The Cobden Centre

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,

1. Sharp increase in the price of an asset.
2. Great public excitement about these price increases.
3. An accompanying media frenzy.
4. Stories of people earning a lot of money, causing envy among people who aren’t.
5. Growing interest in the asset class among the general public.
6. New era “theories” to justify unprecedented price increases.
7. 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.

Defining bubbles

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.[1]

Whereas,

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?[2]

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.

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.

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.