Category Archives: Economic Theory

Look Beyond Supply and Demand to Understand Labor

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We’re all familiar with the Law of Supply and Demand. There is a supply curve that goes up as price goes up, and a demand curve that goes down as price goes up. It’s often drawn like this:

Supply and Demand

 

Using this idea, one would expect immigration to cause wages to fall. It seems obvious. Increasing the supply of labor will push the equilibrium price down. Won’t it?

Not so fast. At best, Supply and Demand is an approximation. If the market were frozen in time and all variables were somehow fixed except supply, then sure, a rising supply of workers would cause a falling price of labor. Maybe. I call this kind of thinking the most common economic error. Just how are we to freeze the economy the way a camera freezes a scene, and yet change that very economy by adding more workers?

There is no such thing as Economic Photoshop.

Static thinking is tempting because it’s easy and seems to appeal to common sense. To borrow a phrase coined by Wolfgang Pauli, it’s not even wrong.

As with every kind of aggregate quantity that economists like to measure, supply and demand are not forces that impel market participants. Hiring managers don’t input the quantity of workers into an equation, and get the wage from that. They’re concerned with something quite different, and much easier. They want to make a profit.

Suppose a worker can make 10 hamburgers an hour. The non-labor costs add up to $3.50, and the customer is willing to pay $5.00. A simple calculation tells the manager that a worker will generate $15.00 per hour ($5.00 – $3.50 = $1.50 x 10). He therefore cannot pay more than $15, or even close to that. He has to offer at least $8 to attract workers. That leaves him a tight profit margin because there are work breaks and slow times during the day.

The supply-and-demander will at this point demand, “well if you add more workers competing for the same job, won’t the hiring manager be all too happy to pay less than $8?” That’s the same fallacy I described above. It presumes that we can hold constant the number of restaurants, burger-eating consumers, and even the percentage meals people eat out. We cannot presume that we can change only the number of workers.

Labor doesn’t work as the so called Law of Supply and Demand predicts. America once had by far the greatest immigration, and at the same time it had by far the fastest wage gains. To understand why, we have to look at what supply demand is trying to approximate.

Marginal utility.

Let me explain. The first unit of a good is bought by the consumer who places the highest value on it. For example, bakeries have long bought wheat to make bread. No higher use of wheat exists than eating it. We need food to live.

When farmers increased efficiency and output, then pet companies could put wheat into dog food. With further price cuts, home decor companies could put wheat into wallpaper paste. As it gets cheaper still, toymakers could make it into a sculpting material for toddlers. And so on (these examples are just my suppositions, so take then with a grain of salt).

The price of wheat is set by this marginal user, because that’s the buyer who will walk away on the first uptick. In other words, the price of wheat is what the maker of Play-Doh can afford to pay.

If farmers can produce even more and sell it to the market, who knows what the next lower use of wheat is? Maybe someone will make recyclable boxes out of it.

The principle for every commodity is the same. As more is produced, the price has to drop to accommodate the next lower use. The marginal utility of wheat declines. So does the marginal utility of copper, crude oil, iron ore, and every other commodity (except gold, but that’s a whole ‘nother discussion).

People say that the price has to fall to find a new equilibrium on the demand curve, but they do not see the cause, declining marginal utility. They see only the effect.

This brings us to human labor. Is work like wheat, descending from high uses to ever-lower uses?

No.

The exact opposite is true. Before the Industrial Revolution, the vast majority of people worked as laborers in agriculture. The work was not only back-breaking, but offered very low value. Ever since then, developed economies have employed more and more people. But they are not employed in lower and lower jobs for them (question: what’s lower than mucking out a stall for a horse?) They are employed in higher and higher jobs. Work is so advanced today, we produce such high value products, that people from the 18th century could not have even imagined it.

The marginal utility of human work does not diminish, as the number of workers increases. As the size of a market grows, the value of firms and workers within it rises.

How Could the Fed Protect Us from Economic Waves?

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Mainstream economists tell us that the Federal Reserve protects us from economic waves, indeed from the business cycle itself. In their view, people naturally tend to go overboard and cause wild swings in both directions. Thus, we need an economic central planner to alternatively stimulate us and then take away the punch bowl.

Prior to the global financial crisis of 2008, a popular term described the supposed benefits created by the Fed. The Great Moderation referred to the reduced volatility of the business cycle. For example, I have written before about economist Marvin Goodfriend, who asserted that the Fed does better than the gold standard.

Fed Whale Cartoon
(Credit: Greg Ziegerson and Keith Weiner)
This belief is inherent in the Fed’s very mandate from Congress. The Fed states its three statutory objectives as, “maximum employment, stable prices, and moderate long-term interest rates.” These terms are Orwellian. Maximum employment means five percent of able-bodied adults can’t find work. Stable prices are actually rising relentlessly, at two percent per year. The meaning of moderate long-term interest rates must be changing, because rates have been falling for a third of a century.

That aside, the basic idea is that the Fed has both the power and the knowledge to somehow deliver an economic miracle. However, we know that central planning never works, even for simple things such as wheat production. Communist states have invariably failed to produce the food to keep their people alive. Stalin, Mao, and other communist dictators have deliberately starved off segments of their populations that they couldn’t feed.

The business cycle is vastly more complicated than the crop cycle. It plays out over decades. It involves every participant in the economy. It affects every price, including, especially, the price of money. It causes changes in how people coordinate in the present and how they plan for the future. And, there are feedback loops. Changes in one variable cause changes in others, which come back to affect the first variable. The very idea of centrally planning money and credit boggles the mind.

This should not be controversial. Yet, even those who know why government food planners fail, somehow retain their faith in central planning of the economy as a whole. Marvin Goodfriend—who spoke in favor of free markets, by the way—called his faith in central banking, “optimism.”

Is it true that the Fed is actually somehow providing stability, or even improving on a free market? Let’s look to the interest rate on the 10-year Treasury bond. The rate of interest is a key economic indicator.

Fed Stability without shading
(sources: National Bureau of Economic Research 1800-2001, US Treasury 2002-2014)

With that giant peak on the right side of the graph, we can immediately reject all claims to Fed-imposed stability. Now let’s label a few key dates.

Fed Stability

The pre-Fed period is pretty stable. Two spikes occur due to wars that we know disrupted the economy—and they’re pretty small, considering. Interest declines to a lower level when the government was paying down its war debt. Things remain stable until the creation of the Fed.

After that, we get a rise, a protracted fall, an incredible and truly massive rise, and an endless freefall. Both rising and falling interest make it more difficult to run a business that depends on credit, such as manufacturing, banking, or insurance. The post-Fed period is a lot less stable than the pre-Fed.

A feature of the free market and its gold standard is interest rate stability. The rate can vary between the marginal time preference and marginal productivity. This tends to be a stable and narrow range.

Fed apologists argue that the economy would be even more unstable, if we had no monetary central planner. However, the fact is that it became a lot less stable after the Fed was created.

 

This article is from my weekly column, The Gold Standard, at the Swiss National Bank and Swiss Franc Blog SNBCHF.com. I encourage readers who are interested to subscribe there, as I don’t plan to regularly post these articles here.

Quack Economic Doctors

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Suppose you go to a doctor. You are in pain and you tell him that you feel like you are going to die. He takes your temperature, and sees that it is a perfectly normal 98.6F. He tells you to go home, you must be fine. He does not seem to be aware of any problem that can cause pain but not a fever (e.g. a broken vertebra, cancer, or bleeding). He is a quack.

It’s a good thing that real doctors have many diagnostics and indicators. They are not limited to just body temperature.

Let’s turn our attention to the monetary system. The quacks focus their attention on prices. The rate of change of prices—which they improperly define as inflation—is the monetary equivalent of body temperature in medicine. In some cases, it’s an important part of making a diagnosis.

And it is far from the only indicator.

If prices are like temperature, then what is analogous to the patient’s pulse? Interest rates. And interest rates have been falling for 34 years.

Is there a doctor in the house? Should we be worried?

The Most Common Error in Economic Debates

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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.