Week 8 - Free Exchange and Wealth Creation
Day 1 - Getting Started
- When it comes to wealth producing projects, how might the incentives of government decision makers differ from those of private investors?
- Government decision makers have the major incentive of getting reelected. This means that they have the incentive to make decisions and policies that look good and offer big benefits right now (in the short term). They do not have the incentive to consider secondary effects (which will have long-term consequences), as it is unlikely that the general public will quickly attribute those secondary effects to the government decision or policy. The government also has the ability to spend other people's money (taxes), so they do not have the strong incentive to conserve resources and spend wisely and frugally. In contrast, private investors do not have the major incentive of getting reelected; they have the major incentive of building wealth. They will have the incentive to invest in projects that will build them wealth long term (not just in the short term). They have the incentive to practice delayed gratification and take care of their property. Furthermore, they have to use their own wealth and resources to further their projects, so they have every incentive to conserve resources and spend wisely and frugally.
- Why would monetary stability be an essential ingredient for economic progress?
- Monetary stability is an essential ingredient for economic progress for several reasons. First, it ensures that the money that people earn and spend maintains the same value. People know that their money will be worth the same amount tomorrow and that prices will not increase suddenly. Second, people will be more likely to invest and innovate when they know that they will be able to profit from their pursuits because the value of money does not plummet. Third, people will be more likely to buy goods and services if their earnings stay consistent with the value of money and, thus, prices.
- Did the “Roaring Twenties” cause the Great Depression?
- The "Roaring Twenties" did not cause the Great Depression. Rather, the Federal government messing with the money supply caused the Great Depression. Deflation followed inflation (this was a boom and bust). The "Roaring Twenties" was the boom, and the Great Depression was the bust.
Day 2 - Helping Out the Economy?
Misdirected Investments, Deals, and Bail-Outs
- 1. What is capital investment? Make sure to include an example of a capital investment in your answer.
- Capital investment is "the construction and development of long-lasting resources designed to help produce more in the future" (72). It "is an important potential source of economic growth" (72). An example of capital investment is "the purchase of an oven by a local pizzeria" (72). The "purchase...will help enlarge [the pizzeria's] future output" (72).
- 2. What is the function of the “capital market” in the market economy and how does it work to both channel funds efficiently into productive projects and bring counterproductive projects to a halt?
- The function of the capital market in the market economy is to "attract savings and channel them into the investments that are most likely to create wealth" (72). In the capital market, private "investors...place their own funds at risk...Investors will sometimes make mistakes; sometimes they will undertake projects that prove to be unprofitable" (73). But in "a world of uncertainty, mistaken investments are a necessary price that must be paid for fruitful innovations in new technologies and products. Such counterproductive projects, however, must be recognized and brought to a halt. In a market economy, the capital market performs this function" (73-74). It is able to do this because if "a firm continues to experience losses, eventually investors will terminate the project and stop wasting their money" (74).
- 3. Why is a private market more successful at consistently channeling investment funds into wealth-creating projects than the government?
- A private market is more successful at consistently channeling investment funds into wealth-creating projects than the government because given "the pace of change and diversity of entrepreneurial talent, the knowledge required for sound decision-making about the allocation of capital is far beyond the scope of any single leader, industrial planning committee, or government agency. Without a private capital market, there is no mechanism that can be counted on to consistently channel investment funds into wealth-creating projects" (74). Furthermore, when "investment funds are allocated by the government, rather than by the market, an entirely different set of factors comes into play. Political influence rather than market returns will determine which projects will be undertaken. Investment projects that reduce rather than create wealth will become far more likely" (74).
- 4. Two large government sponsored corporations, Fannie Mae and Freddie Mac, dominated the mortgage market during 1995-2008. Why did these two firms have a competitive advantage over other mortgage lenders?
- Fannie Mae and Freddie Mac had a competitive advantage over other mortgage lenders because even "though [they] were privately owned businesses, investors perceived that the bonds they issued to raise their funds were less risky because they were backed by the government. As a result, Fannie Mae and Freddie Mac were able to borrow funds at approximately half of a percentage point cheaper than private firms" (75).
- 5. Create a list chronicling the effects of the regulatory policies and mandates put in place to make mortgage funds for housing purchases more readily available to low and middle-income borrowers beginning with Fannie and Freddie’s accepting of little or no down payment mortgages and ending with the debt left to the American taxpayer.
- After Fannie and Freddie accepted little or no down payment for mortgages: 1. Due to "their dominance in the secondary market, their lending practices exerted a huge impact on the lending standards accepted by mortgage originators. Recognizing that riskier loans could be passed on to Fannie Mae and Freddie Mac, the originators had less incentive to scrutinize the credit worthiness of borrowers or worry much about their ability to repay the funds. After all, sale of the mortgages to Fannie Mae and Freddie Mac would transfer the risk to them as well" (76). 2. Subprime "mortgages (including those extended with incomplete documentation) soared from 4.5 percent of the new mortgages in 1994 to 13.2 percent in 2000 and to 33.6 percent of the total share of mortgage originations by 2006. During the same time frame, conventional loans, for which borrowers are required to make at least a 20 percent down payment, fell from two-thirds of the total to only one-third...Predictably, the growing share of loans to those with weaker credit eventually led to higher default and foreclosure rates" (76). 3. The "policies eroded mortgage-lending standards, making credit more readily available for risky loans" (77). As a result, "the initial effects seemed positive. The demand for housing increased, housing prices soared during 2001-2005, and there was a boom in the construction industry" (77). 4. However, by "2004-2005, approximately half of all mortgages were either subprime (including those with incomplete documentation) or loans against the equity people had in their homes. As soon as prices leveled off and then began their decline during the second half of 2006, the house of cards came crashing down. The mortgage default and foreclosure rates immediately began to rise" (77). 5. The "collapse of the housing industry eventually spread to the rest of the economy, and the bad mortgages generated huge financial problems in banking and finance both in the United States and abroad. By summer 2008, Fannie Mae and Freddie Mac were insolvent. Their operations were taken over by the government and the American taxpayer was left with approximately $400 billion of bad debt" (77).
- 6. Who was John Maynard Keynes? (You will need to go outside your textbooks for this answer) What did he believe about taxing and federal spending? Did his theories have a significant influence on United States spending policy?
- John Maynard Keynes was an "English economist, journalist, and financier" (the editors of Encyclopaedia Brittanica, brittanica.com; "John Maynard Keynes"). He believed "that government should tax during times of prosperity and borrow and spend during economic downturns to restart economic growth. His theories influenced much of 20th century big-spending policy, epitomized by President Franklin Roosevelt" (2).
- 7. Fill in the blanks below:
- The specific error behind the “Keynesian Myth is the notion that the government has its own pot of money sitting around waiting to be spent.” The error is: "The pot doesn't exist"!
- 8. How do government bailouts of faltering industries harm economy and what great injustice is done to those private firms and states that have used prudence and wisdom to avoid the need for a “bailout”?
- Government bailouts of faltering industries "harm the economy because they reward reckless private and state spending, leaving it unchecked and effectively encouraging more of the same in the future" (3). The great injustice that is done to those private firms and states that have used prudence and wisdom to avoid the need for a "bailout" is as follows: "Bailouts for private companies usually mean that failing businesses receive taxpayer money, while their more successful competitors do not" (3), and a "federal bailout of the states...would transfer money from families in states that have resisted extravagant spending programs to other states that have spent more recklessly...[It's] wrong to force families who have elected responsible stewards in their states to pay for the folly of those in other states who have elected irresponsible spenders" (3).
Economy Hits Home: Economic Growth Part 1
Day 3 - Monetary Stability
Recessions, Depressions and Inflation
- 9. What are the three ways money functions in an economy?
- First, "money is a means of exchange. It reduces transaction costs because it provides a common denominator into which the value of all goods and services can be converted" (78). Second, money "makes it possible for people to gain from complex purchases with a time dimension, such as the sale or purchase of a home or car, which involve the receipt of income or payment of a purchase price across lengthy time periods. And it provides a means to store purchasing power for future use" (78-79). Third, money "is...a unit of account that enhances people's ability to keep track of benefits and costs, including those incurred across time periods" (79).
- 10. Explain what is meant by the phrase “money is to an economy what language is to communication.”
- The phrase can be explained as follows: "Without words that have a clearly defined meaning to both speaker and listener, communication would be difficult" (79). The same is true of money; if "money does not have a stable and predictable value, it will be difficult for borrowers and lenders to find mutually agreeable terms for a loan, saving and investing will involve additional risks, and time-dimension transactions (such as payment for a house or automobile) will be fraught with additional uncertainty. When the value of money is unstable, many potentially beneficial exchanges are not made and the gains from specialization, large-scale production, and social cooperation are reduced" (79).
- 11. What is inflation and when does it occur?
- Inflation is "when the supply of money expands rapidly compared to the supply of goods and services, [causing] the value of money [to decline] and prices [to] rise" (79). Inflation "occurs when governments print money or borrow from a central bank in order to pay their bills" (79).
- 12. TRUE or FALSE: The connection between rapid monetary growth and inflation has been one of the most consistent relationships in all of economics.
- This statement is true.
- 13. How do high and fluctuating inflation rates undermine prosperity?
- High and fluctuating inflation rates undermine prosperity in the following ways: 1. Fluctuating price increases mean that "individuals and businesses are unable to develop sensible long-term plans...Rather than dealing with [the] uncertainties [of inflation and investments], many decision-makers will simply forgo capital investments and other transactions involving long-term commitments. Some will even move their business and investment activities to countries with a more stable environment" (81). All of this means that "potential gains from trade, business activities, and capital formation will be lost" (81). 2. High and fluctuating inflation rates mean that "people will spend less time producing and more time trying to protect their wealth. Because failure to accurately anticipate the rate of inflation can devastate one's wealth, individuals will shift scarce resources away from the production of goods and services and toward actions designed to hedge against inflation" (84). 3. Cycles of "monetary expansion and contraction" (82) lead to boom-and-bust cycles, "create uncertainty, slow private investment, and reduce the rate of economic growth" (82). Furthermore, when a government takes part in mal-investment, the "badly allocated investments...have to be cleansed from the system" (84) before the "economy can return to a sustainable path of growth" (84). This "is a costly and painful process" (84).
- 14. What is “mal-investment”? This term is bolded in your CSE text, meaning its definition can be found in the GLOSSARY.
- The definition of "mal-investment" is as follows: "Mal-investment is misguided (or excess) investment caused when the Fed keep interest rates artificially low, encouraging too much borrowing. The new bank credit is invested in capital projects that cost more than the value they create. At some point a correction must occur to cleanse these uneconomical investments from the system" (242).
- 15. What is the most frequent reason for printing more money?
- The most frequent reason "is the existence of an unbalanced budget. Unbalanced budgets are caused by extravagant expenditures which the government is unwilling or unable to pay for by raising corresponding tax revenues. The excessive expenditures are mainly the result of government efforts to redistribute wealth and income---in short, to force the productive to support the unproductive" (1).
- 16. How does prolonged inflation affect an economy?
- Prolonged inflation "unbalances, disrupts, and misdirects production and employment" (2).
- 17. What should government do in order to balance the budget?
- In order to balance the budget, the government should act "at the earliest possible moment" (2), and the balance "must be brought about by slashing reckless spending, and not by increasing a tax burden that is already undermining incentives and production" (2).
Inflation In One Page by Henry Hazlitt
Day 4 - Examining an Economic Episode in U.S. History
The Great Depression-Part 1
- 18. Who were the two influential economists of the twentieth century and what did each believe regarding the role of government in the economy?
- The two influential economist of the twentieth century were "John Maynard Keynes and Friedrich A. Hayek" (1). Keynes "argued that rather than be passive, the government needed to proactively intervene in the economy" (1). Hayek, on the other hand, argued that "the economy was far too complex for experts and government planners to manage [and] that not only will the government be unable to plan, but the planning and regulations will cause more harm than good...Hayek believed the role of government in the economy was to be limited to simple things like providing a legal system and protecting property rights...[The] role of government was only to maintain the legal environment for growth and stable monetary policy" (2).
- 19. What achievements of the 1920s contradict the popular view that the 1920s was "the party" and the 30s, was "the hangover"?
- The 1920s included "incredible innovations and economic growth" (2). In the 1920s, "electricity began making its way into homes, telephones became prevalent, radio stations began broadcasting, air conditioning was installed in large stores and theaters, and the mass production of automobiles significantly improved the lives of ordinary people. In conjunction with these innovations, income per person increased by 30 percent from 1921 to 1929" (2).
- 20. What was the "common thread" woven through several earlier depressions and why did this one last many years longer than previous depressions?
- The "common thread" woven through several earlier depressions "was disastrous manipulation of the money supply by government. For various reasons, government policies were adopted that ballooned the quantity of money and credit. A boom resulted, followed later by a painful day of reckoning" (4). The Great Depression lasted many years longer than previous depressions "because the government compounded its monetary errors with a series of harmful interventions" (4). The "Federal Reserve expanded the money supply by more than 60 percent from mid-1921 to mid-1929. The flood of easy money drove interest rates down, pushed the stock market to dizzy heights, and gave birth to the "Roaring Twenties"" (4). However, after this, the Fed "significantly reduced the money supply which caused interest rates to increase and for the next three years presided over a money supply that shrank by 30 percent. This was the worst period of deflation ever experienced by the United States. This deflation following the inflation wrenched the economy from tremendous boom to colossal bust" (4). Then, when "the masses of investors eventually sensed the change in Fed policy, the stampede was underway. The stock market, after nearly two months of moderate decline, plunged on "Black Thursday"...as the pessimistic view of large and knowledgeable investors spread" (4).
- 21. According to the late Murray Rothbard, what did the Federal Reserve do that gave birth to the "Roaring Twenties"?
- The late Murray "Rothbard estimated that the Federal Reserve expanded the money supply by more than 60 percent from mid-1921 to mid-1929. The flood of easy money drove interest rates down, pushed the stock market to dizzy heights, and gave birth to the "Roaring Twenties"" (4). For this estimation, Rothbard used "a broad measure that includes currency, demand and time deposits, and other ingredients" (4).
- 22. What was the "crowning folly" of the Hoover administration, what did it do, and what effect did it have on the economy?
- The "crowning folly" of the Hoover administration was "the Smoot-Hawley Tariff, passed in June 1930" (5). It "virtually closed the borders to foreign goods and ignited a vicious international trade war. Professor Barry Poulson notes that not only were 887 tariffs sharply increased, but the act broadened the list of dutiable commodities to 3,218 items as well" (5). As a result of Smoot-Hawley, foreign "companies and their workers were flattened by [its] steep tariff rates, and foreign governments soon retaliated with trade barriers of their own...American agriculture was particularly hard hit" (5). Farmers "in this country lost nearly a third of their markets. Farm prices plummeted and tens of thousands of farmers went bankrupt. With the collapse of agriculture, rural banks failed in record numbers, dragging down hundreds of thousands of their customers" (5). Furthermore, "with the passage of the Smoot-Hawley Tariff in the spring of 1930, the economy shrank and the Dow [Jones Industrial Average] collapsed" (5).
The Great Depression by Lawrence Reed and Joseph Connors
Day 5 - Examining an Economic Episode in U.S. History
The Great Depression-Part 2
- 23. Despite FDR's promises to reduce federal spending, balance the federal budget, shrink government and end the “extravagance” of Hoover’s farm programs, Roosevelt introduced new programs, laws, and policies that led to massive government growth and expenditures. Briefly describe at least five programs, acts or laws and explain the effect each had on the economy.
- 1. Roosevelt "talked Congress into...imposing the nation's first comprehensive minimum wage law in 1938" (6). Minimum wage laws are laws in which the government sets the minimum wage that workers can be paid. Unfortunately, the "minimum wage law prices many of the inexperienced, the young, the unskilled and the disadvantaged out of the labor market" (6). 2. The Agricultural Adjustment Act (AAA) "levied a new tax on agricultural processors and used the revenue to supervise the wholesale destruction of valuable crops and cattle" (7). The economic "result was higher prices for food for an already starving public" (7). 3. The "National Industrial Recovery Act (NIRA), passed in June 1933...set up the National Recovery Administration (NRA). Under the NIRA, most manufacturing industries were suddenly forced into government-mandated cartels. Codes that regulated prices and terms of sale briefly transformed much of the American economy into a fascist-style arrangement, while the NRA was financed by new taxes on the very industries it controlled" (7). The economic result: some "economists have estimated that the NRA boosted the cost of doing business by an average of 40 percent...In the six months after the law took effect, industrial production dropped 25 percent" (7). 4. FDR "signed into law steep income tax increases on the higher brackets and introduced a 5 percent withholding tax on corporate dividends. He secured another tax increase in 1934. In fact, tax hikes became a favorite policy of Roosevelt for the next 10 years, culminating in a top income-tax rate of 90 percent" (7). The economic result is described by "Sen. Arthur Vandenberg of Michigan" (7). He said that a "sound economy would not be restored...by following the socialist notion that America could "lift the lower one-third up" by pulling "the upper two-thirds down"" (8). 5. The Civil Works Administration "was supposed to be a short-lived jobs program. Roosevelt assured Congress in his State of the Union message that any new such program would be abolished within a year" (8). The economic result of the CWA: it "is known today as the very government program that gave rise to the new term, "boondoggle," because it "produced" a lot more than the 77,000 bridges and 116,000 buildings to which its advocates loved to point as evidence of its efficacy" (8).
- 24. In the fourth phase, what was granted to labor unions via the Wagner Act and what was its consequence?
- In the fourth phase, the Wagner Act ""took labor disputes out of the courts of law and brought them under a newly created Federal agency, the National Labor Relations Board, which became prosecutor, judge, and jury, all in one. Labor union sympathizers on the Board further perverted this law, which already afforded legal immunities and privileges to labor unions"" (9). The consequences were that the ""U.S....abandoned a great achievement of Western civilization, equality under the law"...Armed with these sweeping new powers, labor unions went on a militant organizing frenzy. Threats, boycotts, strikes, seizures of plants, and widespread violence pushed productivity down sharply and unemployment up dramatically" (9). Furthermore, membership "in the nation's labor unions soared; by 1941 there were two and a half times as many Americans in unions as in 1935" (9).
- 25. What is inflation and what affect does it have on prices?
- Inflation is simply defined "as an increase in the supply of money...Only one entity can [increase the money supply] legally; the government" (10). Inflation causes "rising prices" (10).
- 26. Why does how you define "inflation" matter?
- How you define "inflation" matters "because, as economist Percy Greaves explained so eloquently, "Changing the definition changes the responsibility"" (10). If you define "inflation as rising prices [then people] will think that higher energy prices are the culprit, and price controls are the answer. [If you define] inflation as it should be defined as an increase in the supply of money, wish rising prices as a consequence...then [you] have to ask the revealing question, "Who increases the money supply?" Only one entity can do that legally; the government" (10).
The Great Depression by Lawrence Reed and Joseph Connors