Economic Principles

Principles play a critical role in the development of any theory. Including economic theory.

Definition

Principle:
“A fundamental truth or proposition that serves as the foundation for a system of belief or behavior or for a chain of reasoning.” from Oxford Dictionary

Introduction

Reasoning begins with principles. We tend to ignore principles because, frequently, they seem so obvious. When we want to throw a ball over a fence, we don’t think about gravity, air pressure, friction, and other principles. But, they all affect the process of getting the ball over the fence. But, we just want to get it over the fence.

If we want to calculate exactly where the ball will land, we must define all of these principles explicitly and precisely.

The same use of principles applies to economic reasoning.

Implicit Principles

An infinite number of principles influence economic behavior. Even for sound economic reasoning, many principles can remain implicit. The existence of gravity, weather, the curvature of the earth, etc. can remain implicit unless they play an essential role in our analysis.

To think more clearly and precisely, however, we need to make some principles more explicit.

Explicit Principles

Quite a number of economic principles need explicit statement just to acknowledge their influence. Such statements avoid misunderstanding resulting from mistaken assumptions about the principles in play.

Fundamental Elements

All economic goods come from two fundamental elements: land and labor.

Land

All agricultural and “capital” goods originate with land. Agricultural goods require land on which to grow. “Capital” goods originate from elements either grown on land or excavated from land. Goods that come from water also fall within the category of land.

Labor

All goods also require labor for their production. Even the most basic goods found in nature require processing by labor. Hunters and gatherers must expend some labor to make their goods usable.

Value

Value lies at the core of many economic theories. In spite of the disagreement about the source and measure of value, all economists agree that value does exist. Because it plays such a critical role in the development of economic theories, I will discuss the theory of value in more detail in other sections of this blog.

Action

Ludwig von Mises usually gets credit for introducing the “action axiom” to economic thinking. He recognized that all economic activity begins with the action of individuals.

Mises developed this axiom using pure reason. He realized that to attempt to prove non-action a person must act—which verifies the validity of the axiom. The axiom requires no empirical testing. Its truth results from reasoning alone.

Exchange

The principle of exchange might seem obvious. It gets ignored, however, in many discussions of “buying,” “selling,” “international trade” and other market activities. These terms all represent internal references. (Left and right are internal references; north and south are external references.)

Accurate discussions of market transactions require the use of an external reference: “exchange.” A consciousness of the principle of exchange reminds people that all market transactions, as observed by third parties, involve two parties.

When discussing internal references, such as buying and selling, we must always ask about the influence and impact on the other party.

Markets

The combinations and interrelationship of exchanges created the related principle of “markets.” Most economic theory involved markets.

Money

I include money as a principle because its existence and use remains beyond a doubt. That existence provides the basis for chains of reasoning. Much reasoning regarding money remains flawed because of misunderstanding the definition of money and the source and measure of its value.

I will devote most of “Money Matters” to clearing up much of the flawed reasoning regarding money.

More…

I will discover (or reveal) more principles as I examine various topics on this blog.

Conclusion

Without principles, we cannot make theories. Without the explicit statement of important principles, precise reasoning becomes difficult.

I will expand on these principles as I continue the discussions on this blog.

Money Matters: Introduction

The ubiquity of money in market transactions means that a precise understanding of market activity requires a precise understanding of money. Money Matters will expand the understanding of money and reduce much misunderstanding.

The Donkey

A rich man stopped in a small town. He encountered two men haggling over a mule. The rich man, thinking he could use the mule, out bid the two men and bought the mule.

Several weeks later the rich man again stopped in that small town. By coincidence, he encountered the same two men who had been haggling over the mule. The two men asked the rich man what he had done with the mule.

He responded, “That old mule could not do the work for which I wanted him; so, I had him put down.”

The other two men suddenly look very disappointed. The rich man asked them why they acted so disappointed.

The men responded, nearly in a single voice, “Until you came along, we had made a good living trading that mule.”

Market References

Fast food, shoes, iPads, Ferraris, Stocks & Bonds, and the national economy, we relate to all of them through references to money. We use phrases like: it costs…, it’s worth…, it increased by…, all followed by a number of dollars. We use these phrases as if they actually mean something and that we understand that meaning.

But, do these phrases mean anything?

Do we know whether we speak real meaning? If they do speak meaning, do they comprehend that meaning?

The Comprehension Gap

When we discuss market transactions, we tend to either ignore the role of money in those transactions, or we discuss monetary transactions, with little attention to the goods at the focus of the exchange. By ignoring the interrelationship between money and products we tend to expose what I have dubbed a “Comprehension Gap.”

What don’t we understand? Money or markets?

The donkey trade and the economic references provide hypothetical examples of this “Comprehension Gap.”

Money & Markets

You cannot fully understand most economic exchanges without understanding money and its role in exchanges. If we base our understanding of free markets on our current assumptions about money, we could suffer from grave misunderstanding. We need to make those assumptions explicit and precise to assure that our assumptions correlate with the real nature of the transactions.

So many misconceptions exist about money that clear thinking and communication about economics becomes nearly impossible. To clear up this confusion, we must start with some basic concepts

Economic Reasoning

Money exists inside and as part or market systems, not as separate from market activity. Thus, in order to fully understand money (and close the comprehension gap), we must first understand the principles and theories that govern market behavior.

I will address some of the basic elements of economic reasoning that will support our discussion about money.

Market Systems

Expanding production and limited consumption result in savings, and creates the need for exchange and the use of money.

How does the production process create a need for exchange?

How does increased production and exchange benefit all members of an economic system?

Exchange

Nearly all market exchanges involve money. In large markets, systems of exchange become highly complex.

How does that complexity lead to the use of money?

To understand to role of money in complex market exchanges we should know the basics of market exchanges.

We will examine market exchanges at all levels of complexity — from the simplest, which might operate based on direct exchange, to the complex, which require indirect exchange and the use of money.

To be continued…

Green New Deal – 2030

Commenting on The Green New Deal would waste my time, except for the attention some influential people have given it. It would, if passed, lead to a life of misery that would make catastrophic climate change seem like a marvelous alternative.

I receive letters from strange people and strange places. Most of them, If they make reasonable comments, I respond to privately. Recently I received a letter from a rather different place: the future. Because it discusses a topic of present-day interest, I have posted it in its entirety.

Dear Jim,

Roughly 10 years have passed since the signing of the Green New Deal bill in 2020. Climate change hysteria rose to such a fever that voters elected Kamala Harris as President and Cory Booker as Vice President. The House of Representatives elevated Alexandria Ocasio-Cortez to the speaker of the House.

The rapidity with which they passed this legislation surprised many people except a few who remembered chants of,” Better off Red than dead.” I found it equally surprising how quickly they acted on the legislation. I guess people liked the Nirvana promised by the supporters.

I have nearly gotten used to having to make these entries by candlelight. I hardly remember the day before May of 2026 when we had to turn in our last smartphones. We just don’t produce enough power for recharging those devices and transmitting the messages we composed. I do have more time during the day to do my writing since I lost my job. But, I hear that pencil and paper will soon become in short supply.

Losing that job does not bother me so much, because the government sends me a check every month. I had planned, when I first heard of this change, of traveling a lot and seeing the world. I had to scuttle those plans when I found I could not get airline reservations. The airlines were not overbooked by people in my situation. They just could not fly because of the lack of fuel. You can still fly, if you need to, but you have to book your flight three months in advance, and it can cost millions of dollars-subject to increase at boarding time. That brings up the issue of inflation.

I have noticed, when I have an opportunity to walk to the store, that the prices of the few items available have increased dramatically. I get an increase in my government stipend every month, but it never seems to keep up with price increases. I have heard that price inflation amounts to 1,000% per month. I have no way to verify that because I get no regular news. I have to rely on rumor.

Someone told me that the central planners have adopted the strategies of the Modern Monetary Theorists. Having government “spend money into the economy,” according to them, will stimulate the economy. I have not seen the results yet. But, what can I do?

I would like to continue, but I have to leave to get to my Chinese language class.

The Chinese have done relatively well in the past ten years. Maybe not adopting their own “green new deal” has something to do with their progress.

Anyway, they allow a few immigrants each year, if they speak and write Chinese. I might get a job there that pays a lot more than my government stipend, or, I might get a job at one of the companies in the U.S. that the Chinese have acquired.

More later,
Roger

I hope Roger does better than this. We can change the future now, if we choose to.

 

The Politics of Socialism

Even if you’re willing to ignore the economic costs, socialism brings a political cost most people — particularly in America — would find unacceptable. Socialism eventually leads to the loss of liberty and tyranny.

In previous posts, I’ve explained the impracticality of socialism as an economic system. We cannot deliver full value to workers when we don’t know the price of the final products, and we can’t separate the contribution of labor versus the contribution of capital. Although I want to focus primarily on economics in this blog, socialism causes a political price that I don’t think most people would be willing to pay.

Central Planning

Having workers own the means of production sounds like a wonderful program. But, have you ever experienced large groups making decisions? When groups get together and try to make decisions in unison, they tend to be impractical and ineffective. The larger the group, the worse the results achieved. So, imagine a nationwide economy depending on all the owners of production making decisions in unison.

Even ardent socialists agree with this picture. They know that having all the members of society deciding together how resources get distributed simply would not work. Socialism, therefore, requires central planning. When initially presented the idea of “central planning” seems quite reasonable and harmless. Why not let the representatives of the workers decide how does distribute resources and work?

Was it Lord Acton who pointed out the problem of corruption that arises from power? Whether the attribution is correct, the observation certainly is. Central planners would discover the benefit of having the power given to them, and they would do their best to increase that power. The end result would be something we’ve seen in most, if not all, socialist countries: absolute tyranny.

But couldn’t this be avoided with a democratic form of government and a socialist economy?

Democratic Socialism

Democracy, as pointed out by Alexis de Tocqueville and Hans Herman Hoppe, has its own set of problems. But, even in the idealized form of democracy, the socialism part of Democratic Socialism would drag the system down.

In the economic system known as socialism the countervailing power of open markets does not exist. Elected officials would have far more power than they would under a democratic government and a market economic system. Since those who have power tend to strive for more, the system would ultimately break down, and some form of tyranny would arise. Look, for example, at the “democratically” elected president of Venezuela. Not working too well.

Socialism, even under a democratically elected form of government, would eventually lead to lost liberty.

Lost Liberty

The Lurking Threat of Socialism

Regardless of the form of government socialism will always lead to a loss of liberty. In the abstract, that may not seem too bad. Most people would give up a certain amount of liberty in exchange for a bit more certainty on the economic front. Who wouldn’t prefer to have education, healthcare, retirement, and other essential economic concerns guaranteed by someone else?

At a more personal level, however, lost liberty would mean, particularly for Americans, the loss of a reasonable lifestyle. How would you like to have someone else to decide what you do for work, where you go to school, what you eat, whether you eat, where you live, who you associate with, and anything else that you control through your own free choice?

Free stuff comes at an extremely high price.

Conclusion

Socialism represents such an outrageously impractical economic system it seems incredible that anyone would suggest it in the first place. But, even in an idealized form, socialism comes at a price that includes a lot more than the loss of economic well-being.

Under any political system, socialism robs you of free choice and your very humanity.

Serious consideration of socialism represents a far greater threat to humanity than climate change, volcanoes, asteroids, or any other natural disaster. For the sake of your economic well being and your personal liberty, reject the concept now.

 

Wage & Price Discovery

Socialists show reluctance to accept deferred payment or agree to absorb any losses. Even before they face those issues, how can they establish what portion of revenues they actually deserve? They cannot determine the price of the end product beforehand, and they cannot separate their real contribution to revenue. They have a real dilemma.

Value and Price of Product

Socialists don’t seem to understand that, even after having the capitalist subsidizes their wages during the production process, the market price for their wages remains unknown. The consumer has the final say on the price of the end product — the pencil. If the product sells for enough that the capitalist can replenish his subsistence fund and more, he will have profited from the risk he took. For the ongoing business, the replenishment of the subsistence fund allows the capitalist to repeat the process, which includes paying workers at every stage of production.

Yes, the capitalist does gain when he accurately estimates the price at which consumers will buy enough of the product to give him a profit. If, on the other hand, the market price — as established by consumers — does not replenish his subsistence fund. The capitalist will suffer a loss — even after workers have received their agreed upon wage.

Because consumers establish the value and price of products, it becomes impossible to, in any way, extrapolate the value of labor until after the sale of the product. Neither the capitalist nor the worker knows the market price of the product until after the sale.

A close up of a piece of paper Description automatically generated

Neither the value nor the price of any capital or labor involved in the production of the product in question can be determined until after a sale. Even then, the value of labor remains a subjective judgment on the parts of the capitalist on the one hand and the worker on the other hand. The capitalist prefers to pay as little as possible, and the worker prefers to get paid as much as possible. The actual wage — or price — results through the process of negotiation between the capitalist and the worker.

But, of all the ingredients that go into the production of a product, how can a person separate the value of labor alone?

Separating Price of Labor

If we assume that the product will sell for the same amount on the next cycle as it did the last, and we further assume the same amounts of capital and labor are used in the production on the next cycle, how can we extrapolate the proportion of that revenue that accrues to labor? If the socialists would only think about it, they would realize that we cannot determine the proportion that goes to labor.

As a socialist so readily point out, capital and labor must operate together to produce products. Either one without the other would produce nothing. Capital and labor represent two elements of a system — a system in which the whole produces more than the sum of the parts.

Because of the systemic nature of production, the contribution of the individual components cannot be determined separately. The person who contributes the most of the productivity of the manufacturing process is the person who designs the process, usually a person who is either a capitalist or works for a capitalist.

The Solution

Socialist face an economic dilemma. To achieve their ends of being paid “what they’re worth,” they must do all of the following:

  1. Defer payment and allow determination of wages until after consumers buy the product.
  2. Agreed to absorb a share of any losses incurred.
  3. Acknowledge that relative contribution to value is unknown and unknowable.
  4. Accept a negotiated wage after the fact.

In other words, for socialists to resolve the dilemmas created by socialism, they must become capitalists.

They should acknowledge the flaws in socialism and give it up as a failed system.

 

Socialism Would Pay Full Value

Socialists want full pay for their work. Would they delay that payment until completion of production? Would they agree to cover any losses after the sale of the product?

I recently view a video in which a student, who proudly identified himself as a socialist, confronted the speaker with the question: Why don’t workers receive payment equal to the full value of their labor contribution? Since capitalists cannot produce anything without labor, does it make sense that the capitalists should receive a premium — or a profit — above the value of labor? Shouldn’t workers receive the full value of their labor?

The question reveals ignorance on the part of questioner about how the system actually works. And, the speaker’s response, although accurate, did not answer the essence of the question.

I will fill in some of that gap.

Structure of Production

To fully understand why laborers do not receive a greater portion of the revenue received for the end product one must have a basic comprehension of the structure of production. The “structure of production” refers to the series of stages through which a product must pass before it becomes ready to offer to the final consumer.

Depending on the complexity of the final product that structure can extend backward through numerous stages and over a long time. The structure of production tends to exhibit far more complexity than most people expect. Whether by intent or not this conversation used pencils as an example, for Leonard E. Read wrote a marvelous piece titled I, Pencil…” in which he described the complex process of bringing an everyday item like a pencil to market.

Capital Investment

Comprehending the structure of production sets the stage for answering the question about worker pay.

Before he can begin the lengthy process required to bring a pencil to market, the capitalist must find a source of capital— which means not money or machinery but necessary resources to sustain the production process until it can offer the product to consumers. Some use the term “subsistence fund” to refer to those resources. To accumulate a subsistence fund someone — the capitalist — must deny himself an amount of current consumption for some time.

Using money as a medium of indirect exchange, the capitalist will transfer portions of the subsistence fund to workers at each stage of production. The workers receive all of their agreed upon wages from the capitalist before he sells the first unit of product — in this case, the first pencil. Before that sale, the investment represents a total loss for the capitalist. The worker has lost nothing; whether satisfied with his wage or not.

Capital Loss

Socialists, demanding the “full value of their labor,” never offer to go without pay during the lengthy production process. Furthermore, they never offer to absorb any losses incurred from the business venture.

They want full value now.

But how does anyone determine that value? I will address that question in my next post.

 

Systems Thinking in Economics

Systems Thinking helps people understand more clearly the complexity of markets.

You will probably hear me make several references to “systems thinking” in the process of explaining free markets. I thought that this post would be a good way to introduce systems thinking and its relevance to economics and free markets. To start off, I want to offer a concise definition of the system:

Definition

  • “A system is an entity which maintains its existence through the mutual interaction of its parts.” by the late Austrian Biologist Ludwig von Bertalanffy.

An accurate description of free markets fits perfectly with this definition. Markets become a unified system through the interaction of individuals making exchanges and not by an elaborate design imposed upon individuals.

As part of an introduction, I have borrowed “The Laws of the Fifth Discipline” from The Fifth Discipline by Peter Senge. I will give each of the eleven “laws” and provide my own description of how they apply to free markets.

  • “Today’s problems come from yesterday’s ‘solutions.’”

The presence of feedbacks represents one of the distinctive characteristics of systems. Many of the processes in systems create information that, when fed back into the system, change the input to the next iteration. Feedback becomes particularly crucial in human systems — i.e., systems that include humans as an element. For example, the system that includes both car and driver provides feedback to the driver so that he knows when to speed up, swerve, or brake.

The solutions that we apply to today’s problems simply shift the problem to a different time or space. The people who inherit the “new problem” frequently don’t recognize it as the return of an old problem.

This explains why many market interventions seem to address problems for which solutions have already been applied.

  • “The harder you push, the harder the system pushes back.”

Because systems contain “compensating feedback,” well-intentioned interventions frequently stimulate responses from the system that offset the benefits of the original interventions.

The higher lawmakers raise minimum wages, the higher the resulting unemployment.

The more lawmakers attempt to regulate segments of the market, the more frequent the occurrence of black markets or illegal activities.

  • “Behavior grows better before it grows worse.”

Any success at overcoming structural influence will only last for a short while. We find simple, “easy,” interventions enticing because they seem to work — in the short term. Then, again, compensating feedback takes over and things get even worse.

Economic stimulus gets people to spend more money. This causes a nominal increase in GDP. It also causes a lack of savings and investment resulting in a cutback in employment and reduced availability of goods in the future.

  • “The easy way out usually leads back in.”

Familiar solutions to apparently similar problems usually keep us mired in the same problem.

Adjusting tax rates to cure the “Social Security” problem eventually leads us back into the difficulty caused by the structure of this unsustainable “Ponzi” scheme.

Making significant structural changes to a poorly designed system will have more effect on eliminating recurring problems than making small changes to processes that only address symptoms.

  • “The cure can be worse than the disease.”

When we don’t account for the feedback from changes we make, we sometimes don’t see the full impact of our actions. Our central banking system increases the money supply to stimulate the seemingly slow economy. The misinformation sent by this artificial cure causes malinvestment, which leads to a depression worse than the apparent, but natural, slow down.

Sometimes the easy, familiar, solutions have no effect. Indeed, sometimes they become addictive and dangerous. By misguiding market players, monetary expansion creates an addictive dependence that eats away at healthy productive investment.

  • “Faster is slower.”

Remember the tortoise and the hare. Systems operate at the pace allowed by their structure. Pushing them too fast will cause delay or breakdown.

In our persistent efforts to create economic growth, we forget that the economy has a natural rate of growth. Rapid rates of business growth, brought on by market intervention, frequently outrun the capability of businesses to generate capital to support that growth. High rates of broader economic growth have the same effect. High rates of consumption eat away at capital growth, which slows future consumption.

  • “Cause and effect are not closely related in time and space.”

People intervening in market systems frequently commit the error of equating proximity of events with cause and effect. Human systems share the fundamental characteristic that cause and effect do not occur closely in time and space. We may not see the results of the actions we take today either in the same time or the same place. What appears like a sound expenditure now, may prove catastrophic when the effect finally reaches the market.

  • “Small changes can produce big results—but the areas of highest leverage are often least obvious.”

Chaos theoreticians speak of the “butterfly effect” in which a butterfly flaps its wings in some distant location causing a local storm in the future. Although this so-called “butterfly effect” serves mostly as a metaphor, it does give a sense of the importance of small events.

Frequently, the most obvious solutions either don’t work or make matters worse. Small, targeted, actions, however, can often produce significant and enduring changes. These high leverage actions do not seem apparent to the participants in the system. A one percentage point increase in the rate of saving might, through increased investment, improve long-term consumption by more than 15 percent.

  • “You can have your cake and eat it too—but not at once.”

Sometimes dilemmas only appear as opposing choices. For example, the false choice between “low cost” and “high-quality.” The short-term cost of higher quality may lead to both lower cost and higher quality in the long run.

The “low cost” bidding process employed by government frequently leads to the early crumbling of vital infrastructure.

  • “Dividing an elephant in half does not produce two elephants.”

As logical as it may seem, dividing a problem into smaller problems seldom works. If you have a big problem, you must treat it as such. You may have to take sequential steps to the solution, but you must coordinate these steps to solve the single problem.

The integrated, holistic, nature of living systems requires that they must remain intact to realize their full benefit. The whole equals more than the sum of its parts.

Governments build their reputations on promising half an elephant as if it were one elephant. Treating government spending and taxation as independent issues amounts to dividing the government interventionist elephant.

  • “There is no blame.”

We tend to blame outside influences. “Systems thinking shows us that there is no outside; that you and the cause of your problems are part of a single system. The cure lies in your relationship with your ‘enemy.’” (Senge page 67.) Don’t blame the people when they do the best they can within the system in which they operate.

When you encounter a surly government employee, remember they work for a system that does not recognize you as the customer. They owe their allegiance to other bureaucrats and politicians, not to you. You have no influence on a system that you do not pay directly.

Conclusion

Many the characteristics of systems seem counterintuitive, until you think about them. Human systems, such as markets, add a higher level of complexity. These systems reflect on the results of their own behavior and adjusted their behavior to achieve different results. In other words, they learn.

Interventionists simply cannot outsmart markets.

Reference

Senge, Peter M., The Fifth Discipline (New York: Doubleday), 1990

 

Disrupting the Money Cycle

Artificial changes in the money supply always disrupt the money cycle and cause price disruptions that lead to production problems in otherwise normally functioning markets.

Introduction

The complexity of large markets makes the diagramming of market processes difficult at best. One must take great care in not overstepping the bounds of logic and systems thinking.

However, occasionally a small diagram can at least trigger questions that need to be asked about the system under discussion. In this article, I will discuss an extremely simple — possibly overly simple — diagram depicting the cycle of money in two markets.

First, I will describe the cycle of money in a free and voluntary market without monetary intervention.

Second, I will give a brief description of the market subject to monetary intervention.

My objective consists of getting you to ask more pertinent questions regarding assumptions about monetary expansion, used by the Federal Reserve system and strongly advocated by the modern monetary theorists.

Free Market

The ridiculously simple diagram that I have provided below should open your thinking to questions about the operation of a free and voluntary market.

In this diagram, I have represented three producers/consumers named Eddy, Joe, and Max. I think you can see already that this does not accurately portray the immense complexity of any market. But, bear with me, and I think this diagram will help me make a significant point.

I have identified the steps in this process by the circled numerals.

  1. Eddy, also the producer of Good1, finds what I refer to as Good0. (The quantity of this Good found by Eddy represents all that exists in the system.) This Good will, in this diagram, come to be accepted as a form of money—a medium of indirect exchange. I have used dollar signs to indicate money, but dynamics applies to any form of money.
  2. Eddy exchanges his newfound money with Joe for Good2, produced by Joe. Eddy consumes all of the Good2 that he has acquired. The cycle can repeat through time as long as Joe produces more Good2 in Eddy as a source for money. I will explain how Eddy gets money in the next few steps.
  3. Joe uses the money that he received in the exchange with Eddy for Good3 produced by Max. Joe consumes all of the Good3 that he acquires. Max now has money that he can use for exchange.
  4. Max exchanges his newly acquired money for Good1, produced by Eddy. Eddy now has money he can use to repeat the cycle, returning to step 2).

This diagram provides a terribly oversimplified model of the daisy chain of events that make up a market system. A real market will consist of billions of the exchanges similar to those depicted in this diagram, all connected in very complex ways.

Despite the oversimplification of the system depicted in this diagram, each individual transaction works precisely the same as a transaction in the real market. One person exchanges money for a Good he values more than the money he gives up. These individual exchanges provide the foundation of a complex system that provides effective price discovery and efficient resource allocation.

Two essential things happen during this cycle. First, the fixed quantity of money, first found by Eddy, has served for three transactions. The system has required no additional money. Second, each transaction has produced an objective money price — the ratio of money given to goods received. This money price will serve to inform the allocation of resources in future cycles.

For the sake of this example, each person in these exchanges requires the Good that he receives for his subsistence. If he does not receive that good, he will perish.

Monetary Intervention

I have modified the diagram given in the free-market example to demonstrate the effects of monetary intervention. The steps are very much the same as in the first example with one significant difference in step one.

  1. Instead of finding a Good that he can use as money, the government gives Eddy the money he needs to purchase the goods he requires. Eddy produces nothing. (Create your own reason why Eddy produces nothing to trade. Maybe he likes being on the dole.)
  2. Eddy makes the same exchange with Joe and consumes the Good that he receives.
  3. Joe makes the same exchange described above with Max and also consumes all of the Good that he receives.

Max now has all the money he requires to buy Good1 that he requires for subsistence. But, no one in this system now produces Good1 and Max perishes.

With the absence of Max, no Good3 exists to provide subsistence for Joe, who also perishes. With the demise of Joe, Eddy gets no Good2, and he also perishes.

Thus, with the injection of new money into the system, for the purpose of keeping it going, the process has reversed itself and the system has died.

Conclusion

I’m sure that you can see that I have left a number of factors out of this discussion to make it as simple as possible. For example, I have not addressed the effect of rising money prices caused by the addition of new money. And, I have not taken this example to any level of reasonable complexity.

I have created this example the sole purpose of raising one fundamental question: what happens when no one produces any Good to acquire the money that enters the system—regardless of source?

Very complex systems, unlike my oversimplified example, can absorb a large quantity of artificially created money before this question becomes significant. But, at some point, the system responds to this unanswered question.

In the case of the real estate crash that occurred in 2008, it had taken from 45 to 50 years for the money artificially funneled into real estate to wreak havoc on the market. The advocates of MMT want to create a perpetual hole in the production cycle through the artificial expansion of money that they propose.

Watch out for the free lunch. It could cost you everything.

 

The Dangers of Modern Monetary Theory

At the core of Modern Monetary Theory (MMT) lies the implicit premise that the acquisition of money represents an end of itself. MMT bases its argument on what some people refer to as a “missing premise.” They present a proposition that contains an unstated premise that they assume everyone accepts. Give people more money, created out of nothing, and their spending will increase economic activity.

Although this premise seems quite appealing to many people, it contains a flaw that invalidates the entire theory.

Introduction

I first encountered MMT several years ago on one of the social media platforms. The people involved seemed almost fanatical about the idea, but I found it lacking logical consistency. For that reason, I thought the whole idea would die a natural death.

Recently, almost by accident, I have encountered several new references to MMT. This seeming resurgence may have occurred because one of the economic advisors for Bernie Sanders strongly advocates for MMT. In addition, I think that the rise in popularity in socialist ideas has given new vigor the conversation about MMT. People seem to like the idea — advocated by MMT — that you can receive things at no cost, e.g., medical care, schooling, retirement, etc.

I hope to point out, in this post, some of the weaknesses in the argument for MMT. To accomplish this, I would like to address just a few basic premises that the advocates of MMT either ignore or misunderstand.

  • They seem ignorant of the role of money as a medium of indirect exchange.
  • Demand does not exist in the aggregate or without the prior production of goods.
  • Double entry bookkeeping proves nothing about the results of expanding the money supply.

I cannot make exhaustive comments in the space that I have allotted myself. I only want to open your thought to some of the unanswered questions left by advocates of MMT.

The Role of Money

If you consult almost any textbook on economic theory, the author will describe money as a “medium of exchange.” This phrase, although accurate, does not explicitly portray the real role of money. Money actually acts as a medium of indirect exchange. Ignoring the importance of this fact brings MMT to its knees (as it does any theory about monetary manipulation adhered to by the Federal Reserve).

Any good that somebody exchanges for another good acts as a medium of exchange. The important distinction comes in identifying mediums of indirect exchange. With an indirect exchange, one party accepts a good for the purpose of exchanging it a second time for yet another good. That good has little or no value to them without the possibility of exchanging it for the third good. A medium of indirect exchange simply facilitates an otherwise goods-for-goods exchange. One must understand this distinction to comprehend the role of money clearly.

The single role of money consists of its use as a medium of indirect exchange. Unlike other goods, it never gets exchanged for the purpose of consumption. For that reason, the system requires no change in the quantity of money. It only requires, to accommodate declining money prices, that whatever good (or claim on that good) used for money can be divided almost indefinitely. The government or the banking system need not increase the quantity of money—for any reason.

In a market system, with goods prices based on money, the relationship of the goods-for-goods prices become distorted when the quantity of money changes arbitrarily. This price distortion forms the basis for economic malinvestment and boom and bust cycles, which wreak significant havoc on economic activity.

MMT (along with the Federal Reserve) ignore the critical importance of the real role of money. The ignorant use of monetary expansion leads to the economic boom and bust cycles addressed by the Austrian Business Cycle Theory.

Aggregate Demand

MMT relies to a significant degree on the concept of “aggregate demand.” This idea, popularized by John Maynard Keynes, claims that the government should stimulate an economy by doing something to increase aggregate demand. The idea of aggregate demand, however, represents a pure fantasy.

First, demand cannot exist without prior production. In the goods-for-goods exchanges facilitated by media of indirect exchange, some good must be given up in the acquisition of money. Without that good being given up, a reduction in the overall goods and services occurs. With the introduction of artificially created money, some traders find they have exchanged something for nothing. (For more insight, refer to “Increasing Demand Won’t Make the Economy Grow” by Frank Shostak.)

Providing money for nothing means that eventually, some buyer discovers that sufficient goods do not exist to complete transactions. But, we cannot know specifically what goods the economy lacks. Which leads to the second problem with aggregate demand.

Second, one cannot aggregate, or sum, the demand for a multitude of separate goods. You cannot add five chickens, two iPads, four Chevy Volts, etc. and derive a meaningful total. Summing the dollars exchanged in an economy gives no real information about the sum and substance of the goods exchanged.

Double Entry Bookkeeping

MMT advocates make a big deal about the importance of double entry bookkeeping and balance sheets. One person’s spending does indeed represent another person’s income. This tautological statement proves nothing regarding the validity of the argument for expanding the money supply to “stimulate demand.” It only means that in a double entry bookkeeping system debits and credits must always equal.

Since the entries in bookkeeping systems reflect quantities of money (both debits and credits), this only means that when somebody gives up money for a particular good, they record (as a debit) the amount of money given up. They do not record the quantity, or the characteristics, of the thing acquired.

Remember that money denominated double entry bookkeeping does not reveal what goods, if any, were given up to acquire that money. Although the books may balance, if the money used in the underlying transaction has been created ex nihilo (out of nothing), the transaction represents a fraud somewhere in the system.

Conclusion

The increasing popularity the socialism, and socialist politicians, leads me to believe that MMT presents a real danger. The danger lies in its appeal to people’s desire to get something for nothing. Socialism by itself cannot allocate economic resources effectively and efficiently. The implementation of what I would describe as a “free money policy” would only add to the misallocation of resources caused by the administration of a socialist system.

People need to learn the valid propositions behind sound money. We live in an environment in which people accept monetary expansion as a natural phenomenon. Artificial monetary expansion represents a stealthy form of violent intervention—it dilutes the purchasing power of personal property. Despite the problems with our current monetary system (also based monetary expansion), the system could be worse. The implementation of monetary policy based on Modern Monetary Theory would undoubtedly be worse than what we already have.

 

Linguistic Revision

The language used by economists confuses many people—including themselves. Imprecise usage of words and phrases leads to poor communication and flawed thinking. Test the meaning of everything you hear or read about economics and free markets.

I have lifted the title of this post from the title of a chapter in Science and Sanity by Alfred Korzybski. Korzybski deserves credit for establishing the discipline referred to as General Semantics. I may refer to General Semantics in future posts. General Semantics might be described as a discipline that studies the effect of language on human behavior. Korzybski talks about how changes in language can change people’s behavior and some parts of our language require change in order to stimulate new and more effective the behavior.

Korzybski refers to three important thinkers who have influenced our thinking through the ages and continue to today: Aristotle, Euclid, and Newton. The words that we use to describe the thinking of these three mental giants tend to lead us to linear, cause-and-effect, thinking. Korzybski advocates that based on the new knowledge about our world that we need to shift our language to reflect non-Aristotelian, non-Euclidean, and non-Newtonian, thinking. We now live in a world in which A is not always A, straight lines only exist in concept, and gravity no longer acts instantaneously over distance.

The language used in economics and the description of free markets still reflects the old linear, cause-and-effect, thinking. We need to learn how to use language more accurately in order to reflect the reality of the human systems we call markets.

Out of the many words used in economic lexicon I have chosen four to demonstrate how their usage can frequently confuse people’s understanding.

Value

Readers of my blog know that I make frequent references to value. I do so because it lies at the core of economic thinking.

Commonly economists refer to value as something that a person can measure, record, and calculate. The scientific use of value coincides with this meaning.

Economics, however, refers to human systems in which the word value takes on an entirely different meaning. In that context it becomes a subjective judgment limited to the mind of the individual. We cannot measure or calculate value. We can only measure human action based on value.

Demand

The word demand, in popular usage, has several different meanings. Economists make that meaning only slightly more precise, and in some cases totally confusing. In many cases they give the impression that the existence of more people creates more demand. They also described demand as something that can be plotted on a diagram to which suppliers will respond.

Demand only exists when a person brings something of value (to the other party) and offers it in exchange. Without something to exchange demand cannot exist. In addition, the notion that demand can be plotted ex-ante is almost ridiculous. Ask two people who just completed an exchange what the demand curve looked like before they made the exchange.

Aggregate

The word aggregate frequently appears in economic writing and conversation. Frequently economists refer to aggregate demand, aggregate income, or aggregate employment. The term conveys the underlying assumption that these generalized concepts can be summed in some meaningful way.

Summing individual demand, individual income, or individual employment, amounts to a mathematical or logical impossibility. The idea that we can add these things defies logic and insults the importance of individual responsibility and decision.

Inflation

If you look up the term “inflation” in an economics textbook or dictionary, you will usually find it defined as a general rise in prices. When economists start discussing the causes of these general rises in prices, they refer to things like wage inflation, consumer price inflation, or other types of price inflation.

A rise in the general price level (meaning a generalized increase in the prices of individual products) can, in fact, occur. But, the cause has only a single source: monetary expansion. Without an expansion of the money supply, when the price of one good goes up, the price of some other good or goods must go down.

Rising prices caused by monetary expansion create a distortion in the information flow transmitted by the mechanism of prices.

Interest

The concept of interest confuses a lot of people, including those involved in financial transactions. The traditional concept of interest relies on the relative productivity of capital. The productivity of capital does have an influence, but this really confuses the issue. It makes it a little hard to explain interest charged for the purchase of consumer items.

A simpler and more straightforward explanation of interest deals with time preferences. A good in the present always has more value than the very same good in the future. Thus, in order to entice a person to exchange a current good for a future good, a greater quantity of the future good must be offered. Interest consists of the difference between the amount of the current good and the amount of the future good in an exchange.

The reader should note that the amount of interest, and the interest rate, depend on the two independent variables involved in the exchange. No one can change interest rates independent of those two variables. The Fed, for example, cannot control interest rates.

Conclusion

Practitioners of the hard science have the luxury of creating new language to describe their principles and theories. After all, who do cosmologists speak to other than other cosmologists. Economists, on the other hand, do not have that luxury. They talk to other humans about human activities. Yet, they need to promote certain level of precision in the language they use.

When you listen to, or read, the words of an economist take care not to interpret what they say based on the normal meaning of those words. Do they give the same meaning to these words that you do? And, possibly more importantly, do they introduce a certain level of inconsistency into their own thinking by using the common meaning of the words?

I can’t expect to cause linguistic revision just by pointing out a few words that I call into question. But I would hope to encourage readers to question the words that people use in describing free markets. Do they really mean what you think they mean? Do they really make sense?

 

In closing, consider these two phrases:

Innocent until proven guilty.
Innocent unless proven guilty.

Which words would you use?