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By John Phelan, on 12 April 12
In economics as with medicine any cure must begin with a sound diagnosis. But if economists were doctors the patient would have died on the table. Despite its pretensions to scientific exactitude, the discipline has offered a bewildering array of diagnoses; the doctors still arguing.
Some diagnoses can be ruled out. The Marxist theory of economic cycles with its declining rate of profit is clearly useless; businesses were making record profits on the eve of the bust. There was no shock to Total Factor Productivity which a Real Business Cycle explanation would require. Keynesian ‘animal spirits’ are also unsatisfactory. The flight from mortgage backed assets was a totally rational response to the Federal Reserve raising interest rates between 2004 and 2007.
But there is another diagnosis which fits the symptoms quite well; Austrian Business Cycle Theory (ABCT), so called because it grows out of the Austrian School of economics founded in Vienna by Carl Menger in the nineteenth century. It describes the causes and course of the current crisis better than any other theory and offers some insights in to what lies ahead.
ABCT starts with the idea that the interest rate is a price like any other matching the supply of something to the demand for it. Funds for investment are supplied (via saving); savings are demanded (for investment). If people cut back on current consumption and save more to increase future consumption then the interest rate falls and firms are able to borrow more to invest in the means to supply that future consumption. And when people begin drawing down their savings to fund current consumption the interest rate rises and firms cut back on investing for future consumption.
The key insight is that the interest rate is a real phenomenon. As the Austrian School economist Eugen von Böhm-Bawerk put it, it reflects the ‘time preference’ of economic agents, the value they place on consumption of something now compared to the value they place on consumption of the same thing at some given point in the future. The interest rate reflects the compensation/incentive for abstinence on the part of the saver.
But in the real world we have central banks. In response to something like the bursting of the dot com bubble the Federal Reserve can lower interest rates, as it did in that instance, from 6.25% to 1.75% over the course of 2001.
However, the interest rate is not falling because of increased saving (or decreasing time preference), rather it is being forced down artificially by the expansion of credit; the creation of phony capital in other words.
As interest rates fall firms see ever more marginal investment opportunities becoming profitable. They borrow and undertake them. A boom is underway.
But eventually the inflation caused by this credit expansion starts to show even in the central bank’s cooked figures as when inflation went above 4% in the US in 2006. Interest rates are raised; the Fed Funds rate went above 5% the same year. Those marginal investments that looked viable at 1% are now scuppered.
This is the bust. All the enterprises undertaken in the expectation of catering for the demand for future consumption indicated by low interest rates discover that there is, in fact, no such demand. There never was. They are revealed as ‘malinvestments’, with no hope of ever producing a return above their borrowing costs unless interest rates are kept artificially low and cheap credit is kept flowing.
The recession is not some mysterious collapse in aggregate demand which can be stopped with a dose of government spending. It is the liquidation of these unviable credit positions and it will not be over until this process is complete.
The Austrian School economist Ludwig von Mises wrote
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved
This is the Austrian choice; recognize the liquidation and allow zombie banks to collapse and stop soaking up scarce capital so we can get the recovery going or keep putting it off with more monetary and fiscal stimulus. And, as another Austrian Schooler, Friedrich von Hayek, warned,
The magnitude of unemployment caused by a cessation of inflation will increase with the length of the period during which such policies are pursued
True, this is a grim prospect, but that matters less than whether it’s correct. Anyone who says there is a third option, a painless way out which can be found simply by ticking a different box on a ballot paper, truly is peddling snake oil.
By John Phelan, on 9 November 11
A common interpretation of the credit crunch and ensuing global turmoil is that it was all down to unregulated or under-regulated financial institutions and markets. As a result, one of the most commonly advanced solutions is for more and/or better regulation. Indeed, this call is about as close as we get to a firm demand from the presently fashionable ‘occupy’ protests.
There are many things wrong with this view. First, the underlying causes of the recent boom and bust could be found, as so often, in monetary disturbances. In comparison to the damage wrought by a deluge of credit, any regulatory deficiencies are just hundreds and thousands atop a cake that was always going to turn out pretty sour.
Secondly, nothing says ‘profit opportunity’ to financial institutions quite like some new financial regulation. To give just one of countless examples, the Eurodollar market sprang into life thanks to attempts like Regulation Q to impose limits on interest rates. The financial innovators will only ever be one step behind the regulators for as long as it takes them to read the regulation. Then they streak ahead.
And thirdly, it is a mistake to think that financial markets were notably under-regulated. After redesigning British financial regulation almost from scratch, the Labour government never ceased tinkering with it. As Terry Arthur and Philip Booth wrote recently (PDF)
To obtain permission to carry out regulated activities an organisation must meet certain qualifying conditions. These include having adequate resources (financial resources as well as internal systems and procedures). The conditions are laid out in the FSA’s Integrated Handbook…Regulation is bureaucratic in the extreme. It is no longer possible to determine the number of pages in the handbook, but an indication is given by the following example. There are ten main sections in the book. One of those main sections…is that on ‘Listing, prospectus and disclosure’. This contains three subsections which have between nine and 23 sub-subsections each. Taking one of those sub-subsections, under the ‘Listing rules’, there are six sub-sub-subsections
Fortunately we can look at the economic impact of regulation worldwide with the release by the International Finance Corporation of the World Bank of its annual ‘Doing Business’ report which compares regulatory environments and the ease of doing business across countries. The reports message is unequivocal; regulation is mostly bad and those calling for more of it are calling for economic suicide.
A report on the report by The Economist picked out some notably egregious examples
A typical company in Congo with a gross profit margin of 20% faces a tax bill equivalent to 340% of profits…How long, for example, does it take to register a company? In New Zealand it takes one day and costs 0.4% of the local annual income per head. In Congo it takes 65 days, involves ten steps and costs 551% of income per head…Other procedures the IFC measures include registering a property (which takes one day in Portugal, 513 in Kiribati); obtaining a construction permit (five steps in Denmark, 51 in Russia); enforcing a simple contract through the courts (150 days in Singapore, 1,420 in India); and winding up an insolvent firm (creditors in Japan recover 92.7 cents on the dollar, those in Chad get nothing at all)…A young entrepreneur in Liberia who builds a new warehouse must wait on average 586 days to connect it to the power grid. In Ukraine it takes 274 days; in Germany only 17. Guess which of these countries has a thriving manufacturing sector?”
The chart below illustrates the point
Source: ‘Doing Business 2010′ (PDF) and International Monetary Fund ‘World Economic Outlook Database’ – Puerto Rico, Palau, the Marshall Islands, Micronesia and West Bank and Gaza are omitted for lack of a comparable data point
We see that while a light regulatory environment is not a guarantee of wealth, it is a necessary precondition. Not surprisingly, The Economist sees a causal relationship
Cutting red tape makes countries richer, if the 873 peer-reviewed articles and 2,332 working papers that use the “Doing Business” data are anything to go by. A study in Mexico found that simplified municipal licensing led to a 5% increase in the number of registered companies and a 2.2% increase in jobs. It also lowered prices for consumers. Bankruptcy reform in Brazil caused the cost of credit to fall by 22%. Countries with flexible labour rules saw real output rise by 17.8% more than those with rigid ones”
Calls for more regulation are both pointless and dangerous; pointless in that it won’t solve the undoubted problems in our present economic system and dangerous in that it could end up making us even worse off. More regulation is not the answer.
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By John Phelan, on 2 September 11
A very intelligent friend of mine of markedly different political persuasions said the other day that he avoided “technical economic arguments” with me as I’ve just graduated with a degree in economics. I was rather sad to hear this.
The simple truth is that after doing a module called, say, ‘Introduction to Economic Principles and Policy’, you will not study very much more which will add greatly to your understanding of the subject. Beyond that, in an ‘Intermediate Microeconomics’ course for example, you are simply ladling mostly unnecessary algebra onto the subject.
Take this from a course in ‘Intermediate Macroeconomics’ for example:
This is actually some of the more accessible math involved in modern economics. Furthermore, the concepts it is dealing with, constant returns to scale and the per worker production function, are pretty straightforward. Yet many, including almost all university economics lecturers, will tell you that this is economics. It is, in fact, simply applied algebra – mathematics looking for a real world application. Economists eager to give their art the patina of science and mathematicians searching for real world relevance have combined to render economics impenetrable.
This trend also stems from the view of economics as the study of a mechanism. People may now laugh at the model of the economy A.W. Phillips built in the basement of the London School of Economics in 1949 with its gurgling pipes full of different coloured liquids representing money literally sloshing around an economy controlled by sluice gates. But it isn’t conceptually different from the computerised models that are in use today guiding research and government policy.
These models often fail. If your model is based on erroneous assumptions, such as the creation of phantom capital called Quantitative Easing actually stimulating an economy, you will get erroneous outputs; Garbage In Garbage Out as they say. But there is a more fundamental problem. There is no exogenous ‘thing’ called ‘The Economy’ which can be quantified and controlled, there is only each of us doing what we do every day. That is why Ludwig von Mises called his great treatise on economics ‘Human Action’. Or as Friedrich von Hayek rapped recently “The economy’s not a car. There’s no engine to stall. No experts can fix it. There’s no “it” at all. The economy is us”.
It is little wonder that even intelligent people feel themselves cowed and run in terror from the thicket of abstraction that shrouds modern economics. It needn’t be like this. The great works of the discipline, those of Adam Smith or Carl Menger for example, managed to lay the foundations of the subject without it.
And it is sad that people like my friend feel put off because the economy affects all of us and, to return to the point made by the rapping Hayek, it is the study of all of us. Given this we all have economic insights by virtue of being human beings, the very subject of economics itself. As von Mises wrote:
Economics must not be relegated to classrooms and statistical offices and must not be left to esoteric circles. It is the philosophy of human life and action and concerns everybody and everything. It is the pith of civilization and of man’s human existence.
Do not leave economics to the abstract eggheads. Pick up Economics in One Lesson by Henry Hazlitt, Free to Choose: A Personal Statement by Milton Friedman or even Eat the Rich: A Treatise on Economics by P.J. O’Rourke: writers who, in these books and others, passed the economist Armen Alchian’s test of whether they truly understood the subject – they could explain it to someone who doesn’t know a darn thing about it.
Economics is about you. It is your subject. Reclaim and enjoy it.
Editor’s note: the Cobden Centre bookstore is here.
By John Phelan, on 29 July 11
There is a story from the Cold War era about a Soviet official who travelled to London. As he was shown around he couldn’t believe how full the shops were of all sorts of produce. Amazed by this bounty, he eagerly seized his guide and asked “Who is in charge of the bread supply to London?” The baffled reply came – “No one”.
I was reminded of this story and how, from the Austrian viewpoint, economics is about coordination, at an excellent talk I heard in east London last Thursday night by Steven Baker, MP and Cobden Centre board member.
He made the point that this was one of the issues we fought the Cold War over. Unlike the communist east, the capitalist west believed that economies were better organised by the millions of individual decisions taken in a free market on a second-by-second basis than they were by planners ensconced in offices pouring over reports.
The outcome was that Mises, Hayek and others were proved right. Communism collapsed and socialism was rejected. Free markets were reaffirmed under Margaret Thatcher and Ronald Reagan and the planners were pensioned off.
Except, that is, in one vitally important area. In the Monetary Policy Committee of the Bank of England, the Federal Reserve, and the Executive Board of the European Central Bank, the planners still cling on, fixing the price of credit: the interest rate [1].
It is crucial for people to understand that what central banks with boards of price setters represent is not a free market but what Baker called “monetary socialism”. And the central planners have proved no better at setting the price of money then they ever were at setting any other price.
It was the driving down of interest rates by these planners which flooded the financial system with liquidity after the twin shocks of the bursting of the internet bubble and 9/11. It was this liquidity, hosed about by the planners, upon which the housing market floated to ever giddier heights. And it was when the planners acted to raise interest rates to counter the inevitable inflation they had caused that the bubble burst. It was not capitalism but monetary socialism which failed.
Economists of the Austrian School are highly sceptical of the possibility that this central planning of money will produce optimum results. They are cognisant of the long and dismal history of such central planning in other spheres, and their theories have been borne out by recent experience. The Austrians were right about socialism not working. And they have been right about monetary socialism not working.
[1] was “price of money”; thanks to David Friedman for the correction
By John Phelan, on 27 July 11
July 26th saw one of the most eagerly anticipated economic events of recent years. At the London School of Economics (former employer of Friedrich von Hayek), Professor George Selgin and Dr. Jamie Whyte for the Hayekians and Professor Lord Skidelsky and Duncan Weldon for the Keynesians gathered in front of a packed lecture hall to debate Keynes vs. Hayek. Two other lecture halls were required for the overspill. The debate will be broadcast on BBC Radio Four on August 3rd.
In front of a boisterous crowd, Hayek won fairly easily. Skidelsky’s haughty style contrasted with Selgin’s bullishness and the perennial Keynesian failure to look at the origins of the bust won over nobody in an admittedly partisan crowd. But even an hour of discussion left a few things hanging.
China
One questioner asked whether the Chinese stimulus package had been so much more successful than America’s because the totalitarianism of China allowed the government to direct the spending more effectively than in the US with its dispersed government.
To my great surprise this question was largely ignored by the Hayekians and waved through by the Keynesians, Skidelsky murmuring his approval for the proposition. I was surprised this question generated so little comment because it proves one of Hayek’s key propositions, namely that economic control goes hand in hand with political and social control.
To Hayek there was no such thing as ‘the economy’, as some separate area of human activity which can be tweaked and tinkered with. The economy is, instead, the whole arena of what Hayek’s mentor called Human Action. Or as Ronald Reagan put it, “a government can’t control the economy without controlling people”
We see this with Mussolini’s declaration that “Fascism entirely agrees with Mr. Maynard Keynes” or with the fascistic Blue Eagle which represented the National Industrial Recovery Act of Roosevelt’s New Deal. The effectiveness of China’s Keynesian stimulus came at the price of Tiananmen Square.
Keynesian diagnosis
One of Skidelsky’s repeated attacks on Hayek was that while he had plenty to say about how we got into the bust he had nothing to say about how we get out of it. Selgin dealt with this very well, but there is another point: if a doctor has no idea why your foot is hurting, would you blithely accept his prescription that it needs to be sawn off?
Whereas Austrian economics is famous for its theory of business cycles, with unsustainable booms leading to busts in which bad investments are liquidated, Keynesian theory is silent about the business cycle. All we get is the concept of “animal spirits”, which simply states that at some point for some reason business people suddenly decide en masse to stop investing, and boom turns to bust. As an explanation for why an economy hits the skids, animal spirits is up there with “in the long run we are all dead” — a typical Keynesian shrug of the shoulders.
And it doesn’t even fit the current slump. The economy hit the skids, as Austrian theory always suggested it would, when the Federal Reserve raised interest rates to stifle the inflation caused by the unsustainable credit expansion of the boom period. Many investments that were viable in an environment of easy credit were sustainable no longer. Animal spirits played no part in this. If Keynes was wrong about the diagnosis, why should we place any faith in his prescription?
Mellon and liquidation
This led inevitably to the introduction of a quote attributed to Andrew Mellon, Secretary of the Treasury under President Hoover when the Wall Street Crash hit:
liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate…it will purge the rottenness out of the system
There are two grounds on which to question this. First, this quote comes from Hoover’s memoirs and Hoover was the original executor of Keynesian stimulus.
Second, what actually is wrong with it? Look back at the recent boom. In Britain, the US, Ireland, Spain and elsewhere, we had rocketing house prices based on low interest rates. Lots of house building got under way to cash in, and lots of people were drawn into the construction industry.
Now, if we have too many houses as a result of the boom’s over-investment, we do not need new houses built. It follows that we also need fewer people building them. Elements of the construction industry, in other words, will be liquidated just as Mellon said.
They have to be. Consider the alternative: construction workers are laid off in large numbers and a movement begins to ‘do something’. All that can be done is either monetary or fiscal action directed to keeping these workers building houses we do not need. Anything else is Mellon’s liquidation.
Keynes famously said that unemployment could be solved
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez faire to dig the notes up again
His modern day disciples, it seems, think that we can build a prosperous economy around the building of houses no one will ever live in.
Larry Summers
I have to give Weldon some credit. For anyone even vaguely involved in the economic policy making of the last government to show his face in public takes real nerve. He was rewarded with a titter from the smattering of Keynesians when he quoted with approval the words of Larry Summers, who described the coalition’s belief that spending cuts are necessary for recovery as “oxymoronic”. Weldon suggested that Summers could have dispensed with the ‘oxy’.
This is, of course, the same Larry Summers who said of the recent Japanese tsunami
It may lead to some temporary increments, ironically, to GDP as a process of rebuilding takes place. In the wake of the earlier Kobe earthquake Japan actually gained some economic strength
Perhaps Weldon could find an adjective for this?
It is quite a bizarre argument that a man can destroy his house in year one, rebuild it in year two, and at the end of that second year pat himself on the back for increasing his GDP by the cost of his new house. But then you are through the looking glass with Keynesianism. The doctrine holds, after all, that the more you spend the richer you get. Predictably it wasn’t an argument which impressed the tough crowd at the LSE.
By John Phelan, on 26 July 11
With his history in the transfer market there is no guarantee that Carlos Tevez won’t still end up at Brazilian side Corinthians. But even if he doesn’t, some are saying that the bid itself represents a shift in power away from the European clubs, which have traditionally benefited from the players produced in Brazil, and towards Brazilian clubs themselves.
Brazil’s new found wealth is being flaunted elsewhere. Last month Bloomberg reported on a growing number of Brazilians buying property in Florida. According to the report:
“As many as half of the downtown Miami condos that have been sold to foreigners for more than $500,000 since January were purchased by Brazilians, said Craig Studnicky, president of International Sales Group LLC, an Aventura, Florida, property-marketing firm. Buyers from Brazil also accounted for about half of sales of more than $1 million in Miami Beach”.
The reason for this, according to Bloomberg, is “The Brazilian real’s 45 percent increase against the dollar from the end of 2008”
This has come about despite an increasingly difficult situation for the Brazilian central bank. Without reinstating the hard peg to the dollar which shattered amid devaluation in 1999, the Banco Central has tried to maintain an exchange rate with the dollar of about 2:1. However, to maintain this the inflationary policy of the Federal Reserve’s quantitative easing programs has had to be mirrored in Brazil. But, without the reserve currency status of the dollar to tempt a China or United Arab Emirates to stack up Brazilian currency claims, the Brazilians, like any country following the dollar, have had headline inflation.
As a result Brazil has been a noisy participant in the ‘currency wars’ triggered by US devaluation. Brazil’s finance minister Guido Mantega recently said that “struggles between countries” were “absolutely not over”.
But Brazil hasn’t just relied on words. In the face of rising inflation imported from the US via the soft currency peg, the Banco Central has moved aggressively to raise interest rates. This has pushed the real to a near 12 year high and made it possible for Brazilians to go shopping for assets abroad.
But what does this mean for the rest of us? In defending quantitative easing Ben Bernanke says “the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability”. In fact, for all the Fed’s money printing, unemployment remains stubbornly stuck at 9.2% and even the Fed’s diddled measure of ‘core’ inflation which doesn’t include food and energy prices (which have been skyrocketing) is beginning to tick up.
The inflationist policies of the Federal Reserve aren’t doing much for the US economy and they aren’t helping the average American. But Brazilians are benefitting from this shift in wealth and with the Fed preparing the ground for another round of quantitative easing Brazilians will be in the market for more assets, be they condos or centre forwards. When Miami hosts its first carnival for wealthy Brazilian expats Ben Bernanke should be the guest of honour.
By John Phelan, on 6 July 11
Alan Greenspan’s pronouncements used to be described as ‘Delphic’ because of their rarity and mystery of meaning. So his blunt attack on the monetary policies of his successor, Ben Bernanke, last week on CNBC was quite striking.
“I am ill-aware of anything that really worked. Not only QE2 but QE1” Greenspan said, elaborating “There is no evidence that huge inflow of money into the system basically worked”. No doubt it will come as a shock to hear the man who gave his name to the use of huge inflows of money into the system to combat any downturn – the ‘Greenspan put’ – turning his back on the method. It will likewise surprise some, perhaps, to see the man who presided over a dollar which lost about a quarter of its value against the euro expressing concern about policies which might “continue erosion of the dollar”. That would be the erosion he played a large part in.
It shouldn’t come as a total surprise to anyone familiar with the career of ‘The Maestro’. A man who, in 1966, wrote “that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other” was, by 2002, proclaiming the “evident recent success of fiat money regimes.” Even so, it seems slightly rich for the sorcerer to be criticising the apprentice for doing exactly what he taught him to do.
Greenspan highlighted another effect of the mass money expansion of the Bernanke Federal Reserve and, also, the Bank of England under Mervyn King. “(Quantitative Easing) obviously had some effect on the exchange rate and the exchange rate was a critical issue in export expansion”, Greenspan said. Indeed, the idea that the devaluations of the dollar or the pound since the onset of the crisis in 2007 have helped exports and, thus, been a good thing, has become fairly standard.
But it falls foul of one of the most famous maxims in economics; there’s no such thing as a free lunch. If the currency is made cheap so that exports might cost less abroad it also makes imports more expensive at home. Devaluations benefit exporters by harming importers.
The current devaluations are showing that. The rising cost of imports is putting pressure on industrial importers in both the US and UK. The effects aren’t limited to commercial importers. Rising food and fuel prices on both sides of the Atlantic are having a disproportionate effect on lower income households in Britain and the US.
Once again we are seeing that creating money out of thin air isn’t the same as creating wealth out of thin air. The money printing of the Federal Reserve and Bank of England might be a boon for exporters but it does not represent a free lunch, or even a lunch bought at the cost of some paper, ink and a few metal strips. It is paid for in the higher prices faced by importers and consumers of imports, notably people on low incomes who spend proportionately more of their income on purchases such as food and fuel whose prices are rising most rapidly.
The central bankers are not creating wealth, they are simply transferring it.
By John Phelan, on 16 June 11
For such a pervasive term, ‘social justice’ is a notoriously tricky concept to quantify. Karl Marx’s notion of social justice was, famously, “From each according to his ability, to each according to his need”. That of the economists of the late nineteenth century was the Marginal Productivity Theory of Distribution. Friedrich Von Hayek claimed to have spent 10 years pondering the matter only to announce that he had “failed”, writing instead that the term was “an empty formula, conventionally used to assert that a particular claim is justified without giving any reason”.
Indeed, there are probably as many opinions on what constitutes social justice as there are individuals capable of holding one. The issue is also confused by the frivolous insertion of the word ‘social’, as though that gives it more weight. It is simply a matter of justice and, personally, I would regard it as unjust for a government or central monetary authority to expropriate the wealth of the poorest members of society via the debasement of their money. Yet, around the world, that is exactly what is happening.
Tuesday saw the announcement that inflation, at 4.5%, was outside of the mandated target range for the 17th month in a row. Despite this there were still people willing to describe the inflation as “temporary”, the same temporary inflation we’ve been hearing about for nearly a year and a half. And despite the fact that, as Michael Saunders of Citi warned, 80% of the items measured in the CPI are rising by more than 2% year on year reflecting a broadening of inflation Roger Bootle could still be found warning that deflation was the real danger.
Tuesday also saw the release of a report by the Institute for Fiscal Studies which looked beyond the threadbare headline inflation figures and found that
New research shows that poorer households have experienced higher inflation on average than richer households over the past decade. This difference has been especially marked since 2008 (during the recession) when the poorest fifth of households faced an average annual inflation rate of 4.3% whilst the richest fifth experienced a rate of just 2.7%
Neither is this confined to the UK. As reported recently, rising inflation in both China and India has been a driver of rising inequality in those countries. Loose central bank policy, in the UK, the USA and elsewhere, has been making the poor poorer.
This would come as no surprise to anyone sympathetic the Austrian view of the non-neutrality of money. When a credit expansion takes place, the newly created credit is initially passed to one set of economic agents who benefit from increased purchasing power. These people are likely to be well connected socially, politically or financially. But this new credit cannot conjure productive resources out of thin air and, eventually, all it does is bid up prices having distorted the capital structure along the way. By the time the new credit reaches the least socially, politically and financially connected people it has declined in purchasing power by an amount sufficient to reflect its new found abundance relative to goods and services in the economy. Only the initial recipients benefited from the credit expansion.
As the Guardian put it, the IFS report found that “Well-off households were also the main beneficiaries of the Bank of England’s decision to slash interest rates from 5.5% to 0.5% in 2008-09.” Or, as Ludwig Von Mises wrote,
Inflation and credit expansion, the preferred methods of present day government openhandedness, do not add anything to the amount of resources available. They make some people more prosperous, but only to the extent that they make others poorer
This is why ending inflationary monetary policies should not just be the preserve of the “cranks” and “gold bugs” of mainstream economic folklore. Inflation disproportionately harms the poorest in society. Sound money is, to borrow a phrase, an issue of ‘social’ justice.
By John Phelan, on 9 June 11
The joke about Harry Truman asking to see a one armed economist so that they couldn’t say “But on the other hand” has lasted because it is true. How true was proved again this weekend when a group of ‘esteemed’ economists wrote a letter attacking George Osborne’s deficit reduction plan. Sure enough, another group of esteemed economists were soon on hand to defend George Osborne’s deficit reduction plan. What’s a Chancellor to do?
If the economy was roaring back to health we wouldn’t be hearing any of this. But it isn’t. While there are bright spots in areas such as employment economic growth as a whole is anaemic to non-existent and forecasts are being regularly downgraded. But it may well be an economic and political mistake to expect any better.
The economic mistake stems from the fact that surprisingly few economists have actually stopped to wonder what, exactly, the recession is. There is something approaching a consensus on how it came about and there is no shortage of often contradictory schemes to banish it immediately and forever. But few have asked what it is doing and why it is doing it.
For all the rhetoric about greedy bankers from the left and the Community Reinvestment Act from the right the underlying fact of both narratives is loose central bank monetary policy. Low interest rates, artificially pushed below their market rate by the sort of price fixing board which we were told had died with Soviet Russia, flooded banks with cash. When, in turn, this tidal wave of cash flooded out of the banks, the bubble was born.
During the bubble this money was borrowed heavily and spent heavily. Lots of economic activity took place which was paid for with this newly-created, borrowed money. A great deal of this economic activity, be it house building, banking or Woolworths, was reliant for its continuation on the continued availability of cheap credit.
This couldn’t continue indefinitely. Eventually this flood of credit overcame the downward pressure on inflation figures of Chinese goods and services and statistical manipulation and started to show up in the headline. Central banks tightened. Interest rates rose. All that economic activity which was reliant for its continuation on the continued availability of cheap credit ground to a halt, be it house building, banking or Woolworths.
This is what the recession is; the point after the limits of cheap money have been reached when the economic activity based on cheap money stops. Looked at like that, the policy landscape appears starkly different.
You could try, as the Keynesians suggest, using the government to step in as borrower and spender of last resort. This might work in the short term, allowing Ed Balls to trumpet “When Labour left office last spring the economy was strengthening with growth of 1.1 per cent in the second quarter of 2010”, but if you throw £150 billion of borrowed money at an economy you are bound to see some result. And it is suicidal in the long term especially in a country like Britain where the government had already been borrowing for years before the recession hit.
You could try, as the Bank of England and Federal Reserve have, fixing interest rates ever lower in order to keep this flood of cheap credit flowing. But this is simply to encourage borrowing to continue at the previous, unsustainable rate. Again, in the short term this may have some output effect but quite soon, already in the case of Britain, you are going to run into inflationary pressures again.
Either way, the use of fiscal policy, to replace private borrowing with government borrowing, and monetary policy, making it cheaper for everyone to continue borrowing, are wasted efforts. They cannot transform enterprises that rely on an inflationary credit environment into ones that will survive under natural conditions. Those enterprises will cease.
This gives policy options very different outcomes. The recovery will not look like a 45 degree angle rocketing gloriously from bottom left to top right on a graph. Rather, frantic attempts to push the economy up simply cancel out the economy’s downward tendency to give us a flat line, about what we have now. This is what happened to the US in the 1930’s and Japan in the 1990’s. Going into the next election with an economic record like that would be disastrous for the Conservatives and Liberal Democrats.
The alternative is to take a deep breath and go for a V shaped path, a deep but short recession. Of course, this guarantees the dreaded ‘double dip’ but given that the inevitable rise in interest rates makes this dead cert anyway it might be better for Osborne if it happened now rather than nearer to the election, as turnaround time between now and 2015 is disappearing all the time.
The economy is still riddled with enterprises that can only survive with infusions of cheap credit. The market will liquidate these sooner or later, and the coalition would be wise to get the harsh medicine out of the way now. Their failure to prepare the public for the coming pain may prove to be a costly political mistake.
By John Phelan, on 27 May 11
“I’m mortified to have to pay 50%!” So said the phenomenally successful singer Adele in an interview with Q magazine. And why shouldn’t she be? Isn’t it unfair that a person can perform labour for which they get less of the reward than someone else who didn’t perform it? The right to work as you wish and dispose of the fruits of your labour as you wish are essential rights that differentiate free men and women from slaves. Agreeing with Adele seems a moral slam dunk.
Not if you write for or read the Guardian. They took Adele to task for criticising government spending on transport and schools elsewhere in her interview, remarks which are easily dealt with. But their rebuttal of Adele’s complaint about the 50% tax rate was bizarre; the Guardian simply said “The Beatles had to pay 95%”
This is true historically but the obvious response would be ‘So what?’ It’s worth remembering that the period when these penally high tax rates were in place wasn’t exactly a golden one for British economic policy making with the ‘stop – go’ spasms and sterling crises of the 1960’s giving way to the rampant inflation and economic mayhem of the 1970’s. High taxes are no better an idea now than they were then.
The reason high taxes were and remain the wrong policy prescription is a very obvious one; the more you tax something the less of that something there is. That is why governments pile taxes on cigarettes and alcohol, (they claim) they want there to be less smoking and drinking.
The problem the left had when it imposed high taxes before, and has now that it would do so again, is that while it accepts that this obvious and empirically proven proposition applies to fags or booze, it refuses to see it in action anywhere else. It was this economic blind spot which led Labour to campaign at the last election for a tax on jobs under the strange notion that it would not lead to fewer jobs being created.
Fundamentally, this problem stems from the left’s assumption that everyone is (or ought to be) just like them. Because they are happy to be servants of the state, seeing it as some benign Rousseauian manifestation of the General Will, they are happy to hand large chunks of their pay packets over to it.
The rest of us, however, are slightly more sceptical of the obviously crazy notion that every single copper coin of government spending is virtuous of itself. Thus, when taxes on our earnings go up, instead of redoubling our efforts and congratulating ourselves for supplying yet more income for the state we tend to be a bit annoyed and wonder what the point of putting any extra effort in is when more than half of the reward for that extra effort will be taken from you. Your effort slackens. You reduce your labour or you go and do it somewhere else. With less labour going on, the state’s income from taxes on labour falls. We saw all this back in the high tax Keynesian heyday of the 1970’s and look where it got us. Taxes went up and The Rolling Stones rolled off to the south of France with their millions and watched on TV as Denis Healey went to the IMF in 1976 to ask for a loan to pay the government’s bills.
It was all rather gracefully explained by the Laffer Curve which took this obvious insight and formalised it. With a tax rate of 0% the government would obviously receive no revenue. But, Laffer argued, with a tax rate of 100% the government would also receive no revenue as all activity would grind to halt because of the disincentive effect of taxes which took all the reward of your labour.
This was, and remains, a direct challenge to the left wing notion that because all public spending is good there is no disincentive effect from higher taxes; that despite receiving less and less of the reward for their labour, people will continue to provide the same amount of taxable labour regardless. To a left winger there would be no Laffer Curve, simply a diagonal line sloping upwards from bottom left at a 45 degree angle.
There is a Laffer Curve shaped mountain of empirical evidence to support this basic contention. Yet the statists’ opposition to this economic truism has often been simply hysterical, even from noted economists. This is because they understand the implications of the Laffer Curve. It sets a cap of t*, whatever the precise numeric value may be, beyond which the state’s share of the economy cannot advance. At some point taxes will rise so high that they will start to decrease revenue, the limits of statism are reached. That is why people like Adele, Philip Green or, indeed, anyone who questions even taxes of over 50% is considered not just wrong but evil. Adele can take comfort that she has morality and economic fact on her side as well as talent.
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