Y’all ain’t Japanese

A national economy is made up of many organisations and individuals. The activities of some will be profitable and the activities of others will not. The mechansim which ensures that the majority of activities in an economy are profitable (and thus the health and growth of an economy) is that the individuals and organisations concerned bear the costs involved in failure. For when a company makes a loss it means that the resources required to sustain its activities are considered more valuable (by the market place) than the goods and services that came out of it. However the goods flowing into the organisation are (or should be) paid for by shareholders whilst only the goods and services flowing out of it are paid for by consumers and thus by anyone other than the shareholders. As such, when a company begins to make a loss it is first and foremost the shareholders that should call for and bring about the dissolution of the company – for it is they who stand to lose the most.

If this fail-safe mechanism is removed and companies that make losses are allowed to persist through the use of public funds to sustain their existence then we have a problem… a big problem. For in that case there is no incentive for the individuals and organisations to make profits. These loss making entities must be sustained at the expense of profitable activities and hence hinder the ability of the economy to turn a profit, remain healthy and to grow. When the value of the resources consumed by government sustained loss making industries exceeds the value of the goods and services produced both by these and by genuinely profitable activities, the nation’s economy will begin to shrink.

The road to Tokyo

In the United States today, just as in Japan in the early 1990s, the economy is currently suffering the effects of massive losses steming from the banking sector and is in technical recession. No better example can be found of an industry which continues to exist but for the grace of government intervention. The government granted monopoly that the central bank enjoys in the creation of legal tender, the ability of banks to maintain but a fraction of their reserves without fear of a bank run because they are protected by the lender of last resort, FDIC insurance and if all else fails the ad-hoc creation of facilities such as the TARP make absolutely certain that whether you make profits or losses, in the banking industry, there is no such thing as failure. Further, the fractional reserve system ensures that the majority of the money that banks lose is not owned by the shareholders of the banks concerned but by the depositors who trusted those banks (once again as a result of government meddling, for it is government guarantees that has led depositors to think of these institutions as safe houses for money – rather than the highly leveraged investment vehicles that they really are).

However, spectacular as thy are, the losses in the banking sector are but the beginning of a slippery slope that most western nations have begun to walk down and, bizarrely, they seem to be lathering themselves up with soap and smiling in gay Keynesian confidence as they do so. Various mainstream commentators have predicted a return to growth some time in 2009 as the “stimulus plan” starts to take effect and the IEA even takes this as a given when it predicts demand for oil rising in 2009 for the same reasons. However it is hard to see the basis for such optimistic views of a return to recovery – these predictions are merely wild stabs in the dark. Sometimes the estimates for a return to growth are based on empirical evidence such as the “average length” of the last X recessions or the “average fall in house prices” in the last Y housing busts. But we are not in any of the last X recessions – we’re in this one! Surely there must be more fundamental reasons upon which we could base our expectations for the future.

At first glance, the slippery slope that the western nations are lathering themselves up for looks deceptively like the path that the Japanese walked down. I dug up an article written by Benjamin Powell back in 2002 where he described Japan’s Recession (from Keynesian, Monetarist and Austrian perspectives) and 6 years later it appears that very little has changed. Indeed why would it? Would we expect the Japanese economy to have recovered since then based on empirical evidence concerning the average length of recessions in Japan in the last 50, 100 or 1000 years? Certainly not – we’d expect the Japanese recession to end when the Japanese economy returns to profitability and that would require changes that the Japanese have not yet made. For just as it was the case back in 2002 when Powell was writing it is still the case today that Japan’s government and her major trading houses have refused to allow their unprofitable enterprises (starting with their banks) to go under. 

…is blocked

Thus it is tempting to think that if western governments engage in policies similar to those of the Japanese, such as “quantitative easing” and keeping failed companies on life support, then we might expect much the same results. However today, as was the case in the 1990s, Japan is very different from most western nations in one crucial respect: Japan maintains a consistent trade surplus. This is a statement of the obvious, however it was not until recently that I realised why this was so important. Quite by accident I stumbled upon the answer in the Murphy vs. Schiff article that I wrote last week, which analysed an old disagreement between Robert Murphy and Peter Schiff about whether a consistent trade deficit was sustainable or not. It turns out (as I describe in that article) that the answer to that question is, “Yes – providing that both the lending and the borrowing economies are growing and that the economy doing the borrowing is able to increase its productive output by enough to pay the interest on the loan”.

The United States has maintained a persistent trade deficit since the last time it went broke in 1971 and was forced to abandoned the gold standard (and thus refused to redeem certificates of deposit that had previously been exchangeable for physical gold). Remarkably, and presumably because it was the best of a bad set of options, foreign investors continued to put stock in the US dollar following that technical default and have continued to buy US bonds ever since that time. And  so long as the US economy continues to grow more or less consistently, this situation is sustainable. For whilst the US economy is growing, foreign investors have reasonably good reason to believe both that the bonds they purchase are in a currency which will hold its value until the maturity of the bond and that the US financial position will remain sound enough that there is little risk of default.

However it appears that question marks are now starting to form over both of these assumptions with respect to western debt and, in the long term, with respect to the debt of the United States in particular.

Grave digging

Firstly, the Fed’s efforts to “stimulate” the economy through the use of traditional monetarist techniques having amounted mostly to string pushing, the Obama administration seems willing to revive Keynesian investment in shovels and overalls. For those who are unfamiliar with the analogy, Keynes argued for government expenditure in order to get money flowing through the veins of the economy even if all the government did was to pay people to dig holes and fill them in again (since this would at least create a demand for overalls and shovels and get money in consumer’s pockets so that they could demand other products). However, the quantity of available resources in the economy is finite and so if Obama and Co command an even greater percentage of those finite resources than they presently command, (in order to dig holes and fill them in again – or to build highways, as it appears they are promising), this means that there are less resources available for use by the free market – i.e. the guys that actually have to make a profit and, as a consequence, do the lion’s share of the producing. Increased government expenditure will inevitably result in lower productivity and most likely will simply lead to even greater losses… These policies are clearly focused on employment but it is not productive employment. This cannot be expected to achieve anything but keep the crew busy playing cards while the ship is sinking.

Secondly, the myriad of new schemes that have sprung into existence, such as the TARP, which allow the treasury and Fed to purchase rubbish assets from the market in order to pretend that companies and banks that made spectacular losses didn’t actually make losses (and aren’t presently bankrupt), or the use of public funds to bail out loss making entities such as GM and Chrysler, is just more of the bad medicine that the Japanese took  and which will, just as was the case in Japan, delay any return to profitability.

So the Obama plan amounts to starting lots of new loss making entities to run along side the existing ones (which we’re not going to let fail)…. all of which will cost money – a lot of money. The monetary base has expanded, over recent months, at an annualised rate of around 1400% – a staggering rate. Investment analysts such as John Mauldin argue that much of this is simply to cover historic losses and will not result in the extension of new credit and thus monetary and price inflation. However Mauldin also admits that at the same time the Fed is monetising debt directly to the tune of 800 billion dollars… which most certainly is an increase in the real monetary base used to extend credit and could thus form the basis of perhaps 8 trillion in extra money in the market place.

This does not inspire confidence in the stability of the US dollar medium to long term. For the time being, the expansion of reserves has not morphed into additional lending on the part of the commercial banks and thus any significant price inflation. But if government plans to “kick start” the economy (to use their crude analogy) are actually to work then eventually they require companies and individuals to start borrowing again and for banks to start lending again. When that happens, will the Fed be able to prevent the unprecedented expansion in the monetary base above from turning into an unprecedented rise in prices? Typically there is a lag of around 18 to 24 months between Fed monetary policy and resulting inflation, so they will have to be particularly prescient indeed if they wish to avoid serious inflation coming back to bite them as a result of their aggressive monetary policy of late. Although most economists and governments are not presently very concerned about inflation, this is possibly the biggest risk for the US economy in the road that lies ahead, since it could lead to the complete collapse of the monetary unit.

So what’s new?

The US has suffered at least 3 serious recessions in the course of the last 37 years in which it has maintained a trade deficit, and yet the dollar is still intact today. However, as I have already mentioned, we are not in any of the previous recessions – we’re in this one…

In 2001 the economy was able to rise from the ashes by injecting cheap money which lead to a housing boom, putting money in the pockets of consumers – the so called “engine” of the US economy. However this was a false boom funded by the consumption of capital and could not last. Consumer spending during this time was supplemented by Mortgage Equity Withdrawals and a delusion that the economy was still running at a profit. Without these Mortgage Equity Withdrawals (not to mention expenditure funded by a false boom in the price of other asset classes) the US economy would have been in technical recession on more than one occasion in the last 7 years. Indeed many believe that the current crisis is simply the perpetuation of the troubles that first raised their head in 2001… only now the condition is, as the Austrian’s predicted would happen if the patient refused to take their medicine, much much worse.

Analysts such as John Mauldin believe that we are in for a repeat of the 1980s, when US banks once again lost depositors money (to South American governments that time round). In the 80s the troubled banks were permitted (with a little bit of fudging) to pretend that they weren’t bankrupt by swapping bad assets for good, just as is happening at present, for long enough to recover all the money they lost and return to solvency. However Mauldin assumes, just as all mainstream commentators are assuming, that the recession will magically go away in 2009… leading to the profits required to pay off past debts. None of these commentators offers a convincing explanation as to how this magical recovery will come to pass however – all of them assume that the stimulus plan will somehow bring about improvements in the productive output of the economy. The fundamental principles from the first two paragraphs of this article would tend to indicate quite the opposite.

Mauldin ignores the fact that extremely tight monetary policy endured during the 1980s and there are good reasons to believe that precisely that tight monetary policy helped bring about eventual recovery. With mortgage rates in the 10-15% range during that decade, the scarce resources of the economy were not being borrowed willy nilly to build second houses by people who had no incomes. Instead these were being reserved for companies and individuals that could make a good rate of return on money that they borrowed – sufficient to pay hefty interest rates. As such, loss making activities were culled off and profitable activities took their place. This is the direct opposite of what has happened in Japan and what is currently happening in the west today.

If the Monetarist and Keynesian policies that governments are currently pursuing result in stagnation and negative growth, as we would expect, then a repeat of the 1980s does not appear to be likely. Further, although a long drawn out recession such as the one that the Japanese have experienced might take root in the West it cannot hold. The West maintains a trade deficit and the longer that nations with trade deficits take to return to growth, the greater their debts become relative to their GDP and the harder it then becomes to return to growth… a vicious circle is entered as an ever greater portion of their GDP is allocated to paying bond yields rather than investment. We can see glimpses of the possible futures for these economies in the examples of Italy, then Greece, followed by Argentina (which defaulted in 2001) and finally for the really stupid, who refuse to learn even basic economics, the end of the line is Zimbabwe… It is thus a great pity that the people of the west today (and in particular their governments) do not yet seem ready to engage themselves in Volcker style belt tightening. They seem far more inclined to dispense with the belt and indeed the pants in a return to the flower power style economics that brought about the technical default of the United States and forced it to abandon the gold standard in 1971.


If foreign bond holders stick in there through thick and thin (and negative real yields) and if the East continues to see sufficient growth to continue to lend to the West, then western economies might survive despite government intervention (not because of it). Sufficient growth could conceivably be realised by way of technological and business process improvements, in those sectors of the economy that governments keep their paws off, to offset the vast sums of money that governments will lose through their increased involvement. However the western economies will certainly be severely weakened as a result. They may have to sell capital to the East in order to dig themselves out of spiralling debt. The USA may not come out of it as the world’s number one economy any longer and the US dollar may lose its status as the reserve currency of choice (if indeed it survives).

Western nations have few options available to them. They can attempt to “make money cheap” but this will not make real savings (the real problem) any less scarce – it will simply serve to erode the ability of the economy to distinguish between profitable and non-profitable activities, ensuring that what will certainly be a painful correction will also be a long one. They can keep loss making companies on life support, but this will merely keep labour and capital trapped in non-profitable activities rather than freeing it up to move into profitable sectors of the economy. Once again this will merely serve to frustrate the ability of the economy to return to profitability and growth. If they should fail to return to growth and bond holders should slowly come to realise the folly of lending to an entity that is making consistent losses and becoming ever and ever more unlikely to pay back its loans or if those lending to the west should see their own growth (and their ability to lend) arrested, then eventually the reality is going to come home to bite.

We tread a fine line on the precipice of a very slippery slope which, in the worst case, could ultimately end in monetary collapse and which will likely simply bring us closer to the living standards of the former U.S.S.R. Government moves to assume greater control over the economy cannot take western nations further away from that precipice. On the contrary, they plunge us head first over the edge. For what the west lacks is not consumption (public or private) but production of the kind that can only result from profitable economic activity and, thus, from a free market where companies are allowed to fail – a market where neither government nor government sponsored loss making entities can command the scarce resources which are needed by entrepreneurs to run profitable companies. It is profit making individuals and companies which are the real engine of the economy – not just the US economy but the world economy.

Murphy vs. Schiff

Back in September 2007 Robert Murphy posted an article concerning one of the analogies that Peter Schiff makes in his book Crash Proof. Schiff’s argument is essentially that persistent trade deficits are unsustainable and Murphy’s article attempts to refute this.

Since I appear to have fallen into the same trap as Schiff in one of my recent posts, Murphy’s article got me thinking and the following is an attempt to clarify the objections to Schiff’s argument and my previous post, both for myself and the reader. With a bit of luck I can also add a bit to the discussion that was not covered in either Schiff’s book or Murphy’s post.

I’m going to do this by telling a story similar to the one in my somewhat naive Feasts to cure famine post, but where the previous story described farmers who both raised sheep and grew tomatoes, in this story I’m going to dispense with the tomatoes.

American Farm Inc.

Initially our farmers start out with enough sheep to eat a couple of lamb chops a day, as well as keep aside enough breeding sheep to maintain the same level of consumption year after year. In the second year of production the farmers decide to go it rough for a bit and save. Instead of eating two lamb chops per day they only eat one. Their savings (and their short term hardship) mean that at the end of the year they then have enough sheep left for breading that in the following year they have way more lambs and can now eat 3 lamb chops per day (and have enough sheep left over to maintain the same population of sheep the next year).

Basically the point here is to illustrate that savings (and thus delaying immediate consumption) are required in order to provide the capital to invest in improved productive output and thus provide long term gains. Essentially the same process happens in the real economy when savings are invested in factories and other round about production methods but it’s much easier to see in the case of lambs and sheep. In either case, the investment of capital and the decision to delay immediate consumption is made for what is hoped to be even greater profits (and eventual consumption) at some stage in the future.

Now in the fourth year, rather than keeping enough spring lambs and tomatoes aside to sustain their current consumption (long term) they do the opposite of what they did in year two and they consume 4 lamb chops per day. However in order to do this they had to eat into their capital reserves (lambs that were to become breeding sheep for the following year). As such in year 5 they only have enough lambs to provide a dismal 2 lamb chops per day. The farmers thus find themselves in the same situation in which they started. This point is just as important as the point in the previous paragraph. For if delayed consumption and positive savings can provide the necessary capital to increase the productive output of an economy then it is also true that negative savings can have the opposite effect.

Now let’s imagine that in year 6 the farmers decide that they’d like to be back where they were before (eating 3 or even 4 lamb chops per day). However they don’t really feel like saving and going through the whole 1 lamb chop a day thing for another year in order to be able to save the capital required to get their production back up to previous levels. So this time round they decide to borrow some sheep from the Chinese down the road.

The story can now go one of two different directions. If Peter Schiff were telling it then the farmers would, in year 6, eat ALL the sheep that they borrow from the Chinese. If Murphy was telling it then they would invest at least some of the sheep that they borrow in future production (i.e. keep them aside for breeding)… and this is where the analysis of Murphy differs from Schiff [1]. For Schiff assumes that the US trade deficit is currently used entirely to sustain over consumption.

So let’s run with a Bob Murphy version of the tale. Let’s imagine the farmers do not consume all the goods that they import but instead choose to invest a certain portion of them with a mind to boost their future production. What are our possible outcomes? Effectively the farmers are borrowing savings and can choose what portion of those savings they want to use for immediate consumption and what portion they want to invest in future production.

  1. If too much is invested in short term consumption then they will not be able to improve their productive output enough to pay back even all the interest on the loan (much less the principal). In this case the farmers are in a worse position than they were before having taken the loan out… this kind of borrowing is clearly unsustainable and consumption must be curbed in order to bring the economy back within sustainable limits (if this is still possible).
  2. If just enough is invested, their productive output will be increased enough that they can continue to pay the interest on their loan (and thus they don’t go any further into debt). There is no real point in this outcome from the farmers’ point of view although it works out OK for the Chinese lenders.
  3. If they get it right then they can improve their productive output enough to both pay back the interest and have some left over (which could be used either to enjoy higher levels of consumption or to pay down the principle on their loan).
  4. If they invest too much in long term production then they might even run into shortages and insufficient lamb chops to sustain immediate consumption. In the case of our lambs and sheep this isn’t such a problem, since you can go out and cannibalise your capital (i.e. your breeding sheep) and turn them into consumer goods (mutton, if not lamb chops) reasonably easy. In the real world economy it isn’t always so easy to convert factories into cherry pies though and so this is a very real possibility.

Let’s imagine that what played out was scenario number 3. This turned out to be profitable for both the Chinese and the US farmers. Now if borrowing from the Chinese in scenario number 3 turned out to be so profitable in year 6, why wouldn’t the farmers do it again in year 7 for an even larger quantity of sheep? Suppose this is what occurs and suppose the Chinese economy is also growing. In year 6 the famers borrow 10,000 spring lambs and in year 7 they pay back 6,000 of these (so they still have 4,000 outstanding) but they strike a new deal with the Chinese for a further loan of 20,000 lambs. Essentially they now have a net import of 14,000 lambs where in the previous year they had imported only 10,000. Clearly their trade deficit has increased, but so have the revenues that the Chinese are earning from their loans to the US farmers and (the important bit) the productivity of the US farmers has increased by enough to pay for all of this.

What is important then is not the trade deficit, but that the economy which is borrowing is able to improve its productive output, as a result of the loans, by enough to both pay back the interest and to reap some gains (which could be used either for consumption or to pay back the principal). If this is not the case then the lending does not make sense and will only detract from the profitability of the economy doing the borrowing… eventually perhaps to the point where they start to make a loss.

If the productive output of the US farmers were to shrink for any significant amount of time then no doubt both lender and borrower would do well to re-evaluate the wisdom of further borrowing. For the purpose of borrowing should not be to sustain unprofitable economic activity but to enable profitable activity. Just as companies that consistently make losses eventually find it difficult to obtain loans, so too do countries.

Therefore as long as the US (real world US) is able to continue to pay sufficient yeild on their bonds to entice people to buy them and as long as the US economy continues to grow, a persistent trade deficit in and of itself is not necessarily cause for concern.

There is one further complication in the real world, which is not reflected in the simple story above, which is that in the real world international investors in US Inc. are implicitly making a currency play. Anyone purchasing US denominated assets and investing in the United States is taking a risk on the exchange rate. If I live in Japan and buy US bonds that pay a yeild of 2% over 12 months but the USD drops against the Yen over the same period by 10% then it’s clear that I’ve made a real loss, in terms of my buying power. Similarly the USD could shift in the opposite direction and increase my profits. As such, the spectre of inflation is ever looming over the Federal Reserve that runs the printing press over at US Inc. For if they should ever let this cat out of the bag then they will have to pay a hefty yield on their bonds in order to entice ever more wary investors to buy their bonds… and an increased yeild on bonds would perhaps turn an otherwise profitable economy into one that was instead making a loss. On this, at least it seems that both Murphy and Schiff agree that the early signs aren’t good.

[1] Note that Murphy also discusses, at some length, the distinction between service and manufacturing but I figured this was probably because Schiff placed so much emphasis on the recent trend towards service industries in the US. To my mind this wasn’t really relevant. There is no difference between the profits that banks make and the profits that manufacturers make. In both cases what goes into the entity is a set of goods/capital that is considered (by the markets) to be inferior in value to what comes out of them. So a profitable company is a profitable company, regardless of the origin of its profits (service or manufacturing)… similarly a country can export services or manufacturing goods to the world. What is important is not the nature of the goods but their relative values in the free market.

It may be that the conventional statistics measuring imports/exports fail to take account of certain profits but that wasn’t really what interested me. I was interested in discovering, assuming that perfect statistics could be maintained, whether a consistent trade deficit was sustainable and whether continued investment by outside parties count be considered reasonable. I think the analogy we’re using above takes care of this since the only good involved is sheep – thus all profits are measurable and nothing can slip through the cracks.

Let them eat cake

Inflationary booms

Imagine the average price for a house is $100. You buy a house for $100 (putting down $50 and borrowing the other $50 from the bank).  Now imagine that the average price of houses rises to $300 and so you put your house on the market and realise that $200 profit… Then you set out to do some serious shopping! So far so good.

Presuming the productive output of the economy does not change to any great degree, there are two reasons why average house prices might have gone up so much. The first reason would be a change in people’s preferences – so basically houses became more of a priority to them (relative to other stuff). That kind of increase in house prices must necessarily be matched by a decrease the price of one or more other goods in the economy though. The second reason, therefore, why house prices might go up (in nominal terms) is due to an expansion of the monetary supply (monetary inflation).

When house prices go up as a result of inflation, people tend not to take the inflation into account… they see a 50% rise in prices and they feel like they’ve just made 50%. Even when they do take inflation into account they tend to do so on the basis of historical inflation and not on the basis of future inflation (which is much harder to estimate). So when inflation is on the rise (and driving up asset prices) people tend to underestimate inflation and overestimate real capital gains.

For a while, seeing the Jones’ making capital gains on their house can induce the Smiths, McDonalds and Taylors to buy houses of their own, each looking to make a capital gain… which can lead to a speculative boom in housing and a lot of people making a lot of money and doing, as a result, quite a lot of shopping. Life seems good.

However if the boom in housing was indeed driven by inflation, these capital gains are somewhat misleading – for they are nominal profits only, which do not reflect any real profits (i.e. additional goods and services in the economy). They are not the same as real profits, where you start with 10 apples and you end up with 100… these are imaginary profits where the economy as a whole starts off with 100 apples and ends up with exactly the same amount (100 apples) only now the distribution has changed so that some people have more apples and others have less. However, those with more apples then act just as they would if real profits had been made and they proceed to enjoy the benefits of their labour and eat some of their apples.

As such, although those buying and selling houses may be making astute decisions as individuals, the economy as a whole is miscalculating. The inflationary boom does not create real wealth – it merely creates the illusion of wealth for those individuals making the profits, but these profits are paid for 100% by other sectors of the economy (and thus by other individuals). Those who buy houses for $100 and sell then for $300 have the impression that profits have been made and so they proceed to spend  their hard earned money (on furniture, holidays, alcohol etc.). However what they spend is not real profits… for the economy has not actually made any real profits – it’s simply played a game of musical dollar notes. What these people spend is necessarily savings and capital… they eat away at the savings and capital in the economy that are used to produce things.

It can certainly be argued that not all price rises occur as a result of inflation and the example above oversimplifies reality by attributing 100% of the rise in prices to inflation. One could easily imagine a situation in which only 50% of the rise in prices was due to inflation and the other 50% was due to increased demand… in which case you could hazard a guess and say that perhaps 50% of the profits were genuine and 50% merely perceived… However as long as the beneficiaries of the inflationary boom spend 100% of their hard earned gains, at the end of the day they will be spending profits plus savings and will be eating into the savings and capital of the economy.

If we have a stable supply of goods and services then it is impossible to have a general increase in the price of all goods and services without an accompanying monetary expansion. Thus whenever we see general price rises (without a fall in general supply) we necessarily have nominal prices rising as a result of monetary expansion and thus we have people whose expenditure is sustained not by profits but by eating away at the base of savings and capital in the economy.

Of course, such a situation can only persist until such a time as the real savings and capital are exhausted. When that happens there is necessarily a bust to counter the boom and some difficult choices must be made.

The Economist

In The end of the affair we read the bust described in terms that have become depressingly familiar in mainstream media.

The article starts with one Ms Jeffries who, in her role as a sales person at Linens ‘n Things notices that prior to the realisation of the crisis a lot of her customers were heavily indebted. The article describes a long trend of rising asset prices leading up to this situation (at no time is this attributed to inflation); then a reversal of the rising asset prices (unexplained) that is determined to be the cause for lacklustre spending which is, according to the article, the major problem and the one that needs to be addressed. The article then considers the possibility that people’s savings rates are predicted to rise to as much as 4.5% by the end of the year (heaven forbid). Another story follows about an employee at the Maryland country club who describes the reluctance of customers to drink beer and order lunch when they play golf and how, in these troubled times, they’re instead just buying crackers and soda. The article then illustrates once more that credit is harder to come by than it used to be and finally, without any logical connection that I could see, states quite simply, “This makes a strong case for more government stimulus” along with some drivel which basically amounts to broad support for democratic plans for government spending.

Another  article on the same page (in the print version of the magazine) provides a bit more detail about the democratic plans that include giving $25 billion dollars to the car industry (to reward them for being incapable of making a profit), giving $38 billion to state governments (to reward them for not being able to keep expenditure within the confines of their revenues) and issuing $6.5 billion in additional unemployed benefits (to people that don’t have any revenue and so for which the idea of profitability doesn’t even enter into the question). Not a single one of these measures aims to support profitable activities which might produce real wealth. Not a single one of these measures addresses the underlying problem of shrinking savings and thus a shrinking loaf of bread. Without exception the measures focus on how to redistribute savings and thus cut the slices of bread ever thinner and thinner. And when the bread is all gone? Let them eat cake, I suppose…

Consumption driving the economy

The authors at The Economist appear to believe that the current crisis will be aggravated by lacklustre spending. People who only buy crackers and soda instead of buying beer and full lunches are, apparently, the problem. Their conclusion is that their thrifty inclinations must be curbed at all costs – even that of monetary stability and economic calculation. Thus the Federal Reserve should use it’s powers to print money and, if it can’t get people to take out loans to buy beer and full lunches then the Federal Government should step up to the plate to order the food for people.

Following that logic, demand for Ferraris is the reason not everyone drives these. Demand for caviar and champagne is the only reason these are not served on every table on the planet for breakfast, for the mere demand for these things can magic them into existence. All we need is sufficient paper and coins to maintain aggregate demand such that these and any other goods that we find wanting in the economy should be available for all and sundry. The scarcity of anything can now be avoided and poverty will be a thing of the past due to the magic of the printing press and the Federal government who, jointly, are able to maintain aggregate demand at whatever levels we please. Does any of this sound believable?

If demand is so important, why don’t we shift to an economy that is 90% driven by consumption or, heck, maybe even 100% driven by consumption? Ah yes, of course, that pesky issue of supply… and then we realise that all demand, if it is to be satisfied, must be met be supply. Consumption can not ever constitute more than 50% of the economy and where we find this to be the case it is merely due to our definition of the economy being too narrow… we have left from our calculations those portions of the economy doing the supplying and the lending required to temporarily sustain such an imbalance in the portion of the economy that we were concentrating on.

The age old question is therefore not how to increase demand (which, thanks to human creativity, is almost infinite) but how to direct supply such that this best meets demand. If we are to believe these two articles from The Economist, people don’t have what they want because they’re incapable of signalling their demand to producers due to some inexplicable market failure. What is required is for somebody else to print money and step in to order what they believe other people want for them. Government should guess what people demand and then proceed to command the necessary capital required for its construction and deliver it to them, rather than having people signal their demand to suppliers directly. Somehow it is believed that this will result in a more effective economic system to ensure that people’s demands are met by supply. You wanted a Big Mac? Tough, I got you a cheese burger – I’m glad you’re happy. Isn’t this better that the system that we had before where you actually had a say in what you eat?


Feasts to cure famine

You might replace locusts and wolves in this short story with central banks and governments… but that didn’t quite have the dramatic effect that I was after and I would have had to break the flow of the story a bit to explain a whole bunch of other stuff. So, for what it’s worth, here’s some bed time reading for the kids.

Once upon a time…

Imagine a village of around 100 farmers producing enough food that each of them can eat two lamb chops and a couple of tomatoes per day. The famers work hard and save – i.e. they delay immediate consumption. They don’t eat all the tomatoes that they could and they don’t cull all the spare lambs to make chops… instead they invest their savings to replant the seeds of the tomatoes that they don’t eat and let their flocks of sheep grow in number.

For a while, life is pretty tough. They have to get by on a single lamb chop and a single tomato per day, but after a while they manage to improve their productive output such that they now have enough tomatoes and lambs for each farmer to eat 3 tomatoes per day and 3 lamb chops per day. Clearly the standard of living of our village of farmers, in this example, has improved substantially and without doubt their improved standard of living can be attributed to the increase in their productive output, which was made possible by the initial hardship that they endured and consequent savings.

Now let’s imagine that the gods are angry with the farmers for some reason and smite them somehow. Perhaps a swarm of locusts is sent to eat the tomatoes and a pack of wolves attacks the flock. The nature of the disaster is unimportant. For whatever reason, imagine that the locusts eat some of the tomatoes that were set aside for replanting and imagine that the wolves eat some of the lambs that were supposed to be saved to maintain the number in the flock. The result is that the farmers now only have enough tomatoes and lambs to either:

  • 1. Continue to eat 3 chops and 3 tomatoes a day until the end of the year, but only replant sufficient seeds and leave sufficient sheep in the heard such that next year their output will drop to previous levels… levels that would only sustain 2 lamb chops and 2 tomatoes per day.
  • 2. Delay consumption immediately and eat less tomatoes and lamb chops now, so that they are able to replant enough tomato seeds and maintain enough reproducing sheep that they will be able to maintain their productive output for next season… meaning that next year they will be able to eat 3 chops and 3 tomatoes per day again.

As such, our farmers now have a fairly easy choice to make. The locusts and the wolves have come and gone – and they’ve taken some of the famer’s savings with them… as such, there’s going to be some hardship. The farmers are going to see their consumption impacted negatively and all that is left for them to decide is when: now or next year? They have a choice between current consumption and savings (i.e. future consumption).

However one of the farmers is an economist and, after thinking for a bit, he comes up with a theory that he thinks is pretty solid – which he calls the “paradox of thrift”. Basically his theory runs along the lines, look if we start consuming less then farms are going to have less income and thus they’re going to have to cut production to reduce costs, which will mean they’ll be paying farmers less and farmers will have less to spend so they’ll cut consumption even further and on and on until eventually we’re just not producing anything at all. As such, although it might seems a bit counter-intuitive, actually what we need to do is stop saving and consume more. It is not savings that drive our economy, but consumption – it is eating that is the back bone of this community and we have to keep eating in order to maintain our production.

The other farmers find this argument quite persuasive. If the economist is right then they don’t have to delay consumption at all. Their standard of living doesn’t have to drop temporarily… indeed the economist has made it sound like it might not ever have to drop. The main thing that they have to focus on is eating, and eating is something they do best.

Consequently, the farmers agree to continue eating at previous levels, so that their farms can retain the “high incomes” that they had before. However their choice was initially one of current or future consumption and nothing that the economist said has changed that. In choosing to continue current levels of consumption the farmers neglect to keep enough tomatoes and reproducing sheep aside to maintain the size of their crops and flocks and thus, rather predictably, come the next season the farmers are only producing enough to be able to eat 2 lamb chops and 2 tomatoes per day if they want to keep enough tomatoes and reproducing sheep aside to be able to replant crops and maintain the size of these.

The economist is adamant though. He believes the current “recession” is a temporary lull and that all that it will all be fine as long as the farmers can simply maintain a good solid level of consumption. The farmers aren’t so sure any more and they don’t want to eat through yet more savings – they’re worried that perhaps next year they might find themselves down to only a single lamb chop and a single tomato per day… which wouldn’t leave them much room to save and reinvest in production. Still, they don’t really like the idea of doing that immediately either and so they agree to borrow some tomatoes and lambs from the Chinese farmers down the road (who have just had a bumper crop).

The Chinese farmers agree. They say OK look, we’ll lend you 3,650 lamb chops and 3,650 tomatoes (enough for one per famer for an entire year). However when you’ve managed to turn your economy around next year we expect each of you to give us 4000 lamb chops and 4000 tomatoes back. This is decided to be a satisfactory arrangement and so the farmers continue to eat 3 lamb chops and 3 tomatoes per week. For the time being and, as the economist predicted, they have managed to avoid the negative consequences of the locusts and the wolves – they are not had to delay immediate consumption in favour of future consumption (i.e. they have not had to save) and their economy keeps “rolling along”.

Come the next year though, the farmers find them selves in the same situation. Having maintained consumption of 3 chops and 3 tomatoes a week they weren’t able to save any more tomatoes or reproducing sheep to increase their output and so they once again find themselves in the situation where they either need to cut consumption immediately or borrow from the Chinese once again.

The farmers continue to consume more than they produce and they have a consistent and ever growing trade deficit with the Chinese famers. The economist passes away, but has 4 healthy sons and daughters who continue his tradition of recommending that the farmers focus on eating since eating, it is now agreed, is the backbone of their faming community (constituting now well over 60% of “total economic activity” – a fact the farmers find rather peculiar since everything that gets eaten has to be produced right?… They wonder where the other 10% comes from).  As such, and as always, it is recommended that any inclination to increase the level of savings be avoided and indeed the famer’s sons and daughters even go so far as to recommend that should the farmers show any inclination to save then the faming community’s local bank should step in to print money and the farming community’s city council should use that money to purchase lamb chops and tomatoes if necessary, to maintain the aggregate demand in the economy or even increase this if possible.

After 37 years of this kind of carry on the cumulative total of the trade deficit between the local famers and the Chinese famers is half the total yearly output of the local famers and every year the local farmers have to borrow more and more from the Chinese. The Chinese famers start to wonder what the likelihood of them ever getting those tomatoes and lamb chops back is… but they don’t want to stop lending to the village because exports to the local farmers now constitute a fairly significant portion of the Chinese economy. If they stopped lending to the local farmers then that would negatively impact the “incomes” of the Chinese farmers who export to them wouldn’t it? It would cause massive unemployment and unrest, so the Chinese continue lending and the local farmers continue borrowing.

Until one day, the gods decide they’re not very happy with the Chinese farmers either and they send a swarm of locusts and a pack of wolves to visit them.


Any length to prevent deflation

There are 4 things can cause deflation:

  • 1. The supply of money goes down.
  • 2. The supply of other goods goes up.
  • 3. Demand for money goes up.
  • 4. Demand for other goods goes down.

However the Fed concern themselves entirely with the money supply and with the money supply equation. By expanding and contracting the money supply, the Fed believe that they can control not only the rate of inflation (which they certainly can), but also aggregate demand for goods in the market place.

Just about all money in our current economy except paper and coins (the quantities of which are trivial) is essentially just a form of debt – credit issued by commercial banks on the basis of “reserves” (the reserves being the bit the Fed is responsible for). Once credit is issued by the commercial banks people purchase goods with that credit by writing cheques, use credit cards etc. Credit, therefore, is our current medium of exchange. Presently the realisation of massive quantities of bad debts in global markets is causing the evaporation of money that was based on those debts, which gives rise to the semi-plausible risk of deflation.

Since deflation is a dirty word for the Fed, they are attempting to replace any money that might evaporate in order to try to maintain the total quantity of money in they system that is available for you and I to spend… the theory being that in doing so they will be able to avoid a fall in aggregate demand. To that end, they are pushing new reserves into the system and, as long as the quantity of reserves they push into the system does not seriously exceed the quantity that is evaporating due to bad debts, inflation could be kept at present levels.

Presumably their hope is that once the bad debts have worked their way out of the system they will then be able to undo the “temporary”  measures that they have taken, by selling treasuries and withdrawing credit facilities from the market, thus reversing the massive increase in the total quantity of reserves in the system that has occurred over the past 6 months as the result of the various coordinated actions of the US treasury and the Federal Reserve. Thus they could, according to their theory, hopefully avoid any drop in the aggregate demand for goods as a result of monetary contraction (in the short term) and also avoid hyperinflation out the other end of this as the result of all the reserves that they’ve been pumping in of late.

One minor objection to the theory might be that there is a lag on the Fed’s activities. Typically prices in the market only react 18 to 24 months after they do anything and in all likelihood by the time they know that they need to contract the money supply again it will be too late… and inflation will take off well before they get around to controlling it again. Once banks have already loaned out money on the basis of the reserves they hold, it will be extremely difficult to get them to hand those reserves back over again without inducing yet another financial spasm… but for the time being I will ignore this pothole in the road that lies ahead for the Fed.

I believe the more serious problem that the Fed faces is the effects of past inflation just as much as future inflation. When they inflate the currency they are conducting a form of wealth distribution from savers to borrowers. Savers are forced to lend their money out at rates that they would not accept in a free market and borrowers get to borrow at rates below what they would ordinarily have to pay savers to for their savings… This allows bankers to earn more money (since they get to be the middle men in the transaction) and allows money to be borrowed for uses that quite simply are not profitable (government expenditure, businesses, and houses etc.). These unprofitable sectors of the economy effectively exist as the result of subsidies and need the subsidies to continue if they are to continue to exist.

But that isn’t the full extent of the problem because inflating the quantity of money in the economy has the effect of lowering nominal interest rates. However interest rates are a price – they are the price at which savers lend their savings to borrowers. Inevitably, if you cap the price of anything below market rates, there is insufficient incentive for producers to participate in the market and the goods that are available are put to uses which are not profitable (and to which they would not be put if the price of these goods were a true and accurate representation of their scarcity). So, not enough supply and over demand… which leads to – you guessed it – shortages. In the case of interest rates, the goods concerned are real savings and when the shortage hits, no amount of government intervention can magic the underlying good into existence. They cannot “legislate” real savings into existence and further attempts at price controls will only aggravate the problem (leading to more severe shortages).

As such, eventually it must be realized that there are insufficient real savings to support both the profitable and the non profitable industries. Once the shortage of real savings is realized, the government can do one of two things. They can:

  • 1. Try to sustain the unprofitable industries through increased inflation and wealth redistribution.
  • 2. Bite the bullet and let the market readjust, abstaining from inflation and propping up ailing industries.

If they should choose door number one then the unprofitable industries will be sustained at the expense of the profitable ones. Money is given to unprofitable industries that are then able to outbid the profitable industries for the scarce real savings available in the market place and thus profitable industries must go out of business. As a result, productivity will decrease as will the quantity of both goods and services available and ultimately the general standard of living. This may be result in prices rising more quickly than wages or in further shortages of both (Zimbabwe style).

If instead the government show some courage (highly unlikely I know, but just for argument’s sake) and abstain from propping up ailing industries and if the central bank abstains from doing the same then those unprofitable industries will naturally go out of business. There will be a painful readjustment period as resources (including labour) get reallocated into profitable sectors of the economy which will eventually result in monetary profits (representing surpluses of real goods and thus the sorely needed real savings that are missing from the economy at present). The speed at which this process can occur will depend on all sorts of things like the rigidity of employment legislation and the degree of specialization in the economy’s workforce (and thus the timeframes required for people to retrain). But at the very least by passing through door number 2 the economy is headed in the right direction again.

So although the Fed may think it is able to provide the “liquidity required to get the markets functioning correctly again” the fundamental problem is not one of liquidity. It is not the result of an “accounting error” or a lack of paper and coins that has brought the global financial markets to their knees. Additional liquidity might temporarily avoid a drop in the aggregate demand of consumers but if there are good reasons for the aggregate demand of consumers to drop which are not merely monetary in nature then nothing that the Fed can do will help.

Essentially what we have is governments and central banks around the world that refuse to face the music. They don’t want to let non-profitable companies in the economy go bust and so they subsidize these businesses (banks, mortgage lenders, insurance companies and car makers). The fact that they make monetary losses implies that they make real losses though. Loss making companies consume more resources than they produce. You give them nice shinny new clothes and they give you rags back. You give them more than you get back from them. Companies like GM and RBS are the equivalent of giant unemployed things – massive bureaucratic parasites. Not only are they are of no benefit to the economy – they are a liability to it, impoverishing everyone who is forced to participate in the economic system that they are a part of.

Nor does it matter that large loss making companies employ people. I could, personally, employ everyone in the US tomorrow. I could hire them to dig holes and fill them in again and then I could go to congress and say “I need a few trillion dollars to stay afloat – if you don’t give it to me all these people are going to be unemployed”. Congress would be entirely justified in answering, “So what? All you’re doing is getting them to dig holes and fill them in again and we have need for neither. We need food, housing, health care and education”.  That would be an entirely appropriate response. Employing people really isn’t important – finding ways to occupy people’s time is not difficult at all. What is difficult is to find ways to employ people such that their contribution has a positive impact on the economy as a whole – such that their efforts serve to improve both their own lives and the lives of other individuals. That is precisely why companies keep accounts – to gauge whether the sum total of their efforts is profitable… whether their output justifies the labour and capital that they have invested in order to produce that output. If they are not turning a profit then the logical course of action is to cease operations and allocate those resources to something else which is profitable.