There have been huge advances in technology and substantial declines in trade barriers in recent years. While these developments have raised living standards they have been hard on people whose skills were rendered obsolete or uncompetitive. When changes evolve gradually, as when so many people left farming in the last century, the disruption is not so great. Changes are now coming faster and are extending to some high-paid professional jobs. Automated systems can now handle at least the routine aspects of some legal research and medical diagnosis.

Time and time again new doors have opened to workers as old doors closed. Machines replace workers, but they raise productivity and produce new employment opportunities. We can expect this pattern to continue for a long time to come. Still, it is within the realm of possibility that robots and computers could take over so much work that the demand for human workers would shrink drastically. But those very machines would mean higher productivity and thus higher living standards.

A great deal of work can be now be done remotely, providing an advantage to areas with low living costs. Substantial outsourcing of such jobs to foreign countries has occurred (though that trend may be reversing as low-cost areas of the United States become competitive and as customer dissatisfaction and problems with managing offshore workers come up). The benefits of outsourcing and other productivity enhancements are spread across all consumers, but the job losses are concentrated among small and sometimes vocal minorities.

Another theoretical point: Unemployment notwithstanding, it is an empirical fact of life that labor is scarce relative to natural resources, as Murray Rothbard explained. Over time, this gap tends to lessen and could theoretically disappear.

Education Is Key

Problems with education are legion, but two in particular bear on unemployment and underemployment. One is the emphasis on college education over vocational training. Everyone should attend college, says President Obama. Really? What about welders, truck drivers, repair people, retail sales people? These skills are in demand, and for many people the jobs may offer good pay and personal satisfaction. Why not attend a trade school or get an apprenticeship rather than a college degree? Compare four years in school leading to a bachelor of arts in business and a big student debt versus on-the-job learning.

The second problem is that college administrators and instructors lack incentives to prepare students for good jobs. Schools usually have little to say about the jobs their graduates have gotten or the debt burdens they carry.

Even with all the emphasis on college, by 2020 only about a third of the labor force will be equipped with bachelor’s degrees or higher, according to the McKinsey Global Institute. But the glut of dubious business and social “science” degree-holders will continue while STEM (science, technology, engineering, and math) degree holders will remain scarce.

Among employers surveyed by McKinsey, a majority expect to hire more part-time, temporary, or contract workers. One reason for this trend is mandated and generally very expensive health insurance for full-time employees. But more sophisticated resource-management systems also contribute to this trend, in addition to telecommuting opportunities.

Unemployment Figures Are Grim, and Yet . . .

As this is written, the widely followed U-3 measure of unemployment stands at 9.1 percent while the broader U-6 is a whopping 16.2 percent. People are also going longer without work. About 45 percent of those unemployed have been out of work for more than 27 weeks. The number of discouraged workers rose sharply during the recent recession. Speaking of the Great Recession, it officially ended in June 2009, and if we had gotten a recovery along the lines of past recoveries, GDP would be booming by now and unemployment, always the last aspect to recover, would be falling noticeably. Not only is unemployment high, but GDP growth for the first half of 2011 was close to zero. There was talk of a slide back into recession, though this diminished in the fall.

Job losses since the start of the Great Recession number about 7.5 million; three million more people have become discouraged. Total payrolls amount to about 130 million, fewer than in 2000, when the population was about 11 percent lower. Seven people compete for each job opening.

Unemployment varies widely from place to place. The U-3 version varies from 3.2 percent in North Dakota to 12.4 percent in Nevada. Among cities the numbers range from 3.2 percent in Bismarck, North Dakota, to 27.9 percent in Yuma, Arizona. There is also wide variation among job classifications. Nutritionists, welders, and nurses’ aides are in short supply, along with computer specialists and engineers.

Aggregate figures always mask important differences. Many employers still find it hard to locate good people. The McKinsey study reports that 40 percent of companies surveyed have had openings for six months, while 64 percent reported positions for which they cannot find qualified applicants, with managers, scientists, and computer engineers topping the list.

Anecdotally, “Now Hiring” signs are not hard to spot. Friends who own businesses tell me they have difficulty filling even a receptionist’s job with someone who is reliable, can write a passable letter, or create a simple Excel spreadsheet. Alas these days one cannot assume that a holder of a bachelor’s degree in business, for example, has these basic skills.

Recent Government Policy

The Fed has been unable to do anything about unemployment in recent years. The massive doses of money inflation, which tripled the monetary base (currency plus bank reserves) from about 2008 until the present, have not produced any significant price inflation, and unemployment remains stubbornly high. Money inflation has not produced price inflation largely because banks are not lending but instead have accumulated massive amounts of excess reserves—above and beyond the levels mandated by the Fed to back deposit liabilities. (The Fed pays interest on reserves held in the banks’ Fed accounts.)

As we have seen, the distinction between U-3 and U-6 hinges on the rather arbitrary classification of some unemployed workers as “discouraged.” Alternately, one could simply count the number of work-age people who do not hold jobs. For example, one-fifth of all men of prime working age are not getting up in the morning and heading for a job either because they’re officially unemployed or excluded from the labor force.

Labor productivity is way up and with it, corporate profits. This is typical of the early stages of a recovery. Employers realize that they may have gone overboard with hiring during the boom and need to pull back. When they need additional help they usually turn first to temporary workers. Employees work harder with the specter of unemployment looming large. Only later does employers’ confidence pick up enough that they’re willing to take the risky step of adding permanent hires.

Productivity increases are a good thing in the long run, but by this stage of the recovery employment should be picking up. Why isn’t it?

What’s to Be Done?

Businesspeople have to predict the future, so they hate uncertainty, especially the kind that comes from government—and there’s plenty of that around right now. What will Obamacare do to them? Will the Bush tax cuts be allowed to expire next year? Will there be another debt crisis? What will happen to the not-so-almighty dollar? Who will win next year’s election? The best way to get the economy on track again is to lessen these vexing uncertainties. Given the performance of the President and Congress in the recent debt ceiling debacle, this seems unlikely to happen before the next election.

Rhetoric matters. By 1937 unemployment had recovered somewhat from its Great Depression peak of 25 percent. But with the failure of the New Deal becoming evident, FDR, needing a scapegoat, turned against businesspeople with new regulations, antitrust action, new taxes, and hostile rhetoric—he called them “economic royalists” at one point. The recovery stalled, unemployment rose, and only the war brought an end to unemployment—good news if you got a job, bad news if it was a job that got you shot at. (But what was being made? Not consumer goods.) President Obama has referred to “fat-cat bankers” but has backed away from inflammatory rhetoric, perhaps because of adult supervision.

Can stimulus programs mitigate unemployment? Sure, they can put people to work, but the projects are politically motivated and do not represent the best use of scarce resources, as market-based projects must try to do. The projects end, the workers disperse, and there has often been little or no lasting benefit. About all we have to show for those programs are massive new debt levels, a weakening dollar, and a feeble economy—and yes, a frightened and angry populace.

The economics profession must lessen its fascination with dubious macroeconomic aggregates. Production of needed and wanted goods and services is what really matters, not just production of any old thing that gets added to GDP. Economists should focus on conditions that generate real jobs, jobs that produce things people really want, not just any activity that draws a subsidized paycheck.

Congress must make serious spending cuts, and proponents should not pretend these won’t hurt short-term. Cuts should be immediate, because promises about cuts ten years from now are all but meaningless. Today’s Congress has little influence over future officeholders.

The Federal Reserve should be relieved of its unemployment mandate (and the new Consumer Financial Protection Bureau). Its money-creation powers should be reined in, and ultimately it should be abolished.

To begin with some basics, what is work and what is a job? For economists, work is any activity that we would not perform without tangible compensation, usually money. In our work lives almost all of us are also motivated by nonmonetary considerations, and to the extent we diverge from the most remunerative activity available to us, we are blending work and leisure. A retired person who takes up college lecturing may do the work primarily for the satisfaction it brings. If his salary were withdrawn and he continued to teach, he would be enjoying leisure.

The goal of all economic activity is consumption, which to economists means not just mundane goods like faster cars but also “noble” ends like cathedrals. Jobs are therefore not ends in themselves, as much as public discussion would suggest otherwise. They are means to acquire income to be used for consumption and saving, in addition to personal satisfaction, learning opportunities, or socializing.

A person who lacks a job is unemployed if he or she wants work, has suitable skills, and has realistic expectations about compensation. These are vague terms; they make unemployment a murky concept. That goes double for underemployment, though both remain very real phenomena.

What is it about unemployment that makes it so problematic? Why can’t markets cure labor surpluses with lower wages as coffee surpluses are cured by lower coffee prices? Is government interference to blame, or is there something about free markets that allows unemployment to persist?

Both. Let’s look first at natural unemployment, which is unemployment not caused by government policies. Economists Milton Friedman and Edmund Phelps brought this concept to the fore during the 1960s even though, like most modern economic concepts, it had been recognized in various guises long before they wrote of it.

Labor markets, even when unhampered by government interference, are different from other markets. Nonmonetary considerations do not arise in other markets as much as in labor markets. Not just salary, but working conditions, job satisfaction, and advancement opportunities matter to most job seekers, often greatly.

A certain number of unemployed people are holdouts, people who might find some sort of job fairly quickly but are holding out for a higher salary, more job satisfaction, convenient location, and so on. Lumping all holdouts together is problematic. Some may harbor unrealistic expectations. Some feel constrained by their spouses’ wishes. Some have ample savings and can afford to hold out more stubbornly than others.

Some holdouts are reluctant to relocate. Moving is usually expensive and often emotionally distressful, especially to children. The current lingering housing crisis makes moving especially unattractive to some. People who are not only unemployed but also “underwater” in their mortgages—and particularly those who have simply stopped making payments, knowing that their lenders may not get around to their case for months or even years—are strongly inclined to stay put rather than accept distant job offers.

Efficiency Wages

Another form of natural unemployment is a bit subtle but very real. It goes by the name “efficiency wages,” based on the fact that recruitment and training costs are quite significant for most firms. Employers want their new hires to stick around so that these costs can be amortized over a reasonably long and productive term of employment. To motivate valuable new and old employees to stay, firms tend to offer compensation somewhat higher than the going rate for workers in any particular category. If the going rate is the wage that balances supply and demand for a particular labor category and if most offers are somewhat above this rate—efficiency wages—the result must necessarily be some unemployment. No one exemplified this theory better than Henry Ford and his outlandishly high $5-per-day wage beginning in 1914. According to one report, the policy eliminated complaints and reduced absenteeism by 75 percent. Total labor costs actually fell. There was a long waiting list for Ford jobs, but those men had other opportunities in the growing Detroit economy.

Government-Caused Unemployment

Government policies contribute to unemployment above and beyond natural unemployment. The most notorious of these policies are minimum wage laws. These laws make it illegal, effectively, for low-skilled workers to accept employment. Anyone who cannot generate $8 worth of production per hour cannot expect to be paid more than $8. Such unfortunate people might be productive at $6 per hour but are forbidden to accept employment at this rate and are instead condemned to joblessness and all its attendant miseries. This burden falls most heavily on black teenagers, whose unemployment rate (based on those seeking work and excluding those who are in school) is well over 40 percent. The benefits accrue mainly to slightly higher-skilled workers, who have climbed onto the metaphorical ladder leading to better jobs and who are shielded from competition from those excluded by minimum-wage laws.

Unemployment insurance softens the impact of joblessness and reduces the incentives to find a job. Recipients are supposed to show that they are actively seeking work, but this rule is easily sidestepped. There is nothing wrong with unemployment insurance per se. The problem is that the government forces all workers to buy this insurance whether it suits them or not. (Though nominally paid by employers, in fact the burden falls partly on workers and partly on employers.) Some workers might prefer to take that portion of their compensation in cash, but that choice is forbidden. Private carriers that might offer this insurance would, like all insurance providers, take steps to minimize adverse selection (the tendency for riskier workers to buy insurance) and moral hazard (the incentive for those covered to take risks that could get them fired).

Labor unions, as voluntary associations bargaining freely with employers, are unobjectionable. They did a lot of good in the past when working conditions in many places were pretty bad. But now they are granted special privileges by law—basically the privilege to engage in violent or coercive activities. The result is often wage agreements that are above market-clearing levels. Those left out are of course unemployed.

While labor unions can boost their members’ compensation at the expense of non-union workers, higher wages generally and higher living standards are due mainly to increased productivity, which in turn depends on high levels of capital investment. People are more willing to save and invest when they have confidence in the future, and that confidence comes from respect for property rights.

The Pain of Unemployment

Because unemployment, natural or government-caused, is such a personal matter, its impact is highly subjective, extending far behind lost wages.

A teenager looking for work may not be his family’s main source of income, but finding a job could be crucial to his life path. In my day teenagers could earn money delivering papers, mowing lawns, raking leaves, and shoveling snow. The work was unregulated and the income untaxed. Were we exploited? Hardly. We learned to take pride in our work, save for the future, and in contrast to our allowances, savor the special significance of money that we had earned.

A family breadwinner who loses his job and remains unemployed for an extended period of time will surely become discouraged, a term that only begins to describe the psychological devastation that can ensue. Men especially begin to see themselves as failures not just as breadwinners, but as husbands and fathers and more generally. Marital problems often arise. Children pick up on the distress and at certain ages wonder if they are to blame. Domestic violence and suicides are not uncommon. But losing a job may be no big deal for the senior citizen who works mainly for pleasure.

If anguish could be measured we would probably say that one year’s unemployment is more than twice as painful as six months’. As time goes by the jobless not only lose hope, but also suffer erosion of their work skills and attitude. Their former colleagues and clients tend to forget about them. Some without work turn to alcohol or worse in their despair.

Overqualification is a problem for many job-seekers. Employers are reluctant to hire people who are qualified to do better-paying work simply because those workers are likely to leave once they get a more lucrative offer. So some people simply “forget” to list that master’s degree on their résumé.

Unemployment and Macroeconomic Policy

Returning to Friedman and Phelps, the phrase they actually used was the natural rate of unemployment, the rate that would prevail when the economy is operating at full potential. Economies can operate below potential, as ours is presently, and they can sometimes operate above potential. Correspondingly we can have unemployment above the natural rate or, rarely, below. In the latter situation, we might see seniors lured out of retirement or young people lured into jobs before they finish school. But this situation is not our focus here.

Friedman was known for his opposition to Keynesian policies and his championship of free-market ideas. But that one word rate hints at the fact that Friedman fits squarely into the Keynesian macroeconomic project. Friedman viewed economics as an empirical science, not fundamentally different from physics, in direct opposition to the Austrian approach. He and Phelps spawned a cottage industry of searchers for the natural rate. Without that one word his work might not have received the broad attention that it did.

Some economists define the natural rate as an average rate (technically, a moving ten-year average). By this definition the actual rate must always lie above the natural rate at some times and below at other times. But this is simplistic. There is nothing “natural” about a moving average. Natural unemployment lies in the intentions and expectations of the people involved and is not so easily measured.

While the natural rate may be difficult to quantify and the highly subjective effects of unemployment cannot be measured, what about the amount of unemployment? Can it be measured? The Bureau of Labor Statistics (BLS) has that responsibility, and the numbers it announces get more attention nowadays than any others, with the possible exception of GDP growth figures. How does the BLS arrive at its numbers?

BLS Categories

To begin with, it must decide who is in the labor force and who is not. Among those who don’t hold jobs, infants, jail inmates, and people in nursing homes aren’t expected to work and shouldn’t be called unemployed. They are simply excluded from the labor force. Beyond that it starts to get fuzzy. Should that senior person who works mainly for nonmonetary reasons really be counted in the labor force? What about discouraged workers? A discouraged worker is one who wants work and has looked during the past 12 months, but not during the past four weeks. Do the statisticians really know who has looked and who hasn’t, and whether the reason was discouragement or something else?

Because of these and other ambiguities the BLS estimates unemployment in six different ways. U-3 gets the most attention. It is the number of unemployed divided by the size of the labor force. That number was 9.1 percent at press time. The next most widely followed version is U-6, which adds “marginally attached” workers—those who are out of the labor force but want work and have looked within the previous 12 months. It also adds those with part-time jobs who would like full-time work (again, how do they know?). This figure was a whopping 16.2 percent.

So which is the real unemployment figure, U-3 or U-6? There is no right figure, and the emphasis on U-3 is not some sort of conspiracy to hide the “real” situation. The figures are what they are, and it’s a mistake to read too much into them.

The biggest problem with unemployment statistics is not their fuzziness but, like GDP, the implications they carry: the idea that the government can and should proactively attempt to manage the unemployment rate. Such has been the presumption for at least 65 years.

Since 1948 the Federal Reserve System has operated under a dual mandate: maximize employment and stabilize prices. This is a direct reflection of the dominant macroeconomic theory of the time, which assumes the authorities could reduce unemployment by adding a little inflation, or vice versa. The theory seemed to work for awhile but fell apart in the 1970s, when the term “stagflation” appeared. We had the worst of both worlds for a time, and Friedman was ready with an explanation: Inflation could only temporarily boost unemployment—until such time as expectations caught up to reality. The Fed, as we all know, has injected massive amounts of reserves into the banking system with no discernible effect on growth or unemployment. So much for the dual mandate. More about this and other current conditions in part two, which will appear next month.

The minimum amount of recovered funds that can earn a reward is $1 million, but the sky’s the limit on the upside. The whistleblower gets to keep 10 to 30 percent of the amount collected, including fines, interest, and disgorgement of ill-gotten gains. We’re talking about big game here, with awards conceivably topping $100 million.

Eric Havian, an attorney with a law firm that represents whistleblowers, noted in an interview with the San Francisco Chronicle’s Kathleen Pender that the securities laws cover a “huge category of bad conduct,” such as illegal insider trading, cooking the books, market manipulation, stock option back-dating, false or misleading disclosures, and the deceptive sales of securities. Almost anything potentially can be illegal, and these vaguely defined offenses leave much room for government mischief. As for insider trading, this is a practice that does little harm and may actually provide benefits to small investors. (See my January/February 2011 Freeman article, “Inside Insider Trading.”)

If corporations felt they needed limits on insider trading or other conduct to attract shareholders, they could write prohibitions into their bylaws so that violations, if not settled internally, could be remedied under civil law.

The mind boggles at the incentives the whistleblower program establishes. Law firms must be gearing up already to coach whistleblowers in the fine art of identifying and documenting actions that can be gussied up into plausible cases. It would make sense for law firms to take cases on a contingency basis because this sort of lawyering could be very lucrative. The SEC staff, concerned primarily with covering its collective rear end, will shy away from dismissing all but the most frivolous cases.

The road to riches will not be short or direct. Many years could elapse, if only because of bureaucratic inertia, between the time of filing and the bestowal of an award. “There will be more people struck by lightning in a given year than will get a check from the SEC in the next five to ten years,” cautioned Tim Mazur of the Ethics and Compliance Officers’ Association. But once the first awards hit the headlines, “a lot of people will start paying attention,” he added (San Francisco Chronicle).

All whistleblowers run the risk of retaliation from their employers, but in today’s climate this risk seems minimal. Besides, complaints may be filed anonymously.

Whistleblowers will lose their incentive to pursue complaints through their companies’ internal review process, an avenue that could correct any genuine wrongdoing relatively quickly. With such a massive potential pot of gold beckoning, why not wait and let the supposed wrongdoing fester for a while?

To be sure, the SEC rulemakers are aware of at least some perverse incentives. The website announcement contains a section headed, “Avoiding Unintended Consequences,” which excludes certain people from eligibility. The SEC also says information presented must be the whistleblower’s independent knowledge or analysis. But these limits seem to leave enough space to drive a truck through, and the truck drivers are revving their engines.

New Uncertainty

Of course corporate officers will be aware of the new incentives for whistle-blowing, which may well make them more cautious about taking on the risks of new or expanded production. Too bad. Investment is exactly what the country needs to get out of its economic funk. New uncertainty will further delay recovery.

Meanwhile, government whistleblowers aren’t doing nearly so well. Thomas Drake, a National Security Agency employee, found hundreds of millions of dollars being squandered on failed programs and tried to expose them. He did not leak any classified information, and he tried informing his bosses, the NSA inspector general, the Defense Department inspector general, and congressional intelligence committees before taking his findings to the Baltimore Sun. Rather than a pile of cash, Drake’s reward was an indictment on ten felony charges that could have gotten him many years in prison. But earlier this month, following a New York Times article on his situation and a judge’s ruling that certain classified information which prosecutors wanted to use against him could not be kept under wraps, all charges were dropped in a deal in which he pleaded guilty to one misdemeanor.

A recent petition signed by 20 noted whistleblowers calls for rescinding a “Transparency Award” given to President Obama recently. The President “has invoked baseless and unconstitutional executive secrecy to quash legal inquiries into secret illegalities more often than any predecessor,” the complaint noted. “Ignoring his campaign promise to protect government whistleblowers, Obama’s presidency has amassed the worst record in U.S. history for persecuting, prosecuting and jailing government whistleblowers and truth-tellers.”

But hey, we should just be glad the feds are protecting us from those nasty corporate insiders.

So what? It’s darn near a miracle, that’s what, and would seem so to most inhabitants of today’s world and everyone in yesterday’s world. Leonard Read’s phrase “The Miracle of the Market” was only a slight exaggeration. I won’t attempt to describe how markets miraculously motivate and coordinate the actions of the thousands of people who cooperate in providing me with sardines. Nobody can do that better than Leonard Read did in his classic “I, Pencil.” If for some reason you haven’t read it, stop now and do so.

The increased quantity and quality of the conveniences available to us are really amazing. We should stop to think about them from time to time, paying special attention to the incentives that brought them about.

I have vague memories of the Fisher Brothers grocery store where my mother took me around 1950. The place was tiny and the selection limited. Looking back, I wonder about its cleanliness: The owners kept sawdust on the floor to soak up spills. Later they built a supermarket that was much larger but still only a pale precursor of today’s Safeway. A mix of union coercion, government regulation, and perhaps just plain custom kept all supermarkets closed after six p.m. Monday through Saturday and all day Sunday. A working woman had to scramble to get her shopping done before closing time or join the mob on Saturday.

Our local Safeway was remodeled a few years back. Over the perfunctory objections of the union, management installed scanners. Five checkout lanes replaced eight, and waiting time was drastically reduced. Now the clerks seem to enjoy swiping the goods over the scanner. Some do it with the grace and aplomb of a ballerina. Sometimes they finish faster than I can fumble for my credit card and swipe it through the machine.

Credit cards and the machines that accept them are themselves pretty amazing. There were no credit cards in the days of the Fisher Brothers, though they might have extended their own credit to a steady customer. The machine at Safeway validates my credit card and completes the transaction within seconds. How does it do that? More important, how does it do it economically, given the store’s razor-thin profit margins?

As part of the remodel, they laid faux wooden floors and installed special lighting for ambiance—a term that would have baffled the Fisher Brothers. They added a deli, an organic section, and a sushi chef. Those things fascinate me even though I don’t care to partake of them.

Then there’s the “Safeway Club” card. Most retailers offer such things these days. The bargains I get from using the card and the customized coupons are worth the minor sacrifice of privacy. So my eating habits are in a database somewhere. I care not.

As mentioned, supermarkets operate on notoriously low profit margins. From each dollar of revenue, Safeway brought 1.4 cents down to the bottom line in 2010. If someone pilfers a can of sardines, there goes the profit on about 70 more cans. And then there’s corporate income tax. Safeway’s rate was 33 percent for 2010. Of course, corporations don’t really pay taxes; people do. That burden falls on shareholders, employees, and customers, most of whom don’t realize this.

Competition is fierce. Lunardi’s on the opposite corner is a comparable supermarket that gives Safeway a vigorous run for its money. A few miles away, Trader Joe’s and Whole Foods are bustling with high-end customers. There is no Walmart nearby, but Costco and Kmart are but a short drive away. So Safeway struggles to position itself between low-end and high-end competitors.

Shrinkage is a problem for all retailers. This term refers to pilfering by customers or employees, and again the slim profit margins can easily get pilfered away. Safeway’s shrink rate is a company secret, as are the countermeasures it deploys, but it does report progress on that front.

How well have the owners of Safeway been compensated for risking their capital? Just so-so. Earnings per share dropped from $2.21 in 2008 to $1.55 in 2010 but are now recovering. Notwithstanding declining earnings, they have raised their dividend each year but it is still a rather modest 2.3 percent. Investment advisory service Value Line gives Safeway high marks for both timeliness and safety, but I’m not tempted.

Do I love Safeway? Not really. I’m very pleased about my relationship with it, but I reserve my gratitude for the fact that governments haven’t yet ruined it. It’s not for lack of trying—our local planning commission and planning staff are constantly harassing it with petty regulations and subsidized competition in the form of a weekly farmers’ market. (A tale of my experiences as a libertarian planning commissioner can be found at tinyurl.com/3z4pnf6 [pdf].)

Of course Safeway tries to entice me with marketing ploys. High-margin items are prominently displayed. You run a gauntlet of these displays to reach the pharmacy in the back. There are trashy magazines to look at in the checkout line and candy bars up for mindless grabbing. None of this bothers me. I’m all grown up and can take their enticements or leave them.

Am I loyal to Safeway? Not entirely. When I want a sandwich I cross the street to Lorenzo’s, a tiny family-owned shop. They’re a friendly and hard-working bunch, under the same ownership for 26 years, and they always seem to be busy. They have many loyal customers here in Belmont, and provide good job experience for the high school kids they hire, some of them sons and daughters of previous employees. And yes, they make good sandwiches. Watching them hustle is part of the fun of going there. So is the look in their eyes when they speak of the satisfaction they get from their work.

Sometimes I go to Kmart for bargains despite the distance. The clerks seem not terribly bright, and the clientele is mainly lower-class, but the savings on cat food and paper towels make the trip worthwhile. Sears and Kmart merged a few years ago, and the combined firm has been struggling ever since.

The stock fetches a hefty 38 times earnings and pays no dividend although its debt burden is low. Seems like a tempting short sale.

Besides the goodies available to me, I’m pleased about the influence I exert every time I spend a dollar in a competitive market. Ludwig von Mises called this “consumer sovereignty.” Actually this was a rare instance where Mises was somewhat off-base. As sellers of labor services, we naturally want high wages and salaries, but we are also highly motivated by nonmonetary considerations like working conditions. Dave and Marta, owners of Lorenzo’s, might well pass up better-paying jobs with Safeway or Walmart because they like their independence and their customer relationships. Recognizing that producers may pass up monetary profit opportunities in favor of other values, Murray Rothbard rejected Mises’s phrase in favor of “individual sovereignty.” Consumers and producers jointly determine what is produced—consumers don’t hold all the cards. Still, as consumers we exercise considerable sway over what gets produced and in what quantity and quality, leaving aside government intervention.

Speaking of Walmart, it has been trying to penetrate the San Francisco Peninsula for years but has advanced no farther than Mountain View, 35 miles south of San Francisco. The city of Belmont, 20 miles south, owns a piece of land that seems like a dandy Walmart site, but the political elite in our town wouldn’t allow it. A lot of Walmart’s customers would be lower-income people; around here, that means they’re likely to be minorities, particularly Hispanic people, so there’s an element of racism here.

A (Dollar) Tree Grows

Walmart has been held at bay, but Dollar Tree slipped past the barricades. This national chain acquired a moribund shoe store in our town and was able to convert it to its own brand without any special permits. Oh my, the howling! We’re Belmont! We want boutiques and artsy-craftsy shops! But Dollar Tree has done a land-office business since day one. It’s not uncommon to see a Mercedes or a Lexus in the lot, driven perhaps by some of the same howlers.

Its operation is pretty amazing. Everything is priced at a dollar (plus 9.25 percent on most items, extracted by you know who). I returned from my fact-finding trip with a peanut bar, a pack of four pens, a bag of non-licorice sticks, a bag of cashew pieces, a small bouquet of artificial flowers, a pack of four alkaline AA cells, 48 ounces of soda, and a can of Pringles-like chips, each one dollar. Some of this is junk, but shopping there is just so darn much fun! Management must be well aware of that psychology.

Dollar Tree must drive the good people at the Bureau of Labor Statistics batty. What would they do with four ball point pens for a dollar when compiling the Consumer Price Index? That’s perhaps a tenth of the inflation-adjusted price of 25 years ago. The low price is probably due to Dollar Tree’s acumen in scooping up remainder stocks at very low prices more than anything else. Yet this price would contribute to the idea that price inflation is low and therefore the Fed has done a good job of managing our money.

Dollar Tree’s margins, amazingly, are double those of Safeway. And they take credit cards. Though I feel a tinge of guilt when I swipe my card and trigger a merchant fee, I shouldn’t because handling cash is expensive too. It’s unfortunate that the new restrictions on bank debit-card fees may result in the end of debit card use at places like Dollar Tree.

The Great Recession of late is nowhere to be seen in Dollar Tree’s stock chart, and in fact the shares have tripled over the past three years. The downturn clearly attracted lots of cost-conscious customers. DLTR pays no dividend, although they have been buying back shares—a tax-efficient strategy often used in lieu of a dividend.

Perhaps the most important aspect of the three chains I have highlighted, from my point of view as a consumer, is the competition they face. That’s what keeps them scrambling to earn my dollars.

A field trip to a local Safeway, Kmart, or Dollar Tree, or one of their competitors, should be part of every economics curriculum, along with one to a mom-and-pop operation like Lorenzo’s. All of us when we go shopping should think about the amazing goods and services we get and the incentives that keep them coming.

(To sell short means to sell borrowed stock in the hope that the price will decline.  If the stock does fall, sellers buy the shares cheaply, return them to their original owner, and pocket the cash difference.  If the shares rise instead, short sellers have to pay a high price and suffer a loss.  When a number of short sellers cover their positions out of  fear of rising prices, it’s called a short-covering rally.)

What a dreary and stupid move the Europeans have made. They might have learned from the ban instituted in 2008 by U.S. authorities, which accomplished nothing.

Real Fears

There is good reason to fear for the European banks – the problems with European sovereign debt are evident.  Rumors are hardly necessary when the banks’ exposure is well known.  And if false negative rumors justify intervention, what about false positive rumors? Why not ban purchases of stocks when the all-knowing regulators determine they were boosted by bullish rumors?

Is it possible for determined short sellers, perhaps in collusion with one another, to start a downward spiral and run a stock into the ground in defiance of the stock’s fundamentals? Yes, theoretically and perhaps occasionally in practice.  But as a downdraft begins, the temptation to take profits by covering one’s short positions, especially among those who may be in cahoots, becomes overwhelming. A violent upswing is possible when short sellers take profits in such  situations.

Short sales are not always speculative (not that there’s anything wrong with speculation).  They are sometimes part of a hedging strategy, in which a short sale is used to offset a closely related long position.  A ban on short selling is a headache for hedgers, perhaps more so than for speculators.

Those who own the stocks in question won’t likely sit still while the ban is in place. They will be tempted to sell, in anticipation of a price drop once the ban is lifted.  When this happens, share prices may decline as much as they would have without the ban. Also, those who were short when the ban took effect may hold those short positions longer than they would have otherwise, also hastening the drop.

Close Substitute

Put options are a close substitute for short sales.  A buyer of a put option pays for the right to sell shares to the counterparty at a fixed price no matter how low the market price might drop. Another alternative may be to short the bank shares in question on foreign stock exchanges.

So the likely upshot is that the ban will accomplish nothing except to introduce some temporary disruptions, inefficiencies, and inequities into the market.

More important, though, is that today’s sophisticated traders and commentators will probably see this crude move as a sign of weakness or even desperation.  This is not what European economies need – just the opposite.  Like the United States, Europe is suffering from a crisis of confidence.  EU leaders have lurched from one bailout to the next without addressing the root causes of the crisis, each time shedding a chunk of their credibility like a piece of lintel crashing down from the Parthenon.

Central Banking

One root cause is the structure of the Euro, which centralized monetary policy-making at the European Central Bank while leaving fiscal policy to the discretion of each national government.  True, there was a toothless requirement that government deficits be limited to 3 percent of GDP, but that soon fell by the boards.  Frugal Germans are now furious about bailing out the lazy Greeks, Italians, and others, but are trapped by the exposure of their own banks.

European welfare states have been in place for decades now, crushing private initiative. The bills have come due and the cupboard is bare. This is the more fundamental cause of the European crisis, and nothing will be solved until Europeans begin to face up to it.  And rather than indulging in Schadenfreude, we in the United States would do well to apply European lessons to our own troubles.

We can’t get anywhere with these questions until we agree on the meaning of inflation. At one time the word referred to an increase in the money supply. Over time it came to mean a general increase in prices, an unfortunate turn of events not just because we lost the nice metaphor of an inflating balloon, but also because the shift in meaning tended to obscure the relationship between the two phenomena. Some free-market authors hold out for the old definition, but I suggest this is wasted effort. In my classes I use the phrases “price inflation” and “money inflation” to keep the distinction alive without getting too sidetracked by semantics.

In 1970 Milton Friedman said, “[Price] inflation is always and everywhere a monetary phenomenon.” This is not entirely true but understandable because he was writing at a time when the causal relationship had nearly been forgotten. We can have price inflation without money inflation when there is a supply shock. An overthrow of the Saudi government, for example, might well disrupt the flow of oil from that country. A surging oil price, because it is so important to our economy, would likely pull up the price level with it. In this situation the monetary authorities can help things by doing exactly nothing—letting higher energy prices do the work of encouraging marginal users to cut back. Supply shocks, as such one-time events are called, do not of themselves generate sustained price increases and are therefore not classified as inflation by some economists.

Price inflation of a mild sort can also happen as new and more efficient payment systems are devised. When we acquire debit cards and credit cards, we find it less necessary to hold a supply of money for our daily needs or emergencies. We may reduce not just our currency holdings but also our checking account balances. But money is always in someone’s possession, so an aggregate decline in the demand to hold money results in faster spending, which generates price inflation. Those higher prices motivate people to increase their desired money holdings back to the previous level.

Expectations of future price inflation can also be a source of current price inflation. There is a great deal of inertia in inflation expectations. When there has been a long period of stability we tend to gloss over early signs of inflation, and it takes a long time for people to realize that price rises aren’t just temporary. Likewise, when prices have been rising steadily, people are skeptical of deflationary (or disinflationary) developments. During an inflationary period expectations can run ahead of the money supply. Thus during the German hyperinflation of the 1920s people spent their money faster than the authorities could print it, and almost until the end the authorities denied that money printing was the root of price inflation, believing instead that money creation should be stepped up.

Recently Fed Chairman Ben Bernanke said he was not worried about price inflation because investors are currently paying a very low premium for inflation-protected Treasury securities, adding, “The state of inflation expectations greatly influences actual inflation.” Gerald O’Driscoll, well known in free-market circles and a former Fed official, retorted that Bernanke “has the causation precisely backwards” (TheFreemanOnline, Feb. 28). In fact the causation runs both ways. Market participants try to figure out what the Fed will do, and the Fed tries to figure out how it can influence expectations, and on it goes, back and forth. But as in the stock market, expectations may turn out to be wrong, and in the long run only the fundamentals matter.

What of the converse of the Friedman proposition? If there is money inflation must there necessarily be price inflation? The first chart suggests not. Price inflation got ahead of money inflation in about 1980, as Fed Chairman Paul Volcker’s tight money policy did not at first overcome expectations. But since 2008 the monetary base has exploded without any significant price inflation. Why?

The Federal Reserve controls the monetary base, consisting of publicly held currency plus commercial banks’ reserve accounts at the Fed (this is also referred to as M1). The Fed increases the base when it purchases assets, typically government securities, using newly created money. Commercial banks then pyramid on top of the monetary base. A dollar of reserves can support up to about ten dollars in new loans—a multiplier effect. In the 1950s M1 was about 3.5 times the size of the monetary base. That multiplier declined sharply after 2000, until, as the first chart shows, the monetary base raced ahead of M1 money.

New money created by the Fed first goes to the bank accounts of the parties such as bond dealers from whom the Fed buys assets. Typically banks loan out most of that money because that’s how they seek profits. Bankers normally consider reserves in excess of the level required by the Fed as idle assets, which are to be avoided. Total reserves were around $2 billion until the crisis of 2008, at which time they began to skyrocket. They now exceed $1,100 billion. What motivated this huge increase? First, banks seem not to find a lot of attractive lending opportunities at this time. Second, since 2008 the Fed has been paying interest on reserves, currently a very modest 0.25 percent per year.

About Those Reserves . . .

Now for the $64 trillion question: What if banks reverse course and start deploying some of those idle reserves? Suppose they find good loan opportunities and jumpstart the pyramiding process? If the M1 money multiplier were to rebound from 0.8 to 1.6, where it stood just three years ago, assuming no change in the monetary base, we would get about $2 trillion flooding into markets. What could the Fed do to head off the price inflation that would follow?

In the past the Fed might have opted to drain reserves by selling Treasury securities. This would depress the price of those securities and raise interest rates—not good for the economy and not good for the Treasury, which counts on selling large quantities of new securities at low interest rates. The Fed now has an alternative that could restrain price inflation by keeping reserves in place. It could raise the interest it pays on reserves. This would discourage banks from expanding their loan portfolios. This latter method can be applied at a keystroke, in contrast to sales of Treasury securities, which takes time. Still, we have to wonder if Bernanke and friends will apply the brakes at just the right time. Given the dynamics of expectations and the uncertain prospects for supply shocks, it will be a difficult trick to say the least. Higher interest rates could wreak havoc on the federal budget. The President’s budget proposal for FY 2012 sees net interest payments rising from about $200 billion for FY 2011 to $928 billion for 2021. As always, the budget is based on optimistic assumptions about tax revenue growth and spending restraint. But it is also optimistic about interest rates. Higher rates could drive interest expense much higher, and because so much outstanding federal debt is of short duration, the effect might happen quickly.

Price Inflation: Mixed Signals

What of current price inflation? Is it really as low as the CPI suggests? It depends where you look. House prices are way down, and housing is part of the CPI. Homeowners are assumed to charge themselves rent, but lucky for them that charge is down. This may be scant comfort to homeowners facing increases in the prices of things they buy for cash, many of which are up.

The stock market has nearly doubled since the low of early 2009. Commodity prices have been soaring. A recent 12-month period saw increases of 31 percent in crude oil, 79 percent in wheat, 166 percent in cotton, 98 percent in rubber, 44 percent in copper, and 94 percent in silver. But natural gas prices fell 23 percent, and olive oil (extra virgin, that is) is off 12 percent. Firms that process these raw materials into retail products typically hedge their positions with futures contracts, but as those contracts expire they will begin paying more for raw materials. Some of those increases are already finding their way into retail prices.

Crude-oil prices spiked to $140 per barrel in 2008, then collapsed. But in late May they again passed $100. A disruption in supplies of Middle East oil could send the price much higher, or a return to stability could send them lower. No one knows. All we know is that crude-oil price changes make their way very quickly into retail gasoline prices. Truckers and others who are sensitive to fuel prices are adding fuel surcharges to their rates. Other effects lag further behind. Should oil remain above $100 we can certainly expect more retail price increases.

Wholesale price increases on foodstuffs have already affected retail prices. The Food and Agricultural Organization’s world Food Price Index has risen dramatically, as the second chart shows. This is becoming a crisis in poor countries, where food takes a large share of personal income. Prices are beginning to rise in the United States as well. Hershey, for example, announced a 10 percent increase across the board, citing increased raw material and transportation costs. The Agriculture Department is projecting a 5 percent price increase this year for a basket of common food items (basics, not chocolate).

What about other retail prices? Walmart CEO Bill Simon, who ought to know, recently said price inflation is “going to be serious.” The news media are full of articles about inflation. The last big U.S. inflation was in the 1970s, but should it heat up we can expect the younger generation to catch on fast—and for expectations to begin to run with or ahead of price increases.

What’s Ahead

Inflation hawks are inside the gates of the Fed. Kansas City Fed president Thomas Hoenig recently blamed the Fed’s highly accommodative policy for rapidly increasing global food prices and called for an increase in the target Fed funds interest rate to 1 percent in a “fairly short period of time.” Presidents of the Philadelphia, Richmond, and Dallas branches are also considered hawkish on inflation but are opposed by New York Fed president William C. Dudley and by Bernanke himself. Bernanke recently testified that food prices have risen in all currencies, not just the dollar, as if this exonerated the Fed. Markets, after all, are globally connected.

Could China export inflation to the United States? The Communist Party’s new five-year plan is supposed to focus on the well-being of the common folk. This would mean a reduction in the forced savings that have boosted Chinese export industries and thus higher prices for Americans.

The U.S. presidential election is next year, and the political business cycle is with us as ever. The administration, aided and abetted by the Fed, will be doing all it can to reduce unemployment before the election while keeping the lid on price inflation. On the fiscal side there will be no significant budget cuts, which nearly always have negative short-term consequences but benefits that accrue only long after the election.

We would all do well to prepare ourselves, without going overboard, for inflation. Personally, I’m bullish on cat food. Why not stock up on durable goods? Savings accounts pay nothing, and you’re going to consume the stuff anyway.

Stagflation, anyone?

The minimum amount of recovered funds that can earn a reward is $1 million, but the sky’s the limit on the upside.  The whistleblower gets to keep 10-30 percent of the amount collected, including fines, interest, and disgorgement of ill-gotten gains.  We’re talking about big game here, with awards conceivably topping $100 million.

Huge Category

Eric Havian, an attorney with a law firm that represents whistleblowers, noted in an interview with the San Francisco Chronicle‘s Kathleen Pender that the securities laws cover a “huge category of bad conduct,” such as illegal insider trading, cooking the books, market manipulation, stock option back-dating, false or misleading disclosures, and the deceptive sales of securities. Indeed, almost anything potentially can be illegal, and these vaguely defined offenses leave much room for government mischief. As for insider trading, this is a practice that does little harm and may actually provide benefits to small investors. (See my Freeman article.)

If corporations felt they needed limits on insider trading or other conduct to attract shareholders, they could write prohibitions into their bylaws so that violations, if not settled internally, could be remedied under civil law.

The mind boggles at the incentives the whistleblower program establishes.  Law firms must be gearing up already to coach whistleblowers in the fine art of identifying and documenting actions that can be gussied up into plausible cases.  It would make sense for law firms to take cases on a contingency basis because this sort of lawyering potentially could be very lucrative.  The SEC staff, concerned primarily with covering its collective rear end, will shy away from dismissing all but the most frivolous cases.

The road to riches will not be short or direct.  Many years could elapse, if only because of bureaucratic inertia, between the time of filing and the bestowal of an award. “There will be more people struck by lightning in a given year than will get a check from the SEC in the next five to ten years,” cautioned Tim Mazur of the Ethics and Compliance Officers’ Association.  But once the first awards hit the headlines, “a lot of people will start paying attention,” he added (San Francisco Chronicle).

All whistleblowers run the risk of retaliation from their employers, but in today’s climate, this risk seems minimal. Besides, complaints may be filed anonymously.

Forget Internal Review

Whistleblowers will lose their incentive to pursue complaints through their companies’ internal review process, an avenue that could correct any genuine wrongdoing relatively quickly.  With such a massive potential pot of gold beckoning, why not wait and let the supposed wrongdoing fester for a while?

To be sure, the SEC rule makers are aware of at least some perverse incentives.  The website announcement contains a section headed, “Avoiding Unintended Consequences,” which excludes certain people from eligibility. The SEC also says information presented must be the whistleblower’s independent knowledge or analysis.  But these limits seem to leave enough space to drive a truck through, and the truck drivers are revving their engines.

Of course corporate officers will be aware of the new incentives for whistle-blowing, which may well make them more cautious about taking on the risks of new or expanded production.  Too bad.  Investment is exactly what the country needs to get out of its economic funk. New uncertainty will further delay recovery.

Double Standard

Meanwhile, government whistleblowers aren’t doing nearly so well.  Thomas Drake, a National Security Agency employee, found hundreds of millions of dollars being squandered on failed programs and tried to expose them. He did not leak any classified information, and he tried informing his bosses, the NSA inspector general, the Defense Department inspector general, and congressional intelligence committees before taking his findings to the Baltimore Sun.  Rather than a pile of cash, Drake’s reward was an indictment on ten felony charges that could have gotten him many years in prison.  But earlier this month, following a New York Times article on his situation and a judge’s ruling that certain classified information which prosecutors wanted to use against him could not be kept under wraps, all charges were dropped in a deal in which he pleaded guilty to one misdemeanor.

A recent petition signed by 20 noted whistleblowers calls for rescinding a “Transparency Award” given to President Obama recently.  The President “has invoked baseless and unconstitutional executive secrecy to quash legal inquiries into secret illegalities more often than any predecessor,” the complaint noted.  “Ignoring his campaign promise to protect government whistleblowers, Obama’s presidency has amassed the worst record in U.S. history for persecuting, prosecuting and jailing government whistleblowers and truth-tellers.”

But hey, we should just be glad the feds are protecting us from those nasty corporate insiders.

Most macroeconomists see the boom-bust cycle as an unsolved problem.  Like physicists in search of a Grand Unified Theory, they long for a model that accounts for all the major aspects of the business cycle.  Perhaps they are hampered by looking through the wrong end of a telescope.  Mansharamani uses not just one but five “lenses” to examine the subject. In addition to micro- and macroeconomics, they include psychology, politics, and biology.  He is not the first economist to invade these fields.  Rather his accomplishment lies in assembling ideas from each of those areas, applying them to past boom-bust cycles, and putting his ideas on the line by issuing a brave prediction of a forthcoming Chinese economic train wreck.

Austrian Business Cycle Theory

The author’s macro lens includes Austrian business cycle theory. That theory says inflation of the money supply causes a drop in interest rates, which is misinterpreted as an increased aggregate preference for saving over consumption, leading to investments in more roundabout means of production.  When it becomes clear that there has been no such preference shift, these undertakings are seen to be at least partial mistakes, requiring write-offs and retrenchment – a bust.  The boom is the problem, not the bust, which is the market’s attempt to realign itself to the realities of time preference.  Austrian business cycle theory has great merit but leaves some things unexplained.

Mansharamani’s micro lens includes the concept of reflexivity.  Market participants don’t just observe prices but also influence them.  Reflexive dynamics occasionally give rise to instabilities in which rising prices lead to increased demand.  A simpler term would be a “bandwagon effect.”  I recall an office party in 1980 where one of the secretaries asked about buying gold – precisely at the peak, as it turned out. All she knew about gold was that it was way up and therefore must be going higher.  I should have realized that when you see financially unsophisticated people like her climbing on a bandwagon, you can be pretty sure there’s no one left to sell to and nowhere for prices to go but down, which is where gold and  silver prices went in 1980, and in a big hurry.

From psychology Dr. M. borrows ideas and data about cognitive biases.  For example, subjects asked to guess some bland statistic, like the number of African countries that belong to the UN, are influenced by the spin of a wheel of fortune: When the wheel lands on a high number, they guess higher.  He translates this and a dozen other cognitive biases into irrational market behavior that can foster booms and busts.

He introduces his biology lens with an analogy to the spread of an infectious disease.  When the prevalence of a disease reaches a high level, the infection rate necessarily slows and the disease begins to wane, just like the 1980 gold market.  But it is devilishly difficult to “inoculate” oneself against infectious ideas.  Individual investors who can do so have a decent chance to beat the market averages over time, I believe.  (Those who would pursue these ideas in greater depth would do well to find James Dines’s quirky and expensive but worthwhile book, Mass Psychology.)

Unintended Consequences

Turning to politics, Mansharamani illustrates unintended consequences of taxes and regulations.  The U.S. Tax Code (Title 26, Subtitle A, Chapter 1, Subchapter B, Section 179) allows businesses to expense purchases of vehicles heavier than three tons, a provision aimed at helping farmers. Guess what. The BMW X5, a luxury SUV, weighs 3.003 tons!  On a more serious note, he cites the mortgage interest deduction as a magnifying factor in the housing boom and bust.

Mansharamani examines the tulip mania, the Great Depression, the Asian financial crisis, and other past cycles. For each he cites a dozen or so aspects of the cycle and categorizes them under his five lenses.  He summarizes the housing boom, for example, with 14 observations on things including reflexive credit/collateral dynamics, anchoring on prices, perverse tax policies, and popular media.  None of these is particularly surprising, but I found it instructive to see them listed and categorized.

When I was young a book appeared called Are the Russians Ten Feet Tall? It was the post-Sputnik era when Paul Samuelson’s economics textbook pronounced Soviet socialism a workable alternative to markets and CIA “intelligence” analysts  projected that Soviet GDP would overtake ours.  We know how that worked out.  Fast forward to the 1980s when the Japanese were paying top dollar for iconic U.S. real estate.  We know how that turned out too.  Now it’s China.  I can’t help thinking: I’ve seen this movie before.

Chinese Bubble?

Mansharamani goes far beyond my gut feeling, marshaling evidence of a Chinese bubble from each of his lenses.  He gathers tidbits such as garlic fanatics bidding prices up 10- 30-fold in 18 months; the skyscraper indicator – starting with the Empire State Building, record high buildings are consistently started in a boom and finished well into the subsequent bust — and the $230,000 that a Chinese man paid for three bottles of 1869 Château Lafite. Then there’s Ordos, a massive new city meant to house one million souls but left incomplete and unoccupied.

Mansharamani looks at Chinese state-owned enterprises through his political lens, reporting that if they had to pay a market rate of interest, their reported profits would be wiped out.  Through his reflexivity lens he saw Chinese steel production exploding from 23 million tons in 1977 to 650 million through the first half of 2010 — with up to 20 percent being used to construct more steel mills!  “Truly a reflexive dynamic if ever there was one,” he gasps.

Boombustology is a worthwhile read for anyone who seeks a better understanding of booms and busts.  I especially recommend it to individual investors.

Like Atlas Shrugged, his story is set in an immediate future where the economy is collapsing, and more so than in Atlas, personal freedoms are vanishing.  Unemployment is at 20 percent and all communications are recorded and tracked by the NSA.  RFID badges are worn by all federal employees and will soon be required for all citizens.  A small group of patriots takes matters into their own hands, and the action is fast and furious.

Lewis draws the correct battle lines of our time: not left versus right but libertarian versus fascist.  The f-word correctly describes anyone on the left or right who would use government power to suppress personal or economic freedom while leaving nominal ownership in private hands.  The novel’s villains are of both stripes, some of them decent people who entered politics with good intentions but became corrupted.  That leaves libertarians as the only consistent defenders of what Ludwig von Mises called the “Free and Prosperous Commonwealth” founded on the rule of law, particularly respect for property rights.

I had to wonder, when reading his portrayals of  atrocities committed by government agents: How much of this is fiction?  Can they do such things?  Are they close? Have they already?  The Patriot Act is law, so the atrocities seem disturbingly plausible.

Modest Objective

Lewis’s patriots aren’t aiming at a complete reboot of the federal system, but something much more modest: term limits.  It was a bit of a stretch for me to imagine people risking their lives for this goal or that achieving it would make a revolutionary difference.  The basic problem would remain: that the attempt of the framers of the Constitution to limit the power of the federal government has failed.  As long as so much loot and so much power are concentrated in Washington, the flies will be drawn to the honey.

The parallels between this tale and Atlas Shrugged are good news and bad news for author Lewis.  The movie has heightened interest in Rand’s magnum opus, and he might catch some of that wave.  But Rand was a master of theme, plot, characterization, and just plain English composition.  Any first novel is bound to fall at least somewhat short of that high standard.  For example, at one point he informs us that “the suspense was unbearable” rather than letting readers draw that conclusion from the action.

With Rand’s high standard in mind, I give this book four stars, which is high praise from me.  I would give him five for developing his plot.  He advances the story a little in one scene, then leaves the reader in suspense as he moves to another scene. This book kept me up late, and I had to finish its 300 pages in just two sittings.

The plot is convincing.  Lewis knows what he’s talking about when it comes to communications, computer networking, and military installations.  The victories scored by his small band of patriots are amazing but realistic – no deus ex machina here.

Perhaps a Movie?

And what a movie this would make!  John Aglioloro has shown the way with his low-budget production of Atlas Shrugged.  He will no doubt have his hands full producing the next two parts, but maybe some other producer might be inspired to take up An Act of Self-Defense.

Like Rand, Lewis gives us heroes who are inspirational and yet of this world.  They are intelligent, fun-loving, and dedicated to their cause. If there’s anything the young people are starving for these days, it’s heroes such as these.

Tuck this book with you on a long plane ride or to the beach.  You’ll zip through it and if you’re like me you may want to give it another more careful read.

Or not. These are all half-truths and distortions, all too easy to find on the Internet. Bloggers like to begin with the discovery that commercial banks hold shares of Fed stock and those shares pay an annual dividend. A further discovery that the Fed makes big profits is all it takes to send some of them off on a conspiracy tangent. Because shareholders in a profit-seeking corporation are its owners, so it must be with the Fed, they think. Profiteering, world-government schemes, and who knows what else, must surely follow. As I will show, these half-baked ideas are distractions from the serious issues that surround the Federal Reserve System.

Yes, commercial banks hold shares of stock in their local Federal Reserve branch, but these shares do not confer ownership in any meaningful sense. Ownership is defined as the legal and moral right to use and dispose of some asset. Ownership can be conditional or temporary, as when you lease an apartment and acquire the right to occupy it for a limited time, but not to run a business in it or do major renovations. Your purchase of shares of stock in a public corporation gives you rights to vote in shareholder elections, receive any dividends declared, and sell your shares—but that’s about all. You may not walk into the corporate offices and start giving orders; on the other hand, you may not be held liable for any misdeeds of corporate officers or employees. If you acquire shares in a nonpublic company like Facebook, you accept additional restrictions on when and to whom you may sell your shares.

Member banks receive a fixed 6 percent annual dividend on their Fed stock and enjoy limited voting rights. But there the resemblance to ordinary shares ends. The banks are obliged to acquire shares when they become members of the Fed, and they may not sell their shares or pledge them as collateral. An initial issue of stock was seen as a good way to capitalize the Fed when it began, but there has been no need for additional capital and those shares are no longer significant.

Each branch has a board of directors with six members elected by local member banks and three appointed by the central board of governors. However, board members are not all bankers. Moreover, under a rule recently enacted by Congress, only nonbankers may serve on committees that select Fed bank presidents. This new rule is one way in which the ground has been shifting under the Fed recently; more about this below.

In the beginning the Fed was quite decentralized. A dollar bill in my wallet is imprinted “Federal Reserve Bank of San Francisco,” a remnant of the formerly dispersed power. The headquarters operation was initially a modest one, operating out of an office in the Treasury Department, but it now has its own imposing building, greatly expanded powers, and a correspondingly larger staff. With so much power now centralized, the branches engage mainly in monitoring local conditions and passing recommendations up to the board of governors. They have also become known for differing interests and points of view. The St. Louis Fed, for example, has an excellent collection of data available to the public. The Cleveland Fed is known for innovative research.

The Fed is a nonprofit institution, but that designation means only that profits are not its primary mission. The Red Cross is also a nonprofit, and like the Fed, it does earn a profit during any year in which gross income exceeds expenses. From an accounting point of view, such profits are essentially the same as those earned by firms in competitive markets, but not from an economic point of view. Competitive profits serve the vital function of directing scarce capital resources to the most urgent unmet demands of consumers. The Fed’s profits serve no such function.

Its income consists primarily of interest earned on its securities portfolio. Until recently the portfolio was made up almost entirely of Treasury securities. It has expanded greatly since 2008 to include mortgage-backed securities, loans to such pillars of the financial system as Harley-Davidson, and other assets including direct real-estate holdings. It incurs operating expenses of the usual sort: salaries, buildings, supplies, and more.

Remember that $79.3 billion profit? The 2010 figure, far higher than the $47.4 billion recorded for 2009, did not benefit the Fed’s managers or member bank shareholders because the money was remitted to the Treasury. That’s the law. It happens every year. If any private firm earned that much in a year it would be headline news and a boon to stockholders. For the Fed this is just an interesting statistic.

Who Calls the Tune?

The answer to the question “Who owns the Fed?” is that it’s the wrong question. Instead, we should ask: Who calls the Fed’s tune? That’s not such an easy question, yet it’s the only way to reach an understanding of why the Fed acts as it does and why it has done so much economic damage.

First and foremost, the Fed was created by Congress and can be modified or abolished by Congress. Clearly Congress is the Fed’s most important constituent.

The U.S. president also holds substantial sway over the Fed. He appoints the seven-member board of governors subject to Senate confirmation. The powerful Open Market Committee, which makes monetary policy decisions, consists of those seven plus the president of the New York Fed and four seats that are rotated among the 11 regional presidents.

But even though it exercises ultimate control, Congress has given the Fed a degree of independence that no other federal agency enjoys. Although its profits are swept back to the Treasury, the Fed enjoys a sweet deal that is unavailable to ordinary Federal agencies, which must plead with Congress for an annual appropriation. The Fed spends whatever it wants on operations, constrained only by the necessity to keep up appearances—not to look like fat-cat bankers. Its profit is whatever remains after all expenses have been paid, and, in contrast to ordinary corporate accounting, after dividends have been paid.

The Fed’s vaunted independence is a good thing, the thinking goes, because we don’t want the stewards of our money to be caught up in the swirl of day-to-day politics. But independence trades off against accountability. After all, in a democracy the bureaucracies are supposed to be accountable to Congress. The purse strings are the primary means of accountability among the other agencies, but there are no such strings tying Congress to the Fed.

Such control as commercial banks exert is not so much a function of their nominal stockholdings as it is of their connections through the network of good ol’ boys that weaves through government and “private” financial institutions. The Fed surely looks out for the interests of major private institutions, especially big banks, insurance companies, and securities firms. It does not want big-bank failures or a stock-market crash. It must be cognizant of foreigners who hold $3 trillion in U.S. Treasury debt and are keenly aware of the Fed’s actions and pronouncements.

These incentives have little to do with the Fed’s official dual mandate: stable prices and high employment. That mandate was established by the Employment Act of 1946 and the Humphrey-Hawkins act of 1978. These were times when no one questioned the Keynesian idea that inflation and unemployment always trade off against each other (the Phillips curve) and that monetary and fiscal policy must steer a course between two extremes. If the proponents of the mandate could see the relatively stable prices of recent years coupled with high unemployment, they would call for major Fed “easing.” If they then found out how much easing we have already had and the consequent monstrous increases in debt, they would surely be speechless.

Swift Changes

Some congressmen are calling for reassessing the dual mandate. This is just one way in which things are changing fast for the Fed. This once-staid institution is under increasing attack and is finding it necessary to defend itself, as when Chairman Ben Bernanke came out of his cloister to appear on 60 Minutes, a decision he may regret given the reaction to his astonishing claim that further “quantitative easing” will not increase the money supply.

New rooms are being added to the Fed mansion even as the sand shifts under it. Congress has given it extensive new powers unrelated to monetary policy, most notably a new consumer protection agency. The idea is that the Fed’s independence will ward off regulatory capture, something that always seems to happen to ordinary regulatory agencies. We shall see.

Rep. Ron Paul is the Fed’s most prominent critic. Last year his bill to require an audit of the Fed garnered a great many cosigners in the House. He reintroduced it at the start of the 2011 session, this time with his son Rand Paul on hand in the Senate to file the same bill there.

But in some ways the Fed is already quite transparent. Its website has extensive reports, updated regularly and more detailed than any releases from commercial banks or private corporations. And while deliberations of the powerful Open Market Committee are secret, detailed minutes are now made available shortly after each meeting.

In other ways it is quite secretive. For example, the Fed refused to disclose the names of banks that got loans during April and May 2008, denying Freedom of Information Act (FOIA) requests filed by Bloomberg and Fox News. Responding to lawsuits, the Fed did not claim it was a private institution and therefore exempt. Instead it cited potential harm to the banks that had borrowed, but the court sensibly ruled against a “test that permits an agency to deny disclosure because the agency thinks it best to do so. . . .” The information was released.

“End the Fed” has become a rallying cry for Ron Paul and his supporters. His little book by that name will not earn any academic awards, but as a mass-market polemic it does a good job of making his case without conspiracy theories or private-ownership sideshows. There is, however, room for honest debate about fractional-reserve banking, which he opposes.

About the Fed, though, Ron Paul is right. Whatever good intentions its managers may have, the Fed, like all central banks, exists ultimately as an enabler of ever bigger government. My colleague Jeffrey Rogers Hummel may be right when he says the Fed is becoming the central planner of the U.S. economy. But when we argue for replacing the Fed with market institutions, we must take the time and effort to get our facts straight and to expose the complex network of special interests that supports the Fed. Wrongheaded and simplistic arguments only hinder the cause.