In his Outside the Box e-letter,
February 13, 2012, respected economic commentator John Mauldin presents an
interview with Dr. Lacy Hunt, a highly regarded US financial economist.
According to Hunt the key factor behind the current world economic crisis
— in Europe and the United States in particular — is a very high
level of debt relative to gross domestic product (GDP). For instance in the
United States, as a percentage of GDP, both public- and private-sector debt
is currently at around 400 percent, while in the eurozone
it is 450 percent.
This way of thinking follows in the
footsteps of the famous American economist Irving Fisher who held that a very
high level of debt relative to GDP runs the risk of setting in motion
deflation and in turn a severe economic slump.[1]
According to Fisher the high level of debt sets in motion the following
sequence of events that culminate in a severe economic slump:
1.
The debt liquidation process is set in
motion because of some random shock, for instance, a sudden large fall in the
stock market. The act of debt liquidation forces individuals into distressed
selling of assets.
2.
As a result of the debt liquidation the
money stock starts shrinking, and this in turn slows down the velocity of
money.
3.
A fall in money leads to a decline in the
price level.
4.
The value of people's assets falls while
the value of their liabilities remains intact. This results in a fall in the
net worth, which precipitates bankruptcies.
5.
Profits start to decline, and losses
emerge.
6.
Production, trade, and employment are
curtailed.
7.
All this leads to growing pessimism and a
loss of confidence.
8.
This in turn leads to the hoarding of
money and a further slowing in the velocity of money.
9.
Nominal interest rates fall, however; but
because of a fall in prices, real interest rates rise.
Note that the critical stage in
this story is the stage 2, that is, debt liquidation results in a decline in
the money stock. But why should debt liquidation cause a decline in the money
stock?
Take a producer of consumer goods
who consumes part of his produce and saves the rest. In the market economy
our producer can exchange the saved goods for money. The money that he
receives can be seen as a receipt as it were for the goods he produced and
saved. The money is his claim on these goods.
He can then make a decision to lend
his money to another producer through the mediation of a bank. By lending his
money, the original saver — i.e., lender — transfers his claims
on real savings to the borrower. The borrower can now exercise the money
— i.e., the claims — and secure consumer goods that will support
him while he is engaged in the production of other goods, let us say the
production of tools and machinery.
Observe that once a lender lends
his money he relinquishes his claims on real goods for the duration of the
loan. Can the liquidation of credit, which is fully backed by savings, cause
a decline in the money stock? Once the contract expires on the date of
maturity the borrower returns the money to the original lender. As one can
see, the repayment of the debt, or debt liquidation, doesn't have any effect
on the stock of money.
Things are, however, different when
a bank uses some of the deposited money and lends it out. Remember that the
owner of deposited money continues to exercise demand for money — he
didn't relinquish his claims on real savings in favor of a borrower. Therefore,
when a bank uses some of the deposited money, the bank effectively creates
another claim on real savings. This claim is just empty stuff. While in the
case of fully backed credit the borrower, so to speak, secures goods that
were produced and saved for him.
This is however, not so with
respect to unbacked credit. No goods were produced
and saved here. Consequently, once the borrower exercises the unbacked claims, this must be at the expense of the
holders of fully backed claims. The bank here creates money "out of thin
air." On the date of maturity of the loan, once the money is repaid to
the bank, this type of money must disappear, because it never existed as such
and never had a proper owner.
The Money
Supply and the Pool of Funding
The point that must be emphasized
here is that the fall in the money stock that precedes price deflation and an
economic slump is actually triggered by the previous loose monetary policies
of the central bank and not the liquidation of debt. It is loose monetary
policy that provides support for the creation of unbacked
credit. (Without this support, banks would have difficulty practicing
fractional-reserve lending.) The unbacked credit in
turn leads to the reshuffling of real funding from wealth generators to
non–wealth generators. This in turn weakens the ability to grow the
pool of real funding and in turn weakens the economic growth. Note that the
heart of the economic growth is the pool of real funding, or the pool of real
savings, or the "subsistence fund."
According to Böhm-Bawerk,
The entire wealth of the economical community serves as a subsistence fund, or
advances fund, from this, society draws its subsistence during the period of
production customary in the community.[2]
Similarly von Strigl
wrote,
Let us assume that in some country
production must be completely rebuilt. The only factors of production
available to the population besides labourers are
those factors of production provided by nature. Now, if production is to be
carried out by a roundabout method, let us assume of one year's duration,
then it is self-evident that production can only begin if, in addition to
these originary factors of production, a
subsistence fund is available to the population which will secure their
nourishment and any other needs for a period of one year.… The greater
this fund, the longer is the roundabout factor of production that can be
undertaken, and the greater the output will be. It is clear that under these
conditions the "correct" length of the roundabout method of
production is determined by the size of the subsistence fund or the period of
time for which this fund suffices.[3]
Because of prolonged and aggressive
loose monetary and fiscal policies, a situation can emerge in which the pool
of real funding starts shrinking. In short, there are now more activities
that consume real wealth than activities that produce real wealth. Once the
pool of funding starts falling then anything can trigger the so-called
economic collapse.
Obviously, when things are starting
to fall apart, banks try to get their money back. Once banks get their money
(credit that was created out of thin air) and don't renew loans, the stock of
money must fall. Note however that the consequent price deflation and the
fall in the economy is not caused by the liquidation of debt as such, nor by
the fall of the money supply, but by the fall in the pool of real funding on
account of previous loose monetary and fiscal policies.
The Size of
the Debt and the Severity of the Economic Slump
In his writings, Fisher argued that
the size of the debt determines the severity of an economic slump. He
observed that the deflation following the stock market crash of October 1929
had a greater effect on real spending than the deflation of 1921 had because
nominal debt was much greater in 1929.
We, however, maintain that it is
not the size of the debt as such that determines the severity of a recession
but rather the state of the pool of real funding. Again, it is not the debt
but loose monetary and fiscal policies that cause the misallocation of real
funding. (The level of debt is just a symptom, as it were; it doesn't cause
damage as such.)
By putting the blame on debt as the
cause of economic recessions, one in fact absolves the Fed and the banking
system it maintains from any responsibility for setting the whole thing in
motion. Additionally, once it is accepted that debt can set in motion a
monetary implosion and in turn an economic depression, it appears to justify
the idea that the Fed must step in and lift monetary pumping in order to
offset the disappearing money supply.
However, rather than countering the
emerging depression, what monetary pumping in fact does here is to further
weaken the pool of real funding and thereby deepen the economic crisis. (Note
that many commentators are of the view that, because of price deflation, the
debt burden intensifies. Consequently, it is held that, by means of monetary
printing, this burden can be eased, thereby arresting the economic plunge.
Again we suggest that pumping more money only dilutes the pool of real
funding and makes things much worse.) Additionally, the emergence of monetary
deflation is a positive development for wealth generators, because it slows
down the diversion of real funding toward nonproductive activities.
The Fallacy of
Insufficient Aggregate Demand
Now, both Keynes and Friedman felt
that the Great Depression was due to an insufficiency of aggregate demand,
and so the way to fix the problem was to boost the aggregate demand. For
Keynes, this was to be done by having the federal government borrow more
money and spend it when the private sector wouldn't. Friedman advocated that
the Federal Reserve pump more money to revive the demand. Fisher, while
agreeing that the problem was with insufficient demand, held that
insufficiency of aggregate demand was a symptom of excessive indebtedness.
Therefore, what was needed to contain a major debt depression was to prevent
it ahead of time. You have to prevent the buildup of debt.
Again we suggest that Fisher deals
here with symptoms and not the true cause, which is the declining pool of
real funding that results from loose fiscal and
monetary policies. Additionally, there is never such a thing as insufficient
aggregate demand, as such.
We suggest that an individual's
effective demand is constrained by his ability to produce goods. Demand
cannot stand by itself and be independent — it is limited by
production. Hence what drives the economy is not demand as such but the
production of goods and services. The more goods an individual produces, the
more of other goods he can secure for himself.
In short, an individual's effective
demand is constrained by his production of goods. Demand, therefore, cannot
stand by itself and be an independent driving force.
According to James Mill,
When goods are carried to market
what is wanted is somebody to buy. But to buy, one must have the wherewithal
to pay. It is obviously therefore the collective means of payment which exist
in the whole nation constitute the entire market of the nation. But wherein consist the collective means of payment of the whole
nation? Do they not consist in its annual produce, in the annual revenue of
the general mass of inhabitants? But if a nation's power of purchasing is
exactly measured by its annual produce, as it undoubtedly is; the more you
increase the annual produce, the more by that very act you extend the
national market, the power of purchasing and the actual purchases of the
nation.… Thus it appears that the demand of a nation is always equal to
the produce of a nation. This indeed must be so; for what is the demand of a
nation? The demand of a nation is exactly its power of purchasing. But what
is its power of purchasing? The extent undoubtedly of its annual produce. The
extent of its demand therefore and the extent of its supply are always
exactly commensurate.[4]
If a population of five individuals
produces ten potatoes and five tomatoes — this is all that they can
demand and consume. No government or central-bank tricks can make it possible
to increase effective demand. The only way to raise the ability to consume
more is to raise the ability to produce more.
The dependence of demand on the
production of goods cannot be removed by means of loose-interest-rate policy,
monetary pumping, or government spending.
On the contrary, loose fiscal and
monetary policies will only impoverish real wealth generators and weaken
their ability to produce goods and services. It will weaken effective demand.
What is required to revive the
economy is not boosting aggregate demand but sealing off all the loopholes
for the creation of money out of thin air and curbing government spending.
This will enable true wealth generators to revive the economy by allowing
them to move ahead with the business of wealth generation.
Conclusions
Contrary to the popular way of
thinking, the threat to the US economy is not the high level of debt as such
but loose fiscal and monetary policies that undermine the pool of real
funding. Also, the fall in the money stock that precedes price deflation and
an economic slump is actually triggered by the previous loose monetary and
fiscal policies and not the liquidation of debt as such. Also, once the pool
of funding becomes stagnant or begins to shrink, economic growth follows suit
and the myth that government and central-bank policies can grow the economy
is shattered.
According to Mises,
An essential point in the social
philosophy of interventionism is the existence of an inexhaustible fund which
can be squeezed forever. The whole system of interventionism collapses when
this fountain is drained off: The Santa Claus principle liquidates itself.[5]
Notes
[1] Irving Fisher, Boom and Depressions,
London: George Allen, p. 39.
[2] Eugen von Böhm-Bawerk, The Positive
Theory of Capital, book 6, chapter 5, Macmillan and Co., 1891.
[3] Richard von Strigl,
Capital &
Production, Mises Institute, p. 7.
[4] James Mill, "On the Overproduction
and Underconsumption Fallacies." Edited by
George Reisman, a publication of the Jefferson
School of Philosophy, Economics, and Psychology, 2000.
[5] Ludwig von Mises,
Human Action, chapter 36, "The Crisis of
Interventionism."
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