Monday, July 16, 2007

The Ron Paul Economy, or: The Naiveness of the Internet Favorite

By: Michael Akerman

For IVIC's apparent 200th post (according to Blogger's post counter, which probably includes draft posts, making this not number 200), I shall explain why I can't vote for Ron Paul, mostly-conservative though he be.

I shall be succinct first, then expository.

Ron Paul, should he get his economic initiatives passed, would be the worst disaster for the economy since the election of FDR over Hoover.

You probably think I'm crazy in oh, so many ways for that sentence. Onward to the destruction of the inaccurate teachings of your past years!

The Fallacy of Gold

I shall strike down the cornerstone first, that the edifice might fall. Ron Paul has a stated goal, standing foremost in his economic platform and tied in with all of his other economic desires that I can find online, of dismantling the Federal Reserve.

As a conservative, this is truly mind-boggling to me. In dismantling the Federal Reserve, a semi-private entity, Paul wishes to consolidate market control back in the hands of Congress. A supposedly avowed conservative actually wishes to consolidate power in the hands of the biggest possible unit of government in our society! This, of course, is a poor argument against liberals, but should be enough to make conservatives recoil in disgust. It is a No Child Left Behind level of hubris shown by this plank.

So, I shall also attack why this is a bad idea.

The Federal Reserve (hereafter "the Fed," for simplicity), as you should know, regulates the amount of money in the market. In fairly-clear economic terms, it regulates the money supply. It does this through actions known as Open Market Operations, or OMOs. OMOs basically involve buying and selling used treasury bonds on the market. To increase the money supply, the Fed buys a used treasury bond on the market, and deposits money into the buyer's account. This payment is now money that did not exist previously in the economy. The total money supply has risen. To decrease the money supply, bonds are sold on the market. The payment is taken out back, heaped in a big pile, and set alight. Okay, that's not actually true, but the money is destroyed anyway.

But what's the point of this? What is the goal of the Fed in manipulating the money supply?

There are actually a significant number of reasons. The primary long-term reason is to keep the economy at a low, positive rate of inflation in order to allow the continued growth of the economy. In actuality, a zero inflation state would be preferable in the short term, but it is both nearly impossible to attain and undesirable in the long run because it reduces the Fed's flexibility in using the money supply to slow rampant growth or halt recession (both of which are bad things) without causing economic turmoil. That leads to the second reason: in order to use Keynesian economics to mitigate harmful occurrences in the market. The rate of decline of the GDP can be slowed by increasing the money supply. Similarly, the rate of increase in the GDP can be decreased by decreasing the money supply.

Additionally, people need money. If we had limited ourselves as a country to 5 one-dollar bills representing our economic holdings, we would all have a lot of hundredths or thousandths of a penny on us, and holding a dollar bill would be absolutely the best way of getting rich quick. Until, of course, the economy collapsed because of a lack of faith that the money will hold its present value. This would actually be an occurrence of anti-hyperinflation, with money gaining value with extraordinary rapidity. Which brings me to something I should point out.

Inflation is not based solely, or even mostly, on the amount of money in the money supply. Inflation is an effect of the aggregate demand of the economy (that is, all the wanting people do) growing faster than the aggregate supply (all the making people do). Since demand makes supply, there is always a lag in a healthy economy, and so there is a positive inflation rate. The Fed couldn't hold the economy at zero inflation even if it tried really really hard.

Now that you understand why money market control is necessary, let me explain why it's best to let the Fed, and not Congress, carry it out.

Actually, we can look at history easily enough for this. Consider all of the economies that have suffered hyperinflation in the 20th century. We'll take Germany as exemplar. Hyperinflation can only occur under a fiat currency (that is, "unbacked" currency, like the American dollar after Nixon) system, since money can be printed relatively free of charge. It is one of the dangers that come with the astounding benefits of the fiat system, which I'll get to later. Control of the money supply was left in the hands of the government itself. As the government promised more and more spending, they found themselves without the means to pay for it. The solution seemed simple, of course: "We can print our own money!" they said. "And no one will be the wiser!"

Increasing the money supply in this manner works for a very short period of time. They ended up paying off their first promises. Each time they paid people like this, though, they increased the money supply of the economy. According to Keynes (he was right, by the way), increasing the money supply increases aggregate demand. As I stated earlier, aggregate demand growing faster than aggregate supply causes inflation. So, as they keep doing this, their currency devalued. Fast. Each payment they made in this manner cost more units of currency than the last, because the money kept losing value. We know the story of Germany (and now, Zimbabwe), where bread grew to be worth millions of marks.

The Fed avoids this issue. By targeting a specific federal funds rate, they target a specific inflation rate, guarding automatically against hyperinflation. Since they do not fall under the jurisdiction of the legislative branch, but are a government-owned corporation, they do not have the temptation to print money to pay debts. Moving control to Congress under a fiat currency would be disastrous, removing the failsafes of the Fed. The only feasible control would be moving back to gold-backed currency, which would prevent Congress from crapping things up. Well, sort of.

The Fallacy of the Valueless Dollar

Incidentally, Paul also expresses a strong desire to move back to gold-backed money. Currently, he claims, our money has no backing, and so has no inherent value, and thus has no stability. At any time the dollar could go plummeting into oblivion! Doom and gloom! Falsehoods and lack of economic understanding!

Whether or not the dollar has value depends entirely on what you mean by "inherent value." It is inarguable that the dollar has a very high value of exchange (that is, you can buy stuff with it), and it is true that the paper and ink used to make a dollar are exceedingly cheap (compared to metal-backed money). So, one could say that dollars have extremely little inherent value. However, one would also have to say that dollars on the gold standard have exactly the same very low inherent value, since it is made from the same ink and paper. That makes the comparison useless.

More usefully: the gold-standard dollar is backed by a certain quantity of gold, giving it inherent value. What the Paulies don't see is that the fiat dollar is backed in precisely the same way, but by a much larger pool of resources. The American dollar is backed by the total economic output of the American economy. The Almighty Dollar is a stalwart representative of our impressive GDP. And it is backed in the same way. Under the gold standard, a dollar could be exchanged for the gold that backed it. Under the current system, the dollar can be exchanged for the economic output that backs it.

This also reveals something impressive. Fiat currency encourages economic growth. Not just a little growth. A lot of growth. This is because fiat currency is so cheap compared to gold. This is fairly obvious if you think for a moment. We cannot hope to have as much gold as we have economic activity. It's infeasible: gold is a scarce resource. So, the total dollar supply can have far more value under the fiat system for no inherent cost (other than the risk of hyperinflation, but I've covered that, and it could happen under the gold standard anyway). To use very confusing terms, a dollar now costs a couple of cents to make and represents a dollar. A dollar under the gold standard cost far more, let's say 50 cents (gold costs economic output to produce and acquire. Mining is a use of labor), and represented a dollar. That is a net loss of nearly half of the value.

Clearly, moving to the gold standard is a fantastic means of crippling our economy. So, with plenty of reasons to keep the fiat system, it's clear that the Fed only has one more thing that could be used as an argument against it.

The Fallacy of the Falling Dollar

The value of the American Dollar is falling relative to many other currencies on the international market. This is true. Why? Is it because it has no value? No, that couldn't be it: it's backed by our GDP. Could it be because we import more than we export?

Actually, that wouldn't cause it anyway, but I wanted to use the opportunity to blast apart some really poor economics that happens with trade. There is a prevailing idea that having more exports than imports is a "favorable balance of trade." This is false. Rather, it's incomplete. Trade is always favorable because it allows a nation to exploit their comparative advantage. That is, if Japan is better at making TVs, the US can get cheaper TVs by doing something that they are better at and trading. We make pharmaceuticals very well, and we end up with a net increase in economic productivity, and no loss of jobs. Jobs are made by people. You can't lose jobs overseas. Interestingly, Paul understands the first point, but fails to grasp the second, as seen here.

Consider, for a second, if we took this to the extreme. I can't take credit for this paragraph. It was Bastiat's idea first (French economist). If high exports and low imports are the best thing for the economy, it would be quite simple to make the system perfect. We put all of our goods on a boat. We send the boat to the ocean. We take the crew off, light a stick of dynamite, and blow the ship to kingdom come. If every country does this, there are no imports. The only thing is exports. What a paradise!

I can take credit for this paragraph. Why are imports good? Let us again consider the extreme. One day, off the coast of California, a giant whirlpool opens up. A booming voice echoes forth: "I shall give you any good you want, if you supply me with your American dollars!" it says. The Fed hatches a scheme. This is a simple issue! We print up money, and we throw it in the whirlpool. Out pops a TV, a car, a washing machine, a refrigerator, a house. Someone just got a fully furnished house, for the price of a few pieces of paper. And this is truly valueless paper! In a world with only imports, we never have to pay the debts inherent in the dollars we send out, because the owner of the IOU never comes calling, so the dollars sent are not backed by economic output. They're just paper! The best possible situation would be a no-export, all import economy.

Aside: this trade stuff is covered excellently in Russell Roberts' The Choice. Read it. It's the best book on politics and economics I've ever read, and it's only about 100 pages, and it's narrative. Seriously. Stop reading my trash and read that. Go. Now. It's paperback. It's cheap.

End aside.

This can't happen, of course, unbalancing imports or exports. True exports and imports always balance out. If we import more than we export, we make up for it by exporting investment overseas.

And there's the thing!

The value of the dollar is based entirely on the supply and demand for the dollar overseas! It's very simple: when international markets feel like American economic activity is a sound investment, the value of the dollar is high relative to other currencies. In this case, we import more than we export, because other countries don't want to buy our stuff (useless for us anyway. We can't pay taxes in yen), they want to invest in our economy. This increases our growth. It's a capital inflow, and causes our economy to grow stronger still!

The falling dollar is no one's fault. It is an indicator of the coming, and expected, recession. Every seven to nine years or so we have one. It is no indicator of the collapse of the American currency, nor it is a harbinger of a depression. Which brings us back to the Fed again!

The Fallacy of the Dangerous Fed

Okay, I lied. One more reason to dismantle the Fed: the Fed is dangerous, with their mindless meddling leading to the downfall of the economy in the Great Depression.

Actually, this is kind of true. The Fed did cause the Great Depression. So did FDR, which explains the line in the first section that you all thought was crazy.

The Fed's fault: fear of inflation. Remember that in the 20s, the German economy was in an awful inflationary spiral. The cause was clear: unjustified money was being printed. So, the prevailing economic reasoning was obvious: do not print money without extraordinary justification. So, in the 20s, and especially under FDR, the money supply was not expanding. As it turns out, we know today that it was contracting, but this was something of an accident (they didn't intend to shrink the money supply. Eventually, bills break down). At any rate, when the regular (every seven to nine years) recession hit, the slowing economy suffered under a reduction in the money supply, reducing the amount of trade barter in the hands of consumers and slowing aggregate demand growth. In effect, the actions (or inactions) of the Fed served as a strong braking action on the already slowing economy.

This caused the Great Depression, leading to the stock market crash. Most people think the stock market crash caused the Great Depression, but indeed it is the other way around. Hoover tried to get the Fed to help, but largely failed. They were still worried about inflation. While his balanced budget was a mistake, he also didn't add business controls to the economy. Blamed for the Depression, Hoover was ousted and FDR was beckoned in.

This, it turns out, was something of a mistake. FDR was an advocate of balanced budgets. The conventional wisdom went that you couldn't spend more than you made, and you couldn't "print your way to prosperity." The first is untrue for governments, who can spend more than they take in through taxes by borrowing on the promise of future economic performance (if the borrowed capital is invested, they can always pay back any mature debts). The second is true, but misleading. Guided by these, er, "principles," the money supply continued to contract while FDR cut spending in many areas, expanding, admittedly, social services and public works, but making up for it in increased taxes. That is, his budget was balanced, with a net income of around 0. For the expansion that FDR's spending wrought, he applied an equal or greater contractionary force by increasing taxes and reducing spending. He also added controls on business practices, blaming the corporations for ruining the country. Because, you know, they hate profit.

The public works, incidentally, were pretty much entirely worthless for economic recovery. They were no better than stealing money from one person to give to another (welfare, actually). Taking the form of the classic "move this rock here, then back" job, they followed the unqualified principle that jobs are good. In actuality, jobs must create real, valuable economic output to be beneficial.

Adolf Hitler and Hideki Tojo broke the Depression. To face WWII, government spending had to increase drastically. Wartime jobs, making real goods of value, had to be created. The accelerator was stepped on again while monetary policy shifted to an expansionary stance to pay for the war. Upward the economy surged.

That quasi-aside is to illustrate something. The mistakes and inactions of the government were not institutional! They were mistakes of economic theory. The issue that matters, the mistakes of the Fed, were caused by the classical economic theory, where inflation is the greatest evil. The savior of the economy was Keynesian economics! And that is the set of economic theory we work under today.

I bring this up because it shows that dismantling the Fed would do nothing to protect the economy from disasters like these. The alternative to having the Fed, a group of well-trained professional economists, running the money supply is having a group of Congressmen (that is, people trained in, at best, law) running the money supply. Either economic theory would be followed, or so-called common sense would be followed. We are either left in exactly the same position (assuming Congress had the economic understanding to apply economic theory), or a far worse position, stuck at the whims of some lawyers. While economic theory could be wrong, I'd rather learned men apply it than less learned men deny it.

Speaking of learned men...

The Fallacy of the Wealthy Bankers

That was a terrible segue to this. Another claim against the Fed is that it was formed by bankers so that bankers could profit. To be frank, they can't. Not from the actions of the Fed.

Remember first that money supply control is done through OMOs, secret purchasing and sales to the market as a whole. Mark one against the wealthy bankers: they cannot ensure they get the "profits" (which are no bigger than the profits from a normal sale) from this purchase-and-sale cycle. The sale goes to the highest bidder, the purchase to the lowest. This is why the bond market is so powerful at doing OMOs: it represents a democratic purchasing area of the economy (since anyone can buy bonds of many different values).

Mark two: there is no way that money supply control could make a banker usefully rich. Let us imagine that a banker gained control of the entire Fed. No whistle-blowers stood up, so they don't get in trouble. The Fed simply kowtows to their desires. They print money, and keep it for themselves. They spend it, but this causes undue inflation: money that shouldn't be in the market is flooding into it. Herein lies the rub: bankers make money from healthy, low-inflation economies. Far more money than they can make by ruining the economy, actually. People only save money when inflation is low, and bankers use saved money for investments and loans, which are the things that lead to profit. In order to gain a moderate (to them), short term financial gain, they sacrifice long term profitability and large future gains (incidentally, you don't get to be a wealthy banker by screwing up investment).

Admittedly, it's theoretically possible. It won't happen, but it could. So, what happens if we prevent it by shifting control to Congress? Wouldn't that prevent corruption? I hope some of you are laughing by now.

Who I've Decided to Vote For

I've finally decided the basic framework under which I have to view this election so far. Ron Paul is the only candidate avidly espousing economic policies that would cripple the American economy. His misguided views are something three months in a college economics class could remedy, but still he curries favor with his meaningless platitudes and false beliefs. So, rather than risk causing irreparable damage to the American standard of living, I am voting against Ron Paul. To defend the American economy from a crippling blow, I am voting against Ron Paul. Instead of hoping that Congress will have the wits to go against his terrible ideas, I am voting against Ron Paul.

To prove my emphasis on this, I'll clarify: even if the race ends up as a challenge between Ron Paul and Hillary Clinton in '08, I will vote for Hillary Clinton in the hopes that Ron Paul will be kept out of office. Foolish social policies hurt few and are easily remedied. Foolish economic policies can crush the country.

As far as references, I can't find the awesome Great Depression article that I'd like to find, and my economic understanding is from Professor McElroy's EC 302H class (yes, I have the notes. Yes, I checked the notes. No, his book is not currently online since it's the middle of summer). So, aside from the reasoning, which I hope is laid out clearly enough, I can direct you to a few Wikipedia articles if you really want. Actually, I think I have that article saved on my computer. If I find it, I'll comment about it, and I'll gladly email it to anyone who wants it.

By my hand,
~Michael Akerman


Michael Akerman said...

No dice on the article. I checked Google Desktop and can't find it.

Michael Akerman said...

I found a print copy of the article, though. The online copy (it's from the Economist) is Premium Content.

I'll send it to the curious, though, after I scan it.

Anonymous said...

I didn't read your post. I don't have the time.

Know that inflation is at 12% and rising. Confirm it here --

You will not retire if it stays at this rate, or rises for the long-term. You simply will not be able to leverage your investments to beat this constant, rising level of inflation.

The IRS needs to be regulated, or removed. Same goes for the Federal Reserve. The bankers that own the Fed are out of control.

Ron Paul, or no retirement. You decide.

Anonymous said...

I'm a successful, professional trader and now that I've skimmed through your article, I can tell right off that you either work for the Fed, you were paid by the Fed to write this, or you really believe in what you are writing, which is seriously bogus material.

It sounds official. But then again, I've talked to my fair share of CEOs who will say one thing and do another, for personal gain. It's rampant in the industry.

Go read sometime. She has 100 times your experience in the industry, if you're even in the industry, and she completely contradicts everything you are saying in your article.

You, sir, are not to be trusted.

Michael Akerman said...

So, Anonymous, you expect me to believe that Shadow Government Statistics, a website run by a supposed MBA (not a doctor of economics) with no background of sufficient macroeconomic experience save for consulting, is more accurate than the CPI, which is not challenged by most professional economists, because his numbers agree with your views more fully?

The change from the fixed-basket (Laspeyres) method to the geometric-Laspeyres method was to account for the changes in buying habits of the American public. Before this, the CPI calculation had to be changed periodically to reflect the buying habits of Americans directly in a particular survey year. This does not reflect the reality of consumer purchasing: purchases do not stay the same over time. Consumers buy goods that are an equivalent replacement for a now-overpriced good. It is not replacing steak with hamburger but replacing milk with apple juice.

So, the more accurate measure reflects what is clear from the lack of painful, inflation-related price hikes in our lives: inflation is at around the same level as it has been since the American economy abandoned the Phillips curve.

As far as Solari, the "she" you refer to is, I assume, Catherine Austin Fitts, who is not an economist. Degrees: Finance, history, Mandarin, English. Her professional career doesn't help much, listing an impressive array of investment operations but no activity as any form of macroeconomic supervisor. She has no experience in "the industry."

The goal of the company is a ridiculous assertion, on the level of statements about the supposed 9/11 conspiracy. Claiming that banks, for-profit enterprises, are not working in our interest is just redundant. They're working in their best interest! Since their profit is based on the wealth protection and management they afford us (granted by their resources and governmental accountability, which "Solari circles" appear to lack), we get the benefit from their desire for profit.

You know, like a business.

Regardless of her lack of qualifications and her meaningless platitudes, I'm willing to judge her on her arguments, which you seem to have discarded as a possibility toward me (very rude of you). A person with no degree in science can know plenty about biology, after all. So, Anonymous, feel free to send me a link where she discusses the issues in my post. For the life of me, I can't find anything but a blog with no apparent posts by Ms. Fitts and articles full of meaningless platitudes and offers to charge me to know more. It looks like a financial tupperware party, frankly, but if there's an article that touches on the Fed or fiat currency, feel free to send it along.

Sir, when you are prepared to offer some intelligent defense of your position, rather than resorting to attacking my integrity and claiming very serious things while offering no support (the Fed is out of control how, exactly?), feel free to comment again.

Scott said...

I did support Paul for awhile but after I did some research and read this post, I think I may have to abstain from the '08 election not out of apathy, but because none of the candidates seem to represent me. With Giuliani and Thompson leading the Republicans and Clinton and Obama leading the Democrats, I am finding it extremely difficult to pick the lesser of evils as I tend to do with elections. Be it Giuliani's police state or Clinton's welfare state, neither seem really appealing, hopefully something will change by next November.

P.S. Man anonymous, starting off with the "working for/paid by" comment? That's some classic troll lingo.

Nathan Tabor said...

Anonymous, why do you sound scandalized that CEOs are ruthless businessmen? That's capitalism; there are different varieties, but America's always liked its capitalism a little more ruthless and freewheeling than our European cousins. FTheir "kinder, gentler" capitalism hasn't worked out too well--ask the French. As far as the inflation rates and the retirement question, I'm no economist, but growth looks good, and the unemployment rate is at 4.5%. Those aren't signs of a sick economy, or a currency that doesn't have value.