Economic Schools of Thought

The Q&A session for this past week’s Economics 101 class (free online from Hillsdale College) included some definitions of three basic economic schools of thought. I refer to these fairly frequently, so I thought maybe it would be useful to have a short lesson defining them. We’ll look at these: Keynesianism, the Chicago School, and the Austrian school.

When we say “school,” we aren’t referring to a brick-and-mortar institution; we’re referring to a way of thinking. Those who agree with and follow those ideas “belong to” that school of thought. The schools aren’t necessarily mutually exclusive. Two of these three are proponents of the free market.

 

Keynesianism

John Maynard Keynes was a British economist who put forth a theory in the 1930s, purporting that government intervention could accomplish full employment and reduce the impact of business cycles.

There’s a 3-minute video intro to lecture 7 of the Hillsdale Econ 101 course, which explains the Keynesian model.

 

In the actual lecture Professor Gary Wolfram charts out the theory on a supply and demand curve. In the real world, there’s typically a gap between the number of potential employees and the number actually hired. Even in full employment, that’s around 3-4% (which was declaimed as too high all the way through the Bush administration, but has been double to triple that—or worse, depending on your measures—all the way through the Obama administration, while the same people keep claiming the economy is improving. So, one thing about statist/Keynesians is that government intervention is a good thing, to be taken on faith, regardless of measurable evidence.) Keynes’s theory is contained in his main work, The General Theory of Employment, Interest and Money, published in 1936.

Keynes's magnum opus

Keynesianism claims that government spending—any government spending—results in economic growth. (Read my Glass Breaking Fun.) That’s why you see such “growth” in Washington, DC, the past few years, while the rest of the country struggles. The DC growth is because government is literally trying to grow the economy by hiring people to do whatever (metaphorically digging holes and filling them in)—without noticing that any money for that purpose is taken from what could be spent to innovate or invest in the non-government real economy. It is Keynesianism that claims the way we got out of the Great Depression was by spending our way out because of WWII.

Keynesianism is most popular with people who want increased government power, so it’s not surprising that it was championed by such politicians over the past near century. However, as Keynesian theories have been implemented, empirical evidence of their failures has led more and more economists to leave that school of thought and take another look at the free market schools. However, Keynesianism resurged in 2007-2008, with what is now referred to as the Great Recession, which continues apace with ongoing government interference. Hmm.

One of the most prominent Keynesian economists still claiming Keynes was right is Nobel Laureate Paul Krugman, who is widely published and consistently wrong.

 

The Austrian School

Contemporary with Keynes were Ludwig von Mises and Friedrich Hayek, who are usually considered the two main Austrian economists. Ludwig von Mises, who is generally considered the original Austrian theorist, immigrated from Europe in 1940, ahead of the advance of the Nazis, landing in New York; he taught at NYU for most of the remainder of his life. He considered himself a classical liberal—that is, “liberal” in much the way our founders were; he believed in limited government and free markets among a moral people. Mises is often cited by libertarians today, although I’m not sure he completely fits in their world.


Ludwig von Mises
photo from Wikipedia

My personal view is that, on the Spherical Model, Mises is western hemisphere (most local control that can be managed for any given issue), but also northern, where laws protect people’s God-given rights to life, liberty, and property. Libertarian theory tends to encompass the entire western hemisphere, including the below-the-equator belief that government should have no role, and free market should rule, even including addictive drugs and sex trade. (See Why I’m Not Quite a Libertarian.)

Friedrich Hayek, who won the Nobel Prize in Economics in 1974, wrote The Road to Serfdom, which should be required reading for any educated individual. Hayek was a follower of Mises. While friendly with Keynes personally, Hayek disagreed with his theory. (Meanwhile, Keynes read Hayek’s book and said he agreed with it entirely.) When he left Austria, Hayek taught  in Britain for some time before ending up at the University of Chicago. Much of his work describes business cycles. Some of what he demonstrated was that government interference actually causes business cycles—both lengthening and intensifying the pain. Without the interference, the market serves to correct itself, with just minor dips and quick corrections. When there is a shortage of labor, the economy self-corrects by raising pay rates, until there is equilibrium. When there is a surplus of labor, the economy self-corrects by lowering pay rates, until there is equilibrium. He favors trust in the free market and government restraint.

Friedrich A. Hayek
photo from Wikipedia

Henry Hazlitt, another Austrian commentator, wrote a point by point rebuttal of Keynes’s The General Theory, called The Failure of the New Economics. The Austrians looked more at innovation and various movements from equilibrium, accepting that those are not necessarily negative things to be avoided.

 

The Chicago School

The Chicago school of economics usually refers to Milton Friedman, and also his wife, Rose Director Friedman. Thomas Sowell, a former Marxist who later studied in Chicago under Friedman, is probably included.

Friedman is a free-market economist. He is against government intervention. The difference between his work and the Austrians is more a matter of focus than disagreement. The Austrians look at movement from one cycle to the next. The Chicago school examines the conditions that exist at equilibrium. They look at government intervention, what it does, and why it always goes wrong: the information needed is unknowable, the timing will always be late. And government interference obscures the market signal: producers get incorrect signals about whether to produce long-term capital products or short-term consumer products—or producers fail to get a signal, because of uncertainty in the market, and therefore hold back production until there is clarity (what we’re seeing in the market now). Some of the “interference” is control of the money supply, and the Chicago school looks closely at that.

Milton Friedman
photo from Wikipedia

All of these theories deal with macroeconomics—the movement of the economy as a whole—rather than microeconomics, which is the study of why individuals make the economic decisions they do. If there is a basic macroeconomic principle for government it should be “first, do no harm.” The argument “Well, we have to do something,” is wrong; doing nothing is always an option and often the best one. Government is not responsible for the economy; government’s only economic role is preservation of rights—enforcing contracts, protecting property rights, settling disputes over property claims, and possibly standardize monetary units (although Wolfram actually discusses the suggestion of privatizing money supplies, which is an interesting idea).

Less government interference, beyond its limited role, always leads to greater prosperity. Imagine the economic prosperity we would be experiencing if government had refrained from interfering this past century.

Interference and Consequences

Last week’s Economics 101 lesson (week 6, through Hillsdale College, online for free) was on “Incentive and the ‘Information Problem.’” There were several points worth repeating.

Hillsdale Courses online

Early on, lecturer Gary Wolfram, asks the question, why can’t centrally planned systems provide wealth for the masses?

Market Capitalism, Wolfram tells us, solves a number of problems:

·        Information Problem—how can a central planner possibly know what all the Americans are going to want for breakfast tomorrow, or what they’ll want to read seven months from now? Market capitalism answers this through the price system.

·        Incentive Problem—innovation requires risk taking, and without an incentive to take risk, producers don’t innovate; they do the safe or easy thing.

One example he gives about the incentive problem, near the end of the lecture, is a caveman example—because economists like to demonstrate principles with simple societies. Suppose you’ve got a caveman, and he comes up with the idea of a stone axe. He has to form the axe head out of stone. He has to fashion some kind of handle, and figure out how to attach the axe head to the handle. All this is going to take time—time that he could have been spending grubbing for roots and berries. That’s his opportunity cost.

Suppose then, some other big ol’ caveman comes and takes it from him, because there are no property rights. It wasn’t worth the risk of time and effort, if he couldn’t guarantee that he could keep what he’d made for his use. Without property rights, there’s no incentive to innovate.

There are two types of systems that fail to protect property rights. I’ll give you a clue: on the Spherical Model, they are both southern hemisphere. There’s the anarchy side, like in the caveman example. And there’s the statist/government control side.

The pleasant alternative is the northern freedom zone. In economic terms, it’s where you find free markets. And, he agrees with the Spherical Model, that political freedom and free market systems go together.

Wolfram offers comparative examples between free market capital systems and centrally planned systems. Think about where you’d rather be planted, if you were destined to be poor. Always it’s better to be poor in a market-based economy, rather than an authoritarian ruled system. Think about, if you had to be poor, but could choose anywhere in the world to be born and live, where would it be.

As he points out, “Nobody says, ‘Send me to North Korea.’ They all say, ‘Send me somewhere that’s a market economy. Send me to Australia. Send me to the United States. Send me to Canada….’” We know centrally planned states cannot produce wealth for the poor. Only market capitalist states can do that. [31:30 into the video]

He referred to studies comparing economic freedom across the globe, done by the Fraser Institute and the Heritage Foundation—the Index of Economic Freedom, and compared countries in the to 25% of economic freedom—Hong Kong, Singapore, Australia, New Zealand, Switzerland, Canada, Chile, Mauritius, Denmark, and the United States—and the bottom 25% of countries, including Iran, Turkmenistan, Equatorial Guinea, Democratic Republic of Congo, Burma, Eritrea, Venezuela, Zimbabwe, Cuba, and North Korea.

The average per capita income of those in the top 25% countries is $36, 691. The per capita income of the bottom 25% countries is $5,188. If you’re in those top 25% countries—the ones most like market capitalism and least like authoritarian centrally planned—you’re seven times wealthier on average than those countries in the bottom 25%. [34:00]

It’s even clearer when you compare the poorest of one set of countries to the poorest in another. The poorest 10% in those freer countries make on average $11, 382 (per capita income). Or more than double the average per capita income of those in the centrally controlled countries. Worse, the poorest 10% in those controlled countries make on average $1,209. The poor in market system countries are nearly ten times wealthier than the poor in controlled economies.

Wolfram says, “It’s not a matter of theory; it’s a matter of fact. Governments that rely on central planning simply can’t produce wealth for the masses.” [35:00]

Why is that? Why are centrally controlled governments/economies such abysmal failures at providing wealth? One of the problems is the ever-increasing unintended consequences of interference. He referred to Ludwig von Mises, in his 1927 book Liberalism [a term that refers to freedom the way our founders thought of it, rather than the way the word has been co-opted by central controllers since then].

Once government begins to intervene in a system, intervenes in a market, it’s going to create these unintended consequences…. When it creates these unintended consequences, what happens is we get further government intervention, because there’s a political clamor. “Oh, now we need to deal with this problem.” So the government intervenes again. More political clamor as it creates more unintended consequences. With Mises arguing that eventually you end up with central planning. The government continually intervenes, creates more problems, intervenes again, creates more problems, intervenes again—until it’s intertwined with our economic system in such a way that markets aren’t allocating resources anymore; the political system is allocating resources. [35:30]

If we were to look at current events, and try to come up with some example of this happening, what could it possibly be? Oh yeah, Obamacare.

He gives us the  history, in more detail than I’ve done in the past. (The transcript of that section more than doubles this blog post length, so I’ll summarize, but, really, you should listen to the whole 40-minute speech, and especially this example, from about 36:00 to 44:00.)

·        There was a labor shortage during WWII, with labor resources going to the war effort.

·        Government didn’t want the price of labor to rise, so it set price controls on labor, which guaranteed greater shortages.

·        Someone who wanted to attract manufacturing labor came up with the idea of supplementing wages with employer-based health care insurance—as additional pay for labor that wouldn’t count as higher wages.

·        Employer-based health care insurance separated the receiver of care from the payment, thus causing a rise in demand for health care.

·        A rise in demand for health care increased costs of health care.

·        In 1954 the IRS ruled that employer-based health care insurance did not count as income, which was a way for employees to receive higher payment without paying the exorbitant (91% top margin) income tax.

·        This meant that employer-based health care insurance became more widely used, raising demand for health care from people who weren’t paying for it, and thus raising health care costs.

·        In 1965 government stepped in to help those who were retired or not employed, who could no longer afford to pay the artificially high health care costs without insurance, and government created Medicare and Medicaid.

·        So of course, with more people getting health care they weren’t paying for, health care costs rose further.

·        Eventually government intervenes with the Affordable Care Act, which forces employers to provide health care coverage, forces insurance companies to provide insurance for pre-existing conditions, and forces healthy young people to purchase health care insurance they wouldn’t otherwise purchase, and forces everyone to purchase a standard of plan the central planners decide, rather than the individuals making the purchases.

·        Results of the interference: higher health care costs, lower quality of service, bankruptcy for insurers, devastating costs and fines for people who can’t afford the new standards.

We have this system of health care insurance tied to employment. We don’t have that connection for car insurance, or homeowner’s insurance. The only reason health care is tied to employment is government intervention, followed by unintended consequences, followed by clamor to fix the new problems, followed by more government intervention, then more unintended consequences, and on and on.

It looks like it might be a good idea to just get rid of government. But that’s not the solution either; remember the caveman anarchy problem? What we need is just enough government to protect us—our lives, liberty, and property. In economic terms, government is there pretty much just to protect our property rights: with contract laws, police, armies, courts for settling disputes.

Wolfram gives this rule of thumb:

So when we look at a law, we ought to decide, does that law in making it easier for markets to work, or does it make it harder for markets to work? And fundamentally, is that law expanding our property rights? Is that law expanding our ability to act according to our own plan? If it is, it’s a good law. If it’s making it harder for markets to work—if it’s infringing on our property rights—if it’s making it harder for us to act according to our own plan, then that law ought not be there.

I think that’s pretty much what the writers of our Constitution had in mind when they delineated limited government.

Beanie Baby Economics

I have long maintained that Economics is the fun science (for example, 8-29-2011, 8-30-2011, 11-4-2011, 3-21-2012, 3-21-2013).  And I thought we needed a little fun on a Monday. We'll be reviewing how Beanie Babies fit in to the economic picture.

This was part of the lecture for last Monday’s Hillsdale College Economics 101 online course. The title for lecture 5 is “The Role of Profit.” [These courses are free, but you may need to sign up for a course to get access.]

Before we get to the economics of Beanie Babies, we need to cover a few preliminary concepts.

·         Profit is revenue minus costs.

·         Economic profit includes opportunity costs when subtracting costs from profit.

Our teacher, Gary Wolfram, describes economic profits this way:

We want to include all the opportunity costs of all the resources that are being used up. Now, generally the opportunity cost of a resource is its price, but for some things it might not be included. So, for example, suppose you’re running a t-shirt shop in Hillsdale, and at the end of the year your accountant says, wow, you made $20,000. You might think that you earned economic profits of $20,000, but an economist would say, “Wait a minute. You might’ve earned $30,000 being the manager of the local Burger King.” So you have to include your opportunity cost of $30,000 when looking at total cost. So, to an economist your economic profit would actually be negative because, although you earned $20,000 in your revenue minus your cost in your t-shirt business, you could have made $30,000 being the manager at the Burger King.

So we often hear that firms make zero economic profit in a competitive market, at least whenever we take a Principles of Economics class, and you might say, well, gee, why is it that the firms are still making things if they’re making no profit? It’s because when we say they’re making zero economic profit, it means that they’re making exactly what those resources could have made in their next best alternative. You couldn’t have been doing better somewhere else. And so, economic profit just includes in the total cost all the cost including the opportunity cost of the people that are running the firm and all the labor and other inputs that are being used up.

Professor Wolfram explains that economic profit affects attraction to the market. When economic profits are positive, more firms are willing to enter that industry in hopes of making good use of their resources. He uses the e-reader market as an example.  First there was an innovator. Then others see high prices and growing demand, so they enter the industry. Soon you have Kindle, iPad, Nook, and others, providing choice as well as lower prices for consumers.

What’ll eventually happen is the price will fall and more will be produced. So, economic profit attracts new firms into that industry. Shifting the supply curve to the right, driving prices down, increasing the quantity, and we generally observe that. If we observe a firm that’s making economic profit because it introduced a new product, the price is generally high, not too many are sold, other firms enter, compete against them, driving that supply curve out, driving down prices, increasing quantity.

The opposite can also happen. Once demand is low enough that economic profits become negative, firms leave the industry. This is where the Beanie Babies example comes in, when there’s a loss of consumer demand at any price. Here’s the slightly technical part that makes sense with the chalkboard chart:

Gary Wolfram teaching Hillsdale's Econ 101 class, lecture 5

If firms are making economic losses, they’ll exit the industry. As they exit the industry, because an economic loss says they’re making less with those resources than they could be making somewhere else. As those firms exit, we get a shift in the supply curve now to the left: price will rise to P2, and quantity will fall to Q2.

He makes several other good points in this half hour lecture. Here are some samples (some are paraphrased rather than exact quotes):

·        Now, there are a number of things to observe about economic profit. First is that economic profit is a celebration. Firms must be doing what? They must be producing something of greater value than what the opportunity costs of those resources were.

·        So, the net of this is that we don’t have a minister of culture, or we don’t have a production czar that says, “Producers, you need to do something because consumers’ demand has changed, increasing or decreasing.” The price system and the attraction of profits moves the resources from those industries where consumer demand is declining to those industries where consumer demand is increasing. That’s why markets are so dynamic. That’s why it instantly responds to changes in what your preferences might be.

·        Economic profit is a celebration. Firms must be producing something of greater value than what the opportunity costs of those resources were. Rather than thinking of profit as a sign of exploitation, we should think of profit as a celebration, as saying that this firm made more with those resources than any other way of using those resources.

·        Monopoly is only a problem when it’s something you are forced to buy (very few things—electricity, phone, for example) and there’s a barrier to entry into the industry. Usually a barrier to entry is caused by government regulation, or government choosing how many (often one) entities may be in the market. “Normally when we look at a barrier to entry, it’s because government created that barrier to entry.”

·        Innovation is someone is thinking about what we are going to want three years from now—when we don’t even know yet that we’re going to want that—but when the time comes and we want it, the product will be there. Not good enough to do unto others what you want others to do unto you. You have to do unto others what they have no idea yet they will want done for them.

·        Innovation requires risk; profit is incentive to take the risk.

So, what happened with Beanie Babies? Demand at any price decreased, such that it was no longer a profitable industry, and the product stopped being made. In some cases, such as vinyl records, demand increases to a point that the product gets made. But in some cases, demand never resurfaces (8-track tape players, for example), and we don’t get the product anymore.

This is an ongoing problem for me, because I tend to like specific products and lack enough fellow consumers to keep companies making them. Mr. Spherical Model requests that I stop insisting that this is the entire consumer industry pinpointing what I like so they can purposely stop production of those things just to spite me.

But I do not feel that way about Beanie Babies. We had a few, back in the day. Mostly the tiny ones given away with kids’ meals, plus a few received as gifts. I didn’t understand how a toy could be valuable only if you left the tag on it and didn’t play with it. Eventually the rest of the world caught on.

Now that you understand the economic profit concepts behind Beanie Baby, you’re ready to more fully enjoy this “real life” Beanie Baby scene. Studio C started as a college campus improv group that developed into a TV comedy sketch show—in its third season on BYUtv (available on various television services) and also online, a sketch at a time. Enjoy.