A number of people have asked me to expand on how the rapid expansion of money supply leads to an effect the opposite of that intended: a fall in economic activity. This effect starts early in the recovery phase of the credit cycle, and is particularly marked today because of the aggressive rate of monetary inflation. This article takes the reader through the events that lead to this inevitable outcome.
There are two indisputable economic facts to bear in mind. The first is that GDP is simply a money-total of economic transactions, and a central bank fosters an increase in GDP by making available more money and therefore bank credit to inflate this number. This is not the same as genuine economic progress, which is what consumers desire and entrepreneurs provide in an unfettered market with reliable money. The second fact is that newly issued money is not absorbed into an economy evenly: it has to be handed to someone first, like a bank or government department, who in turn passes it on to someone else through their dealings and so on, step by step until it is finally dispersed.
As new money enters the economy, it naturally drives up the prices of goods bought with it. This means that someone seeking to buy a similar product without the benefit of new money finds it is more expensive, or put more correctly the purchasing power of his wages and savings has fallen relative to that product. Therefore, the new money benefits those that first obtain it at the expense of everyone else. Obviously, if large amounts of new money are being mobilised by a central bank, as is the case today, the transfer of wealth from those who receive the money later to those who get it early will be correspondingly greater.
Now let’s look at today’s monetary environment in the United States. The wealth-transfer effect is not being adequately recorded, because official inflation statistics do not capture the real increase in consumer prices. The difference between official figures and a truer estimate of US inflation is illustrated by John Williams of Shadowstats.com, who estimates it to be 7% higher than the official rate at roughly 9%, using the government’s computation methodology prior to 1980. Simplistically and assuming no wage inflation, this approximates to the current rate of wealth transfer from the majority of people to those that first receive the new money from the central bank.
The Fed is busy financing most of the Government’s borrowing. The newly-issued money in Government’s hands is distributed widely, and maintains prices of most basic goods and services at a higher level than they would otherwise be. However, in providing this funding, the Fed creates excess reserves on its own balance sheet, and it is this money we are considering.
The reserves on the Fed’s balance sheet are actually deposits, the assets of commercial banks and other domestic and foreign depository institutions that use the Fed as a bank, in the same way the rest of us have bank deposits at a commercial bank. So even though these deposits are on the Fed’s balance sheet, they are the property of individual banks.
These banks are free to draw down on their deposits at the Fed, just as you and I can draw down our deposits. However, because US banks have been risk-averse and under regulatory pressure to improve their own financial position, they have tended to leave money on deposit at the Fed, rather than employ it for financial activities. There are signs this is changing.
Rather than earn a quarter of one per cent, some of this deposit money has been employed in financial speculation in derivative markets, or found its way into the stock market, gone into residential property, and some is now going into consumer loans for credit-worthy borrowers.
In addition to the government’s deficit spending, these channels represent ways in which money is entering the economy. Furthermore, anyone working in the main finance centres is being paid well, so prices in New York and London are driven higher than in other cities and in the country as a whole. They spend their bonuses on flashy cars and country houses, benefiting salesmen and property values in fashionable locations. And with stock prices close to their all-time highs, investors with portfolios everywhere feel financially better off, so they can increase their spending as well.
All the extra spending boosts GDP, and to some extent it has a snowball effect. Banks loosen their purse strings a little more, and spending increases further. But the number of people benefiting is only a small minority of the population. The rest, low-paid workers on fixed incomes, pensioners, people living on modest savings in cash at the bank, and part time employed as well as the unemployed find their cost of living has gone up. They all think prices have risen, and don’t understand that their earnings, pensions and savings have been reduced by monetary inflation: they are the ultimate victims of wealth transfer.
While luxury goods are in strong demand in London and New York, general merchants in the country find trading conditions tough. Higher prices are forcing most people to spend less, or to seek cheaper alternatives. Manufacturers of everyday goods have to find ways to reduce costs, including firing staff. After all if you transfer wealth from ordinary folk they will simply spend less and businesses will suffer.
So we have a paradox: growth in GDP remains positive; indeed artificially strong because of the under-recording of inflation, while in truth the economy is in a slump. The increase in GDP, which reflects the money being spent by the fortunate few before it is absorbed into general circulation, conceals a worse economic situation than before. The effect of an expansion of new money into an economy does not make the majority of people better off; instead it makes them worse off because of the wealth transfer effect. No wonder unemployment remains stubbornly high.
It is the commonest fallacy in economics today that monetary inflation stimulates activity. Instead, it benefits the few at the expense of the majority. The experience of all currency inflations is just that, and the worse the inflation the more the majority of the population is impoverished.
The problem for central banks is that the alternative to maintaining an increasing pace of monetary growth is to risk triggering a widespread debt crisis involving both over-indebted governments and also over-extended businesses and home-owners. This was why the concept of tapering, or putting a brake on the rate of money creation, destabilised worldwide markets and was rapidly abandoned. With undercapitalised banks already squeezed between bad debts and depositor liabilities, there is the potential for a cascade of financial failures. And while many central bankers could profit by reading and understanding this article, the truth is they are not appointed to face up to the reality that monetary inflation is economically destructive, and that escalating currency expansion taken to its logical conclusion means the currency itself will eventually become worthless.
This article was previously published at GoldMoney.com.
Recent statistics are confirming “economic recovery” in the UK and even some of the weaker eurozone states. I put this in quotes, because what we are seeing is expanding nominal GDP, which is not the same thing. GDP reflects money and credit going into the economy, which everyone believes is the same thing.
Instead of economic recovery, GDP is reflecting money leaving financial markets, particularly bonds, for less interest-rate sensitive havens. Globally, bonds represent invested capital of over $150 trillion, or more than twice global GDP, so even marginal amounts unleashed by rising bond yields can be financially destabilising and the effect on GDP growth could be electric. The mistake of confusing economic progress (a better description of what we all desire) with GDP is about to bite the economic establishment big-time and pressure for interest rates to rise early and substantially will intensify as a result, dragged up by those rising bond yields.
The problem facing central planners is that this GDP chimera is driven by a predominantly financial community that has money to invest in capital assets such as housing and even motor cars. The vast majority of economic actors, comprised of pensioners, low-wage workers living from payday to payday and the unemployed are simply disadvantaged as prices, already often beyond their reach, become even more unaffordable. It is a misfortune encapsulated in the concept of the Pareto Principle, otherwise known as the 80/20 rule, the law of the vital few, where the substantial majority will be badly squeezed by rising prices generated by the spending of that few.
The central planners are understandably focused on the misfortunes of the majority. For many of them, as prices start to rise so too do costs for their employers, many of which will be squeezed out of business. How can interest rates possibly be permitted to rise in the face of these dangers?
Central banks have drawn their line in the sand over interest rates and they will eventually be forced to reconsider their position. They are almost certain to be too slow in raising interest rates and so the markets will continually expect higher bond yields and higher interest rates to come. For those of us with long memories it is a repeat of the late-seventies stagflation era. Except this time, aggressively raising interest rates to stabilise the purchasing power of the currency is not an option: it will simply break the banking system lumbered with its share of the $150 trillion invested in bonds.
Markets are blithely assuming that central banks are in control of events. They are not even in control of their own governments’ profligacy, and they are losing their control over markets as well, as the tapering episode showed. The fatal error of rescuing both the banking system and government finances by reckless currency inflation is in the process of becoming apparent to all. Unless this policy is somehow reversed we risk a global rerun of the collapse of the German mark in 1923.
This article was previously published at GoldMoney.com.
Neil Macdonald of the CBC recently did an investigative piece on central bankers and what they’re doing to the world’s economies. Mark Carney was featured heavily. He told Macdonald, “there is no secret cabal orchestrating things,” despite CBC’s own findings earlier in the program. Central bankers around the world meet in Basel, Switzerland for secretive meetings. Of course, central banks have – and have always had – enormous power that remained more-or-less hidden until 2008. A paradigm shift is occurring where a large number of people (particularly young people) are questioning their assumptions. Some of them are even beginning to read economists like Ludwig von Mises and Murray Rothbard. The “economics” of central bankers can now be revealed for what it truly is: statistical propaganda. Not only is the “Keynesian school” of economics unsound – the entire social science is bunk. Only the Austrian tradition can explain economic phenomena in such a way that makes common sense, scientific. Carney is asking us to trust him. This cannot be done. He is not speaking truth; he is speaking nonsense.
Who is Mark Carney?
Mark Carney: Bank of Canada governor, soon-to-be Bank of England governor. He was born in the Northwest Territories 48 years ago. He graduated from the University of Alberta in Edmonton before studying economics at Harvard and getting his master’s and doctorate from Oxford. He spent 13 years with Goldman Sachs in London, Tokyo, New York and Toronto. He then worked for the Department of Finance under both the Liberal and Conservative governments. He joined the Bank of Canada as a deputy governor before moving on into the top position. This was in 2007, just in time for the bursting of US housing bubble. Like every other central banker in the wake of the crisis, Mark Carney lowered interest rates and helped governments bail out large institutions.
What makes Carney unique is that he bumped up rates by a percent in 2010. Hardly a radical reversal, but it is something the US Federal Reserve has yet to accomplish. Carney got away with it because, at the time, Canadians were not as heavily indebted. The “boom” was still in its infancy. Carney still threatens to raise interest rates, but nobody believes him. All he does is give verbal warnings to Canadians that “taking advantage” of low rates is a bad idea. Despite all those educational institutions under his belt, Mark Carney does not understand human action.
Now he is bailing himself out from Canada’s certain crash and heading across the pond to lead the Bank of England. An already depressed economy, Britain won’t be any better under Carney’s rule unless he dismantles the Bank or at the very least raises interest rates to astronomical levels. Carney won’t do either of those things, though, because Mark Carney is a Keynesian. This ideological view of society and its economic structure is one where no capital structure exists. Absurd, given that nearly all consumer goods need some kind of input of capital stock. Keynesians also have a peculiar view on scarcity – a view that makes no economic sense whatsoever.
The public tend to have an unfavourable view of economics and economists – and for good reason. “Economics” is as dismal as it sounds; making economic sense is a whole other ball game. For Mark Carney, “economics” resembles something like physics and history. Although Carney would probably concede to the notion that an economy needs entrepreneurs and capital accumulation, his ideology assumes inherent failures in this process that must be corrected by state intervention. In actuality, it is state intervention that inhibits entrepreneurship, savings and investment. Therefore, the Bank of Canada publishes nonsense. Their CPI indexes and growth estimates are results of computer models that produce the results they expect. Lately, this method has been failing as economies stagnate where the BoC’s arithmetic predicts growth.
Mark Carney’s economic methodology mimics the “hard” sciences like physics and chemistry. But economics is not a mathematical discipline; it involves agents who have free-will. Making economic sense requires understanding praxeology. Praxeology is the scientific study of human action. It is empirical but not in the sense of quantitative data. Praxeology begins with what we know is true and broadens its horizon through deductive reasoning. Instead of making a hypothesis of what we don’t know and then using empirical testing to validate the hypothesis, praxeology begins with what we do know – such as individuals act on purpose and value is subjective – to build logical constructs. The axioms – and the deductive reasoning built from them – are not trying to “prove” a hypothesis. They are true because of human language and the semiotic sign-systems we use to communicate and validate what’s real. Therefore the logical constructs in praxeological economics don’t need empirical testing since they can be traced to their irrefutable origin.
The Austrian tradition studies economics as understood through praxeology. This method has a long history, starting with the Late Scholastics and revived later by Austrians such as Carl Menger, Eugen Böhm-Bawerk and Ludwig von Mises. It survived the 20th century thanks to a small group of Americans before exploding worldwide via the internet. With this school comes a deeper understanding of how we know. Human perception is a filter of information – five senses experiencing infinite possibilities. Language is crucial for understanding ideas. When individuals communicate we are quickly guessing and making decisions. Guessing if the words correspond to an objective reality and whether to choose those words. The process happens so fast that most of us are unaware of it; we do it instinctively.
Generations of state education have perverted the language to a degree that knowledge from logic is questionable, open to interpretation or deemed utterly unscientific. Bureaucratic schooling demotes common sense to the lowest common denominator. Mark Carney is a product of this conditioning but with a more intellectually rigorous indoctrination from Harvard and Oxford. It’s quite possible that he truly believes in what he’s doing.
Austrian Capital Theory
The Austrian School of Economics could in some cases also be called capital-based macroeconomics. Building from the irrefutable axioms that individuals act, value is subjective and the assumption that leisure is a valuable good, the Austrians can build an entire framework on the structure of production and interest rates. The clearest example I’ve ever come across is from Murray Rothbard’s Man, Economy & State. Particularly Figure 41:
This figure is showing an “evenly-rotating economy,” a logical construct where certain things are assumed as to make economic principles more clear. In this economy, Mark Carney would experience reality as if every day were the same as the last. Risk, opportunity and uncertainty cease to exist. People still act – there is interest income, income to land and labour and consumer expenditure. But it is a closed system; everything behaves like clockwork.
On the right-hand side of the figure there are numbers ascending 1-6 starting with C. C is consumption, above it is the first-stage of production, then the second, third, etc. etc. If C is a nicely cooked t-bone steak, the stages of production are the process in which a cow becomes a steak on your plate. The cow is at the top, 19 ounces of gold to land and labour.
At each stage of production, a capitalist is purchasing capital goods (the shaded blocks) to be transformed by land and labour (the white blocks with numbers 8, 13, 12, 16, 15). For example, at the 1st stage of production a capitalist is purchasing t-bone steaks for 80 ounces, using 15 ounces worth of land and labour to cook it and collecting 5 ounces in interest. 80 + 15 + 5 = 100 ounces, which is what consumers spend on the product. If we trace the t-bone steak back to its nature-given resource we find cows. The capitalist at the fifth stage of production buys a cow for 20 ounces, earns 1 ounce in interest by investing in the 8 ounces (land and labour) required to butcher the cow and sell it to the next capitalist for 30 ounces. At each stage of production, value is added to the goods. This value is determined by the consumers willing to spend 100 ounces on cooked t-bone steak each period.
In Man, Economy & State, Murray Rothbard constructs sound economics step-by-step. Prices, he shows, are determined by individual valuations. This process is evident in this construct which has features to it that are not accidental. 83 ounces to land and labour and 17 ounces in interest equal the 100 ounces on consumer expenditure. While in the real world of uncertainty these price ratios would be constantly changing – the reality of human action keeps the economy heading in the direction of this stationary economy. However, the evenly-rotating economy will never arrive due to people’s ever-changing valuations and actions.
Mark Carney’s low interest rates are messing up the production structure. If the Bank of Canada analysed Figure 41, they’d conclude that GDP every period is 100 ounces and driven completely by consumer spending. If the economy were in a slump, the BoC would report that GDP is 100% consumer spending therefore we need consumers to drive us out of recession. But how do they get that GDP figure? By comparing consumption to net investment, where Y= 100 ounces, Y=C+I+G+(X – M).
In this economy, the Keynesian framework would tell central bankers that there’s no investment and that everything is driven purely by consumption. But that’s not true. Consumption is 100 ounces each period, but 318 ounces are being invested. There are 418 ounces spent each period, only 100 are directed to consumption.
Keynesians, if they are intellectually honest, must take this absurdity further. It takes six stages of production to get to this consumer good, but Keynesians would say everybody should consume as much as they can and that will grow the economy. But if all those capitalists at those various stages said “okay, let’s consume more,” and they went to buy t-bone steaks instead of reinvesting, that would a) push up the price of t-bone steaks, and b) create a shortage of t-bone steaks since the capitalists didn’t bother replenishing their capital stocks.
A Keynesian may argue, “but this is good; higher prices entice producers. Bigger, final demand.” But this is nonsensical. There aren’t more goods to go around just because people are spending more. There can only exist what’s actually been produced. If more buyers enter the market and push up the price, we won’t have more goods, just higher prices.
But won’t that stimulate production? No, it can’t because the capitalists invested less in production and more in consumption. There is no way around the physical reality of scarcity. The Keynesian solution is to dilapidate the capital structure by diverting resources out of gross investment and into consumption. Sometimes people change their preferences and consume more in the present and less in the future. This naturally changes interest rates and businesses adjust accordingly. When Mark Carney manually lowers interest rates, he’s leading you to believe that we can get a free lunch.
Carney’s Fallacies Exposed
Neil Macdonald sat down to interview Mark Carney for his CBC report. Although the full interview has yet to be released, it’s evident from excerpts that Mark Carney did not like Macdonald’s reasoning.
Carney says, “There is a logic to some of your questioning which is that wouldn’t it be better if interest rates were really high? … You wanna talk unintended consequences, I’ll give you intended consequences of that scenario, which is let’s get interest rates back to historic levels, so that the money you’ve saved … and the return on that in your bank account is going to commensurate with what you expected.” In other words, let’s make it so your money isn’t losing its purchasing power. Carney continues, “and we have double unemployment in this country, hundreds of thousands of people losing their homes, their businesses because we have deflation.”
Mark Carney’s ideology is illogical. It claims that an economy with high unemployment can be fixed by printing money because mass unemployment and mass inflation never occur together. The 1970′s pretty much ended this Keynesian argument until the ’08 crisis revived the monster. The paradox of high unemployment with high inflation is corrected by changing how governments and banks measure inflation. No longer defined by the money supply, inflation in Canada is defined by the Consumer Price Index. A collection of prices of goods chosen by central bankers. Naturally, food and energy prices are excluded. The bias is blatant.
Mark Carney has no capital theory. The effect on savings in a low interest rate environment is to him, “a distributional implication.” Interest rates are an objective expression of individual time preferences – not tools to be wielded. It’s true, high rates will cause immediate recession if not depression, but this is temporary and necessary as the malinvestments liquidate and labour and capital find more productive uses. When savers are no longer punished, economic growth can occur.
In additional footage of his CBC interview, Mark Carney reveals that he really has no idea what he’s talking about. For example: the US Government issues bonds to finance their massive debt. Increasingly, only the Fed is willing to buy them. So the US Federal Reserve is the bond market. They might as well print money and mail a cheque to everyone. But according to Carney, this is a monetary stimulus where the Fed buys all the bonds to encourage investors to go into something risky. Without risk, says Carney, economies don’t grow. “You find risk in lending money to corporates or buying their shares,” he says, “or… by investing in another country.” He doesn’t elaborate much further, simply stating that, “that’s how economies grow and that’s the process by which central banks are trying to restart real growth in the economy.”
The financial crisis, according to Carney, was not a result of government and central banking interventions. Carney thinks that money – “created in the private sector” – collapsed. By creating new money central banks are merely “leaning into” this collapse of money that threatened a repeat of the Great Depression. When Macdonald asks about central banks causing asset bubbles through quantitative easing, Carney answers in the affirmative. He says, “those are intended consequences, not unintended consequences.”
Mark Carney has no scientific backing to justify his actions. He is in a position that is dangerous and should not exist in a free society. Money is a commodity; not magic wand created by state decree. Is there an exit strategy for the Bank of Canada? What is Mark Carney’s plan to get England out of depression? It looks as if he isn’t too worried. Carney believes that everything depends on how governments act. “People can elect governments that do what they want,” says Carney. Funny, coming from the head of an institution that is supposed to remain independent of government influence.
This article was previously published at Mises.ca
Many politicians and commentators such as Paul Krugman claim that Europe’s problem is austerity, i.e., there is insufficient government spending. The common argument goes like this: Due to a reduction of government spending, there is insufficient demand in the economy leading to unemployment. The unemployment makes things even worse as aggregate demand falls even more, causing a fall in government revenues and an increase in government deficits. European governments pressured by Germany (which did not learn from the supposedly fateful policies of Chancellor Heinrich Brüning) then reduce government spending even further, lowering demand by laying off public employees and cutting back on government transfers. This reduces demand even more in a never ending downward spiral of misery. What can be done to break out of the spiral? The answer given by commentators is simply to end austerity, boost government spending and aggregate demand. Paul Krugman even argues in favor for a preparation against an alien invasion, which would induce government to spend more. So the story goes. But is it true?
First of all, is there really austerity in the eurozone? One would think that a person is austere when she saves, i.e., if she spends less than she earns. Well, there exists not one country in the eurozone that is austere. They all spend more than they receive in revenues.
In fact, government deficits are extremely high, at unsustainable levels, as can been seen in the following chart that portrays government deficits in percentage of GDP. Note that the figures for 2012 are what governments wish for.
The absolute figures of government deficits in billion euros are even more impressive.
A good picture of “austerity” is also to compare government expenditures and revenues (relation of public expenditures and revenues in percentage).
Imagine that a person you know spends 12 percent more in 2008 than her income, spends 31 percent more than her income the next year, spends 25 percent more than her income in 2010, and 26 percent more than her income in 2011. Would you regard this person as austere? And would you regard this behavior as sustainable? This is what the Spanish government has done. It shows itself incapable of changing this course. Perversely, this “austerity” is then made responsible for a shrinking Spanish economy and high unemployment.
Unfortunately, austerity is the necessary condition for recovery in Spain, the eurozone, and elsewhere. The reduction of government spending makes real resources available for the private sector that formerly had been absorbed by the state. Reducing government spending makes profitable new private investment projects and saves old ones from bankruptcy.
Take the following example. Tom wants to open a restaurant. He makes the following calculations. He estimates the restaurant’s revenues at $10,000 per month. The expected costs are the following: $4,000 for rent; $1,000 for utilities; $2,000 for food; and $4,000 for wages. With expected revenues of $10,000 and costs of $11,000 Tom will not start his business.
Let’s now assume that the government is more austere, i.e., it reduces government spending. Let’s assume that the government closes a consumer-protection agency and sells the agency’s building on the market. As a consequence, there is a tendency for housing prices and rents to fall. The same is true for wages. The laid-off bureaucrats search for new jobs, exerting downward pressure on wage rates. Further, the agency does not consume utilities anymore, leading toward a tendency of cheaper utilities. Tom may now rent space for his restaurant in the former agency for $3,000 as rents are coming down. His expected utility bill falls to $500, and hiring some of the former bureaucrats as dish washers and waiters reduces his wage expenditures to $3,000. Now with expected revenue at $10,000 and costs at $8,500 the expected profits amounts to $1,500 and Tom can start his business.
As the government has reduced spending it can even reduce tax rates, which may increase Tom’s after-tax profits. Thanks to austerity the government could also reduce its deficit. The money formerly used to finance the government deficit can now be lent to Tom for an initial investment to make the former agency’s rooms suitable for a restaurant. Indeed, one of the main problems in countries such as Spain these days is that the real savings of the people are soaked up and channeled to the government via the banking system. Loans are practically unavailable for private companies, because banks use their funds to buy government bonds in order to finance the public deficit.
In the end, the question amounts to the following: Who shall determine what is produced and how? The government that uses resources for its own purposes (such as a “consumer-protection” agency, welfare programs, or wars), or entrepreneurs in a competitive process and as agents of consumers, trying to satisfy consumer wants with ever better and cheaper products (like Tom, who uses part of the resources formerly used in the government agency for his restaurant).
If you think the second option is better, austerity is the way to go. More austerity and less government spending mean fewer resources for the public sector (fewer “agencies”) and more resources for the private sector, which uses them to satisfy consumer wants (more restaurants). Austerity is the solution to the problems in Europe and in the United States, as it fosters sustainable growth and reduces government deficits.
But does austerity not at least temporarily reduce GDP and lead to a downward spiral of economic activity?
Unfortunately, GDP is a quite misleading figure. GDP is defined as the market value of all final goods and services produced in a country in a given period.
There are two minor reasons why a lower GDP may not always be a bad sign.
The first reason relates to the treatment of government expenditures. Let us imagine a government bureaucrat who licenses businesses. When he denies a license for an investment project that never comes into being, how much wealth is destroyed? Is it the expected revenues of the project or its expected profits? What if the bureaucrat has unknowingly prevented an innovation that could save the economy billions of dollars per year? It is hard to say how much wealth destruction is caused by the bureaucrat. We could just arbitrarily take his salary of $50,000 per year and subtract it from private production. GDP would be lower.
Now hold your breath. In practice, the opposite is done. Government expenditures count positively in GDP. The wealth destroying activity of the bureaucrat raises GDP by $50,000. This implies that if the government licensing agency is closed and the bureaucrat is laid off, then the immediate effect of this austerity is a fall in GDP by $50,000. Yet, this fall in GDP is a good sign for private production and the satisfaction of consumer wants.
Second, if the structure of production is distorted after an artificial boom, the restructuring also entails a temporary fall in GDP. Indeed, one could only maintain GDP if production remained unchanged. If Spain or the United States had continued to use their boom structure of production, they would have continued to build the amount of housing they did in 2007. The restructuring requires a shrinking of the housing sector, i.e., a reduced use of factors of production in this sector. Factors of production must be transferred to those sectors where they are most urgently demanded by consumers. The restructuring is not instantaneous but organized by entrepreneurs in a competitive process that is burdensome and takes time. In this transition period, when jobs are destroyed in the overblown sectors, GDP tends to fall. This fall in GDP is just a sign that the necessary restructuring is underway. The alternative would be to produce the amount of housing of 2007. If GDP did not fall sharply, it would mean that the wealth-destroying boom was continuing as it did in the years 2005–2007.
Public austerity is a necessary condition for private flourishing and a rapid recovery. The problem of Europe (and the United States) is not too much but too little austerity — or its complete absence. A fall of GDP can be an indicator that the necessary and healthy restructuring of the economy is underway.
This article was previously published at Mises.org.
The US Congressional Budget Office (CBO) said on August 22nd that scheduled tax increases and spending cuts in 2013 would reverse the current modest economic recovery. The CBO and other experts are of the view that large government spending cuts and tax hikes will cause severe economic slump.
Experts hold that without action by Congress to avoid a “fiscal cliff” Americans should expect a significant recession and the loss of some 2 million jobs. The CBO predicts that the real GDP could shrink by 0.5% next year while the unemployment rate could climb to around 9%.
The “fiscal cliff” refers to the impact of around $500 billion in expiring tax cuts and automatic government spending reductions set for 2013 as a result of successive failures by Congress to agree on some orderly alternative method of reducing budget deficits.
According to the CBO projection the budget deficit could fall to $641 billion in 2013 from $1.128 trillion in 2012.
We suggest that the goal of fixing the budget deficit as such could be an erroneous policy. Ultimately what matters for the economy is not the size of the budget deficit but the size of government outlays – the amount of resources that government diverts to its own activities. Note that since the government is not a wealth generating entity, the more it spends the more resources it has to take from wealth generators. This means that the effective level of tax here is the size of the government and nothing else.
For instance, the government outlays are $3 trillion and the government revenue is $2 trillion – the government has a deficit of $1 trillion. Since government outlays have to be funded it means that the government would have to secure some other sources of funding such as borrowing or printing money, or new forms of taxes. The government is going to employ all sorts of means to obtain resources from wealth generators to support its activities. What matters here is that government outlays are $3 trillion and not the deficit of $1 trillion. For instance, if the government revenue on account of higher taxes would have been $3 trillion then we would have a balanced budget. But would this alter the fact that the government still takes $3 trillion of resources from wealth generators?
According to the CBO data government outlays are expected to fall in 2013 by $9 billion to $3.563 trillion after a projected decline of $40 billion in 2012.
Given that there is a time lag between government outlays and their effect on economic activity it strikes us that it is the cut of $40 billion this year rather than the cut of $9 billion next year that should be of concern to various worried commentators.
We hold that an increase in government outlays sets in motion an increase in the diversion of real savings from wealth generating activities to non-wealth generating activities. It leads to economic impoverishment.
So in this context is it really bad news for the economy if on January 1, 2013 we will have an automatic cut in government outlays? Most commentators such as the IMF and the CBO are of the view that cutting government outlays could inflict severe damage to the real economy.
We suggest that a cut in government outlays should be seen as great news for wealth generators. It is of course bad news for various artificial forms of life that emerged on the back of increases in government outlays.
What about the fact that we will also have an increase in taxes as a result of the expiration of the Bush tax cuts? To the extent that government outlays are going to be curtailed the increase in taxes should be regarded as a monetary withdrawal from the economy. In this sense it is like a tight monetary policy. A tighter monetary stance in this respect should be seen as positive for wealth generators since it weakens various bubble activities that sprang up on the back of past loose monetary policies.
(Conversely, a reduction in taxes whilst government spending goes up is not a tax reduction as such but should be viewed as loosening in the monetary stance. Again, an increase in government amounts to an increase in effective tax. The government has to divert resources from wealth generators to support the increase in spending).
Note that the CBO projection of the future state of the US economy is in terms of GDP. Given that GDP is in fact monetary turnover its ultimate course is going to be dictated by the rate of growth of the money supply. The more money that is pumped the stronger GDP is going to be.
Contrary to the CBO and most commentators, we suggest that what is likely to undermine the growth momentum of GDP next year is the current visible decline in the growth momentum of money supply. In the week ending August 13 our monetary measure AMS fell by $70.9 billion from July. The yearly rate of growth of AMS fell to 6.5% from 12.3% in July. Observe that in October last year the yearly rate of growth stood at 14.7%.
As a result the yearly rate of growth of real AMS (AMS adjusted for CPI inflation) fell to 5.1% in the mid August from 10.9% in July. Based on the lagged by 14 months yearly rate of growth of real AMS we can suggest that the growth momentum of industrial production is likely to weaken sharply from the second half of next year.
Whilst the growth momentum of industrial production and real GDP could be in trouble from the second half of next year the underlying economy however should start strengthening. The demise of bubble activities will be good news for wealth generators.
Against the background of a still weak labour market we suspect that Fed officials are likely to introduce another massive pumping in a few months time. Given the current time lag structure it is unlikely however that more pumping can avoid a decline in the pace of economic activity in terms of GDP from the second half of next year.
Summary and conclusions
According to the US Congressional Budget Office (CBO) scheduled tax increases and spending cuts in 2013 (the so called “fiscal cliff”) could reverse the current economic recovery. We suggest that a cut in government outlays is actually going to be good news to wealth generators. It is, however, going to be bad news for various non-productive activities that emerged on the back of increases in government outlays. In the meantime, a serious threat to economic activity in terms of GDP is posed by a visible fall in the growth momentum of money supply. We suggest that the present fall in the growth momentum of money supply is likely to undermine the GDP rate of growth from the second half of next year.
The assessment of economic growth based on Gross Domestic Product is a fallacy, because GDP is merely a measure of the amount of money in an economy. The one thing it does not measure, which is central to economic progress (note progress, not growth), is the level of entrepreneurial activity. This has important implications for the efficacy of government interventions and solutions to the current economic crisis.
I have written about GDP before, but to refresh the reader’s memory, GDP is basically the sum total of recorded business activity at the consumption level plus government spending expressed in money terms. If the government spends more, GDP rises; give more money to consumers, GDP rises; give more bank credit to consumers or business, GDP rises. Cut government spending, GDP falls. This is not contentious and has nothing to do with economic progress. Importantly, it excludes future entrepreneurial activity, except to the extent that an entrepreneur has actually spent some money putting his future plans into action. The obsession with GDP means that entrepreneurial activity, which is Adam Smith’s unseen hand that guides our future, is invisible to economic planners.
If that was the only consequence of confusing a money quantity with economic progress the results would not be so serious. Instead, misleading statistics such as GDP are leading all governments into bad policy decisions, and their choice has narrowed down to either ever-greater reflationary attempts to pump up GDP, or alternatively facing a collapse in the GDP number as bank credit contracts. The situation facing the eurozone already precludes any compromise between these extremes, while other nations believe they can print their way out of this difficulty.
The twin errors of misunderstanding GDP are the failure to see that monetary inflation is concealing a deepening economic depression, and it encourages policies that destroy entrepreneurial activity, or economic progress itself. This is a deadly combination, the equivalent of being in a hole and continuing to dig.
We cannot expect politicians to stop digging deeper and faster when their economic advisors are calling for more shovels. All politicians are fully committed to the fallacies that result from confusing GDP with economic progress. They pursue economic policies that are the equivalent of eating their own children. The children being eaten are savers, increasingly raided to sustain the status quo: savers whose savings are a precondition for entrepreneurial activity, and without which increasing numbers of us become reliant on the state.
There can be little hope that this lunacy will be abandoned while statistical nonsense such as GDP growth persists. The underlying economic depression, evidenced by high levels of unemployment, is symptomatic of economies burdened by misallocated resources. The solution is to do exactly the opposite of actions currently being pursued. To quote Calvin Coolidge: “Perhaps one of the most important accomplishments of my administration has been minding my own business. Government shouldn’t play a part in everyday life.”
It is still possible to do this. What is required in our leaders is a sound understanding of economics instead of belief-based neoclassicism. Thus armed, a politician should be able to explain the proper course of action to the reasonable majority, and implement it with their support.
This article was previously published at GoldMoney.com.
Here is a puzzle for Keynesian and other neo-classical economists.
When a consumer buys something, he must choose; and if he increases his purchase of one product, he must reduce his purchases of other products by the same amount. In other words he cannot buy both. This must be true for whole communities as well. How then can you have economic growth?
It is of course impossible without monetary inflation. This is because any statistical average, in this context GDP, can only grow if people are not forced to choose between alternatives, a condition that can only occur if they are given extra money. Not even a draw-down on savings to spend on consumption creates extra spending, because it is merely reallocates spending on capital goods to consumption goods. This simple point has been ignored by all neo-classical economists. The result is that in their pursuit of so-called economic growth, they have committed themselves to monetary inflation. Their concept of growth is to make that extra money available to consumers, so that they are not limited to what they earn and forced to choose. It has also become the basis for economic modelling, which takes known demand for products and services and from it extrapolates growth for an average of all of them.
The means by which GDP is adjusted for inflation is inadequate, because if it was adequate, this law of choice proves that the real GDP statistic will remain the same. Reported real growth in GDP is therefore no more than a statistical gap. Anyway, it is irrelevant: not only is it impossible to have wholly accurate statistics, but it is also impossible to predict the future consumer preferences that should be the basis of economic forecasting.
So the gap cannot ever be closed, and it does not help that the neo-classical establishment yearns for results that confirm their misplaced concept of economic growth. Government has money on the result as well, with a variety of bonds and welfare benefits indexed to prices. There are therefore compelling reasons to under-report the effects of monetary inflation and so to ensure that real growth is always recorded.
Understanding these dynamics is central to a proper understanding of our economic condition. It is not just a question of modern statistics measuring quantity and not quality as some critics assert. The whole basis of macro-econometric measurement is flawed and as long as we think in terms of GDP, CPI and other aggregated data we will continue to mismanage our affairs. Any reported GDP growth is statistical rather than real, a point that should be borne in mind every time the subject of economic growth crops up.
The establishment has been deluding itself in this matter ever since the Second World War, when price indices and GDP began to be widely used. The answer to the conundrum we have posed is that growth in GDP cannot be a measure of economic activity, because of the paradox posed by choice. Instead an economy progresses as entrepreneurs come up with products consumers will want tomorrow. Even though we pay lip-service to their role in society, none of their future input is reflected in the static economic models of the neo-classicists, which is why they resort to base subterfuge.
This article was previously published at GoldMoney.com
Last Monday night, before the US markets opened after President’s Day, bailout terms for Greece were announced. The detail is secondary to assessing whether or not it will work, or whether only a little time has been bought. Theoretically the deal can work, but it is extremely unlikely that it will. Almost everyone knows or suspects this, but the survival of the European political system is at stake, and this systemic priority is more important than hard economic reality.
The sceptics are right for the wrong reasons. Few analysts correctly define the problem and how it might best be resolved, because they only understand intervention. Some insist that Greece should leave the euro and allow a new drachma to float lower, so that the cost of Greek labour becomes competitive. The fallacies in this argument are numerous and obvious; suffice it to say that a new drachma backed by nothing more than misplaced hope would immediately collapse, ensuring complete chaos, while euro-denominated debts would remain unpaid.
Others say that GDP is falling at whatever-rate-per-cent and that cutting government spending will make it fall even faster: by postponing economic growth, Greece’s ability to pay down the debt will be severely limited. This confused argument ignores the economic burden of excessive government and consequently the benefits of cutting it to the bone.
The idea that government has resources not raised from its citizens is a Santa Claus fable, elevated to the dignity of an economic doctrine and endorsed by all those expecting a personal benefit. A government can only spend what it takes from its citizens, and the more a government spends the greater the burden it imposes upon them. Therefore, if the creditor-imposed unwinding of government spending results in the net transfer of resources (net, that is, of debt repayments) back to the private sector it will have a chance of success. However, all those citizens banking on hand-outs from the government will need persuading that it is for the best.
This is a difficult task, and given decades of interventionism no one is equipped to argue a cohesive case for reversing government expansion. It has been successfully done before, most notably by Britain after the Napoleonic Wars. The difference then was that public opinion was not entrenched in a benefits mentality.
Unwinding economic distortions, the result of the public sector’s intrusion into and imposition upon the productive economy, will be a very difficult political task. At the end of the day a prosperous private sector is Greece’s only hope, and it requires sound money to support capital investment, radical cuts in the public sector, and the lowest taxes possible consistent with sound government finance. The instincts of the interventionists are to do the exact opposite.
The chances of the powers-that-be getting it right are frankly, very slim. It can only be done by giving up all pretentions that intervention has economic benefits, and convincingly arguing the case in front of a sceptical public which is now minded to rebel against all authority.
Unfortunately, the Greek crisis is far from resolved, and will most probably worsen.
This article was previously published at GoldMoney.com.
The most important objective for any government is to achieve economic growth. Out of this growth develops employment and taxes to fund government itself. It is in other words the primary focus of all economic planning. Much effort is also spent perfecting the statistics deemed vital to quantifying everything that might contribute to the attainment of this end. Furthermore, “independent” monetary policy long ago migrated from the principal objective of controlling inflation to stimulating the economy into more growth. Almost everyone in developed economies knows and supports this objective, even if they argue over the means. However, not only have governments consistently failed to achieve this fundamental objective, they are now increasingly worried that government spending cuts will propel us all into a deep economic contraction.
But are we right to think in terms of economic growth or contraction? The concept is essentially Keynesian and stems from mainstream economic analysis. It presupposes that governments actually have a positive interventionist role and can improve economic outcomes, a supposition that is on examination completely flawed. Instead, an economy that successfully delivers the products and services people actually want does so in an unplanned, random fashion. It is the sum of all activity, which organises the production of goods and services by entrepreneurs and business proprietors in the considered belief they will be wanted.
The strength behind a free-market economy is the randomness of productive actions, and progress of mankind’s condition is the result. It only expands if the factors of production expand; otherwise the distribution of available resources depends on entrepreneurial anticipation of people’s needs and wants. When government intervenes in this unplanned but productive chaos it destroys this random quality, harnessing economic actions into in a common direction.
Destructive cycles of boom and bust have always been the result. Governments seek to co-ordinate randomness for an outcome they commonly call growth, and for a short time they might appear to succeed. But it is not long before these co-ordinated economic actions inevitably drive up prices, because extra factors of production (raw materials, labour and capital goods) only become available at higher price levels. Higher prices inevitably lead to higher interest rates, to the point where those who have fallen for the bait of artificially cheapened credit have to cut and take their losses. Capital theory predicts this outcome, events always confirm it, yet mainstream economists continually ignore it[i].
Intervention is as likely to succeed as water is to run uphill. Economic growth or the lack of it, the success or failure by which it is measured, is its child. The question then arises as to whether or not we can have economic growth without intervention.
The logical answer is no. A free-market economy in the absence of external factors does not grow: it progresses, which is a very different thing. It discards those things consumers do not want and produces things they are likely to want. It adjusts the price of products to a level which satisfies the consumer and is at the same time profitable. Overproduction is punished and underproduction invites competition. No one knows what the consumers will buy tomorrow or how much they are prepared to pay, but randomly-acting entrepreneurs are generally pretty good at guessing, because they put their own time and money on the line. They have to anticipate levels of demand and also prices for their output for at least as far in advance as it takes to plan, produce and market any product. This is progress, not growth. Progress is about better products and services tomorrow than today, using the resources actually available. Progress is about better value for money tomorrow, which means that prices tend to fall. And as prices tend to fall, more things can be bought for the same money. What governments do instead is destroy this process of progression in an attempt to replace it with statistical growth.
The statistics devised to measure it, principally gross domestic product, cannot measure anything other than the money in the productive economy, which it does imperfectly. Government spending, which is an economic cost, is included pari-passu with valued production. Efficient producers such as the manufacturers and suppliers of electronic goods and services, who reduce their prices over time, see their output diminished as a proportion of the statistical whole, while those that maintain their prices by monopolistic or subsidised means keep and even increase their weightings. This is simply the result of the indiscriminate use of a money-aggregate to measure the fallacious concept of economic growth. So GDP and related statistics do not measure progress: if anything they promote economic regression.
Instead, we must conclude that GDP is an approximation of the amount of money deployed in an economy. It is equal to a combination of measured production, government spending and price changes. Let us assume for a moment that extra factors of production at a given price level are not available, so production only progresses depending on how existing factors of production are redeployed. Let us further assume government spending and regulation of the private sector is also unchanged. These two conditions being the case, economic growth must be a reflection of price changes, which in turn is the result of changes in the quantity of money deployed in the economy. And in recording “real” economic growth, that is economic growth adjusted by a price-inflation index, statisticians avoid recording most of the effects of monetary inflation. Therefore, economic growth is not growth at all: it is just an alternative and flawed measure of unreported monetary inflation.
We would not take the central planners’ flawed attempts to manipulate an economy and the statistical outcomes seriously were it not for the ultimate consequences. Not only have they completely deceived the public over economic growth, but they deceive themselves. For this reason they are unequipped to deal with the developing crises, which are the result of earlier interventions. They now claim that economic growth, the ultimate source of tax revenue and government solvency is jeopardised by spending cuts. Statistically, this is obviously true, because if you take away government costs and support for unwanted economic activities, GDP will fall. But the important point that is commonly missed is that a government which stops draining an economy of its private sector resources actually releases them to be deployed more effectively for the common benefit by those randomly-acting entrepreneurs.
And that, ultimately, is the way out of all economic difficulties.
[i] There are some excellent analyses of Capital Theory, but the error of converting random actions into common objectives, central to understanding the destructive effects of central planning, gets little attention. This is a mistake.
This article was previously published at FinanceAndEconomics.org
In yesterday’s article I emphasised that it is profit that is beneficial, not revenue.
I’ve just read an excellent article (H/T Sean Corrigan) by Jerry L. Jordan, past president of the Federal Reserve Bank of Cleveland. He makes the same point, with particular reference to government “investment” and national accounting.
He opens with an analogy to warm the hearts of American readers:
It is tempting to think that the Soviets perfected negative-value-added investment — the stuff produced is worth less than the value of the resources to produce it. However, most families have experienced this first hand.
It usually surfaces with an entrepreneurial adolescent deciding it would be a good idea to sell lemonade at the curbside to passersby
Parents, wanting to encourage the idea that working and making money is a good idea, drive around to buy the lemon, sugar, designer bottled water, cups, spoons, napkins, a sign or two, and probably a paper table cloth.
Aside from time and gas, the outing adds up to something north of $10. At the opening of business the next day, the kids find business is slow to nonexistent at $1 per cup. So, they start to learn about market demand and find that business becomes so brisk at only 10 cents per cup that they are sold out by noon, having served 70 cups of lemonade and hauled in $7.
The excited lunch-time conversation is about expanding the business. A stand across the street to catch traffic going the opposite direction; maybe one around the corner for the cross-street traffic. The kids see growing revenue; the “investors” see mounting losses.
There is a strand of economics, we’ll call it the K-brand, that sees all this as worthwhile. They add together the $10 spent by the parents to back the venture and the $7 spent by the customers and conclude that an additional $17 of spending is clearly a good thing. Surely, the neighborhood economy has been stimulated.
To the family it is a loss, chalked up as a form of consumption. If this were a business enterprise it would be a write-off. In classical economics it is a “mal-investment.”
But of course the government “invests” on a much larger scale:
To K-brand economics, such “investing” is better done by the government because there never has to be a write-down for bad ideas. So, Japan spent a couple of decades “investing” in airports few people fly to, highways few people drive on and bullet trains that not enough people ride on. All the expenditures were recorded as investment and were additions to national output, never recognizing that the value of what was produced is less than the value of the resources needed to produce it — negative-value-added. Surely it is clear that Japan was made poorer by lots of bad “investments.”
The U.S. recorded a great amount of “residential investment spending” in the central valleys of California that added to national output, only to have the houses bulldozed because there were no buyers. Subsequently, the homebuilders incurred losses, reducing business income, thus shrinking national output.
Nevertheless, the national accounts will never be revised to reflect that the “investment spending” of a few years earlier was all “mal-investment” and should have been recorded as a form of business consumption. Such “investment” actually made us poorer.
The irony of this example is the expenditures incurred to bulldoze the vacant houses is recorded as “stimulus” to the economy. Thanks for that to K-brand economics. They now want California to “invest” in a Japanese-style bullet train that is negative-value-added economics.
I recommend the whole article.