Ran Aground on the Black-Scholes

I am again teaching Foundations of Economics, the course that bears the name taken from my book. Toward the end, we examine various economic methods that are alternatives to praxeology, the causal-realist method reflective of the Christian view of man. One of the less-than-satisfactory methods, albeit one of the presently most popular, is the mathematical method.

Among various criticisms of this method, I point out one reason mathematical economics is not ideal as an economic method is that mathematical economics presupposes constant quantitative economic relationships. In fact, there are no such things. Economic interaction is human action and human volition, the driving force of human action, precludes any quantitative constants.

Sometimes this loss of reality might have relatively minor consequences. Demand functions derived by Mr. Mathematical Economist, Leon Walras, did exhibit the law of demand, after all. On the other hand, sometimes, conceiving of the economy as if it is a machine in which all of the parts are related in a constant quantitative way can have disastrous consequences.

A few weeks ago, The Guardian had an interesting article documenting the havoc the Black-Scholes equation strewn throughout financial markets, greatly contributing to the economic crisis of 2008. Ian Stewart's article, "The Mathematical Equation that Caused the Banks to Crash," should serve as a warning for those who are tempted to think that the equations of mathematical economists can be swallowed whole.

Stewart gets to the heart of the matter when he writes,

Any mathematical model of reality relies on simplifications and assumptions. The Black-Scholes equation was based on arbitrage pricing theory, in which both drift and volatility are constant. This assumption is common in financial theory, but it is often false for real markets. The equation also assumes that there are no transaction costs, no limits on short-selling and that money can always be lent and borrowed at a known, fixed, risk-free interest rate. Again, reality is often very different.

Stewart is right not to blame the entire economic meltdown on the Black-Scholes equation and other equations like it. The entire escapade was bank-rolled by the federal reserve. Without the new money investors could spend based on the Black-Scholes model, none of the malivestment that caused the recession would have occurred.

Unfortunately, the author ends on a sour note. "The world economy desperately needs a radical overhaul and that requires more mathematics, not less. It may not be rocket science, but magic it's not."  Here Stewart reveals a bias that assume economic science must be quantitative, because that is what sciences are. If it ain't quantitative, it ain't science. It's magic.

To the contrary, I suggest that one can jettison the problems associated with attempting to mathematically modelling human action, yet still engage in scientific inquiry regarding economic phenomena. A good place to start is business cycle theory developed by Mises, Hayek, Rothbard, Garrison, Huerta de Soto and Salerno.

Congratulations to This Year's Fox Prize Winners!

Each year at the Austrian Student Scholars Conference, the Richard E. Fox prizes for the best papers are awarded immediately before the Mises memorial lecture. Congratulations to the following participants for winning this year's prizes! 

First Prize of $1,000

Matthew McCaffrey, PhD student at the University of Angers, for his paper "Neglected Austrian Theories of Entrepreneurship: Bohm-Bawerk and Fetter"

Second Prize of $750

Soren Krieder, economics major at Grove City College, for his paper  “Systemic Uncertainty: An Examination of Its Causes and Repercussions"

Third Prize of $500

Patrick Newman, economics and mathematics major at Rutgers University, for his paper “A Defense of the Rothbardian Structure of Production” 

Is President Obama Deliberately Trying to Drive Up Energy Prices?

Atmospheric physicist S. Fred Singer thinks so. In a blistering critique, he details many consequences of the President's energy policy and then concludes:

In his 2008 election campaign, Obama promised to make electricity prices “skyrocket.” He seems to be succeeding beyond all expectations, as a combination of White House policies is raising fuel prices. But as the cost of essential energy jumps upward, households are sliding into poverty; they can no longer afford to buy treats for the children; it’s more important to keep them from starving and freezing to death. “Skinning the cat” may be a neat way of getting around the express wishes of the Congress and the public, but it is sure to backfire against the Obama White House in the November elections.

Austrian Student Scholars Conference!

This evening begins our eighth annual Austrian Student Scholars Conference hosted by Grove City College! The ASSC is the largest conference in existence devoted to bringing undergraduates and graduate students from colleges and universities across the country to present their own research papers written in the tradition of the great Austrian School intellectuals such as Ludwig von Mises, F.A. Hayek, Murray Rothbard, and Hans Sennholz.

Hans Sennholz (1922-2007)

The conference starts with a banquet for registered participants followed by the Hans Sennholz memorial lecture at 7:00 p.m. in Sticht Auditorium. As always, ASSC keynote lectures are free and open to the public. This year's Sennholz lecture will be delivered by Philipp Bagus, Assistant Professor of Economics at the Universidad Ray Juan Carlos in Spain. Professor Bagus' lecture is entitled "Will Europe Survive?" Timely as today's headlines, as they say.

Myths About the Great Depression

Here is a good brief video featuring Historian Steven Davies explaining that Herbert Hoover was no free market ideologue, the New Deal did not end the Great Depression, and neither did World War II. I wish it would be longer so as to allow for more depth, but what is there is quite good. Have a look:

More on Herbert Hoover as Interventionist-in-Chief

Yesterday, I linked to excellent posts by Steven Horwitz and Phillip Scranton documenting Herbert Hoover's interventionist ways in responding to the recession and stock market crash of 1929.

Today I want to direct your attention to a debate of sorts over the nature of Herbert Hoover's intervention in the labor market. The Volume 13, No. 3 issue of The Quarterly Journal of Austrian Economics is devoted to a symposium on modern macroeconomics and the recession of 2008. One of the articles included is Douglas W. MacKenzie's "Industrial Employment and the Policies of Herbert Hoover." The article's abstract reads as follows:

Most historians claim that Herbert Hoover adhered to a policy of laissez faire after the stock market crash of 1929. This laissez faire policy is allegedly responsible for the severity and persistence of unemployment during the early years of The Great Depression. Herbert Hoover actually reacted to the crash of 1929 by urging industrial leaders to keep money wages high. Hoover believed that high wages would support consumer spending and spur recovery. This paper extends the hypothesis advanced by Rothbard (1972) that Hoover’s high wage policy intensified and prolonged unemployment during the depression. Analysis of wages and employment in specific industries indicates that Herbert Hoover successfully increased real wages. There are strong correlations between real wages and employment losses in the industries that Hoover intended to influence. The evidence indicates that Hoover’s activist high wage policy prolonged and intensified unemployment during the early years of the Great Depression.

The most recent issue of the QJAE includes a response by Daniel Kuhn who takes issue with MacKenzie's characterization of the efficacy of Hoover's wage policy. Kuhn argues the following:

In a recent article appearing in this journal, Douglas MacKenzie (2010) argues that President Hoover’s business conferences artificially propped up wages in the early years of the Depression, aggravating unemployment. MacKenzie’s (2010) critique of Hoover fails on at least two counts: it commits an aggregation fallacy and ignores the vast literature on real wage cyclicality, and it exaggerates a series of historical points on the authority that Hoover had to implement his high-wage policy. Readers of MacKenzie (2010) could also benefit from new research on Hoover’s business conferences by Rose (2010), although MacKenzie (2010) himself certainly cannot be blamed for failing to incorporate such recent research.

In the same issue Richard Vedder and Lowell Gallaway weigh in on the debate with a rejoinder that sides with MacKenzie and against Kuhn. Vedder and Gallaway conclude:

Hoover was successful in implementing the “high-wage doctrine,” just as many contemporary observers opined. If this is the case, in the process, he produced the most precipitous rise in unemployment in American history. We accept this interpretation, and come down on the side of MacKenzie in this debate.

Anyone interested in the economic history of the Great Depression should read the debate which provides much food for thought.

Herbert Hoover, Interventionist

As noted by Steve Horwitz, yesterday Paul Krugman again trotted out the old Herbert-Hoover-was-a-laissez-faire-radical-when-responding-to-the-Great-Depression canard. Horwitz is understandably outraged at Krugman's intellectual antics noting that, "At some point, this is no longer about laziness but about an intentional attempt to obfuscate and deceive, and to use propaganda to score ideological points." Horwitz recounts Hoover's efforts of economic intervention during the early years of the Great Depression and points to his Cato Briefing paper "Herbert Hoover: Father of the New Deal." I also have also briefly noted that, far from being a proponent of fiscal austerity, Hoover was a Keynesian.

Providentially, a full week before Krugman's latest adventure in economic history, Phillip Scranton authored a fascinating post on Bloomberg News' Echoes Blog that is quite relevant to the very issue in question. In his post, "Hoarding Cash After the Crash," Scranton documents President Hoover's effort in moral suasion, encouraging people to put their money back in banks, so banks can start lending again. What is quite prescient for the question of Hoover's economic policies are the perceptions of those contemporaries affected by his policies. Scranton quotes from the diary of Benjamin Roth, a lawyer from Ohio.

"Even those who invested after 1930 -- after the crash -- at what they considered bargain prices, now find their 'bargains' selling at half price or lower." He added: "Business shows no sign of pick-up. People are already looking toward the next presidential election when a Democrat will probably replace Hoover. In the meanwhile, Hoover adds to his long list of artificial stimulants."

It is the last sentence that I find revealing. Clearly Roth thought that Hoover was interventionist enough to refer to his "long list of artificial stimulants." In other words, no Ludwig von Mises, he.

The BBC Agrees with Me on Cash for Clunkers

According to the BBC, "One of the unintended consequences," of the Cash for Clunkers program, "was to remove a significant amount of supply from car dealerships and auctions around the country." This is essentially what I said yesterday.

Why Are Used-Car Prices on the Rise?

My thoughtful wife alerted me to a story from last week's Wall Street Journal ostensibly investigating the same question. Unfortunately the reporter, Jeff Bennett, does not get to the heart of the answer.

Prices of used cars increased by 3% in 2011 and are on track to rise another 1.2% this year. If so, 2012's increase would mark the third-consecutive rise in  used-car prices. After documenting these facts, Bennett identifies what he understands are the causes.

After the economic crisis of 2008,

Consumers began holding on to their cars longer. Auto makers cut production, pinching new-vehicle shipments to rental-car companies, which in turn slowed the flow of vehicles into the used-car lots. Even repossessions, another source of used cars, have declined. The number of repossessed cars in 2011 was 1.3 million, down 32% from 2009, according to Manheim Consulting, which also tracks the used-car market.

Now, the things listed above no doubt contributed to the current state of the used car market.

However, the elephant in the room Bennett does not think to mention is also a (perhaps the) main culprit--President Obama's "Cash for Clunkers" boondoggle. The Department of Transportation reveals that the Car Allowance Rebate System (CARS) took nearly 700,000 used cars out of the market at a cost to U.S. taxpayers of $2.7 billion. A report by two economists from the University of Delaware found that the program's cost exceeded benefits by about $2,000 per car.

Basic economic theory explains that reducing supply naturally results in higher prices. When supply for a good falls the quantity demanded exceeds the quantity supplied at the original prevailing price. More eager buyers, those willing to pay a higher price, bid up the price in order to mitigate the potential frustration of not being able to buy a used car at a price they are willing to pay. As the price gets bid up, those not willing to pay the higher price will exit the market. The market will clear at a higher price.

In this instance, however, the higher price is due to a government driven restriction of supply. Not only was the program itself not economically sound, but those who rely on the used car market for effective transportation are left holding an automotive bag that has become ever more expensive. One more in an endless list of examples documenting how government intervention in a free society reduces social welfare.

The Western Tradition on the Biblical Foundations of Economics

Jason Jewell has written a nice overview of the first chapter of my book, Foundations of Economics, at his blog, The Western Tradition. For those who want a very quick summary of why Christian doctrine is important for the foundations of economics and why Christian doctrine is not opposed to economic analysis, it is an excellent place to start. I, of course, recommend that you go on to read the first chapter and then the rest of my book as well.

Work for Profit or for Propaganda

In 1922 Ludwig von Mises wrote his monumental Socialism, one of the first full sociological treatments of socialism as an economic system. In his treatise, he notes that one major challenge for any system without private ownership of the means of production is the incentive problem. In socialism people are unable to work for profit or any wage with an organic link to their productivity.

Socialists took to arguing that in a communist society, people would work anyway for the mere joy of labor. Mises explains the problems of relying on the "joy of labor" as a motivating device and than explains the crux of the stimulus to labor.

It is the duty of the citizen of the socialist commonwealth to work for the community according to his powers and his ability: in return he has a claim against the community for a share in the social dividend. He who unjustifiably omits to perform his duty will be recalled to obedience by the usual methods of state coercion. The economic administration would exercise so great a power over individual citizens that it is inconceivable that anyone could permanently withstand it.

One way the Soviet state sought to mitigate the incentive problem is through propaganda. Part of its propaganda program was publishing and broadly displaying varying posters encouraging diligence in working for the state. Below are a couple of my favorites, along with their captions translated into English.

WE WILL NOT LET YOU DO A BAD JOB!

Note the seriously stern faces on those accosting the worker who looks ashamed at not giving it his all.

Here is another:

BUILD LIKE YOU WOULD FOR YOURSELF!

I cannot help noticing the blatant symbolic message: You are a worker bee in the massive Soviet Hive.

Yes. . . .QE Infinity

Last August I suggested that, because the Fed announced that they were going to hold the targeted Federal Funds rate at an all-time low until mid-2013, we seemed to be entering the age of QE Infinity. All quantitative easing, all the time.

Well, Business Insider's Chart of the Day reveals that, sadly, it does seem to be the case that we have entered a brave new world of central bank inflation. Spyros Andreopoulos at Morgan Stanley produced this graph showing how aggregate central bank assets as a percentage of GDP for the Federal Reserve, the Bank of Japan, the Bank of England, and the European Central Bank has changed over the past six years.

The direction has been seriously up. Central bank assets as a percentage of GDP  has increased dramatically--from 16 to 36 percent--since the first quarter of 2007. Central bank assets have been increasing because these banks have been buying up bonds with newly created cash. The more assets they hold, the more money they interject into commercial bank reserves. The more reserves held by commercial banks, the more potential inflation that could be on the horizon.

What the Bible Says About Capitalism

Aryeh Spero has a very thoughtful essay on that very topic in this past Monday's Wall Street Journal. Spero is a Jewish Rabbi, so not surprisingly he limits his discussion to the Old Testament. Nevertheless, what he says is quite good. His thesis is that the general religious ethos at our nations founding was, as he puts it Judeo-Christian, and provided legal, institutional, and moral support to capitalism.

More than any other nation, the United States was founded on broad themes of morality rooted in a specific religious perspective. We call this the Judeo-Christian ethos, and within it resides a ringing endorsement of capitalism as a moral endeavor.

Spero notes the Bible's stressing personal responsibility, the importance of labor, the implications of our being made in the image of God, the necessity of honesty in business dealing, and equality under the law. All of these things are important for sustaining a prosperous and free economy.

Spero also discusses the important example of Joseph's plan in dealing with the famine in Egypt (Gen. 41; 47).

At the end of Genesis, we hear how after years of famine the people in Egypt gave all their property to the government in return for the promise of food. The architect of this plan was Joseph, son of Jacob, who had risen to become the pharaoh's top official, thus: "Joseph exchanged all the land of Egypt for pharaoh and the land became pharaoh's." The result was that Egyptians became indentured to the ruler and state, and Joseph's descendants ended up enslaved to the state.

Spero ends with a very profound insight about how corrosive the sin of envy is for the good society.

God begins the Ten Commandments with "I am the Lord your God" and concludes with "Thou shalt not envy your neighbor, not for his wife, nor his house, nor for any of his holdings." Envy is corrosive to the individual and to those societies that embrace it. Nations that throw over capitalism for socialism have made an immoral choice.

The entire essay is well worth your thoughtful reading.

Money, Morals, and Missions

Today I am very honored to be presenting one of the plenary lectures at the 2012 Faith and the Academy Conference. This year's theme is Money, Morals, and Missions. My lecture is entitled "Fruitful Dominion: Genesis 1 and the Free Society," and draws upon themes in my book, Foundations of Economics: A Christian View.

My main thesis is that fulfilling the material aspect of the cultural mandate found in the first chapters of Genesis requires economic development, which requires taking advantage of the division of labor, capital accumulation, and entrepreneurship. These engines of prosperity, in turn, require private property, which is why a free society is conducive to our fulfilling the cultural mandate.

My friend and department chair, Jeffrey Herbener, is also presenting remarks entitled, "The Ethics of Money Production: The Fed, Wall Street, and Sound Money." The full range of speakers and talks sounds very inviting.