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Key Lesson #8: Hidden changes in the amount of money matter

Us: Money is simply a medium of exchange. This is, the intermediary step between what we have and what we want. Money represents potential goods and services. Think of it as a “Jack of All Trades” sort of good. It can be transformed into anything you may want. Therefore, a certain amount of money is equivalent to a certain amount of goods or services. This relationship (aka the “exchange” or the “purchase”) is determined by buyers and sellers alone. They assume the total amount of money is constant and because of this assumption, they can estimate the value they give to goods and services. Based on this estimation, they either bargain, buy or do nothing. However, if the amount of money is being changed (increased or decreased) without their knowledge, all their estimates of value are wrong. If they are wrong, then their decisions about bargaining, buying or doing nothing are also wrong. If these decisions are wrong, then the price is wrong. If the price is wrong, then markets cease to be efficient. If this happens, our quality of life decreases.

Them: Changes in the amount of money do not matter. This is so because increases or decreases cannot be hidden from people and therefore they know, instantaneously, the real amount of money that is out there. If they know this, then their estimations of value are accurate and the markets remain efficient.  Does this seem like something reasonable to you? That we can have perfect information instantaneously? Or is it something farfetched and theoretical that only an academic working with pure math can concoct? We though so too…


Key Lesson #9: Corollary – Inflation matters

Us: If the hidden changes in the amount of money matter, what does this say about inflation? Any increase in the amount of money not offset by an identical increase in the demand for money, will rise prices. However, as we have seen, assuming that people will know instantaneously how much more money is there is ridiculous. Therefore, some people will know sooner than others. These people will adjust their estimates of value and this will reflect on prices. Some other people will not know and therefore their estimates will be incorrect. In other words, prices will be distorted. If this happens, markets become inefficient and our quality of life decreases. Printing money does not increase wealth because money is a means to exchange “stuff”; it is a mechanism. It is not “stuff” by itself. We cannot create “stuff” out of thin air. “Stuff” is real wealth, money is not. Inflation is destructive because:

  1. Governments use it to confiscate our wealth (they spend the money first, when there is no inflation)
  1. Debtors benefit over Creditors (interest payments on debts are agreed based on an inflation estimate – if inflation rises, creditors receive less purchasing power than agreed)
  1. It makes markets less efficient (this lowers everybody’s standards of living)

Them: Inflation is necessary to “stimulate” the economy. As government creates wealth out of thin air and spends it, this wealth is spread out throughout the citizens and therefore everybody benefits. Small amounts of inflation are OK because everybody knows instantaneously what the inflation will be and therefore they can adjust their prices instantaneously. If any of it would be true then why not simply print enough “wealth” to satisfy everybody’s needs? Why bother working, just print money and we can all be on permanent vacation! Voila! Instant wealth for everybody. Does this sound like something realistic? Or does it sound more like a fairy tale?


Key Lesson #10: Efficient manufacturing depends of careful resource use

Us: This one seems obvious, but it is a little bit more detailed. If we make a gadget, we need many things, from plastic to machines, from a factory to metals, from electricity to workers and so on. All these are resources and must all be coordinated for gadgets to be built. If even one of these resources is not available or is more expensive than anticipated, gadgets do not get build. You see, manufacturing is always an estimation of future profits. A maker of gadgets cannot know the price people will be willing to pay for it, but it must estimate it. Based on this estimation, the maker will know if it is worth manufacturing gadgets or not. Based on this calculation, the maker then proceeds to buy the necessary resources. This calculation is what makes the market efficient. If the maker reaches the conclusion that there is no profit, then something else will be built with those resources. Something that will yield a profit. However, what happens if there is inflation? Let’s assume that the calculation estimates a profit. The maker buys all those resources and then, due to inflation, the maker realizes that there is no profit. If this person is clever, he will find another use for those resources that will produce profits. This person will have to reorganize those profits and then manufacture something else. However, in the meantime, all those resources are lost. They are either an expense or are not being used. This is a gigantic waste of resources, and it makes markets inefficient.

Them: Because the maker knows instantaneously what the current inflation is and he knows what the inflation will be in the future (because he got assurances from the government that they will only print so much), valid profit estimates can be calculated. Therefore, gadget manufacturing can begin and markets remain efficient.  Does this sound like something reasonable to you? Do you know instantaneously what the inflation is? Do you trust the government not to print more in the future, even if there is an “emergency”? Of course not! This is all make-believe creative economy!


Key Lesson #11: Economic efficiency is an unintended consequence

Us: If we look at history, we will find that markets evolved literally out of nothing. When people started to exchange goods, there were no governments giving them trading rules. They made those rules as they went along. Their only goal was to improve their own lives; they were not thinking of other people’s lives at all. However, despite of their intentions, they created a complex market with complex rules. As a consequence of these market rules, markets became efficient and was this efficiency that improved other people’s lives. Markets were not designed nor intended at all! But markets are not the exception to this rule, they are rather mainstream examples of this rule. Almost any social institution (money, law, language, science, medicine, etc.) was created by people trying to improve their own lives. In so doing, they also improved the lives of other people. But there is more. Since the goal was to improve their lives, they actually optimized this improvement, which was later on carried to other people. For example, let’s say that I suffer from headaches and no medication works. I try to improve my life by experimenting with herbs. As such, do you think that I will purposely be seeking a herb that does a so-so job getting rid of headaches, or will I be looking for a herb that does the best possible job? Of course the latter! Why would I seek a herb that still leaves me with a half-resolved problem? If I find such herb, this knowledge will be passed to other headache suffers who will benefit from it. They will get the best product I could create. It may not be the absolute best, but it will the best I can come up with given my resources. In other words, the underlying mechanism by which markets are created are already biased very heavily towards optimization. Hence, their product, the market is optimized. Furthermore, this optimization did not happen by design, but as an unintended consequence!

Them: They believe that markets are a necessary evil. They understand that without markets, production becomes infinitely less efficient. However, they believe that they need to “limit” market’s “destructive” power towards society. This would be so because markets embody the concept of selfishness and society needs to be driven to selfness by design. They are trying to create a “new” society where everybody is selfness…or else! As part of this process, they need to “manage” the market. Impose rules and regulations, do’s and don’ts, taxes, levies, fines, fees, and so on towards the infinite. This is, of course, a leftover from communist thinking… and we know how well communism worked in real life. The problem with all these manipulation is that they are decreasing market efficiency enormously by trying to “improve” on an already optimized process! Consider this: rain is necessary for a good harvest. However, from time to time there is drought. There is water in the atmosphere, but it is just not raining. So, in the 50’s scientists try to “seed” clouds using chemicals. It worked. It rained. They saved that growing season. However, they not only created drought in other places where there wasn’t but they made other droughts much worse! This is what happens when one tampers with an optimized system, it becomes less optimized, its efficiency decreases. This is what happens when they “regulate” markets, they become far less efficient and with this drop, our quality of life also drops. Does this sound like something you would like?

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to Austrian Economics In Theory - Part 7


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