Goofball Economics

Austrian economists have made some of the most important contributions to economic theory. Chief among these are Carl Menger’s Subjective Theory of Value (from which came the concepts of marginal utility and consumer and producer surplus), Mises’s formulation of the Economic Calculation Problem, Hayek’s work on dispersed knowledge, and Gottfried von Haberler’s restatement of comparative advantage.

Alas, today the Austrian school is an object of ridicule, and Austrians have only themselves to blame. They insist on using separate terminology which is incomprehensible to outsiders. They also reject empirical evidence, and insist on religiously applying “praxeology” to make predictions about human behaviour.

To their list of sins we can now add another. Namely, they attack mainstream economic theory without trying to understand it first.

Consider this post by Robert Wenzel, where he calls indifference curves “laughable”. First he takes the standard diagram of indifference curves from Mankiw’s textbook, which shows that two goods are imperfect substitutes.

He then proceeds to straw-man it as follows.

Now, how idiotic can you get?

This theory is a serious case of the Emperor has no clothes. Compared to this, Keynesian nonsense looks like pure genius.

Let’s take a real life look at Mankiw’s example.

Suppose that after a long night out on the town, I stop into a local pizza shop for a Pepsi and a slice of pizza. I place my order. It’s a special, a slice and Pepsi fountain drink for $5.00.

But they are out of pizza, so the clerk, who is a student at Harvard and who just took Mankiw’s intro class,  looks at me and says, “I’m sorry, we are out of pizza. How many Pepsis would you like instead?”

I say, “What?”

He says, “Where are you on the indifference curve between pizzas and Pepsis. We are out of pizzas, so how many Pepsi fountain drinks do you want to substitute for the pizza, three, four, what?”

My choice: I walk out.

Except, Mankiw is not the idiot here. Wenzel is. Mankiw’s indifference curves were for imperfect substitutes. Of course they won’t reflect Wenzel’s scenario.

There are L-shaped indifference curves for that, as shown below.

As the diagram shows, the consumer is unwilling to substitute Pepsi for pizza. He wants a glass of Pepsi to go with every slice of pizza and vice-versa. If there is no pizza available, the consumer will walk out of the pizza shop.

What Wenzel thinks is a brilliant objection has been answered decades ago. He would have known this had he taken the trouble of opening a slightly more advanced textbook, such as Deirdre McCloskey’s The Applied Theory of Price (a similar diagram to mine is there on page 35).

There might very well be ways in which the Austrian approach is superior to the mainstream one. But to prove that, Austrians must understand mainstream theory first. Modern Austrians like Wenzel have tarnished Menger’s legacy by spouting ignorant nonsense.

On November 8, a wildfire started in California. The “Camp Fire”, as it has been named, is still burning as of this writing and has already been called the deadliest and most destructive wildfire in California’s history. On the same day, the “Woolsey Fire” started in the Los Angeles and Ventura counties.

The Woolsey Fire has destroyed more than 1500 buildings and killed 3 people so far, and required almost 300,000 people to be evacuated from their homes. The Camp Fire has destroyed more than 17,000 buildings and killed 81 people, while hundreds of people are missing.

This is not the first time such a tragedy has struck. Ever since formal recording began in 1932, there have been numerous large fires which have collectively burned millions of acres, destroyed thousands of buildings and killed dozens of people.

Tale of two states

Right beside California is the Mexican state of Baja California. Both states have the same kind of climate and vegetation, therefore one would expect Baja California to suffer from the same kind of devastating wildfires. But that does not happen, as ecologist Richard Minnich found in a detailed study spanning nine years (1972 to 1980).

To understand why California burns but Baja California does not, consider the landscape of a forest. There are tall trees, and in between them the forest floor is covered with shrubs, grasses, and dead wood, which are all easily combustible because of their low moisture content, whereas trees take longer to catch on fire because they contain more moisture.

In Baja California, when fires ignite on the forest floor, they are allowed to burn naturally. These low intensity fires regularly clear out the forest floor and prevent the spread of large conflagrations. In California, on the other hand, there is an over-zealous policy that mandates extinguishing every fire, no matter how small.

What this does is to allow all the shrubs and dead wood to accumulate, allowing for rapid spread of large fires later. Fires are less frequent in the forests of California, but if a flame manages to go undetected for a little while, the results are disastrous.

This wasn’t always the case, however. Minnich mentions historical accounts from the 19^th century stating that California too had regular low intensity fires similar to those in Baja California, before the current fire suppression techniques were implemented starting from the 1920s.

Surprisingly, I find myself in agreement with Donald Trump, when he says that officials in California are simply wasting money on fire suppression with little to show for it. Trump has threatened to stop federal payments to California, which seems like a good first step. After all, officials in Baja California have a far smaller budget than their Californian counterparts, which has prevented them from committing the same mistakes.

A far more sensible fire control regime would be to have small controlled burns regularly to clear out the forest floor in California. If there is a concern about burns being uncontrollable near residential areas, the forest floor can be cleared out manually. Almost any policy is better than the current game of whack-a-mole which forest rangers are playing.

Fire and Finance

In the 1980s, there was a big financial crisis in the US known as the Savings and loan Crisis, in which a majority of Savings and Loan Associations (S&Ls) and over a thousand banks failed. How did this happen? Arthur J. Rolnick, of the Federal Reserve Bank of Minneapolis, blames deposit insurance by the government.

In 1934, the Federal Deposit Insurance Corporation was established to protect the deposits of small savers. Initially deposits in banks and S&Ls were insured for up to $5,000. This was increased gradually to $100,000 by 1980, meaning almost all the deposits were fully insured. Eventually protection was extended to all the uninsured deposits as well.

Essentially, the government eliminated the very possibility of bank runs, just like the over-zealous fire suppression in California. What this did was to create moral hazard. Banks and S&Ls started investing in high risk assets, safe in the knowledge that government would bail them out. The high risk assets are akin to the shrubs and dead wood on the forest floor. And when panic struck, over a thousand banks failed. The wildfire.

Rolnick correctly claims that occasional bank runs impose discipline on banks. If banks know that they must bear the entire cost of failure, they will take on less risky portfolios. Thus, if an occasional bad bank fails, the failure will not be contagious. There is some empirical evidence for this.

A cross-country comparison shows that countries which had higher levels of deposit insurance in 1996 had a higher rate of systemic banking crises in subsequent years. The findings are summarised in the table below.

Deposit Insurance Coverage in 1996	Banking Crises in Subsequent Years
	No	Non-Systemic	Systemic	Total
Low	21	0	1	22
High	14	3	6	23
Full	4	0	3	7
Total	39	3	10	52

As we can see, 22 countries had low levels of deposit insurance, and only one of them faced a systemic crisis. That’s a crisis rate of 4.54%. Next, out of 23 countries in which a large proportion of deposits were insured, 6 (or nearly 26%) faced systemic crises. Out of 7 countries where all deposits were insured, 3 countries (around 43%) faced systemic crises.

What this suggests is that instead of trying to prevent all bank runs, regulators should allow the occasional bank run to get rid of bad banks without destabilising the entire financial system, just like small fires in Baja California.

Economy and Ecology

I have drawn parallels between economies and natural ecosystems before as well. What this example shows us is that in each case, intervention can have effects contrary to its intent. This is not just because of the inherent complexities present in the systems, but because of their vast proportions. Regulators cannot catch each instance of flames in the forest or stressed balance sheets in banks before it is too late. Therefore they must sometimes allow small problems to run their course rather than suppress them and have them erupt later, unpredictably and with devastating results.

Recently a man in Navi Mumbai was fined Rs 2000 by the police. His offence? He offered a ride to strangers who were stranded in the rain. Here is a slice of a news report of the shameful incident:

Nitin Nair, an employee of a finance consultancy in Navi Mumbai, said he was fined near Airoli Circle last Monday and the on-duty officer took his driving licence for offering lift to three men, who were stuck at a bus stop during a downpour. Nair said the officer issued him an e-challan and asked him to collect his licence from the chowkie (police station) after paying fine.

Apparently, it is illegal in India for private car owners to offer a ride to strangers. The police later issued a “clarification”:

Traffic police officers said not every motorist who offers a lift to strangers is penalised, but only those whom they suspect might take money from people — which is an offence.

“Only a vehicle with a yellow number plate (tourist vehicle) can charge passengers. We have observed that drivers charge anywhere between Rs 30 to Rs 50 for dropping people to Panvel, Belapur, Kharghar and Vashi from Airoli junction,” said a traffic police officer.

As if that makes things any better. Even if not every motorist is penalised, the fact that anybody driving with passengers can be stopped at a police officer’s whim and be questioned and treated like an outlaw is enough to discourage people from helping those who need a ride.

This is especially troubling during the monsoon. When it rains heavily in Mumbai, public transportation virtually shuts down, and it is next to impossible to get an auto-rikshaw or a cab. In such cases, most people rely on assistance from good samaritans such as Mr Nair to get around.

The government, however, cares more about the licence fees and tax revenues it gets from commercial transportation services than it does about people being able to get where they need to on time. In its zeal to collect taxes, it is willing to leave thousands of people stranded.

A Pervasive Problem

Acts of charity being punished is by no means a problem unique to India, In many American cities, for example, it is illegal to feed homeless people, at least until they get costly permits. For example, in Tampa, Florida, one needs to have $1 million in liability insurance and pay an additional sum of money to the local government for a permit to feed the homeless.

Governments say they do this for health reasons. If the food is not government approved, their logic goes, homeless people will die of food poisoning. In Kansas City, for example, the police bleached over 4000 pounds of barbeque food because it was from an “unapproved source”. More than 3000 people slept hungry that day.

NPR explains that the real reason governments don’t want the homeless being fed is greed for more revenues, mainly from tourism. If homeless people congregate in public areas regularly for meals, tourists might not visit those areas. Government cares more about revenues it can generate from the tourism industry than it does about ensuring that everyone has enough food.

In Fort Lauradale, Florida, regulation dictates that sites for feeding the homeless be restricted to one per city block, and interestingly, at least 500 feet away from residential properties. I’m guessing the latter is to ensure higher property prices, so that the local government can collect more property tax.

Feeding aside, even sheltering the homeless is illegal in many places. Consider the church which was fined $12,000 for allowing homeless people to sleep inside without a room and board permit. Or consider time when the Los Angeles government seized tiny houses from homeless people, all in the name of “health and safety”.

How Civilisation Works

Civilisation is best defined as people helping each other and working together to create a better life. This need not necessarily take the form of charity. As Adam Smith wrote in the Wealth of Nations, most people unintentionally help others; purely out of self interest. Business activity is even more important than charity for a civilisation to function. Even charity relies on surplus wealth, which can only come from profitable business.

Government action prevents and punishes acts of charity, as we have seen so far. It also punishes business through taxes and regulations. Every time government taxes the sale of a product, or creates a regulation, it pushes up the price of that product leading to fewer people’s needs being fulfilled.

It is not just big business which is affected though. Governments routinely penalise children’s lemonade stands, or kick out food trucks for serving hurricane victims, because they did not pay for permits first. Clearly governments refuse to let people help each other unless they can derive some form of tax revenue out of it.

Statists often tell us that “taxes are the price we pay for civilisation”. The truth, however, is that civilisation is the price we pay for taxes.

Vultures are ugly creatures. However, they serve a very vital function. They help get rid of animal carcasses safely. The putrid carcasses of animals carry many pathogens such as those which produce botulinum toxin, or cause cholera or anthrax, among other things which are deadly to humans.

Vultures have very powerful stomach acids which kill all such pathogens and safely remove them from the environment.

This was especially useful in India, where the majority Hindu population considers cows sacred. Since most cows are not destined for a dinner table, vultures served as an effective disposal system for dead cows and other livestock. The Parsi community, due to their religious beliefs, preferred to leave its dead for vultures to consume, rather than cremate or bury them.

The problem started in the 1990s, when farmers began using a drug called diclofenac to treat their livestock. Diclofenac is toxic to vultures, and the contaminated carcasses decimated India’s vulture population. From as many as 80 million vultures in the 1980s, today only few thousand vultures remain in India.

What happened in the absence of vultures? Dogs and rats stepped in to feed on the carcasses. Unlike vultures, whose digestive tracts destroy all deadly pathogens, dogs and rats became carriers. The incidence of anthrax, plague and rabies skyrocketed. More than half the world’s rabies deaths annually occur in India.

The Parsi community had to stop their funeral practices, because there aren’t enough vultures to get rid of the corpses, and the bodies were rotting and causing a stench which troubled the residents of nearby localities, not to mention the environmental threats posed by rotting corpses.

The Vulture Capitalists

Private equity firms and hedge funds are often derisively referred to as “vulture capitalists”. These evil firms, detractors allege, care only about their own profits. They will buy failing firms at a low price, take them apart, and sell them piece by piece to make easy money, while putting thousands of people out of work.

They have been blamed for the impending demise of Toys ‘R’ Us, and more recently for the staff cuts at the Denver Post newspaper. In the case of Toys ‘R’ Us, the real reason for its bankruptcy was the inability to compete with online retailers such as Amazon, as well as failure to adapt to changing consumer preferences (children preferring to play on iPads, for example, rather than with toys).

Even with the Denver Post, the plain fact is that most people get their news online these days, which shrinks the market for physical newspapers. Rather than wait till the paper dies a slow, painful death, the owners have decided to extract the maximum value from it while they still can. Had they expected it to be profitable far into the future, they would not be doing this.

As Steve Horwitz explains, the vulture capitalists perform a useful function. They try to revive failing businesses, and if they don’t succeed they sell off the assets of those businesses (land, buildings, machines and so on). This reallocation of labour and capital from an inefficient, failed business to a new, more efficient business is important for the economy to grow.

Let us now, for a moment, imagine a world without vulture capitalists. What would happen to failing companies? The government officials, like the dogs and rats, would step in and nationalise the business.

Consider the bailout of General Motors and other auto-mobile manufacturing firms in 2008 (which wasn’t the first time). It was a massive failure, resulting in tax payers getting ripped off and other unseen costs, such as jobs which were never created elsewhere. Indeed, leaving the failing companies to the vulture capitalists would have ensured that their assets would be reallocated to more profitable foreign firms.

Vulture capitalists help not only in getting rid of inefficiency in the private sector, but in government as well. Consider Argentina, whose government was left to the vulture capitalists, most notoriously Paul Singer, when it was in a debt crisis. Because people like Singer imposed harsh penalties on the Argentine government, it was forced to get its act together. Today the Argentine economy is performing much better, and its fiscal health has also improved.

Contrast that with Greek government, which was bailed out by the other European governments during its debt crisis. Not surprisingly, Greece continues to be a basket case, with exorbitant tax rates, a large and bloated welfare state and an overall ruinous fiscal policy.

Just like the birds they are named after, vulture capitalists are unjustly derided for the essential service they render to society.

Economy and Ecology

An economy is very similar to a natural ecosystem. It would interest readers to know that Charles Darwin’s theory of natural selection was inspired by the economist Thomas Malthus’s essay on population growth. Darwin, in turn, inspired the economist Herbert Spencer to coin the phrase “survival of the fittest”.

While a fuller exposition on the similarities between an economy and an ecosystem are best left for numerous future articles, I wish to make one point here. All participants in a system, whether ecological or economic, serve vital and indispensable functions. Even though these might sometimes appear ugly to us, as in the case of vultures, the alternatives are far uglier.

I have always maintained that black markets are the best way to alleviate poverty. They are also proving themselves the best way to preserve freedom. Two interesting cases came to my attention last week alone, to illustrate beautifully how a little entrepreneurship does far more to defend life and liberty than all political action combined.

Make Your Own Medicine

High drug prices are a huge problem in the US. Because government grants monopolies to pharmaceutical companies, a pill that costs only 5 cents in India, costs $750 in the US. That’s a one and a half million percent difference in price. It also leads to stuff like EpiPens costing $600 dollars.

Politicians have been ranting about it. From Bernie Sanders to Donald Trump, everyone says that drug prices are too high. Advocacy groups have been telling Congress to lower drug prices. But none of that has yielded results.

In contrast, bio-hacker Michael Laufer has done far more to make life saving medicines cheaply accessible. He created the EpiPencil, a cheaper version of the EpiPen, which costs only $35. Laufer also has plans to launch what he calls the “Apothecary Microlab”, which is a chemical reactor costing $100. That, along with free recipes, would enable people to make their own medicines at home.

Now there are some risks to doing this. Medicines require chemicals to be mixed in a very specific manner and quantity. A few micrograms off could mean the difference between life and death. It is important to note that none of this is Laufer’s fault.

If the United States government could learn something from its Indian counterpart and stop supporting monopolies, drug prices would instantly come down and people could just buy them cheaply. The Food and Drug Administration was established to ensure that drugs are safe. Ironically, by backing pharmaceutical monopolies, they might just make drugs a lot more dangerous.

There are possible market solutions that will emerge, however. One is that cheap DIY testing kits could be made available to ensure that home made medicines are safe. Another alternative is that small scale, black market manufacturers could crop up in each locality, with the technical know how to test the drugs they produce.

Rendering Gun Control Useless

Defense Distributed founder Cody Wilson has been innovating in a similar spirit. The self-described “crypto-anarchist” is selling a milling machine, called the “Ghost Gunner”, for $1600. The machine allows the user to fabricate their own metal guns at home. Wilson says the user simply has to download open source design files onto their computer, and use a point and click interface to get started. No expertise required.

This also means serial numbers are not required (they are required only when selling guns) so users can evade detection by the government. Background checks, waiting periods, permits and paperwork cannot be enforced any longer. This will be useful not only in the US, but also in developing countries where the police are corrupt/ineffective, and people would rather defend themselves.

The machine itself cannot be regulated. In Wilson’s own words.

“It’s just as regulated as a hammer — so good luck, there’s nothing you can do,” he [Wilson] said. “It’s just a mill. It’s agnostic. It’s not like it’s specially designed for gun stuff, it’s just that we also write gun software for this mill that we make. So, by breaking up these components, there’s no way of getting in-between any of it and stopping it from proliferating.”

 

Contrast Wilson’s entrepreneurship with what the NRA does. The NRA is portrayed as the number one threat to gun control. That’s nonsense. It would interest younger people to know that for most of the 20^th century, the NRA was the main advocate for gun control, and even helped draft the first gun control laws in America. Even today, the NRA can and does support gun control legislation when it feels like it.

Cody Wilson has, in four years, done far more to protect gun rights than the NRA has done in its entire history.

 

Business vs Politics

What makes Laufer’s and Wilson’s strategy more effective than political action? The main reason is that instead of pleading with politicians to do something, entrepreneurs just do it themselves, and innovate out of the mess. As Mike Munger also points out, it is better to ask for forgiveness than permission.

Had Laufer and Wilson lobbied government to allow their activities, they would have been flat out denied. Now that they have already done it and posted the know how online, it is impossible to put the genie back in the bottle. Government cannot do anything to control guns or keep drugs expensive for much longer.

It is also very profitable, as seen in Wilson’s case, meaning many more entrepreneurs will copy the business model and improve upon it. The approach of business is scalable and easily replicable, which makes it more effective than political action. That is why I trust a single entrepreneur over entire political lobbies to preserve freedom in society.