Bastiat on Why Protectionism Fails: Money is Not Wealth

One of the fundamental flaws of protectionism have been to mistake money, which is a medium of exchange, for wealth. Thus, the obsession by the mainstream for inflationism-protectionism as popular political solutions to economic predicaments.

The great classical liberal Frédéric Bastiat explodes this myth more than a century back. (From Mises Institute/The Bastiat Collection) [bold emphasis mine]

Do you desire to be in a situation to decide between liberty and protection? Do you desire to appreciate the impact of an economic phenomenon? Inquire into its effects upon the abundance or scarcity of commodities, and not upon the rise or fall of prices. Distrust nominal prices; they will only land you in an inextricable labyrinth.

Mr. Matthieu de Dombasle, after having shown that protection raises prices, adds:

"The enhancement of prices increases the expense of living, and consequently the price of labor, and each man receives, in the enhanced price of his products, compensation for the higher prices he has been obliged to pay for the things he has occasion to buy. Thus, if everyone pays more as a consumer, everyone receives more as a producer."

It is evident that we could reverse this argument, and say:

"If everyone receives more as a producer, everyone pays more as a consumer."

Now, what does this prove? Nothing but this, that protection displaces wealth uselessly and unjustly. In so far, it simply perpetrates spoliation.

Again, to conclude that this vast apparatus leads to simple compensations, we must stick to the "consequently" of Mr. de Dombasle, and make sure that the price of labor will not fail to rise with the price of the protected products. This is a question of fact that I remit to Mr. Moreau de Jonnes, that he may take the trouble to find out whether the rate of wages advances along with the price of shares in the coal mines of Anzin. For my own part, I do not believe that it does; because, in my opinion, the price of labor, like the price of everything else, is governed by the relation of supply to demand. Now, I am convinced that restriction diminishes the supply of coal, and consequently enhances its price; but I do not see so clearly that it increases the demand for labor, so as to enhance the rate of wages; and that this effect should be produced is all the less likely, because the quantity of labor demanded depends on the available capital. Now, protection may indeed displace capital, and cause its transference from one employment to another, but it can never increase it by a single farthing.

But this question, which is one of the greatest interest and importance, will be examined in another place. I return to the subject of nominal price; and I maintain that it is not one of those absurdities that can be rendered specious by such reasonings as those of Mr. de Dombasle.

Put the case of a nation that is isolated, and possesses a given amount of specie, and that chooses to amuse itself by burning each year one-half of all the commodities that it possesses. I undertake to prove that, according to the theory of Mr. de Dombasle, it will not be less rich.

In fact, in consequence of the fire, all things will be doubled in price, and the inventories of property, made before and after the destruction, will show exactly the same nominal value. But then what will the country in question have lost? If John buys his cloth dearer, he also sells his corn at a higher price; and if Peter loses on his purchase of corn, he retrieves his losses by the sale of his cloth. "Each recovers, in the extra price of his products, the extra expense of living he has been put to; and if everybody pays as a consumer, everybody receives a corresponding amount as a producer."

All this is a jingling quibble, and not science. The truth, in plain terms, is this: that men consume cloth and corn by fire or by using them, and that the effect is the same as regards money, but not as regards wealth, for it is precisely in the use of commodities that wealth or material prosperity consists.

In the same way, restriction, while diminishing the abundance of things, may raise their price to such an extent that each party shall be, pecuniarily speaking, as rich as before. But to set down in an inventory three measures of corn at 20s., or four measures at 15s., because the result is still 60s. — would this, I ask, come to the same thing with reference to the satisfaction of men's wants?

It is to this, the consumer's point of view, that I shall never cease to recall the protectionists, for this is the end and design of all our efforts, and the solution of all problems. I shall never cease to say to them: Is it, or is it not, true that restriction by impeding exchanges, by limiting the division of labor, by forcing labor to connect itself with difficulties of climate and situation, diminishes ultimately the quantity of commodities produced by a determinate amount of efforts? And what does this signify, it will be said, if the smaller quantity produced under the regime of protection has the same nominal value as that produced under the regime of liberty? The answer is obvious. Man does not live upon nominal values, but upon real products, and the more products there are, whatever be their price, the richer he is.

In writing what precedes, I never expected to meet with an anti-economist who was enough of a logician to admit, in so many words, that the wealth of nations depends on the value of things, apart from the consideration of their abundance. But here is what I find in the work of Mr. de Saint-Chamans (p. 210):

If fifteen million worth of commodities, sold to foreigners, are taken from the total production, estimated at fifty millions, the thirty-five million worth of commodities remaining, not being sufficient to meet the ordinary demand, will increase in price, and rise to the value of fifty millions. In that case the revenue of the country will represent a value of fifteen million additional.… There would then be an increase of the wealth of the country to the extent of fifteen million, exactly the amount of specie imported.

This is a pleasant view of the matter! If a nation produces in one year, from its agriculture and commerce, a value of 50 million it has only to sell a quarter of it to the foreigner to be a quarter richer! Then if it sells the half, it will be one-half richer! And if it should sell the whole, to its last tuft of wool and its last grain of wheat, it would bring up its revenue to 100 million. What a way of getting rich, by producing infinite dearness by absolute scarcity!

Again, would you judge of the two doctrines? Submit them to the test of exaggeration.

According to the doctrine of Mr. de Saint-Chamans, the French would be quite as rich — that is to say, quite as well supplied with all things — had they only a thousandth part of their annual products, because they would be worth a thousand times more.

According to our doctrine, the French would be infinitely rich if their annual products were infinitely abundant, and consequently, without any value at all.

Think of it, if you alone have been stranded in a remote and inaccessible island inhabited by primitive tribes, what will your bag filled with $10 million buy (if they should accept your greenbacks at all)?

A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino

This article is dedicated to my friends at RC Mandaluyong.

People normally bear the misimpression that stock markets function as some variant of gambling “casino”.

Never have they realized that stock markets bear a significant financial and economic merit. Any country that desires to adopt some degree of market based economy requires the presence of a stock market. Even in places which are deemed as economically, socially or politically chaotic or unstable such as Iraq, Zimbabwe or Nigeria has an operating stock market.

Basic Function

The stock market operates similar to the markets where we buy our food. Basically both of these markets function as platforms for conducting exchanges between buyers and sellers. The difference is in the products traded. For our “conventional” markets, it is based on comestible stuffs and or other household wares, whereas for the stock market they involve corporate financial securities such as common stock or preferred stocks or Exchange Traded Funds (ETF).

Going deeper, stock markets- as part of the capital markets- often reflect the basic function of money as medium of exchange, unit of account and a store of value.

-they function as a platform to trade financial securities (medium of exchange),

-they serve as a repository of collateral since they represent ownership in companies that are backed by assets and stream of revenues (store of value) and

-they are valued through the pricing mechanism whether these are driven by momentum or emotions, corporate fundamentals or micro/macro economy as “inflation” (unit of account).

Since all financial markets are driven by the price mechanism, the following variables represent as key drivers in ascertaining prices:

-a collective assessment of the fluctuating balance between demand and supply

-accounts for the subjective value judgments by market participants

-signifies the time dimension in shaping for market participants expectations, whether it short medium or long term, and lastly

-primarily influenced by psychological dimensions (such as greed or fear) and cognitive biases (such as overconfidence, anchoring, risk aversion etc.)

And because markets are determined by divergent psychological expectations they result to a variable flux in prices as seen in the tickertape. This is known as volatility.

Yet prices are always set on the margins. What you read on the stock market section in the newspapers account for as prices determined by marginal investors, where daily traded volume represent only a fraction of total shares outstanding or market capitalization, and not the majority owners.

And the resultant price volatility set by marginal investors is what accounts for as the conventional impression of gambling “casino” like actions.

Risk and Uncertainty

The common impression of the public is that price fluctuations or volatility are a function of sheer randomness. And because of the perception of such unpredictability they are deemed to be risky, which adds to the gambling misperception.

But as market savant James Grant says, ``The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price.”

Of course, whether it is stock market or any non-financial enterprise or even public governance the fundamental problem will always be tomorrow’s uncertain outcome. We can’t even be certain if we will see the sun shine tomorrow. As an old saw goes, there is nothing certain in this world except death and taxation.

The point is- the aversion to the stock market is generally not about its unpredictability, but about having an insufficient understanding of how markets operate. To quote, the world’s richest and most successful stock market investor Mr. Warren Buffett, ``Risk comes from not knowing what you are doing.”

Yet if one scrutinizes the market, it can be generally observed that markets rarely operate on random.

This makes uncertainty of the future a measurable component. The same uncertainty is what can be translated to as “risk” or a “state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome” to quote economist Frank Knight.

In addition, compared to a dice toss, or a bet on a lottery, or a horse race which is immediately determined by the end result of one particular event, markets can be distinguished from these high return high risk activities, because they operate as a continuing process.

This makes time a significant contributor to risk assessment.

From the distinguished finance author Peter L. Bernstein, ``Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field.”

Reward Risk Tradeoff

Everyone wants to profit. But in financial or stock markets or in any “market based” entrepreneurship endeavor, profits come by as returns of investments (ROI). In other words, one has to accept some degree of risk in order to generate profits.

Applied to regular business enterprises, this also translates to same dynamics: risk capital has to be deployed, in the expectations of future stream of revenues, which fundamentally determines your return on capital. The difference is that in the stock market as a shareholder, you become a passive investor.

Yet because we are uncertain about tomorrow, there is always the risk of undesirable or adverse outcome in the marketplace.

Again like any entrepreneurial activities, success or failure in the stock market always entail offsetting risks relative to your capital to determine your expected returns. This is what is known as the Risk-Return Tradeoff.

Put differently by understanding and limiting your risk, you can amplify or optimize your returns.

This brings us to the basics of risk identification. Fundamentally, there are 3 major risks to consider;

-systematic risks or market risk- risks to the general stock market such as government policy repercussions as war, protectionism, regulatory overkill, monetary policy mistakes, excessive taxation or risks of an economic recession or risk from bubbles: asset-liability mismatch seen in domestic balance sheets or in currency framework or overleverage in the financial or economic system etc…

-residual common factor risks or risks relative to a specific industry such as industry directed regulations, tariffs, etc... and lastly,

-residual specific risks (e.g. risk relative to a particular stock or company such as profitability, management, labor, inventory, etc…)

This means that once the above risks can be assessed, which correspondingly may determine one’s risk reward profile and subsequently applied to the configuration of a portfolio mix, the much feared losses can be minimized while the profit opportunities optimized.

Let me cite a common example; some financial institutions as banks offer Unit Investment Trust Funds (UITFs). Such investment vehicle essentially accounts for as fiduciary fund generally designed to cater to an investor’s risk appetite. But the portfolio mix is standardized; it is offered in either foreign (US dollar) or domestic (Peso) denominated funds and generally split into a choice of equity, fixed income (bond or money market) or balance fund (50% equity-50% balance).

For an investor of the UITF it means 3 things:

First, passive investment-investment allocation is determined by the fund manager assigned for a particular portfolio distribution. Your risk reward ratio is subject to the fund manager’s risk distribution activities. This means your portfolios performance is also subject to management risk.

Two, since the balance of accepting risk is standardized; a choice of all fixed income (conservative risk taking), balance fund (moderate risk) and equity fund (aggressive), the unforeseen risk is the opportunity cost of being “flexible”. In short, a standardized portfolio could be deemed as rigid.

Lastly, a foreign currency denominated fund means expanding your risk spectrum to include the currency risk or volatility from currency valuations.

However in an actively managed portfolio, you can apply the same risk allocation strategies, but this time, being more malleable to your risk profile and time frame based returns expectations.

Market Cycles

Whether we talk about economics or markets, we always deal with psychology.

It is because people act, based on their perceived values or priorities or guided by incentives, to attain certain desired ends.

Thus, the prevailing social psychology, as reflected in moods and actions, underpins the economic activities of savings-consumption-investment decisions, aside from cycles in the financial markets.

Here is an example of flow of the psychological cycle that drives market and or economic cycles.

Generally speaking, since people as social beings, we tend to act in crowd like fashion. This essentially forges extreme swings from outright optimism to downright depression, brought upon by our base instincts of “fear and greed”.

Applied to the economy we see the same wavelike movement…

Thus, economic trends transit from recovery, prosperity, contraction and recession which defines the general economic cycles, and which are nearly identical with the flow of the public’s social moods or psychology.

And as mentioned earlier, stock markets are likewise driven by crowd psychology. This in essence determines the price actions. And because crowd psychology is shaped by time influences, such invariably leads to trends which determine what is known as the stock market cycles.

The stock market cycle can be identified as bottom, advance, top and decline. In the above, the Philippine Phisix chart since 1980 shows that we appear to be undergoing a second leg of a long term cycle.

Again whether it is the stock market, or real estate or any asset class subjected to price actions, they are all influenced by the general trends of psychology.

The same can be applied to boom-bust cycles.

Boom bust cycles account for as the extreme flow of fund swings to certain industries which are typically manifested or vented on financial markets. Boom cycles are usually fueled by massive credit expansion, overspeculation and euphoria, while the bust cycles are the opposite of boom cycles; credit contraction, massive losses from liquidations, liquidity constraints, retrenchment of economic activities or plain risk aversion.

The present bust in the US, preceded by a boom in its housing industry, is emblematic of this phenomenon.

Speculation and Economic Benefits of the Stock Market

Because we can’t foretell of the future accurately, any act of capital allocation basically represents as speculative activity. But where the difference lies, again, is in the degree of volatility. A dentist may have less volatile flow of patient visits compared to a businessman engaged in distribution of cellphones.

However, most speculative actions in the marketplace are always associated with short term movements. Yet, unknown to most, the speculative component helps increase the liquidity or tradeablity of a security or markets, which essentially produce greater pricing efficiency or reliability of market price signals.

Remember, price signals function as our principal incentives for deciding how to allocate resources which can be seen in the context of saving, investing or consuming.

Finally, there are other economic benefits that the stock market provides to the society:

1. The stock market is a vital part of the process from which we coordinate production. Ideally stock prices should reflect the productivity of business firm aside from market’s discernment of the entrepreneurial judgments concerning future productivity.

2. It competes with the banking sector in determining the degree of mobilization of savings into investment. From a national scale this becomes a formidable channel for economic advancement in terms of efficiency of capital deployment.

3. Unknown to many, stock markets often function as forward indicators, such that they have been known to predict upcoming recessions or prospective recoveries. Thus, movements in the financial and stock markets can give a clue to the transitioning business environment, which should help management or businessmen, in allocating resources or in applying their business strategies going forward.

4. It operates as alternative avenues for fund raising (public listing), intermediation (using shares as collateral for borrowing-lending) or liquidity generation (buying or selling a company).

5. Because the markets operate as an organized platform of exchange, the ease from a market’s liquidity allows companies to save on transaction costs: search cost (matching buyers and sellers), contracting costs (cost of negotiation) and coordination cost (meshing securities of different industries into a single platform), which frees up capital for other usage.

6. Allows wider public participation in the ownership of major companies, which expands the concept of private property ownership.

7. Allows some individuals to save from taxation (e.g. inheritance taxes)

8. Because stock markets function as repository of collateral or store of value, it can serve as protection or safehaven against hyperinflation or a severe form of a loss of purchasing power of a currency.

In the case of Zimbabwe where (hyper) inflation rate has reached an astounding 231,000,000%, its stock market has skyrocketed 960 QUADRILLION percent on a year to date basis as of November 4^th, (All Africa.com) considering more than 5 years of severe economic contraction and 85% unemployment rate. Unfortunately because of some political reasons, the Zimbabwe Stock Market has been suspended since December 17^th (Bloomberg).

Stock Market Is Generally Not A Casino Until…

The overall the goal of this article is to enlighten the public from the mistaken notion that stock markets generally represent as gambling casino.

Given that the stock market has measurable risk-reward variables, involves time continuum dynamics and value added functions (as dividends) it operates like any entrepreneurial undertaking.

Moreover, it has an economic wide and social significance which is largely unappreciated by the uninformed public.

Hence, the speculative ‘casino’ trait is often associated to individual actions or participants who engage in the markets with a short term outlook and without the proper understanding and scrutiny of risk. [Further reading please see Professor Alok Kumar of McCombs School of Business, University of Texas in a recent paper, Who Gambles in the Stock Market?]

Lastly of course government interventions can tilt or distort any markets away far from its price signaling efficiency. This is where the level of the playing field or the distribution share of the odds are skewed to favor one party over the others, mostly the recipients or beneficiaries from these interventions. Where the governments assume the role as the HOUSE and the beneficiaries as the DEALERS, then all other participants operate as PLAYERS, hence your basic description of a gambling casino.