Notes from the train

I finished reading Prophet of Innovation during my train ride, and thumb-typed the following on the way:

I am starting to understand the fourth division of the factors of production: entrepreneurship. While the other three are necessary for the continuation of existing productive structures, the creation of new ones requires the entrepreneur, and successful entrepreneurship is rewarded by profits. The rewards of capital are necessary for the maintenance of capital, the rewards of labor maintain labor. Potential profits are the spur of innovation, and actual profits are evidence of success.

The rewards of land, on the other hand, maintain nothing, and it is from there that the funds of mischief can be found, and it is there that public funds can be safely and justly appropriated.

When I was taking economics classes, I was surprised to learn that my teachers spoke not of three factors of production, but four, with the additional one being "entrepreneurship", "profit" being the name for that particular revenue stream. I wondered: what differentiates "entrepreneurship" from other forms of labor (which can take both physical and mental forms) that it gets its own category? Sure, the entrepreneur's "wage" is more dependent on the success or failure of a business than the hourly or salaried worker, but that's no different than the independent laborer who works directly with marginal land.

But according to Schumpter (or at least, according to his biographer) the entrepreneur isn't just any businessman, and economic profit isn't just any revenue stream. It's an exceptional revenue stream, the result of being among the first to engage in some vital new enterprise. It's a huge, but temporary revenue stream, a sudden reward for innovation that dwindles as competitors enter the market. The entrepreneur doesn't make changes that modestly improves efficiency; he introduces new products, services, and modes of business organization that alter the landscape, people's ways of life, in fundamental (and in the long term, highly beneficial) ways.

Land, Labor, and Capital were the only terms needed by the early economists, before the art of finance matured to the level where the entrepreneur and the financier could be separate entities: banks make loans to entrepreneurs so they can try their ideas. The banks then collect interest (which is most likely the sum of the rewards of both capital and land), or they lose the money if the entrepreneur defaults. But if the entrepreneur is correct, revenues can greatly exceed labor costs and bank obligations (including the opportunity cost of working for himself instead of someone else)... and the entrepreneur himself collects a tidy sum, which is rightly called "profit".

This was a new phenomenon when economics got its start, and I think Joseph Schumpter is recognized as the first economist to formally recognize the role of the entrepreneur in the capitalist economy. Wages, interest, rent: these provide for the maintenance of the status quo. But profit: that is what spurs men to wrack their brains and work ridiculously long hours in an effort to do what none have done before. The freedom to do this, and to reap the rewards, is the thing that makes a national economy great.

In Defense of Savings: Credit Card Cancer by Peter Schiff

Peter Schiff has written an article on the subject of savings and credit which expresses similar sentiments to what I have been posting over the past few months, so I thought I'd link it here. He simply makes the point that, contrary to what the economists our politicians are currently listening to seem to say, credit is not the bedrock of a healthy economy; savings is. Without savings, credit cannot be extended. What this means is that if one is relying upon an open line of credit (a credit card) as one's supply of emergency funds, those emergency funds will not be available when one needs it most: during a recession. Savings, however, would be, and can continue to serve as the base for the extension of credit.

I'll have been on a train for three days by the time I would normally post, so that's all I've got for this week.

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McCulloch vs. Maryland: The Anti Magna Carta

I just finished reading William Norman Grigg's latest article over at Lewrockwell.com, The Martial Law Mind-Set. It basically details a number of incidents of assault and murder by policemen in response not to any actual criminal activity, but rather to simple insistence on the part of citizens that they be treated as citizens and free men, rather than simply cringing in servile obedience. It includes a number of contemporary examples, and one ancient one: the murder of Archimedes by an occupying Roman soldier... making the point that many policemen today are behaving much more like an occupying army under a condition of martial law, than as peace officers.

The thing that got me thinking was the idea that policemen may never be prosecuted as individuals. They are generally subject only to departmental discipline, and otherwise above the law... not subject to it... at least when they are on duty and in uniform. The theory behind this, in its basest expression, is that a man acting in the name of the State is not subject to the law, but rather IS the law.

This is far from the ideal, derived from ancient English tradition, that all, even the King himself, are subject to the law. This ideal is best known, to me, through the myths of King Arthur. The best historical expression that I am aware of, perhaps the starting point, is the Magna Carta. Signed at swordpoint by a defeated king, it was the first document detailing certain rights which have survived to this day, including the right of Habeas Corpus. Also included was an explicit declaration that the King is subject to the law, and it even established a procedure for a particular group of barons to take matters into their own hands should the King violate the law. This portion was repudiated at the time, but it indicates the trend of the day, which continued for a very long period of the history of English speaking peoples.

Then came McCulloch vs. Maryland. The State of Maryland attempted to levy a tax on all banks not chartered by the Maryland legislature, including the then new Second Bank of the United States, which had opened a branch in Baltimore, Maryland. McCulloch was the head of the Baltimore branch, and refused to pay the tax on the grounds that institutions established by Congress are immune to State laws. All Maryland's state courts sided with Maryland, until the Supreme Court overturned it on appeal, establishing the principle that the United States Government was supreme. Nobody acting on behalf or the United States Government could be held subject to the law of the several states in any fashion that could be construed as interfering with the actions of the United States. The Court chose the position of the Bank, which the Constitution did not authorize, rather than the States, which the ninth and tenth amendments stated were to be deferred to in all matters not explicitly delegated to the Federal government.

True, this governed only the relationship between the two levels of government. However, it established a principle: our community is not a community of equals, but of higher and lower. The higher are those blessed by their association with the State, exclusively represented by the United States Government (and increasingly by the President alone). The lower is everyone else, and wherever their interests clash, higher must always defer to lower. State governments are subject to their federal superior; ordinary citizens must submit, without complaint or caveat, to those who serve the United States.

I'm not sure if I have a point in this. I simply found the comparison of the two events interesting, representative of two incompatible principles. It was Grigg's article that got me thinking about this.

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Interest Rate Manipulation: Insights From Joseph Schumpter

About a week ago, I finished reading Progress and Poverty, and started up a biography called Prohpet of Innovation: Joseph Schumpeter and Creative Destruction, by Thomas K. McGraw. It's a very enjoyable read. Schumpeter himself, as told by McGraw, is turning out to be a very interesting character. Even better, some of the description of his intellectual influence upon the field of economics is cluing me in to some of the logic behind interest rate manipulation in the interest of economic progress. I've barely begun to read (I'm only on the sixth chapter or so), but it has inspired me to tackle this issue from another angle. I don't know, yet, if it is Schumpeter's angle, but it may be a good one, nonetheless.

Schumpeter, apparently, was the first to effectively make the point that the proper pricing for a product is not necessarily based upon the average cost per unit, but rather upon the marginal cost. The idea is that if one charges the marginal cost, the low price will result in increased demand, meaning that, in the long run, one who charges the marginal cost will make a better profit.

Say you're a kid with a lemonade stand. You plan to make fifty glasses of lemonade. It will cost you $40 (totally arbitrary number out of a hat) to produce those fifty glasses. Average cost is $20/50 glasses, or $0.40. Fifty cents is a nice round number, and gives you a small profit over the average cost.

However, you could make one more glass of lemonade for, say, ten cents. This is because, once you've bought your equipment (your table, sign, lemon squeezer, pitchers, etc?), you don't have to buy it again (economy of scale). According to Schumpeter, you'd do better to base your price off that ten cent marginal cost, than the fourty cent average cost. You take a loss in the short run, but in the long run, people come running for the cheap lemonade, and you end up selling hundreds or thousands of glasses at a larger total profit than you would have sold the fifty around average cost.

However, the businessman who prices in this manner must be able, somehow, to cover the losses on those initial units. He has to start off in the hole... and this requires financing. The lower the interest rate he's offered, the more likely he is to to enact such a plan. A plan of this sort is very good: the entrepreneur makes a profit, and lots of people get a desired product much cheaper than they used to. Resources are being used more efficiently. Everybody wins.

If lower interest rates induce entrepreneurs to innovate, lower interest rates are automatically better, right? John McCain was correct to wish the interest rate would go to zero, right? Not really. Associating low interest rates with innovation, then deciding that it causes the innovation by itself, is, I think, an example of post hoc ergo proctor hoc. It's a bit like the modern economics equivalent of a cargo cult: planes with gifts land on airstrips, therefore we can cause such planes to land on our island by building an airstrip.

Returning to our hypothetical lemonade stand kid, imagine if he established his stand in the middle of winder. Imagine if he established it in the depths of an industrial recession, amid people poor enough they'd rather drink fetid water than pay ten cents a glass. Imagine if he established it in the middle of a sparsely populated desert (sure, folks are thirsty, but there aren't many customers out there). Imagine if he spent hundreds, thousands, millions of dollars on equipment that would bring his marginal costs down to one cent per glass at a certain level of production... and not enough people showed up even to cover his fixed costs. With a zero percent interest rate, he could try... but he could not succeed unless economic conditions were such that people were "ready" for this particular innovation.

This is particularly true for new products that customers don't know enough about to know whether they want one or not.

It isn't enough for the entrepreneur to establish a new productive process; his potential customers must be in a position to buy. A whole host of factors go into this: their current perceived financial security, their attitude regarding novel products, the marginal utility of the new product as compared to their existing stock of wealth, the number of competing new products, and so on. While lemonade stand kid could easily figure this out through simple observation, for larger scale production the information necessary to appraise the likelyhood of customer acceptance is much more difficult to come by.

However, there is one piece of information that reflects conditions better than any other, and it is very easy to find: the interest rate. The interest rate is the price of borrowing money: the intersection between the supply and demand curve for loanable funds. When these curves are not interfered with by government action, they accurately transmit the necessary information to the entrepreneur.

The supply curve indicates, most basically, the aggregate savings rate of all the individuals in a given society, and how available those funds are for loan. (If they're not available for loan, this savings rate expresses itself in lower factor prices, which can work nearly as well, I think.) It indicates a willingness on the part of people to contribute to production without immediately consuming the results, which is necessary for the establishment of new capital. It also indicates how financially secure people might feel, and how much people might be willing to spend on new products (the wealth effect).

The demand curve, on the other hand, telegraphs just how much competition there is for the available loanable funds, and therefore the available resources they represent. If there's a load of new construction, innovation, consumption, and such already happening, there isn't much left in the way of resources to divert to yet more new production. Divert more, and you end up diverting it from basic necessities. It's a bit like a new colony full of people who spend the summer digging for gold, and enter the winter with little to no food stores. What it is actually, is what we call the business cycle: a burst of activity and optimism, followed by sudden disaster.

These two numbers set a barrier of sorts to innovation, which is higher or lower depending upon the conditions. A higher rate might indicate either a society not receptive to trying out new things; or a society that is quite ready, but also with a great deal of competition as to who is going to do the innovation. Either way, the high barrier dissuedes new entrepreneurs from entering the fray, diverting their abilities to safer efforts. A low rate definitely indicates a consumer base that is ready for new products and factors of production available for use in the production of such, and possibly a dearth of entrepreneurs... assuming the supply curve isn't being manipulated by dishonest banking practices, nor the demand curve by excessive borrowing by the government.

In other words, low interest rates don't cause progress. They merely indicate that conditions are ripe for progress, and invite the would-be entrepreneur to try his hand. Artificially low interest rates, the result of an inflationary monetary policy, trick the would-be entrepreneur into innovating at a time when the economy is not yet ready for it. The naturally high rates that result from such conditions would encourage consumers to cut their consumption, thus preparing the ground for future innovation.