Restoring Economics

In a sense, no one really knows what’s going on with the economy; and even if they do, they don’t know what to do about it. But academia is partly responsible for the public mystique about the economy. In formalizing learning, academia has the unfortunate result of making some subjects overly complicated. There are no in-built checks to make topics simple; and I’ve come across many egotistical professors, who, in an attempt to exploit their power, relish in making concepts more difficult than necessary.

Yet the following class discussion with a professor, from an undergrad course on corporate finance, demonstrates how people can approach economics without that much formalized knowledge. It was quoted at the start of a book review for The Ethics of Money Production.

It was one of those rare moments when the entire class listens attentively and participates in the discussion. That it occurred with this particular class was even more instructive to me personally. This was a principles-of-finance course, required not only of finance majors, but of all students pursuing either a major or minor offered by the school of business at my institution.

While the typical principles class contains some highly motivated students who aspire to careers in finance, banking, and accounting, it is also filled with a fair number of students who look upon the course as a sort of dreaded, compulsory disruption to their nonfinance curriculum. But on this day, they were unified and engaged. A rare moment indeed!

At this point, the reader might consider this a strange way to begin a book review. The anticipated segue is provided by a voice in the back row of the classroom, where a rather quiet and normally imperceptible student began the following exchange with me:

"You know, we hear all about these bailouts and stimulus packages coming out of Washington."

"Yes, I know."

"Hundreds of billions, even trillions of dollars, right?"

"That's right."

"They don't really have the money, though, do they?"

"No, they don't."

"And so they are just going to print it, aren't they?"

"Yes, the banking system is going to print it and loan it to the government."

"Out of nothing, right?"

"That's right."

"But that's not right, is it?"

Just to be clear, the student was not suggesting that the premise was not right, as in not correct. He was asserting that this massive production of money out of thin air was not right, as in not ethical.

(from The Right & Wrong of Money Production, 2/18/2008, by Michael King)

Although not everyone might agree with the student, it doesn’t take much background knowledge to follow the discussion. We all know what he’s getting at.

In contrast though, you do need a lot of background knowledge in order to take such an economics course. Specifically, you need strong math skills and you have to be prepared to apply them. One of the first concepts you’re likely to learn is that of the production possibility curve. This is touted as a useful concept early on, because it can be used as a theoretical model to map the economy on both the macro and micro-scales. At the same time, you’re hit with such boring and dry explanations as the following (from Wikipedia)

The move from point A to point B indicates an increase in the number of computers produced, but it also indicates a decrease in the amount of food produced. Assuming that productive resources do not increase, making more computers requires that resources be redirected from making food to making computers. If production is efficient, FA of food and CA of computers could be made (as Point A shows), or FB of food and CB of computers could be made (as Point B shows).

In reference to figures like these


This is just the start of the long and arduous journey that the undergrad takes to complete his intro to economics. Is it any wonder then that the public at large seems to be grossly ignorant about economics? After all, if they didn’t take one of these boring courses, they most likely heard horror stories from peers who did.

The frustrating part is that, as the above dialogue demonstrates, economics doesn’t have to be boring. We all deal with money, prices, and incentives. Add a little guided thought on top of that, and it’s not hard to teach economics in a wholly engaging manner. Thomas Sowell accomplished this in his book, Basic Economics.

Sowell can be divisive and you might disagree with him on points, but all he asks of the reader is a hint of interest into current events and he’ll get you thinking about the wider economic role of actions like banking, risk-taking, measuring the macroeconomy, and investment. He uses everyday news articles, along with common sense, to build upon the reader’s intuitive understanding of economics.

The phrase intuitive understanding economics may seem a little odd. After all, what’s intuitive about the something like the production probably plot? Very little, and that’s why it doesn’t belong at the front of an introductory course. But insofar as everyone engages in the marketplace, intuition - not math - is a rather suitable place to start.

You’ll often hear the argument that education is an integral aspect of a democracy; and without it, our citizens can’t make informed decisions when they go to the polls. Nonetheless, those who subscribe to such notions tend to be more liberal, and it shows in their quality of education. In high school you’re more likely to learn about FDR’s New Deal than the Federal Reserve; and in college, economics is presented as a dismal mathematics model while courses in political science are more welcoming and palatable.

Part of this, I suspect, is because universities err on making things overly complicated and verbose. If mathematics can possibly be integrated into a major, then it absolutely will. The university has nothing to lose by erring on too many courses and prerequisites. And when there are a plethora of potentially interested students, this can be a way to weed some of them out.

Insofar as public education has a social obligation to produce informed citizens (and maybe it doesn't, but this is presumably why it exists), it's partly to blame for the public’s current ignorance about the economy. Few citizens can readily grasp the importance of banks and the Federal Reserve to the economy. This has a two-fold effect: It shrouds economics in a veil of unnecessary complexity hidden to the public's scrutiny; and it allows public policy experts take advantage of this ignorance. Such a rapidly growing ignorance can even be considered dangerous in the same sense that many would consider an ignorance of politics dangerous.

The Washington Post, for instance, just had an editorial which urged consumers to spend rather than save their hard-earned money. The author tries to guilt-trip the reader into spending based on the presumption that saving money would cost the economy some 53,000 jobs. It doesn’t take very sophisticated knowledge about economics to see the fallacy in that one – namely, that you can’t have a sound economy when each individual household is living beyond their means. But without such knowledge, what do you say to the family that sympathized with the author’s points, and spent their way into years of debt in order to help the American economy? And then encouraged their neighbors to do the same? Afterall, the author does sound pretty convincing when he writes:

Borrow and spend, borrow and spend is what got us into this mess. Apparently, borrow and spend will get us out of it.

He then goes so far as to encourage individuals to glue together their torn up credit cards. I couldn’t believe what I was reading! Even if you subscribe to the (Keyensian) view that spending on consumer goods fuels the economy, what good would come from spending on increasing interest from credit card debt?

Although I’ve never been a fan of public education, economics is an area in which it has utterly failed. And for this the nation has suffered.

-KJ


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Media (in order of appearance):

Photo: (1) Production possibility curve; (2) Sleepy, 06/13/2008, by Barbcalie; (3) Grocery cart, 11/30/2007, by Buxmama; (4) Federal Reserve Building, 05/20/2006, by Dystopos; (5) NYC National Debt Clock, 06/24/2006, by WallyG.

Video: (1) Stimulus: Because all economies have performance issues., 02/04/2009, Reason TV. Sphere: Related Content

Starbucks vs. Harley Davidson: What you see and what you don't

We live in a consumer-driven economy, liberals often say, and how much more can we produce until we’re too chock-full of gadgets and gizmos? This concern is easily manifested in a company like Starbucks: How can they grow when they’re already located on every street corner in every city? Such concerns, like so many misunderstandings about the economy, come back to Henry Hazlitt’s single lesson about economics: What you don’t see is often more important than what you see. We’ll begin by talking about what we see, which is too many Starbucks stores.

What you See

Starbucks originally hooked me on coffee. I was in 8th grade and a location next to my school was giving out samples of their new Frapuccino with brownie bits. Since around that time, Starbucks expanded to over 16,000 locations worldwide. Its horizons seemed endless, as numerous books popped up about the genius idea behind the business, no doubt perhaps conceived in the cozy intellectual confines of the coffee shop’s atmosphere.

But in 2006, way before our current recession, it was clear that Starbucks had over-expanded itself. Since then, it’s closed over almost 1,000 stores and has plans to close hundreds more. In the meanwhile, Starbucks has certainly lost its edge. The issue seems simple enough, and the conversation almost one-dimensional: They need to open more stores. More stores means more money. But the economy - maybe even the world - isn’t big enough. They can only open so many stores in the same city before there’s no room left to expand. Companies rely on growth. What are they to do? In the meanwhile, they’re worried that the Starbucks brand has become stale and too expensive for a society in recession.

What you Don't

The solution to the path that Starbucks should have taken struck me while I was reading about The Harley Davidson Company in Motley Fool’s recent book, Million Dollar Portfolio. The following quote summarizes a bit of the history of Harley Davidson before getting into their success:

In 1901, a 21-year-old William Harley designed a motor to put onto a bicycle. He was soon joined by his good friend Arthur Davidson, and together they started a company that would eventually build motorcycles. Over the next 70 years, the company was private, surviving the ups and downs of the American economy, with major contributions to the war efforts of both World I and World War II. By the 1950’s and 1960’s, though, the company saw its reputation diminished, as it was associated with the Hell’s Angels and other less savory characters.

In 1967, the company was bought by American Machinery and Foundry (AMF), which produced leisure equipment such as snow skis, golf clubs, and bowling balls. AMF mismanaged the company to the point of near death, and sold it for $80 million in 1981 to a group of private investors, including Willie Davidson, a descendant of the original Davidson family. They rebuilt the company, placing a new emphasis on quality that had gotten away from them for decades. Customers returned. In 1987, Davidson and Friends took the company public.

That was the beginning of a spectacular ride. Shares of Harley at the end of 2007 were worth roughly 110 times what they traded for when the maker of the Fat Boy first went public…(p. 85-6)

What was responsible for this turnaround?

For the better part of two decades, Harley had the opportunity to do the right thing with its profits – sink them back into the business, making new and better products, and reaching out to loyal customers. In fact, the true glory years for Harley’s stock were those when management limited how fast the company made bikes. Rather than make all the hogs it could sell, Harley increased production at a rate of only %10 a year, lower than what the marketplace could bear. The ensuing scarcity of bikes raised the value of those machines that did make it to the market. For the better part of a decade, customers were willing to pay more than the manufacturer’s recommended price. (p. 86)

Something clicked when I read this, as I realized that Starbucks’ problem was not over-expansion, but a lopsided view on the meaning of growth.

Certainly more locations is one way to increase profit, but did it never occur to them to improve their product, similar to Harley Davidson? Starbucks' extra cash placed them in a position to improve their product, or at least to make it more efficiently. Or they could have experimented with real cappuccinos, which are generally thicker and have less foam, rather than switching to automated machines. Or they could have lowered the price of their products, which would have enabled them to compete more effectively with McDonalds and Dunkin Donuts. Instead, they’re stuck with too many stores which need to charge an arm and a leg for a cup of coffee in order to make a profit.

None of these strategies were guaranteed to work, but they get at a very basic aspect of economics: Differentiating between what you see and what you don’t see. Starbucks chose to err on the former by expanding everywhere, rather than the latter. However, the alternative strategies – which err on what you don’t see – were certainly viable, as seen in the success of Dunkin Donuts. In a very real sense, both were strategies behind growth. Yet do you hear liberals decry that Dunkin Donuts is taking over the world with their expansion of quality and lowering of price?

As Harley Davidson’s history shows, companies don’t just grow by getting physically bigger and taking up more space. As Hazlitt proclaimed in 1946, growth in areas that you don’t physically see right in front of you are often the most important types of growth.

The More Important

I want to end on this concept because I’m entranced by it.

Mankind necessarily begins with the concrete and what’s right in front of him, and over generations he forms laws of nature, which get at what Plato called underlying forms. Plato believed that the forms behind the manifestation of reality are inherently more important than physical objects, because the forms govern their existence. In other words, the law of gravitation is more important than the objects which are being gravitated, because the law allows us to understand the objects.

Hazlitt was saying something very similar, only in relation to economics: What we don’t see is often more important than what we see. We visually see Starbucks everywhere, but we don’t visually see the quality of coffee increasing. Hazlitt elaborated with an analogy to a broken shop window: If a shop’s window breaks, we see extra business go to the repair man. Judging just from what we see, broken windows are good because they produce business. What we don’t see, however, is more important. We don't see the foregone opportunities given up by shop owner. Perhaps he now has to make his goods more expensive, or he can’t expand his business. Economist John Maynard Keynes - whose influence has exceeded Marx in determining liberal economic policy - was notorious in his inability to grasp Hazlitt's law. He once famously suggested that we should bury money under ground, so that industries can form by digging holes to get them out.

I’m fond of intellectualizing issues, often to a fault (see this post and every other). For this reason, though, I’m often amazed at how intellectual liberals fail to grasp anything about the economy that's not in plain sight in front of their eyes; because Hazlitt’s law is the bare essence of intellectualization, by moving the discussion to the underlying principles, rather than just what’s out there in front of you. How can you be intellectual and fail to grasp that there’s more to the world than just what you see?

Nonetheless, liberals often chide at attempts to get at the underlying forms of the economy, such as Adam Smith's notion of the invisible hand, under the presumption that it's an oversimplified attempt to avoid reality. On the contrary, however, discussing physical economic things without reference their underlying economic form is like trying to move a rotating object without thinking about gravitational forces. Stated more succintly, its easy to change something's outward physical appearance, like an item's price, but its not easy to alter the form, like the information that a price conveys.

Of course, applied to the economy, this mistake is not specific to intellectual liberals. Many economists and politicians, in the tradition of Keynes, overemphasize consumer goods and end-products, which we see, over investments and savings, which we don't see. One instance of this was when former President Bush urged Americans to go shopping after 9/11 upon the assumption that this would stimulate the economy. Contrary to Bush's intention, buying random things when you don’t need them is pointless, and spending beyond your means is in fact harmful for the economy. When you buy a product that you need and can afford, you’re signaling to the manufacturer – along with anyone involved in its profit – that the product is valuable. You're telling them that you enjoy their product more than you would have enjoyed your extra money somewhere else. You're signaling them to make more of that product, or to keep doing what they were doing. Buying useless products that you can’t afford just adds noise to that signal, and it depletes from your savings. Savings again represent what you don’t see: They don’t just sit in a bank vault. They’re loaned to businesses or people, or are reinvested into the economy. That money is given a purpose, and in line with Hazlitt, that purpose is arguably more important than your consumption, particularly if you don’t need or want that consumption.

This misconception is magnified in the use of GDP – gross domestic product – to measure the macroeconomy. GDP is the total measure of exactly what you see: product. It doesn’t include what you don’t see, particularly savings and investment. When a window breaks, or another Starbucks opens, GDP increases, regardless of any depletion in savings; when a company like Harley Davidson focuses on making better motorcycles (and spends on R&D), GDP suffers.

Economist Mark Skousen, among a few others, hotly debates the usefulness of GDP. Using a statistic called gross output, he estimates that end-product consumer goods account for only a third of the economy. And this makes sense, because changes in the GDP usually lag behind changes in the stock market by a few months. It takes money to make money, and it also takes money in the right hands as well. That's why savings and investments are more important than consumption.

Right now most every company is in trouble, although to varying degrees. Starbucks used one strategy for expansion, though it certainly wasn’t the only strategy, and in hindsight it probably wasn’t the wisest. Harley Davidson management has recently turned south as well, as they’ve somehow managed to pile on a huge amount of debt while being aware of their shrinking baby-boomer customer base. But the important lesson is that these companies had options, as growth doesn’t always occur in areas that you see. Often the best things in life – love, joy, happiness – you can't see directly at all.

-KJ

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Media (in order of appearance):

Photo: (1) Careful, 11/10/2006, by Carlos Aldana; (2) Fuel, 09/30/2006, by Nathan Makan; (3) 1907 Harley Davidson, photo by Rmhermen; (4) Harley Davidson Heritage Model 2004; (5) DUNKIN' DONUTS, 12/03/2006, by Paul Downey; (6) Concave modular origami : collection so far, 11/17/2008, by fdecomite; (7) Shattered Lens, 03/06/2006, by kandyjaxx; (8) Westfield White City, 11/25/2008, by Manuel. Sphere: Related Content

Keynesian Economics

Lil Wayne - New Music - More Music Videos

-KJ

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Media (in order of appearance)

Video: (1) Music video of the song "Got Money" by Lil Wayne from the 2008 album Tha Carter III. Sphere: Related Content