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By Dr Frank Shostak, on 12 August 11
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 Dr Frank Shostak, on 25 July 11
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.
By Dr Frank Shostak, on 19 July 11
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.
By Dr Frank Shostak, on 14 June 11
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
By Dr Frank Shostak, on 25 May 11
U.S. Treasury Secretary Geithner said in a letter to Senator Michael Bennet, a Colorado Democrat, that a default arising from failing to raise the $14.29 trillion debt limit could cause “irrevocable damage” to the economy and risk a “double-dip” recession and increase unemployment.
Missing or delaying payments on various obligations, including those to businesses for goods and services and bond payments to investors, would result in a massive and abrupt cut in federal spending and aggregate demand, the letter warned.
‘The abrupt contraction would likely push us into a double-dip recession’, Geithner said. According to Geithner, he is currently using an emergency reallocation of funds so that the government can meet its obligations, including payments to Treasury bondholders.
Those measures are only expected to enable the government to operate normally until August 2 from when it will start defaulting on payments including those on Treasury debt, an event that could trigger chaos in world financial markets. Geithner is of the view that a default or any missed payments would not only increase borrowing costs for the U.S. government but also for average Americans, businesses and local governments.
Now, when a lender transfers his real savings to a borrower he expects to receive his real savings plus interest after an agreed period, i.e. on the maturity date. In order for the borrower to be able to honour his debt he must be able to generate real wealth that will be sufficient to cover the original debt plus the interest.
Government however, is not a wealth generator; it can only engage in a consumption of real wealth. How then does it repay the debt? – by borrowing again. It uses new borrowings to repay previous borrowings.
As long as the private sector is capable of supporting an expanding pool of real savings, this enables true real economic growth to stay in force. As long as this is the case, the government can engage in its endless borrowing game without ever being caught out – note that government borrowings result in the diversion of real savings from wealth generating activities, which in turn only weakens the economy. Obviously, then, if the ability of the government to borrow is curtailed this means that its ability to undermine the formation of real wealth is also curtailed – so what is wrong with this?
Once the ability of the government’s capacity to engage in non-productive activities is curtailed, various activities that are supported by government spending come under pressure – these activities cannot support themselves because they survive through a diversion of real savings from wealth generating activities. The emerging crisis then is not a crisis of the real economy as such, but a crisis of non-productive activities. On the contrary, now wealth generators will be able to retain more real savings at their disposal and expand the overall real pie.
The major threat to the economy is not failing to expand the debt limit but failing to arrest endless non-productive borrowings by the government.
By Dr Frank Shostak, on 28 April 11
In his various writings, the famous Austrian economist Murray Rothbard argued that in a free market economy that operates on a gold standard the creation of credit that is not fully backed up by gold (fractional reserve banking) sets in motion the menace of the boom-bust cycle. In his The Case for 100 Percent Gold Dollar Rothbard wrote,
I therefore advocate as the soundest monetary system and the only one fully compatible with the free market and with the absence of force or fraud from any source a 100 percent gold standard. This is the only system compatible with the fullest preservation of the rights of property. It is the only system that assures the end of inflation and, with it, of the business cycle.[1]
Prominent Austrian School of economics economists George Selgin and Lawrence White have contested this view. In his article in The Independent Review, Summer 2000 George Selgin argued that it is not true that fractional reserve banking must always set in motion the menace of the boom-bust cycle.
According to Selgin,
In truth, whether an addition to the money stock will aggravate the business cycle depends entirely on whether or not the addition is warranted by a pre-existing increase in the public’s demand for money balances. If an expansion of the supply of bank money creates an overall excess of money, people will spend the excess. Borrowers’ increased spending will, in other words, not be offset by any corresponding decline in spending by other persons. The resulting stimulus to the overall level of demand for goods, services, and factors of production, together with changes in the pattern of spending prompted by an artificial lowering of interest rates, will have the adverse business-cycle consequences described by the Austrian theory.[2]
However, argues Selgin, no business-cycle will emerge if the increase in the money supply is in response to a previous increase in the demand for money.
Such an expansion, instead of adding to the flow of spending, merely keeps that flow from shrinking, thereby sustaining normal profits for the “average” firm. The expansion therefore serves not to trigger a boom but to avoid a bust. As far as business-cycle consequences are concerned, it makes no difference whether the new money is or is not backed by gold.[3]
Likewise in their joint article Selgin and White wrote,
We deny that an increase in fiduciary media matched by an increased demand to hold fiduciary media is disequilibrating or set in motion the Austrian business cycle.[4]
Note that Selgin and White raise several issues here. First, for them the business cycle emerges only if the increase in the supply of money exceeds the increase in the demand for money.
Second, a bust is set in motion if an increase in the demand for money is not matched by a corresponding increase in the supply of money.
Finally Selgin and White imply that an increase in the supply of money, which is fully backed up by gold, in excess of the demand for money, will also trigger the menace of a boom-bust cycle.
Money out of “thin air” and boom-bust cycle
According to Selgin and White, it would appear that if counterfeit money enters the economy in response to an increase in the demand for money, no harm will be done. In other words, the increase in the supply of money is neutralised, so to speak, by an increase in the demand or the willingness to hold a greater amount of money than before. As a result the counterfeiter’s newly pumped money won’t have any effect on spending and therefore no boom-bust cycle will be set in motion. But does it make sense? What do we mean by demand for money? And how does this demand differ from demand for goods and services?
Now, demand for a good is not a demand for a particular good as such, but a demand for the services that the good offers. For instance, individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and well being. Demand here means that people want to consume the food in order to secure the necessary elements that sustain life and well being.
Also, the demand for money arises on account of the services that money provides. However, instead of consuming money, people demand money in order to exchange it for goods and services. With the help of money, various goods become more marketable – people can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.
An increase in the general demand for money, let us say on account of a general increase in the production of goods, doesn’t imply that individuals sit on the money and do nothing with it. As we have seen, the reason an individual has a demand for money is in order to be able to exchange money for other goods and services.
In the process of exercising their demand for money, some individuals lower their demand by exchanging their money for goods and services, whilst other individuals raise their demand for money by exchanging goods and services for money. Note that whilst overall demand did not change, individuals’ demand did change. We will show below that it is individuals’ demand and not the overall demand for money that matters in setting boom bust cycles.
Some holders of money may lend the money to some other individuals in return for an IOU. By accepting the IOU, the lenders are relinquishing their claims on final consumer goods and services for the duration of the loan to borrowers. The borrowers can now exchange the money for goods and services they require. (Note that the existence of banks helps to match between lenders and borrowers).
Now let us assume that for some reason some individual’s demand for money has risen. One way to accommodate this demand is for banks to find willing lenders of money. In short, with the help of the mediation of banks, willing lenders can transfer their gold money to borrowers. Obviously such a transaction is not harmful to any one.
Another way to accommodate the demand is that instead of finding willing lenders, the bank can create fictitious money – money unbacked by gold – and lend it out.
Note that the increase in the supply of newly-created money is given to certain individuals. There must always be a first recipient of the money freshly created by the banks.
This money, which was created out of “thin air”, is going to be employed in an exchange for goods and services, i.e. it will facilitate an exchange of nothing for something. The exchange of nothing for something amounts to the diversion of real wealth from wealth-generating to non-wealth-generating activities, which masquerades as economic prosperity. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy.
Once banks curtail their supply of credit out of “thin air”, this slows down the process of an exchange of nothing for something. This in turn undermines the existence of various false activities that sprang up on the back of the previous expansion in credit out of “thin” air, and an economic bust emerges.
We can thus conclude that what sets in motion the boom-bust cycle is the expansion of credit out of “thin air” regardless of the state of the general demand for money. Again, irrespective of whether the total demand for money is rising or falling, what matters is that individuals employ money in their transactions. As we have seen, once money out of ‘thin air’ is introduced into the process of exchange, this lays the foundation for the boom bust cycle.
Contrary to Selgin and White, we can further infer that it is not the failure to accommodate the increase in general demand for money that causes an economic bust, but actually the accommodation by means of money out of “thin air” that does it.
Does an increase in commodity money in relation to demand cause boom-bust cycles?
The introduction of money made it possible for individuals to specialise and engage in trade on a much wider scale than the barter economy would have permitted.
In the early stages of the emergence of money it was an ordinary commodity that people demanded because it contributed some tangible benefits to their life and well being. In other words, people already attached some importance to this commodity. In addition to offering benefits pertinent to this commodity, people also discovered that this commodity, let us call it X, had some other features that made it more marketable than other commodities. For instance, commodity X is durable and it is also portable. The various producers of perishable goods found that it was to their benefit to exchange their produce for commodity X and then use commodity X in exchange for other goods.
Would an increase in the supply of X, in response to an increase in the demand for X, undermine the process of real wealth formation? The answer is no. Since X is a commodity it implies that individuals attach importance to it on account of the benefits it offers. So the fact that producers of this commodity derive a much greater benefit than otherwise on account of the fact that X is also demanded as a medium of exchange is no different from any other commodity which for some reason suddenly experiences much stronger demand than before.
Now, if all of a sudden the supply of X were to increase sharply in excess of demand, people would find that its purchasing power would fall and this in turn would diminish its marketability. Should this persist, the demand for X as a medium of exchange would decline and people would seek the services of another commodity as a medium of exchange. Once a commodity loses its appeal as the medium of the exchange, it remains in demand for its other attributes. However, all this is not going to set the boom-bust menace in motion.
Now, the introduction of paper money, which is fully redeemable into commodity X, doesn’t alter anything we have said so far. Paper money should be seen as a receipt or a claim on the commodity X. So whenever this certificate is exchanged for goods and services the seller of these goods acquires a claim on X, while the seller of the claim acquires goods and services. Note that in the process of the exchange useful goods have been traded.
This is, however, not so when a bank prints a certificate which is unbacked by X. The bank then lends this unbacked certificate to some individual. What we have here is a claim on money that was created out of “thin air”. Note that in the case of a fully backed certificate an exchange of useful goods takes place, i.e. something useful is exchanged in return for something useful. In the case of unbacked certificate, we have a situation that once this certificate is employed in an exchange it leads to an exchange of nothing for something useful. We have shown above that the exchange of nothing for something is what sets in motion the menace of the boom-bust cycle.
We can therefore conclude that in contrast to money out of “thin air”, a market chosen money can never be harmful to individuals well being – it cannot set in motion the menace of boom bust cycle. An increase in the supply of fully backed money in relation to demand will only lead to a fall in the purchasing power of money. This, however, will not give rise to a misallocation of resources and to the boom-bust cycle. Again, an increase in the excess supply of proper money doesn’t set in motion an exchange of nothing for something. (We still retain here the act of an exchange of some useful goods for some other useful goods). Contrary to Selgin and White, then, as far as the business cycle is concerned of course it matters whether the new money is or is not fully backed up by gold.
Selgin also maintains that fractional reserve banking (the creation of money out of “thin air”) was responsible for the industrialization of developed countries.
According to many scholars, including Adam Smith, the industrialization of the West and of developed countries elsewhere was crucially dependent on funds mobilized by fractional reserve banks. Other nations’ failure to industrialize has to a significant extent been due to their repressive financial legislation, including laws (typically aimed at enhancing central bank profits) that forced banks to maintain needlessly high reserve ratios.[5]
This does not make much sense once it is realized that fractional reserve banking (the creation of money out of “thin air”) is actually instrumental in creating the dilution of real wealth formation and boom-bust cycles. After all, if fractional reserve banking is an important source of wealth formation, surely world poverty should have been eliminated a long time ago.
It seems that Selgin is confusing funding with money. What gives rise to the expansion of real wealth is the expansion in the pool of real savings. It is real savings that funds the production of various capital goods, i.e. tools and machinery. In short, it is real savings that sustain various individuals that are engaged in various stages of production. All that money does in all of this is to provide the facility of the medium of the exchange. It makes it possible for individuals to exchange goods and services.
The services of money are not enhanced on account of its greater supply. If anything, the increase in the supply undermines the services of money. After all when people’s demand for money rises they don’t want more money as such, but rather more purchasing power – it is the increase in the purchasing power of money that makes goods and services more marketable. The increase in the supply of money only prevents an increase in the purchasing power of money from taking place.
According to Mises,
The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power.[6]
Conclusion
Also, on a gold standard – contrary to Selgin and White – fractional reserve banking will always set the platform for boom-bust cycles. The main problem in Selgin and White’s analysis is that they look at the demand for money from a macro perspective rather than from the perspective of the individual. In short, Selgin and White’s macro-analysis forces them to ignore the misallocation of resources that unbacked credit expansion produces.
This article was previously published on 19 March 2007 by BrookesNews.com.
[1] Murray N. Rothbard – The Case For A 100 Percent Gold Dollar, Cobden Press 1984.
[2] George Selgin – Should We Let Banks Create Money?, The Independent Review, Summer 2000 p 93-100.
[3] Ibid.
[4] George Selgin and Lawrence White. In Defense of Fiduciary Media; or, We Are Not Devolutionists, We Are Misesians! Review of Austrian Economics 1996, 9:83-107.
[5] George Selgin – Should We Let Banks Create Money?, The Independent Review, Summer 2000 p 93-100.
[6] Ludwig von Mises, Human Action, 3rd rev.ed. (Chicago: Contemporary Books, 1966) p 421.
By Dr Frank Shostak, on 19 April 11
In their various statements, central bank policy makers have said that the key to economic growth is a smooth flow of credit. For them, it is credit that provides the foundation for rising living standards. So from this perspective whenever credit dries up, it makes a lot of sense for the central bank to ensure it flows again.
Following the teachings of Friedman and Keynes, it is almost the unanimous view of most experts that if lenders are unwilling to lend, then it is the duty of the government and the central bank to keep the flow of lending going.
For instance, if in the commercial paper market lenders are not there, then the Fed should step in and replace these lenders. The important thing, it is held, is that various businesses that rely on the commercial paper market to keep their daily operations going should be able to secure the necessary funding.
Now, it is true that credit is a key to economic growth. However, one must make a distinction in this regard between good and false credit. It is good credit that makes real economic growth possible and thus improves people’s lives and well being. False credit, however, is an agent of economic destruction and leads to economic impoverishment.
Good credit versus false credit
There are two kinds of credit: that which would be offered in a market economy with sound money and banking (good credit), and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (false credit).
Banks cannot expand good credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (lenders) to borrowers. To understand why, we must first understand how good credit comes to be and the function it serves.
Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight. He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one-week’s time. Note that credit here is the transfer of ‘real stuff’, i.e. eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes.
Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only four loaves of bread, the amount of credit would have only been four loaves instead of eight.
Note that the saved loaves of bread provide support to the shoemaker, i.e. it sustains him while he is busy making shoes. Credit thereby gives rise to the production of shoes, and therefore to the formation of more real wealth. This is a path to real economic growth.
Money and credit
The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend them to shoemaker. With eight dollars the shoemaker can secure either eight loaves of bread or other goods to support him while he is engaged in the making of shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things also has eight loaves of bread that the baker has produced. Also note that without real savings, the lending of money is an exercise in futility.
Money fulfils the role of a medium of exchange. Thus when the baker exchanges his eight loaves for eight dollars he retains his real savings so to speak by means of the eight dollars. The money in his possession will enable him, when he deems it necessary, to reclaim his eight loaves of bread or to secure any other goods and services. There is one provision here that the flow of production of goods continues. Without the existence of goods, the money in the baker’s possession will be useless.
The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker.
In the process the baker earns interest for his loan, while the bank earns a commission for facilitating the transfer of money between the baker and the shoemaker. The benefit that the shoemaker receives is that he can now secure real resources in order to be able to engage in his making of shoes.
Despite the apparent complexity that the banking system introduces, the essence of credit remains the transfer of saved real stuff from lender to borrower. Without an increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings.
Now, when the baker lends his eight dollars we must remember that he has exchanged for these dollars eight saved loaves of bread. In other words, he has exchanged something for eight dollars. So when a bank lends those eight dollars to the shoemaker, the bank lends fully ‘backed-up’ dollars so to speak.
False credit – an agent of economic destruction
Trouble emerges, however, if instead of lending fully backed-up money, a bank engages in issuing empty money (fractional reserve banking) — money backed-up by nothing.
When unbacked money is created, it masquerades as genuine money that is supposedly supported by a real stuff. In reality however, nothing has been saved. So when such money is issued, it cannot help the shoemaker since the pieces of empty paper cannot support him in producing shoes — what he needs instead is bread.
Since the printed money masquerades as proper money it can be used to “steal ” bread from some other activities and thereby weaken those activities. This is what the diversion of real wealth by means of money creation “out of thin air” is all about. If the extra eight loaves of bread weren’t produced and saved, it is not possible to have more shoes without hurting some other activities, which are much higher on the priority lists of consumers as far as life and well-being is concerned. This in turn also means that unbacked credit cannot be an agent of economic growth.
Rather than facilitating the transfer of savings across the economy to wealth generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of wealth formation. It has to be realised that banks cannot ongoingly pursue unbacked lending without the existence of the central bank, which by means of monetary pumping makes sure that the expansion of unbacked credit doesn’t cause banks to bankrupt each other.
We can thus conclude that as long as the increase in lending is fully backed-up by real savings it must be regarded as good news since it promotes the formation of real wealth. False credit, which is generated out of “thin air”, is bad news – credit which is unbacked by real savings is an agent of economic destruction.
Neither the Fed nor the US Treasury are wealth generators and hence they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot lift lending unless the pool of real savings is expanding. On the contrary the more money the Fed and other central banks are pushing, the more they are diluting the pool of real savings.
Yet most commentators are of the view that given the present fragile state of the financial system, the central bank and the government must intervene to prevent the collapse. But then how can the government and the central bank help in this regard? How can the central bank or the government generate more real savings?
The only thing that the government and the central bank can do is to redistribute real savings from other people and give it to banks. Now if the pool of real savings is still expanding this can “work” – and lending might flow again. If, however, the pool of real savings is falling then it will not be possible to increase the flow of productive, i.e. good, lending.
This article is based on a longer piece for Mises.org, published in October 2008: Good and Bad Credit
By Dr Frank Shostak, on 21 March 11
The idea of a neutral interest rate emanates from the writings of the Swedish economist Knut Wicksell. According to Wicksell,
There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods.
In other words, the neutral rate of interest is defined as the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes. (Note that once the neutral rate is reached, the state of equilibrium is attained — implying that the economy is now well balanced and the price level is stable).
The main source of economic instability, it is held, is the variance between the money market interest rate and the neutral rate. If the market rate falls below the neutral rate, investment will exceed saving, implying that aggregate demand will be greater than aggregate supply. Assuming that excess demand is financed by an expansion in bank loans, this leads to the creation of new money, which in turn pushes the general level of prices up.
Conversely, if the market interest rate increases above the neutral rate, savings will exceed investment, aggregate supply will exceed aggregate demand, bank loans and the stock of money will contract, and prices will fall. Hence, whenever the market rate is in line with the neutral rate, the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level.
Again, this theory posits that deviations in the money market interest rate from the neutral rate is what sets in motion changes in the money supply which in turn disturb the general price level. Consequently, it is the role of the central authority to bring money market interest rates in line with the level of the neutral rate of interest.
According to this view, in order to establish whether monetary policy is tight or loose it is not enough to pay attention to the level of money market interest rates; rather one needs to contrast money market interest rates with the neutral rate. If the market interest rate is above the neutral rate then the policy stance is tight. Conversely, if the market rate is below the neutral rate then the policy stance is loose.
However, how is one to implement this framework? The main problem here is that the neutral interest rate can’t be observed. How can one tell whether the market interest rate is above or below the neutral rate?
Wicksell suggested that policy makers pay close attention to changes in the price level. A rising price level would call for an upward adjustment in the money market interest rate, while a falling price level would signal that the money market interest rate must be lowered.
According to the Wicksellian framework, in order to maintain price stability and economic stability, once the gap between the money market interest rate and the neutral rate is closed the central bank must at all times ensure that a gap does not re-emerge. In the Wicksellian framework a monetary policy that maintains the equality between the two rates becomes a factor of stability. But is this possible? After all, maintaining this equality means that the central bank would have to manipulate the supply of money, which in turn will only make things unstable. (In the present monetary system the Fed is actually directly engaged in the manipulation of the federal funds rate rather than money supply).
What the Fed is trying to achieve belongs to the world of a true free market economy. In a free market economy without a central bank, there would be no such thing as monetary policy. In the absence of central bank monetary policies the interest rates that emerge would be truly neutral.
Also, in a free market no one would be required to establish whether the interest rate is above or below some kind of imaginary equilibrium. In a free market, with the absence of money creation, there is no need for a policy to restrain increases in the price level.
The whole idea of the neutral interest rate is unrealistic insofar as we have a Fed that continuously tampers with interest rates and the money supply. Given the impossible goal that the Fed is trying to achieve, we do not expect Fed policy makers to become wise and all-knowing with regard to the correct level of the interest rate.
For a broader exposition of the ideas in this article, see this Mises.org article, on which it is based.
By Dr Frank Shostak, on 14 March 11
Economists have always been envious of the practitioners of the natural and exact sciences. They have thought that introducing the methods of natural sciences in economics could lead to a major break-through in our understanding. In 2002 the Nobel prize in economics was awarded to Vernon Smith for the building of a laboratory where various economic theories could be verified. But while a laboratory is a valid way of doing things in the natural sciences, it is not so in economics. If anything, the introduction of a laboratory in economics only stifles our understanding.
Why is that so? A laboratory is a must in physics, for there a scientist can isolate various factors relating to the object of inquiry. Although the scientist can isolate various factors he doesn’t, however, know the laws that govern these factors. All that he can do is hypothesize regarding the “true law” that governs the behaviour of the various particles identified. He can never be certain however, regarding the “true” laws of nature. On this Murray Rothbard wrote,
The laws may only be hypothecated. Their validity can only be determined by logically deducing consequents from them, which can be verified by appeal to the laboratory facts. Even if the laws explain the facts, however, and their inferences are consistent with them, the laws of physics can never be absolutely established. For some other law may prove more elegant or capable of explaining a wider range of facts. In physics, therefore, postulated explanations have to be hypothecated in such a way that they or their consequents can be empirically tested. Even then, the laws are only tentatively rather than absolutely valid.[1]
Contrary to the natural sciences, the factors pertaining to human action cannot be isolated and broken into their simple elements. The realities of human action are complex historical factors that have emerged on account of many causal variables. However, contrary to the natural sciences, we know the meaning of human action.
One can observe that people are engaged in a variety of activities. They are performing manual work, they drive cars, and they walk on the street and dine in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.
Manual work may be a means for some people to earn money, which in turn enables them to achieve various goals like buying food or clothing. Dining in a restaurant can be a means to establishing business relationships. Driving a car may be a means for reaching a particular place. In other words, people operate within a framework of ends and means; they use various means to secure ends.
In short, we know that actions are conscious and purposeful. Also, note that this knowledge that human action is conscious and purposeful is certain and not tentative. Any one who tries to object to this in fact contradicts himself for he is engaged in a purposeful and conscious action to argue that human actions are not conscious and purposeful.
Various conclusions that are derived from this knowledge of purposeful action are valid as well, implying that there is no need to subject them to various laboratory tests as is done in the natural sciences. For something that is certain knowledge, there is no requirement for any empirical testing.
Vernon Smith, however, rejects the view that human actions are conscious and purposeful. Thus Smith writes,
He (Mises) wants to claim that human action is consciously purposeful. But this is not a necessary condition for his system. Markets are out there doing their thing whether or not the mainspring of human action involves self-aware deliberative choice. He vastly understates the operation of unconscious mental processes. Most of what we know we do not remember learning, nor is the learning process accessible to our conscious experience—the mind………
Even important decision problems we face are processed by the brain below conscious accessibility.[2]
Moreover, argues Smith,
The workings of the economy are not the product, nor can they be the product, of conscious reason.[3]
Not only does Smith downplay the importance of the use of reason in decision making but he argues that good decision making is in response to emotions. He writes,
People like to believe that good decision making is a consequence of the use of reason, and that any influence that the emotions might have is antithetical to good decisions. What is not appreciated by Mises and others who similarly rely on the primacy of reason in the theory of choice is the constructive role that the emotions play in human action.[4]
Obviously once the importance of reason, consciousness and purposeful action is dismissed, what is then left is the possibility of mimicking the natural sciences and treating human beings like objects. According to this way of thinking human action is not navigated by reason but by outside factors that act upon men. By means of a given stimulus one can then observe various human reactions and draw all sorts of conclusions regarding the world of economics. According to Mises however,
It is impossible to describe any human action if one does not refer to the meaning the actor sees in the stimulus as well as in the end his response is aiming at.[5]
By rejecting the importance of the human mind, Vernon Smith treats man as another animal. In fact, some of the experimental economists are indeed conducting various experiments on pigeons and rats in order to verify various propositions of mainstream economics.[6]
An important foundation for experimental economics is the 1944 publication of von Neumann and Morgenstern’s “Theory of Games and Economic Behavior” ( Princeton, 1944, p. 86). Accordingly, it is held that human choices can be ascertained from game-like experiments. The problem with all this is that a game is not the real world. According to Mises,
The immediate aim in playing a game is to defeat the partner according to the rules of the game. This is a peculiar and special case of acting. Most actions do not aim at anybody’s defeat or loss. They aim at an improvement in conditions. It can happen that this improvement is attained at some other men’s expense. But this is certainly not always the case. It is, to put it mildly, certainly not the case within the regular operation of a social system based on the division of labor.
There is not the slightest analogy between playing games and the conduct of business within a market society. The card player wins money by outsmarting his antagonist. The businessman makes money by supplying customers with goods they want to acquire. There may exist an analogy between the strategy of a card player and that of a bluffer. There is no need to investigate this problem. He who interprets the conduct of business as trickery is on the wrong path.[7]
[1] Murray N. Rothbard, “Towards a Reconstruction of Utility and Welfare Economics”, On Freedom and Free Enterprise: The Economics of Free Enterprise, May Sennholz, ed. (Princeton, N.J.: D.Van Nostrand, 1956), p3.
[2] Vernon L. Smith “ Reflections on Human Action after 50 years.” Cato Journal, 19, No.2 (Fall 1999), p200.
[3] Ibid.,p201
[4] Ibid.,p203.
[5] Ludwig Von MisesThe Ultimate Foundation of Economic Science. Chapter 2 Mises Institute website.
[6] Frances K. McSweeney and Samantha Swindell, “Behavioral Economics and Within-Session Changes in Responding,” Journal of the Experimental Analysis of Behavior 72, No.3 (November,1999): 355-71
[7] Ludwig Von Mises, Human Action, p116.
By Dr Frank Shostak, on 9 March 11
According to popular thinking, not every increase in the supply of money will have an effect on the production of goods. For instance, if an increase in supply is matched by a corresponding increase in the demand for money, then there won’t be any effect on the economy. The effect from the increase in the supply of money is neutralized, so to speak, by the effect of an increase in the demand for money or the willingness to hold a greater amount of money than before.
What do we mean by demand for money? And how does this demand differ from demand for goods and services?
Now, demand for a good is not demand for a particular good as such but rather demand for the services that the good offers. For instance, individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and well-being. Demand here means that people want to consume the food in order to secure the necessary elements that sustain life and well-being.
Likewise, demand for money arises on account of the services that money provides. However, instead of consuming money, people demand money in order to exchange it for goods and services. With the help of money, various goods become more marketable – they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.
Take for instance a baker, John, who produces ten loaves of bread per day and consumes two loaves. The eight loaves he exchanges for various goods such as fruit and vegetables. Observe that John’s ability to secure fruits and vegetables is on account of the fact that he has produced the means to pay for them. The baker pays for fruit and vegetables with the bread he has produced. Also note that the aim of his production of bread, apart of having some of it for himself, is to acquire other consumer goods. Now, an increase in John’s production of bread, let us say from ten loaves a day to twenty, enables him to acquire a greater quantity and a greater variety of goods than before. As a result of the increase in the production of bread, John’s purchasing power has increased.
In the world of barter, John may have difficulties securing the various goods he wants by means of bread alone. It may happen that a vegetable farmer may not want to exchange his vegetables for bread. To overcome this problem, John would have to exchange his bread first for some other commodity, which has much wider acceptance than bread. In short, John is now going to exchange his bread for the acceptable commodity, and then use that commodity to exchange for goods he really wants.
Note that by exchanging his bread for a more acceptable commodity John in fact raises his demand for this commodity. Also, note that John’s demand for the acceptable commodity is not to hold it as such but to exchange it for the goods he wants. Again, the reason why he demands the acceptable commodity is because he knows that with the help of this commodity he can convert his production of bread more easily into the goods he wants.
Now let us say that an increase in the production of the acceptable commodity has taken place. As a result of a greater amount of the acceptable commodity relative to the quantities of other goods, the unitary price of the acceptable commodity in terms of goods has fallen. All this, however, has nothing to do with the production of goods. The increase in the supply of acceptable commodity is not going to disrupt the production of goods and services. Obviously, if the purchasing power of the commodity were to continue declining, then people are likely to replace it with some other more stable commodity.
Through a process of selection people have settled on gold as the most accepted commodity in exchange. In short, gold has become money.
Let us now assume that some individual’s demand for money has risen. One way to accommodate this demand is for banks to find willing lenders of money. With the help of the mediation of banks, willing lenders can transfer their gold money to borrowers. Obviously such a transaction is not harmful to anyone.
Another way to accommodate the demand is that instead of finding willing lenders, the bank can create fictitious money – money un-backed by gold – and lend it out.
Note that the increase in the supply is given to certain individuals. There must always be a first recipient of the bank’s newly-created money.
This money, which was created out of “thin air”, is going to be employed in an exchange for goods and services. It will set in motion an exchange of nothing for something. The exchange of nothing for something amounts to the diversion of real wealth from wealth-generating to non-wealth-generating activities, which masquerades as economic prosperity. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy.
Could a corresponding increase in the demand for money prevent the damage that money out of “thin air” inflicts on wealth generators?
Let us say that on account of an increase in the production of goods the demand for money increases to the same extent as the supply of money out of “thin air”. Recall that people demand money in order to exchange it for goods. Hence, at some point, the holders of money out of “thin air” will exchange their money for goods. Once this happens, an exchange of nothing for something emerges, which undermines wealth generators.
We can thus conclude that irrespective of whether the total demand for money is rising, what matters is that individuals employ money in their transactions. As we have seen, once money out of ‘thin air’ is introduced into the process of exchange, this weakens wealth generators, and this in turn undermines potential economic growth. Clearly, then, the expansion of money out of “thin air” is always bad news for the economy. Hence, the view that an increase in money out of “thin air” is harmless when fully backed by demand doesn’t hold water.
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