The Lean Startup Will Not Fix the Economy

I’m doing a marketing internship for a startup this summer and my boss sent me an article about the “lean startup”; this is an idea I heard about before but had no real interaction with until now. The lean startup is essentially a new methodology for starting businesses. It emphasizes testing hypotheses and responding to customer feedback with iteration and pivoting over the older methodology of forming a long-term business plan with “elaborative design” and “intuition,” as Steve Blank puts it in his article, “Why the Lean Start-up Changes Everything.”

I find the methodology very appealing. Attempting to make long term predictions about human choice among many different products appears absurd to me. Even with all the flaws in empirical testing to confirm hypotheses, the lean startup seems like a better method to use in the field of business (but not economics, as I explain in this article about the minimum wage).

However, I disagree with one point Blank makes in his article, a point made often elsewhere in articles about the lean startup. It is his belief that the introduction and spread of this startup methodology will have “profound economic consequences.”

Blank writes:

A lower start-up failure rate could have profound economic consequences. Today the forces of disruption, globalization, and regulation are buffeting the economies of every country. Established industries are rapidly shedding jobs, many of which will never return. Employment growth in the 21st century will have to come from new ventures, so we all have vested interest in fostering an environment that helps them succeed, grow, and hire more workers. The creation of an innovation economy that’s driven by the rapid expansion of start-ups has never been more imperative.

…

Lean start-up techniques were initially designed to create fast-growing tech ventures. But I believe the concepts are equally valid for creating the Main Street small businesses that make up the bulk of the economy. If the entire universe of small business embraced them, I strongly suspect it would increase growth and efficiency, and have a direct and immediate impact on GDP and employment.

In this post, I’m going to focus on explaining my disagreement rather than trying to prove that it is correct. My view is based on Austrian economic theory, particularly Austrian business cycle theory, which I have set out in more detail elsewhere. I will explain the basics here (feel free to skip to part 5 if you already understand Austrian economics).

1)      The concept of demonstrated preference:

Mises stated that individual humans act purposefully, choosing means to attain their chosen ends. The ability of humans to choose, means that humans have preferences. They prefer, and therefore choose, one end over another, and again prefer, and therefore choose, one set of means over another. When two individuals exchange with each other, each individual is showing that he prefers one good over the other. When Jim trades his house for Simon’s 300,000 dollars, Jim is demonstrating that he prefers $300,000 over his house, and Simon is demonstrating that he prefers the house over his $300,000. This is called demonstrated preference. Every time individuals act, they demonstrate a preference, just as displayed by the exchange between Jim and Simon.

2)      Prices are predicated on demonstrated preferences:

As persons exchange, prices are formed. The price of the house in the previous exchange was 300,000. Likewise, we could say the price of a dollar was 1/300,000th of a house. As multiple men make exchanges among the same goods (houses and dollars), market prices are formed. Even most people who have never had an actual economics course have heard of supply and demand. But often they don’t understand the basis for supply and demand.

Supply and demand curves are just a graphical representation of a group of people’s real preferences. So maybe person A would be willing to buy 1 house at a price of 330,000, and 2 houses at a price of 300,0000. Maybe person B would be willing to buy 1 house only if the price was 300,000. And so on. These preferences added together would form the demand curve, stating how many houses (quantity on the x-axis) people together would demand at such and such prices (on the y-axis). The same thing would occur for the supply curve, being the preferences of sellers added together. In other words, it would state how many houses (quantity on the x-axis) people together would be willing to supply at such and such prices (on the y-axis).

3)      The importance of the market clearing price:

Where the demand and supply curves meet and intersect is known as the market-clearing price. At this price, all buyers’ (“demanders”) and sellers’ (“suppliers”) preferences are satisfied. At any other price, there would either be more people wanting to buy than people wanting to sell, or vice versa. In other words, there would be a deficit of goods if the price was lower than the market clearing price or a surplus if the price was higher than the market clearing price. What brings it toward the market clearing price if exchanges occur at some other price? Arbitrage: the profitable reselling of goods (this isn’t that important for this post so if you don’t completely understand arbitrage, don’t worry about it).

4)      Prices function as signals:

As we said before, prices change based on preferences, but there a number of other reasons that are derivative from preferences. For example, scarcity affects prices as well (through people’s preferences). If a good becomes more scarce, (people will value the remaining units more and) its price will go up. Considering this, prices are invaluable signals to individuals participating in the economy. For example, if a piece of machinery that a producer buys to make a product becomes more scarce and goes up in price, it is a signal to producers that they must use it more sparingly. Fewer can buy it now that its price is higher and marginal producers (those who barely profited from it before the price change) are driven out of the market as they now earn losses.

5)      The government manipulates the interest rate, an invaluable price in a market economy:

When the government (and fractional reserve banking) prints money, it essentially increases the supply of loans (because they distribute this new money through the banking system by giving it out as loans), lowering the interest rate (for simplicity’s sake, the price of loans) below its free market level. This causes the business cycle. The interest rate like all prices is a signal. It represents the time preferences of individuals. If individuals want to consume more now and consume less in the future, they spend more and save less, and therefore lower the amount of money that they can loan out. By decreasing supply, this increases the interest rate. Likewise, if consumers want to consume less now and consume more in the future, they spend less and save more, and therefore increase the amount of money they can loan out. By increasing supply, this decreases the interest rate.

What happens when the government manipulates the interest rate? An exposition of complete Austrian business cycle theory goes beyond this post, but again, you can check that out here. Essentially though, now the manipulated interest rate functions as a bad signal. It does not represent the real preferences of individuals in the economy. If the interest rate is lower than what it would have been otherwise, it appears as if consumers are saving more (look at the last paragraph) when they really are not. Since the rate is cheaper, businesses can borrow more money to buy more capital goods (such as machinery; see the example in #4) to produce more goods for the future. But consumers don’t really want more goods in the future. They are spending on goods now and not saving enough money to buy those goods. As such, businesses invest in the wrong goods and start producing the wrong goods to sell at the wrong times.

Therefore, if the government does not allow price signals to work, it doesn’t matter what methodology businesses are using. They will not be able to improve the situation. If a signal is a bad signal, it doesn’t matter whether businesses are checking with it more often (as they do in the lean startup) or less often (as they do in the traditional startup methodology). In fact, if they are checking the bad signal more often, maybe they’ll make worse decisions and make the economy worse! (I say this somewhat jokingly, but certainly the reasoning is plausible)

What has to go are the structural impediments, the intervention in the economy by the government. That’s the only way the economy can recover. Then the lean startup methodology will be able to increase standards of living if it indeed is a better way of responding to consumer’s desires. But as long as the interest rate, the price representing the time preferences of individuals, is skewed, increasing the response rate to this incorrect signal will either have no effect, or at worst, be deleterious.

Are Deflation and Depression Correlated?

In a 2004 study titled “Deflation and Depression: Is There and Empirical Link?,” Atkeson and Kehoe investigate the relationship between deflation and depression. Their conclusion after examining 17 countries over a period of 100 years is no, there is not a strong link.

In the Great Depression, they find a coefficient of .40 (with a standard error of .28) for a regression of the inflation rate on output growth. In other words, for a 1% decrease in inflation, there was an average .4% decrease in output. However, this result is not statistically significant.

Outside the Great Depression, they find a coefficient of .04(.03). This is neither statistically nor economically significant.

Overall, they find a coefficient of .08(.03). This is statistically significant but not economically significant.

Salerno argues here that it’s a good thing raw data was used in the study. He states:

From the Austrian standpoint, it is precisely the virtue of the Atkeson-Kehoe study that it uses raw data that have not been subjected to arbitrary statistical manipulations. For it is unaveraged, unsmoothed, unadjusted data that are the direct and immediate outcome of unique and non-repeatable human choices in the marketplace. As such, these data are the most meaningful in applied theoretical analysis and for the interpretation of economic history.

As Murray Rothbard often emphasized: ”Austrians realize that empirical reality is unique, particularly raw statistical data.  Let that data be massaged, averaged, seasonals taken out, etc. and then the data necessarily falsify reality.”[6]

Rothbard objected even to the seemingly innocuous practice of seasonally adjusting the data: ”In our view the further one gets from the raw data the further one goes from reality, and therefore the more erroneous any concentration upon that figure. Seasonal adjustments in data are not as harmless as they seem, for seasonal patterns, even for such products as fruits and vegetables, are not set in concrete.  Seasonal patterns change, and they change in unpredictable ways, and hence seasonal adjustments are likely to add distortions to the data.”[

Of course, there is an argument to be made for using control variables, even from an Austrian point of view. That said, it’s hard to conclude anything from this study other than that a relationship between deflation and depression is not very clear and that we should be skeptical of (empirical) theories based on this type of connection without any further proof.

There are several other studies on this topic, so I plan on looking at them to find out what sort of results they’ve gotten if I have time.

Fantastic Analysis of the Money Supply

by Robert Wenzel, here.

His key point is that the monetary base is not the money supply. The monetary base is useful for understanding the potential of the money supply to expand, but the money supply is the amount of money that is actually out in the real economy. Money “parked” at the Federal Reserve as excess reserves are not physically in the economy. Considering this, it is no surprise that price inflation has not yet jumped to high levels when 1.7 trillion/2 trillion of the Fed’s printed money is being held as excess reserves. If this money leaks out, you could see drastic price inflation, eventually forcing the Fed to pull back and raise interest rates, driving the economy into the dirt.

It is worth reading this and looking at the data Wenzel cites to get a proper grasp of the money supply yourself.

The Current State of Economics

Easily summarized by a quote from my econometrics book (Introduction to Econometrics, third edition, by Stock and Watson):

“Rather, the slow rise of inflation is now understood to have occurred because of bad luck and monetary policy mistakes…” [my emphasis]

When you have to appeal to bad luck to theorize causality, you know your “science” is not doing very well.

Nope, That’s Not What Price Elasticity Means

I’m taking an Information Systems Management course. One of the textbooks (Information Systems: A Manager’s Guide to Harnessing Technology, v.1.4 by John Gallaugher) has been fairly good up till now.

It states:

“When technology gets cheap, price elasticity kicks in. Tech products are highly price elastic, meaning consumers buy more products as they become cheaper.”

In Austrian economics, the law of demand states that individuals will buy more as goods become cheaper, ceteris paribus. Of course, even in neoclassical economics, the law of demand states the same thing, with certain exceptions.

Price elasticity (of demand) refers to the % change in quantity divided by the % change in price. If the resulting calculation is less than -1, it is price elastic. If it is equal to -1, it is unit elastic. If it is between -1 and 0, it is price inelastic. High price elasticity would refer to an elasticity that is in the <-1 range (a large negative number).

So in layman’s terms, what exactly does this mean? For a given percentage change in price, the percentage change in quantity demanded will be very large. So for small price shifts, you can expect big changes in quantity demanded.

In other words, a fixed (yet imprecise, but I could live with that) version might say “When technology gets cheap, price elasticity kicks in. Tech products are highly price elastic, meaning consumers buy many more products as they become cheaper.”

I often have minor quibbles with textbooks that I decide not to post about, but this is something easily fixable with a few more words. The difference between high price elasticity and the law of demand is something that not just economists should be aware of, but something that managers should as well, if they’re going to be taught about it at all.

Take Some Time Off to Contemplate

I’ve gone through most of my life in auto-drive mode. I didn’t think much in terms of “is this really worth it?” or “is there something more fundamentally necessary that I should be allocating my time toward?” We all have to allocate our time, a scarce resource, to particular ends that we choose. And sure, we do this on a daily basis; e.g. do I really want to do this assignment or should I go and play pingpong instead? But up till college, I had never really considered these type of questions on a more fundamental level. “Is my time worth doing this at all? Could it be a complete waste in the end?”

I consider myself lucky. When I fell ill two years ago, I found some answers that I may have not found otherwise. Two things really pop out to me. The first is Austrian economics, a deductive method of economics that teaches us a lot about the world, even if only with its simplistic truths. For example, ex ante, two individuals that exchange different goods voluntarily both gain. This is fairly indisputable, and knowing such obvious truths allows us to build a base of knowledge with which we can expand on top of. Most people don’t spend much time scrutinizing their base. They simply take it for granted (and once again, go into autodrive mode).

The second is pai-da/la-jin. Because I was ill with a disease contemporary, mainstream doctors could not cure, I was in a sense, forced to try something I may not have tried otherwise. Now I’ve found something that can help with almost all deficiencies in human health, and once again, it is simplistic. In fact, it’s something you could teach someone in a minute.

Unfortunately (? or maybe fortunately), what I’ve realized is that the base probably extends even further below. And so I have to keep scrutinizing it. While auto-drive is useful for many activities, there are points where we have to sit back and think: examine our lives and asks ourselves questions we have been avoiding. We may not always come up with precise answers. In fact, precise answers are usually the exception.

Why do we avoid these simple questions? As mentioned before, sometimes we are constantly doing activities and the thought never reaches us. But sometimes we are also scared of the answer. “Well, I don’t want to realize the last 10 years of my life was a waste so I’m just going to avoid thinking about this.” No! Don’t fall into this trap. Experiences are rarely useless. I only say rarely because I am uncomfortable using the absolute “never.” You can almost always find ways that experiences have benefited you. The only reason you think it’s useless is because the experience is useless with your original purpose in mind. For example, if I learned to be a mainstream economist, and then found Austrian economics 20 years into my career and thought its simplistic truths actually had more explaining power than mainstream models, I might initially feel as if my investment into mainstream economics was a waste. The original purpose was to explain certain occurrences in the world, e.g. exchange, prices. etc, and basically all of my learning for that purpose is now a waste. But this set of skills and experiences can be used in other ways. You could use your knowledge of mainstream economics to argue against it for what you now believe is true. You could use your hard work and the ability you developed in writing and teaching to now spread Austrian ideas. There are many other possibilities, but this is for you to think up for your particular situations.

Rousseau Blowing Up the “Right of the Stronger”

I really enjoyed this passage when I read it a year ago in David Gordon’s Political Thought Through the Ages course; while re-reading it for my Political Philosophy class in college, I realized my appreciation for it has not swayed one bit.

The right Rousseau is discussing is the “right of the stronger,” a claim that morality is derived from the greater force.

The following is from the Cambridge edition, edited by Victor Gourevitch.

But will no one ever explain this word to us? Force is a physical power; I fail to see what morality can result from its effects. To yield to force is an act of necessity, not of will; at most it is an act of prudence.

…

Let us assume this alleged right for a moment. I say that it can only result in an unintelligible muddle. For once force makes right, the effect changes together with the cause; every force that overcomes the first, inherits its right. Once one can disobey with impunity, one can do so legitimately, and since the stronger is always right, one need only make sure to be the stronger. But what is a right that perishes when force ceases? If one has to obey by force, one need not obey by duty, and if one is no longer forced to obey, one is no longer obliged to do so. Clearly, then, this word “right” adds nothing to force; it means nothing at all here. (Rousseau, The Social Contract, Book 1, Ch.3)

It’d be an interesting argument if someone contended morality existed but immorality didn’t. I have not seen such an argument and don’t know if it can be made. Nevertheless, any one that accepts the existence of both morality and immorality logically cannot propose that force creates right.

For proof, consider the following: if you are forced to do something, by definition, you had no choice in the matter. If force created right, then your forced action was also moral.  However, the absence of choice means that you cannot be immoral! Thus, the right of the stronger eliminates the possibility of immorality.

Cenk Uygur Unknowingly Proves His Hypocrisy While Attempting to Disprove It

Here

In a video about gun control laws being introduced in Colorado and Connecticut, Cenk reveals his support for them. In many videos before, Cenk has backed state laws for marijuana but has simultaneously called gun control nullification laws unconstitutional. So he has received a lot of flack from me and others for this apparent inconsistency.

In this video though, he states:

Now, of course, by the way, unlike the hypocritical right-wing, I have always maintained that states’ rights depends. Now if you’re doing experimentation at the state level that does not take away fundamental rights, absolutely, of course you should do experimentation. That’s part of the genius of the founding fathers. Now you can’t take away people’s fundamental rights away. You can’t say “alright, well this is Connecticut, so I’d like to, you know, say that Chinese people don’t have constitutional rights anymore.” Of course you can’t do that. Now I know that some gun rights advocates will say, well, the second amendment’s a fundamental right, but there’s never been an argument made that you can’t regulate it in any way, shape or form. Even the first amendment, which is a fundamental right has some regulations. You can’t yell fire in a crowded theater. So experimenting at the state level with incredibly lax gun control and strict gun control laws makes sense.

So let’s think about this for a second. Cenk thinks state experimentation is fine as long as it doesn’t take rights away. If that’s the case, then the recent states that have nullified federal gun control laws should be completely fine by him. After all, as his last sentence shows, he thinks that some states should have lax gun control laws and others should have strict ones. But the recent nullification proposals were not fine by him. In fact, he reacted extremely emotionally against it.

Fortunately, for Cenk, I can actually think up an answer for him to this from watching previous videos (e.g this and this). Cenk could say, he likes state experimentation, but he also doesn’t want them to come into (real, violent) conflict with federal authorities. So extending this possibility to marijuana, he might say he doesn’t mind states legalizing marijuana, but he doesn’t want them arresting federal agents who try to enforce federal marijuana laws within those states.

So that seems sensible. Has Cenk been acquitted of his hypocrisy?

In fact, no he has not.

Let me explain. According to Cenk, he is for state experimentation as long as it doesn’t take away rights. Let’s say the federal government passes a law regulating cigarettes to a high level. Even if a state passes a law regulating cigarettes to a lower level, it, by the fact of the stricter federal law, is as if there is not even a state law. There is actually no state experimentation, because Cenk says federal law trumps state law. At least that’s how he wants it to be.

Cenk says he likes state experimentation when it comes to marijuana and even gun control now! But this is actually not true. Cenk only likes state experimentation for marijuana and not for gun control. He is in fact, unintentionally deceiving both himself and others.

This is clear because he 1) does not want the current federal marijuana laws and 2) wants federal gun control laws. In other words, he wants state experimentation for marijuana but does not want state experimentation for gun control, as is evident from his claim that federal law trumps state law.

What is our conclusion then? Cenk wants states’ rights for issues he agrees with and doesn’t want states’ rights for issues he disagrees with.

If what I have explained went over your head, let me try to summarize it. Cenk believes in state experimentation, but only under a framework of “federal law trumps state law”. Therefore, he can claim to be for state experimentation everywhere, but at the same time, desire for there to be lots of state experimentation only in some areas and practically none in others. This is evident from the fact that Cenk supports federal marijuana legalization, but wants harsher federal gun control laws. The harsher federal gun control laws get, the less state experimentation in gun control there is, and this is what Cenk really wants. If he actually wants state experimentation and a respect for states’ rights, he must be for lax federal laws not just for marijuana, but for gun control as well.

Gresham’s Law and Coin Clipping

Champions of the government’s coinage monopoly have claimed that money is different from all other commodities, because “Gresham’s Law” proves that “bad money drives out good” from circulation. Hence, the free market cannot be trusted to serve the public in supplying good money. But this formulation rests on a misinterpretation of Gresham’s famous law. The law really says that “money overvalued artificially by government will drive out of circulation artificially undervalued money.” – Murray N. Rothbard, What Has the Government Done to Our Money?, p. 24

Rothbard goes on to give an example of this occurring, which I’ll state in my own words here (I was annoyed earlier because I couldn’t explain this myself). Centuries ago, before the rise of fiat (paper) currencies and money substitutes, governments had to find alternative ways of inflating their money supplies and profiting. Since coins were often in use, governments would try to establish monopolies on the supply of money and “clip” the coins, removing some amount out of their base value. For example, if one ounce gold coins were the norm, the government, after getting some of the supply in its hands, would clip 1/10 of the gold off of the coins. The coins would then have 9/10 of its previous value, and governments could use the extra metal to create new coins. Through this method, they could achieve profits.

What does this have to do with Gresham’s Law? If the government mandated that all coins were equal, that the 9/10 ounce gold coins must be treated the same as the full ounce gold coins, Gresham’s law would come into effect. People, realizing that the 9/10 ounce gold coins could be used in exchange the same way as the full ounce coins, would exchange all of the former coins away domestically. As for the latter, they would either hoard these (A) because they might perceive some chance of government removing this artificial price control in the future, in which case their full ounce coins would be worth more, or B) because they could attempt to use these metals to their full value in some other respect rather than exchange, such as melting them down) or trade these overseas (because other countries would not be so accepting of the “illegitimate” coins). Thus the “good coins” would be driven out of circulation, not because of the free market, but because of the government.

I’ll post examples of Gresham’s Law occurring with gold/silver coins and fiat currencies later.

Economics is About Human Action, not Mechanical Processes

 

It is misleading, furthermore, to say that money “circulates.” Like all metaphors taken from the physical sciences, it connotes some sort of mechanical process, independent of human will, which moves at a certain speed of flow, or “velocity.” – Murray N. Rothbard, What Has Government Done to Our Money?, pg. 33

This is one of the major problems with economics, as well as other social sciences today. By attempting to create mathematical formulas that describe human action, economists are sucked into the trap of assuming these “laws” will hold forever. Unfortunately, even if a formula describes a historical circumstance well, there is no certainty it will apply to future circumstances. Not only can expectations change, but humans can invent new ways to act or act differently due to different pieces of knowledge, different circumstances, and lastly of course, because they are completely different human beings.