The scariest thing in economics

November 22nd, 2007

You know what phrase is most likely to scare an economist? “I’m an engineer, and have some thoughts about economics”. Something in the training of engineers seems to make them think that they can apply their knowledge to a completely different field.

A prime example from the National Review talking about the falling dollar.

After constructing a lovely straw man (go marvel at the craftsmanship!) this engineer starts in:

Economic transactions involve the exchange of “something” for “money.” The “something” is specified in terms of number (1, 2, 3, etc.); length/area/volume (“the foot”); weight (“the pound”); and/or time (“the second”). “Money” is specified in terms of “the dollar.”

This is quite simply completely and utterly wrong. There is nothing in all of economics that requires money to be part of a transaction. Economics says that two parties will engage in a transaction when they both receive something of value to them. Back in the days before currency, perhaps I’d trade two pigs to you for a cow. I’m only willing to accept the cow in exchange for the pigs because it has value. So the setup is wrong here from the start: it’s not “something” and “money”, it’s “value” and “value” – the trade is symmetrical.

The problem with this scheme is that the magnitude of our fundamental unit of market value, “the dollar,” is not defined. Being undefined, the value of the dollar can change. This fact gives rise to huge economic costs and risks for which there are no offsetting benefits.

This is true. But I don’t trade money with you because I have an intrinsic value of money. I trade money for goods because I value money. Why value money? Because other people also value money and will trade me goods for it in return.

There’s a kind of collective illusion going on here. It only works because we all sit down and agree that it will work. There’s no guarantee that it will, but somehow our collective delusion holds. We could go back to exchanging everything in barter, but that would cost us a lot of time and effort.

Can the value of the dollar change? Sure, it might. And in the past it has. That’s why we need a system to stabilise inflation.

Rather than being rigorously defined like all other units of measurement, the value of the dollar is left to the market. This is an extraordinarily strange way to determine the magnitude of a basic unit. For one thing, the absolute magnitude of a fundamental unit doesn’t matter — what matters is that it be precisely defined and unchanging. The market also has absolutely no way of determining what the value of a unit “should” be, whether that unit is the foot or the dollar.

Here’s where we see the logical fallacy at full flight. There’s a desire for a nice, absolute resting point – some central value that is determined. But it can’t ever happen. We trade things because we value them. But we’re also human and unique – why should I value anything the same amount as you? And if money is simply a medium ultimately used for buying goods of value, then why on earth should money have any kind of intrinsic value at all?

(Economists who’ve dealt with engineers of this ilk already know where this one’s going at this point).

Having had the job of determining the value of the dollar thrust upon it, the market does the best it can. Moment by moment it equilibrates the supply of dollars and the demand for dollars at some market value. This market value is reflected in the price of gold.

Ah ha! And here we are, another gold bug. Told you the economists could read this play a mile off.

This is really simple to answer: why on earth would gold hold any kind of intrinsic value at all? It’s not that useful a metal, really. It’s not clear how much there is, but there certainly isn’t a fixed supply yet because we haven’t finished digging it all out of the ground. Sure it’s shiny, but plenty of things are shiny. So why gold?

What’s that you say?

Because other people value it too?

Simply put, there is almost no difference between so called ‘fiat’ currency and gold backed currency. There are a few technical points relating mainly to international trade and monetary policy, but in terms of day to day use nothing at all.

And what about the mighty Federal Reserve? Well, the Fed could exercise absolute control over the value of the dollar since it controls the supply of dollars. The Fed has the power to vary the size of the monetary base from zero to infinity. Given this, the Fed has the power to fix the dollar’s value (in terms of gold or anything else) at any level it chooses.

However, the Fed doesn’t do this. Instead, it exerts a vague influence over the size of the monetary base by targeting the federal funds rate.

Now isn’t the time to explain about open market operations, and the way monetary policy works. It’s pretty technical, and not for the non-specialist really. But this is exactly wrong: by changing the interest rate the bank is changing the money supply. It’s just doing it in a fashion that more directly controls the reaction.

A simple analogy might explain: if you wanted to increase the price of some good by 10 per cent, what would you do? Would you reduce the supply of that good until the price went up, or would you just increase the price?

That is, the Fed creates money in response to demand for short-term capital. Given that one use for short-term capital is commodity speculation, and given that commodity speculation is one way to profit from inflation, the Fed is operating a system that is designed to respond to inflation by creating more money.

Such a system exhibits “positive feedback” (like a nuclear reactor) and is dangerous.

We’re now reaching the territory where the lack of knowledge of economics and financial markets is making this very very difficult to understand. While I’m prepared to be corrected by someone with better knowledge of financial markets than me, this appears to be pure gibberish. The federal reserve isn’t doing anything in response to demand for short-term capital – it’s acting in response to unemployment and inflation rates.

Nonetheless, the real problem is the confusion about the fed’s role: the fed does not just reduce inflation, sometimes it wants to increase it. A bit of inflation is a good thing in an economy (just look at what happened in Japan with some deflation).

I think he might be referring to the recent credit crunch, in which case what the Fed was doing wasn’t really increasing the money supply per se, so much as replacing some of the money supply that had disappeared off to non-liquid sources. If they hadn’t acted the money supply would have shrunk, raising interest rates and reducing economic activity. They were just trying to keep things as they were, more or less.

Why would the Fed employ a monetary-control approach that is both indeterminate and dangerous? I believe the underlying problem is an intellectual confusion between “money” and “capital.”

The irony of accusing the Fed of “intellectual confusion” here had me laughing for about five minutes.

Anyway, I’ll skip a few more paragraphs of deep confusion to get to the funniest bits of this article.

A logical definition of the dollar might be “equal in market value to one five-hundredths of an ounce of gold.” The value of all the dollars in the U.S. monetary base would then be maintained by having the Fed’s open-market operations target the price of gold to keep it near $500 per ounce. Because the real market value of gold cannot run away to zero or infinity, the new monetary control system would be determinate and stable.

What I am describing is not a classic “gold standard.” Back then, gold was the monetary base. Instead, the monetary base would be the same “fiat” currency that we have now. Banks would maintain the value of their dollars the way they do now — by redeeming them with the dollars of the monetary base upon demand.

Oh boy.

OK, firstly: “not a classic gold standard”? Rubbish. This is the gold standard with a silly hat. If your dollar is worth 1/500th of an ounce of gold, then it doesn’t really matter if you go to a jeweller rather than a bank to get the 1/500th of an ounce, it’s still a fixed currency. Sure it’s not backed by gold, but the economic effect is exactly the same.

But what’s wrong with this solution? Well, the same problem any fixed currency has, it’s vulnerable to speculative attack. So what would you do? Well, you might continually buy gold to try and force the price up. The Fed would have to sell to you in order to meet its mandate. But the Fed doesn’t have an infinite amount of gold – sooner or later they’ll run out, the price of gold will go up, and confidence in the currency will collapse.

This relates to the earlier suggestion that ‘money supply would be irrelevant’: if there’s more money than gold, then the currency will collapse. So no free banking, no infinite money supply. Too much money and the economy could collapse.

That’s not going to help keep interest rates low, by the way.

This new system would not be concerned with the federal deficit or the U.S. trade deficit. These relate to capital, and capital is not money. Similarly, the system would not be concerned with interest rates, which represent the cost of capital, not money. (As an aside, if the dollar were as stable as the foot, interest rates would be very low.) There would still be a role for the Fed as “lender of last resort,” but this would be a “banking” function separate from monetary control.

Interest rates are the cost of capital, not money???

Just in case you had any lingering thoughts this guy knew what he was talking about, there’s this gem.

Of course interest rates are the cost of money. If I spend money, I’m foregoing the interest on it. There is no definition of cost that can possibly mean that interest rates are not the cost of money.

The distinction between “money” and “capital” here isn’t that silly – but the idea of a ‘cost of capital’ is. There’s a cost for how much money you had to borrow to build the capital. And there’s a return on the capital. In an equilibrium, both of those are equal to the interest rate. The ‘cost of capital’ in economics normally means the cost of building an office block, or making an assembly line.

So, to summarise: this guy is a complete idiot with no understanding of economics whatsoever, or the role of monetary policy. His proposed solution would create massive problems and remove one of the most important arms of economic policy.

That conclusion would be obvious to anyone with first year training in economics. And even if it wasn’t, you might think twice when you realise that everyone with a background disagrees with you (including, by the way, many engineers with actual training in economics).

But for some reason a few engineers seem immune to the kind of self analysis required to actually think that it’s possibly that they’re wrong, and maybe the experts are right. And I don’t know why, but it’s only engineers.

Wait, he’s not done?

Fixed exchange rates between the dollar and (say) the euro are just as desirable as between the foot and the meter. The belief that “floating” exchange rates are needed to deal with trade imbalances between nations represents more intellectual confusion between money and capital.

!

Wow. Now I need to explain international trade, capital accounts, and the role of the exchange rate?

Nah, too tired for that. This article is already over two thousand words long.

If you want real prosperity, give monetary control to the engineers.

Or, rather, if you’d like to screw the economy, create a massive recession and destroy large parts of the economy, let an engineer look after things. Alternatively, stick with the remarkably effective monetary policy system that has created almost two decades of prosperity and stability in the developed world unmatched in all of history.