Tuesday, December 28, 2010

Lombard Street

Too Long to Read Summary: I read Lombard Street by Walter Bagehot. I learned that a powerful financial market requires a large amount of demand deposits. These accrue during times of political stability at institutions that specialize in monetary matters. The English Money Market (centered around Lombard Street and the Bank of England), was an example of such a powerful financial market. It's scale and efficiency allowed England to undertake great business ventures with speed and ease, and gave the entire nation a significant economic advantage. The cost of this power, however, was that a run on these deposits could utterly destroy all these financial institutions. Bagehot cautioned that all of this relied on the success of the Bank of England, a private institution that actually had a huge public role. In order to stay a panic, he urged that the bank of England lend freely to businesses and banks alike (perhaps at elevated interest rates). Failing to do so, or doing so hesitantly, would surely result in the destruction of the Money Market. Finally, he concluded that to run the bank in the interest of the public, the reserve should be kept above the public apprehension minimum (which can only be found by trial and error), and maintained by an experienced manager, who is overseen by a working committee of the board of directors, and supervised by a temporary but distinguished governor.

I first heard about Lombard Street while I was making my way through Friedman andSchwartz's "The Great Contraction" (something I've already posted about). Friedman referred to it as the seminal work on banking, central banking, and the money market. Naturally, I was curious. It was written by the 19th century English business analyst Walter Bagehot, and it is an exposition on the financial markets of Lombard Street in London, England (the 19th century Wall Street). Now, onto the book!


  • The money market is not abstract or obtuse, it is concrete and plain. If it appears abstract and obtuse, it is a failure of communication on the part of the analyst or writer.
  • In the 19th century, Lombard Street represented the greatest economic power and knowledge on the planet. Much more money could be raised and channeled than anywhere else in the world. Why? Because Lombard Street had the largest Money Market.
  • Money in the market (deposited in the banking system), is more powerful than cash balances in the hands of the public, because it can be intelligently and systematically supplied to borrowers.
  • Cash deposits lower the transactions costs of borrowing large sums of money to finance business undertakings.
  • Diversification of funds and specialization in lending further lower the transactions cost of loans, ultimately resulting in a lower general price level.
  • Easy access to financial capital makes it possible to seize business opportunities quickly, allowing for more competition in the economy.
  • However, easy access to financial capital (when there is asymmetric information), worsens principle-agent problems such as moral hazard.
  • Financial capital is much more mobile than other forms of physical capital, thus capital adjusts to more profitable trades quicker in nations that have larger amounts of financial capital.
  • A powerful financial market requires large cash deposits in banks, but a bank run on these cash deposits can destroy any financial market abruptly.
  • Bank reserves are meant to head off these panics, by reassuring the public. But the incentive of a bank is to keep as little of a reserve as possible, which may or may not be sufficient depending upon shifts in the public psyche.
A General View of Lombard Street

  • The institutions that make up a mature money market are: the cental bank, the private banks, the joint-stock banks, and the bill brokers.
  • Credit is loosely defined as a set of promises to pay resources loaned out, which are backed by the reputation of the party requesting the loan.
  • There are infinitely many possible systems of credit, but the main test of any credit system is its "soundness", or how confident the lender and borrower are collectively on the successful outcome of their arrangement.
  • In order to meet extraordinary and infrequent demands, such as bank runs or waves of loan defaults, banks must hold a certain amount of cash in reserve.
  • Most English banks in the 19th century kept their reserve with the bank of England, which was a private bank.
  • However, private banks have an incentive to keep their own reserves as low as possible, in order to maximize profits.
  • Thus, in the 19th century, the entire banking reserve of the English money market was in the hands of a private bank, who did not have the clear incentive to maintain a large enough reserve to meet its obligations as a private bank, and the oblations of all the other banks during a panic.
  • As the central bank, the Bank of England can use the interest rate it charges to control cash flows in the country. Higher interest rates slow business activity by making loans more expensive, lower interest rates speed it up by making loans less costly.
  • To address a banking panic, the central bank should lend freely at elevated interest rates.
  • To counter a drain on its cash reserve by foreign nations, a central bank should raise its interest rate, but also lend freely if there is a panic.
  • "A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times."
  • A panic generally starts with concerns about the solvency of minor businessmen and speculators. However, if banks refuse to lend to these parties so that the concerns can be addressed (if they are not valid), then the panic can spread to the banks.
  • If all creditors demand their cash at once, it will never be possible to satisfy their demands, and the banking system must inevitably collapse, but this is unlikely to occur.
  • As the holder of the banking reserve for the nation, the activities of the Bank of England are a matter of the public interest, although it is a private institution.
  • The Bank of England, as a private bank, has not acknowledged its public role as keeper of the reserve, and this might prompt it to be hesitant to lend during a panic, as a private bank would be inclined to do.
  • Lending hesitantly is the worst course of action during a panic.
  • Fundamentally changing this system of credit in England is impractical, but adjustments can be made to make it better, such as:
  1. Having the Bank of England (BOE) Acknowledge its role as the reserve publicly.
  2. Ensuring that the Board of Directors of the BOE have special training for their responsibilities.
  3. Taking steps to diminish the reliance of other banks on the reserve of the BOE.
How Lombard Street Came to Exist, and Why it Assumed Its Present Form

  • To begin deposit banking, it is necessary for a large amount of people to come to trust a small amount of people with their money.
  • Many of the large banks of Europe, including the BOE, began as organizations to make loans to governments, or as keepers of high quality currency, or as institutions for channeling funds abroad. Adam Smith has a good account of this in "The Wealth of Nations".
  • Deposit banking also requires a large circulation of bank notes, which are seen as reliable. This requires a prolonged period of social and political stability, in conjunction with the other factors. This was the case in England after the Glorious Revolution in 1688.
  • The status of the BOE as the government's bank, it's monopoly grant of limited liability, and its historical monopoly over the printing of bank notes conspired to make it the central reserve bank of England.
The Position of the Chancellor of the Exchequer in the Money Market
  • If the government does not keep its own finances, and instead uses a bank, then the money market becomes vital to the public interest, and some form of government intervention is inevitable.
  • Under a perfectly competitive banking system, where the government kept its own finances, there would be a great number of banks all keeping their own reserves.
  • However, when the government favors one bank with its finances, it has natural advantages over other banks, and it generally becomes much larger than other banks, with greater security based on public backing.
  • This is how the Bank of England, as a private bank, came to be the reserve bank of the English Money Market. Other banks rely on the BOE as their reserve instead. This generates a number of problems, namely:
  1. Since the banking system is depending on a bank which can call on the state for aid, it is likely that this system will be taken advantage of more than a totally private system.
  2. The total level of reserves is lower than under a totally private system, because the BOE only sees fit to keep reserves to secure their own losses, not the losses of the entire banking system.
  3. The stability of the banking system rests essentially with one private board of directors, who are obligated only to their shareholders. There is no acknowledgement of the public role with the BOE has to play in monetary policy.
The Mode in Which the Value of Money Is Settled in Lombard Street
  • The value of money, like other goods, is settled by the laws of supply and demand, only the particulars vary.
  • Banks with monopoly power of the currency can alter short-term interest rates, but not average rates.
  • If a bank with monopoly power of the currency increases the money supply, and thus lowering the short-term rate of interest, the consequence is a rise in prices, with three consequences;
  1. It makes everyone want to borrow money (because it has become more expensive to perform the same level of business).
  2. As asset prices inflate, people are able to borrow more money against them, in nominal terms.
  3. If the price rise is confined to one country, it stimulates imports, as domestic goods become more expensive relative to foreign goods. Thus, currency is sent out of the country.
  • Since banks can control short-term, but not average interest rates, they have some control over the volatility of the business cycle. If the banks manage the rate of interest poorly (by having a large standard of deviation from the mean), the business cycle will be more violent.
Why Lombard Street Is Often Very Dull, and Sometimes Extremely Excited
  • Shocks to the economy, especially negative ones, can lead to an increase in preference for more liquid assets, which can freeze credit markets.
  • Classical Economics does not emphasize the importance of the transactions costs of time in the market, namely that ideally:
  1. Goods should be exchanged as quickly as possible.
  2. Producers and consumers should be able to locate each other as soon as possible.
  • However, as the number of market connections utilized and relied upon widens, the power of positive and negative shocks is magnified.
  • A functioning credit market cuts down on the amount of time required for transactions.
  • When deposits are long term, the bank can channel them to expand credit. This fuels business activity.
  • Gradual inflation and good credit are associated with the expansion of business, while deflation and credit freezes are associated with contractions. However, growth driven only by rising prices is transitory.
  • Business expansion based upon increases in productivity are real by volatile, and transitory expansion based upon higher prices ultimately only results in a redistribution of wealth to those who raise their prices first.
  • Since the health of Lombard Street, the Bank of England, and the Money Market, are intimately connected with the health of business in England (even more so due to BOE's status as a reserve bank), the public should realize how their own fates are tied to the prudent conduct of these financial institutions.
How the Bank of England Has Approached It's Duty as a Reserve Bank
  • The Bank of England, as of the publication of the essay, had never publicly acknowledged its role as a reserve bank.
  • Furthermore, no public authority seems to have taken an interest in the BOE's role either.
  • Finally, many economic scholars have preached the virtues of a hands off approach to the banks, which upon further consideration, is clearly against the interests of the nation.
  • "Men of business have keen sensations, but short memories, and they will care no more next February for the events of last May than they now care for the events of October 1864".
  • The supply of loanable funds is more sensitive, in the short term, to expectations about the future, than is the demand for loanable funds.
  • In a panic, the goal of a reserve bank should be to loan freely to all businesses that would be otherwise considered sound during ordinary times, not just to the banks, because they will only hoard the funds.
  • A board of directors is not usually quick to respond to urgent situations.
  • Managers rely mostly on their experience, their knowledge of theory is often antiquated. Even without knowledge of theory, they must act on experience, because timid managers are often behind and ultimately ruined.
  • Banks cannot replenish their reserve during a panic, and it is often impossible to raise more capital by selling stock.
The Government of the Bank of England
  • Boards are often composed of successful capitalists utilizing their leisure time.
  • The executive management in a bank should not be a rotating position, experience and consistent policy are important, although entrenched interests can be a concern.
  • To counter the concern of entrenched interests, the governor of the bank should be appointed and rotated, but the day to day management should be undertaken by a long-term subordinate.
  • In the end, banking should be more about caution (and less about risk) than ordinary commerce.
The Joint Stock Banks
  • In banking, there is a premium generated by longevity in the business.
  • Banking requires at the utmost: attention to detail, prompt decision making, and the ability to make decisions on a case by case basis.
  • Far more money is often lost in banking due to errors and incompetence than fraud, because there are limits to the size of fraud.
  • Joint stock banks are becoming more popular, and will be the ultimate form of banking eventually due to their ability to raise capital.
  • A board that oversees a joint stock bank should have a fixed working committee that is always in session, for the purpose of reviewing the major actions of the management.
The Private Banks
  • Private banks used to be dominant in England, but they are unable to achieve the scale of joint stock banks.
  • Private banks also have more difficulty with finding good management, which damages confidence in their longevity.
  • Thus, private banks have been and continue to be phased out by joint stock banks, and one day might disappear entirely.
The Bill-Brokers
  • Bill-Brokers act as intermediaries between banking capitalists and borrowers, deriving a premium or profit from their proximity and knowledge (Coase Theorem).
  • Credit is not a direct function of wealth, it also involves history and reputation.
  • Bill-Broking was originally about the soundness of the bills being traded, as the industry has grown, it has become more about the credit of the bill-broker. Consequently, he/she must now pay interest on the funds they use to broker bills.
  • Thus, bill-brokers now have a greater opportunity cost to maintaining their funds, which puts them in a precarious position during a credit freeze.
Principles to Regulate the Amount of Reserve Kept by a Central Bank
  • The size of the reserve depends on the size of the liabilities, but also on the probability of withdrawals within certain time horizons.
  • Rigid rules to the size of a reserve are dangerous in a dynamic business environment. They can hurt the profitability of banks, and even ruin them under certain circumstances.
  • Publishing of Bank Balance Sheets can go a long way to promote prudent conduct and provide assurance to the public.
  • There seems to be some variable "apprehension minimum" to the size of the reserve of a bank, below which the bank drastically increases the probability of a bank run.
  • In the end, the reserve should be kept above the apprehension minimum (which can only be found by trial and error), and maintained by an experienced manager, who is overseen by a working committee of the board of directors, and supervised by a temporary but distinguished governor.

Friday, October 22, 2010

The Grumbling Hive

I'm not sure where I first heard about "The Fable of the Bees", but it was reading Keynes's General Theory that really prompted me to take the time to understand it. For those of you who are interested in more than just my take, the full text is available here. The fable is a long poem by the early 18th century intellectual Bernard Mandeville. It is, in my opinion, an elegant satire of the incompleteness behind the economic philosophy of capital fundamentalism. This philosophy, associated closely with the early classical economics, proscribed perpetual austerity as the best path to economic might. Despite it's incompleteness, this philosophy lives on (and is even being heard now from many prominent politicians and policy makers). Thus, teaching the shortcomings of capital fundamentalism is especially important today. Now, on to the fable!


I will discuss the fable by picking out what I feel are relevant sections of the poem and then attempting to interpret them for the reader:

"Vast Numbers thronged the fruitful Hive;
Yet those vast Numbers made 'em thrive;
Millions endeavouring to supply
Each other's Lust and Vanity;
Whilst other Millions were employ'd,
To see their Handy-works destroy'd;
They furnish'd half the Universe;
Yet had more Work than Labourers."

This section appears near the beginning of the poem, and describes the initial state of the thriving hive. It is thriving, according to Mandeville, because the bees have an insatiable appetite for consumption that is coupled with the freedom and ability of other bees to supply the things all desire to consume.

Thus every Part was full of Vice,
Yet the whole Mass a Paradice;
Flatter'd in Peace, and fear'd in Wars
They were th'Esteem of Foreigners,
And lavish of their Wealth and Lives,
The Ballance of all other Hives. [160]
Such were the Blessings of that State;
Their Crimes conspired to make 'em Great;
And Virtue, who from Politicks
Had learn'd a Thousand cunning Tricks,
Was, by their happy Influence,
Made Friends with Vice
: And ever since
The worst of all the Multitude
Did something for the common Good.

This is an early reference to the general moral of the poem. It was the insatiable need to consume (a vice), that was the source of the colony's power. In fact, this vice made the colony an object of envy by outsiders, leading to the outcome envisioned by those who proselytize virtue.

How vain is Mortals Happiness!
Had they but known the Bounds of Bliss;
And, that Perfection here below
Is more, than Gods can well bestow,
The grumbling Brutes had been content
With Ministers and Government.
But they, at every ill Success,
Like Creatures lost without Redress,
Cursed Politicians, Armies, Fleets;
Whilst every one cry'd, Damn the Cheats,
And would, tho' Conscious of his own,
In Others barb'rously bear none.

The seeds of the downfall of the hive are revealed here. The bees want to "have their cake, and eat it too." Since the vice of insatiable consumption is frowned upon by moralists, though it is the basis of the society's power, there is a kind of cognitive dissonance. According to Mandeville, those who fall behind in this competitive and fast moving society are likely to condemn the vices practiced better by others. This may or may not undermine consumption in good times, but it seems much more likely to prevail when the chips are down.

No Honour now could be content,
To live, and owe for what was spent.
Liveries in Brokers Shops are hung,
They part with Coaches for a Song;
Sell Stately Horses by whole Sets;
And Country Houses to pay Debts.

Vain Cost is shunn'd as much as Fraud;
They have no forces kept Abroad;
Laugh at the Esteem of Foreigners,
And empty Glory got by Wars;
They fight but for their Country's Sake,
When Right or Liberty's at Stake.

Now mind the glorious Hive, and see,
How Honesty and Trade agree:
The Shew is gone, it thins apace;
And looks with quite another Face,
For 'twas not only that they went,
By whom vast Sums were Yearly spent;
But Multitudes, that lived on them,
Were daily forc'd to do the same.
In vain to other Trades they'd fly;
All were o're-stocked accordingly.

The Price of Land, and Houses falls
Mirac'lous Palaces, whose Walls,
Like those of Thebes, were raised by Play,
Are to be let; whilst the once gay,
Well-seated Houshould Gods would be
More pleased t'expire in Flames, than see;
The mean Inscription on the Door
Smile at the lofty Ones they bore.
The Building Trace is quite destroy'd,
Artificers are not employ'd;

Now, we have the state of things when virtue finally triumphs over vice. Everyone, from the richest to the poorest, decides to swear off their consumption of that which is not necessary. They choose, instead, to pay off their debts and take on no more, and charge no interest (in keeping with the good books). The result: rather abrupt and self inflicted impoverishment. Why? The economy is an interconnected and interdependent system. Goods and services in one sector are dependent and contingent upon goods and services in another sector. It's an often overlooked and rather complicated truth that everyone simply can't all save for the future at once.


Then leave Complaints: Fools only strive
Be famed in War, yet live in Ease
Without great Vices, is a vain
Eutopia seated in the Brain.
Fraud, Luxury, and Pride must live;
We the Benefits receive.
Hunger's a dreadful Plague no doubt,
Yet who digests or thrives without?
Do we not owe the Growth of Wine
To the dry, crooked, shabby Vine?
Which, whist its neglected flood,
Choak'd other Plants, and ran to Wood;
But blest us with his Noble Fruit;
As soon as it was tied, and cut:
So Vice is beneficial found,
When it's by Justice, and bound;
Nay, where the People would be great,
As necessary to the State,
At Hunger is to make 'em eat.
Bare Vertue can't make Nations live
In Splendour; they, that would revive
A Golden Age, must be as free,
For Acorns, as for Honesty.

The moral of this poem is a subtle but important distinction between the immortal words of the infamous Gordon Gekko from the movie Wall Street "Greed, for lack of a better word, is good." The moral of this story is: Greed can be good.

Too Long to Read Summary: Greed can be good.

Friday, September 24, 2010

Galbraith on the Crash of 1929

From looking at my previous posts, the reader might think that I have a preoccupation with the Great Depression. This is not really so. The fact is that during and shortly after the Depression, a flurry of good economic work was done on both the Micro and Macro level. That such a catastrophic economic collapse could take place under a regime that was much more along the lines of what the classical economists would refer to as "business friendly", opened the door to some fundamental changes in economic theory. By my estimates, it took about forty years to forget a lot of what economists learned from the Crash of 1929 and the subsequent
Depression. I think it is still an open question as to whether contemporary economists have the capacity to respond to our current difficulties as creatively.

But I digress. The point of this post is to present a play by play of the Great Crashof 1929 according to the famous Institutional Economist John Kenneth Galbraith. From his book, we learn a great deal about the psychology behind booms and busts. We are also privy to a laborious account of how institutions in the United States responded to the collapse. I think this is a good addendum to the post on Milton Friedman, as it acts as a sort of prequal. Now, to the book!

Vision and Boundless Hope and Optimism

Galbraith opens up his book with a section on the Roaring Twenties, a time familiar to most students of United States History. In hindsight, it seems obvious that the spectacular growth of the twenties was too good to be true. Still, the issue is raised as to how some of the more obviously unsound or unprofitable practices were allowed to continue for so long, with little or no notice by voracious speculators.

The first point that Galbraith raises is that mass delusion of this sort usually does not take place on such a large scale, and it requires some considerable time to build up. Essentially, at some point in the early twenties, enough people became convinced that they could get reasonably rich fairly quickly, because modern financial genius had changed the rules of making money. Convinced that they could benefit from rising prices, individuals and firms became more willing to take on debt, and lenders (also noting the rising prices) became more lax in their standards. And, as more people and more money poured into financial markets, prices rose. Rational Investors, Galbraith notes, might recognize the transience of this kind of price increase. But, he points out that many well respected businessmen and political figures "talked up" the market, leaving investors assured that greater forces were protecting their fortunes.

Something Should be Done?

By 1929, Galbraith asserts, some learned individuals in business and policy recognized that a correction in financial markets was imminent. Easing the pain of this correction was the responsibility of:

  1. The President of the United States
  2. The Secretary of the Treasury
  3. The Federal Reserve Board
  4. The Governor and Directors of the New York Fed.
However, none of the people wanted (or perhaps even knew how) to rock the boat. The President and the Secretary of the Treasury didn't have the expertise to understand what was going on, and the factions in charge of the Federal Reserve system were overall opposed to direct intervention in the market. To their credit, Galbraith argues that their attempts to use Open Market Operations or Discount Rate hikes wouldn't have frazzled speculators, and only would have harmed sounder business transactions. After a failed attempt at "moral suasion", or essentially trying to warn speculators to slow down, he asserts that the Fed chose the course of letting the bust play out.

In Goldman Sachs We Trust

In this section, Galbraith discusses the role that investment corporations and banks (like Goldman Sachs) played in fueling the speculative bubble. It has already been noted that investors were given the added comfort of assuming that powerful forces were working to keep the market moving in their favor. One such source of comfort came from investing in large scale funds headed by financial "experts". These "experts" used the power of increasing the leverage of their funds to take advantage of rising prices. On paper, modest price increases to a hugely leveraged company appear to be vast increases in wealth. But Galbraith notes that a slight decrease in price to the same leveraged firm can just as easily wipe them out. This is what ended up happening.

The Twilight of Illusion

When reading the title of this section, one cannot help but think of Nietzsche's "Twilight of the Idols", and the similarity of the message leads me to believe that this is intentional. It begins by noting two of the more familiar aspects of a runaway bubble in financial markets:

  1. Prices rose daily, almost never falling.
  2. The volume of trading was consistently heavy.
Galbraith then goes on to talk about another element in the psychology of the boom. The first, we have already noted, was a faith that some greater forces were at work to keep the market tilted in the favor of the investor. Another element to support the boom was the spread of supposed market "experts". Sailing past reality for a boom essentially means that the money being poured into the market comes from taking on debt in an effort to profit from price increases that are solely based on increases in demand prompted by other people taking on similar debt. While this can only last while the expectations and utility functions of borrowers and lenders stand in a particular relation to one another, it is still the case that prices will rise. People who know people that benefit from this, or who benefit from it themselves, are only too eager to attribute the gains to their own genius. They make idols of themselves or others, and imbue them with similar powers to the other great forces at work in their favor. Galbraith thinks this lasted until around September 3, 1929 when these previous relationships began to reverse themselves.

The Crash

Galbraith begins this section by pointing to the peculiar relationship that businessmen and politicians tend to have with the meaning of movements in the stock market. One such view is that the stock market is a slightly delayed indicator of the situation prevailing in the economy as a whole (in this case, the crash just reflected a reality check). An opposing view is that the stock market is, in fact, the canary in the coal mine (where the crash actually told us where the market was going). Still others think that the stock market confounds both of these views all the time, and is thus a poor measure of any economic "fundamentals". A final view is that the stock market does, in real time, represent the actual state of the economy. Furthermore, each of these views seems to have its own day in following the business cycle. During a boom, many people believe the stock market has it right. During the bust, the foreboding and the correction camps fight it out. Near the bottom, it is usually the sense of disillusionment that dominates. Then, back to the foreboding and correction camps on the way up, until people decide again that the market is "right".

Things Become More Serious

Galbraith opens this section up with a marvelous quote describing what followed the crash of 1929: "The singular feature of the great crash of 1929 was that the worse continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune." (Galbraith 180). Indeed, one of the features that distinguishes our Great Recession from the Great Depression is that there are notable sections of our population who seemed to be missing out on the misery, or actually profiting from it.

During the period following the crash, investors and speculators seemed to realize in great numbers that not only were they wrong in believing that the price of their holdings could only go up, they were wrong in believing that they had the slightest idea what the prices of their holdings actually were. Panicking investors, banks, and other financial entities tried to dump their assets only to find that there was no one to dump them on. Attempts at organized support, by asserting that corrections had been made and the market was now sound, failed at every turn, taking public confidence to new lows each time.

Aftermath I and II

In this section, Galbraith turns his attention to some of the socio-political phenomena that followed the crash, discussing how they related to modern society in general.

1. The tales of mass suicides by wealthy businessmen was more rumor than anything else, but it says something about the effect of the crash on the country's imagination.

2. There seems to be a cycle of embezzlement that is related to the business cycle. During booms people are freer and less careful with their money, so the supply of embezzlement or "bezzle" increases. When a crash comes, and people start to look to their funds, people uncover the previous fraud, and the supply of bezzle shrinks. This was particularly evident in the boom and bust of the Great Depression.

3. A classic political method designed to restore confidence is the "no business" meeting. Here, officials meet with no real agenda, besides portraying an image of action and control to the public.

4. In the great congressional circus that sought to get at the cause of the crash and the depression, many of the former captains and titans of industry found themselves suddenly unable to recall any particular transactions that they engaged in prior to the crash.

Cause and Consequence

In an effort to help understand the causes and consequences of the Crash and the following Great Depression, Galbraith first takes note of five weaknesses in the American Economy around 1929.

1. An unequal distribution of income that was quite large by historical standards.

2. Inadequate oversight of corporate investment practices.

3. A fundamentally unsound banking system.

4. Predatory trade practices i.e. high tariffs meant to encourage positive trade balances.

5. Poor economic knowledge on the part of policy advisors.

All of these factors could have conspired together to make what would have been an ordinary market correction into something worse. The unequal distribution of income might mean that the sudden collapse in demand due to uncertainty from the crash battered businesses harder than usual. Many of these businesses were already battered by their own speculation in the market. Furthermore, as both individuals and businesses tried to hold more cash for security, they helped bring about a collapse of the banking system (which could not handle such a large demand for currency). During all this time, policy advisors wrongly advocated austerity measures (balanced budgets etc). The result of this: a decade or so of misery.

Too Long to Read Summary:

Galbraith's book "The Great Crash", discusses the stock market crash of 1929 and its connection to the Great Depression. He argues that individuals and firms got carried away with economic growth in the roaring twenties, and started taking on risks they did not fully understand. For years, it seemed validated by rising prices. When it became evident that something had to give, most institutions and political figures were hampered by doctrines of austerity or fear of causing a violent correction. When prices reached a point that too many individuals wanted to take their profits, the market collapsed. Prices went from certainly increasing to unknown. Overleveraged firms and individuals quickly became insolvent. Attempts by politicians and businessmen to support the market by declaring the correction completed, failed at every turn. The general destruction of perceived wealth helped destroy projections of demand by businesses, and preference for liquidity lead to collapses of the banking system and credit markets. This resulted in a decade or so of misery.

Tuesday, August 24, 2010

The Tragedy of Capitalism According to Schumpeter

I first learned of the famous Austrian economist Joseph Schumpeter as I imagine most economics students do, by his concept of creative destruction. In several of my classes, this merited a footnote or a short passage in a few of my textbooks. In its simplistic form, creative destruction is just the acknowledgement that capitalism is dynamic. That the process by which firms compete, perfectly or imperfectly, takes place over time. And, over time, many of these firms are destroyed and replaced by new firms with better ideas and more motivated owners. This, according to Schumpeter, is the real characteristic that makes free market capitalism so good at raising standards of living.

In studying his most famous work, Capitalism, Socialism, and Democracy, I soon learned that creative destruction is just one part of Schumpeter's work. It is part of, and integral to, his attempt to describe capitalism and its future. Thus, I shall present my interpretation of this system, so that the reader can understand the mind behind creative destruction.

*One important note about Schumpeter is that he seems preoccupied with the concept of
someone being right, but for the wrong reasons. A memorable phrase from his book is, "A prejudiced man may yet speak the truth." He seems to enjoy setting his peers straight by
providing his own logic to justify what they already believe.

Now to the Book:

The Main Argument: "The thesis I shall endeavor to establish is that the actual and prospective performance of the capitalist system is such as to negative the idea of its breaking down under the weight of economic failure, but that its very success undermines the social institutions which protect it, and 'inevitably' creates conditions in which it will not be able to live and which strongly point to socialism as the heir apparent" (Schumpeter 61).

1. The first four chapters of CS&D cover Schumpeter's thoughts on Marxism, which I will not belabor. It should suffice to say that the thesis of this book shows, in my opinion, that Schumpeter thinks Marx is right about the future of Capitalism, but for the wrong reasons. Thus, I will skip discussions of Marxism and save them for a later post.

Chapter V: The Rate of Increase of Total Output
  • Despite periodic recessions, robber barons, and the Great Depression, the western world experienced an average annual growth rate in total output of about 3 percent from 1870 to 1930.
  • This growth has not come at the expense of the poor, as socialists claim. On the contrary, mass production and electrification are examples of the nearly incalculable benefit to the masses of capitalism, while doing very little to improve the standards of living for the very wealthy.
  • The true frustration with capitalism in this period comes from the fact that, despite its remarkable success, it does not yet have the resources to cope with the bouts of high involuntary unemployment associated with the business cycle.
  • Since classical economics, with its comparative static analysis, denies the possibility of involuntary unemployment, it fuels socialist criticism by its inability to explain the business cycle.
  • However, if output continues to grow at this same rate of 3 percent, the capitalist engine will produce enough resources to properly aid the unemployed.
  • Neither the classical economics, nor the socialist economics, can properly explain this continued growth in output.
Chapter VI: Plausible Capitalism
  • In order to determine if output will continue to grow at a rate high enough to alleviate the involuntarily unemployed, one must discern a causal relationship between capitalism and output growth, and understand the mechanism by which this is achieved.
  • Free market capitalism, and the Bourgeois society associated with it, has fostered a more meritocratic elevation of individuals than any previous social structure. Thus, it should at least be concluded that capitalism fosters a more efficient distribution of talents and skills than past economic paradigms.
  • The classical economists were of the opinion that the self interest motive was channeled by free market capitalism in a way that benefited the whole society, and were staunchly against feudal and mercantilist practices. They would immediately attribute the steady rise in output to capitalism.
  • The chief contributions of the classical economists were the observation that the profit motive was actually beneficial to society, and that properly channeled savings were necessary to some degree for aggregate output to grow. But the logic behind their conclusions is flawed.
  • The neoclassical economists, such as Marshall, Walras, and Wicksell, refined the classical observations with partial and general equilibrium analysis which led to the exposition of the First Welfare Theorem. However, the strong assumptions behind this proof make its application limited.
  • The presence of some degree of market power in almost all industries mean that there may be multiple or no static equilibrium in most industries, and that there is no reason to assume that even these equilibrium are efficient. Thus, as Keynes also said, while the neoclassical proof is valid, it is also irrelevant.
Chapter VII: The Process of Creative Destruction
  • Though some degree of imperfect competition seems to be the rule, and it was the case from 1870 to 1930, it can still be true that output growth was due to capitalism. But, a better justification than classical or neoclassical views must be offered.
  • Some argue that, in the early 20th century, monopolistic practices began to destroy the perfectly competitive ideal. But, this is a fantasy history with no basis in fact. The truth is that economic growth and monopolization have increased together.
  • In reality, capitalism is a dynamic process of economic change. Economists real area of study should be how capitalism's meritocratic structure constantly allows for the creation of new things and methods, and irreverently destroys the old ones. This is creative destruction.
  • If it is understood that the timing of creative destruction is uncertain, but its movement is inevitable, monopolistic practices take on a new meaning. High prices, product differentiation, and advertising efforts, are all attempts by firms to extract the most profit from their products, while they last.
  • This will appear inefficient from a static neoclassical perspective, but a statically inefficient process can be dynamically more efficient. And this is true in this case.
Chapter VIII: Monopolistic Practices
  • Taking the process of creative destruction as given, many monopolistic practices turn out to be an attempt to secure long-term investment from the majority risk averse populace. Without them, the extreme uncertainty would make most investment unprofitable.
  • This also explains why price rigidity is observed in many firms over the short run, but is completely lacking in evidence in the long run.
  • The Keynesian observation of sticky prices and wages should be considered valid, and is actually beneficial to a real economy. Perfectly flexible wages and prices could actually lead to a business cycle that spirals out of control at the elation or fright of the population.
  • Considering that monopolistic practices allow for wage and price rigidities, allow some security for long-term investment, are increasingly able to exploit economies of scale, and yet are comparatively short lived due to creative destruction, the case is strong that they are actually a socially beneficial result of capitalism.
  • The neoclassical analysis of perfect competition reached the right conclusion about capitalism, but for the wrong reason. Using perfect competition as the measuring stick for social welfare creates fundamentally flawed regulatory structures, and unnecessarily boosts socialist criticism.

The previous chapters made up the heart of Schumpeter's book. His description of the process of capitalism was unique, and it has been lasting. I will briefly touch on the third part of his book, which concerns his thoughts on why this system of Capitalism cannot last.

The Fate of Capitalism According to Schumpeter

Like Marx, Schumpeter also believed that capitalism had within it the seeds of its own destruction. Unlike Marx, however, Schumpeter believed that it was the great success of capitalism, and not its shortcomings, that would eventually overpower it. He saw its downfall as an inevitable eventuality, and thought socialism was the most possible successor. Of course, this does not make him a socialist, nor a support of socialism, he saw this as a detached assessment of reality.
The simple fact, according to Schumpeter, is that the Bourgeois class is not a fighting class. It is a pragmatic class. While capitalism has allowed their class to exist and thrive, by their nature the majority don't hold onto it with any kind of religious fervor. Socialists, on the other hand, are endowed with such fervor, and a socialist society requires this religious fervor to function. Furthermore, as the capitalist enterprise grows and becomes more complex, a kind of socialized mentality will become increasingly necessary even within the firms. In the end, the Bourgeois class will not have reason nor heart to fight socialism, and it will take the place of the capitalist paradigm.

Too Long To Read Summary: The Austrian economist Joseph Schumpeter described capitalism as a dynamic process of creative destruction. His book, Capitalism, Socialism, and Democracy, is what appears to be his trademark attempt at explaining why someone is right for the wrong reasons. He believes Marx is right, that capitalism must end, but for different reasons. He believes that the classical and neoclassical economists are correct, capitalism is beneficial to society, but for different reasons. It is the meritocratic process of creative destruction that makes capitalism "good"; perfect competition is not useful for these purposes and leads to misconceptions. Monopolistic practices can actually be beneficial because they give some security in an uncertain world and also exploit economies of scale. Capitalism's demise will be due to the pragmatic mentality of the Bourgeois class, and the inevitable socialist takeover will not necessarily be an improvement.

Tuesday, August 17, 2010

From Keynes to Friedman, and Back Again!

As many undergraduates are prone to do, I took the words of one of my economics professors without any grain of salt whatsoever, and felt comfortable with the assumption that Milton Friedman was an idiot. However, if you really pushed me at the time, I probably couldn't have told you what it was exactly that made him this way. And, as you might have guessed, in time I noticed that this did not exactly mesh so well with my goal of examining primary sources in economic theory. This discomfort prompted me to purchase The Great Contraction (at an outrages price I might add). This "book" is actually a section from Friedman and Schwartz's Monetary History of the United States. I'm sure I'll get to it all in due time, but for now, I've only read the most famous chunk. Part of me thinks it is
inappropriate to discuss this work before I've covered The General Theory by John Maynard Keynes. But, "The Great Contraction" is a simpler work, and a kind of commentary within Keynesian theory. This is why, before I touch on the major points of the work, I'd like to skip a bit through time and tell you how I felt after reading both Keynes and Friedman.

I began to read "The Great Contraction" with a determination to throw away all my presuppositions about Milton Friedman. When I finished it, my mind had been changed. He is a talented historian, a relatively thorough economic theorist, and he makes convincing arguments. However, after reading Keynes, I found his work to possess a degree of genius far superior to Friedman. And, in fact, Friedman's contributions are largely indebted to the superior intellect of Keynes. Thus, my esteem for both economists increased absolutely, but I still feel that Keynes comes out on top.

As for "The Great Contraction"

1. The argument that Friedman and Schwartz make is that the severity of the Great Depression (1929-1933) can to a great extent be explained by FED policy that allowed the Money Supply to collapse. This happened both by allowing banks to fail, and using discount rate in conjunction with open market operations in contractionary ways. This froze credit markets and destroyed the already weak incentive to invest, and might have been the catalyst for turning the recession into a depression.

2. They make this argument by referring to several historical "episodes". Their goal is to use these episodes to extract a causal relationship between FED policy, the money supply, and the overall direction of the economy. The episodes are:

*The Stock Market Crash (October 1929): This event is known to most. The crash, and the great economic uncertainty that arose thereafter, gave individuals the incentive to hold cash. Thus, not only was a great deal of wealth wiped out by the crash, but the desire to hold cash meant less money for banks to lend out. Thus, the money supply contracted. The recession begins.

*First Banking Panic (October 1930): Runs on banks, prompted by fears about their solvency, actually cause major banks to fail. The FED largely chooses a policy of inaction, thinking it is proper to punish bad banks. The Money Supply shrinks further. The recession deepens.

*Second Banking Panic (March 1931): Continued uncertainty about the soundness of banks sparks a more violent run. Banks try to dump assets on the market to satisfy their depositors, these assets promptly plummet in value. More banks fail, and the Money supply shrinks further. The recession deepens.

*Britain Leaves the Gold Standard (September 1931): The UK severs its ties to Gold, because it feels it can no longer follow the deflationary spiral that seems to be in place. Fears that the US will follow prompt speculators to attack the dollar. The FED raises the discount rate (a contractionary measure) to restore confidence in the Gold Standard. The depression deepens.

*FED begins Expansionary Policy (April 1932): After years of inaction or contractionary policy, a faction in the FED raises enough support to experiment with expansionary Open Market Operations. The Money Supply expands. The depression eases!

*FED Expansionary Policy Terminated. Third Banking Panic Ensues. Glass-Steagall is Passed. Banking Holiday is Declared (1933): Factions against Expansionary policy regain control and terminate Open Market Operations. Another Banking Panic arises, and President Roosevelt responds by declaring a Banking Holiday. Glass-Steagall expands the powers of the FED. Money Supply shrinks. The depression returns.

3. Apart from this historical evidence, Friedman and Schwartz attempt to explain the seemingly odd behavior of the FED during this time. They assert that, following the death of a man named Benjamin Strong (a powerful influence in the FED), the collection of central banks lost their center of leadership and essentially suffered from gridlock. Friedman, a staunch Libertarian, might be expected to approve of this--but he doesn't!. This is because the FED was designed specifically for the purpose of keeping an eye on the economy through the money supply. Banks that suffered from a run counted on their help--and they did not get it.

4. True to his Libertarian roots, though, Friedman does point out that the banking system prior to the FED had a policy of acting together to restrict the ability of depositors to take out their funds. Thus, they had an internal mechanism for halting runs on banks. The FED dismantled this tool, and then essentially left them bleeding on the field when the next panic hit.

5. Friedman and Schwartz make the case for the preventative measures that should have been taken. Namely, that the FED should have taken action to maintain the money supply. The reasons for doing so can best be expressed by Friedman and Schwartz:

"Because no great strength would be required to hold back the rock that starts a landslide, it does not follow that the landslide will not be of major proportions."
--Friedman and Schwartz (pg 207).

Too Long To Read Summary: I assumed Milton Friedman was an idiot, and I was wrong. Still, I find Keynes to be the better economist. Friedman and Schwartz make a convincing argument that, in allowing the money supply to contract too far (and thus depressing credit and investment), the FED worsened the Great Depression. This happened due to a failure of leadership in a centralized organization that was designed to lead. The FED should either do this job, or return their powers to the banks. And, finally, just because something is easily preventable, doesn't mean it isn't serous.

Saturday, August 14, 2010

Economics and Net Neutrality

Given the current popularity of the subject of Net Neutrality, I thought I might present some of my own work on the subject, and point out some of my conclusions. I would first state that the goal of all of my work here is to share knowledge of economic theory and issues that I have acquired from exploring primary sources. Thus, it would be quite hypocritical of me to not urge you to check out my references for yourselves. This literature review is the culmination of my work in a graduate course on Public Economics. As far as peer reviewing is considered, it was criticized and revised according to the instructions of my Professor, and underwent further revision as a result of my correspondence with the author of the primary work I used for my analysis (Special thanks to Dr. Christopher Swann and Tim Wu). Most of the literature review material is my interpretation of other sources; the section on game theory, however, is to the best of my knowledge the result of my own unique application.

Having said all this, feel free to use any part of it at no cost other that the time it would take you to create a proper citation!

Net Lit

Too Long To Read Summary: The principle of net neutrality in the economic sense boils down to determining the effect that allowing firms in this market to differentiate their products would have on social welfare. Supporters of net neutrality claim it is a method of leveling the playing field, which encourages competition, and is beneficial in the short and long run. Opponents assert that forbidding product differentiation destroys the incentive to innovate, and is costly to enforce, making it harmful to social welfare in the long run.

I believe that the case is strong for market failure in internet service, and that specific net neutrality regimes based on price discrimination go a long way to reconciling both sides and providing a solution. This solution involves giving the FCC the legislative authority to preserve net neutrality, when it feels the principle is being violated, without legally compelling them to do so. Using this power as a tool of moral suasion could preserve the incentive to innovate, and protect the consumer.

Wednesday, August 11, 2010

A Mix-up at the Ludwig von Mises Institute

In the fall of 2009, I decided to order a book by the relatively mysterious but acclaimed economist Richard Cantillon. Due to his emphasis on entrepreneurship, I found that the Ludwig von Mises Institute had his work "An Essay on the Nature of Commerce in General". I ordered it, and in a few days I received "An Essay on the nature and Significance of Economic Science", by Lionel Robbins. I informed LMI about their mix-up, and like the good free market junkies that they are, they sent me Cantillon's book and allowed me to keep the one by Robbins. Yay Capitalism!

My interpretation of Mises and Cantillon will come later; suffice to say I decided to read Robbins essay. In this essay, Robbins seeks to clarify subject-matter of economics in general and discuss the limitations that its approach imply. Here is what I found:

1. Robbins feels that the common sense definition of economics as a study of wealth and its generation is mistaken. Rather, he argues that economics is the study of the behavior of agents when they face constraints or are endowed with scarce resources. This is a reiteration of the idea that economics is the study of scarcity.

I tend to disagree categorically with this definition. I think it applies to microeconomics. It is certainly true of the theory of the firm and consumer demand, but I think macroeconomics is exactly concerned with the study of wealth and its generation.

2. Economists should not judge the end goods to which individuals strive, nor are they meant to give advice concerning the technique used to achieve those ends. It is the way an individual prioritizes multiple ends and multiple means that interest economists.

Once again, I would categorically disagree concerning macroeconomics.

3. Scarcity has powerful roots in the perceptions of human beings, and it determines value to a great extent. One can easily recall seemingly priceless fad items that become worthless overnight, when the next rage hits.

4. Economists care about how the the relative individual valuation of scarce goods affect their individual decisions and others; they are not concerned about the origin of these differences in value, that is psychology or sociology.

5. Economists should not make comparisons between individual utility functions. This means that just because person A has higher utility than B according to our measurement, we have no grounds for assuming that A is happier than B or for transferring goods from person A to B. These values only matter within individuals. This is called incommensurability.

6. In the end, economics only really applies if we do make the normative judgement that rationality and coherence of ends and means are desirable. If this judgement does not hold for a situation, the application of economic theory to it is limited.

Too Long To Read Summary: Ludwig von Mises Institute sent me the wrong book, I read it anyways. It defined economics as the study of scarcity and not wealth, which I feel is a better description of the difference between micro and macro. The writer also asserted that economists should take ends and techniques as given, and only analyze the efficient allocation of means. But, to be of any use, economists must make the normative assumption that rational and coherent decisions are "good".

"I am not David Ricardo!"

In the fall of 2009, my graduate program at UNCG had the honor of hosting the famous Nobel Prize winning economist--Dr. Paul Krugman. He gave us a brief but enlightening lecture on exploring the origins and the direction of our recent financial crisis and resulting recession. After the lecture, I was fortunate enough to have time to speak with him. Though I hadn't read any of his books at the time (no longer true), I still wanted something for him to sign. At the time, I was reading David Ricardo's "Principles of Political Economy and Taxation". Since Ricardo was the father of comparative advantage in International Trade, and Krugman's Nobel winning work was in that area, I thought I had enough of a connection to justify using this book to get Krugman's autograph. Of course, he noticed what the book really was, made a quick joke, and proceeded to write in it "I am not David Ricardo!". This leads me to the point of this post: who is, or rather who was, David Ricardo.

While I would consider Adam Smith every man's
Economist, David Ricardo is more of every Economist's Economist. He lived during the early 19th century, and was the man who did the most to turn Adam Smith's work into an extended theoretical model. This model, known today as the classical model, still has a lot to tell us about how economies work and trade. Finally, he also introduced the concept of making use of how changes in increments or margins can inform us about optimal decisions and responses.

Here are the important points in his work, according to me:

1. The relative scarcity of a good with other goods is one of the fundamental determinants of its value, and should be taken in conjunction with its utility to consumers and its marginal production cost.

2. Labor spent on the production of capital (investment), must also factor into the cost of production of goods for immediate consumption.

3. When labor is not the sole input in a production process, but also capital of varying durability, a rise in wages has an ambiguous affect on the price of the good.

4. A rise in wages is most often associated with a fall in profits, and vice versa.

5. The implementation of land, labor, and capital are subject to diminishing returns.

6. A productive activity should be undertaken until its marginal return to the producer just equals the cost. And, if an agent can monopolize this product, it can extract all of the surplus from consumers up to that equimarginal condition.

7. If transactions costs are not too great, labor and capital will gravitate to where they are most productive, reducing the return in these industries to the average return, which is set by societal preferences and institutions.

8. All else held constant, the wages of the worker tend to fall toward the subsistence level, which is also set by societal preferences and institutions.

9. Wages tend to rise as the economy grows, because of the diminishing returns to the cultivation of land (perhaps no longer true).

10. If children are normal goods, rising wages mean a rising population, which will erode wage gains. Thus, making children inferior goods might be beneficial to workers in the short run.

11. Profits fall as the economy grows, assuming there is no improvement in technology or the division of labor.

12. As the economy expands and profits fall, wages rise but can be eventually eroded by increases in population. Thus, all else held constant, an expanding economy eventually results in a redistribution of wealth to monopolists.

13. Limited factor mobility within nations allows them to benefit from their own unique division of labor so that they can trade with another nations in a way that can leave at least one party better off without leaving any others worse off. This is true absolutely as well as comparatively.

14. Attempting to control the balance of trade by laws or taxes will either be totally ineffective, or leave both parties worse off in the long run.

15. In a static economy, the consumption of the government must eventually come out of wages, rent, or profit. They ultimately require workers, entrepreneurs, or landlords to reduce consumption or to liquidate capital stock. Either of these can be harmful to overall national output.

16. The ability of a tax to meet Adam Smith's requirements depends on elasticities of demand and the availability of substitute goods.

17. In the long run, the money supply should not affect the equilibrium output of an economy. (Take this with a huge grain of salt, and think about the limitations of this true statement).

18. Placing a tax on goods that a country exports and has a significant comparative advantage might be the least disruptive to overall output.

19. Profit inequalities are what determine the flow of capital at home and abroad.

20. Increasing output per capita should be the overall goal of all national economic policy.

21. An increase in value, and an increase in riches are NOT the same thing. A product can increase in value by becoming scarcer or harder to produce. This will reduce the wealth of society. Thus, declining value of products is usually a sign of the increasing wealth of a nation.

22. Increasing output per capita through the division of labor and technology is better that relying on pure savings and capital formation.

23. Real interest rates are ultimately governed by expected profits, but these are so volatile in the short term that any point estimate is usually unreliable.

24. Monopolists have more to gain from from protectionist policies than those facing competition.

25. Paper money is a good that derives its value most from its scarcity.

26. Banks are, by their design, vulnerable to consumer panics. Thus, no private bank should be allowed too much control over the money supply.

27. The economy as a whole benefits from substituting machines for workers, but the workers themselves may be harmed by frictional unemployment. Wealth redistribution of the surplus generated by the machines can compensate for this inconvenience.

28. Classical Doctrine for Output Growth: Division of Labor ==> Increased Savings ==> Capital Accumulation ==> Output Growth ==> Increase in Labor Demand ==> More Workers ==> Division of Labor.

Too Long to Read Summary: Paul Krugman signed my copy of David Ricardo's book. Ricardo formalized a lot of Adam Smith's work with his classical model of an economy. He argued that long run production costs at the margin make up natural prices, wages and profits move inversely, wages gravitate to subsistence levels and profits to zero as the economy expands, international trade is not a zero sum game, paper money should be regulated, monopolists play the subversive role of Adam Smith's Merchants, and the end goal of economic policy should be growth in output per worker.