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By Dr Frank Shostak, on 16 May 13
In his New York Times article of May 7, columnist Bruce Bartlett laments that given the current state of economic affairs we need more Keynesian medicine to fix the US economy. According to Bartlett the core insight of Keynesian economics is that there are very special economic circumstances in which the general rules of economics don’t apply and are in fact counterproductive. This happens when interest rates and inflation rate are so low that monetary policy becomes impotent; an increase in the money supply has no boosting effect because it does not lead to additional spending by consumers or businesses. Keynes called this situation a “liquidity trap”. Keynes wrote,
There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest [1]
Bartlett holds that under such circumstances government spending can be highly stimulative because it causes money that is sitting idle in bank reserves or savings accounts to circulate and become mobilized through consumption or investment. Thus monetary policy becomes effective once again. Bartlett regards this as an extremely important insight that policy makers have yet to grasp. According to our columnist, despite massive monetary pumping by the Fed since 2008, it has produced very little boosting effect on the economy. The Fed’s balance sheet jumped from $0.897 trillion in January 2008 to $3.3trillion in early May 2013. The Federal Funds
Rate target stood at 0.25% in early May against 3% in January 2008.
According to Bartlett, in normal times one would expect such an increase in money pumping to be highly inflationary and sharply raise market interest rates. That this has not happened says Bartlett, is a proof that we have been in a liquidity trap for several years. Bartlett concludes that we needed a lot more government spending than we got to get the economy out of its doldrums. Note also that Nobel Laureate in economics Paul Krugman holds similar views. For them what is needed is a re-activation of the monetary flow that for some unknown reasons got stockpiled in the banking system. Observe that in the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure.
Why is money not the driver of economic growth?
Contrary to popular thinking monetary flow has nothing to do with an economic growth as such. Money is simply a medium of exchange and nothing more than that. Also, note that people don’t pay with money but rather with the goods and services that they have produced.
For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange. Again, money is just employed to exchange goods and services. Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer.
What drives the economic growth is savings that are used to fund the increase and the enhancement of tools and machinery i.e. capital goods or the infra-structure that permits the increase in final goods and services i.e. real wealth to support people’s lives and well beings.
Contrary to popular thinking, an increase in the monetary flow is in fact detrimental to economic growth since it sets in motion an exchange of something for nothing – it leads to the diversion of real wealth from wealth generators to wealth consumers. This in the process reduces the amount of wealth at the disposal of wealth generators thereby diminishing their ability to enhance and maintain the infrastructure. This in turn undermines the ability to grow the economy.
What is behind the so called liquidity trap?
The fact that so far the Fed’s massive pumping has not resulted in a massive monetary flood should be regarded as good news. Imagine that if all that pumping were to enter the economy it would have entirely decimated the machinery of wealth generation and produced massive economic impoverishment. It seems that market forces have so far managed to withstand the onslaught by the US central bank. What allowed this resistance is not some kind of ideology against aggressive pumping by the Fed (in fact most experts and commentators are of the view that the Fed should push a lot of money in difficult times) but the fact that the process of real wealth generation has been severely damaged by the previous loose monetary policies of Greenspan’s and Bernanke’s Fed.
The badly damaged process of wealth generation has severely impaired true economic growth, and obviously this has severely reduced the number of good quality borrowers and so has reduced banks’ willingness to lend. Remember that in essence banks lend real wealth by means of money. They are just intermediaries. Obviously, then, if wealth formation is getting impaired, less lending can be done. We suggest that it is this fact alone that explains why all the pumping by the Fed has ended up stacked in the banking system. So far in early May banks have been sitting on over $1.7 trillion in surplus cash. In January 2008 surplus cash stood at $2.4 billion.
Given the high likelihood that the process of real wealth generation has been severely damaged this means that the pace of wealth generation must follow suit. Now, contrary to popular thinking an increase in government spending cannot revive the process of wealth generation, but on the contrary it can only make things much worse. Remember: government is not a wealth generating entity so in this sense increases in government spending generate the same damaging effect as monetary printing does (it leads to the diversion of wealth from wealth generators to wealth consumers). Observe that in 2012 US Government outlays stood at $3.538 trillion, an increase of 98% from 2000.
As long as the rate of growth of the pool of real wealth stays positive, this can continue to sustain productive and nonproductive activities.
Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more wealth than the amount it releases.
This excessive consumption relative to the production of wealth leads to a decline in the pool of wealth.
This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. (The shrinking pool of real wealth exposes the commonly accepted fallacy that loose monetary and fiscal policies can grow the economy.)
Needless to say, once the economy falls into a recession because of a falling pool of real wealth, any government or central-bank attempts to revive the economy must fail.
This means that a policy such as lifting government outlays to counter the liquidity trap will make things much worse.
Not only will these attempts not revive the economy; they will deplete the pool of real wealth further, thereby prolonging the economic slump.
Likewise any policy that forces banks to expand lending “out of thin air” will further damage the pool and will further reduce banks’ ability to lend.
Again the foundation of lending is real wealth and not money as such. It is real wealth that imposes restrictions on banks’ ability to lend. (Money is just the medium of exchange, which facilitates the flow of real wealth.)
Note that without an expanding pool of real wealth any expansion of bank lending is going to lift banks’ nonperforming assets.
Summary and conclusion
Contrary to various experts we suggest that in the current economic climate an increase in government outlays is not going to make Fed’s loose monetary policies more effective as far as boosting economic activity is concerned.
On the contrary, it will weaken the process of wealth generation and will retard economic growth.
What is needed to get the economy going is to close all loopholes for money creation and drastically curtail government outlays.
This will leave a greater amount of wealth in the hands of wealth generators and will boost their ability to grow the economy.
[1] John Maynard Keynes, The General Theory of Employment, Interest, and Money, MacMillan & Co. Ltd. (1964), p. 207.
By Dr Frank Shostak, on 9 May 13
According to a European Central Bank Governing Council member Ewald Nowotny, Federal Reserve Chairman Ben Bernanke sees no risk to inflation in the United States. According to Nowotny, Bernanke had given a “very optimistic” portrayal of the U.S. outlook.
“They see absolutely no danger of an expansion in inflation,” Nowotny said. Bernanke had said U.S. inflation should be 1.3 percent this year.
Fed forecasts put inflation by the end of this year in a range of 1.3 to 1.7 percent. The yearly rate of growth of the consumer price index (CPI) stood at 1.5% in March against 2% in February and 2.7% in March last year.
Also the growth momentum of the core CPI (the CPI less food and energy) has eased in March from the month before. Year-on-year the rate of growth has softened to 1.9% from 2% in February and 2.3% in March last year.
For Bernanke and most experts the key factor that sets the foundation for healthy economic fundamentals is a stable price level as depicted by the consumer price index.
On this way of thinking a stable price level doesn’t obscure the visibility of the relative changes in the prices of goods and services.
Consequently, it is held, this leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals.
A stable price level enables businesses to see clearly market signals that are conveyed by the relative changes in the prices of goods and services.
For instance, let us say that a relative strengthening in people’s demand for potatoes versus tomatoes took place. This relative strengthening, it is held, is going to be depicted by the relative increase in the prices of potatoes versus tomatoes.
Now in a free market businesses pay attention to consumer wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumer wishes will lead to the wrong production mix of goods and services and will lead to losses.
Hence in our case businesses, by paying attention to relative changes in prices, are likely to increase the production of potatoes versus tomatoes.
On this way of thinking if the price level is not stable then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.
This leads to a misallocation of resources and to the weakening of economic fundamentals. In short, unstable changes in the price level obscure changes in the relative prices of goods and services.
Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.
Based on this way of thinking it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability i.e. a stable price level.
By means of various quantitative methods the Fed’s economists have established that at present policy makers must aim at keeping price inflation at 2%. Any significant deviation from this figure constitutes deviation from the growth path of price stability.
Observe that Fed policy makers are telling us that they have to stabilize the price level in order to allow the efficient functioning of the market economy.
Obviously this is a contradiction in terms since any attempt to manipulate the so called price level implies interference with markets and hence leads to false signals as conveyed by changes in relative prices.
By means of setting targets to interest rates and by means of monetary pumping it is not possible to strengthen economic fundamentals, but on the contrary it only makes things much worse. Here is why.
Policy of price stability leads to more instability
Let us say that the so called price level is starting to exhibit a visible decline in growth momentum. To prevent this decline the Fed starts to aggressively push money into the banking system.
As a result of this policy, after a time lag, the price level has stabilized. Should we regard this as a successful monetary policy action? The answer is categorically no.
Given that monetary pumping sets in motion the diversion of wealth from wealth generating activities to non-wealth generating activities obviously this leads to the weakening of the wealth generation process and to economic impoverishment.
Note that the economic impoverishment has taken place despite price level stability. Also, note that in order to achieve price stability the Fed had to allow an increase in the growth momentum of its balance sheet and consequently in the growth momentum of the money supply.
It is the fluctuations in the balance sheet and the subsequent fluctuations in the growth momentum of money supply that matter here. It is this that sets in motion the menace of the boom bust cycle regardless of whether the price level is stable or not.
While increases in money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors.
Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place.
In other words, while money growth is buoyant prices might display low increases.
Clearly, if we were to pay attention to the so called price level and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.
On this, Rothbard wrote,
“The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware”
(America’s Great Depression, Mises Institute, 2001 [1963], p. 153).
During the 1926 to 1929 the alleged stability of the price level caused most economic experts including the famous American economist Irving Fisher to conclude that US economic fundamentals were doing fine and that there was no threat of an economic bust.
The yearly rate of growth of the CPI displayed stability during 1926 to 1929 (see chart). Most experts have ignored the fact that the yearly rate of growth of the US central bank balance sheet jumped to 42% by June 1928 from minus 14% in February 1927.
The sharp fall in the growth momentum of the Fed’s balance sheet after June 1928 (see chart) set in motion an economic bust and the Great Depression.
At present the Fed continues to push money aggressively into the banking system with its balance sheet standing at $3.3 trillion as at the end of April against $0.9 trillion in January 2008. We suggest however that a fall in the growth momentum of AMS since October 2011 raises the likelihood of a bust in the months ahead.
If one adds to all this the possibility that the process of real wealth generation has been badly damaged by the Fed’s loose policies it shouldn’t surprise us that we could enter a severe slump in the months ahead.
Summary and conclusion
For most economists the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability. We suggest that by means of monetary policies that aim at stabilizing the price level the Fed actually undermines economic fundamentals.
By Dr Frank Shostak, on 15 April 13
Many economists and financial commentators believe that in the unregulated market of the internet economy, new forms of money can be created that bypass central-bank and government supervision. The latest development is the emergence of a new electronic means of exchange, the bitcoin (BTC). The BTC is the invention of a programmer who called himself Satoshi Nakamote, who launched the bitcoin on January 3, 2009.
The basic idea behind the BTC is to create, by means of a mathematical algorithm, a substance that is scarce and fungible.
Nakamote devised a software system that enabled people obtain bitcoins as a reward for solving complex mathematical puzzles. The resulting coins are then used for online trading. Nakamote also arranged that the number of BTC can never exceed 21 million.
Some experts maintain that BTC will displace the existent fiat money and will usher in a new era of free banking, which will finally put to rest the menace of inflation.
Unfortunately, this is a pipe dream. Electronic money will not replace fiat paper money. The belief that it can stems from a failure to understand the nature and function of money and how it emerges on the market.
To see where this view goes wrong, let’s first see how money comes about. Money emerges out of barter conditions that permit more complex forms of trade and economic calculation. The distinguishing characteristic of money is that it is the general medium of exchange, evolved from private enterprise from the most marketable commodity. On this Mises wrote,
There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money. [1]
In short, money is the thing for which all other goods and services are traded. Furthermore, money must emerge as a commodity. An object cannot be used as money unless it already possesses an objective exchange value based on some other use. The object must have a pre-existing price for it to be accepted as money.
Why? Demand for a good arises from its perceived benefit. For instance people demand food because of the nourishment it offers. With regard to money, people demand it not for direct use in consumption, but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value, it is exchangeable in terms of other goods and services.
The benefit money offers is its purchasing power, i.e. its price in terms of goods and services. Consequently for something to be accepted as money, it must have a pre-existing purchasing power: a price. This price could have only emerged if it had an exchange value established in barter.
Once a thing becomes accepted as the medium of exchange, it will continue to be accepted even if its non-monetary usefulness disappears. The reason for this acceptance is that people now possess previous information about its purchasing power. This in turn enables them to form the demand for money.
In short the key to the acceptance is the knowledge of the previous purchasing power. It is this fact that made it possible for governments to abolish the convertibility of paper money into gold, thereby paving the way for the introduction of the paper standard. Again the crux here is that an object must have an established purchasing power for it to be accepted as general medium of exchange, i.e. money.
In today’s monetary system, the core of the money supply is no longer gold, but coins and notes issued by governments and central banks. Consequently coins and notes constitute the standard money we know as cash and employ in transactions. Notwithstanding this, it is the historical link to gold that makes paper money acceptable in exchange.
Observe that a bitcoin (BTC) is not a thing, it is a unit of a non-material virtual currency. A BTC has no material shape, hence from this perspective the notion that it could somehow replace fiat money is not defensible.
BTC can function only as long as individuals know that they can convert it into fiat money, i.e. cash on demand (see, e.g., Lawrence H. White “The Technology Revolution And Monetary Evolution,” Cato Institute’s 14th annual monetary conference, May 23, 1996).
Without a frame of reference or a yardstick, the introduction of new forms of settling transactions is not possible. On this Rothbard wrote,
Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media – in almost all exchanges – and these are called money. [2]
It was through a prolonged process of selection that people had settled on gold as the most marketable commodity. Gold therefore had become the frame of reference for various forms of payments. Gold formed the basis for the value of today’s fiat money.
Besides, BTC is not a new form of money that replaces previous forms, but rather a new way of employing existent money in transactions.
The fact that the price of BTC has jumped massively lately implies that people assign a high value to the services it offers in employing existent money. This is no different from the case when in a country which imposes restrictions on taking money out people will agree to pay a high price for various means to secure their money.
[1] Ludwig von Mises, The Theory of Money and Credit, pp. 32-33.
[2] Murray N. Rothbard, What Has Government Done to Our Money?
By Dr Frank Shostak, on 9 April 13
On Thursday April 4 the Federal Reserve Vice Chairman Janet Yellen said in Washington the Federal Open Market Committee (FOMC) should be prepared to alter its $85 billion monthly pace of bond buying based on changes in the economic outlook.
Yellen’s comments support a proposal by St. Louis Fed President James Bullard to reduce the pace of purchases as the economy improves, or expand it if the economy weakens.
Also, the Fed Chairman Ben Bernanke said last month the FOMC is considering this strategy to “appropriately calibrate” its policy.
The view that the Fed should calibrate its monetary policy in line with the likely state of the economy stems from the popular way of thinking that the role of the central bank is to make sure that the economy stays on a path of balanced economic growth.
According to this way of thinking the economy is seen as some kind of space ship that has deviated from its trajectory.
To bring it back onto the correct path, policy makers must give it an external push. So if the push in terms of loose monetary policy doesn’t produce the required results then policy makers must become more aggressive until the space ship is brought onto the desired path.
Conversely, if the economy, for whatever reason, is pushed onto the path of high inflation, then the central bank by means of a tighter monetary stance must bring the space ship onto the “correct” path.
Within this way of thinking, given that the economy is currently way below its right growth path there are plentiful of unemployed resources. Consequently, this permits policy makers to adopt a very aggressive loose stance without igniting inflation.
We suggest that this way of thinking is erroneous. An economy is about human beings and not about a space ship that follows along a growth path.
A policy that attempts to bring the economy onto the “correct” trajectory leads to a diversion of wealth from wealth generators to non–wealth-generating activities, thereby weakening the process of the wealth generation, i.e. it leads to an economic impoverishment.
In the meantime, the latest economic data seems to support the view that the Fed is unlikely to reverse its loose monetary stance soon.
The ISM manufacturing activity index fell to 51.3 in March from 54.2 in the previous month – whilst the ISM services index eased to 54.4 last month from 56 in the month before.
Non farm employment increased in March by 88,000 against the median forecast of economists for an increase of 190,000. Year-on-year employment increased by 1.91 million after rising by 2.027 million in February and an increase by 2.03 million in January. Additionally the diffusion index of employment in the private sector fell to 54.3 last month from 59.6 in February and 65.2 in December last year.
Elsewhere we have suggested that fluctuations in economic data are set in motion by fluctuations in the growth momentum of money supply as depicted by our monetary measure AMS.
After closing at 2.2% in June 2010 the yearly rate of growth of AMS climbed to 14.8% by October 2011.
Afterwards the yearly rate of growth has been following a declining path closing at 7.3% in March this year. (A change in the money supply rate of growth doesn’t affect all activities instantly – there is a time lag. For some activities the time lag is short while for others it is much longer).
We suggest that the fact that the growth momentum of AMS has been declining since October 2011 implies that downward pressure on economic activity has already been set in motion.
As time goes by the supporting effect on economic activity from the rising growth momentum of AMS during June 2010 to October 2011 is likely to weaken whilst the fall in growth momentum since October 2011 onward is likely to start to dominate the economic scene.
Based on the lagged growth momentum of real AMS (AMS adjusted for CPI) we suggest that the growth momentum of industrial production could come under strong pressure from the second half of this year. This is likely to undermine the growth momentum of employment (see chart).
We hold that massive monetary pumping by the Fed not only didn’t provide support to the economy but on the contrary has severely damaged the process of wealth generation. Elsewhere we have shown that it is the formation of real wealth that funds and thereby supports underlying economic growth.
This runs contrary to the popular way of thinking that loose monetary policy can somehow fund and grow an economy. All that loose monetary policy can do is to give rise to various non-productive bubble activities and thereby undermine underlying economic growth.
As long as the pool of real wealth is expanding loose monetary policies can give the impression that they grow the economy. Once however the pool becomes stagnant, or starts to decline, the economy follows suit.
In this case if central bank policy makers try to enforce aggressive monetary pumping this weakens the wealth generation process and weakens the pool of funding further. There are signs that this might be already happening. As a rule when the central bank pushes money into the banking system banks lend this money out thus boosting the money supply rate of growth and after a time lag this boosts the economic activity.
At present this mechanism is not working. Despite a massive increase in the Fed’s pumping as depicted by its balance sheet, banks so far have chosen to sit on the pumped cash rather than lend it out. In early April the Fed’s balance sheet stood at $3.2 trillion against $0.9 trillion in January 2008. Banks surplus cash jumped to $1.726 trillion in early April from $1.578 trillion in January. In January 2008 surplus cash stood at around $2.4 billion.
As the pool of real wealth comes under pressure banks find it much harder to acquire good quality borrowers, hence the supply of lending is slowing down. Now if the Fed were to attempt to force banks to increase lending this is not going to help real economic growth if the pool of funding is under pressure. The best thing the Fed could do to help the economy is to do nothing as soon as possible. This will strengthen wealth generators and in turn the wealth generation process.
Summary and conclusion
Some Fed officials have suggested that once the US economy gains strength it will be appropriate to reduce monetary pumping. The latest economic data seems to support the view that the US central bank is unlikely to reverse its loose monetary stance soon. The ISM manufacturing and services indexes have weakened last month whilst employment increased in March well below economists’ expectations. We suggest that the fact that the growth momentum of AMS has been declining since October 2011 implies that downward pressure on economic activity has already been set in motion. We also hold that the process of wealth generation was badly damaged by loose monetary policies of the Fed. This runs the risk of a prolonged economic slump. The best thing the Fed could do to help the economy is to do as soon as possible nothing.
By Dr Frank Shostak, on 12 March 13
According to Ben Bernanke, the Chairman of the Federal Reserve Board, the pulling back on aggressive policy measures too soon would pose a real risk of damaging a still-fragile recovery.
The Fed Chief is of the view that for the purposes of financial stability a continuation of the central bank’s aggressive stimulus conducted through purchases of Treasury and mortgage securities remains the optimal approach.
In response to the financial crisis and the deep recession of 2007-9, the Fed not only lowered official rates to effectively zero, but also bought more than $2.5 trillion in assets in an effort to keep long-term rates low.
But is it true that a loose monetary stance provides support to economic activity? Furthermore, if this is the case then why after such an aggressive lowering of interest rates and massive expansion of the Fed’s balance sheet does the economic recovery remain fragile?
Surely if loose monetary policy could revive economic activity then a very loose policy should produce very strong so called economic growth – so why hasn’t it happen this way?
Contrary to popular thinking, loose monetary policy, which leads to a misallocation of resources, weakens the economy’s ability to generate final goods and services, i.e. real wealth.
This means that loose monetary policy not only cannot provide support to the economy but on the contrary undermines the foundations for economic growth.
The so-called recovery that Bernanke and most commentators are referring to is nothing more than the revival of various non-productive or bubble activities, which in a true free market environment wouldn’t emerge in the first place.
These bubble activities are funded by means of loose monetary policies, which divert real wealth from wealth generating activities thereby weakening the process of wealth generation.
From this we can infer that a still fragile economic recovery, i.e. a fragile revival of bubble activities, despite the very loose Fed monetary stance could mean that the wealth formation process must have been badly hurt. (Note that notwithstanding very loose monetary policies, without the expanding pool of real wealth it is not possible to stage a strong recovery of bubble activities).
If our assessment is valid then obviously the sooner the loose stance is reversed the better it is going to be for the economy.
Needless to say, bubble activities are not going to like this since the diversion of real wealth to them from wealth generators will slow down or cease all together.
A fall in economic activity in this case is in fact the demise of various bubble activities.
Contrary to Bernanke, we can conclude that the continuation of loose monetary policies could only lead to financial instability and prolong the economic crisis.
Some commentators, among them Bernanke himself, blame the fragile economic recovery on banks’ reluctance to aggressively lend out the money pumped by the Fed. Without the cooperation of banks, the Fed’s aggressive pumping is not translated into a strong expansion in the money supply.
On this the growth momentum of commercial banks lending shows softening. Year-on-year the rate of growth of real estate loans fell to 0.1% in February from 2.3% in the month before.
The yearly rate of growth of business loans eased to 11.3% last month from 13.5% in January.
Also the growth momentum of commercial banks consumer loans has eased last month. The yearly rate of growth softened to 3.8% from 3.9% in January.
The pace of overall commercial bank lending, which includes lending to government, has eased visibly last month. Year-on-year the rate of growth fell to 3.7% from 6.2% in January.
The growth momentum of inflationary lending remains in a visible decline with the yearly rate of growth closing at 6.2% in February from 11.3% in January.
The banks’ reluctance to lend is also seen in the strong increase in their holdings of surplus cash. In the week ending March 6 excess cash reserves stood at $1.648 trillion against $1.546 trillion in March last year and $0.8 trillion in January 2009. Also note that in the week ending March 6 the yearly rate of growth of Fed’s balance sheet jumped to 7.6% from 4.7% in February.
Once the pool of real wealth comes under pressure, the number of good quality borrowers tends to decline. Obviously this tends to reduce the supply of lending. We suggest that if the pool of real wealth is stagnant or worse declining then regardless of whether banks will start lending or not, no meaningful economic expansion can emerge.
Summary and conclusion
According to the Fed Chairman Ben Bernanke pulling back on aggressive policy measures too soon would pose a threat to economic recovery. Our analysis indicates, however, that the sooner the Fed reverses its loose stance the better it is going to be for the underlying fundamentals of the US economy. A reversal in the current loose stance, whilst good news for wealth generators, is going to undermine various non-productive wealth consuming activities. Meanwhile the growth momentum of US commercial bank lending displays a visible weakening.
By Dr Frank Shostak, on 29 January 13
On January 22, 2013 policy makers of the Bank of Japan (BOJ) voted for a 2% inflation target, to be achieved “at the earliest possible time”, with a planned 13 trillion yen a month ($145 billion) in extra securities buying. The action came after months of intense pressure on the BOJ from the country’s new Prime Minister, Shinzo Abe, to take more aggressive action to boost the economy.
Mr. Abe maintains that deflation will undermine any efforts to grow the economy and the government and the central bank must act together to get prices rising again.
The yearly rate of growth of the consumer price index (CPI) stood at minus 0.1% in December against minus 0.2% in the previous month. This was the 7th consecutive monthly decline.
Furthermore, the yearly rate of growth of industrial production fell to minus 5.5% in November from minus 4.5% in the previous month.
Most economists are in agreement with Prime Minister Abe that falling prices, labeled as deflation, are a major threat to Japanese economy. They are in agreement with Prime Minister Abe that the way out of the economic slump is for the central Bank of Japan (BOJ) to aggressively increase the money supply. This, it is held, will raise inflationary expectations and lift people’s willingness to spend, which in turn will set an economic recovery in motion. In short, the key to economic recovery is lifting the demand for goods and services by arresting the fall in prices.
However, many experts were disappointed by the BOJ’s latest plans because the planned expanded asset purchases will not begin until 2014.
Also, many of the securities the Bank of Japan will be purchasing are in the form of short-term debt that will quickly mature hence experts hold that the yearly additional purchase of assets will equal less than $150 billion per year. By contrast, experts argue, the Fed’s balance sheet is expected to expand by a trillion dollars in 2013.
Is a fall in prices bad news?
Contrary to conventional wisdom, there is nothing wrong with declining prices. In fact, it is the essential characteristic of a free-market economy to select as money those commodities the purchasing power of which is growing over time. What signifies an industrial market economy under commodity money such as gold is that the prices of goods follow a declining trend. According to Salerno,
In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75 percent per year, while real income rose by about 85 percent, or around 5 percent per year.[1]
In a free market, the rising purchasing power of money, i.e., declining prices, is the mechanism that makes the great variety of goods produced accessible to many people.
On this, Murray Rothbard wrote,
Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.[2]
It is argued by most experts, however, that a general fall in prices could be “bad news,” for it slows down people’s propensity to spend, which in turn undermines investment in plant and machinery. All this sets in motion an economic slump. Moreover, as the slump further depresses the prices of goods, this intensifies the pace of economic decline. But does it all make sense?
According to Salerno,
Thus, for example, a mainframe computer sold for $4.7 million in 1970, while today one can purchase a PC that is 20 times faster for less than $1,000. Note that the substantial price deflation in the high-tech industries did not impair and, in fact, facilitated the enormous expansion of profits, productivity and outputs in these industries. This reflected in the fact that in 1980 computer firms shipped a total of 490,000 PCs while in 1999 their shipments exceeded 43 million units despite that fact that quality-adjusted prices had declined by over 90 percent in the meantime[3]
Moreover, it does not make any sense to argue that a fall in prices as a result of real wealth expansion causes consumers to postpone purchases of goods and services. To suggest that consumers postpone their buying of goods because prices are expected to fall would mean that people have abandoned any desire to live in the present. Without the maintenance of life in the present, however, no future life is conceivable.
Should “bad” price deflation be fought against?
Even if we were to accept that declines in prices in response to an increase in the production of goods promotes the well-being of individuals, what about the case when a fall in prices is associated with a decline in economic activity? Surely this type of deflation is bad news and must be fought against.
Whenever a central bank pumps money into the economy this benefits various individuals engaged in activities that sprang up on the back of loose monetary policy, and it occurs at the expense of wealth generators.
Through loose monetary policy, the central bank gives rise to a class of people who unwittingly become consumers without the prerequisite of making any contribution to the pool of real wealth. Their consumption is made possible through the diversion of real wealth from wealth producers.
Not only does the easy monetary policy push the prices of existing goods higher, but the monetary pumping also gives rise to the production of goods which are only demanded by non-wealth producers.
Now, goods that are consumed by wealth producers are never wasted, for these goods sustain wealth generators in the production of goods and services. This is not so, however, with regard to non-wealth producers who only consume and produce nothing in return.
As long as the pool of wealth is growing, various goods and services that are patronized by non-wealth producers appear to be profitable. However, once the central bank reverses its loose monetary stance, the diversion of real income from wealth producers to non-wealth producers is arrested. This in turn undermines the demand of non-wealth producers for various goods and services, thereby exerting downward pressure on their prices. The fall in the prices of various goods and services signifies that there was never a genuine demand for these goods.
The tighter monetary stance that undermines various activities which sprang up on the back of previous loose monetary policy arrests the bleeding of wealth generators. The fall in the prices of various goods and services comes simply in response to the arrest of the impoverishment of wealth producers and hence signifies the beginning of economic healing. To reverse the monetary stance in order to prevent a fall in prices, amounts to the renewal of impoverishment of wealth generators. As Mises said,
Prices of the factors of production–both material and human–have reached an excessive height in the boom period. They must come down before business can become profitable again. . . . Thus any attempt of the government or the labor unions to prevent or delay this adjustment merely prolongs the stagnation. [4]
As a rule, what the central bank tries to stabilize is the so-called price index. The “success” of this policy, however, hinges on the state of the pool of real wealth. As long as the pool is expanding, the reversal of the tighter stance creates the illusion that the loose monetary policy is the right remedy. This is because the loose monetary stance, which renews the flow of real wealth to non-wealth producers, props up their demand for goods and services, thereby arresting or even reversing price deflation. Furthermore, since the pool of real wealth is still growing, the pace of economic growth stays positive–hence, the mistaken belief that a loose monetary stance that reverses a fall in prices is the key in reviving economic activity.
The illusion that, through monetary pumping, it is possible to keep the economy going is shattered once the pool of wealth begins to decline. Once this happens, the economy begins its downward plunge. The most aggressive loosening of monetary policy will not reverse the plunge. Any attempt to boost the demand for goods cannot be effective. The means to support this demand are not there. Moreover, the reversal of the tight monetary stance will eat further into the pool of real wealth, thereby deepening the economic slump.
Even if loose monetary policies were to succeed in lifting prices and inflationary expectations, they cannot revive the economy while the pool of real wealth is declining. (Real wealth is required to fund various activities). Since the key to an economic recovery in Japan is the state of the pool of real wealth, how can we ascertain its status? How does one know whether it is growing, stagnating, or declining?
If the pool had been growing, then the underlying growth trend of economic activity would have been following suit. This, in turn, would have made loose monetary and fiscal policies appear to be successful.
From the level of 8.56% in March 1991, the BOJ has lowered the interbank call interest rate to almost nil. Moreover, despite the accusation that the BOJ was not aggressive enough, on average since 1990 the pace of monetary pumping by the central bank stood at 14% per annum. Despite all that, the growth momentum of bank lending remains subdued. The yearly rate of growth of lending stood at 1.4% in December against 1.3% in November. The yearly rate of growth of Japanese AMS stood at 1.9% in December against 2.3% in the month before.
Notwithstanding the BOJ’s stimulatory policies, economic activity has continued to deteriorate. This therefore raises the likelihood that the pool of real wealth is either stagnant, or, worse, declining. Consequently, the only way left to revive the economy – which is also the only way authorities are reluctant to pursue – is to allow wealth producers to take over. However, this means that various activities that cannot support themselves must be allowed to disappear. The worst thing that the central Bank of Japan could do is to further intensify monetary injections.
Summary and conclusion
Contrary to the popular view, price deflation as a rule is always good news for the economy. When prices are falling in response to the expansion of real wealth, this means that people’s living standards are rising. When prices are falling as a result of the burst of the financial bubble, it is also good news for the economy, for it indicates that the impoverishment of wealth producers was arrested. The latest proposed Japanese policy to raise the pace of the monetary pumping in order to counter deflation amounts to furthering the economic impoverishment of wealth producers, thereby delaying any meaningful economic recovery from taking place.
[1] Joseph T. Salerno “An Austrian Taxonomy of Deflation” presented at “Boom, Bust, and the Future,” January 19,2002, The Mises Institute, Auburn, Alabama p 8.
[2] Murray N. Rothbard What Has Government Done to Our Money? p 17.
[3] Joseph T. Salerno An Austrian Taxonomy of Deflation presented at “Boom, Bust, and the Future,” January 19,2002, p 8
[4] Ludwig von Mises Human Action p 568-569.
By Dr Frank Shostak, on 21 January 13
At the annual meeting of the American Economic Association in San-Diego on January 4-6 2013 Harvard professor of economics Benjamin Friedman said,
The standard models we teach… simply have no room in them for what most of the world’s central banks have done in response to the crisis.
Friedman also advises sweeping aside the importance of the role of monetary aggregates. On this he said,
If the model you are teaching has an “M” in it, it is a waste of students’ time. Delete. it.
According to most economic experts the Fed has re-written the central banking play book, cutting interest rates to near zero and tripling its balance sheet by buying bonds. The federal funds rate target is currently at 0.25%. The Fed’s balance sheet jumped from $0.86 trillion in January 2007 to $2.9 trillion in January 2013.
Professors who say they agree with the Fed’s approach to the 2008-9 economic crisis are nonetheless challenged by how to explain this new world of central banking to their students. Dramatic action by central banks to counter a global financial crisis cannot be explained by traditional models of how monetary policy works, it is argued.
So what seems to be the problem here?
Now according to the traditional way of thinking, a lowering of interest rates activates the overall demand for goods and services and this in turn, via the famous Keynesian multiplier, activates general economic activity. Furthermore, according to the traditional way of thinking massive monetary pumping should also lead to a higher rate of inflation.
Yet despite the massive monetary pumping, both economic activity and the rate of inflation remain subdued. After closing at 8.1% in June 2010 the yearly rate of growth of industrial production fell to 2.2% in December 2012. The yearly rate of growth of the consumer price index (CPI) fell to 1.7% in December 2012 from 3.9% in September 2009. Additionally the unemployment rate stood at the lofty level of 7.8% in December 2012 with 12.2 million people out of work.
So why has the massive monetary pumping by the Fed and the near zero federal funds rate failed to strongly revive economic activity and exert visible upward pressure on the prices of goods and services?
Is the comment by Benjamin Friedman that money is not relevant now valid? We would suggest that the fact that massive pumping by the Fed has failed to produce results along the line of mainstream models doesn’t indicate that money supply is not important any longer in understanding what is going on.
The fact that economic activity is currently not responding to massive monetary pumping as in the past is indicative that prolonged reckless monetary policies have severely damaged the economy’s ability to generate real wealth. Contrary to Friedman, we maintain that money very much matters. Contrary to mainstream thinking, an increase in money supply doesn’t grow but rather destroys the economy.
The ongoing monetary pumping coupled with an ongoing falsification of the interest rate structure has caused a severe misallocation of scarce real capital. On account of reckless monetary policies, a non-wealth generating structure of production was created – obviously then, on account of the diminishing ability to generate real wealth, it is not possible to support (i.e. fund) strong economic activity.
Remember that monetary pumping is always bad news for the economy since it diverts real funding from wealth generating activities to wealth consuming activities. It sets in motion an exchange of nothing for something.
As long as the economy’s ability to generate wealth is still there the reckless monetary policies of the central bank can be absorbed. Loose monetary policies can create the false impression that they are the key drivers of economic growth.
However, once wealth generating activities as a percentage of total activities falls below the 50 percent line the reality takes over and general economic activity has to fall.
In response to the weakening in the wealth generating process various non-wealth generating activities that were supported by wealth generators are coming under pressure. To stave off bankruptcy they are forced to lower the prices of goods and services that they produce (the goods they produce are very low on consumers’ preference scales). According to Mises,
As soon as the afflux of additional fiduciary media comes to an end, the airy castle of the boom collapses. The entrepreneurs must restrict their activities because they lack the funds for their continuation on the exaggerated scale. Prices drop suddenly because these distressed firms try to obtain cash by throwing inventories on the market dirt cheap.[1]
It is not clear whether we have already reached this stage in the US. But the fact that despite massive pumping by the Fed economic activity remains subdued raises the likelihood that the US economy is not far from sinking into a black hole.
Aggressive policies by the Fed have highlighted the destructive nature of loose monetary policies. Contrary to popular theories, the actions of the Fed have shown that monetary pumping cannot grow an economy, it can only set in motion a process of destruction.
Mainstream economic thinkers are of the view that one can make the Fed’s policies more effective by making the central bank’s policies more transparent and consistent. According to Michael Woodford, a professor at Columbia University and one of the most influential current thinkers about monetary policy, “the recent events…have given us a lot of reason to change what we teach when we talk about monetary policy”. In future, Woodford said he would incorporate a lot more discussion about the importance of stability in the financial sector on the macro economy, and tell students why future expectations for central bank interest rates can be vital.
“Explain why expectations are important for aggregate demand,” he told the panel. “Make it credible that the central bank will actually follow through with the policy it is indicating,” Woodford said, referring to the importance of convincing businesses and households to invest and spend.
The belief that if Fed’s policies were to become more transparent and consistent will lead to stable economic growth is fallacious. We have seen that it is the Fed’s actual policies that are the key factor behind the destruction of the wealth generating process. Hence the damage inflicted by these policies cannot be avoided even if the Fed is consistent and transparent.
Also, observe that the key problem with the mainstream perspective is the emphasis that all that is needed for economic growth is boosting the demand for goods and services, i.e. demand creates supply.
It is for this reason that mainstream thinkers used to hold the view that increases in the money supply and the subsequent increase in the overall demand for goods and services is a catalyst for economic growth.
We have seen that once money is pumped, it sets in motion an exchange of nothing for something, i.e. the diversion of real wealth from wealth generators to non-wealth generators, and subsequent economic impoverishment.
Summary and conclusion
At the annual meeting of the American Economic Association in San-Diego on January 4-6 2013 academic economists said that the latest monetary policies of the Fed made it difficult to employ accepted theories regarding the effect of central bank policies on the economy. Experts are of the view that in the “new world” because of Fed’s policies there is little room left for money supply to explain the latest events, such as why economic activity and the rate of inflation are subdued despite the Fed’s aggressive policies since 2008. Contrary to mainstream thinking the aggressive policies of the Fed have highlighted the destructive nature of loose monetary policy – hence money supply matters more than ever.
[1] Ludwig von Mises Human Action 4th revised edition p 562.
By Dr Frank Shostak, on 17 December 12
On Wednesday December 12, 2012 Fed policy makers announced that they will boost their main stimulus tool by adding $45 billion of monthly Treasury purchases to an existing program to buy $40 billion of mortgage debt a month.
This decision is likely to boost Fed’s balance sheet from the present $2.86 trillion to $4 trillion by the end of next year. Policy makers also announced that an almost zero interest rate policy will stay intact as long as the unemployment rate is above 6.5% and the rate of inflation doesn’t exceed the 2.5% figure.
Most commentators are of the view that the Fed Chairman Ben Bernanke and his colleagues are absolutely committed to averting the mistakes of the Japanese in 1990’s and the US central bank during the Great Depression. On this Bernanke said that,
A return to broad based prosperity will require sustained improvement in the job market, which in turn requires stronger economic growth.
Furthermore he added that,
The Fed plans to maintain accommodation as long as needed to promote a stronger economic recovery in the context of price of stability.
But why should another expansion of the Fed’s balance sheet i.e. more money pumping, revive the economy? What is the logic behind this way of thinking?
Bernanke is of the view that monetary pumping, whilst price inflation remains subdued, is going to strengthen purchasing power in the hands of individuals.
Consequently, this will give a boost to consumer spending and via the famous Keynesian multiplier the rest of the economy will follow suit.
Bernanke, however, confuses here the means of exchange i.e. money, with the means of payments which are goods and services.
In a market economy every individual exchanges what he has produced for money (the medium of exchange) and then exchanges money for other goods. This means that he funds the purchase of other goods by means of goods he has produced.
Paraphrasing Jean Baptiste Say, Mises argued that,
Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.[1]
Printing more money is not going to bring prosperity i.e. more goods and services. Money as such produces nothing.
According to Rothbard,
Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.[2].
Contrary to popular thinking there is no need for more money to keep the economy going. On this Mises argued,
The services which money renders can be neither improved nor repaired by changing the supply of money. … The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.[3]
Printing more money will only result in the diversion of goods from those individuals that produced them to those who have produced nothing i.e. the holders of the newly printed money.
According to Mises,
An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.[4]
What is required to set in motion a broadly based prosperity is to enhance and expand the production structure of the economy. Printing money, however, will undermine the expansion and the enhancement of the wealth generating infrastructure.
Now, if by means of money printing and the lowering of interest rates one can generate prosperity why after all the massive pumping by the Fed are things not improving? – The reply of Bernanke and his colleagues is that the pumping wasn’t aggressive enough.
We suggest that if Bernanke’s way of thinking were to be implemented he runs the risk of severely damaging the process of wealth generation and deepening economic impoverishment.
If money printing can create prosperity then why are all the poor nations still poor – these nations also have central banks and know well how to print money? A good recent example in this regard is Zimbabwe.
Even if we were to accept that the Fed ought to pump money to revive the economy, we are still going to have a problem here if banks were to refuse to channel the pumped money into the economy.
It must be realized that after being badly hurt in 2008 banks are likely to be reluctant to embark on an aggressive lending of the money pumped by the Fed.
For the time being, banks still prefer to sit on the cash rather than lend it out aggressively. (Embark on a large scale lending out of “thin air”). The latest data for the week ending December 12 indicates that the banks’ holding of excess cash increased by $25 billion from the end of November to $1.464 trillion.
We suggest that we should be grateful to the banks for resisting aggressive lending so far – it has prevented an enormous economic disaster. Obviously if the Fed were to force the banks to push all the pumped money into the economy then this could inflict severe damage which will take a long time to fix.
Summary and conclusion
On Wednesday December 12 Fed policy makers announced that they will boost their main stimulus tool by adding $45 billion of monthly Treasury purchases to an existing program to buy $40 billion of mortgage debt per month. This decision is likely to lift the size of the Fed’s balance sheet from the present $2.86 trillion to $4 trillion by the end of next year.
The Fed Chairman Ben Bernanke, the initiator of this plan, is of the view that aggressive money pumping is going to strengthen US economic expansion. We hold that without the cooperation of banks the massive pumping of the Fed is unlikely to enter the economy.
We maintain that if banks were to push the money the Fed is going to pump into the economy this will inflict serious damage on the economy’s ability to generate real wealth.
By Dr Frank Shostak, on 14 November 12
There were a lot of commentaries regarding the Ireland and Iceland 2008-12 financial crises. Most of the commentaries were confined to the description of the events without addressing the essential causes of the crises. We suggest that providing a detailed description of events cannot be a substitute for economic analysis, which should be based on the essential causes behind a crisis. The essential cause is the primary driving force that gives rise to various events such as reckless bank lending (blamed by most commentators as the key cause behind the crisis) and a so called overheated economy.
Now in terms of real GDP both Ireland and Iceland displayed strong performance prior to the onset of the crisis in 2008. During 2000 to 2007 the average growth in Ireland stood at 5.9% versus 4.6% in Iceland. So what triggered the sudden collapse of these economies?
Central bank policy the key trigger for economic boom
What set in motion the economic boom (i.e. a strong real GDP rate of growth) in both Ireland and Iceland was an aggressive lowering of interest rates by the respective central banks of Ireland and Iceland. In Ireland the policy rate was lowered from 13.75% in November 1992 to 2% by November 2005. In Iceland the policy rate was lowered from 10.8% in November 2000 to 5.2% by April 2004.
In response to this, bank lending showed a visible strengthening with the yearly rate of growth of Irish bank assets rising from 7.4% in June 2002 to 31% by November 2005. In Iceland the yearly rate of growth of bank lending to residents climbed from 26.5% in September 2004 to 57.8% by April 2006.
The growth momentum of money supply strengthened visibly in both Ireland and Iceland. The yearly rate of growth of our measure of money supply (AMS) for Ireland jumped from minus 6.7% in March 2003 to 22% by March 2006. In Iceland the yearly rate of growth of AMS climbed from minus 1.6% in January 2003 to 61.6% by June 2004 before closing at 47.7% by July 2004.
The aggressive lowering of interest rates coupled with strong increases in the money supply rate of growth gave rise to various bubble activities. (The central bank’s loose monetary stance set in motion the transfer of wealth from wealth generating activities to non-productive bubble activities).
Central bank policies trigger economic bust
On account of strong increases in the money supply rate of growth a visible strengthening in price inflation took place in Ireland and Iceland. In Ireland the yearly rate of growth of the consumer price index (CPI) rose from 2.9% in January 2006 to 5.1% by March 2007. In Iceland the yearly rate of growth of the CPI jumped from 1.4% in January 2003 to 18.6% by January 2009.
To counter the acceleration in price inflation the central banks of Ireland and Iceland subsequently tightened their stance. The policy interest rate in Ireland rose from 2.25% in January 2006 to 4.25% by July 2008. In Iceland the rate shot up from 10.2% in January 2006 to 18% by February 2009. Furthermore, the pace of money pumping by the central bank of Ireland fell to minus 8.2% by July 2007 from 25% in January 2007. The pace of pumping by the Iceland’s central bank fell to 43% by February 2008 from 123% in July 2006.
The yearly rate of growth of AMS in Ireland plunged from 32% in August 2009 to minus 30% by November 2011. In Iceland the yearly rate of growth of AMS fell from 96% in October 2007 to minus 18% by September 2009.
The sharp fall in the growth momentum of money supply coupled with a tighter interest rate stance put pressure on various bubble activities that emerged on the back of the previous loose monetary policy stance.
Consequently, various key economic indicators came under pressure. For instance, the unemployment rate in Ireland rose from 4.4% in January 2006 to 14.9% by July 2012. In Iceland the unemployment rate climbed from 2% in January 2006 to 9.2% by September 2010. Year-on-year the rate of growth of Irish real retail sales fell from 3.8% in January 2008 to minus 25% by September 2009. In Iceland the yearly rate of growth of real retail sales fell from 11.9% in Q1 2008 to minus 31% by Q1 2009.
Most commentators blame the crisis on the conduct of banks that allowed the massive expansion of credit. It is held that this was responsible for the massive property boom in Ireland and to overheated economic activity in Iceland.
We hold that the key factor in the economic crisis was the boom-bust policies of the central banks of Ireland and Iceland. Loose monetary policy had significantly weakened the economy’s ability in both Ireland and Iceland to generate wealth. This resulted in the weakening of various marginal activities. Consequently, a fall in these activities followed by a decline in the pace of lending by banks and this in turn coupled with a tighter stance by central banks set in motion an economic bust. With the emergence of a recession, banks’ bad assets started to pile up and this in turn posed a threat to their solvency.
From May 2007 the banks’ stock prices on the Irish stock market declined markedly – they had halved by May 2008. This had an inevitable effect on banks capital adequacy ratios and therefore their ability to lend ever higher amounts that were necessary to support property prices.
As a result house loans as % of GDP plunged from 70.5% in Q2 2009 to 49.2% by Q2 this year. At the height of the boom a fifth of Irish workers were in the construction industry. The average price of a house in Ireland in 1997 was 102,491 euros. In Q1 2007 the price stood at 350,242 euro’s – an increase of 242%. The average price of a home in Dublin had increased 500% from 1994 to 2006.
Now in Iceland at the end of Q2 2008 external debt was 50 billion euros, more than 80% of which was held by the banking sector – this value compares with Iceland’s 2007 GDP of 8.5 billion euro’s. The liabilities of the three main banks were almost 10 times the size of the Iceland’s GDP.
With the emergence of the bust, Icelandic authorities allowed its banks to go belly up whilst the Irish government decided to support the banks. According to estimates the cost to the taxpayers of providing support to Irish banks stood at 63 billion euros. (The private debt of the failed banks was nationalized). In Iceland the government, by allowing Icelandic banks to fail, made foreign creditors, not Icelandic taxpayers, largely responsible for covering losses.
The fact that Iceland allowed the banks to go bankrupt was a positive step in healing the economy. Unfortunately Iceland introduced a program of safeguarding the welfare of the unemployed. Also, the collapse of the Icelandic Krona hit hard homeowners who borrowed in foreign currency.
In response to this the authorities orchestrated mortgage relief schemes. Iceland has also imposed draconian capital controls. Obviously all this curtailed the benefits of allowing the banks to go belly up.
Whether the Icelandic economy will show a healthy revival, as suggested by some experts, hinges on the monetary policy of the central bank. We suggest the same applies to Ireland. (What is required is to seal off all the loopholes for the creation of money supply).
Bad policies are coming back
For the time being in Iceland the yearly rate of growth of AMS jumped from minus 11.3% in May 2010 to 34% by May 2012. Also, in Ireland the growth momentum of AMS is showing strengthening with the yearly rate of growth rising from minus 30.3% in November last year to 4.7% in September 2012.
The rising growth momentum of money supply is a major threat to sound economic recovery in both Ireland and Iceland.
Also note that the policy interest rate in Ireland fell from 1.5% in October 2011 to 0.75% at present. In Iceland the policy rate was lowered from 18% in February 2009 to 4.25% by July 2011. All this sets again in motion a misallocation of resources and new bubble activities and in turn economic impoverishment.
Summary and conclusion
Many commentators blame reckless bank lending as the key cause behind the 2008-2012 Ireland and Iceland financial crises. Our analysis, however, suggests that it was not the banks as such that caused the crisis but rather the boom-bust policies of the central banks of Ireland and Iceland. It is these institutions that set in motion the false economic boom and the consequent economic bust. Whilst Iceland allowed its banks to go bankrupt the Irish government chose to bail out its banks. So in this sense the Icelandic authorities did the right thing. We hold that despite this positive step, Iceland’s authorities have introduced various welfare schemes which have curtailed the benefits of letting banks go belly up. Furthermore, both Ireland and Iceland have resumed aggressive money pumping thereby setting in motion the menace of boom-bust cycles.
By Dr Frank Shostak, on 31 October 12
Would it be possible in a world without money to establish the rate of return on present goods in terms of future goods? In a world without money all that one would have are the rates of exchanges between various present and future real goods. For instance, one present apple is exchanged for two potatoes in one-year’s time. Or, one shirt is exchanged for three tomatoes in a one-year’s time. All that we have here are various ratios.
There is, however, no way to establish from these ratios what the rate of return is for one present apple in terms of future potatoes (It is not possible to calculate the percentage since potatoes and apples are not the same goods). Likewise we cannot establish the rate of return on a shirt in terms of future tomatoes. In other words, we can only establish that one present apple is exchanged for two future potatoes, and one present shirt is exchanged for three future tomatoes. Only in the framework of the existence of money can the rate of return be established.
For instance, the time preference of a baker, which is established in accordance with his particular set-up, determines that he will be ready to lend ten dollars – which he has earned by selling ten loaves of bread – for a borrowers promise to repay eleven dollars in a one year’s time.
Similarly the time preference of a shoemaker, which is formed in accordance with his particular set-up, determines that he will be a willing borrower. In short, once the deal is accomplished both parties to this deal have benefited. The baker will get eleven dollars in one-year’s time that he values much more than his present ten dollars. For the shoemaker the value of the present ten dollars exceeds the value of eleven dollars in one-year time.
As one can see here, both money and the real factor (time preferences) are involved in establishing the market interest rate, which is 10%. Note that the baker has exchanged ten loaves of bread for money first, i.e. ten dollars. He then lends the ten-dollars for eleven dollars in one-year’s time. The interest rate that he secures for himself is 10%. In one-year’s time the baker can decide what goods to purchase with the obtained eleven dollars. As far as the shoemaker is concerned he must generate enough shoes in order to enable him to secure at least eleven dollars to repay the loan to the baker.
Observe however, that without the existence of money – the medium of exchange – the baker isn’t able to establish how much of future goods he must be paid for his ten loaves of bread that would comply with the rate of return of 10%.
Consequently, there cannot be any separation between real and financial market interest rates. There is only one interest rate, which is set by the interaction between individuals’ time preferences and the supply and demand for money.
Since the influences of demand and supply for money and individuals’ time preferences regarding interest rate formation are intertwined, there are no ways or means to isolate these influences. Hence, the commonly accepted practice of calculating the so-called real interest rate by subtracting percentage changes in the consumer price index from the market interest rate is erroneous.
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