Update 30/10/2009: Apologies for the previous chart - an honest mistake was made and the GDP figures used were quarterly and not annual. This has been fixed and the charts below are accurate. This does not change the essence of the story - although it is not as bad as first thought it is still a huge problem! If you received the FLASH update before 1500 AEDT please download the correct version here.

Talk about a welfare state!

What is going to happen when resource prices fall? Who is going to support the economy?

Unfortunately, the nomenklatura will attempt to dig themselves out of this hole by increasing government involvement in our lives. And who is going to support a move to more government? Why, the significant and growing portion of the country who, as Mises said, rely on the government to provide "...thousands and thousands of people with safe, placid, and not too strenuous jobs at the expense of the rest of society."

When China stops picking up the bill and the party ends we are going to have one hell of a hangover!

I have been rather busy over the past week with work and other things so to ease the inactivity I thought I would simply quote from Hazlitt (quoting Sumner) about the Forgotten Man. It is important to always think about the Forgotten Man when considering whatever the latest political ideal floating around is...as Bastiat would say, to see what is not seen, to understand the full effects of a policy, not just the immediate.

In the course of our study, also, we have rediscovered an old friend. He is the Forgotten Man of William Graham Sumner. The reader will remember that in Sumner’s essay, which appeared in 1883:

As soon as A observes something which seems to him to be wrong, from which X is suffering, A talks it over with B, and A and B then propose to get a law passed to remedy the evil and help X. Their law always proposes to determine what C shall do for X or, in the better case, what A, B and C shall do for ... .. What I want to do is to look up C.... I call him the Forgotten Man.... He is the man who never is thought of. He is the victim of the reformer, social speculator and philanthropist, and I hope to show you before I get through that he deserves your notice both for his character and for the many burdens which are laid upon him.

It is a historic irony that when this phrase, the Forgotten Man, was revived in the 1930s, it was applied, not to C, but to X; and C, who was then being asked to support still more Xs, was more completely forgotten than ever. It is C, the Forgotten Man, who is always called upon to stanch the politician’s bleeding heart by paying for his vicarious generosity.

I would also like to quote from Friedman's 1991 discussion of Gammon's law and healthcare as it seems relevant - there is no doubt in my mind that Rudd is going to come out soon, whether as an election promise or a radical pre-election move, and propose to drastically increase federal involvement in healthcare.

"[Gammon] was led to enunciate what he called "the theory of bureaucratic displacement." In his words, in "a bureaucratic system . . . increase in expenditure will be matched by fall in production. . . . Such systems will act rather like `black holes,' in the economic universe, simultaneously sucking in resources, and shrinking in terms of `emitted production.'"

I suggest everyone read the full (brief) article as it will hopefully shed some light on why more government involvement in healthcare is a bad idea.

"Shutting it [the government healthcare venture] down is an admission of failure, something none of us is prepared to face if we can help it. And they need not shut it down. Instead, in entire good faith, the backers can contend that the apparent lack of success is simply a result of not carrying the venture far enough. If they are persuasive enough, they can draw on the deep pockets of the tax-paying public, while replenishing their own, to finance a continuation and expansion of the venture. Little wonder that unsuccessful government ventures are generally expanded rather than terminated."

Sounds familiar doesn't it.

I was recently asked to do some work involving choice modelling as a method to calculate 'willingness to pay' for things such as job losses; wetland expansion; waterbird breeding; number of endangered species; and so on. What I do not understand[1] is why it is even necessary?

I'm a firm believer in subjective rather than objective values and that the nature of human beings is that values are constantly changing. You can measure values at a point in time – you can say that because I traded an apple for an orange at point x, I valued the orange more at that point in time (and the person I traded with valued the apple more at that point in time). But values change – an hour later I may prefer the apple. You also cannot prescribe a monetary value to that trade – money itself is an economic good, subject to the same changing preferences and diminishing marginal utility as any other economic good. It would be like trying to say the apple and orange transaction was worth a total of one pear.

Choice modelling does not measure past actions (exchange), it merely relies on a survey asking people to reckon their demand curves based on a few options…no doubt due to the impossibility of mapping a full schedule of preferences. But that means that, by necessity, a certain number of alternatives must be excluded from the menu of options over which a person can hypothetically spend their money. The result is that the conclusions about people's 'willingness to pay' will be misleading at best[2].

In the surveys, people are asked to choose between certain 'costs', but how can a choice be made, unless there is some common unit of measurement by which to calculate human vs. environmental vs. other costs? Value is subjective, therefore so is cost, meaning information about human cost is not directly observable…the only information we have about human cost is revealed through voluntary exchange; through trade. In a voluntary exchange, each person reveals that the thing they acquire is ranked higher on their personal value scale than the thing they give up.

For example, environmental degradation for one person may not be another person's degradation. A farmer viewing the encroachment of the wetland onto his cultivated field may regard it as damaging while another person may find it beneficial. Without reference to the impact on a decision-making individual the whole idea of an environmental cost is nonsensical. So if that’s the case, then we’re back to the problem of comparing human valuations.

The only solution that I can see – the solution that works elsewhere – is a price system, which implies private property rights and the freedom to voluntarily exchange that property. Anything to the contrary will lead to superficial or misguided claims and potentially damaging policy recommendations. To put it bluntly, we need a free market for water.

How about this as a solution: instead of the government forcing everyone to pay additional fees to create more wetlands, create a holding company (which owns the land) and auction off shares, say one billion shares at whatever price people are willing to pay, to anyone willing to buy. Then if the majority wanted to preserve the wetlands, waterbirds and endangered species, as owners of the land, they could reduce the amount they supply for irrigation. If the farmers value the water more than the residents value the wetlands, then they will outbid them for water. They are not going to drain the thing dry; and as with every good, water has a diminishing marginal utility. The first x amount of water has far more value to the farmer than the remaining y. It is likely that residents will value y more than the farmers and will therefore outbid them. This is just one of an infinite number of potential ways the market could fix the problem of water shortages and is the beauty of the market system; we can never know in advance how it will solve problems until it does.

Yes, market prices would probably end a lot of farmers, but it is the only fair way. Why is it that only government is allowed to buy up water – why not allow private citizens to do it as well (they are ultimately paying for it anyway). Under a private system of ownership – or even a quasi-private one in which water rights would be created then bought and sold freely between whomever was interested (if the government wanted to keep land ownership but sell water) – the water would go to the people willing to pay for it. If people actually had to pay market prices for water, and that water were privately owned, it is doubtful that the kind of waste that has occured and is still occuring would exist today. Government policies have resulted in misallocated resources and development that cannot be sustained. The solution, as with most things, is not more government involvement and 'choice modelling' to determine how much they can plunder from the populous without a voter backlash, but a free market in water.

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[1] I do understand: there are a lot of socialists in charge who will not even comprehend a non-governmental solution. As a socialist system cannot calculate, they are forced to resort to these 'second best' solutions.

[2] Not only that, but due to 'budget and time constraints', something called 'benefit transfer' has been developed, where preferences from prior surveys on different (but 'similar') issues are used to estimate 'willingness to pay' for a new scenario. The problem with this is that it makes little sense to talk about how much people value something independent of them being in a specific situation where they have to make their choice. How much people value things will always be contingent on the time and place and therefore 'benefit transfer' will be even more misleading than a normal choice model.

Treasury Secretary Dr. Ken Henry has stated what everyone already knows: if the stimulus is wound down early, jobs will be lost. Absolutely. No one is denying this. But the problem from a year ago has not changed one iota: government spending cannot create permanant jobs. The state takes its money from the private sector. It does not produce its own wealth. It cannot create any kind of meaningful employment.

"If all the stimulus scheduled to impact in 2010/11 was cancelled that would mean a further detraction of 1.5 per cent from GDP (gross domestic product) growth and the loss of up to an additional 100,000 (jobs)," he said.

The jobs are going to go anyway. I think what Dr. Henry means is that he wants to delay the job losses as long as possible to give his lackeys down at the Reserve Bank enough time to kickstart another fiduciary boom. You see, if we can get enough funny money into the economy before the stimulus is wound down then these jobs created out of nowhere suddenly look sustainable and indeed necessary to businesses around the country. They get misled into thinking we have all been saving more than we actually have been and that capital is abundant when in fact it is anything but.

Eventually we have to bear the costs of these inflationary policies. The longer we delay it, the more painful it becomes. But, luckily for Dr. Henry, Kevin Rudd and Glen Stevens, they will all have retired on fat government pensions by then. Ah, the beauty of short-term solutions!

In other news, Jesús Huerta de Soto has given a speech on the causes of the crisis which everyone should check out if they have the time.

Have a good weekend.

The recent interventionist policy enacted by ACT chief Minister John Stanhope represents a gross misunderstanding of the nature of competition. It will result in nothing more than higher prices for consumers to protect a small minority of businesses. The only reason independent retailers fail to succeed is, quite simply, because they are not profitable enough to stay open. Whether this is because they are not efficient enough due to poor economies of scale, labour costs, or some other reason is irrelevant.

Funnily enough, "...the architect of the ACT policy is John Martin, who was a long time commissioner at the Australian Competition and Consumer Commission with special responsibility for small business." So a man with a vested interest in helping out a particular lobby group, small business, is using his coercive powers in government to impose legislation that consumers do not want. Why does this not surprise me? Apparently, "...Mr Stanhope is turning the ACT into a test bed for interventionist polices aimed at improving competition policy." In other words, he is using flawed logic of 'more firms = more competition = lower prices' to justify his intervention.

As long as the government stays out of the way, which also includes not providing favours to the big three retailers, a free market dominated by a few firms is not a bad thing. The cheaper prices provided by Woolworths, Coles and IGA provide everyone in the economy with additional income to spend elsewhere (the savings they now make they can use to acquire more goods than they could before). This savings will then be spent in other areas of the economy enabling everyone to gain additional products and will also create jobs in the process.

If people honestly wanted to support small retailers, they would vote with their wallets. The minister should remove the intervention and let the people speak through their own actions rather than using the strong arm of government to impose his views on others. The big three cannot charge monopoly prices without illegal coercion (bribes, intimidation, etc), government-created barriers to entry (regulation, etc) or other government involvement (political favours, subsidies, etc). The only way they can keep competition out and then maintain their position is by improving their products and/or narrowing their profit margin to the point that competitors cannot enter.

To me, that sounds like a win for everyone involved, unless of course you're a small business lobby group or a politician handing out and receiving favours.

In a "better late than never" move, the RBA raised the cash rate by 25 basis points to 3.25 per cent earlier today based on stronger than expected "economic conditions" and "measures of confidence". This was not entirely unexpected, as we reported last month the only way rates would remain at 3 per cent was if the incumbent Labor party had enough sway to 'persuade' the RBA to hold rates.

The only way to artificially keep interest rates down is to increase the money supply – whether through the purchase of government securities, increasing the amount of cash in the economy or lowering the discount rate (encouraging banks to borrow more).

Record growth in M3 thanks to the loose money policies around the world following the last 'bust' (2001ish) saw the pressure on interest rates soar considerably leading up to the crash and instead of further raising rates[1] – a move that was necessary to allow the prior malinvestment to liquidate and for prices to coordinate downwards – the RBA simply flooded the financial sector with additional money thereby preventing any restructuring from occurring.

The structural flaws in the economy – a capital structure still swarming with malinvestments that are not aligned with the intertemporal (time) preferences of the consumers – have resulted in inflated prices in several industries such as housing, construction, banking and finance.

"As soon as deflation makes itself felt, there will be immediate attempts to combat it—often when it is only a local and necessary process that should not be prevented," Friedrich August von Hayek.

Inflating the money supply is a short-term solution that cannot create any additional long-term wealth. Real savings are the barometer for investments that can be successfully carried through to completion: by inflating the money supply the RBA merely deceives investors into thinking the pool of real savings is larger than it actually is. It gives them the impression that consumers have forgone current consumption thereby freeing up more capital for longer-term projects aimed at increasing the productive capacity of the economy.

Think of inflation as you would drug taking: it is disastrous for long-term health, but it can work wonders and make you feel great in the short-term. Likewise, deflation is akin to a drug taker going through withdrawals – it can be quite painful in the short-term but will result in improved long-term health. Unfortunately, the nature of politics is that only one option, inflation, is viable.

Following the outbreak of the 'credit crunch', the governments fearmongering strategy was put into good effect to gain short-term popularity and, more importantly, push for favoured policies that have turned a necessary market correction in a few selected industries into a much more severe, economy-wide problem.

To offset the inflation set in motion by the reckless monetary pumping of the past year, the RBA is raising interest rates. This will attract foreigners seeking a higher yield and should therefore strengthen the dollar relative to other currencies in the short-term. It can only be expected that the RBA will to continue to breach their policy of abstaining from currency manipulation to keep the $AUD below one $USD under the guidance of their mercantilist think bots in an attempt to avoid a slowdown in export growth. This directly contradicts their attempt at keeping inflation at bay and will instead lead to further increases in the money supply and, consequently, price inflation.

Despite relatively small 'inflation' – the CPI figure is up 1.5% YoY, the record amount of pumping undertaken by the RBA cannot be swept under the rug; it will have a serious effect on the wider economy in the future. While businesses are reducing their risk by reducing leverage, banks are still increasing their loans year-on-year (we never came close to having a 'credit crunch') within the banking sector, to consumers and into mortgages.

Unfortunately for the economy, the seeds of the next fiduciary inflationary bubble have been well and truly sown.

"The market rate of interest cannot be lowered by a credit expansion except for a short time, and even then it brings about all those effects which the theory of the trade cycle describes," Ludwig von Mises.

The Australian economy has been flooded with a fresh batch of cheap money. The level of savings is below 5% of disposable income. Private debt is still over 150% of disposable income. Housing is as expensive as ever. The 'stimulus' simply, at best, kept people employed where they happened to be (hint: areas of malinvestment), at worst further distorted the distribution of labour and capital structure of the economy. Public debt is at record highs. Unemployment will continue to get worse as the stimulus wears off and the jobs that were 'saved' are once again, necessarily, 'lost'. Price inflation will rear its head (of course with a mighty lag thanks to the heavily manipulated CPI) and interest rates will have to rise further.

The above are hardly what you would call solid pillars of growth. The economy is anything but healthy and any recovery will not be sustainable.

Unless the free market is given permission to work and the necessary liquidation and restructuring allowed to occur, problems will continue to appear and will be addressed, again and again, by policies that only deal with the immediate, visible effects; effects caused by the very policies designed to combat them! The result will be bigger government, higher inflation and our very own 'lost decade'.

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[1] Of course the best way would be to leave interest rates - effectively the price of borrowing money - for the free market to determine. Government price controls never, ever end well.