The common wisdom is that deflation of the currency is bad. When money deflates, it becomes more valuable, even when you do nothing. So the theory is that people won’t spend their money, because it will become ever-more valuable.

That theory cannot be true.

Look at the PC market over the last 30 years. In each one of those years, the PC became more reliable, faster, came with more memory and storage. The original MDA display was one color and text only. The CGA had 16 colors and 640×200 bits. The price — of the computer you really want to have — has stayed constant, at about $5000.

If the story told about deflation was true, then you would always be better off delaying your purchase of a PC by 6 months. You could be confident that the PC you would buy would be a more valuable PC.

Except … that people did that very rarely, if ever. The standard advice was always “don’t wait to buy a computer, because there will always be a better computer on the horizon.”

So, in a situation where people can predict a constant stream of increase in value, people STILL made the trade. Thus, I think it’s safe to predict that in a similar situation, where people could predict a constant increase in the value of their money, they would spend their money as needed.

Related posts:

1. Inflation, Deflation, Recession
2. Deflation and Helicopter Ben: the U.S. economy on the line
3. The mystery of inflation, deflation and printing money

Related posts:

1. Readings for This Week
2. To what extent are perceptions of freedom based on objective factors?

Instead, it is actually true that demand created its own supply, like the “supply” of new “neighbors” at the storage place are demanding (“demand”) that I get that stinking, festering fecal mess out of there or they are going to sue me or something, to which I said “Great! I’ll pay you off with some of these ashtrays, which will make wonderful gifts for your friends and family!”

I bring this up not, as is often rumored, as a last minute appeal to you, the American consumer, to buy a bunch of these dog-poo ashtrays with their “keepsake quality”, and take them off my, literally, stinking hands, but to show you that one of the reasons why the economy is doing badly is that the latest unemployment numbers are Bad News Aplenty (BNA), as people do not buy as much stuff (demand) when they don’t make as much as much money, and the people who make stuff (supply) are then laid off, proving, once again, that supply follows demand.

And, since we are talking about it, people are not buying as much stuff, which I cleverly conclude from the fact that consumer installment debt has been going down since September 2008 as the American consumer is gradually, slowly, ever so slowly, almost glacially, paying down some of their super-sized, staggering $2.5 trillion in consumer installment debt.

How much? Consumers have, in a year and a half, paid down a measly $135 billion! Hahaha!

At this rate, one wonders, at 20% interest on the unpaid balance, how many freaking lifetimes will it take just for consumers to pay off their $2.5 trillion in existing debt, which doesn’t even count the debt they are going to incur in the future, just trying to buy the basics, as the inflation in prices from the insane inflation in the money supply makes things so costly that they get to the choice of debt or starvation, and even then, most people will buy food instead of gold, silver and oil.

Hoping to gently motivate them, and to provide the apparently necessary motivation delivered in a non-threatening, person-centric, positive way, I say, “Hey! You could stand to lose a few pounds there, chubby! Stop eating for a couple of days and use the ‘found’ money to buy yourself some gold, silver and oil, you moron!” but even then, they always act upset, like I said something wrong! See the kind of stupid crap I have to put up with around here all the damned time?

Anyway, their only hope is that everything survives a massive inflation, so that $135 billion dollars is, in terms of buying power, less than a week’s average minimum wage or something like that! Hahaha! Problem solved! Hahahaha!

In case you were curious, I put a lot of it down to the unholy combination of moronic do-gooders trying to save my life and greedy governments trying to drain my blood, as they, all over the place, raised cigarette taxes by several dollars per pack, so that the quarter of adults (54 million) who smoke a theoretical carton a week, have $40, $50, $60 sometimes more than $70 a week less money to spend on everything else, which comes to, at an average of $6 per pack, $3.24 billion per week, or a tidy $168 billion a year in lost spending power!

In short, tobacco addicts stopped buying other things so as to afford one thing that has become so expensive.

If they were smart, smokers would be spending their money on gold, silver and oil, waiting a little while until their prices soar as the government deficit-spends the massive, monstrous amounts of money that the Federal Reserve creates, and THEN taking up smoking when they could easily afford cigarettes at any price, the higher price for insurance, and the needed medical treatments, also at any price!

It’s enough to make you say, “Whee! This investing stuff is easy!”

Consumer Debt and the Supply-Demand Dynamic originally appeared in the Daily Reckoning.

Related posts:

1. Supply, Demand and Price
2. True Fiscal Insanity: Creating Money to Buy Government Debt
3. Gold and Silver Supply: Get Some While You Can

By late 1919, America was facing inflation in prices as measured by CPI of 20%.  Between 1920 and 1921, unemployment doubled from 5.2 to 11.7%.  During this same period, from their peak in June of 1920, prices declined by 15.8% on a year-over-year basis, a 50% greater deflation in prices than during ANY 12-month period during the Great Depression.  So what was Harding’s proposal to deal with this mess? To understand how to get out of recession, Harding looked towards how we got into it in the first place.

For America was coming out of World War I.  Government was controlling huge swaths of the economy, as it had mobilized land, labor and capital towards war production and away from normal commerce as dictated by consumer demand.  In addition to the mass of resources that needed to be reallocated according to market forces, the economy had been further distorted due to the policies of the Federal Reserve which had inflated the money supply by 71% from 1913-1919 (while the physical volume of business had only increased by 9.6%), and whose policies had led to an increase in prices of a staggering 234% between 1914 and 1920.  Prices needed to readjust according to the reallocation of resources.  In addition, not surprisingly, due to the costs of war, the federal budget had grown to $18.5bn.

One will note the parallels to our economic situation today.  Just as war led resources to be allocated away from where an unfettered economy would have directed them, so too did the artificial boom fueled by the Federal Reserve and various government policies lead resources to be misallocated towards assets such as houses and stocks during our most recent boom and bust cycle.  While unsustainable businesses and concomitant rises in prices developed in the private sector, the government too drastically increased.

Harding understood the root cause of recession.  As he noted in his inaugural address:

The economic mechanism is intricate and its parts interdependent, and has suffered the shocks and jars incident to abnormal demands, credit inflations, and price upheavals. The normal balances have been impaired, the channels of distribution have been clogged, the relations of labor and management have been strained. We must seek the readjustment with care and courage…All the penalties will not be light, nor evenly distributed. There is no way of making them so. There is no instant step from disorder to order. We must face a condition of grim reality, charge off our losses and start afresh. It is the oldest lesson of civilization.

And so what was his big Keynesian stimulus plan to bring the economy back from the abyss?  He argued during his Republican nomination speech:

Gross expansion of currency and credit have depreciated the dollar just as expansion and inflation have discredited the coins of the world. We inflated in haste, we must deflate in deliberation. We debased the dollar in reckless finance, we must restore in honesty. Deflation on the one hand and restoration of the 100-cent dollar on the other ought to have begun on the day after the armistice, but plans were lacking or courage failed. The unpreparedness for peace was little less costly than unpreparedness for war. We can promise no one remedy which will cure an ill of such wide proportions, but we do pledge that earnest and consistent attack which the party platform covenants. We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican capacity. We promise that relief which will attend the halting of waste and extravagance, and the renewal of the practice of public economy, not alone because it will relieve tax burdens, but because it will be an example to stimulate thrift and economy in private life.

And so, shockingly Harding practiced what he preached.  Regarding deflation, the Federal Reserve jacked up interest rates from 4.75% in January 1920 to 7% in June 1920, and held this rate through the aforementioned major drop in prices through May of 1921.  Harding slashed the federal budget from $18.5bn in 1919 to $6.4bn in 1920 all the way down to $5.1bn in 1921.  Meanwhile, the government actually ran surpluses during these years, allowing them to pay down the debt by $300mm from 1920-21.  The Chief Economist of Chase National Bank of the era, Benjamin Anderson summed Harding’s philosophy and his attack on the recession as follows:

The idea that a balanced budget with vast pump-priming government expenditure is a necessary means of getting out of a depression received no consideration at all. It was not regarded as the function of the government to provide money to make business activity. It was rather the business of the US Treasury to look after the solvency of the government, and the most important relief that the government felt that it could afford to business was to reduce as much as possible the amount of government expenditure, which had risen to great heights during the war; to reduce taxes—but not much; and to reduce public debt.

Nor did the government increase public employment with a view to taking up idle labor. There was a reduction in the army and navy in the course of these years, and there was a steady decline in the number of civilian employees of the federal government. This policy on the part of the government generated, of course, a great confidence in the credit of the government, and the strength of the gold dollar was taken for granted. The credit of the government and confidence in the currency are basic foundations for general business confidence. The relief to business through reduced taxes was extremely helpful.

According to Anderson, how did the recession end?

…we took our losses, we readjusted our financial structure, we endured our depression and in August 1921 we started up again. The rally in business production and employment that started in August 1921 was soundly based on a drastic cleaning up of credit weakness, a drastic reduction in the costs of production, and on the free play of private enterprise. It was not based on governmental policy designed to make business good.  (See Benjamin Anderson’s Economics and the Public Welfare or his gratis “The Return to Normal“)

Now we can debate fiscal and economic policy all day, but across the spectrum, it should be clear to all that a government that intervened and created the conditions for economic crisis will not be able to solve it.  If government’s can create prosperity when the private sector is imperiled, then why would Americans be against government central planning when all is rosy?  Do the rules of economics not apply during downturns?

If we can agree that recessions are the result of resources being improperly allocated, then we can also agree that the only way to return to economic health is to allow for their reallocation according to the market.  This involves allowing nonproductive business ventures to go belly-up, prices to naturally fall where they have unjustifiably risen and reduction in the size of government allowing resources to be released to entrepreneurs to reverse the ills of the artificial boom and spur growth.  All measures that impede the natural cleansing of an economy will only ensure pain and suffering like that witnessed over the last few decades in Japan.  Harding had things right and it would do our lawmakers good to follow his lesson: central planning and government control creates problems; innovative Americans are the only ones who can solve them.

Related posts:

1. The Recession of 1920 – Causes, Responses and Insights
2. Gold And The Oil Majors Revisited
3. Warren Buffet’s Appeal to Our Dead Consumer Culture: ‘Buy American’

Question: History reveals that every international crisis leaves a lasting mark on the world, once the crisis is over and the difficulties it brought have been encountered, things tend to change. Similarly, do you think that the current global economic crisis must lead to a fundamental reassessment of how power and influence is expressed through the world?

I belive that the current financial crisis have accentuated what we already knew and what has been present in the data and the discourse for some time. Specifically I am talking about the idea that big emerging markets such as India, Brazil, China, Indonesia, Chile, Turkey etc have slowly but steadily taken over as the global powerhouses in terms of economic growth and thus it is also natural that they are gunning for more political and institutional power. When it comes to financial crises in particular the latest batch of proposals from the Obama administration to regulate the financial industry is another and more micro oriented theme which is a recurring event in the context of economic crises. Crises are often, in this way, catalysts for abrupt discrete changes in the economic and political environment.

Ultimately then I think that this fundamental reassessment of power and influence in the world (both politically and economically) have not been initiated by this crisis but it may be reinforced.

Question: As the Great Depression paved the way to World War II and to a new world order, how far the present crisis produce grave repercussions on the global economic order?

This intimately depends on how you define world order naturally. If I have to point towards the most enduring change which appears to have come on the back on this crisis it is the attitude to debt and long term sustainability of public finances. Those of us who have been interested in demographics and its effect on macroeconomic processes have long been waiting for (and predicting) the inflection point where the mismatch between expensive welfare systems and the increasingly broken demographic structure as as result of persistently below replacement fertility. In this way, the ability to take on debt today as a liability for the future and despite the theatricals on sovereign spreads and CDS on Greek and Spanish government debt, are in fact fundamentally driven by long term liability problems. For an excellent excursion into this topic in the context of Australia/New Zealand and beyond I warmly recommend this one by John Hempton.

Extrapolating to the idea of a new economic order this brings us into a fundamental dilemma. With every part of the national identity overlevered [1] and in need to rebuild their balance sheet most economies are looking to the last part of the identity to make up for the shortfall of savings; the external balance. The problem is that not everyone can export excess savings (i.e. run a current account surplus) at the same time. In my opinion this is where the big new emerging economies come in and despite by personal skepticism towards China pulling the world anywhere it remains obvious that those who can reasonably be expected to run sustainable net external borrowing positions (i.e. current account deficits) are exactly those economies mentioned above who are about to ascend as the new drivers of economic growth. If they don’t, it is not easy to see where the growth is going to come from.

Question: The world financial crisis has been a defining moment in the ascension of emerging economies onto the international economic stage. Please comment.

Not really. In my opinion this goes back to the idea of decoupling from the US economy and how, before the crisis, many observers had their hopes pinned on the Eurozone (and the Euro) as well as Japan (and the JPY) to take over the baton from the US economy in steering forward global demand. In the context of Bretton Woods II this seemed a turkey shoot of an argument. Just de-peg from the US dollar and re-peg to the Euro and it is all engines go. Obviously, this was always going to be a mirage and essentially a smoke screen puffed up by those who have a fundamental desire to see the US economy fail and cave in on itself. So, why this detour in answering the question above?

Well, quite simply, the world “decoupled” for the US and indeed the advanced (G7) economies a long time ago.

From 1980 to 2008 the share of total world GDP made up by G7 economies declined from 51.33% to 42% and the corresponding figure for newly industrialised Asian economies rose from 7.17% to 21% and according to IMF this trend is set to continue. This is the real decoupling and it represents a major structural change in the global economy which goes far beyond the current financial and economic turmoil. Whether there will be anything particularly defining about the role of emerging economies as a result of the financial crisis is too early to say. A sovereing default in Greece or elsewhere in the Eurozone should increasingly make investors aware that global risk is not primarily present in emerging markets but actually right at the heart of the G7 and OECD edifice. Perhaps this will be a definining moment, but the general ascend of big emerging economies to the center of the world stage is not a product of the current turmoil.

Question: To what extent will emerging economies remain the drivers of global economic growth in 2010?

To a very large extent I would argue. In 2010 the IMF estimates (in their October 2009 Outlook) that the world economy will resume growing at an annual rate of 3.1% after having contracted by -1.06% in 2009. Breaking this up on the major advanced economies (G7) and developing and emerging economies the IMF estimates that the former will grow by 1.7% and the latter by 5.1% in 2010. Yet this difference does not tell the whole story. Consider then the fact that measured in US dollars (current prices) the share of world GDP made up by the G7 as well as the emerging and developing economies was 53.8% and 30.7% respectively. Yet still, and out of a total estimated value of 2010 world GDP growth at trn 3.267 USD the G7 is expected to contribute to this with only trn 1135 USD while emerging and developing economies are expected to contribute with trn 1674 USD.

More generally, this is a tendency we should expect to continue. Consequently and while global GDP forecasts into 2014 are quite fickle, forecasts by the IMF has the current price value of total world output (in USD) rising from trn 60.429 USD in 2010 to trn 74.660 USD in 2014. Out of these trn 14.165 USD, the G7 and the emerging and developed world are expected to contribute with trn 4886 USD and trn 7871 USD respectively.

In this way and I hope that my readers will forgive me the excessive arithemetic; if we take the IMF’s forecast to heart, emerging markets are definitely going to be the main drivers of global headline GDP growth in 2010 and beyond.

Question: As the evolving international order is going to be Asia centered and polycentric for a variety of reasons. Do you think that India is ready to play a larger role to ensure stability, security and peace in the world?

I sure hope so. A lot of the future stake of the global economy is pinned on India, China, Brazil, etc to develop and evolve both politically and economically. India already plays a very big role in the global economy, but is somewhat dwarfed (in terms of attention at least) by China. However, I believe this will change. Despite some well described and severe issues with a growing gender gap (which is also an issue in China) India is set to enjoy a much more stable and slow demographic transition into old age than China who will age very quickly due to its one child policy.

In this sense I forsee that India will slowly but surely take over from China as the big global emerging economy powerhouse. However, and beyond the obvious political responsibility this entails it also comes with an economic ditto. Thus, one of the biggest problems with China is that she will never be able to run a respectable external deficit that would resolve and alleviate global macroeconomic imbalances. A deliberate mercantilist policy and the effects of the one child policy which strips the economy of the capacity to suck up its own (let alone foreign) savings are two crucial factors here. In my opinion we have one shot to correct these global imbalance and much will hinge upon India (and the rest of the emerging pack) here. Specifically, India must ensure that the demographic transition is kept in check from below as well as, currently, from above. By this I mean that Indian must ensure that it does not fall into a fertility trap with total fertility rates lingering below 1.5 children per woman. Secondly, India should shy away from mercantilist policy. Standard economic theory tells us that external borrowing is not an ill if matched by a sound and long term oriented investment policy as well as capacity in the economy proxied by a large share of young to mature workers out of the total population.

Especially the argument on preventing fertility to fall too far and too rapidly is quite politically incorret at the current juncture with climate and overpopulation (still) dominating the discourse. However, it is crucial in my opinion that we are able to differentiate the debate to look at both sides of this coin. Otherwise, India and the rest of us will regre it.

—

[1] – (investments, consumption and the government)

Related posts:

1. Protecting yourself from World War III: Debtors vs Creditors
2. The System of the World (Part II)
3. We Grow Enough Food to Feed Everyone in This World, So Why Don’t We? (Part 1)

During the first part of his discussion, he spoke to his encounters with a variety of notable economists including Milton Friedman, Murray Rothbard, Ludwig von Mises and Gary Becker amongst others.  With his characteristic Brooklyn sense of humor, Block had the audience laughing as he recounted stories like that of his defense of his dissertation on rent control against one of his judges, a rent control commissioner, and his meeting with Nathaniel Branden and Ayn Rand back when he was a rabid young socialist and subsequent conversion to libertarianism.

He then dealt with more substantive issues across the spectrum of political economy with aplomb.  Block tackled the mainstream economists’ failures in their dealing with welfare economics, in which as Block argues there is a lack of recognition of each individual’s unique subjective utility with regard to various products proving amongst other reasons why marginal utility as justification for wealth redistribution fails, and in dealing with the absurdity of antitrust laws that are either used to prosecute companies for evil price gouging, ruthless undercutting or dastardly collusion.

Block also tackled fractional-reserve banking.  Now we can all agree that fractional-reserve banking is an evil and fraudulent system that is the principle mechanism for inflating the money supply.  However, my view had been that if two parties agreed to a contract that allowed demand deposits to be lent out, this was fine as both parties did so at their own risk.  Block argues that two parties agreeing to a contract based upon fractional reserve proves illegitimate because a contract has to be consonant with property rights.  In Block’s view, fractional reserve creates a system where multiple titles are given to a single piece of property (money); the obligations to the parties are greater than the assets involved, so the system is thus not Kosher.

Block also tackled social issues such as immigration, where he made a couple of interesting arguments.  First, he rightly pointed out that those who wish to restrict immigration because of the belief that immigrants would take advantage of the welfare state were dealing with the symptoms rather than the root cause of the problem which is the welfare state.  Second, he argued that being against immigration meant being against babies, since they both represent new additions to the population.  I would differ with Block in that I don’t believe babies born into a certain society are equivalent in their socialization to those coming from societies with differing values.  This is not to say I am against legal immigration, but that I do not believe newborns and immigrants are necessarily equivalent in terms of their effect on society.  I also have not sufficiently examined my immigration views with respect to defense.  If a certain group clearly poses an existential threat to your society, then should you invite them over the border and deal with them only when mass murder has been committed?  This may be dealing with a symptom of immigration rather than a root cause of the militancy of a foreigner or group of foreigners, but nevertheless these issues amongst many others must be reconciled.

He also argued against intellectual property, as in Block’s eyes ideas are not scarce and can’t be owned.  The argument goes that if ideas were property, then one would not be able to speak because someone else would have laid claim to each word.  Again, IP is an issue which I have yet to study enough to firmly pick a side on, but at face value to me the issue seems to deal on the one hand with incentivizing people to produce things (by granting them a monopoly right to that product for a limited time), and on the other trying to ensure a free market in which competition amongst producers is robust, driving down costs while increasing quality for the consumer.  I know the Boldrin book addresses a variety of discoveries that occurred without the incentive of a patent or copyright, but again I have not settled on this issue.

Block also put forth the view that man is not naturally predisposed towards liberty because while he initially developed explicit cooperation in helping out his fellow hunter-gatherers, he was never hardwired for implicit cooperation through the price system of the market.  The argument goes that this spontaneous system coordinating the wants of individuals is foreign to us inherently because back in the days of hunting and gathering, we were not dealing with voluntary transactions with people from all over the world.  We simply worked together in small traveling groups.  To this argument, he also added that the ruling class has brainwashed the people and quashed perceived “radical” voices like that of Ron Paul.  I don’t believe these reasons are sufficient to explain why collective tyranny continues to trump individual liberty, especially when many people support legalized plunder because they benefit from it, and because there are certain Judeo-Christian values some construe as supporting socialism, amongst many other reasons.

Finally, Block addressed one of my questions on the private provision of defense.  Since I find the defense as private insurance companies argument interesting, I asked Block what happens if one’s enemies buy out their defense company.  Block admitted there would be a problem here, but made the case that a government military could be bought out by enemies as well.  This was a fair though in my view somewhat tenuous response, and there are numerous other arguments as a practical matter that can be made against private defense.  Briefly, in my view, defense is not about economic efficiency, but defending a group of people with common values.  And too, in our society we have allowed for the proliferation of private defense forces to assist our public defense — in other words we allow our military to yield the benefits of free market institutions.  I believe that defense and the courts are the proper realms of government, problem-riddled as they may be.  I believe in our Constitution when read in its plain language.  To expound upon this debate will be left for another occasion.

Overall, Block’s arguments were welcome banter for this writer so infrequently exposed to anarcho-capitalist ideas promulgated by a real person in the flesh.  The evening made for great entertainment and deep reflection on a plethora of issues.  It was a pleasure to hear Professor Block’s unique perspective on the world.  To be exposed to radical arguments on either side of the issues certainly helps one to check one’s principles and grow intellectually.  Without challenges to our beliefs and constant intellectual criticism, we become complacent.  Luckily, as I have found on my intellectual journey of the past few years, the libertarian community keeps its members constantly on their toes.

Related posts:

1. Distributism: A New Economic Philosophy for the Post-Crisis Age?
2. “Privatize The Roads!” Says PhD Economist
3. Why Immigration Laws Don’t Stop Illegal Workers from Entering U.S.

The real convergence is a complex mathematical and empirical issue, so I will rather outline the key patterns of GDP per capita gap between the U.S and Europe and the economic explanation of it. I downloaded the data from the IMF and composed a graph which shows the GDP per capita (PPP-adjusted) in European countries as a percentage of the U.S GDP per capita. Switzerland is the only European country whose level of GDP per capita is more than 90 percent of the U.S level. Ireland, where the output contracted by 7.5 percent in 2009 (link), was once the poorest country in the European Union. Today, its GDP per capita reached 85 percent of the U.S level. In spite of the notorious advantages of the Nordic model, the GDP per capita level of all Nordic countries (excluding Norway), is below 80 percent of the U.S level. The UK GDP per capita is also far below the U.S level (75 percent). The levels of GDP per capita of the less developed countries in European Union (Slovenia, Greece, Portugal, Czech Republic and Slovakia) are all below 62 percent of the U.S level.

Source: IMF, World Economic Outlook

The basic economic question is the length of the gap between the U.S and European countries. To answer the question, we have to set certain assumptions. So, let’s assume that the U.S output will increase by 2 percent in the long run. The economic theory would predict faster growth of less developed countries, since countries with lower levels of standard of living (GDP per capita) tend to follow-up the countries with higher GDP per capita. In economic literature, that is the so-called “catch-up effect”. So, what would happen if the UK economy increased by 3.5 percent in the long run. A quick estimate shows that the time gap between the UK and US is 19 years. So, what happens of the US economy increases by 2 percent in each of the next year while, at the same time, the UK GDP per capita is 75 percent of the U.S level? A fairly quick estimate shows that, if the UK GDP per capita will reach the U.S level in 10 years (although an unlikely scenario), the UK GDP per capita would have to increase by 4.9 percent each year to catch-up the U.S level of GDP per capita. If France’s GDP per capita reached the U.S level in 10 years (assuming 2 percent growth in U.S GDP per capita), it would have to increase the economic growth to 5.3 percent in each of the next 10 years. If the convergence objective is set at 20 years, the French economy would still have to grow at the annual rate higher than 3 percent.

The main question is why the European countries are still behind the U.S level of GDP per capita? There are, of course, many plausible explanations. As far as the GDP per capita is concerned, the difference in the level and growth of productivity is the most important figure in setting conclusions. After all, in the long run, productivity determines the standard of living across countries.

First, the European disease is mostly the result of high tax burden. High tax rates diminished the incentives to work, since each additional hour of labor reduced worker’s marginal productivity. Hence, as professor Mankiw explains, the rise of European leisure (link) is mostly the result of fewer working hours. In addition, early retirement is a common phenomena across Europe. By 2030, each worker will support one retired individual in Germany. The coming of Europe’s pension crisis (link) is a consequence of generous PAYG pension systems. Lower employment-to-population ratio led to higher tax rates to finance the financial liabilities for the retired. In addition, high government spending and periodic budget deficits discouraged productivity growth.

Second, another key to the explanation of the anemic growth rates in Europe is rigidity of the labor market. In many European countries, labor costs are very high (link). If the cost of labor market entry is high, people prefer longer studying and working in the shadow economy. The shares of shadow economy are relatively high in all European countries (link). The highest rates of shadow economy are in the following countries:

1. Slovenia 27%
2. Greece 26%
3. Italy 24%
4. Spain 21%
5. Belgium 20%
6. Germany 15%
7. France 13%

Source: ATKearney (2009), Friedrich Schneider (2005)

Third, Europe’s relative decline compared to the U.S, is not a consequence of the lack of R&D investment. High percentage of R&D investment in the GDP is not a cure for the real cause. In fact, European universities rank far below the top universities in the world. In the field of engineering and computer sciences, the first non-US university is in the 15th rank. Europe’s brain-drain is a known phenomena since many bright European minds immigrate to places such as the U.S, Canada and Australia. The outcome is deteriorating international ranking of universities and low efficiency of R&D expenditure on misguided projects such as the intention of the European Commission to build a “European MIT” (link) to boost Europe’s global technology leadership.

Without higher growth of GDP, productivity and market working hours, European countries will hardly sustain the convergence towards the U.S level of GDP per capita. To boost economic growth, bold structural reforms are required to cut the rates of shadow economy, reduce tax and social security burden, decrease government spending and deregulate the labor markets.

Related posts:

1. Is Slovenia The Next Sick Man of Europe?
2. Economic Costs and Benefits of German Unification
3. The Political Economy of Europe and the U.S.

“Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy…”

Related posts:

1. Five Questions on Asset Prices and Monetary Policy
2. What Risk Models are Useful?
3. AIG, Wall Street Bailouts: Is the Federal Reserve’s Independence at Risk?

This raises questions about the effects of economic reforms on perceived changes in the quality of life. Do people in countries undergoing economic reforms tend to perceive that their lives were better prior to the reforms? My initial thought was that this would depend on the success of the reforms in raising economic growth rates.

I have now attempted to test this view empirically. In the analysis the perceived improvement in quality of life over the last five years is calculated as the difference between the rating of life today and life 5 years ago using data from the Gallup World Poll. Regression analysis has been used to explain variation in perceived improvement in life for 104 countries in terms of economic growth rate over the five years to 2007, improvement in governance over the same period (the average change in the 6 World Bank governance indicators), change in regulatory quality (the World Bank governance indicator most closely related to reforms that increase economic freedom) and a variable reflecting the extent to which assessments that people in different countries make of their lives tend to differ from the ratings that would be expected on the basis of income levels.

The regression explains about 40 per cent of the variation in perceived improvement in life among the 104 countries. The results show:
• Economic growth has a positive effect on perceived change in quality of life.
• Improvements in governance have a positive effect
• Improvement in regulatory quality have a negative effect on perceived change in quality of life.
(These results pass the standard statistical test relating to standard errors of estimates. Anyone who wants to see the results is welcome to contact me by email.)

It is important for the negative impact of change in regulatory quality to be seen in context. Economic reforms are generally undertaken in the hope that they will result in improvements in quality of life through higher economic growth. The chart below shows that countries which undertook regulatory reforms generally had relatively high economic growth rates. There was only one country undertaking regulatory reforms which had a negative economic growth rate.

The green diamonds in the chart denote the 10 countries in which people had the greatest perceived improvement in their quality of life. The red diamonds denote the countries with the greatest perceived decline in quality of life. The green diamonds are generally associated with higher economic growth rates than the red diamonds.

The evidence seems to support my intuitions – which are probably similar to the intuitions of most other economists interested in public policy – about the painfulness of economic reforms. Reforms often involve removal of regulatory barriers that protect the incomes of some groups at the expense of the broader community. The people who experience these income losses tend to resist reforms and to perceive that their lives were better before they were undertaken. When reforms are successful in promoting economic growth, however, these perceived losses tend to be outweighed by the benefits to those who gain from the reforms. Ad hoc attempts to promote reform of particular regulations are likely to be less successful than reform programs that are sufficiently broad and persistent to enable a high proportion of the population to perceive that their lives have improved.

Related posts:

1. Does ‘Unhappy Growth’ Explain Failure to Adopt Economic Reforms?
2. How Credible is Rudd’s Spin on the History of Economic Reform?
3. Is Economic Growth Causing the Chinese to Become Discontented or Just More Optimistic?

2. The Federal Reserve has the monopoly power to print or inflate the money supply, thus artificially lowering the cost of money (the aforementioned interest rate).  This means that they can (and always do) devalue the money in your pocket as every dollar printed decreases the value of all dollars to come before them.  Inflating the money supply may not lead to an increase in prices if an equal or greater amount of goods is produced, but the purchasing power of the dollar will still be reduced because without printing money, your dollars would have been able to buy more goods.  Alternatively, if more dollars are printed than goods are produced, prices will increase though not necessarily uniformly across all goods.  Inflation may not manifest itself in explicitly higher prices but merely impede prices from falling for certain goods as they would were the money supply to remain constant.

3. When you deposit money in a regular checking account, the bank doesn’t hold onto this money.  Banks only keep a small percentage of the money you deposit on hand in their reserves, lending the majority of the money you (or the Fed for that matter) deposit to others who lend it to still others and so on, in the process substantially increasing the money supply.  This is known as fractional reserve banking.  If everyone in America or even a decent percentage of Americans tried to take their money out of the bank on a given day, millions would be unable to access their cash.  Effectively, even with FDIC Insurance, all of the banks are insolvent as they do not hold anywhere near 100% of the money you deposit in their vaults.  The hypothetical that the Fed could potentially print up money for the FDIC to distribute is beyond the scope of this post.

4. The government’s debt is merely an insidious tax like inflation.  Government debt can only be paid down by taxing the people.  This tax can occur through direct confiscation by government, or indirectly when holders of our government’s debt demand a higher rate of interest, which in turn signals to markets that our economy is not generating sufficient revenues to pay down the debt, which leads to a perception of economic weakness and thus an increased cost of borrowing for everyone in the economy.  If the government prints money to pay down debt (which in and of itself should cause our creditors to flood the markets with our debt and thus raise interest rates on everyone), this will represent a tax on the people as well.

5. Deflation, or a decrease in the money supply is the only antidote to inflation.  If the money supply is decreased, each dollar in your pocket becomes worth more.  The concomitant fall in prices will correct the artificial initial rise in prices from government printing of money.  In the process, since decreasing the money supply increases the cost of money, unsustainable enterprises with heavy debt loads will be put out of business, cleansing the economy by freeing up unproductive resources.  Where debtors benefit from an increase in the money supply because they can pay down their borrowings with cheaper dollars, creditors will benefit from a decrease in the money supply because they are paid back with more valuable dollars, which is one of the reasons why government prefers to inflate as it can lessen its own debt load and that of its constituents.  Deflation in prices while a symptom of deflation of the money supply is also the natural result of increases in productivity, as goods produced more cheaply in greater quantities (in the absence of money printing) will lead to falling prices which benefits consumers.  The so-called “paradox of thrift” that the MSM uses to vilify deflation in prices is wrongheaded, as people will spend on all sorts of products knowing that over time they will fall in price, as we have witnessed with numerous electronics over the years.  Even during a depression, when asset prices fall to certain levels there will necessarily be buyers, presumably those who saved prior to the downturn.  And if people are paying off their debt and/or saving in a time of falling prices in lieu of spending, this will be good for the economy because deleveraging corrects the excesses of the boom and increasing the pool of real savings lowers the interest rate and allows businesses and individuals to borrow funds for investment at a lower cost, legitimately stimulating the economy.

6. The last point mentioned above is imperative.  Growth in an economy occurs when real savings increase.  This is true whether in a booming market or a depression.  In fact, saving is the only way out of a depression.  Saving creates a pool of funds for banks to lend to businesses so they can expand their capital, increase expenditures on R&amp and generally take the entrepreneurial risks necessary for innovation and growth.  Americans have long consumed far more than we have produced, leaving us as massive net debtors to the rest of the world.  The only way to get out of debt and expand our economy is to save.  One cannot solve a problem of too much money and credit with more money and credit.  This however is what our government is trying to do by continuing to run the printing presses, trying to inflate our way out of debt.

7. Government cannot create wealth.  All it can do is take money from some people and redistribute it to others.  Every dollar the government uses must be taken from the private economy. Printing money to pay for things as we noted merely devalues your dollars, effectively taxing you.  Government financing through debt represents a claim on your wealth, a tax which as noted may be paid directly or indirectly.  Thus, while federal, state and local taxes may appear on a historical basis relatively low, the tax rate is deceptively masked by excluding government bilking through inflation and debt.  In addition, all government enterprises ultimately fail because government is not subject to the profit and loss mechanism of the market and thus does not respond to the demands of consumers, amongst other reasons.  In the process of failing, government wastes resources that could be better put to use by private individuals.  Government is a wealth killer, not a wealth creator.

8. The purchasing of all sorts of less than creditworthy assets from the big banks by the Federal Reserve allows the government to pump money into the financial system, and allows the banks to foist assets it doesn’t want onto the back of the taxpayer.  When we combine these asset purchases with the rest of the wasteful deficit spending on government jobs and reckless bailouts of the financial institutions and auto companies, our appraisal of the situation is as follows: while the little guy delevers, the government counteracts this necessary private balance sheet cleansing by levering up its own balance sheet at the expense of the taxpayer,  for the benefit of the financiers and the unions.

9. The real estate problem in our economy centers on the fact that people owe more money on their mortgages than they are able to pay down.  The only fix to this problem is for people to either generate more income to service their mortgages, or default.  Any intervention to keep people in homes they can’t afford will merely perpetuate market imbalances, propping up the value of real estate and preventing qualified buyers from purchasing homes at fair prices.  There will be no true recovery in the mortgage-backed securities  market until the forces of supply and demand sort out this mess (a mess which will be made worse as there are continued resets in mortgage rates over the coming years).  The same goes for any of the other assets whose values were bid up to unjustified levels because of easy money and credit.

10. Our economic crisis at the most basic level occurred because too much money and credit were pumped into the economy, given that again the interest rate was set artificially low not by supply and demand in the market but by government fiat.  The recession signals that we must fix the distortions and malinvestments resulting from the centrally planned interest rate. The healthy path to recovery is to allow prices to fall (aided by debt repayment), liquidate failed enterprises (reallocating of land, labor and capital to more productive and profitable lines of business) and encourage saving to increase the pool of loanable funds for economic expansion. Any actions to the contrary (i.e. more or less all government policies being implemented or bandied about) will merely prolong the pain.

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