Why the Price of Oil Will Not Rise?

The price of oil after reaching nearly $50 per barrel in mid 2016 is rapidly descending to a level below $40 per barrel. The pundits explain this as a problem of Supply and Demand. Supply and Demand is the catchall phrase popular among followers of Keynesian Economics, but it is a superficial explanation. Supply and Demand does not incorporate the thousands of factors that compose the market system. Supply and Demand does not recognize the importance of the two actors in every purchase and sale decision. In every transaction there is a buyer and seller. There is only a completed transaction if the buyer is happy with the offered price and the seller is happy with the given price. Each party has the option of refusing the price offered. The strength of the negotiators will determine the direction of prices not Supply and Demand.

Certainly, the competitive environment can affect the negotiating position of one party over another. The seller will find it difficult to negotiate a high price when other suppliers offer lower prices, but that is not Supply and Demand. That is competition. There is competition, because other suppliers have product they want to sell. Oil sellers would be wise to recognize this competitive environment instead of just throwing up their hands in disgust, they should develop strategies to deal with their competitors. Most products on planet earth exist in a competitive environment. Oil is not unique.

Why is the oil industry so handicapped? One reason is the oil industry origins are not as entrepreneurial as most industries. The oil industry grew out of a monopoly environment where there was no competition. Second, today most of the largest oil companies are government owned, and so vital to their country's economy that they must sell under any conditions. This requirement makes negotiation impossible. This is where much of the world's oil industry finds itself. This situation is not hopeless. It requires creativity, a characteristic not often found in the oil industry.

What can the oil industry do to level the negotiating field? First, leave the field. The industry should seek to find more niche markets to sell in. Instead of the large customers getting price breaks divide the sellers up into smaller segments and sell directly to them at the higher prices they pay to their suppliers. Second go down the supply chain and provide more refined products. Instead of just selling crude oil look at selling partially processed oil that allows smaller and more specialized refiners to buy. This increases the competition for the product and raises prices.

Just one more example. The best strategy for sellers is to refuse to sell at low prices, but how is that possible in the oil industry? One way is to use a financial option to fund the holding costs of the product. Simply leave the oil in the  ground and sell an option to deliver it at a set price (higher than the current market price) one year from today or two years from today. Obviously, these options can not be written for more oil than purchaser's are demanding so it requires some wise constraint.

One last thought, before I move on to another topic. Countries should consider establishing oil banks, storage facilities that serve as security for national currencies. I would certainly prefer having my currency backed by oil rather than a promise to pay or gold. After all, oil is black gold.

Oil seen through Supply and Demand

Gas prices continue to slide. Prices have now gone below the cost of production. Why doesn’t the Law of Supply and Demand intervene and allow prices to rise? Is there something wrong with the market system? Clearly, there is more supply than the market needs. Clearly, there is less demand than there is supply. Why do these factors not equilibrate like Keynes told us they would? What is going on here?

I suppose if I told you Keynes is wrong you would stop reading, so let me put it this way. Keynes neglected to mention the importance of a "normal" market for the proper functioning of supply and demand factors. Let’s look at the special cases in a market. You know when a market is dominated by a single large supplier, it is a monopoly. In a monopoly supply and demand do not equilibrate. You know when a market is dominated by a small group of suppliers, it is an oligarchy. Again prices do not equilibrate. You know when there are many suppliers and many demanders it is a "normal" commercial market. Keynes states in such a situation prices will equilibrate. The oil market has many suppliers, but they are not all equal. What happens under that circumstance?

The purchase and sale of crude oil operates in an unusual market. It is a type anti-oligarchy where most participants do not operate in a "normal" standard commercial market. Most of the big oil companies are not companies at all, but surrogates of their government. They do not follow the rules of private companies. They do not need to make a consistent profit to operate. Keynes did not understand the importance of profit. In lean times like these, quasi-government companies will borrow money or seek other concessions from their government to remain operational and producing product. Since in most countries oil is taxed on a per barrel basis governments are not concerned most about profitability, but only the quantity of oil produced (when oil is taxed on the amount produced). Keeping production high is the demand of governments. Making a sizable profit is not their concern. It is barrel count that matters. Or rather it is all about maintaining the tax basis. Oil in the oil patch is not a business, but the primary method for states to obtain tax revenue. The state's revenue is the most important factor guiding operation of the oil patch, not some company's desire for a profit. Consequently, the rule of Supply and Demand is corrupted.

The point is without a necessity for profit a government organization can operate with impunity outside normal commercial channels, so there is no pressure to conform to the pressures of Supply and Demand—or a normal commercial market. Supply and Demand does not operate in this corrupted market environment.

Why does Supply and Demand only work in a market environment? It is profit. When there is a profit constraint on an organization the rules of Supply and Demand come into play and restrain production. If your goal is to make a profit you cannot operate when that is impossible. Those parts of the world with a normal commercial market will be the first to slow the production of oil. Other parts of the world where oil is produced by a quasi-government organization will be slow to act. This mix of private companies and quasi-government organizations will prevent market forces from acting to equalize Supply and Demand. This is a good example of why countries would be wise to outlaw the operation of businesses by government. It is also why oil prices will rise first in the United States where a true market exists.

Oil seen through Supply and Demand

Gas prices continue to slide. Prices have now gone below the cost of production. Why doesn’t the Law of Supply and Demand intervene and allow prices to rise? Is there something wrong with the market system? Clearly, there is more supply than the market needs. Clearly, there is less demand than there is supply. Why do these factors not equilibrate like Keynes told us they would? What is going on here?

I suppose if I told you Keynes is wrong you would stop reading, so let me put it this way. Keynes neglected to mention the importance of a "normal" market for the proper functioning of supply and demand factors. Let’s look at the special cases in a market. You know when a market is dominated by a single large supplier, it is a monopoly. In a monopoly supply and demand do not equilibrate. You know when a market is dominated by a small group of suppliers, it is an oligarchy. Again prices do not equilibrate. You know when there are many suppliers and many demanders it is a "normal" commercial market. Keynes states in such a situation prices will equilibrate. The oil market has many suppliers, but they are not all equal. What happens under that circumstance?

The purchase and sale of crude oil operates in an unusual market. It is a type anti-oligarchy where most participants do not operate in a "normal" standard commercial market. Most of the big oil companies are not companies at all, but surrogates of their government. They do not follow the rules of private companies. They do not need to make a consistent profit to operate. Keynes did not understand the importance of profit. In lean times like these, quasi-government companies will borrow money or seek other concessions from their government to remain operational and producing product. Since in most countries oil is taxed on a per barrel basis governments are not concerned most about profitability, but only the quantity of oil produced (when oil is taxed on the amount produced). Keeping production high is the demand of governments. Making a sizable profit is not their concern. It is barrel count that matters. Or rather it is all about maintaining the tax basis. Oil in the oil patch is not a business, but the primary method for states to obtain tax revenue. The state's revenue is the most important factor guiding operation of the oil patch, not some company's desire for a profit. Consequently, the rule of Supply and Demand is corrupted.

The point is without a necessity for profit a government organization can operate with impunity outside normal commercial channels, so there is no pressure to conform to the pressures of Supply and Demand—or a normal commercial market. Supply and Demand does not operate in this corrupted market environment.

Why does Supply and Demand only work in a market environment? It is profit. When there is a profit constraint on an organization the rules of Supply and Demand come into play and restrain production. If your goal is to make a profit you cannot operate when that is impossible. Those parts of the world with a "normal" commercial market exists will be the first to slow the production of oil. Other parts of the world where oil is produced by a quasi-government organization will be slow to act. This mix of private companies and quasi-government organizations will prevent market forces from acting to equalize Supply and Demand. This is a good example of why countries would be wise to outlaw the operation of businesses by government. It is also why oil prices will rise first in the United States where a true market exists.

Keynes belittled famous Chinese economist

Many of you have read my article about how Keynes belittled Jean Baptiste Say and Market Economics. Keynes built his reputation by dismissing his rivals. Keynes also belittled the most famous Chinese economist, Fan Li, the first scholar to engage in economic analysis. Keynes when asked if he knew about Fan Li's theory stated he did, "Buy low, sell high." Keynes was ahead of his time. He twice misstated a rival's economic views to belittle them and by inference advance his own theory. This is precisely the technique employed by today's media economists to promote their viewpoints.

Let's spend a few moments looking at some of Fan Li's ideas and see if he deserves to be dismissed. We should use his proper Chinese name, Tao Zhu Gong, in this discussion. First, we should acknowledge that Tao Zhu Gong's ideas are still studied and applied in China and Chinatowns throughout the world with great outcomes. Whether it is Singapore, Mumbai, Dubai, New York, London, Paris or San Francisco, Chinese business people are highly admired for their expertise. This expertise is founded on principles first expressed by Tao Zhu Gong. His ideas stressed that an entrepreneur should be decisive, but cautious in borrowing, never procrastinate, but be flexible and accommodate change.

Many of Tao Zhu Gong's business principles seem very modern. He emphasized being sensitive to customer wants and needs. In the 1980s Michael Porter's five forces theory was seen as the basic tool of business management. The idea was that a firm's survival rested upon defending against competitive forces. One of those forces was the power of customers to switch loyalties. It took companies like Walmart and Costco to deliver customer's desires for quality and low price to reveal the flaws in Michael Porter's model and support the basic ideas of Tao Zhu Gong. Walmart and Costco became the model for "customer-oriented" product offerings and "single-minded" in their determination to control costs (Tao Zhu Gong ideas in quotes). Apple is another company that followed the path Tao Zhu Gong set out, "Be captivating in your sales promotion." Their TV advertisements sticking it to the IBM machine followed this Tao Zhu Gong dictum. Amazon is another company that achieved great success by following another Tao Zhu Gong's dictums, "Be selective to recruit only the best." Amazon is well known for seeking the best people.

The loyal followers of Keynes and Marx spend all their time trying to justify why their leaders economic pronouncements did not meet with success when implemented. On the other hand, followers of Tao Zhu Gong and Jean Baptiste Say can list thousands of examples of real world success and draw a straight line from a modern example to one of the principles of the Tao Zhu Gong.

Government Investment

One of the great ironies of foreign aid is that it creates poorer countries. The assumption of foreign aid is that the government of the receiving country can make an infrastructure 'investment' that will pay dividends. But as we look around the world we cannot find any examples of that happening. In fact, most of the time the foreign money is diverted into the pockets of corrupt politicians and placed in remote banks were the funds remain on account. Where the funds are not lent or used to expand bank borrowing in the deposit country, but simply left to be slowly eroded by fees or spent on luxuries from the donating countries.

Even when the funds are used for road construction or bridge building it does not help the receiving country since the contractors are either government agencies or private companies owned by politicians. In the first case the funds are not an investment since the government does not pay a dividend on the expense. An investment is an expenditure that makes a return in future years. In the case of a bridge built by a government agency the cost will be excessive since it is necessary to feed all the government leeches that will need to be nourished and the techniques used to construct the bridge will need early replacement and early maintenance. Government contractors have no motivation or incentive to be efficient or maintain high quality standards.

In the second case of a hand-picked private contractor there are still fewer incentives to be efficient or maintain high standards. The focus in this situation is to hide their crime and loot the project as early as possible. Consequently, the project team is concerned with falsifying documents and bribing regulators to file false reports.

A private investment achieves an economic push that is not possible with a donation to a government agency. On the other hand, a private investment puts money into a local bank to make more private loans and fund secondary projects that can sustain a tax-paying cash flow for bridge maintenance.

World's First Economist

An imaginary conversation with Fan Li

“Okay, what is your best idea?” I inquired of the ancient sage.
“Suspenders.”
“What?”

“Things that work. Suspenders hold up pants. Most economic concepts don’t hold up anything. They need the support of facts, authorities and long-winded explanations. If support exists at all it is usually a contentious balancing act or a weak link.

“That is why I like Chinese and Market Economics. Chinese Economics is taught like Geography. In a Geography class you learn the names of countries. The name is never in dispute or requires a proof. Names are facts. The location of cities, the length of rivers, the height of mountains, and the depth of lakes are all facts. The price of Barbie dolls, the amount of milk fat in a dairy product, the make of new cars sold at the local dealership, the weight of a sack of flour are all facts. The western economic approach is composed of equations and concepts: supply and demand, velocity of money, natural rate of unemployment, monopoly, Income Elasticity of Demand, equity, assets, returns, etc. All these concepts are subject to interpretation,” Fan Li explained.

Fan Li is considered the first economic thinker. He lived south of modern day Shanghai in the 6^th century B.C. near an area of fresh water lakes and lowland agriculture. Unlike the western economic tradition that looks at people as equal and similar acting, Fan Li emphasizes knowing and evaluating customers and suppliers. This gets to the issue of which customers will be granted credit and which will be denied credit. Fan Li states each participant in an economic activity should have their character evaluated. A business person should have the “ability to know people's character. You must perceive evidence of characteristics from experience.” This gets to the idea of whether a person can fulfill the commitment they are making. The western tradition is based on social rights and the legal system’s interpretation of those rights. Does the person have the legal right to enter into a contract? Whether the person can fulfill the contract is left to the party making the contract.

I think you can see where the western tradition leads to trouble like occurred in the Housing Bubble of 2007. Loan originators looked only at the market to see whether they could sell the loans they were originating. The originators felt their responsibility extended only as far as ensuring the loans met the legal requirements of HUD and the GSEs. In the Chinese tradition begun by Fan Li the originator would evaluate the character and ability of the borrower to repay the loan. If such an approach was applied in the United States between 2004 and 2007 there would have been no Housing Bubble.

Fan Li’s system involved evaluating each borrower. This is the way the western tradition began, but it was subverted when the state stepped in to expand the qualifying pool of people. The government’s actions to set qualification hurdle tests destroyed the individual evaluations that Fan Li and early bankers established. Removing this step from the loan qualification system removed the support of reasoned evaluation from the loan portfolio. Everyone was evaluated according to an inflexible set of standards established by HUD. HUD relaxed the qualification hurdle to include groups of people who lacked financial maturity. The result was a built-in failure rate like a circus clown wearing trousers six sizes too big without suspenders. Exposure was guaranteed.

Poverty

Help me out with something. I think poverty can be solved with jobs. Am I a naive selfish right-wing bourgeoisie? Well, not entirely. Maybe I should let you decide. I spent part of my childhood in a public housing project called Rainier Vista in Seattle. We had our own school in the project. I assume so we would not contaminate the strain of people who could pay market rents.

My First Grade school yard was a 50' x 50' fenced enclosure about the same size as the chimp enclosure at the zoo, but without the elaborate play equipment or high fence. Escape was tolerated after check-in. Our teachers explained to us numerous times throughout the year that if we were not in class when attendance was taken the state would not pay the school. It worked on me. I had a job to do. I was there every morning at 8:10 to be counted. Perfect attendance. I was learning. I was surely on the path to college.

I learned other skills. I learned to tell time, so I would know how long I had to wait for recess. What I didn't learn in class I more than made up for with the learning experiences at recess. On the playground the girls played hop-scotch on the paved half, and the boys played marbles on the dirt half. All the boys played marbles in circles scratched into the dirt. My family was too poor to buy a sack of marbles, and I was to shy to ask anyway. One day my friend, Jerome, and I were digging around the drain cover at the edge of the playground when we got the cover loose. Inside half buried in the mud we found six marbles. We split the loot. Over the next couple of months I watched the other boys play on the dirt patch and practiced on the carpet at home. Carefully I started to play at school and did surprisingly well. I eventually had a lunch sack of marbles, maybe two pounds of glistening round gems. I even named a couple. My books stayed at school, but my marbles traveled everywhere with me. Then one spring day an older boy walked on to our schoolyard and challenged me. He was good. He could balance a marble on his thumb, use his fingers to rise above the dirt circle and send the marble through the air striking a pack of sleeping marbles in the center of the circle. I used the typical grade school technique with a shy marble poking out from a curled fist cave like a hot dog sticking its head out of a bun. I lost two things that day; all my marbles and my confidence. I learned a lot on the playground and nothing in the classroom where I specialized in coloring, tracing and keeping my head down, so I wasn't called on.

But did I learn about poverty? Not really, I was too young to understand what was happening around me. What I did learn about is want and disappointment. These are the scars of poverty. My stupid question to you is this: Do the poor want free medical care, food subsidies, transit subsidies, good condition used clothes, or do they want the ability to support themselves? Do they want some of your money, or do they want their own money?

Humor me. Assuming poor people want their own money, how would you go about that? Would you have the government create more jobs. Recognize if the government does that, it would be a huge expense to you. It might put you and your children in debt for the rest of you life and their lives. And then how would you pay off the debt? Government's only source of revenue is taxes. Each paycheck government will take a little of your earnings to repay the debt. There is a way to avoid dying a pauper. To keep the government out of your pockets, the business sector has to create the jobs and pay the salaries. Think about it. Do you have enough extra money to pay another person's salary? The business sector is the only sector that can afford it. They have a trick to create new money. They use new ideas to create new jobs, and profit to pay for those jobs. The two horrible P's, profit and productivity allow the business sector to provide jobs without taking our money. They do it by providing services and products we want to spend our money on. Instead of kicking and screaming when the government takes our money, the business sector can get us to give up our money willingly. Somehow by making me happy with new products and services, business is able to provide jobs to the unemployed.

Okay you say, but that is not always the case. Sometimes the economy is too weak to support new businesses. What can we do in that case? Appeal to the government for help?

That is a blind alley. The government is not a source of solutions. Government is simply a source of funding. New ideas must originate outside of government. They must have a private sector structure.

Government should be an reservoir of needs. The government can poll their constituents for a list of services or products that they want. For example they might state they want childcare for two hours after school. The next step for government would be to seek solutions from the business community, simply asking the business community how to solve this problem with a private sector solution. The government can require that a certain percentage of employees come from the ranks of the unemployed. The government can require the business firm use only private sources of funding. Maybe, the firm can get some funding from Kellogg's to test taste new cereals? Maybe, Mattell will pay to test some new games? Maybe, Randomn House will pay to have the children rate different books? Maybe, Amazon will pay to wear test some clothing? Maybe, Safeway will pay to test some vegetable dishes and teach a class on nutrition? I can imagine an entire curriculum developing from private sector involvement.

Here is another example. Citizens might ask for more drug abuse councilors. A private company could step forward to train unemployed people to work as councilors for their company in exchange for the education. The government could sweeten the burden on the training company through tax credits that the company could sell.

So what am I proposing? A system that uses a private company to provide a service or product and reduce the government's burden to provide these services and products to their community. The initial operating costs (tax rebates) might reduce tax revenues over the short term, but overall if structured properly the tax revenue and income from new workers is going to expand the economy and increase the overall wealth in the private sector. Public sector financial burdens should be reduced. It is a true win-win.

If this technique is employed properly by government, the bidding for service and product supply rights could become a source of revenue. Imagine bidding out security services at airports, or ambulance services, or taxi services, or even fire protection services. Huge national companies will develop providing thousands of jobs with world class performance levels. All this paid for by the users of the services, reducing the administrative costs and tax collection bureaucracy of government. Win-win.

What is Conventional Economics?

Conventional Economics is a term I use in N Theory to describe all currently promoted theories of economics. As Jonathan Schlefer in his book, The Assumption Economists Make, states there are three main schools of thought: Rational Expectations; Real Business-cycle Theory; and DSGE (Dynamic Stochastic General Equilibrium). Rational Expectations theory explains people use their judgment about the future based on what they expect to happen. The prominent factors that influence this judgment are product quantities, quality and prices. Real Business-cycle Theory assumes the market chugs along until conditions change. The main conditions are the cost to borrow money, the cost of labor and the size of the market. DSGE puts all these conditions and factors into a predictive model.

In a world with these three theories, what are we left with to evaluate? We could question whether people make rational judgment about the economic future. We could question whether change in the market will affect market performance. We could put all the factors affecting the market into a model and make predictions about how change may affect the market.  Nothing is wrong with any of these approaches, but they do not get us very far and they can be dangerous when used to tell us what to do next. In any case, this is the three groups of ideas I term Conventional Economics.

DSGE theory was a total failure in the Financial Crisis of 2007. One reason for the dismal performance is that is not a theory. It is a technique and a technique without a purpose spits out meaningless hogwash. So let's put it aside and concentrate on the other two theories. History partially supports both. Ingredient labeling on food packaging caused many consumers to rationally reevaluate what they were buying for their families. The Dot Com bubble did not put an end to electronic technological change, or alter the high premiums for companies in that market segment. Both partial theories are valid. We need both the intelligence of the consumer and the durability of the market incorporated into a robust economic theory. Something similar to the DSGE approach can provide insight, but mathematics alone does not explain what is happening in the economy. It is far too simplistic and artificial. Economics is not physics. Economics is about people. People act less uniformly than do subatomic particles.

Here is another insight about Conventional Economics. Economics is the academic study of the marketplace. Why are we studying Economics? The goal is to design a marketplace that provides products and services with employment opportunities sufficient for a satisfying life for the maximum number of people.

Often we get diverted from the goal of creating an improved marketplace. Our leaders take us in a different direction. They focus on the defects in the marketplace. They argue for having power over the shopping environment regulating the slope of sidewalks and the architecture of facades. Power in the economic equation is never good. European socialist countries, Asian communist states and African dictatorships often try to capture the cash proceeds from commerce, and use those funds to support their lifestyle. This tendency results in two approaches to market management. State regulation of the market, or market participant regulation. Participant regulation is the much better approach. It has at least a twenty thousand year history, sufficient time to work out the kinks. Participant management leaves market regulation to the experts. The other part of that equation is that state regulation is always an economic burden. It takes money out of the market to spend on offices, vehicles and salaries for the State regulators. This is the core of Conventional Economics. It is just not theory, but the artifice and bureaucracy created by a government following a specific Economic theory.

Is Money a Commodity?

One of the most critical issues in Economics is whether money is a commodity. All the major schools of Economics: classical, Keynesian, Austrian and Behavioral agree money is a commodity. Why? Economists observed governments issuing new or additional currency that caused a devaluation of the currency already in circulation.  Another example they looked at was common commodities and observed price movements. It didn't matter if the commodity under the spotlight was gold, silver, oil, corn, sugar, wheat or cotton they all seemed to act the same way when the quantity in the market moved up and down. Looking at the history of money economists found a parallel. When governments increased the supply of money the value of other money seemed to decrease. Money seemed to perform just like cotton. The larger the cotton harvest the less valuable. So economists concluded, if it walks like a duck it must be a duck. Money was declared a commodity.

To simplify the economic logic of money as a commodity you must believe the value of money fluctuates just like the value of apples, the classic example of a commodity. Both act like they may be influenced by the forces of supply and demand. The more apples (Supply) on a store's shelves it is necessary to drop the price (increasing Demand) to encourage a higher rate of purchase. One of the great fears of private economists during the Financial Crisis of 2008 was a fear of inflation from the Fed's strategy of injecting two trillion dollars into the economy. Fortunately, that fear was not realized.

This experience from the Financial Crisis was counter to the money as commodity theory, but few people took notice. Maybe, money is not a commodity. Let's look at money in the marketplace to see the parallels with apples. Clearly, money is not a fruit. Money does not grow on trees. Money is not harvested by farmers. Money is not sold on grocery store shelves. Money is not seasonal. Money is not perishable. Money doesn't taste good or provide a nutritious snack. Does this deductive track lead anywhere? It is interesting, but leads only to a baffling syllogism. Money is called a commodity, but money does not share features with other commodities, therefore money is not a commodity. The question about what money is remains unanswered.

Let's delve into that question. Money seems as mysterious as an alien from outer space. If we encountered a space alien how would describe what we saw? First, we would describe what it is similar to "about the size of a dog, but walking upright and carrying a rifle like object in its four hands." We can make a description of money, "Two and a half inches by eight, made of paper, printed on both sides with a picture of a politician on one side and a building on the other." The description tells us nothing about what it is used for or how it works in the economy. It seems like part one might be a description, but part two needs to be an explanation of the role it plays in the economy. I can see some of you wiggling in your chairs to tell me money is a 'a medium of exchange.' I bet you can even explain how the barter system needed a reservoir of value if a seller did not want to make a product for product exchange, and that prompted the creation of money. True, but money is more. Money can be thought of as an equality of value. What? Money represents value. The value of the chicken you traded or the work you did in the field.

Money is a value equivalency. If I do 'x' you will give me six of those green bills. Done. It is not a commodity that will change value, or age and spoil. It is money, a marker of value usually earned through the accomplishment of work. Why is that important? It creates a connection between work and money. So money can not be circulated unless there is a work product to anchor its value.

Think about this for a moment since it radically alters conventional Economics. This concept is the basis of my textbook, Rule of Money.

Do low interest rates stimulate economic growth?

Starting in the mid 1990's Japan pursued a low interest rate policy. Unfortunately, the reason the Central Bank lowered rates did not have the intended result. Japan's finance ministers wanted to induce economic growth. Instead the economy faltered. Why? Don't lower interest rates reduce the cost of borrowing for companies? Of course, but unless the companies need to borrow, low interest rates have no effect. Often low interest rates are imposed in times of economic stress. Many companies are unwilling to borrow in such perilous times. Consider the effect of a stagnant economy on Japanese business. In Japan the size of corporate debt went from 147% of GDP in 1990 to 99% in 2011 (Mariko Oi for BBC News, Tokyo, 17-09-2012). One should conclude low interest rates actually reduced corporate borrowing by 50%.

Although Keynesian Economics argues low interest rates are the cure for economic malaise, the facts indicate the opposite. Why? Keynesian Economics is built on the assumption of interest rates driving the economy. The fact is other economic conditions weigh heavier on markets than interest rates. What are these economic conditions? First, it is the confidence in the future of economic management, i.e., the government's ability to manage the economy. Keynesians take this as a given, but business people see it quite differently. Low interest rates are a perfect example. Keynesians see low interest rates as an inducement to business to expand. Business people see low interest rates as an indication of a stagnant economy. Governments see a stagnant economy as an opportunity to utilize Keynesian debt strategy to spark a recovery.  A government supported by an economic theory that lauds their economic prowess is a strong inducement for government to increase their borrowing and the national debt. Unfortunately such a strategy did not work during the Great Depression or the Great Recession. It did solidify the business sector's opinion that the economy was in a downward spiral. In the same article noted above Mariko points out public sector borrowing went from 59% of GDP in 1990 to 226% in 2011.

Even if governments behave themselves and do not increase debt, low interest rates are not good for the economy except in the short term. The short term being a couple of years to induce capital purchases put off because of the weak economic situation.  I would argue it is never good for the government to try and manipulate the market. But there are other reasons besides my opinion. Low interest rates encourage marginal loans. The group of business ideas that work with a 1% interest rate is not the same quality as those that work at 5%. In addition, the origination revenue banks obtain from low quality loans and 1% interest is marginal at best. A healthy banking sector is fundamental for a vibrant economy. Banks play an essential role in taking the new money creation allowed by a central bank and finding places to invest it. If banks buy notes from the Treasury of a country to earn interest no new business is created that can grow. The interest banks earn in the feedback loop and new business creation expands the economy. It is tax paying job creating business that expands the economy; not money creation by the government. A strong economy can not exist supported on a thin feedback loop. The thinnest possible loop is a low interest government bond.

Who creates Money

Does the origin of the money in your wallet make a difference? Often. If the money is counterfeit you may have your money confiscated before you can spend it. If your money was manufactured by certain countries you may find it impossible to get the face value in other countries. For instance, the 5 trillion note issued by Zimbabwe will never be equivalent to any other currency. Why is that? The value of a currency is not the value stated on the bill, but is the value when used to make a purchase. If the note from Zimbabwe can be exchanged for a new Xbox, then is equivalent to $319 US dollars since that is the amount of currency necessary to purchase the product in the United States. The comparative value of a currency defines a currency into a known item. Think about "one." Your first question is "one" what? In the case of currency the "one" is the number of another currency.

There is one unique difference about paper money. Other products get a value when they go to market. Walmart will put a product on their shelves at a price they hope the product will sell for, but if it doesn't sell, they will reduce the price until a value is found that customers accept. Money has a value printed on the front of each bill, but banks will not reduce the notational value on the face to get their depositors to take the bills out of the bank. In fact the government dictates the currency must be accepted at the face value. Consequently, if the currency value is greater than the public will accept the product value must go up. This situation occurs everyday throughout the world to various currencies. What do banks do? If they are exchanging one currency for another they adjust the exchange rate. If a customer is withdrawing funds to make a now higher priced purchase, they will complain to the bank, but are powerless to restore the value of their currency. The result is what we call inflation. These movements in the value of currency are very destructive to a stable economy. Stability is extremely important. Why? Pricing is based on convention and forces that upset or change economic conventions often result in economic stress and uncertainty.

How do the institutions in the United States attempt to maintain stability? The Federal Reserve does not give money away to individuals, they use the private banking system to distribute it. The Fed distributes money through banks or federal agencies to maintain control. Ignore distribution through federal agencies for the moment. Most money is distributed through banks so let’s look at that process. Physically the money does not exist until it is utilized. The Fed sets certain rules to ensure more money is not created by the banks than products. The Fed creates potential, but money only comes into existence when a bank takes it figuratively out of the Fed. And, this is the most important point, banks only take it out when they have a borrower able to repay the funds. The amount of dollars requested by the borrower sets the value of money created. Let's look at that from a slightly different angle. The federal government does not create money, the Fed does not create money, the banks do not create money; borrowers create money by agreeing to expand the quantity of circulating currency by starting a profit earning business or investment, and repaying their loan. Note the importance of profit. It is one of the most important economic concepts. Note the insignificance of government printing presses and regulatory restraints or incentives. The final judgment is in the hands of a country's entrepreneurs. The cleverness of entrepreneurs determines the growth rate of a society not a government agency.

Now you can see why rising interest rates is an effective deterrent to economic expansion. Higher interest rates place a roadblock in the way of the money creators, the borrowers.  But let me return to the point of this brief article. Money creation by the government is meaningless unless the money is utilized by borrowers. Most governments outside the top twenty focus on the wrong strategies to grow their economies. They buy things: roads, bridges, schools, military equipment, etc. to increase the appearance of government. Nothing is wrong with these acquisitions, but building wealth in the private sector is the only way to put in motion a mechanism to pay for such purchases. Public services and facilities are great, but if a private sector does not exist to pay taxes then the facilities will not be maintained. Governments should put the focus on creating entrepreneurs. This is the strategy China is utilizing to grow their economy.

Lessons from the Great Depression

Here we are in the sixth year the economic plague we call the Great Recession. Although the Great Depression lasted twice as long it did not infect as much of the world. Are there lessons to be learned from this earlier crisis? The classic work on the Great Depression is The Great Crash 1929 by esteemed economist John Kenneth Galbraith. Professor Galbraith’s book is a magnificent work of research and his account of the events surrounding and contributing to the cause of the Great Depression is greatly admired and studied. His description of the events from 1928 to 1940 is enthralling and enhanced by his elegant language. A very high standard for economic literature, but does his analysis rise just as high and does it help us understand our current financial crisis?

It is acknowledged by Professor Galbraith and most other economists that the trigger event of the Great Depression was the loss of money in the stock market. Investors were stopped out of their margin accounts when the market suddenly declined. These margin accounts were constructed by using broker’s loans (loans collateralized by the securities purchased on margin).  The popularity of this type of loan increased substantially during the 1920s from one billion early in the decade to more than 6 billion in 1928. A billion in 1929 is equivalent to a 100 billion today. Banks were not deterred from making these loans since they could “borrow money from the Federal Reserve Bank for 5 per cent and re-lend it in the call market for 12.” Not unlike the sweet arbitrage the banks could make in the prelude to our Great Recession by packaging mortgage loans into large bonds and turning a substantial profit by holding the bonds for a couple of years. During both periods people realized there was a speculative bubble, and that eventually the bubble would burst. This fact did not deter speculation even though voices were warning of impending disaster. Paul M. Warburg of the International Acceptance Bank in March 1929 predicted unless the “unrestrained speculation” was halted an eventual collapse would “bring about a general depression involving the entire country.”

The irony is everyone benefited initially from the bubble’s rise. Caution was not a serious concern. There was a general feeling among speculators that the market was supported by three strong legs. The action of speculators was one leg of support for the market. The second leg was the upward momentum of exuberant expectation of a continual rise. The third leg of support was a general sense that there was nothing to fear since who would move to deflate the bubble. In other words ineffective regulation was seen as support for the market since the government was unlikely to act and everyone in the market was benefitting from the rise.  Unfortunately, no one stopped to consider how other investors would react if the market turned downward and whether there would be time to exit.

After the Great Depression, Professor Galbraith pointed out, “it has become obligatory for the regulators at every opportunity to confess their inadequacy, which in any case is all too evident.” In March of 1929 the Federal Reserve Bank began daily meetings. They did not inform anyone outside the Fed what the subject of the meetings concerned. Suspicion and rumor focused on the stock market, but that was unconfirmed. During 1929 there were some breaks in the market caused by rumor, but overall the speculative stampede continued. Corporations and even wealthy individuals lined up to provide more liquidity as the banks struggled to provide more and more funding for brokerage loans. By that summer these loans were growing by “$400 million a month.”  There was concern about the degree of speculation that these brokerage loans implied. These concerns were dismissed as coming from people who “simply did not know what was going on.” The 1920s were the period when Wall Street arose as an investment opportunity for the public. It was a very immature industry without a history and a culture of caution and restraint. This exuberance was supported by the highly-regarded academic community. In the autumn of 1929 the foremost American economist of the time, Professor Irving Fisher of Yale made his often quoted estimate of the market, “Stock prices have reached what looks like a permanently high plateau.”

Irving Fisher’s comments reflected the fact that stock speculation had become part of the culture. This trend during the 1920s legitimized an activity that had not earned a place in the economic system through trial and error. Likewise, in the Great Recession housing speculation and expansion of the mortgage market to include lower and lower income participants would also prove disastrous. When A&E launched the TV show Flip this House in 2005 starring Armando and Veronica Montelongo house speculation or flipping was an accepted get rich scheme. Two years later the Housing Bubble burst.

One of the most interesting sections in Professor Galbraith’s book is his debunking of the suicide myth surrounding the Crash of 1929. He shows that statistical analysis supported a slight rise, but nothing to justify the media's characterization of crowds standing on sidewalks waiting for the next businessman to jump to his death. The media similarly misled the public in explaining the cause of the crisis. Instead of looking at the government they focused on finding someone in the private sector to blame. There were Bernie Madoffs in the Great Depression, but like Madoff they were crooks not promoters of speculation.

The real tragedy was the Press’ failure to understand what happened and outline what to watch out for in the future. Professor Galbraith made it clear in his 1954 summary, “It would be unwise to expose the economy to the shock of another major speculative collapse.”  Do you recall anyone in 2006 drawing a parallel between the Housing Bubble and the Stock Market Bubble of 1928? I do not. Why? It is because the gurus over complicated it. We would be better off to simply look into get rich quick schemes and asset bubbles for the next financial crisis rather than a trend line of monetary expansion.

There is no quick way to riches. There is only hard work and slow steady returns. Blaming the cause of financial disasters on lack of self-control or greed is counter-productive. These are characteristics of the human species. Criticism is better directed at the people who create our economic institutions and fail to structure them to constrain speculative impulses and greed. Speculation is only a problem when the economic system lacks proper controls. The problem is an economic system without proper curbs, not people who lack adequate self-control.

When Professor Galbraith asks himself what the cause of the Great Depression is he looks first at why business activity slowed. He finds his answer in the unequal distribution of income. His argument is that if the middle class had more money they could sustain the economy. Isn’t it much more likely that with the financial shock of their monetary loss in the Crash many wealthy investors lost their appetitte for new investment? Looking back we know private investment collapsed reducing job creation and economic growth. These two factors are the cornerstones of business activity. Professor’s Galbraith’s explanation lacks credibility since middle class income levels did not change until after business activity slowed. The Great Depression was led down and kept down by business people unwilling to take risk.

What we can say definitively is that people lost money. Losing money has quite an impact on people. Imagine a gambler from New Jersey arriving in Las Vegas with hope and cash-filled pockets. He leaves his bags with the front desk and goes straight to the tables. Six hours later he has lost 75% of the money he brought along on his vacation. How enthusiastic is he going to be to go back to the tables after dinner? This is precisely what happens after a financial bubble bursts. The shell-shocked business people and investors are not going to charge out of their trenches into the battle again. They are going to hunker down, reassess and wait for a “real” opportunity. Professor Galbraith misses the real causes of the Great Depression and misunderstands the pivotal role of banking and business in making the system work. The problem is the system, not the people in the system.

Rereading this book made me realize Professor Galbraith focused on stock speculators and not on the characteristics of the financial system which nurtured speculation. We now know that the crisis would not have occurred if margin loans were disallowed. We also know that the stock exchanges could have employed curbs to retard large daily movements. Risk curbs also could have been created to protect novices in the market by tying their investment actions to the facilitating brokerage firm. In other words, if the clients of a brokerage firm lost a certain percentage of their client’s money, funds could be removed from a reserve account required to be held by the brokerage firm to reimburse their clients for bad advice. This technique would tie an investor’s risk to a firm’s risk, making both parties act with more caution. Another problem in almost all financial crises is excessive leverage.  Leverage is easily regulated by market rules.

When economic conditions are not persuasive for business expansion investment is going to dry up. Without new investment an economy is going to slowly decline as loans are repaid and money is removed from the economy. It is not the potential for investment that matters, but actual new money coming from banks to create new business lines. More investment means many more jobs and more money looking for products to purchase. Whether this money is equally shared is not significant. One rich man spending an extra $100,000 or 100 people spending an extra $1,000 makes no difference to an economic system. 

Seventy-seven years later a speculative bubble again devastated the economy, an event we now call the Great Recession. The two events are almost twins. The approach of the Great Recession could be seen by a blind economist, but not by a sighted economist looking for help from a government regulator. Sighted and blind economists before and after both crises suggested fine tuning government action was the key to avoiding a repetition. The whole idea of government action doing anything to improve an economy is an inheritance from Galbraith and Keynes. Their focus on government as our financial savior implies the coach is more important than the players. It is the team on the field that plays the game and determines the outcome, not the coach. When the players refuse to play a loss is inevitable. Even if the coach implores the players to play harder and the general manager increases their compensation, if the players decide not to expend all their effort in a game, the team will lose. Speculators did not cause either crisis. The economic field was not prepared properly for the intensity of the game.

 

Corrected GDP

 

We all know what the Gross Domestic Product or GDP is. It is as common as Fahrenheit or Celsius. It is on the nightly news everyday. It has a prominent role in most political speeches about the economy. Gross Domestic Product (GDP) throughout the world is the standard measure of the economic health of a country and particularly when divided by the population to get GDP per capita. Surprisingly, it is not an ancient measure. It was developed by Simon Kuznets in 1934 for a Congressional study. GDP was formalized at the Bretton Woods Conference in 1944 as the measure of a country's economic vitality. Today this calculation is performed by a government agency in each country across the world. Each country makes adjustments to fit their particular social environment, but largely the method of calculation is close enough for statistical analysis. In the United States the figure is produced quarterly by the BEA, Bureau of Economic Analysis.

The importance and wide use of GDP to provide a picture of the economic health of a country is accepted by political leaders across the world, but many economists have concerns. Austrian Economist, Frank Shostak, questioned the underlying assumption that all expenditures reflected economic growth. He provided the example of a pyramid built by a country. Today, we often assert these projects should be part of GDP since they provide income for people and profit for suppliers of construction materials. Frank Shostak's point was that the money was diverted from being invested by a business that could expand production and create "real" jobs into a boondoggle government project.

The idea that who spends the money makes a difference when growth is concerned is subtle, but very important in understanding how an economy actually works. The issue is that governments do not make "investments." When a government spends or "invests" it is not to create a revenue flow. While business does make "investments." Their purpose is to create a revenue stream of profits to repay the investment and a continuing revenue stream. If a company built a pyramid they would put up a billboard and advertise their products enabling them to earn a return out of the pyramid.

Government spending is like giving candy to children. It has no lasting effect. In children it only diverts their attention from playing quietly to demanding more candy. I call this type of government spending an example of the Candy Rule: Government spends to make people happy, not to make a profit. On the other hand, business spends to earn a profit and to make their shareholders happy.

What is the point of this article going into the world of children and candy? I am trying to explain government spending is not the same as business spending. Government spending differs in two ways. The money government spends is not earnings they generate, but earnings taken out of the hands of business. As a society if we allow this, we must do it because we feel government expenditures can use the money better than business can. The second difference is government spending is a dead end. The money is not repaid. It is not invested. Government only consumes money. Sometimes it is necessary to feed the giant, but ideally we would like most of the money to be used to feed the citizens.

Why is this distinction important? When you consider GDP it makes a huge difference. If a country allows their government to spend all the tax money collected each year plus additional borrowed funds, what would happen? Let's assume the government spends all the money on interest payments due foreign investors. All the money would end up in foreign hands. Eventually the economy would go bankrupt since there was no money available for their home businesses to earn a profit and pay a portion in taxes.

Now, let's assume the polar opposite. All the money is spent by businesses to expand production and pay their employees handsome salaries. The businesses make a huge profit and their employees spend their salaries in the local community. The businesses retain much of their profit to expand and grow. This stimulates further growth.

Clearly, it is easy to see that all the money spent in the second example goes toward economic growth. GDP is the total amount spent. In the first example of government spending none of the money goes into local economic growth. Yet, the way we calculate GDP today, all the money in the government spending example would also be calculated as GDP. GDP in both examples would be equivalent.

What does this say about the calculation of GDP? Let me simplify it for you. Instead of including government expenditures in GDP we should only include business and personal expenditures, but not the taxes they pay. It doesn't matter what or how government spends these tax dollars since it is not an investment. When a government borrows a trillion dollars it does not strengthen the economy. It only further burdens the individual citizen.

Governments like the United States and Japan are not as rich as they think they are. The wealth of their citizens is overstated by including government expenditures (especially debt) in the calculation of GDP.

Definition of Money

There are two common ways to characterize money. The first is the idea that money is a commodity like gold, silver or apples. And like any commodity when the supply increases the value or price declines. The second theory of money stated in my book, Rule of Money, defines money as a coupon equivalent to the work effort expended. Money, in whatever form, equals the work done to earn it.  Money is the physical evidence of earnings obtained by working for someone. It is a chit that can be exchanged for products equal to the value of the service provided to earn it. This right of exchange is guaranteed by law in most countries.

I define the Rule of Money as it must be earned to distinguish it from money created by the Central Banks of the world. I draw this distinction and show in my book that funds that Central Banks create do nothing to increase the wealth of a country unless the money is earned. If this was not the case countries with hyperinflation rates approaching 1,000,000% like Zimbabwe or Hungry and Greece after WWII would be the envy of the world with their currencies denominated in billions and trillions. When currency is stated in a billion or trillion Zimbabwe dollars or Hungarian pengo it is no longer connected to the value of work. It is only a point on an inflationary spiral. At this point money is no longer connected to reality. Money must be grounded in the value of work otherwise it is a meaningless value.

Money is not a new invention. It began as a way for Kings, Pharaohs, Sultans and similar political leaders to increase their wealth. They could make money for less than the value they stamped on the coin. The more they produced the richer they became. Most early inflation occurred when these Princes decided to reduce the thickness of a coin or insert lower valuable minerals during casting, but left the value stamped on the back unchanged. Their attempt to gain some unearned income usually failed. Most of the time this attempt to maintain the value of their coinage while reducing the precious metals inside was rejected by users of the coins resulting in currency inflation. The value of coinage dropped, but still reflected  the market value of the precious metals contained within the coins. If a monarch reduced the silver content by half, the value of the coin lost half its value.

When money is defined as a commodity it is subject to supply and demand pricing. Supply and demand pricing of money allows Central Banks to push the value of money up and down by adjusting interest rates for people or banks that have money. For people and companies that need to borrow money it makes their life more difficult and more expensive. Conversely, when money is defined as a receipt for work it is not affected by changes in interest rates.

Similarly, when money is defined as a commodity it is subject to inflation. The value of money fluctuates up and down with the commodity the currency contains or is redeemable for. On the other hand when money is defined as a receipt for work it is not affected by changes in commodity prices. It is affected by changes in labor rates. This is why in the 2000s inflation was low in western countries and high in Asian countries as labor rates adjusted.

One of the prevailing theories in modern Economics is the assumption that simply increasing the quantity of money in circulation causes inflation. When money is defined as a receipt for work it is not affected by changes in the quantity of money in circulation, because there is a one to one relationship to increasing earning and an increasing quantity of money.  On the other hand, when money is defined as a commodity the quantity of money in circulation is paramount, because an increase in a commodity reduces the overall value of the commodity in circulation. It is the level of supply that determines value. In conventional Economics, if a government increases the quantity of money in circulation the theory states the value of money will fall, because the demand for money is less relative to the supply. Whereas, N Theory states the quantity of money does not matter as long as the money is earned through work. But “unearned” money added to the money supply causes the value of all money to fall. One of the most prevalent kinds of unearned money is sovereign debt. Sovereign debt is unique among all other debt. It is not an investment, but only a promise to repay. It is not backed by an asset or redeemable by acquisition of collateral.

When a Central Bank like the Federal Reserve Bank in the U.S. decides to increase the amount of money in circulation they do so to stimulate business activity, thereby creating more jobs. But by modeling money as a commodity the Fed is constrained by their fear that increasing the amount of money in circulation will cause inflation. On the other hand, if the Fed understood money as only earned revenue according to the rules of N Theory they would not fear inflation. They would expand monetary assets by encouraging new business creation.

 

The way the Fed defines money affects how they manage the monetary resources of the country. The definition of money affects government policy. When money is considered a commodity the government is in charge of opening and closing the money spigot. Unfortunately, this opening and closing is governed more by a fear of inflation than by the factors of employment or business creation. On the other hand, when money expansion occurs according to N Theory employment is step one. Consequently, the justification for monetary expansion precedes the increase in the money supply effectively preventing currency inflation since there is no excess.

How should money be defined? Money is any object or equivalent electronic notation recorded to an account in a financial institution that is earned through work, and that can be exchanged for different products or services.

Redistribution

Adam Smith defined Economics as the process of wealth creation, but by the early 20th century the economists of the time stated a different purpose for Economics. Economics became the process of redistributing wealth. Redistribution is one of the cornerstones of Keynesian economic policy. The idea begins with the assumption that money is unfairly distributed. This is based on the observation that the amount of money possessed by some people does not seem to be based on fairness. This was definitely the case when Kings and Sultans possessed most of the wealth in their countries. This unequal distribution resulted from their control over the manufacturing of money. For hundreds of years money was simply a product of the monarchy. The common man earned money by doing things for the monarch. This traditional way of distributing money is still advocated by many economists as a solution to the disruptions of money flows during a financial crisis. Their logic is that the state creates the money, let the state decide who gets a share. These economists believe the state is much wiser at determining who gets what than the market system. Or that the market system is imperfect and can be improved by strategic monetary infusions by the state. This modified monetary structure is justified, because it is the right thing to do. The poor need care. The weaker members of the flock need shelter and food, and only the state can do so with the proper level of concern.

The origins of these traditions trace back to the concept of compassion. Compassion is a key virtue promoted by all major religions in the world. It is a quality that all religious people should seek to integrate into their actions. Therefore, the fact compassion permeates our economic traditions is no surprise. Likewise, it is no surprise that the competing secular philosophy of the market system is characterized as evil or godless. Such criticism is simply a protective religious response to a system that does not on first glance appear to have compassion at its heart.
 
Money must be distributed throughout a community for there to be a vigorous and robust economy. If money is left in the local bank or buried in the backyard, most people will not earn enough money to feed their family or pay their bills. Money needs to circulate and expand. Circulation or distribution can occur in two ways. A strong political leader can control all money through taxation or by managing the printing presses. Then it is a simple matter of determining who gets what. Most monarchies tried this method with greater or lesser degrees of success through the 19th century. Louis XIV used the construction of Versailles to distribute money in his society through the craftspeople and suppliers working on the project. Napoleon used his soldiers to spend money into the French economy. In other countries he used his soldiers to rob or plunder for survival. In the twentieth century Central Banks allowed private banks to make loans to emerging businesses to encourage economic expansion of the economy. The amount of wealth created in the twentieth century is greater than all the previous centuries combined. Clearly, no other system worked as well as the system employed in the 20th century when it came to the amount of wealth created. So what does history teach us? Based on the results obtained in the twentieth century versus the wealth creation in all previous centuries, it is clear the market system creates more wealth and quicker than any other system of wealth accumulation.
 
Redistribution is not a system of wealth accumulation. It is really a system of reengineering the last stage of the wealth accumulation process to redirect the final destination of the money accumulated. Redistribution ends up being a mirage even for those people who benefit from the redistribution. Why, because the government’s tax piece will be quickly replaced by higher prices and greater profits by the people who run businesses. This is why it costs more to live in New York or San Francisco (two of the most highly taxed communities in the country).
 
So, if I have convinced you redistribution is not a wealth accumulation process than what is the wealth accumulation process for the followers of the redistribution mantra? The wealth creation process for the business sector is capitalism. The wealth accumulation process for the government sector is the taxation process. One can argue that this is not really a wealth accumulation process since all the money is created by the market economy of the private sector.
 

The conclusion economists must draw from this process is that redistribution is not an effective wealth creation process. Redistribution just moves money from one side of the table to the other. It is a redistribution process like poker is a redistribution process without the fun. Just like a casino, government takes a fee for setting up the game.

Redistribution is not an economic concept. Redistribution is a justice concept. It is based on fairness and judgments about what is "right." This type of legal right does not belong in an economic discussion, because economics is not morally based. Redistribution is used as a justification for government to intervene in the market economy and correct the errors. This makes redistribution a government technique, not an economic principle. Redistribution may be the right thing to do, but that is only because the citizenry agreed it was.

To return to Adam Smith, redistribution is not a wealth creation process so it does not fit the definition of an economic process. Redistribution is a social process. As such redistribution should not be a consideration during optimization of the economic system. Many economists claim Economics is about a "fair" distribution of income, but it is not. Economics is about creating wealth.

Scarcity

Economics does not seem like the kind of thing that was invented by one person. It seems like it probably came together slowly as customs became established and slowly turned into rules.  Today it is an immensely elaborate and complex system. Many of the most interesting features are relatively modern. Transportation certainly began with a man or a woman simply walking between tribal settlements, but now involves planes, trains and ships of immense size and complexity. Although it began hundreds of years ago, the whole banking structure of trade in just the past one hundred years has evolved into numerous complex currency and interest rate swaps and loans of millions of dollars. Corporations begun in Roman times to share the rewards of collecting taxes are now multi-national organizations with factories across the world producing everything from Barbie dolls to industrial acids that can cut through metal. The intricate metallic machinery and robots involved in the manufacturing process seem to be the inventions of Hollywood.

Are we on the right path? Do you think this was the direction of the tribal councils of Africa who began this process? What were they trying to achieve? It seems like the motive would be quite basic.  One tribe has a surplus of fish, but would like to get more berries from their neighbor who has a large berry patch on their tribal grounds. It is easy to visualize this process evolving into a structure needing a system of weights and measures and then money, next more advanced techniques for growing crops, then improvements in tools, organizations to produce manufactured products and along the way a system to make more money. Bottom line, it does seem reasonable to assume our economic system evolved as a trading mechanism.

The reason I asked this question is the simple feature of our humanness that makes us more efficient and focused when we know what direction to go in to reach our goals.  No economics book I know about declares the foundation of economics is trade. In fact, almost all economics’ textbooks start by explaining economics is about allocating scarce resources, i.e., deciding who gets a fish and how often. I must disagree with the esteemed academic community. I think this process of deciding how the tribal bounty is divided is a political decision.

The fisherman who caught the fish certainly feels the fish belong to him and that he will decide who gets what.  It requires some political might to wrestle control of the fish away from the fisherman.  I cannot imagine a fisherman in a primitive society giving up his fish to the tribal leadership to be redistributed without some political force in play. It is also not as clear how that process leads to the creation of money or huge trading vessels. Therefore, I believe scarcity leads not to the creation of Economics, but to the creation of Politics.

Economics does not originate with scarcity, but the need to have an efficient and effective trading system.

Freefall Critique

Freefall published in 2010 by liberal economist, Joseph E. Stiglitz, is his analysis of the cause of the Great Recession of 2008, and the lessons he feels we should take from this catastrophic event and its aftermath. This is not a standard economics book. It is more like a newspaper article from a journalist with a strong viewpoint that he wants to spread. One of the key points Professor Stiglitz sets out to make in his book is that the Great Recession proves that the so-called self-correcting function of a market economy does not work: "One might have thought that with the crisis of 2008, the debate over market fundamentalism--the notion that unfettered markets by themselves can ensure economic prosperity and growth--would be over." (xiii) As somewhat of a student and victim of the Great Recession and Housing meltdown I find this conclusion off point. I believe the Housing meltdown as the acknowledged cause of the Great Recession is not about why markets did not self-correct, but what happens to markets when government mandates (HUD Affordable Housing Policy) require 50% of housing loans be made to marginal borrowers. The Great Recession is not about self-correcting markets. It is about government interference into markets to enforce an unrealistic social policy. Professor Stiglitz is trying to make the opposite point: he wants to show an economy in private hands doesn't work. He does that by seeking to find a private sector entity to blame for the crisis. Stiglitz chooses the banking system in his blame game.  He tries by accusation and through a circumstantial case to convict the banking system or at least to suggest a strict home monitoring system. The primary purpose of this effort is to make the case that the economy should be under the control of government, an idea first proposed by Keynes.

To make his case, Stiglitz creates his own reality. He repeatedly refers to the "financial system" as a "self-regulating apparatus." (xiv) As an ex-banker I know, for a fact, the banking industry is probably the most regulated activity in society. Nuclear energy has modest regulation by comparison. The Congressmen in control of the financial industry are household names to most Americans. Ask an American who the head of the Atomic Energy Commission is and they would not have a clue.  Ask them if they know who Ben Bernacke, Senator Dodd or Barney Frank are and people will explain their role in the financial crisis, and know some of the common accusations against them for complacency in the development of meltdown.

Stiglitz also creates his own history. He accuses believers in the market economy of arguing the financial crisis was the result of a few "rotten apples." (xix) I was in the middle of the financial crisis and I do not recall any traditional economist placing the blame on a few individuals. I do recall President Obama and Stiglitz blaming the financial industry for the crisis. Nevertheless, in this book Stiglitz is arguing the cause is "systemic." (xix) I am sure many traditional economists would agree with that assessment. They would argue the systemic failure was not in the private sector, but due to excessive regulation by the government housing agencies and specifically HUD. Stiglitz has the opposite view. He states it is government that saved "markets from their own mistakes." (xx)

When the book opens Stiglitz puts much of the blame for the crisis on a "deregulated market awash in liquidity." (1) The actual precipitating events of the Great Recession were just the opposite, a heavily regulated industry trying to comply with HUD requirements for subprime lending that reached 50% of a bank's portfolio in 2007, and a fear by other banks and lenders providing liquidity that these loans would not be viable. History would certainly prove their caution was justified, and that government mandates were unwise and the primary factor in magnifying risk. Stiglitz continues his attack on the financial industry by accusing them of developing residential loan products for "maximizing their returns," (5) when the truth is variable rate interest loans were first developed in Europe and that the bonds sold by Wall Street followed SEC regulations to the letter. The problem was not the types of loans, but the fact HUD regulations made it necessary to lower lending standards to serve the subprime borrower. The result was when the economy faltered these marginal borrowers could not refinance their loans or escape their obligation. Stiglitz also accuses the financial industry of "promoting securitization" (6) when the reasons large packages of loans were securitized was to sell them to Fannie Mae and Freddie Mac. The GSEs did not want to fuss with small bond packages. The government mandated the size of the securitized loan packages. The government was the main destination for most of these securitized packages.

Stiglitz blames the mortgage companies, banks and rating agencies for the financial crisis, but never mentions HUD's role in manipulating the system. If it is a systemic failure like he asserts we should look at the system architect and not at the carpenters. Some of Stiglitz's arguments against the banks and the mortgage originators are just simply untrue: "The banks jumped into subprime mortgages--an area where, at the time, Freddie Mac and Fannie Mae were not making loans--without any incentives from the government." (10) The banks were middlemen between the mortgage lenders and the GSEs, Fannie and Freddie. The banks assembled bonds to feed the GSE's appetite.  Fannie and Freddie were also victim's of HUD. Just like the banks they were mandated by HUD to have a certain percentage of subprime loans (35% starting in 1992 with passage of the GSE Act). Stiglitz is correct it was not an incentive, it was a mandate. Everyone involved made subprime loans since the government mandated the GSEs and banks finance a specific percentage of subprime loans each year. Failure to comply meant the GSEs and banks could not make prime loans. This was the main business of both entities.

This gets us to the "too big to fail argument." Stiglitz asserts that banks knowing "they were too big to fail provided incentives for excessive risk-taking." (15) Let's evaluate this common statement of liberal academic economists. Bankers make money by making loans that return a profit. Why would they push it to a point where the government takes over their business and kicks them out? They would not. "Excessive risk" is not appealing when the risk is losing your career, and your retirement investment in a company that has provided your livelihood. Mortgage bankers did not take on "excessive risk," because of a big annual bonus. They were forced into a no win situation by a government that required they make loans to people likely not to repay them (GSE & CRA Acts). Why did they make those loans? Loaning to subprime borrowers was a precondition of making loans to the most lucrative real estate segment, prime borrowers. The conflict between Stiglitz's argument that insufficient regulation is the cause of the Great Recession and the evidence that over regulation is the cause of the housing meltdown is not explained in Freefall.

Stiglitz clearly states the cause of the Great Recession is "the reckless lending of the financial sector, which had fed the housing bubble, which eventually burst." (27) I would suggest lending that the government required for participation in the prime market segment is not properly characterized as "reckless," but better described as a mandated risk.

Stiglitz indicates the solution to the Great Recession is a monetary stimulus coming from the government. Sitting here in 2012 it is clear that after two and a half monetary stimulus attempts this antiquated economic concept works no better today than it did in 1933. He argues a government stimulus provides a 1.5 multiplier while a bailout provides no stimulus: "Spending money to bail out the banks without getting something in return gives money to the richest Americans and has almost no multiplier." ( 62) Stiglitz provides no explanation for his comment, "gives money to the richest Americans," but whatever Bill Gates and Warren Buffet did with their "gift," I am sure it will spent on people in need throughout the world.

Eventually, Stiglitz admits the borrowers may have had a role in the financial crisis: "many of these borrowers were financially illiterate and did not understand what they were getting into." (78) This begs the question of where were the regulators hired to prevent such situations? It also brings us back to asking why HUD required banks and the GSEs to make such loans. Such logic misses Stiglitz as he continues to hurl vindictive and hyperbole at the baking industry: "The securitization process supported never-ending fees, the never-ending fees supported unprecedented profits, and the unprecedented profits generated unheard-of bonuses, and all of this blinded the bankers." (79) If the Great Recession made banks so wealthy, why did they cancel dividends, layoff thousands and let their share price slip to 30 year lows. Obviously, the stock market saw something entirely different from Joseph Stiglitz.

I must admit I am not above blaming a group of people, like Stieglitz does, for some of our problems. In my case it is lawyers, so I was delighted when I came across this statement: "Besides, many of those in charge of the markets, though they might pride themselves on their business acumen and ability to appraise risk, simply didn't have the ability to judge whether the models were good or not. Many were lawyers, untrained in the subtle mathematics of the models." (84) Stiglitz in Chapter Four proposes a few new ideas that totally ignore five thousand years of financial development. One of these ideas is his proposal of separating housing debt from the home owner's wealth called a "homeowners' Chapter 11, (where) people wouldn't have to go through the rigmaroles of bankruptcy, discharging all of their debts. The home would be treated as if it were a separate corporation." (103) Maybe I am overly critical, but isn't this just allowing the homeowner to escape their liability? He does propose an interesting idea for a tax credit rather than a tax deduction for mortgage interest. (105) Another intriguing idea taken from Denmark that Stiglitz proposes is the idea that the mortgage originator bares the first loss on a default or resale. (106)

The biggest flaw of this book is putting the blame for the Great Recession on the bankers like this statement from page 109: "The bankers who got the country into this mess should have paid for their mistakes." The case for blaming the bankers is unclear. In fact, the bankers and homeowners bore the brunt of the financial loss, but the evidence of guilt during the crisis seemes to indicate it was HUD and their partner in the crime, the U.S. Congress. These government institutions required banks to lend to homeowners who "were financially illiterate" and encouraged market products that were financially not viable. Are the banks to blame, because they took this mandated medicine so they could make prime loans? Similarly, it seems ridiculous to blame "illiterate" homeowners. It seems correct to blame the government institutions that got us into this mess.

The argument of Freefall is further eroded when Stiglitz ventures into a lecture on what is morally correct behavior for an economy. At one point he states, "Capitalism can't work if private rewards are unrelated to social rewards." (110) This line of argument is way out there! Capitalism is not a reward for moral behavior. Heaven is a reward for moral behavior. Capitalism is a wealth creation system. Besides line of argument fallacies, I question the application and use of some of the factual statements included in the book like the following: "In the United States, the magnitude of guarantees and bailouts approached 80 percent of U.S. GDP, some $12 trillion." (110) This sum is only reached by double counting the investments of money market funds in U.S. Treasury Bills that the government guaranteed when they were originally purchased. Likewise, the following statement from the book is at least an unfair, if not an outright lie: "But by now, it is clear that there is little chance that the taxpayers will recover what has been given to the banks and no chance that they will be adequately compensated for the risk borne," (112) As a taxpayer I feel more than compensated for the "risk borne" knowing the world economy did not collapse, even if all I received in return was the face value of the funds the banks borrowed for a couple of years. Also, Stiglitz gives the impression the banks did not pay back the face value of the loans which is untrue.

It is not surprising Stiglitz's solution to the difficulties the banks went through is for the "shareholders (to) lose everything; bondholders become the new shareholders." (116) My only question is what did the shareholders do to deserve this punishment? Stiglitz argues the taxpayer should not bear the cost of the bailout. There is no cost to the taxpayers since the banks repaid the funds lent to them. Oh, I am forgetting the $3 trillion dollars of bailout funds. Following Stiglitz's logic: the liberal economists who encouraged the government to spend"stimulus" money on new office furniture for government buildings should repay the poorly invested stimulus funds. The banks repaid the money they borrowed to restore the banking system. It only seems fair the government should repay the stimulus money they borrowed that did not help to restore the economy. Both investments are equally bad. Since the plan directed by the liberal economists did not work. It seems like the government has a responsibility to recover those consulting fees paid to the liberal economists for advise that was clearly flawed.

Halfway through the book, Stiglitz turns his venom on the Fed, "The Fed played a central role in every part of this drama, from the creation of the crisis through lax regulation and loose monetary policies through the failure to deal effectively with the aftermath of the bursting of the bubble." ( 141) Stiglitz does not explain the role the Fed played in the "creation of the crisis." That is an unfortunate oversight on his part since it weakens his argument. To support his argument Stiglitz resorts to some of the most discredited economic theories, like the idea of "trade-offs between inflation and unemployment." (142) Finally, Stiglitz blames the computer programs written to evaluate the real estate products offered for sale: "Valuation of the complex products wasn't done by markets. It was done by computers running models that, no matter how complex, couldn't possibly embrace all of the relevant information." (160)

Stiglitz's solution to the Great Recession is more regulation and more government; "will require government taking on a larger role." (185) "Deregulation played a central role in the crisis, and a new set of regulations will be needed to prevent another crisis and restores trust in the banks." ( 216) Regulation is just policing. The issue is why did homeowners run the red light? More police does not alter the action of the inattentive driver. Logic insists that the cause of the Great Recession must be an action taken before the value of Residential Mortgage Bonds collapsed. The collapse was due to homeowners defaulting on their mortgages. Why did homeowners default? They could not pay the increasing cost of their mortgages. So the crisis comes down to who encouraged homeowners to purchase mortgages they could not afford. Even after Professor Stiglitz's explanation it still looks like HUD's reduced borrowing standards went too far. A policy to encourage expanded home ownership reduced all the standard economic safeguards.

Stiglitz expands his arguments into the absurb. At one point he declares that people do not make economic decisions in a "rational" manner: "The belief in rationality is deeply in grained in economics. Introspection--and even more so, a look at my peers-- convinced me that it is nonsense." (248) I personally have a hard time believing in an economic system not based on rationality. How could you model a person's expected response if you do not expect them to act rationally. I suppose life in an insane asylum would be a good model. I only hope that is not what Stiglitz is suggesting.

Let me end this  critique with a quote from Joseph Stiglitz since it aptly describes his book and his life: "The best ideas do not always prevail, at least in the short run." (274) Later he argues that "materialism" has "led to rampant exploitation of unwary and unprotected individuals and to an increasing social divide." (276) This 1920s liberalism is not a very potent argument in a world largely composed of a single middle class (the 99%). Stiglitz argues one of the probelms is the community defines our social structure by their choices in the marketplace. He is appalled that we "allowed markets to blindly shape our economy." In Stiglitz's preferred world the government makes those choices. Apparently, allowing consumers to influence the market is morally wrong. Since as Professor Stiglitz points out, "the unrelenting pursuit of profits and the elevation of the pursuit of self-interest may not have created the prosperity that was hoped, but they did help create the moral deficit." (278) It must be this "moral deficit" that caused bankers throughout the world to risk our economic prosperity for their personal pursuit of profits. I do not know about your personal banker, but mine is a guy who watches his kids play soccer on the week-end and mows his lawn with a push mower. If he is part of the moral deficit, he hides it very well. I should give Stiglitz a break.Part of his problem is his New Yorkcentric world view.

News blast: New York is not the center of the universe!

Stiglitz defines something he calls economic rights: "why should these economic rights--rights of corporations--have precedence over the more basic rights of individuals, such as the rights of access to health care or to housing or to education?" (287)  Stiglitz is confused over what a "right" is. Everyone has the freedom to obtain health care, housing or education. But, no one is entitled to receive these things without earning them. Being a human being is not an entitlement to an expensive education, housing or health care. These things like all products of society are a benefit of hard work.

Professor Stiglitz concludes his book by blaming particular segments of the private sector for manipulating our economic and social policy: "the special interest groups that shape American economic and social policy include finance, pharmaceuticals, oil and coal. Their political influence makes rational policy making all but impossible." (294) The only time I see industry representatives come before Congress is to be criticized and ridiculed. I am sure their message is delivered to Congress, but clearly employees of the government including Professor Stiglitz have much greater access and influence.

His entire book is an attempt to place blame on the bankers for the Great Recession. There is no tracing of events or causes that makes that argument persuasive. His arguments do not disprove that HUD caused the crisis by lowering lending standards and requiring an unrealistic large percentage of mortgage loans to be subprime. The book is simply a retelling of the events of the Great Recession, and then making a statement that the blame for these events lies at the feet of the banking system. Stiglitz's solution of more regulators and government power over the banking industry is not persuasive. In fact, Professor Stiglitz's shaky case adds credence to the opposite theory that the events of the Great Recession occurred because of government interference in the residential real estate market.