to India, which entailed crossing the equator twice and sailing around the tip of Africa. As Tudor earned profit from his venture, more people were attracted to the ice.

To continue to earn a profit, therefore, he had to find a way to outcompete everyone else. In 1825 Tudor enlisted the help of Nathaniel Wyeth, one of his suppliers. Tudor noticed that Wyeth’s ice was always significantly cheaper than everyone else’s and was cut in neater blocks which packed more easily. Wyeth had converted some old farm plows into ice-cutting plows and had fastened horseshoes with spikes to allow horses to pull these modified plows across the ice. By scoring the ice in such a fashion, Wyeth could break uniform sized blocks much quicker than his competitors, who were using hand saws that produced very rough and uneven edges.

These wouldn’t be the only contributions of Wyeth, as he went on to invent many other cost saving techniques. For example, Wyeth developed a conveyor-belt system that would haul the ice from the pond into the waiting icehouse.  He also invented bigger plows that could cut more blocks at once and poles that were used to guide the floating ice blocks onto the conveyor belt;  refined the above-ground icehouse, which allowed ice to be stored anywhere in the world for months on end without any external source of refrigeration.

New Insulation

Tudor and Wyeth also experimented with new means of insulating the ice from the heat, discovering that sawdust was not only a fantastic insulator but was also cheaply available from the sawmills around Boston. They also taught their customers new ways to use the ice, including making ice cream and storing the ice in iceboxes to preserve foods longer.

In short the three Ps lead to the three Is: Prices, property rights, and profit (and loss) lead to information, incentives, and innovation.  With these firmly in place, a free and prosperous society will follow.

David Hebert is a Ph.D. Fellow at the Mercatus Center at George Mason University.

This article was originally published by The Foundation for Economic Education.