Video: How the Pricing System Works

Duke University Prof. Michael C. Munger, in the following video from LearnLiberty.org, explains how the price system works

To quote the great Austrian economist Friedrich von Hayek

We must look at the price system as such a mechanism for communicating information if we want to understand its real function — a function which, of course, it fulfils less perfectly as prices grow more rigid. (Even when quoted prices have become quite rigid, however, the forces which would operate through changes in price still operate to a considerable extent through changes in the other terms of the contract.) The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

Quote of the Day: The Virtue of Market Inefficiency

an inefficiency exists when, for a given person at a given time and place, the cost of an action outweighs the benefit.  We’ve seen that to rationally calculate costs and benefits you need money prices of inputs and outputs, of steel and bridges.  So when government erodes private property rights, interferes with trade, distorts prices, and manipulates money, it doesn’t just make it harder to be efficient; it also pulls the rug from under the very ability to spot inefficiencies at all.

Using the rules of arithmetic, for example, it’s easy to see that the statement 1 + 2 = 4 is wrong, but what about  _ + _ = _ ?  What’s the solution to this “problem”?  Is there even a problem here?  Money prices fill in the blanks; they “create errors”—i.e., reveal mistakes that no one could see without them—that alert entrepreneurs might then perceive and correct. If mistakes and inefficiencies remain invisible, the search for better ways of doing things could never get off the ground.

An economy without inefficiencies is either one where knowledge is so perfect that no one ever makes a mistake, or it’s one in which government policy has effectively foreclosed the very possibility of inefficiency.  In a world of surprise and discovery, of experiment and innovation, the former is impossible; the latter sort of economy, as Mises showed almost 100 years ago, is impossible as well as intolerable.

So a living economy needs to “create” inefficiencies, and lots of them, to set the stage for greater efficiency and ongoing innovation.

This excerpt is from Professor Sandy Ikeda at the Freeman talking about the essence and or the significance of the price mechanism.  (hat tip Prof. Don Boudreaux)

How Inflationism Undermines the Division of Labor

Technology guru and Forbes columnist Josh Wolfe writes, (bold and italics original)

Chief Investment Officer of Guggenheim Partners Scott Minerd has just noted the Faustian bargain the Fed has made with quantitative easing (a term itself in its complexity quickly confuses the masses). He notes simple bond math that shows the real risk to the Fed’s actions and the the strength of our dollar [paraphrased here]:

In 2008 pre-crisis

• The Fed had $41B in capital and ~$872B in liabilities = debt/equity ratio of 21:1
• The Fed’s had a portfolio with $480B in Treasuries with duration of ~2.5 years. (a useful rule of thumb is that duration of a bond x the change in interest rate = change in value of the bond)
• Thus a 1% rise in interest rates would cause a 2.5% drop in its holdings ~$12B

In 2011 post-crisis

• The Fed’s had portfolio of $2.6 T in liabilities = debt/equity ratio of 51:1 (up from 21:1)
• Duration = ~8 years.
• Thus a 1% rise in interest rates would cause an 8% drop in its holdings ~$200B
• That decline would exceed its capital by about $150bn

From here: as Minerd’s clear logic lays out: if the economy expands, then interest rates rise, then the Fed’s holdings drop, then it might not have enough sellable assets to reduce the money supply and maintain the value of the US dollar. And then if there are doubts about the dollar, the Fed is the buyer (and printer) of last resort, setting the stage for the risk of runaway inflation. So: “To hedge against [a decline] in the dollar’s purchasing power, investors [are migrating to] gold, commercial property, and artwork.”

While these may prove to preserve capital for the individual, for society it may be far better to have these assets invested in productive profit-seeking business and financing innovation and emerging technologies, than sitting in vaults, piling up on dirt or hanging on walls.

Inflationism drives economic imbalances through the pricing system by disrupting the feedback mechanism (profit and loss to reflect on demand and supply), in conjunction with the coordination process of the allocation of resources (through the production system).

As Professor Gary North explains,

Without reliable, predictable pricing, most people would make errors most of the time in estimating what things should cost. This is as true of our decisions as producers as consumers.

Money allows us to make bids in the market for the ownership or use of scarce resources. These bids are our responses as both consumers of goods and suppliers of goods. If prices no longer convey predictable information over time, planning becomes chaotic. Producers and consumers will erroneously forecast the state of supply and demand. Our errors add up over time. We produce losses. We find that we have consumed our capital. We cannot replace what we have consumed at prices we thought would prevail.

Hedging on assets against inflation keeps capital away from productive undertaking.

More the inflationism means greater volatility, instability and most importantly reduced economic activities. Inflationism also rewards political class and their cronies at the expense of society.

Cartoon of the Day: Prices are Evil

From Karen De Coster:

Raising prices is “gouging.”

Lowering prices is “predation.”

Keeping them the same is “collusion.”

Cutting costs is “scheming.”

So for governments, market prices signify a ‘damned-if-you and damned-if-you-don’t’ thing.

Yet without the pricing system there won’t be economic calculation which functions to coordinate or discoordinate the distribution of resources.

As Ludwig von Mises aptly pointed out.

A government that sets out to abolish market prices is inevitably driven toward the abolition of private property; it has to recognize that there is no middle way between the system of private property in the means of production combined with free contract, and the system of common ownership of the means of production, or socialism. It is gradually forced toward compulsory production, universal obligation to labor, rationing of consumption, and, finally, official regulation of the whole of production and consumption.

The Bolsheviks have tried this and failed, from the PBS.org (bold emphasis added)

1917-1920: With the October 1917 revolution, the Marxist concept of the moneyless economy becomes a desired goal, but not yet a practical one. The Bolsheviks nationalize the banks, but make no attempt to restrict inflation. With the destruction of the market economy, inflation soars, and money becomes virtually valueless. A black market based on barter develops to fill the vacuum.