The Cobden Centre

Take for instance company X, which has equity of $200. The company borrows $800 and buys an asset worth $1000. In this example we can say that company X has a leverage of 5. That is to say the equity of $200 represents 1/5 of the $1000 asset. If the value of the asset falls by 10%, that is, to $900 given the debt of $800, it implies a fall in equity or net worth to $100 — or 1/9 of the $900 asset, raising the leverage from 5 to 9 and making company X less solvent.

Let us now assume that company X has decided to deleverage and to lower its leverage back to 5 (by doing this the company will become more solvent). To achieve this company X sells assets for $400 and reduces its debt to $400. Consequently company X will now have $500 in assets, $100 in equity and $400 in debt: the leverage is now 5 again. But if many companies try to lower their leverage then there is a risk that the value of assets will fall. If, for instance, the value of company X’s assets falls by 10% to $450, then, given the value of debt of $400, net worth falls to $50 implying that the leverage goes back to 9.

Some commentators are of the view that pressure on European banks to bolster capital could force them to cut assets. However, by cutting lending — trimming their assets — banks are forcing various borrowers to sell off their assets to prevent insolvency. Consequently this sets in motion asset-price deflation. This in turn lowers borrower collateral and causes banks to reduce their lending further, etc.

It follows that if all financial institutions are doing the same thing (trying to fix their balance sheets), they could drive asset prices down, which for a given debt will shrink their net worth and increase their leverage, or make them less solvent. This is the paradox of deleveraging.[1] If this process is not arrested in time it could seriously damage the real economy, so it is held.

So what should be done here? According to popular thinking, the central bank or the government must step in and start buying the assets that banks are trying to get rid of. This, it is held, will stop the asset-price deflation and prevent the nasty dynamics that can ruin the real economy.

Some commentators are of the view that “the paradox of deleveraging,” follows the same principle as “the paradox of thrift,” which was put forward by John Maynard Keynes.

The “paradox of thrift” states that if everyone acts more carefully with his money and saves more, then this will lower aggregate demand, which in turn will lead to a fall in economic growth. As a result, total savings in the economy will actually decline.

In this way of thinking, spending by one individual is income for another individual and it follows that if all individuals were to increase their savings — that is, lower their spending — the overall income in the economy will fall. A smaller income will permit less saving.

From this it is concluded that if people are hesitant to spend, then the government must step in and lift overall monetary spending to prevent the economy from falling into a recession.

In his writings, Keynes relied on the ideas of Bernard Mandeville to provide credence for the “paradox of thrift.” According to Mandeville,

As this prudent economy, which some people call saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbours. This, I think, is an error. [2]

To reinforce his view that saving is bad for economic growth, Keynes also quotes Malthus:

I distinctly maintain that an attempt to accumulate very rapidly, which necessarily implies a considerable diminution of unproductive consumption, by greatly impairing the usual motives to production must prematurely check the progress of wealth… But if it be true that an attempt to accumulate very rapidly will occasion such a division between labour and profits as almost to destroy both the motive and the power of future accumulation and consequently the power of maintaining and employing an increasing population, must it not be acknowledged that such an attempt to accumulate, or that saving too much, may be really prejudicial to a country?[3]

Monetary Expenditure and Real Savings — What is the Connection?

Observe that spending, saving, and income in this way of thinking is in terms of money. We suggest that what matters as far as real economic growth is concerned is not monetary expenditure, as such, but real savings. It is real savings and not money that funds tools and machinery, i.e., capital goods, which in turn permits the expansion in real wealth.

Monetary expenditure as such does nothing as far as formation of real savings is concerned. By means of money a wealth producer exchanges goods that he has produced for the goods of another wealth producer. So in this sense, payment is always with goods. Money just makes it possible to exchange various goods. Note that without the existence of goods there cannot be any exchange.

Contrary to popular thinking, the heart of credit is not money but saved final goods and services. If John the baker produces ten loaves of bread and consumes one loaf, his saving is nine loaves of bread. The baker’s saving now permits him to secure other goods and services.

For instance, the baker can now exchange his saved bread for a pair of shoes with a shoemaker. Observe that the baker’s saving is his real means of payments — he pays for the shoes with saved bread. Likewise the shoemaker pays for the nine loaves of bread with the shoes that are his real saving.

The baker may also engage in a different transaction with the shoemaker. He could lend him nine loaves of bread in return for ten loaves of bread in one week’s time. Note that the loaned bread sustains the shoemaker and allows him to continue making shoes. After one week, hopefully, the shoemaker has produced enough shoes to be able to secure the ten loaves of bread needed to repay the baker the loan of nine loaves of bread plus the interest of one loaf.

The introduction of money in our story doesn’t alter what has been said so far. Without the medium of exchange — money — no market economy could take place. By means of money people can channel real savings, which in turn permits the widening of the process of real wealth formation.

Whenever an individual lends some of his money, he transfers the medium of exchange to a borrower. By means of money, the borrower can access the existing pool of final goods and services. By means of money, the borrower can now secure real savings (final goods and services) that will support him while he is engaged in the production of other goods and services. Note however that the final goods must already be in existence for the exchange to take place.

In the same way that real savings sustain the producers of final consumer goods, such as the shoemaker in our example, savings also fund the production of tools and machinery, which in turn permits the expansion of final goods and services. This increase in turn permits a further increase in savings that can now support the buildup of a more sophisticated production structure, which in turn permits a further expansion in the production of final goods and services. In this sense real savings are the key to economic expansion. This is contrary to popular thinking, which argues that savings can be bad for economic growth.

Observe that popular thinking reaches erroneous conclusions because it is only concerned with monetary flows without paying attention to real stuff. Again, for mainstream thinking what matters is monetary spending, since the more people spend, the greater the monetary income is going to be. From this it is concluded that an increase in saving, which is less monetary spending, must be bad news.

But does it make sense to suggest that people save money?

Demand for Money and Savings

People don’t save money as popular thinking suggests but rather exercise a demand for money. Once real savings are exchanged for money the recipient of money can exercise his demand for money in a variety of ways. This however will not have any effect on the existent pool of real savings.

An individual can exercise his demand for money either by holding it in his pocket or in his house or by placing it in the custody of a bank in a demand-deposit or even in a safe-deposit box. Whether the individual lends out his money or puts it under the mattress, it does not alter the given pool of real savings.

By putting the money under the mattress, an individual doesn’t engage in an act of saving – he is just exercising a demand for money. What individuals do with money cannot alter the fact that real savings are already funding a particular activity. (Whether individuals decide to hold onto the money, or lend it out alters their demand for money, but has nothing to do with savings).

Whenever an individual lends some of his money to a borrower this means that he transfers a medium of exchange that the borrower could activate in order to secure real goods and services. By lending money, the individual has lowered his demand for the services of the medium of exchange. Conversely the borrower has increased his demand for the services of the medium of exchange.

Note that the act of lending money doesn’t alter stock; he simply transfers the services of the medium of exchange to the seller of financial assets — no present real savings are affected as a result of these transactions.

Also note again that people don’t demand money to hold it, as such, but rather to use it in an exchange. Even if prices are going down, it doesn’t follow that people will start hoarding money. They will still continue to use it to maintain their life and well-being.

The greater the expansion in the production of goods and services, the greater the demand for the medium of exchange is going to be. Again the increase in the demand means an increase in the demand for the services of the medium of exchange to enable a greater amount of goods and services to be exchanged.

Once it is realised that saving is real stuff and has nothing to do with money as such the so-called paradox of thrift turns out to be a logical impossibility. If we have two bakers and each of them has increased savings from five to nine loaves of bread, collectively we cannot have less then eighteen loaves of bread saved as the paradox of thrift implies. We can also conclude that, contrary to the “paradox of thrift,” the increase in savings is the key for economic prosperity.

Is Deleveraging Really Bad for the Economy?

The existence of banks enhances the use of real savings. By fulfilling the role of middleman, banks make it easier for a lender to find a borrower. When a bank lends money, it in fact provides the borrower with the medium of exchange that can be employed to secure goods and services.

What determines the flow of lending is the flow of real savings. If the baker were to consume his entire production of ten loaves of bread then there will be nothing left for lending.

It is therefore futile to urge banks to lend more if real savings are not there. Likewise it doesn’t make much sense to suggest that a central bank can somehow replace nonexistent real savings — in this case nine loaves of bread — by printing more money. (It is also an exercise in futility to raise government spending to fix the problem. After all if a government spends more it means that somebody else will have less resources left.) All that adding more money to the economy will do is to weaken wealth generators and thereby reduce the future supply of real savings and weaken future real economic growth.

So what then are we to make of the “paradox of deleveraging”?

Is it true that if every bank were to attempt to “fix” its balance sheet, the collective outcome would be disastrous for the real economy? On the contrary, by adjusting their balance sheet to reflect true conditions, banks would lay the foundation for a sustained economic recovery. After all, by trimming their lending, banks are likely also to curtail the expansion of credit “out of thin air.” It is this type of credit that weakens wealth generators and hence leads to economic impoverishment. Contrary to the proponents of the “paradox of deleveraging” we can only conclude that if every bank were to aim at fixing its balance sheet, and in the process curtailing the expansion of credit “out of thin air,” this would lay the foundation for a healthy economic recovery.

Conclusion

For most commentators, it is a major threat to an economy if banks are curtailing their expansion of credit in order to improve their net worth and hence solvency. This, it is argued, sets in motion a vicious process that leads to asset-price deflation, which for a given value of liabilities actually weakens banks’ net worth and makes them less solvent.

When all banks are trying to “fix” their balance sheets, the outcome could be the exact opposite of what they intended to achieve, so it is held. So what should be done to arrest this vicious process? According to popular thinking, the central bank and the government must step in and start buying assets that banks are trying to get rid of.

Note that this conclusion is in line with the writings of Keynes. Contrary to this way of thinking we have concluded that, by adjusting their balance sheets to the facts of reality, banks actually set up a process that permits sustained economic growth.

On this Ludwig von Mises had the following to say:

The unprecedented success of Keynesianism is due to the fact that it provides an apparent justification for the “deficit spending” policies of contemporary governments. It is the pseudo-philosophy of those who can think of nothing else than to dissipate the capital accumulated by previous generations. Yet no effusions of authors however brilliant and sophisticated can alter the perennial economic laws. They are and work and take care of themselves. Notwithstanding all the passionate fulminations of the spokesmen of governments, the inevitable consequences of inflationism and expansionism as depicted by the “orthodox” economists are coming to pass. And then, very late indeed, even simple people will discover that Keynes did not teach us how to perform the “miracle … of turning a stone into bread,” but the not at all miraculous procedure of eating the seed corn.[4]

A version of this article was previously published at BrookesNews.com on 25 August 2008. The same ideas were presented in article for Mises.org yesterday: Will the Latest Plan “Fix” the Eurozone?.

[2] John Maynard Keynes, The General Theory of Employment, London Macmillan &Co ltd 1964 p 361 (Notes on Mercantilism,etc.).

[3] Ibid, p362-363.

[4] Ludwig von Mises, Lord Keynes and Say’s Law – in The Critics of Keynesian Economics edited by Henry Hazlitt D.Van Nostrand Company, Inc p 320-321.

Most experts are of the view that still-subdued economic activity requires a more aggressive stance from policy makers in order to revive the economy. Since the end of 2007 the Federal Reserve pumped about $2 trillion into the banking system while the US central bank policy rate – the federal funds rate target – was lowered from 4.25% in December 2007 to 0.25% at present.

A week ago US President Obama suggested a $450 billion stimulus package to revive the economy. Observe that in February 2009 the Congress had approved Obama’s first stimulus package of $787 billion. Despite all the aggressive measures taken by the Fed and the US government the economy remains depressed. Since the approval of the first fiscal stimulus package almost 2 million jobs were lost. While since the end of December 2007, when the aggressive pumping by the Fed was introduced, almost 7 million jobs have disappeared. The unemployment rate has jumped from 5% in December 2007 to 9.1% in August this year.

Why then should Obama’s additional fiscal stimulus package and more aggressive Fed pumping revive the economy? The experts are of the view that given the lack of positive response by the US economy to all the fiscal and monetary stimulatory policies, it implies that the economy has strongly deviated from the path of balanced economic growth. On 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 first push in terms of loose monetary and fiscal policies didn’t produce the required results then policy makers must become more aggressive until the space ship is brought onto the correct growth path.

Loose policies can only damage not strengthen the economy

The purpose of production is to generate final consumer goods and services that maintain and improve individuals’ life and well being. Various means are employed for this such as tools and machinery and labor. All these resources whilst important are not sufficient.

What is required is an adequate pool of final consumer goods and services that will maintain the life and well beings of individuals engaged in various stages of production that range from the production of final consumer goods and services to the production of tools and machinery i.e. capital goods. It is the pool of final consumer goods and services that funds various activities. The size of this pool dictates the type of activities that can be undertaken.

For instance, if the size of the pool permits the building of a very basic tool then the building of more advanced machinery cannot be undertaken, notwithstanding the plentiful of natural resources, technological knowhow and skilled labor.

In order to be able to make more advanced machinery individuals, instead of consuming existent produced final goods, would have to save a portion of these goods and allocate them towards the enhancement and the expansion of tools and machinery. With better tools i.e. capital goods, a greater production of final consumer goods can be undertaken, which in turn will permit the making of a more sophisticated infrastructure.

Note that any form of economic activity must be funded by means of final consumer goods and services. Neither the government nor the Fed have the ability to generate final consumer goods to fund the building and the enhancement of infrastructure.

For instance when the Fed pushes more money to the economy all it is doing is increasing the amount of the means of exchange. An increase in money supply sets in motion an exchange of nothing for something i.e. it diverts final consumer goods or wealth from wealth generating activities towards non-wealth generating activities. This in turn undermines rather than strengthens the economy’s ability to expand real wealth. (It is exactly the same outcome produced by a counterfeiter).

Likewise loose fiscal policies produce the same results as printing money does – it diverts wealth from wealth generators to non-wealth generating projects. What then is the point of trying to boost employment by means of loose fiscal policies, which in the process weakens the economy’s ability to generate more wealth (such as digging ditches and making pyramids)?

Once the central bank tightens its stance for whatever reasons the diversion of wealth to non-productive activities stops and various useless projects must be aborted. Obviously various individuals employed in these projects become unemployed.

It is true that now we have idle resources. Contrary to popular thinking the employment of idle resources with the help of loose policies is not cost-free, this requires the diversion of wealth from wealth generating activities.

Also, it is false that loose fiscal and monetary policies are required to fix the unemployment and revive the economy.

Remember that loose policies only weaken the ability to generate wealth. Obviously then we require less and not more of these policies to grow the economy.

A better alternative is to curtail the ability of the Fed and the government to engage in aggressive loose policies. This will leave more wealth in the hands of wealth generators and will enable them to get on with the job of setting in motion true economic growth.

With the expansion in the production of wealth, all other things being equal, a greater demand for resources including labor will ensue. In short more wealth will make it easier to absorb so called idle resources.

Conclusion

Despite aggressive fiscal and monetary policies the US economy remains subdued. Since December 2007 almost 7 million jobs have disappeared. Experts, however, are of the view that a more aggressive monetary and fiscal stance is required to revive the US economy. We suggest that loose monetary and fiscal stance will only further damage the foundations of the economy.

Let us take an American individual who earns his money by exchanging something useful for it — he produces consumer goods. He then decides to exchange the money for some other consumer goods that are manufactured in China i.e. he is importing from China. A Chinese producer who has received the American dollars uses them to buy consumer goods from the above American producer; i.e., he is importing from the United States. So what we have here is a situation in which the American producer has paid for the Chinese consumer goods with his saved consumer goods. Likewise the Chinese producer has paid with his saved consumer goods to secure American consumer goods. The American and Chinese trade balances are in balance.

Now let us assume that instead of using the dollars to buy American consumer goods the Chinese producer decides to invest his dollars in US corporate bonds. The US trade account in this case will move into a deficit whilst China’s trade account will show a surplus. From the trade deficit perspective, as espoused by the popular way of thinking, this will be seen as bad news since American foreign debt has risen by the size of the deficit.

In the above example one is tempted to conclude that as a result of the trade deficit America’s economic fundamentals have deteriorated, or at least there are signs that this may be the case. A closer inspection of what has really happened would show that an American importer has paid for Chinese goods with money that he has earned by producing useful consumer goods. The fact that the Chinese producer has invested the dollars in American corporate bonds doesn’t pose any threat to American economic fundamentals. What we have here is a situation where claims on real savings have been channelled to America Inc. Once these claims are exercised and real savings are employed efficiently it only promotes a further expansion in US real wealth. Is anything wrong with this? All we have here is a situation where instead of buying final American consumer goods, the Chinese producer buys future US goods.

According to Rothbard,

More nonsense has been written about balances of payments than about virtually any other aspect of economics. This has been caused by the failure of economists to ground and build their analysis on individual balances of payments. Instead they have employed such cloudy, holistic concepts as the ‘national’ balance of payment without basing them on individual actions and balances.

Contrary to the popular way of thinking, an emerging trade deficit doesn’t mean that Americans are now saving less. We have seen that an American producer has exchanged unconsumed final consumer goods that he produced, i.e., saved consumer goods for money — claims on real savings. This means that we have an increase in real savings.

Additionally if the Chinese producer transfers the received claims i.e. US dollars, in return for his goods, to an American corporation (the Chinese producer bought corporate bonds) this will further lift the pool of real savings at the disposal of Americans. This is because real savings were obtained from China — via the import of Chinese consumer goods — in addition to the real savings generated by the American producer.

What matters as far as real economic growth is concerned is real savings. The balance of payments statements, which deal with monetary flows, cannot tell us much about the flow of real savings. For instance, Americans are importing tools and machinery from Japan and exporting consumer goods to Japan. In terms of the net flow of money it turns out that the value of American imports from Japan exceeds exports to Japan — i.e., a trade deficit emerges.
The conventional wisdom would argue here that Americans are now saving less and are in fact funded by the Japanese. In reality the exact opposite takes place. Americans are in fact supplying real savings — final consumer goods — to Japanese producers of tools and machinery. In other words, it is the American real savings that in fact support (i.e., fund) the Japanese producers of capital goods. Observe that Japanese tools and machinery do not as yet produce any real wealth, they are just potential future wealth. Also, note that it is not money that funds economic activity but real savings. Money is just the medium of exchange; it is not however the means of payment, and it never funds anything.

Let us now consider an American individual who borrows money from a bank and uses the dollars to buy goods from China. The bank has transferred money — claims on real savings — to the borrower of money. The bank has obtained the money from some other American producer who instead of exchanging the money for goods has decided to lend them out. Again, if the Chinese producer uses the dollars to buy US corporate bonds or stocks, this will lead to a US trade deficit and to a so-called increase in US foreign debt, which in turn will be seen as bad news. But all this is just a misguided perspective. Every transaction here is fully backed up by real wealth or expectations of real wealth.

The trade account and monetary pumping

Consider an American counterfeiter who uses counterfeit money to buy goods from Japan. The money that he has exchanged is not supported by anything useful. The counterfeiter has produced nothing useful and is not expected to produce anything useful in the future. He is exchanging nothing for money and then he exchanges money for useful Japanese goods. The Japanese producer who gets the fraudulent dollars — unbacked by real-wealth dollars — will have difficulties realizing them for real wealth. (The Japanese producer will have to bid US prices higher to secure some US goods. This however, will undermine the purchasing power of dollars held by the Japanese producer). As far as the US dollar flow is concerned the trade account is actually in balance. The counterfeit dollars spent on Japanese goods are matched by the same counterfeit dollars spent by Japanese on goods in the US. Since the trade account is in balance, some economists may even conclude that the state of savings is also in healthy shape. However, the story of the trade account here will be false and incomplete because the monetary pumping has been overlooked. American wealth producers are being hurt because Japanese, by exercising the counterfeit dollars, are now diverting real wealth from wealth producers. As a result American wealth producers’ ability to produce has weakened. Consequently, the flow of real savings, all other things being equal, is going to come under pressure.

Conclusions

What matters for the process of wealth formation is the flow of real savings. The balance of payments statement doesn’t provide such information. Consequently, it is not possible to determine the implications of a given state of the current account on the well being of Americans without information regarding the state of the flow of real savings. Therefore various assessments regarding the US economy, which are based on the state of the balance of payments, are likely to be without much foundation.

This article is based on one previously published at Mises.org in February 2006

A report from America, previously published at Mises.org

On Monday, August 8, the S&P 500 stock-price index fell 6.7 percent to close at 1,119.46. The index fell 13.4 percent from July, and this was the fourth consecutive monthly decline. It has fallen 17.9 percent from its high of 1,363.61 in April this year.

Also, the index’s growth momentum has fallen visibly. Year on year, the rate of growth declined to 6.7 percent from 17.3 percent in July.

The trigger for the plunge in stocks was Standard & Poor’s lowering of the US Treasuries’ rating from AAA to AA+. But while the trigger may have been this downgrade, the key factor that set in motion the plunge in stocks is the sharp deterioration in the state of the pool of real savings as a result of loose monetary and fiscal policies.

Normally, what matters for the stock market is the state of monetary liquidity.

As economic activity slows down, the demand for the services of the medium of exchange that money provides in the real economy declines. Therefore, a surplus of money or an increase in monetary liquidity emerges. As a rule this surplus is put to work in financial markets, including the stock market. Consequently, the prices of financial assets and stocks are pushed higher. (Remember, the price of an item is the amount of dollars paid for the item. Likewise the price of a stock is the amount of dollars paid per stock.)

For instance, the yearly rate of growth of industrial production fell from 3.5 percent in January 1974 to negative 12.4 percent in May 1975. The yearly rate of growth of the CPI fell from 12.3 percent in December 1974 to 9.4 percent in June the following year. Changes in the industrial production and the CPI can be seen as a proxy for changes in the demand for money.

As a result, the yearly rate of growth of surplus money climbed from negative 7.7 percent in March 1974 to positive 7.6 percent in May 1975. In response to the increase in liquidity, the S&P 500 climbed from 68.6 in December 1974 to 95.2 by June 1975 — an increase of 38.8 percent.

Historically, fluctuations in liquidity precede fluctuations in the S&P 500 stock-price index (see chart below).

For July this year, the growth momentum of liquidity displays a visible uptrend — the yearly rate of growth stood at 4.5 percent against 3 percent in June. So from a liquidity perspective the S&P 500 appears to be well supported. What’s more, there is a growing likelihood that the Fed will embark on more money pumping.

So why then has the stock market declined despite a strengthening in the growth momentum of monetary liquidity? Most experts believe the reason is the S&P downgrade of US government debt and a weakening in some key economic data. The yearly rate of growth of real personal-consumption outlays fell to 1.8 percent in June from 2 percent in May. The ISM manufacturing index fell to 50.9 in July from 55.3 in June, while the ISM services index eased to 52.7 in July from 53.3 in the previous month.

The growth momentum of real AMS (the Austrian money supply[1] ) has been in an uptrend since April last year. After closing at 0.8 percent in April last year, the yearly rate of growth of real AMS jumped to 7.8 percent in July this year. (In June the rate of growth stood at 6.4 percent.) The increase in the growth momentum of real AMS should provide good support ahead for the ISM manufacturing and services indexes (see charts below). All other things being equal, an uptrend in the growth momentum of monetary liquidity coupled with a likely bounce in the yearly rate of growth of key economic data should be good news for stocks.

If the pool of real savings is in trouble, then various key economic data will have difficulty performing well. If the pool of real savings is falling, then an increase in liquidity is not likely to be employed in the stock market. The state of the pool of real savings dictates the economy’s ability to generate wealth — that is, economic growth.

For instance, the yearly rate of growth of industrial production fell from 15.3 percent in January 1929 to negative 24.6 percent in October 1930. The growth momentum of the consumer-price index (CPI) also had a large fall during this period. The yearly rate of growth fell from negative 1.2 percent in January 1929 to negative 6.4 percent in December 1930.

In response to these large falls, the yearly rate of growth of surplus money increased from negative 16.6 percent in May 1929 to a positive figure of 25.5 percent by November 1930. Despite this strong increase in liquidity, the S&P 500 fell from 24.15 in October 1929 to 15.34 by December 1930 — a fall of 36.5 percent. The index in fact continued to slide falling to 4.4 by June 1932 — a fall of 81.8 percent from October 1929.

The inability of the increase in liquidity to affect the stock market from May 1929 to December 1930 was because of a fall in the pool of real savings. The ensuing depression and massive unemployment pushed people to stay out of any form of risky investment for safety reasons.

We maintain that, regardless of the downgrade by Standard & Poor’s, if currently the percentage of wealth-generating activities out of all activities is still above 50 percent, then it is likely that the pool of real savings or the pool of funding is still growing. Consequently, real economic growth should follow suit. In this situation, the Fed could perpetuate the illusion that monetary pumping can grow the economy. Indeed, in this situation an increase in the money supply’s rate of growth is likely to be associated with a rebound in various key economic data and with a strengthening in the stock market.

If, however, less than 50 percent of all activities are wealth generators, then more pumping will only make things much worse. (Loose policies will only further weaken the pool of real funding, deepen the economic slump, and deepen further the slide in stocks.)

Although we cannot quantify whether the pool of real savings is currently expanding or stagnating, we can definitely say that the loose policies of the Fed and the US government have weakened the pool. The fact that, despite the aggressive pumping by the Fed (QE1 and QE2), the economy remains depressed raises the possibility that perhaps the pool of real funding is stagnant or worse. Obviously in this case, given the fact that the Fed and the government will try to “revive” the economy, the downtrend in the stock market could last much longer. (Such policies will only undermine the pool of real funding further and delay meaningful economic recovery.)

But what about the fact that corporate earnings are doing very well? More than 75 percent of corporations in the S&P 500 index have exceeded earnings estimates of Wall Street analysts for the second quarter. Furthermore, most experts are of the view that corporate earnings will rise by 18 percent in 2011 and 14 percent in 2012.

We suggest that, irrespective of how supposedly well various companies are doing, if the pool of real funding begins to slide the performance of so-called good companies will follow suit.

Conclusion

While Standard & Poor’s downgrade of US government debt has triggered the plunge in the stock market, the underlying cause behind the stock market’s sharp decline is loose monetary and fiscal policies that have badly damaged the ability of the US economy to generate wealth. Historically, fluctuations in monetary liquidity have preceded fluctuations in the S&P 500 stock-price index. The recent visible strengthening in the growth momentum of monetary liquidity will be of little help to the stock market if the pool of real savings is stagnating or, worse, declining.

By fulfilling the role of an intermediary, banks are an important factor in the process of real wealth formation. Banks facilitate the flow of real funding by introducing ‘suppliers’ of real funding to ‘demanders’. When a saver lends money, what he in fact lends to borrowers is final consumer goods he has not consumed. Credit then means that unconsumed goods are loaned by one productive individual to another, to be repaid out of future production.

For instance, a farmer Joe produced 2kg of seeds. For his own consumption he requires 1kg, and the rest he decides to lend for one year to a farmer Bob. The unconsumed 1kg of seeds that he agrees to lend is his savings. In short, the precondition of lending is that there must be savings first. This means that lending must be fully backed up by savings.

By lending 1kg of seeds to Bob, Joe agrees to give up for one year the ownership of this quantity of seeds. In return, Bob provides Joe with a written promise that after one year he will repay 1.1kg of seeds. The 0.1kg constitutes an interest.

What we have here is an exchange of 1kg of present seeds for 1.1kg of seeds in a one year’s time. Is there anything wrong with this type of transaction? Not at all, both Joe and Bob have entered into this transaction voluntarily because they both have reached the conclusion that it would serve their objectives.

The introduction of money will not alter the essence of what lending is all about. Instead of lending 1kg of seeds Joe will first (sell) exchange his 1kg of seeds for money, let us say for $100. Joe may now decide to lend his money to another farmer John for one year at the going interest rate of 10%. John the farmer in turn buys a piece of equipment, which lifts his production to 200 seeds in one year’s time. Observe that the introduction of money didn’t change the fact that real savings precede the act of lending.

Now, when credit is fully backed up by saving and in turn is employed in the production of real wealth, then everything is ok. However, when real savings do not back up credit then it means that no real savings have been exchanged in this mirage transaction. The borrower that holds the empty money, so to speak, exchanges them for goods and services. In short, what emerges is an exchange of nothing for something, or consumption of goods that is not backed up by a corresponding production. This leads to the diversion of real wealth from wealth-generating activities towards the holders of credit, which was generated out of “thin air”.

Obviously such types of credit lead to the depletion, i.e. consumption, of real savings, which undermines the production of real wealth – what we then have here is an increase in money debt and a money supply and the weakening in the real wealth generation process. (Needless to say, the weakening of the production of real wealth diminishes the borrowers’ ability to repay their debts).

Fractional reserve banking as the source of money out of “thin air”

How is it possible that lenders can generate credit out “of thin air”? As we have already seen, ordinary lenders cannot lend something that they do not have. However, things are different once we introduce the central bank and fractional reserve banking into our analysis.

The existence of the central bank and the system of fractional reserve banking permits commercial banks to generate credit which is not backed up by real funding, i.e. the production of credit out of “thin air.” For instance, a farmer Joe sells his saved 1kg of seeds for $100. He then deposits this $100 with the Bank A. Note that the $100 is fully backed up by the saved 1kg of seeds. Also, observe that Joe is exercising his demand for money by holding them in the demand deposits of the bank A. (Joe could have also exercised his demand for money by holding the money at home in a jar, or under his mattress).

Whenever a bank takes a portion of Joe’s deposited money and lends it out it sets in motion serious trouble. Let us say that bank A lends $50 to Bob by taking $50 out of Joe’s deposit. Remember that Joe still exercises his demand for $100. No additional real savings back up these $50. Once Bob uses the money he in fact engages in an exchange of nothing for something. This amounts to non-productive consumption of real wealth. What we have here is $150 that only backed by $100. (Remember, that $100 is fully backed up by 1kg of seeds – real savings).

Now, when loaned money is fully backed up by savings, on the day of the loan’s maturity it is returned to the original lender. Thus, Bob – the borrower of $100 – will pay back on the maturity date the borrowed sum plus interest. The bank in turn will pass to Joe the lender his $100 plus interest adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender.

In contrast, when credit is created out of “thin air” and returned to the bank on the maturity day this amounts to a withdrawal of money from the economy, i.e a decline in the money stock. The reason for this being that there wasn’t any original saver/lender because this type of credit was created out of “thin air”.

As long as banks continue to expand credit out of “thin air” various non-productive activities continue to prosper. Once however the extensive creation of credit out of “thin air” lifts the pace of real-wealth consumption above the pace of real-wealth production the positive flow of real savings is arrested and a decline in the pool of real funding is set in motion. Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to rise. In response to this, banks curtail their lending activities and this in turn sets in motion a decline in the money stock. (Remember, the money stock declines once the loan that was generated out of “thin air” is repaid and not renewed). The fall in the money stock begins to undermine various non-productive bubble activities, i.e. an economic depression emerges.

Note that a depression is not caused by a collapse in the money stockas such, but comes in response to a shrinking pool of real funding on account of previous loose money. It is the shrinking pool of real funding that leads to the decline in the money stock. Subsequently, even if the central bank were to be successful in preventing a fall of the money stock, this cannot prevent a depression if the pool of real funding is declining.

After rising to 3.33% in March, the differential between the 10-year US Treasury Note and the federal funds rate eased to 3.07% at the end of June. Historically a narrowing in the differential, also called the ‘yield curve’, has occurred many months before the onset of a recession.

The most popular explanation of the causes that determine the shape of the yield curve is provided by the so-called Expectation Theory (ET). The key to the shape of the yield curve is that long-term interest rates are the average of expected future short-term rates.

If today’s one-year rate is 4% and next year’s one-year rate is expected to be 5%, then the two-year rate today should be (4+5)/2=4.5. It follows then that expectations for rises in short-term rates will make the yield upward sloping, for long-term rates will be proportionately higher than short-term rates.

Conversely, expectations for a decline in short-term rates will result in a downward sloping yield curve, for long-term rates will be proportionately lower than short-term rates. (Thus if today’s one-year rate is 5% and next year’s one-year is expected to be 4%, then the two-year rate today (5+4)/2=4.5 is lower than today’s one-year rate of 5% – downward sloping yield curve).

According to the practitioners of ET, an economic slump is associated with falling interest rates. Consequently, whenever investors expect an economic slowdown or a recession they shift their money from short-term securities towards long-term bonds. This shift raises short-term rates and lowers long-term rates, i.e. “narrowing in the spread” or the “inversion in the yield curve” emerges.

Conversely, an economic expansion is associated with rising interest rates. Hence whenever investors expect economic expansion they shift their money to short-term securities away from long term bonds. This shift leads to the lowering of short-term yields and an increase in long-term yields.

But is it possible to have a sustained downward sloping yield curve? One can show that in a risk free environment neither an upward nor a downward sloping yield curve can be sustainable.

An upward sloping curve will provoke an arbitrage movement from short maturities to long maturities.  This will lift short-term interest rates and lower long-term interest rates, i.e. leading towards a uniform interest rate throughout the term structure. Arbitrage will also prevent the sustainability of an inverted yield curve by shifting funds from long maturities to short maturities thereby flattening the curve.

Another theory called the Liquidity Preference Theory (LPT) seems to have better reasoning for the upward sloping yield curve. According to the LPT, people demand a liquidity premium for longer maturities over the short-term maturities on account of a risk factor. The problem with the LPT, however, lies in its inability to explain inverted yield curves, i.e. when short-term interest rates are higher than the long term rates.

(Now, in a free unhampered market economy, the tendency towards the uniformity of rates will only take place on a risk-adjusted basis. Consequently, the yield curve that includes the risk factor is likely to have a gentle positive slope. It is, however, difficult to envisage a downward sloping curve in a free unhampered market economy – since this would imply that investors are assigning a higher risk to short-term maturities than long-term maturities, which doesn’t make sense).

Even if one were to accept the rationale of ET for the changes in the shape of the yield curve, these changes are likely to be of very short duration on account of arbitrage. Yet historically either an upward sloping or a downward sloping yield curve held for quite a prolong period of time (see the chart above). What, then, is the primary mechanism that causes the curve to slope so consistently? The culprit is the central bank’s tampering with financial markets via monetary policy.

The Fed and the shape of the yield curve

While the Fed can exercise a control over short-term interest rates via the federal funds rate, it has less control over longer-term interest rates. It is this that gives rise to an upward or a downward sloping yield curve. An upward or downward sloping curve develops on account of the Fed’s monetary policies that disrupt the natural tendency towards the uniformity of interest rates along the term structure.

For instance, the artificial lowering of short-term interest rates, which is reinforced by the increase in the monetary pumping of the Fed gives rise to an upward sloping yield curve. This upwardly sloping curve (in excess of the slope that allows for the risk factor) cannot be sustained since it sets in motion forces that are working towards the flattening of the curve.

An easy monetary stance prompts investors to borrow money at lower short-term interest rates and invest in higher yielding longer-term investments. This in turn puts upward pressure on short-term rates and downward pressure on long-term rates.

To sustain the positive sloping curve the Fed must persist with its easy stance. (Should the central bank cease with its monetary pumping the shape of the yield curve will tend to flatten).

The loose monetary policy of the Fed gives rise to various activities that prior to loose policy were never on the cards – an economic boom emerges. (The loose monetary policy leads to a shift of real funding away from wealth generating activities towards less profitable activities).

Whenever the Fed reverses its stance by slowing its monetary pumping and in the process raises short-term interest rates various activities that emerged on the back of the previous loose stance are now coming under pressure – this sets in motion an economic bust.

A tighter stance manifests itself through a flattening or an inversion of the yield curve. In order to sustain the narrowing in the yield spread the central bank must maintain its tighter stance.

Should the Fed abandon the tighter stance, the tendency for an equalisation of rates will arrest the inversion of the yield curve.

Whenever the Fed reverses its monetary stance, which manifests itself through the change in the shape of the yield curve, the effect of this change in the stance doesn’t assert itself immediately on the entire economy.

The effect of a change in monetary policy shifts gradually from one market to another market. It is this that prompts the change in the shape of the yield curve to be seen as a leading indicator of economic activity.

For instance, when during an economic expansion the Fed raises the fed funds rate target, which causes the narrowing in the yield spread, the initial effect is minimal for economic activity is still dominated by the previous easy monetary stance.

It is only later on once the tighter stance begins to dominate the scene that economic activity begins to weaken.

Likewise, when during a recession the central bank lowers the short-term interest rate this steepens the yield curve. However, the effect of this loosening, which is manifested by a steepening in the yield curve only asserts itself after a time lag.

Observe that according to the popular framework of thinking it is not the central bank that alters the shape of the yield curve but people’s expectations.

Consequently, according to this way of thinking via a close scrutiny of the shape of the yield curve, one can establish people’s psychological dispositions and thus the future course of the economy.

To the extent that investors form expectations regarding the future course of monetary policy, this only tends to reinforce the shape of the yield curve as set by the central bank.

Thus in the late stages of an economic expansion investors begin to anticipate a tighter monetary stance and this tends to reinforce the upward slope of the yield curve. Investors begin shifting their money away from long term- securities towards short-term securities. This lifts long-term rates and lowers short-term rates.

During an economic slump investors begin anticipating a further easier monetary stance and the downward slope of the yield curve is reinforced. Investors shift their money towards long term securities away from short-term securities.

This means that the dominant factor behind the shift in the shape of the yield curve is the central banks’ monetary policies and not investors’ expectations as such. At best, expectations can only reinforce the slope of the yield curve.

Hence the reason for the predictive powers of the yield curve is not on account of expectations but rather on account of the monetary policy of the Fed.

Things, however, need not always work this way. For instance, if the pool of real savings is declining, the pumping by the Fed may not lift economic activity.

On the contrary, such pumping will deplete the pool further and make things much worse.

For instance, in such a set-up an upward sloping yield curve will not send a correct signal regarding the future course of economic activity.

We can thus conclude that as long as the pool of real savings is expanding the yield curve will appear to be a useful forecasting device.

Once, however, the pool of real savings becomes stagnant or declining the illusion that the central bank can navigate the economy is shattered.

Hence, commonly accepted signals that emanate from monetary policy are likely to be of a confusing nature as far as the future course of the economy is concerned.

In such a scenario relying on monetary indicators such as the yield curve could lead to a misleading analysis.

At the International Monetary Conference in Atlanta June 7, 2011 the Fed Chairman Ben Bernanke said,

As is often the case, the ability and willingness of households to spend will be an important determinant of the pace at which the economy expands in coming quarters….. Developments in the labor market will be of particular importance in setting the course for household spending.

Seasonally adjusted non-farm employment increased by 54,000 in May after rising by 232,000 in the month before – below market expectations for a 165,000 increase. The growth momentum of employment fell last month. Year-on-year 0.870 million jobs were created in May after rising by 1.274 million jobs in the previous month. Factory employment fell by 5,000 last month following a gain of 24,000 in April. The unemployment rate rose to 9.1% in May from 9% in the month before.

But does it make sense that the key to economic growth is the lowering of unemployment? If this is the case then it is valid to conclude that changes in unemployment are an important causative factor of real economic growth.

This way of thinking is based on the view that a reduction in the number of unemployed means that more people can now afford to boost their expenditure. As a result, economic activity follows suit.

We suggest that the main driver of economic growth is an expanding pool of real savings. Fixing unemployment without addressing the issue of real savings is not going to lift the economy.

It is real savings that funds the enhancement and the expansion of the infrastructure. An enhanced and expanded infrastructure permits an expansion in the production of the final goods and services required to maintain and promote individuals’ life and well being.

If unemployment were the key driving force of economic growth then it would have made a lot of sense to eradicate unemployment as soon as possible by generating all sorts of employment. For instance, policy makers could follow the advice of Keynes and Paul Krugman and employ people in digging ditches, or various other government sponsored activities. Again the aim is just to employ as many people as possible.

A simple common sense analysis, however, quickly establishes that such a policy would amount to a waste of scarce real savings. Remember that every activity whether productive or non-productive must be funded. Hence employing individuals in various useless activities simply leads to a transfer of real savings from wealth generating activities and this thereby undermines the real wealth generating process.

Unemployment as such could be relatively easily fixed if the labour market were to be free of tampering by the government. In an unhampered labour market, any individual who wants to work would be able to find a job at a going wage for his particular skills. Obviously if an individual demands a non-market related salary and is not prepared to move to other locations, there is no guarantee that he will find a job. For instance, if a market wage for John the baker is $80,000 per year yet he insists on a salary of $500,000, he is likely to be unemployed.

Over time a free labour market makes sure that every individual earns in accordance to his contribution to the so-called overall “real pie”. Any deviation from the value of his true contribution sets in motion corrective competitive forces.

Ultimately what matters for the well-being of individuals is not that they are employed as such but their purchasing power in terms of the goods and services that they earn. It is not going to be of much help to individuals if what they are earning will not allow them to support their life and well being. Individuals’ purchasing power is conditioned upon the infrastructure that they operate. The better the infrastructure, the more output an individual can generate. A higher output means that a worker can now command higher wages in terms of purchasing power.

As we have seen, the key for an enhanced and expanded infrastructure is an increase in the pool of real saving. However, any government and central bank policies aimed at lowering unemployment by means of stimulus policies amounts to a policy of redistribution, which leads to economic impoverishment, i.e. it undermines the living standards of most individuals. Again, such policies do not expand the pool of real savings but rather result in the weakening of the growth of this pool.

Thus when the Fed pumps money through the purchase of Treasury bonds the point of buying bonds is to drive down long-term interest rates and encourage more lending by banks. This, it is held, will provide a boost to economic growth.

The artificial lowering of interest rates cannot as such lift the supply of credit if the pool of real savings is in trouble. It should be realised that banks just fulfil the role of intermediaries – they can facilitate the distribution of available real savings. However, they cannot create real savings – the key to economic growth. Hence, bank activities as such cannot boost real economic growth.

An artificial lowering of interest rates cannot generate more lending that is fully backed by real savings. The only credit that commercial banks can expand is credit out of “thin air”, or inflationary credit. An increase in inflationary credit amounts to an increase in money supply and hence to a diversion of real savings from wealth producers to non-wealth generating activities. Obviously then an expansion in credit on account of inflationary credit is bad news for economic growth.

Note that for Bernanke and most other experts the key factor that keeps the economy going is policies that allow the lowering of interest rates. Again the lowering of the interest rate structure, it is held, boosts consumption and businesses expenditure and this in turn lifts economic growth through the famous Keynesian multiplier.

Additionally, according to this way of thinking, loose government spending is important to economic growth. Hence Bernanke holds that one needs to be careful in the short run in curbing government outlays in order not to damage the economy.

A sharp fiscal consolidation focused on the very near term could be self-defeating if it were to undercut the still-fragile recovery.

However, Bernanke and other experts are also of the view that if government expenditure significantly surpasses government revenues an emerging deficit could curtail the benefits of loose fiscal policy by pushing the interest rate structure higher.

So what is then the solution? According to Bernanke,

The solution to this dilemma, I believe, lies in recognizing that our nation’s fiscal problems are inherently long-term in nature. Consequently, the appropriate response is to move quickly to enact a credible, long-term plan for fiscal consolidation. By taking decisions today that lead to fiscal consolidation over a longer horizon, policymakers can avoid a sudden fiscal contraction that could put the recovery at risk. At the same time, establishing a credible plan for reducing future deficits now would not only enhance economic performance in the long run, but could also yield near-term benefits by leading to lower long-term interest rates and increased consumer and business confidence.

We suggest that the focus shouldn’t be the fiscal deficit as such, but curbing government outlays. Cutting government is the best policy to normalize the economy and must be implemented as soon as possible.

In similarity to loose monetary policies, loose government policies also cause the diversion of real savings from wealth generating activities to non-wealth generating activities. Hence, contrary to Bernanke, we suggest that a severe cutback in government outlays in the very near term will help and not damage the economy.

Obviously various false activities that emerged on the back of loose fiscal policies will suffer. However, wealth generators will now have more real savings at their disposal, which will enable them to generate more real wealth. With all other things being equal, more wealth will lead to more real savings. Failing to curb government outlays will only weaken the process of wealth generation and will plunge the economy into a prolonged stagnation.

We can conclude that what matters is not to have strong economic activity as such but strong wealth generating activities. Hence the focus must always be on whether a given or suggested policy is good or bad for the wealth generating process.

This post is based on an earlier article published at mises.org on 21 September 2010