E-mail Debate on Austrian View: Help addressing his arguments

[DPatty]

I am currently having an email debate with a friend and am trying to explain the Austrian view. He has recently made some statements and I am not 100% sure how best to address them or able to find perhaps the flaws in his argument. He is a smart individual and if I can present him with a logical rebuttal as opposed to a baseless emotional one then I know he will gravitate more to the Austrian side. Any help would be greatly appreciated in how I should respond.

Previously I was trying to explain how government intervention was essentially bad, and he is giving his opinion which is that although government intervention may cause the initial dip, the massive collapse is due to the interlocking economy and its complexity. He gives an example with Long Term Capital Management (LTCM) which I do not know enough about to properly refute. He was part of his email below:

@Friend

I want to address something I do know a fair amount about: market crashes. Specifically, the Black Monday crash of 1987 and the LTCM collapse of the late 90s. From what I know of these neither can properly be blamed on government manipulation, and I believe the present financial crisis is closely linked to these two. Since you’ve been recommending reading, I’d recommend An Engine Not a Camera by Donald Mackenzie and A Demon of Our Own Design by Richard Bookstaber, which are the main sources of my intuitions.

The 1987 crash went something like this: there was initially a small dip in the market. Large institutional investors had recently started using portfolio insurance on a massive scale. Portfolio insurance basically hedges against stock losses by purchasing compensating options. When the portfolio loses value, there is an automatic selling process that kicks in to minimize the losses based on option pricing theory. The theory seemed sound, but what happened is that a huge number of people started using the same formula to drive their mechanical selling. When the market dipped, all of these massive portfolios tried to implement the same selling strategy at once, so there was a massive automatic selloff, which pushed the market lower, causing more automatic selloffs, and so on. There were so many automatic transactions happening that the stock exchange couldn’t even keep up.. this was at a time when trades happened manually in the pits with guys shouting at each other.

Now I don’t know, maybe that initial dip in the market can be blamed on the government. But even it that case it would be wrong to argue that the government caused the crash. What caused the crash were these massive automatic selloffs, and the fact that nobody (well almost nobody) foresaw the problem or understood what was happening in the heat of the moment. It was this tight coupling effect that magnified the initial dip—it was the cause of the problem.

For LTCM a similar story can be told. LTCM was a very successful hedge fund in the mid 1990s. They were run by really awesome economists who were better than anyone else at finding hedges (unfair / assured profits). They were massively leveraged, and many people blame the leveraging on the problem, but I don’t think that’s quite right. What happened is that LTCM was so good that everyone else did their best to copy them. LTCM kept their hedges secret as much as possible, but every market transaction needs a counterparty, so they couldn’t be fully secret. The result was that everyone started making the same hedges that LTCM did to try to get in on their profits. When one hedge went bad (to do with Russian currency I think), LTCM was forced to sell some other assets to compensate, but everyone else did too, and whenever LTCM took an action to compensate for yet more losses eveyone else followed suit and there was this cascade effect where everything just collapsed. If nobody had been copying LTCM then the Russia thing would have been bad for them, but by no means fatal. By all accounts they were well-prepared for individual plays going wrong, but they didn’t anticipate the cascade effect. That’s what killed them.

So again, maybe we can blame a stupid government for the initial dip, but the massive collapse was due to all of these interlocking deals.

OK, so the present crisis. I see the major problem as this: banks had a bunch of these equity tranch securities that they had valued at something reasonable. They were pretty well-diversified, so if any local real estate market went south, things would be fine. They’d lose a little money, but no big deal. But two things ended up happening. First, creating all of these mortgage backed securities ended up tying real estate markets together, so that (for the first time in history I believe) national housing markets went down at the same time. The second thing that happened is that, when the markets went down, everybody tried to sell securities to compensate for their losses, but the coordinated selling of these securities caused the values of all the derivative securities to drop, leading to more selling, and so on. There was a cascade of selling due to the interlocking nature of the securities. What we’ve currently got is a situation where the banks have all of these assets that either have a value of zero, or a value that nobody can figure out because the dependencies are so complex.

I probably didn’t explain that all that well, but I hope you get the idea. The claim is that the real problem (leading to these crashes) is the interlocking complexity of the economy, not any government intervention. We shouldn’t blame the crash on the proximate event that led to the crash, whether or not the government had anything to do with it, because the nature of the system is such that some event, some time, was bound to cause this cascade. If it wasn’t one minor event it would have been another. There is a structural problem with the market system that inevitably leads to massive crashes (this is Bookstaber’s thesis as I understand it).

He then also gives the following economic scenario which I am pretty sure is making some incorrect/faulty deductions of economic laws. Could someone please help me find these?

@Friend

I saw a nice photo in the Toronto Star last week (can’t find it on the site sadly). It was of a massive lot of new cars that hadn’t left their factory because there was no demand. Ford probably thinks of these cars in much the same way as my bartender thinks about beer, “Do not want.” When you defer consumption, you might say, the bartender still has his beer, and Ford still has its cars. But the bartender doesn’t need more beer and Ford doesn’t need more cars. The bartender needs to sell the beer so the bartender can buy food, etc. Our economy is based on division of labor. The bartender needs to sell beer.

Now here’s a way you could save while not decreasing the savings of others: buy a house. Now you are actually spending money, employing people, and allowing others’ savings to increase, because you’re incentivising production by being a consumer (of houses). But if you just stick your money in a savings account you are going to cause production to drop and won’t increase the level of ‘real wealth’ of the economy. Now if everyone did this maybe all of our assets would be houses with nobody to live in them, which would be kind of silly, but ideally if you want to keep the economy growing then what you have to do is buy stuff, find new things to buy. A third car, a plasma for every room in the house, a personal jet, another vacation home, etc.

I think one thing you and I might agree on is that economic growth isn’t all it’s made out to be. Maybe what we do want is to lower consumption and have economic contraction. But we should at least recognize that if this does happen it will be quite painful for a lot of people for a decent amount of time, essentially because (in my mind at least), the division of labour would have to readjust.

And lastly, if anyone has read this far ;), he sort of charges the Austrians with the fact that they use the word “distortion” much in the same way that Marxists use the word “exploitation”. Does anyone have any advice on how I could more fully explain how these distortions caused by intervention wreak havoc on the economy? Here was his statements:

@Friend

I think of the word “distortion” from Austrian economists in the way I think of “exploitation” from Marxist economists. I think both are referring to something rather benign and unremarkable with a word that has a heavy moral connotation. If Marxists want to convince me of anything they have to do it without using the word “exploitation”. If Austrians want to convince me of anything they have to do it without the word “distortion”. I think the words just confuse the issue and don’t really mean a heck of a lot. (I think you can replace “exploit” with something like “profit” and “distort” with something like “affect” and maintain most of the meaning of each while losing much of the rhetorical power.)

Thanks again to anyone who helps with any of these arguments. It is greatly appreciated.

[twistedbydsign99]

Tell him if he wants his arguments answered to not write you a novel, instead some concise arguments. If I wanted to get into the mind of a gas bag I would read something Obama wrote.

[Jon_Irenicus]

There is a structural problem with the market system that inevitably leads to massive crashes (this is Bookstaber’s thesis as I understand it).

No, there isn’t. Or does he intend to actually provide an argument that there is? Where is it?

I think of the word “distortion” from Austrian economists in the way I think of “exploitation” from Marxist economists.

Not really. Does he have any better arguments than piss poor attempts to compare Austrianism to Marxism? If I want to “convince” this person of anything I’ll use any words I please. The word “distort” is perfectly apposite here and is not an inherently value-laden term. It refers to an interference in the functioning of the market. Since when did “distort” become a moral term?

[DPatty]

Yeah, I know what you mean but he responded with that sort of length because my previous emails were also fairly involved.

His first bit on LTCM is lengthy for sure, but I guess his argument there would be: “Sure the government may cause the initial dip, but the cascading effect is due to the intertwined economies, and it’s the cascading that is the problem. Therefore it is an unfair charge to blame government.”

The other two posts are not very long, particularly the the one on the Austrian’s use of the word distortion. I’m surprised nobody has jumped on it in an effort to rid the thought of the Austrian comaprison to Marx ;).

Hopefully you get the time to respond to the abbreviated argument above or the other much shorter ones. Thanks for the response!

[DPatty]

Jon, I guess he’s saying that the word distortion has a negative connotation, but just saying it does not explain WHY the distortions wreak havoc on an economy.

[Jon_Irenicus]

OH NOES!

Golly gee, perhaps because it’s a term used in the explanation? [:O]

His first bit on LTCM is lengthy for sure, but I guess his argument there would be: “Sure the government may cause the initial dip, but the cascading effect is due to the intertwined economies, and it’s the cascading that is the problem. Therefore it is an unfair charge to blame government.”

Nonsense. The government provides the fuel with which the fire can grow so huge in the first place. It doesn’t just cause the initial “dip”…

[DPatty]

@""

Nonsense. The government provides the fuel with which the fire can grow so huge in the first place. It doesn’t just cause the initial “dip”…

But if I were to respond with this he would attack me for not justifying this argument and only asserting it. He would say that I have provided not logic as to how the “government provides the fuel with which the fire can grow so huge”.

[Jon_Irenicus]

Which the Austrians have. That is the point of the ABCT. So what is his problem? Similarly, so far he’s provided nothing but assertions. So why is the onus on you to justify the opposite of what he asserts? I wonder…

[Bad_Alumni]

@Friend

Now I don’t know, maybe that initial dip in the market can be blamed on the government. But even it that case it would be wrong to argue that the government caused the crash. What caused the crash were these massive automatic selloffs, and the fact that nobody (well almost nobody) foresaw the problem or understood what was happening in the heat of the moment. It was this tight coupling effect that magnified the initial dip—it was the cause of the problem.

Suggesting that automatic (massive) sell offs cause market instability or crashes is absolutely ridiculous. These are the byproduct of a market realigning itself with the true value of a commodity/stock; or, in order words, it was a bubble. These bubbles occur specifically because of government interference (guarantees, insurances, propping up markets, regulations, for example) and credit expansion (the misallocation of resources) which inevitably end up sending false indicators, believed to be true or sound (for a while), to the market. Your friend is describing a bubble, or an economy on credit (more likely). If it were truly a massive sell off it would simply be a great buyers opportunity to pickup bargain-priced stocks and commodities. The reality, however, is that the original price, before the sell off, was not the true value of said stock or commodity; especially because no buyers are coming in to meet this sell off.

@Friend

So again, maybe we can blame a stupid government for the initial dip, but the massive collapse was due to all of these interlocking deals.

You are correct that we should not blame the initial triggering event, but the underlying economic problem; which, as mentioned before, is not the sell off and realignment of the market but the misallocation of capital in a bubble/credit market thanks to government intervention and credit expansion.

@Friend

The claim is that the real problem (leading to these crashes) is the interlocking complexity of the economy, not any government intervention…There is a structural problem with the market system that inevitably leads to massive crashes (this is Bookstaber’s thesis as I understand it).

Ah, the true explanation! Almost forgot that people naturally make fearless investments in commodities/stocks with the blissful and speculative hope that prices will continue to go up! It’s a good thing you mention this because, for a while, the Austrians had us convinced that it was the government and Federal Reserve guaranteeing the stabilization (or a rise in the price) of these commodities and stocks; which, consequently, mitigates the risk in these investments! Are we to be fooled by those silly Austrians with such a simple explanation, i.e., government guaranteeing risky mortgages and lending practices?! Absurd!

@Friend

The bartender needs to sell beer.

It is not one’s obligation to buy something someone else is producing or selling. That is the power of the market. The things we want and need are produced and the things we don’t want or need are not. Again, ultimately we should blame the expansion of credit which led Ford to produce this excess amount of product (labor having gone to waste, resources that could have been used elsewhere are now sitting idle).

@Friend

Now here’s a way you could save while not decreasing the savings of others: buy a house. Now you are actually spending money, employing people, and allowing others’ savings to increase, because you’re incentivising production by being a consumer (of houses). But if you just stick your money in a savings account you are going to cause production to drop and won’t increase the level of ‘real wealth’ of the economy.

In other words you are saying “you should spend” so “your neighbor can save”. Is this not conflicting? A hint of altruism…

Real wealth comes from savings.

[Truth_and_Liberty]

@DPatty

@Friend

I saw a nice photo in the Toronto Star last week (can’t find it on the site sadly). It was of a massive lot of new cars that hadn’t left their factory because there was no demand. Ford probably thinks of these cars in much the same way as my bartender thinks about beer, “Do not want.” When you defer consumption, you might say, the bartender still has his beer, and Ford still has its cars. But the bartender doesn’t need more beer and Ford doesn’t need more cars. The bartender needs to sell the beer so the bartender can buy food, etc. Our economy is based on division of labor. The bartender needs to sell beer.

Unfortunate for Ford and the bartender that they overestimated demand and overpriced their products, but entrepreneurial errors happen.

@DPatty

@Friend

Now here’s a way you could save while not decreasing the savings of others: buy a house. Now you are actually spending money, employing people, and allowing others’ savings to increase, because you’re incentivising production by being a consumer (of houses). But if you just stick your money in a savings account you are going to cause production to drop and won’t increase the level of ‘real wealth’ of the economy. Now if everyone did this maybe all of our assets would be houses with nobody to live in them, which would be kind of silly, but ideally if you want to keep the economy growing then what you have to do is buy stuff, find new things to buy. A third car, a plasma for every room in the house, a personal jet, another vacation home, etc.

Classic Keynesian fallacy, thinking that consumption spending stimulates growth and increases wealth. It is actually saved capital that is required for growth and more wealth. Refer your friend to this comic book: How An Economy Grows And Why It Doesn’t

There’s no better book for defeating Keynesian fallacies than Hazlitt’s Economics In One Lesson.

Or for an Austrian analysis of the present situation, try: Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse