At the International Monetary Conference in Atlanta June 7, 2011 the Fed Chairman Ben Bernanke said,
As is often the case, the ability and willingness of households to spend will be an important determinant of the pace at which the economy expands in coming quarters….. Developments in the labor market will be of particular importance in setting the course for household spending.
Seasonally adjusted non-farm employment increased by 54,000 in May after rising by 232,000 in the month before – below market expectations for a 165,000 increase. The growth momentum of employment fell last month. Year-on-year 0.870 million jobs were created in May after rising by 1.274 million jobs in the previous month. Factory employment fell by 5,000 last month following a gain of 24,000 in April. The unemployment rate rose to 9.1% in May from 9% in the month before.
But does it make sense that the key to economic growth is the lowering of unemployment? If this is the case then it is valid to conclude that changes in unemployment are an important causative factor of real economic growth.
This way of thinking is based on the view that a reduction in the number of unemployed means that more people can now afford to boost their expenditure. As a result, economic activity follows suit.
We suggest that the main driver of economic growth is an expanding pool of real savings. Fixing unemployment without addressing the issue of real savings is not going to lift the economy.
It is real savings that funds the enhancement and the expansion of the infrastructure. An enhanced and expanded infrastructure permits an expansion in the production of the final goods and services required to maintain and promote individuals’ life and well being.
If unemployment were the key driving force of economic growth then it would have made a lot of sense to eradicate unemployment as soon as possible by generating all sorts of employment. For instance, policy makers could follow the advice of Keynes and Paul Krugman and employ people in digging ditches, or various other government sponsored activities. Again the aim is just to employ as many people as possible.
A simple common sense analysis, however, quickly establishes that such a policy would amount to a waste of scarce real savings. Remember that every activity whether productive or non-productive must be funded. Hence employing individuals in various useless activities simply leads to a transfer of real savings from wealth generating activities and this thereby undermines the real wealth generating process.
Unemployment as such could be relatively easily fixed if the labour market were to be free of tampering by the government. In an unhampered labour market, any individual who wants to work would be able to find a job at a going wage for his particular skills. Obviously if an individual demands a non-market related salary and is not prepared to move to other locations, there is no guarantee that he will find a job. For instance, if a market wage for John the baker is $80,000 per year yet he insists on a salary of $500,000, he is likely to be unemployed.
Over time a free labour market makes sure that every individual earns in accordance to his contribution to the so-called overall “real pie”. Any deviation from the value of his true contribution sets in motion corrective competitive forces.
Ultimately what matters for the well-being of individuals is not that they are employed as such but their purchasing power in terms of the goods and services that they earn. It is not going to be of much help to individuals if what they are earning will not allow them to support their life and well being. Individuals’ purchasing power is conditioned upon the infrastructure that they operate. The better the infrastructure, the more output an individual can generate. A higher output means that a worker can now command higher wages in terms of purchasing power.
As we have seen, the key for an enhanced and expanded infrastructure is an increase in the pool of real saving. However, any government and central bank policies aimed at lowering unemployment by means of stimulus policies amounts to a policy of redistribution, which leads to economic impoverishment, i.e. it undermines the living standards of most individuals. Again, such policies do not expand the pool of real savings but rather result in the weakening of the growth of this pool.
Thus when the Fed pumps money through the purchase of Treasury bonds the point of buying bonds is to drive down long-term interest rates and encourage more lending by banks. This, it is held, will provide a boost to economic growth.
The artificial lowering of interest rates cannot as such lift the supply of credit if the pool of real savings is in trouble. It should be realised that banks just fulfil the role of intermediaries – they can facilitate the distribution of available real savings. However, they cannot create real savings – the key to economic growth. Hence, bank activities as such cannot boost real economic growth.
An artificial lowering of interest rates cannot generate more lending that is fully backed by real savings. The only credit that commercial banks can expand is credit out of “thin air”, or inflationary credit. An increase in inflationary credit amounts to an increase in money supply and hence to a diversion of real savings from wealth producers to non-wealth generating activities. Obviously then an expansion in credit on account of inflationary credit is bad news for economic growth.
Note that for Bernanke and most other experts the key factor that keeps the economy going is policies that allow the lowering of interest rates. Again the lowering of the interest rate structure, it is held, boosts consumption and businesses expenditure and this in turn lifts economic growth through the famous Keynesian multiplier.
Additionally, according to this way of thinking, loose government spending is important to economic growth. Hence Bernanke holds that one needs to be careful in the short run in curbing government outlays in order not to damage the economy.
A sharp fiscal consolidation focused on the very near term could be self-defeating if it were to undercut the still-fragile recovery.
However, Bernanke and other experts are also of the view that if government expenditure significantly surpasses government revenues an emerging deficit could curtail the benefits of loose fiscal policy by pushing the interest rate structure higher.
So what is then the solution? According to Bernanke,
The solution to this dilemma, I believe, lies in recognizing that our nation’s fiscal problems are inherently long-term in nature. Consequently, the appropriate response is to move quickly to enact a credible, long-term plan for fiscal consolidation. By taking decisions today that lead to fiscal consolidation over a longer horizon, policymakers can avoid a sudden fiscal contraction that could put the recovery at risk. At the same time, establishing a credible plan for reducing future deficits now would not only enhance economic performance in the long run, but could also yield near-term benefits by leading to lower long-term interest rates and increased consumer and business confidence.
We suggest that the focus shouldn’t be the fiscal deficit as such, but curbing government outlays. Cutting government is the best policy to normalize the economy and must be implemented as soon as possible.
In similarity to loose monetary policies, loose government policies also cause the diversion of real savings from wealth generating activities to non-wealth generating activities. Hence, contrary to Bernanke, we suggest that a severe cutback in government outlays in the very near term will help and not damage the economy.
Obviously various false activities that emerged on the back of loose fiscal policies will suffer. However, wealth generators will now have more real savings at their disposal, which will enable them to generate more real wealth. With all other things being equal, more wealth will lead to more real savings. Failing to curb government outlays will only weaken the process of wealth generation and will plunge the economy into a prolonged stagnation.
We can conclude that what matters is not to have strong economic activity as such but strong wealth generating activities. Hence the focus must always be on whether a given or suggested policy is good or bad for the wealth generating process.
This post is based on an earlier article published at mises.org on 21 September 2010
This all sounds plausible enough to me, but that’s only because I share some of the underlying assumptions.
It would be good to have a clearer definition of ‘wealth’ and ‘wealth-generating’. Can government ever create wealth? Is it purely a matter of turning a profit (do prostitutes generate wealth?), or does it require innovation and/or capital investment that allows future consumer goods to be produced more efficiently?
Ralph Musgrave has raised this issue in the comments on previous articles, and I don’t think it has been adequately addressed.
Until we get clarity here, we’re left with a lot of repeated assertions.
Wealth = goods and services.
Wealth generation = more goods and services with a more efficient use of the same factors of production and or the discovery of new factors of production and an ability to put them in more efficient combinations. Savings and time are key components and the entrepreneur to make it happen.
Government takes wealth from A and gives to B, this is at best a zero sum game. More often than not, B is a consumer of the wealth only.
Government takes from A and invests in a capital project of B that produces income of X. Would X be higher invested by profit motive orientated investors or by the government? I think the empirical work is with the former view.
Ralph Musgrave says what Frank says implies a teacher in the public sector does not create wealth and one in the private sector does.
What Frank would say I am sure would be the extraction of wealth from A to pay the teacher and the inefficient system they run in the state sector v private provsion would lead to overall less provision of teaching services.
I hope this is clear.
Thanks for your reply. I’m not sure I’d agree that
“Wealth = goods and services”
Is this a standard definition? To me it’s the services bit that seems problematic: it’s really the capacity to offer services, rather than the services themselves, that constitute wealth (that latter cannot be stored; they are instantly consumed).
On this model, wealth exists in anyone who is trained in a particular skill, and training is an act of wealth generation.
Therefore, to the extent that schools train people, they create wealth. Both state and private schools create wealth. I agree with you about which tend to do a better job of it.
Given a straight choice between letting people spend their money on private schools, and confiscating that money to spend it on less efficient state schools, clearly society is made poorer by taxing and spending.
However, suppose that many of the people from whom the funds are confiscated would instead have spent their money on private sector wealth destroying activities, like drinking beer and eating kebabs. In this case society could be made richer by forcibly diverting some of those funds into wealth-generating activities like education.
In this manner, it is theoretically possible that government can create wealth, and many socialists are indeed of the view that the government knows how to spend our money better than we do.
I think they’re wrong, and I think that it would be immoral for them to forcibly confiscate our money even if they were right.
But if we’re to get through to these people, we have to argue those points, rather than simply asserting that all private sector activity is wealth-generating, and all public sector activity is wealth-destroying (or, as Frank probably really means, that on net the private sector creates wealth while the public sector destroys it).
Repeated assertion here.
If the government directly creates the Trillions needed for infrastructure improvements over the next ten years(paid into existence as in the Great Muscle Shoals Money Debate), and thus pushes the unemployment rate down to 5 percent, THEN we have created real national wealth using the power of government, restored economic stability(somewhat) and without increasing the national nor private debt.
What’s wrong with that, again?
I keep forgetting.
1. Print more money.
2. People who get it are more happy.
3. At point 1, say there were 100 goods and services with 100 money units and now 110.
4. More happy people think they are better off.
5. More happy people spend a bit and employ more people.
6. All costs go up.
7. The boom is revealed as nothing more than more units of money in circulation chasing the same goods and services.
8. If we could mint our way to prosperity, why not do it all the time, do not by shy, go for zillions of government minting!
1. Repeat from 1 again.
Very simplified, but I trust you get the point.
The flaw in Shostak’s claim that we need more “real savings” just at the moment is that capacity utilisation is at very low levels, as is normal in a recession. That is, there is a lot of plant, machinery etc sitting idle.
Re his idea that “curbing government outlays” is some sort of solution, there is precious little correlation, far as I know, between the proportion of GDP taken by the public sector, and unemployment rates. Plus I can’t for the life of me see why there should be a correlation.
I realise that Rogoff has written a paper claiming there is a relationship. But Prof Randall Wray has poured cold water on Rogoff’s claims.
As to Shostak’s claim that employing people on “various useless activities” is not worthwhile, that really is the revelation of the century.
Sorry, but I don’t get the point at all.
Unless its rhetoric, there must be more to it.
Infrastructure represents the distribution mechanism for goods and services to be produced and consumed.
In this country, architects/engineers have identified $4 – $5 Trillion in infrastructure needs to keep more bridges from collapsing, roads to keep our vehicles from falling apart and water and sewer systems to keep us all healthy, not to mention the shortfall in health and education.
We need money to allow those infrastructure projects, which consist of goods and services being produced and consumed in their development, to proceed.
So, how can it be in any way wrong, or inflationary, to provide the means of exchange directly by the government to pay for that infrastructure and, as Ford and Edison argued – pay for them only once because there is no interest involved in their funding?
That’s the part I don’t understand.
At point 2 there are not 100 units of goods and services because we have produced ADDITIONAL goods and services in developing the infrastructure.
So, the question becomes, IF there are 110 units of goods and services, THEN what is wrong with there being 110 units of permanent money and no debt?
Because, if there’s nothing wrong with it, then at point 4 above, people think they are happy and better off for good reason – Trillions of infrastructure improvements – they are better off.
Toby’s right. Printing money doesn’t magic up any more real wealth. If it did, we wouldn’t have anyone living in poverty, and every country would have infrastructure to rival the best.
As Rothbard puts it:
If the money supply is doubled by a bad fairy (the government), who keeps all of the new money to herself, then it is clear that she is enriching herself at the expense of society at large. She will now have claims on half of its real wealth. Far from simply creating a ‘means of exchange’, every time she hands over one of her magically-created notes in exchange for a meal or a drink, she will be exchanging nothing for something (just as a counterfeiter does).
What you’re advocating is stealth taxation. Rather than impose a 50% wealth tax on every citizen, the government can achieve the same effect by doubling the money supply. Their new money is indistinguishable from the old, and they’re left in command of a greater portion of society’s wealth.
This is to Toby and mrg –
Take the blinders off guys(?).
I never thought of nor mentioned JUST increasing the money supply – and doing nothing. So, please stop arguing with yourselves.
I’ve read Rothbard’s (Hayek’s, Menger’s, von Mises, de Soto’s) treatise on monetary inflation, but they are not relevant to my question.
I only want the EXACT amount of money increase that is equal to the additional goods and services produced and consumed in the infrastructure project – LESS COST than if it were privately developed(no IDC nor ever paid).
No inflation. No loss of the currency’s buying power. No stealth taxation.
The article here suggests that infrastructure is needed and MUST BE funded by savings to have any economic value.
I made a pitch for public infrastructure investment funded directly by government money – citing both the need for same and the great Muscle Shoals project debate involving Ford and Edison.
It was a public project. Private interest would never see its development as the ROI is ALWAYS better somewhere else.
Ford and Edison, correctly IMHO, suggested the government print up the money to pay for the goods and services going into the project.
So, I repeat, with a public infrastructure improvement comprised of the production and consumption of $20 Million in goods and services, what is wrong with government paying that money into existence rather than borrowing from some bankers that create it out of nothing in the first place – never lifting a shovel.
I know the fully-reserved, savings-derived argument, but we’re not there.
So, if there is no inflation and there is no stealth taxation and if we thus maintain the stable buying power of the currency, then what is wrong with it?
In these highly stylised circumstances set in the above, all other holders of money, instead of having a boost in their purchasing power which is their just reward, they get nothing. Then instead of purchasing power being directed to goods and services demanded , they are now tilted toward a set of goods and services that were not demanded . This is the start of the boom bust cycle.
I trust this is clear.
If you refer to von Mises theory of inflationism where ALL new money debases all existing money – JUST BECAUSE – well I think I understand the theory, but I don’t buy it.
See the top of p. 125 in the Theory of Money and Credit.
In order for there to be inflation:
“a fall in the objective exchange value of the money must occur.”
First, in the above circumstances, the infrastructure improvements are DEMANDED as a result of the architect/engineers inspection reports, on which the government has collectively acted in its budgeting process.
So, we the people, DEMAND the improvements.
Second, in the above circumstances, all those who contributed produced goods and services to the infrastructure project will be paid in circulating medium by the national government whose national economy benefited from the improvements to public infrastructure. The purchasing power of the laborers, contractors, materials providers, etc. will all be enhanced as a result, exactly according to their contribution.
The rest of the holders of money get NOTHING because they have contributed nothing.
Their purchasing power is NOT diminished as the project cannot become inflationary in any real sense of the word(above von Mises Theory).
There was a $20 Million project(goods and services produced and consumed) built for $20 Million in real money.
Again, IF the need exists, then the project cannot be inflationary just because the government builds it without creating any debt. It would cost even more – AGAIN – if it were built by private industrialists.
No Boom and Bust Cycle.
I trust this is also clear.
Good Morning Jobhead,
“First, in the above circumstances, the infrastructure improvements are DEMANDED as a result of the architect/engineers inspection reports, on which the government has collectively acted in its budgeting process.
So, we the people, DEMAND the improvements.”
Random officials saying we want X is not market participants demanding product or services for entrepreneurs to produce. No clear logical set of deductions do you proceed along, thus, I suspect you fall foul here at the first hurdle of running a coherent argument. Sorry to be blunt.
If a fall in the objective exchange value has taken place. This means the process observed in the economy is rising prices.
Govt blesses into existence more money units and my purchasing power goes down – end of story.
If people demand to hold more bank IOU’s or demand deposits or bank notes, all liabilities of the bank, prices will fall. Some of the Austrian School such as Selgin, Horwitz , White and from the British Hard Money Subjectivist School, our very own Kevin Dowd also now with Anthony Evans, and I note Tom Clougherty also on our board do think it is OK to mint into life more money units to offest a increase in the demand to hold more cash balances. I think this is maybe what you are trying to suggest. In this falling in prices, then yes, the Govt could mint up more units, pay to random officials to start projects that create work. Price appear to stay stable. Oh happy days. We appear to have something for nothing. The problem is when the demand changes back agian, price rise. This is boom and bust inducing. My purchasing power that should have be able to command more over goods and serives for me has been diminished and a load of goods and services have been built that there was never a true sustainable demand for.
Monetary disequilibrium or monetary equilibrium theory is what is is called. Maybe this is what you mean. I do not subscribe to this part of it.
Toby – I don’t think it’s “ok” to mint new money out of nothing, and think you are misrepresenting what the people you’ve mentioned have said on this issue.
I only want the EXACT amount of money increase that is equal to the additional goods and services produced and consumed in the infrastructure project – LESS COST than if it were privately developed(no IDC nor ever paid).
No inflation. No loss of the currency’s buying power. No stealth taxation.
What you’re describing is a speculative project. If we’re being charitable, we might say that some people want to pursue it because they believe the benefits will exceed the costs, and that this project involves better use of the available resources than any other project that might be undertaken.
You’re not proposing that the government expand the money supply after the project is complete, to account for the increased real wealth that now exists in the economy.
What you’re suggesting is that the government expands the money supply in advance on the assumption that it will one day deliver benefits that meet or exceed its costs.
You acknowledge that they need the new money up front in order to purchase the inputs for the project (materials, labour, equipment). But printing money does not conjure up more inputs; these must be diverted from other uses to which they could have been put.
This diversion of resources from the private sector is achieved by fiat. The government doesn’t already have the money to command the resources, so it simply prints some up. Rather than taking money directly from the private sector through taxation, they confiscate purchasing power, because their new money competes with all pre-existing money for the same materials, labour, and equipment. This is taxation by stealth.
What is not seen is all the wealth that would have been created by the private sector if the purchasing power had been left in their hands.
There is no such thing as a free lunch.
“we the people, DEMAND the improvements.”
If you really believe that’s the way government works (or if you’re prepared to say it despite not really believing it), then I don’t think there’s much point in continuing this discussion.
As Toby says, “Random officials saying we want X is not market participants demanding product or services”.
Others have given the argument in Austrian terms, I agree with them, but those terms are difficult to understand for non-Austrians. So, here I’ll give a little bit more of a neo-classical view…
Let’s suppose, for the sake of argument, that the government can do some of the “public enterprise” that Joe mentions. Now, I’m quite sceptical about that like Toby and Mrg. I think that in most situations where the government can do this it’s because they have removed the private sector from the picture by law. (Take roads for example, many of those were private in the past). However, for the sake of argument let’s suppose that the government can create value above the cost of the inputs, that it can create a “societal profit” (*).
The first thing to notice here is that the total value of the improvements cannot possibly be the same as the “societal profit”. That’s because the government must compete input resources away from other uses, that is, there are costs. Keynesians will argue that the opportunity cost of employing unemployed labour is zero. This can be true, but the opportunity cost of employing imperishable resources can’t be. Also in most practical government projects the opportunity cost of employment isn’t zero because these projects generally require highly skilled labour, i.e. not the unemployed.
Putting that aside we can presume that there is a “societal profit” as I described above. Does this mean that the government can print the money needed to fund the project without causing inflation? No it doesn’t.
We don’t need the sophisticated apparatus of the Mises’ theories of money flow and the Cantillon effect, in this case the quantity theory will do. At the beginning we have:
M = Amount of money supply, in this case I’m including current accounts as well as base money.
T = Total real value of money transactions in a year.
P = Price of the T above.
V = “The Velocity of Money”, the number of times a unit of money is exchanged per year. This is closely related to money demand. (Specifically it fluctuates inversely with the accepted demand for money to hold).
MV = PT
Now, I know very well that there are lots of problems with the quantity theory and the use this identity, but in this case they really aren’t very relevant.
Now, let’s suppose that the government print into existence enough an new amount of money I’ll call “dM”. That means we have:
(M + dM) * V = P *T
Now, T has not increased. It we don’t have a recession or crisis then V will only change slowly. So, that means that P must rise, that is prices must rise.
Now, folks like Joebhed will say – but T will increase too because we are richer. That is true in general *only after* the new resources are in existence. However, even then our price inflation problem isn’t solved. That’s be the left hand side of the equation has risen from MV to (M+dM)V, that is …
(M + dM) * V – M * V = dM * V
If prices are to remain the same then the right hand side must increase by P * dT. Here dT is the real increment in new transactions brought about by the increase in wealth. P * dT is the money value of that increment in transactions.
So, in order for prices to stay the same we must have:
dM * V = P * dT
Will this happen, if you think about it the answer is clearly NO. Let’s be extremely optimistic. Suppose the government creates $2 billion to spend on a project which creates $1 billion of new wealth (that is the costs are $1B and the “societal profit” is $1B). In this case we’ll assume government print all the money needed to fund the project, so dM=$2B, then we have, $2B * V. Though V is difficult to measure it is certainly greater than 1 and probably much greater(**). Let’s suppose it’s 10, so dM * V = $20B.
Now, for prices to remain stable we must suppose that P * dT will also be $20B. Will this happen? Will the creation of $1B of new wealth make people wish to make an extra $20 billion of transactions every year? No, that’s so extremely unlikely we may as well call it impossible. The market would demand much less than $20B of extra transactions. As a result there would be price inflation.
If this sort of funding projects by money printing were done on a large scale there would be very significant price inflation. The public would pay for these projects through inflation. A very expensive payment method because of all problems, such as ABCT and adjustment costs, it causes.
* – How can such a profit be measured? This is the essence of the socialist calculation problem.
** – Notice I’m talking about total transactions there, not just output transactions. The central banks measure that “output velocity”, and it’s ~1.5-2. But, it omits transactions on assets or intermediate goods. Velocity including these would be much higher.
To AJE, when an increase in money demand happens, the banks faced with more liabilities held , use this opportunity to make what you all call an “accomodation” ie in laymans terms, mint up more loans as a result. You know this is the essence of Money Equilibruim Theory, therefore I am correct to say what I have said. Granted these newly minted loanable funds, aka money to the layman, you would rather go to enterprise and real people who want it, leaving aside the problem of who would be the chosen lucky ones and the potential Cantillon effects thereafter, and not to the govt to do daft projects etc. So this is better than rank Keynesianism and better than monetarism like say a Congdon, but far short of a pure Austrian hard money only policy.
Hi Toby, I don’t want to debate MET here, I just wanted to make it clear to readers of this site that I don’t believe what you have attributed to me. That’s all.
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