News from Galt’s Gulch

It seems to be common “knowledge” that sweatshops are an evil machination of profit-driven companies; this sophism is about as true as most other wives’ tales. Sweatshops are the foundation upon which true economic freedom can be built upon. Instead of chopping down the roots of true change, we should be watering it and encouraging it to grow to its full potential.

Let me preface this with a simple illustration; when you go to the store for groceries, you exchange your money for food. At the end of the transaction the cashier says “Thank you” and you likely respond “Thank you”. Why the mutual thanks? They exchanged something they valued less (their food) for something they valued more (your money). You received something you valued less (your money) for something you valued more (your food). In this case everybody wins! Economists would term this shared benefit as a positive externality resulting from trade. From this simple allusion one can conclude that any type of voluntary trade is a good thing. If it wasn’t beneficial for everyone, the trade would not have happened.

Many of my well-intentioned friends do not shop at certain stores because of the poor working conditions of that store’s factories in other countries. Most people know these places as sweatshops and have no respect for them. Not that many years ago, though, the United States had factories with similar conditions. Factory conditions improve as corporations mature; just as the features on automobiles improve over time, so do conditions in sweatshops. Attempting to make a vehicle with cruise control before the engine works properly is nonsensical. In much the same manner, attempting to ensure that working conditions are at the same level as American’s enjoy before the economy is able to naturally supply said conditions is premature and does little to improve the actual living conditions. In fact, it can make them much worse. Sweatshops are horrible; on the ladder of economic sophistication they’re the bottom rung. What concerns me is that the very people who champion the anti-sweatshop movement aren’t helping to pull up the individuals grasping onto that bottom rung with all their might; instead they’re treading on the very fingers of those they believe they are helping.

Workers in sweatshops endure awful conditions; they work long days doing repetitive and dangerous tasks for small amounts of pay. So what’s worse than working in a sweatshop? That’s easy: not working in a sweatshop. With alternatives such as substinence farming and prostitution, a nice cozy job in a sweatshop doesn’t look so bad. Some may argue that sweatshop labor is slave labor. If this is true and the worker is forced to remain at the job, then we are addressing a separate topic. Given that it’s a voluntary position, the only conclusion is that the best choice possible was made by the individual in the position and that choice lead to the current job in a sweatshop. If we truly want to end sweatshop labor, we should focus on expanding those possibilities instead of eliminating their best alternative currently available. The best way then to help those working in sweatshops is quite simple: buy more goods produced by them, instead of less.

If you’re interested in this topic, check out the debate happening Monday, December 1^st at 7pm in the Cook-DeWitt Center on Grand Valley’s Allendale Campus. More information is available at www.gvsuECONclub.com or the campus calendar of events.

You can RSVP via Facebook here.

Much of my knowledge on this subject comes from with the publications of the Wall Street Journal, the Foundation for Economic Education, Walter Block, Murray Rothbard, Larry Reed, Isaac Morehouse, Fredric Bastiat, Henry Hazlitt, NPR’s This American Life and numerous others. Please credit these individual’s with only the good things; I retain all misinterpretations and errors for myself and in no way mean to speak for these people.

Our media and government have painted a very bleak picture of what would have happened if the bailout hadn’t occurred. Our President pleaded “for the financial security of every American, Congress must act” so that we can get the economy “movin’ again”. How has government been doing? Politicians have commended that they wish they didn’t have to do what they’re doing, but that they must.

Because housing prices always go up, it didn’t really matter if anyone could afford the real estate. Banks would happily lend money for speculators because in a few years, the individual would flip the home and both he and the bank would make a profit. When real estate values failed to increase, individuals who had gotten no down payment loans simply walked away from the properties. And why shouldn’t they? They had nothing invested; banks now have these properties that nobody wants and it has to write down its loans according to “mark-to-market” regulations. Because of the way our banks work, any write down reduces their ability to loan by a multiple of 10. We’re currently experiencing what pundits call a “credit crunch” because the amount of credit that banks can lend has plummeted. This can be seen by looking at the TED spread. This is simply the difference between what commercial bank lend each other and the risk free rates of return earned by U.S. treasuries. A large increase signals fear among banks regarding lending money to each other. The Federal Reserve has assumed many hidden powers that it apparently has always had the “right” to use, but just never had the need. Banks have certainly taken advantage of the cheap money being lent to them by the Fed, but, because they fear future write-downs, they’re keeping the money on hand instead of lending it out.

So is there a credit crunch? Absolutely! If you define a credit crunch as a situation where more people want loans than can obtain them. What about all the other crunches? Don’t you have a vacation crunch? A nicer car crunch? As a child I experienced many candy crunches (and not the good kind from Nestle). My parents knew, though that if I was given everything I wanted, I would never learn to appreciate those things. People definitely want credit, and it would sure make things easier if everyone were able to get everything they wanted: unfortunately, as one will learn in Econ 101, economics is about how limited resources get distributed to individuals with unlimited wants. If another business or individual is unwilling to loan you money, that’s really the end of the story. You’re not entitled to loan just as a child is not entitled to candy.

A famous French philosopher by the name of Fredric Bastiat tells a story of a shop keeper who one day has his window broken when a brick goes flying through it. The crowd outside gathers to watch as the shopkeeper inspects the damage. One of the members of the crowd comments that, while unfortunate for the shopkeeper, this will surely benefit the window repair man and spur the economy. The others begin to agree; indeed, after the window repair man receives the $50 he might subsequently go to the baker’s shop and spend the money there which might then be spent buying a new suit. The crowd comes to the conclusion that it would be selfish, greedy, and wrong for the shopkeeper to try to prevent this damage in the first place because he would be interfering with the success of the rest of the economy. This line of thinking leads you to the ludicrous idea that breaking windows is a good thing! This clearly makes no sense. The fallacy in this type of thought is that the crowd is recognizing only the easy part of the equation: the seen. What about the unseen? What about all the other places that the money could have been spent? What about the plans the shopkeeper had to go and purchase a new product to sell in his store? Had the window not been broken, he could’ve spent the $50 on something that would’ve benefit everyone the same as if the money goes to the window repair man. Instead, he finds it necessary to spend the money simply to get back to the position that he was at initially. Thus, no additional wealth was created; the shopkeeper spent $50 and is still in the same position.

What does this have to do with the current situation? Well, government doesn’t create wealth, it simply redistributes it. In order for it to give money to some it must first take it from others. $700,000,000,000 has been taken from all Americans to be “invested” in mortgage backed securities (MBEs) partly through equity forced “voluntary” holdings in commercial banks. We’ve heard many individuals talk of the benefits of bailing out financial institution. In fact, if you remember how the marketing on this thing works, Monday it was a bailout, but by Friday it was an “economic recovery package” promoting “stabilization”, lending “liquidity” to the market, and restoring “confidence” In the system. This latter title sounds much better than the previous. Much like Bear Stern’s “High Grade Structured Credit Enhanced Leverage Fund” sounded much better than “a fund full of subprime mortgages”. While I do take issue with the ostensible “benefits”, the real key is to look at what must be given up to obtain these “benefits”. It’s very easy to look at the good things of any policy; after all almost anything someone does has some type of benefit to someone, but what about the costs? The real goal in analyzing policy is to ensure that the benefits exceed the costs. There are many things that American’s could’ve done with that money (like paying down debt). If we’re conservative and say that out of 300 million Americans, 2/3 are tax payers. 700 billion divided by those tax payers comes out to $3,500/tax payer. Can you think of something (other than the “liquidity” of our financial system) that you’d rather invest in?

So how did this bout of political and financial legerdemain occur? Did you notice how after Congress voted down the bill all the financial institutions started detailing how “Wall Street affects Main Street”? Here’s how they justified it: banks won’t lend to anyone because they have all these “toxic” MBEs on their books. The belief is that if someone removes these loans from the banks books, then the banks will start lending again. The question then becomes how to remove these loans from the banks books? Henry Paulson and Ben Bernanke have decided that the government should “invest” in them. How do two esoteric people make that happen? By convincing everyone that it’s their problem too because without the government to clear out the pipes of the financial markets, you’ll be forced to live within your means instead of living on credit as Americans have become accustomed to. The Journal recently announced plans for the government to hold equity shares in many of the largest banks. It also noted that many weren’t happy about this, but after the government insisted, they “coincidently” acquiesced.

You and I will be paying to return liquidity to the credit markets long into the future. But should we really be so eager to return to business as usual? We’ve been living in a Keynesian world for so long that our money doesn’t really stand for anything anymore. Keynes said that in the long run we’re all dead. He’s right, of course, but as Hazlitt observed, “Today is already the tomorrow which the bad economist yesterday urged us to ignore.” This may be a band-aid to today’s current problem, but we can’t forget about the surgery that we really must undergo. The reason this entire mess was possible is because of the banking cartel, more commonly known as the Federal Reserve, that we have manipulating our money. Let’s take a brief look at the history of our money:

Individuals began by doing everything themselves; they cooked, cleaned, hunted, sewed, etc. Subsistence farming was the only occupation.

Individuals slowly recognized the benefits of trade and started engaging in direct exchange (i.e. I realize that if I do the farming and someone else builds the machines that I need that we can trade and both be better off at the end of the day). This is what economists today call comparative advantage. Of course, there’s plenty of mathematics to back this up, but intuition is usually enough. After all, when is the last time that you prepared your entire meal…from scratch…no boxes, no containers, but straight from the field all the way to your plate? Instead you specialize in whatever occupation you’re best at and trade for the rest.

Individuals begin to see the difficulties of direct exchange. Economists would call it a lack of coincidence of wants. If I specialize in building cars and want a dozen eggs, it’s quite difficult for me to perform this trade because I would have no need for the amount of eggs required in a fair trade of a car for eggs.

Individuals seek out the most marketable good to serve as a medium of exchange. This good is quite important: it has to have, as Block would say, many “ilities” that is, divisibility, portability, durability, recognizability, rarity, reliability, etc. Different societies choose different mediums of exchange from shells to beads to gold; most societies end up with some form metal. America was no different and was on the gold standard for a while until the government seized gold and went to a paper currency.

Since gold is valuable, individuals prefer to store it somewhere safe; the gold miner has the vaults and knows gold quite well. Individuals go to him and ask him to store their gold for them. For a price the gold miner agrees to warehouse the gold and issues a receipt saying that Bob has 500 oz. of gold stored at The Safe-Haven Gold mine. Now Bob is able to go about his day; when he finds something he’d like to buy, he goes to the gold miner, hands him the warehouse receipt, and gets his gold back. Bob then proceeds to buy his groceries from Fred. Fred receives Bob’s gold and takes it back to the gold miner who then issues him a new warehouse receipt.

After this occurs for a while Bob and Fred have a wonderful idea; instead of going back and forth to the bank, they’ll simply exchanged warehouse receipts! That is, instead of paying in gold, Bob will sign over his warehouse receipt in exchange for groceries. Next, they ask the gold miner if they can get smaller denominations so that they’re better able to trade; they also ask him to just make it payable to whoever possesses the note which eliminates the transaction cost of having to sign notes over every time they change hands. Up to this point, the medium of exchange has represented work of some sort. In order to obtain this medium of exchange, an individual must first do something of value for someone who possesses that medium. Of course, if someone were to steal a portion of this medium, then that person would have gained possession of the medium of exchange without doing any real work for it. This would be a crime as it is a clear violation of an individual’s property.

The system works well until the Jones’ get a new pool and remodel their kitchen. The gold miner’s wife starts complaining that she wishes they could keep up with the Jones’. The gold miner thinks for a while and realizes that he has 5,000 ounces of gold in his vault and 5,000 ounces outstanding in warehouse receipts. Because most people in town warehouse their gold with him, it’s very unlikely that he would ever have to present everyone with their gold at the same time. Thus, he simply writes up a few additional warehouse receipts and goes out and gets a pool with both a slide and a diving board. Everybody trusts that the warehouse receipts represent a certain amount of gold in the gold miner’s vault and thus accepts the additional warehouse receipts without any questions.

What actually going on here? Some may claim that the gold miner hasn’t done anything wrong especially if he intends to buy the warehouse receipts back and destroy them at some point in the future. This is akin to saying that it’s okay for an employee to embezzle money from the payroll account (assuming it’s not going to be paid out for two weeks) as long as he returns the money before the money is needed for payroll. That logic is flawed; the crime is committed the moment the embezzler takes what isn’t his. Likewise, a crime occurs when the gold miner passes off warehouse receipts that aren’t backed by the medium of exchange in his vaults (which subsequently represent work that someone did).

If the gold miner prints too many warehouse receipts, other individuals will start to become suspicious and demand their gold back. When it turns out that there isn’t enough gold to go around a bank run will occur. In the end, the gold miner will be bankrupt, thus there is a very high incentive not to print too much money that people start to lose their trust that all the gold is safe in the vault.

So is this the way we got to where we are? Well, many individuals did understand that banks didn’t operate on 100% reserves. As my Professor very kindly pointed out: under a free banking situation, individuals understood that banks inflated and still deposited their money with them to earn interest. How does this differ from our current situation? It’s very simple: with free banking the system operates on contracts. The bank tells you exactly how much money it will have on hand and you agree to the terms. Maybe instead of a demand deposit it’s subject to a two week holding period allowing the bank to collect on its loan portfolio. The current system operates by government mandate (which is essentially the nice way of saying force). The Fed was created by a group of bankers which allowed all banks to inflate the same amount thus taking away any due diligence that would’ve previously been done. Without the Fed, you’d be interested in knowing exactly who your bank lends your money to, how much they keep on hand, and the relative risk of that money. If the government, though, says that all banks are allowed to lend ten times as much of the number of deposits that they have and then sticks on FDIC insurance which will cover everyone in case the bank loan goes bad, why does anyone care which bank they keep money at. Now everyone just cares which one gives away the better toaster!

Not only does due diligence fly out the window, but banks can take on whatever loans they want without worrying that I might want to take a look at their portfolio. But if banks under a free banking system inflate anyway, what’s the difference? After all, an artist can “inflate” a masterpiece by having it reproduced. The artist will likely benefit, but whoever possessed the original will see a drop in his price. Again, it’s basic economics. Increase supply and the price drops. So banks can just increase the supply and the value of money will fall. Why should this concern us? Well, the additional painting brought additional value to another individual. Just as we all benefit when there’s more farming equipment (more equipment means cheaper prices both for the equipment and in prices of our food), we all benefit from “inflation” of most goods.

However, there is a very interesting characteristic of money that sets it apart from all other goods; if you think about any regular good, society benefits when there’s more of it. For example, if we double the number of Ferrari’s, ceterus paribus, the world as a whole is better off: more individuals are able to drive a nice car. If we double the number of refrigerators again the world as a whole is better off. Eliminate half of the cruise ships in the world and society is worse off. Now what about money? Double the supply of money and everything will get twice as expensive. Eliminate half the supply of money and everything will become half as expensive. What this means is that it really doesn’t matter how much money there is when comparing two separate situations. It does matter, however, if the money supply changes. If I lend you $100 for a year and charge you 12% interest then at the end of the year you will owe me $112. Assuming that inflation is 2%, that means that in real terms I have made 10%. To say that another way, you have compensated me $10 for the use of my $100 for a year. Obviously this was a good deal for both of us or else one of us wouldn’t have made the deal. I valued earning $10 more highly than using my $100 for a year and you valued using my $100 for a year more than you did the prospect of having $10 in one year. If, during the course of the year, inflation where to increase to say 5%, then the math changes a bit. Instead of me earning $10 for letting you use my money for a year, I only receive $7 in real terms [100*(12%-5%)]. Who benefits in this situation? Well, obviously you, being the borrower do. You were willing to pay $12 in nominal dollars but only had to pay me $7. From this emerges the general principle: under inflation, the borrower benefits at the expense of the lender.

So why would government want to have anything to do with the money supply? Well, who in this country is the largest borrower? Who benefits when inflation happens, the lender or the borrower?

In a society where sound money with a 100% reserve existed, the condition that the financial markets are in wouldn’t be possible. Currently we have a domino effect in which each firm’s losses will ripple through the economy. A credit contraction is necessary simply because of the way banks functions. Take away $1 and the bank has to take back $10 in loans (as the reserve ratio is currently 10:1) This means that if a bank has to write off a dollar, it can’t lend out the $10 that it otherwise would have. Why can’t you get approved for a home loan? Because banks have to write off these bad debts and therefore don’t have the reserves to loan out to you. Under a free banking system with commodity backed money a bank would simply write off the bad loan and be more careful the next time. Nobody else would be affected.

Given that in the free market 100% reserve banking doesn’t occur, we then must ask ourselves where along the spectrum is a better place to be? Allowing all banks to inflate the money supply at the same time regardless of what they’re investing in or holding them accountable for their loaning practices? A free banking system allows for a system much more in line with this than the current one that you and I are paying dearly to return to. What this allows is for competition. If I prefer to use a bank as a warehouse with 100% reserves, I would have to pay the bank a fee for this service (just a boat owner must pay the marina a few). If I preferred to earn a little interest, I might use a bank that promised to have 50% reserves on hand at all time. What would happen is that each bank would have its own type of bank note. An individual using a bank note with 100% reserves would be trusted more than one that operated on only 10% reserves and thus would be more valuable and more likely to be accepted at face value in any exchange that one might participate in.

So, does the government have to do something? Absolutely! It should limit itself. Since that hasn’t happened yet it’s important that we limit it. The market has been everyone’s whipping boy; however our economy was a pseudo-free market because the medium of exchange was government fiat. This leaves out the fact that much of the situation we’re in was caused by government regulation forcing banks to reinvest in communities and government sponsored entities like Fannie and Freddie. If you own a guard dog that bites one of your friends, what do you do? Would you go out and buy another guard dog to protect your friends from the first guard dog? Absolutely not! You’d get rid of the first guard dog. So, if bad legislation caused us to arrive at this situation, do we write more legislation to help us get out? I would suggest we simply remove the bad legislation and move on. The New Individualist recently published an article tracking our most recent bubbles: liquidity was pumped into the market to stop a crisis from happening when Long Term Capital Management failed. This lead to the Internet bubble. When this bubble exploded, more liquidity was pumped in to the system. What we see is that each time the government tries to fix the situation, it only makes it worse. Government is short-sighted and is ignoring the long term implications of its policies. Bastiat would say that the unseen is being ignored. Which do you think politicians are more interested in? The long-term or the short term?

Upon a recent visit to our friendly District 7 Federal Reserve Bank (Chicago), one of their representatives’ commented that the Fed and the government are working on two things: the first is restoring liquidity to the market and the second is to restore investor confidence. They “restore” liquidity by pumping extra money into the economy by printing more money and raising taxes (by expanding the national debt meaning that our future tax liabilities have increased). When markets realize that this money is really fake (nothing has been done to earn this money, it was just created) the government doesn’t understand why confidence is dwindling. How should one restore confidence to the market? Maybe by banning government manipulation of the currency. Many of the issues that I’ve discussed involve a lot of common sense; when politicians and authority figures tell you some “truth” that conflicts with your logic, I’d encourage you to question it. If anything I’ve said here conflicts with your logic, challenge it! Find out for yourself and discover what’s truly correct!