Monday, 21 September 2009

Free trade and Austrian economics

I have a lot of time for Austrian School economics (AE). Peter Schiff (an Austrian) is one of my all time favorite economists. Austrians believe that the free market sorts out a great many economic problems all by itself, both to the benefit of workers and bosses. From what I have read so far I have realized that there are a surprising number of areas where this appears true. Many more areas than I had assumed before analyzing in detail.

Unfortunately it appears that because this principle is true very often, many Austrians have taken the intellectual leap to assuming that it is absolutely 100% always true. Even to the extent that their answer to all economic problems is "The government should do nothing at all". I firmly disagree with this position and developed the following thought experiment to argue that an AE based economy should not "do noting at all" when faced with a question of whether to control free trade with other countries:

I get the impression that a large part of AE is based on the premise that if A sells B product X then that proves that both sides are happy with the deal. But that's only true at the precise moment of exchange. It may be that B finds out that the product X, wrapped in the shiny paper, breaks after a few days and he wishes he had never purchased it in the first place. Now Austrians then say that if B was disappointed with X then A gets a bad reputation and so the system gradually "fixes" itself. But that's only true if there is a reasonable number of trials of purchasing X from A. But with a big trade imbalance it seems that the side that builds up the pile of IOU's does not really get to have many "trials" to see what they're worth...

Imagine there are just two countries in the world. One base on AE the other is rather like America. In the AE country, people like to save for the future. Oil may be running out, global warming may be coming, people are aging... etc etc, they better save for the future. One way to save for the future is to consume less than you make, sell the excess to the other country in return for IOU's and store your IOU's for the future. After all, when the hard times come they can always cash in their IOU's. Meanwhile the other country (USA) is rather short sighted - their government are interfering with the market, the national philosophy is spend spend spend. They see that this neighboring AE country is willing to swap their real produce for IOU's and they take full advantage. Both economies will gradually become skewed towards this arrangement. The USA will become full of shopping malls and have few factories. This may go on for a few decades. Both countries appear to be doing fine, the people in both countries seem fully employed (the Americans in shops, the AE country in factories). Now fast forward a few decades and some hard times hit the AE country. Oil shortages hamper production. The people are getting poorer... but never mind, they have the big pile of American IOU's. They can make up for their shortfall of produce by buying some from the Americans. But as soon as they start spending their IOU's on American goods the (now very few) American factories quickly reach full capacity and their prices will shoot up. This effectively slashes the value of the IOU's.... Product X, wrapped in the shiny paper, has broken..... Maybe the leaders in the AE country should have seen this coming and taken some kind of evasive action rather than doing "nothing at all".

Wednesday, 16 September 2009

Bank of england answers questions on Q.E.

The deputy governor of the Bank of England answers questions submitted by the public about quantitative easing here.

Saturday, 5 September 2009

Social security - a disagreement with Peter Schiff

I just saw this YouTube video in which Peter Schiff, Max Kaiser, Ron Paul all criticized the US social security system as a Ponzi scheme. Now I agree that it is a Ponzi scheme - but that's not necessarily bad! And here's why...

First of all I will describe a bad Ponzi scheme and then explain how a slight tweak can make it good.

Imagine I set up a financial institution or "retirement club" for people on average earnings. My advertising states - "save 20% of your income with us for 40 years, then on retirement we'll pay out a 'pension' which will have grown in line with national average earnings". Say I limit the club to exactly 1000 members. During the initial 40 years I need not invest a single cent of the money that was coming in - I could even spend it all on a luxury lifestyle. But when people started retiring I would, at that point, have to stop my extravagant spending and simply start paying the retired people the money that was coming in from the working savers. This "Ponzi scheme" is now no longer working to my benefit. I'll get nothing from now on. Over the years the amount of money paid out would automatically adjust in line with wages because the money coming in is always a fixed fraction of the (working) club members earnings. Now, ignoring the problem of what I live on, this is now a stable state and could continue indefinitely so long as I could always keep the membership fully subscribed. This is a bad, dangerous scheme for my members however because if at some point I failed to find new members then the retirees would lose everything - a disaster.

Now for the tweak. Imagine that this exact same scheme is run by the government. Imagine that instead of a 1000 member club, it is now a membership of "the entire nation". Now it is guaranteed that there will always be new members. Now the one flaw in the "Ponzi" scheme has disappeared. It is no longer a bad scheme! It works! It can go on forever! No problem!

I wrote a related article about pensions a few months ago here.