Thursday, January 27, 2011

Economics ramblings


"A laptop is a third-order good. The machinery used to produce a laptop is a second-order good. The mines used to produce the machinery are a first-order good. An economy grows when consumers save their money instead of buying laptops, and it gets invested in mines and machinery that yield cheaper/more laptops in the future. The economy knows to invest in mining equipment when there is a low interest rate/lots of savings, because there will be savings consumed in the future when the mine's material has been made into laptops. When gov't price fixes the interest rate low and there is a shortage of savings, the economy invests in more mining equipment, but the consumer is buying laptops and not saving, so the economy's resources are stretched too thin, and the Hayekian triangle on the top left becomes concave, and as consumption (C) and investment/savings (I/S) become uncoordinated and increase at the same time, the two points diverge and their average is inside the possible production frontier."

My slightly rambling reply to the following question, posted by a user in the dicussion:

Question: "This explanation sounds counter intuitive ... why would I save when interest rates are low? Why would I invest in mining equipment if there's no demand for laptops and an uncertain future demand? Any suggestions for further study on this subject?"

Disclaimer, I'm no expert, but if I understand correctly causality is probably the opposite: In a normal i.e. non-Fed-distorted economy (i.e. one in which savings don't automatically lose their value over time, because inflation is artificially created by printing money creating a disincentive to save) people anyway save naturally 'for a rainy day' and for the future (for their retirement and for kids etc.), and if they're expecting tougher times, will save even more - so they cut back on spending on consumption goods. The overall rise in pools of savings should mean more money (more genuine capital, as distinguished from Fed 'funny money') generally available to lend out via more sources, and competition between lenders would drive down interest rates (note again, market-set interest rates, not artificially-centrally-set Keynesian rates). The fact that people are saving more, which then reflects in the interest rate, means the interest rate, which is basically the 'price of borrowing', should effectively represent a signal as to whether people's savings habit are more future- or present- oriented. If people are overall doing more 'saving for the future' (thereby lowering interest rates), there would be two reasons for an investor to tend to rather invest in long-term projects: Firstly, the higher savings indicate that people are becoming less likely to spend on short-term consumption goods (so less reason to invest in them), and more likely to buy things 'later on' (since people save for the future, so you want to be there with goods for them when they start spending again), and secondly the lower rate helps make it more affordable to borrow for long-term periods.

Note that there is an important distinction to be made between 'market-determined' interest rates, and the artificial ones set by the central bank and through credit expansion ('funny money').

As a massive generalization, people tend to save more when they perceive times to be bad, and save less when they perceive times to be good (or based on painful memories thereof - e.g. those that lived through the Depression or the World Wars were/are more likely to implore their offspring to save). American savings rates went up through the latest recession (but only marginally so, and not for long, as more funny money and easy credit on its way). This puts some (usually good, in a proper market economy) natural feedback into the system, as people judge the economic climate and adapt based on it. The Chinese currently have both high savings (as most still remember poverty in much more recent years, therefore have a natural culture of thrift), and probably unsustainably high capital investment:

"How has China been able to maintain its high—8 percent–plus—growth despite the collapse of its net exports? It did not do it by reducing its saving and consuming more; rather, it has boosted further fixed investment in real estate (commercial and residential), in infrastructure (roads, airports, bullet trains), and in manufacturing capacity, which already suffers from a glut. Fixed investment in China is now close to 50 percent of GDP.

But no country can be so productive that it can take, every year, half its GDP and reinvest it into more capital stock without eventually ending up with a huge excess capacity and a mountain of bad loans. Thus, China needs to radically change its growth model from net exports and investment to reduced saving and more consumption."

- Nouriel Roubini

Why is this? It's an interesting case, it's because they're historically major exporters - basically they build stuff cheap and export it and then live cheap/thrifty themselves, and save the money they earn and re-invest it in more and more actual PRODUCTION infrastructure (mines, power stations, factories, transport etc.) to churn out still more (export) goods. Their exports will drop off a.o. as the dollar declines and as their currency appreciates, but it seems like a perfect opportunity to transition to a higher consumption economy, thereby raising their own quality of life: I.e. basically they'll steadily start exporting fewer of the things like big-screen TVs that they manufacture, and (since they have a huge market right at home that just saves their money) start buying those goods from each other instead, i.e. shifting toward higher consumption, and finally becoming an independent economic superpower instead of one based on exports. (And who knows, perhaps in another few decades it will be the young generation of Americans who knew and remember poverty and hunger, and a new generation of grown-up spendthrift Chinese who think good times never end and have lost their ability to manage money.)

Me: "The overall rise in pools of savings should mean more money (more genuine capital, as distinguished from Fed 'funny money') generally available to lend out via more sources"

Two (or Three) Towns in Parallel Universes

To try put that another way. Imagine a small town with three banks. The town has 10,000 people of which say 100 are business-oriented. Imagine it's the 50's or whatever, and most the townsfolk still recall the stories from their parents or grandparents of how tough times were in the Great Depression, and how important it is to save. So those 10,000 people save 30% of their salaries each month 'for a rainy day', of which some are just storing the money, but some have agreed with their banks to allow the funds to be made available to loan to businesses in exchange for a share of profits (interest) to compensate for the risk. So each bank has, say, $10,000,000 available to loan out for business ventures, and those 100 smart business-folk who want that money to invest in projects. The three banks WANT the business of those entrepreneurs, so they can earn that interest - but the 100 borrowers can borrow from any of the three banks - the banks thus compete with one another in the 'market for borrowing money'. One bank says they want 4% per annum, another bank offers 3% --- and the bank offering the best interest rate, gets to choose the best of those entrepreneurs to lend to (the Steve Jobs type).

Now imagine a parallel universe, same town, everything the same but there was no Great Depression. People have no cultural recollection of what tough times are like, so their universe has been one of more or less continual prosperity, they've never known hunger. Of course they still need to save, but these people only save 10% of their salaries. So there is only enough money going into savings to support one bank. That bank has $10,000,000 available to lend out to those same 100 businessfolk. But that bank can now charge, say, 7% or 8% interest for lending that money out, and the borrowers have no choice.

Note the above assumes there is no such thing as the "Fed" or 'funny money' credit through money supply expansion. There is a third parallel universe, more like ours, where everything else in the town equal, there now exists a chap named Bernanke that sits thousands of miles away from the town, but has the means to artificially effectively dictate that the banks must in all cases charge 1% interest. Now the local conditions will scarcely be taken into consideration anymore, and there is no more interest rate 'price signal' that tells the borrowing market whether it's more future-oriented or consumption-oriented. Furthermore this Bernanke chap and his cohorts, who are very good friends with the guy who runs the town bank, print huge piles of new 'funny' money each month (not based on real wealth/savings i.e. capital and economic potential) and give it to their buddy who runs the bank, who can then loan it out to the townsfolk (in this arrangement, the banker and the Fed benefit, especially as losses are socialized). The unsuspecting townsfolk suddenly see huge piles of what appear to be real money available for borrowing - funny money - suddenly the bank has $200,000,000, available at low interest rates. The townsfolk go on a spending spree, suddenly thinking they're all so wealthy now, they can all live in nice big houses! The townsfolk all start buying property (and some make money from profit-taking as speculation and easy money drives property prices higher), and for a while the town is expanding rapidly (a true "boom" - or so the townsfolk think) as many of the people who were previously employed in construction or mining, these production resources are diverted to building thousands of new and bigger houses - in the end some 40% of the town's limited production capacity is diverted toward building (and painting and furnishing and landscaping) new or upgraded homes (while local mines and factories close). To make matters worse, the government has promised that if you can't pay the loan back, you can just walk away, and so the bank has given out bad loans to the town's homeless wanderer's and re-sold the risk fraudulently by covering it up in market instruments like derivatives.

(A downward cycle of foreclosures and collapsing property prices awaits this poor third town, and then unemployment because whereas the town's economy used to be based on its mines and factories, many of those were closed down in order to fund its housing development "boom", and it will take time to re-open them - eventually the bank will also lose so much money from defaults and foreclosures that the townsfolk all try grab their savings out the bank at once, savings which are gone, but Bernanke steps in and simply prints even more massive amounts of funny money than ever before and hands it out to his friend at the bank, thereby "saving the bank" but keeping the downward spiral of inflation and malinvestment going for just a little longer - probably, he hopes, just long enough so that the real catastrophe lies beyond the re-election horizon of his friends in the administration.)

Question: "Why would I invest in mining equipment if there's no demand for laptops and an uncertain future demand"

Future demand is never fully 'certain', but this is reflected in 'investment risk', and it has never, in the history of humans, prevented entrepreneurs from taking risks. When Steve Jobs started developing the iPad, it was far from certain whether or not there would be high market demand (obviously Jobs believed so, but many predicted a flop). Likewise for actual market flops. But, when someone undertakes to e.g. build a new platinum mine, it's a long-term thing, the difference is he is making CALCULATED risks though on what he expects the market demand for platinum to be five or ten years later. But these are not simply random ventures, e.g. when you decide whether you want to invest some of your savings in either, say, a new office park or in a new platinum mine instead, you don't just flip a coin, you study the market and try make the best educated guess you can as to what will pay off later.

Risk levels are usually factored into the cost of borrowing. Company stock/bond markets help determine the cost of borrowing for individual ventures. Guys with a track record e.g. Steve Jobs end up with better ability and market trust for raising capital for their ventures, thus the market intrinsically helps ensure those who manage the money (representing production resources) best, can get more production resources diverted to them. It's never a "sure thing", and there will always be some failures along the way, some disastrous.

But market mechanisms help minimize the failures, through various means. E.g. people lending their own money (or their own customers money) have the most vested interest in making the best and most calculated 'guesses' on future demand, and thus studying and analyzing the most, and thus making fewer mistakes.

Market-distorting mechanisms raise the rate of failures. Easy credit through credit money supply expansion and with socialized losses is one such market-distorting mechanism. If you run a bank and the Fed gives you a billion dollars in new fake printed money to lend out (and promises to 'bail you out' if you lose it), you no longer have as much incentive to worry about investing that properly. It's not your money, it's not really even your customer's money, it's "easy money" - easy come, easy go - you didn't work hard for it. And everyone's doing it! So hey, just throw that funny money all over the place, wherever you can, and see where it 'sticks'. This results in malinvestment: The mis-allocation of society's production resources towards ventures that are less efficient or more likely to fail. (The problems also compound, because all that central bank 'counterfeit' money mixed into the system makes it hard to tell how much of any investment vehicle's price is a bubble and how much much is 'real', or when any particular bubble will pop - to what degree are equities in a bubble? Who knows. To what degree are commodities' or food pricing a bubble? Who knows. Are current market movements in, say, oil pricing based on fundamentals or these malinvestments? Who knows.)

Anyway, put another way, future demand is never 100% certain, but you will invest probabilistically. You may be able to forecast the future demand of laptops within 70% accuracy over 5 years, or, say, forecast the future supply of platinum ore within 50% accuracy over 10 years. Those fudgy risk factors are then weighed against returns. As long as this method remains good enough for humans to be able to 'make the correct guesses more often than not', then economies can grow --- and they do, and it is.

Anyway, for interesting and more informed discussion on these issues, check out Robert Murphy's excellent Reply to Krugman on Austrian Business-Cycle Theory, as well as his simplified Sushi Model of Capital Consumption that forms part of the hopefully still unfolding discussion thread, as well as this article Putting Austrian Business-Cycle Theory to the Test, which contains and explains this highly interesting graph showing a real-world example of how Austrian economics predicts employment patterns in different (higher and lower order) sectors to follow:

UK Economy

On a tangentially related vein, there is an interesting graph here in this article on the latest "unexpected" (by Keynesian economists, who seem to be forever "surprised" and forever scratching their heads) drop in the UK economy:

What's again interesting and important is not just the overall unemployment levels, but levels in different sectors - in this case, the biggest drops have been in the 'higher-order' sectors of the economy - construction and mining. This while the UK central banks have been following the Bernanke-like Keynesian policy of low interest rates and printing money (aka "stimulus"), all the while proclaiming a "recovery" has been underway. That should sound familiar by now (hint: it's town number three's story yet again).

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