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