“'[M]onetary policy' ... is in fact very difficult to understand—given it effectively operates as a political programme within the muddled field of macroeconomics ... dictated by political expediency.
"As for money itself, there is nothing so difficult about it conceptually. A hundred and fifty years ago Carl Menger explained how money arose as the most saleable commodity in the marketplace, with the best properties to be a store of value and medium of exchange. Thus money solved the problems and inefficiencies of barter. Forty years later Ludwig von Mises relied on Menger’s subjective marginal-utility theory to solve the circular problem of explaining how money obtained value in the first place ... explaining how commodities’ 'moneyness' value evolved from their preexisting nonmonetary uses. No government or central bank was necessary ...
"These two concepts give us the baseline conceptual understanding of money’s origin and value. But every shrewd merchant and trader over the centuries already understood money instinctively.... Many people intuitively understand money. What they don’t understand is monetary policy. The idea that exceedingly intelligent people at central banks and national treasuries must 'run' complex monetary 'systems' surely is one of the greatest swindles ever perpetrated. It nonetheless remains widely accepted ...
"At its core, economics is conceptually simple: humans make choices in an environment of 'scarcity' to achieve ends. Money is a means to those ends, not an end in itself. It is the market’s answer to the inefficiency of barter....
"Today, however, the concept of money is overwhelmed and completely obscured by politics. Modern money is political (fiat) money, which is to say it is a tool of government and an instrument of political power....
"Thanks to political money, confusion reigns.... [M]ostly we hear confusion between wealth and money, rooted in the politicised, zero-sum nature of monetary policy. More money and credit do not magically create more goods and services, more capital investment, or a more productive economy. Prosperity cannot be legislated by politicians or engineered by central bankers.
"What to do? The best approach in a confused world is a return to fundamentals. Mises’s 'The Theory of Money and Credit' is a great place to start, as is Murray Rothbard’s 'What Has Government Done to Our Money?' and Robert Murphy’s recent 'Understanding Money Mechanics'. For most lay readers, any of these books would be sufficient to puncture today’s money mythology. Circulate them among friends and family to help build the future cadre of monetary policy deniers. What the world needs today is champions of commodity money, sound money, hard money with a high stock-to-flow ratio, all of which is to say money that retains or increases purchasing power even when held in a simple savings account. This will require all of us ... to push for a great awakening.
"Money is simple, but opposing the political tool of monetary 'policy' is not."~ Jeff Deist, from his post 'Money versus Monetary Policy'
Showing posts with label Marginal Productivity of Debt. Show all posts
Showing posts with label Marginal Productivity of Debt. Show all posts
Wednesday, 22 February 2023
"Monetary Policy is very difficult to understand—given it effectively operates as a political programme ... dictated by political expediency."
Thursday, 12 May 2022
Exorbitant Money Creation + Unhampered Government Spending = Stagflation
The problem is not just local, it is worldwide. Again and again, the belief has been proven wrong that central bankers could guarantee so-called price stability, and that fiscal policy could prevent economic downturns. The looming inflationary crisis is one more piece of evidence that interventionist monetary and fiscal policies are disruptive. Instead of a permanent boom, explains Antony Mueller in this guest post, the result is stagflation....
Stagflation—a Keynesian Curse
Guest post by Antony Mueller“Stagflation” characterises economies that are plagued by inflation, combined with economic stagnation. This is where most of the world is right now, because of the failed (and failing) economic policies they have all followed. In this case, the conventional Keynesian macroeconomic toolkit of monetary and fiscal policy, that offers no help in fixing the crisis it has caused.
Rising price inflation rates and tanking economies are the results of the policy mix that has dominated past decades. It has become common to believe that decades of expansive monetary and fiscal policies would not cause price inflation; that the expansion was 'all under control'; that policies of so-called price stability had somehow 'tamed' the inflation caused by the state's usual money printers.
As recently as 2020, economic policy worldwide followed the false consensus that combatting the fallout from the lockdowns with additional money creation and higher government spending would lead to an economic recovery without higher price inflation. It was blithely assumed that what appeared to work in 2008 -- flooding economies with newly-minted cash -- would also function in 2020. However, policymakers ignored the difference between the two episodes.
In the aftermath of the financial crisis of 2008, the stimulus policies did not immediately turn into price inflation, as it's commonly measured, because the newly-created money remained largely in the financial sector and it only spilled over into the real economy in a big way in rocketing house prices (exacerbated in NZ by sclerotic land and housing policies). Outside of this generational calamity, the main effect of the policy of low interest rates was to support the stock market and to provide a windfall to financial investors. While Wall Street flourished, Main Street was left on the sidelines -- and while profits surged, wages remained stagnant.
But this time it's different. In 2008, the production side of economies were 'mismatched' due to the earlier credit expansion, but still intact; but this time, they are severely damaged by a major pandemic. The crisis of 2008 left the capital structure of the real economy intact. Due to the lockdowns, however, this is no longer the case. Consequently, severe interruptions of the global supply chains have happened. In such a constellation, new stimulus measures further weaken already fragile economies.
In the aftermath of the financial crisis of 2008, the stimulus policies did not immediately turn into price inflation, as it's commonly measured, because the newly-created money remained largely in the financial sector and it only spilled over into the real economy in a big way in rocketing house prices (exacerbated in NZ by sclerotic land and housing policies). Outside of this generational calamity, the main effect of the policy of low interest rates was to support the stock market and to provide a windfall to financial investors. While Wall Street flourished, Main Street was left on the sidelines -- and while profits surged, wages remained stagnant.
But this time it's different. In 2008, the production side of economies were 'mismatched' due to the earlier credit expansion, but still intact; but this time, they are severely damaged by a major pandemic. The crisis of 2008 left the capital structure of the real economy intact. Due to the lockdowns, however, this is no longer the case. Consequently, severe interruptions of the global supply chains have happened. In such a constellation, new stimulus measures further weaken already fragile economies.
The present situation is less like 2008, which most of of us still remember, and more like the oil price shock in 1973 -- which too many current economic practitioners and advisers have forgotten. At that time, like now, the external shock hit an economy rampant with liquidity. Stimulating the economy by fiscal and monetary expansion produced not prosperity but long-lasting stagflation. Back then, along with “stagflation,” the term “slumpflation” was coined to characterise an economy that is mired in a deep slump that then gets devastated by price inflation.
When stagnation and recession show up together with price inflation, the conventional macroeconomic policy becomes impotent. Applying the Keynesian recipe to an economy whose capital structure is still intact inflates bubbles; but applying it to one who capital structure has already been ravaged invites disaster.
Intentionally or by ignorance, policymakers neglected the long-term effects of their doing. Going this wrong way led to such aberrations that policymakers and their intellectual bodyguards even tended to believe that some truth could be found in the alchemy of the so-called modern monetary theory and market monetarism.
The consequences of these policy errors have now come to light. They are particularly grave because they were committed by all major central banks and the governments of all leading industrialised countries. They all follow the concept of “inflation targeting.” Other than timing, there has been not much difference among the policies of major Western economies. Japan is a special case only insofar as its policymakers have applied the Keynesian recipe for over three decades by now.
Let us have a look at Japan first and then at the United States -- who both offer lessons for New Zealand.
Japan
Japan began applying vulgar Keynesianism as early as in 1990. Faced with a slight downturn after the boom of the 1980s, instead of allowing things to cool down, the Japanese leadership instead insisted on going on with the show.
Yet, the more the government began to accelerate public spending and increases the fiscal stimuli, the less its spending policy produced economic recovery. Even when monetary policy fully supported the government’s expansive fiscal policy, the hoped-for recovery did not materialise.
John Maynard Keynes, on whose theories this "rescue" was based, once advised that policy-makers should ignore advice that such loose spending would lead to destruction in the long run -- "in the long run," he quipped, "we're all dead." But Japan's short run is now the long run: its policy mix of fiscal and monetary expansion has been going on now for three decades. In recent times, the Bank of Japan even doubled down, setting extremely low-interest rates and finally resorting to negative interest rates (NIRP). In the meantime, public debt as a percentage of the gross domestic product (GDP) rose to a whopping 266 percent (see figure 1).
Figure 1: Japan: Policy interest rate and public debt as a percent of GDP
Source: Trading Economics.
Despite its magnitude, this stimuli did not lift the Japanese economy out of its quagmire. Instead, economic growth remained anemic for a quarter of a century (figure 2).
Figure 2: Japan: Annual economic growth rates of real GDP
Source: Trading Economics.
As an “early starter” in applying vulgar Keynesianism to its 'macroeconomy,' the Japanese economy was also early to suffer from productivity stagnation. Unlike economies like the United States, France, Germany, and many other industrialised countries, which have continued with productivity gains over the past decades, after it had begun with its extreme Keynesianism in the 1990s Japan's has moved sideways (and New Zealand, for slightly different and equally tragic reasons, has followed a similar path -- figure 3).
Figure 3: Productivity per hour worked: Germany, United States, France, Japan, New Zealand
Source: Our World in Data.
It is important to note that one of the most devastating effects of the Keynesian policy mix is its effect on productivity. A country’s long-run economic progress (or growth, as it's often called) is mostly the result of productivity gains. Labour productivity is the main determinant of wages. A slowdown in productivity precedes the economic decline. When the output per unit of input tends to fall, even lower interest rates will not stimulate business investment. The marginal productivity of debt, already low, diminishes even faster -- and further.
And when government then jumps in to compensate for this “lack of aggregate demand,” things get even worse because governmental enterprises are fundamentally less productive than the private sector.
Confronted with the financial crisis of 2008, the US government abandoned any sense of economic responsibility and decided instead to launch a series of stimulus packages. The American central bank provided full support, drastically reducing its interest rate.
The United States
Confronted with the financial crisis of 2008, the US government abandoned any sense of economic responsibility and decided instead to launch a series of stimulus packages. The American central bank provided full support, drastically reducing its interest rate.
As a result, the ratio of public debt to GDP rose from 62.6 percent (in 2007) to over 91.2 percent just three years later (in 2010), reaching a full 100.0 percent in 2012. The next two boosts came in the wake of the policies to counter the effects of the economic lockdowns, when the ratio of public debt to GDP rose to 128.1 percent in 2020 and to 137.2 in 2021 (see figure 4). It took less than fifteen years to more than double an already barely-sustainable debt -- and, unfortunately, New Zealand governments chose a similar destructive trajectory.
Figure 4: The United States: Policy interest rate and federal debt as a percentage of GDP
Figure 4a: New Zealand: Policy interest rate and government debt as a percentage of GDP
Source: Trading Economics.
In the face of the crisis in 2008, the American central bank brought down its interest rate quickly from over 5 percent in 2007 to under 1 percent in 2008 (NZ's meanwhile dropped its rate from 8% to 2.4% over the same period). After a short-lived period when the American central bank tried to raise the interest rates, the consequent market reaction of falling prices of bonds and stocks induced the Fed to resume its policy of “quantitative easing” that combined low interest rates with the massive expansion of the monetary base.
Then, in early 2020, still trying to escape from the bear-trap of quantitative easy, it also began trying to "ease" the economic effects of the lockdowns with its patent brand of monetary salve, deciding to continue with its expansive monetary policy. And not just to continue, but to accelerate! In due course, the central bank’s balance sheet rose to $7.17 trillion in June 2020, reaching $8.96 trillion by April 2022. Once again, New Zealand's Reserve Bankers followed the lead.
Figure 5: Balance sheet of the US Federal Reserve System & NZ Reserve Bank
Source: Trading Economics.
As figure 5 shows, the Fed had tried to trim its balance sheet somewhat from 2015 to 2019 when it had brought down the sum of its assets to $3.8 trillion in August 2019. Yet beginning already in September 2019, many months before the lockdown was implemented, the balance sheet of the American central bank began to expand again and reached over four trillion before the additional big increase happened due to the fallout from the lockdowns. (And, once again, NZ's central
Since the time before the financial crisis of 2008, the assets of the Federal Reserve System rose from $870 billion in August 2007 to a whopping $4.5 trillion in early 2015 and to around nine trillion US dollars in early 2022.
Even when inflation rates began to rise towards the end of 2020, the US central bank had kept its policy of tapering small and refrained from tightening. The monetary authorities had simply abandoned the objective of reining in the money supply, becoming instead almost Wall Street's banker. Each time they tried to tighten monetary policy, the financial markets began to tank and tended to crash. As soon as the central bank began to raise its policy rate of interest, the bond market began to tank and took the stocks down with it. In 2022, it was not different. Yet in early 2022, the policymakers could not shrink back. Different from the episodes before, the price inflation had begun to skyrocket (see figure 6, and NZ following in almost lockstep, figure 6a).
In the first months of 2022, stagflation became fully visible. While price inflation rose, the rate of real economic growth began to fall. In the first quarter of 2022, the US inflation rate moved up to a rate of 8.5 percent, while the real annual growth rate fell by 1.4 percent. Similar things were happening in the South Pacific.
Figure 6: United States: Policy interest rate and official consumer price inflation rate
Figure 6a: New Zealand: Policy interest rate and official consumer price inflation rate
Of course, none of this should come as any surprise. With global supply chains in disarray, and national protectionism on the rise, the assistance that came from the expansion of international commerce after the crisis of 2008 is no longer with us. The lockdown of economies has severely hurt the global system of supply chains -- and now, a huge monetary overhang meets a shrinking production. The war in Ukraine, which started in February 2022, is not to blame for the distortions, albeit it will make them more severe.
Conclusion
The levee broke. Price inflation is on the rise. This is the result of the accumulation of liquidity that has been going over decades. There is the risk that things will get worse because the world economy has been severely wounded by the lockdown. More so than only mild stagflation, a “slumpflation” looms on the horizon as the world economy gets mired in the morass of a deep slump combined with steeply rising price inflation.
But the problem was not inevitable -- it is a result of specific policies followed out on the basis of flawed economic theory. Local politicians are right in one way to blame the problem on global issues -- the problem is that this destructive Keynesianism is everywhere, and as long has it is, so will the problems.
* * * *
Author: Dr. Antony P. Mueller is a German professor of economics currently teaching in Brazil. See his website and blog. A version of this post previously appeared at the Mises Wire.
Friday, 13 November 2020
What Drives Progress: The State or the Market?
Two views of what drives progress dominate: that it is driven by state action, or by individual entrepreneurialism and innovation. A recent book tries to turn the division on its head, arguing for the benefits of the 'entrepreneurial state.' But as Ethan explains in this post, this reveals a complete misunderstanding of how innovation and economic progress happen.
What Drives Progress: The State or the Market?
by Ethan Yang“History never repeats itself," declared Mark Twain, "but it does often rhyme.”
A little over a hundred years ago, U.S. President Woodrow Wilson kicked off a drastic expansion of government power and scope with the general assumption that the state can scientifically plan society. Other wartime leaders around the world followed his lead. Two decades later, U.S. President Franklin Roosevelt greatly expanded on this idea -- with more government programs promising to solve all manner of societal ills, to bring a level of centralised progress that the market couldn’t (allegedly) provide.
From those who favoured market-based mechanisms, advocated by economists such as Ludwig Von Mises, this sparked caution and critique. They pointed out that the market was far superior to the state in organising society. That the market process begins with each individual choice for 'this over that'; that individuals' differing wants are harmonised by voluntary exchange; that the price system tells producers what is most (and least) valued; that 'the market' itself is simply the sum of each individuals' valuation, directing human action to making the best use of the most highly-valued resources.
This is the story of humanity, a struggle between the individual and the state. Those who believe in statism on one side and, on the other, those who understand the power of liberty unleashed.
Many of the Wilson and Roosevelt type of statists either never got to grips with the mechanism by which the self-correcting system of market prices delivers progress (dismissing the very notion as some kind of magic-ism). And they simply assumed that progress would always emerge from the maw of government action.
The Keynesian statist would go one better, preaching that prosperity will emerge out of the expanded use of the government printing press. After World War Two, Keynesians and other thinkers of the big state braced for economic turmoil as people returned from war and government spending plummeted. Instead, the exact opposite happened, and as war finished the economy boomed.
Anyone with eyes to see could understand that the state does not drive economic growth. In the latter half of the 20th century, sweeping market reforms confirmed the story, deregulation and 'more market' bringing prosperity to countries all around the world and savaging poverty worldwide as never before. Another blow to the idea of state-run industry.
Some thought that the free-marketeers won the intellectual argument against the Keynesian brand of statism in the 1970s. This is when stagflation completely upended the assumption that inflation and unemployment are always inversely related. It turned out that simply using expansionary monetary policy to drive economic growth was not as good an idea as many people thought. But the arguments for the benefits of big government did not go away.
In 2013 Dr. Mariana Mazzucato, a leading economist of the Keynesian persuasion, published the oxymoronic The Entrepreneurial State, which makes the case that the public sector can do far more than it is currently doing; that the private sector necessarily needs generous guidance and intervention from the state; and that in many cases the state is equal if not superior to the market in generating efficient and innovative services to society.
Well, here we go again!
Mazzucato and her allies posit that society can be so much better if we ditched market-based principles and delegated more responsibility to the state. Think people like Senator Elizabeth Warren.
In response, economic heavyweights Dr. Deirdre McCloskey and Dr. Alberto Mingardi teamed up to write The Myth of the Entrepreneurial State. The book stands on its own in the ongoing debate over the market and the state. The book also serves as an outstanding work of economic history.
Well, here we go again!
Mazzucato and her allies posit that society can be so much better if we ditched market-based principles and delegated more responsibility to the state. Think people like Senator Elizabeth Warren.
In response, economic heavyweights Dr. Deirdre McCloskey and Dr. Alberto Mingardi teamed up to write The Myth of the Entrepreneurial State. The book stands on its own in the ongoing debate over the market and the state. The book also serves as an outstanding work of economic history.
The Idea of the Entrepreneurial State
“Mainstream policy conceptions and prescriptions” [she argues] are “normative postulations for a permanent state planning for more markets, mainly organising ‘deregulation cum privatization’ rather than deliberate sets of conditional recommendations based on pondering alternatives and paths.”
Essentially this suggests that mainstream economic thought is dominated by ideas put forth by those like Milton Friedman, who advocate for more privatisation and deregulation to create growth.
Mazzucato believes that this is unpredictable and suboptimal. Rather we should allow big goverment's experts to ponder better alternatives with a scientific level of precision. Mazzucato likes to reference government programs like DARPA and The Manhattan Project as examples that the government can be very innovative.
This is an odd assertion. I would agree that many economists hold the belief that privatisation and markets are good. However, McCloskey and Mingardi point out that
This is an odd assertion. I would agree that many economists hold the belief that privatisation and markets are good. However, McCloskey and Mingardi point out that
“In the past century, government expenditure as a percentage of GDP drifted up towards 50 percent, compared with its pre-Keynesian level of 10 percent”… “ Democratically elected politicians, and behind them their constituents in the voting public were finally convinced that budget balance carried little or no normative weight.”Sadly -- and contrary to Mazzucato’s point -- amongst policymakers and the commentariat there is no widespread consensus about the wonders of privatisation, instead we see sloppy paeans to never-ending government spending, and calls for ongoing never-ending expansion. [See for example the latest idiotic call by Bernard Hickey for the Reserve Bank to turn the printers on full-speed to pay bigger benefits.] Once you embrace the idea that innovation and big progress may only emanate from big government, one quickly forgets the real sources of growth and progress, and blind to the destruction teh growth of government causes.
This is how government works, especially in democracies. It’s sloppy, it’s imprudent, it’s cumbersome and it is utterly desensitised to important market forces. If you empower the state to take on more and more planning of society, this problem will only exacerbate. Nonetheless, say McCloskey and Mingardi:
Mazzucato, a loyal daughter of the left, is suspicious of private gain, of the sort you pursue when you are shopping, say, and is therefore suspicious of people doing things for a private reward. She wants the State, advised by herself, to decide for you.In essence that is what the idea of the entrepreneurial state ultimately boils down to. A rationalisation of leftist political economy that has politicians and university professors jumping for joy. A very mild form of central planning that says that great things are possible as long as I am in charge.
What Drives Innovation
One of the main premises of those who believe in an entrepreneurial state is that central-bank credit drives economic activity, and that public investment drives innovation. Mazzucato contends that the government should exert a sort of directionality over private businesses to drive them towards some optimal point determined by experts.However, this is a false view of how innovation and economic progress happens.
First, the experiment with central-bank-created credit has now proceeded for just over half a century, in which we have seen a rapidly declining marginal productivity of debt (however you measure it, one dollar of new 'counterfeit capital' creates very much less than one dollar of economic growth), and a steady increase in financial-market turbulence.
Second, innovation comes not from the top down but from the bottom up. Free people acting in spontaneous and self-interested ways create the innovative products of tomorrow. Private firms jockeying for supremacy in handheld communication gave us the genius of the iPhone. Tesla produces some of the most advanced electric cars in the world available for mass consumption. Tesla CEO Elon Musk is the antithesis of the pondering bureaucrats that Mazzucato believes drive innovation. A man who offers four car models named S, 3, X, Y, sells flame throwers, privatised the space race, and now just launched a line of tequila.
Elon Musk’s rambunctious personality would be one representation of how innovation happens. Not by deliberate planning by experts but by the rambunctious and oftentimes chaotic enterprise of free individuals failing and succeeding, often many times in many ventures heading in many different directions. Another would be a James Watt, driven to perfect the steam engine that would eventually come to power a whole Industrial Revolution. Neither are going to work well, or innovate, under a bureucrat's direction.
Mazzucato and others like her contend however that it is the state that drives innovation. The authors disagree and state that the ultimate source of innovation is
the liberal idea and its emancipation of human creativity.”As statists lament over the alleged “normative postulation” regarding privatisation, McCloskey and Mingardi feel exactly the opposite. Getting the state out of the way of free individuals unleashes the driving force behind innovation.
Does Government Investment Contribute to Innovation?
One of the few convincing observations made by Mazzucato and others like her is that the advanced military research agency known as DARPA [Defence Advanced Research Projects Agency] invented things like the internet. Therefore, they argue, the state may be capable of impressive feats of innovation. If we invested more, then we would get even more spectacular results.McCloskey and Mingardi offer a rebuttal that can be summarised as “important if true.” They write
The question is whether the American government envisioned anything like the internet. The answer is obvious: of course it didn’t. There was no “mission-oriented directionality.” The investments by the military look like Christopher Columbus’ voyages: the entrepreneurial State discovered the West Indies having left for the East Indies.Furthermore, even when it stumbled upon what became the acorn from which the internet grew, the bureaucratic state had no idea it had any value whatsoever.
In the 1960s the Air Force considered how a decentralised communications grid distinct from the traditional telephone might operate. But the Department of Defense then terminated the research and took no action.McCloskey and Mingardi also go on to point out that one of the leading developers of ARPANET, the technical foundation for the modern internet, observed that
DARPA "would never have funded a computer network to facilitate email", because [in their view] the telephone already served person-to-person communications perfectly.Any government contribution to creating things like the internet was not only wholly unintentional, it may even have been detrimental. Innovation is a chaotic endeavor that leans less on the approval of experts, but instead requires a genuine test in the marketplace. If invention and progress rested on the opinions of whether a room full of PhD’s (or bureaucrats) thought it would be productive, we might not have made it past the horse-drawn plough!
One famous example is the advent of airborne flight which, after a failed test, government officials and many others understandably believed was not obtainable. Looking back, these comments seem comedic but if we allow the state and its army of experts to impose “directionality,” innovation would grind to a halt.
In fact, in 1903 the New York Times predicted that flight was approximately 1-10 million years away. Then just a couple of months later two bicycle mechanics, Wilbur and Orville Wright made the first functional airplane in their garage, proceeding to change the world forever.
Innovation happens in the absence of state direction. It’s not innovative if it was completely planned.
The authors go even further to point out that, as regulations bog down progress in various industries, oftentimes innovation takes place simply to outmanoeuvre the state . This can partially explain things like the emergence of private equity over public equity in the world of finance. One of the key benefits of private equity is not having to abide by the cumbersome regulations that govern public financial markets.
Key Points
This debate between whether or not the state can be a competent and worthy driver of innovation is a necessary one. Although the state continues to grow regardless of who wins this intellectual argument, it was thought that proponents of limited government had won this discussion in the late 20th century when the world experienced a sweeping wave of liberalisation.Today we find ourselves at a crossroads, with much of the Western world embracing or starting to consider a view of government that sees it as much more than just a steward of our rights. They see the state as a force of positive and competent change in a capacity that McCloskey and Mingardi believe is only possible through the market. That a more powerful and unrestricted government can reliably be a steward of society.
The idea of an entrepreneurial state as proposed by Mazzucato is a romantic one. It’s an idea that people can come together and through sheer will can make innovation happen. That some very smart people with fancy degrees and prestigious titles can steer society to an optimal location. The only problem with that is just about everything.
ETHAN YANGEthan is an Editorial Assistant at the American Institute for Economic Research and a graduate of Trinity College. He received a BA in Political Science alongside a minor in Legal Studies and Formal Organisations.
He currently serves as Local Coordinator at Students for Liberty and the Director of the Mark Twain Centre for the Study of Human Freedom at Trinity College.
Prior to joining AIER, he interned at organizations such as the American Legislative Exchange Council, the Connecticut State Senate, and the Cause of Action Institute.
Ethan is currently based in Washington D.C.
Thursday, 7 May 2020
Money Pumping Won’t Fix What’s Wrong with the Economic System
Central banks everywhere, including our own, are in the process of "expanding their balance sheets" to "counter the side-effects of lockdowns, to buy exploding government debt, to "stimulate" the economy, to avoid the possibility of a severe recession ... but as Frank Shostak argues in this guest post, both history and sound economics tell us that expanding the money stock to reverse an economic slump undermines the process of wealth generation, and it prolongs the slump. In other words ...
Money Pumping Won’t Fix What’s Wrong with the Economic System
by Frank ShostakTo counter the likely severe side effects of the "lockdowns" on the economy—introduced to prevent the spread of the coronavirus—the U.S Federal Reserve has embarked on massive expansion of its balance sheet. The size of the Fed’s assets jumped to $6.2 trillion in April this year from $3.9 trillion in April last year—an increase of 58.9 percent. [In NZ, the size of the Reserve Bank's assets jumped to $42.3 billion in March this year from $26.0 last year, an increase of 62.7%!]
In response to this pumping, the momentum of the money supply has jumped sharply, with the yearly growth rate climbing to 23.7 percent in the week ending April 13, from 13.1 percent in March and 2.4 percent in April 2019. [In NZ
, the increase to March was 8.3%. The April number is not yet in.]
It seems that the Fed is eager to avoid the possibility of a severe recession, hence the reason for its aggressive stance. By this way of thinking, an increase in the growth rate of the money supply will strengthen the demand for goods, which will in turn strengthen the production of these goods.
Most economists are of the view that during periods of economic difficulties it is the duty of the central bank to pursue aggressive monetary pumping to prevent the economy falling into a severe recessionary black hole. An important influence behind this way of thinking is the work of Milton Friedman.
In his writings, Friedman blamed central bank policies for causing the Great Depression in the 1930s. According to him, the Federal Reserve failed to pump enough reserves into the banking system to prevent a collapse in the money stock. As a result of this failure, Friedman argued, the money stock M1, which stood at $28.264 billion in October 1929, had fallen to $19.039 billion by April 1933—a decline of almost 33 percent. [1]
Friedman held that because of the fall in the money stock, economic activity followed suit. By July 1932, year-on-year industrial production had fallen by over 31 percent. Also, year-on-year the consumer price index (CPI) had plunged: by October 1932, the CPI had fallen by 10.7 percent.
In fact, contrary to Milton Friedman’s view, the fall in the money stock took place regardless of the Fed’s alleged failure to aggressively pump money. The sharp fall in the money stock was in response to the shrinking pool of wealth brought about by the previous loose monetary policies of the central bank.
Essentially, the pool of wealth is the quantity of consumer goods available in an economy to support future production. In the simplest of terms, an individual on an island is able to pick twenty-five apples an hour. With the aid of a picking tool, he is able to raise his output to fifty apples an hour. Making the tool, however, takes time.
During the time he is busy making the tool, the individual will not be able to pick any apples. In order to have the tool the individual must first have enough apples to sustain himself while he is busy making it. His pool of wealth or his means of sustenance for this period is the quantity of apples he has saved for this purpose.
The size of this pool determines whether a more sophisticated tool—a more sophisticated means of production—can be introduced. If this tool requires one year of work to build but the individual has only enough apples saved to sustain him for one month, then the tool will not be built—and the individual will not be able to increase his productivity.
More sophistication is added to the island scenario by the introduction of multiple individuals who trade with each other and use money. The essence, however, remains the same—the size of the pool of wealth (i.e., the stock of consumer goods) puts a brake on the development of more efficient methods of production.
Trouble erupts whenever the banking system makes it appear as if the pool of wealth is larger than it is in reality. When the supply of money expands, this does not enlarge the pool of wealth. This expansion instead sets in motion an exchange of newly-created money for existing goods. It gives rise to the consumption of goods that has not been preceded by the production of these goods. It leads to a decline in the means of sustenance. It is true that the expansion of money supply lifts the demand for goods, but this demand cannot support an expansion in the production of goods without an accompanying expansion in the pool of wealth.
If and for as long as the pool of wealth continues to expand, loose monetary policies give the impression that the expansion of the money supply is the key factor in economic growth.
That this is not the case however becomes apparent as soon as the pool of wealth begins to stagnate or shrink. Once this happens, the economy begins its downward cycle. The most aggressive monetary pumping will not reverse the plunge (for money cannot replace apples).
The existence of the central bank and fractional reserve banking permits commercial banks to generate credit that is not backed by the prior creation of real wealth. Once this unbacked credit is generated, it produces the same effect that the expansion of money does: it sets in motion the consumption of goods without the preceding production of these goods.
Whenever the extensive generation of credit out of "thin air" lifts the pace of wealth consumption above the pace of wealth production (as we have described above in relation to central bank monetary pumping) this starts to undermine the pool of wealth. Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to increase. In response to this, banks curtail the expansion of lending out of “thin air,” setting in motion a decline in the money stock. An example clarifies how this decline emerges:
Let us assume that an individual, Tom, places $1,000 in saving deposit for three months with Bank A. The bank lends the $1,000 to Mark for three months. On the maturity date, Mark repays the bank $1,000 plus interest. After deducting its fees, Bank A returns the original money plus interest to Tom.
In this scenario, Tom has lent his $1,000 for three months, i.e., he has transferred the $1,000 to Mark through the mediation of Bank A. The lending is fully backed, since existent money from Tom to Mark and then back via the mediation of Bank A.
Things are different when Bank A lends money out of “thin air.” For instance, let's say Tom exercises his demand for money by placing $1,000 in demand deposit with Bank A. By placing the money in demand deposit, he retains total claim to the $1,000. This means that the $1,000 is Tom’s exclusive property and no one is allowed to violate this right.
Now, Bank A may decide to take $100 from Tom’s demand deposit without Tom’s agreement and lend it to Mark. As a result, Bank A generates a demand deposit for Mark to the tune of $100. The money stock has now increased by $100. Because of this lending, we now have $1,100 that is only backed by $1,000 proper. In this case the $100 loaned also does not have an original lender, as it was generated out of “thin air” by Bank A.
When Mark repays the borrowed $100 to Bank A on the maturity date, it disappears. The money supply is now back at $1,000. If the bank continues to renew its lending out of thin air, then the stock of money will not decline. Indeed, the more lending out of “thin air” supplied by the bank, the greater the expansion of money supply will be.
The existence of fractional reserve banking (banks creating several claims on a given dollar) coupled with the subsequent unwillingness to renew and expand this lending out of “thin air” is the key factor in money disappearance. There must be a reason, however, why banks do not renew their “thin air” lending, causing this disappearance of money.
A key reason is the weakening of the process of wealth generation, which makes it much harder to find quality borrowers. [The result of a declining marginal productivity of debt.] Remember that what weakens this process is the previous expansion in money supply due to the easy monetary policies of the central bank.
Loose monetary policies set in motion an exchange of nothing for something—i.e., consumption that is not supported by the prior production of wealth. This results in the transfer of real wealth from wealth generators to non–wealth generators.
This means that a decline in the money supply (i.e., monetary deflation) emerges because of the prior monetary inflation that diluted the pool of wealth. It follows that a fall in the money supply is really just a symptom. The fall in the money stock comes in response to the damage that the previous monetary inflation caused to the process of wealth formation.
Note that between December 1920 and August 1924, the U.S. Federal Reserve was pursuing a very easy interest rate policy and as a result the yield on the three-month government Treasury bill fell from 5.9 percent in December 1920 to 1.9 percent by August 1924.
Because of the fall in the money stock from October 1929 to April 1933, various activities that had sprang up on the back of the previous monetary expansion found it hard going.
It is those non–wealth generating activities that ended up having the most difficulties in servicing their debt, since those activities never really generated any real wealth and were, so to speak, riding on the coattails of genuine wealth generators. [As Warren Buffett says, it's only once the tide goes out that you see who has been swimming naked.] After closing at 8.7 percent in November 1929, the yearly growth rate of bank loans had plunged to –20.8 percent by September 1932 (see chart). As a result the money supply (M1) collapsed (see chart).
With the fall in the money out of “thin air,” the support provided to non–wealth generators was arrested. This set in motion the demise of various non–wealth generating activities, which manifested in the economic nightmare that we now label the Great Depression.
Contrary to the popular view, it was not the Fed’s failure to pump aggressively during the 1930s that was behind the Great Depression of the 1930s, instead it was the loose monetary policy of the Fed during the 1920s.
Even if the central bank had been successful in preventing the fall in the money stock, if the pool of wealth had been declining this would not have been able to prevent the economic slump.
Contrary to popular thinking, the lifting of the money stock to reverse an economic slump undermines the process of wealth generation and prolongs the slump. Being the medium of exchange, money can only facilitate the flow of goods and services in an economy—it cannot expand the of production of goods and services as such. The key to this expansion is an increase in the pool of real wealth.
Most economists are of the view that during periods of economic difficulties it is the duty of the central bank to pursue aggressive monetary pumping to prevent the economy falling into a severe recessionary black hole. An important influence behind this way of thinking is the work of Milton Friedman.
In his writings, Friedman blamed central bank policies for causing the Great Depression in the 1930s. According to him, the Federal Reserve failed to pump enough reserves into the banking system to prevent a collapse in the money stock. As a result of this failure, Friedman argued, the money stock M1, which stood at $28.264 billion in October 1929, had fallen to $19.039 billion by April 1933—a decline of almost 33 percent. [1]
In fact, contrary to Milton Friedman’s view, the fall in the money stock took place regardless of the Fed’s alleged failure to aggressively pump money. The sharp fall in the money stock was in response to the shrinking pool of wealth brought about by the previous loose monetary policies of the central bank.
The Essence of the Pool of Wealth
Essentially, the pool of wealth is the quantity of consumer goods available in an economy to support future production. In the simplest of terms, an individual on an island is able to pick twenty-five apples an hour. With the aid of a picking tool, he is able to raise his output to fifty apples an hour. Making the tool, however, takes time.
During the time he is busy making the tool, the individual will not be able to pick any apples. In order to have the tool the individual must first have enough apples to sustain himself while he is busy making it. His pool of wealth or his means of sustenance for this period is the quantity of apples he has saved for this purpose.
The size of this pool determines whether a more sophisticated tool—a more sophisticated means of production—can be introduced. If this tool requires one year of work to build but the individual has only enough apples saved to sustain him for one month, then the tool will not be built—and the individual will not be able to increase his productivity.
More sophistication is added to the island scenario by the introduction of multiple individuals who trade with each other and use money. The essence, however, remains the same—the size of the pool of wealth (i.e., the stock of consumer goods) puts a brake on the development of more efficient methods of production.
Trouble erupts whenever the banking system makes it appear as if the pool of wealth is larger than it is in reality. When the supply of money expands, this does not enlarge the pool of wealth. This expansion instead sets in motion an exchange of newly-created money for existing goods. It gives rise to the consumption of goods that has not been preceded by the production of these goods. It leads to a decline in the means of sustenance. It is true that the expansion of money supply lifts the demand for goods, but this demand cannot support an expansion in the production of goods without an accompanying expansion in the pool of wealth.
If and for as long as the pool of wealth continues to expand, loose monetary policies give the impression that the expansion of the money supply is the key factor in economic growth.
That this is not the case however becomes apparent as soon as the pool of wealth begins to stagnate or shrink. Once this happens, the economy begins its downward cycle. The most aggressive monetary pumping will not reverse the plunge (for money cannot replace apples).
How Fractional Reserve Banking Leads to the Disappearance of Money
The existence of the central bank and fractional reserve banking permits commercial banks to generate credit that is not backed by the prior creation of real wealth. Once this unbacked credit is generated, it produces the same effect that the expansion of money does: it sets in motion the consumption of goods without the preceding production of these goods.
Whenever the extensive generation of credit out of "thin air" lifts the pace of wealth consumption above the pace of wealth production (as we have described above in relation to central bank monetary pumping) this starts to undermine the pool of wealth. Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to increase. In response to this, banks curtail the expansion of lending out of “thin air,” setting in motion a decline in the money stock. An example clarifies how this decline emerges:
Let us assume that an individual, Tom, places $1,000 in saving deposit for three months with Bank A. The bank lends the $1,000 to Mark for three months. On the maturity date, Mark repays the bank $1,000 plus interest. After deducting its fees, Bank A returns the original money plus interest to Tom.
In this scenario, Tom has lent his $1,000 for three months, i.e., he has transferred the $1,000 to Mark through the mediation of Bank A. The lending is fully backed, since existent money from Tom to Mark and then back via the mediation of Bank A.
Things are different when Bank A lends money out of “thin air.” For instance, let's say Tom exercises his demand for money by placing $1,000 in demand deposit with Bank A. By placing the money in demand deposit, he retains total claim to the $1,000. This means that the $1,000 is Tom’s exclusive property and no one is allowed to violate this right.
Now, Bank A may decide to take $100 from Tom’s demand deposit without Tom’s agreement and lend it to Mark. As a result, Bank A generates a demand deposit for Mark to the tune of $100. The money stock has now increased by $100. Because of this lending, we now have $1,100 that is only backed by $1,000 proper. In this case the $100 loaned also does not have an original lender, as it was generated out of “thin air” by Bank A.
When Mark repays the borrowed $100 to Bank A on the maturity date, it disappears. The money supply is now back at $1,000. If the bank continues to renew its lending out of thin air, then the stock of money will not decline. Indeed, the more lending out of “thin air” supplied by the bank, the greater the expansion of money supply will be.
The existence of fractional reserve banking (banks creating several claims on a given dollar) coupled with the subsequent unwillingness to renew and expand this lending out of “thin air” is the key factor in money disappearance. There must be a reason, however, why banks do not renew their “thin air” lending, causing this disappearance of money.
What Causes Banks to Curtail Lending?
A key reason is the weakening of the process of wealth generation, which makes it much harder to find quality borrowers. [The result of a declining marginal productivity of debt.] Remember that what weakens this process is the previous expansion in money supply due to the easy monetary policies of the central bank.
Loose monetary policies set in motion an exchange of nothing for something—i.e., consumption that is not supported by the prior production of wealth. This results in the transfer of real wealth from wealth generators to non–wealth generators.
This means that a decline in the money supply (i.e., monetary deflation) emerges because of the prior monetary inflation that diluted the pool of wealth. It follows that a fall in the money supply is really just a symptom. The fall in the money stock comes in response to the damage that the previous monetary inflation caused to the process of wealth formation.
Note that between December 1920 and August 1924, the U.S. Federal Reserve was pursuing a very easy interest rate policy and as a result the yield on the three-month government Treasury bill fell from 5.9 percent in December 1920 to 1.9 percent by August 1924.
By December 1925 the yield had climbed back to 3.5 percent before declining to 3.1 percent by April 1926.
Thereafter the yield followed a rising trend, closing at 5.1 by May 1929. (Observe that the average of the yield on the three-month Treasury Bill from September 1924 to October 1929 stood at 3.5 percent—below the average of 3.9 percent from December 1920 to August 1924.)
Coupled with the increase in money supply from January 1927 to October 1929 (the yearly growth rate of M1 money supply shot up from –2.2 percent in January 1927 to almost 8 percent by October 1929), setting in motion an economic boom, and inflicting severe damage on the process of wealth generation, i.e., severely undermined the pool of wealth.
Coupled with the increase in money supply from January 1927 to October 1929 (the yearly growth rate of M1 money supply shot up from –2.2 percent in January 1927 to almost 8 percent by October 1929), setting in motion an economic boom, and inflicting severe damage on the process of wealth generation, i.e., severely undermined the pool of wealth.
Note that the yearly growth rate of industrial production by April 1929 stood at 22 percent! Also, note that the previous massive booms had likely damaged the pool of wealth when the yearly growth rate of industrial production had stood at 42 percent in December 1922, and 28 percent in June 1926.
Because of the fall in the money stock from October 1929 to April 1933, various activities that had sprang up on the back of the previous monetary expansion found it hard going.
With the fall in the money out of “thin air,” the support provided to non–wealth generators was arrested. This set in motion the demise of various non–wealth generating activities, which manifested in the economic nightmare that we now label the Great Depression.
Summary and Conclusions
Contrary to the popular view, it was not the Fed’s failure to pump aggressively during the 1930s that was behind the Great Depression of the 1930s, instead it was the loose monetary policy of the Fed during the 1920s.
Even if the central bank had been successful in preventing the fall in the money stock, if the pool of wealth had been declining this would not have been able to prevent the economic slump.
Contrary to popular thinking, the lifting of the money stock to reverse an economic slump undermines the process of wealth generation and prolongs the slump. Being the medium of exchange, money can only facilitate the flow of goods and services in an economy—it cannot expand the of production of goods and services as such. The key to this expansion is an increase in the pool of real wealth.
______________________________________________________________________________
1.Milton Friedman and Rose Friedman, Free To Choose: A Personal Statement (Melbourne: Macmillan Company of Australia, 1980), pp. 70–90.
Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. His post previously appeared at the Mises Wire.
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Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. His post previously appeared at the Mises Wire.
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Monday, 6 April 2020
"Stimulus" from the Santa Claus state will fail us as badly as their phony boom
The world was already awash in debt, borrowed into thin air by the banking system. The cracks had already begin to open up. In setting interest rates to such historically-low levels the financial engineers had already red-lined everything, grievously discouraging savings, grossly inflating every single asset price beyond anything approaching reason, and grotesquely distorting a structure of production already bruised from the disaster of 2008 from which it had never been allowed to repair itself.
But now these bastards have an alibi for the collapse they'd set in motion. This phoney-baloney bubble was already bursting, spectacularly, just as this pandemic hit the globe. It's killing people. But it's rescued the creators of financial apocalypse because everyone's to focused on coronavirus to see their fingerprints for what they are. And everyone can continue to ignore the reality that should be staring them in the face: that we have been consuming the seed corn for decades, and we are just beginning to face the consequences; that for decades now we have over-invested in speculative bubbles, under-invested in productivity-increasing assets, and squandered borrowed money on consumption; that rather than boost productivity, we have lowered productivity via mal-investment, propped up unproductive sectors with immense sums of borrowed money, and finessed the figures to make things look like we were moving forwards.
'Cos the harsh reality is that we weren't moving forwards at all. And it wasn't the pandemic that exposed the lie. It's this pandemic that's allowing the liars to escape responsibility for the destruction that their policies of lose lending and fiscal stimulus unleashed.
And now -- as we're all locked up under home arrest, with nobody allowed to go out and make stuff -- with governments worldwide sending people cheques to keep buying the dwindling amount of stuff that is being made -- mainstream economists everywhere are still scratching their chins on new "fixes," as if "stimulus" from the Santa Claus state will save us instead of sink us all.
For years they've ignored the coming consequences of their economic programme -- which is based on nothing more than promoting the bizarre idea that economic prosperity means living on debt forever. They watched, these central bank planners and mainstream economic engineers, as interest rates had to go ever lower to get the tiniest amount of effect, and as the marginal productivity of every dollar of new debt sunk ever lower. They talked smack about "rock-star economies" and "tech-led booms" while refusing to see the reality in front of them, or to ask themselves the slightest question about their methods.
And now that the consequences are upon us all, they're arguing about a "v-shaped recovery" or a "u-shaped recovery" as if that isn't just fantasy land. And instead of being exposed as the charlatans that they are, instead they're hiding behind the "exogenous shock" of the pandemic as if their gross irresponsibility wasn't responsible for leaving us so unable to cope.
And on panels and advisory committees everywhere, the very people who are responsible for the global economic meltdown their own advice set in motion are now being called on to deliver advice on what to do next.
It's like asking an arsonist how to rebuild after the fire he himself set.
It's grotesque.
LISTEN: And how little intelligent commentary is there at the moment analysing the twin problems of the bursting bubble coupled with the pandemic -- and the irresponsible government and central bank responses. Here's one of the few that I've found: Professors Joseph Salerno and Peter Klein join Tom Woods "to discuss the economics of the extraordinary episode we are currently living through, as well as the likely consequences of how the U.S. federal government and the Federal Reserve Bank are responding."
Tuesday, 12 June 2018
QotD: "The world has so much debt that the cracks could happen anywhere... "
"The world has so much debt that the cracks could happen anywhere... If debt were a drug, we would outlaw it. But we also know that people get hooked on illegal drugs all the time... [So we have too much] debt and (not much) deleveraging."~ John Mauldin, who says the Debt Clock is Ticking
"Any economist can paint a rosy picture by, for example, showing rising GDP. If you object that debt is rising with GDP, the economist switches to a chart of debt/GDP. He will tell you that the solution is to grow GDP with the right fiscal and regulatory policies.
"However, we can look at how much additional GDP is added for each newly-borrowed dollar. This is called marginal productivity of debt. This [below] shows a clear picture, a secular decline over many decades... this is a long-term falling trend."
~ Keith Weiner on the Falling Productivity of Debt
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