Stateless History - Iceland

When studying examples of anarchy in history it is comforting to find that practically everything I have learned and advocate plays out almost flawlessly in the real world.  Of all recorded civilizations in history there are few better examples of a society free of violent archons than Iceland from 930 - 1262 AD.  Iceland is a prime empirical example proving the Hobbesian nightmare of "war of all against all" in the absence of an all-powerful ruler a ridiculous assertion.  While the Icelandic method of anarchy is not necessarily a system I personally advocate (for reasons you'll find out as you read), there is much to be learned from its structure, as well as its ultimate collapse into statism.

Iceland was colonized by a group of tax-evaders seeking to escape King Harald Fairhair’s attempt to impose property taxes on all of Norway.  Initially there was no structure in Iceland.  Living in Iceland was a life on the frontier.  There were few natural resources, and the climate was not particularly conducive to farming or human survival.  Despite these difficulties, the art, literature, and culture of medieval Iceland have been compared by many scholars to that of ancient Greece.

According to Ari Þorgilsson in the Icelandic historical account Íslendingabók, around 930 AD a local assembly called the Kjalarnesþing established a sort of parliament called the Alþing.  The Alþing was not a parliament in the way we would understand, insofar as they did not legislate laws to apply to all those living in the geographic region called Iceland.  Rather it was an assembly of respected leaders called godhar (singular godhi), whom I shall call chieftains for lack of a better word.  According to the Íslendingabók, this assembly sent a man named Úlfljótur to learn of the Western Norwegian law of Gulaþing.  This supposedly became the basis of Icelandic law, however many historians question this account, on the grounds that there are stark differences between medieval Icelandic law and medieval Norwegian law, differences so remarkable that it is almost impossible the former could have been derived from the latter.

Individual Icelanders did not project authority onto the Alþing in the way citizens project authority onto Kings or Congresses.  Each individual subscribed to a chieftain, to whom they paid a fee.  At any time individuals could withdraw their subscriptions to their chieftain for any reason and subscribe to another chieftain.  One had the option of withdrawing from the chieftainship system altogether, but this meant complete lack of protection under the law.  Individuals who did not subscribe to chieftains could be robbed, injured, or murdered, and would have no capacity for retribution.  There's not much said about anyone who withdrew from the system, but I imagine for these reasons it was an uncommon occurrence.

Since all individuals living in Iceland could withdraw from their chieftainships as they pleased, competition between chieftains was significant.  Each was required to charge prices low enough to appeal to their assemblymen.  Since chieftains were not elected, but had to convince people to subscribe to them on an individual basis, they needed to achieve an exemplary understanding of Icelandic law, to the point that in the same way the Greeks recounted stories of great feats of warrior heroism, the medieval Icelanders recounted legends of great debaters of the law, particularly in Njal's Saga.  The great respect Icelanders had for the law can be illustrated in the means through which Pagan religious leaders conducted exorcisms.  Law courts were convened and a trial was held to determine whether the ghost had permission to reside in the plaintiff's house.  It would be decided that the ghost was violating the homeowner's property rights and was thus required to leave or cede protection under the law.  Apparently following such trials the hauntings were no longer an issue.

The court system was extraordinarily complex, but I will attempt to describe it here.  Each year the chieftains would convene at the Alþing to negotiate law.  At these meetings Iceland was divided into four quarters.  Each of these quarters was divided into nine godard.  Within each godard the chieftains were clustered into groups of three called "things."  Every three years a lawspeaker was elected by one of the quarters.  The quarter with the right to elect the lawspeaker was chosen by lot.  The lawspeaker's job was to memorize the laws, recite them through once during his term in office, provide advice on difficult legal points, and to preside over the lögrétta, the "legislature."  The lögrétta was composed of a representative from each godard plus one additional representative from each thing.  Laws were agreed upon by majority vote, subject first to attempts at unanimity.  If a chieftain did not agree with an amendment to the law, he was not required to enforce it, or could use another law, to the extent his most closely-related fellow chieftains were willing to accommodate him.  By and large the laws passed by the lögrétta were implemented in the courts.  The lowest level of courts were private courts, formed by the individuals in conflict.  Half of the court was composed of members on the side of the plaintiff, and the other half on the side of the defendant.  Above this was the "thing" court, which was presided over by 36 individuals, three sets of twelve chosen by each of the chieftains who were members of the relevant "thing."  If this court could not resolve the dispute it was taken to the quarter court, composed of various members in the same quarter.  Above this was only the Alþing, or the annual national assembly.  If anyone was unhappy with the decisions or services of the particular legal body to which they subscribed, they could change, or even start their own.  Becoming a chieftain only required a substantial number of supporters, as well as recognition from the other chieftains.  Chieftainships could be sold, however if the assemblymen were not happy with the new chieftain, they could subscribe to another.  Chieftainships were non-geographic, in that there were no lines between territories.  Multiple people in the same village could belong to a variety of chieftainships.

In terms of executing the law it should be noted that there were no criminal cases.  All cases were civil, and upon reaching a verdict the execution of the verdict was left up to the victim of the crime.  Rather than imprisonment or execution, nearly all cases were resolved through some sort of monetary compensation.  Theft was recompensed through restitution of property to the victim.  Rape and murder were also compensated through a debt to the victim.  If the criminal was too poor to compensate the victim, they were required to contribute a portion of their labor to the victim until the debt was paid off.  In some cases the criminal was temporarily enslaved to pay off the debt.  This capacity for the victim to benefit more from the criminal alive than dead was noted to have prevented many revenge killings, and the law was thus seen as something beneficial for both potential murderers and potential victims.  If the criminal and victim reached a consensual agreement outside of the chieftain court system, the case was considered moot.  If the criminal refused to compensate the victim, he was denied protection by all chieftains, and the relevant chieftains informed their assemblymen that the criminal should be boycotted.  On occasion the criminal was banished from the town.  If he refused to leave within three months and continued to ignore the sentence, the victim was considered in his lawful right to execute the criminal.  Those who were too weak or poor to engage in legal activities or carry out the sentencing were permitted to sell their right to someone more able.  This guaranteed protection and restitution for everyone under the law, including the poor, and prevented the rich from achieving any great advantage.  In this way Icelanders overcame the obstacle of discouraging crime without an ever-present police force.

It should be noted that except for the final civil war which resulted in the emergence of the state (which I will discuss shortly), there was not a single war in these 300 years of Icelandic civilization.  Not a single one.  There were occasional feuds, however these conflicts never escalated beyond a couple dozen participants.  This stands in stark contrast to the bloodthirsty ravaging wars of Europe throughout the entirety of the Middle Ages.

In terms of money Iceland traded in silver, measured in marks (approximately 8 oz) and a woolen cloth called wadmal.  The wadmal had a standard width of approximately one meter and was measured in the Icelandic unit of ells, which were equal to about 56 centimeters.  The value of one ounce (eyrir) of silver varied between 6 and 7.5 ells of wadmal.  Geagas, the earliest book of Icelandic law, apparently attempted to set a maximum wage in Iceland.  This was part of an attempt by a particular "thing" to initiate a cartel against their assemblymen.  We can't say with certainty, but based on this information historians have estimated that the typical Icelandic farmer made approximately one mark of silver per year.

Here is a chart of estimated various expenses in medieval Iceland.  A wergeld is the price for murdering a man.  A thrall was a slave.  Yeah, I know, not cool.  It was medieval times.  Slavery wouldn't be abolished for 700 years.  This is the big reason why I would not personally advocate a system like Iceland's.  Some questions have risen as to whether Iceland can be considered a stateless society because of the presence of slavery, and I would say yes.  Not that I don't abhor slavery - I abhor it for the same reasons I abhor the state.  However a state is a group of people who claim a universal land monopoly and the right to use violence against everyone living on that land.  Slavery is, I think, more individual ownership (obviously there's not an absolute line, like with serfdom, but I think this is the basic distinction).  Since Iceland (and Ireland actually) are both examples of how slavery can exist in a stateless society (and that states can exist in a society free of slavery, as we've seen) it is important that as a movement we do not stop at anarchy.  Anarchy is one conclusion resulting from the application of the non-aggression principle, which is a conclusion arrived at through a greater philosophical system of reason and evidence.  Opposition to slavery is just another necessary conclusion resulting from the application of the non-aggression principle, and it is vital we oppose it.  I have run into some anarcho-capitalists who do not oppose slavery so long as it's "voluntary."  If you ever encounter such a person, know that I disagree PASSIONATELY with them, and think they are being disgustingly inconsistent with their values.

COLLAPSE

So what caused the collapse into statism?  Icelanders worshiped the Norse gods inherited from their ancestry.  In the 990s AD King Olaf I of Norway sent two teams of Christian militants to convert the Icelandic population through harassment and intimidation techniques.  Those who refused to convert to Christianity were frequently beaten or killed.  On many occasions the King captured and held captive the loved ones of prominent members of Icelandic society, particularly chieftains.  King Olaf threatened to maim or kill the families unless Christianity was declared the official religion of Iceland.

Iceland was a resource-poor civilization with little military, and Norway was an indispensable trading partner.  They had to take Olaf's threats seriously, however a significant percentage of the population was unwilling to abandon their pagan beliefs.  Civil war seemed inevitable, yet as was Icelandic tradition, the decision was left to arbitration.  Throgeirr Thorkelsson, a prominent pagan chieftain with ties to the Christian camps, was chosen to make the decision.  Such was the respect the population held for Thorkelsson and the law that his decision, to reluctantly embrace Christianity, was adopted voluntarily by the Icelandic population.  In 1000 AD Christianity became the official religion of Iceland.

Icelandic anarchy continued unabated until in 1097 a compulsory land tithe was instituted on all Christians.  The fee was divided into four parts - bishop, local priests, welfare relief, and the churchstead fee.  The churchstead fee was the most significant, as in Iceland the church property was privately owned.  When a priest died, rather than having the property return to the church as a whole, it was inherited by the children of the priest.  Through the institution of this tithe, a landed aristocratic class had formed which could flourish without having to labor.  This stood in stark contrast to the chieftains, who could lose their funding if viewed by their assemblymen as ineffective at upholding the law.  Payment to the churchstead was mandatory.  Furthermore, these land tithes were based on evaluations of the value of one's home, which allowed the church to create a graduated tax to soak the rich (that is, the rich not associated with the church).  This aristocratic religious class is what ultimately led to the demise of Iceland's anarchic society.

Over time wealth and power became concentrated in the hands of a few.  In the Sturlung period (1230-1262) emerged Christian religious chieftains called storgodhar ("Big" Chieftains).  Since the total number of chieftains at this point was fixed by law, but this group of chieftains were able to enforce their payments through the church, competition between chieftains was slowly eliminated.  The reduction in competition allowed some chieftains to charge higher rates, making several assemblymen propertyless dependents on church welfare.

Towards the end of the Sturlung period the storgodhar were so powerful they were able to directly impose transfers of wealth from the population to the elite without the guise of religious justification.  Conflicts over the inheritance of churchsteads became among the most important matters in Iceland, and rather than being resolved through arbitration, competitors tended to resort to violent feuds.  Iceland entered its first and only war, however I must say this with a caveat.  This period of extreme conflict and violence, for which there was great unrest and horror in the Icelandic community, is estimated to have had a per-capita murder rate equal to that of the United States today.  Iceland's worst period in its entire anarchic history, during which a state was emerging, and during the Middle Ages, when war, murder, and infanticide were commonplace in Europe, had a murder rate equal to that of the modern United States.  This should give you an idea of how infinitely superior it was prior to this period, particularly when compared to European states at that time.

Throughout these final conflicts King Haakon of Norway lurked in the background.  He constantly encouraged the competing chieftains to enlist him for support in the conflict, and in true political fashion, frequently helped both sides.  Iceland grew less stable each year.  Finally, in 1262, King Haakon offered to quell the conflicts he helped to create.  The desperate Icelanders, exhausted by civil war, accepted his offer.  The Icelandic commonwealth, formed 332 years earlier to avoid the taxes of King Fairhair, fell to the power of King Haakon.

Iceland's collapse into statism was not a result of anarchy - it was a consequence of not being anarchic enough.  If they had resisted the initial imposition of religious intolerance when it arose, the final civil war would not have taken place.  A landed aristocracy could not have formed, and the Christians would have coexisted with the pagans.  If there is anything we can learn from the story of Iceland it is the danger of religion and of the influence of foreign states on the emergent leaders of the society.  If anarchy is ever achieved, these seem to be the only ways in which a state could re-emerge, and anarchic peoples must be vigilant to recognize these threats when they arise.

That's the story of anarchic Iceland.  Thanks for reading!

References:

Ordered Anarchy: Evolution of the Decentralized Legal Order in the Icelandic Commonwealth by Birgir T. Runolfsson Solvason:
http://www3.hi.is/~bthru/iep.htm

The Decline and Fall of Private Law in Iceland by Roderick T. Long:
http://www.libertariannation.org/a/f13l1.html

Privatization, Viking Style: Model or Misfortune? by Roderick T. Long:
http://www.lewrockwell.com/orig3/long1.html

Private Creation and Enforcement of Law: A Historical Case by David Friedman
http://www.daviddfriedman.com/Academic/Iceland/Iceland.html

Introduction to Economics Part 9 - The Business Cycle

Of all topics in macroeconomics there is none so widely misunderstood as the business, or boom-bust, cycle.  By the end of this note you will understand its nature, its cause, and how to end it forever.


Change in GDP Growth 1923 - 2008

If you look at various economic charts - employment, GDP growth, average salaries, etc., you will notice a pattern.  The economy seems to move in the shape of a wave, with tremendous growth for several years followed by a collapse.  During the boom, many jobs and much wealth are created.  When it peaks, employees are laid off, businesses close, and the economy enters a recession.  While many make tremendous profits during the booms, the busts can be absolutely crippling, particularly for the poor.  The most devastating bust to date was the Great Depression, due to its length.

Since the Great Depression was so devastating, a movement began in the western countries to find ways of minimizing these booms and busts and provide some predictability to their otherwise chaotic economies.  To the rescue came perhaps the most widely renowned economist today.

John Maynard Keynes was a British economist and intellectual who rose to prominence in the early to mid 20th century.  Keynes argued that the business cycle was an inherent quality of capitalism.  Booms are caused by unions and businessmen bidding up prices to increase their profits.  Busts are caused when the prices get so high that consumers simply refuse to purchase any longer, thus causing a collapse.  In order to save capitalism from itself, the government must intervene.

Keynes' theories met with a great deal of optimism, in large part thanks to the reports from traveling intellectuals citing the communism of Russia as a glorious success.  If the business cycle was indeed an inherent quality to capitalism, it was pretty damning.  "Our system has these crazy oscillations motivated by greed.  It subjected us to bank runs for decades before plunging us into the Great Depression, and the only reason we got out of it was by fighting the most terrible war in the history of the world."

So how does one regulate this beast called capitalism?  The best and most direct way to alter economic incentives is to manipulate the one product all economic actors have in common - the money supply.  During the booms, the role of the government is to increase taxes, thus reducing the enormous, uncontrollable surge upwards, preventing inflation.  The government saves its extra revenue to be spent later on.  When the inevitable bust arrives, and the consumers refuse to continue purchasing, the government is to serve as their replacement.  The government spends its savings in place of the consumers, thus preventing employees from having to be laid off and businesses from collapsing.  In this way you can see that rather than these obscene rolling hills of boom and bust, the intervention of the central planner allows for a level, consistent economy.

This way of thinking was adopted by neoclassical economists and remains the pervasive economic belief structure today.  In the 1970s, however, the United States entered a period considered impossible by this economic theory.  The US economy experienced stagflation, which is when there is both inflation and rising unemployment at the same time.  There is no lever to pull in such a situation.  You cannot tax, or you will cause more unemployment.  You cannot spend, or you will cause more inflation.  Ultimately the situation was "solved" by Ronald Reagan through an enormous increase in spending funded through national debt.  He solved nothing, but merely delayed the disaster to be endured by a future generation.

The events of the 1970s demonstrated that Keynes's theory of the business cycle was nonsense.  First of all, people in government are no different from any other group of people.  They are not separated from the profit motive as neoclassical economists claim.  They are motivated by greed just as the capitalists are.  They do not save money during the booms, and they go into debt or print money during the busts.  They are no more able to understand how to regulate the economy than any other capitalist in the economy.  As we learned in lesson four about the wisdom of crowds, individuals can only be aware of their own desires and of those with whom they directly interact.  All cases for centrally-planned economies necessitate the existence of a god-like omniscient regulator.  Lacking this, there are errors, and the result is economic disaster.

If we can't use central planning to manage the business cycle, are we doomed?  Are we condemned to endure these horrific waves of greed and destruction?  Fortunately no.  Keynes made a critical error.  The business cycle is by no means an inherent quality of capitalism.

THE AUSTRIAN THEORY OF THE BUSINESS CYCLE

If you were studying the life forms in a lake, and one day you arrived to find 40% of the population dead, what would you suspect?  Would you conclude that there was some inherent quality of organisms to spontaneously eliminate 40% of the community every so often?  Or would you suspect there was something wrong with the environment they all held in common, specifically, the lake water?  You would probably first suspect the latter, and check it for acidity, bacteria, or pollution.

As I mentioned in my discussion on Keynesian economics, the one thing all economic actors have in common is the currency.  Since the business cycle is an economy-wide phenomenon, would it not make sense to first suspect that it may have something to do with the currency?  When you investigate this, you find that is precisely the case.  The business cycle is a monetary phenomenon, possible only because we have a single organization forcing a monopoly on a single currency.

As I mentioned in the previous lesson, fractional reserve banking causes a dramatic expansion in the money supply.  This expansion is equal to 1 / Reserve Rate, and can vary depending on the whims of the Federal Reserve.  The printing of money also causes an expansion in the money supply, and is multiplied many times over if this printed money is distributed into the economy via the fractional reserve banking system.

As money floods into the system, economic actors mistake it for increased productivity and wealth.  And why wouldn't they?  If your business doubled its revenue over the course of several years, you would believe your business's real profits were increasing dramatically, and that the demand for your products was rising.  Unfortunately, this new money does not represent an increased number of goods and services.  It is just devalued currency, and thus only represents a fraction of the goods and services which already exist.

Entrepreneurs, believing their future prospects are bright, hire new employees, rent new offices, buy more capital, and so on.  Everyone else does the same.  As the demand for their products rise, they think "There's an enormous amount of demand for my products.  I can raise my prices," and do so.  At some point everyone finishes raising their prices and reality strikes.  Entrepreneurs, who once believed their futures looked bright, find themselves unable to afford their office buildings, capital, and employees at the higher prices.  They are forced to lay off employees and liquidate capital, or even close down completely.  The economy enters the bust.

The business cycle has nothing to do with free market trading and everything to do with expansions and contractions in the money supply.  It is precisely because the government forces everyone in the United States to use a single currency, and because of the passage of the National Banking Act of 1862 requiring banks to use fractional reserve banking, and the manipulations and expansions performed by the Federal Reserve, that the business cycle occurs.  If participants in the economy were permitted to utilize multiple currencies, or if laws were designed to prevent fractional reserve banking, the business cycle would not occur.  The very disasters Keynes believed could only be solved through central planning are a direct result of central planning.  The state breaks your leg, hands you a crutch, and tells you that without its help, you couldn't walk.

There was no business cycle before the 1860s because expansions in the money supply of this kind were impossible.  Inflation was practically nonexistent for all of recorded history until the introduction of fractional reserve banking, and exacerbated after the creation of the Federal Reserve.  By forcing the population as a whole to endure the inflation caused by the predatory practices of banks, the Federal Reserve and United States government have established a permanent dependent underclass and enslaved workers all over the country.  This, more than any other reason, is why families across America require both parents to work full time to achieve a fraction of what a single income achieved in the 1950s.

This is the final chapter of my Introduction to Economics series.  You now know everything you need to understand economics in the real world.  I hope you enjoyed learning what I had to share; I certainly enjoyed writing it.  Thanks for reading and have a great day!

Introduction to Economics Part 8 - The Fractional Reserve System

The fractional reserve banking system is the system the banks of the United States have used since the National Banking Act of 1862.  It affects every single one of us every day, which is why I'm talking about it here.

What happens to your money when you deposit it in a bank?

Let's say you have $1,000, and you deposit your $1,000 in a savings account.  To illustrate how the bank views your $1,000, let's use an old-fashioned method of accounting called the T Chart.

When you deposit $1,000, the bank now has an extra $1,000 in its reserves, so the amount gets added to the assets column.  However, since you can withdraw your $1,000 at any time, it also serves as a liability, and is added to the liability column.  The net balance is $0, which makes sense, since it is your money, not the bank's.  This means...

LIABILITIES ALWAYS EQUAL ASSETS

So now the bank has possession of your $1,000.  What happens next?  Well, in order to make a profit, the bank will loan your $1,000 out to borrowers and charge interest.  How much will they lend out?  The Federal Reserve sets a quantity known as the reserve requirement.  This is the minimum percentage of deposited funds a bank must keep in its reserves.  If the reserve requirement is 100%, then the system is called full reserve banking.  This means that the banks have enough money in reserve to give to all of their depositors, even if they all come at the same time.  This is not what happens.

The reserve requirement is less than 100%, so we have what's called a fractional reserve banking system.  This means that a bank only has to keep a certain percentage of deposits in reserve, and can loan the rest out.

A typical requirement of the Federal Reserve is 10%.  This means that each bank must keep 10% of the money deposited in their reserves, while 90% of it can be loaned out.  They can keep more, but not less.  The Federal Reserve constantly audits its member banks to make certain they do not fall below the reserve requirement.

For our purposes, we will assume that the reserve requirement is 10%, and that all banks loan out the maximum amount of money they can.

So, out of your $1,000, they will keep $100 and loan out $900.  They still have $1,000 in the liabilities column.  In the assets column, they have the $100 in reserve, and $900 in loans, since from the bank's perspective, a loan is an asset.  The values on both sides of the chart are equal, as they always should be.

This is where it gets a little tricky.

The $900 gets loaned to someone, and that someone uses that $900 to pay for whatever he wanted the loan for.  Whomever he pays deposits that money in their bank account.  It could be the same bank, or a different bank.  Either way, it's a new deposit in the banking system.


When this $900 is deposited, the bank gets another $900 in reserves and another $900 in liabilities, since the new depositor can withdraw this money at any time.  Both sides of our T Chart have $1,900, not just the original $1,000.  $900 have been created out of nothing.  If both of these depositors demanded their money, the bank would have to pay them $1,900, but the bank only has $1,000 in reserves.  This is a serious problem.  The bank cannot meet the demands of both depositors.  This is what is called a bank run.

In order to pay back its depositors, the bank must borrow money from other banks.  If other banks are unwilling or unable, the Federal Reserve was established to be the lender of last resort.

$900 has been created out of nothing, but this is transparent to the bankers.  If you ask them if they're creating money, they will say no - they are merely loaning part of what has been deposited.  But we can keep going with this process to create even more money.  Keeping 10% in reserve and loaning the rest, the numbers work out like this.

Notice how the quantity gets smaller each time.  Sooner or later it will disappear.  Notice also, however, that the overall total liabilities continues to increase, while in reality the bank still only has $1,000.

When this has all worked out, the number in the liabilities column will have multiplied by a factor of one over the reserve rate.

1 / RR

In our case, with a 10% reserve ratio, the money multiplier will be X10.  Our original $1,000 will turn into $10,000 by the time this is all done.

If the government runs a $100 Billion deficit (tiny by today's standards), the treasury sells bonds to the Federal Reserve, and the Federal Reserve increases the amount of money in the treasury's account by $100 Billion.  Once it goes through the banking system, $900 Billion dollars will have been created out of thin air.  All $900 Billion contribute to inflation and ultimately take the value from paychecks and savings accounts by increasing prices in stores and for services.

Wealth Taken:

$3,278 for each man, woman, and child.
$4,591 for each adult.
$8,928 per household.

This allows the government and the banks to spend beyond their means.  Since they are the first ones to spend the money, they can purchase at the full power of the dollar.  By the time it trickles down to everyday people, it has lost nearly all of its value to inflation.

This is why inflation is a tax, and an extremely regressive one.  The fractional reserve system benefits the government and the rich at the expense of the poor and middle class.

Thanks for reading!

Introduction to Economics Part 7 - How Inflation Works

What is inflation?  What happens when prices go up?  Is that inflation?  What happens when prices go down?  Is that deflation?

Let's say we have a teddy bear, and the teddy bear costs $20.  What does this mean?  It means that the value of the teddy is twenty times the value of a dollar.  Price is the ratio between the values of two goods, in this case, between the teddy and the currency.  In this case, the ratio is 1:20.

So what happens if the price of the teddy bear changes?  Suppose it goes up to $25.  Has the value of the teddy bear gone up?  Perhaps.  But remember that price is a ratio.  It may not be the value of the teddy that has gone up; it may be the value of the dollar that's gone down.

Economists talk about two different values for goods and services - the nominal value and the real value.

The nominal value is the market price of the good.  The real value is the actual value of the good.  Expressing the real value is difficult, as it is usually expressed in terms of a currency like dollars, which can change.  There is a calculation which takes inflation and deflation into account which determines a resource's real value.  This calculation is beyond the scope of what I want to talk about in this note.  Simply understand that objects have a real value in addition to a nominal value.

Let's say the nominal value of the teddy has gone up.  To determine if this is inflation, we need to see if the real value of the panties has also gone up.  If the real value goes up, then the new price is simply a reflection of the increased demand for teddies.  Perhaps a resource used to make teddies has become scarce.  Perhaps a new use for teddy bears has been found.  Perhaps a notorious teddy thief has pillaged the local Build-a-Bear.  These would all increase the price.  If both the nominal and real values of the teddies decreased, then this price is a reflection of real value.  If new technology results in teddy manufacturing requiring fewer resources and less labor, real teddy prices will drop.

What if this happens economy-wide?  Many economists and politicians describe economy-wide change in prices as inflation.  Is it?

In the last 30 years, computers have improved the efficiency of every single business sector in western civilization.  In every industry, at every level, computers have made it possible to do every job in less time with fewer resources.  All other things being equal, this would result in a drop in all prices.  The economists and politicians mentioned above would call this deflation, but it is not.  The efficiency of the new technology has caused real values of products to decrease.  This is a different phenomenon from deflation.

In the Great Depression, prices across the country dropped without a corresponding drop in real value.  What happened?  Remember that prices are a ratio between the value of a resource and the value of a dollar.  If the real value of the resource is not changing, but the nominal value is, then the value of the dollar must be changing.  Since the prices of the goods and services across the USA dropped, but their real value did not, the value of the dollar must have increased.  This increase in the value of the currency is what we call deflation.

Going back to our teddies - if the price of the teddy bears goes up, but the real value of the teddies does not, then the change in price is due to inflation.

If the price of the teddies goes down without a change in the real value of the teddies, then the cause is deflation.  Since these changing prices are due to changes in the dollar, these changes will be witnessed economy-wide.  The change of economy-wide prices is therefore descriptive of inflation or deflation and not prescriptive.

IS INFLATION NECESSARY?

Some economists claim that inflation is necessary when prices fall in order to maintain price stability.  What effect does this have?  Let's go back to the computer revolution.

As the real prices of various resources fell due to the use of computer technology, capital formerly devoted to those resources could now be spent elsewhere.  This results in economic growth and greater wealth.  What if, in order to maintain price, the government inflates the money supply?  The government prints dollars, exchanges them with banks via the sale of bonds, and thus increases the number of dollars in the economy.  The greater quantity of dollars in circulation decreases the value of each dollar.

Let's say you have $10,000.  After the inflation, you still have $10,000, but this is only the value nominally.  In real value terms, perhaps your dollars only purchase the amount of resources that $9,000 used to purchase.  Without the inflation, you would have had an extra $1,000 to spend, save, donate, or otherwise use.  That amount of value has been taken from you and used by the government, exactly as if you'd been taxed that $1,000.  This is why many economists refer to this as the "inflation tax," as it is the transfer of wealth from the population to the government.

The inflation tax is a particularly regressive tax, because the primary sufferers are the poor, the middle class, and the small businesses, as they are the last to receive the printed money.  The first to receive the printed money have the advantage of spending it at its pre-inflation value.  These groups include the government, the banks, and the politically-connected corporations.  In effect, the inflation tax is a transfer of wealth from the poor and middle class to the rich.  Among the lower classes, those with wages and salaries suffer most of all, as wages and salaries change much more slowly than prices.  To make things even worse, when wages and salaries adjust to inflation, their nominal values increase.  This may put workers into a higher tax bracket, even though their income has, in reality, stayed the same, or even gone down.  This is exactly the same as if the US government started taxing lower wage earners a higher tax rates without ever holding a single vote in Congress.

But it gets even more perverse.  That $1,000 of wealth you lost?  Let's say you really needed it for something, so you're forced to take out a loan to cover the change in price ($1,111).  You are able to take out this loan because the Fed printed money to give to the banks, but you wouldn't need to borrow this money if the Fed had not printed the money in the first place!  Now you're in debt $1,111, which you will have to pay back with interest, when by all rights every penny of that money loaned to you should have been yours to begin with.

From all of this we can easily see that in order to have a robust economy, as well as the greatest benefit for the poor, government should not be striving for price stability, but monetary stability.  Inflation is a tax that increases the gap between the rich and the poor while benefiting politicians and corporations, and the idea that an economy needs inflation to grow or to maintain stability is yet another myth perpetuated by those who benefit from it most.

Thanks for reading!

Introduction to Economics Part 6 - Unemployment

Someone who is unemployed is:

1. Currently not working
2. Willing and able to work
3. Actively searching for work

The unemployment rate is the ratio of workers unemployed compared to the number of workers both employed and unemployed.

Unemployment Rate = Unemployed Workers / Total Labor Force

There are two types of unemployment:

Voluntary Unemployment
Involuntary Unemployment

Voluntary unemployment refers to people who are unemployed by choice.  Why would anyone want to be unemployed?  A few reasons.  Perhaps they have quit their job because they wished to pursue another.  This is a rational voluntary choice.  Contractors who are between jobs are also considered voluntarily unemployed due to the nature of their job.  After his contracts expire, the contractor may be out of work, but he is considered voluntarily unemployed because he has made the rational choice to live the life of a contractor, which has its own advantages and disadvantages compared to a steady career.

The third factor that commonly causes voluntary unemployment is changing industries.  One example of this was when automobiles first began to replace horse-drawn carriages.  People who built buggy whips found their industry much less lucrative than it used to be, so many buggy whip manufacturers chose to close their shops and find other jobs.  While they were certainly under economic pressure to make this choice, it was still a voluntary choice, and thus considered voluntary unemployment.

Voluntary unemployment is overall a good thing for the economy.  It encourages new ideas, expires obsolete ideas, and keeps up competition.  The "bad" kind of unemployment is involuntary unemployment.

Involuntary unemployment is what most people are talking about when they mention unemployment.  It represents the total number of people who are willing and able to work and are looking for work, but are unemployed for reasons other than their own choices.  Involuntary unemployment can be divided into two types:

Perpetual Unemployment
Cyclical Unemployment

Perpetual unemployment pretty much stays the same over years, with very slow, gradual changes.  Cyclical unemployment happens in cycles - it goes up and down regularly and (usually) predictably.

Perpetual unemployment is our primary concern.  The greatest cause of unemployment in the United States is the minimum wage, for reasons discussed in the previous lesson.  Minimum wages set above the equilibrium point cause perpetual unemployment, but could there be other culprits as well?  The influence of unions and choices made by influential businesses can also cause wages to be set above the equilibrium point, however these two are relatively uncommon causes of unemployment.  The wage demands of unions are usually just trying to keep up with inflation, and employers tend not to suffer the problem of paying their employees "too much."  Additional government intervention besides the minimum wage tends to be the culprit.  Legal requirements for various kinds of insurance and benefits add to the expenses firms must pay to hire new employees.  Government licensing laws and paperwork requirements act as barriers to entry.  An employer may have to pay several times your monthly salary just to file the paperwork associated with hiring you.  This disincentivises new employment, particularly of unskilled laborers, and encourages protectionism within firms.

MYTHS ABOUT UNEMPLOYMENT


Every once in a while we get this sort of neo-luddite movement.  People fear that new technology, specifically, labor-saving devices, result in unemployment.  This is simply not the case, and five seconds of logical thought can recognize why.  If technology resulted in unemployment, then we would have lower employment today than any other time in history, due to our advanced technology.  Furthermore, new technological developments would never result in new jobs.  Neither of these are the case.

When someone had a job screwing a bolt into a door, and is replaced by a drill, that laborer is now a free resource that can be working elsewhere more productively.  Rather than screwing in the bolt, the employee can work in door construction, build engines, or provide some other service that was not efficiently provided before.  He may change fields - work in airplane construction or boat manufacturing, or even become a supervisor for his business.  Far from resulting in fewer jobs - technology results in more production, more wealth, and better employment.

While it is true we could achieve 100% employment by eliminating technology, this would not be a healthy economy.  We could eliminate planes, trucks, and trains, and carry all materials on our backs across the country, thus employing every man, woman, and child in America.  Would this really benefit our society?  Of course not.  A healthy economy is not an economy in which every single person is employed.  A healthy economy is one which operates at maximum efficiency, and that means it is flexible and allowed to reach equilibrium.  It is when equilibrium is not allowed to be reached that poverty and exploitation occur.

Another common myth about unemployment is that it is caused by immigration.  Let's say you have an immigrant move in who does your job for minimum wage while you're being paid $3 more than minimum wage.  People claim that these immigrants "crowd out" employment for everyone else.  They don't, and the people who think this is true are running into yet another fallacy associated with THE LESSON.  They are looking only at the first order reaction of the new immigrants - the unemployed or lower-salaried worker.  However we must remember that these immigrants are not just workers - they are consumers as well.  When they are paid, they will buy food, clothing, housing, electricity, water, toys for their children, and all sorts of other resources.  If the immigrant brings in a whole family, all the better!  He will have only taken one job, but a whole family of consumers will be purchasing on the market.  The immigrant will have to work very hard to provide for his family, and his work will increase the wealth of the entire community.  Immigration is never a bad thing for the economy for the same reasons a massive influx of food or energy are never bad things for the economy.  More production results in greater wealth for everyone.

If you lose your job to someone willing to be paid less than you, and his wage does not change within a few months of employment, all this means is that the true wage value of your job is less than what you were being paid.  You were one of the lucky ones able to demand a higher pay than your work was worth on the market.  You probably held a monopoly on your skills until the arrival of the immigrant, and you could not compete.  You will either have to accept a lower wage, like any business, or improve your skills to become more valuable to the market. 

If the immigrant is working for below minimum wage, then that's a sign that the minimum wage is higher than the equilibrium wage.  The free market is attempting to reach equilibrium through immigration.  If it can't do it in the white market, it will have to do it in the gray market.  Any forced manipulation of the market by governments, corporations, unions, or individuals will injure everyone, including the manipulators, and it should best never be done.

Thanks for reading!

Introduction to Economics Part 5 - Price Controls

Today I'd like to go into more detail regarding the nature of price, and how artificially altering the prices determined by the wisdom of crowds affects the economy.

Why would anyone want to alter prices?

1. Consumers want prices to be lower so they can buy more stuff.
2. Producers want prices to be higher so they can acquire more money.

In this regard the desires of producers and consumers are in direct conflict.  In order for trade to take place, each side must give in slightly to appeal to the desires of the other side.  This is what happens every day, and when such a resolution cannot be met, the transaction simply does not occur.

But what would happen if one of these sides were to acquire a weapon?  If one side can force the other to succumb to a threat of violence, the potential gains are tremendous.  Why would this ever be legal?  As it happens, our society has an institution with the legal right to use violence.  Since people act in a way to best serve their desires, both consumers and producers fight to gain control of this institution.  This institution is, of course, the state.  Consumers have their lobbies arguing and bribing for lower price regulations, while producers have their lobbies arguing and bribing for monopoly protection.

PRICE GOUGING

Every once in a while prices for a necessary product will skyrocket and consumers will complain about price gouging.  Price gouging is when a producer sells a resource at a much higher price than is considered reasonable or fair.  This is only possible through a government-enforced monopoly.  In the absence of a government-enforced monopoly, enormous profits made by the monopoly would motivate other capitalists to enter the field and undercut the monopoly's prices.  Because of this, in the absence of violence, producers cannot exploit consumers in this way.

If prices rise and are not due to a monopoly, it is usually the result of a disaster or some other extra-market force.  For example, when hurricane Katrina hit, several gasoline refineries were knocked out and prices went through the roof.  Though many consumers mistook this for price gouging, it was actually a shortage in the quantity gasoline supply due to the disaster.

Gas companies could not produce the same amount of gasoline at the same price level.  Due to the drop in quantity, the supply curve shifted to the left, resulting in higher prices.  Mistaking this for price gouging, some governments instituted price ceilings.  We did this at a nation-wide level in the 1970s.

By artificially setting prices, the market was unable to rise to its equilibrium point.  Demand was higher than supply.  More people wanted to buy gas than there was gas available.  The result was endless lines and hoarding, preventing many from getting the gasoline they needed.  Capping the price did not increase the availability of gasoline.  Instead, it just shifted the competition for the scarce resource from being one of price to one of "first-come, first-served."

MINIMUM WAGE

Minimum wage works in a similar way, since as far as the economy is concerned, labor is another resource. Wages are the price of labor, and the quantity of labor is the number of workers.  The workers make up the supply, and the employers comprise the demand.  The supply curve is upwards sloping because more people want a job if it has a higher wage.  The demand curve is downward sloping because a firm can hire more people if they don't have to pay individual employees as much.  Again, there's an equilibrium quantity, which comes out as the number of jobs, and there is an equilibrium price, which becomes the wage to be paid.

When you institute a minimum wage, there are two possibilities.  If the minimum wage is below the equilibrium wage, there is no effect.

If the minimum wage is above the equilibrium wage, it has the same effect as a price set above the equilibrium price.  There is a greater supply of workers than there is a demand for employment.  The difference between these two quantities is unemployment.

The only way the economy has to establish full employment is to allow prices and wages to adjust based on economic conditions.  If the economy is in a bad situation, and the market cannot support wages at a certain price level, and paying below a certain price level is banned by the government, anyone who's work is worth less than that price level will simply not be employed.

When you understand this, you realize that far from being a law that forces employers to respect their workers' time, the minimum wage is devastating for the worker.  The minimum wage is a law which bans anyone from working who cannot produce more than the minimum wage's worth of value for their employer.  It is the single greatest cause of unemployment in modern society.

This is why minimum wage is such a gruesome law against the poor.

INTEREST RATES

In the funds market we have supply and demand as well.  The supply is the amount of loanable funds. The demand consists of everyone out there who wants to take out a loan.  The government manipulates interest rates by manipulating the supply of loanable funds.  As with other products, there is competition between the consumers and the vendors.  Borrowers wish to borrow more money at lower interest rates while lenders wish to lend at higher interest rates.

Through trial and error banks have learned of the terrible disasters that occur when you impose a price floor or a price ceiling on interest rates.  Instead of taking these actions, the Federal Reserve manipulates interest rates by depositing money into or taking money out of the banking system.  If the Federal Reserve wishes to inject money into the banking system, they may announce that they are buying bonds.  The banks sell the bonds to the Federal Reserve, the Federal Reserve prints money to give to the banks, and the banks now have more money they can lend to borrowers.  This increases the supply of loanable funds, dropping the price of the loans (the interest rates).  This can also be done in the other direction by selling bonds back from the banks, thus raising interest rates, decreasing the overall amount of money in the system, and decreasing the amount of loanable funds.

This activity has consequences of its own.  When you increase the amount of money in the system, you get inflation, or the devaluing of the currency.  When you decrease the amount of money in the system, you get deflation, or an increase in the value of the currency.  The capacity to manipulate interest rates comes at the cost of price stability.

Thanks so much for reading!  Have a nice day!

Introduction to Economics Part 4 - The Wisdom of Crowds

It is often proposed that through centrally planned economies efficiency and benefit for all can be better achieved than through the "chaos" of the market. At the end of this note you will begin to understand why this is, firstly, completely impossible, and more importantly, undesirable.

GALTON'S OX

Francis Galton, cousin of Charles Darwin, was an English-Victorian polymath, inventor, geographer, proto-geneticist, meteorologist, and statistician. In 1906 he attended a livestock fair where he was intrigued by a contest - "guess the weight of this ox." When the contest had concluded, he looked at the winning guess, looked at the actual weight of the ox, looked at all of the guesses, and noticed something very peculiar! The winning guess was the median of all the other guesses. There were just as many guesses above the winning guess as there were below the winning guess!

Ox's Weight - 1198 lbs
Median Guess - 1208 lbs

Even more interesting, he took the mean (average) of all the guesses, and it turned out to be just one pound off from the correct value.

Mean - 1197 lbs

Keep in mind that this was a livestock fair. There were butchers, large-animal vets, and farmers present, dozens of experts in the field. Yet not one of them was able to guess the actual weight of the ox as accurately as the combined whole of fair attenders. This phenomenon is what we call the wisdom of crowds.

Since this event, numerous studies have been done showing how the wisdom of crowds is more accurate than the estimates of any single individual. You've probably participated in one.

JELLY BEANS

The most common way the wisdom of crowds experiment shows up is at fundraisers involving a jar of jelly beans. Everyone guesses how many jelly beans are in the jar, and the closest guess gets to keep it, or something along those lines. This is an easy way to test this phenomenon on your own if you ever want to. It's been done many times, and over and over again the wisdom of crowds proves more accurate than any single person. The only way the crowds can be fooled is to outright cheat, such as by putting a Styrofoam ball in the middle of the jar to alter the crowd's perception.

WHEN DOES IT WORK?

In order for the wisdom of crowds to work reliably, there are four requirements.

1. Diversity of opinion and knowledge
-You need people from different walks of life, different amounts of knowledge, different biases, and different lifestyles. The more diverse, the better.

2. Independence
-Everyone must make their own independent guess without influences from anyone else

3. Decentralization
-All the guessers must be part of different organizations.

4. Aggregation
-There must be some way of combining all the parts into a whole.

HOW CAN IT GO WRONG?

-The group can be too homogeneous. If the group is all part of the same culture or the same background, they may all be biased in the same direction.
-It can be too centralized. If everyone is from the same authority, it will not work.
-Incorrect information. There cannot be one set of information for one group and another set of information for another. When this happens, it usually indicates fraud or lies.
-Imitation - People copy the same methods other people use. If the methods are flawed, the results will be flawed.
-Emotion - If the decision is too emotional, the wisdom of crowds will not work.

THE WISDOM OF CROWDS IN THE ECONOMY

The wisdom of crowds is a big determining factor in economics. One of the most common ways it is disrupted is with government intervention.

The market, as we discussed before, is always moving towards total employment and maximum output. A lot of people don't trust the market, so they try to use the government to control it. The Federal Reserve is perhaps the most obvious manifestation of this fear. The idea behind the Federal Reserve is that an organization full of people who are knowledgeable and skilled in economics are more able to manage an economy than the population as a whole. They can anticipate total output, control the inflation rates, control the money supply, and so on, thus avoiding the boom and bust cycles.

Unfortunately for proponents of the Federal Reserve, there is a flaw. It is completely impossible for any individual human being to know the information they are ascribing to these financial experts. People can only be aware of their own personal desires and production, and have a vague idea of the desires and output of those with whom they directly interact. The idea that individual central planners can possibly comprehend the economic actions of over 300,000,000 people is as ludicrous as attempting to give a human being the responsibility of allocating oxygen to the millions of red blood cells in a person's body. This information is beyond human capacity to calculate, even with computers, and even if it was not, the data necessary to begin the calculations cannot be collected. No one knows what the total output of the economy is at any given time. The only way observers can make any sort of estimate is by relying on the wisdom of crowds to approximate reality. This interaction of millions of people supplying and demanding millions of goods and services is what determines prices. When you do not allow the wisdom of crowds to function, and instead leave this responsibility to a small group of limited human beings, they will get it wrong, and the result will be disastrous.

Thanks for reading! Have a nice day :-)

Introduction to Economics Part 3 - What is Money?

In my conversations with people on economic issues I have found a frequent misunderstanding regarding what money actually is.  For this reason I feel it's important to clarify this issue early on in my Introduction to Economics series.

Let's say you're a farmer with a cow.  You milk your cow and go to the market to exchange it for bread.  If the baker wants milk, you can negotiate how much milk is worth how much bread, and the exchange can take place.  But what if the baker does not want milk?  What if the baker needs a new shoe for his horse?  You will have to go to the blacksmith to see if he is willing to accept your milk in exchange for shoeing the horse of the baker who will then provide you with bread.  But what if the blacksmith does not want milk?  You will have to figure out what the blacksmith desires, and continue around town until you find someone who desires your milk and is providing something you need, and do so before the milk spoils!  You can understand how this is a troublesome and inefficient process.  There's GOT to be an easier way!

Money is the solution to this problem.  Money is a commodity that is universally valued.  If you have a product everyone values, you can exchange your milk for this commodity, and then exchange this commodity for the bread.  In order to properly fill this function, money must meet four requirements.

1. Medium of Exchange
2. Unit of Account
3. Store of Value
4. Standard of Deferred Payment

1. The medium of exchange is the most important characteristic.  Every individual participating in the economy must be willing to exchange this money for their good or service.  Why would they be willing to do this?  Every once in a while I hear someone say "money is just something people project value onto."  It's not quite that simple.  Money must meet five separate characteristics in order to be a medium of exchange.

a. Transportable - It must be portable, so the dairy farmer can take it from his home to the baker, for example.
b. Divisible - If the value of the bread is less than the value of the milk, he must be able to divide the money and keep the surplus for another good or service.
c. High market value in relation to its volume and weight
d. Recognizable as money
e. Resistant to counterfeiting - If people can simply create the medium of exchange at will, it is valuable to no one.

2. The unit of account is related to the money being divisible.  By having a standard unit, it's easy to tell how much value you possess.  By being divisible, it can be broken into smaller units without losing any of its overall value.  This is why diamonds make bad currency, since a large diamond is worth more than it would be if split into two pieces.  It must be fungible, which means that all units must be seen as equivalent to all other units.  Lastly, it must be verifiably countable.  If one person counts a pile of money, anyone else who counts that pile of money should come out with the same result.

3. The store of value is extremely important.  Money must be savable, storable, retrievable, and of the same value when it is retrieved.  This is why food products make bad money, even though they are demanded by everyone.  A pile of rice stored in a barn is worth less after fifty years than when it was first deposited.

4. Lastly is the standard of deferred payment.  Individuals must see money as a means of managing debt and credit.  If the baker is going to give us bread in exchange for money, he must be assured that he will be able to collect milk in exchange for this money at a later point in time.

So what makes good money?  Historically precious metals have filled the role very nicely, as they meet all four of these requirements.  Gold has been universally recognized as valuable all over the world, and all ounces of gold are equivalent to all other ounces of gold.  When divided in two, the two half-ounces of gold are worth the same as the combined one ounce.  It is a fantastic store of value since it does not deteriorate, rust, or decay.  Since it is good at holding its value, it is a good standard for deferred payment.

But what about paper money?  Is it not the same as gold?  Gold cannot be eaten as food after all, and it has limited practical uses.  Do we not simply project value onto gold, and can we not simply project value onto paper money in the same way?  The answer to this is no, for a reason you may find somewhat shocking.

There is no such thing as paper money.  Paper is not a medium of exchange.  In our system, there are different types of paper that have different values.  A $100 bill has the same amount of paper as a $1 bill.  Paper is not a store of value, nor is it a standard for deferred payment.  People do not actually believe there are $100 worth of ink and paper in a $100 bill.  The paper is acting as a proxy for a different kind of value.

This is a $20 gold certificate from 1905.  If you lived in any time before the United States got off the gold standard, you could take this $20 certificate to any bank or assayer's office and exchange it for 32 grams, or one troy ounce, of gold.  The $20 would then be taken out of circulation.  Similarly, you could take your gold to a bank and exchange it for certificates equal to the amount of gold you gave up.  This would be new money in circulation.

So what about today?  If paper money is a proxy, but is not a proxy for precious metals, what do we use for value now?

Our monetary system is known as fiat money.  That is, the money is declared to be valuable by government fiat.  It has value because the government says so.  That's all.  This mandate is used to enforce a standard of deferred payment.  All individuals living in the United States are legally required to use fiat dollars as their means of resolving debts, or be arrested.

What has been destroyed in this process is its store of value.  If you have $10 in your pocket, it is not worth the same it was 10 years ago, or even five minutes ago.  The reason why is because the Federal Reserve has complete power to print however much money it wants, and it doesn't cost much to run a printing press.  If you had the power to print $100 bills for 3 cents each, wouldn't you do it?  A lot?

The printing of money indicates to the economy at large that more goods and services are being provided when in fact the money is merely a representation of a fraction of the goods and services that already exist.  This sends false information into the economy, and since the money is moved into the economy via the banking system, the problem is exacerbated by fractional reserve banking, which we will discuss in a later note.  These false currency signals cause misallocations of resources, for which all economic participants eventually pay the price.

In conclusion, the most important thing to understand about money is that it is a representation of value.  There is nothing powerful or supernatural about it.  It is a stand-in for goods and services, and serves primarily as a medium of exchange for people to acquire that which they desire.  When people seek monetary profits, they are simply seeking to acquire more of what they value in life, which is completely subjective.  This is why it is important not to confuse monetary profits as something different from any other sort of gain in life.  There is nothing inherently evil or dishonest about money.  It is the means through which people acquire money, or the means through which they get what they want, that is problematic.

Thanks for reading!

Introduction to Economics Part 2 - THE LESSON

If there is any economics lesson you need to learn, it is this one. This note is based on LESSON ONE from the book Economics in One Lesson by Henry Hazlitt. A link to the free version is here:

http://jim.com/econ/

Hazlitt's lesson is summed up in this way:

"The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups."

In other words, when you look at an economic policy, you need to not only look for the results you intended to occur, but also any side-effects. This is what is called...

THE LAW OF UNINTENDED CONSEQUENCES

It's not really a law any more than Murphy's Law is a law... it just sort of refers to hidden costs. Unexpected things will happen, like when you take a medicine - you get the effect you want, but there are side-effects as well. The Law of Unintended Consequences simply reminds you that when you pass an economic policy, there will be consequences aside from the ones you intended to occur.

Let's say you're driving down the road and all the sudden you see the edge of a cliff. You think, "Wow, that's really dangerous, the government should put up a barrier there," and you proceed to drive very slowly and cautiously until the cliff side is no longer a danger. About a week later, you come back and find the government has put up a barrier. You are now more at ease, and you don't use as much caution in your driving. The thing is, while the barrier may have reduced the severity of any accident that happened there, the psychological results of the barrier actually increase the likelihood an accident will happen, because drivers will drive less cautiously. This result on the psychology of the drivers is an unintended consequence of adding the barrier. If the drivers overestimate the safety the barrier brings, they may be in more danger because of the barrier than they were if it had not been installed. Thus, when taking such safety measures, all consequences, both intended and unintended, must be taken into account in order to decide what the best course of action is.

THE BROKEN WINDOW

To illustrate the Law of Unintended Consequences in Economics, we have a story! It was first introduced by Federic Bastiat, and later used by Hazlitt. It's the Parable of the Broken Window.

One day a mischievous little boy throws a rock through the window of a baker's shop. The baker, furious, runs out of his shop and yells at the little boy, who immediately runs away. Within seconds a crowd has gathered around the baker's shop, regarding the shattered window with various reactions. After a few minutes, the crowd becomes philosophical.

"Why is he so angry? Does he not realize what a fantastic thing this is? Because of the broken window, a glazier in town will now be employed to fix it. The actions of the little boy have brought stimulation to our town's economy. Far from being a public menace, he is actually a hero."

This is a fallacy, and an all-too common one. The crowd immediately understands the first-order reaction of the broken window - the employment of a glazier. What they fail to recognize is the economic activity which would have taken place had the window not been broken. Perhaps, that very afternoon, the baker had intended to go to the tailor and purchase a new suit. Unfortunately, now that the window has been broken, he can no longer afford the suit. The glazier's business comes at the expense of the tailor. Overall, if we view the town as a system, the entire town is poorer one suit as a result of the little boy's mischief.

This may seem obvious, but you'd be astounded how many economists, politicians, and pundits fail to recognize this fact. When the tsunami hit southeast Asia, there were many pundits around the world who claimed that the tsunami had a bright side, since it would cause economic activity. Since all those villages had been destroyed, they would have to be replaced by new infrastructure, which would employ builders, electricians, plumbers, and all sorts of people. The tsunami was in fact a blessing!

You can't say that the new infrastructure is more valuable than the old because the whole value of the old infrastructure had not yet been extracted. How many cities begin their reconstruction processes by evacuating the population, bombing the cities to the ground, and then starting from scratch? They don't do it because it's not worth it! The only way the claims of these pundits could ever possibly be true is if the tsunami happened to strike at the exact moment the population had wished to dismantle and rebuild their villages anyway. This is the Broken Window Fallacy, and it is very important people recognize it when they hear it.

Now, in any parable, different characters represent different things. By and large, the little boy represents the government. The government runs over, breaks a window, and goes "Oh look, I'm so fantastic, I'm making jobs!" The breaking of the window takes many forms from taxation to minimum wage laws to other controls on the economy. While people may see the bridge constructed by the government, they are unable to see the projects which would have been possible had the government not taxed the population to build the bridge. While people may see the workers making minimum wage, they cannot see the workers who would have been employed if the minimum wage did not exist.

This is why we must constantly look beyond the obvious, visible, direct consequences of an action and recognize the second and third-order consequences.

Thanks for reading! Have a nice day :-)

Introduction to Economics Part 1 - The Basics

Welcome to my series on economics!  Through this series we'll go step by step from the basics to some of the most misunderstood topics in economics today.  By the end of these notes, you will understand economics better than the vast majority of the population, and in some cases, better than most economists.

For starters, there are two basic facts of existence you need to understand.

RESOURCES ARE FINITE

There's only so much stuff in the world people can use.  There's only so much food, water, oil, land, time, and so on.  However...

DESIRES ARE INFINITE

Everyone always wants more. This isn't a bad thing, and can mean anything.  People can want more stuff, a better life, a better life for their kids, to help the poor, to go to the moon, whatever.  Once in a while I'll meet someone who says, "I'm not like that.  I'm perfectly happy with my life.  I'm happily married, I have good friends, enough food, and no worries, so this second principle doesn't apply to me."  Well... that's just not true!  If your wife got sick, would you be interested in curing her?  Are you interested in being as healthy in twenty years as you are today?  Are you interested in traveling to distant places cheaper and more quickly?  Everyone always wants more, and while these desires are subjective, this is a universal fact.  It can range from "I want a new kitty" to "I want to continue breathing."  However lofty or impossible the desire, everyone always wants more, and these desires are unlimited.

From the principle of finite resources and the principle of infinite desires, we get a third principle:

PEOPLE WILL TAKE ACTION TO SATISFY THEIR DESIRES

Since people want stuff they don't have, they will dedicate their resources to acquiring their desires.  They will make use of all available resources, including people, to achieve their desires, and for this reason...

THE MARKET TENDS TOWARDS FULL EMPLOYMENT

The physical resources associated with acquiring economic desires are what we call CAPITAL.  In order to convert raw resources into consumable resources, the LABOR of people is required.  In order to achieve maximum satisfaction of everyone's desires, the market will tend towards maximum use of people's labor and capital.

In choosing how to allocate our resources, however, there is a very important question -

AT WHAT PRICE?

Since resources are finite, and desires are infinite, how much of one's resources is one willing to contribute in order to achieve one's infinite desires?  In other words, at what point does one better achieve one's desires through keeping one's resources than expending them?  This constant decision-making between keeping one's resources and using one's resources eventually arrives at a central point.  This point is the maximum PRICE at which one is willing to part with one's resources to acquire what one desires.

VOLUNTARY TRANSACTIONS

A transaction is a voluntary agreement between two people in which resources are exchanged.  They both give something, and they both get something.  All voluntary transactions are mutually beneficial, win-win, or they would not take place.  If this is not the case, then force or fraud must be involved.

Example:

You go to a convenience store and buy a coke.  The coke costs $1.  You go to the counter and give the shop owner $1, and he gives you the coke.

Why did this happen?

It happened because you valued the coke more than you valued your dollar, and conversely, the shop owner valued your dollar more than he valued his coke.

If this was not the case on both sides, this transaction would not have taken place.

Since in all voluntary transactions both sides increase their amount of perceived wealth...

IN A FREE MARKET, WEALTH ALWAYS INCREASES

Wealth is a nebulous concept.  Wealth is simply "things you value."  Since in every exchange people acquire more of what they desire, and since desires are infinite, the tendency of the free market is the creation of more wealth.  In other words, by whatever criteria people wish to use, they always end up better off than they were before.  If this is ever not the case, it is usually due to some government intervention, natural disaster, theft, or other external action outside of market forces.

Finally, we get to how we describe market forces.  There are two sides to the market - those who produce goods and services, and those who desire goods and services.

SUPPLY AND DEMAND

As quantity increases, supply increases and price decreases.  As demand increases, price increases and quantity decreases.

In other words, if something is at a lower price, people wish to buy more of it.  If it's at a higher price, they don't want to buy it as much.  If there's a lot of something available, people won't be willing to pay much to get it.  If it's scarce, they will pay more.

Where these two curves meet is the equilibrium point.  This point represents an equilibrium price and an equilibrium quantity.  All other things being equal, the economy will always be seeking the equilibrium point, so there are no shortages or surpluses and there is no overcharging or undercharging.

IN SUMMARY:

1. Resources are finite
2. Desires are infinite
3. People will act to acquire more resources
4. There is an amount people are willing to exchange for what they desire.  This is the price
5. All transactions are voluntary and mutually beneficial
6. Because all transactions are mutually beneficial, overall wealth always increases
7. Supply and Demand interact to find an equilibrium price and an equilibrium quantity.

Thanks for reading, and have a nice day!

Practical Anarchy Part 9 - How a Stateless Society Prevents the Re-Emergence of a State

By far the most common objection to the stateless society, exceeding even the questions of helping the poor, providing roads, or providing defense, is the belief that one or more of the private Dispute Resolution Organizations would overpower the others and create a dictatorship. This belief is erroneous at every level, but has a sort of persistence that is almost admirable.

Here is the general objection:

"In a society without a government, whatever organizations arise to resolve disputes or protect the public will inevitably become replacement governments. These agencies may initially start as competitors in a free market, but as time goes by, one will arise to dominate the others economically, and will then wage war against its competitors, and ultimately impose a new state on the population. The instability and violence that this "DRO civil war" will inflict upon the population is far worse than any constitutional democracy. Thus, a stateless society is far too risky an experiment, since we will just end up with a government again anyway!"

This objection to an anarchic social structure is considered self-evident, and thus is never presented with actual proof. Since discussion of a stateless society involves a future theoretical situation, it is difficult to use empirical evidence one way or the other.

However, like all propositions pertaining to human action, the "replacement state" hypothesis can be subjected to logical examination.

PREMISE

The premise behind the replacement state hypothesis is that human beings will tend to maximize their income while minimizing their expenditure of energy. The motivation for the DRO to use force is that, by eliminating its competition and taking military control over a geographical region, a DRO can make much more money than through free market competition, and that it is worth investing resources in military conflict in order to secure the permanent revenue of a tax base.

We can accept this premise so long as we apply it universally to all human beings in a stateless society. To make the "replacement state" case even stronger, we shall assume that no ethics will get in the way of such decision-making, and it shall be nothing but a pure cost-benefit calculation.

STARTING POINT

Let us assume a stateless society in which customers can voluntarily contract with a DRO for the sake of dispute resolution and property protection. Each citizen also has the right to withdraw from his or her DRO contract.

There are essentially three ways a DRO could conceivably go about achieving military control over a geographical region.

1. By secretly amassing an army and suddenly unleashing it on its competitors.

2. By openly amassing an army and doing the same thing.

3. By posing as a "Defense DRO," amassing arms under the guise of providing legitimate defense to the citizens, and then turning those arms against the citizens and instituting itself as the new government.

There is one additional possibility, in which a wealthy private citizen attempts to amass an army on his own. Let us deal with each of these in turn.

THE SECRET ARMY

In this scenario, our DRO executive Bob has decided he is tired of dealing with customers on a voluntary basis. He decides he is going to spend enormous amounts of company money buying arms and training an army. (For the moment, let us assume Bob can make this decision entirely on his own, and need not get approval from shareholders, a board of directors, or other executives).

Let us assume that Bob's business has annual revenues of $500 million per year, and profits of $50 million per year.

The most immediate challenge Bob faces is - how on Earth am I going to pay for this army? Given that, in a free society, there is no way of knowing how many citizens are armed, where those armed citizens are, or what kinds of weapons they have, it is better to err on the side of caution when forming a conquering army. Bob must assemble an overwhelming army to gain control of the entire region, or else Bob's investment will be lost in military defeat, and he will suffer harsh consequences under the DRO system.

Such armies are not cheap. For the sake of this argument, let's say that the army will cost $500 million over five years - surely a low estimate.

RAISING RATES

The most obvious way for Bob to acquire the funds to raise the army is to raise DRO rates. The $500 million Bob needs represents ten years of his DRO's annual profits. Thus, in order for Bob to pay for his army within five years, he will have to more than DOUBLE his prices. Since we have already assumed that it is Bob's greed that leads him to take this action, we must therefore assume Bob's customers will also behave in a greedy way. They will not be pleased by his increase in rates. Just like Bob, his DRO's customers wish to maximize their profits and minimize their expenditures.

The moment that Bob doubles his rates while failing to provide additional services, Bob's customers will leave and pursue business with another DRO. Bob's DRO will go bankrupt. Sadly, no army for Bob.

FULL DISCLOSURE

Perhaps Bob recognizes this danger, and thus plans to keep his customers by informing them that he is raising rates in order to form an army. "Help me buy an army by paying me double your current rates, and I will share with you the plunder when I take over X community." Even if we assume Bob's customers believe him and are willing to fund such a scheme, Bob's secret is out. The society as a whole, including all other DROs, have been informed of Bob's nefarious intentions. Clearly, in fear of their own economic well-being, all other DROs in the society will cease doing business with Bob's DRO. Since the central value of any DRO is its capacity to interact with other DROs - just as the core value of a cell phone company is its ability to interact with other cell phone companies, or banks with other banks - Bob's DRO will be crippled. Bob will be doubling his rates for five years while providing immensely inferior service, all for a highly uncertain and dangerous "profit."

In addition to the DROs, Bob's banks would fear for their own well-being, and likely cease doing business with him. Bob will be unable to withdraw any funds he had stored in the banks, and will be unable to seek retribution, since no other DROs will represent him, and his DRO is not respected. Bob will be unable to pay his employees, his office rental, or his bills. Bob will find his business without electricity, and his plumbing will mysteriously run dry. Bob's phones will be cut off, and road businesses are suddenly much more difficult to work with. People do not respond well to an open announcement of intention to murder them and impose dictatorial rule. It is difficult to imagine Bob lasting five days in this situation, much less five years.

Even if all the above problems could somehow be overcome, it is difficult to imagine that Bob's customers would be happy to arm Bob in hopes of sharing in the plunder. Unlike the government which can tax at will, DROs must actually provide value and effective service to retain business. Defense associations must actually protect property. DROs must actually resolve disputes. Given that those who form contracts with DROs will be those most interested in protecting themselves and their property, it is unlikely they would voluntarily fund Bob's army, as they'd have no control over the army once it was created, and thus no way of enforcing their "plunder contract." In a free society, people would not try to "protect" their property by funding a powerful army that could take it from them at will. This sort of madness only exists in the world of states.

ALTERNATIVE FUNDING

Perhaps Bob will try to fund his army in other ways. He may try to borrow the money, but his bank will only lend him the funds if he provides a credible business plan. If Bob's business plan openly states his desire to create an army, his bank would cease supporting him in any way, shape, or form, since the bank would stand only to lose should such an army come into existence. If Bob took the money from the bank by submitting a fraudulant business plan, the bank would become aware of this almost immediately and retrieve the remaining funds, with contractual penalties to boot! No army for Bob.

What if Bob tried to pay for his army by reducing the dividends paid to shareholders? Naturally the shareholders would resent this and would either have Bob thrown out or would simply sell their shares and invest their money elsewhere, thus crippling Bob's DRO. Perhaps Bob would try paying his employees less, but this would only drive Bob's experienced employees into the arms of other DROs - also destroying his business.

It is safe to say that it is impossible for Bob to acquire the funds necessary to raise an army from within the free market DRO system. There are, however, other dangerous possibilities that need addressing.

DEFENSE AGENCIES

The most likely threat would come from defense agencies, or those agencies which have already amassed weapons and combat-trained personel for the protection of their customers from crime and outside invasion. These resources could potentially be used against the general population. However, this would be very difficult for two reasons. Firstly, defense agencies would require banking and investment relationships in order to grow and flourish. Given that banks and investors would not want to fund an army that would steal their property, they would be certain to require a myriad of "failsafe" clauses in their contracts with the defense agencies. They would make certain all arms purchases were tracked, that all monies were accounted for, and that no secret armies were being assembled.

Citizens would never contract with a defense DRO that refused to submit to regular third-party inspections. If Dave, a defense agency CEO, attempted any of the nefarious things Bob did in his DRO, he would encounter all of the same difficulties in funding his army. He can't raise rates, undercut his investors, take out loans, or reduce wages. How will he pay for it?

There is no viable way for a business to form an army without destroying its business in the process. Armies are only possible when governments can use taxpayers to subsidize them.

INDEPENDENTLY WEALTHY?

Perhaps, instead of Bob or Dave, we have an independently wealthy dude named Bill who wants to take over his community. Bill decides to found a new army and install himself as the new dictator. Due to his immense wealth, he is not dependent on customers, employees, banks, or shareholders. Let's say he can pay for an army out of his own pocket, immediately.

Bill's main challenge is that he can't exactly pick up an army at his local Wal-Mart. Armies are fundamentally uneconomical, expensive overhead, and thus the most likely defense for a geographical region of an anarchist society would be a series of nuclear warheads to deter invaders. Even if Bill could acquire a nuclear weapon, it would do him little good, since he probably could not overcome the might of all of the defense agencies.

What about more conventional weapons? Part of the service of a defense agency, aside from deterring outside invaders, would be to prevent the formation of an aggressive army within the business's region. DROs and defense agencies alike would thus wish to interact closely with arms manufacturers, making certain they provide rigorous accounts of everything they were producing and selling, to be certain they weren't selling arms to a secret army. If people were worried about the formation of a secret army, they would only do business with the defense agencies which did business exclusively with "open and honest" weapons manufacturers - subject to independent verification.

Thus when Bill comes along and wants to buy $500 million worth of M16s, and hire an army of tens of thousands of soldiers, one question would be - where did they come from? Arms manufacturers would not be sitting on $500 million of unsold inventory. There's limited demand, and the costs of making and storing such merchandise are high. Arms manufacturers would have to dramatically ramp up production, which could not be long hidden from the general population or the defense agencies. If it was discovered that a weapons manufacturers was cooperating with an insane multi-billionaire to enslave the population, no one would ever do business with that manufacturer again.

Also, no manufacturer would ever expand production that dramatically for a "one-time purchase," any more than you would buy a car to make a single trip. Also, why would a manufacturer make so many weapons, knowing that those weapons could then be used against the manufacturer?

Even if Bill could somehow acquire all the weapons necessary, where will he find the thousands of troops? In a stateless society, military participation would not be the sort of "in-demand" career it is today. In order to assemble an army of tens of thousands of men, Bill would need to advertise, recruit, pay them, train them, etc. This would be impossible to hide.

If Bill's bank is concerned, it could request a contract clause giving it the right to refuse any payments that are involved with the formation of a new army. Secondly, no DRO would do business with Bob, or his soldiers, the moment it became apparent what they were up to. Acquiring food, water, energy, and other resources would thus become very difficult. Furthermore, there would no longer be any guarantee Bill's soldiers would be paid. Even if they were, who would they trade with? When society as a whole wants to stop doing business with you, life becomes pretty difficult. Their rule would have to be an absolute violent dictatorship. No one would view it with legitimacy. Historically, such states collapse almost immediately.

PROFIT?

Remember that this whole scenario operated under the assumption that Bill, Bob, or Dave could achieve greater profits by imposing taxes on the population than through doing honest business. Let us see if this is the case.

Let's say our first friend Bob somehow got his army. Can he make his army profitable?

Remember, it cost Bob $500 million to assemble his army. Let's assume the modest price of $1 billion to subdue a reasonably-sized region over five years. What kinds of financial returns can Bob expect?

If you knew that Bob's army was on his way to your house, what would you do? Chances are, you'd take everything you had of value with you and burn down your house. This was exactly what the Russians did to defeat Napoleon, Hitler, Alexander the Great, and so on. You leave Bob with nothing to consume from his conquest.

However, let's assume that Bob CAN steal something of value through his conquest. How much would he have to steal to make a profit?

First let's look at what Bob would have made had he invested his money in something other than an army. If Bob had invested his $500 million in his DRO, rather than his army, and made a 10% return on investment, in five years he would have had $832.61 million.

In order to complete his conquest, Bob had to invest $1 billion in his war. $1 billion invested over five years would have net him $1,655.22 million, or $1.655 billion. His $832 million could also have been further invested to net him $1,340.93 million.

Thus, if Bob had invested his money in his business rather than raise an army, he could have saved $1.5 billion and made an additional $1.5 billion. Bob could have doubled his value! Bob's investors probably would have made this projection, and understanding the ridiculous risk associated with his war effort, would have demanded an enormous ratio of the war profits in exchange for their participation, perhaps 20:1 - comparable to the software industry today. In order to pay back his investors and get some money for himself, Bob would have had to plunder over $60 billion from his conquered territory.

What is worth $60 billion? The houses? The cars? It is hard to imagine anything Bob got his hands on would be worth much, particularly since he could not possibly trade it.

Bob's war effort would have resulted in an enormous financial loss. If we seek empirical evidence for this, it is abundant. Throughout history imperialism has proven to be utterly destructive, and all sides lose enormous amount of capital. The only ones who benefit are those connected with the coercive power of the state.

We could talk about Bob attempting a spring attack on customers and taxing them, but once again, everyone would seek protection from this through their DROs with various "checks and balances." If people are really concerned about defense agencies forming armies, then customers could simply include in their contracts enormous fines to be paid to the customer by the agency should any evidence be found of aggression against the customers. "If sufficient evidence is found (sufficient as determined by a third party) that my business intends on aggressing against you, my business will pay you $1 million, and this will be enforced by X, Y, and Z DROs and guaranteed by competing defense companies A, B, and C." Clearly such a provision would encourage defense agencies to find all possible means of displaying their trustworthiness. Unlike the state, they would be utterly committed to the defense, and not the enslavement, of their customers.

ONE FINAL NOTE

The "replacement state" hypothesis relies on an error that is important to address. Many people believe that states emerged organically from a need - that old wise men in ancient times became leaders of organizations and were given a monopoly on violence to resolve disputes. This is not how states emerged.

States are a product of early cults. In early civilizations such as Uruk and Egypt, certain individuals claimed to be able to communicate with gods, or claimed to be gods themselves. Since farmers were extremely vulnerable to the elements, these cult leaders preyed on the fears of these farmers by claiming they could control the elements, and demanded tribute. These tributes allowed these cult leaders to survive and flourish without having to provide goods and services. They used these tributes to hire body guards and later to raise armies. When these armies were sufficiently powerful, tributes became enforced through violence. Taxation was born.

States are not a result of a need, but of superstition. The state, much like slavery, is an obsolete, barbaric relic from the ancient days of humanity. You scarcely find anyone who thinks that slavery was a good idea, nor anyone who advocates its rebirth. When the state is abolished, so will it be regarded. You do not witness a gang fight on the street and view the violence as legitimate. In the same way members of a stateless society will not view a private business attempting to enslave them as legitimate. All violence will be regarded as unjust aggression. Though the stateless society has many ways to prevent the re-emergence of a state, it is not required. States do not emerge organically from needs - they are cults. The more rational the civilization, the less likely a state will ever need to be put down again.

Thanks for reading!