[ExI] Psychology of markets explanations

dan_ust at yahoo.com dan_ust at yahoo.com
Tue Jun 9 20:32:20 UTC 2009

--- On Fri, 6/5/09, Stathis Papaioannou <stathisp at gmail.com> wrote:
>> 2009/6/5  <dan_ust at yahoo.com>:
>> You probably know much of this, but it's perhaps best
>> to look at the role of the interest rate.  Yes, it sets the
>> cost of borrowing money.  If the interest rate is set by
>> market interactions -- by suppliers and demanders of
>> loanable funds -- then the rate will tend to equilibrate
>> savings and loans under full reserve banking.  (Fractional
>> reserve banks can inflate, but even they will approach a
>> sort of equilibration.)  If the interest rate is
>> artificially lowered, under full reserve banking, then this
>> will have the same effect as artificially lowering prices:
>> there will be a shortage of loanable funds as the demand
>> will not be equilibrated with supply.  (The opposite
>> happens if the rate is artificially increased.  Of course,
>> the same happens if entrepreneurs make mistakes -- setting
>> the rate too high or too low -- but they have an incentive
>> to get it right -- specificaly to make profits and to avoid
>> losses -- whereas central bankers don't experience the
>> same incentive (if Bernanke gets it wrong, it's not
>> his money in play) or, if they do, not as quickly (since
>> Bernanke is very far removed from the actual goings on,
>> there's a huge time lag between his crew's setting rates and
>> what actually happens; add to this, the Fed and other
>> central banks are generally reactive not proactive).)
> Then why does every country have a central bank?

I don't have a rock solid explanation, but recall my mention David Glasner's essay "An Evolutionary Theory of the State Monopoly Over Money"?*  In that essay, Glasner posits that states tend to interfere in and gain monopolies over money to deny financial resources being used to alter or overthrow their rule.  This need not have been a conscious policy.  States that arose that were didn't try to control money might find themselves, on average, losing to those that did -- as a short run inflation could pay to keep a regime in power until a crisis or war was over.  This appears to backed by the historical record.  The pattern of inflations prior to the widespread use of paper monies and even well after and until the 20th century was usually inflationary boom during war followed by a recession

The problem for earlier states was raising money for war via taxes often resulted in a revolt of the taxed classes.  Even after states developed the means to efficiently tax populations, taxes remained unpopular as the taxed class easily linked a given policy with a tax increase.  If taxes rose to pay for a war, all else being equal, that war was that much less popular among the taxed class -- and the demand to end the war or limit it in other ways was much stronger.  Borrowing, likewise, set limits.  Lenders would often loan at high interest and demand collateral -- and even set rates or deny loans according to whether that thought a given state would succeed.

Inflation represented, then as now, an alternative to taxation and borrowing.  The usual way inflations were carried out before the widespread use of paper monies was by "inflating" coins -- clipping and sweating coins to make more coins from the same total amount of money metals, debasing coins by alloying them with cheaper metals, and the like AND either tricking or forcing people to accept these at par with other monies** -- and forcing people to use the lower value new coins at par with the older full value ones.  (In essence, all of this is a form of legalized counterfeiting.)

> If they just muck
> things up you would think that over time a country that
> tries out an
> economic system without a central bank would prosper, and
> its
> neighbours would either take note and copy it or else fall
> further and further behind.

I believe that's because inflations take time to cause problems and avoid some of the problems of other means of raising money and resources -- taxation, borrowing, and direct confiscation.  Why would a state give up this source of funding?  (One might ask why other members of society tolerate this at all.  After all, with states nonexistent or extremely limited, wouldn't everyone else be better off?  I believe so, but this is not clear to everyone involved and I also believe in modern democracies the ruled expect to become the rulers.  This perhaps doesn't explain everything.  After all, some people are ideologically commited to statism or other forms of coercion -- aside from personal benefit.  Still others -- probably most people in any society -- just go along with whatever order is present and only want, at most, minor reforms.  Under market anarchism (again, the only logical, sane, and moral system:), these folks would, while not being
 hardcore market anarchists, would just go along with it regardless of the benefits.)

Actually, too, during competitions between states, it's often the case that both competitors inflate, but the more inflationary regime loses.  I don't want to simplify this history, but there's good evidence that while, during the US "Civil" War, both the Union and the Confederacy inflated, the Confederacy inflated a whole lot more.  The short-run benefits of inflation -- real goods and services were bought by the state involved (i.e., the Union and the Confederacy were both able to pay for stuff they wanted to fight the war) -- made this palatable, but eventually the long run effects caught up with both sides, but one side lost because its level of inflation was much higher (of course, it lost for host of other reasons; again, don't want to oversimplify this to be merely inflation deciding the outcomes of wars).  (See _Tariffs, Blockades, and Inflation_ by Mark Thornton and Robert Ekelund for more on how bad economic policies influenced the outcome
 of that war.)

(The South also did a lot more confiscation and placed all sorts of demands and restrictions on blockade runners.  Outright confiscation, of course, usually results in lower production and people hiding production.  I've read that Union armies found a lot of food in the Southern fields because farmers didn't want to harvest it and have it confiscated at the market by Confederate authorities.  With regard to blockade runners, Thornton and Ekelund mention restrictions on what runners could bring in -- only "essentials" -- and fines and confiscations of nonessentials.  This reduced the incentive to run blockades.)

If inflation didn't have short run benefits -- if it were all bad -- I admit, no one would do it save by accident.  But it does have short run benefits -- and these tend to be localized to big players in credit markets, such as the state (often the biggest borrower and the biggest player in an economy) and large financial institutions.

> The US did not have a central bank in the
> 19th
> century, and experienced multiple boom/bust cycles, more
> than in the 20th century.

Actually, the US had a sort of central bank at certain times during the 19th century -- the Bank of US and the 2nd Bank of US -- and also had interventions of the sort that led to credit expansion in money and banking.  (Without these interventions, for the most part, it's likely an credit expansion would have been limited -- as banks that expanded credit beyond their reserves would eventually go under.)  The various large scale panics and crises -- most of which were short-lived -- can mostly be traced to either the operations of these banks or these interventions.  There was a relatively free period -- the "free banking" era -- from about 1837 to 1860.

>> Given time lags in a large money economy -- like the
>> US's or the world's -- artificially lowering interest rates
>> under a fractional reserve system creates new money.  The
>> new money enters the system via the loanable funds markets
>> -- typically benefiting the biggest debtors first.  (In any
>> modern economy, the biggest debtors tend to be the state and
>> large financial institutions.)  The loans they take are
>> then spent -- or, in the case of fractional reserve banks,
>> re-loaned out (the banks get a loan from the Fed (this money
>> simply didn't exist before) and since they only need to keep
>> a fraction in reserves, so this creates more new money. 
>> Were the process instantaneous, there would be an immediate
>> rise in prices across the board -- as the value of the money
>> unit instantly dropped.*
>> This is not the case, however, as new money (whether
>> as new credit or not) takes time and is path dependent. 
>> Those who first get new monies (e.g., new loans) can early
>> on buy up resources for their projects.  This drives up the
>> prices in the markets they first enter.  (Supply and demand
>> in action.)  Even if some entrepreneurs anticipate this --
>> e.g., if I guess that Big Bank just got a billion in new
>> funds and generally invests that in, say, bird feeders, I
>> might, before Big Bank even makes an investment, invest in
>> factors used to make bird feeders.  But unless we assume
>> perfect entrepreneuers -- i.e., people able to perfectly
>> forecast all of this*** -- some of this new money is going
>> to flow into a market before people can adjust.  Some real
>> factors will change hands and the later price adjustments
>> will only come afterward.  Beforehand, this means, just
>> about everyone was acting as if there was no new money.
>> This process continues to ripple through the economy.
>> The actual path is takes is not predictable beforehand --
>> save for generalities like the first people who get the new
>> money or new credit will have an advantage and later players
>> will not (because they will be in an environment where some
>> prices have already adjusted, more or less, upward).  As it
>> proceeds, though, the effect is as if the earlier holder of
>> the new money had real savings.  This is how savings and
>> loanable funds or investments get disequilibrated.  (Or, to
>> be more precise, since no real world market is ever in
>> equilibrium, they become more equilibrated than normal.)
>> Does this make sense?
> Yes, it makes sense, except when it doesn't work that way.
> Japan in
> the 1990's lowered interest rates to near zero, printed
> money, and
> went for big time government deficit spending. This might
> have been
> expected to caused inflation, maybe even hyperinflation,
> and a
> collapse in the value of the yen. Instead, Japan had
> continuing deflation and the yen remained strong.

Money supply has increased in Japan, but prices have, on the whole, fallen.***  Why is that?  The falling prices can't be the result of the increased money supply -- because increasing the supply of money while holding all else constant would result in higher prices (i.e., there would be more money (after increasing the supply) than the things traded for money, so one would expect prices to rise).  In this case, it could be either some increase on the supply side of goods and services offsetting the growth in money supply.  (This doesn't really neutralize inflation.  It merely masks it.  An analogy might prove helpful.  If I take from your supply of canned beans, then your supply of such will fall.  Eventually, you'll notice the pile getting smaller and wonder what's happening.  However, imagine I steal a few cans a day, but BillK adds in twice as many cans as I steal.  Let's say you don't see him adding in those extra cans, but you do notice me taking
 some cans each day.  You might, wrongfully, conclude, my taking the cans is making your total supply of canned beans.)

Or it could be the demand to hold money has grown.  In this case, the demand for goods and service actually must fall: people prefer to spend less even though more money's being adding into the money supply.  And this probably does play a role in the Japanese economy and in any economy when an inflationary boom finally crashes: though inflation might continue, people desire to hold more cash, so prices don't rise (or don't rise as much).

Or it could be a combination of the two.

> But perhaps the recession would
> have been even worse in the absence of these policies,

How so?  They've had now year upon year of declines.  There has been some debate about V, U, and L style recessions.  A V is a fast decline followed by a fast recovery.  This seems to be what happened with the 1921 recession.  In that example, the Harding Administration did almost nothing save for shave the government.  (Of course, one could argue that this was a postwar recession and that it was purely a quick readjustment to peacetime.  Even so, there was an inflationary boom during the war.)

> and perhaps a
> tighter monetary policy might have prevented the Japanese
> asset price
> bubble from inflating to the extent that it did.

In which case, what?  A "tighter monetary policy" would've been what?  If not deflationary, at least disinflationary or less inflationary.  With less money being pumped in, all else being the same, I think there would've been either a smaller bubble (and maybe a weaker and shorter recession, though I believe the strength and duration of recessions depends also on how monetary and other government authorities react to them and not just on the raw amount of inflation).
>> Also, this is not an irrational belief model.  It's
>> people acting on the local information they have --
>> particular prices, particular interest rates, and other data
>> -- without anticipating inflation.  Now, of course, people
>> do try to anticipate inflation in real markets -- hence
>> things like inflation premia on loans or COLA in labor
>> contracts -- but such anticipation is never perfect and path
>> dependencies don't allow a robust prediction of relative
>> price changes.  (Relative changes are critical here.
>  Again, if all price rose in lockstep or instantly, then
> little would change (but see ** below) -- as a 10% return on
> investments would remain 10% and a person's salary would
> rise in step with the prices of good and services she buys.
>  This would be, IIRC, just like Hume's angel -- the one
> who, in an effort to aid humanity, doubles everyone's cash
> supply.)  But as soon as people do start to anticipate
> inflation more, their real behavior will change too:
>> they, in general, will become more present-centered
> as they will expect savings to not be worth as much (e.g.,
> if I save $1000 today, it might only be worth, say, $900
> next year, so why not spend it now?  This is why in really
> inflation, people start buying up anything at all in hopes
> of getting something for money they expect to fall ever more
> in value) and more reckless in their investing.  And this
> is, in fact, what we do empirically see, no?
> In general it is what we see, but it also depends on the
> population.

Yes, it would vary, though the point is the incentives are set in one direction.  Cultural norms and such might incline people not to take advantage of this, but why have perverse incentives in the first place?  It's almost as if we passed a law in our countries that allowed anyone to shot people wearing striped shirts without fear of retribution.  Sure, few people would, given cultural norms, go out looking to shoot people wearing striped shirts, by a few would and why set up that kind of rule in the first place?

> The aforementioned Japanese seem constitutionally less
> inclined to
> borrow money for consumer spending than Americans are, no
> matter how cheap and easy it is to get a loan.

Perhaps, but then this fits in with a rise in the demand for money.  And, in fact, Americans often do that too during recessions: they often slow down their spending and hold larger cash balances.  This is, in my mind, a reasonable reaction to a financial downturn.  You don't know if you'll have a job, so you spend less.  You might even cut back on investments because the market looks shakey and you're not sure if XYZ stock or your mutual fund will ever recover.  (People and firms might overshoot, cutting back too much, but there's no iron law of economics that says they always overshoot or that a monetary authority or government official -- all of whom have incentives to downplay downturns (no pun intended) -- will do any better.  In fact, my guess is they'll do worse.  Witness, e.g., the current crisis and their reaction to it, including President Obama's reaction to recent economic data -- the data showing that the stimulus is not working.)



*  In _Money and the Nation State: The Financial Revolution, Government, and the World Monetary System_, edited by Kevin Dowd and Richard H. Timberlake, Jr.

**  Obviously, a coin-clipping ruler would probably not want his subjects or others he was dealing with to know the coins had been clipped, so this would be trickery -- rather than outright forcing people to accept these coins at face value.  Typically, with coin clipping and sweating (shaking coins en masse so that some of the base metal is "sweated" off), new coins were minted with the clippings or sweatings.  The coins used, obviously, had lower metal content.  Naturaly, after a while, all of these methods could be detected and the coins would trade at a lower value.  The usual hope, though, was that by the time this happen, the ruler would have already paid for whatever he needed -- troops, ships, supplies, bribes, etc. -- and the problem would be over.

***  We are perhaps using different definitions, too, of inflation and deflation.  For Austrian economists, inflation and deflation are, respectively, increases or decreases in the money supply.  For mainstream economists, they are, respectively, rises and falls in the price level.  Austrians would say this confuses the symptom with the cause.  Also, with regard to inflation (and deflation), the focus of Austrians is NOT on the overall price level, but relative price changes.  Recall Hume's Angel Gabriel -- well meaning and trying to help humanity by doubling everyone's supply of money overngiht without changing the supply of real goods and services.   This type of instant increase would, assuming everyone figured it out, result in an instant double in prices -- no boom, no bust, no change save for the minor costs of changing price tags and holding more cash to pay for higher prices.


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