Nationalization, regulation and economic reality

The business of banking has long been rather exceptional with regards to the way that it treats profits and losses. In any industry, when a company makes profits these are either retained by the company as capital or distributed to shareholders – and so it is in banking. However, in most industries when a company makes losses these must be born by the shareholders – not so in banking. Banks enjoy various government guarantees including the ability to borrow from the central bank and to use tax payer’s money to insure bank deposits. When banks lose money, only  a fraction of the money that they lose actually belongs to bank shareholders.

So we have the problem that, whilst the profits resulting from profitable lending serve to enrich bank shareholders and bank employees, the losses resulting from unprofitable lending serve to impoverish those who are forced to guarantee bank loans, which generally means tax payers. This fact has led some economists (such as Jeffrey Sachs) to suggest that the banks should be nationalized. Since tax payers always end up shouldering the losses when times are bad, say these economists, perhaps it would make more sense if those same tax payers at least stood to make some profits when times were good.

Banking is not entirely unique in this respect – this condition exists wherever there are government guarantees. Henry Hazlitt quite plainly pointed out the risks of extending government guarantees to mortgage lenders in his great classic Economics in One Lesson over 30 years ago:

The case against government-guaranteed loans and mortgages to private businesses and persons is almost as strong as, though less obvious than, the case against direct government loans and mortgages. The advocates of government-guaranteed mortgages also forget that what is being lent is ultimately real capital, which is limited in supply, and that they are helping identified B at the expense of some unidentified A. Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to “buy” houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief in the long run they do not increase overall national production but encourage malinvestment.

Hence government guarantees have meant that in addition to paying for the losses of banks, taxpayers today must also pay for the losses of mortgage lenders such as Freddie Mac and Fannie Mae, and once again this fact has led certain economists and policy makers to suggest nationalization.

However this is a very dangerous road to walk down. We could hardly expect government to start making good loans where private banks that were risking (at least in part) shareholder funds were unable to do so. The concepts of profit and loss mean very little to governments, whose primary source  of funds is the barrel of a gun, and if governments are not motivated by profit (which it is clear they are not) we would do well to remember that they are not there simply for our amusement. Principally they are there to achieve political goals and when loans in the economy are extended by government they will be extended not on the basis of economic profitability but instead on the basis of political gain. Where the votes of troubled home owners could tip the balance of power, loans will be made to home owners on the basis of their ability to vote for politicians rather than on their ability to repay the loans and the economic good sense of extending such loans. Companies will receive loans not because they are in a position to pay these back but because they have friends in government, contributed to one or other politician’s campaign or because they are considered “strategic” to some political pressure group (such as the UAW).

Under a system of nationalization, economic activity would be directed not by profit and loss and not by human needs and the satisfaction of those needs (i.e. supply and demand) but by central government and bureaucracy. The pricing system as a means for rationally allocating scarce resources would be replaced by the kind of democracy and political pressure groups that have brought about shortages and rationing of water in Australia, petrol in Indonesia and bread in Egypt… however where the later are examples of governments bungling the delivery of individual commodities the nationalization of banking and the institution of government lending would see the soviet style collapse of the rational distribution and use of savings more generally across all categories, from paper to silicon chips and from road workers to neurosurgeons.

Sadly, many of these undesirable side-effects of nationalization have already been brought about, even without having officially nationalized banks, mortgage lenders and insurance companies, since their true cause is not whether government is the legal owner of such institutions but the government guarantees that have been provided  to them. These government guarantees are almost as explicit now as they would be if these institutions were nationalized and so should their nationalization come to pass then probably very little would change down in the trenches. However this is all the more reason to to think that nationalizing these already highly political institutions would in no way cure any of our current problems – it would change very little and merely ensure that our current problems stayed with us for years to come.

Two wrongs do not make a right and nationalizing banks cannot be considered an adequate solution to the problem of moral hazard presented above, whereby shareholders and bank employees take profits but tax payers shoulder losses. Rather than trying to take the profits of these institutions as some form of compensation for the government guarantees that have brought them so much pain, tax payers should instead attempt to alleviate themselves of the requirement to shoulder the losses of these institutions in the first place. This is the root of the problem and if government guarantees (backed with tax payer’s money) were withdrawn then the problem would go away. If government guarantees are instead made explicit by way of nationalizing the affected instittutions then our current problems will merely worsen and become permanent.

Regulation for show

The most commonly suggested alternative to nationalization is that government regulation should be reviewed and improved to “ensure this doesn’t happen again”. This is a half-arsed solution and those suggesting it are usually sorely short on details as to how their new super-regulations might work, where the plethora of regulations that came before them have failed so miserably. Previous attempts at regulation over the past 80 years haven’t even been able to prevent the basic Ponzi scheme. We can perhaps give the pro-regulation cheerleaders a helping hand by pointing out that the regulations that would be required would need to ensure that the folks making loans were a little more careful with the money they were lending… indeed ultimately we want to make sure these folks are as careful lending that money as they would be lending their own money (since that would be the only way to truly counter the moral hazard resulting from the fact that they’re not lending their own money).

Here, of course, we have a problem. How can we possibly ensure that someone is as careful lending out other people’s money as when they lend out their own money? One possibility would be to make sure that they are lending at least a portion of their own funds but, here again, if they are lending $X of their own money and $Y of someone else’s money, and taking a percentage of the gains on the whole of the money that is invested during the good years but only being limited to losses concerning a portion of the money during the bad years then the equation remains fundamentally skewed in favor of excess risk taking and no moral hazard has been averted. The risk appetite of fund managers should be testament to this – fund managers are happy to lose 100% of the few million that they invest in a bad year, providing the preceding years saw them take 20% of the profits on the billions of dollars that they were investing on behalf of their clients. In short, no requirement for bank shareholders to invest a percentage of their own money, short of a requirement that they invest 100% of their own money, can avoid moral hazard.

A 100% reserve requirement would definitely be an improvement on the current situation. Deposit insurance would no longer be necessary, since deposits would not go missing (except where it was criminal, which would result in bankers going to jail). Bankers certainly wouldn’t be happy about it initially… with 100% reserves it would be impossible for them to leverage depositors money by lending out multiples of the cash that they had on hand and no doubt both the volume of the loans that banks extended and the size of the banking sector overall would shrink considerably. However, although the total receipts of banks would fall and the size of the banking sector would shrink, under a system of 100% reserves banks would be much more solid institutions. They would not need  government handouts since they could only ever lose as much money as either shareholders or investors had contributed (like all other companies) and so those wearing the losses for failing banks would only be those who had chosen to risk their funds. Thus the banks would be able to pay their management whatever salaries they pleased without needing government approval and, more importantly, the public could rest assured that those banks that still existed were, on the balance of things, profitable and thus contributing to the broader economy rather than weakening it.

However a 100% reserve requirement still would not address the problems that result from the existence of a central bank and legal tender laws. This would leave control over  the supply of money and therefore interest rates in the hands of government, who cannot possibly know what what an appropriate price for savings is, at any one time, and even if they were capable of knowing what an appropriate price for savings was they certainly could not be trusted to try to bring such a price about and nor would there be any need for their involvement if that was all that they wanted to achieve. A market price for savings would emerge from a free market  for money without any government involvement at all. The only reason to involve government and the central bank is in order to alter prices and shift them away from their market rate for political reasons rather than economic ones… a problem which has plagued us for centuries, ever since the existence of legal tender laws and lenders of last resort and which has led to ever more frequent and ever more serious booms and busts, as has been pointed out by Mises, Hayek and numerous Austrian scholars since.

As such, far from the addition of new government regulation, a proper and lasting solution would be the removal of all and any government guarantees which are responsible for moral hazard. Trouble in the market for savings and loans has been inevitable ever since government gave implicit baking to loans made on the basis of fractional reserves and put in place legal tender laws, a lender of last resort and deposit insurance. The only genuine way to resolve the problem of moral hazard that has developed as a result of these government guarantees would be the complete removal of such guarantees. 

Pretend solutions

In mainstream media, the suggestion of private banking (i.e. the removal of all government guarantees for banks and the dissolution of the central bank) is generally either treated as laughable or met with complete incomprehension. Most individuals are unable to conceive of a world in which money might not be controlled and made by government (as can be evidenced by the reaction of interviewers during Jim Rogers’ March 2008 interview on CNBC when Rogers suggests dissolving the Fed – Maria considered Rogers’ suggestion to be no less fantastic than trolls and wizards and was obviously incapable of wrapping her head around the idea that the central bank might not really be required or the possibility that Rogers’ suggestion was actually a very good one).

In political circles private banking fares no better. The words “change” and “reform” are heard quite frequently in elegant speeches made by politicians and financial authorities, however it is clear at the same time that they want neither. Those making such speeches show no inclination to remove the government guarantees which are the root cause of the problems. At the same time, they are clearly quite reluctant to formally nationalize the banks. What they want then is not change but stasis. They want to be able to keep the current system but somehow cover up its problems and pretend this whole messy affair never happened.

As such, instead of real solutions we’ll probably see the formation of things like Bad Banks, which are no solution at all. These basically involve wiping out the shareholders, making tax payers pay for the rest of the losses and then selling anything of worth to someone else, simply to get it out of government hands. It’s not nationalization (which is good) but the creation of a Bad Bank in no way addresses any of the structural issues that brought about the current crisis – it is simply a way to make shareholders and tax payers wear the losses in an orderly fashion.

Additionally we’ll see new regulations being proposed to make certain that this doesn’t happen again. But the new rules will be just as ineffective as the old rules and the rules before them, because no regulation is capable of negating the moral hazard that results from the government guarantees which allow bankers to invest more money than they actually have and to lose other people’s money, rather than their own. Additional regulation is mere posturing by politicians who want to be seen to be “doing” something but it cannot address the underlying issues which neither politicians nor mainstream commentators make any mention of.

Economic realities

None of the current measures being suggested are real solutions to our current problems. However it must be admitted that these problems are hardly make believe and that they are vast indeed. If CNBC are to be believed then when all is said and done the losses from the current financial crisis could weigh in at as much as $7.36 trillion dollars (more than double the inflation adjusted cost of World War II). That sounds like a fantastically big and irrelevant figure, but these losses are not mere numbers in accounting ledgers. The whole purpose of accounting is to estimate real profits and losses and, in the case of the losses that we’re currently incurring, what has been lost is savings… not money but what money represents – the savings of real goods and services (such as wood, bread and health care). If those savings had not been wasted by financial institutions as a result of misguided government guarantees then they might have been available to be used for other things. For example, the estimated cost of Hurricane Katrina was $81.2 billion. Insurance company AIG lost more than that last year alone and has, to date, been the recipient of very nearly double that in government bailouts!  When AIG announces such losses they are announcing the loss not just of dollars but of real savings sufficient to rebuild entire States in the wake of national disasters. Were government money not used to bailout these loss making entities, it might instead be used for such disaster relief… of even better left in the hands of private companies and relief agencies. Regardless, the point is that these are real losses paid for with real savings.

Over the past few decades these real losses have been largely masked by borrowing in Western countries. Whenever our economies were short of money because they incurred massive losses (which they had no savings to guard against) or simply because they wanted to consume or invest more, they were able to borrow from the East. Where money (and thus real savings) was borrowed from the East in order to fund extra investment and to increase future production – production that could be used to repay such loans – the borrowing did not present any insurmountable problems. However, borrowing on the part of government to bail out loss making institutions is not investing in future production – it’s investing in past mistakes. Nor do housing or personal consumption in any way serve to improve the productive output of the economy – two activities that have recently accounted for nearly 80% of the U.S. GDP, according to Stephen Roach in the February 2009 edition of Foreign Policy magazine. This recent borrowing on the part of Western nations is not sustainable and the longer it persists the more remote the possibility of ever repaying our debts becomes.

Every few years we have another financial crisis or another natural disaster that we don’t have the money to pay for and every few years we postpone addressing the underlying issues. Politicians smooth talk and pretend to make things better whilst sweeping the problems under the rug with deficit spending that drives our economies further and further into debt. Sales taxes, energy taxes and all manner of other sneaky little taxes get introduced to try to plug a few of the cracks in the dam – but the walls are starting to rumble as the pressure mounts on the other side. Sometimes we have even been offered “tax cuts” in one form or another but these are always financed through yet more deficit spending and so are more accurately described as “tax tabs” – invoices for taxes to be paid at some future (unspecified) date when the East tires of buying bonds that pay no yield, denominated in currencies that do not hold their value. Government debt and future commitments climb steadily whilst personal savings rates hardly fare any better. After all, why save when interest rates are almost zero?

But if the East ever falters… if the Chinese and Japanese economies ever stumble and they’re not in a position to buy Western bonds, what would happen if we had another financial crisis then?

Rather than begging from the East, the economies of the West need to learn to stand on their own two feet again and that is not going to happen while our politicians and financial authorities are doing everything that they can to avoid real change. What is required is that the economies of the West return to profitability and that means that

  1. the borrowing that we are doing has to become profitable again and
  2. we must reduce both our trade deficits and our current account deficits

The first step to making borrowing profitable again is to get it out of the hands of government – not just in name but in spirit – borrowing needs to go back to the private markets. Once government guarantees are removed so that private banking can be stable and once the central bank is removed so that interest rates can rise to natural levels that would require funds be borrowed only for those activities that are truly profitable, our economies would stop lending so much money to consumers and start lending more to investors who are able to make profits. And if we wish to avoid selling the farm to buy the milk (i.e. selling  assets like companies, mining rights etc. to the East) then the new industries that will be built by these investors must not service domestic demand but must export goods and services back to the East in order to pay down debt.

Reducing the twin deficits would require massive shifts of western currencies in the downward direction with respect to Eastern currencies… implying higher prices (since we are net importers) without larger pay checks. 

Largely what is required is belt tightening and a lower standard of living for the West, but her citizens don’t want to hear it and her politicians don’t want to tell it to them. So the charade continues with governments borrowing to delay the realization of economic reality. They patch up symptoms rather than treating causes and they pile wrong upon wrong in the vain hope that the sum total will eventually be a right. Further control is given to government to cure problems resulting from previous government control and, slowly but surely, the free market pricing system is smothered and replaced by soviet style allocation that further frustrates the ability of our economies to turn a profit. Indeed the ability of our economies to even function is now starting to be called into question.

In 1920 Ludwig von Mises famously postulated, in his essay Economic Calculation in the Socialist Commonwealth, that government intervention begets even further government intervention leading eventually to economic collapse and/or total central control. Today, I’m not sure which I fear most. I’d like to be optimistic, but in order for this story to have a happy ending both politicians and the general public would need to be far more willing to accept economic realities than they currently appear to be. My only hope is that perhaps economic reality will force Western nations to do the right thing. Perhaps with China planning a little deficit spending of its own and Japan in serious trouble, we’ll finally get the push we need in the right direction from that old mother of invention – necessity.

Lending without exception

U.K. Prime Minister Gordon Brown and U.S. President Obama appear to have some rather peculiar ideas about the role of lending in the economy. Both men appear to believe that more lending (no matter how it is achieved) will be a source of wealth and prosperity. Thus they both tirelessly insist upon the importance of getting banks lending again.

However, this is rather to put the horse before the cart. If I lend someone money to dig a hole and fill it in again, has any additional wealth been created? Certainly not – at the end of the process we have nothing more than that which we started with (indeed we now have one slightly worn shovel and a pair of dirty overalls where before we had brand new ones). On the other hand, if I lend someone money to start the next Microsoft or the next Google – someone who could invest the money in a venture which was capable of turning a profit and thus repaying both the principal and the interest on the loan – then the loan would most certainly have given rise to the creation of wealth.

The origin of wealth is therefore not lending, per say, but profitable economic activity more generally. Lending is an important form of economic activity, to be sure. However the importance of lending in no way changes the fact that it can either be profitable or unprofitable. Lenders who consistently lend to entities that turn profits and are able to repay their loans clearly facilitate profitable economic activity and are therefore sources of wealth and prosperity in the economy (a fact which will be reflected by the overall profitability of such lenders). Lenders who consistently make poor judgments about the loans that they make and who’s loans thus go unpaid, to the point that these lenders themselves are no longer able to turn a profit, are not sources of wealth but engines of poverty. Such lenders merely serve to squander scarce resources.

Knowing then, that what we require is not just more lending (as Obama and Brown tend to suggest) but more accurately profitable lending, how might Obama and Brown be able to facilitate such a thing? Making profits is, after all, not exactly the strong suit of most governments and nor is it something they’ve ever been able to “force” on the broader public. Indeed even most private companies, risking shareholder funds and despite their best efforts, are unable to turn a profit. The only reason that the majority of companies running today are still profitable is that we constantly let the unprofitable businesses fail and thus attrition ensures that only the strong survive. 

So how could Obama and Brown’s attempts to get money “flowing through the veins of the economy” possibly succeed? Where money flows as the result of loans, real economic wealth will only come about if the borrowers are profitable and thus, over the long term, if the lenders themselves are profitable. Profitable lending can only come about in a free market of lenders selected for their proven ability to make profits – a market where loss making entities are allowed to fail. All that governments can do is to frustrate free market profit and loss incentives by preventing the failure of loss making entities or by transferring money from profitable companies to unprofitable ones. Far from helping direct money to where it is needed, government interference forces it to somewhere that it plainly should not be. This is most certainly not “getting money flowing through the veins of the economy”. A better analogy would be that Brown and Obama are taking blood from the patient’s aorta and pumping it into the stomache instead.


Milton Friedman did much to further the cause for political freedom during the 20th century, and helped to dispel many popular economic fallacies. However, although Friedman was mostly in favour of the free market where political policy is concerned, he most certainly did not think these free market principles could be extended to the banking sector and he was essentially a socialist where monetary policy is concerned. Friedman was a Monetarist.

Let me quote from the opening paragraph of Hoisington Investment Management Company’s Quarterly Review and Outlook – Fourth Quarter 2008 :

“The late Nobel Laureate, Milton Friedman, noted in his 1963 book, Monetary History of the United States (coauthored with Anna Swartz), that the money stock decreased by a massive 31% in the Great Depression. The turnover of that money, called velocity, fell 21%. Nominal GDP equals money multiplied by velocity. Consequently, from 1929 to 1933 the breakdown of both measures resulted in a contraction in nominal GDP of approximately 50%. However, Friedman postulated that if the Fed had not let money shrink, velocity would have been steady and the Great Depression would have been averted, i.e., nominal GDP would not have collapsed.”

This betrays the completely opposite ways in which Monetarist economists and Austrian economists view the economy.  Where Friedman and Swartz view the a recession as a monetary problem that can be fixed by monetary policy, the Austrians view a recession as having been caused by monetary policy but very much a real problem which can only be fixed by allowing real changes in the economy occur. This perhaps requires some clarification so let me elaborate on the two different points of view.

The Monetarist Perspective

Friedman believed that changes in the money supply could bring about changes in real productive output and, more particularly, that a contracting money supply would cause a corresponding contraction in the real productive output of the economy. 

It can certainly be argued that significant and unexpected changes in the money supply (either upward or downward) will cause widespread miscalculation as to the real profits and costs of lending and borrowing and so to this extent, severe and unanticipated deflation or inflation of the monetary unit might certainly undermine its effectiveness as a common unit of account or as a medium of exchange… and probably most of the Austrians would agree that an unstable currency could lead to real miscalculation and real losses in the economy.

However the monetarist theory does not stop there – monetarists do not merely advocate stable currencies… for if they did then they would advocate target inflation rates of 0% rather than target interest rates. They would advocate a monetary policy that concerned itself entirely with preventing any form of aggregate inflation or deflation, rather than a monetary policy that tried to balance “growth against inflation”. The real view of the monetarists is that money, in the economy, can speed and slow real economic growth like the accelerator and break pedals in a car. Monetarists believe, in the bottom of their hearts, that by expanding the money supply by smallish amounts (say 5%) they can bring about real economic growth and that similar minor changes in the downward direction (for example deflation of 5%) would be the cause, and not the effect, of a real loss of wealth.

The Austrian Perspective

Monetary inflation may create an illusion of wealth that tricks some people into genuinely producing more (real goods) than they would have if the money supply was stable. Those living in an inflationary environment may, temporarily, be tricked into working somewhat harder than they otherwise would have when they receive a nominal pay rise that is actually a real pay cut or merely a sustaining of their real pay (once inflation is taken into account), however in the long run people eventually start to see what’s going on and come to factor inflation into their behavior. Unions come to demand pay rises “to keep up with inflation”, lenders subtract inflation from the interest rates they charge in order to calculate real rates of return and companies do the same with their profits. As such, inflation could only ever have the effect of stimulating real economic growth if it is unanticipated and people have not already altered their behaviour to account for it. Even then, it could easily be alleged that these “real” stimulatory effects of inflation are likely to be only minor and most certainly only temporary.

In any event, if inflation or deflation are unexpected then they will certainly, as we have already mentioned, cause various actors in the economy to miscalculate the rates of return that they might expect from lending or to miscalculate the true costs of borrowing. This may cause people to mistake nominal profits for real profits and overconsume, which may result in a temporary spike in the GDP figure that so concerns the monetarists, however this consumption is effectively fuelled by the cannibalization of capital as opposed to any productive increases brought about by a significant or prolonged increase in the real output. A perfect example of this is that of home owners in the USA and around the world recently increasing their consumption based on the belief that they were becoming ever and ever richer because of increasing real estate prices.

This is not to say that the Austrians view inflation as irrelevant and nor are the above comments the main objections that Austrians have to inflationary monetary policy. Primarily the Austrians view increases in the money supply as a transfer of wealth and control over labour/capital from those who have cash and savings to those doing the lending (in the first instance), to those who receive the money at “favourable” interest rates (in the second instance) and  to the suppliers of the industries where that borrowed money is spent (in the 3rd, 4th and nth instances). Its primary effect is not to increase the aggregate output of the economy but to tax savers and subsidise lenders. For every extra real unit of goods that is commanded by the borrowers of the new loans (which are bringing about the monetary expansion) one real unit of goods less is commanded by those people in the economy who had cash in their hands or balances in their checking accounts before the monetary expansion took place. No extra buying power is created and no extra goods will be produced – all that changes is what kind of goods are produced. As such the Austrians hold that monetary expansion distorts the structure of production by funnelling money away from genuinely profitable activities into unprofitable ones

A full explanation of Austrian Business Cycle Theory is beyond the scope of this article. However for our purposes it is sufficient to recognize that during an inflationary boom many of the goods that are being produced are subsidized by newly created money (i.e. by inflation) and were it not for the subsidies then the production of these goods would not be profitable… as such, many of the industries that develop during an inflationary boom are not really profitable either, and the existence of these industries is only made possible by forcing money from savers and lending it to these industries at subsidized interest rates. The ventures that are invested in during inflationary booms are not ventures that produce those things that people want most urgently and, left to their own devices, people would have chosen to invest their resources more wisely in things they felt a more pressing need for (and which consequently brought better returns – sufficient returns to pay the going rate of interest rather than merely a subsidized rate).

This funnelling of money from profitable activities to unprofitable ones is the equivalent of dismantling your house in the city (which you need so that you can go to work), transporting all the bricks, roofing tiles, wood and nails out to the beach and constructing a beach house, which is certainly very flash and would be nice to have but which you don’t really need (and certainly don’t need at the expense of your primary residence in the city). The beach house is a luxury that you cannot afford. The dismantling of your primary residence is a very real problem and not one that can be “papered over” by “revaluing the beach house” since what you cannot afford is not the “paper value” of the beach house, but the very real price that was paid for it (i.e. your primary residence).

Action and Reaction

Given their differing views as to the real effects of monetary inflation and deflation, it will hardly be surprising that the recommendations of the Austrians and Monetarists differ markedly in the face of a financial crisis. As companies start to make losses and people start to get laid off, when debts start to go bad and consequently (in the context of a monetary system based on fractional reserves) when the total quantity of money in the economy starts to shrink, the two camps have completely opposite recommendations.

Friedman, Swartz and Bernanke see the monetary contraction and they believe this is the cause of the problem. They believe that real output is the result of changes in the money supply and so all that concerns them is making sure that the monetary base does not contract. If they can do this, whilst at the same time avoiding inflation, then they believe they will be able to keep their beloved GDP intact and the problem will be solved. For a monetarist the problem is principally a mathematical problem, with perhaps a little bit of a psychological twist (the drop in GDP is sometimes blamed on the reluctance on the part of consumers to spend). It never occurs to the monetarists, by measuring and tracking broad aggregates, that there may in fact be real problems with the structure of production in the economy and that the tell tale signs of businesses collapsing all around them might reflect more fundamental problems than a simple lack of ink and paper.

And for the Keynesian Monetarists, if piling reserves into the hole that has been dug does not serve to prop up the GDP then it is argued that money should be quite simply given to those industries that need it (i.e. the industries that could only exist on the back of inflationary subsidies) or injected into the economy by government spending or both (nationalize unprofitable industries). If those industries can keep pumping out goods and if we can get money into the pockets of consumers to buy those goods then our beloved GDP will remain intact, right? It never occurs to the monetarists that the reason these industries are failing is because they are not making the goods that people really want.

The Austrians, on the other hand, view the problem rather differently. For the Austrians, the industries that rise on the back of inflation are doomed from the start. For a time, subsidized industries are able to make nominal profits quite simply because they do not accurately accounted for one of their primary costs – namely that of interest (and nor are they able to, for the market rate of interest becomes completely unknowable). But the monetarists do not view interest in the same way as the Austrians. The monetarists believe that interest rates can be set by edict rather than, as the Austrians believe, that these are a price aned therefore can only emerge naturally from the market as a result of the personal preferences of individual lenders and borrowers. Interest rates are the controls of the car that the monetarist drives – the means by which he “steers” the economy. For the Austrian nothing is more ridiculous – interest rates are the most fundamental price in the economy and can only be determined, like all prices, by supply and demand. In the case of interest rates, that supply is not ink and paper but real capital (tractors, oil, wood and human labour) and the demand is the potential uses to which that capital might be put by borrowers (to build homes and start companies).

Certainly there is some demand for the products produced by subsidized industries (citizens in the US were quite happy to have a second home – particularly those citizens who had no incomes). However life is full of choices and if you spend $100 on shoes then you can’t simultaneously spend it  on groceries… as such, people must prioritize their expenses. The new industries paid for by inflation quite simply are not a priority for people – if they were then they would not require inflationary subsidies either to spring into existence or to sustain their existence. Industries that produce things that people truly want (in light of the genuine costs of production) would be profitable even at the higher rates of interest that would have existed had the money supply not been expanding. To put it simply, although people might like to build beach houses, most people would choose not to if they knew that the real cost of building a beach house would be that they would lose their primary residence. Pretending, for a while, that they can have beach houses for free and that the cost of starting new companies is minimal to nil is just to engage in fantasy – nothing is free where economics is concerned – everything is a choice between two or more alternative possible uses for a particular resource and savings are no exception. 

The Austrian analysis, therefore, is that there is a real problem in the economy – technical recessions are not merely mathematical riddles but symptoms of very real problems that demand very real changes. The Austrians suggest that people have to stop dismantling their primary residences and stop building beach houses. Essentially the Austrians recommend something entirely obvious – that we do not continue to subsidize unprofitable industries. Certainly the removal of inflationary subsidies will cause a contraction in the industries that depended on these subsidies. Many of the companies in these industries will realize nominal losses at the new rates of interest that will be discovered in the market place and people will lose their jobs as a result. Eventually, the workers and capital having been freed from previously unprofitable uses will find new uses either rebuilding the industries that were damaged during the inflationary boom or in the construction of new and genuinely profitable industries… however the transition to this new equilibrium will certainly take time.

In any modern economy the different industries are not completely separate from one another but rather are intricately linked. Many industries depend heavily on others – for example a failure of one or more of the large automobile manufacturers would no doubt have domino effects on many of their suppliers. And no doubt the degree of specialisation in modern economies makes it difficult for employees in one industry to shift into other more profitable lines of work. As finance workers in London take jobs as teachers it may not appear to them that they are “shifting into more profitable lines of work”, given the massive nominal pay cut that they must accept in making this transition – however the sad fact is that their old jobs simply are not profitable. It may take many of these workers many years to become as efficient in new lines of work as they were in their previous posts and indeed some of them may never again have the same real salaries that they had before. This is unfortunate and no doubt it will be difficult for the individuals concerned. It is even more unfortunate that this malaise should affect so many people in the economy at the same time and some Austrians would no doubt think it appropriate for the Monetarists, who have guided monetary policy for the last century, to offer some form of apology for having provoked such a situation.

The Austrian does not disagree that these events are unfortunate, nor are they unaware that the recommendations made by the Austrian school will require sacrifices and hardship for many individuals. However the Austrian does hold that if the advice of the Austrian school is not heeded then these sacrifices will not be avoided but will merely be greater – for these are sacrifices that must be made for mistakes of the past. The question is not how we can avoid past mistakes (we cannot) but how we can avoid future mistakes.

The monetarists would have us focus not on our real standard of living and the things that we really want, but on sustaining nominal GDP – even to the point of having the government spend money on things in order that this technical goal should be attained, quite regardless of whether we need the things that government buys (and implicitly we don’t, since otherwise government wouldn’t have to take our money off us to purchase them as we’d buy them of our own free will). But if the Gross Domestic Product consists entirely of  the production of polka dot ties that no body wants, and which the government must therefore buy, of what possible relevance could the GDP actually be? Surely this is just reviving the policies of the former USSR? The GDP statistic becomes more and more irrelevant, to individuals, as an ever greater proportion of the nations production is directed by government and the central bank.

The Austrians would have us focus on root causes and addressing real problems for the man on the street, which requires adjustments in the structure of capital and that we shift our focus from building beach houses that we do not need (and cannot afford) back to the things that we really want and need.

Whether present policy is formed primarily by monetarist recommendations or primarily by Austrian recommendations will determine whether we are solving imaginary problems or real ones, and thus how many of us will know hardship tomorrow.

Standing in buckets

Government taxes mean that individuals and corporations only keep a certain portion of their gains whilst at the same time they realize 100% of their losses. As Hazlitt put it in Economics in One Lesson:

“When a corporation loses 100 cents of every dollar it loses, and is permitted to keep only 60 cents of every dollar it gains, and when it cannot offset its years of losses against its years of gains,  or cannot do so adequately, its policies are affected.”

This is a particularly pertinent point at present, since many corporations are starting to make some serious losses following a series of years in which they made bumper profits. If we were to regard the activity of these corporations over their entire lifetime then, on the balance of things, many of these corporations might actually be running at a profit, if we were to take taxes out of the equation… so they are still, even in the wake of their most recent losses, net contributors to the overall economy and perhaps were it not for taxes their shareholders would choose to continue operations. For practical reasons, however, taxes are levied annually and because these companies are unable to offset their current losses against earlier profits (which they have already paid taxes on) they are declared to be unprofitable and in many cases are driven into bankruptcy…

For example, Widgets Inc. starts up business and makes $100 in their first year of operation… on which they have to pay taxes of $40. They now have $60. In their second year of operation they make a loss of $70 and thus, unless they are able to find funding, they are technically under the water. Despite having made an effective profit of $30 over the course of the two years that they have been running, the tax burden that they have to shoulder has forced them out of business.

I guess this culls off the least profitable of the profitable companies, however Hazlitt’s point can hardly be denied – Taxes Discourage Production. Essentially a nation that imposes a 40% income tax is setting a bar over which all companies must jump if they are to stay afloat. For although some years they will make losses and others they will make profits, they will not be able to adequately offset their profits against their losses (particularly in times like these) and so over the long term companies must not merely break even but they must make a certain minimum amount of profit simply in order to stay afloat, and the magnitude of that profit is necessarily dependent upon the proportion of their revenues that are spent on taxes.

We could state the above somewhat more mathematically by saying that in order for a company to remain profitable, their EBIT (Earnings Before Interest and Taxes) must be greater than both the Interest that they pay on loans and the taxes that they pay during any profitable years of operation.

EBIT > Interest + Taxes

At this point you can perhaps start to see the enormous contradiction inherent within present government policy. For at the same time as the imposing income taxes governments around the world have also established the vast apparatus of central banking that has been assigned the task of controlling interest rates. In the United States this organization (The Federal Reserve) has two mandates: that of “stimulating growth” and that of “controlling inflation”.

Setting aside their deplorable track record with regards to controlling inflation, let us focus for a moment on their other role of stimulating growth. Despite price fixing having shown itself to fail time and time again, the manner in which the central bank purports to “stimulate growth” is by artificially lowering nominal interest rates so as to tip the equation above in favor of businesses. For if one of the main costs that businesses incur is interest then why don’t we simply write laws to lower interest rates (or even better, come up with a fantastically complex system to achieve the same thing indirectly, with vastly more effort and at a vastly greater cost)? The rather warped view of those supporting the central bank is that if they can keep nominal interest rates down then entrepreneurs, with the prospect of cheaper capital, will be more inclined to start businesses.

Ignoring the numerous difficulties that the central bank must face in order to actually make capital cheaper (rather than just cause a shortage, as is what we would expect in any industry where price caps were imposed) the central bank’s attempts to make capital cheaper are in direct conflict with the policy of taxation. For as we have already described, the bar that companies must jump over is not that of interest rates but that of interest rates + taxes.

It is therefore ironic that the government should be trying to tax itself out of the current mess. For in increasing government spending the government is implicitly and unavoidably raising taxes. All government revenue, without exception, comes from taxes and so there is no way that government can increase its expenses without implicitly increasing taxes. The irony is that both the bumper profits of recent years and the sudden crisis resulting from this, in which a disproportionate number of companies all go bust at the same time, placing us squarely in the midst of a recession and falling government revenues, are a direct result of government sponsored policy to artificially lower interest rates (supposedly to lower the costs  to business and stimulate growth).

And so recent moves to raise taxes in California and guarantees of future taxation implicit in Obama’s promises to increase government expenditure are both very much a direct result of the insane efforts of government to “stimulate growth”. Like children in a bath tub they have seen the rubber ducky of Interest rates bobbing towards them and, in an effort to make it disappear through force of will, they have tried to push it under the water. Unwittingly, the very force of their hand serves to raise the overall water level of taxation and other expenditure upon which the rubber ducky floated and so now a whole bunch of other kids in the bath tub (who weren’t tall enough) are now in the process of drowning. OK, I’m maybe straining an analogy there a little bit but, quite simply, the Federal Reserve trying to push down interest rates in order to lower the bar that businesses have to jump over has resulted in their pushing up (by vastly more) taxation and has thus raised the bar that not only businesses but all of the hapless victims that participate in their monetary system must jump over just to survive.

What is the current wave of taxation to be used for? Almost without exception, attempts to prop up the various collapsing walls of the very low interest rate policy that got us where we are today: to bail out failed banks, to bail out mortgage lenders and insurers or perhaps even to bail out the borrowers themselves… or sometimes to bail out companies that would have been profitable neither with nor without taxes (such as the auto makers).


Efforts by government to “reduce the costs” to businesses by lowering nominal interest rates merely increase the costs to business by at least that degree to which government participates.

In order for businesses to survive, as a rough guide to sustainability, they must ensure EBIT > Interest + Taxes. Any attempt by government to decrease the Interest component of the equation necessarily increases the Taxes component by at least as much (and almost doubtless by more, since the bureacrats and bankers effecting this transformation of Interest into Taxes must be paid).

At times like these, I cannot help but be reminded of one of Churchill’s better quotes:

“We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle” – Winston Churchill

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.

At what price?

When we speak of profitability we are talking about a cost benefit analysis. Am I better off sitting on the couch or going to get a slice of pizza from the fridge? That will no doubt depend upon the degree to which I’m either hungry or tired. If I’m more tired than I am hungry then I can best maximise the use of my time by lounging around on the couch. On the other hand, if I’m more hungry than tired then I’m perhaps happy to pay the cost (getting up and walking to the fridge) of obtaining pizza since I consider the benefit of eating pizza to be greater than that cost. When the benefits of doing something outweigh the costs (including opportunity costs) that action is said to be profitable.

Let’s say I’m hungry though and there’s no pizza in the fridge – there’s just an apple in the fridge. Outside in the yard there’s a plum tree and at the top of the plum tree I can see a nice juicy plum and, as it happens, I prefer plums to apples. However, the cost involved in obtaining the plum is significantly higher than the cost involved in obtaining the apple. The apple is right there in front of me for the taking but eating the plum would require I spend 5 minutes clambering around in the yard… If I really like plums way more than apples then maybe I’m willing to go out and clamber around in the yard, but I’d have to really like plums a lot more. Now what if, at the time when hunger strikes, I’m currently dressed in a suit ready to go to work? In that case the cost benefit analysis would change yet again – not only would I have to spend 5 minutes clambering around in the yard but I’d have to change my clothes first (so as not to ruin my suit) and then get dressed again for work afterwards… perhaps under these circumstances I’d no longer be willing to do what was required to have the plum and I’d just take the apple. In any event, through the construction of more and more elaborate (but hardly unrealistic) scenarios you can easily envisage that we will eventually arrive at a point where the additional cost of having that plum (as opposed to the apple) is greater than the perceived additional benefits that this would bring me. Above a certain price, the plum simply isn’t worth having – and the price paid is ultimately my time and effort. Above a certain price I’d rather spend my time eating apples (or doing something else like going to work) than I would jump through the necessary hoops required in order to be able to eat plums.

Now most of the time people think of petrol as coming from Saudi Arabia out of massive pumps which can, like taps, simply be opened or closed to produce more or less petrol as needed. And indeed for the better part of the last 2 decades it appears that tap has been running rather freely with oil and petrol prices during that period being what most people would now, in hindsight, see as a relatively cheap. More recently, from 2000 until around 2004 the price of light crude oil was hovering somewhere around $30 per barrel. However from 2004 until mid 2008 the price exploded from around $35 to approximately $160 per barrel and, at the time of this writing, has now settled down to around $50 a barrel again.

At a certain price, and from a producers point of view, people aren’t willing to do much for oil… they’re willing to “turn on the tap”, so to speak, but they’re certainly not going to be clambering around in the yard for it. However if you pay someone enough then they will go to great lengths in order to obtain oil for you. Indeed, when the price of oil is higher than about US$70 per barrel they’ll be willing to move to some of the most inhospitable places on earth, invest in 400 tonne dump trucks and expend vast amounts of heat, water and (ultimately) effort to process tonnes of tar sand in order to bring you a barrel of oil.

However, as we noted above, those people investing not inconsiderable sums of capital in 400 tonne dump trucks and those people spending their time living in a camper vans next to Canada’s tar sands in order to operate such dump trucks are making an economic choice… they are investing that capital in dump trucks to the exclusion of all other possible uses of that capital and their decision to spend their time mining tar sands necessarily precludes the possibility that they might do something else with that time instead. Quite simply, the mining of the tar sands of Canada (and the additional oil that is produced as a result of this) comes at a cost – a cost we will never know since the alternative possible uses of that capital and labour will never be known but you can be certain that as a result of mining the tar sands of Canada there is something else that was not produced instead.

Had the price of petrol never surpassed $70 a barrel and, in a hypothetical situation, had the price of croissants in Canada skyrocketed to $15 each then perhaps the capital that was invested in dump trucks would instead have been invested in bakeries and, rather than spending their time training to be machine operators perhaps the pool of Canadian labourers would have spent their time instead as apprentice bakers. Would that have been so bad? I don’t know – it’s like asking if it’s better for someone to get pizza or lay on the couch… what is the best (and most profitable) course of action really depends on their personal preferences. However, in the case of the choice between croissants and petrol what we are asking is not the preferences of an individual but the aggregate sum of all the preferences of all the individuals in the economy, which are reflected in the prices that they are willing to pay for both croissants and petrol. If the relative prices of croissants and petrol remained reasonably consistent with the ratios that we’ve seen over the last few years then we probably wouldn’t expect dump trucks to be melted down and turned into pastry ovens any time soon. On the other hand, if the price of croissants shifted significantly against that of petrol then we might well expect to see basic goods such as metal and machine tools reoriented to support the baking industry instead of the petroleum industry. In a free market, if such a shift occurred then it would simply be indicative of a change in consumer’s preferences and the new investments in baking equipment could be applauded by the (soon to be) satisfied consumers in the market place.

The problem is that presently our prices appear to be sending some pretty mixed signals. One day the price of oil is through the roof and the next it’s through the floor… and nor is the price of oil in isolation here. Stocks, housing, commodities, durable goods – pretty much across the board we have yoyo prices. Economists wondering what is causing the volatility in prices are no doubt tempted to try to interpret these in terms of supply and demand (since, as we’ve all been told, that’s where prices come from right). And on a case by case basis, with a bit of imagination, such economists might find semi-plausible explanations for many of the price shifts that we’ve seen lately (in the case of wheat, for example, the issue of government subsidied for biofuels is often raised). However it is not the price of any one good in the market or even any one category of or group of goods that has seen volatility. Practically everything is on the move and the economy looks like it’s walking on sailors legs. The economy looks drunk… the kind of legless drunk that usually comes just before someone throws up all over your trousers and collapses unconscious on the floor.

It is absurd to try explaining the volatility in these prices in terms of fickle and changing consumer preferences. Consumer preferences simply have not changed (both in the upward and downward directions) sufficiently to justify the price swings we’ve seen of late. Nor am I inclined to believe that these price changes are the result of supply shocks. This would be peculiar indeed on such a global scale. The bigger the market the smaller you would expect the shocks to be. The effect on prices, of regional problems with the supply of products, would typically be dampened by the sourcing of alternative products from other countries. But that’s not what we’re seeing – we’re seeing global and massive price shifts. So if we’re not willing to accept changes changes in demand as the cause of our changing prices and we’re not willing to accept changes in supply as sufficient to have caused recent price volatility either then we’re only really left with one other choice… and that’s that the prices are not functioning correctly – which is to say that they do NOT reprepresent a relationship between supply and demand.

More and more, I’m starting to doubt the accuracy with which the prices in our market places reflect supply and demand. Of course the US government handing over hundreds of billions of dollars to subsidise various non profitable industries in the US (notably in the banking sector) certainly doesn’t help. The fact that banks can bid up the prices of goods in certain sectors of the economy without having to make sure their activities are profitable raises serious questions about the relevance of the prices of those goods. If government coercion is used to force money to be spent “recapitalizing” Citibank then is any of the capital that Citibank controls or are any of the goods that Citibank purchases currently priced at levels that reflect the preferences of consumers? The answer, quite obviously, is no. And the more the government interferes with the economy (whether that be by way of propping up ailing banks or by fiddling with interest rates to try to boost share prices and “keep home owners in their homes”) the more we have to admit that prices in the market are not being set by the market but are, in fact, being set by government. As in the socialist commonwealth, we have prices in name only – but those prices are not what you think they are. They don’t express the relative importance of goods to individuals in the economy and they don’t reflect the scarcity or abundance of those goods either. These are not prices that will ensure demand is met by supply and nor will they protect us against shortages (of things like savings) and wasteful gluts (of things like cars and houses). 

Our prices find themselves forced into a rather unnatural ménage les trois – no longer solely the marriage of supply and demand (as is natural). More and more they are the perverted prices that central planners have either explicitly sought to place on these goods or have inadvertently brought about by way of their hubris, incompetence and stupidity. What will be the price we pay for all this government fiddling? Ask the Russians – they know from experience. When you take away prices you take away the freedom of consumers to choose and the rational basis for production. The result is poor people without choices and without economy.