fallacyman

The Most Common Error in Economic Debates

Have you ever been in an argument about whether we should raise taxes and then someone tosses out a real whopper? “The top tax rate for decades after World War II was over 90% and look how the economy boomed!”

Or perhaps you read a Paul Krugman column where he said that, “there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation [he means rising prices]?”

Both the Internet troll and Professor Krugman are making the same mistake. Let me explain.

Economists love to use the Latin phrase ceteris paribus. It means all else being equal. It’s great in a thought experiment. For example, what would happen if we made a change in America today? Suppose we criminalized all use of fossil fuels. We can’t really do that (I hope!) but it can serve a pedagogic purpose.

It should be pretty obvious that the consequence of shutting off the motors is to shut off production, and people will soon starve. If this isn’t obvious, then you don’t need my blog entry on economic argumentation. You need The Moral Case for Fossil Fuels by Alex Epstein.

Every economist is aware that in comparing a historical time to the present, or comparing two different countries all else is not equal. There is not one difference between the immediate postwar period and today. There are innumerable differences. You can’t just assume that the one difference you’re debating is the only one that matters.

To say explicitly, “The postwar prosperity was solely due to its over-90% marginal tax bracket,” makes the error clear. I propose we call this the fallacy of assuming only one variable, or in Latin (as elegantly as I could make it with Google Translate) argumentum ad variabilis*.

Krugman is perpetrating the same fallacy. He assumes that the only force that moves prices is monetary policy. It’s not a bad gambit, actually, if he wants to Gruber his reader into supporting disastrous Fed policies. Most people, including Krugman’s critics, assume that prices rise as a direct result of increases in the money supply.

In the 1970’s there was perhaps a tripling of the money supply, depending on how you measure it. According to the Consumer Price Index, prices doubled. But so what? If there is one take-away I hope everyone gets from my theory of interest and prices, it is that prices are set in a system driven by positive feedback loops and resonance. Prices have anything but a simple linear relationship to the quantity of dollars.

It just isn’t possible to compare the rate of money supply growth today to the rate in the 1970’s and predict what will happen to prices. Well, you can try but then you may go bankrupt. Here is my comparison of the two time periods, looking at some startling differences.

Krugman commits an additional, similar, fallacy. He assumes that the Fed’s quantitative easing policy only affects one variable (perhaps this should be called argumentum ad effectum*?) Or least, there’s only one bad effect: rising prices. If prices aren’t rising, then he thinks that’s all there is to say. As I have been writing in my Forbes column, there are many other ways that QE harms us. Rising consumer prices is the least of it.

There are many reasons why economics does not work like physics. In physics you can measure the acceleration when you apply a force to a mass. Then you can increase the mass and measure the acceleration again. If you design and execute your experiments carefully, you can be sure that your result is caused by one variable. A doubling of mass causes acceleration to halve, ceteris paribus.

However, even the simplest economic system has thousands, if not millions of people, with unknown (to the economist) relationships between them. It has various productive enterprises with changing methods of production, entrepreneurs and inventors, etc. You cannot isolate any one of them, in order to conduct an experiment. You can only observe two different economies. If you focus on only one variable and exclude all others, it is not the controlled experiment that you’d like it to be, at all.

You’re just putting blinders on.

 

*I am no Latin scholar. My guesses as to the proper Latin names for these fallacies are crude. I would welcome anyone who is an expert in this language to suggest better names.

venti frapuccino

Chinese GDP Surpasses USA (*when Measurement Adjusted)

A story has been echoing around the financial news for a few weeks. One article about it, It’s official: America is now No. 2 by Brett Arends at MarketWatch, came to my attention. Arends asserts that the Chinese economy is now larger than the economy in the US. Here’s what he said.

“We’re no longer No. 1. Today, we’re No. 2. Yes, it’s official. The Chinese economy just overtook the United States economy to become the largest in the world.”

With GDP data from the IMF, we can easily see that the US economy is bigger than China’s. The IMF estimates 2014 GDP at $10.4T for China and $17.4T for the USA. So how does Arends claim the contrary? He uses different data that IMF adjusts. By this methodology, the Chinese economy is “really” $17.6T.

Really?

Although Chinese GDP is lower when measured in yuan and converted to dollars, Arends and others claim that this isn’t right. Goods and services are cheaper in China. So they don’t think we should convert yuan to dollars using the market exchange rate. They use a concept called Purchasing Power Parity (PPP). PPP is used to determine a different exchange rate for the yuan than the market rate. This is how they arrive at a “real” Chinese GDP of $17.6T.

We have long been trained to accept purchasing power as the means of adjusting the dollar from historical periods. For example, JP Morgan was worth $68M at his death in 1913. To calculate what that’s worth in today’s dollars, most people would refer to the Consumer Price Index. They use CPI to adjust the $68M figure from 1913 to a $1.6B modern value. As I wrote on Forbes, that approach is wrong. They should use gold which, unlike the dollar, is the same in 1913 as in 2014. Morgan was worth 3.4M ounces of gold, which is $4.1B today.

Adjusting the Chinese economy by PPP is simply applying the consumer price idea to a whole economy. If we use prices to adjust dollar figures from historical periods in the US, why not use them to adjust foreign but contemporary dollar amounts? If we can use consumer prices to measure the net worth of a man who died in 1913, then it seems like we can use them to measure the economic output of China also.

The approach is fatally flawed, because the value of a currency isn’t derived from prices. As an analogy, suppose you are using a steel meter stick to measure a rubber band. When you stretch the rubber band, it gets longer. This is not equivalent to saying that the meter stick gets shorter. You do not measure meter sticks by how many rubber bands fit end to end. Measurement is one-way.

Money is the meter stick of economic value (though this principle is clouded in paper currencies, because they are falling). Prices rise or fall for non-monetary reasons. Prices may be cheaper in China for a variety of reasons, such as lower wages. Money measures these changes, not the other way around.

By the same principle, prices may be higher in New York than in Phoenix. Does anyone dare to say that these are different dollars? Should we adjust New York dollar downwards towards the Phoenix dollar, based on PPP? How about the Scottsdale dollar (Scottsdale is a ritzy suburb) vs. the south Phoenix dollar?

Standards of living certainly vary based on local prices, but that is a separate issue. The dollar is the same in New York as it is in Phoenix. We say that the dollar is fungible—a dollar is a dollar is a dollar, and each is accepted in trade the same as any other.

Arends uses the Starbucks venti Frapuccino as an example, which he says is cheaper in Beijing than in Minneapolis. A cup of coffee produced in China cannot be sent to Minneapolis where it will fetch a higher price. However, money is unlike coffee. It can go from Beijing to Minneapolis instantly. That’s why there is one price for the yuan globally, but a different price for coffee on every street corner. Bulk commodities are of course more transportable than cups of coffee, but even they cost time and money to transport.

It’s an essential property of money that it is quick and cheap to send it somewhere. Money will always move from where it has less value to where it is valued more highly. The result is that money’s value is consistent everywhere.

This consistency allows us to convert the yuan to dollars, to compare Chinese GDP to American GDP. This is perfectly valid (well, if you accept that GDP itself is valid), because the comparison is instantaneous. We do not have to worry about the falling value of either currency that occurs over longer periods of time. We could use gold to compare the Chinese economy to the American, but it’s not necessary in this.

The price of Frapuccino in China may be important to caffeine addicts who travel to Beijing, but it cannot be used to adjust a currency or a country’s GDP.

Chinese GDP is a lot smaller than American GDP. Will that change? Maybe, but it’s not the job of economists to embed such speculative assumptions into the data.

wages

The Doctor-Laborer Inversion

The battle over minimum wage is raging. Emotions are running hot. Some cities are setting the bar very high. For example, Seattle is mandating a $15/hour wage.

Economically, the issue is very simple. Minimum wage laws do not raise anyone’s wage. This is because it’s not sustainable to overpay.

Suppose you run a small tailor shop. Customers are willing to pay $20 to repair a pair of slacks. Why are they willing to pay that, and no more? It’s not just their budget, but also the relative value of fixing their old trousers compared to buying new. A higher wage for your employees will have no effect on customer willingness to pay.

You have rent, utilities, insurance, wear and tear on your sewing machines, etc. that add up to $10. Therefore your maximum gross profit is $10. You cannot pay someone $11, much less $15, to do this work. If the law attempts to force you to overpay, then you have to lay off workers or even close your doors. Going out of business is no fun, but it beats losing more money.

This is black and white. Minimum wage law can destroy jobs and businesses but it cannot raise wages. However, many people become very emotional on this issue. So let’s look at the issue from a different angle.

There is an endless outpouring of sympathy and support for the unskilled laborer. How is this poor downtrodden helpless victim supposed to feed a family, cover medical expenses, and save for retirement earning only $7.25 per hour?

I don’t know.

My lack of an answer to this question is no justification for minimum wage laws. This is not even the right question. It is an example of the logical fallacy known as begging the question—when you presume what you should be asking. We should ask if one man’s need creates a duty in anyone else. Then the answer is a lot clearer.

The last time I checked, we had not adopted the Communist Manifesto as our new constitution. There is no law saying that each is to be given according to his need.

In comparison to the general sympathy for unskilled laborers, there is none for doctors. Just look at the endless commentary about Obamacare. What are the most popular complaints today? In my admittedly non-scientific sampling, the most common are higher costs, reduced choices, or a broken website. Some people worry about lower quality or less access to care.

There is virtually no discussion of what Obamacare will do to doctors. Doctors make far more than the minimum wage. One presumes that their needs are covered by their incomes, and therefore of no worry to us.

Need is the wrong way to look at it.

Instead of asking what someone’s need is, you should ask what are these people doing for you? What do they create? What value do they add? This brings the issue into sharp focus.

The unskilled laborer can be put to work turning a crank. He needs lots of supervision, which is an additional cost. The crank is paid for by someone else’s saved and accumulated capital, and this investor must be paid a return on capital for placing it at risk in a business. The laborer can be held accountable for showing up every morning and turning the crank all day, but not for business profitability.

This, by definition and by nature, is what unskilled labor is. He brings no capital, no skills, no knowledge, no expertise, no prior learning. He may be a young and inexperienced worker. Or he may have years of prior experience, but he is the sort of person who learns nothing from experience. Either way, the employer is taking on real risks and expenses.

Finally, the unskilled laborer is virtually indistinguishable. Many towns have a street corner, where construction contractors go to pick up a few laborers for a day’s work. There is a standardized market wage for these workers, and the employer doesn’t care who jumps in the back of the truck on any given workday.

How much does one of these workers impact your life? What would happen to you, if one of them stopped working?

For the next part of the discussion, please bear with me. I am assuming a free market in healthcare. In a free market, patients pay doctors for their services, the same way that homeowners pay plumbers, and diners pay restaurants.

Suppose you notice a lump in your neck. You’re worried it may be cancer. Catching it early is the key to surviving with maximum quality of life. You really want to see the best doctor that you can afford. You get a recommendation, and you call his office. They tell you he just retired. You get a second recommendation. You call this doctor’s office, but her receptionist says she was hit by a car this morning and is in critical condition. You open the phone book and call the last specialist. He is on sabbatical, teaching head and neck surgery in Thailand.

Now what do you do? Three doctors are unavailable, and you already feel a bit desperate.

You widen your search, and keep calling more. Suppose for some reason, all the doctors you call are unavailable. One by one, you hear why they can’t see you and you become increasingly frantic.

Why?

The doctor contributes the most value to your life, including saving it. By contrast, the laborer contributes the least. If 10 doctors stopped practicing medicine, you could die. In comparison, if 100 laborers stopped working, you wouldn’t even notice it.

What would you be willing to pay someone who saved your life?

If you would like a doctor to be available, in case your life needs saving, you must change how you think about wages. Start thinking about the value someone produces, and stop thinking about need. Your willingness, indeed your happiness—no your eagerness—to pay the doctor big money has nothing to do with his need. It has everything to do with what he does for you. Your life is worth more to you than the money you spend.

In comparison you aren’t willing to pay the same to someone who washes your dishes or trims your front lawn. If you would like restaurants and landscaping to be available, you must approach it the same way as with doctors. Start thinking about the value they provide and stop thinking about the needs of their unskilled workers.

democracy

Why The Founders Didn’t Give Us a Democracy

As the famous story goes, when Ben Franklin left Independence Hall after the Constitutional Convention in 1787, Mrs. Powel of Philadelphia had a question she wanted answered.

“Well Doctor, what have we got, a republic or a monarchy?”

Franklin replied, “A republic, if you can keep it.

No one today (well, seemingly other than the current president) wants a monarchy. However, too many call our once-Republic a “democracy”. They love the idea of the will of the people, directly determined by vote and imposed by force of law.

The primary argument against this form of government is that it’s tyranny. A majority has no right to take away the rights of any individual, no matter how unpopular he may be. However, that is precisely the consequence of giving the people the power to vote for anything, with no constitutional limits to the power of government.

Let’s explore another argument against democracy. I just published an article critical of a gold initiative in Switzerland. Of course, I favor the re-monetization of gold. That is not why I think the initiative will do more harm than good. I looked at the economics of the banking system, and concluded that the law could cause bank insolvencies. If the banks fail, there goes the people’s money.

No layman would see the problem, unless an expert explains it. Indeed, a hundred thousand laymen signed the petition to put this initiative on the ballot. They simply want to move towards the gold standard and stop their central bank’s endless currency debasement, and robbery of the saver.

Too often, scoundrels hide behind their proclaimed good intentions, which is typically an appeal to collectivism. Then they claim the bad outcome was unintended. It’s disingenuous. If you hike the minimum wage, for example, you will cause higher unemployment. Workers who produce less than the cutoff are always laid off.

In the case of the Swiss gold initiative, the promoters are appealing to honesty and justice. I do not doubt the good intentions of the people behind this initiative. I am sure they mean well. Whether their intentions are good or not, the law has bad consequences. It’s based on an economic mistake.

This exemplifies another fundamental and irreparable flaw in democracy. Even well intentioned people have limited knowledge. No one can be an expert in everything. Yet, that is precisely what democracy requires. It assumes that because the people have an interest in the outcome, they know what will lead to good outcomes.

If your car breaks down, do you sample the opinions of nearby motorists, in order to know how to fix it? If you are sick, do you ask for medical advice from other patients in the hospital ward? No, you call a mechanic or a doctor. What if your monetary system is broken down and sick? Everyone suffers from the monetary disease, but that doesn’t make them experts in monetary economics. In the same way, motorists or patients are not experts in engines or healthcare. In order to work, Democracy depends on everyone being an expert in everything.

This is one more reason why your life should not be ruled by the decisions of others. Even when those decisions truly are well intentioned, they can still hurt you. Democracy is not the right form of government.

This is why the Founding Fathers gave us a republic.

Debates That Ought Not to Be

Every so often (ok, at least once a day) I encounter seemingly intelligent, rational, and educated people debating a black-and-white point of contention. The topic under debate is no mere opinion, but a matter of fact. Yet despite this—or perhaps because of this—the contention is irresolvable, and the debate bitter.

For example, ever discuss the probability of a flipped coin coming up heads? Many adults still cling to the belief that if you got tails four times in a row that means heads is now due.

fool

 

I know an engineer who works at a large corporation. Many engineers and managers there don’t understand how to design experiments. He told me about an hour-long facepalm moment. A manager was trying to order some engineers to do the absurd. Based on his misunderstanding of statistics, he wanted them to achieve a higher confidence interval. This does not mean to become more confident. It basically means to increase the size of the data set—i.e. waste more time and money collecting unnecessary data.

There is only one thing worse than when someone doesn’t know something. It is when what he knows just isn’t so (with due respect to Will Rogers and Ronald Reagan). It’s much easier to teach than to persuade someone to unlearn that which is false.

I see the same kind of error all the time in entrepreneurial circles. Clayton Christiansen defined the term disruptive innovation very precisely. Yet despite this, many entrepreneurs and business managers use the word disruptive merely to mean big, or perhaps competitive. Existing customers of incumbent businesses don’t particularly want the disruptive product. However, it has the potential to slowly eat the market from the low-margin soft underbelly up to the high-margin top end.

The transistor radio is a textbook example. In 1954 when Sony released the first transistor radio, were the existing makers of tube hi-fi equipment thinking to replace their good-sounding sets with tinny transistors? Within a few short decades, transistors took over the market.

Another error, closer to home, is when people think they can raise the wage by raising the minimum wage. Marginal productivity, like confidence interval or disruptive innovation, sounds like something it is not. Who would object to raising productivity?

But that is not what marginal productivity means. If you raise marginal productivity—for example by raising the legally mandated wage—you increase the bar. This is the hurdle all workers must get over, or else be rendered submarginal. Submarginal means unemployable.

When you find yourself in such a debate, be aware of what you’re up against.

The above examples are fictional, and purely for entertainment purposes. Any resemblance to actual errors made in monetary economics is purely coincidental.

Nobel Prize Awarded to Regulatory Apologist

Only last week, I published an article about the madness of Fed regulation. I presented several key assumptions behind all regulation, and exposed them to be false.

  1. Regulators Are Smart and They Care
  2. Compliance Makes Things Safe
  3. Unregulated Businesses Will Harm Us
  4. Regulation Turns Crooks Into Producers
  5. The Financial Crisis Occurred Due to Private Crimes
  6. The Fed Can Create Stability
  7. Central Planning Works

And now the Nobel committee has chosen to honor Jean Tirole with the prestigious prize. He earned this award and recognition for his work on the best way to regulate large, powerful firms in industries including banking.

He helped show, “what sort of regulations do we want to put in place so large and mighty firms will act in society’s interest,” Tore Ellingsen, the chairman of the prize committee, said after the award announcement.

How many of the fallacies I debunked are implicit in this? I count at least 5…

The Wrong Idea About Inflation

Here is a post I made to Facebook yesterday.

FB post

I was making two points. One, virtually all commodities are in falling trends now (except certain foods affected by the government-create drought conditions in California). Two, it has nothing to do with the money supply.

Some comments on the thread reminded me most people accept the idea that changes in the money supply lead to changes in prices (though not necessarily evenly or instantaneously). This idea is tempting, convenient, and it seems only “common sense”. However, it is facile.

I decided to write this post to add some context. Since 2008, there has been a massive increase in the money supply. M0 has increased from about $875B to $4T. It is now 3.5X what it was. M1 went from $1.4T to $2.8T, or 2X. M2 went from $7.8T to $11.4, or about 1.5X.

Prices haven’t done any such thing. The Bloomberg Commodity Index fell from about 175 to 118 today. In other words, the commodity index is 0.67X what it was.

How do we explain this? I have offered my theory of interest and prices. To condense 12,000 words into a sentence: rising interest rates and rising prices go together.

Here is a graph of the Bloomberg Commodity Index overlaid with the 10-year US Treasury yield, going back to 1996. The correlation is imperfect, but quite visible.

int com

I would like to share a few additional thoughts about this correlation.

At least as far back as 1897, Knut Wicksell observed it. It is interesting to note that he was a believer in the quantity theory of money, but he was honest enough to recognize when the data did not fit the theory. Here is a quote from his address before the Economic Association of Stockholm on April 14, 1898:

“Logically speaking it does not seem possible to give any other answer to our question… than the following:… the level of commodity prices must depend… on the rate of interest. A low rate of interest must lead to rising prices, and a high rate of interest to falling prices. This is in full agreement with the basic principles of the quantity theory of money… Unfortunately, we are once more faced with the same regrettable circumstance: a lack of correspondence between theory and reality [emphasis added]. If we compare… the wholesale prices in Hamburg… on the one hand and the rate of interest in Berlin… on the other, it must be admitted (if it is possible to discover any connection between them at all) that a high rate of interest is associated with high commodity prices and a low rate of interest with low commodity prices, rather than the other way around…”

Irving Fisher, a monetarist, and promoter of the Quantity Theory of Money, realized that rising prices caused high interest rates and falling prices caused low interest rates. He thought the connection worked in the other direction as well, but didn’t know why.

Gilbert E. Jackson was the first to see the bidirectional linkage between prices and interest. He studied wholesale prices and interest rates in Britain from 1782 to 1947. But he could not give a full theoretical explanation.

Antal E. Fekete was the first to propose the theory that there is normally a positive spread between the marginal time preference of the saver and the marginal productivity of the entrepreneur (also integrating the two major theories of the formation of the interest rate). The market rate of interest can move freely between those two boundaries. However, when government interferes, it can either invert this spread or it can push the market rate of interest outside the boundaries (e.g. when the central bank buys bonds). Then, it sets off a self-perpetuating trend.

interest-spread

I think it’s important to acknowledge that the economy is not stateless. A change in one variable—e.g. money supply—may have a different effect depending on the states of individual actors in the economy. It may even have the opposite effect one time as compared to another.

I like to use the example of a pilot pulling back on the yoke. The layman expects that this will cause the plane to climb. However, if the plane is in a spiraling descent, then it will cause the spiral to tighten, and the plane will auger into the ground if the pilot does not correct.

When you’re saturated in debt, you don’t behave the same way as when you’re unencumbered.

Interest rates have been falling for three decades, with no sign of (nor reason to expect) a reversal. Therefore we should expect a trend of falling commodity prices (consumer prices are more sensitive to labor law, taxes, regulations, and other factors).

 

The Gold Standard Institute Presents The Gold Standard: Both Good and Necessary, in Manhattan on Nov 1. You are cordially invited to join us for a discussion of ideas you won’t get anywhere else. The gold standard is the monetary system of the free market—of capitalism. Dr. Andy Bernstein, a rock star of the liberty movement, shows why capitalism is good. In my talk, I explain why capitalism is impossible with fiat money, and why we have not recovered from 2008, and we won’t without gold.