economic theory

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An underappreciated idea in economics is what I call the capital/labor ratio. This ratio is not really some kind of numerical statistic, but rather, a way of thinking about problems and solutions. It can be used to illustrate some of the difficulties of free trade, and also, what we should do about them.

From the beginnings of industrialization, around 1780, people wondered if machines would replace human labor, and thus lead to mass unemployment and disenfranchisement. If one person with a steam-powered spinning machine could replace 100 people using old-fashioned spinning wheels, what would happen to those 100 people?

If there was only one spinning machine, then 99 people might be destitute, or be reduced to low-value menial work, like sweeping the factory floor or raking the factory-owner’s yard. They are underemployed. The economy would actually grow. It would have not only the output of the spinning machine, equivalent to the previous output of all 100 people, but it would also have the output of whatever those 99 people ended up doing. Although the one person operating the spinning machine would be very productive, their wages would not be very high, because they could be replaced at any time with one of the 99 low-paid underemployed people. The average productivity of all 100 people would still not be very high.

This is a situation where there is just a little capital – one spinning machine – and a lot of underemployed labor.

However, if there were 100 spinning machines, then all 100 people could be very productive. The output of the economy would be much higher – a hundred times higher than when everyone used old-fashioned spinning wheels. Wages would be high, because you could not get the output of the machines without the employees to run it. Capital would compete for limited labor with higher wages. Any new investment would have to bid away labor from the textiles business, by offering a higher wage; consequently, to be profitable, that labor would have to be used in a manner even more productive than in the textile business. The toilets would still have to be cleaned, and the factory owner would still pay to have the leaves raked from his yard, but he would have to pay a high wage for it.

This is a situation where there is a lot of capital – 100 spinning machines – and no underemployed labor.

“Job destruction” is a normal part of economic expansion, wealth creation, increasing productivity and higher wages. It takes fewer and fewer people for more and more output. But this must be matched by “job creation” – and not just low-paid/low productivity jobs, which consume a lot of labor to create a product or service that can’t be sold for very much, but high-paid jobs which themselves represent the investment of large amounts of capital, to create high productivity.

 Factors such as the end of centrally-planned communism in both China and the former Soviet sphere, or cheap telecommunications which have enabled people from India to make use of their English skills, have radically increased the amount of underemployed labor available in the increasingly globalized world economy. It turns out that a lot of manufacturing is not all that hard. Who would have thought that the miracle of the two-terabyte hard drive could be created by Malaysians, or the iPhone 7 by Chinese? The developed economies, such as Germany, Japan and the United States, have been driven toward manufacturing of capital goods rather than consumer goods, and also, a few industries (like chemical production) where so few employees are needed that labor costs are a minor factor.

Free trade can be a little like the spinning machine. It now takes one person with container ship to create what used to take 100 employees to do.

Our retail stores are filled with a profusion of goods from China, Mexico or Malaysia. We don’t see the complicated capital goods, which are mostly purchased by big corporations. These are things like telecommunications equipment, electric power generation and distribution equipment, the defense industry, the barcode and conveyor-belt systems used in the warehouses of or UPS, equipment for the medical industry like MRI scanners or laboratory test equipment, hardware for the oil and gas or mining industry, the huge industrial plants that make yogurt and beer, or the commercial software that helps it all to function. These kinds of high-value products are the likely future of American manufacturing.

What American labor – the middle class, and the below-middle class – needs today, most of all, is capital investment. This is best accomplished by making the U.S. a great place to do business. It should include tax reform, such as the 15% corporate tax rate that president-elect Donald Trump has proposed. Eventually, this should be extended to everyone, a flat income tax with a rate also around 15%. It also means a rollback of regulatory burdens, which is especially choking off the smaller companies that have always accounted for most job creation. Ideally, it also means a stable dollar – in U.S. history, this means a dollar linked to gold – which does not confuse the capitalist system of prices and returns on capital with monetary distortion, manipulated interest rates, and wild exchange-rate swings. We need real investment in the real, nonfinancial economy, not weird asset bubbles, financial chicanery, and all the other elements of “malinvestment” that arise from unstable money.

This will create a situation where there is a lot of capital investment, relative to available underemployed labor – a situation similar to the 1950s and 1960s.

Where will that capital investment go? It will go, of course, to wherever the return on capital is the highest. This might mean the kind of high-value manufacturing I’ve described. But, we might find that we have enough stuff. People would rather spend their next dollar on something interesting to do. Much of the new investment might be in a variety of services. These would be high-value services. These could be in healthcare and education, for example. But, they could also be in things like restaurants and hospitality. A high-end hotel resort, or a high-end restaurant, takes just as much labor as the low-end versions. The difference is capital – a Four Seasons costs a lot more to build than a Motel 6. Instead of a spinning machine that radically increases the production of cotton cloth, our increasing productivity might express itself as a profusion of high-end restaurant and travel options – if that is what provided the highest return on capital.

Related to all of this is the raw increase of capital itself. The earliest economic writers understood that it was the steady increase of capital invested that made societies wealthier. They always focused on capital accumulation. More spinning machines. This capital investment is the flip side of savings–more savings means more investment. Decades of Keynesian promotion of “consumption” has led to a diminution of savings, and thus, domestic capital creation. This capital deficiency is remedied somewhat by imported capital – a “current account deficit” – but that is problematic on many levels. For one thing, a lot of small business creation arises from personal capital (personal savings), and also friends and family. The local accountant, chiropractor, marriage counselor, construction contractor or rental-apartment investor might never become listed on the NYSE, but these kinds of high-value service businesses, multiplied by the hundreds of thousands, can form the foundation of middle-class prosperity. They are largely locked out other sources of capital, including their local banks, until they reach sufficient size and stability. None of this happens if everyone, and their friends and family, are deep in credit card, automobile and student loan debt; or if oppressive regulatory burdens make it impossible for small businesses to form.

Much more capital investment requires much more capital to invest. This will have to be the foundation of any economic revival in the U.S., whatever trade or tariff policy may be. Without it, nothing much will be accomplished.

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Employment security is a concept that generates legal and economic controversy. This is due to the conflict between the rights of capital to run a business to its maximum profitability and the argument that employees have a right to employment security.

For people living and working in an advanced economy, viz. an economy where there is specilisation within the process of production in goods or services, then employment security ought to depend on access to a market that demands their goods or services.

The law however adds some further stipulations: that employment security can also be taken to include all factors that affect a person’s employment opportunities. These would include factors such as additional protection for limited periods if they choose to leave paid employment to raise children.

The need for employment security was summarised by Judge Perkins, who, was the Judge in my recent case.

“A heavy onus rests upon an employer before a dismissal can be validly effected. The reasons for this are obvious. The right to be in employment and earn the means to support oneself and one’s dependants is a substantial right requiring protection. There is a strong societal imperative behind this, supported by economic need for full employment as founding a strong overall economy. A position of employment is a valuable asset. Employees are the most valuable asset of any business hoping to thrive. If the employment is to be terminated it is essential that it be justifiably fair.”

Clearly the Judge is not an economist.

Employment in production, when analysed as an economic proposition, can be analysed as a series of property rights, which, lends itself to a concurrent legal analysis.

The first right enumerated is ‘the right to be in employment’. This is another way of saying that as an entrepreneur, who supplies the capital, must provide employment.

Clearly this is incorrect. I have a legal right to my property, in this case capital. There is no requirement that I subjugate that right to another who has no legal claim to my property. There can be no ‘right to employment.’

Employees are a valuable asset, but they are no more valuable than other economic inputs, such as raw materials etc. The most valuable asset is capital, without which, there is no business and no employment. Capital pays the wages of the employee.

This is clearly true, as, production takes place over time. Employees are paid before the production results in consumer goods and the capitalist can earn the market return on those consumer goods.

What the law is actually talking about is the right of the employer to discard under-performing employees. Employees who earn less than their ‘discounted marginal value product’. These employees can create losses to capital and quite rationally, the employer wants to discard this underperforming factor of production.

The law does allow this, but requires that the employer evidence this and thereby justify their dismissal. This prevents the employer dismissing employees, not because they are underperforming, but because there is a personality clash and the employer wants to dismiss on this basis.


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From Ray Dalio

Now that we’re a month past the election and most of the cabinet posts have been filled, it is increasingly obvious that we are about to experience a profound, president-led ideological shift that will have a big impact on both the US and the world. This will not just be a shift in government policy, but also a shift in how government policy is pursued. Trump is a deal maker who negotiates hard, and doesn’t mind getting banged around or banging others around. Similarly, the people he chose are bold and hell-bent on playing hardball to make big changes happen in economics and in foreign policy (as well as other areas such as education, environmental policies, etc.). They also have different temperaments and different views that will have to be resolved.

Regarding economics, if you haven’t read Ayn Rand lately, I suggest that you do as her books pretty well capture the mindset. This new administration hates weak, unproductive, socialist people and policies, and it admires strong, can-do, profit makers. It wants to, and probably will, shift the environment from one that makes profit makers villains with limited power to one that makes them heroes with significant power. The shift from the past administration to this administration will probably be even more significant than the 1979-82 shift from the socialists to the capitalists in the UK, US, and Germany when Margaret Thatcher, Ronald Reagan, and Helmut Kohl came to power. To understand that ideological shift you also might read Thatcher’s “The Downing Street Years.” Or, you might reflect on China’s political/economic shift as marked by moving from “protecting the iron rice bowl” to believing that “it’s glorious to be rich.”

This particular shift by the Trump administration could have a much bigger impact on the US economy than one would calculate on the basis of changes in tax and spending policies alone because it could ignite animal spirits and attract productive capital. Regarding igniting animal spirits, if this administration can spark a virtuous cycle in which people can make money, the move out of cash (that pays them virtually nothing) to risk-on investments could be huge. Regarding attracting capital, Trump’s policies can also have a big impact because businessmen and investors move very quickly away from inhospitable environments to hospitable environments. Remember how quickly money left and came back to places like Spain and Argentina? A pro-business US with its rule of law, political stability, property rights protections, and (soon to be) favorable corporate taxes offers a uniquely attractive environment for those who make money and/or have money. These policies will also have shocking negative impacts on certain sectors.

Regarding foreign policy, we should expect the Trump administration to be comparably aggressive. Notably, even before assuming the presidency, Trump is questioning the one-China policy which is a shocking move. Policies pertaining to Iran, Mexico, and most other countries will probably also be aggressive.

The question is whether this administration will be a) aggressive and thoughtful or b) aggressive and reckless. The interactions between Trump, his heavy-weight advisors, and them with each other will likely determine the answer to this question. For example, on the foreign policy front, what Trump, Flynn, Tillerson, and Mattis (and others) are individually and collectively like will probably determine how much the new administration’s policies will be a) aggressive and thoughtful versus b) aggressive and reckless. We are pretty sure that it won’t take long to find out.

In the next section we look at some of the new appointees via some statistics to characterize what they’re like. Most notably, many of the people entering the new administration have held serious responsibilities that required pragmatism and sound judgment, with a notable skew toward businessmen.

Perspective on the Ideology and Experience of the New Trump Administration

We can get a rough sense of the experience of the new Trump administration by adding up the years major appointees have spent in relevant leadership positions. The table below compares the executive/government experience of the Trump administration’s top eight officials* to previous administrations, counting elected positions, government roles with major administrative responsibilities, or time as C-suite corporate executives or equivalent at mid-size or large companies. Trump’s administration stands out for having by far the most business experience and a bit lower than average government experience (lower compared to recent presidents, and in line with Carter and Reagan). But the cumulative years of executive/government experience of his appointees are second-highest. Obviously, this is a very simple, imprecise measure, and there will be gray zones in exactly how you classify people, but it is indicative.

Below we show some rough quantitative measures of the ideological shift to the right we’re likely to see under Trump and the Republican Congress. First, we look at the economic ideology of the incoming US Congress. Trump’s views may differ in some important ways from the Congressional Republicans, but he’ll need Congressional support for many of his policies and he’s picking many of his nominees from the heart of the Republican Party. As the chart below shows, the Republican members of Congress have shifted significantly to the right on economic issues since Reagan; Democratic congressmen have shifted a bit to the left. The measure below is one-dimensional and not precise, but it captures the flavor of the shift. The measure was commissioned by a National Science Foundation grant and is meant to capture economic views with a focus on government intervention on the economy. They looked at each congressman’s voting record, compared it to a measure of what an archetypical liberal or conservative congressman would have done, and rated each member of Congress on a scale of -1 to 1 (with -1 corresponding to an archetypical liberal and +1 corresponding to an archetypical conservative).

When we look more specifically at the ideology of Trump’s cabinet nominees, we see the same shift to the right on economic issues. Below we compare the ideology of Trump’s cabinet nominees to those of prior administrations using the same methodology as described above for the cabinet members who have been in the legislature. By this measure, Trump’s administration is the most conservative in recent American history, but only slightly more conservative than the average Republican congressman. Keep in mind that we are only including members of the new administration who have voting records (which is a very small group of people so far).

While the Trump administration appears very right-leaning by the measures above, it’s worth keeping in mind that Trump’s stated ideology differs from traditional Republicans in a number of ways, most notably on issues related to free trade and protectionism. In addition, a number of key members of his team—such as Steven Mnuchin, Rex Tillerson, and Wilbur Ross—don’t have voting records and may not subscribe to the same brand of conservatism as many Republican congressmen. There’s a degree of difference in ideology and a level of uncertainty that these measures don’t convey.

Comparing the Trump and Reagan Administrations

The above was a very rough quantitative look at Trump’s administration. To draw out some more nuances, below we zoom in on Trump’s particular appointees and compare them to those of the Reagan administration. Trump is still filling in his appointments, so the picture is still emerging and our observations are based on his key appointments so far.

Looking closer, a few observations are worth noting. First, the overall quality of government experience in the Trump administration looks to be a bit less than Reagan’s, while the Trump team’s strong business experience stands out (in particular, the amount of business experience among top cabinet nominees). Even though Reagan’s administration had somewhat fewer years of government experience, the typical quality of that experience was somewhat higher, with more people who had served in senior government positions. Reagan himself had more political experience than Trump does, having served as the governor of California for eight years prior to taking office, and he also had people with significant past government experience in top posts (such as his VP, George HW Bush). By contrast, Trump’s appointees bring lots of high quality business leadership experience from roles that required pragmatism and judgment. Rex Tillerson’s time as head of a global oil company is a good example of high-level international business experience with clear relevance to his role as Secretary of State (to some extent reminiscent of Reagan’s second Secretary of State, George Shultz, who had a mix of past government experience and international business experience as the president of the construction firm Bechtel). Steven Mnuchin and Wilbur Ross have serious business credentials as well, not to mention Trump’s own experience. It’s also of note that Trump has leaned heavily on appointees with military experience to compensate for his lack of foreign policy experience (appointing three generals for Defense, National Security Advisor, and Homeland Security), while Reagan compensated for his weakness in that area with appointees from both military and civilian government backgrounds (Bush had been CIA head and UN ambassador, and Reagan’s first Secretary of State, Alexander Haig, was Supreme Allied Commander of NATO forces during the Cold War). Also, Trump has seemed less willing to make appointments from among his opponents than Reagan was (Reagan’s Chief of Staff had chaired opposing campaigns, and his Vice President had run against him).\

By and large, deal-maker businessmen will be running the government. Their boldness will almost certainly make the next four years incredibly interesting and will keep us all on our toes.

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Scholarly considerations of economic regulation and governance generally take the state as a precondition, the necessity and centrality of which is not to be seriously questioned. The bold, creative scholarship of Edward Peter Stringham has, for some time now, begged leave to differ. Stringham explores the possibilities of private law and private governance, never more ably than in his new book.

Private Governance: Creating Order in Economics and Social Life sets out to show that, despite strong biases against them in the academic and public policy communities, voluntary associations and their private solutions to social and organizational problems continue to prevail and propagate, undermining the “deus ex machina theory of law.” This theory, “popular in bad social science,” treats the law as an “exogenous corrective device”  that exists entirely outside of the people and institutions on which it acts.

Stringham’s work draws extensively on public choice theory to expose the flaws in the deus ex machina outlook, challenging the largely unexamined assumption that law is uniquely and necessarily the province of government. As he notes, “Even if one assumes that certain problems require legal rules, one need not assume that a compulsory monopoly must provide them.” Indeed, observation of existing governmental monopolies should have taught us the very opposite: that unaccountable, concentrated power yields arbitrary results and opens the door to serious abuses of power and discretion, and that these are exactly the conditions a stable legal system ought to avoid.

Private Governance is a comprehensive and sophisticated answer to a question with which libertarians, particularly those of the free-market anarchist sort, are confronted: “But how would it work?” Stringham shows that a completely private, stateless system of governance is not only practicable but far superior to the coercive monopoly systems from which we derive our governing structures today.

The author previously edited an authoritative collection on this kind of ordered, private-property anarchism, Anarchy and the Law: The Political Economy of Choice (2007), which spanned a period of over a century and included contributions from such libertarian luminaries as Murray Rothbard, David Friedman, and Benjamin Tucker. His conversance with the extensive libertarian literature in this area is unsurpassed.

Stringham’s work follows directly from that of radical libertarians like Gustave de Molinari in the 19th century and Murray Rothbard in the 20th. It bears noting that “anarchism” may not be the most helpful of labels to apply to these thinkers, since it has long been fused to the economically retrograde, anti-market, and anti-property philosophy found in the works of, say, Peter Kropotkin or Mikhail Bakunin. In this case private property and market competition are not evil but good; these “anarchists” seek not their abolition but their universalization—their application to areas of political and social life that are today dominated by governmental monopolies.

Molinari’s The Production of Security (1849) argued that the free market could provide even defensive services. We in turn find the germ of this revolutionary idea in the “industrialism” of French radical liberals Charles Comte and Charles Dunoyer (the former of whom was an acolyte and son-in-law of the great classical economist, Jean-Baptiste Say). Comte and Dunoyer sought to depoliticize society, to “municipalize the world,” allowing peaceful free market forces to decentralize and ultimately dissolve governments.[1]

The themes of Private Governance hinge to a great extent on questions about how our institutional frameworks could better channel incentives and human nature. Public choice analyses are therefore at the center of Stringham’s project: if human beings are self-serving and avaricious in markets, then they will likely be no less so when inhabiting governmental bodies, at least if we’re being realistic rather than romantic about governmental agencies.

Early in the book, Stringham frames the question this way: the Nobel Laureate James Buchanan “never applied public choice to law . . . , but what if he did?” He proceeds to take the application of public choice to questions of law and social order as far as anyone before has dared—and then farther—cogently combining theory, historical lessons, and empirical research. The results are embarrassing for legal centralism, the idea that only government can supply law and order.

To replace legal centralism, Stringham posits a polycentric legal system “in which courts are engaged in an ongoing, dynamic discovery process of experimentation, trial and error, and feedback.” Drawing on Adam Smith, Stringham observes that even among governmental courts, competition “led to ‘superior dispatch and impartiality.’” Potential litigants might avail themselves of the law merchant, or the chancery, or manorial courts, just to name a few, the contest between these courts impelling each to produce fast, fair justice.

We can generalize from this and turn ever more governance functions over to market mechanisms. And we should because, as it happens, governments are not very well positioned to protect our rights. As Stringham explains, “Legal centralists’ wishes notwithstanding, law enforcement officials may not have maximizing utility in society or maximizing Kaldor-Hicks efficiency in their objective function.” Rather, it is just taken for granted that government bureaus and the “public servants” that inhabit them will automatically act selflessly, devoted undeviatingly to the common good.

It is as if the human beings working for the government were of a different kind, exempt from the assumptions we make about the fundamentally self-interested nature of those working in capitalist firms. Of course, those who accept such facile explanations don’t bother to confront either the fact that the “public good” is a famously slippery notion, or that people do not magically metamorphose into messengers of the heavens when they move from the private sector to the public. Public choice theory doesn’t let political philosophy’s gospelers of statism off the hook so easily; if people are selfish and incentives matter, then these facts hold across the board.

Public choice reveals that in fact there is no deus ex machina. It shows that, if our institutional designs are going to work, they have to work with and for actual human beings, not the perfectly altruistic constructs of Progressive political theory. Economic thinking, when applied to policy questions and political theory, contests many of the facile assumptions of the deus ex machina notion of government.[2]

And that’s where Stringham’s book enters the scene, filling a gap in the literature and explaining how market mechanisms and spontaneous orders account for these flaws in human nature. Centralized, unilateral power and discretion, Stringham shows, are not the solutions they pretend to be but are fraught with moral hazard and information problems. Historically, market relationships—horizontal, decentralized, and voluntary—have actually been much better at managing risk and protecting interested parties. The array of historical examples and case studies that Stringham has collected give the lie to the argument that private governance is just the fantasy of fanatical libertarians.

We learn, for example, that during the Gold Rush in San Francisco, when the city’s police failed the people who lived in the city and were often “considered worse than the private criminals,” businessmen worked together to organize a private police service. This example is especially compelling insofar as San Francisco was then a rowdy boom town, just the kind of place for which private governance is supposed to be inadequate. At the middle of the 19th century, it was a Wild West maelstrom of criminals and single young men (80 percent of the population) in search of quick riches. And this rogues’ gallery had in it rogues who had emigrated from every corner of the globe. Such conditions are thought to preclude “social cooperation without government,” yet small business owners mobilized efficiently for their own protection.

Where government did not have the ability, knowledge, or incentive to solve the problem, concerned merchants did. Stringham likewise shows how the rules of the London Stock Exchange emerged from the specific needs and challenges of its participants, faced with laws that forbade many of their contracts. Undeterred, brokers devised ingenious rules and procedures through which to guarantee investments and prevent fraud.

The progenitors of such private forms of governance were not Rothbardian anarcho-capitalists or libertarian ideologues. They were practical businessmen, concerned with creating an environment in which economic value is protected cost-effectively. Thus were their solutions developed spontaneously, responding to specific, identified problems, often on an ad hoc basis.

“Providers of private governance,” writes Stringham, “recognize government is not the solution, so they take the initiative and provide private ones.” They are different from government bureaucrats in that they have a concrete incentive to take the initiative and, better still, to come up with solutions that actually work. With skin in the game and specialized knowledge of their own businesses and industries, private governance innovators are uniquely equipped to problem solve.

Just as important is their lack of the kind of binding coercive power possessed by legislators and government regulators. Where the customer is not a captive, bound by law to a package of services, a given provider must constantly readjust to changing circumstances and consumer preferences. Participants in such voluntarily ordered systems want and expect to deal with one another again; this expectation of repeated business interactions—if not with the very same individual, then at least within the same small network—is part of a highly complex, extra-governmental groundwork for honesty and fair dealing.

All that governments can ever do is compel and coerce, and this they often do rather arbitrarily, without due regard for the unforeseen (and indeed unforeseeable) consequences of their meddling. Government bureaucrats have an incentive problem: they are paid to meddle, whether it is necessary or not. And they aren’t rewarded for coming in under budget, for the efficient use of time and resources.

Private Governance demonstrates that free market competition in law and order is not unprecedented and does not yield an unregulated chaos in which the consumer is defenseless against greedy capitalists. Regulation is indeed everywhere: it is competition, rather than compulsion, that serves as the regulatory tool. The sophistication of markets, itself an outgrowth of expressed consumer needs and preferences, enables them to allocate risk much more effectively and safely than governments. Market actors with financial skin in the game, it turns out, end up formulating rules far superior to those arbitrarily handed down by regulators, too often oblivious or (what is often worse) just overzealous. The mandatory, one-size-fits-all rules of government are not without their costs. And when everyone is locked into government rules and regulations, the costs of bad rules—those that don’t actually serve regulators’ purported consumer safety goals—are that much higher.

Stringham shows that private organizations, equipped, unlike government, with specialized knowledge (peculiar to time, place, or their profession) can outperform government and formulate better protocols for social and economic behavior. The effective assembly of such rules is in fact just the kind of task to which specialization within a market economy is most well-adapted.

Classical liberal and conservative readers who are unable to follow Stringham to full-fledged private-property anarchism are nonetheless likely to find his arguments persuasive. Private Governance handily levels conventional wisdom about the necessity of coercive monopolies for the provision of law and law enforcement. As Molinari explained over a century and a half ago, free and voluntary associations are more than competent to dispense law and justice, however uncomfortable this fact may be.

With a careful combination of historical examples, empirical evidence, and old-fashioned (in the best sense) political economy, Edward Stringham offers an stimulating and challenging perspective on the intersection of law, politics, and economics. Destined to be a libertarian classic for all three fields, Private Governance is a testament to the power of free individuals, to the potential of a society without sanctioned coercion.


[1] The definitive treatment of Comte and Dunoyer’s radical liberalism is David M. Hart’s Class Analysis, Slavery and the Industrialist Theory of History in French Liberal Thought, 1814-1830: The Radical Liberalism of Charles Comte and Charles Dunoyer. Unpublished doctoral dissertation, King’s College, Cambridge, 1994.

[2] Economist and political scientist Michael Munger calls this the “unicorn fallacy,” observing “that people who favor expansion of government imagine a State different from the one possible in the physical world.” When these people imagine the state, they quite unconsciously ascribe to it a range of superhuman qualities; that is, they abstract it from its component parts, which are the very same self-interested human beings who make up market institutions. On its face, this is a problem for those who favor compulsory monopoly for some goods or services (for example, providing police and roads) but not others (for example, the manufacture of shoes and widgets).

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Paradoxically, the biggest source of white noise are economists. Much of modern macroeconomics is bunkum, which means that its findings  and predictions contribute negatively to the sum total of human knowledge. Paul Romer, one of the world’s preeminent macroeconomists and a professor at the Stern School of Business at New York University, has made his own inflammatory contribution to this debate, and many are now being forced to address this critical problem.

In The Trouble with Macroeconomics, a working paper, he argues: “For more than three decades, macroeconomics has gone backwards.” The emperor is stark naked. He claims that “post-real macroeconomics illustrate a general failure mode of a scientific field that relies on mathematical theory.”

It’s devastating stuff, but Romer is right. Academic macroeconomic theory is broken – but so are the models used by central banks and the spreadsheet forecasting in the City. It’s an intellectual catastrophe. Thousands of intelligent, well-meaning economists are at best contributing noise to the debate and at worst leading governments, companies and investors down the wrong paths.

Romer’s attack on macroeconomics , if anything, doesn’t go far enough.

Progress had indeed been made by the 1970s, in particular as a result of Milton Friedman and Anna J Schwartz’s Monetary History of the United States, a book that Romer agreed was a scientific triumph. But the economic consensus  – the majority view – keeps calling the big macroeconomic questions wrong. It failed to see the boom of the 1920s, it didn’t predict the Great Depression (those such as Ludwig von Mises or FA Hayek, who did, were ignored), it messed up disastrously during the 1930s on everything from the gold standard to the reaction to the Depression, before catching the pernicious Keynesian virus.

It wrongly fell in love with central planning in the Second World War and in the 1960s Paul Samuelson’s best-selling economic textbooks were happily predicting that Soviet per capita income would soon catch up with America.

On the greatest question ever – is capitalism or communism best – the economic establishment got it wrong. Not content with that, the consensus failed to see the stagflation of the 1970s coming (it was deemed impossible by simplistic Keynesians); 364 economists campaigned against Margaret Thatcher’s macroeconomic policies of the early 1980s (most still don’t get it); they didn’t spot the bubble of the 1980s or the subsequent housing crash and they backed the disastrous European Exchange Rate mechanism.

It’s almost a case of take your pick – choose a disastrous policy and you can be sure that most economists backed it. In a poll in 1979, 65 per cent of economists said joining the euro would have been in the UK’s interest; that number rose to 73 per cent of among those specialising in the economics of the EU and of monetary union. Then they all missed the financial crisis, and they missed the recovery.

More recently, the economic consensus (as against a few brilliant exceptions) also failed to predict everything from the collapse of inflation, the UK jobs boom to the productivity slowdown, not forgetting that many saw a non-existent double or even triple dip recession coming a few years ago.

A month or two ago, the consensus was predicting immediate Armageddon, a Lehman-style freezing of markets, and in many cases a recession or numerous negative quarters of growth if we voted Brexit. It’s a woeful, abysmal record, one for which the very concept of “rewards for failure” was invented.

So yes, Romer is right – and if anything, he doesn’t go far enough. So those seeking out alpha – when it comes to Brexit or anything else – need to tread carefully. They must weigh up the evidence, the claims and counter-claims on all issues. But the fact that 90pc of economic forecasters agree with something should be no more relevant than the latest phase of the moon.

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“Every time I see it, that number blows my mind.”

Erik Hurst, an economist at the University of Chicago, was delivering a speech at the Booth School of Business this June about the rise in leisure among young men who didn’t go to college. He told students that one “staggering” statistic stood above the rest. “In 2015, 22 percent of lower-skilled men [those without a college degree] aged 21 to 30 had not worked at all during the prior twelve months,” he said.

“Think about that for a second,” he went on. Twentysomething male high-school grads used to be the most dependable working cohort in America. Today one in five are now essentially idle. The employment rate of this group has fallen 10 percentage points just this century, and it has triggered a cultural, economic, and social decline. “These younger, lower-skilled men are now less likely to work, less likely to marry, and more likely to live with parents or close relatives,” he said.

So, what are are these young, non-working men doing with their time? Three quarters of their additional leisure time is spent with video games, Hurst’s research has shown. And these young men are happy—or, at least, they self-report higher satisfaction than this age group used to, even when its employment rate was 10 percentage points higher.

It is a relief to know that one can be poor, young, and unemployed, and yet fairly content with life; indeed, one of the hallmarks of a decent society is that it can make even poverty bearable. But the long-term prospects of these men may be even bleaker than their present. As Hurst and others have emphasized, these young men have disconnected from both the labor market and the dating pool. They are on track to grow up without spouses, families, or a work history. They may grow up to be rudderless middle-aged men, hovering around the poverty line, trapped in the narcotic undertow of cheap entertainment while the labor market fails to present them with adequate working opportunities.

Here is the conundrum: Writers and economists from half a century ago and longer anticipated that the future would buy more leisure time for wealthy workers in America. Instead, it just bought them more work. Meanwhile, overall leisure has increased, but it’s the less-skilled poor who are soaking up all the free time, even though they would have the most to gain from working. Why?

Here are three theories.

1. The availability of attractive work for poor men (especially black men) is falling, as the availability of cheap entertainment is rising.

The most impressive technological developments since 1970 have been “channeled into a narrow sphere of human activity having to do with entertainment, communications, and the collection and processing of information,” the economist Robert Gordon wrote in his book The Rise and Fall of American Growth. As with any industry visited by the productivity gods, entertainment and its sub-kingdoms of music, TV, movies, games, and text (including news, books, and articles) have become cheap and plentiful.

Meanwhile, the labor force has erected several barriers for young non-college men, both overt—like the Great Recession and the decades-long demise of manufacturing jobs—and insidious. As the sociologist William Julius Wilson and the economist Larry Katz have both told me, the labor market’s fastest growing jobs are not historically masculine or particularly brawny. Rather they prize softer skills, as in retail, education, or patient-intensive health care, like nursing. In the 20th century, these jobs were filled by women, and they are still seen as feminine by many men who would simply rather not do them. Black men also face resistance among retail employers, who assume that potential customers will regard them as threatening.

And so, at the very moment that the labor market obliterated manufacturing jobs and shifted toward more soft-skill service jobs, diversion became a vastly discounted experience that could provide a moment’s joy at home. As a result, entertainment has become an inferior good, where the young and poor work less and play more.

2. Social forces cultivate a conspicuous industriousness (even workaholism) among affluent college graduates.

The first theory doesn’t do anything to explain why rich American men work so much harder than they used to, even though they are richer. That’s odd, since the point of earning money is ostensibly to afford things that make you happy, like free time.

But perhaps that’s just it: Rich, ambitious Americans are already spending more time on what makes them fulfilled, but that thing turned out to be work. Work, in this construction, is a compound noun, composed of the job itself, the psychic benefits of accumulating money, the pursuit of status, and the ability to afford the many expensive enrichments of an upper-class lifestyle.

In a widely shared essay in the Wall Street Journal last week, Hilary Potkewitz hailed 4 a.m. as “the most productive hour.” She quoted entrepreneurs, lawyers, career coaches, and cofounders praising the spiritual sanctity of the pre-dawn hours. As one psychiatrist told her, “when you have peace and quiet and you’re not concerned with people trying to get your attention, you’re dramatically more effective.”

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The world is rich and will become still richer. Quit worrying.

Not all of us are rich yet, of course. A billion or so people on the planet drag along on the equivalent of $3 a day or less. But as recently as 1800, almost everybody did.

The Great Enrichment began in 17th-century Holland. By the 18th century, it had moved to England, Scotland and the American colonies, and now it has spread to much of the rest of the world.

Economists and historians agree on its startling magnitude: By 2010, the average daily income in a wide range of countries, including Japan, the United States, Botswana and Brazil, had soared 1,000 to 3,000 percent over the levels of 1800. People moved from tents and mud huts to split-levels and city condominiums, from waterborne diseases to 80-year life spans, from ignorance to literacy.

You might think the rich have become richer and the poor even poorer. But by the standard of basic comfort in essentials, the poorest people on the planet have gained the most. In places like Ireland, Singapore, Finland and Italy, even people who are relatively poor have adequate food, education, lodging and medical care — none of which their ancestors had. Not remotely.

Inequality of financial wealth goes up and down, but over the long term it has been reduced. Financial inequality was greater in 1800 and 1900 than it is now, as even the French economist Thomas Piketty has acknowledged. By the more important standard of basic comfort in consumption, inequality within and between countries has fallen nearly continuously.

In any case, the problem is poverty, not inequality as such — not how many yachts the L’Oréal heiress Liliane Bettencourt has, but whether the average Frenchwoman has enough to eat. At the time of “Les Misérables,” she didn’t. In the last 40 years, the World Bank estimates, the proportion of the population living on an appalling $1 or $2 a day has halved. Paul Collier, an Oxford economist, urges us to help the “bottom billion” of the more than seven billion people on earth. Of course. It is our duty. But he notes that 50 years ago, four billion out of five billion people lived in such miserable conditions. In 1800, it was 95 percent of one billion.

We can improve the conditions of the working class. Raising low productivity by enabling human creativity is what has mainly worked. By contrast, taking from the rich and giving to the poor helps only a little — and anyway expropriation is a one-time trick. Enrichment from market-tested betterment will go on and on and, over the next century or so, will bring comfort in essentials to virtually everyone on the planet, and more to an expanding middle class.

Look at the astonishing improvements in China since 1978 and in India since 1991. Between them, the countries are home to about four out of every 10 humans. Even in the United States, real wages have continued to grow — if slowly — in recent decades, contrary to what you might have heard. Donald Boudreaux, an economist at George Mason University, and others who have looked beyond the superficial have shown that real wages are continuing to rise, thanks largely to major improvements in the quality of goods and services, and to nonwage benefits. Real purchasing power is double what it was in the fondly remembered 1950s — when many American children went to bed hungry.

What, then, caused this Great Enrichment?

Not exploitation of the poor, not investment, not existing institutions, but a mere idea, which the philosopher and economist Adam Smith called “the liberal plan of equality, liberty and justice.” In a word, it was liberalism, in the free-market European sense. Give masses of ordinary people equality before the law and equality of social dignity, and leave them alone, and it turns out that they become extraordinarily creative and energetic.

The liberal idea was spawned by some happy accidents in northwestern Europe from 1517 to 1789 — namely, the four R’s: the Reformation, the Dutch Revolt, the revolutions of England and France, and the proliferation of reading. The four R’s liberated ordinary people, among them the venturing bourgeoisie. The Bourgeois Deal is, briefly, this: In the first act, let me try this or that improvement. I’ll keep the profit, thank you very much, though in the second act those pesky competitors will erode it by entering and disrupting (as Uber has done to the taxi industry). By the third act, after my betterments have spread, they will make you rich.

And they did.

You may object that ideas are a dime a dozen and that to make them fruitful we must start with adequate physical and human capital and good institutions. It’s a popular idea at the World Bank, but a mistaken one. True, we eventually need capital and institutions to embody the ideas, such as a marble building with central heating and cooling to house the Supreme Court. But the intermediate and dependent causes like capital and institutions have not been the root cause.

The root cause of enrichment was and is the liberal idea, spawning the university, the railway, the high-rise, the internet and, most important, our liberties. What original accumulation of capital inflamed the minds of William Lloyd Garrison and Sojourner Truth? What institutions, except the recent liberal ones of university education and uncensored book publishing, caused feminism or the antiwar movement? Since Karl Marx, we have made a habit of seeking material causes for human progress. But the modern world came from treating more and more people with respect.

Ideas are not all sweet, of course. Fascism, racism, eugenics and nationalism are ideas with alarming recent popularity. But sweet practical ideas for profitable technologies and institutions, and the liberal idea that allowed ordinary people for the first time to have a go, caused the Great Enrichment. We need to inspirit masses of people, not the elite, who are plenty inspirited already. Equality before the law and equality of social dignity are still the root of economic, as well as spiritual, flourishing — whatever tyrants may think to the contrary.

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For a good many years, Tony Lawson has been urging economists to pay attention to their ontological presuppositions. Economists have not paid much attention, perhaps because few of us know what “ontology” means. This branch of philosophy stresses the need to “grasp the nature of the reality” that is the object of study – and to adapt one’s methods of inquiry to it.
5112X+PoJkLEconomics, it might be argued, has gotten this backwards. We have imposed our pre-conceived methods on economic reality in such manner as to distort our understanding of it. We start from optimal choice and fashion an image of reality to fit it. We transmit this distorted picture of what the world is like to our students by insisting that they learn to perceive the subject matter trough the lenses of our method.

The central message of Lawson’s critique of modern economics is that an economy is an “open system” but economists insist on dealing with it as if it were “closed.” Controlled experiments in the natural sciences create closure and in so doing make possible the unambiguous association of “cause” and “effects”. Macroeconomists, in particular, never have the privilege of dealing with systems that are closed in this controlled experiment sense.

Our mathematical representations of both individual and system behaviour require the assumption of closure for the models to have determinate solutions. Lawson, consequently, is critical of mathematical economics and, more generally, of the role of deductivism in our field. Even those of us untutored in ontology may reflect that it is not necessarily a reasonable ambition to try to deduce the properties of very large complex systems from a small set of axioms. Our axioms are, after all, a good deal shakier than Euclid’s.

The impetus to “closure” in modern macroeconomics stems from the commitment to optimising behaviour as the “microfoundations” of the enterprise. Models of “optimal choice” render agents as automatons lacking “free will” and thus deprived of choice in any genuine sense. Macrosystems composed of such automatons exclude the possibility of solutions that could be “disequilibria” in any meaningful sense. Whatever happens, they are always in equilibrium.

Axel Leijonhufvud

The whole basis of Austrian economics is deductivism. The axiom that is relied upon is ‘human action’. That ‘human action’ unarguably is an axiom should be beyond debate.

The Austrian method also uses the ‘open system’ in that acting man is employed to illustrate the economic phenomena being investigated.

Ultimately all economic systems are comprised of individuals. Therefore it is the individual that must be accounted for in any theoretical investigation of economic systems.


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The rise of passive asset management threatens to fundamentally undermine the entire system of capitalism and market mechanisms that facilitate an increase in the general welfare, according to analysts at research and brokerage firm Sanford C. Bernstein & Co., LLC.

In a note titled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism,” a team led by Head of Global Quantitative and European Equity Strategy Inigo Fraser-Jenkins, says that politicians and regulators need to be cognizant of the social case for active management in the investment industry.

“A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management,” they write.


High fees and subpar returns, coupled with the creation of a plethora of relatively inexpensive exchange-traded funds that track major equity indexes have helped fuel a massive shift in asset flows away from active management in favor of passive. While policymakers are quick to praise the benefits of these low-cost options for retail investors, Bernstein argues that this is a short-sighted view that doesn’t take into account the potential downsides involved with the increase in passively-managed assets.

Source: Investment Company Institute

Fraser-Jenkins notes that the rise of indexing should theoretically entail that stocks tend to move in the same direction more often (though such a simple relationship isn’t necessarily borne out by the data), and cites research indicating that “if the correlation of stocks increases then that impedes the efficient allocation of capital. That is, there isn’t as big of a difference in capital expenditures on a sector by sector basis than what would be expected based on relative profit growth.

The social function of active management, in a capitalist society, is that it seeks to direct capital to its most productive end, facilitating sustainable job creation and a rise in the aggregate standard of living. And rather than be guided by the Invisible Hand and profit motive, capital allocation under Marxism is conducted by an oh-so-visible hand aimed at producing use-values that satisfy each member of the society’s needs. Seen through this lens, passive management is somewhat tantamount to a nihilistic approach to capital allocation.

To adapt a line from a Coen brothers classic: Say what you will about the tenets of Marxism, Dude, at least it’s a formal attempt to direct capital to achieve a desired end.


“The commonality between both active market management and the Marxist approach is that in both cases there are a set of agents trying – at least in principle – to optimize the flows of capital in the real economy,” writes Fraser-Jenkins.

Bernstein’s team isn’t asking for governments to bail out active managers, but merely advises that lawmakers and regulators “may wish to consider the broader benefits of a functioning active asset management industry to society as a whole so that when policy initiatives are undertaken they do not explicitly undermine active management.”

While the question of whether the rise of passive investing is an existential threat to capitalism remains an open one, Bernstein’s team acknowledges one uncomfortable truth: it certainly looms as a major downside risk for the livelihoods of people who produce sell side equity research.

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A fall in the US velocity of money M2 to 1.44 in June from 1.51 in June last year and 2.2 in May 1997 has alarmed many experts. Note that the June figure is the lowest since January 1959 (see chart). Some commentators are of the view that this points to a severe liquidity crunch, which could culminate in a massive stock market collapse and an economic disaster in the months ahead.

According to a popular thinking the idea of velocity is straightforward. It is held that over any interval of time, such as a year, a given amount of money can be used again and again to finance people’s purchases of goods and services. The money one person spends for goods and services at any given moment can be used later by the recipient of that money to purchase yet other goods and services.

For example, during a year a particular ten-dollar bill might have been used as following: a baker John pays the ten-dollars to a tomato farmer George. The tomato farmer uses the ten-dollar bill to buy potatoes from Bob who uses the ten dollar bill to buy sugar from Tom. The ten-dollars here served in three transactions. This means that the ten-dollar bill was used 3 times during the year, its velocity is therefore 3.

A $10 bill, which is circulating with a velocity of ‘3’ financed $30 worth of transactions in that year. If there are $3000 billion worth of transactions in an economy during a particular year and there is an average money stock of $500 billion during that year, then each dollar of money is used on average 6 times during the year (since 6*$500 billion =$3000).

The $500 billion of money is boosted by means of a velocity factor to become effectively $3000 billion. This implies that the velocity of money can boost the means of finance. From this it is established that

Velocity = Value of transactions / supply of money

This expression can be summarized as

V = P*T/M

Where V stands for velocity, P stands for average prices, T stands for volume of transactions and M stands for the supply of money. This expression can be further rearranged by multiplying both sides of the equation by M. This in turn will give the famous equation of exchange

M*V = P*T

This equation states that money times velocity equals value of transactions. Many economists employ GDP instead of P*T thereby concluding that

M*V = GDP = P*(real GDP)

The equation of exchange appears to offer a wealth of information regarding the state of the economy. For instance, if one were to assume a stable velocity, then for a given stock of money one can establish the value of GDP. Furthermore, information regarding the average price or the price level allows economists to establish the state of real output and its rate of growth.

Does the Concept of Money Velocity Make Sense?

From the equation of exchange it seems that money together with velocity is the source of funding for economic activities. Furthermore, from the equation of exchange it would appear that for a given stock of money an increase in velocity helps finance a greater value of transactions than money could have done by itself – obviously then that the decline in velocity should be seen as a great concern.

As logical as it sounds, neither money nor velocity have anything to do with financing transactions. Here is why.

Consider the following: a baker John sold 10 loaves of bread to a tomato farmer George for $10. Now, John exchanges the $10 to buy 5kg of potatoes from Bob the potato farmer. How did John pay for potatoes? He paid with the bread he produced. Observe that John the baker had financed the purchase of potatoes not with money but with bread. He paid for potatoes with his bread using money to facilitate the exchange. In other words money fulfills here the role of the medium of exchange and not the means of payment. The number of times money changed hands has no relevance whatsoever on the bakers’ capability to fund the purchase of potatoes. What matters here is that he possesses bread that can be exchanged by means of money for potatoes.

How is it that the fact that the same $10 bill used in several transactions can add anything to the means of funding? Imagine that money and velocity would have indeed been means of funding or means of payments. If this was so then poverty world-wide could have been erased a long time ago. Moreover, since rising velocity is supposed to boost effective funding then it would have been to everyone’s benefit to make sure that money circulates as fast as possible. This implies that any one who holds on to money should be classified as menace to society for he slows down the velocity of money and hence the creation of real wealth.

Velocity Does Not Have an Independent Existence

Contrary to popular thinking velocity has not got a “life of its own.” It is not an independent entity — it is always value of transactions P*T divided into money M ie P*T/M. On this, Rothbard wrote in Man Economy and State:

But it is absurd to dignify any quantity with a place in an equation unless it can be defined independently of the other terms in the equation. [emphasis in the original]

Since V is P*T/M, it follows that the equation of exchange is reduced to M*(P*T)/M = P*T, which is reduced toP*T = P*T, and this is not a very interesting truism. It is like stating that $10=$10 and this tautology conveys no new knowledge of economic facts. Contrary to popular thinking the velocity of money doesn’t have a life of its own. It is not an independent entity and hence it can’t cause anything. We can then conclude that the fact that the so called velocity of money fell to the lowest level since 1959 doesn’t by itself suggest that the stock market and the economy are poised for massive collapses in the months ahead.

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