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Economists are currently divided
on the issue of how strong the US economic recovery is going to be. Some are
of the view that as a result of the stimulus policies of the Fed and the
Federal government, the recovery is going to be quite strong. Some others are
more pessimistic given still-rising unemployment, which they believe will
keep consumer spending subdued. In October the unemployment rate jumped to 10.2%
from 9.8% in the previous month and 6.6% in October last year.
Most economists assess the
so-called economy in terms of gross domestic product, or GDP. This indicator
reflects the amount of money that was spent during a period of time on final
goods and services.
The major component of this
indicator is personal outlays, which comprise almost 70% of GDP. Obviously,
the more money people have, the greater the spendable income is going to be,
hence the greater the GDP is going to be. Consequently, fluctuations in money
supply lead to fluctuations in spendable income and thus to fluctuations in
GDP. To establish the rate of growth of "real GDP," changes in GDP
are adjusted for changes in the prices of goods and services.
Boom-Bust Cycles and the Fed
In our writings we have argued
that the key factor for swings in the money-supply rate of growth is
central-bank monetary policies. Whenever the central bank, i.e., the Fed,
embarks on a loose monetary policy and lifts the money-supply rate of growth,
this increases the monetary expenditure on goods and services, i.e., we have
an increase in the rate of growth of GDP.
Whenever the central bank reverses
its stance, this slows down the expansion in money supply. As a result, the
monetary expenditure on goods and services follows suit, i.e., we have here a
decline in the rate of growth of GDP.
Again, for boom-bust cycles
— i.e., fluctuations in the GDP rate of growth and hence so-called
economic recoveries and recessions — the key is fluctuations in the
rate of growth of money supply.
When the Fed embarks on loose
monetary policy and raises the pace of monetary pumping, this pumping is
taken further by commercial banks. The initial Fed pumping gets amplified by
banks lending out of thin air through fractional-reserve banking.
"By diverting real savings,
increases in money supply in fact strengthen nonproductive activities and
weaken wealth-generating activities."
Now, the key reason for the Fed's
boom-bust monetary policy is the view that economic fluctuations are caused
by various shocks. The role of the central bank is supposed to be to counter
the effect on the economy from these shocks.
It is held that if, in response to
psychological factors, consumers and businesses are not spending enough
money, the central bank must step in and lift the pace of money pumping to
prevent the economy from falling into a recession. Conversely, if, on account
of positive psychological factors, people are overspending, the central bank
must step in and cool off the excessive spending by curtailing the pace of
monetary pumping.
In this way of thinking, the
economy is a ship, and the Fed is the captain who must navigate it onto the
growth path of economic stability.
Money Supply and the Pool of Real
Savings
Changes in money supply not only
set in motion fluctuations in monetary expenditure, but also affect the
underlying real economy.
For instance, whenever the central
bank loosens its monetary stance, the injection of new money into the economy
benefits individuals who receive the newly created money first at the expense
of those individuals who receive the new money later or not at all. The early
recipients can then purchase a greater amount of goods while the prices of
these goods are still unaffected.
Furthermore, because the early
recipients of money are much wealthier now compared to before the monetary
injections took place, they are likely to alter their patterns of
consumption. With greater wealth at their disposal, their demand for
less-essential goods and services expands. The increase in the real wealth of
the first recipients of money gives rise to the demand for goods which, prior
to monetary expansion, would not have been considered.
A change in the pattern of
consumption draws the attention of entrepreneurs who, in order to secure
profits, start to adjust their structure of production in accordance with
this new development. Now, on account of loose money policy, entrepreneurs
find it easy to secure new loans from the banking system — an economic
boom ensues.
What all this means is that
increases in money supply divert real savings from wealth-generating
activities to various activities that emerged on the back of increases in
money supply. Note that without the support from the increase in the money
supply these activities wouldn't emerge, since they wouldn't be able to fund
themselves.
This means that, by diverting real
savings, increases in money supply in fact strengthen nonproductive
activities and weaken wealth-generating activities.
As the pace of monetary pumping
strengthens, the pace of the diversion of real savings also strengthens,
thereby weakening the process of real-wealth generation. As time goes by, the
pace of production of goods and services slows down.
Note that increases in money
supply mean that more money is paid for each unit of real goods, i.e., the
prices of goods have gone up.
With a faster money-supply rate of
growth and a decline in the rate of growth of production of goods, the rate
of increase in prices of goods strengthens further. At that stage, the Fed
tightens its monetary stance to cool off the economy.
"Real GDP has nothing to do
with the real world."
In the final stages of the boom, a
tighter stance by the Fed coupled with the pressure on the pool of real
savings also causes banks to slow down their expansion of credit out of thin
air. So all this leads to a decline in the money supply rate of growth and to
a consequent reduction of the pressure on the pool of real savings.
With the decline in the money-supply
rate of growth, the support for various goods and services that emerged on
the back of the previous, loose monetary policy weakens, and consequently
various structures that were created to support these goods and services
become too expensive to run.
As a result, various activities
that prospered on the back of increases in money supply now find it difficult
to stay alive. In short, a tighter stance weakens the diversion of real
savings to these activities.
In this sense a tighter monetary
stance is good news for wealth generators, since less real savings is now
being taken away from them.
As the tighter monetary stance
intensifies and the recession deepens on account of the liquidation of
various nonproductive activities, wealth generators can move ahead and
strengthen the pool of real savings.
At some point, however, the Fed
aborts its tight stance and thus renews the support for nonproductive
activities by again diverting real savings.
Commercial-Bank Lending and the
State of the Pool of Real Savings
As long as the pool of real
savings holds up, commercial banks are likely to cooperate with the Fed's
monetary pumping and convert it into a stronger money-supply rate of growth.
However, if the pool of real
savings is in trouble, banks are likely to ignore the pumping by the Fed. Why
is that so?
A fall in the pool of real savings
means that less real wealth can be generated. This in turn means that the
quality of banks' assets is likely to come under pressure. Obviously, this
leads to the curtailment of credit and the curtailment of the expansion of
credit out of thin air.
All this puts pressure on the rate
of growth of the money supply. When the damage to the pool of real savings is
severe, this is likely to be mirrored by a much more severe curtailment in
credit expansion by banks.
As a rule, an important factor
that inflicts damage on the pool of real savings is loose monetary policies
of the Fed. By means of strong monetary pumping and a drastic lowering of
interest rates, the Fed can seriously damage the process of real-savings formation,
thereby setting in motion a severe economic crisis.
Another factor that inflicts
damage on the pool of real savings is the government's loose fiscal policies.
Loose fiscal policy also diverts real savings from wealth generators to
nonproductive activities.
From what was said so far we can
infer that as long as the pool of real savings is growing, the Fed is likely
to find it relatively easy to revive commercial banks' expansion of credit
out of thin air and boost the money-supply rate of growth via loose monetary
policy.
In the framework of a shrinking
pool of real savings with the consequent decline in credit expansion out of
thin air, the Fed's loose monetary policy is likely to encounter difficulties
in setting in motion a sustainable increase in the money-supply rate of
growth.
Consequently, the Fed's loose
monetary stance is likely to encounter difficulties in generating a sustained
economic recovery in terms of real GDP.
Does Real GDP Reflect Reality?
In our writings, we have shown
that monetary pumping cannot be a catalyst for economic growth. If it could,
then world poverty would have been eradicated a long time ago.
The so-called real economic growth
as depicted by real GDP has nothing to do with the real world. It is only on
account of misleading price deflators that the increase in money supply leads
to the increase in so-called real GDP.
"The fall in bank credit
raises the likelihood that the pool of real savings is actually
declining."
In reality, however, an increase
in money supply by a given percentage in a particular market simply raises
the price of a given good in this market by the percentage increase in money
supply. This in turn means that the change in spending in real terms will be
nil.
Thus, if monetary expenditure on
tomatoes goes up by 10%, all other things being equal, the price of tomatoes
will also go up by 10%. (Remember, the price of a good is just the amount of
money paid for it). In real terms, however, the rate of increase is nil,
since the 10% increase in monetary expenditure is offset by the 10% increase
in the price of tomatoes.
If instead we were to employ an
average-price increase (the GDP framework deals with average prices) and use
it in the calculation of spending in real terms, we could get misleading results.
For instance imagine that money moved only to tomatoes and didn't as yet move
to the market for potatoes. The average increase in the prices of these two
goods will be (10% + 0%) / 2 = 5%. If we now adjust the increase in monetary
expenditure of 10% by 5% we will get an increase in real spending of 5%.
Note again that if monetary
pumping could be an agent of economic growth, then all our economic
difficulties would have been fixed a long time ago.
What Does It All Mean for the
Economy in Terms of GDP Ahead?
As long as the pool of real
savings is growing, loose monetary and fiscal policies can appear to be
effective in driving the real economic growth in terms of so-called real GDP.
However, once the pool of real
savings is in trouble, the illusion that monetary and fiscal policies can
grow the economy in terms of real GDP is shattered.
We suggest that the loose monetary
policy of the Fed from 2001 to 2004 was instrumental in a severe depletion of
the pool of real savings. The manifestation of this damage is the gigantic
bubbles that sprang up in various parts of the economy, in particular the
housing market. Also, the fact that banks are now curtailing credit raises
the likelihood that the pool of real savings is severely depleted. This could
be indicative of a sharp fall in the percentage of wealth-generating
activities versus nonproductive, wealth-consuming activities.
Despite massive pumping by the
Fed, banks have so far chosen to curb lending and sit on a massive amount of
cash. (The yearly rate of growth of the Fed's balance sheet jumped to 153% in
December last year). So far in November, banks' excess cash reserves stand at
$1,046 billion against $1.9 billion in August last year.
 
Year on year, the rate of growth
of bank loans fell in November so far to −7.5% from −7.4% in
October — this is the seventh consecutive monthly decline.
Our monetary measure AMS[1] has
fallen 9.9% so far in November this year from November last year. This is the
second consecutive monthly decline.
The various rescue packages and
further monetary pumping by the Fed are bad news for the process of wealth
formation. Consequently, all the positives for wealth generation on account
of a tighter monetary stance from June 2004 to September 2007 have likely
been erased by the stimulus policies since. Hence, the fall in bank credit
raises the likelihood that the pool of real savings is actually declining.
Based on this, we suggest that
until the pool of real savings starts to expand again, banks will have
difficulty engaging in an expansion of credit. As a result, the money-supply
rate of growth, all other things being equal, will stay under pressure.
Obviously, this cannot be good news for economic growth in terms of real GDP.
There is always the possibility
that the Fed could embark on the so-called helicopter-money scheme and try to
bypass the banking sector. This, however, would only damage the true economy
further and thus force the Fed to abort such a scheme.
Quantifying the Future Course of
Real GDP
After closing at 1.8% in August
last year, the yearly rate of growth of our monetary measure AMS jumped to 33%
by November. Since then, the rate of growth has been on a declining path: it
stood at 23.8% in August this year before falling to −6.3% in October
and −9.9% so far in November.
The strong money pumping from
August last year until August this year is likely to manifest itself in the
strengthening in the growth momentum of GDP. Given the still-subdued price
indexes, this is likely to result in a visible strengthening in the real-GDP
rate of growth. (Remember, this is on account of misleading deflators).
As a result of a recent, steep
fall in the growth momentum of AMS, we forecast that the growth momentum of
real GDP will come under pressure in Q2 next year. (Year on year, the rate of
growth is forecast to rise to 1.7% in Q1 next year before falling to −0.2%
in Q4). Again, please note that real GDP has nothing to do with the true
state of the economy.
Conclusions
In the so-called
"normal" business cycles since the post World War II period, the
Fed seemed to be able to revive the US economy with relative ease whenever it
fell into recession. All that the US central bank had to do was raise the
pace of monetary pumping and the rest would appear to follow suit. It seems
that the Fed is now encountering massive difficulties in reviving economic
activity in terms of real GDP.
Despite massive pumping — in
December last year the yearly rate of growth of the Fed's balance sheet
jumped to 153% — economic activity remains depressed. We suggest that
the key here is commercial-bank lending. Without support from commercial
banks, the Fed will find it difficult to revive economic activity. As a
result of past and present loose monetary and fiscal policies, the process of
real-wealth generation has been severely damaged. This, we suggest, has
increased the risks that banks would incur in lifting the supply of credit.
As long as the
pool of real savings — the key for the process of real-wealth formation
— is under pressure, bank lending is also likely to remain paralyzed.
On account of a strong rebound in the money-supply rate of growth between
August last year and August this year, the economy in terms of GDP is likely
to strengthen in the months ahead. However, a collapse in the money supply
since October raises the likelihood of a fall in the GDP rate of growth from
the second half of next year. Various measures to revive the economy are
likely to make things much worse because they only weaken the pool of real
savings.
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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