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 Most experts and commentators are of the view that
the worst of the US recession may be over by year's end. My own prediction is
for an illusory recovery of government-constructed economic indicators, but
nothing more than that.
It is held by most experts that a recession is
typically set in motion by various unpredictable shocks. For instance, it is
argued that the present recession was triggered by the crisis in the real
estate market. Since, as a rule, various shocks tend to weaken consumer
demand, it is the role of the central bank and the government to replace this
shortfall in demand by boosting monetary pumping and government outlays.
Thus, the central bank and the government counter the effects of various
negative shocks by means of monetary and fiscal stimulus policies.
The monetary and fiscal stimulus is aimed at
boosting overall expenditure in the economy, which (it is believed) is the
key for economic growth. On this logic, spending by one individual becomes
the income for another.
Following this way of thinking, since September 2007
the US central bank has aggressively lowered its interest rates. The federal
funds rate target was lowered from 5.25% in August 2007 to almost zero at
present. The yearly rate of growth of the Fed's balance sheet (that is, the pace
of monetary pumping) jumped from 4% in September 2007 to 152% by December
2008.
With respect to the fiscal stimulus, aggressive
government spending has resulted in a massive deficit. For the first nine
months of fiscal year 2009, the budget deficit stood at $1.086 trillion. That
compares with a shortfall of $285.85 billion in the comparable year-ago
period. The twelve-month moving average of the budget had a deficit of $105
billion in June — the largest deficit since 1960.
It would appear that recent strengthening in some
key economic data raises the likelihood that various stimulus measures have
succeeded in reviving the economy. Seasonally adjusted retail sales increased
by 0.6% in June after rising by 0.5% in the month before — this was the
second consecutive monthly increase. The pace of deterioration in industrial
production appears to be softening as well. Seasonally adjusted production
fell by 0.4% in June after a fall of 1.2% in May. (Note that in January
production fell by 2.2%.)
If recessions are caused by a fall in consumer
demand as a result of various unforeseen shocks, then it makes a lot of sense
for the government and the central bank to beef up the overall demand in the
economy.
Why Popular Statistics Provide Misleading Signals
Observe that various economic data, which serve as a
guide to establishing the state of the economy, are derived from monetary
expenditure data. This means that the more money that is created, the larger
the expenditure (in terms of money) is going to be. Hence, various derived
statistics are going to mirror this strengthening. For instance, the
so-called gross domestic product (GDP), which is pivotal in the analysis of
various experts, reflects the rate of growth in money supply.
Once the state of an economy is assessed in terms of
GDP, it is not surprising that the central bank appears to be able to counter
any recessionary effects that emerge. By pushing more money into the economy,
the central bank's actions will appear to be effective, since GDP will show a
positive response to this pumping, following a time lag.
Even if one were to accept that GDP depicts a
well-defined "economy," there is still a problem as to why
recessions are of a recurring nature. Does it make sense that unconnected,
various shocks cause this repetitive occurrence of recessions? Surely there
must be a mechanism here that gives rise to this repetitive occurrence?
Also, how can an increase in demand boost economic
growth? After all, in order to be able to generate an increase in the output
of goods and services, there must be an increase in various means to support the
increase in the production of goods.
If the key to economic growth is an increase in
demand, then poverty world-wide would have been eradicated a long time ago. Every
central bank in the world could have generated massive demand by means of
monetary pumping, which according to popular thinking would have generated
massive economic growth. That this is not the case — have a look at
Zimbabwe — should raise questions regarding the soundness of this
popular way of thinking.
Loose Monetary Policies Cause Boom-and-Bust Cycles
Careful examination actually shows that, rather than
protecting the economy, loose monetary policies are the key source of
boom-bust economic cycles.
The source of recessions turns out to be the alleged
"protector" of the economy — the central bank itself. Further
investigation demonstrates that the phenomenon of recession is not an
indicator of the weakness of the economy as such, but rather an indication of
the liquidation of various activities that sprang up on the back of the loose
monetary policies of the central bank.
Loose monetary policy sets in motion an exchange of
nothing for something, which amounts to a diversion of real wealth from
wealth-generating activities to non-wealth-generating activities. In the
process, this diversion weakens wealth generators, which in turn weakens
their ability to grow the overall pool of real wealth.
The expansion in activity that sprang up on the back
of loose monetary policy is what constitutes an economic boom — in
reality, false economic prosperity. Note that once the central bank's pace of
monetary expansion has strengthened, irrespective of how strong and big a particular
economy is, the pace of the diversion of real wealth will also strengthen.
However, once the central bank tightens its monetary
stance, it slows down the diversion of real wealth from wealth producers to
non-wealth producers. And as activities that sprang up on the back of the
previous loose monetary policy receive less support from the money supply,
they fall into trouble — an economic bust, or recession, emerges.
From what we have shown, we can conclude that
recessions are essentially the liquidation of economic activities that were
created and sustained by the loose monetary policy of the central bank. The
process of a bust is set in motion when the central bank reverses its earlier
loose stance.
Having established this, we must investigate why
recessions are recurrent. The reason for this is that the central bank's
ongoing policies are aimed at fixing the unintended consequences arising from
its earlier attempts to stabilize the economy — or rather, what it
believes to be the measure of the economy: the GDP. On account of the time
lag between changes in money supply to changes in GDP, the central bank is
forced to respond to the effects of its own previous monetary policies. These
responses to the effects of past policies give rise to fluctuations in the
rate of growth of the money supply and, in turn, lead to recurrent boom-bust
cycles.
Wealth Generators Key for Economic Growth
The key drivers of the economy are wealth
generators. Hence, the fact that various non-wealth generators come under
pressure as a result of the central bank's tighter stance is indeed good news
for wealth generators and real economic growth. A tighter stance means that
less real wealth, which is required to support economic growth, is taken from
wealth generators.
From this we can infer that the government's and
Fed's loose monetary policies have only weakened the wealth generators'
ability to grow the economy by diverting real wealth to nonproductive
activities.
Can the economy recover despite aggressive policies
of the Fed and the government? We suggest that this depends on whether wealth
generators have managed to retain their ability to generate wealth despite
destructive central bank and government policies. The ability to support
economic growth hinges on the pool of real savings. Once this pool is
starting to move ahead, the economic growth follows suit. This in turn means
that economic growth is emerging, despite government and central bank
aggressive policies.
We suggest that the aggressive policies of the Fed
from 2001 to June 2004 — during which time the fed funds rate was
lowered from 5.5% to 1% — have significantly damaged wealth generators'
abilities to keep the flow of real savings going. While the Fed's tight
interest rate stance from June 2004 to September 2007 provided good support
for wealth generators, the loose stance since
September 2007 has most likely undone anything positive from that time.
Hence, we doubt that the US economy is on the verge of solid economic
recovery, if at all.
Some commentators hold the view that the present
economic crisis is the result of the Greenspan-chaired Fed's extremely loose
monetary policy between 2001 to June 2004. Yet for some strange reason the
same commentators hold the view that Fed's loose monetary policy since
September 2007 has saved
the economy from massive disaster. According to this way of thinking, at
certain times pumping money is bad for the economy, while at other times it
can be of great benefit. We find this logic extraordinary. Something that is
bad cannot also be good. Printing money always undermines the bottom line of
the economy. This is why it is always bad news.
We also find it extraordinary that many experts are
urging the US government to increase its fiscal stimulus in order to strengthen
the expected economic recovery. Again, as with loose monetary policy, loose
fiscal policies can only redistribute the existing pool of real savings. The
greater the fiscal stimulus, the less that is left for wealth generators to
promote real economic growth.
Fed May Consider a Tighter Stance
On account of massive monetary pumping, the growth
in momentum of various key economic data is likely to strengthen in the
months ahead. This, we maintain, may prompt Fed policy makers to consider
curtailing the pace of monetary pumping. In an interview with Reuters, the
Kansas City Federal Reserve Bank president Thomas Hoenig said that the Fed's
massive monetary stimulus must be gently withdrawn as the economy improves.
"There are ways to pull it out when you see the economy showing signs of
stability, pulling out the liquidity slowly, carefully," he said.
Furthermore, Hoenig argues that it is important to
raise interest rates from current levels to a range around their
"neutral" setting — the level where they neither stimulate
nor restrict economic activity in order to prevent future inflation.
According to Hoenig, "[O]nce we get the policy rate in a range —
around neutral — you stay within that range. What we need to do is get
to some level of policy that is more constrained, around a neutral level, and
then let the economy work its way through."
We, however, suggest that once the Fed tightens its
stance — regardless of the neutral interest rate fiction — this
will set an economic bust in motion; that is, it is going to hurt the various
activities that emerged on the back of the Fed's previous loose monetary
stance.
Conclusion
Most experts are of the view that the worst of the
US recession may be over by year's end. Common opinion holds that the key
reason for the expected turnaround is the positive effect that the policies
of the government and Fed have on various economic indicators. The pace of
monetary pumping by the US central bank jumped from 4% in September 2007 to 152%
by December 2008. With respect to fiscal stimulus, aggressive government
spending has resulted in a record deficit of over one trillion dollars in the
first nine months of fiscal year 2009. Careful examination shows that, rather
than protecting the economy, it is loose monetary policies that are the key
source of boom-bust economic cycles. Loose Fed and government fiscal policies
have only weakened the wealth generators' ability to grow the economy.
Aggressive policies have inflicted severe damage to the sources of funding
that support real economic growth. Hence, we are doubtful that the US economy
is on the verge of a solid economic recovery. On account of massive monetary
pumping, the growth in momentum of various key economic data is likely to
strengthen in the months ahead. We maintain this may prompt Fed policy makers
to consider curtailing the pace of monetary pumping, and we suggest that this
will set in motion a new economic bust.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
Also
by Frank Shostak
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