The Wonder of The Free Market – 3

The Wonder of The Free Market – 3

Question from MBA Candidate  (student) – “But can citizens and the free market really fix themselves? A comment from the website of the Department of Justice (2011) states that the competitive process, which is found within free markets, only works when competitors set prices honestly and independently.”

I guess I’m partial because I work for a state agency, but they do have their benefits. True, when the government steps in, their intervention never seems to be truly successful, but we as humans are imperfect, therefore an imperfect market exists; when there are such practices as price-fixing and bid-rigging, then that tells me there are flaws everywhere.

References:
(2011) Price fixing, bid rigging and market allocation schemes.  Retrieved from http://www.justice.gov/atr/public/guidelines/211578.htm

PJU Response:

Basically, you are pointing out illegal ways that some people try to manipulate price, and just like you, I agree this illegal behavior calls for government action. But it does NOT call for government price intervention, rather 1) either putting people in jail or 2) heavily fining them for violating the rules of the game or 3) otherwise removing them from the marketplace. Just like you, I want and the free market needs, in fact demands, regular and reasonable enforcement of a reasonable rule-of-law that fosters competition.

A different take from the DOJ website might be that free markets only work when government enforcement reasonably and regularly enforces a reasonable rule-of-law such that competitors firms feel free to set honest and independent prices.  A meaningful motto might be: Government price intervention – never! Government refereeing, of course!

However, perhaps you might read this DOJ comment more carefully. First of all, the only way free markets really work is that almost all firms are price-takers, not price-makers or price-setters. This observation does not include monopolies, which are almost all heavily regulated by local, state-wide or regional government regulatory bodies, like corporation commissions. Or cartels like OPEC, which manipulate supply, therefore manipulate price, and which entities are outside of the reach of US law enforcement.

Yes, I agree that someone in the firm sets a price for the firm’s product or service, then the consumers in the marketplace either buy the product or service, on not. But these type of ‘price-setters’ are really only gauging the market and mechanically setting a price at what they think the market will bear.

Take bread, for instance. If your grocery store started charging eight dollars a loaf for bread you could buy bread loaves at a dozen other nearby places for four dollars a loaf, how much of the eight dollar loaves would you buy? None, right? Why?

Because the free market, without government intervention, sets the price, based on supply and demand interaction and either your firm follows, or your firm might reap zero revenues. This is true with almost any product or service, as long as there is a free market. This price mechanism is called the “invisible hand” and is the hallmark of free markets.

Collectively, imperfect human beings DO NOT create imperfect markets very often, if the government wisely referees. Unless they are not truly free markets, of course, which is what happens when the government intervenes!!!

 

Theory or Practice, Which Matters?

Theory or Practice, Which Matters?
STUDENT QUESTION:  I do understand that there is something special you get from experience that you cannot get from a book or class, but with classes having more hands on approaches can you think of something specific experience can give a person that pure education cannot?

MY RESPONSE: That’s an easy question. If one looks at the textbook, they will find that the textbook writer, a highly educated Ivy League Professor, David Colander, talks about economic theories as if they are all created approximately equal, except Keynesian Theory, which theory he really likes. Colander has probably forgotten more about various economic theories than most regular people have learned. And in my opinion, he is one of the best textbook writers I have ever read.

But here is the difference. I have found myself in the trenches with companies actually executing according to a  forecast that did not fit reality. When one is in the middle of a turbulent stream paddling for dear life, one does not worry about whether a theory may or may not apply, but whether you are paddling hard enough. When death and destruction try to muscle into your space, then you adapt to reality in ways that theory never prepared for or even contemplated.

Keynesian Economic Theory
Let’s apply this to reality. In the last 75 years the main concepts of Keynesian Economic Theory have been applied over and over again in the American economy starting with the Great Depression. Politicians who enjoy spending taxpayer’s money really like that Keynesian Economic Theory justifies big government and more or less unlimited  government spending. Yet an honest analysis of the last 75 years shows that Keynesian Theory does not work as advertised, has never worked in America, and therefore, to my small mind, will not work.

The latest example is the $800 billion stimulus bill advocated by President Obama which made it through Congress in early 2009. We were assured by the theory experts that passing the bill and thus applying economic theory would cause the unemployment rate to rapidly fall. Surprise, government spending did not work the way we were promised. Yet one prominent economist, Paul Krugman, (another highly-educated Ivy League Professor) called for a do-over, and said the reason it  did not work was that the package was too small and needed to be twice as large!

But who looks at history? No other economic theory justifies government spending like Keynesian Economic Theory and tenured professors in academia do not worry about their jobs or whether the theories work in reality, just that those theories work on paper. You know, econometrics, elegant curves, regression analysis,  and all that. And Keynesian Theory works quite well on paper.

It is just weird human behavior that we need to adjust, because IT IS NOT cooperating! So the next generation of students will learn Keynesian theory too, I suppose, and the madness continues!

Static Scoring versus Dynamic Scoring
That reminds me of another economic reality. If you want to increase economic activity, then lower tax rates. 100% of my students get that. But the government politicians refuse to study history and do not believe that an increase in economic activity is quickly followed by more government revenues, at lower tax rates. Four times out of four, (it has only been tried in America four times over the last 90 years) or 100% of the time, government revenues have grown with lower tax rates.

Works like a charm in practice, but not on paper. Why does it not work on paper? It is that pesky human behavior again, always changing by adjusting to new tax rates. This is because when we use paper, we use “static” scoring, but with lower tax rates, human behavior changes, so to capture this we must use “dynamic” scoring, which is lots harder and which thing the CBO (Congressional Budget Office) refuses to do.

Bottom line is that though there often is a wide gap between theory and practice, especially as regards economic theory, but unless one is motivated by results, one does not have to be concerned by whether the theory actually works in reality.

 

 

Energy Policy, Global Warming and Economics

One of my economic students wondered what all the ruckus was about “Global Warming” and how its might be related to the recent bankruptcy of Solyndra. We had the following conversation.

We can talk about Global Warming, or whatever that notion might be called today, but that is not the point. The point is money, or in the language of economics — supply and demand interaction, specifically.

Alternative fuels like solar, or wind, or thermal, or wave power, are not cost efficient at this time. Production costs are high, demand is low and therefore the price willingly paid by consumers is also low.  That is why Solyndra asked for and got over $500,000,000 in government loan guarantees, then filed for bankruptcy a few years later, because their product was not selling. These alternative fuels mostly exist today because of government subsidy — not because entrepreneurs are getting rich producing them.

Why does the government subsidize alternative fuels?

Good question. Perhaps it is because burning oil and natural gas produce carbon dioxide (CO2) emissions that ends up in the atmosphere, which is bad. Don’t forget, coal fuel burns carbon too, producing more CO2 emissions, so more bad, because when CO2 gets into the atmosphere, climate changes occur, according to many scientists.

BTW – If you are concerned about the approximate doubling in gasoline prices during Obama’s four years in office, you may not want to raise those gasoline price increase issues with Obama’s Secretary of Energy, because he (Steven Chu) likes the price increases as government subsidies for alternative fuels paid for with taxpayer dollars are more effective today than they were four years ago.

But science is untainted by money or politics, so we can believe scientists, can’t we?

Of course we can, therefore, we MUST use alternative fuels immediately, or disaster lurks. Or does it?

Is there a  mostly cost efficient,”clean” fuel whose burning does not produce CO2 emissions?

Yes, there is – nuclear power, and France produces 70% of their energy using nuclear plants, but that is another story.

Wait, nuclear power  is dangerous, so claimed the movie China Syndrome – and movies only tell the truth, right? Stop please, you are confusing me. What is exhaled by humans when we breathe oxygen?

That is an easy question, CO2. Oops, we humans are bad too, I guess.

But wait, what do plants breathe?

Oh, yeah, CO2. And guess what plants give off during photosynthesis — oxygen, which humans breathe!

Hold on, I am really confused — is there a hoax going on here, or something?  All we need to do is plant more trees and we should be fine? Is this a joke? What about the money trail?

As I said earlier, the entire matter is really related to economics. Billions and billions of dollars are at stake, even trillions of dollars, over whether the taxpayers support alternative fuels as the main energy source to be tapped in the future such that coal, oil and natural gas are supplanted around the world.

Power and control and money are all bound up together with energy policy. If politicians successfully change the energy policy to one they can tax and control, then they can easily find the money for their re-election campaigns. Finding money for election campaigns is a hard and arduous task. President Obama went to over 140 campaign fund-raisers this election cycle. Much easier to change the energy policy and create an endless supply of new energy money by rewarding special interests with political favors you can control.

If you ask the question “who benefits?” when you hear government officials and people like Al Gore demonizing natural gas, oil, and coal, then your picture of what is happening grows clearer. If one follows the money and asks reasonable questions, then the game is up. Look at recent history. Over the last 12 years or so, the temperature of the earth has cooled a bit. In response, the wordsmiths changed the name from “global warming” (since it was no longer happening) to ‘climate change’.

Hold on, how can ‘climate change’ not happen?

Of course climate change happens, but it is just natural and not necessarily harmful.

Are you suggesting that scientists are not telling the whole story? Are you saying that in order to obtain funding (billions of dollars a year) there is a conclusion your research into so-called “scientific climate studies” must draw to be eligible for funding?

Hmm. Drawing a conclusion, before you do the study and amass data to test your hypothesis, is not science. It seems science has been politicized and money is really at the heart of the notion of “Climate Change”.

So what is going on, really?

Another good question. Anyway, is there really such a thing as man-caused climate change? I see too much money and too much power being chased by people who want to influence policy issues to come to that ballyhoo-ed conclusion.

Practical Economics: How to make the economy go zoooom in the night.

Practical Economics:  How to make the economy go zoooom in the night.

Part 2 of 2 TAXES, REGULATION & ECONOMIC GROWTH

Animal Spirits

Former Federal Reserve Chairman Alan Greenspan regularly spoke of the need to unleash ‘animal spirits’ to attain and sustain robust economic growth. Greenspan identifies the uncommon motivation impelling certain entrepreneurs to spend 100 or more hours per week for years building their own new business as ‘animal spirits’. That type of entrepreneur is convinced the world needs the products and services to be produced by their new company, which production requires new jobs.

Most of us are not much like Bill Gates or Steve Jobs or Jeff Bezos (or Henry Ford a century ago) and the first difference most of us might notice is the inhuman hours these entrepreneurs put in for many years, until their company (Microsoft, Apple, Amazon and Ford, respectively) succeeds.

Today, each of these firms employ tens of thousands of highly-paid employees. Nearly all the many millions of people employed in the private sector fill jobs created by successful entrepreneurs. If we truly seek long-term economic growth, (assuming the education issues are properly addressed) perhaps the right question to ask is which tax and regulatory environment cause ‘animal spirits’ to flourish, allowing Herculean efforts (100-hour weeks for years) to be rewarded appropriately?

We are seeking to understand the underpinnings of economic prosperity. We know that when the overall capital stock (not ‘capital’ as a factor of production) is growing, then so too is the macro-economy. Therefore, we need to explore how we make the capital stock grow.

INVESTMENT ENVIRONMENT

Capital Stock Growth

Perhaps a closer look at Apple’s products will prove instructive. Mainly Apple sells a mix of notebook computers, smart phones, desktop computers, computer tablets, digital music players and access to digitized melodies. In the fiscal year 2011, Apple reported revenues of $108 billion.

The total cost to make or provide access to these products in 2011 was approximately $74 billion, leaving $34 billion before-tax profit, or $26 billion, after taxes, to add onto and grow the capital stock.

In other words, we consumers, in a mostly free global marketplace, willingly traded $108 billion of our own money for Apple items we valued at $108 billion – but that only cost Apple $74 billion to produce! Subtracting the $8 billion of taxes paid to government entities, the remaining $26 billion can be added to the capital stock.

Each time that profitable transactions like these take place in the global marketplace, the capital stock can grow. If a significant majority of the private companies around the world experience similar profitable bounty, even if not to the same degree as happened at Apple, then the total world capital stock can grow, which is desirable. Especially when this capital stock growth happens at a fast pace, like it did for most of the 17 years from 1983 to 2000, in America.

Uncertainty Due to Tax Rates

What has changed to cause the business activity among many global players and wannabe entrepreneurs to be subdued? What exactly unleashes ‘animal spirits’ over the long-term that allows for economic prosperity?

If we look at the financial statements of American financial institutions and large American public companies in 2012, we discover over $3 trillion of unused capital sitting on their balance sheets. Why? What might cause entrepreneurs to step forward and take calculated risks, using that $3 trillion to build the capital stock and create new jobs?

Here is one answer.

Making Money

First of all, entrepreneurs like to make and keep money. But making money is not really their primary goal, because after earning $10 million, or $100 million or perhaps their first billion dollars, these entrepreneurs do not stop, and additional money earned just becomes a way to keep score. Often entrepreneurs, rather than slow down, instead accelerate their immense efforts to make larger sums of their own money.

However, if government entities seem to be demanding an ever-growing percentage of what these entrepreneurs are creating, then a significant portion of the satisfaction quotient (Abraham Maslow’s hierarchy of needs term is ‘self-actualization’) is removed from the business environment and such achievement becomes much less interesting. If entrepreneurs feel unable to predict what the top marginal tax rate will be that affects them, then the consequence is restraining those invaluable ‘animal spirits’.

Specifically, if the effective tax rate to be paid by the entrepreneur is perceived by the entrepreneur to be relatively unpredictable during the five-year or ten-year or longer planning horizon, then entrepreneurs wonder why they ought to make Herculean efforts today. Why not just wait until the planning-horizon tax-rate facing the entrepreneur is more settled?

Laffer Curve

We might also profitably ask what tax rate is seen as too high by the entrepreneur? Though seldom by name, the Laffer Curve peak also enters the entrepreneur’s calculation. On 4/24/2012, an article in the WSJ opined that 50% or even 70% marginal tax rates would not lower tax revenues.

Peter Diamond and Emanuel Saez argue that the investment environment in America is to the left of the peak of the Laffer Curve, therefore an increase in US tax rates from where they are today will not decrease tax revenues. But at the URL http://www.bobkrumm.com/blog/?p=2354 Bob Krumm demolishes their argument.

More to the point, what the economist Art Laffer alleges is that there is some marginal tax rate, (probably between 28% [Reagan tax cuts] and 35% [Bush tax cuts]), that represents the real maximum marginal rate of tax revenues that government can hope to collect. This unknown, yet still reasonable top marginal tax rate likewise significantly affects entrepreneurial behavior.

Uncertainty Due to Regulation

Additionally, because entrepreneurs like Henry Ford, Jeff Bezos, Bill Gates and Steve Jobs are building global-size firms, the current and future regulatory environment also enters their decisions to go or not go with establishing and building new companies and new endeavors within established companies. This consideration makes sense because their new future entity will cross many political boundaries, bumping into all sorts of known and unknown government regulations.

It is not complying with the regulations, per se, that causes entrepreneurs hesitation, but the added costs to be borne because of these regulations and the follow-on lawsuits that potential “damage to the environment” manufacturing may generate. One way to check the accuracy of this assertion is to look around at the manufacturing landscape in America.

When Henry Ford established his automobile-making firm in America in the early 1900s, his factories were desirable to have nearby as factory jobs paid better wages than farming jobs.

Today, Apple avoids NIMBY (Not In My Back Yard) by doing most of its “messy” manufacturing in Asia, not America. Amazon does not really do manufacturing, nor does Microsoft. Likewise, the ‘dirty’ petroleum industry has seen no new oil refineries built in America for 33 years. The doubling of refined oil output occurring during this period has happened by building out the production facility already in place and adding more production shifts, as the NIMBY sentiment and potential lawsuits has prevented approval of new locations.

More Regulations Are Coming

In addition to these known concerns for manufacturing in America, the added burdens and potential increased costs of new regulations to come are magnifying the unknowns and adding greater uncertainty to the investment environment.

For example, consider the 2000-page Wall Street Reform and Consumer Protection Act (Dodd-Frank) which has not been fully fleshed out, or the 2500-page Patient Protection and Affordable Care Act (Obamacare) also not really fleshed out, and together these two new laws put thousands of new rules all entrepreneurs must follow on the books in America.

Is it really any wonder that the uncertainty in the investment environment caused by future likely higher marginal tax rates and likely large new regulatory costs, makes the entrepreneurial ‘animal spirits’ noises heard today akin to a whimper instead of a healthy roar?

CONCLUSION

It is reasonable to conclude that shoring up the investment environment certainty regarding future marginal tax rates and solidifying regulatory rules is akin to feeding the ‘animal spirits’ inside wannabe entrepreneurs red meat! In order to undertake the outsize risks which lead to outsize rewards, these risk-seekers still like the risk related to taxes and regulations to be as small as possible.

In this analysis, we have primarily looked at successful entrepreneurs who end up building large companies. But the same logic herein applies to successful entrepreneurs who end up building small to medium-size companies.

In fact, successful entrepreneurs create many more small companies, than large companies, and it is not the few large companies, but the many smaller success stories that contribute the most to economic prosperity. Yet the desirability of reasonable certainty regarding tax and regulation issues in the investment environment faced by wannabe entrepreneurs is exactly the same.

To summarize, if we want long-term economic prosperity, then we must  reduce the uncertainty surrounding the investment environment, after dealing well with the education issue explained in my 4/11/2012 blog, by 1) cementing for 10 years or more the marginal income tax rate at or below 35% (likewise, fixing the corporate tax rate at or around 20%)  and 2) solidifying the unknown regulatory environment faced by wannabe entrepreneurs.

To enjoy long-term economic prosperity, there is no other way!

Economic Indicators: Consumer Price Index or Inflation.

Economic Indicators: Consumer Price Index or Inflation.  

Should we be worried?   

The classic explanation for inflation is too much money chasing too few goods, which certainly describes well the current situation in America. Why then, aren’t we plagued by inflation today? Without getting too technical, may I offer some perspective?

In the two-year period from late 2009 to late 2011, according to Federal Reserve statistics, the US dollar monetary base grew around 28%. And M2, the broadest measure of the money supply, increased 12.9% for the similar two-year period between November 2009 and October 2011. During that time-frame, America’s GDP grew perhaps 5%, or approximately 40% slower than the growth of the money supply.

The Nobel-prize-winning economist, Milton Friedman, claimed that the primary function of the Federal Reserve ought to be basically matching the growth of the money supply with the growth of real GDP, keeping the inflation-dragon at bay. But that is not happening at the moment as the Fed is busy monetizing debt.

Currently, if product prices go up, then consumers quickly seek substitutes.

Most retailers today tend to lower prices to make sure that inventory turns over regularly, even at a lower margin, instead of simply raising prices to generate larger profit margins. Nor are there widespread strikes over wages being too low. Instead of wage demands to raise the cost of labor, causing ripples that beget rising inflation, most employed Americans are grateful to have a job.

Obviously, business activity of the entrepreneurial sort is strongly muted today, during what has been dubbed the ‘Great Recession’. As I noted in the last two AZ Fraud Fighter newsletters, though GDP is up a bit, at least nominal GDP is, the real Unemployment Rate, at 12.1% (if we count those people who used to be employed, yet at this time are too discouraged to even look for a job) is still significant enough to heavily constrain inflation pressures, at this time.

While we are not in a recession, technically, as GDP is growing, but because so many people are still unemployed, the effect is that the economy feels like it is still in a recession, to many people.

What about when a significant recovery finally comes – will we experience significant inflation then? Probably we will, because Ben Bernanke, the current Fed Chairman, has not shown the same aptitude for monetary manipulation that has been demonstrated by either previous chairmen like Paul Volcker or Alan Greenspan.

 

Economic Indicators: Unemployment Rate – January 2012

Economic Indicators:  Unemployment Rate –  A Look Behind the Numbers.   

From the Bureau of Labor statistics.

A                         B                           C                      D                   E

2007              231,867,000         153,124,000      7,078,000       4.6%
2008              233,788,000         154,287,000      8,924,000       5.8%
2009              235,801,000         154,412,000     14,265,000       9.2%
2010              237,830,000         153,889,000     14,825,000       9.6%
2011              239,618,000         153,617,000     13,747,000       8.9%
Dec-2011              240,584,000         153,887,000     13,097,000       8.5%
www.bls.gov/web/empsit/cpseea01.htm

Column A = Year or Period

Column B = Non-institutionalized Americans in Civilian Population ages 16 – 65

Column C = American Civilian Labor Force

Column D = Number of Americans Reporting They Are Unemployed

Column E = Calculated Unemployment Rate

Commentary:

Did the unemployment rate reported for December 2011 really decrease? Yes.

Better question – Why?

Answer – Because over 5 million otherwise eligible people, since 2009, are not included in the official unemployment rate calculation as they are likely too  discouraged to look for employment, and have withdrawn themselves from the Civilian Labor Force.

Proof:

During the ten-year period from 2000 – 2009 the Civilian Labor Force (column C) averaged a utilization rate of 66.3% (column C divided by column B) of the eligible Americans. Today, as of January 2012, only 64.0% of the eligible population are actually seeking employment, or 2.3% less. This difference of 2.3% means that 5,533,432 fewer Americans are seeking employment because they are too discouraged to look for a job. If they were included in the calculation, then the Unemployment Rate would skyrocket to 12.1%.