The Invisible Hand: Balancing Supply and Demand in a Capitalist Economy

How the Federal Reserve's quantitative easing has mutated the DNA of the global economy, and how well-meaning economists running central banks don't know the correct price of money or the consequences of their actions.

The Invisible Hand: Balancing Supply and Demand in a Capitalist Economy

The Federal Reserve’s changing of the guard — the end of the Janet Yellen’s tenure and the beginning of the Jerome Powell era — has me remembering what it was like to grow up in the former Soviet Union.

Back then, our local grocery store had two types of sugar: The cheap one was priced at 96 kopecks (Russian cents) a kilo and the expensive one at 104 kopecks. I vividly remember these prices because they didn’t change for a decade. The prices were not set by sugar supply and demand but were determined by a well-meaning bureaucrat (who may even have been an economist) a thousand miles away.

If all Russian housewives (and house-husbands) had decided to go on an apple pie diet and started baking pies for breakfast, lunch, and dinner, sugar demand would have increased but the prices still would have been 96 and 104 kopecks. As a result, we would have had a shortage of sugar — a common occurrence in the Soviet era.

In a capitalist economy, the invisible hand serves a very important but underappreciated role: It is a signaling mechanism that helps balance supply and demand. High demand leads to higher prices, telegraphing suppliers that they’ll make more money if they produce extra goods. Additional supply lowers prices, bringing them to a new equilibrium. This is how prices are set for millions of goods globally on a daily basis in free-market economies.

In the command-and-control economy of the Soviet Union, the prices of goods often had little to do with supply and demand but were instead typically used as a political tool. This in part is why the Soviet economy failed — to make good decisions you need good data, and if price carries no data, it is hard to make good business decisions.

When I left Soviet Russia in 1991, I thought I would never see a command-and-control economy again. I was wrong. Over the past decade the global economy has started to resemble one, as well-meaning economists running central banks have been setting the price for the most important commodity in the world: money.

Interest rates are the price of money, and the daily decisions of billions of people and their corporations and governments should determine them. Like the price of sugar in Soviet Russia, interest rates today have little to do with supply and demand (and thus have zero signaling value).

For instance, if the Federal Reserve hadn’t bought more than $2 trillion of U.S. debt by late 2014, when U.S. government debt crossed the $17 trillion mark, interest rates might have started to go up and our budget deficit would have increased and forced politicians to cut government spending. But the opposite has happened: As our debt pile has grown, the government’s cost of borrowing has declined.

The consequences of well-meaning (but not all-knowing) economists setting the cost of money are widespread, from the inflation of asset prices to encouraging companies to spend on projects they shouldn’t. But we really don’t know the second-, third-, and fourth derivatives of the consequences that command-control interest rates will bring. We know that most likely every market participant was forced to take on more risk in recent years, but we don’t know how much more because we don’t know the price of money.

Quantitative easing: These two seemingly harmless words have mutated the DNA of the global economy. Interest rates heavily influence currency exchange rates. Anticipation of QE by the European Union caused the price of the Swiss franc to jump 15% in one day in January 2015, and the Swiss economy has been crippled ever since.

Americans have a healthy distrust of their politicians. We expect our politicians to be corrupt. We don’t worship our leaders (only the dead ones). The U.S. Constitution is full of checks and balances to make sure that when (often not if) the opium of power goes to a politician’s head, the damage he or she can do to society is limited.

Unfortunately, we don’t share the same distrust for economists and central bankers. It’s hard to say exactly why. Maybe we are in awe of their Ph.D.s. Or maybe it’s because they sound really smart and at the same time make us feel dumber than a toaster when they use big terms like “aggregate demand.” For whatever reason, we think they possess foresight and the powers of Marvel superheroes.

Warren Buffett — the Oracle of Omaha himself — admitted that he doesn’t know how the QE experiment will end. And if you think well-meaning economists running central banks know, you may have another thing coming.

Alan Greenspan — the ex-pope of the Federal Reserve — in a 2013 interview with the Wall Street Journal said that he “always considered [himself] more of a mathematician than a psychologist.” But after the 2008-09 financial crisis and the criticism he received for contributing to the housing bubble, Greenspan went back and studied herd behavior, with some surprising results. “I was actually flabbergasted,” he admitted. “It upended my view of how the world works.”

Just as the well-meaning economists of the Soviet Union didn’t know the correct price of sugar, nor do the good-intentioned economists of our global central banks know where interest rates should be. Even more important, they can’t predict the consequences of their actions.

Related Articles

Inflation: Not Transitory Yet

Inflation Update: Not Transitory Yet!

Today we are experiencing a perfect storm of inflation. A perfect storm is formed by seemingly small factors. Each one on its own may not be particularly significant, but once combined they result in an event that significantly exceeds the sum of all parts. I provide an update on my previous two inflation articles, and the risks I see on the horizon in the next few quarters.
Is Tesla Theranos?

Is Tesla Theranos?

Tesla bears make the argument that Elon Musk is similar to Elizabeth Holmes, CEO of Theranos, who resorted to deception and fraud. What would happen to Tesla if something were to happen to him?
Elon Musk’s Notorious Promises: Why Tesla’s Future Success Might Not Be in His Hands

Elon Musk’s Notorious Promises: Why Tesla’s Future Success Might Not Be in His Hands

Elon Musk is an incredibly ambitious leader with seemingly impossible goals, who has changed the auto industry and accelerated human progress. His success is mostly dependent on the capital he can raise to finance his dreams, which is made possible by the faith people have in him and Tesla. However, it is difficult to tell which of his goals will turn into realities and when.
Autopilot: Musk’s Wishful Thinking or Tesla’s Greatest Advantage?

Autopilot: Musk’s Wishful Thinking or Tesla’s Greatest Advantage?

Autopilot has some useful features, but can be dangerous on roads with unclear lane markings. Is the autopilot Tesla's greatest advantage?

1 thought on “The Invisible Hand: Balancing Supply and Demand in a Capitalist Economy”

  1. A useful book is John F. Cogan’s The High Cost of Good Intentions: A History of U.S. Federal Entitlement Programs. It being published by
    Stanford in 2017, it doesn’t deal with the current disorder in which Congress has thrown Americans under the Omnibus. Then there’s
    Rand Paul’s Festus 2022 report in which he reports we’re paying to teach Ethiopians how to wear shoes. I’d like to see a congressional
    name attacted to each of these expenditures so that the proponents can receive the riidcule they deserve.

    Reply

Leave a Comment