Archive for May, 2009

A freemarket of fools

May 30, 2009

So I’m switched on to the McAlvany podcast which makes for really good and easy listening since I found it through the InvestmentPostcards blog. My late father, Jos Gerson, who got his PhD in Economics under Professor Harold Demsetz, would have I’m sure enjoyed this kind of Chicago Economics style programming. It’s especially interesting for me as it fills in some areas missing from my limited economics education. Most of what I learned in my 2 years of undergraduate economics at the University of Cape Town came from my dad ranting about how outdated the Keynsian textbook was. In fact I’m both a little embarrassed and proud to admit that I only went to one lecture in my entire 2nd year course. I didn’t see any point wasting my time when I knew that the exams would all be set out of the textbook material. Although my dad went on at length about the work of Milton Friedman, he never mentioned the likes of Hayek to me. Well nothing that Wikipedia can’t fix… 🙂

I do have an issue though with the two recent podcasts I have been listening to, interviewing Thomas Woods Jr. and Walter Block. The theme of both episodes is how the US Central Bank’s tampering of the money supply is largely responsible for the current recession.  Thomas, siting Hayek, stating that the Fed is responsible for the whole boom and bust cycle and Walter saying largely the same thing advocating that a gold standard would be a more responsible system. Although I think that they might have valid points overall, I think that their arguments are overly simplistic and to blame the Fed entirely is unfair.

First off, bubbles have occurred under the gold standard since it was formalized in the early 1700s. The railway speculation around the world in the 19th century was very real and ultimately very painful for a lot of people who didn’t get out at the right time. To deny the gravy train phenomenon as part of human make up is to be very naive. People want in on the action they perceive others to be enjoying. It’s why McDonalds would pay 1000 people to stand in line for a new product line release. I’ve also heard of experiments of people joining bogus queues simply because they existed without knowing what they were for but I can’t find the links. Unless detractors of the Fed are going to make claims that the gold standard wasn’t enforced properly during these periods, which I’d like to see evidence for, I can’t see how a completely slanted view of the Fed is justified. It’s not true when Mr Wood says there is no reason for stating the Free Market comes part and parcel with boom and bust cycles.

Here in South Africa, the Reserve Bank (Fed equivalent) has a policy of inflation targeting given that they’d like to ideally keep the price of bread constant for the masses of predominantly poorer population. This means that although there are pressures that would influence the Reserve bank otherwise, usually the way rates move are quite predictable to the private sector in theory. So how is this then reconciled with Mr Woods’s idea that people don’t know the true value of their own wealth? The McAlvany podcast spoke of inflationary pressures in the bond market and the housing market. The fundamental formulae that tie bond pricing to interest rates and longer term trends in terms of both the housing market and the bond market are public knowledge. So unless the Fed/Reserve bank moves rates in ways that come as a surprise to the market, I don’t understand how one can blame the Fed entirely when the market over-inflates these asset classes. The analogy about giving a builder more alcohol tries to blame the would be barman for the fact that the builder actually drinks the alcohol. This is separate from government stimulus which is the barman drinking his own alcohol.

Having said this, I do potentially agree with Mr Block’s assessment that the Fed may do more harm than good. Mr Block more obviously acknowledges that the boom and bust cycles exist but could be shorter lived. I actually do believe that in theory the Fed could help to smooth out the boom and bust cycle, but in practise it is unlikely to ever work. The incentives not to spoil the party during good times are simply too strong for any politically appointed body. Standing stead fast to a policy of price stabilization is just too hard.  However the gold standard brings the risk of deflation if gold is not dug out of the ground at the same rate as legitimate production increases. Mr Block mentions that deflation is not a bad thing for computers and cars. In fact it’s a brilliant thing when deflation happens with consumable asset classes and those involved in the means of production. The population expects this and it means that everyone is richer in real terms and can produce more. The problem is when deflation happens in those asset classes used by the population for the preservation of wealth. This is not a happy thing as it means everyone is poorer in real terms. To fully convince me, Mr Block would have to present a model which shows that the potential gold standard deflation in wealth preservation asset classes is less of a problem than what would be caused by the exacerbated cycles the Fed causes over and above regular cycles. All this specifically in terms of matching peoples expectations… although the evidence does make me lean in favour of the gold standard as the lesser of two evils.

This gets me to the subject of this piece. As far as I can see it doesn’t matter what system you have to change the money supply as long as the majority of the population understands fully how it affects their wealth. The incentive to be foolish, whether it’s from ignoring fundamentals and wanting to get in on the action during bubbles, or whether it’s the fed not wanting to spoil the party, or whether it’s people not willing to put in the effort to understand the complex asset they are buying, all makes for a bad end. There will always be investors, like Grantham last year, who saw the bubble for what it was and didn’t allocate his resources to it. The problem is that he is in the minority and will probably always be. If the population is not willing to do the homework to evaluate which bank will best protect their money then you need systems like the depositor insurance program, which shouldn’t be a necessary tool in a market of perfect information. Likewise the ideal system for controlling the money supply should be one that the majority of people can cope with intellectually for protecting their wealth.

To leave you with something to think about. I propose a system where the money supply is linked to the size of the population, which I’d imagine probably better correlates to a country’s production than the gold standard which is arbitrarly the rarity of the precious metal on the planet in human hands. Fat chance though that any adopted system won’t be suspended towards a fiat currency when the political pressure becomes too great, just as the gold standard was in order to solve the funding problem of/after WWII.

Anyone who thinks I’m pro Keysian government spending has misunderstood this blog. The question is how do we best allocate the size of the money supply which is a necessary but not naturally occuring part of the free market economy.