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Some Fed officials and various commentators, such as
professor Paul Krugman, are of the view that the US central bank should be
ready to consider additional steps to boost the US economy in the wake of a
visible softening in key economic data. For instance, the yearly rate of
growth of retail sales after climbing to 8.5 per cent in March, have fallen
to 4.8 per cent in June. The ISM manufacturing purchasing management index
fell to 56.2 last month from 59.7 in May.
Visible weakening is also seen in the housing
market. The growth momentum of new home sales has plunged in May. The yearly
rate of growth of sales fell to minus 18.3 per cent in May from 30.8 per cent
in April. Also, the growth momentum of housing starts displays a visible
decline. Year-on-year the rate of growth fell to 7.8 per cent in May from
38.2 per cent in the month before. Additionally, in the week ending July 9,
demand for loans to purchase homes, as depicted by the mortgage purchase
index, fell 3.1 per cent to 163.3 the lowest level since December 1996.
In his articles in the New York Times on the
27 of June and 11th of July professor Paul Krugman has warned that without a
dramatic fiscal and monetary stimulus the US economy is running the risk of
falling into a prolonged depression. According to Krugman things were
different in 2008-2009,
In 2008 and 2009, it seemed as if we might have
learned from history. Unlike their predecessors, who raised interest rates in
the face of financial crisis, the current leaders of the Federal Reserve and
the European Central Bank slashed rates and moved to support credit markets.
Unlike governments of the past, which tried to balance budgets in the face of
a plunging economy, today's governments allowed deficits to rise. And better
policies helped the world avoid complete collapse: the recession brought on
by the financial crisis arguably ended last summer. (Paul Krugman, The Third
Depression, The New York Times June 27, 2010.)
Despite the stimulus, which Krugman labels as good
policy, this wasn't sufficient to erase still very large unemployment. Hence
Krugman's view that more stimulus is required. Unfortunately, argues our New
York Times columnist, policy makers are currently moving away from sound
policies.
Around the world …. Governments are obsessing
about inflation when the real threat is deflation, preaching the need for
belt-tightening when the real problem is inadequate spending. (ibid.)
Krugman maintains that the current move towards more
conservative policies, which he labels as hard money and balanced-budget
orthodoxy, has little to do with rational analysis. According to our
professor, this type of thinking will lead to another economic depression and
massive unemployment,
And who will pay the price for this triumph of
orthodoxy? The answer is, tens of millions of unemployed workers, many of
whom will go jobless for years, and some of whom will never work again. (Ibid.)
In the face of a weakening in the rate of growth of
various price indexes Krugman holds that the Fed should start act swiftly to
prevent the economy falling into a deflationary black hole.
Mr Bernanke's "it" isn't a hypothetical
possibility, it's on the verge of happening. And the Fed should be doing all
it can to stop it. (Ibid.)
More Keynesian ideas can only make things much worse
Following in the footsteps of John Maynard Keynes
most economists, and in particular Krugman, hold that one cannot have
complete trust in a market economy, which is seen as inherently unstable. If
left free the market economy could lead to self-destruction. Hence there is
the need for governments and central banks to manage the economy. Successful
management in the Keynesian framework is done by influencing the overall
spending in an economy.
It is spending that generates income. Spending by
one individual becomes income for another individual according to the
Keynesian framework of thinking. Hence the more that is spent the better it
is going to be. What drives the economy then is spending. If during a
recession consumers fail to spend then it is the role of the government to
step in and boost overall spending in order to grow the economy.
In the Keynesian framework of thinking the output
that an economy can generate with a given pool of resources i.e. labour,
tools and machinery, and a given level of technology without causing
inflation, is labelled as potential output. Hence the greater the pool of
resources, all other things being equal, the more output can be generated.
If for whatever reasons the demand for the produced
goods is not strong enough this leads to an economic slump. (Inadequate
demand for goods leads to only a partial use of existent labour and capital
goods). In this framework then, it makes a lot of sense to boost government
spending in order to strengthen demand and eliminate the economic slump. What
is missing in this story is the subject matter of funding. For instance, a
baker produces ten loaves of bread and exchanges them for a pair of shoes
with a shoemaker. In this example the baker funds the purchase of shoes by
producing ten loaves of bread.
Note that the bread maintains the shoemakers' life
and well being. Likewise the shoemaker has funded the purchase of bread by
means of shoes that maintains the bakers' life and well being. Now, let us
say the baker has decided to build another oven in order to increase the
production of bread. In order to implement his plan the baker hires the services
of the oven maker.
He pays the oven maker with some of the bread he is
producing. Again what we have here is a set-up where the building of the oven
is funded by the production of a final consumer good — bread. If for
whatever reasons the flow of bread production is disrupted the baker would
not be able to pay the oven maker. As a result the making of the oven would
have to be aborted.
From this simple example we can infer that what
matters for economic growth is not just the existing stock of tools and
machinery and the pool of labour, but an adequate flow of final goods and
services that maintain individuals life and well being. Now, even if we were
to accept the Keynesian framework that the potential output is above actual
output, it doesn't follow that the increase in government outlays and loose
monetary policy will lead to an increase in the economy's actual output.
It is not possible to lift overall production
without the necessary support from final goods and services or from the flow
of real funding or the flow of real savings. (For instance, out of the
production of ten loaves of bread if the baker consumes two loaves his real
saving or real funding is eight loaves). We have seen that by means of a
final consumer good — the bread — the baker was able to fund the
expansion of his production structure.
Similarly other producers must have saved final real
consumer goods — real savings — to fund the purchase of the goods
and services they require. Note that the introduction of money doesn't alter
the essence of what funding is. (Money is just a medium of exchange. It is
only used to facilitate the flow of goods, it cannot replace the final
consumer goods).
The government as such doesn't create any real
wealth, so how can an increase in government outlays revive the economy?
Various individuals who are employed by the government expect compensation
for their work. The only way it can pay these individuals is by taxing others
who are still generating real wealth. By doing this the government weakens
the wealth-generating process and undermines prospects for economic recovery.
(We ignore here borrowings from foreigners).
The only way fiscal and monetary stimulus could
"work" is if the flow of real savings i.e. real funding, is large
enough to support i.e. fund, government activities and activities that sprang
up on the back of loose monetary policy whilst still permitting a positive
rate of growth in the activities of real wealth generators. (Note that the
overall increase in real economic activity is in this case erroneously
attributed to the loose fiscal and monetary policies).
If however the flow of real savings is falling then
regardless of any increase in government outlays and monetary pumping overall
real economic activity cannot be revived. In this case the more the
government spends and the more the central bank pumps the more will be taken
from wealth generators, thereby weakening any prospects for a recovery.
When loose monetary and fiscal policies divert bread
from the baker he will have less bread at his disposal. Consequently the
baker will not be able to secure the services of the oven maker. As a result
it will not be possible to boost the production of bread, all other things
being equal. As the pace of loose policies intensifies a situation could
emerge whereby the baker will not have enough bread to even maintain the
workability of the existing oven. (The baker will not have enough bread to
pay for the services of a technician to maintain the existing oven in a good
shape). Consequently, his production of bread will actually decline.
Similarly other wealth generators, as a result of
the increase in government outlays and monetary pumping, will have less real
funding at their disposal. This in turn will hamper the production of their goods
and services and will retard and not promote overall real economic growth. As
one can see, not only does the increase in loose fiscal and monetary policies
not raise overall output, but on the contrary it leads to a weakening in the
process of wealth generation in general. According to Ludwig von Mises,
…there is need to emphasize the truism that a
government can spend or invest only what it takes away from its citizens and
that its additional spending and investment curtails the citizens' spending
and investment to the full extent of it quantity.<>
Money supply and economic indicators
Now the so called economic recovery that Krugman and
most commentators attribute to the success of loose fiscal and monetary
policies during 2008-9 is just a reflection of monetary pumping by the Fed.
Year-on-year the rate of growth of the Fed's balance sheet (monetary pumping)
climbed to 152.8 per cent in December 2008 from 1.5 per cent in February
2008.
The pace of pumping remained very high during 2009
hovering at 125 per cent during January to September. As a result the yearly
rate of growth of our monetary measure for the US jumped to almost 33 per
cent in November 2008. During December 2008 to September 2009 the yearly rate
of growth of AMS hovered at around 22 per cent.
Since most economic indicators reflect monetary
expenditure obviously the stronger the monetary pumping is the stronger
various economic indicators become. This of course means that the expansion
of various economic indicators reflects a weakening in the process of real
wealth formation. Yet most commentators including Krugman label monetary
driven expansion as good thing. (Note that this expansion is labeled economic
recovery).
From this we can infer that a decline in the pace of
pumping since September last year is behind the current decline of the rate
of growth in various economic indicators. The decline in the rate of
expansion slows down the rate of damage to the process of real wealth
formation. Hence the slowdown in the expansion should be regarded as good
news for the economy. (Note that there is a variable time lag between changes
in the monetary expansion and changes in various economic indicators).
The yearly rate of growth of Fed's balance sheet and
AMS stood at 13.7 per cent and 2.3 per cent respectively in June. Obviously
the Fed can accelerate the pace of pumping by embarking on a very aggressive
buying of assets. This pumped money however is unlikely to enter the economy
as long as commercial bank lending remains depressed. (We ignore the case of
the Fed buying assets directly from non-banks). Now even if pumped money were
to enter the economy it will only undermine further the process of real
wealth formation and make the already bad economic environment much worse.
The fact that at present banks are reluctant to go
full ahead with the expansion of credit is indicative that the pool of real
savings is in trouble, after all the essence of credit is about the lending
of real savings. Lending amounts to a transfer of real savings from a lender
to a borrower by means of the medium of exchange i.e. money.
The existence of banks enhances the use of real
savings. By fulfilling the role of middleman, banks make it easier for a
lender to find a borrower. When a bank lends money, it in fact provides the
borrower with the medium of exchange that can be employed to secure real
stuff that is required to maintain people's life and well being.
It is therefore futile to urge banks, as various
commentators including Bernanke and Krugman are doing, to lend more if real
savings are not there. If the banks were to be forced to expand lending
whilst the pool of real savings is declining this would mean that they have
started to expand credit out "thin air" or inflationary credit.
Needless to say that such type of credit can only make things much worse.
Why economic cleansing promotes economic growth?
The conventional thinking headed by Krugman presents
economic adjustment — also labeled as "economic recession"
— as something terrible, even the end of the world. In fact, economic
adjustment is not menacing or terrible; from an economic point of view, it is
nothing more than a time when scarce resources are reallocated in accordance
with consumers' priorities.
Allowing the market to do the allocation always
leads to better results. Even the founder of the Soviet Union, Vladimir
Lenin, understood this when he introduced the market mechanism for a brief
period in March 1921 to restore the supply of goods and prevent economic
catastrophe. Yet for some strange reason, most experts these days cling to
the view that the market cannot be trusted in difficult times.
If central bankers and government bureaucrats can
fix things in difficult times, why not in good times too? Why not have a
fully controlled economy and all the problems will be fixed forever? The
collapse of the Soviet Union's centralized system is the best testimony one
can have that controls don't work. A better way to fix economic problems is
to allow entrepreneurs the freedom to allocate resources in accordance with
peoples priorities. In this sense, the best stimulus plan is to allow the
market mechanism to operate freely. Allowing the market to do the job will
result in some activities disappearing all together while some other
activities will in fact be expanded.
Take, for instance, a company that has six
profitable activities and four losing activities. The management of the
company concludes that the four losing activities must go. To keep them alive
is a threat to the survival of the company; these activities rob scarce
funding from profitable activities.
Once the losing activities are shut down, the
released funding can now be employed to strengthen the winning activities.
The management can also decide to use some of the released funding to acquire
some other profitable activities. This is precisely what the government and
central bank stimulus policies prevent from happening.
Loose fiscal and monetary policies are not going to
rescue the economy, but will rescue activities that the economy cannot afford
and that consumers do not want. It will sustain waste and promote
inefficiency, draining resources from growth and efficiency. Remember:
government is not a wealth generator; it can only take resources from A and
give them to B.
Why doing nothing is the best policy to revive the
economy
Contrary to Krugman and other commentators we
suggest that the best economic policy for the Fed and the government is to do
nothing as soon as possible. By doing nothing the Fed will enable wealth
generators to accumulate real savings. (The policy of doing nothing will
force various activities that add nothing to the pool of real savings to
disappear. This will make the life of wealth generators much easier). As time
goes by the expanding pool of real savings will set a platform for the
further expansion of various wealth generating activities. So the sooner the
Fed and the government stop with the tampering the sooner an economic
recovery will emerge.
We suggest that decades of reckless monetary and
fiscal policies have severely depleted the pool of real savings. So again
more of the loose policies cannot make the current situation better. On the
contrary such policies only further delay the economic recovery. Hence
contrary to Krugman we can suggest that a move towards greater conservatism
is the step in the right direction.
Also contrary to Krugman the unemployment rate can
be lowered rather quickly if the labour market were to be freed. What is
required however, is not the lowering of unemployment as such but the
creation of an environment where individuals can earn incomes that will
enable them to lift their living standards. The key for such an environment
is to stop sabotaging the process of real wealth generation by means of loose
policies.
Conclusion
Contrary to Krugman and other mainstream economists
neither the Fed nor the government's loose monetary and fiscal policies can
cause an expansion in the pool of real savings. On the contrary loose
policies only weaken the process of real wealth formation thereby weakening
prospects for a sustained economic expansion.
If loose monetary and fiscal policies could have
been instrumental for economic growth then by now all the poverty in the
world would have been eradicated. The only reason why in the past loose
monetary and fiscal policies appeared to have been effective is because the
pool of real savings was expanding. However, once this pool becomes stagnant
or is declining the illusion of the effectiveness of loose monetary and fiscal
policies is shattered. The more aggressive the fiscal and monetary policies
stance is the worse the economic conditions become.
Now if the pool of real savings is still ok then
there is no need for Krugman's policies to revive the economy — the
pool will do it. If the pool is in trouble Krugman's policies will only make
things much worse and we could end up in a prolonged economic depression. Hence the best, policy is to do nothing.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
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