Kenneth Allen Hopf, a FB friend, was commenting on markets and central banking to another FB person in relation to the article I've commented upon separately here.

In a market economy, people aren't just digging holes and filling them back up again. Rather, they're adding value in some way, which is what allows them to make a profit. If they cannot make a profit they go out of business. Our overall standard of living rises only because the participants in the market are all adding value, and they're doing that in millions of different little ways — so that, when some efforts become misguided, they can be corrected or eliminated quickly and without having a large impact on the whole economy. 

 

More importantly, these efforts to add value are guided by millions of different prices in the market, as long as the market is free to move, i.e., as long as the prices are not disturbed by external interference and thereby distorted.

 

Prices in a free market serve as a signal, they're informational. They are like traffic lights that give you an assessment of every available resource in terms of every other available resource, because every time you employ some resource there's an opportunity cost attached to it. If I'm working at Intuit, then I can't be working at Costco. Where is my labor most valuable? Where does it add the most value? At Intuit, at Costoc, or at one of thousands and thousands of other places I might work? There is no way to answer this question in the absence of a free market for my labor. I will go to where I can get the best return on my effort, because that return, in the form of salary, indicates my value to the economy as a whole.

 

So prices are an emergent phenomenon. They arise out of billions of transactions in which every expenditure gets weighed against every other expenditure. These kinds of calculations cannot be solved mathematically. Even if we had some technique that could do it, the overhead cost would simply be prohibitive. This is the socialist calculation debate, and the defenders of markets won that argument decades ago. Computer scientists subsequently rediscovered this truth in the field of distributed processing.

 

The spontaneous order of the market utilizes information that exists only in highly dispersed and distributed form, in the minds of millions of individual market participants. This is why a market order produces new wealth and raises the standard of living. 

 

But now what happens when you extract wealth from that self-generating order and simply force it into some other service? [Sanjeev: This is what Keynesian stimuli purport to do] You're practically guaranteed to get a suboptimal deployment of resources.

 

In other words, however you use that wealth, whether it does some obvious good or not, there's an opportunity cost attached to it. If you have to force those resources into some particular use through taxation you're tacitly admitting that the wealth is being consumed in a suboptimal way, for if it was not the market would've already ventured in that direction. So every dollar you spend in the public sector is a dollar spent in a way that produces less value added than it would have done if allowed to remain in the private sector. And this is why it's possible to cut your way to prosperity.

 

Of course, economic efficiency is not the only thing that matters. If you don't have a framework of laws, if you don't have some measure of justice and protection of rights, your market order will break down. So you need to protect that. It's somewhat like being a farmer protecting your crop. You have to make sure it gets enough water and that the pests are kept away and so forth. At the same time, you could not possibly construct by design the thousands of plants that make up your crop. Each plant vastly exceeds in complexity and efficiency anything you could design and implement.

 

A healthy economy therefore is a grown order, not a deliberately design and constructed order. In short, if you want to have public expenditure, this has to be aimed at the maintenance and growth of the market order which alone is responsible for adding wealth and raising the standard of living. Any other use of public funds is indefensible, because it will actually lower the standard of living below what it would have been had that money been left in the private sector. 

 

btw .. central banking, among other egregious faults, produces a monoculture. As we know, monocultures are highly susceptible to systemic die-off. They may have efficiencies that a plethora of smaller institutions cannot match, but they do not have the robust resistance to failure. So, when catastrophe hits, you will lose the entire crop, not just a small part of it. This is what's happening today with global central banking. If we had free market currencies and free banking, we wouldn't be facing the kind of global meltdown that's now going on.

 

I'm not suggesting that the market isn't free when you have public roads and bridges and stuff like that. You can have substantial public expenditures for stuff like that and still have free markets in other areas. We actually don't know how far we can take free markets when it comes to providing what we usually think of as public services. My guess is that our framework of laws is not entirely up to the task. That's the crucial thing .. what kind legal order do we have? The history of waterway laws in the US is very instructive along these lines. 

 

In any event, things are somewhat different with central banking and legal tender laws, because money is used throughout the economy. So it touches everything. Now it is not the case the central banking has "worked perfectly". I think it is just that you're not aware of the history and the causal connections.

 

For instance, I think it is impossible to really understand the great depression and the world wars of the last century without understanding the role played by central banking. On this subject, The Lords of Finance by Liaquat Ahamed is quite instructive. Also see When Money Dies by Adam Fergusson.

 

No, I think that the history, once you know it, and find out the role played by central banking, is very damning.

 

One more thing… here's an analogy I sometimes use that I think might be helpful. 

 

Imagine that you're driving down 101 at 80 MPH. Imagine that your car represents the economy. Now as you drive, you need to keep your car in your lane and on the road. To do this you need to make constant small adjustments in the steering. You're constantly moving the wheel by small amounts. 

 

The idea that central banking stabilizes the economy is a lot like the idea that you can drive down the highway at 80 mph and keep your car precisely where it should be without making all those small adjustments in the steering. If you held your steering wheel absolutely rigid, you would eventually go careening off the road into a ditch, because the road curves. 

 

The mistake that most people make is that they think it's the other way round. They think that having monetary policy controlled by a political committee (FOMC) offers better control. This is not true. 

 

If money was just a function of market forces, the overnight bank lending rate would be constantly squirming around, not to mention what would happen if endless reserves of empty fiat where not (1) always available to the bank (sweep accounts), and (2) legal tender laws did not force creditors to accept Federal Reserve notes. 

 

This would change everything in our financial system, and it would especially change the behavior of the banks. 

 

On this whole subject I recommend The Denationalization of Money by F. A. Hayek [Sanjeev. The book is FREELY available in PDF here]

 

So .. the problem with Ben Bernanke is not that he's stupid or evil. The problem is that what he's trying to do cannot be done.

 

Also .. while I agree that you CAN cut your way to prosperity, I also think that, when you try that approach, things are at first going to get massively worse. The relevant analogy here is with the drug addict. When you go off the drug, i.e., the deficit spending, you're going to have horrible withdrawal symptoms. Things are going to look and feel really bad, as if you did exactly the wrong thing. But the fact is, unless you get off the drug, you will die. It is only by going through the withdrawal that you have a chance of returning to health.

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1. Larry White’s excellent talk – and writings on banking, India, and economic history
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3. Review of Demsetz’s masterpiece: From Economic Man to Economic System
4. If you STILL believe that capitalism caused the financial crisis, then read this
5. Economic design of democracy and bureaucracy
6. John Allison of Cato Institute demonstrates how misregulation caused the financial crisis
7. Taleb’s excellent insights on the economy and international affairs
8. A summary of Hayek’s Constitution of Liberty
9. India can become twice as rich by following Gujarat’s economic policies
10. A brilliant video summary of various classical liberal ideas