January 12, 2018
Equity interventions are intended to help the poor acquire the goods and services that they currently cannot afford. Although a heartfelt case is easily made for these well-intentioned interventions, Eugen Böhm-Bawerk, F.A. Hayek and other Austrian economists consider them to be an attack on freedom and puts our posterity on the road to serfdom. I demonstrate this using a simple model of demand and supply. In this process, we discover the true source of white privilege.
In a free society, the government does not interfere in the voluntary transactions and contracts between consumers and producers, or between workers and employees. In this system of free enterprise, the forces of supply and demand efficiently allocate goods and services. The figure below illustrates how this occurs.
In the figure above, the price is determined by market forces, supply and demand. At point A, the blue consumer’s demand curve meets the red firm supply curve. If the product in this market is a laptop and each consumer buys one laptop in a given period of time, 3500 laptops are purchased by 3500 consumers, and each of them pays $350 for a laptop.
However, all consumers are not equal in terms of their willingness to pay. Suppose consumers are placed in a queue according to willingness to pay. The highest willingness to pay is at the left endpoint of demand and the lowest willingness pay is at the right endpoint. The above demand curve would then imply that the first consumer is willing to pay $700 (the left endpoint of demand) for a laptop, but the last is willing to pay $0 (the right endpoint of demand). Since all consumers pay the market price, $350, a benefit of $350 accrues to the first consumer, the difference in the price that is paid and what he or she is willing to pay. Since demand declines from left to right, the benefits of having to pay just $350 declines from the first consumer ($350) to the 3500th consumer ($0). Summing these benefits across laptop buyers is called consumer surplus. It is modeled by the semitransparent blue triangle in the above diagram.
Because a point on the supply curve can be interpreted as the minimum price firms are willing to accept for a given level of output, the difference this price and the market price represents a benefit that accrues to firms. For the first laptop sold, the figure indicates that the minimum price firms are willing to sell it at is about $0. Thus, the benefit that accrues to the firm that sells the first laptop at the market price is $350. Since supply increases from left to right, the benefit of selling each additional laptop declines from $350 for the first laptop to $0 for the last laptop. Summing these benefits across laptop sold is referred to as firm surplus, which is modeled by the semitransparent red triangle in the above diagram.
If the above diagram models a labor market, price is the hourly wage rate, the red line is the labor supply of workers, the blue line is the labor demand of firms, worker surplus is the semitransparent red area, and employer surplus is the semitransparent blue area.
The sum of consumer and firm surpluses (or worker and employer surpluses) yields the measure of social welfare that economists call total surplus. It is maximized at the competitive equilibrium, point A. Since only the most efficient producers can produce products below market prices, economic efficiency is greatest when markets are competitive and government does not intervene. This means the collective economic well-being of people who participate in free and competitive markets cannot be improved by government interventions.
The question that separates economists is whether government should intervene or not. Economists battle each other in this equity-efficiency debate. Those who side with intervention use normative arguments like: Government should intervene in markets to legislate a wage that allows the working poor to deal with the skyrocketing cost of living. Such normative arguments are difficult to oppose politically because they tug on our heartstrings and can be easily made in the few seconds one is granted in a segment on the evening news. The minimum wage rate and rent control laws are great examples of such equity interventions.
If the above figure is used to describe Hypothetical City’s rental market and its low-skilled labor market, the market determined monthly apartment rent and the weekly wage rate are both equal to $350. Suppose the majority of Hypothetical City’s aldermen believe rents are too high and wages are too low. As a result, they enact a minimum wage rate of $500 per week and legislated rent of $200 per month. The horizontal black line in the left graph below is the city’s minimum wage while the same in the right graph is the city’s maximum rent.
The two polices are intended to boost the standard of living of Hypothetical City’s residents. For the residents who continue to work 40 hours per week, 50 weeks a year, the minimum wage raises their pay by $150 per week, or $7,500 per year. If rent control does not alter their housing status, rents would decline by $150 per month, or $1800 per year. The net annual benefit that accrues to said workers is $9300. This simple analysis illustrates why normative arguments supporting equity interventions are so difficult to oppose.
Positivist arguments against equity interventions are a much harder sell since much more time is needed to demonstrate their consequences. In the left figure above, the minimum wage reduces employment from 3500 (point A) to 2000 (point E) and increases the number of people wanting to work from 3500 (point A) to 5000 (point L). The result is 3000 unemployed workers, which corresponds to a 60% unemployment in Hypothetical City. Meanwhile, in the right figure above, rent control reduces the number of people living in homes to just 2000 (point H) and increases Hypothetical City’s population to 5000 (point N). The 3000 people who are now looking for housing must either room with the 2000 who were lucky enough to keep their apartments or live on the streets. If the apartments are just big enough for one person, rent control would result in a homeless population of 3000, which is 60% of Hypothetical City’s larger population.
The consequences of equity interventions are far more reaching than Hypothetical City’s 60% unemployment rate and 60% homeless rate.
If job skills are correlated with education and education is correlated with household income, then the workers raised in the wealthiest households would have today’s most valuable job skills and those raised in the poorest households would have today’s least valuable job skills. Since labor demand can be interpreted as a queue that orders workers with the most valuable job skills on the left to those with the least valuable skills on the right, by assumption, it would also order workers from those raised in the wealthiest households on the left to those raised in the poorest households on the right.
Before the minimum wage was imposed, all 3500 of Hypothetical City’s original residents worked for $350 per week. Its enactment induced 1500 new residents to move to Hypothetical City. None of them were able to find work because their job skills were less valued than those possessed by the city’s original residents. By assumption, the 2000 workers who kept their jobs were raised in the wealthiest households, the original residents who lost their jobs were raised in middle-class households, and the newest residents who could not find work were raised in the poorest households.
With regard to product demand, suppose willingness to pay for products and housing is positively correlated to income. Under this assumption, the blue demand curve in the right figure above represents a queue with the richest resident of Hypothetical City being at the left endpoint and the poorest being at the right endpoint. The richest person would be willing to pay $700 per month for an apartment but would only have to pay $200. If Hypothetical City does not have the resources to police bribery or black market activity, the richest person is willing to pay a bribe as high as $500. Bribes decline along housing demand to $300, the bribe the 2000th richest person is willing to pay. However, since the rent was $350 prior to rent control, bribes would be much lower. If apartments are of unequal quality, the richest resident would get the nicest apartment with biggest bribe and the 2000th richest resident would get the last apartment with 2000th largest bribe.
Prior to rent control, all 3500 of Hypothetical City’s original residents had homes. However, rent control displaced the city’s middle class, the 2001st to 3500th richest residents. All ended up living on the street with the 1500 people who were induced to moving to the city with its artificially low rents.
Suppose that Hypothetical City also set a maximum price on laptops to make them more affordable to the poor. For simplicity, suppose the demand and supply curves above also model the annual demand and supply of laptops. If the city imposed a price ceiling of $200 on each laptop, the right graph in the figure above implies that only the richest 2000 residents are able to replace their aging laptops. This is so because they are willing to pay higher prices in emerging black markets. If the price ceiling had not been imposed, all of the city’s original residents could continue to replace older laptops every year. The price ceiling means the members of the city’s former middle class are stuck with aging laptops.
Thus the policies that are intended to help the poor—rent control, price ceilings and the minimum rate—harms the poor, destroys the middle class, and widen wealth and income gaps. Since these policies had little effect on the residents who were raised in the wealthiest households, equity interventions, at least in Hypothetical City, are grants the their privilege.
Hal Snarr: Will the cocktails the policy mixologists keep serving result in the nastiest economic hangover ever?
September 13, 2017
When the economy begins to sink into recession, politicians, economists, policy wonks, and bureaucrats at the Federal Reserve (the Fed) start serving up cocktails of fiscal and monetary stimulus. Although history has shown that the cocktails that these mixologists concoct ultimately gives us a nasty economic hangover, it seems that they have not learned this lesson.
The graph below shows how inflationary monetary policy affects the Case-Shiller Home Price Index. In this diagram, quarterly home prices are plotted versus the M2 money stock from just over two years earlier. Since both variables are in log-scale, the red line in this graph implies that after the Fed raises the growth rate of M2 by 1%, the home prices rise by around 0.367%, nine quarters later. Since the average quarter-to-quarter change in the M2 growth rate is about 16% (this was the case between 1995 and 2004), the line it the graph implies that raising M2’s growth rate by 16% per quarter causes the growth in home prices to increase by 6% per quarter.
The compounding effect of a 16%-quarter-to-quarter rise in M2 has a substantial effect on home prices. For example, suppose the M2 growth rate is 2% (M2 growth rate was 1.7% in the third quarter of 1995) at a time when the Fed decides to set interest rates low for an extended period of time. After 12 consecutive quarters of compounding, the quarter-to-quarter M2 growth rate would accelerate up to 10% (the M2 growth rate was 10.2% in the second quarter of 1998). Further, suppose that the quarter-to-quarter home price growth rate is 12% nine quarters prior to the Fed commencing its inflation (the average growth rate in the home price index was 12% from 1997 to 2007). With home prices accelerating at 6% per quarter, the quarterly growth rate in home prices would reach 119% after 12 consecutive quarters of M2 growing at 16% per quarter.
The acceleration in an asset’s price is referred to as an asset bubble. These are popped after the Fed pokes bubbles with restrictive monetary policy. Poking asset bubbles usually pushes the economy into a recession. This seems obvious in the graph below. It shows that prior to every recession since the early 1980s, a rapid rise in the federal funds rate has resulted in a recession a few months later.
The graphs below illustrate how restrictive monetary policy slows economic growth. In these diagrams, quarterly economic growth rates are plotted versus the quarterly federal funds rate from the previous year. Since both variables are in log-scale, the red lines in these graphs imply that after the Fed raises the federal funds rate by 1%, the economic growth rate declines by 0.4% (0.37% for the earlier period and 0.46% for the latter period). Since the Fed’s average quarter-to-quarter adjustment of the federal funds is 23% (this was the case between 2009 and 2017), the two charts imply economic growth declines by 10% per quarter after the federal funds rate is raised by 23% from the previous quarter.
The compounding effect of a 23%-quarter-to-quarter increase in the federal funds rate is substantial. For example, suppose the Fed wants to normalize rates after it had set its target at 1% for an extended period to push economic growth back up to 3%. Further, suppose that 4.25% is considered “normal” for the federal funds rate. To raise the fed funds rate from 1% to 4.25%, the Fed has to boost its target by 23% a quarter for eight consecutive quarters. Doing this dampens economic growth by around 10% per quarter. After the dust settles and negative compounding kicks in over eight consecutive quarters, the economic growth slips to 1.43%, two years after it had recovered to 3%.
The chart below plots the average annual federal funds rate over time. It suggests that the monetary policy mixologists at the Fed have failed to learn the lesson that its policies cause the business cycle. The first part of this lesson, call it Lesson 1, is: Economic expansions, the white areas in the graph, begin after the Fed pushes the price of credit too low for too long. The second lesson, Lesson 2, is: Economic recessions, the shaded vertical bars in the graph, begin after the Fed pushes the price of credit well above the natural rate of interest.
Is it comforting that the tail end of the above graph, from 2009 and on, appears to show that the Fed has learned Lesson 2? The graph shows that the Fed has slowly pushed the federal funds rate from near zero to around 1 percent in the nine years following the 2008 financial crisis. Keeping the price of credit near zero for such a long time seems to show that the Fed has finally learned that normalizing interest rates from a very low rate triggers recession.
On the other hand, the right tail of this graph also suggests that the Fed has not learned Lesson 1. The last time it kept interest rates at around 1% for a few years resulted in the longest recession since the Fed was given the keys to the economy. Since 2008, the Fed has kept interest rates at an even lower level for nine years and counting. If Austrian Business Cycle Theory is correct, then the historic monetary stimulus party of the last nine years may trigger the most painful economic hangover ever.
April 19, 2017
Equity interventions promise to help the poor acquire goods and services that they currently cannot afford. Although a heartfelt case can be made for these interventions in the short run, the period where contracts fix wages and construction of buildings and roads is ongoing, F.A. Hayek’s The Road to Serfdom explains why they eventually trap our posterity in poverty.
In a free society, the government does not interfere in the voluntary transactions and contracts between consumers and producers, or between workers and employees. In this system of free enterprise, or free market capitalism, the forces of supply and demand efficiently allocate goods and services.
The figure below illustrates how markets efficiently allocate products. The price is determined at point A, where consumer demand (the blue line) intersects firm supply (the red line). The blue triangle is called consumer surplus since each unit sells for just $4, but the maximum prices consumers are willing to pay for the first unit purchased to 3500th declines along demand from $7.50 on the left to $4 at point A. The pink triangle is called firm surplus since each unit sells for $4, but the minimum prices firms are willing to accept for the first unit produced to 3500th rises along supply from $0.50 on the left to $4 at point A. The sum of consumer surplus and firm surplus is total surplus. It is a measure of social welfare, which reaches its maximum at competitive equilibrium point A.
If the above diagram represents a labor market, the price is the hourly wage rate, the red line is the labor supply of workers, and the blue line is the labor demand of firms. In a free market system, social welfare, as measured by the sum of worker surplus (the pink area) and firm surplus (the blue area), is at its highest level at the competitive equilibrium.
The economists in the equity-efficiency debate use positive or normative arguments to make their cases. Normative economics says the government should intervene to help the poor, limit pollution, or provide consumers with more information. Positive economics opposes intervention because the accompanying consequences tend to harm those the policy was supposed to help. Normative statements are difficult to oppose because they tug on our heartstrings and are easily made in the few seconds one is given in today’s news media.
The ongoing political discussion regarding the minimum wage is a great example of an equity-efficiency debate. In the figure below, the minimum wage (the horizontal black line) succeeds in raising the hourly wage from $4 to $5. Workers who continue to work 40 hours a week have a higher standard of living. Their weekly pay rises from $160 to $200. Over a year, their pay rises from $8,000 to $10,000, assuming employees work 40 hours per week, 50 weeks a year. The minimum wage is an easy sell for normative economics. Anyone who opposes it comes off as being heartless.
The positivist economics argument against a minimum wage is much harder to make because much time is needed to demonstrate the many harms from the intervention’s unintended consequences. In the figure above, notice that the minimum wage reduces employment from 3500 at point A to 2500 at point E. It separates workers into 2500 winners and 1000 losers. The winners keep their jobs that now pay $5 per hour. The losers were making $8000 a year, lost their jobs and incomes, and continue to look for work.
The minimum wage also increases the labor force by 1000, from 3500 at point A to 4500 at point L. Adding this value to the 1000 workers who lost their jobs results in 2000 unemployed workers. Dividing this sum by the size of the labor force yields an unemployment rate of 44%, which was 0% prior to the minimum wage.
The minimum wage harms the people it was supposed to help the most. To see this, place all workers in a queue according to the value of their job skills. The worker with the most valuable job skills is on the left, while the one with the least valuable job skills is on the right. Since the wage reflects the value of one’s labor, this queue traces out labor demand. It says firms are willing to pay the worker with the most valuable skill-set $7.50 per hour. It also says that firms are willing to pay the 3500th worker just $4 per hour. In this light, the minimum wage harms the people with the least valuable job skills, the 1000 displaced workers.
The minimum wage reduces social welfare by the small green triangle in the above figure. It also benefits workers who kept their jobs at the expense of firms, as measured by the increase in worker surplus (the shaded pink area got larger) and the decrease in firm surplus (the blue triangle got smaller).
If production levels are maintained after the minimum wage is implemented, firms that rely on low-skilled labor may eliminate perks (e.g., free coffee, meals, tickets to various events and parking) or move some of their operations to overseas facilities. Some firms may decide to replace low-skilled labor with automation. Examples of this include the self-checkout lanes that have replaced cashiers or the robots that will eventually replace janitors and hamburger cooks. The workers who are displaced by automation remain jobless or must invest much time and money into acquiring valuable new job skills.
Suppose government compensates the 1000 displaced workers and the 1000 people who unsuccessfully entered the labor force with transfer payments equal to the income they would have earned had they been able to find or keep minimum wage jobs. In the above figure, the rectangle formed by the minimum wage line, the horizontal axis, and the two dashed lines implies that this program costs $10,000 per hour. This translates to $400,000 per week or $20,000,000 per year.
The above compensation program approximates reality well. In 35 states, the monetary value of receiving public assistance exceeds the pay from a minimum-wage job. This encourages the unemployed to stop looking for work. It may also discourage many of them from acquiring new job skills. Either way, the average length of joblessness is higher than it would have otherwise been. Unless public assistance payments are curtailed, the costs of these programs will accelerate over the long run as increasingly more people learn that work does not pay.
Public assistance is not free. The money paid out to program participants comes from somewhere. Government raises this money by imposing taxes on others.
In the diagram below, government levies a $2 tax on firms. This tax reduces product supply from the dark red line to the pink line. The vertical distance between these two lines is the $2 tax. The tax reduces output from 3500 at point A to 2500 at point B. It raises tax revenue by $5000, the area of the green rectangle. The tax punishes firms and consumers, as measured by the reductions in consumer surplus (the blue triangle) and firm surplus (the pink triangle). It also reduces social welfare by $1000, the area of the white triangle that points from the left toward point A.
If the $2 tax is also levied on consumers, product demand shifts inward to the light blue line below. At point F, it intersects the supply curve that resulted from firms being taxed (the pink line). Although the tax on consumers increases the green tax revenue box’s height from $2 (in the above diagram) to $4 (in the below diagram), the width of this box falls to 1500. The smaller width results from the equilibrium quantity falling from 3500 at point A to just 1500 at point C. Together, the two taxes generate $6000 in tax revenue (the area of the green rectangle below) but lower social welfare by $4000 (the area of the white triangle that points toward point A).
The minimum wage’s unintended consequences does much harm. This is why politicians, like former President Clinton, argue for modest incremental increases to it. Economists who support raising the minimum wage point out that past increases have not been associated with a higher unemployment. This argument, however, skirts the fact that these small incremental increases occurred during economic expansions. This suggests that the minimum wage is rarely set above market wages. This would delay the unemployment effect of a minimum wage increase years into the future. Since economic variables are recorded as the economy enters a recession at the higher minimum wage, it is difficult to determine what portion of the resulting rise in unemployment is attributable to a higher minimum wage.
Equity interventions distort markets, raise prices, and fail to accomplish policy makers’ goals. This is precisely why Eugen Böhm-Bawerk and other Austrian economists consider equity interventions to be an attack on freedom that ultimately puts our posterity on the road to serfdom.
March 17, 2017
The way that macroeconomics is politically applied today produces a rift that separates it into demand-siders and supply-siders. Demand-siders advocate for temporary changes like tax cuts, higher government expenditures, and lower interest rates to stimulate aggregate demand when the economy is in a high-unemployment rut. The former pair of policies, however, produce budget deficits. To pay them off, demand-side economics proposes temporary changes in fiscal policy like higher tax rates or cuts in government expenditures. Although these policies pay down deficits, they are politically unpopular and have little chance of being enacted. Oddly, this is not the case with temporary interest rates hikes by the demand-siders at the Fed. In fact, most expect it since overstimulated aggregated demand needs to be pushed back down to head off the inflation that economic stimulus creates.
Supply-siders, like Robert Mundell and Art Laffer, focus on stimulating aggregate supply by setting marginal tax rates low and reducing government regulations. These policies reduce the costs of production and regulation compliance. The increase in the supply of goods and services that results lowers prices, which puts more money in the pockets of consumers. The increase in product supply also raises the demand for labor. More people working results in greater product demand. In total, as economic activity swells, tax receipts rise at lower tax rates.
The Laffer curve is the relationship between a tax rate and the revenue it generates. It is a core principle of supply-side economics. It got its name during a 1974 dinner attended by Jude Wanniski, Art Laffer, Donald Rumsfeld, and Dick Cheney. Although a 14th-century Muslim philosopher, Ibn Khaldun, discussed the relationship in The Muqaddimah, Wanniski dubbed it the Laffer curve after Laffer drew it on a napkin to show why President Ford’s tax increase would not raise tax revenue. (For the complete story, go to LafferCenter.com.)
The Laffer curve was the topic of discussion in Ferris’ economics class while he was ditching high school in the classic 1986 movie, Ferris Bueller’s Day Off. According to Ferris’ Economics Teacher, played brilliantly by Ben Stein, the Laffer curve explains why the Hawley-Smoot Tariff Act of 1930 did not work as intended:
In 1930, the Republican-controlled House of Representatives, in an effort to alleviate the effects of the… Anyone? Anyone?… the Great Depression, passed the… Anyone? Anyone? The tariff bill? The Hawley-Smoot Tariff Act? Which, anyone? Raised or lowered?… raised tariffs, in an effort to collect more revenue for the federal government. Did it work? Anyone? Anyone know the effects? It did not work…
The Laffer curve indicated by the arrow in the above picture suggests that tax receipts max out at the green dot. Tax revenue is zero at the red dot because a 100% tax rate drives all economic activity underground. Tax revenue is zero at the yellow dot since the tax rate is 0%. Raising the tax rate along the curve from the yellow dot to the green dot raises tax receipts as it reduces legitimate economic activity. Raising the tax rate from the green dot to the red dot reduces tax receipts because it drives increasingly more economic activity underground.
The Laffer curve does not imply what the “optimal tax” rate is for a given year. In the figure below, tax receipts peak at a 20% tax rate on the red Laffer curve, but at 50% and 80% on the black and blue Laffer curves. These curves simply say that tax receipts rise when the tax rate is raised from a very low level or is lowered from a very high level.
The Laffer curve also suggests there is a limit to the amount of money that government can seize from the public via taxation. Thus, elected officials interested in balancing the fiscal budget can only spend up to the tax revenue that the optimal tax rate generates. At any other tax rate, a budget deficit occurs.
The figure above can also be used to demonstrate how the optimal tax rate for a given country evolves over time. If people and capital are free to move across borders, the tax rates in other nations will affect a country’s optimal tax rate. Suppose all governments had their tax rates set at 80% at one point. If all but the government of nation A reduced their tax rates to 50%, and then to 20%, firms and citizens in nation A will eventually move to other countries to avoid paying an 80% tax rate. This implies that a country’s optimal tax rate can fall as other nations reduce their tax rates.
A temporary reduction in the tax rate has no effect on an economy’s long-run productive capacity. However, since it temporarily reduces production costs and raises disposable incomes, aggregate demand and short run aggregate supply shift outward. With long run aggregate supply unchanged, the economy ends up in an inflationary gap, the situation where unemployment is below its natural rate. Since this creates a bidding war for labor, aggregate supply falls back before the tax-rate cuts sunset. Aggregate demand retreats after the tax-rate cuts sunset.
For supply-side economics to work, low tax rates must be permanent. This is so because it creates certainty, which is important to firms as they adjust their long run plans. Instead of moving operations overseas, they expand domestically. This shifts long run and short run aggregate supply outward at a pace higher than what would have prevailed otherwise. Aggregate demand increases too after the lower tax rate boosts disposable incomes. In theory, supply-side economic policy results in no inflation over the long run and ever-expanding GDP. In practice, however, low tax rates are never permanent since Congress cannot bind future Congresses to the policies it enacts.
The above suggests that it is difficult to evaluate supply-side economics. The curve below is a crude estimate of the U.S. Laffer curve. The horizontal axis is the top marginal income tax rate (from TaxPolicyCenter.org). The vertical axis is real per capita tax revenue. It equals individual income tax receipts (from Table 2.1 of the OMB’s Historical Tables) divided by population and by the GDP Implicit Price Deflator. Since real per-capita tax receipts are in log-scale, the red line in the graph implies that per-capita tax revenue falls by 1.8% if the top marginal tax rate is raised from 39.6% to 40.6%. With 2015 income tax receipts of $1.5 trillion, or $4,785 for each of the 322 million Americans, this estimate implies that a 1-point increase in the top marginal tax rate will lower annual federal income tax receipts by $28 billion.
The graph on the left in the figure below supports the Laffer effect. After accounting for the effects of the 2001 and 2009 recessions, the trends in this graph show that people in the upper half of the income distribution generally paid an increasingly greater share of all income taxes collected as the top marginal tax rate was lowered to 39.1% in 2001, 38.6% in 2002, and 35% in 2003.
The graph above on the right shows the relationship between the growth rates in real GDP and federal tax receipts. The red line in this graph implies that each percentage point increase in economic growth increases the growth rate of tax receipts by 1.8 percentage points. This suggests that pro-growth policies push the Laffer curve upward. Thus, those who advocate for a large welfare state should perhaps become supply-siders or embrace their pro-growth policies.
Supply-side economics has its critics. Does it even exist if Congress cannot bind future Congresses to a low tax rate that it enacts? Austrian Economics regards it with the same esteem as it regards monetarism. Monetarists legitimized the Fed when they concluded that it was here to stay. Supply-siders legitimize expenditures on welfare and warfare programs and theft via income taxation when it supports the tax rate that maximizes tax receipts. When these pragmatists accepted a little government intervention, they left open the door to the creeping tyranny of the State that Murray Rothbard warns of in chapter 12 of his 1962 book, Man, Economy, and State.
The solution to the new normal, anemic economic and wage growth, that mainstream economics seems to be embracing is not more demand-side or supply-side tinkering. The solution is a restoration of the economic and personal liberty that we once cherished. In our heart of hearts, we know this to be true. The long run evidence is everywhere. Prices fall and quality rises in markets that are relatively free of government ownership, management, or subsidization. Prices rise, quality stagnates, or moral hazard is rampant in enterprises owned, regulated, managed, or subsidized by government.
March 10, 2017
Recent labor market news is being hailed as the beginning of the recovery that should have been. Commentators on CNBC and the Fox Business Network are glowing over this week’s ADP report. It showed employment surging by nearly 300 thousand over the previous month. It also showed that goods producers were responsible for over a third of those new jobs. The chart below shows initial jobless claims touching a 44-year low, and unemployment dropping to its lowest rate since before the Great Recession.
Source: Federal Reserve Economic Data
Celebrating the recent labor market news is like appreciating a Monet painting from two inches away. Both are myopic views that mask the real picture. Backing away from a Monet reveals that the dots of many colors become an increasingly beautiful Victorian scene. Backing up in time from today’s lows in jobless claims and unemployment reveals that recession is around the bend when labor market news cannot get much better.
Mainstream economists embrace such news as the ideal time for the Fed to return the federal funds rate to a more normal level. Doing this heads off the inflation produced from monetary stimulus. The chart below shows how setting rates near zero for eight years and counting has put upward pressure on inflation, which is heading north after touching zero in 2015.
Source: Federal Reserve Economic Data
The recent acceleration in inflation coincides with the S&P 500’s post-election burst. After the election triggered a short-lived sell off between October 24th and Election Day, which is highlighted inside the green circle in the chart below, an epic rally followed. This rally could be from traders pricing in Trump’s pro-business policies. However, it could also be a result of bottled up inflation, in the form of the trillions of dollars in excess reserves that the Fed digitized into existence, finally being unleashed on the economy.
Source: Yahoo Finance
The problem with the mainstream view regarding rate normalization is that the Fed usually goes too far when implementing restrictive monetary policy. Why? For one, it relies on flawed aggregated data that is months, quarters, and years old. Second, the Fed seems to fear low unemployment something fierce. The chart below shows the Fed hiking the federal funds rate substantially after unemployment gets too low. In about a year’s time, the Fed hiked the rate by 50% after unemployment got too low for comfort in 1988. After unemployment dipped to 4.3% in January 1999, it hiked the rate 41% over the next couple of years. It hiked the rate by 430% in the two years following unemployment dropping to 5.6% in May 2004. Each of these hikes preceded recession, the vertical gray bars in the graph.
Source: Federal Reserve Economic Data
Whether or not excessive monetary expansion is driving the recent stock market rally, if history is correct, the Fed will respond to it and the acceleration in CPI and PCE inflation by hiking the federal funds rate. Just this week the Bloomberg World Interest Rate Probability hit 100%. That implies traders are all but certain that the Fed will hike rates.
To normalize rates, the Fed abandons its bubble inflating policy of keeping interest rates too low for far too long. Austrian Business Cycle Theory says the switch to higher rates and slowed money growth busts easy-credit booms. The 5-year and 10-year TIPS spreads, graphed below, suggest that markets could be pricing in this possibility. The recent flattening out of both graphs is suggesting that expected rate hikes are going to slow aggregate demand in the future.
Source: Federal Reserve Economic Data
The graph of excess reserves below shows the expansion may be coming to an end as well. In the aftermath of the 2008 financial crisis, the Fed raises the federal funds rate by setting interest on reserves at a higher rate. When this price floor is increased, banks are more likely to lend to the Fed (in the form of holding more reserves) than to consumers and firms. So perhaps the recent uptick in excess reserves is from banks pricing in recession that rate hikes usher in.
Source: Federal Reserve Economic Data
Low jobless claims, low unemployment, and strong job growth are signaling the Fed’s historic monetary party is coming to an end. If The Doors were still touring today, they might be singing: This is the end, my only friend, the end of the Fed’s elaborate plans, the end.