It is possible that economics could once again become useful

The entrepreneur is the missing ingredient in economics about which I have written. What cannot be linked is the paper I did on “The Absence of the Entrepreneur in the Economic Theories of the English-Speaking World”. What there is a link for is Origin and Evolution of the Term “Entrepreneur” in English, unpublished alas but available online.

But when it comes to the study of entrepreneurship, the names that matter are William Baumol and Israel Kirzner. Baumol has unfortunately gone to his reward, but Kirzner, bless him, at 88 has now been formally recognised by the American History of Economics Association. The citation below virtually leaves out his work on the entrepreneur but still does focus on his Austrian perspective. But even in awarding him the Distinguished Fellow Award, they also added, “our recommendation is, of course, based on his scholarly contributions and not on his political views”. Heaven forfend that that anyone should think that his political beliefs should matter, but you may be sure that they did. Nevertheless, here we are. There is also finally recognition that mainstream economics has no penetration in allowing us to understand how an economy works. A straw in the wind, but a good sign all the same.

The 2018 HES Distinguished Fellow Award was presented to Israel Kirzner at the recent HES conference at Loyola University, Chicago. Several strong candidates were proposed by the membership this year. The nominating committee, formed by Robert Leonard, Jeff Biddle and Mauro Boianovsky (chair), unanimously agreed that the most deserving of these candidates was Israel Kirzner and recommended to the HES Executive Committee that he should be the recipient of the HES Distinguished Fellow Award in 2018. The nominating letter was submitted by Peter Boettke, together with supporting letters by Bruce Caldwell, Karen Vaughn and Mario Rizzo. Our recommendation resulted from our consideration of several aspects of Kirzner’s work and career.

Born in 1930, Kirzner is well known as a leading scholar in the Austrian economic tradition. His work forcefully illustrates how the history of economics can be used as an important heuristic tool to cast light on current economic research. In that sense, Kirzner shares with members (e.g. Stigler, Robbins, Dobb, Viner, Galbraith, Schumpeter, Hayek, Patinkin and Sraffa) of what Craufurd Goodwin used to call the “Golden Age” of the history of economic thought (HET) a commitment to understanding economic problems through the use of HET as an analytical device instead of a separate sub-discipline. As put by Bruce Caldwell, “precisely because he works within the Austrian tradition, Kirzner often draws on history to make comparisons between the view he endorses and those he criticizes, and often the criticisms are methodological”. This shows especially in his main books The Economic Point of View (1960), Essay on Capital (1966) and Competition and Entrepreneurship (1973).

The highlights of Kirzner’s specific contributions to the history of economics are his 1994 edition of Classics in Austrian Economics (which includes a number of essential translations) and several essays on Von Mises and particularly Carl Menger. As pointed out by Karen Vaughn, Kirzner has been instrumental not only in explaining Menger’s ideas as the founder of Austrian economics, but also in encouraging a revival of interest in his writings. Moreover, as observed by Mario Rizzo, Kirzner is not just a historian of Austrian economics – for instance, in his works on the theories of profit and capital, Kirzner discusses carefully contributions by J.B. Clark, F.B. Hawley, F. Knight, I. Fisher, J. Schumpeter and others.

Kirzner has produced a body of work deeply imbued with a historical-philosophical sensibility. Although our recommendation is, of course, based on his scholarly contributions and not on his political views, it should be noted that Kirzner has shown that it is possible to combine political beliefs and scholarly scruple, and that this has been a source of inspiration for his followers, in whom we see that same attitude perpetuated.

The economic role of saving

There are two ways to understand the word “saving”. It is either:

(1) deferring the use of one’s purchasing power to a later date

OR

(2) that part of the capital, labour and other existing resources of a community that are used to maintain and extend the productive apparatus of an economy.

If you confuse (1) with (2) you will never understand how an economy works. (1) is of course modern and Keynesian, while (2) is classical and Austrian.

But these things are very very difficult to keep straight in the midst of analysis unless you really have the distinction absolutely clear.

Let me therefore take you to a sad example of how these issues became muddled in the midst of an interview with an Austrian economist who was trying to explain (2) to someone who thinks only in terms of (1). This is the title, Our Obsession with Consumption — while Ignoring Saving and Investment — Is a Big Problem. I have adopted his explanation from his Austrian treatment and translated into how things would be looked at from a classical perspective.

In economics today very little attention is given to the role of savings. This is a very curious situation.

There can be no production without prior saving.

Nature on its own provides us with only very few consumer goods eg apples on a tree.

For anything more, we must first produce the goods that we then afterwards can consume.

But to produce these goods we must first devise and construct tools, instruments or machines.

But to devise and construct tools, instruments or machines we already need a stock of already existing tools, instruments or machines. This stock is what is meant by “saving”.

Without prior savings no increase of future consumption is possible.

But then the interviewer asks this question, which transfers the issue from (2) to (1).

Do the current saving systems for retirement in the West work? If not, with what should they be replaced?

Suddenly the issue is about the future real potential purchasing power that lies behind money saving in the present. And from there the conversation never gets back to the need to widen and deepen our productive capabilities. They do go on to discuss who should make the decisions on what capital to build but by then it is too late.

The real problem for me is that even the interviewer, who was trying to provide soft questions so that the issues could be explained clearly, was too muddled himself and never allowed the interview to go where it needed to go, so another opportunity to make things clear disappeared.

The ongoing scandal of modern economic theory

Here’s the sub-head: Economists show increased research efforts are yielding decreasing returns. And if they mean negative returns, then I am with them all the way. Economic theory is at a lower level of competence today than in the 1850s. It is such a scandal, but once a subject matter falls into a hole the way economic theory has done, it is near on impossible for it to find its way out. The conclusions drawn from modern theory are literally classical fallacies. An economist raised any time between say 1776 and the 1930s would look at a modern text and disagree with almost every word. There would be almost no overlap between anything found in a modern text and a text written before 1930.

I wrote a paper, published by the skin of its teeth in 2015, on John Stuart Mill’s Fourth Proposition on Capital: “demand for commodities is not demand for labour”. You cannot increase the level of employment by increasing aggregate demand. Everyone once knew this. No one now does. Not one economist in a thousand can any longer understand what was plain as day for a century and a half. We keep growing because we keep inventing things. But the generation that is following behind us will find their living standards falling into a great pit, and the last place anyone will be able to find out why will be from economists.

I have mentioned this already, but perhaps another look might be of interest: What is the difference between Keynesian and classical economics? which is a reply I put up on Quora. Go have a look.

Then there’s this I did not so long ago on marginal analysis which, as presented in a modern text, is as near to empty of content as a theoretical demonstration can be. This is how I look at it which is also classical to its bootstraps.

The diagram represents my own version of the marginal revenue and marginal cost diagram. The traditional version has a series of lines many of which can never be realistically drawn (such as the demand curve), with the ultimate point to show the price-quantity configuration for the sale of a single product. The conclusion is that if a firm wishes to maximise profitability on the sale of some good or service, it will price the product just exactly where a lower or higher price would lead to a lower return over cost. Fatuous and useless, with many bits of the real world left out, such as the actual ability to work out the effect on revenue of changing a price. Modern micro truly is as useless as modern macro.

The above diagram – discussed fully in my Free Market Economics – brings in a number of crucial factors:

  • it is about whether some decision should be made rather than deciding on what price to charge
  • it is about trying to make a decision in the face of a future that can never be foretold but is filled with endless uncertainties
  • it recognises that there are costs that almost invariably must be borne before there is a return [Area A]
  • costs continue even after revenues commence and only eventually, in a profitable venture, will revenues exceed costs [when B = A]
  • the point of origin is the present moment when some decision must be made – all of the lines drawn are the expectations of the decision maker
  • reality may turn out to be much different, with losses instead of a net positive return
  • only when total revenue and total costs are equal – that is, when the expected addition to revenues is equal to the expected addition to costs (when MR=MC at the moment the decision is made) does the firm go ahead with the venture

This is the way a business, or anyone else for that matter, makes a decision: in the present with only one’s own conjectures as a guide.

I will lastly mention a very nice note I received the other day:

Steve

Just finished reading your book Free Market Economics and wanted to congratulate you.

I have read plenty of economic texts, but yours is the best by far and helped crystalize a number of things that have been swirling around in my mind.

Great work.

It was truly appreciated. You can get a copy for yourself right here. I didn’t make any of it up myself. It is just a distillation of classical theory, the economics of John Stuart Mill and his contemporaries. It’s never been improved on and I doubt it ever will be. But so what. It is a massive improvement on that junk science we go around teaching today.

Me – a different me – in 1968

Where was Jordan Peterson then to tell me what I needed to know:

“It’s what I tell 18 year olds. Six years ago you were twelve. What the hell do you know? You’re under the care of the family or the state, you haven’t established an independent existence, you haven’t had children, you haven’t started a business, you haven’t taken responsibility for anything, you don’t have a degree, you haven’t finished your course, you don’t know how to read, you can’t think, you don’t know how to present yourself, well Jesus, it’s not right to tell people in that situation that they should go out and change the world.”

And while this was taken in Toronto well before I came out to Oz, the hat I am wearing was an Australian soldier’s slouch hat which I wore for many years!

The difference between Keynesian and classical economics

Just posted on Quora in answer to the question: What is the difference between Keynesian and classical economics? There are 13 other replies which not much more than prove to me that no one without a truly specialist knowledge of classical theory would have the slightest idea what an economist between the late eighteenth and nineteenth centuries would have understood about anything in relation to the operation of an economy. Their ignorance of what classical economists believed is matched by their ignorance of how an economy actually works. Anyway, this is what I wrote.

The differences between classical and Keynesian economics are so vast that to accept one version of how an economy works means you must reject the other. Classical economic theory is the theory that was developed between let us say 1776 and the 1870s, almost entirely by philosophers and business people who were actually looking at the economy. Modern economic theory has almost entirely been developed within universities by people who have neither a philosophical training nor have ever run a business as their primary mode of earning a living.

Here’s the difference. Classical economic theory begins from the existence of a market economy in which, on one side of the equation, there is a mass of people who would like to buy goods and services, and on the other side there are people who would like to earn their living by producing and selling things to others. The producers continually try to work out what to produce that others will buy, and do it by trying to decide what buyers will pay enough for in total to cover their production costs. These producers hire employees and the combined incomes of producers and wage earners become the purchasing power of the community.

Classical economic theory is thus entirely supply-side driven. And what is particularly interesting about reading the classical literature is that government regulation was an important part of how the economic system worked. The very first Factory Act in Great Britain was introduced in 1802, and there were many others that came after. The notion that classical economics was simply leave everything to the market is 100% wrong. If you look at the greatest economics text of the era, John Stuart Mill’s 1848 Principles of Political Economy, the final 200 pages are devoted to discussing the role of government in ensuring that economic activity was carried out in a morally acceptable way to the benefit of the entire community.

But crucially, classical theory assumes the role of the independent entrepreneur as the linchpin in making an economy work. Try to find a modern economic text that starts from there. Other than my own – Free Market Economics, Third Edition – none of the major mainstream texts starts from the supply side and none – as in zero – feature the role of the entrepreneur.

Keynesian economics assumes economies are driven from the demand side. That is, it is buying goods and services that makes an economy grow and employ, not their production. It is based on the total confusion between the demand for a single product – the greater the demand for shoes the greater the production of shoes will be along with the greater the level of employment for shoemakers. Demand affects individual products; demand in aggregate does not affect the level of output in total. The more that is produced, the higher the level of demand, for the obvious reason that the more that is produced, the more there is that buyers are able to demand. But if you are a Keynesian, you will go on believing that the cause of higher output is higher demand, whereas the reason more can be demanded is that more output is being produced. Public spending may have many benefits, but increasing the level of income and speeding up the rate of economic growth is not one of them. If anything, higher levels of public spending slow things down and lower real incomes below levels that otherwise would have been reached.

Keynesian economics is based on the fallacious belief that buyers will not buy as much as an economy can produce, and therefore demand must be stimulated to ensure everything produced is bought and that everyone who wants to work is employed. A great theory if you are in government and need a justification for taking as much money as you can get away with from income-earning citizens and spending it yourself. But a pernicious theory if you are interested in raising living standards as rapidly as possible.

 

A lesson in trade theory

“Every economic answer is a political question.”

Here then is a question for all you experts on international trade, taken directly from my Free Market Economics [pp. 248-249]. Picture two countries, A and C.

Suppose in Country A, in one hour it can produce either one car or 1000 shirts. [It’s also the same answer if Country A can produce ten cars and 10,000 shirts per hour!]

Meanwhile in Country C, in two hours it can produce either one car or 500 shirts.

According to the economic theory of comparative advantage, how many cars will Country A produce? OK, once you’ve worked that out, now tell me if you get the same answer using common sense. As chrisl said, “economic theory is all right in theory”. Personally, I’m not even sure of that, but you get the idea.

So here’s the thing. It is entirely possible that the US is tired of carrying most of the burden for the defence of the West and would like a bit of sharing the burden. It might also find some respite for itself in strengthening those parts of its economy which are more closely associated with its defence industries. And it might even wish for some kind of gratitude from others, supposedly on the same side, in trying to assist the US in resurrecting its strength. And then there are the straightforward economic issues, which are not the same as the political. So let us go to these.

And of course the issue economically is comparative advantage, and not pure let the most efficient producer produce each product. With comparative advantage, it is not always the most efficient low-cost producers who produce. If you don’t even understand that, you should keep right out of this debate.

Why encourage free trade:

  • competition is what drives improvement and growth – without competition most businesses would just coast along to the fullest extent they could
  • innovation is driven by competition – the way to take on an established business is to find a better way to do something
  • all other things being equal, free trade is best

Why “free trade” is not working for the US:

  • cheating is rife – try to sell an American car in Japan – not possible for all kinds of products in all kinds of countries
  • many countries subsidise exports while imposing non-tariff barriers to trade on imports along with tariffs themselves
  • currency manipulation – artificially holding exchange rate lower to discourage imports and encourage exports is not unknown
  • $US is world reserve currency it is unable to adjust to repair a balance of payments deficit
  • there are many forms of approved trade restrictions everywhere you look – the EU for example – such as:

Trading blocs

A regional trading bloc is a group of countries within a geographical region that protect themselves from imports from non-members. Trading blocs are a form of economic integration, and increasingly shape the pattern of world trade. There are several types of trading bloc:

Preferential Trade Area

Preferential Trade Areas (PTAs) exist when countries within a geographical region agree to reduce or eliminate tariff barriers on selected goods imported from other members of the area. This is often the first small step towards the creation of a trading bloc.

Free Trade Area

Free Trade Areas (FTAs) are created when two or more countries in a region agree to reduce or eliminate barriers to trade on all goods coming from other members.

Customs Union

A customs union involves the removal of tariff barriers between members, plus the acceptance of a common (unified) external tariff against non-members. This means that members may negotiate as a single bloc with 3rd parties, such as with other trading blocs, or with the WTO.

World Trade Organisation

There are then the WTO rules of trade engagement which are not designed to create a world where free trade is on the only answer. The rules were devised when the US economy was a lot more robust than it now is, and when the US was both willing and able to make sacrifices of all kinds to help others withstand the spread of communism. None of this is applicable today. The US is therefore no longer willing to watch others cheat their way into a stronger trade position, at the cost of its own national security, economic strength and domestic employment. Here is part of what the WTO is up to.

WTO Rules

1. Most-favoured-nation (MFN): treating other people equally Under the WTO agreements, countries cannot normally discriminate between their trading partners. Grant someone a special favour (such as a lower customs duty rate for one of their products) and you have to do the same for all other WTO members.

2. National treatment: Treating foreigners and locals equally Imported and locally-produced goods should be treated equally — at least after the foreign goods have entered the market. The same should apply to foreign and domestic services, and to foreign and local trademarks, copyrights and patents.

3. Developing countries have transition periods to adjust to the more unfamiliar and, perhaps, difficult WTO provisions — particularly so for the poorest, “least-developed” countries – so these basket case economies are allowed to whittle away at the economic strength of the developed world.

Meanwhile, economic ministers around the world increase unproductive public spending every chance they get, add new regulations on top of old, and increase business taxes at every turn, and then job on their chairs screaming, “Eek, a tariff!’

The quote at the top, by the way, is from Joan Robinson, who has quite a lot to say about free trade that ought to be read by the economic illiterates who populate the world, who are now found speaking on behalf of the status quo, as harmful as the status quo is to most of the lower half of the income distribution. Robinson was not just a Keynesian but also a big supporter of Mao, so I’d be very careful, but the above quote seems as accurate as anything else you are likely to hear about economics.

There are Keynesians in even the most unlikely places

This is from, of all places, Maurice Newman’s article in The Oz today on Trump’s news might be bad for his forgotten flock. So which is the absolutely wrong word in this passage?

Despite a decade of easy money, continued fiscal stimulus and a personal savings rate that has tumbled from 6.6 per cent to 2.4 per cent in just 12 years, the US economy during calendar 2017 grew at 2.5 per cent, hardly a number to write home about. Indeed, adjusted for the once-off hurricane rebuild effect, it managed just 1.5 per cent in the last quarter.

It is, of course, the first word, “despite”. If he had said instead, “because of …” then all would be clear. Artificially low rates of interest, high levels of unproductive public spending and falling savings are the very recipe for stagnation.

Ho hum; trillion dollar deficit

us fed debt

Here’s the US debt story with a bit of historical perspective. Here we find an example of Change You Can Believe In care of the blessedly departed Barack Obama. Consequences include slower growth, limited if not actually negligible increases in the real wage, additional upwards pressure on the price level and some additional increases in rates of interest. But really, where’s the constituency to do anything else? How many non-Keynesians are there, never mind anti-Keynesians?

Remember this? Remember how it ends?

What’s changed and how you gonna change it? Still, there are  regulations going and public spending is being better targeted. Large numbers are being peeled from the welfare rolls. Not good, but if the deficit is rising and you’re a Keynesian, what’s the problem? And if you’re not, what are you going to say to convince them otherwise?

Of course, there is then this from Drudge yesterday:

Then there’s this from today:

But then there’s this also from today.

Really, you only wish people knew how things worked, as in some business comes up with an idea, borrows some money to buy in some capital and labour, and then produces that are sold on the market for a profit. There is endless entrepreneurial drive in the US. With a President who is an entrepreneur, who knows what’s possible.

This is classical economic theory

No one can really see it yet but classical economic theory is coming back. This post at Instapundit by Mark Tapscott is presented and discussed in exactly the way economics would have been discussed by the great classical economists between 1776 and 1936. The issue is not about demand. It is about the redeployment of actual physical resources – capital goods – from less productive and even non-productive uses into more productive and positively productive uses. You may think you have heard this said before, because you think that is how economic theory and policy should be discussed, but I keep an eye out for it and this is the first time I have come across anything discussed in that way.

I have posted this paper before – Making Sense of Classical Theory – which is a pre-print of a paper that will appear in the April 2018 edition of the Journal of the History of Economic Thought. If you are at all interested in understanding how pre-Keynesian economists thought about the structure of an economy and what made it grow and flourish, you should read that paper. It describes in theoretical terms how Mark Tapscott explains the sudden flourishing of the American economy. This is exactly how classical economists looked at things.

TRUMP’S FIRST-YEAR BOOM IS LARGELY DUE TO DEREGULATION BUT THINK ABOUT THIS: Merely cancelling an expensive federal regulation doesn’t immediately convert the compliance cost into a potentially productive new investment. The capital has to be reallocated and some time is required for the new investment to produce sufficient return to offset the former compliance costs. Huh?

In other words: “It takes time for the economy to recover the costs of excessive regulatory compliance and to redirect capital to productive uses, so the gains seen during Trump’s first year are likely attributable in significant part to the expectations generated by his slashing the red tape. The full impact of the deregulation is still to be felt.”

And remember, the Trump tax cuts aren’t in effect until February. Wayne Crews of the Competitive Enterprise Institute estimates regulatory compliance cost the U.S. economy $1.9 trillion. Trump can’t repeal all federal regulations but what if his tax cuts and the continuing positive impact of deregulation in coming years produces an economic boom that far exceeds the Reagan era? Ponder that one a bit!

The value of tax cuts is in their ability to divert resource use away from consumer goods and governments into the hands of productive business who are then able to invest. Cuts to regulation play their role by reducing wasted efforts within business in complying with government directions and instead use the resources at their disposal to create value. It works like magic, because to a modern macroeconomist it is magic since they have no means of explaining what was once perfectly well understood by everyone.

C’mon, who’s really clueless about trade?

From Forbes, the kind of thing you find in among Chamber of Commerce types: Trump’s Tariffs Are A Reminder He’s Clueless About Trade. Sure he is, and the evidence keeps piling up day by day. If we lived in a crony-capitalist-free world, and no one ever cheated in their trade relations,* maybe such blanket statements would make sense. But truly lacking in any penetration is the manipulation of arithmetical statistical identities as if they were actual theoretical constructs where a change in one variable is the cause of a change in another. In reality, with such identities, these are accounting balancing items which have no effect on actualities in the real world, but are only a record of what took place.

Now here is where the simple analytics of the trade deficit can be used to prove the cluelessness of the Trump trade team on “trade,” of all things, and the utter futility of its policy prescriptions having any impact on America’s aggregate trade deficit. In economics, identities play an important role. These identities are obtained by equating two different breakdowns of a single aggregate. Identities are interesting, and usually important, by definition. In national income accounting, the following identity can be derived. Indeed, it is the key to understanding the trade deficit.

(Imports – Exports ) ≡ (Investment – Savings) + (Government Spending – Taxes)

Given this identify, which must hold, the trade deficit is equal to the excess of private sector investment over savings, plus the excess of government spending over tax revenue. So the counterpart of the trade deficit is the sum of the private sector deficit and the government deficit (federal + state and local). The U.S. trade deficit, therefore, is just the mirror image of what is happening in the U.S. domestic economy. If expenditures in the U.S. exceed the incomes produced in the U.S., which they do, the excess expenditures will be met by an excess of imports over exports (read: a trade deficit).

This is the same as fiddling with Y=C+I+G and pretending that an increase in G can cause an increase in Y. Complete sophistry. There is much more to say about free trade and I have been meaning to say it for a while. This might therefore be what finally stirs me to spell it out in more detail, but this will have to do for now.

* See, for example, Australia takes Canada to WTO over rules on selling wine. My dual nationality obviously makes it impossible for me to see the rights and wrongs of this, but let me say that no Australian will ever understand the liquor laws of Canada, which were introduced as temporary measures during World War I. There’s a lesson in there as well.