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The latest financial crisis sparked public interest in economics and rekindled the debate concerning the proper role the dismal science should play in our lives: books by and about dead economists such as Keynes, Hayek, and Schumpeter are in high demand; economic blogs are more popular than ever; and the public is bombarded with introspective monologues by contemporary economists, all the way from Paul Krugman to John Chochrane. The latest contribution is a Wall Street Journal article by Prof. Russ Roberts. Unlike the opposing so-called scientific explanations for the crisis suggested by various economists, Roberts is questioning whether economic science is at all a science and suggests that more than anything, economics might be suffering from a crisis of identity. 

Roberts points out that unlike most sciences - in which progress is steady and concrete - in Economics 'theories that were once discredited surge back into favor' and since it is impossible to control for all the relevant factors in an economic experiment, each effect can be explained by a variety of causes, or a combination of causes. This, in turn, means that the  explanations for economic phenomena change in line with the political climate.

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More fresh photos from Hiroshima and Miyajima here.
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'Google News is a computer-generated news site that aggregates headlines from news sources worldwide, groups similar stories together and displays them according to each reader's personalized interests...

Our articles are selected and ranked by computers that evaluate, among other things, how often and on what sites a story appears online....

As a result, stories are sorted without regard to political viewpoint or ideology and you can choose from a wide variety of perspectives on any given story.'
We often read about the explicit ways in which those in power use the media to manipulate public opinion through censorship, 'spinning', and news management. However, each type of media (TV, the Internet, the Newspaper) affects political consciousness and ideology, even in the absence of any editorial control. 

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'The Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive.'
Paul Samuelson died this week. Samuelson was the first American economists to win the Nobel Prize in 1970, and was one of the most influential proponents of Keynsian economics. His introduction to the field sold millions of copies and was used to train a generation of economists.

Samuelson was a big fan of government management of monetary affairs (printing money, setting interest rates), and so it is no surprise that the list of economists that saw him as their mentor includes contemporary "superstars" such as Ben Bernanke and Larry Summers. 
 
The above quote is taken from the 13th edition of Samuelson's introduction to economics, published in 1989. A few months later, the Soviet Union collapsed. 

Samuelson lived with the times and his error is excusable. The real question is why, twenty years later, contemporary economists still preach soviet-style policies. May Samuelson rest in peace. Communism, for now, is still alive and well. 
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One of the most popular memes repeated by mainstream media since the collapse of Lehman Brothers last year is the idea that China will manage to avoid the consequences of the economic downturn by shifting from an export-based economy to one based on local consumption. 

Back in the middle of 2008, many publications, most prominently The Economist magazine, suggested that a downturn in developed countries might not have any significant effect on developing economies, since the latter have already "decoupled" and are no longer heavily dependent on demand from consumers in rich countries.

Within a few months, the "decoupling" theory proved to be false: The downturn in the developed world had a significant impact on China's economic well-being, causing a dramatic rise in unemployment and a sharp slowdown in economic growth. The Chinese government, just like the American one, responded with massive stimulus spending and expansion of cheap credit.
 
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Big cop, small cop.
In a recent discussion with an American friend, I pointed out the colossal damage caused to America by the accumulation of additional debt and the bailouts of failed financial institutions. 
My friend, who agreed with me in principle, defended Obama's policies by saying that Obama is conducting the bailouts 'under the guidance of... Bernanke, Summers, Geithner' and that he merely 'continued the bailout started by Bush'. This is a common argument. The gist of it is that things are bad, we need to fix them, but there is no need to hurry. In addition, it justifies the errors of the current president on the fact that these same errors were committed by his predecessor. 

For the purpose of this analysis, we can ignore the fact that Geitner, Bernanke, and Summers were appointed by Obama himself. If someone believes that bailing out financial institutions, in the way it was done is a good policy - that's fine. What piques my curiosity is that people who think it is a bad policy are nonetheless willing to accept it and even justify it, and do not see any urgency in eliminating it. 
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"People are always shouting they want to create a better future. It's not true. The future is an apathetic void of no interest to anyone. The past is full of life, eager to irritate us, provoke and insult us, tempt us to destroy or repaint it. The only reason people want to be masters of the future is to change the past"
History is written by the winners. The above is taken from Milan Kundera's Book of Laughter and Forgetting and refers to the consistent efforts of Soviet officials in Eastern Europe to rewrite history. Soviet communism is a thing of the past, but the battle to control the future in order to rewrite the past is far from over. 

In the midst of a global financial crisis, it is interesting to see how our understanding of the Great Depression, 80 years ago, shapes current attitudes. It is even more interesting to examine the discrepancies between actual facts and the history currently taught at elementary schools and published in mainstream newspapers. 

We can summarize the common view of the Great Depression as follows:

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"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some... As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of Society than to debauce the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."
John Meynard Keynes wrote the above in 1919, in an essay about Inflation and Deflation. This is the same Keynes whose theoretical work and policy recommendations serve to justify current calls for increased government spending, money printing, and cheap credit. How does one reconcile his views on the peril of inflation with the solutions that are being proposed in his name? More on this next time. 
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"In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil. "
Frederick Bastiat wrote the essay That Which is Seen, and that Which is Not Seen in 1850. Today, as government is increasing its involvement in economic matters in unprecedented ways in order to "cure" the economy of its ails, it is important to remember that the goals of politicians - producing "measurable" and "communicable" results - are not necessarily the goals of society, especially when it comes to economic policy. The "recovery" we see in the newspapers today, is the foundation for the bigger, longer crisis of tomorrow. More on this soon. (I am traveling for the next couple of weeks)
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"Has it ever occurred to you, Winston, that by the year 2050, at the very latest, not a single human being will be alive who could understand such a conversation as we are having now?...The whole climate of thought will be different. In fact, there will be no thought, as we understand it now. Orthodoxy means not thinking--not needing to think. Orthodoxy is unconsciousness."
In 1984, George Orwell introduced Newspeak, a new language being gradually adopted by citizens of a fictional country called Oceanaia. As Orwell notes, the intention was that once Newspeak had been fully adopted, 'a heretical thought should be literally unthinkable, at least so far as thought is dependent on words'. This was done through the invention of new words and, more importantly, by 'eliminating undesirable words and by stripping such words as remained of unorthodox meanings.'

Words, of course, don't change their meaning by coincidence. As Orwell points out in his 1946 essay Politics and the English Language, the 'decline of a language must ultimately have political and economic causes'. Of course, if we think foolish thoughts, our language would become full of foolish words, but the effect becomes a cause and the new language encourages more foolish thoughts. But what exactly does it mean that the decline of language has political and economic causes? Well, since the civilized world happens to be in the middle a severe ideological crisis, we can use a contemporary example to show how this process works. 

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National Effort.
We live in a time of immense confusion. Words that used to mean one thing suddenly mean another. The values which made us prosperous and free are being questioned and trampled on. We are in a mess, and our instinctive reactions seem to make things worse. 

In 1989, following the collapse of the Soviet Union, Francis Fukuyama declared "The End of History" and noted that 'The triumph of the West, of the Western idea, is evident first of all in the total exhaustion of viable systematic alternatives to Western liberalism'. Twenty years later, the ideological appeal of classic liberal values  - free markets, property rights, civil liberty, and individual responsibility - is in decline, following an economic meltdown in developed countries and the perceived success of the authoritarian-socialist model, most notably in the People's Republic of China. Capitalism as we know it is dying. Some say it already died a long time ago. 

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Fish.
Once upon a time, there was a little island in the middle of the ocean. The islanders harnessed the waves to power local industry. They got fish from the water to feed their families. They built their houses along the coast. 

Every now and then, a natural storm destroyed a few houses, disrupted the supply of fish for a few days, and sometimes even drowned a few of the locals. The islanders knew that the world is full or surprises, so they were careful - they always saved part of the fish they caught in special reserves for a rainy day, appointed lifeguards to sit on the most dangerous beaches, kept themselves in good shape, and taught all their children how to swim.   

One day, a bunch of local businessmen came to the island's government with a proposition:  Give us a license to manage the ocean and we'll save you all these unexpected troubles! This way, you can spend more time on productive activities, and make long term plans. We can build a perimeter around the island to control the flow of waves. In addition, we  can make sure that all of the fish in the special reserves are protected and well-nourished, and regulate the number of fish who reach the coast every day".

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'One-party autocracy certainly has its drawbacks. But when it is led by a reasonably enlightened group of people, as China is today, it can also have great advantages. That one party can just impose the politically difficult but critically important policies needed to move a society forward in the 21st century.'
The above was not written by the speaker of China's Communist Party; it was not published on China Daily or the Global Times. It was written by Thomas Friedman and appeared in yesterday's New York Times. Friedman is so in love with central-planning, that he is willing to give up his so-called liberal ideology and dismiss China's ruthless and violent control mechanism - which holds 20% of the world's population under considerable oppression - as a system with some "drawbacks", led by "enlightened people". 

Just to recap, Friedman is talking about a country in which people do not have the freedom to decide how many kids to have, which city to live in, where to spend their holidays, or which web sites to visit. They are also denied the right to voice their opinion on a variety of issues, and are required to register with the authorities if they wish to publish a blog, leaflet, or spend 30 minutes in an internet cafe.

Continue reading PRC 2009 = USSR 1929? >>>.
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Earlier this year, Zhou Xiaochuan, governor of the People's Bank of China, called for the establishment of a new global reserve currency to supplant the US Dollar. Zhou suggested that the new currency will be super-sovereign. That is, not belonging to any state. The actual exchange value, according to Zhou, will be determined through discussion between different countries. Zhou claims that his new plan would 'secure global financial stability and facilitate world economic growth'. Sounds like a good idea? In addition, if China wants to undermine the US Dollar's supremacy, why not use it's own currency, the Yuan, as a replacement? Let's put things in context. 

Over the past 60 years, The US Dollar has been the reserve currency of choice for most of the world's major economies. This means that governments chose to hold significant amounts of their currency reserves in US Dollars, and the that Dollar was the main currency used in international trade. It still is.

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Helmates.
Chinese banks gave out more than USD 1 billion during the first 6 months of 2009. This is equal to 25% of China's total GDP. The plan is to boost the economy by sponsoring viable projects that will create new jobs and increase productivity. However, even according to Chinese government sources, about 20% of these new loans already found their way to the stock exchange. Prof. Michael Pettis from Beijing University, estimates that 20-33% of these new loans go directly to the stock exchange, real estate market, or even the gaming tables in Macau. 

This means that a big chunk of the loans are not even going to the projects they are supposed to sponsor and are instead used to inflate prices in other parts of the economy. It is not surprising, then, that the Shanghai stock market went up about 70% since the beginning of the year, and that real estate prices in many Chinese cities are going up, despite declining occupancy rates. 

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Above is a chart of the US Monetary Base - the total amount of currency in circulation and in central bank deposits. As you can see, the total amount of money in the America more than doubled since the end of 2008. This was achieved through the actions of Federal Reserve, in the service of the US Government. It was done in order to create money to pay for the government's bailouts, stimulus package, and other obligations. 

But, can money be created just like this? Yes. Can it maintain its original value? No. So... all the people who are saving in USD were essentially taxed by the US government (through diminishing the value of their savings). 
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As China absorbs the decline in exports created by the global financial crisis, the government is emphasizing the need to increase domestic demand and expedite the development of a local consumer culture. To put it simply - the Chinese government wants local consumers to spend more money in order to reduce the country's dependence on consumers from other countries. China's ability to shift from a production to a consumption-based economy depends on a variety of social and economic factors.  

In 1949, China had a population of 450 million; by 1980, it was close to 1 billion; today, it is over 1.35 billion. The UN's World Population Prospects, updated last year, estimate that China's population will continue to grow slowly during the next two decades and then begin to decline. The number of young people joining the workforce each year is expected to decline from 2010 (see Michael Pettis' blog for more on this). China's population is getting older and might soon begin to get smaller as well. Plenty of commentary is published about the implications this has for China's social security network and economic growth. In addition, it is worthwhile to consider the impact such demographic changes might have on local consumption patterns. 

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Looks like the world is going crazy. Yesterday, the Chairman of the Federal Reserve, Ben Bernanke, gave a testimony to the US Senate panel on Fed policy. 

As you may remember, the Fed has a monopoly on printing money and fixing interest rates. Mr. Bernanke tried to explain to the Senators how the Fed would eventually 'let go' of its current policy of 'near-zero' interest rates and flooding the market with newly-printed cash. He noted that things are getting better and that already "many markets are functioning more normally".

Bernanke openly talks about his policy of (i) manipulating interest rates in order to increase borrowing, (ii) printing more and more cash in order to create inflation and 'growth',  and (iii) using public money to bail out banks and other companies that made the wrong choices, instead of letting them pay for their mistakes and go bankrupt. At the same time, he mentions that "markets are functioning more normally". What "market" is there when so many parts of the economy are centrally controlled and manipulated by the Fed?

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I often write about the importance of free markets and the dangers of big government. There seems to be a lot of confusion these days about the meaning of those two concepts, especially when seen through the prism of traditional political left/right divisions.

Yesterday, a friend of mine pointed out that the current crisis was created under George W. Bush. If free markets and small government are really the solution, how come a "right-wing" president who "reduced taxes" brought us into this mess?

That's a great question, and president Bush is a perfect example of all the misconceptions people have about economic policy and the right-left division in US politics. How so? Let's look at the numbers.

Bush may have reduced (some) taxes, but federal spending during his two terms went up 19.7% and 25.3% respectively, not including defense spending. If you include spending on security and other adventures, the growth is almost 50%.

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"Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion....To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection - a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.... It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression."
Karl Marx once wrote that every historical occurnce happens twice: first as a tragedy, second as a farce. Above is an excerpt from an essay published by F.A. Hayek in 1933, at the height of the Great Depression. It is based on an essay he published in German in 1928. Not much has changed.
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Note: The views and observations expressed on this web site are published for the sake of public discussion and do not represent my personal opinion or the opinion of my companies, clients, and/or employers. If you would like to get my opinion on anything, ask me.