Demand is constrained by the ability to produce goods. The more goods that an individual can produce, the more goods he can acquire. The same can be said for the economy at large because what drives an economy is not demand but rather the production of goods and services.
Producers, not consumers, are the engine of economic growth. Obviously, a producer must produce goods and services in line with what other producers require.
According to James Mill,
When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation that constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation’s power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation. . . . Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.
The idea that the government grows the economy originates from the belief that increases in government outlays expand the economy’s output by a multiple of the initial government increase.
John Maynard Keynes, who popularized this idea, wrote,
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.
Given Keynes’s influence, it is not surprising that most economists today believe that it is possible via government spending to prevent a recession. Countering that notion requires that we examine the effect of an increase in the government’s demand on an economy’s wealth formation.
Take an economy comprised of a baker, a shoemaker, and a farmer, and assume a government enforcer enters the scene who demands goods by means of force. The baker, the shoemaker, and the farmer are forced to part with their products in exchange for nothing, weakening the flow of production of final consumer goods. The increases in government outlays do not raise overall output by a positive multiple; on the contrary, they undermine the process of wealth generation.
Through taxation, the government forces producers to part with their products for government services that are likely a low priority. According to Ludwig von Mises, “There is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.”
Monetary pumping and government spending cannot remove the dependence of demand on the production of goods. On the contrary, loose fiscal and monetary policies impoverish real wealth generators and reduce their ability to produce goods and services, thus weakening effective demand for other goods.
Therefore, curbing government spending is required to revive the economy, not increasing spending and monetary creation to boost aggregate demand. Limiting government spending enables wealth generators to revive the economy. Hence, by strengthening the economy’s ability to produce goods and services, we also strengthen overall demand.
Keynesians believe that recessions are the result of unexpected events that push the economy away from a trajectory of stable economic growth. Shocks weaken the economy and cause lower economic growth.
In contrast, we suggest that recessions occur because of the central bank’s monetary policies in which monetary authorities first inflate the currency, then pull back on money growth. Loose monetary policies lead to a strong money growth rate which ultimately leads to inflation, prompting the central bank to reverse course.
These activities cannot support themselves; they survive because the increased money supply provides support for them. The increased supply diverts money from wealth-generating activities to unproductive ones, weakening the wealth-generating process. From there, the tight-money stance ends the malinvestment of resources, leading to the recession.
Thus, nonproductive and unprofitable activities cannot support themselves once the growth rate of money supply declines. Aggressive fiscal policies, which are enacted to support nonproductive activities, continue to undermine the wealth-generation process, thereby damaging the prospects for an economic recovery.
During an economic crisis, the government should not intervene. When there is no monetary or fiscal tampering, wealth generators can retain their wealth, allowing them to expand the pool.
A larger pool of wealth makes it much easier to absorb various unemployed resources and eliminate the crisis. Aggressive fiscal policies, however, damage the process of wealth generation and make things even worse.
Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.
Article cross-posted from Mises.
]]>The head of the monetarist school, the late Milton Friedman, held that inflation is always and everywhere a monetary phenomenon. Friedman and other monetarists believed that the key driving factor for general increases in prices is increases in money supply.
This viewpoint has come under scrutiny since the early 1980s because the correlation between inflation and money supply disappeared. According to Ip in 2020, Alan Detmeister, an economist at UBS Group AG and formerly of the Fed, found inflation’s correlation to M2 since the early 1980s was weak and its correlation to both the monetary base and M1 was negative. Most economists have stopped using money supply as an indicator for inflation since the early 1980s.
Many mainstream economists have attributed the breakdown in the correlation between the money supply and inflation on the unstable velocity of money. What is it? According to the famous equation of exchange, MV = PT, where:
This equation states that money multiplied by velocity equals the value of transactions. Many economists employ GDP (gross domestic product) instead of PT, thereby concluding that
MV = GDP = P (real GDP).
The equation of exchange appears to offer a wealth of information regarding the state of an economy. For instance, if one were to assume stable velocity, then for a given stock of money one can establish the value of GDP. Furthermore, a given real output and a given stock of money enables us to establish the price level.
For most economists the equation of exchange is regarded as a very useful analytical tool. The debates that economists have are predominantly with respect to the stability of velocity. If velocity is stable, then money is seen as a very powerful tool in tracking the economy. The importance of money as an economic indicator however diminishes once velocity becomes less stable and hence less predictable.
However, an unstable velocity could occur because of an unstable demand for money. Most experts believe that since the early 1980s, innovations in financial markets made money velocity unstable. This in turn made money an unreliable indicator of inflation.
We believe the alleged failure of money as an indicator of inflation emanates from an erroneous definition of inflation and money supply. This failure has nothing to do with an unstable demand for money, and just because people change their demand for money does not imply instability. Because an individual’s goals may change, he might decide that it benefits him to hold less money. Sometime in the future, he might increase his demand for money. What could possibly be wrong with this? The same goes for any other goods and services—demand for them changes all the time.
According to Murray Rothbard and Ludwig von Mises, inflation is defined as the increase of the money supply out of “thin air.” Following this definition, one can ascertain that increases in money supply set economic impoverishment in motion by creating an exchange of nothing for something, the so-called counterfeit effect.
General increases in prices are likely to be symptoms of inflation—but not always, however. Note that prices are determined by both real and monetary factors. Consequently, it can occur that if the real factors are “pulling things” in an opposite direction to monetary factors, no visible change in prices is going to take place. If the growth rate of money is 5 percent and the growth rate of goods supply is 1 percent then prices are likely to increase by 4 percent. If, however, the growth rate in goods supply is also 5 percent then no general increase in prices is likely to take place.
If one were to hold that inflation is about increases in prices, then one would conclude that, despite the increase in money supply by 5 percent, inflation is 0 percent. However, if we were to follow the definition that inflation is about increases in the money supply, then we would conclude that inflation is 5 percent, regardless of any movement in prices.
Prior to 1980, it was popular to employ various money supply definitions in the assessment of the changes in the prices of goods and services. The criterion for the selection of a particular definition was its correlation with national income. However, since the early 1980s, correlations between various definitions of money and national income have broken down. Some analysts believe that this breakdown is because of changes in financial markets, making past definitions of money irrelevant.
A definition presents the essence of a particular entity, something no statistical correlation could ever provide. To establish the definition of money we have to explain the origins of the money economy. Money has emerged because barter cannot support the market economy. Money is the general medium of exchange and has evolved from the most marketable commodity. Mises wrote:
There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.
Since the general medium of exchange was selected out of a wide range of commodities, the emerged money must be a commodity. Rothbard wrote:
In contrast to directly used consumers’ or producers’ goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold).
Through an ongoing selection process, individuals settled on gold as standard money. In today’s monetary system, the core of the money supply is no longer gold, but rather coins and notes issued by the government and central bank that are employed in transactions as goods and services are exchanged for cash. Hence, one trades all other goods and services for money.
Part of the stock of cash is stored through bank deposits. Once someone places money in a bank’s warehouse, he is engaging in a claim transaction, never relinquishing his ownership of the money. Consequently, these deposits, which are labelled demand deposits, are part of money.
This is contrasted with a credit transaction, where the lender relinquishes his claim over the money for the duration of the loan. In a credit transaction, money is transferred from a lender to a borrower, but the overall amount of money in the economy does not change because of the credit transaction.
The introduction of electronic money seems to cast doubt on the definition of money. It would appear that deregulated financial markets generate various forms of new money. Notwithstanding, various forms of electronic money or e-money, like digital currency, do not have a “life of their own.”
Various financial innovations do not generate new forms of money but rather new ways of employing existing money in transactions. Irrespective of these financial innovations, the nature of money does not change. Money is the thing that all other goods and services are traded for. Once the essence of money is established by excluding various credit transactions, one can identify the status of inflation. Changes in prices are not going to be relevant here.
Contrary to popular thinking, inflation is not about increases in the prices of goods and services but about increases in money supply. Following this definition, we can establish that the key damage caused by inflation is economic impoverishment through the exchange of nothing for something. What matters as far as inflation is concerned is not the correlation between money supply and the prices of goods and service but increases in money supply.
Contrary to popular thinking, the essence of money did not change because of various financial innovations. Money is a thing that is employed as a medium of exchange. Furthermore, according to Mises’s regression theorem, the historical link between paper currency and gold is what holds the present monetary system together.
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Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.
Image via Shutterstock. Article cross-posted from Mises.
]]>Krugman expresses strong disagreement that the decline in interest rates caused bubbles and that the decline was artificial. For Krugman, the Federal Reserve sets short-term interest rates, which in turn determine long-term rates. He then suggests that there’s no such thing as an interest rate unaffected by policy.
The columnist then argues that what matters for the Fed’s policy is the natural rate of interest, which is consistent with price stability and economic stability—i.e., economic equilibrium. This means that the key objective of Fed policies should be to target the policy rate to the natural rate in order to attain this state of equilibrium. Given that the natural rate was trending down it is not surprising that the policy rate followed suit.
Why has the natural rate been trending down? According to Krugman, the downtrend was caused by demography. “When the working-age population is growing slowly or even shrinking, there’s much less need for new office parks, shopping malls, even housing, hence weak demand.” Krugman warns, “These demographic forces aren’t going away. If anything, they’re likely to intensify, in part because the rate of immigration has dropped off. So there’s every reason to believe that we’ll fairly soon go back to an era of low interest rates.”
Krugman also says that the Fed’s interest rate policy has been in line with the neutral rate, which fell very sharply. Again, the key reason for this decline is aging population and reduced demand for the investment in the infrastructure. However, does it all make sense?
Again, according to Krugman, the Fed is the key factor for the determination of interest rates via its control of the short-term interest rates. The Fed influences short-term interest rates by influencing monetary liquidity in the markets. Through the injection of liquidity, the Fed pushes short-term interest rates lower. Conversely, by withdrawing liquidity the Fed exerts an upward pressure on the short-term interest rates.
On this thinking, long-term rates are the average of current and expected short-term interest rates. If today’s one year rate is 4.0 percent and the next year’s one-year rate is expected to be 5.0 percent, then the two-year rate today should be 4.5 percent ((4+5)/2=4.5 percent). Conversely, if today’s one-year rate is 4.0 percent and the next year’s one-year rate expected to be 3.0 percent, then the two-year rate today should be 3.5 percent (4+3)/2=3.5 percent.
On this logic, it would appear that the central bank is the key in the interest rate determination process. However, is this the case?
We believe it is individual time preferences rather than the central bank that hold the key in the interest rate determination process. What is it all about?
An individual who has just enough resources to keep himself alive is unlikely to lend or invest his paltry means. The cost of lending, or investing, to him is likely to be very high—it might even cost him his life if he were to consider lending part of his means. Therefore, he is unlikely to lend, or invest even if offered a very high interest rate. Once his wealth starts to expand, the cost of lending, or investing, starts to diminish. Allocating some of his wealth towards lending or investment is going to undermine to a lesser extent our individual’s life and well-being at present.
From this we can infer, all other things being equal, that anything that leads to the expansion in the wealth of individuals is likely to result in the lowering of the premium of present goods versus future goods. This means that individuals are likely to accept lower interest rates.
Note again, interest is the outcome of the fact that individuals assign a greater importance to goods and services in the present against identical goods and services in the future. The higher valuation is not the result of capricious behavior, but because of the fact that life in the future is not possible without sustaining it first in the present. Hence, various goods and services that are required to sustain a man’s life at present must be of a greater importance to him than the same goods and services in the future.
The lowering of time preferences—i.e., the lowering of the premium of present goods versus future goods due to wealth expansion—is likely to become manifest by a greater eagerness to invest wealth. With the expansion in wealth, individuals are likely to increase their demand for various assets—financial and nonfinancial. In the process, this raises asset prices and lowers their yields, all other things being equal.
As a rule, a major factor for the discrepancy between observed interest rates and the time preference interest rate is the actions of the central bank.
Again, by popular thinking, the neutral rate is one that is consistent with stable prices and a balanced economy. Hence, by this thinking in order to attain economic and price stability, Fed policy makers should navigate the federal funds rate towards the neutral rate range.
By the neutral interest rate framework, in order to establish whether monetary policy is tight or loose it is not enough to pay attention to the level of money market interest rates, but rather one needs to contrast money market interest rates with the neutral rate. Thus if the market interest rate is above the neutral rate then the policy stance is tight. Conversely, if the market rate is below the neutral rate then the policy stance is loose. Hence, whenever the money market rate is in line with the neutral rate, then the economy is in a state of equilibrium and there are neither upward nor downward pressure on the price level.
In the popular framework, the neutral interest rate is formed at the point of intersection between the supply and demand curves. The supply and demand curves as presented by popular economics originates from the imaginary construction of economists. None of the figures that underpin these curves originates in the real world; they are purely imaginary. According to Ludwig von Mises, “It is important to realize that we do not have any knowledge or experience concerning the shape of such curves.”
Consequently, this implies that it is not possible to establish from the imaginary curves the neutral interest rate. The employment of sophisticated mathematical methods does not solve the issue that the neutral rate is not observed. So what are the basis for Krugman to suggest that the neutral rate has been trending down? None whatsoever. Contrary to Krugman, the Fed by being a major source for money creation has been instrumental in the formation of bubbles.
Contrary to Krugman the main source for money creation out of “thin air” is the central bank. Consequently, various bubble activities created are the outcome of the Fed’s monetary pumping and nothing else.
Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.
Image by 00Joshi via Flickr, CC BY-NC-SA 2.0. Article cross-posted from Mises.
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