Together with colleagues spanning four parties – Michael Meacher (Lab), Caroline Lucas (Green), Douglas Carswell (UKIP) and David Davis (Con) – I have secured a debate on Money Creation and Society for Thursday 20 November. Here’s a quick guide to understanding the debate.
First, we have a system of paper or “fiat” money: it exists due to legal mandate as opposed to being a physical commodity like gold. Reserves, notes and coins are created by the state but claims on money are created by the banks when they lend. Most of the money we have was created by banks lending.
I published a short paper on what is wrong with the current system and what to do about it, first inBanking 2020 and then Jesús Huerta de Soto kindly republished it in his journal Procesos De Mercado Vol.X nº2 2013. A further monetary economist privately reviewed the paper but errors and omissions remain my own. You can download it here:
Recent emergency monetary policy has been dominated by Quantitative Easing: the Bank of England has provided a report on The distributional effects of asset purchases (PDF). However, the financial system has been chronically inflationary throughout my lifetime, ever since the Bretton Woods currency system ended.
If QE has distributional effects, why not all money creation?
Why are we in this debt crisis? I have just checked the M4 money supply figures—I am sorry to return to aggregates, but needs must. When Labour came to power the money supply was about £700 billion and it is now about £2.1 trillion, so it has tripled over the past 14 years. Unfortunately, most economists talk about money flowing into the economy as if it were water poured into a tank that found its own level immediately, but what if it is like treacle or honey? What if it builds up in piles when poured into the economy and takes a while to spread out? What if that money was loaned into existence in response to individual choices led by the excessively low interest rates pushed by the central bank? What if it was loaned into existence in particular sectors, such as the housing sector, where prices have more than doubled over the same period, and what if it was the financial sector that received the benefit of that new money first? Would that not explain why financiers and bankers are so much wealthier than everyone else, and why economic activity and wealth has been reorientated towards the south-east?
This debate will explore the effects on society of long-term money creation by private banks’ lending in the context of the present financial system.
It is generally held that for an economist to be able to assess the state of the economy he requires macro-economic indicators which will tell him what is going on. The question that arises is why is it necessary to know about the state of the overall economy? What purpose can such types of information serve?
Careful examination of these issues shows that in a free market environment it doesn’t make much sense to measure and publish various macro-economic indicators. This type of information is of little use to entrepreneurs. The only indicator that any entrepreneur pays attention to is whether he makes profit. The higher the profit, the more benefits a particular business activity bestows upon consumers.
Paying attention to consumers wishes means that entrepreneurs have to organise the most suitable production structure for that purpose. Following various macro-economic indicators will be of little assistance in this endeavour.
What possible use can an entrepreneur make out of information about the rate of growth in gross domestic product (GDP)? How can the information that GDP rose by 4% help an entrepreneur make a profit? Or what possible use can be made out of data showing that the national balance of payments has moved into a deficit? Or what use can an entrepreneur make out of information about the level of employment or the general price level?
What an entrepreneur requires is not general macro-information but rather specific information about consumers demands for a product or a range of products. Government lumped macro-indicators will not be of much help to entrepreneurs. The entrepreneur himself will have to establish his own network of information concerning a particular venture. Only an entrepreneur will know what type of information he requires in order to succeed in the venture. In this regard no one can replace the entrepreneur.
Thus if a businessman assessment of consumers demand is correct then he will make profits. Wrong assessment will result in a loss. The profit and loss framework penalizes, so to speak, those businesses that have misjudged consumer priorities and rewards those who have exercised a correct appraisal. The profit and loss framework makes sure that resources are withdrawn from those entrepreneurs who do not pay attention to consumer priorities to those who do.
In a free market environment free of government interference the “economy” doesn’t exist as such. A free market environment is populated by individuals, who are engaged in the production of goods and services required to sustain their life and well being i.e. the production of real wealth. Also, in a free market economy every producer is also a consumer. For convenience sake we can label the interaction between producers and consumers (to be more precise between producers) as the economy. However, it must be realised that at no stage does the so called “economy” have a life of its own or have independence from individuals.
While in a free market environment the “economy” is just a metaphor and doesn’t exist as such, all of a sudden the government gives birth to a creature called the “economy” via its constant statistical reference to it, for example using language such as the “economy” grew by such and such percentage, or the widening in the trade deficit threatens the “economy”. The “economy” is presented as a living entity apart from individuals.
According to the mainstream way of thinking one must differentiate between the activities of individuals and the economy as a whole, i.e. between micro and macro-economics. It is also held that what is good for individuals might not be good for the economy and vice-versa. Within this framework of thinking the “economy” is assigned a paramount importance while individuals are barely mentioned.
In fact one gets the impression that it is the “economy” that produces goods and services. Once the output is produced by the “economy” what is then required is its distribution among individuals in the fairest way. Also, the “economy” is expected to follow the growth path outlined by government planners. Thus whenever the rate of growth slips below the outlined growth path, the government is expected to give the “economy” a suitable push.
In order to validate the success or failure of government interference various statistical indicators have been devised. A strong indicator is interpreted as a success while a weak indicator a failure. Periodically though, government officials also warn people that the “economy” has become overheated i.e. it is “growing” too fast.
At other times officials warn that the “economy” has weakened. Thus whenever the “economy” is growing too fast government officials declare that it is the role of the government and the central bank to prevent inflation. Alternatively, when the “economy” appears to be weak the same officials declare that it is the duty of the government and central bank to maintain a high level of employment.
By lumping into one statistic many activities, government statisticians create a non-existent entity called the “economy” to which government and central bank officials react. (In reality however, goods and services are not produced in totality and supervised by one supremo. Every individual is pre-occupied with his own production of goods and services).
We can thus conclude that so called macro-economic indicators are fictitious devices that are used by governments to justify intervention with businesses. These indicators can tell us very little about wealth formation in the economy and thus individuals’ well-being.
Dr Frank Shostak is a leading Austrian economist and director of Applied Austrian School Economics Ltd, which aims to assess the direction of various markets using the Austrian School methodology. AASE aims to make Austrian economics accessible to businessmen. | Contact us
3 November 14 | Tags: Economics, Insight | Category: Economics | One comment
Recent evidence points increasingly towards global economic contraction.
Parts of the Eurozone are in great difficulty, and only last weekend S&P the rating agency warned that Greece will default on its debts “at some point in the next fifteen months”. Japan is collapsing under the wealth-destruction of Abenomics. China is juggling with a debt bubble that threatens to implode. The US tells us through government statistics that their outlook is promising, but the reality is very different with one-third of employable adults not working; furthermore the GDP deflator is significantly greater than officially admitted. And the UK is financially over-geared and over-dependent on a failing Eurozone.
This is hardly surprising, because the monetary inflation of recent years has transferred wealth from the majority of the saving and working population to a financial minority. A stealth tax through monetary inflation has been imposed on the majority of people trying to earn an honest living on a fixed salary. It has been under-recorded in consumer price statistics but has occurred nonetheless. Six years of this wealth transfer may have enriched Wall Street, but it has also impoverished Main Street.
The developed world is now in deep financial trouble. This is a situation which may be coming to a debt-laden conclusion. Those in charge of our money know that monetary expansion has failed to stimulate recovery. They also know that their management of financial markets, always with the objective of fostering confidence, has left them with market distortions that now threaten to derail bonds, equities and derivatives.
Today, central banking’s greatest worry is falling prices. The early signs are now upon us, reflected in dollar strength, as well as falling commodity and energy prices. In an economic contraction exposure to foreign currencies is the primary risk faced by international businesses and investors. The world’s financial system is based on the dollar as reserve currency for all the others: it is the back-to-base option for international exposure. The trouble is that leverage between foreign currencies and the US dollar has grown to highly dangerous levels, as shown below.
Plainly, there is great potential for currency instability, compounded by over-priced bond markets. Greece, facing another default, borrows ten-year money in euros at about 6.5%, while Spain and Italy at 2.1% and 2.3% respectively. Investors accepting these low returns should be asking themselves what will be the marginal cost of financing a large increase in government deficits brought on by an economic slump.
A slump will obviously escalate risk for owners of government bonds. The principal holders are banks whose asset-to-equity ratios can be as much as 40-50 times excluding goodwill, particularly when derivative exposure is taken into account. The stark reality is that banks risk failure not because of Irving Fisher’s debt-deflation theory, but because they are exposed to a government debt bubble that will inevitably burst: only a two per cent rise in Eurozone bond yields may be sufficient to trigger a global banking crisis. Fisher’s nightmare of bad debts from failing businesses and falling loan collateral values will merely be an additional burden.
Macro-economists refer to a slump as deflation, but we face something far more complex worth taking the trouble to understand.
The weakness of modern macro-economics is it is not based on a credible theory of prices. Instead of a mechanical relationship between changes in the quantity of money and prices, the purchasing power of a fiat currency is mainly dependent on the confidence its users have in it. This is expressed in preferences for money compared with goods, and these preferences can change for any number of reasons.
When an indebted individual is unable to access further credit, he may be forced to raise cash by selling marketable assets and by reducing consumption. In a normal economy, there are always some people doing this, but when they are outnumbered by others in a happier position, overall the economy progresses. A slump occurs when those that need or want to reduce their financial commitments outnumber those that don’t. There arises an overall shift in preferences in favour of cash, so all other things being equal prices fall.
Shifts in these preferences are almost always the result of past and anticipated state intervention, which replaces the randomness of a free market with a behavioural bias. But this is just one factor that sets price relationships: confidence in the purchasing power of government-issued currency must also be considered and will be uppermost in the minds of those not facing financial difficulties. This is reflected by markets reacting, among other things, to the changing outlook for the issuing government’s finances. If it appears to enough people that the issuing government’s finances are likely to deteriorate significantly, there will be a run against the currency, usually in favour of the dollar upon which all currencies are based. And those holding dollars and aware of the increasing risk to the dollar’s own future purchasing power can only turn to gold and subsequently those goods that represent the necessities of life. And when that happens we have a crack-up boom and the final destruction of the dollar as money.
So the idea that the outlook is for either deflation or inflation is incorrect, and betrays a superficial analysis founded on the misconceptions of macro-economics. Nor does one lead to the other: what really happens is the overall preference between money and goods shifts, influenced not only by current events but by anticipated ones as well.
Recently a rising dollar has led to a falling gold price. This raises the question as to whether further dollar strength against other currencies will continue to undermine the gold price.
Let us assume that the central banks will at some time in the future try to prevent a financial crisis triggered by an economic slump. Their natural response is to expand money and credit. However, this policy-route will be closed off for non-dollar currencies already weakened by a flight into the dollar, leaving us with the bulk of the world’s monetary reflation the responsibility of the Fed.
With this background to the gold price, Asians in their domestic markets are likely to continue to accumulate physical gold, perhaps accelerating their purchases to reflect a renewed bout of scepticism over the local currency. Wealthy investors in Europe will also buy gold, partly through bullion banks, but on the margin demand for delivered physical seems likely to increase. Investment managers and hedge funds in North America will likely close their paper-gold shorts and go long when their computers (which do most of the trading) detect a change in trend.
It seems likely that a change in trend for the gold price in western capital markets will be a component part of a wider reset for all financial markets, because it will signal a change in perceptions of risk for bonds and currencies. With a growing realisation that the great welfare economies are all sliding into a slump, the moment for this reset has moved an important step closer.
[Editor’s Note: The following piece was written exclusively for The Cobden Centre by Axel Kaiser, the Executive Director of think tank Fundacion para el Progresso, based in Santiago. It gives a good outline of how Austrian/free market ideas are developing in South America. Many young people globally are now embracing the ideas of Mises and Hayek, but we are also currently seeing undesirable reactions among many people, who now tragically associate free market ideas with crony capitalism and bailouts for the wealthy in society.]
The Austrian school of economics has gained increasing attention since the 2008 financial crisis and Latin America has not been an exception in this trend. It is mostly young people who have been captivated by the ideas of Hayek, Mises, Rothbard and Huerta de Soto. The most powerful proponents of these ideas in the Spanish-speaking world presently are the Juan de Mariana Institute and the Universidad Rey Juan Carlos in Spain. The first actively participates in the public debate while the second has introduced both a Masters degree and a PhD in Austrian Economics under the leadership of Austrian economist Jesús Huerta de Soto. Many Latin Americans have been trained in the Universidad Rey Juan Carlos and returned to their countries to teach and influence in the public debate.
But there are also several institutions supported by private sponsors that actively promote Austrian economics and classical liberalism in Latin America itself. A remarkable case is Caminos de la Libertad in Mexico. Financed by Ricardo Salinas Pliego, head of the Salinas Group, Caminos de la libertad focuses on educating students in the ideas of liberty. It also organizes the most competitive classical liberal essay contest for scholars in the Spanish-speaking world. Fundación Libertad in Rosario, Argentina is another think tank that advances the Austrian school with great success among young people. Perhaps the most notable case of an institutional effort made to spread classical liberalism and the Austrian school is the Universidad Francisco Marroquín in Guatemala, which was founded entirely on a classical liberal philosophy. Its contributions to the cause of liberty have been considerable in a region dominated by socialist and populist worldviews.
Other important think tanks are CEDICE that does an extraordinary complex work in Venezuela, CREES in the Dominican Republic, IEEP in Ecuador and Fundación para el Progreso in Chile. This last one emerged as a classical liberal reaction against the dramatic rise that socialism and populism experienced over the last years. The Cato Institute has also a special concern with Latin America and permanently finds in these institutions support for organizing the “Cato University”, which brings together students from all over Latin America to learn classical liberalism and fee market economics from leading Latin American scholars.
Despite all these efforts, Latin America at large seems to be moving in the direction of populism and statism. The best and most alarming example is Chile. Long considered a bastion of free market reforms, the country has started a violent departure from the path of progress that followed the last three decades. The hegemony of left-wing and populist ideas has overwhelmed public opinion and caught pro market opinion leaders off guard. If the new statist trend is not stopped on time, the now most prosperous country in the region could follow an Argentinian type of institutional evolution in the next decades that would leave Latin America without a role model on sound economic policy.
Like in Europe and the United States, one of the central causes for the hegemony of statism in Latin America is the fact that most intellectuals and especially university professor are strong supporters of government intervention. This is extremely problematic in countries that are developing and require a wide consensus on policies needed for overcoming poverty. The free market movement in Latin America is still too weak to counterbalance this hegemony and achieve the shift in the intellectual climate of opinion necessary to move towards sound economic policies. It remains to be seen if in the long run the failure of statist ideas will allow once again for change that is desperately needed in the region. It that comes to happen, current pro market think tanks and intellectuals will play a decisive role in shaping the new institutional arrangements and in creating the public support for ensuring their survival.
Axel Kaiser is a Chilean public intellectual, financial columnist and writer dedicated to spreading classical liberalism in Latin America. He is also executive director of the think tank Fundación para el Progreso based in Santiago.
Max Rangeley is the Editor of The Cobden Centre. He is the CEO of ReboundTAG Ltd, which produces microchip luggage tags and has been showcased by Lufthansa and featured on BBC World among other media outlets. Max has a Master’s in economics, following this he was given a scholarship to do a PhD at the London School of Economics, but decided instead to go straight into business. | Contact us
5 August 14 | Tags: Economics, Latin America | Category: Economics | Comments are closed
It was something of an irony last week when the idiots savants who constitute the upper ranks of the ineffable current incarnation of the IMF decided briefly to forgo their penchant for the politics of the Montagnard – more inflation, higher wages, death to the speculators, les aristocrats à la lanterne, that sort of thing – in favour of those of the ancien régime. Specifically, this took the form of updated proposals for a ‘Visa’ of the kind twice instituted in early 18th century France; the first to try to clear up the fiscal mess which was the principle legacy of the military vainglory of the just departed Sun King and a second time to mop up after that QE disaster of its time, John Law’s infamous ‘System’.
Sorting the participants into five classes whose activities were deemed to have been increasingly speculative – and hence liable to more swingeing penalties – those in charge of the Visa saw to it that the bigger players (or at least those bigger players unable to use their royal connections to secure themselves an indemnity) suffered haircuts, retrospective tax assessments, forcible debt extensions, property confiscation – and, in one or two cases, a salutary trip to the Bastille.
Jump forward three centuries and in its latest position paper on sovereign debt ‘resolution’ the IMF is drooling about dipping, in a not wholly dissimilar fashion, into people’s pension funds and insurance policies – since these are seen to be easy targets – as well as about imposing arbitrary prolongations of tenor on outstanding securities should the state’s chronic mismanagement end up rendering it temporarily unable to entice sufficient new or repeat suckers into enabling the maintenance of its naked fiscal Ponzi scheme.
As the reader may be aware, we are all for adopting a stance of unsentimental realism when it comes to facing problems of over-indebtedness and, further, that we have long bemoaned the readiness of governments to swell their own commitments in the aftermath of financial crises, not just because of the inherent cronyism and inequity which riddles most TBTF assistance packages, but because sovereign debt is intractable in a way that private sector obligations generally are not. We are, therefore, more than happy to see all breaches of contract – which is what the unpayability of a debt involves – dealt with in as clinical and judicial way as possible, no matter whether these failures are misjudgements, examples of malfeasance, of ‘acts of god’. Moreover, we are exceedingly happy to see anything which reminds people that, despite the modern fiction of the ‘risk-free’ rate which attaches to them, Leviathan’s IOUs have always been among the least trustworthy of all pledges to pay.
However, that principal is not what is at issue here, but what does gall is the IMF’s glib reliance on the sneaky, archly legalistic, announce-it-once-the-banks-are-closed repudiation of existing agreements by a borrower which has not only promoted itself as the one true guardian of the people’s well-being, but which has frequently given its subjects precious little choice but to trust a goodly part of the surplus they have wrung from their already sorely-taxed income to those same instruments whose terms the state is now unilaterally amending in its favour.
As yet one more example of the sinister creed of ‘Gemeinnutz geht vor Eigennutz’, this betrays the classic statist proclivity to view all notionally private property as really belonging to the Collective, even if this is rarely expressed so clearly today as it was when last elevated into a central tenet of axe-and-bundle political theory in the 1920s and 30s.
‘What’s yours is only truly so to the extent that we, the functionaries of the Hive, do not decide that we have a better use for it and so do not exercise what we insist is our prior claim to it, ‘ they imply, though a little more disingenuously than heretofore. Having ignited an all too short-lived burst of outrage at last year’s more overt Visa proposal to go for a straight confiscation of 10% of ‘wealth’, this latest business of simply denying people an exit route has the poisonous virtue of being more subtle in its operation and therefore of being more likely to pass into effect all unremarked, even if the effect upon those being locked in would be broadly equivalent in many respects.
Moreover, for all the weasel words uttered in the Fund’s blueprint about limiting moral hazard, the plan explicitly endorses what it archly terms the ‘reprofiling’ measure on the grounds that it serves to deliver a ‘larger creditor base’ into the meat-grinder and hence helps limit damage to ‘longer-term creditors who would have otherwise had to shoulder the full burden of the debt reduction’ As an added bonus, stiffing one’s existing creditors in place of begging a payday loan from Uncle IMF ‘…increases the chances of a more rapid return to the market, as the debt stock will be less burdened by senior claims’ – i.e., those emanating from the IMF itself. A third, tacit advantage would be that since the IMF would not be not committing an actual monies, there need be no debate among its members about the implementation of such a programme, while the softening of the criteria calling for its use from one where the state’s finances are categorically ‘unsustainable’ to one where there is a mere inability to rule out the arrival of such a contingency drastically lowers the nuclear threshold.
One might object that the very knowledge that such steps could be taken would be enough to destroy any residual element of ‘sustainability’ with which a given sovereign’s budget might otherwise be imbued. If people became aware that in buying a 3-month T-bill (and buying it at vanishingly small rates of interest at that) they were also selling their overlords a 30-year put, or that the YTW calculation of their security really ought to include the chance of a 10% principal reduction, would they not try to incorporate this in its price, thereby pushing up yields and so aggravating any incipient funding difficulties? Might they, indeed, not halt their discretionary purchases altogether and so advance rather than retard the onset of the crisis?
Given that they are each, in their own way, subject to the compulsions of so-called ‘prudential’ regulations with regard to the assets they must hold to ensure their solvency and liquidity, would such ‘captives’ as the banks, pension funds, and insurers thus be left the only buyers outside of the ever-eager to oblige central bank? A moment’s consideration of what could happen to the most fragile of these – the already–impaired banks – if their assets were suddenly to suffer another sizeable mark down as a result of state defalcation shows why the IMF wants the universe of the afflicted to be as all-inclusive as possible. That way, however large the absolute loss might be, the percentage loss to each holder could be conveniently minimized as the poor individual innocent was once again mulcted to provide a subsidy for the rich, corporate players whose fate is so closely entwined with that of their overlords.
Thus, under the terms of this new wheeze, we might imagine a day when the following missive drops onto the doormat of the Forgotten Men and Women up and down the country
“Dear Grandma and Grandad, thank you for making the valiant effort over these past decades to achieve a measure of self-reliance in your dotage and for allowing us jacks-in-office full use of your savings in the meanwhile as both a means to fulfil our political ambitions and as a way to act out our own economically-illiterate and usually illiberal prejudices at the expense of you and yours.”
“Sadly, it transpires that we have not only wasted a goodly part of your savings, but we have greatly added to the host of irredeemable promises which we made to you, in the form of a mountain of even more pressing pledges issued to the Biggest of Big Fish in the financial markets. So that we do not entirely dissuade these latter sophisticates from again indulging our follies at the earliest opportunity, we shall now have to ask you to share – and thereby greatly to reduce – their pain.”
“Be assured, however, that the loss for which you have my heartfelt sympathy will patriotically ensure that we can continue to live well beyond our means. In this way your sacrifice will see to it that the least possible harm will come to any of us in the political classes (a.k.a. the agents of your misfortune), to our army of placemen, patronage-seekers, and dole-gatherers, or to our plutocratic enablers for – as the IMF puts it – ‘…resources that would otherwise have been paid out to creditors will have been retained [to] reduce [our] overall financing needs.’ Nor will we have to suffer the indignity of modifying our existing approach overmuch by actually only spending money on the things for which you, in true democratic fashion, have openly voted the taxes since – here let me cite those marvellous chaps in Washington, once again – ‘resources could be efficiently employed to allow for a less constraining adjustment path.’, i.e., to allow one demanding as little fundamental ‘adjustment’ as possible.”
“I feel confident you will join me in looking forward with some enthusiasm to the next, inevitable ‘reprofiling’, just as soon as we can arrange to overspend enough to make one necessary once again. Should I have already laid down the heavy burden of selfless public service by the time this comes about and gone instead to my just reward as a highly-paid ‘consultant’ to a global investment bank, I would urge you to give your full support to my successor, of whatever political stripe he or she may be. In such an event, there will, of course, be precious little different in the treatment you receive at the hands of any of the mainstream parties as currently constituted”
Yours Insincerely, The Minister of Finance.
It is all too easy at present to make fun of the IMF, though in so doing we should bear in mind that such ridicule is perhaps the only weapon we have in our fight to prevent it from lending a spurious air of rationality to the worst predilections of our national nomenklatura.
A case in point is that, at the conclusion of its periodic, Article IV review of the economic condition of the homeland of so many of those in the upper reaches of the Fund, the website prominently carried the triumphant banner, “France: Policies on the Right Track.”!
Truly, you could not make this up. For a slightly less self-justificatory assessment, one only has to trawl briefly through the Bloomberg series or consult the most recent verdict of the official ‘auditor’ of the nation, the Cours de Comptes.
There it becomes readily apparent that while the two decades prior to the first oil shock saw Real GDP, ex-government trend upward at a 5.5% annualized rate, and the next three decades managed 2.3% compound, the last seven years have seen no progress made whatsoever. Similarly, real capital formation by non-financial business has decelerated from 7.5% to 2.9% to zero over those same divisions of time. Exports stand at close to a 6 ½ year low and two-way trade at the weakest in more than three years. Industrial output – a whisker off the worst since the rebound from the GFC – lies 13% below its peak and hence no higher than it first reached in 1988
Government expenditures, meanwhile, have swollen to a record 58% of overall GDP, 80% of private, with taxes some 4-5% behind. These are levels only exceeded in the EU by Finland, Denmark, Greece, and Slovenia. The EU-calibrated debt:GDP ratio has risen by 30% of GDP since the Crash and by 12% since 2010 alone (that latter a slippage of 15% compared to the German pathway from an almost identical starting point). Here, fast approaching €2 trillion outright, it stands at 94% of overall GDP and therefore at 120% of that of the private component out of whose income that debt must be ultimately serviced.
Yes, policies are indeed on the right track, assuming that track itself is an economic highway to hell.
Given the foregoing, it was of note that the Governor of the Banque de France, Christian Noyer, insisted over the weekend that it might be highly counter-productive to speculate publicly about any programme of even partial debt repudiation.
“This all corresponds to a somewhat contrived definition of sustainability and ignores the highly disruptive effects… besides, it relies on a very pessimistic growth outlook,” he argued. “Once one starts not to pay ones debts, borrowing becomes very expensive and the impact on growth greatly exceeds that of managing a gentle reduction in debt.”
The only problem with such a judgement is that M. Noyer’s preferred – if sometimes implicit – remedy is for a reinforcement of the policies which have so signally failed France over the past several years – viz., further extreme monetization of assets (to include equities, if need be) and a weaker currency.
As a result, we find ourselves ensnared in nest of Keynesian paradoxes and economic canards. We need more investment, we are told, but the only means we can imagine to stimulate it is to lower interest rates. We understand that debt levels are too high, but we are so terrified that they might actually begin to be reduced that we subsidize profligacy as the default option of policy. We fret that prices of assets are rising as a result, not the price of labour (which we implicitly want to increase so we can reduce debt ratios, rather than debt itself) and in order to offset a form of inequality we ourselves have engendered, we stultify an economy already overburdened with rules and regulations with that en vogue form of top-down, baby-with-the-bathwater interference we style ‘macroprudential’ policy.
We want to see more people in work, on the one hand we work manfully to introduce ingenious tax and benefit ‘wedges’ which act to discourage marginal job seekers and, on the other, we call for the cost of labour to be raised through higher minimum wage rates (and or plain-old monetary inflation). We decry the fact that businesses will not hire while lowering the prospective economic returns to such hiring by seeking to tax profits more heavily.
The reality is that it does not have to be like this. The curse of macroeconomics is that it takes what should be a crude metalanguage which merely attempts the convenient shorthand of describing an impossibly complex but largely self-organising whole using a few, hopefully representative general features and attempts to elevate it into a rigorous, cybernetic control system to be twiddled and fiddled by the fingers of Philosopher Kings. Given this assertion, let us try instead to work from the other – the microeconomic – end and see if we can shed a little light on this dark and dismal scene.
If Robinson Crusoe wishes to survive his enforced sojourn on his remote island, he must only engage in such activities as provide him with a flow of the needs – at their most elementary, sustenance and shelter – that is at minimum no smaller than their accomplishment costs him in the expenditure of time and effort. The more astute he is in doing this, the more alert and adaptable he is in going about it, the wider will be the margin of success he enjoys, the more rapidly his most essential requirements will be satisfied, and the sooner he can move on to meeting a broader range of desires and to building up a precautionary reserve against misfortune.
It should then be obvious that, when Friday washes up over the reef, Crusoe – unless driven by an inexhaustible fund of potentially-self-endangering altruism – will not be able to offer his new companion an ongoing share in his accomplishments, free access to his stock of implements, or the instant ability to draw upon his, Crusoe’s, hard-won skill and understanding if Friday does not at the very least act in a manner which exacts no net toll of Crusoe (including the unseen one of foregoing better opportunities for gain in their use elsewhere). In fact, he would be unlikely to take the risk of depleting his own scarce resources and of squandering his finite energies if Friday does not contribute something beyond such a bare material parity, the which surplus he, Crusoe, will be able to use to increase the future possibilities open for the two of them to exploit.
If we stop to think about it clearly, Crusoe’s surplus income – and let us not be shy to call this his profit – is what enables him firstly to improve his own standard of living (to invest) and eventually to afford Friday the means with which to leapfrog away from the perils and privation of shipwrecked destitution to the more secure and less impoverished existence he may lead if he contracts to work under the guidance of Crusoe’s entrepreneurial instincts while utilising some of Crusoe’s already-produced stock of capital. For this, Friday earns himself the right to avail himself of an agreed proportion of the goods (the income) they generate through their mutual collaboration. Once more, it is Crusoe who rightly accedes to and disposes of any subsequent excess which he by his craft, and they two by their sweat, can conjure out of the unforgiving surroundings of their savage little world.
Assuming Crusoe to be as diligent in his way as Friday is in his, the generation of each successive surplus will allow Crusoe progressively to improve the quality, quantity, and variety of means they each can employ, so that Friday, as well as he, can enjoy those better returns on his effort which accrue from the fact that his capital endowment has risen, those better returns being what we call a higher real wage.
It is all very well to bewail the fact that, in the modern world, the admirably rugged individual, Crusoe, has been transformed into that bête noire of the scribbling and scriptwriting classes – the faceless and vaguely sinister Crusoe Incorporated – and it may equally be a matter of unthinking dogma that ‘profit’ like ‘property’ is theft, but the truth remains that what applied to our pairing of Lost-prequel cast members still applies in the disembodied world of distributed shareholding and managerial agency: profit is both the sign of entrepreneurial success and the seedcorn of capital provision; labour will only be – can only be – hired if the value of its product exceeds the cost of its retention; and the more capital each worker has at his disposal (including the kind contained between his ears), the greater will be the likely worth of his product and hence the more lavish his reward.
There are no short cuts on offer. Or perhaps none which bear up to the test of self-sustainability. Thus, the would-be macro-puppeteers of the kind characterised by Deputy BOE Governor Jon Cunliffe when he waxed metaphorical in a recent speech about how the Old Lady’s duty was to ‘steer’ the economy ‘at the highest speed that can be achieved… down a winding road’ can be seen both to seriously overate their powers to do good and to vastly underestimate their proclivity to do harm.
Allow a man the scope both to make and keep a profit (to win receipts greater than costs, adjusted for the passage of time); place no restrictions on the terms of the mutually-beneficial, freely-contracted co-operation into which he enters with less adventurous, but no less assiduous, persons as he seeks to do so; do as little as possible to add to the costs of any such contract (monetary manipulation herein included) and thus to dissuade either party from entering into it; subject our man to no deterrent to ploughing the fruits of this cycle’s endeavours back into the attempt to make those of the next more succulent and more plentiful and, by and large, though failures will occur and frauds will not be unknown, all those involved will flourish – even if they happen to live in a France where, the last we heard, the laws of economics still applied and where it was not the people who were failing but those who ruled over them.
But let us not to be too unfair to the worthies who reside among the splendours of the Elysée, the Matignon, or Bercy: as the Cours de Comptes points out, the performance of their counterparts on the other side of the Channel has in many ways been just as unimpressive.
The UK, after all, still runs a deficit of around ₤100 billion a year, 6% of total and 8% of private sector GDP. Net debt of more than ₤1.4 trillion amounts to 85% of overall and 110% of private GDP (even without counting in the obligations pertaining to the bailed-out banks) and has doubled in five years, tripled in nine. Total spending has risen by a half since 2005, climbing 5% of pGDP in that time to reach a very lofty 52.5% – and this despite all the bleating about swingeing ‘austerity’. The ₤650 billion which comprises that churn amounts to around ₤200, or more than 31 hours of minimum wage pay, per week for every man, woman, and child in the country. Not entirely unrelated is the fact that the current account gap yawns as wide as ₤75 billion a year, equivalent to what is fast approaching a post-war record of 4.5% of total, 6% of private GDP.
Here, too, the optimists have been somewhat deceived by their hopes of undergoing a true economic revival. Though the series is bumpy, manufacturing output in May appears to have stalled, suffering its largest drop since the harsh winter of 2013 and leaving overall industrial production barely 3.5% off 2012’s 27-year lows and still having 80% of its GFC losses to make up.
Despite the glaringly obvious construction that the UK is once more undergoing a lax money, too-low interest rate, classic, Tory Chancellor pre-election boom – all about non-tradables, a housing mania, an excess of imports, and plagued with soft-budget government incontinence – the myopically GDP-fixated macromancers cannot resist becoming ecstatic at the results.
Jack Meaning, a research fellow at the highly-regarded National Institute of Economic and Social Research, for example, was quoted this week in the broadsheets in full Trumpet Voluntary mode:-
“The outlook is very positive,” he exulted. “Growth now is very much entrenched, and given all the positive data that has come out, it looks like growth is here to stay.”
Hmmmm! While it is true that the Carney-Osborne duumvirate will do nothing to restrict access to the punch bowl (a) before the Scottish Independence referendum; (b) before the UK General Election next spring ; and (c) if it can be managed, before our beloved Governor quits (in 2017?) to leave his palm print on the pavement of Grauman’s Chinese Theater en route to what is rumoured to be his apotheosis at the pinnacle of the Canadian Liberal Party hierarchy, the longer this particular locomotive of ‘growth’ progresses along its current track, the more certain we can be that it will terminate in the same, drear Vale of Tears where all its predecessors have hit the buffers.
As for the US – where policy has retrogressed through some sort of Phillips Curve warping of the space-time continuum to make un(der)employment the only real matter of concern – well, let’s not get too bogged down in the to and fro about Birth:Death adjustments, the household versus the establishment survey, competing explanations for a falling participation rate, part-time versus full-time job issues and all the rest of the minutiae.
Taking the data at face value, private sector jobs (adding agriculture and self-employed to the establishment total) seem to have risen over the whole of the last four years by a remarkably steady 180k a month, 1.8% a year, for a cumulative 870k gain which is pretty much in tune with the simultaneous official estimate of 910k in population growth. While similar to the pace mapped out in the 2003/07 expansion (then 210k and 1.6% off a higher base), this is one of the slower episodes in the last half century. If we calculate the real wage fund (2.1% outright and 1.4% per capita) or real private GDP (3.0% outright and 2.3% per capita) we get similar results: the US private sector has been expanding reasonably, if a little tardily, in real terms though it has also been more obviously lagging in nominal ones.
Why no faster rebound? Certainly not because interest rates are too high, or government outlays too parsimonious, or because the ‘low-hanging fruit’ of human progress has been well and truly plucked to leave us the unpalatable choice between ‘secular stagnation’ and an invigorating burst of warfare.
Read the Crusoe paragraphs again: incentives matter, especially at the margin. And among the many perverse incentives to limit hiring we have, just as in the 1930s, a whole host of programmatic and regulatory barriers to take into account – extended benefits, changes to health care, access to classification as ‘disabled’, unemployment insurance rules, and so on.
Though America is not as sorely afflicted with these hindrances as are many Western nations, it is not hard to see that the sort of work done by Richard Vedder and Lowell Galloway, by Lee Ohanian, by Robert Higgs, and lately by Casey Mulligan all come back to the same basic conclusion: that for the micro-economics of job-creation to take hold, the legal and institutional framework must not only be conducive to fostering the hope of gain among those seeking to employ both capital and labour (including their own), but it must be straightforward to negotiate and stable in its composition. Neither constant bureaucratic tampering, nor wrenching shifts in fiscal or monetary policy – with all the wilder swings they transmit via the financial markets through which they act – can contribute much that is positive, for all the arrogance of the Colossi who never cease to promulgate them.
Sean Corrigan is an economist of the Austrian School Liberal Tradition. Corrigan is Chief Investment Strategist at Diapason Commodities Management. | Contact us
17 July 14 | Tags: Central Banking, Economics | Category: Economics | Comments are closed
Within the framework of our econometric model the key variable that drives a currency rate of exchange is the relative money supply rate of growth between respective economies. On this score our analysis shows that since October 2011 the money growth differential is currently favourable for the US$ against major currencies. Various key US data continue to display strength. We hold that on account of a downtrend in the growth momentum of AMS since October 2011 economic activity is likely to come under pressure in the months ahead. Meanwhile the growth momentum of the Euro-zone consumer price index has likely bottomed in May. We hold that a fall in the lagged growth momentum of German AMS is behind the weakening in some of the recent key German data. The S&P500 index could weaken for a few months before bouncing back. By next year our model expects the S&P500 to follow a declining path. According to our model the yield on the 10-year US T-Note is forecast to follow a declining path during 2015.
Prospects for US$ against the Euro
At the end of June the price of the Euro in US$ terms closed at 1.369 versus 1.363 in May – an increase of 0.4%. The yearly rate of growth of the price of the Euro stood at 5.3% against 4.9% in May. After closing at 13.6% in October 2011, the money growth differential (expressed in terms of our AMS) between the US and the Euro-zone settled at 0.7% in April. On account of long time lags we suggest that for the time being the effect of a rising differential between June 2010 and October 2011 is likely to dominate the scene. As time goes by the effect from a fall since October 2011 is expected to assert itself. (The US$ should strengthen).
The simulation of the model against the actual data is on the chart on the left below. Based on our model we expect the price of the Euro in US$ terms to close at 1.37 by March before settling at 1.36 in December next year.
Prospects for the British pound (GBP) against the US$
The price of the GBP in US$ terms closed at the end of June at 1.71 versus 1.675 at the end of May – an increase of 2.1%. Year-on-year the rate of growth climbed to 12.4% in June from 10.2% in the month before. The money growth differential fell from 10.4% in October 2011 to 0.6% in April.
We have employed our model to assess the future trend of the rate of exchange. The model simulation against the actual is presented on the left below. We expect the effect from the declining growth differential of money supply to gain strength as time goes by. By December next year the £Sterling-USD rate of exchange could settle at 1.66.
Prospects for the A$ against the US$
At the end of June the price of the A$ in US$ terms closed at 0.943 – an increase of 1.3%. The yearly rate of growth jumped to 3.2% from minus 2.7% in May. After closing at 15.5% in April 2012 the money growth differential between the US and Australia fell to minus 8.1% in April this year. Note that between January 2011 and April 2012 the yearly rate of growth was trending up.
According to our model (see the simulation on the left below) based on a declining money growth differential the A$ could come under pressure as time goes by. By June next year the Australian $ could close at 0.896 before settling at 0.91 by December next year.
Prospects for the Yen against the US$
The price of the US$ in Yen terms closed at the end of June at 101.3 – a fall of 0.5% from May. Year-on-year the rate of growth of the price of US$ rose to 2.2% from 1.3% in May. The money growth differential between the US and Japan fell from 12.8% in August 2011 to 3.9% in January 2013. There after the yearly rate of growth followed a horizontal path closing at 4.6% in May this year.
The simulation of the model is presented on the left below (see chart). According to the model the price of the US$ could increase to 102.3 by March before falling to 101.5 by May. Afterwards the price is forecast to follow a sideways movement closing at 101.2 by December 2015.
Prospects for the CHF against the US$
The price of the US$ in CHF terms closed at 0.887 at the end of June – a fall of 0.9% from May when it increased by 1.7% from April. The yearly rate of growth of the price of the US$ in CHF terms stood at minus 6.2% against minus 6.3% in May. The money growth differential between the US and Switzerland climbed to 4.8% in April 2013 from minus 6% in August 2012. This strong increase in the differential is providing strong support to the CHF against the US$ – note also that the differential fell sharply to minus 2.8% in April from 3.1% in January this year.
The simulation of the model against the actual data is presented on the left below (see chart). According to our model the price of the US$ in CHF terms is forecast to settle at 0.890 by December this year. By September next year the price is forecast to fall to 0.83 before stabilizing at 0.834 by December 2015.
Focus on US economic indicators
Manufacturing activity in terms of the ISM index eased slightly in June from May. The index closed at 55.3 versus 55.4 in May. Based on the lagged growth momentum of real AMS we suggest that the ISM index is likely to follow a declining path. The growth momentum of light vehicle sales has eased in June from May. The yearly rate of growth stood at 6.9% in June against 8.3% in the previous month. Our monetary analysis points to a likely further softening ahead in light vehicle sales.
The growth momentum of manufacturing orders eased in May from April. Year-on-year the rate of growth fell to 2.4% from 5.1%. Based on the lagged growth momentum of AMS we can suggest that the growth momentum of manufacturing orders is likely to follow a declining trend. Also, the growth momentum of expenditure on construction eased in May from April with the yearly rate of growth softening to 6.6% from 7.9%. Using the lagged yearly rate of growth of AMS we hold that the growth momentum of construction expenditure is likely to come under pressure ahead.
US employment up strongly above expectations in June
Seasonally adjusted non-farm employment increased by 288,000 in June after rising by 224,000 in the month before. That was above analysts’ expectations for an increase of 215,000. The growth momentum of employment has strengthened last month. Year-on-year 2.495 million jobs were generated in June after 2.408 million in the prior month. Using the lagged manufacturing ISM index we can suggest that from July the growth momentum of US employment is likely to visibly weaken (see chart). The diffusion index of employment in the private sector one month span, which increased to 64.8 in June from 62.9 in May is forecast to follow a declining trend in the months to come (see chart).
Manufacturing employment increased by 16,000 last month after rising by 11,000 in May. Based on the lagged growth momentum of real AMS we expect the growth momentum of manufacturing employment to come under pressure in the months to come. In the meantime, the unemployment rate stood at 6.1% in June against 6.3% in May, while the number of unemployed declined by 325,000 last month to 9.474 million.
Focus on non US economic indicators
Manufacturing activity has eased slightly in Australia in June from May. The manufacturing purchasing managers index (PMI) fell to 48.91 from 49.22 in May. Based on the lagged growth momentum of Australian real AMS we suggest that the Australian PMI is likely to be well supported ahead. The yearly rate of growth of the EMU consumer price index (CPI) stood at 0.5% in June the same as in May. Using the lagged growth momentum of EMU AMS we hold that the yearly rate of growth of the EU CPI is likely to strengthen ahead.
Year-on-year the rate of growth of German factory orders in real terms fell to 5.8% in May from 6.6% in April. Using the lagged growth momentum of German real AMS we can suggest that the yearly rate of growth of German factory orders is likely to weaken further in the months ahead. Meanwhile, the Swiss manufacturing PMI rose to 53.96 in June from 52.54 in the month before. According to the lagged growth momentum of Swiss real AMS the Swiss PMI is likely to display volatility (see chart).
Prospects for the CRB commodity price index
At the end of June the CRB commodity price index closed at 308.22 – an increase of 0.9% from May when it fell by 1.3%. The growth momentum of the index has strengthened with the yearly rate of growth rising to 11.8% in June from 8.4% in May.
The CRB index to its 12-month moving average ratio eased to 1.0546 in June from 1.055 in the month before.
We have employed our model to assess the future course of the CRB index (see chart). The model is driven by the state of US and Chinese economic activity and by US monetary liquidity.
According to our large scale econometric model the CRB index is forecast to close at 303 by November before jumping to 316 in February. There after the index is forecast to follow a slightly declining path closing by December at 312.
S&P500 up on the week
The S&P500 added 0.55% on Thursday to close at 1,985.43. For the week the index climbed 1.25%. The stock price index rallied after strong employment report for June with the employment rising by 288,000 against the consensus for an increase by 215,000. Against the end of June the stock price index advanced 1.3% whilst year-on-year the rate of growth eased to 17.8% from 22% in June. The S&P500 to its 12 month moving average ratio has eased to 1.0833 from 1.0843 in June.
We have employed our large scale econometric model to assess the future course of the stock price index. Within the model’s framework the S&P500 is driven by our measure of monetary liquidity and by the state of US industrial production. (See the actual versus the model data on the left below). According to our model the S&P500 index could weaken for a few months before bouncing back. By next year our model “expects” the S&P500 to follow a declining path.
US long – term Treasuries yields up against the end of June
On Thursday US Treasuries fell – pushing 10-year note yields to the highest in two months in response to a strong June employment report. This lifted bets that the US central bank may consider raising interest rates sooner than previously thought. The yield on the 10-year T-Note rose one basis point to close at 2.64% against 2.53% at the end of June. Two-year note yield rose three basis points to 0.51%. Traders pushed up their bets for a June rate increase to 49% from 44% and 33% at the end of May. The yield spread between the 10 year and the 2 year T-note stood at 2.13% versus 2.08% in June.
The “TED” spread stood at 0.222% against 0.205% in June. We have employed our econometric model to establish the future direction of the yield on the 10-year T-Note. In the model’s framework the yield on the 10-year T-note is driven by monetary liquidity, by the state of US economic activity and by price inflation (see chart on the left below). According to our model the 10-year yield is forecast to follow a declining path during 2015.
Dr Frank Shostak is a leading Austrian economist and director of Applied Austrian School Economics Ltd, which aims to assess the direction of various markets using the Austrian School methodology. AASE aims to make Austrian economics accessible to businessmen. | Contact us
14 July 14 | Tags: Central Banking, Economics, Inflation, money supply | Category: Economics, Money | Comments are closed
[Editor’s note: The Cato Institute will be publishing Cobden Senior Fellow Kevin Dowd’s work “Competition and Finance” for free in ebook format. The following outlines the contributions of this important work.]
Originally published in 1996, Cato is proud to make available in digital format, Professor Kevin Dowd’s groundbreaking unification of financial and monetary economics, Competition and Finance: A Reinterpretation of Financial and Monetary Economics.
Dowd begins his analysis with a microeconomic examination of which financial contracts and instruments economic actors use, after which he extends this analysis to how these instruments impact a firm’s financial structure, as well as how firms manage that financial structure. After bringing the reader from individual agent to the foundations of corporate financial policy, Dowd then builds a theory of financial intermediation, or a theory of “banking”, based upon these micro-foundations. He uses these foundations to explain the role and existence of various forms of intermediaries found in financial markets, including brokers, mutual funds and of course, commercial banks.
Most scholarship in financial economics ends there, or rather examines in ever deeper detail the workings of financial intermediaries. Dowd, after having developed a theory of financial intermediation from micro-foundations, derives a theory of monetary standards, based upon his developed media of exchange and its relation to the payments system. While much of Competition and Finance breaks new theoretical ground, it is this bridge from micro-finance to macro-economics and monetary policy that constitutes the work’s most significant contribution. In doing so, Dowd also lays the theoretical groundwork for a laissez-faire system of banking and money, demonstrating how such would improve consumer welfare and financial stability.
As Competition and Finance has been out-of-print in the United States, our hope is to make this important work available to a new generation of scholars working in the fields of financial and monetary economics. If the recent financial crisis demonstrated anything, it is the need for a more unified treatment of financial and monetary economics. Competition and Finance provides such a treatment.
Professor Kevin Dowd is a Senior Fellow with the Cobden Centre and a long-standing free market economist whose main work has been on free banking and unregulated monetary systems. Over the years, he has written extensively on the history and theory of free banking, the mechanics of monetary systems without the state and the failings of central banking and financial regulation. | Contact us
9 July 14 | Tags: Economics, Financial Stability, monetary policy, Regulation | Category: Economics | Comments are closed
“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”
Professor Robert Shiller, 25th June 2014, quoted in John Hussman’s weekly market comment.
“Paid promoters have helped push CYNK [CYNK Technology Corp] market cap to $655 million after a 3,650% increase in the share price on Tuesday.
“CYNK had assets of just $39 (no zeroes omitted) as of March 31, 2014 and a cumulative net loss of $1.5 million. The “company” has no revenue.
“CYNK claims that it is “a development stage company focused on social media.” However, the “company” does not even have a website and has just one employee [who acts as President, Chief Executive Officer, Chief Financial Officer, Treasurer and Company Secretary].
“With no assets, no revenue and no product, CYNK has no value. Author expects that CYNK shares are worthless.”
Article on CYNK Technology (which is based in Las Vegas) from Seeking Alpha.
Lord Overstone said it best. “No warning can save people determined to grow suddenly rich.” But there is clearly a yawning chasm between the likes of those folk cheerfully bidding up the share price of CYNK, and prudent investors simply trying to keep their heads above water. What has effectively united these two otherwise disparate communities is today’s central banker. Andy Haldane, the chief economist for the Bank of England, speaking at an FT conference last week, conceded that ultra-accommodative monetary policy had “aided and abetted risk-taking” by investors and that policy makers had wanted to use higher asset prices to try and stimulate the wider economy (that is to say, the economy) into a more robust recovery: “That is how [monetary policy] is meant to work. That’s why we did it.” If the Bank of England had not slashed interest rates and created £375 billion out of thin air, “the UK economy would have been at least 6 per cent smaller than it is today.” A curiously precise figure, given the absence of any counterfactual. But regardless of the economic “benefits” of quantitative easing, Haldane did have the grace to admit that
“That will mean, on average, that financial market volatility will be somewhat greater than in the past. I think it will mean, on average, that those greed and fear cycles in financial markets will be somewhat more exaggerated than in the past. That, for me, is the corollary of the risk migration.”
Which is a bit like an arsonist torching a wooden building and then shrugging his shoulders and saying,
“Well, wood will burn.”
Our central bankers, of course, will not be held accountable when the crash finally hits, even if the accumulated dry tinder of the boom was almost entirely of their own creation. Last week the Bank for International Settlements, the central banker’s central bank, issued an altogether more circumspect analysis of the world’s current financial situation, in their annual report. It concluded, with an entirely welcome sense of caution, that
“The [monetary] policy response needs to carefully consider the nature and persistence of the forces at work as well as policy’s diminished effectivenessand side effects. Finally, looking forward, the issue of how best to calibrate the timing and pace of policy normalisation looms large. Navigating the transition is likely to be complex and bumpy, regardless of communication efforts. And the risk of normalising too late and too gradually should not be underestimated.” (Emphasis ours.)
Translation: ZIRP (Zero Interest Rate Policy – and in the case of the ECB, which has taken rates negative, NIRP) is no longer working – if it ever did. Hyper-aggressive monetary policy has side effects. Getting out of this mess is not going to be easy, and it’s going to be messy. Forward guidance, which was meant to simplify the message, has instead hopelessly confused it. And there are big risks that central banks will lose the requisite confidence to tighten policy when it is most urgently needed, and allow an inflationary genie entirely out of the bottle.
The impact of central banks’ unprecedented monetary stimulus on financial markets is so overwhelming that it utterly negates any sensible analysis of likely macro-economic developments. On the basis that sometimes it’s simply best not to play some games, we no longer try. What should inform investors’ preferences, however, is bottom-up asset allocation and stock selection. The US equity market is clearly poor value at present. That doesn’t mean that it can’t get even more expensive, and the rally might yet have some serious legs. But overvaluation at an index level doesn’t preclude the existence of undervalued stocks well away from the braying herd. (We think the most compelling macro value is in Asia and, if we had to single out any one country, Japan.)
“The central thesis among investors at present is that they have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades..”
“Investment decisions driven primarily by the question “What other choice do I have ?” are likely to prove regrettable. What we now have is a market that has been driven to one of the four most extreme points of overvaluation in history. We know how three of them ended.”
The conclusion seems clear to us. If one chooses to invest at all, invest on the basis of valuation and not on indexation (the world’s largest stock market, that of the US, is one of the most seemingly conspicuously overvalued). As an example of the sort of valuations currently available away from the herd, consider the following. You can buy the US S&P 500 index today with the following metrics:
Price / earnings: 18.2
Price / book: 2.76
Dividend yield: 1.89%
Meanwhile, Greg Fisher in his Halley Asian Prosperity Fund (albeit currently closed) is buying quality businesses throughout Asia on somewhat more attractive valuations. (By geography, the fund’s largest allocations are to Japan, Vietnam and Malaysia.) The fund’s current metrics are as follows:
Average price / earnings: 7
Average price / book: 0.8
Average dividend yield: 4.5%.
But the realistic prospect of growth is also on the table. The fund’s average historic return on equity stands at 15%.
[Editor’s Note: this piece, by Steve H Hanke, Professor of Applied Economics and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore, was previously published at Cato.org and Globe Asia. Please also see our earlier postings here at The Cobden Centre on Mark Skousen’s intrepid work on GDE. As Lord Kelvin said, “To measure is to know”. ]
In late April of this year, the Bureau of Economic Analysis (BEA) at the U.S. Department of Commerce announced that it would start reporting a new data series as part of the U.S. national income accounts. In addition to gross domestic product (GDP), the BEA will start reporting gross output (GO). This announcement went virtually unnoticed and unreported — an unfortunate, but not uncommon, oversight on the part of the financial press. Yes, GO represents a significant breakthrough.
A brief review of some history of economic thought will show just why GO is a big deal. The Classical School of economics prevailed roughly from Adam Smith’s Wealth of Nations time (1776) to the mid-19th century. It focused on the supply side of the economy. Production was the wellspring of prosperity.
The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon — courtesy of John Maynard Keynes — this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.
Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.
All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand — namely, a fiscal stimulus (read: lower taxes and/or higher government spending).
Keynes was wildly successful. With the publication of the General Theory, the supply side of the economy almost entirely vanished. It was replaced by aggregate demand, which was faithfully reported in the national income accounts. In consequence, aggregate demand has dominated economic discourse and policy ever since.
Among other things, Keynes threw economics into the sphere of macro economics. It is here where economic aggregates are treated as homogenous variables for purposes of analysis. But, with such innocent looking aggregates, there lurks a world of danger. Indeed, because of the demand-side aggregates that Keynes’ analysis limited us to, we were left with things like the aggregate sizeof consumption and government spending. The structure of the economy — the supply side — was nowhere to be found.
Yes, there were various rear-guard actions against this neglect of the supply side. Notable were economists from the Austrian School of Economics,such as Nobelist Friedrich Hayek. There were also devotees of input-out put analysis, like Nobelist Wassily Leontief. He and his followers stayed away from grand macroeconomic aggregates;they focused on the structure of the economy. There were also branches of economics — like agricultural economics– that were focused on production and the supply side of the economy. But,these fields never pretended to be part of macroeconomics.
Then came the supply-side revolution in the 1980s. It was associated with the likes of Nobelist Robert Mundell. This revolution was carried out, in large part, on the pagesof The Wall Street Journal, where J.-B.Say reappeared like a phoenix. The Journal’s late-editor Robert Bartley recounts the centrality of Say in his book The Seven Fat Years: And How to Do It Again (1992) “I remember Art Laffer telling me I had to learn Say’s Law. ‘That’s what I believe in’, he professed. ‘That’s what you believe in.’”
It is worth mentioning that the onslaught by Keynes on Say was largely ignored by many economic practitioners who attempt to anticipate the course of the economy. For them,the supply side of the economy has always received their most careful and anxious attention. For example, the Conference Board’s index of leading indicators for the U.S. economy is predominantly made up of supply-side indicators. Bloomberg’s supply-chain analysis function (SPLC) is yet another tool that indicates what practitioners think about when they conduct economic and financial analyses.
But, when it comes to the public and the debate about public policies, there is nothing quite like official data. So, until now, demand-side GDP data produced by the government has dominated the discourse. With GO, GDP’s monopoly will be broken as the U.S. government will provide official data on the supply side of the economy and its structure. GO data will complement, not replace, traditional GDP data. That said, GO data will improve our understanding of the business cycle and also improve the quality of the economic policy discourse.
So, what makes up the conventional measure of GDP and the new GO measure? And what makes up the gross domestic expenditures (GDE)measure, a more comprehensive, close cousin of GO? The accompanying two tables answer those questions. And for readers who are more visually inclined,bar charts for the two new metrics — GO and GDE — are presented.
Now, it’s official. Supply-side (GO) and demand-side (GDP) data are both provided by the U.S. government. How did this counter revolution come about? There have been many counter revolutionaries, but one stands out: Mark Skousen of Chapman University. Skousen’s book The Structure of Production, which was first published in 1990, backed his advocacy with heavy artillery. Indeed, it is Skousen who is, in part, responsible for the government’s move to provide a clearer, more comprehensive picture of the economy, with GO. And it is Skousen who is solely responsible for calculating GDE.
These changes are big, not only conceptually, but also numerically. Indeed, in 2013 GO was 76.4% larger, and GDE was 120.4% larger, than GDP. Why? Because GDP only measures the value of all final goods and services in the economy. GDP ignores all the intermediate steps required to produce GDP. GO corrects for most of those omissions. GDE goes even further, and is more comprehensive than GO.
Even though the always clever Keynes temporarily buried J.-B. Say, the great Say is back. With that, the relative importance of consumption and government expenditures withers away (see the accompanying bar charts). And, yes, the alleged importance of fiscal policy withers away, too.
Contrary to what the standard textbooks have taught us and what that pundits repeat ad nauseam, consumption is not the big elephant in the room. The elephant is business expenditures.
Max Rangeley is the Editor of The Cobden Centre. He is the CEO of ReboundTAG Ltd, which produces microchip luggage tags and has been showcased by Lufthansa and featured on BBC World among other media outlets. Max has a Master’s in economics, following this he was given a scholarship to do a PhD at the London School of Economics, but decided instead to go straight into business. | Contact us
7 July 14 | Tags: Austrian School, Economic Cycles, Economics, Financial Stability | Category: Economics, Money | 2 comments
“A balanced Input-Output framework…provides a more accurate and consistent picture of the U. S. economy.”
– Survey of Current Business
Starting in spring 2014, the Bureau of Economic Analysis will release a breakthrough new economic statistic on a quarterly basis. It’s called Gross Output, a measure of total sales volume at all stages of production. GO is almost twice the size of GDP, the standard yardstick for measuring final goods and services produced in a year.
This is the first new economic aggregate since Gross Domestic Product (GDP) was introduced over fifty years ago.
It’s about time. Starting with my work The Structure of Production in 1990 andEconomics on Trial in 1991, I have made the case that we needed a new statistic beyond GDP that measures spending throughout the entire production process, not just final output. GO is a move in that direction – a personal triumph 25 years in the making.
GO attempts to measure total sales from the production of raw materials through intermediate producers to final retail. Based on my research, GO is a better indicator of the business cycle, and most consistent with economic growth theory.
GO is a measure of the “make” economy, while GDP represents the “use” economy. Both are essential to understanding how the economy works.
While GDP is a good measure of national economic performance, it has a major flaw: In limiting itself to final output, GDP largely ignores or downplays the “make” economy, that is, the supply chain and intermediate stages of production needed to produce all those finished goods and services. This narrow focus of GDP has created much mischief in the media, government policy, and boardroom decision-making. For example, journalists are constantly overemphasizing consumer and government spending as the driving force behind the economy, rather than saving, business investment, and technological advances. Since consumer spending represents 70% or more of GDP, followed by 20% by government, the media naively concludes that any slowdown in retail sales or government stimulus is necessarily bad for the economy. (Private investment comes in a poor third at 13%.)
For instance, the New York Times recently reported, “Consumer spending makes up more than 70% of the economy, and it usually drives growth during economic recoveries.” (“Consumers Give Boost to Economy,” New York Times, May 1, 2010, p. B1) Or as the Wall Street Journal stated a few years ago, “The housing bust has chilled consumer spending — the largest single driver of the U. S. economy…” (“Home Forecast Calls for Pain,” Wall Street Journal, September 21, 2011, p. A1.)
Or take this report during the economic recovery:
“Friday’s estimates of second-quarter gross domestic product [1.3%, well below consensus forecasts] provided a sobering look at how a decline in public spending and investment can restrain growth….The astonishingly slow growth rate from April through June was due in large part to sluggish consumer spending and an increase in imports, which subtract from growth numbers. But dwindling government spending also held back growth.” (“The Role of Government Spending,” New York Times, July 29, 2011.)
In short, by focusing only on final output, GDP underestimates the money spent and economic activity generated at earlier stages in the production process. It’s as though the manufacturers and shippers and designers aren’t fully acknowledged in their contribution to overall growth or decline.
Gross Output exposes these misconceptions. In my own research, I’ve discovered many benefits of GO statistics. First, Gross Output provides a more accurate picture of what drives the economy. Using GO as a more comprehensive measure of economic activity, spending by consumers turns out to represent around 40% of total yearly sales, not 70% as commonly reported. Spending by business (private investment plus intermediate inputs) is substantially bigger, representing over 50% of economic activity. That’s more consistent with economic growth theory, which emphasizes productive saving and investment in technology on the producer side as the drivers of economic growth. Consumer spending is largely the effect, not the cause, of prosperity.
Second, GO is significantly more sensitive to the business cycle. During the 2008-09 Great Recession, nominal GDP fell only 2% (due largely to countercyclical increases in government), but GO collapsed by over 7%, and intermediate inputs by 10%. Since 2009, nominal GDP has increased 3-4% a year, but GO has climbed more than 5% a year. GO acts like the end of a waving fan. (See chart below.)
I believe that Gross Output fills in a big piece of the macroeconomic puzzle. It establishes the proper balance between production and consumption, between the “make” and the “use” economy, and it is more consistent with growth theory. As Steve Landefeld, director of the BEA, and co-editors Dale Jorgenson and William Nordhaus state in their work, A New Architecture for the U. S. National Accounts (University of Chicago Press, 2006), “Gross output [GO] is the natural measure of the production sector, while net output [GDP] is appropriate as a measure of welfare. Both are required in a complete system of accounts.”
The history of these two economic statistics goes back to several pioneers. Two economists in particular had much in common — they were both Russian Americans who taught at Harvard University, and both won the Nobel Prize. Simon Kuznets did breakthrough work on GDP statistics in the 1930s. Following the Bretton Woods Agreement in 1946, GDP became the standard measure of economic growth. A few years later, Wassily Leontief developed the first input-output tables, which he regarded as a better measure of the whole economy. I-O accounts require examining the “intervening steps” between inputs and outputs in the production process, “a complex series of transactions…among real people.”
I-O data created the first estimates of Gross Output. However, GO was not emphasized as an important macroeconomic tool until my own work, The Structure of Production,was published in 1990 by New York University Press. In chapters 6 and 9, I created a universal four stage model of the economy (see the diagram below) demonstrating the relationship between total spending in the economy and final output.
In chapter 6, I made the point that GDP was not a complete picture of economic activity, and compared it to GO for the first time, contending that GO was more comprehensive and more accurately revealed that business investment was far bigger than consumption in the economy.
Since writing Structure, I discovered that the BEA’s Gross Output does not include all sales at the wholesale and retail level. The BEA only includes value-added data for commodities after they become finished products. Gross sales are ignored at the final two stages of production. David Wasshausen, a BEA staff researcher, offers this rationale: since “there is no further transformation of these goods…to the production process, they are excluded from wholesale/retail trade output.”
Therefore, in the 2nd edition of Structure, published in 2007, I created my own aggregate statistic, Gross Domestic Expenditures (GDE), which includes gross sales at the wholesale and retail level and is therefore significantly larger (more than double GDP). For a comparison between GDE, GO and GDP, see my working paper.
The BEA has been compiling GO statistics from input-output data for years, but the media have largely ignored these figures because they came out only every five years (known as benchmark I-O tables). Since the early 1990s, the BEA has been estimating industry accounts annually. Even so, the data was never up-to-date like GDP. (The latest input-output industry accounts are for 2011).
That has gradually changed. Under the leadership of BEA director Steve Landefeld, the BEA now has the budget to report the input-output data, including Gross Output, on a quarterly basis, and has already begun publishing quarterly data prior to 2012. This is a major breakthrough involving the cooperation of the Bureau of the Census, Bureau of Labor Statistics, the Federal Reserve Board, and other government agencies.
Controversies Over This New Statistic
Several objections have been made over the years to the use of GO and GDE. Economists are especially fixated over the perceived problem of “double counting” with GO and GDE. I am the first to note that GO and GDE involve double counting. A commodity is often sold repeatedly as it goes through the resource, production, wholesale and retail stages. Why not just measure the value added at each stage rather than double or triple count? they ask. GDP eliminates double counting and measures only the value added at each stage.
There are several reasons why double counting should not be ignored and is actually a necessary feature to understanding the overall economy. As accountants and financiers know, double counting is essential in business. No company can operate or expand on the basis of value added or profits only. They must raise the capital necessary to cover the gross expenses of the company — wages and salaries, rents, interest, capital tools and equipment, supplies and goods-in-process. GO and GDE reflect this vital business decision making at each stage of production. Can publicly-traded firms ignore sales/revenues and only focus on earnings when they release their quarterly reports? Wall Street would object. Aggregate sales/revenues are important to measure on an individual firm and national basis.
In my own research, I find it interesting that GO and GDE are far more volatile than GDP during the business cycle. As noted in the chart above, sales/revenues rise faster than GDP during an expansion, and collapse during a contraction (wholesale trade fell 20% in 2009; retail trade dropped over 7%).
Economists need to explore the meaning of this cyclical behavior in order to make accurate forecasts and policy recommendations. Double counting counts.
Another objection involves outsourcing and merger/acquisitions. Companies that start outsourcing their products will cause an increase in GO or GDE, while companies that merge with another company will show a sudden decrease, even though there is essentially no change in final output (GDP).
That’s a legitimate concern. Similar problems occur with GDP. When a homeowner marries the maid, the maid may no longer be paid and therefore her services may no longer be included in GDP. Black market activities often fail to show up in GDP data as well. Certainly if a significant trend develops in outsourcing or merger & acquisition activity, it will be reflected in GO or GDE statistics, but not necessarly in GDP. It bears further investigation to see how serious this issue is. No aggregate statistic is perfect, but GO and GDE offer forecasters an improved macro picture of the economy.
In conclusion, GO or GDE should be the starting point for measuring aggregate spending in the economy, as it measures both the “make” economy (intermediate production), and the “use” economy (final output). It complements GDP and can easily be incorporated in standard
national income accounting and macroeconomic analysis. To see how, take a look at the 4th edition of my textbook, Economic Logic (Capital Press, 2014), available in paperback and Kindle.