Mises Daily : Mises Institute on Austrian Economics and Libertarianism

Drowning in a Liquidity Trap?

Fri, 24 May 2013 00:00:00 -0500

Bruce Bartlett recently lamented in The New York Times that given the current state of economic affairs we need more Keynesian medicine to fix the US economy. According to Bartlett, the core insight of Keynesian economics is that there are very special economic circumstances in which the general rules of economics don’t apply and are in fact counterproductive. This happens when interest rates and inflation rates are so low that monetary policy becomes impotent; an increase in the money supply has no boosting effect because it does not lead to additional spending by consumers or businesses. Keynes called this situation a “liquidity trap.” Keynes wrote,

There is the possibility ... that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.[1]

Bartlett holds that:

Under such circumstances government spending can be highly stimulative, because it causes money that is sitting idle in bank reserves or savings accounts to circulate and become mobilized through consumption or investment. Thus monetary policy becomes effective once again.

Bartlett regards this as an extremely important insight that policy makers have yet to grasp. According to our columnist, despite massive monetary pumping by the Fed since 2008, it has produced very little boosting effect on the economy. The Fed’s balance sheet jumped from $0.897 trillion in January 2008 to $3.3 trillion in early May 2013. The Federal Funds Rate target stood at 0.25 percent in early May against 3 percent in January 2008.

According to Bartlett,

In normal times, one would expect such an increase in the money supply to be highly inflationary and sharply raise market interest rates. That this has not happened is proof that we have been in a liquidity trap for several years. We needed a lot more government spending than we got to get the economy out of its doldrums.

Note also that Nobel Laureate in economics Paul Krugman holds similar views. For them what is needed is a re-activation of the monetary flow that somehow got stockpiled in the banking system. Observe that in the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure.

Why is money not the driver of economic growth?

Contrary to popular thinking, monetary flow has nothing to do with economic growth as such. Money is simply a medium of exchange and nothing more than that. Also, note that people don’t ultimately pay for goods and services with money, but rather with the goods and services that they have produced.

For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange.

Again, money is just employed to exchange goods and services. Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer.

What drives economic growth is savings that are used to fund the increase and the enhancement of tools and machinery, i.e., capital goods or the infrastructure that permits the increase in final goods and services: real wealth to support the lives and well being of people.

Contrary to popular thinking, an increase in the monetary flow is in fact detrimental to economic growth since it sets in motion an exchange of something for nothing — it leads to the diversion of real wealth from wealth generators to wealth consumers. This in the process reduces the amount of wealth at the disposal of wealth generators thereby diminishing their ability to enhance and maintain the infrastructure. This in turn undermines the ability to grow the economy.

What is behind the so called liquidity trap?

The fact that so far the Fed’s massive pumping has not resulted in a massive monetary flood should be regarded as good news. If all that new money were to enter the economy, it would have entirely decimated the machinery of wealth generation and produced massive economic impoverishment.

It seems that market forces have so far managed to withstand the onslaught by the US central bank. What allowed this resistance is not some kind of ideology against aggressive pumping by the Fed (in fact most experts and commentators are of the view that the Fed should create a lot of money in difficult times), but the fact that the process of real wealth generation has been severely damaged by the previous loose monetary policies of Greenspan’s and Bernanke’s Fed.

The badly damaged process of wealth generation has severely impaired true economic growth, and obviously this has severely reduced good quality borrowers and subsequently has reduced banks willingness to lend. Remember that in essence banks actually lend real wealth by means of money. They are just intermediaries. Obviously then, if wealth formation is being impaired, less lending can be done. We suggest that it is this fact alone that explains why all the pumping by the Fed has ended up stacked in the banking system. So far in early May banks have been sitting on over $1.7 trillion in surplus cash. In January 2008 surplus cash stood at $2.4 billion.

Given the high likelihood that the process of real wealth generation has been severely damaged, this means that the pace of wealth generation must follow suit. Now, contrary to popular thinking an increase in government spending cannot revive the process of wealth generation, but on the contrary it can only make things much worse.

Remember government is not a wealth-generating entity, so in this sense increases in government spending generate the same damaging effect as monetary printing does; it leads to the diversion of wealth from wealth generators to wealth consumers. Observe that in 2012, US government outlays stood at $3.538 trillion, an increase of 98 percent from 2000.

As long as the rate of growth of the pool of real wealth stays positive, this can continue to sustain productive and nonproductive activities.

Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more wealth than the amount it releases.

This excessive consumption relative to the production of wealth leads to a decline in the pool of wealth.

This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. The shrinking pool of real wealth exposes the commonly accepted fallacy that loose monetary and fiscal policies can grow the economy.

Needless to say, once the economy falls into a recession because of a shrinking pool of real wealth, any government or central-bank attempts to revive the economy must fail.

This means that a policy such as lifting government outlays to counter the liquidity trap will make things much worse.

Not only will these attempts not revive the economy; they will deplete the pool of real wealth further, thereby prolonging the economic slump.

Likewise any policy that forces banks to expand lending “out of thin air” will further damage the pool and will further reduce banks’ ability to lend.

Again the foundation of lending is real wealth and not money as such. It is real wealth that imposes restrictions on banks’ ability to lend. (Money is just the medium of exchange, which facilitates the flow of real wealth.)

Note that without an expanding pool of real wealth, any expansion of bank lending is going to lift banks’ nonperforming assets.

Summary and conclusion

Contrary to various experts, we suggest that in the current economic climate an increase in government outlays is not going to make Fed’s loose monetary policies more effective as far as boosting economic activity is concerned.

On the contrary, it will weaken the process of wealth generation and will retard economic growth.

What is needed to get the economy going is to close all loopholes for money creation and drastically curtail government outlays.

This will leave a greater amount of wealth in the hands of wealth generators and will boost their ability to grow the economy.

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Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. See Frank Shostak's article archives.

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Notes

[1] John Maynard Keynes, The General Theory of Employment, Interest, and Money, MacMillan &

Co. Ltd. (1964), p. 207.

A Deadlier Disaster for the Third World: Unemployment

Thu, 23 May 2013 00:00:00 -0500

The recent collapse of a garment factory building in Bangladesh, resulting in the death, at latest count, of more than 1,100 workers who were employed there, has led to international outrage not only against the building’s owner but also against the various retailers in the United States and Europe, many of them prominent, that have sold clothing produced in that building. It is demanded that they assume responsibility for working conditions in the factories that supply them and not deal with factories that do not provide safe and humane conditions and pay fair wages.

Such demands rest on the belief that, if left free of government interference, the profit motive of businessmen or capitalists leads them to pay subsistence wages to workers compelled to work intolerable hours in sub-human conditions. And, more, that the profits wrung from the workers in this way exist in the hands of the capitalists as a kind of disposable slush fund as it were, at least some more or less substantial portion of which can be given back to the workers from whom they were taken, or used on behalf of those workers, with no negative effect except to deprive the capitalists of some of their ill-gotten gains. It is generally taken for granted that the reason the kind of conditions that prevail in Bangladesh and the rest of the Third World do not exist in the United States and Western Europe is the enactment of labor and social legislation, and that what is needed is to extend such legislation to the countries that do not yet have it.

Every aspect of this set of beliefs is wrong and its consequences are highly destructive, above all to the masses of workers in the Third World who already live close to starvation and who are in danger of being driven into it by needlessly increasing the cost of employing them either by arbitrarily raising their wages or by requiring that they be provided with improved working conditions that must be at their expense and which they cannot afford.

One of the most elementary propositions of the science of economics is that the higher the price of anything, the smaller is the quantity of it that will be purchased. This applies to labor no less than to goods. If wage rates in Bangladesh are arbitrarily increased, fewer workers will be employed in Bangladesh. In that case, workers who would have earned low wages will earn no wages. They will starve. If employers in Bangladesh are compelled to make improvements in working conditions of a kind that do not pay for themselves, the cost of those improvements represents the equivalent of a rise in wage rates. Again, there will be unemployment. The unemployment could be avoided only if workers’ take-home wages could fall sufficiently to offset the cost of the improvements. In that case, the situation would be comparable to making the workers use their already meager wages to pay for improvements that they simply cannot afford.

These are not outcomes that the advocates of imposing labor standards want. What they want is higher wages and better working conditions. Their problem is that they do not realize what is actually necessary to achieve these results.

What will achieve these results is leaving business firms in Bangladesh and throughout the Third World alone, to be as profitable as they can be. (It should be obvious that the loss of a factory building and its machinery was not profitable and that while it may be legitimate to denounce the building’s owner for criminal recklessness and negligence, it is simply absurd to denounce him for seeking profit, when what he actually achieved, and could only achieve through such conduct, was total loss.)

The high profits that can be earned in a Third World country, if not prevented by too many obstacles, will be heavily saved and invested, mainly in that Third World country. As the experience of Taiwan, South Korea, and now even mainland China shows, a generation or more of such a process results in a vast accumulation of means of production in the country—i.e., numerous new factories, with better and better equipment. This results in an intensified competition for labor and thus rising wage rates. As wage rates rise, workers can more and more afford to accept lesser increases along with improved working conditions of a kind that must be at their expense.

Economic freedom, not government interference, is the road that the wealth of nations travels.

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George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996; Kindle Edition, 2012). See his Amazon.com author's central page for additional titles by him. His website is www.capitalism.net and his blog is www.georgereismansblog.blogspot.com. See George Reisman's article archives.

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Martial Law vs. Market Law: Reflections on Boston

Wed, 22 May 2013 00:00:00 -0500

There are two kinds of people in the world: those who respect coercive authority and consider it legitimate, and those who do not. The former group is likewise split into two factions: a relatively small group that, for whatever reason, essentially worships power, and a much larger one whose members merely tolerate authoritarianism, either as a matter of expedience or habit. In the wake of the recent bombing at the Boston Marathon and subsequent military-style manhunt, it seems clear that the great majority of Americans may be categorized as either power-worshiping or power-tolerant.

To be sure, the police came in for a fair share of vehement criticism from a number of established commentators. Ron Paul, for example, stated flatly that the people of Boston had been given “a taste of martial law” and likened the situation to “a military coup in a far off banana republic,” while at the other end of the spectrum, the World Socialist Website denounced the tactics of the police as having “no precedent in American history,” compared Boston to “a city under occupation or in civil war,” and claimed that the news media had “fomented fear and hysteria, spread ungrounded rumors and justified the police state measures of the Obama administration.”[1]

Yet to the great majority of Americans, as well as to most Bostonians, the authoritarianism of the police was fully justified by the extraordinary circumstances. The aim of the “lockdown”[2] was to protect the public from a fugitive and presumably armed terrorist. Any means to achieve this goal were therefore a priori acceptable, the fact that US citizens are about eight times more likely to be killed by a police officer than by a terrorist notwithstanding.

Can the two parties of this debate both be satisfied? Can the Ron Pauls of the world be free of tyranny and the “Boston Proud” set feel safe at the same time? Yes, but not so long as the provision of security services remains monopolized.

Market Law vs. Martial Law

In law enforcement as in any other hampered or fully centralized market sector, the real problem is never the visible, concrete symptom, but rather the underlying condition that has brought it about. Whatever the particular type of problem may be in any given case, the catalyzing condition, almost invariably, is monopoly.

Being the sole legal provider of any service allows for greater flexibility in customer relations (to put it politely) than would otherwise be practicable, and when the service involves sending men with guns to people’s homes, this is not a trivial consideration. Over time, monopoly policing will tend to become increasingly autocratic, even in circumstances far less extreme than a full-scale manhunt.

We need look no further for evidence of this than Boston, which in a very real sense was already under quasi-lockdown even before the marathon began. In this video released by the Massachusetts Bay Transportation Authority Police a few days before the event, the Authority made clear the types of conduct by citizens that it would tolerate. Residents were lectured on the need to be “respectful to one another,” warned that any public drinking or “rowdy behavior” would be met with “zero tolerance,” and were even expressly prohibited from gathering on their own rooftops and porches.

Yet all this, it seems, raised nary a Bostonian eyebrow. Is it any wonder they acquiesced so readily in the manhunt as well?

We may protest the unconstitutional invasiveness of these things all we like, but they are merely effects that, without some form of monopoly protection, could never arise. Under free competition, any private security firm that resorted to draconian tactics would be swiftly abandoned by its subscribers in favor of its less intrusive competitors, thus marginalizing or driving it out of business altogether.

This is another way of saying that in the market law society it is the citizens who would tell the police which types of conduct would be tolerated, and the latter could not place the former under anything resembling “lockdown.” Nor would this situation be in any way analogous to a political system of direct democracy in which the majority could use the police as a tool for imposing its own arbitrary behavioral standards on the minority. For a private firm with multiple competitors, the alienation of any segment of its customer base, however minute relative to the whole, could easily mean bankruptcy. A private police company in a free security market could no more subjugate its own customers than a restaurant can force-feed its patrons. And tyrannizing non-subscribers would bring it into violent conflict[3] with its competitors and society as a whole — something no private business could afford.

All this has been pointed out many times. However, a competitive law enforcement market offers other less apparent but equally valuable mechanisms for the avoidance of conflict and the promotion of efficiency, goodwill, and cooperation between the police and public.

Consider a high-priority manhunt along the lines of the one in Boston. Under state monopoly policing, the government dispatches SWAT teams riding in “armored personnel carriers,” which, coincidentally, happen to look a lot like tanks. Upon reaching their target neighborhoods the officers disembark, fan out across the area and show up unannounced on people's doorsteps, armed to the teeth and looking like the Imperial Storm Troopers in Star Wars. Confusion ensues. Babies cry, children gawk, cats scurry up trees, and millennialists think it’s the Second Coming. Residents are told to come out with their hands up and wait outside while strangers with assault rifles search their homes. Enough marijuana gets flushed into the municipal sewage system to stone the city’s entire rat population.

Market-based policing could not be conducted in this way. However odd it may sound at first, in a private law society, individual firms might differ significantly in the sorts of “manhunt services” they offered. Depending on consumer preferences, they might even offer individualized contracts. Much as insurers can customize policies to suit individual needs, and medical patients can sign a “do not resuscitate” order in the event of catastrophic illness or accident, clients of private police companies could stipulate in advance the sorts of invasive actions they would accept and under what circumstances.

Some might be perfectly comfortable letting officers enter their homes without notice and for almost any reason; others might insist on prior notification and/or third-party verification of emergency conditions or probable cause. Modern data management and communications technologies would make it a simple matter for officers in the field to know instantly which houses could be searched right away, while an automated phone system could call hundreds or even thousands of other homeowners simultaneously, inform them of the situation using a digital voice recording, and allow them to instantly grant or refuse permission to enter simply by pushing a button or saying the words “yes” or “no.”

This idea is easy to ridicule (just imagine picking up the phone and getting a recorded message that said “To allow officers to search your home for a deranged fugitive terrorist, please press 3.”). But hyperbole aside, something along these lines would easily be feasible, as would many other possibilities as yet undreamed of. It would certainly represent an immense improvement in any case over the present system of tax-funded monopoly policing in which officers may enter anyone’s home at the discretion of their superiors, and even order residents off their own porches and roofs.

Many people will reflexively dismiss these unfamiliar ideas as “utopian,” and may raise numerous objections to them. They may counter, for example, that any system of pre-existing contractual arrangements would allow armed and dangerous criminals to evade capture simply by taking refuge on property where police are bound by “no search” clauses. Moreover, a small group of, say, terrorist bombers could even purchase their own house in advance, insist on a strict “no search” provision in their security contract, and then simply go home after committing their crimes and enjoy full immunity from prosecution!

Such objections are, however, plainly groundless. The first fails because it overlooks the obvious fact that the terms of contracts between security firms and their subscribers would be strictly confidential; criminals would have no way of knowing which houses were “safe” and which were not.

The second objection is untenable because, absurdly, it transforms the “no search” provision into de facto immunity from prosecution — an entirely different thing and an arrangement to which no police company could possibly consent.[4]

A “no search” clause in a police contract would and could be valid only for cases involving more or less random searches. If the police, whether public or private, had strong reason[5] to believe that a wanted criminal was hiding on X’s property, X would then have to allow his property to be searched because a refusal to do so would be tantamount to an assertion that his right to privacy superseded the rights, not only of the criminal’s victims to justice, but also of the community at large to protection from a known victimizer.

If we furthermore assume that the suspect really has taken refuge on X’s property, then by refusing a search request, X would also be precariously close to aiding and abetting, which is a crime in itself and cannot be protected by any sort of legal contract whatever.

Finally, some people may fear that giving homeowners such a large measure of control over access to their property would result in almost everyone opting for “no search” contracts. Although it is not immediately clear why this should be considered problematic, the conclusion itself, at least, seems prima facie defensible. However, it suffers from two problems. First, even under the present system, citizens supposedly already have a “no search clause” in their “contract” with the government. It’s called the Fourth Amendment. The only difference is that the state, being a monopoly service provider, can breach the contract with virtual impunity.

More importantly, however, this final objection overlooks what may be the single greatest virtue of market law. In simplest terms, coercion provokes conflict. In fact, coercion is conflict. In all coercive relationships one party — the coercer — must necessarily assume a superior role vis-à-vis the other.

Such relationships therefore naturally foster antagonism, defiance, and a sense of victimhood that makes peaceful cooperation impossible. Voluntary association, on the other hand, simply by respecting individual preferences, communicates genuine respect for the person as an autonomous individual, thereby promoting trust and goodwill between and among contracting parties.

It follows that if law enforcement were to be governed by this principle, fear and/or resentment of the police would be much less intense and far less common, leading property owners to be more amenable to on-the-spot searches. Indeed, many otherwise recalcitrant people might well abandon all reluctance and cooperate fully with the police, simply because the latter had the common courtesy to ask for permission in advance. And since officers, as representatives of their companies, would be fully constrained in their behavior by the freedom of each and every citizen to take his business elsewhere, no one would need to fear that they were letting bulls into a china shop.

Since the catastrophe in Boston, a few other advantageous aspects of market law have been obliquely touched on in the media as well. These include the fact that despite what was surely one of the most intensive manhunts in US history, it was not the police, but a private citizen who discovered the suspect hiding in his back yard and notified the authorities; that the sequestration of people in their homes, whether voluntary or not, probably prevented the suspect from being discovered sooner; and that it was a private and not a municipal security camera that allowed him and his fraternal accomplice to be identified in the first place.

To this list we might add the perverse misallocation of police manpower before the bombing, as officers were focused on deterring such “crimes” as the quaffing of a few beers on the sidewalk, “rowdy” celebrations, and unlawful socializing on porches.

In a private law society, security officers would be freed from the ludicrous burden of fun-prevention so they could concentrate on spotting real criminals before they commit their crimes. There would also be much greater incentives for prevention, since all public events (i.e., private events open to the public) would be taking place on someone’s property, giving the owners of such property a very compelling reason to carry liability insurance to compensate the victims of any crimes that might occur there.

This means that even those with no individual insurance of their own would be indemnified against any injuries caused by the actions of others at public events, even if the perpetrators could not be located. Looking to minimize payouts, the insurance companies would in turn offer incentives to owners to invest heavily in preventive measures, such as the installation of security cameras, better lighting, controlled entrance, the use of bomb-sniffing dogs, or simply the hiring of lay personnel to walk around with walkie-talkies and serve as “extra eyes.”

Final Thoughts: The Structure of Social Revolutions

By now I have had enough conversations with assorted statists on both the “left” and the “right” to know that most people with an established, mainstream view of society and the law will not be persuaded by what is written here, nor probably by any other criticisms, however valid, or visions, however vivid.

All attempts at conversion of the entrenched are likely to fail, and almost everyone these days appears entrenched to some degree. At times it may seem futile even to begin the discussion. Yet, I believe there is reason to be hopeful.

In The Structure of Scientific Revolutions, Thomas Kuhn famously showed how new paradigms in science become accepted. Truly revolutionary ideas, he said, do not suddenly triumph when the scientific establishment becomes convinced of their superiority over existing doctrine, but rather take root slowly as the old guard retires and the torch is passed to the new generation of scientists. “Almost always,” Kuhn wrote, “the men who achieve these fundamental inventions of a new paradigm have been either very young or very new to the field whose paradigms they change.” He also offered an explanation as to what it is that induces the emerging generation to embrace fundamental cognitive shift: “The usual prelude to changes of this sort is … the awareness of anomaly, of an occurrence or set of occurrences that does not fit the existing ways of ordering phenomena.”

$14.00 $10.00

We live in anomalous times, and not just with regard to science. Today’s young people know this. They recognize all too clearly that something about the society they live in doesn’t fit the standard explanations their elders have accepted so uncritically for so long, and they are willing to approach the essential questions with an open mind and tremendous energy. In keeping with Kuhn’s thesis, it is they who must come to appreciate the full potential of the market law society, since they are the only ones who can bring it about anytime soon. It is therefore this group to whom we need to speak.

Like the good people of Boston, we libertarians — especially those of us in the anarchist tradition — have our own marathon to run. Thomas Kuhn has supplied us with a map of the territory, and Ron Paul has given us a far more auspicious start than we had any reason to hope for. It’s up to us to keep running, no matter how many bombs go off before we reach the finish line.

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David Greenwald received his BA in German from Hendrix College and his master's in counseling studies from Capella University. He currently teaches high school English in Slovenia, where he conducts extracurricular projects on entry-level Austrian economics, banking and the business cycle, and the sociology of violence. He is also a lecturer at the Cato Institute's Liberty Seminars. Send him mail. See David Greenwald's article archives.

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Notes

[1] My own cursory perusal of mainstream media reports suggests that they tended primarily to trivialize rather than glorify the use of force as such, while portraying the officers personally as heroes. Time Magazine, for example, describes SWAT teams as innocuously going “block by block, knocking on doors and asking people if they had seen anything suspicious,” whereas this video shot from the window of a private home clearly shows police with weapons drawn, forcing the occupants of a neighboring house to come out with their hands in the air while officers search the premises. This article from the New York Times sports a picture showing local celebrities (Boston Red Sox players) lined up and applauding as uniformed police offers walk past them, in an image that clearly calls to mind the patriotic fervor of a military parade.

[2] Boston officials have denied the imposition of a “lockdown,” claiming that it was rather a request to “shelter in place.” It is not my intention to settle this question here. Those interested can find more here.

[3] For a detailed discussion of why private police companies would not and really could not attempt to dominate each other or settle inter-agency disputes by violence, see Murray Rothbard’s For a New Liberty, pages 224-26.

[4] The modern state does offer a few select individuals what amounts to a "no arrest" clause. It's called "diplomatic immunity."

[5] The question might reasonably arise as to who gets to decide what is and is not "strong reason." Different societies might answer this question in different ways, of course, but there seems to be no reason why procedures very similar to the state's currently-existing bench warrant system could not be used, with the difference that instead of a government employee (judge) issuing a search warrant, each police company would turn for authorization to a committee of private citizens, all of whom would be subscribers to the company's services.

A Virtual Weimar: Hyperinflation in a Video Game World

Tue, 21 May 2013 00:00:00 -0500

As virtual fantasy worlds go, Blizzard Entertainment’s Diablo 3 is particularly foreboding. In this multiplayer online game played by millions, witch doctors, demon hunters, and other character types duke it out in a war between angels and demons in a dark world called Sanctuary. The world is reminiscent of Judeo-Christian notions of hell: fire and brimstone, with the added fantasy elements of supernatural combat waged with magic and divine weaponry. And within a fairly straightforward gaming framework, virtual “gold” is used as currency for purchasing weapons and repairing battle damage. Over time, virtual gold can be used to purchase ever-more resources for confronting ever-more dangerous foes.

But in the last few months, various outposts in that world — Silver City and New Tristram, to name two — have borne more in common with real world places like Harare, Zimbabwe in 2007 or Berlin in 1923 than with Dante’s Inferno. A culmination of a series of unanticipated circumstances — and, finally, a most unfortunate programming bug — has over the last few weeks produced a new and unforeseen dimension of hellishness within Diablo 3: hyperinflation.

Austrian Economics and Inflation

In casual use, the term “inflation” is used in conjunction with price increases. From the perspective of the Austrian School of economics, though, that phenomenon is a secondary effect of increases in the money supply. As Henry Hazlitt wrote,

When the supply of money increase[s], people have more money to offer for goods. … Each individual dollar becomes less valuable because there are more dollars. Therefore more of them will be offered against, say, a pair of shoes or a hundred bushels of wheat than before. A “price” is an exchange ratio between a dollar and a unit of goods. When people have more dollars … [goods] rise in price, not because [they] are scarcer than before, but because dollars are more abundant.[1]

Furthermore, inflation is not simply an increase in the supply of money within an economy; it is the increase in that portion (if any) not backed by a commensurate increase in specie: most common in history, market commodities like gold or silver. Thus fiat currencies are, unless tightly controlled as to the amounts being created versus being destroyed (with the latter typically only occurring due to wear), notably susceptible to inflation.

As virtual currencies are digitally-created and not commodity-backed — therefore, not particularly dissimilar from real world currencies in this day and age — those such as Diablo 3’s gold are de facto fiat currencies.

Sinks, Faucets, and Inflation

In virtual economies, the primary instruments used to control the money supply are “faucets” and “sinks.” Faucets are ways through which game currency is injected into the game. This generally involve players receiving currency from the game system itself, as opposed to other players. In such situations, the received currency is created anew. Sinks are ways through which game currency is removed from the game. This generally involve players paying currency into the game system itself, as opposed to other players. In such situations, the paid currency is destroyed.[2] Examples of faucets and sinks in Diablo 3 are included below:

Faucets

Drops — When a player defeats a foe, they often receive a reward of virtual gold or a good saleable into virtual gold;
Rewards — The game involves the player undertaking “Acts,” and within each act are a number of “quests.” For completing these, players are typically awarded virtual gold;
Buyers — Players can sell items to “in-game” (computerized, non-human) buyers, receiving virtual gold.

Sinks

Repairs — Over time, a player’s equipment will become damaged in combat and suffers wear-and-tear, requiring periodic restoration from an in-game craftsman in exchange for virtual gold;
Forging — Players pay virtual gold to an in-game blacksmith for weapons;
Rakes — Using the gold auction house costs players both a listing fee and a transaction fee, removing virtual gold from the economy;
Consumables — Players can purchase potions, scrolls, and other items from vendors for virtual gold.

Diablo 3 was rolled out in May 2012, and there seem to have been early concerns among players that gold sinks within the game were insufficient. One site noted,

[M]ost of us (probably including Blizzard) assumed that the Blacksmith would be widely used — he was, after all, the only major gold sink in the game … but dropped items alone selling in the [auction house] have been enough to satiate the appetite [of players] and crafting is … a waste of [gold] when one could easily buy an optimal item from the [auction house] rather than pumping 50 to 170K of gold into [a Blacksmith-crafted weapon.][3]

The establishment by Blizzard of a real money auction house (“RMAH”) alongside a virtual gold auction house in the game provided players with an incentive to both farm the game for real world profits and to pursue arbitrage opportunities. The RMAH was also created, at least in part, to disincentivize players from patronizing third party markets outside the game. Nevertheless, bots — automated game participants whose sole purpose is to farm the game world for items to sell — quickly emerged.

Although its anonymity may make it subject to skepticism, several weeks after the game’s debut a source claimed that there were at least 1,000 bots active 24/7 in the Diablo 3 game world, allegedly “harvesting” (producing) 4 million virtual gold per hour.[4] Most of the gold generated by the ruthlessly productive, rapidly adapting bots found its way to third party vendors in a black market which undercut the prices in the sanctioned, in-game auction houses.

The combined effect of heavy bot activity and insufficient sinks immediately impacted the gold markets, and inflationary pressures were soon apparent. An exasperated player complained in August 2012:

I purchased most of my gear for around 5 mil [gold] early on. I’ve been farming for awhile [and] have saved around 30 million gold [but now] I can’t upgrade the gear I have ... Where is all this money coming from? Why is everything so expensive?[5]

And as in real world economies, the price effects of money inflation often arise unevenly. With gold prices falling, prices began spiking in certain goods. Another player noted with curiosity:

[Y]esterday Fiery Brimstone was 150K, now almost 300K. Each time I hit refresh it seems to be going up a bit[.][6]

Gold Floors vs. Black Markets

The RMAH had minimum and maximum dollar amounts for in-game gold transactions: $0.25 minimum, $250 maximum. Market participants were also limited to dealing in increments of a certain size, called a “stack.” The “stack” was initially set to 100K gold. But as gold prices fell owing to rapidly building supply, the stack size was changed in August 2012 to 1 million. This practice, known as redenomination, is a fairly standard (if cosmetic) method of addressing inflation, but was viewed by some players as tacit devaluation.[7]

If you’re changing the [price] of gold from 0.25 per 100,000 to .25 per 1,000,000 I would like to cancel my gold auctions before you do that. You’re completely shifting the market in less than a day, and those of us that have auctions listed that will be affected by this change cannot cancel them until after the patch hits, which is potentially too late.[8]

To be clear, at the time at which the redenomination was introduced, gold was still trading above the floor rate. But being artificial, caps and floors not only prevent markets from clearing, but give black markets a target to undercut, to say nothing of offering players an opportunity to avoid the 15 percent fee — another intended gold sink — levied upon transactions within the auction house. Another player predicted,

[T]his [change] will likely have 2 effects … [it] could kill the private 3rd party market for gold and hopefully discourage botting … [but] because the real money price of gold is decreasing on the RMAH … [g]old will become cheaper as botters flood the market in an attempt to unload their massive surplus of gold before it becomes absolutely worthless. … This decision will further destabilize the economy [as in the gold auction house] prices shoot from 100,000 gold to 1,000,000 gold … [or] 10,000,000 gold to 100,000,000 gold. … The same would happen if the [Federal Reserve] decided to suddenly release a flood of currency into the U.S. economy[.][9]

By early 2013, the gold price had fallen to the exchange floor set by the game managers — $0.25/million — and players began to show signs of concern. One asked,

[Are] there any plans of lowering the floor of gold[?] … It has been at .25 for about 2 weeks now … should I sell my gold now before it gets lowered?[10]

A Delirium of Stacks

Hyperinflation is the economist’s equivalent of an astrophysicist’s quasar cluster or a marine biologist’s dolphin “stampede”: a rare exhibition of a unique set of circumstances which arise infrequently and are closely studied when they materialize. Such events are exotic enough that they become legendary: many individuals knowing little about monetary policy are aware of the recent outbreak in Zimbabwe, or familiar with the defining instance in the post-WWI Weimar Republic.

Economically, the tipping point in the transformation of inflation into hyperinflation is characterized by a profound drop in the outstanding demand for money: when holders of money expect the supply of money to increase — particularly without any sense of timing, bounds, or other guidance — monetary demand in the present drops in favor of surrendering money for vendibles.

The focus of possessors of money, therefore, devolves into an effort to capture known, present purchasing power against the likelihood of its decline in the near future. Saving, in any event, delaying consumption, is chastened; and if a cycle of declining purchasing power and rapidly rising prices ensues, ultimately the propensity to hold money declines precipitously and may fundamentally disappear.

This was demonstrated when, in a message board entry prefaced by stating “Sell Equipment before Patch 1.0.5 Hits!” (a patch is a piece of software added to an operational program or application as bugs are found, changes desired, or ways of improving performance discovered), a player warned that,

Blizzard just announced that the drop rates for [certain] items are going to be doubled … if you haven’t already, you should consider converting your current gear to cash … since real $ [are] the best hedge against gold devaluation[.][11]

If historical cases of hyperinflation — real, and now virtual — have one thing in common, it is the instinct among its victims to blame the symptoms rather than the disease. The Austrian economist Hans Sennholz noted that during the German hyperinflation, “intrigue and artifice” were believed to be at work.[12] Similarly, a handful of Diablo 3 players, frustrated about the decimation of their purchasing power, expressed increasing suspicion of manipulation and conspiracy theories.

[W]hy [are] certain items priced [s]o astronomically high? Many of them are not even that good yet cost 100’s of millions of gold. … I have about 45,000,000 gold saved up [and] check every few days to see if I can get any upgrades that are worth the gold, but … everything is vastly overpriced … clearly controlled by the gold sellers.[13]

And, predictably, any number of baleful remedies were proposed.[14]

While RMAH prices for virtual gold rallied occasionally, the prevailing direction of black market prices for virtual gold was inexorably lower as third party sellers undercut the in-game gold floor. In February 2013, Patch 1.0.7 was rolled out, introducing a range of new gold sinks intended to sop up ever-increasing virtual gold; they included new weapons and items not eligible for sale on the RMAH. One month later, with gold prices continuing to decline, a player made the following diagnosis:

[A]dditional gold sinks [are] unfortunately comparable to spitting on a fire ... [they] do nothing to limit the core issue which is that players are earning gold faster than they [want] to spend it. Repairing is not a … good gold sink as it works best [for] players who are [dying]. … Crafting is the same, works well on players who can get the items to craft with … but leaves players with limited gold supply out of the picture. … The amount of gold that drops … needs to be nerfed, and not softly.[15]

The effort appears to have been futile, as the growth of the virtual gold supply continued to grow.

Several competing definitions for hyperinflation exist, with the strictest — an increase of 50 percent in one month — defined by economist Philip Cagan in his 1956 book The Monetary Dynamics of Hyperinflation.[16] By his definition, the Diablo 3 economy appears to have entered hyperinflation between February and March of 2013, when the black market price of gold fell from $0.20/million to $0.05/million — a decline of over 75 percent in a few weeks.[17] At around that time, a player commented that he was

watching the markets collapse and gold become worthless. … So you feel rich that you have a billion or two in gold[?] … [W]ell guess what, you aren’t … there is nothing you can invest in to hold value. The only thing worth anything has become $$$.[18]

With a sardonic irony that markets sometimes display, real world currencies had assumed the role of commodity gold, and virtual gold had gone the way of all flesh and fiat currencies.

This, however, was still only the penultimate stage. On May 7th 8th, 2013, Blizzard rolled out Patch 1.0.8, which contained the seeds of the last, hyperbolic surge of gold superabundance. One change was the altering of the gold stack size from 1 million to 10 million per $0.25: a simultaneous redenomination and 90 percent devaluation (sitting, as the price was, at the RMAH floor) of virtual gold, targeting black market rates of roughly 4 cents per 10 million. In addition, a bug within the patch allowed users to cancel transactions in the auction house before completion, essentially allowing them to double their gold on demand.[19]

In just a few hours, the already gold-swamped economy saw trillions more created: a mammoth deluge of, by then, worthless virtual gold chasing finite goods, driving prices upward in leaps and bounds. It was, at last, the hyperbolic blow-off characteristic of real world hyperinflationary episodes. Some of the price increases (in Diablo 3 gold) are shown below:

	2013 avg price	1-6 May avg price	7-8 May price
radiant star amethyst	17.4M	41.2M	85.8M
radiant square ruby	187K	260K	337K
flawless square topaz	491	5,170	8,700
star emerald	764K	1.1M	1.6M
tome of jewelcrafting	694	3,400	3,100

And in a noteworthy departure from real world hyperinflation, rather than resorting to barter (which frequently takes the form of food for skilled labor), as runaway inflation became hyperinflation, many chat channels — through which some measure of trade was consummated — seem to have fallen empty: without a need to eat or clothe oneself in the virtual world, some players simply appear to have turned away.[20]

Aftermath

Blizzard quickly closed the in-game auction houses and audited transactions which took place during the blowout, banning players who took advantage of the bug and donating the proceeds of certain sales to charity. The gold stack size was also moved back from 10M to 1M. One week later, on May 15th, the above-cited items were quoted at the following, approximate virtual gold prices: radiant star amethyst, 26.1M; radiant square ruby, 375K; flawless square topaz, 8,600; star emerald, 797K; tome of jewelcrafting, 1,350.

In May of 2012, the price of virtual gold was approximately $30/100,000 or $0.0003/gold.[21] As this article was completed — and bearing in mind that these prices may be erroneous, stale, or merely indications of interest — one site showed Diablo 3 gold being offered by four third party sellers at an average price of $1.09/20M, or $0.0000000545/gold: one ten-thousandth its market price one year earlier.[22] In the RMAH, virtual gold was priced at $0.39/1M.

Remembering that game economies are private and players are voluntary members, there’s no explicit mandate to ensure rigid inflation control as one often sees (however rarely pursued) in public economies. That said, knowing that gaming experiences can be upended by economic missteps, there is a clear business interest for gaming firms in keeping virtual currencies and the greater economies as a whole stable.

Frequently, hyperinflationary episodes have ended by substituting a currency outside the political and central banking control of a nation for the sovereign currency. During the early 1990s, during Serbia’s hyperinflation,

[t]he authorities could not print enough cash to keep up. On Jan 6th, 1994, the dinar officially collapsed. The government declared the German mark legal tender … [which] end[ed] the hyperinflation.[23]

Two obvious solutions for managers of virtual economies include more vigilant bot restrictions and close — indeed, real-time — monitoring of faucet output, sink absorption, prices, and user behaviors. More critically, though, whether structured as auctions or exchanges, markets must be allowed to operate freely, without caps, floors, or other artificialities. Unrestricted (real) cash auctions would for the most part preempt and obviate black markets. [24]

$15.00 $14.00

One also surmises, considering the level of planning that goes into designing and maintaining virtual gaming environments, that some measure of statistical monitoring and/or econometric modeling must have been applied to Diablo 3’s game world. The Austrian School has long warned of the arrogance and naïveté intrinsic to applying rigid, quantitative measures to the deductive study of human actions. Indeed; if a small, straightforward economy generating detailed, timely economic data for its managers can careen so completely aslant in a matter of months, should anyone be surprised when the performance of central banks consistently breeds results which are either ineffective or destabilizing?

By no means does this analysis intend to equate the actions of virtual gaming firms with the policies of governments or central banks, or to malign their indisputably talented managers, designers, and programmers. While their actions may ultimately generate similar outcomes, central planners seek and wield power whereas the actions of commercial gaming interests are undertaken to compete with other online entertainment providers by delicately balancing opportunities for newer players with the need to continually challenge experienced players.

By all accounts Diablo 3 is a great game; one hopes that with this episode passed, it will reacquire its former glory. But while decision-makers at online gaming firms can and should be forgiven for not anticipating the perilous and unpredictable torsions of rapidly expanding money supplies, the events of the last week provide a stark reminder of the power and inescapability of the laws of economics.

[Editor's Note: What would be the best multiplayer video game monetary system? Should there be a fixed amount of in-game money? Should the only source of new money be “mining,” à la Bitcoin? Should there be no designated in-game money at all, so as to allow a market-selected money to arise via the barter of in-game commodities? Sound off in the comments!]

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Peter C. Earle's website can be found at: PeterCEarle.com. Follow him on Twitter. Send him mail. See Peter C. Earle's article archives.

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Notes

[1] http://wiki.mises.org/wiki/Inflation

[2] While the focus seems, at least on the part of players, to have been largely directed toward increasing gold sinks, there are more subtle elements which can influence virtual money supply. For example — on the faucet side — as players level up, it is critical to ensure that the difficulty in generating gold as well as amounts generated rises commensurately.

[3] http://www.gamerluck.com/Diablo-3-Gold-Price-analysis-in-black-Market--news-200-html

[4] http://www.gamerluck.com/blog/2012/06/10/making-diablo-3-gold-4million-per-hour-chinese-professional-gamer/

[5] http://us.battle.net/d3/en/forum/topic/5978857946#1

[6] http://us.battle.net/d3/en/forum/topic/6308701168#1

[7] Redenomination is the practice of changing the face value of banknotes or coins in circulating currency, and though customarily implemented by “adding zeroes” to paper bills doesn’t automatically imply devaluation.

[8] http://us.battle.net/d3/en/forum/topic/6368188197#1

[9] http://us.battle.net/d3/en/forum/topic/6368188197#1

[10] http://us.battle.net/d3/en/forum/topic/7593741500#1

[11] http://us.battle.net/d3/en/forum/topic/6714702877#1

[12] Hyperinflation in Germany, 1914-1923 (Mises Daily)

[13] http://us.battle.net/d3/en/forum/topic/7592581113#1

[14] Some recommendations on game message boards included daily taxation, Cyprus-styled virtual gold account levies and — incredibly enough — increasing the amount of virtual gold in the economy.

[15] http://us.battle.net/d3/en/forum/topic/8196600858#1

[16] http://en.wikipedia.org/wiki/Hyperinflation

[17] http://www.d3-bot.com/index.php/the-curious-case-of-diablo-3-economy-and-diablo-3-gold-price-we-need-an-answer/

[18] http://us.battle.net/d3/en/forum/topic/8568988090#1

[19] http://diablo.incgamers.com/blog/comments/diablo-iii-patch-1-0-8a-notes

[20] http://us.battle.net/d3/en/forum/topic/8568990771#5

[21] http://www.gamerluck.com/Diablo-3-Gold-Price-analysis-in-black-Market--news-200-html

[22] http://www.mmobux.com/compare/d3/diablo-3-gold

[23] Dinar Inflation (Mises Daily)

[24]There is no doubt a fear among game designers that a fixed amount of in-game currency would reward the first, most active players, who’d then save (“hoard”) their winnings and leave decidedly fewer opportunities for later or less active players; online gaming is a business, after all. But this is essentially the theoretical underpinning of the Keynesian concept of a “liquidity trap”, which is countered by Austrians who note that in the real world there is always some level of consumption, given that individuals need to eat, shelter and clothe themselves; in desperate economic times individuals cut back their expenditures but nevertheless continue consuming goods. How best to accomplish regular, periodic player consumption is beyond the scope of this article, but persistent deflation in a virtual world - not unlike what the United States experienced throughout most of the Nineteenth Century - would benefit newer players and encourage longer-term players to remain active.

Regulating Banks the Austrian Way

Mon, 20 May 2013 00:00:00 -0500

Most people — from young to old and from all ends of the political spectrum — are united by a common bond. The idea that banks are deserving of taxpayer support is viewed as morally repugnant to them. Business owners see bank bailouts as an unfair advantage that is not extended to all businesses. Those typically on the political left see it as support for the establishment, and a slap in the faces of the little people. Those more at home on the political right see it as just another form of welfare: a wealth redistribution from the hard working segment of the population to the reckless gambling class of banksters.

Despite this common disdain for bankers, there is considerable disagreement on how to deal with them. One group sees less regulation as the solution — letting market forces work will allow the virtues of prudence and industry to prevail. This formulation sees these same market forces as limiting firm size naturally to evade the “too big to fail” issue, through many of the same incentives that foment competitive economic advancement.

Another group sees the solution as more regulation. The natural tendency in business, according to this group, is for large monopolies to form. As companies grow in size, they gain political influence as well as an aura of indispensability. The consequence is that not only will a company come to be seen as too big to fail, but it will also be politically influential enough to seek such recourse if troubles surface.

Like most answers, the truth lies somewhere in the middle.

$20.00 $18.00

The first group correctly notes that there are two specific drawbacks of increasing regulation. On the one hand, “one size fits all” regulatory policies (such as is commonly the case on the Federal level) are rarely capable of handling the intricacies and dynamics of business. They also have the effect of relaxing the attention individuals and businesses afford to their own behavior. Under the pretense that the state has enacted wise regulations, individuals see little need to actively monitor companies to make sure they behave in a responsible manner. Businesses too succumb to this mentality. By abiding by the existing regulatory regime, they take solace in knowing that any attack on their integrity can be brushed aside as an attack placed more appropriately on the failures of the regulating body.

On the other hand, increased regulation breeds the problem of what economists call “moral hazard.” An activity is morally hazardous when a party can reap the benefits of an action without incurring the costs. The financial industry is very obviously afflicted with moral hazard today.

Banks and other financial companies have largely abided by the law. I would venture a guess that there is no industry more heavily regulated than the financial services industry, and no industry that spends more time and resources making sure that it complies with this complex regulatory maze. Capital levels must be maintained, reporting must be prompt and transparent, and certain types of assets must be bought or not bought. Banks following these regulations get a sense that they will survive, if not flourish, provided they work within the confines of the law.

However, it is increasingly evident that the financial regulations put in place over the past decades are woefully inept at maintaining a healthy financial industry. In spite of (or perhaps because of) all these regulations, a great many companies are, shall we say, less than solvent. So, who is to blame? It would be easy to blame the companies themselves, except that they did everything that the regulators told them to do.

Why not at least consider relaxing regulations? Doing so would have a two-fold advantage.

On the one hand, businesses would be more obviously responsible for the instability they have now created. On the other hand, without regulations, more reckless or clumsily managed companies would have gone out of business already, lacking the benefit of a regulatory “parent” scolding them for their mistakes. The result would be fewer unstable businesses, and more attention to the dangers of one’s own actions.

I previously mentioned that both sides are correct to some degree, implying that those calling for more regulation had some merit to their arguments. And this is indeed true. However, to paraphrase Inigo Montoya, when they use the word “regulation,” I do not think it means what they think it means.

It is true that not all companies play on a level field. In the financial services industry, and particularly in the banking sector, this is especially apparent. Banks are granted a legal privilege of “fractional reserves.” The result is that banks behave in a way which is fundamentally different from any other type of business, and which is easy to misdiagnose as “inadequate regulation.”

A depositor places money in his bank. The result is a deposit, and the depositor has a claim to this sum of money at any moment. One would think that the bank would be obliged to keep the money on hand, much in the same way that other deposited goods — like grain in an elevator — must be kept on hand. The law begs to differ. Banks are obliged to keep only a portion, or fraction, of that deposit in their vaults and are free to use the remaining sum as they please. Canada and the United Kingdom are examples of countries where there is no legal requirement for a bank to hold any percentage of that original deposit in its vault. In the United States, if a bank has net transactions accounts (deposits and accounts receivable) of less than $12.4 million, the reserve ratio is also set at zero. This differs greatly from grain elevators, where the law strictly states that the elevator owner must keep 100 percent of the deposited grain in the silo.

There are two results of the practice of fractional reserve banking, neither of them positive for the average person.

First, banks grow larger because they have access to a funding source that would otherwise not be available if they conducted themselves by the same laws as other businesses. When commentators say “banks are different,” there is truth in the statement. They have a legal privilege that enables them to grow in scope beyond that which they could naturally. This also explains why many banks, and financial services companies, come to be viewed as too big to fail.

Second, banks become riskier. Every time a deposit is not backed 100 percent, the depositor is exposed to the possibility of not getting his deposit back in full. If a bank uses his deposit to fund a mortgage, and the borrower defaults and cannot repay the bank, there is a risk that the original depositor will lose some of his money. A more common case is a bank run, in which many depositors try to withdraw money at the same time. The result will be insufficient funds to simultaneously honor all redemption demands. This occurred with various banks in Iceland, Ireland, Britain, and Cyprus over the last four years.

Few people worry about this latter problem, however, because of the former one. Since banks have become too big to fail, we are assured that if one goes bankrupt, we as depositors do not stand to lose personally. The government has pledged implicitly, or even explicitly through deposit insurance, that it will step in and bail out the irresponsible actors.

The result is the confusing state of affairs that we have today with two sides both arguing for the same thing — banking stability — via two diametrically opposed means. The “more regulation” camp is pitted against the “less regulation” camp.

A Solution

These two camps are not mutually exclusive. We can solve the problems of moral hazard and “too big to fail” in one fell swoop by ending fractional reserve banking.

By ending this legal privilege, we eliminate the ability for banks to grow to such inordinate sizes. By abiding by the same legal principles (or “regulations,” if you will) as any other deposit-taking firm, banks are not unduly advantaged. If banks shrink in size, the “too big to fail” doctrine is eliminated, or at least greatly reduced. This means that depositors and bankers will realize that if a loss occurs to their bank, they personally stand to lose.

The risk of loss is a great force in removing moral hazard. Remember that it only arises when one person’s ability to gain is not constrained by the threat of a loss. Cognizant of ensuing losses, depositors will demand that their banks adhere to more prudent operating principles, and bankers will be forced to meet these demands.

The critics worried about “too big to fail” are right. We do need more “regulations,” in a sense. We need banks to be regulated by the same legal principles regarding fraud as every other business. The critics worried about moral hazard are also right. We need fewer of every other kind of regulation.

Repairing a broken financial system does not have to be hampered by irreconcilable political differences. Recognizing the true issues at stake — legal privilege and unconstrained risk taking — allows one to bring together advocates of widely differing solutions into one coherent group. Getting bankers to agree to all this is another story.

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David Howden is Chair of the Department of Business and Economics, and associate professor of economics at St. Louis University, at its Madrid Campus, and winner of the Mises Institute's Douglas E. French Prize. Send him mail. See David Howden's article archives.

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