Wednesday, August 12, 2009

Personal Economics--Rule VI

Personal Economics--Rule VI
"For we wrestle not against flesh and blood, but against principalities, against powers, against the rules of darkness of this world, against spiritual wickedness in high places."
Rule VI says basically, "Know your enemy and keep your guard up." This rule stems from the work of Ludwig von Mises and Frederick Hayek, but Hayek shared the Nobel Prize for his work in explicating it. In economics it is simply the explanation of what is called the business cycle or boom-bust cycle. Karl Marx had explained it simply as an inherent feature of capitalism. Others had tried to explain it in a more detailed manner, but had failed. For example Stanley Jevons had attempted an explanation that correlated the boom-bust cycle with sunspots. At first glance, this sounds even more mysterious than the Marx it-is-just-an-inexplicable-part-of-capitalism theory. But Jevons theory attempted to make it more rationalistic, because it would tie the boom-bust cycle to a crop productivity cycle.
What von Mises and Hayek did was to show that the boom-bust cycle in the economy was tied to credit expansion. Banks increase their profits by making more loans and, hence, the temptation is to cut back on their reserves and loan more of their available capital. Of course, if a single bank does this and becomes over-extended, they quickly get into trouble. The problem is self-correcting. The problem only becomes a national one when there is a government controlled central bank, such as the Federal Reserve. Most countries have these. They are able to extend the money supply, i.e. allow all the member banks to expand their credit, thus lowering the interest rate. Unfortunately, this creates an artificial boom. It sends false signals to entrepreneurs who are eager to launch new enterprises, but are restrained from doing so for all but the most promising enterprises by the shortage of available investment capital. When, however, the money supply is expanded, i.e. inflated, the illusion is created that there is plenty of capital for investment in enterprises that earlier seemed unpromising. Unfortunately, all that has been expanded is credit. In an uncorrupt society, capital is available only as people save--hence, leaving vital resources, e.g. capital goods, available entrepreneurs. Thrift is a virtue not only because it allows individuals and families to prepare against a rainy day, but because it permits investment in new tools, equipment and plants and, thereby, increases the value of the labor of the people who have better equipment and tools to work with. Hence, the virtue of thrift increases prosperity.
Credit expansion, i.e. inflating the money supply gives the illusion that society is ‘better off’, i.e. more virtuous, without actually being so. Entrepreneurs feel that there is more capital available but the amount of capital goods remains the same. This becomes clear when it is apparent that many entrepreneurs have invested in enterprises that cannot be sustained. They lay off workers, some even go bankrupt and the economy is said to be in the bust part of its cycle.
If, for example, I, and thousands of others, decide to put off buying a new car, and put the money saved in the bank, then there is not only money available to loan, but there is additional steel so if an entrepreneur decides to build a new factory, the necessary steel is available. If, however, I, and thousands of others, go ahead and buy the new car, and the so-called capital is available only because the money supply has been inflated, there is no additional steel available for the building of the factory and before it can be built, the price of steel rises to the point that the new factory enterprise is clearly not going to be profitable and is abandoned.
The bottom line is that the desire to have "something for nothing", to succeed without effort, to have all the good of virtuous living without any actual virtue, has put pressure on the government to expand the money supply and, hence, create a boom. This undermines the work of entrepreneurs who become bitter because they have been misled, and misinformed. They feel betrayed and turn to political entrepreneurship. People become convinced that only political action is effective and that the only way to succeed is to use the force of law. In economics, credit expansion is analogous to sin--enticing at first, but leaves disaster in its wake.
On a personal level it is a reminder that if life is getting easier, you better be awfully careful that you are not entering an artificial boom made possible by an enemy creating an illusion. Hence, it is always a good idea to "know your enemy and what he is up to."

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