According to commentators, sanctions imposed by the US and the European Union are pushing Russia towards a recession. However, we hold that some key Russian economic data have been displaying weakening prior to the annexation of Crimea to Russia. This raises the likelihood that sanctions might not be the key factor for an emerging recession.
The yearly rate of growth of monthly real gross domestic product (GDP) eased to 0.3% in February from 0.7% in January and 1.8% in July last year. After closing at 12.2% in March last year the yearly rate of growth of retail sales fell to 7.7% in January before settling at 9.6% in February.
We suggest that the key factor behind any emerging slowdown and a possible recession is a sharp decline in the yearly` rate of growth of money supply (AMS) from 67.1% in May 2005 to minus 12.2% by September 2009. We hold that the driving force behind this sharp decline is a strong decline in the growth momentum of the central bank’s balance sheet during that period (see chart).
There is a long time lag from changes in money supply and its effect on economic activity. We suspect that it is quite likely that the effect from a fall in the growth momentum of money during May 2005 to September 2009 is starting to dominate the present economic scene.
This means that various bubble activities that emerged on the back of the prior strong increase in money supply are at present coming under pressure. So from this perspective irrespective of sanctions, the Russian economy would have experienced a so-called economic slowdown, or even worse a recession.
Now, to counter a further weakening in the ruble against the US$ the Russian central bank has raised the seven day repo rate by 1.5% to 7%. The price of the US$ in ruble terms rose to 36.3 in March from 30.8 rubles in March last year – an increase of 18%.
Whilst a tighter interest rate stance can have an effect on the present growth momentum of money supply this is likely to have a minor effect on the emerging economic slowdown, which we suggest is predominately driven by past money supply.
There is no doubt that if sanctions were to become effective they are going to hurt economic activity in general i.e. both bubble and non-bubble activities.
On this one needs to exercise some caution given the possibility that major world economies are heading toward a slower growth phase.
Hence from this perspective, regardless of sanctions the pace of the demand for the Russian exports is likely to ease.
We hold that it is quite likely that the Euro-zone, an important Russian trading partner, is unlikely to enforce sanctions in order to cushion the effect of the possible emerging economic slowdown in the Euro-zone. (Sanctions are likely to have a disruptive economic effect not only on Russia but also on the Euro-zone). Observe that Russia’s export to the Euro-zone as a percentage of its total exports stood at 54.1% in 2013 against 52.9% in 2012. In contrast Russia’s export to the US as a % of total stood at 2.1% in 2013. As a percentage of total imports Euro-zone imports from Russia stood at 8% in January whilst American imports from Russia as a percentage of total imports stood at 0.8%. Note that the Euro-zone relies on Russia for a third of its energy imports. Hence it will not surprise us if the Europeans are likely to be more reluctant than the US in enforcing sanctions.
Russia’s foreign reserves have weakened slightly in February from the month before. The level of reserves fell by 1.1% to $493 billion after declining by 2.1% in January. The growth momentum of reserves also remains under pressure. Year-on-year the rate of growth stood at minus 6.2% in February against a similar figure in January. A possible further weakening in China’s economic activity and ensuing pressure on the price of oil is likely to exert more pressure on foreign reserves.
Meanwhile, the growth momentum of the Russian consumer price index (CPI) displays a visible softening. The yearly rate of growth stood at 6.2% in February against 6.1% in January. Observe that in February last year the yearly rate of growth stood at 7.3%. Based on the lagged growth momentum of our Russian monetary measure AMS we can suggest that the yearly rate of growth of the Russian CPI is likely to weaken further in the months ahead.
Summary and conclusion
According to some experts sanctions imposed by the US and the European Union are likely to push Russia into a recession. We suggest that the key factor which is likely to push Russia into a recession is not sanctions as such but a sharp decline in the growth momentum of money supply between May 2005 and September 2009. Given the possibility that major world economies are heading towards a renewed economic slowdown, we suggest that regardless of sanctions the pace of the demand for Russia’s exports is likely to ease. Now, given that the Euro-zone relies on Russia for a third of its energy imports it will not surprise us if the Euro-zone proves likely to be more reluctant than the US in enforcing sanctions.
After settling at 3.9% in July 2011 the yearly rate of growth of the consumer price index (CPI) fell to 1.6% by January this year. Also, the yearly rate of growth of the consumer price index less food and energy displays a visible downtrend falling from 2.3% in April 2012 to 1.6% in January.
On account of a visible decline in the growth momentum of the consumer price index (CPI) many economists have concluded that this provides scope for the US central bank to maintain its aggressive monetary stance.
Some other economists, such as the president of the Chicago Federal Reserve Bank’s Charles Evans are even arguing that the declining trend in the growth momentum of the CPI makes it possible for the Fed to further strengthen monetary pumping. This, Evans holds, will reverse the declining trend in price inflation and will bring the economy onto a path of healthy economic growth. According to the Chicago Federal Reserve Bank president the US central bank should be willing to let inflation temporarily run above its target level of 2%. He also said that an unemployment rate of about 5.5% and an inflation rate of about 2% are indicative of a healthy economy.
But how is it possible that higher price inflation will make the economy stronger? If price inflation slightly above 2% is good for the economy, why not aim at a much higher rate of inflation, which will make the economy much healthier?
Contrary to Evans a strengthening in monetary pumping to lift the rate of price inflation will only deepen economic impoverishment by allowing the emergence of new bubble activities and by the strengthening of existing bubble activities.
It will increase the pace of the wealth diversion from wealth generators to various non-productive activities, thereby weakening the process of wealth generation.
Evans and other economists are of the view that a strengthening in monetary pumping will strengthen the flow of monetary spending, which in turn will keep the economy stronger.
On this way of thinking an increase in the monetary spending of one individual lifts the income of another individual whose increase in spending boosts the incomes of more individuals, which in turn boosts their spending and lifts the incomes of more individuals etc.
If, for whatever reasons, people curtail their spending this disrupts the monetary flow and undermines the economy. To revive the monetary flow it is recommended that the central bank should lift monetary pumping. Once the monetary flow is re-established this sets in motion self-sustaining economic growth, so it is held.
Again we suggest that monetary pumping cannot set in motion self-sustaining economic growth. It can only set in motion an exchange of something for nothing i.e. an economic impoverishment.
As long as the pool of real wealth is still growing monetary pumping can create the illusion that it can grow the economy. Once however, the pool is declining the illusion that the Fed’s loose policies can set in motion an economic growth is shattered.
If on account of the deterioration of the infrastructure a baker’s production of bread per unit of time is now 8 loaves instead of 10 loaves and the shoemaker’s production per unit of time is now 4 pair of shoes instead of 8 pair of shoes, then no amount of money printing can lift the production of real wealth per unit of time i.e. of bread and shoes. Monetary pumping cannot replace non-existent tools and machinery.
On the contrary the holders of newly printed money who don’t produce any real wealth will weaken the ability of wealth generators to produce wealth by diverting to themselves bread and shoes thereby leaving less real wealth to fund the maintenance and the expansion of the infrastructure.
Now, Fed officials give the impression that once they put the economy onto the so called self-sustained growth path the removal of the monetary stimulus will not generate major side effects. Note that a loose monetary policy sets in motion bubble activities. The existence of these activities is supported by the monetary pumping, which diverts to them real wealth from wealth generating activities.
Once monetary pumping is aborted bubble activities are forced to go under since they cannot fund themselves without the support of loose monetary policy – an economic bust ensues. The illusion that the Fed can bring the economy onto a self-sustaining growth path is shattered.
Summary and conclusion
On account of a visible decline in the growth momentum of the US price index many economists have concluded that this provides scope for the US central bank (the Fed) to maintain its aggressive monetary stance. Some economists such as the president of the Chicago Federal Reserve Bank, Charles Evans, even argue that the declining trend in the growth momentum of the CPI makes it possible for the Fed to further strengthen monetary pumping. This, it is held, will reverse the declining trend in price inflation and will bring the US economy onto a path of healthy economic growth. We suggest that contrary to Evans a strengthening in monetary pumping will only deepen economic impoverishment by allowing the emergence of new bubble activities and by the strengthening of existing bubble activities.
Some key US economic data shows visible weakening. The National Association of Home Builders/Wells Fargo sentiment index slumped to 46 in February from 56 in January.
The New York Federal Reserve Bank’s Empire State general business conditions index fell to 4.48 in February from 12.51 the month before.
Also, the yearly rate of growth of housing starts fell to minus 2% in January from 6.6% in the month before. Whilst the yearly rate of growth existing home sales fell to minus 5.1% in January from minus 0.2% in December – the third consecutive month of negative growth.
Furthermore, the Philadelphia Fed business index fell to minus 6.3 in February from 9.4 in January.
Most economic commentators blame the weakening in economic data on bad weather conditions that have gripped much of the US. On this way of thinking the economy remains strong and short setbacks are on account of consumers and businesses putting off purchases. However, this should reverse, so it is held, once the weather improves.
There is no doubt that weather conditions can cause disruptions in economic activity. However, we hold that the recent weakening in the data could be in response to the emerging economic bust brought about by a decline in the growth momentum of money supply (see more details below).
Also, we suggest that the phenomena of recessions is not about the weakness of the economy as such as depicted by various economic indicators, but about the liquidation of various activities that sprang up on the back of the increase in the rate of growth of money supply. Here is why.
An increase in money supply sets in motion an exchange of nothing for something, which amounts to a diversion of real wealth from wealth generating activities to non-wealth generating activities. In the process this diversion weakens wealth generators and this in turn weakens their ability to grow the overall pool of real wealth i.e. weakens their ability to grow the economy.
The expansion in the activities that sprang up on the back of rising money supply is what an economic ‘boom’, or false economic prosperity, is all about.
Note that once there is a strengthening in the pace of monetary expansion, irrespective of how strong and big a particular economy is, the pace of the diversion of real wealth is going to strengthen. Once, however, a slowdown in that pace of monetary expansion emerges, this slows down the diversion of real wealth from wealth producers to non-wealth producers.
This means that various bubble activities or non-productive activities are now getting less support from the money supply – they fall into trouble.
A weakening in bubble activities is what a recession is all about. Irrespective of how big and strong an economy is, a decline in the rate of growth in money supply is going to undermine various uneconomic activities that sprang up on the back of the previous increase in the money supply.
This means that recessions or economic busts have nothing to do with the so-called strength of an economy, improved productivity, or better inventory management by companies.
For instance, as a result of a loose monetary stance on the part of the Fed and the subsequent expansion in the money supply rate of growth various false activities emerge.
Now, even if these activities are well managed and maintain very efficient inventory control, this fact cannot be of much help once the central bank reverses its loose monetary stance. Again, these activities are the product of the loose monetary stance of the central bank. Once the stance is reversed, regardless of efficient inventory management, these activities will come under pressure and run the risk of being liquidated.
Having established that recessions are about the liquidations of unproductive activities, why are they recurrent? The reason for this is the central bank’s ongoing policies that are aimed at fixing the unintended consequences that arise from its earlier attempts at stabilising the so-called economy.
On account of the time lags from changes in money to changes in economic activity the central bank or the Fed is forced to respond to the effects of its own previous monetary policies. These responses to the effects of past policies give rise to the fluctuations in the rate of growth of money supply and in turn to recurrent boom – bust cycles.
We suggest that a fall in the yearly rate of growth of AMS from 14.8% in October 2011 to 8.1% in January 2014 poses a threat to various bubble activities that emerged on the back of an increase in the yearly rate of growth of AMS from 2.2% in June 2010 to 14.8% in October 2011.
Given the fact that there is a time lag between changes in money and changes in economic activity it is quite likely that the increase in the growth momentum of AMS during June 2010 to October 2011 is still dominating the economic scene.
As time goes by however, we suggest that a fall in the growth momentum of AMS during October 2011 to January 2014 can be expected to assert its dominance. This will be mirrored by the decline in bubble activities and in turn in various economic activity indicators.
In countries such as Turkey and Argentina a tighter stance implemented by central banks has set in motion an economic bust. In Turkey the central bank has raised the one week repo rate to 10 percent from 4.5 percent while in Argentina the 3-month Treasury bill rate climbed to 25.89 percent from 16 percent in early January. In Argentina an increase in rates took place once the central bank aggressively curbed its monetary pumping, while in Turkey the central bank raised its policy rate.
What prompted the tighter stance? The main reason was the sharp decline in the exchange rate of domestic currencies against the US dollar. The Turkish lira fell to 2.39 per US dollar from 1.76 liras in January last year — a depreciation of almost 36 percent. The price of the US dollar in terms of the Argentina peso jumped to 8 pesos from 5 pesos in January last year — an increase of 60 percent. Note that in the black market the price of the US dollar stood at 12.5 pesos.
The catalyst for the currency depreciation in both economies has been strong increases in the money supply on account of the loose monetary policies of the respective central banks. In Turkey the yearly rate of growth of AMS stood at 30 percent in August this year while in Argentina the yearly rate of growth stood at 40 percent. The underlying currency rate of exchange is set in motion by the relative increases in the money supply. This means that if Turkey and Argentina allow their money supply rate of growth to exceed the rate of growth of the US money supply, both Turkey’s and Argentina’s currency will weaken against the US dollar.
Observe that in Turkey and Argentina the strong increase in the money supply rate of growth was accompanied by strong increases in so called real GDP. In Turkey by Q1 2010 the yearly rate of growth stood at 12.6 percent while in Argentina in Q2 2010 the rate of growth stood at 11.8 percent. Given that GDP reflects changes in the money supply rate of growth we suggest that the growth in GDP mirrors the build-up of bubble activities. The stronger the GDP the stronger the pace of bubble formation is. Obviously then a tighter monetary stance is going to undermine the rate of growth of money supply and thus weaken the support for various bubble activities. It is this that sets in motion an economic bust. We suggest that a similar scenario is awaiting other economies that have been generating a strong real GDP rate of growth by means of monetary pumping.
This article was previously published at Mises.org.
According to the popular way of thinking, bubbles are an important cause of economic recessions. The main question posed by experts is how one knows when a bubble is forming. It is held that if the central bankers knew the answer to this question they might be able to prevent bubble formations and thus prevent recessions.
On this, at the World Economic Forum in Davos Switzerland on January 27, 2010, Nobel Laureate in Economics Robert Shiller argued that bubbles could be diagnosed using the same methodology psychologists use to diagnose mental illness. Shiller is of the view that a bubble is a form of psychological malfunction. Hence the solution could be to prepare a checklist similar to what psychologists do to determine if someone is suffering from, say, depression. The key identifying points of a typical bubble according to Shiller, are,
- Sharp increase in the price of an asset.
- Great public excitement about these price increases.
- An accompanying media frenzy.
- Stories of people earning a lot of money, causing envy among people who aren’t.
- Growing interest in the asset class among the general public.
- New era “theories” to justify unprecedented price increases.
- A decline in lending standards.
What Shiller outlines here are various factors that he holds are observed during the formation of bubbles. To describe a thing is, however, not always sufficient to understand the key factors that caused its emergence. In order to understand the causes one needs to establish a proper definition of the object in question. The purpose of a definition is to present the essence, the distinguishing characteristic of the object we are trying to identify. A definition is meant to tell us what the fundamentals or the origins of a particular entity are. On this, the seven points outlined by Shiller tell us nothing about the origins of a typical bubble. They tell us nothing as to why bubbles are bad for economic growth. All that these points do is to provide a possible description of a bubble. To describe an event, however, is not the same thing as to explain it. Without an understanding of the causes of an event it is not possible to counter its emergence.
Now if a price of an asset is the amount of money paid for the asset it follows that for a given amount of a given asset an increase in the price can only come about as a result of an increase in the flow of money to this asset.
The greater the expansion of money is, the higher the increase in the price of an asset is going to be, all other things being equal. We can also say that the greater the expansion of the monetary balloon is, the higher the prices of assets are going to be, all other things being equal. The emergence of a bubble or a monetary balloon need not be always associated with rising prices – for instance if the rate of growth of goods corresponds to the rate of growth of money supply no change in prices will take place.
We suggest that what matters is not whether the emergence of a bubble is associated with price rises but rather with the fact that the emergence of a bubble gives rise to non-productive activities that divert real wealth from wealth generators. The expansion of the money supply, or the monetary balloon, in similarity to a counterfeiter, enables the diversion of real wealth from wealth generating activities to non productive activities.
As the monetary pumping strengthens, the pace of the diversion follows suit. We label various non-productive activities that emerge on the back of the expanding monetary balloon as bubble activities – they were formed by the monetary bubble. Also note that these activities cannot exist without the expansion of money supply that diverts to them real wealth from wealth generating activities.
From this we can infer that the subject matter of bubbles is the expansion of money supply. The key outcome of this expansion is the emergence of non wealth generating activities.
It follows that a bubble is not about strong asset price increases but about the expansion of money supply. In fact, as we have seen, bubbles – i.e. an increase in money supply – can take place without a corresponding increase in prices. Once we have established that an expansion in money supply is what bubbles are all about, we can further infer that the key damage that bubbles generate is by setting non-productive activities, which we have labelled as bubble activities. Furthermore, once it is established that formation of bubbles is about the expansion in money supply, obviously it is the central bank and the fractional reserve banking that are responsible for the formation of bubbles. As a rule, it is the central bank’s monetary pumping that sets in motion an expansion in the monetary balloon.
Hence to prevent the emergence of bubbles one needs to arrest the monetary pumping by the central bank and to curtail the commercial banks’ ability to engage in fractional reserve banking – i.e. in lending out of “thin air”. Once the pace of monetary expansion slows down in response to a tighter central bank stance or in response to commercial banks slowing down on the expansion of lending out of “thin air” this sets in motion the bursting of the bubbles. Remember that a bubble activity cannot fund itself independently of the monetary expansion that diverts to them real wealth from wealth generating activities. (Again bubble activities are non-wealth generating activities).
The so-called economic recession associated with the burst of bubble activities is in fact good news for wealth generators since now more wealth is left at their disposal. (An economic bust, which weakens bubble activities, lays the foundation for a genuine economic growth). Note again that it is the expansion in the monetary balloon that gives rise to bubble activities and not a psychological disposition of individuals in the market place.
Psychology and economics
Psychology was smuggled into economics on the grounds that economics and psychology are inter-related disciplines. However, there is a distinct difference between economics and psychology. Psychology deals with the content of ends. Economics, however, starts with the premise that people are pursuing purposeful conduct. It doesn’t deal with the particular content of various ends.
According to Rothbard,
A man’s ends may be “egoistic” or “altruistic”, “refined” or “vulgar”. They may emphasize the enjoyment of “material goods” and comforts, or they may stress the ascetic life. Economics is not concerned with their content, and its laws apply regardless of the nature of these ends.
Psychology and ethics deal with the content of human ends; they ask, why does the man choose such and such ends, or what ends should men value?
Therefore, economics deals with any given end and with the formal implications of the fact that men have ends and utilize means to attain these ends. Consequently, economics is a separate discipline from psychology. By introducing psychology into economics one obliterates the generality of the theory, and renders it useless. The use of psychology is counterproductive as far as economic analyses are concerned.
Summary and conclusions
Contrary to Shiller, in order to establish that a bubble is forming we don’t need to apply the same methodology employed by psychologists. What we require is the establishment of a correct definition of what bubbles are all about. Once it is done, one discovers that bubbles have nothing to do with some kind psychological malfunction of individuals – they are the result of loose monetary policies of the central bank.
Furthermore, once we observe an increase in the rate of growth of money supply we can confidently say that this sets the platform for bubble activities – for an economic boom.
Conversely, once we observe a decline in the rate of growth of money supply we can confidently say that this lays the foundations for the burst of bubble activities – an economic bust.
 Murray N. Rothbard, Man, Economy and State, (Los Angeles: Nash Publishing) p63.
On September 17-18 US central bank policy makers are likely to decide on the reduction in their monthly purchases of bonds by between $10 billion to $15 billion. A major determining factor on the size of the reduction is going to be set by their view regarding improvements in the labour market. On this the yearly change in employment stood at 2.2 million in August against the same figure in the month before.
Most experts are of the view that given the still subdued growth momentum of employment Fed policy makers are likely to announce that the US central bank is going to keep its near zero interest rate policy for a prolonged period of time. This, it is held, should prevent negative side effects coming from the reduction in bond purchases.
For instance, in 1994 when the Fed started a tightening cycle the federal funds rate rose from 3.05% in January 1994 to 6.04% in April 1995. This, it is held, caused a sharp fall in the pace of economic activity. The yearly rate of growth of industrial production fell from 7% in December 1994 to 2.7% by December 1995.
We suggest that it is changes in money supply rather than changes in interest rates that drive economic activity as such. Interest rates are just an indicator as it were.
A fall in the growth momentum of industrial production during December 1994 to December 1995 occurred on account of a sharp decline in the yearly rate of growth of AMS from 13.7% in September 1992 to minus 0.3% in April 1995.
This sharp fall in the growth momentum of AMS has weakened the support for various bubble activities that sprang up on the back of the previous rising growth momentum of AMS.
(Now even if the Fed would have kept the fed funds rate at a very low level what would have dictated the pace of economic activity is the growth momentum of AMS).
Note that a fall in the growth momentum of AMS was in line with the fall in the growth momentum of the Fed’s balance sheet – the yearly rate of growth of the balance sheet fell from 12.7% in June 1993 to 4.4% by December 1995.
What ultimately limits the pace of growth of AMS is the growth momentum of bank inflationary lending. The yearly rate of growth of inflationary bank lending fell from 23.3% in September 1992 to minus 0.7% by July 1995 – note that a fall in the growth momentum of the Fed’s balance sheet during June 1993 to December 1995 exacerbated the decline then in the growth momentum of banks inflationary lending.
Contrary to the 1993 to 1995 period, this time around the Fed’s monetary pumping as depicted by the growth momentum of its balance sheet has been ineffective in boosting the growth momentum of money supply given the banks reluctance to aggressively expand lending. (Bank’s lending growth at present doesn’t respond to changes in the Fed’s balance sheet).
The yearly rate of growth of the Fed’s balance sheet stood at 29.8% so far in September versus minus 1.4% in September last year.
Despite this pumping banks have chosen to accumulate cash rather than lending it out and are sitting on $2.1 trillion in cash. Given banks reluctance to aggressively expand lending the yearly rate of growth of AMS fell from 14.8% in October 2011 to 7.7% by August 2013.
We suggest that it is this fall in the growth momentum of AMS that will dictate the future pace of economic activity regardless of what the Fed is going to do.
(Note that the effect of changes in money supply on economic activity works with a time lag. It takes time for changes in money supply to diffuse its effect on the various parts of the economy).
We need to add to all of this the possibility that the pool of real wealth might be currently in difficulties on account of the Fed’s reckless policies.
(The near zero interest rate policy has caused a severe misallocation of scarce real savings – it has weakened the wealth generation process and thus the economy’s ability to support stronger real economic growth).
If our assessment is valid on this, we can suggest that a stagnant or declining pool of real wealth is likely to put more pressure on banks’ lending. Remember that it is the state of the pool of real wealth that dictates banks ability to lend without going belly up.
We can conclude that regardless of changes in the Fed’s balance sheet it is a fall in the growth momentum of AMS since October 2011 that will determine the pace of economic activity irrespective of the planned actions by the Fed. Given the possibility that the pool of real wealth might be in trouble this could put further pressure on the growth momentum of bank lending and thus the growth momentum of money supply.
Some commentators such as Mohamed El-Erian, the chief executive officer of Pacific Investment Management (PIMCO), are of the view that the Federal Reserve’s policy of massive asset purchases has added very little to economic growth. A study published by the Federal Reserve Bank of Kansas City (Arvind Krishnamurthy and Annette Vissing-Jorgensen, August 9, 2013) explores various channels through which monetary pumping can grow the US economy. On this the study indicates that the Fed’s purchases of mortgage backed securities (MBS) can have a strong beneficial effect. The study however suggests that with respect to the purchases of Treasury Bonds the effect on the economy is minimal.
Now, as a result of the Fed’s quantitative easing (QE) the long term mortgage interest rate fell from 6.32% in June 2008 to 3.35% by November 2012. Consequently, the growth momentum of the housing market has had a strong response to this fall in rates with the yearly rate of growth of housing starts jumping from minus 55% in January 2009 to 42% by March 2013. The yearly rate of growth of new home sales climbed from minus 46.4% in January 2009 to 35.5% by January 2013.
But does it all make much sense? Contrary to the popular way of thinking and the Kansas Fed study, we argue that it is erroneous to suggest that there are some channels through which monetary pumping can exert a beneficial effect on the economy.Now, the yield on the 10-year Treasury – Note fell from 4.07% in May 2008 to 1.615% by November 2012. After rising to 3.3% in Q1 2012 from minus 4.1% in Q2 2009 the yearly rate of growth of real GDP has been displaying softening, closing at 1.6% by Q2 this year. From this it is concluded that it is much more effective for economic growth if the Fed were to focus on purchases of MBS’s given the strong response of the housing data to declining interest rates.
For instance the so called benefits to the economy from the interest rate channel are on account of an artificial lowering of interest rates by the central bank. Such a lowering cannot set the wealth generation process in motion – this latter is what real economic growth is all about. It can only lead to the misallocation of scarce capital and the weakening of the wealth generation process.
Likewise the real balances channel (not discussed in the study but popular with the mainstream thinking) i.e. an increase in the money supply relative to the increase in price inflation, will only result in an increase in the consumption un-backed by the production of real wealth – and leads to the consumption of capital and to the weakening of the wealth generation process.
Hence various studies that supposedly show that the Fed’s quantitative easing can grow the US economy are fallacious. To suggest that monetary pumping can grow an economy implies that increases in the money supply will result in increases in the pool of real wealth.
This is however a fallacy since all that money does is serve as the medium of exchange. It enables the exchange of the produce of one specialist for the produce of another specialist and nothing more. If printing money could somehow generate wealth then world wide poverty would have been eliminated by now.
On the contrary, monetary pumping sets in motion a process of economic impoverishment by activating an exchange of something for nothing. It diverts real wealth from wealth generating activities towards non-productive activities.
We suggest that as the Fed continues with its aggressive monetary pumping there is the risk that the pool of real wealth – the key for economic growth, will become stagnant or worse will start declining. If this were to happen, economic growth will follow suit and no monetary tricks of the Fed will be able to help.
On the contrary, the more aggressive the monetary pumping becomes the faster the pool of real wealth is going to shrink and the worse economic conditions will become.
Eventually even the government’s own data such as GDP will start displaying weakness. Remember that changes in GDP are a reflection of changes in monetary pumping – the more is pumped the greater the rate of growth of GDP.
Once, however, the pool of real wealth comes under pressure, bank lending weakens and this in turn weakens the expansion of credit out of “thin air”. Consequently, the growth momentum of money supply comes under pressure, which in turn after a time lag puts pressure on the growth momentum of real GDP.
On this the yearly rate of growth of the Fed’s balance sheet (monetary pumping) jumped to 27.6% in August from 1.8% in January. The yearly rate of growth of inflationary credit however fell to 2.3% in August from 14.4% in August last year.
The yearly rate of growth of our monetary measure AMS has been in a steep decline since October 2011 with the yearly rate of growth falling from 14.8% in October 2011 to 7.1% in August 2013.
Summary and conclusion
A study published by the Federal Reserve of Kansas City explores various channels through which monetary pumping by the Fed can grow the US economy. On this the study indicates that as opposed to Treasury bonds purchases the Fed’s purchases of mortgage backed securities (MBS) can have a strong beneficial effect. We maintain that it is erroneous to hold that there are some channels through which monetary pumping can produce a beneficial effect to the economy. We hold that monetary pumping is always bad news for the economy since it leads to the weakening of the wealth generation process and thus to economic impoverishment.
On Tuesday July 2, US central bank policy makers voted in favour of the US version of the global bank rules known as the Basel 3 accord. The cornerstone of the new rules is a requirement that banks maintain high quality capital, such as stock or retained earnings, equal to 7% of their loans and assets.
The bigger banks may be required to hold more than 9%. The Fed was also drafting new rules to limit how much banks can borrow to fund their business known as the leverage ratio.
We suggest that the introduction of new regulations by the Fed cannot make the current monetary system stable and prevent financial upheavals.
The main factor of instability in the modern banking system is the present paper standard which is supported by the existence of the central bank and fractional reserve lending.
Now in a true free market economy without the existence of the central bank, banks will have difficulties practicing fractional reserve banking.
Any attempt to do so will lead to bankruptcies, which will restrain any bank from attempting to lend out of “thin air”.
Fractional reserve banking can, however, be supported by the central bank. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking.
The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out.
By means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.
The consequences of the monetary management of the Fed as a rule are manifested in terms of boom-bust cycles.
As times goes by this type of management runs the risk of severely weakening the wealth generation process and runs the risk of severely curtailing so called real economic growth.
We maintain that as long as the present monetary system stays intact it is not possible to prevent a financial crisis similar to the one we had in 2007-9. The introduction of new tighter capital requirements by banks cannot make them more solvent in the present monetary system.
Meanwhile, banks have decided to restrain their activity irrespective of the Fed’s new rules. Note that they are sitting on close to $2cg trillion in excess cash reserves. The yearly rate of growth of banks inflationary lending has fallen to 4.1% in June from 4.2% in May and 22.4% in June last year.
Once the economy enters a new economic bust banks are likely to run the risk of experiencing a new financial crisis, the reason being that so called current good quality loans could turn out to be bad assets once the bust unfolds.
A visible decline in the yearly rate of growth of banks inflationary lending is exerting a further downward pressure on the growth momentum of our monetary measure AMS.
Year-on-year the rate of growth in AMS stood at 7.7% in June against 8.3% in May and 11.8% in June last year.
We suggest that a visible decline in the growth momentum of AMS is expected to bust various bubble activities, which sprang up on the back of the previous increase in the growth momentum of money supply.
Remember that economic bust is about busting bubble activities. Beforehand it is not always clear which activity is a bubble and which is not.
Note that once a bust emerges seemingly good companies go belly up. Given that since 2008 the Fed has been pursuing extremely loose monetary policy this raises the likelihood that we have had a large increase in bubble activities as a percentage of overall activity.
Once the bust emerges this will affect a large percentage of bubble activities and hence banks that provided loans to these activities will discover that they hold a large amount of non-performing assets.
A likely further decline in lending is going to curtail lending out of “thin air” further and this will put a further pressure on the growth momentum of money supply.
In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan was originated out of nothing, it obviously couldn’t have had an owner.
In a free market, in contrast, when money i.e. gold is repaid, it is passed back to the original lender; the money stock stays intact.
Since the present monetary system is fundamentally unstable it is not possible to fix it. The central bank can keep the present paper standard going as long as the pool of real wealth is still expanding.
Once the pool begins to stagnate – or worse, shrinks – then no monetary pumping will be able to prevent the plunge of the system.
A better solution is of course to have a true free market and allow the gold to assert its monetary role. As opposed to the present monetary system in the framework of a gold standard money cannot disappear and set in motion the menace of the boom-bust cycles.
Summary and conclusion
Last week US central bank policy makers voted in favour of tighter rules on banks’ activities. The essence of the new rules is that banks maintain high quality capital equal to 7% of their assets. The new rules are aimed at making banks more solvent and to prevent repetitions of the 2008-2009 financial upheavals. We suggest that in the present monetary system which involves the existence of the central bank and fractional reserve banking it is not possible to make the monetary system more stable and immune to financial upheavals. As long as the Fed continues to tamper with interest rates and money supply we are going to have boom-bust cycles and financial upheavals.
According to most commentators, reducing monetary stimulus and winding down the balance sheet of the Fed without major economic disruptions is going to be a major challenge for US central bank policy makers. On Wednesday June 19, the Chairman of the Fed Ben Bernanke said that given an improved outlook on the economy, the US central bank may moderate the pace of monetary pumping. According to Bernanke, by mid-2014 the Fed may even end the purchasing of assets.
Is it possible to slow down the pace of monetary pumping without major side effects?
According to the popular way of thinking, on account of major shocks prior to 2008 emanating from disruptions in the credit markets the US economy was severely dislocated from a path of self-sustained economic growth.
As a result since 2008 the Fed has had to step in with massive monetary pumping to bring the economy onto the path of self-sustaining economic growth.
Now in this way of thinking the spending of one individual becomes the income of another individual whose spending in turn gives rise to the income of other individuals etc. In the absence of shocks this process tends to become self-sustaining. The role of the central bank here is to make sure that the process does not get disrupted and prevent bad dynamics. (Thus if on account of a shock consumers curtail their spending this could lead to an implosion in economic activity).
Note that the central bank is expected to intervene not only in response to negative shocks but also on account of positive shocks that tend to move the economy strongly above the path of self-sustaining economic growth.
Now, the manifestation of negative shocks is a decline in the growth momentum of prices and a fall in economic activity. In contrast the manifestation of a positive shock is overheated economic activity and a rising growth momentum of prices of goods and services.
On this way of thinking, if the central bank is not careful enough in its response to negative shocks this could push the economy into a so-called overheated zone.
It seems that although not an easy task, experienced and wise policy makers should be able to navigate the economy away from various disruptions and keep the economy on a healthy growth path.
Hence policy makers must carefully monitor key economic data in order to make sure that the economy, once it is brought onto a self-sustaining economic growth path, stays there.
Builders expectations index jumped to 52 in June from 44 in May. The growth momentum of housing starts shot up in May from the month before. Year-on-year the rate of growth of starts climbed to 28.6% from 13.5% in April.
Also economic activity in general appears to be gaining strength. The Philadelphia Fed business index had a big increase in June from May rising to 12.5 from minus 5.2. The New York Federal Reserve economic activity index had a visible strengthening rising to 7.84 in June from minus 1.43 in May.
It is against this background that one can understand the logic of Ben Bernanke and his colleagues when they say that given the strengthening in economic activity and the likely strengthening in the labour market US central bank policy makers are likely to trim the pace of monetary pumping in the months ahead.
Note again that what is required here for the successful accomplishment of the Fed’s monetary policy is the correct assessment of the future course of the US economy.
Even if one were to accept this way of thinking, the dynamics of events is never possible to predict with great accuracy. The Fed’s policymakers are likely to be in the dark as to whether the economy is approaching the self-sustaining growth path or has already surpassed this path and has entered a rising inflationary path.
Note that policy errors are likely to add to various shocks that these policy measures mean to counter. (The key policy measures of the Fed are monetary pumping and interest rate manipulations).
On this score, whenever the Fed changes the pace of pumping the effect on various markets is not instantaneous. The newly injected money moves from one market to another market – there is a time lag.
For some markets the time lag is short for other markets it can be very long. Whenever the new money enters a market it means that now more money is chasing a given amount of goods in that market. The monetary expenditure or the monetary turnover in the particular market is now higher.
Now, various economic indicators depict changes in monetary turnover in various markets. For instance, changes in money supply after a time lag of nine months will manifest in changes in the so-called gross domestic product (GDP). Note that the alleged economic growth in this indicator has nothing to do with true economic growth but comes in response to past increases in the money supply rate of growth.
Given that the time lags are variable, various indicators such as price indices might be responding to changes in monetary policy that took place several years earlier.
Hence a situation could emerge that on account of the variability in the time lags there could be a variety of responses in various indicators at a given point in time. (For instance a strengthening in the yearly rate of growth of the CPI whilst economic activity is declining).
We know that Fed’s policy makers tend to be – most of the time – reactive to changes in economic indicators, which means that most of the time policy makers are responding to past policies. (It is like a dog chasing its own tail). Needless to say that such types of policies tend to amplify rather than mitigate shocks.
Now we are of the view that the entire framework of thinking regarding the existence of some kind of a growth path that the Fed supposedly could navigate the economy onto is erroneous. There is no such thing as an economy as such; there are only individuals that are engaged in various activities to maintain their lives and well being.
Whenever the central bank raises the pace of monetary pumping in order to bring the economy onto a self-sustaining growth path it in fact sets the platform for various non-productive bubble activities. The increase in these activities, which is hailed as economic prosperity, sets in motion the diversion of real wealth from wealth generators towards bubble activities. It weakens the process of wealth generation.
Whenever the Fed curbs its monetary pumping this weakens the diversion of real wealth towards bubble activities and threatens their existence. Note that bubble activities cannot support themselves without the monetary pumping that diverts real wealth from wealth generators. This leads to an economic bust.
Obviously then there is no way that the Fed could somehow curb the monetary pumping without setting in motion an economic bust. It would contradict the law of cause and effect. The severity of the bust is in accordance with the percentage of bubble activities out of overall activities. The larger this percentage is the greater the bust is going to be.
This percentage in turn is dictated by the magnitude and the length of the loose monetary stance of the Fed. Once this percentage gets out of hand the pool of real wealth comes under pressure. Consequently, banks willingness to engage in the expansion of lending despite the central bank’s loose stance is reduced. This leads to a decline in the growth momentum of the supply of credit out of “thin air”, which in turn leads to the decline in the growth momentum of money supply. After a time lag this works towards a decline in economic activity i.e. sets in motion an economic bust.
Meanwhile after closing at minus 1.4% in September 2012 the yearly rate of growth of the Fed’s balance sheet jumped to almost 20% in June. On account of banks reluctance to lend (surplus cash stood at $1.963 trillion in June) the downtrend in the growth momentum of US AMS remains intact. (After closing at 14.8% in November 2011 the yearly rate of growth stood so far in June at 7.7%). We suggest this has already set in motion an economic bust.
Summary and conclusion
According to most commentators, although not an easy task, experienced and wise policy makers should be able to navigate the US economy away from various bad side effects that come in response to a tighter Fed stance. We suggest that whenever the Fed raises the pace of monetary pumping in order to “revive” the economy it in fact creates a supportive platform for various non-productive bubble activities that divert real wealth from wealth generators. Whenever the US central bank curbs the monetary pumping this weakens the diversion of real wealth and undermines the existence of bubble activities – it generates an economic bust. We suggest that there is no way that the Fed can tighten its stance without setting in motion an economic bust. This would defy the law of cause and effect.
In his Financial Times article on June 4th the FT columnist Martin Wolf praised Ben Bernanke for saving the US economy and the world from another Great Depression. He dismisses various critics of Bernanke as lacking in imagination as to what would have happened had Bernanke and the US central bank not acted.
Central banks, including the Fed are doing the right thing. If they had not acted as they have over the past six years, we would surely have suffered a second Great Depression.
According to Wolf, the central bank’s role is to stabilize the economy against financial upheavals. He holds that the source of these upheavals is the credit driven private financial sector of the economy. On this way of thinking the instability that is generated in the private sector can culminate in a full blown economic crisis which disrupts the monetary flow and this in turn weakens economic activity and economic growth. (A weakening in the monetary flow weakens the demand for goods and services and in turn undermines incomes).
The solution to the weakening in the monetary flow is aggressive monetary pumping by the central bank to restore the flow.
Now if the central bank fails to do its job and doesn’t intervene, according to this way of thinking, this could lead to an implosion of the monetary flow and in a collapse in economic activity and economic growth.
A major manifestation of such collapse is a sharp fall in economic activity. It is for this reason that once a fall in economic activity is observed the central bank must step in aggressively to reverse the implosion in the monetary flow and economic activity.
Hence all the critics of the Fed that blame it for excessive monetary pumping since 2008 don’t really know what they are talking about, argues Wolf.
Granted there is a cost involved in such intervention, but consider the other alternative of not intervening – i.e. the Great Depression.
On this logic America owes a lot to Bernanke for if not for his quick response to the emerging implosion in the monetary flow by now the America would have been in a deep economic crisis.
In a lecture given at the George Washington University on March 27, 2012 Ben Bernanke had already anointed himself as the savior of the American economy before waiting for Martin Wolf.
The Chairman of the Fed said that the US central bank’s aggressive response to the 2008-2009 financial crisis and recession helped prevent a worldwide catastrophe.
According to Bernanke various economic indicators were showing ominous signs at the time. After closing at 3.1% in September 2007 the yearly rate of growth of industrial production fell to minus 14.8% by June 2009.
The yearly rate of growth of housing starts fell from 20.5% in January 2005 to minus 54.8% in January 2009.
Also, retail sales came under severe pressure – year-on-year the rate of growth fell from 5.2% in November 2007 to minus 11.5% by August 2008.
The unemployment rate jumped from 4.4% in March 2007 to 10% by October 2009. During this period the number of unemployed people increased from 13.389 million to 15.421 million – an increase of 2.032 million.
In response to the collapse of key economic data and a fear of a financial meltdown the US central bank aggressively pumped money into the banking system. As a result the Federal Reserve balance sheet jumped from $0.884 trillion in February 2008 to $2.247 trillion in December 2008. The yearly rate of growth of the balance sheet climbed from 1.5% in February 2008 to 152.8% by December of that year. Additionally the Fed aggressively lowered the federal funds rate target from 5.25% in August 2007 to almost nil by December 2008.
Despite this pumping the growth momentum of commercial bank lending had been declining with the yearly rate of growth falling from 11.9% in January 2007 to minus 5.3% by November 2009. As a result of the fall in the growth momentum of lending the growth momentum of money supply would have followed suit if not for the Fed’s aggressive pumping to the commercial paper market. This pushed the yearly rate of growth of our measure of US money supply from 1.5% in April 2008 to 14.3% by August 2009.
In his speech Bernanke blamed reckless lending in the housing market and financial engineering for the economic crisis. He also acknowledged that the supervision of the Fed had been inadequate.
According to Bernanke once the crises emerged the Fed had to act aggressively in order to prevent the crisis developing into a serious economic disaster.
The Fed Chairman holds that a highly accommodative monetary policy helps support economic recovery and employment. We hold that various reckless activities in the housing market couldn’t have emerged without the Fed’s own previous reckless policies.
After closing at 6.5% in December 2000 the federal funds rate target was lowered to 1% by May 2004. The yearly rate of growth of our monetary measure AMS jumped from minus 0.9% in December 2000 to 11.5% by December 2001. The strong increase in the growth momentum of money supply coupled with an aggressive lowering of interest rates set the platform for various bubble activities, or an economic boom.
A reversal of Fed’s loose stance put an end to the false boom and put pressure on various bubble activities. The fed funds rate target was lifted from 1% in May 2004 to 5.25% by June 2006. The yearly rate of growth of AMS plunged from 11.5% in December 2001 to 0.6% in May 2007. As it happened the effect of this tightening was felt in the housing market first before it spilled over to other bubble sectors. (A tighter monetary stance slowed down the diversion of real wealth towards bubble activities from wealth generating activities).
Contrary to Bernanke, we suggest that his loose monetary policy didn’t save the US economy but only saved various bubble activities, which came under pressure on account of the tighter monetary stance.
Note the loose monetary stance had been aggressively diverting real funding from wealth generators towards bubble activities thereby weakening the wealth generation process. The only reason why loose monetary policy supposedly “revived” the economy is because there were still enough wealth generators to support the Fed’s reckless policy. Also, pay attention that all the gains on account of the previous tighter stance have been wasted to support bubble activities.
As long as the pool of real wealth is still growing Fed policy makers can get away with the illusion that they have saved the US and the world economies. Once the pool of real wealth starts stagnating, or worse declining, the illusory nature of the Fed’s policy is revealed – note that the economy follows the state of the pool of real wealth. Any aggressive monetary policy in this case is going to make things much worse.
The actions of Bernanke to revive the economy run contrary to the basic principles of running a company. For instance, in a company of 10 departments, 8 departments are making profits and the other 2 losses. A responsible CEO will shut down or restructure the 2 departments that make losses – failing to do so will divert funding from wealth generators towards loss-making departments, thus weakening the foundation of the entire company.
Without the removal, or restructuring, of the loss-making departments there is the risk that the entire company could eventually go belly up. So why then should a CEO who decides to support non-profitable activities be regarded as a failure when Bernanke and his central bank colleagues are seen as heroes that saved the economy?
Bernanke and commentators such as Martin Wolf are of the view that by pumping money the central bank had provided the necessary liquidity to keep the financial system going.
We suggest that this is false. What permits the financial sector to push ahead is an expanding pool of real wealth. The financial sector does not have a life of its own; its only role is to facilitate the real wealth that was generated by the wealth producers. Remember that banks are just intermediaries; they facilitate the flow of real wealth across the economy by means of money (medium of exchange).
By flooding the banking system with money one doesn’t create more real wealth but on the contrary depletes the pool of real wealth. Most commentators are of the view that in some cases when there is a threat of serious damage to the financial system the central bank should intervene to prevent the calamity, and this is precisely what Bernanke’s Fed did.
We suggest the severe threat here is to various bubble activities that must be removed in order to allow wealth generators to get on with the job of creating wealth. If a lot of bubbles must disappear, so be it.
Any policy to support bubbles, be they large banks or other institutions, will only make things much worse. As we have seen, if the pool of real wealth is not there a central bank policy to prop up bubbles will make things much worse, after all the Fed cannot generate real wealth.
Bernanke’s policy, which amounts to the protection of inefficiency i.e. bubble activities, runs the risk of generating a prolonged slump with occasional rallies in the data. It could be something similar to Japan (that Bernanke himself has in the past criticized).
Summary and conclusion
We can conclude that, contrary to various commentators, Bernanke’s loose policies didn’t save the US economy from a depression but have damaged the process of real wealth generation.
Bernanke’s loose policies have provided support to bubble activities, thereby destabilizing the economy. So in this sense his policies have saved the bubbles, thus undermining wealth generators. We suggest that the more forceful the Fed’s response to various economic indicators is the more damage this does to the pool of real wealth. This runs the risk that at some stage the US could end up having a stagnating or worse, declining, pool of real wealth.
If this were to occur then we could end up of having a severe economic slump. If any one needs examples in this regard have a look at countries such as Greece, Spain and Portugal.
Over a prolonged period of time the policies of these countries (an ever growing government and central bank involvement in the economy) have likely severely damaged the heart of economic growth – the machinery of wealth generation. Again, if the pool of real wealth is to become stagnant, or worse, starts declining, any attempt by the Fed to make things better is going to make things actually much worse by depleting the pool of real wealth further.