The Parable of the Broken Traffic Lights. Bad signals.

Steven Horwitz.

Suppose on some sunny afternoon in a large city somewhere in the western world, a man discovers on awaking from a two-hour nap that several hundred car accidents had occurred in the city while he slept.  He wonders why.  First he considers the possibility that the weather was the cause, but the gorgeous afternoon sun pushes that thought aside.  The odds of many hundreds of cars having simultaneous mechanical problems seems infinitesimally small, so he rules that out as well.  He ponders the question further and eventually asks himself whether the drivers in that fair city just had a bout of group psychosis or mass delusion.  The odds of that also seem pretty low.

As his brain slowly awakens, he stumbles across the likely culprit: Something must be wrong with the traffic lights.  He concludes that the lights are not working, leaving the drivers to figure out how to negotiate the intersections on their own.  Wouldn’t that, he wonders, cause many accidents?  He turns to his wife and suggests that explanation.  She replies:  “If you came to a traffic light and saw it was not working at all, wouldn’t you slow down and proceed cautiously?  In fact, after Hurricane Katrina didn’t people in New Orleans just treat broken traffic lights like four-way stops, without explicit direction to do so?”  Our fellow acknowledges his wife’s insightfulness and continues to ponder.

Soon it hits him: It’s not that the traffic lights were not functioning at all, but rather they were all green.  If all the lights were green, drivers would have no reason to think the lights were not working and would proceed through every intersection — with the result being the hundreds of accidents.  It strikes our fellow that not only do green lights mean go, they also mean that the cross-traffic has stopped.  This is how traffic lights do their job of coordinating the plans of drivers on both streets.

Reckless Drivers Blamed

Our man begins to watch the coverage of the accidents on TV, where breathless commentators are blaming the crashes on the irrational and reckless behavior of drivers.  He thinks:  “That’s not fair.  They did not act irrationally;  they simply responded reasonably to a signal whose meaning they’ve long understood.”  As he gets angrier about the blame being placed on the drivers, he realizes that the irrationality that caused the crashes was not in the actors but in the traffic signals.  When traffic signals don’t tell the truth, in this case that the cross-traffic has stopped, even the most rational, cautious drivers will get into accidents at intersections.  He is stunned that the TV commentators can’t see this.  In despair he goes back to sleep, hoping it was all a dream.

Not only was it not a dream, it was the reality of the post-2001 boom that generated the financial crisis and Great Recession.  The Austrian economist Israel Kirzner has long used traffic lights as an analogy for prices. In the case of the boom and bust, the key price was the interest rate.  In a free market, interest rates and the banking system coordinate the plans of the cross-traffic of lender-savers and borrower-spenders.  If saving increases, it means consumers are more willing to wait for goods.  Their saving leads banks to offer lower interest rates, providing a traffic signal (and an incentive) for borrowers to borrow for longer-term projects that match the greater patience of consumers.  If consumers are more impatient and save less, banks raise rates, leading borrowers to go more short term to match this preference.  Each side’s behavior is consistent with the other’s, thanks to the traffic-signal role of the interest rate.

Central Bank Tampering

When the central bank intervenes, however, it turns all the lights green.  Expansionary monetary policy provides loanable funds to banks, which enables them to lower rates as if there were more saving.  However, that saving is an illusion; consumers have not become more patient.  With lower rates, borrowers find longer-term projects more profitable and so divert resources to them and away from others.  The problem, of course, is that consumers do not in fact wish to wait longer than they did before.  So producer-borrowers invest in longer-term projects while consumer-savers continue to want relatively shorter term ones.  This, like traffic patterns with broken signals, is not sustainable and will eventually lead to the economic equivalent of car crashes: the onset of a recession as this discoordination is revealed.

Of course robust economies can mask underlying discoordination for a fairly long time before it is revealed.  A city suffering through a plague of all-green traffic lights sees a more immediate and visible result.

Like our drivers, borrowers were not irrational during the boom.  They simply responded rationally to an irrational signal.  The source of that irrational signal was the Federal Reserve System.  The next time a friend blames the boom and bust on irrational investors, you might recall our protagonist’s city and say: “The irrationality, dear friend, is not in our markets but in our government, that is, the central bank.”

Creating Jobs versus Creating Value

Steven Horwitz.

Picking on New York Times columnist Paul Krugman is one of the largest participation sports on the Internet. And rightfully so, since he often says ridiculous things that demand a response from those who understand basic economics better than he does, despite his having won a Nobel Prize. His January 26 column has him, once again, making such an argument. This time it’s on the subject of job creation.

Krugman claims that the Republican argument for the importance of job creation relies too heavily on the “heroic entrepreneur,” rather than recognizing that “successful companies — or, at any rate, companies that make a large contribution to a nation’s economy — don’t exist in isolation.” For Krugman this means there’s plenty of help from government. Although I can’t speak for all Republican politicians, I can say that Krugman’s view of the argument for free markets is utterly mistaken.

The argument for the market is based precisely on the fact that the entrepreneur exists in a social context that helps to determine how effective her actions will be. The most heroic entrepreneur imaginable cannot be very productive if she is shackled by government regulations or is trying to operate in a society with ill-defined or poorly enforced property rights. As Ludwig von Mises recognized as far back as 1920, this is the same reason that successful entrepreneurs fail miserably when they try to run government agencies like businesses: What gives the entrepreneur the ability to succeed are market signals, which are necessary to determine what people might want and how well it was provided. Even the smartest person can’t learn if a teacher uses black chalk on a blackboard in a dark room. No entrepreneur can succeed in isolation.

The Hard Task

More important, though, is that both Krugman and politicians from both parties are much too concerned about jobcreation when they should be concerned about value creation. Creating jobs is easy; it’s creating value that’s hard. We could create millions of jobs quite easily by destroying every piece of machinery on U.S. farms. The question is whether we are actually better off by creating those jobs — and the answer is a definite no. We wantlabor-saving, job-destroying technology because it creates value by enabling us to produce things at lower cost and thereby free up labor for more urgent uses.

A century ago 40 percent of Americans worked in agriculture; today it’s less than 2 percent. The former farm workers didn’t all go unemployed. The wealth created by higher farm productivity and lower prices enabled us to demand all kinds of new products that in turn created many more jobs than were lost in agriculture. This is the story of innovation everywhere.

So rather than talking about job creation, let’s focus on value creation. The case for freeing markets is that such freedom best enables individuals to find ways to use their knowledge and skills to create value for others and thereby create wealth for themselves. The more wealth that value creators can keep, the more likely they are to continue to create it. Even if a value-creating innovation destroys jobs in the short run, the increased wealth will bring a great deal of job creation in its wake.

Ancillary Jobs

Krugman tries to criticize Apple by pointing out that the “heroic” Steve Jobs has only created about 43,000 Apple jobs in the United States (though around 700,000 overseas). But this misses the point: The real job-creation number that matters here are all the ancillary jobs created through the invention of the Mac, iPod, iPhone, and iPad. Those inventions, along with every other technological innovation, have created tens of millions of jobs in programming, web design, app design, hardware maintenance, and more.

Krugman also takes a swipe at fans of Ayn Rand by referring to “the John Galt, I mean Steve Jobs-type ‘job creator.’” But Krugman is blind to the error of his own joke: John Galt’s innovative motor took static electricity out of the air and turned it into useful energy, which would have been a huge job destroyer! Again, the triumph of entrepreneurial innovation is not in creating jobs, but in creating value. Galt’s motor would have freed up a lot of labor to be devoted to new wants made possible by the cheap source of energy. Krugman can’t even see that his own example undermines his argument.

The next time anyone starts talking about job creation, stop listening. Jobs come into existence when entrepreneurs are free to create value. Aiming directly at job creation is a recipe for waste and poverty. Set people free to use their talents to create value for others and the jobs will follow.

Are the poor getting poorer? Steven Horwitz

People often say that "the rich are getting richer while the poor are getting poorer." Economics professor Steve Horwitz explains why in the United States, this characterization is largely a myth.


Real income levels of the poorest 20 percent of Americans have actually risen over time. Further, the individual households that comprise the bottom income bracket do not stay the same. The majority of Americans in the poorest 20 percent become wealthier over the course of their lives. Want to learn more? Check out these resources:


• Op-ed on Inequality, by Prof. Horwitz: http://www.ajc.com/opinion/data-overlook-upward-mobility-816832.html


• Cox. W. Michael and Richard Alm. Myths of Rich and Poor: Why We're Better Off Than We Think, New York: Basic Books, 1999.


• Reynolds, Alan. "Has U.S. Income Inequality Really Increased?" Policy Analysis 856, Cato Institute, January 5, 2007. Available online at: http://www.cato.org/pubs/pas/pa586.pdf

The Importance of Failure. Steven Horwitz and Jack Knych

In today’s society failure has become something to fear, avoid, and therefore prevent at all costs. Whether it is unemployment compensation, farm subsidies, or bailouts for failing companies, the world seems to view failure as having no redeeming social value. If success is all good and failure is all bad, then it seems as though we should do everything we can to remedy or prevent failure.

But is that so? Without denying the value of perseverance, and recognizing that the slogan “never give up” can be useful in overcoming certain obstacles, we must keep in mind that failure can act as a guide to more worthwhile activities. For example, in 1921 Walt Disney started a company called the Laugh-O-Gram Corporation, which went bankrupt two years later. If a friend of Disney or the government hadn’t let him fail and move on, he might never have become the Walt Disney we know today.

More important than this individual learning process is the irreplaceable role failure plays in the social learning process of the competitive market. When we refuse to allow failure to happen, or we cushion its blow, we ultimately harm not only the person who failed but also all of society by denying ourselves a key way to learn how best to allocate resources. Without failure there’s no economic growth or improved human well-being.

Economists, especially those of the Austrian school, often emphasize how entrepreneurs discover new knowledge and better ways of producing things. But entrepreneurial endeavors frequently fail and the profits thought to be in hand often don’t materialize. According to the U.S. Small Business Administration, over half of small businesses fail within the first five years. But failed entrepreneurial activity is just as important as successful entrepreneurial activity. Markets are desirable not because they lead smoothly to improved knowledge and better coordination, but because they provide a process for learning from our mistakes and the incentive to correct them. It’s not that entrepreneurs are just good at getting it right; it’s also that they (like all of us) can know when they’ve got it wrong and can obtain the information necessary to get it right next time.

Read full in The Freeman on line.

Horwitz on the Financial Crisis and Recession. Steven Horwitz

Letters to the Editor
Watertown Times
260 Washington St.
Watertown, NY 13601

To the Editor,

In his letter of October 23 criticizing George Will’s column on Elizabeth Warren, Mark MacWilliams of Canton repeats a number of fallacies about the recession and financial crisis that should not go unchallenged.

MacWilliams refers to Congress deregulating the financial industries but offers no specifics. In fact, since 1980, Congress has passed four new sets of regulations for every one deregulatory act, and between 2001 and 2008, there were nine new sets of regulation and not one bit of deregulation. Those recent regulations included the Basel capital requirements, which created powerful incentives for banks to sell off the mortgages they originated and buy them back as mortgage backed securities, which they otherwise would not have done.

Contrary to MacWilliams, our current mess was not the result of “predatory capitalism,” but the predictable consequence of government intervention and crony corporatism. Nowhere does he mention the Federal Reserve’s role in pushing interest rates so low that banks were being paid to borrow, nor does he have a word to say about Fannie Mae and Freddie Mac having privileged access to the Treasury to buy up all of the questionable mortgages that banks originated. He also ignores two decades of Congress’s role in mandating that banks lend to marginal borrowers.

MacWilliams needs to ask himself why, if this was really capitalism, banks would make loans to people they thought could not pay them back. If corporations are greedy profit-seekers, why would they risk customers not being able to pay unless they believed that those mortgages could be sold off to government-sponsored enterprises like Fannie and Freddie who would, as they did, get bailed out by the government?

If all the traffic lights in Watertown were stuck on green, we’d hardly blame the drivers for the ensuing accidents. When government distorts the signals and incentives facing producers and consumers, the blame for the resulting disaster should fall on government not the private sector. The crisis and recession are what happens when you put “people before profits.”

Finally, MacWilliams should learn who does assure that his toaster doesn’t explode by actually looking at it. He’ll find the stamp of not a government agency, but Underwriters Laboratory, a private firm that provides quality assurance for appliance makers and consumers. Unlike the government cartel of financial rating agencies that failed miserably last decade, the privately operated UL has decades of success behind it.

Sincerely,

Steven Horwitz

Source: Cafe Hayek.

Is the Cost of Living Really Rising? Steven Horwitz

Via Cafe Hayek.

According to Prof. Steven Horwitz, one contemporary economic myth is that the cost of living has consistently risen for Americans over the past century. In fact, prices are higher today than they were 100 years ago. However, prices today have been heavily influenced by inflation. One way of avoiding inflationary distortions is to look at amount of labor hours required to make a purchase. Using this analysis, Prof. Horwitz finds that most goods and services have never been cheaper.