Straddling the Siren Song

Last night during my Austrian economics class I argued that some of the mathematics in neoclassical economics is useful for a few things, a sentiment some (all perhaps?) of my classmates did not share. Jason Briggeman challenged me to note one insight the Cobb-Douglas production function (one example I offered that could be useful to economics) but the conversation went in another direction and I was too tired to backtrack to his inquiry so I could address it. After class I promised to answer his question in a blog post so here it is.

The C-D production function is a pretty uninteresting claim: GDP depends on how much labor and how much capital a country has. However, if we combine it with the Solow growth model we can use it to prove the existence of convergence (poor countries grow faster than rich countries). In the real world, absolute convergence (all countries converge) is a myth however conditional convergence (countries with similar institutions converge) is quite real.

We do not need C-D or Solow to learn this--we can simply look at the data--but it does help explain why this happens in a clean but still useful way. Similarly, we could use pure math to explain or demonstrate conditional convergence but that would be of little use; words are much more appropriate for that. In my defense of math in economics, I ask that Austrians recognize something they've always asserted: people are heterogenous. One person may instantly grasp the intitution of convergence while another may be assisted in the calculus. To dismiss all of mathematics in economics is to deny a potential tool economists can use to demonstrate how the world works. To embrace it completely is also a mistake for it nullifies the most important questions. Mathematics misses the point in some ways, but is appropriate in others.

Math in economics is a siren song. It is beautiful and pure, but also dangerous if we focus too much on it. Yet if we completely avoid the music we will deny ourselves valuable knowledge and drastically limit where we can go (Odysseus had to travel past the sirens' island in order to continue his journey). Economists must learn to straddle this siren song: to hear it but not to succumb to it. If we can force ourselves to stay grounded, like the hero The Odyssey who tied himself to the mast of his ship, we won't miss what can be learned from mathematics nor will we drown in a barren attempt to worship this dirge.

The Downsides to Capitalism

I've been thinking about this for a bit, and wanted to try and share what I think is one of the fundamental problems we have in communicating ourselves to non-believers. They think we don't care what happens as a result of the free market. Some seem to think that means that people can be bought and sold, abusded and thrown away. Others might just despise corporate layoffs and the whole bother about the bottom line trumping the people involved.

Businesses fail (sometimes spectacularly, like Enron), businesses can hurt people (firing them when they really need the job), and so on. I don't deny any of that. But I think these failures and personal injuries are not only magnified by government involvement, I think they're rather the products thereof as often as not.

The Austrian theory of the business cycle revolves around the money supply, and as the Fed has been inflating it (or inversely, devaluing the dollar) at a fairly steady rate since founded in 1913, it's been fueling booms and the subsequent market corrections, in which people get hurt. In boom times there aren't many layoffs, but man, when the corrections come around and people realize that there's really no value in a business, jobs go flying.

This, compounded by the warping of time-prefernce spurred by the availability of easy money (via credit) and the constant erosion of savings (via inflation), leads to a great many negatives, which people rightly criticize - but rarely do they pin the blame on the institution that's actually causing the inflation, creating malinvestment, and ultimately, causing loss of jobs, productivity, and so on. They blame the proximate cause, the business that cuts the jobs, and not the government bank-cartel that fueled the problem.

Believing that, am I cruel to say that the real solution, at least in my eyes, would be to liquidate the Fed, instead of implementing stringent business regulations? To me, that's just bandaging a compound fracture; it may help keep out infection, but it's not helping to make the fundamentals any more sound. You can cover up problems, like the USSR did for more than 70 years - but eventually, debts need to be paid.

I firmly believe that this sort of action is helpful and moral; does that make me a monster? I don't think so.

The Edge of Austrian Theory

Here's another question for you all to ponder with me:

How does the Austrian school identify and adress in terms of its praxeological consequences the phenomena of addiction, and other impulse-driven behavior? I believe that most people are able to control their impulses, but even momentary laspses can lead to a third beer, a second child, etc.

I guess you could say that the experience or expectation of a pleasure can in some cases warp a person's time-preference, cloud their judgment, or otherwise make them do dumb stuff they wouldn't do in a "right" state of mind.

I'm not saying people are any less responsible for their actions, but I think it's a given that people are generally going to experience a corresponding rise in their time preference with a rise in their... well, you know.

Any thoughts or comments of interest?

I'll describe later WHY I'm thinking about this, so tune in, same Bat Time, same Bat Channel!

An open question

Force and coercion are major historical themes, but the roles of which I fear may be somewhat underplayed by Austrian economists. While I'm surely hoping for a minarchist state or better to come about, the conspicuous absence of any readily identifiable forms of such existing in practice doesn't encourage. While it may be that such states are possible, they're not in evidence around every crook and corner.

So, I ask all of you, what role does force play in the collapse of market relationships (i.e. free, voluntary) into political relationships (i.e. coercive)?

Taking the accumulation and inheritence of property in a typical society revolving around intensified agricultural production, especially sedentary and with a complex division of labor, social stratification is almost bound to occur. Once you have a stratified society, you have different power-potentials - that is, different abilities, due to the accumulation of prestige, wealth, skills, etc. to work your will above and over the will of others.

Now given this scenario, I believe that rational self-interest will inevitably lead to attempts at violence and coercion. Situations that encourage high time preference (i.e. instant gratification over maximized future returns) are likely to see the worst of it. Ultimately, I think this almost precludes a developing society with a complex division of labor and stratification, high population density, and with an overall high social rate of time preference from becoming anarcho-capitalist or minarchist - there's too much short-term gain to be had by fleecing your neighbors, making such a turn fleetingly unlikely.

Any thoughts? Does that sound about right, or am I full of it? Tell it to me straight, people!

A World Without Patents

This past weekend I went to the SEA conference in DC and had a wonderful discussion with economist Howard Baetjer of Towson University.

Howie wrote a wonderful article in the Review of Austrian Economics called "Capital As Embodied Knowledge" (pfd here). Capital, he says, get its value because it's infused with knowledge, thus other people can use it even if they don't understand the technology. I can use my car even though I can't even change my oil. If I had no knowledge of how computers work, I could still use one just fine.

We got to talking about patents and how screwy they are. For a long time I always figured patents as a necessary evil. Yes, they are subject to terrible abuse but I couldn't think of an alternative to protecting intellectual property. He suggested re-enginneering, say software, to encrypt it better so its patent is protected.

This is where it gets really interesting. I realized that what he's proposing is the seperation of service (what the technology does) and technology (how it works). This is what patents basically do: seperate service from technology. Patents allow people to enjoy what a technology does but disallow the replication of that technology. Firms cannot "reverse-engineer" a patented item (usually). But if there were no patents, they could (and do).

In a world without patents, the costs of reverse engineering is their grace period (not the length of the patent). Thus, I propose firms will adjust their behavior to get the most out of the technology they developed.

First, they will attempt to make it as hard as possible to reverse-engineer the product by doing extra work to seperate service from implementation. I call this practice "black-boxing" because you want to turn your product into a "black box;" all the people know is what comes from it (the service), not how it works (implementation). We can imagine firms hiding circuts, creating false relays, adding "self-destruct" programs (overheat the circuts if the case is broken) and maybe even coating the inner-casing with a tough structure that's physically hard to remove.

Second, firms will engage in multi-incremental technology growth. With patents, marketing the absolute latest makes sense because no one else can make that technology. Without patents, firms will not release a product the moment they perfect the slightest improvement because that will be easy to reverse-engineer. Instead we'll likely see new products that not only contain generations of a particular improvement, but several of them at once. With all these leaps in one product, it becomes exponentially more complex to figure out how it works. (Think of the difference of giving a six-shooter to the founding fathers and giving them a machine gun.)

Third, firms will reduce their prices faster for new technology because they want to get a bigger foot in the door. With patents, they have greater monopoly power (because they know when their power ends). Without patents, their length of their monopoly power becomes uncertain; it would be as if they are competing with a company even before they replicate the technology.

Fourth, all of these things will encourage corporate espionage, and that's just cool.

Fifth, there will be more focus on technology with greater originality and novel approaches. Reverse-engineering such technology is harder because you're less certain where to start.

All of these things would, of course, increase the costs for firms, (just like removing a licensing law increases the costs). I do not think firms will embrace this change in law. However, it is possible it could work in their favor if they black-box and spy well enough.

Sunrise, Sunset

Every news network today was a buzz with the Fed’s decision to raise the federal funds rate (FFR) by a quarter of a point, yet not one of them went into much discussion about what it means. The banking industry has huge ramifications throughout the entire economy and the interest rate is one of it central mechanisms. Let’s take a moment and unravel what today’s news really means.

The interest rate is basically the price of money, reflecting the time preference of lenders and borrowers. If the rate is 3%, then $1,000 now will cost you $1,030 later. Borrowing money is useful for economic development because it provides the funds needed to expand production. The FFR is the rate which banks charge each other. Since banks can always borrow from other banks to have the money lend to customers, changes in the FFR directly change the interest rates for consumers and businesses (which are used to build factories, start businesses and so on).

The Fed claims it needs to adjust the FFR as to create a balance between growth and inflation. What the Fed doesn’t tell the public is that its constant meddling in this vital tool for economic growth causes instability and recessions.

This is the Austrian theory of the business cycle. By artificially lowering the interest rate, businesses borrow and expand their production (the boom), thinking the lower interest rate is due to people saving more. If businesses produce more, people will take money out of the bank and use it to spend on the new goods and services. But because these consumer cash reserves don’t actually exist, the businesses won’t sell any of these goods (the bust) and recession—or worse—will set in. Firms will have loans without any way to repay them. This theory was first proposed by Ludwig von Mises, who used it to predict the Great Depression. He was the only economist at the time who foresaw the collapse.

Today we see a similar pattern. The Fed pushed the FFR down to about 1% to counterfeit a boom after 9/11). Its recent increases (six since last summer) are attempts to hold back inflation amidst a recovering economy. But the FFR is still just 2.5%, hardly enough to staff off the bust that will inevitably follow the oncoming (and false) boom. While Americans are celebrating the newly expanding economy, we should watch our back; in 20 or 30 years, it’ll be 1999 all over again.

Books that Changed My Life

If you're looking for something to read, be inspired or educated by, or just want to understand some of the thought behind my brand of libertarianism, here're a few of the most significant books that I've ever read.

Economics for Real People: An Introduction to the Austrian School (Gene Callahan)
Just great, a very basic introduction to the Austrian school that nobody should go without reading. Entertaining as well as informative.

Culture of Fear (Barry Glassner)
While suffering from the same flaw it points out in the rest of American culture, the author rightly points out the misuse of fear in politics and social life.

The Future and its Enemies (Virginia Postrel)
One of David's favorites, I love the premise. The authoress draws a distinction between those that seek to control development (economic, cultural, and otherwise) and those that permit it and make it happen, those the author calls Dynamists. Dynamists drive the economy as well as all manner of change, and the future, like it or not, is in their hands - and that's OK!

Democracy: The God that Failed (Hans-Hermann Hoppe)
This book woke me up to the possibility of the absolute dispensibility of government.

The Evolution of Cooperation (Robert Axelrod)
Axelrod does a good job of demonstrating how cooperation can spontaneously arise from the interaction of self-interested agents. His later books are worth checking out after reading this one.

The Selfish Gene (Richard Dawkins)
Dawkins explains the nature of life, and why we shouldn't expect any help from our genetic heritage in the establishment of an altruistic social order.

The Philosophy of Aristotle (ASIN = 0451627830)
A stunning masterpiece, covering everything from logic and metaphysics to politics and ethics. Aristotle's philosophy continues to provide a practical foundation for the conduct of inquiry. Get it.

Suicide (Emile Durkheim)
Durkheim's exploration into the social phenomenon of suicide introduces some powerful concepts of social integration and control. Essentially functionalist, his paradigm can be used to explain and analyze many phenomena.

Law/Society (John Sutton)
This book made me very keenly aware of the lengths to which a special interest group will go to further their own security, power, wealth, etc. In this case, we're talking about the American Bar Association, but the AMA and other professional groups can be plugged into the analysis with equal applicability.

The McDonaldization of Society (George Ritzer)
A great introduction to the sociology of Max Weber with very specific applications in modern society and everyday life. Detailing the seemingly inexorable progression of rationality (i.e. attempts to control things) in institutions, this book will acclimate you with some of the most important trends to be aware of.

I hope this list finds you readers well, and that some of these selections enrich your lives as they have my own.

Why Austrians Should Love Google

I have been doing some writing on the Google IPO (more on that later), which reminded me of how much Google demonstrates a number of things that Austrians have believed for a long time. I have started using this example to illustrate Austrian principles, to some success.

Clearly, with such a vast amount of data out there on the internet (isn't it something like a few thousand pecobytes?), no single human could possibly know everything that is out there. Enter the search engine, a way to connect viewer with website. In the early days of the search engine, information was "searched" by one or a combination of two methods. Most search engines were no more than a glorified F4 button. They worked no differently than search in Word or a web browser. Others would have a team of people compiling sites and categorizing them by topic, etc. Yahoo! started off with an engine that used some aspects of both, but entrepreneurs quickly realized that the only thing needed to get a top result on a search engine was to put the important words down as many times as possible. The computer would just assume that a high frequency of a word would imply a site is relevant to that word. Since Yahoo's algorithm assumed that any webpage with the word insurance must be relevant to a search on insurance, an insurance company would be wise to have a part of the page that just included the word a few hundred times in size 1 font. Categories were inefficient as well. How do we place the site that includes both Metallica lyrics and information on gardening in the bay area?

We can compare this method to rough attempts by the government to understand the market. Plenty of government agencies try to monitor as much economic activity as possible, and are understandably overwhelmed. Try looking at a CPI report on the item level. And merely allowing sites to self-identify creates a horrible incentive structure. A website would succeed in the early Yahoo! era not by being a quality website, but by tricking the algorithms. Similarly, we see plenty of industries rewarded for going through the motions of obeying various regulations.

Enter Google. Google brings to the table two now-obvious insights. First, that the internet is not a collection of independent sites, but a vast community of interconnected and interdependent information. Second, that the community understands itself better than any computer could. Roughly, Google determines the relevance of a given site to a given phrase not by the incidence of that phrase on the page, but by the incidence of the phrase in reference to that site. I know much better which websites are relevant to Austrian Economics, because I actually read them. Thus, Google looks at what amounts to price signals on the internet: the ever-important link. Additionally, links from a given page carry weight. We here at Law, Legislation, and Lunacy, add very little to the strength of Glen Whitman's blog in Google's eyes because we have a relatively low status on the web. Meanwhile, Volokh linking to him boosts him rather quickly, as they have themselves an immense number of websites linking to them.

Thus, the Google algorithm becomes a market process. The entire algorithm is recursive; my linking to you boosts the strength of your linking to me, and so on. Information is distributed efficiently, because the algorithm genuinely understands the importance of local knowledge. Now if we could only get it to grasp the value of tacit knowledge (i.e. that some of us can blog with less effort than others), we would have the perfect Austrian solution.

Full Disclosure: Blogger is owned by Google, so we are broadcasting these views to you on Google's dime. I would be quite happy to continue evangelizing for Google if they were to send me an offer.

An Austrian's D-Day Lesson

Tomorrow is the sixtieth anniversary of D-Day and about a quarter of my day is spent at the History Channel which is running a week-long marathon on all D-Day things. Keep in mind, the week isn’t about WWII in general or even an overview of the Western Front. It’s hour after hour of the events directly leading up to D-Day, including the day itself. I think they’ve spent more time talking about these events than the time it took for the events to take place.

“Well, so what?” you ask. What does Austrian economics have to do with D-Day? Obviously, that’s a simple question—economics has to do with everything. But allow me to dwell on one point—knowledge. We Austrians love knowledge and according to the History Channel, just enough went right for the Allies so that D-Day succeeded and much of these advantages were knowledge in nature.

Allow me to focus on my favorite military operation: Operation Bodyguard—aimed to convince the Nazis that the Allied invasion would occur at Pas de Calais. Using double agents, fake tanks and, in one case, an actor pretending to be an Allied general, the Allies were able to convince the Nazis to move hundreds of thousands of troops, including the crucial Panzer tanks, precisely where the Allies wanted them to be—away from Normandy, away from Paris and away from Berlin. On D-Day, Allied troops lost less than ten thousand men, half what was expected. There is no doubt that without this operation, the Allies would have not been able to establish a foothold in Europe. D-Day changed the entire course of the war. The deception was so effective that after the success of D-Day, the Allies continued to send fake messages, convincing the Nazis (for a while) that the landing at Normandy was just a diversion.

A little bit of knowledge changes everything. By altering perceptions, it changes the means-ends framework, which completely changes the playing field. On the sixtieth anniversary of D-Day, let us be reminded about the power of knowledge and its role in today’s society. This lesson is especially important to learn in our modern military—spy networks are more important than ever before because the nature of war is so different. No longer is it army versus army but cloaked insurgents versus army. As the fight against terrorism continues and we rapidly approach the June 30th handover date of Iraq, let us remember that one Austrian interpretation of D-Day tells us to favor focus on good intelligence and deception rather than brute force, a lesson that is all the more true now than it was sixty years ago.

(Correction: For some reason I thought it was the 5th rather than the 4th when I wrote this blog. Obviously, the anniversary is Sunday, not Saturday.)