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?
[View:http://www.youtube.com/watch?v=bNmcf4Y3lGM&ref=patrick.net:550:0]
Jimmy,
Good article, but here is a question a little off the direct topic. You seem like a guy who clearly understands this stuff, so I am wondering if you can provide a short analysis or clear up some misunderstanding that I have and I am sure many others do as well.
As you know, Peter Schiff (who adheres to the Austrian School) is popularizing the Austrian take on the situation. But I have to admit, that as someone who is rather familiar with the Austrian take myself, he is a bit confusing. He seems to emphasize in the media, that the current economic problem stems from too much consumption and too little production. He repeatedly states that American borrow all this money from overseas and simply blow it all off on consumption. Thus, his message seems to be that other nations like China save, while we then borrow that saving and spend it all. He attributes the economic disaster basically to our prolonged trade deficit. He does mention the loose monetary policy of the FED from time to time as the cause of the housing bubble, but I think that he is not emphasizing that as much as the trade deficit. Now, I personally think that the two are related – loose monetary policy caused or enabled a prolonged trade deficit, but I am not sure that this is the point that he is trying to make. I am making the connection based on what I think is correct but I cannot be sure. If you listen to Ron Paul and then to Peter Schiff, and you are not familiar with the sound economic theory, then I think people are hearing two different explanaions for the same problem. What is your take on this? How do you explain peter schiff’s analysis of the cisis, and do you agree with him?
Hm, it actually seems quite relevant to the post above and, indeed, to a number of the posts I’ve made recently.
I think basically Shiff and you are talking about two sides of the same coin. Yes consumption that consistently exceeds production is definitely a problem and Shiff quite correctly points out that this is unsustainable in the long term.
There are various different reasons why such a situation might come about. The Fed puting a price cap on interest rates certainly doesn’t help domestic over-consumption. The currency peg/target that the Chinese impose and the loans that they make to the US sustain a trade imbalance between those two countries.
I tend to think that, in most cases, what is occuring is some kind of subsidy. Whether the subsidy is made directly (e.g. European agricultural subsidies) or whether it is made indirectly (e.g. central banks maintaining artificially low interest rates) you end up with a market distortion that is brought about by government, which effectively sustains unprofitable activities at the expense of profitable activities.
When total consumption plus the losses (that come about as a result of the subsidised unprofitable activities) exceeds the total production of the economy, you end up with negative savings and thus people have to borrow. In the case of the US, this appears to have been the situation for the last 3 or 4 decades and is what has caused both a consistent trade deficit and a mounting current account deficit (both of which Shiff bemoans).
When will it end? If we knew that, we could both become very rich men indeed. I don’t think anyone knows how long it can go on for. The decline of the Roman empire took some hundreds of years… that of the USSR was rather more brutal.
Interesting, are you saying that the chinese price fixing of the exchange rate has something to do with it? In other words, you are suggesting that the chinese tried to increase their exports with respect to their imports. I have heard this before. But what did they gain out of this? Did they do this out of economic ignorance?
I always hypothesized that it is the inflationary policies of the FED with no Gold standard. That is the FED is constantly debasing the dollar and making it harder and harder for the chinese to spend here and giving us every incentive to import vs produce anything for ourselves. With a Gold standard, Gold would eventually have to flow out and force the FED to deflate in order to avoid loosing all the gold, but with he FIAT standard, the FED can keep on the inflationary boom forever (so he thinks). But from the currency peg/target you are mentioning, it sounds like the Gold standard wouldn’t have helped because the chinese would not have redemed their paper dollars for Gold. Are you basically saying that they wanted to produce goods for nothing? Assuming I understnd you correctly, why do you suppose they did this?
Chines price fixing has certainly caused distortions in the global economy (as have all subsidies). The cost of those subsidies is born primarily by the Chinese but they facilitate US over consumption in as much as the Chinese purchase US debt to maintain their currency peg… so indirectly they lend US customers the money required to purchase Chinese goods. The Fed then provides cheap interest rates to maintain levels of consumption that would not exist in a free market for money, so the US trade deficit is probably a result of both US and Chinese monetary policy.
I don’t think US consumption can be attributed entirely to low interest rates though. Japan, for example, shows us that even a country with almost zero interest can have net savings, and in the case of the Japanese I think this is cultural.
Similarly, the motives of the Chinese may also be more subtle. I’d recommend Gavin Menzies’ book 1421… in there you discover that the Chinese have a long history of ensuring that their trading partners are always in their debt. As Menzies explains it, the reason for this is that the Chinese feel when someone is indebted to you, you have power over them… maybe there’s something to that.
Motives are a little hard to guess. Perhaps government intervention causes imbalances or perhaps these come about of their own accord (for cultural reasons). One thing is certain though – without government intervention these imbalances could not persist and the market would swiftly cull off uneconomic activity. So the solution is not to think about the reasons why people conduct uneconomic behaviour (that is their own business) but to remove the mechanism that sustains it.
To my mind, the main problem with government then is its persistent use to sustain non-profitable activities at the expense of profitable ones – whether that be through the use of subsidies, trade barriers, price floors, price ceilings, legislation confering advantages to special interest groups or any number of other forms of government meddling.