Your country faces a stagnating economy. Let us assume your Prime Minister (or President if that is who holds the executive power) seeks advice from two imaginary economists.
PM: You two economists have different views on what our economic policy should be. What is your advice?
FIRST ECONOMIST (Austrian school): Prime Minister, the reason we face a stagnant economy is your central bank perpetuated the credit cycle by suppressing interest rates when the economy turned down after the banking crisis and lending risk escalated. That has left us with a legacy of under-performing businesses, which should have been left to go bankrupt. Instead they are struggling under a burden of unrepayable debt. Capital is not being reallocated to the new enterprises of the future. The dynamism of free markets has been throttled.
The extra money and credit created by the banking system has not been applied to the real economy. Instead they are fuelling a financial boom in asset prices, which have become dangerously separated from production values.
Eventually, current monetary policy will lead to a fall in the purchasing power of the currency, and the central bank will be forced to raise interest rates to a level that will precipitate the next financial crisis, if the crisis has not already occurred by then. Overvalued assets become exposed to debt liquidation. It happens every time, and if you think the last crisis, which led to the Lehman collapse was bad, on current monetary policies the next one will be much worse, just as Lehman was much worse than the aftermath of the dot-com boom.
A monetary policy that relies on the transfer of wealth from savers to debtors always fails in the end, as certainly as death and taxes exist. It is also the real reason the bankers are getting wealthy while ordinary people become poorer. The time has come to recognise that your central bank, by licencing and encouraging the banks to create credit out of thin air, is the source of the problem.
Sadly, your central bank seems blissfully unaware of the debilitating effect of monetary inflation on your voters’ wages and savings, and if I may say so Prime Minister, your administration pays little regard to the natural injustice of rewarding profligate borrowing and penalising thrift.
I advise you to stop your central bank from manipulating interest rates and to let the markets sort themselves out. Furthermore your central bank must stop debasing the currency as a cure-all. So this is what I suggest.
First, encourage savers to rebuild their wealth directly through tax policy. When someone has paid tax on his income he should be entitled to keep his savings. The evidence from Germany and Japan in the post-war years is that a stable source of low-taxed savings is a prerequisite for a strong, yet stable, economy. And as savers rebuild their personal wealth, the state can scale back its future welfare commitments, which as you must be aware, are in danger of escalating out of control.
Second, I would reform the financial system. Banks should manage their affairs on the basis of reputation, and not hide behind regulation. Instead of looking after their customers, they use their regulated status to game the system. Regulating the banks has led to crony capitalism of the most pernicious sort. In future banks must set their own standards and be answerable to their customers first and foremost, not to a government regulator.
Third, the state must always run a budget surplus, to pay down its high level of debt. In balancing the books it is important to bear in mind that money taken in taxes destroys wealth. For a truly prosperous economy, you should plan in the longer term to reduce the state’s tax take to below 30% of GDP, and lower still in the fullness of time.
You will only put a stop to successively worsening cycles of boom-and-bust in the future if you return to sound money, free markets and small government. Your ministers must stop pretending they can run the economy. They have no basis for making commercial judgements. Government interventions are always politically-driven. Nor should your ministers listen to big business, which always seeks to influence policy in its favour.
I realise all this will take time to implement and must be done in steps so that the private sector can adjust. For this reason I recommend you structure these changes over a ten year period, announcing the legislative schedule in advance. You will find that businesses will reposition themselves to your new policies ahead of their implementation. The benefits to your economy and your voters are more likely to flow smoothly without disruption, and deliver economic benefits much sooner than you think.
SECOND ECONOMIST (Neo-Keynesian): Prime Minister, I cannot believe what we have heard from my esteemed colleague. He lives in a world that no longer exists. I really don’t see the relevance of nineteenth century values to the economic conditions of today. The disciplines of macroeconomics and econometrics have made great advances, allowing us to plan the course for the economy in greater detail than before.
I am confident that I have the solution to your problem. I firmly believe that your government’s monetary and economic policies are going in the right direction, but you are not bold enough. People are too reluctant to spend, so you must do everything to encourage them to do so, perhaps forcing the banks to cut the cost of consumer credit. Alternatively, you should explore means of distributing extra money to consumers through government spending, along with negative interest rates perhaps, to jump-start economic growth.
I am convinced your government can safely increase its budget deficit, injecting money into the economy by creating more jobs in the public sector. You should bring forward spending on infrastructure, which will boost the construction industries. Creating employment by expansionary measures will reduce the cost of unemployment, offsetting some of the budget deficit.
Prime Minister, it would be a huge mistake to cut back now, because the result will certainly be a deepening recession, widespread bankruptcies and increasing unemployment. I am convinced that with government support, the welfare state and vital industries can be safe-guarded, and if your central bank increases the money supply further and encourages the banks to lend we shall get through this temporary problem. It’s vital we get consumer confidence going again, and I firmly believe progressive economic and monetary policies can save the day.
The time to cut back is not now. When the economy resumes its long-term sustainable growth trend, increasing tax revenues will then close the deficit, bringing government finances back into balance. There really is no need for any cuts in public spending, which will only lead to disaster.
I have presented both arguments unadorned with any compromises, but they capture the essence of the chasm between the laissez-faire Austrians and the anti-market neo-Keynesians. The difference between the two is the Austrian argues from a sound theoretical basis, while the Keynesian approach is founded on beliefs and a reluctance to consider second-order effects.
It should be apparent that a politician driven by short-term considerations, which describes just about every leader in Western democracies, will have great difficulty in dealing with the destructive credit cycle. For a start, they all claim that their central banks are independent, which is code for “we don’t understand monetary policy, so we don’t want to be responsible for it.”
This is why the order of events is crisis first, solution second. The solution is always to address the symptoms and not the underlying problem. It is not for nothing that everyone refers to the Lehman crisis as if it was the crisis. No, the crisis was the over-inflation of asset prices relative to their productive capacity, and the speculative greed that drove it. Lehman, AIG, Bear Stearns and all the rest were merely the subsequent casualties.
Very few people understand the fundamental truth that in properly functioning markets, assets are valued by their productive capacity: property yields a rent, or the equivalent use-value for an owner-occupier. Machinery produces manufactured goods, and the value of the goods produced determines the value of the machinery. Even art produces a return in aesthetic value, hard though that is to value. But when speculation drives values for values’ sake, as was the case with the dot-coms and the liar-loan property boom seven years later, a financial crisis always follows. Yet again, this description fits the conditions of today.
The only time asset values can continue to rise on a non-speculative basis is when the public as a whole changes its preference against money and in favour of goods. In this instance it is the purchasing power of money falling, and not the value of goods rising. This does not apply today, as the price of gold attests. However, it is likely to apply when the central banks react to the coming crisis.
The truth is it is too late for our politicians to act, because the speculative peak that precedes the crisis is already upon us. Last time round, the Federal Reserve Board wrote open-ended cheques to save the banking system, estimated at the time to be as much as $13 trillion or thereabouts, though not all this facility was drawn down. It followed this with zero interest rates and three rounds of quantitative easing. What will it take this time?
Whatever it takes, as Mario Draghi famously said in 2012. This time it will almost certainly be currencies that end up taking the hit.
Advice from a third economist.
Dear Prime Minister there is a better way.
With real economies, prices adjust, including the value of bonds, the cost of monthly payments, the rate of increase in National Average Earnings, and the value of the currency..
We do not have real economies because we destroyed them.
• We insist that the value of bonds must not adjust upwards, but downwards.
• That property values must adjust downwards not upwards.
• That the cost of housing finance just leaps upwards not rising to offset the falling value of money as spending levels rise – raising prices of everything and devaluing money relative to everything.
• We insist on managing interest rates – a price – and so distorting them and getting into this mess.
• The Fed has been trying to eliminate the down part of the credit cycle – by nudging interest rates down. It does not work. Some central banks want to nudge them down below zero with the same thing in mind. They think it is called boosting the economy. It just distorts everything and keeps debt levels rising.
• Nations use capital to manipulate currency prices. Currency prices are not then free to adjust when capital gets confused with trade and the balance of trade. A separate door is needed for capital so that the value of the currency can adjust, not too fast and not too slowly, to the falling value of money.
As Keynes pointed out, in his ‘A Tract on Monetary Reform’, 1923, if all prices were to adjust a man would have twice the income and twice the costs and so would be basically unaffected.
Why would prices adjust? Answer: Because supply and demand are still the same. Only the value of money has fallen.
In a real economy, prices adjust to re-balance everything so that people are basically unaffected.
But Keynes made a mistake. Some prices lag behind, making us all better off. Therefore the inverse rate of growth needed to offset the falling value of money is not prices inflation as he claimed. That is too little. This means that real interest rates are not enough to keep pace unless they are high enough to offset the real rate of economic growth.
How many economists know all of the above? They know prices adjust – if they are allowed to. Then they turn the page.
A real economy without all of these man made distortions will not have difficulty in returning to balance. People will be basically unaffected. In a real economy there will be no fixed interest bonds. There will be a new kind of housing finance invented by me, there will be a new kind of commercial and government finance which protects the values, and there will be management of liquidity and of demand, not management of interest rates. There will be another door open for international capital swops so that people can invest in other economies without upsetting their exchange rates or their interest rates.
I spend decades writing this up and confirming with others – top economists and practitioners. Now they all seem to like it.
My book will be called “A Tract on Financial Stability”
Whereas Keynes accepted the economic and financial structures in existence I do not accept them. If we correct these mistakes, a little inflation will not matter much. Everyone will be basically unaffected.
Central banks will set the pace and all prices and employment levels will adjust to maximise economic output.
See my other comment
Both economists are foolish, neither grasps reality of resource constraints … caused by the success of industrialization.
Austrians consider debt to be a defect that assails otherwise productive interests. The theory is false b/c it runs against thermodynamics. Wealth is not created by business interests but is annihilated by them, instead. As a result debt is necessary to provide ‘returns’ that cannot be gained otherwise. The longer the business operations take place the greater the debt.
Government debt is necessary because governments are the only components in the economy that can borrow perpetually and not go out of business.
Keynesians assume industrialization is productive rather than making a determination by way of analysis. It turns out, industries require non-stop debt subsidy along with underpriced capital — resource — inputs in order to keep the doors open. Increasing final demand by any- and all means simply puts industries further underwater: that this is so is self-evident. At this point in time both the direct costs of industries plus the cost of borrowing needed to keep everyone afloat has become unaffordable.
The problems we face are not defects in the current regime but with the cannibalistic, non-remunerative regime itself. Our precious economy cannot afford itself … one way or the other the world is being deindustrialized
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