Friday, December 31, 2010

Expansion of the Exchange Media in a Closed Economy with no Production

What follows is a piece of correspondence I sent to a friend regarding money expansion and price changes. It is meant to suggest that money inflation may not show up in price inflation for all goods.

"The purpose here is to consider the effects on nominal prices of goods and services when exchange media expand in a closed economy with free exchange. I choose prison as an adequate metaphor here, with cigarettes as the media of exchange.

Suppose that there is a prison where the inmates provide goods and services to each other, and some goods are delivered from outside the prison. These latter can be considered to be ‘endowments’ from a neoclassical point of view. In fact, in prison, the endowments are likely to be the dominant goods available. The endowment includes cigarettes. Every day, the prisoners will be endowed with goods, (e.g. food, cigarettes, books) and then they may consume, store, or trade with each other.

Services are traded within prisons too. One of the most important services may be protection. This is not endowed, although the guards may provide some protection among inmates. Thus the inmate-provided protection is on the order of extra protection that may be purchased.

Now, consider a prison after all endowments have been made. Trade will occur, facilitated by cigarettes, and prices of various goods and services in terms of cigarettes will be set. These prices will reflect each prisoner’s value scale, including the consumption value of cigarettes, not just the exchange value. Note that cigarettes, then, are basically commodity money.

Imagine that cigarette endowments are now restricted to the ‘replacement’ level, such that when a cigarette is used up or wears out, it will be replaced. This assures the current arrangement of prices will not change unless the prisoners’ value scales change. So as new endowments (sans cigarettes) occur, trade occurs using a constant price matrix. We should expect no inflation or coordination problems in this case, assuming value scales are stable (constant).

Suppose now that one inmate is given an endowment of cigarettes that is reasonably large given then amount of cigarettes currently available. This could be from visiting family, for example. Now what will happen to the prices of available goods and services?

Suppose the inmate really enjoys small powdered cake doughnuts, the kind made by Hostess and other companies. The first thing, then, our inmate (call him A) might do is go and locate some doughnuts and procure them. He may already have some that he purchased previously. So he might go back to the same person (call him B) he traded with before to get the doughnuts. If that person (B) still has some doughnuts, then A will offer some cigarettes in exchange for the doughnuts. There are two possible outcomes here. The first is that B accepts A’s offer and an exchange is made. The second is B rejects A’s offer and no exchange occurs.

Remember now that all trading had ceased prior to the injection of new cigarettes. Thus, the last price offered to B was too low to trade any more doughnuts. So if A wants some of B’s doughnuts, A will have to offer a higher price than B accepted before in order to induce B to sell doughnuts to A. Alternatively, A can seek someone else from whom to buy doughnuts (person C). But since trade had ceased, the higher price required by B will also be required by C, although B’s price may be higher than C’s price, both prices will be higher than the previous market-clearing price.

Now, A might go on like this buying more things he likes. The prices of the things he likes will go up. But notice, too, that his trading partners will have more of the medium of exchange, so that they can buy more of the things they like. Thus one may  trace from A’s increase of exchange media a price increase in a variety of goods, according to the desirability of goods from the perspective of A and his initial trading partners.

A benefits the most from the increase in exchange media, and the benefit declines as the trading partners increase. A benefits more than others because he is using the new media before any of the other inmates are aware of the new media and so they have not yet adjusted their prices. In fact, it is A that causes the initial price adjustment and so he faces the minimal adjustment required to get his doughnuts, for example. Anyone coming after A to get doughnuts will have to pay a higher price than even A paid.

Note that if A hoards his new media of exchange and only uses a bit to get a small edge in trading whenever new endowments are delivered, the price effects will be minimal. But, if A exchanges all his new media quickly after receiving it for goods, price effects will be very rapid and may be large, depending on other inmates’ trading behavior.

After A’s new media have entered and circulated in the system, prices will have changed permanently. The price of doughnuts has gone up. Perhaps also the price of protection services, or books, has increased. We cannot know ahead of time. What is important to note is that i) prices didn’t increase immediately; ii) prices didn’t increase uniformly. In fact, a different pattern of trade may exist after prices change, assuming inmates’ value scales haven’t changed.

 If no new media are injected, the current price pattern will be constant. If new media are injected, two events are possible. If the media are injected by B (or C, D, whomever) then the price pattern will change to reflect first B’s most desired goods, and then his trading partners’ desires, and so on. However, consider what would happen if A were given the endowment of media again, and this became common knowledge. Then, as A were to go out and spend his new cigarettes, he would find B’s price of doughnuts already adjusted to (close to) the new market-clearing price. Since B wouldn’t know exactly what the new market-clearing price would be, he would estimate it but it would be, in any case, higher than the previous market-clearing price and likely higher than A’s initial offer would have been, since B anticipated A’s desire. This anticipation of higher market-clearing prices would move through the system in this case, and clearing prices would be reset much more quickly than when new media injections were unknown.

However, what would happen if A changed his pattern? Suppose A decided doughnuts were no longer on the menu. Then the anticipated price changes would be all wrong and have to go through a re-coordination process as A’s new media moved through the prison markets. This would likely through a lot of planned exchanges, perhaps ones that had already been agreed to (a forward exchange), out of whack and cause them to be less desirable than anticipated. Those plans that could be called off would be, and those that could not may result in value losses for those involved. At any rate, likely there would be less value gained than anticipated. A new price pattern would emerge, but now if A got another endowment and it was common knowledge, prices would not likely adjust since the other inmates cannot predict A’s behavior.

Finally, what would happen if the same size endowment of exchange media was given, but it was divided among 2 or more inmates? Unless the inmates had the exact same value scale, the exchange media would enter the prison economy more quickly than if just one inmate received the endowment, but the resulting price pattern would look different, since the inmates have different value scales. We cannot know, a priori, if the pattern would be a more or less general increase in prices than if just A got the endowment, although it is likely to be so. We do know, however, that as N becomes large, where N is the number of inmates receiving an endowment, the probability of a uniform increase in prices goes to 1."

Uncle Sam – Stay out of my business!

It seems every day the State confiscates more and more freedoms once enjoyed by the individual.  The latest freedom to fall victim is the ability to obtain credit.  The Credit Card Act, signed into law last year, was supposed to prevent credit card companies from preying on young college kids – you know, sign up for a Visa and get a free T-shirt deal.  In the age of entitlements, I suppose the college kids thought their new credit card bill would be footed by someone other than themselves.  Nevertheless, the Fed is considering new rules to further clamp down on credit, and save us from ourselves.

The new and improved rule would require a borrower to qualify independently, regardless of household income.  So, if Mary is a stay-at-home mom, she wouldn’t qualify for a new Gap charge card, even though her husband earns $250,000 annually.  While many men may be secretly applauding the new rule, I think it stinks.

My decision to contract with a credit card company (or anyone else for that matter!) should not be predetermined by the Federal Reserve.  This new rule trotted out by the Fed is just another great example of an overbearing State.  And of course, the new rule is designed to further protect consumers.  Really!?  I’m afraid that unscrupulous lenders are becoming the least of our worries.  We are entering an age where the State is regulating every facet of our lives, all in the name of “protection”.  How long will we sit idly by as our freedoms and liberties are taken from us – all for our own good, of course?

Here’s the link to the Federal Reserve website should you desire to comment on the new rule.

“It is seldom that liberty of any kind is lost all at once” ~ David Hume.

Thursday, December 30, 2010

Austrian Economics: Objectivity and Choice

One of reasons I like Austrian economics stems from its objectivity.  Each of us values things differently, and we makes choices and trade-offs based on our individual and unique preferences.  Because we live in a world of scarce resources (yes, even Bill Gates makes trade-offs), we constantly choose between competing alternatives.  And in a capitalist society, we have lots of choices.

Austrian economics refrains from assigning values of “right” or “wrong” to individual decisions.  To impose my value system upon another violates the consumer sovereignty of the individual.  Moreover, only the individual acting in his own self-interest can make the best choice to satisfy his own unique preferences at that particular instant.  To suggest otherwise necessarily violates his consumer sovereignty. 
As an example, suppose my neighbor enjoys dining out, and frequently spends hundreds of dollars on expensive meals at fine restaurants.  Simply because my neighbor spends a lot of money on dining out doesn’t mean he’s making bad choices.  He’s simply making a choice.  He obviously places extraordinary value on the dining experience.  I’m happy for him, and I quietly acknowledge that he’s making trade-offs.  Expensive meals mean other things won’t get accomplished.  I may scoff at forking out that kind of money for food, but he has made the best decision for himself.  Why should I impose my values on him and vice versa?  He is free to choose, and I celebrate that we live in a society with numerous choices. 
What I refuse to do, though, is criticize him or subjectively label his decisions.  It would be easy for me (some might even say appropriate) to criticize his choice and substitute my own value system in place of his.  I could easily offer up a number of alternatives for the money spent on food, but those are my preferences, not his.  What right do I claim to have to say he made a bad choice?  None.   Likewise, I expect him to refrain from labeling my choices, and to accept them as that: choices among competing alternatives. 
I believe the more folks come to accept and ascribe to this way of thinking, the more we can all go about enjoying the many choices we make.

Wednesday, December 29, 2010

Gas Mileage and EPA

I stopped by the tire shop today, and while I was waiting, I picked up a copy of Popular Mechanics.  I happened upon an interesting article about car mileage (the magazine was dated January 2006).  PM was testing the accuracy of the posted mileage.  As it turned out, the window sticker mileage, as reported by the benevolent EPA, fell well short of what the PM drivers actually got driving the car.  Imagine that!?

My first thought was “the EPA is duping consumers into buying a car with better gas mileage”.  After all, if you care about the environment, you’ll buy a hybrid, right?  The second thought in my head was “why is the EPA, or anyone else for that matter, legally obligated (federal law) to post mileage on the sticker of the car, especially since they cannot be relied upon for accuracy?”  If I want accurate mileage figures, I’ll do the research myself, thanks.
I also learned the EPA will be changing the way it reports gas mileage on the sticker of the car.  They are adding a lettering system to the normal skewed mileage figures.   As you can imagine, cars getting government-approved gas mileage will receive a letter of A or B, while cars getting non-government approved mpg will get a letter of D or F.  No, I’m not kidding.

This is nothing more than government attempting to guilt consumers into buying a more fuel-efficient vehicle, and it’s shameful.  Naturally, the EPA denies it is trying to influence consumers, but I give the EPA an F for honesty here.  If they truly wished to inform consumers about mileage, they’d leave it to some unbiased and more reliable third party to do the reporting. 

Tuesday, December 28, 2010

Land of the Free? Not so Much.

Heritage Foundation publishes, on a regular basis, its index of economic freedom.  This chart is for 2010.  You can find this graphic at, and it’s worth visiting.  The website allows you to drill down into the data and discover much more about the rankings.

What’s very disheartening is the U.S. ranked 8th overall, actually falling 2.7 points from the previous score.  That’s the wrong direction.  Not only is our overall score troubling, but so is our score in relation to other countries.  Some of these might surprise you.

On “Trade Freedom”, 37 countries bested the U.S.  Some of those countries were Israel, Romania, and Turkey.

On “Property Rights”, 19 countries fared better than the U.S.  Countries beating us were Chile, United Kingdom, and Hong Kong.

Our lowest score was a 58 for “Government Spending”.  Our highest score was “Labor Freedom” at 94.8.  In our quest to become “safe and sound”, we are actually becoming less free.  We are trading liberty for the appearance of safety.  We are allowing our government to take what’s most precious, all in the name of “safety” or “it’s good for you”.  

“Government big enough to supply everything you need is big enough to take everything you have ... The course of history shows that as a government grows, liberty decreases.” ~ Thomas Jefferson.