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".
Monday, 21 September 2009
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.
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.
Monday, 3 August 2009
Inflation vs Hyperinflation vs Deflation (again).
This issue is so critical and yest so hard to decide that I think it is worth looking at from every possible point of view. I'm going to make two lists, one for things that increase the money supply and one of things that decrease it:
("customers" = individuals, businesses, foreign governments etc. MS = money supply. MB = monetary base)
Don't forget that MB is much smaller than MS.
Factors that can lead to increases:
("customers" = individuals, businesses, foreign governments etc. MS = money supply. MB = monetary base)
Don't forget that MB is much smaller than MS.
Factors that can lead to increases:
- Customers taking out new loans from banks. (Directly increases MS)
- Governments printing money to buy their own bonds to "pay" for their debt. (Directly increases MB)
- Governments printing money expressly for the purposes of avoiding deflation. (Directly increases MB)
- Lowering reserve requirements (gives permission to increase MS via extra allowed loans, but that's if the banks can find suitable borrowers)
- Lowering capital requirements (gives permission to increase MS via extra allowed loans, but that's if the banks can find suitable borrowers)
- Customers paying back loans to banks (Directly decreases MS)
- Customers defaulting on bank loans (Directly decreases MS)
- Raising reserve requirements (leads to decreased MS)
- Raising capital requirements (leads to decreased MS)
Saturday, 1 August 2009
Laissez-faire economics is sub-optimal - a proof.
There are many people that seem to believe that the solution to every problem in economics can be solved by removing regulation and "letting the markets decide". Other people disagree and will produce all sorts of "hand waving" arguments to explain why that's sub-optimal. I recently realized that a certain, reasonably well studied, statistical conundrum has a striking parallel to a problem in economics and its study could remove the need for some of these "hand waving" arguments and replace them with mathematical proof. The conundrum is known as "the multi-armed bandit problem" - but before I explain what it is, or its solution, I'd better explain the problem in economics that I believe it so neatly parallels.
The problem in economics is this: who should make new product X. Communists might say "lets have an expert government committee choose a single company Y and only allow them to make it" whereas the free marketeers would say "let multiple companies A, B, C, D and E make it and the market will decide which is the best and let the others go bust - and for gods sake don't let the government interfere with this process!".
Now I will introduce the statistical conundrum. Its called the multi-armed bandit problem:
Imagine you have a collection of one armed bandits in a casino. Each one has a certain "payout rate" which corresponds to the percentage of the money paid in to it, that it will pay out (in the long run). In real casinos this is often set at something like 80-90 percent, but imagine that this particular model of one armed bandit can be set to a any predefined payout rate (0% to 100%) using a dial inside the machine that the casino owner can set with a screwdriver. Now let’s say that one night the casino owner comes in and sets each bandit to a different payout rate, no two are the same. Now you arrive the following morning with a great big bag of coins. You are determined to spend the whole day playing on these bandits and you have complete freedom to choose which ones you play on... you are allowed to switch from one to another at will. Now the question is, what is your strategy for selecting bandits such that you come home with the greatest winnings?
I'll give you one possible solution: put 50 coins in each of the bandits in order to make an estimate of the payout rates. Then stick to the one that appeared to have the highest rate for the rest of the day. This solution is certainly better that simply selecting the bandits at random, but can be mathematically proven to be sub-optimal, i.e. there are known strategies that will lead to greater winnings. One problem with this strategy is that if two bandits paid out rather good, but very similar, amounts than it may not be very clear which is better. It may be more profitable to continue playing these two for a greater number of trials to gain more confidence in your determination of which is the best one. The problem illustrates what is known as an "exploitation-exploration dilemma". The "exploration" referring to the effort exploring which bandit may be the best (e.g. the 50 coin trial at the start) and the "exploitation" refers to simply repeatedly playing the bandit which you estimate is the best.
I believe this conundrum is analogous to the process of choosing companies to make products in a free market. The bandits are like the companies, the payouts are like the goods and the gambler is like the public, choosing the “company” that produces the best “goods”. At the start of the process the gambler/public does not know for sure who can make the best version of product X so he must try each one. Then, if it becomes obvious that some companies are better than others, the known bad companies will cease to be tried (= “go bust”) while the still-possibly-best will get tried some more.
Now there is one more complication that needs to be added to the standard multi-armed bandit problem to make it even more analogous to real life business. There is a variation called the “restless bandit problem” where the payout rates are not fixed but rather, evolve over time. This is more like a real company where the management and employees will change over time. Their manufacturing equipment may wear our, break or become redundant and a host of other things may happen that will change the ability of the company to produce good products. Now in the restless bandit problem it is essential to do more “exploration” than in the case of the standard multi-armed bandit problem. You would never want to entirely give up trying a previously poorly performing bandit because it may have now evolved into a better performing bandit.
It can be mathematically proven that for the restless bandit problem, a strategy of “playing all for a short while and then exclusively playing on the one that appeared best forever more” is a sub-optimal strategy. There is too little “exploration”. It is sub optimal for at least two reasons.
1. You may be mistaken in your estimate of which one is the best (how could this be?**)
2. The true best bandit may change over time.
This result has important implications for free marketeers. I believe it proves that the free market is sub optimal. This is because a free market acts like the “too little exploration” strategy. The thing is that in a free market, companies that fall short of producing the best goods tend to go bust even if they only fall short by a small margin. Obviously when a company goes bust, it can never be “tried” again, it doesn’t get a second chance. The succeeding company (or very small number of companies) tends to grow and dominate the market. Once a company dominates a market then it can start to raise its prices and employ a plethora of strategies to suppress rivals, that have nothing to do with producing the best goods for the consumer. For example:
• Tying up exclusive distribution channels
• Using your size to get raw materials for less than any new rivals can
• Using your size to negotiate higher prices from retailers than any new rivals could.
These factors make the “too little exploration” strategy even more sub-optimal in the restless bandit domain because it’s as if, as soon as we make up our minds and settle on the bandit that we think is best, it almost certainly reduces its payout rate.
Now in the exploration-exploitation dilemma, it is perfectly possible to do too much exploration. In the extreme that would be like playing all of the bandits equally often. And this can easily be proven to be sub optimal. So there is a balance to be struck.
In the real world there are many things that could be done to make sure that there is enough “exploration” in an economy, many of which are already in place to a greater or lesser extent in many countries around the world. Any laws that aim to prevent monopolies or encourages overly large companies to split in to smaller parts are a good start. So, one might say that effectively the world is already aware of the problem. But I hope that this article A) gives some mathematical support for these kind of policies and B) proves that free market fundamentalism is a sub-optimal strategy.
---
** Say you have 2 bandits A and B. A has a payout rate of 60% (in the long run), B has a payout rate of 70% (in the long run). If the sample you have measured so far is small (e.g. 10 coins or so) then it is very easy for A to have paid out more than B just by fluke. The same kind of "mistake" can happen in the economic world with two companies. Say you have two companies A and B. Say that company A is currently fundamentally better than company B, it's management are smarter, it's workers are more hard working etc and in the long run, given a choice of 10 yet-to-be-invented products to make, it would make 9 of them better than B would. Unfortunately the first of these products to be invented was the one product it makes worse than B so the consumer would incorrectly guess that B was the better company.
The problem in economics is this: who should make new product X. Communists might say "lets have an expert government committee choose a single company Y and only allow them to make it" whereas the free marketeers would say "let multiple companies A, B, C, D and E make it and the market will decide which is the best and let the others go bust - and for gods sake don't let the government interfere with this process!".
Now I will introduce the statistical conundrum. Its called the multi-armed bandit problem:
Imagine you have a collection of one armed bandits in a casino. Each one has a certain "payout rate" which corresponds to the percentage of the money paid in to it, that it will pay out (in the long run). In real casinos this is often set at something like 80-90 percent, but imagine that this particular model of one armed bandit can be set to a any predefined payout rate (0% to 100%) using a dial inside the machine that the casino owner can set with a screwdriver. Now let’s say that one night the casino owner comes in and sets each bandit to a different payout rate, no two are the same. Now you arrive the following morning with a great big bag of coins. You are determined to spend the whole day playing on these bandits and you have complete freedom to choose which ones you play on... you are allowed to switch from one to another at will. Now the question is, what is your strategy for selecting bandits such that you come home with the greatest winnings?
I'll give you one possible solution: put 50 coins in each of the bandits in order to make an estimate of the payout rates. Then stick to the one that appeared to have the highest rate for the rest of the day. This solution is certainly better that simply selecting the bandits at random, but can be mathematically proven to be sub-optimal, i.e. there are known strategies that will lead to greater winnings. One problem with this strategy is that if two bandits paid out rather good, but very similar, amounts than it may not be very clear which is better. It may be more profitable to continue playing these two for a greater number of trials to gain more confidence in your determination of which is the best one. The problem illustrates what is known as an "exploitation-exploration dilemma". The "exploration" referring to the effort exploring which bandit may be the best (e.g. the 50 coin trial at the start) and the "exploitation" refers to simply repeatedly playing the bandit which you estimate is the best.
I believe this conundrum is analogous to the process of choosing companies to make products in a free market. The bandits are like the companies, the payouts are like the goods and the gambler is like the public, choosing the “company” that produces the best “goods”. At the start of the process the gambler/public does not know for sure who can make the best version of product X so he must try each one. Then, if it becomes obvious that some companies are better than others, the known bad companies will cease to be tried (= “go bust”) while the still-possibly-best will get tried some more.
Now there is one more complication that needs to be added to the standard multi-armed bandit problem to make it even more analogous to real life business. There is a variation called the “restless bandit problem” where the payout rates are not fixed but rather, evolve over time. This is more like a real company where the management and employees will change over time. Their manufacturing equipment may wear our, break or become redundant and a host of other things may happen that will change the ability of the company to produce good products. Now in the restless bandit problem it is essential to do more “exploration” than in the case of the standard multi-armed bandit problem. You would never want to entirely give up trying a previously poorly performing bandit because it may have now evolved into a better performing bandit.
It can be mathematically proven that for the restless bandit problem, a strategy of “playing all for a short while and then exclusively playing on the one that appeared best forever more” is a sub-optimal strategy. There is too little “exploration”. It is sub optimal for at least two reasons.
1. You may be mistaken in your estimate of which one is the best (how could this be?**)
2. The true best bandit may change over time.
This result has important implications for free marketeers. I believe it proves that the free market is sub optimal. This is because a free market acts like the “too little exploration” strategy. The thing is that in a free market, companies that fall short of producing the best goods tend to go bust even if they only fall short by a small margin. Obviously when a company goes bust, it can never be “tried” again, it doesn’t get a second chance. The succeeding company (or very small number of companies) tends to grow and dominate the market. Once a company dominates a market then it can start to raise its prices and employ a plethora of strategies to suppress rivals, that have nothing to do with producing the best goods for the consumer. For example:
• Tying up exclusive distribution channels
• Using your size to get raw materials for less than any new rivals can
• Using your size to negotiate higher prices from retailers than any new rivals could.
These factors make the “too little exploration” strategy even more sub-optimal in the restless bandit domain because it’s as if, as soon as we make up our minds and settle on the bandit that we think is best, it almost certainly reduces its payout rate.
Now in the exploration-exploitation dilemma, it is perfectly possible to do too much exploration. In the extreme that would be like playing all of the bandits equally often. And this can easily be proven to be sub optimal. So there is a balance to be struck.
In the real world there are many things that could be done to make sure that there is enough “exploration” in an economy, many of which are already in place to a greater or lesser extent in many countries around the world. Any laws that aim to prevent monopolies or encourages overly large companies to split in to smaller parts are a good start. So, one might say that effectively the world is already aware of the problem. But I hope that this article A) gives some mathematical support for these kind of policies and B) proves that free market fundamentalism is a sub-optimal strategy.
---
** Say you have 2 bandits A and B. A has a payout rate of 60% (in the long run), B has a payout rate of 70% (in the long run). If the sample you have measured so far is small (e.g. 10 coins or so) then it is very easy for A to have paid out more than B just by fluke. The same kind of "mistake" can happen in the economic world with two companies. Say you have two companies A and B. Say that company A is currently fundamentally better than company B, it's management are smarter, it's workers are more hard working etc and in the long run, given a choice of 10 yet-to-be-invented products to make, it would make 9 of them better than B would. Unfortunately the first of these products to be invented was the one product it makes worse than B so the consumer would incorrectly guess that B was the better company.
Wednesday, 1 July 2009
Properties of monetary systems
The following article is thinking out loud...
How can it possibly be that some leading economists think we need to worry about deflation, while at the same time other leading economists think we need to worry about hyperinflation? The answer I believe is our damned fractional reserve banking system. The way it behaves is just so hard to understand. I believe this is fundamentally because it so poorly reflects the true nature of trade. Let me explain with a little thought experiment and some mathematics:
Imagine a "barter" system which had developed in the modern world. Imagine that all sorts of sophisticated transactions were arranged with the help of some I.T. and a good legal system such that you could have phenomena like lending and investment and all the "financial" interactions you'd expect in a capitalist system. You could envisage the flow of goods and services between people as a flow or vector field. This field would have both "sources" and "sinks". With the sources corresponding to the addition of value (e.g. assembling raw materials in to goods) and sinks corresponding to the loss of value (wearing out of goods).
The I.T. and the legal contracts would have to be very complex indeed to make this work and so people may want to introduce a system of "money" to simplify things. Now it seems obvious to me that the money system should as accurately as possible mirror the transactions that are going on in this barter system and an easy way to imagine this, is to consider that we have cash that simply flows in the opposite direction to the goods. You would have two equal and opposite vector fields. Unfortunately money can not do this precisely because it can not have sources and sinks in the same way as goods, but it would be a close approximation and money can always adjust its own value to make up for the minor discrepancies.
So why then have we ended up with this crazy fractional reserve banking system in which the total amount of money in the system can grow and shrink by a factor of ten!! In what way does that mirror the flow of trade?
I believe that the immense difficulties of understanding the world economy are largely due to this non-correspondence.
How can it possibly be that some leading economists think we need to worry about deflation, while at the same time other leading economists think we need to worry about hyperinflation? The answer I believe is our damned fractional reserve banking system. The way it behaves is just so hard to understand. I believe this is fundamentally because it so poorly reflects the true nature of trade. Let me explain with a little thought experiment and some mathematics:
Imagine a "barter" system which had developed in the modern world. Imagine that all sorts of sophisticated transactions were arranged with the help of some I.T. and a good legal system such that you could have phenomena like lending and investment and all the "financial" interactions you'd expect in a capitalist system. You could envisage the flow of goods and services between people as a flow or vector field. This field would have both "sources" and "sinks". With the sources corresponding to the addition of value (e.g. assembling raw materials in to goods) and sinks corresponding to the loss of value (wearing out of goods).
The I.T. and the legal contracts would have to be very complex indeed to make this work and so people may want to introduce a system of "money" to simplify things. Now it seems obvious to me that the money system should as accurately as possible mirror the transactions that are going on in this barter system and an easy way to imagine this, is to consider that we have cash that simply flows in the opposite direction to the goods. You would have two equal and opposite vector fields. Unfortunately money can not do this precisely because it can not have sources and sinks in the same way as goods, but it would be a close approximation and money can always adjust its own value to make up for the minor discrepancies.
So why then have we ended up with this crazy fractional reserve banking system in which the total amount of money in the system can grow and shrink by a factor of ten!! In what way does that mirror the flow of trade?
I believe that the immense difficulties of understanding the world economy are largely due to this non-correspondence.
Saturday, 27 June 2009
My experience with Wikipedia
I recently had a go at making a couple of edits of some disingenuous statements in the "Fractional Reserve Banking" section in Wikipedia. Now maybe I need to R.T.F.M., but the F.M. of Wikipedia seems just endless... It seems that after you make an edit you are supposed to explain your changes in a single line of text... which I duly did. But in no time at all someone undid my changes giving no explanation whatsoever. Then I tried to contact him through Wikipedia so that we could perhaps resolve the disagreement between us, but I found that I was barred from doing so because I wasn't a sufficiently established user. I was stumped. So now I have just tried making one of my edits again, stating that I'd like some explanation if anyone wanted to undo it. I wanted to add as part of my explanation that anyone about to undo my change should contact me but it seemed that the space Wikipedia allowed me was not big enough for such a sentence! I'm sure I have something wrong here - if anyone would like to explain to me the error of my ways please do.
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