Recovery or Illusion?
[Presented at Boom, Bust, and the Future: A Private Retreat with Austrian Economists, January 20, 2002.]
Does the recent revival in various economic data raise the possibility that the Fed's aggressive loose monetary stance is starting to yield results?
The GDP edged up slightly in the fourth quarter of last year (though even press reports credited government spending for that). The purchasing management index rose to 48.2 in December from 44.5 in the previous month. New home sales increased by 6.4 percent in November after growing by 1.7 percent in October. Also, indices of manufacturing activity in the New York and Chicago areas increased in December from November. Furthermore, the consumer confidence index jumped to 93.7 in December from 84.9 in November.
Notwithstanding all this, what determines whether the U.S. will experience a meaningful economic recovery is not the Fed's aggressive lowering of interest rates but whether the real pool of funding is growing.
The Heart of Economic Activity
According to mainstream economics, consumer demand is the most important factor in an economy. If consumers are active, it is regarded as a good sign of economic health; if consumers do not spend enough, it is seen as a bad omen. Whenever a deficiency in overall demand emerges, it is argued that the government and its central bank must step in to prevent the economy from falling into a slump.
The theory goes like this: If demand is increased, an increased production of goods and services will follow suit and, consequently, prosperity will be restored. In other words, what enables economic growth is demand for goods and services. Within this way of thinking nothing is ever said about how the demand for goods and services is funded. Moreover, is it enough that by means of demand for goods and services the economy can be kept going?
The distinguishing characteristic of human activities is that they are purposeful--people employ means to promote their life and well-being. In the real world one has to become a producer first before one can demand goods and services. That is, it is necessary to produce some useful goods (means) that can be exchanged for other goods (goals). Means fulfill the role of funding--they make it possible to secure individuals goals.
For instance, with given resources at his disposal, a baker can produce a given amount of bread. The bread that the baker has produced is his means in securing ends--the bread is his pool of funding. Thus the baker might use a portion of the bread for his own consumption. Another portion might be exchanged for other consumer goods, i.e., they might fund his consumption of other goods and services. The rest of the bread might be used to buy a new oven and to hire workers to install this oven.
The portion of bread that the baker has exchanged to acquire and install the oven is what saving is all about. Instead of consuming the bread directly, or exchanging it for other final consumer goods, the baker has exchanged the bread to acquire a better oven. The new oven, in turn, will permit a greater production of bread. This in turn permits a further expansion and enhancement of the baker's production structure, which subsequently enables the baker to lift the production of bread further.
Note that as long as the baker's pool of funding, i.e., the amount of bread at his disposal, continues to expand, he is in a position to raise both consumption and savings; his living standard will rise.
Saving is required not only for the expansion of a given production structure but also for its maintenance. If the baker fails to maintain the oven and replace its worn-out parts, the production of bread will suffer. This in turn will undermine the baker's pool of funding and lower his living standard. (In other words, to keep the production of bread going, some of the bread must be exchanged for the new parts.)
Note that when the baker exchanges his bread for the oven and other consumer goods, he is supplying individuals that have been engaged in the production of these goods with the means that promote their life and well-being. Likewise, final consumer goods that the baker has secured for his bread promote his life and well-being.
Money and the Pool of Funding
The introduction of money into our discussion does not alter the essence of what saving and the pool of funding is all about. Money fulfills the role of the medium of exchange. It enables the produce of one producer to be exchanged for the produce of another producer. Observe that while money serves as the medium of exchange, it doesn't produce goods and services; it only enables these goods and services to be exchanged.
Another important role of money is to serve as a medium of saving. Instead of saving goods, which requires storing them, people can now save money. In the world of barter, perishable goods are difficult to save for very long. These difficulties are resolved in the money economy. Once a producer has exchanged his goods for money, he has begun saving. When a baker sells his bread for money to a shoemaker, he has supplied the shoemaker with his saved, i.e. unconsumed, bread. The supplied bread, in turn, which sustains the shoemaker, allows him to continue making shoes. Being the medium of exchange, money enables the baker to secure goods and services some time in the future whenever he may require them.
Through money, people channel real savings, which permit economic activity to take place. Thus the saving of money by one individual supports the production of another individual, who in turn, by exchanging his produce for money, supports a third individual. In this way money enables real savings to permeate across the economy and lift the pace of production of goods and services.
However, it does not follow that one can lift economic growth through printing presses. When money is printed--i.e., created "out of thin air"--it sets in motion an exchange of nothing for money and then money for something, i.e., an exchange of nothing for something. An exchange of nothing for something amounts to consumption that is not supported by production. Since every activity has to be funded, it follows that an increase in consumption that is not supported by production must divert funding from wealth-generating activities. In short, consumption that is not preceded by production amounts to unearned consumption; i.e., it takes from the pool of funding without making any contribution to this pool.
Consequently, when a central bank expands the money stock, it does not enlarge the pool of funding, but, on the contrary, dilutes the pool, thereby weakening the rate of economic growth. Thus when money "out of thin air" gives rise to consumption that is not supported by prior production, it diverts the funding that supports production of goods and services of the first wealth producer.
This in turn undermines his production of goods and thereby weakens his effective demand for the goods of another wealth producer. The other producer in turn is forced to curtail his production of goods, thereby weakening his effective demand for goods of a third wealth producer. In this way, money "out of thin air," which destroys savings, sets in motion the dynamics of the consequent decline of the growth of real wealth production.
In the money economy, the pool of funding is comprised of all the final consumer goods produced by various producers. In contrast with gross domestic product (GDP) that only pays attention to the final stage of production, the pool of funding deals with the funding for all the stages of production, i.e., final and intermediate. By ignoring funding to the intermediate stages of production, the GDP framework lapses into a world of illusion where final goods and services emerge "out of the blue." However, in the real world, no final product can ever emerge without intermediate stages.
Recession versus Depression
Contrary to popular thinking, recessions are not about two quarters of a negative growth in real GDP, or declines in various economic indicators; they are about the liquidation of business errors brought about by previous loose monetary policies. In short, they are about the liquidation of activities that sprang up on the back of previous loose monetary policy. The ensuing adjustment of production may or may not manifest itself through a negative GDP rate of growth.
As a rule, symptoms of a recession emerge once the central bank tightens its monetary stance. But what determines whether an economy falls into a depression or just suffers an ordinary recession is the state of the pool of funding. As long as this pool is still growing, a tighter central bank monetary policy will culminate in a recession. In other words, notwithstanding that various false activities (i.e., business errors that sprang up on the back of a loose monetary policy) will now suffer, overall economic growth will be positive.
As long as the pool of funding is expanding, the central bank and government officials can give the impression that they have the power to reverse a recession by means of monetary pumping and the artificial lowering of interest rates. In reality, however, these actions only slow or arrest the liquidation of false activities, thereby continuing to divert funding from wealth generators to wealth consumers. What in fact gives rise to a positive rate of growth in economic activity is not monetary pumping but the fact that the real pool of funding is actually growing.
The illusion that through monetary pumping it is possible to keep the economy going is shattered once the pool of funding begins to decline. Once this happens, the economy begins its downward plunge, i.e., the economy falls into depression. The most aggressive loosening of money will not reverse the plunge (for money cannot replace bread). In fact, rather than reversing the plunge, loose monetary policy will further undermine the flow of savings and thereby further weaken the structure of production and thus the production of goods and services.
The size of the pool of funding imposes a limit on the type of projects that can be accomplished. In a situation where the accomplishment of a particular project requires funding for one year of work while the pool of funding is only adequate to support six months of work, the project cannot be made feasible and no amount of monetary pumping can make the project possible. If money could have replaced real funding, then poverty would have been eliminated a long time ago.
In his writings, Milton Friedman blamed central bank policies for causing the Great Depression. According to Friedman, the Federal Reserve failed to pump enough reserves into the banking system to prevent the collapse in the money stock1 and thus in economic activity. For Friedman, the failure of the U.S. central bank is not that it caused the monetary bubble during the 1920s but that it allowed the deflation of the bubble.
An economic depression, however, is not caused by the collapse of the money stock as suggested by Professor Friedman, but rather by the collapse of the real pool of funding. The shrinkage of this pool is set in motion by the previous monetary pumping of the central bank and fractional reserve banking2. Moreover, a fall in the pool of funding triggers declines in bank lending and thus in the money stock. This in turn implies that previous loose monetary policies cause the fall in the pool of funding and trigger collapses in economic activity and in the money stock.
Declines in stock prices and the prices of goods and services follow declines in money supply. Most economists erroneously regard this as "bad news" that must be countered by central bank policies. However, any attempt to counter price declines by means of loose monetary policies further undermines the pool of funding. Furthermore, even if loose monetary policies were to succeed in lifting prices and inflationary expectations (as suggested by Professor Paul Krugman), this cannot revive the economy while the pool of funding is declining.
Lastly, it is erroneous to regard falls in stock prices as causing recessions. The popular theory argues that a fall in stock prices lowers individuals' wealth and this in turn weakens consumers' outlays. Since it is held that consumer spending accounts for 66 percent of GDP, this means that a fall in the stock market plunges the economy into a recession.
However, we have already shown that it is the pool of funding and not consumer demand that permits economic growth to take place. Furthermore, prices of stocks mirror individuals' assessments regarding the facts of reality. As a result of monetary pumping, these assessments tend to be erroneous. But, once the central bank alters its stance, individuals can see much more clearly what the facts of reality are and scale down previous erroneous evaluations. Observe that while individuals can change their evaluations of the facts, they cannot alter the existing facts which influence the future course of events.
The Current State of the U.S. Economy
Whenever the central bank changes interest rates, the effect of this change on producers is not instantaneous. It takes time before the effect of a change starts to assert itself. Historically, the average time lag between changes in the federal funds rate and changes in the yearly rate of growth of industrial production has been twelve months.
Using this historical time lag, we can suggest that in response to the tighter interest rate stance between June 1999 and May 2000, the current recession, or the current cyclical downturn, began in June 2000 (see chart). In other words, by raising the federal funds rate from 5 percent in June 1999 to 6.5 percent in May 2000, the Fed had set in motion in June 2000 the process of liquidation of businesses that sprang up on the back of previous loose monetary policy.
In January 2001, the Fed embarked on a new stage of lowering interest rates. The central bank lowered the federal funds rate from 6 percent to 1.75 percent, i.e., by 425 basis points. This artificial lowering has set in motion a renewed misallocation of resources. Using the lagged-by-twelve-months federal funds rate, we can suggest that there is a growing likelihood that a cyclical upturn in the manufacturing sector has already begun.
As such, a cyclical upturn doesn't cause real economic growth. It only misdirects the given pool of real funding, thereby weakening potential economic growth. As long as the real pool of funding is growing, an aggressive loose monetary policy can "stage a strong cyclical upturn"--i.e., strong positive year-on-year percentage rises in economic activity. If, however, the real pool of funding is stagnating, the cyclical rebound will be associated with a stagnant rate of growth in real economic activity.
As has been shown, a major negative for the real pool of funding is increases in money supply. These rises set in motion an exchange of nothing for something, which weakens the flow of real savings and thereby undermines the real pool of funding. Since 1980, the U.S. has experienced large monetary injections. A major cause of this is the "liberalization" of financial markets, which, for all its merits in permitting financial entrepreneurship, also removed various restrictions on banks' lending "out of thin air." The magnitude of money creation since 1980 is presented in the chart below.
Observe that in December 2001, money AMS3 was 80 percent above the trend, which is based on the history between 59 and 79. This massive increase in the money stock has been associated with a corresponding collapse in personal savings (see chart). In short, every dollar that was created "out of thin air" amounts to a corresponding dissaving by that amount.
This large money creation has also been accompanied by the relentless lowering of federal funds rates, which stood at 19.1 percent in June 1981.
While it is true that businessmen react to interest rates, what permits the expansion of tools and machinery, i.e., the infrastructure, is not interest rates but the growing pool of funding. As long as interest rates are not tampered with, they serve as an important medium in facilitating the flow of real savings toward the build-up of a wealth-generating infrastructure. In this sense interest rates can be regarded as an indicator.
Whenever the central bank tampers with interest rates through an artificial lowering, it falsifies this indicator, thereby breaking the harmony between the production of present consumer goods and the production of capital goods, i.e., tools and machinery. In short, an overinvestment in capital goods and an underinvestment in consumer goods emerge. While an overinvestment in capital goods results in a boom, the liquidation of this overinvestment produces a bust. Hence the boom-bust cycle.
The prolonged artificial lowering of interest rates must have contributed to a large overinvestment in capital goods versus consumer goods production (a severe misallocation of resources), thereby severely hurting the pool of funding (see chart).
The Rest of the World
From what has been said so far, it will come as no surprise that the real pool of funding might be in bad shape. This in turn raises the likelihood that the U.S. may follow the path of the Japanese economy.
The question that needs to be addressed is how, despite prolonged monetary pumping, the U.S. managed to perform so exceptionally well, at least in terms of real GDP, while Japan, which has been also pursuing aggressive loose monetary policies, has fallen into a severe economic slump. Thus both the U.S. and Japan have been aggressively pushing money supply (see chart) and aggressively lowering interest rates.
It is quite likely that the mighty U.S. production structure has managed so far to offset by a big margin the negatives of a prolonged monetary pumping. In short, despite loose monetary policies, the U.S. pool of funding has been growing. The U.S. pool has further benefited from the imports of goods and services from the rest of the world. The balance on goods and services stood at -$340 billion in 2001 against -$376 billion in 2000.
Contrast this with Japan's massive exports of goods (see chart) in return for U.S. government bonds, which has likely undermined Japan's production structure and thus its pool of funding. (Bear in mind that the Japanese government has been pursuing for decades policies that promote exports at the expense of other sectors of the economy.) In other words, Japan has diverted a large portion of its pool of funding in exchange for U.S. government promises. Imagine that instead of investing his saved bread in a new oven, the baker exchanges his bread for government bonds. Obviously this will impoverish the baker, for his savings are not employed to keep his production structure going. His savings are wasted on various government non-wealth-generating activities.
In Q3 2001, Japan held $311.6 billion in U.S. Treasury securities--26.6 percent of total foreign holdings and 11.2 percent of total private holdings. Moreover, foreign holdings of Treasury securities as a percent of total privately held debt stood at 42.2 percent in Q3 2001 against 15.8 percent in Q1 1986.
It seems that Japan is currently paying a very high price for policies that were aimed at promoting exports. In this respect it must be reiterated that policies that aim at boosting any economic activity at the expense of other economic activities are likely to undermine the harmony between consumption and production and thereby cause economic impoverishment. What we are saying here applies to policies that aim at boosting either aggregate demand or aggregate supply. Only the environment of a free unhampered market will guarantee the harmonious interplay between supply and demand.
An important factor that helps the diversion of real funding from the rest of the world to the U.S. is the increase in the American money supply. The fact that the U.S. dollar is the main international medium of exchange makes it possible for it to divert real funding from other countries to itself. In short, when new dollars are created, the first recipients of these dollars are Americans who can exchange them for foreign goods and services. Americans are in a position to practice the exchange of nothing for something because only the U.S. can produce American dollars. On this Mises wrote:
Let us assume that the international authority increases the amount of its issuance by a definite sum, all of which goes to one country, Ruritania. The final result of this inflationary action will be a rise in prices of commodities and services all over the world. But while this process is going on, the conditions of the citizens of various countries are affected in a different way. The Ruritanians are the first group blessed by the additional manna. They have more money in their pockets while the rest of the world's inhabitants have not yet got a share of the new money. They can bid higher prices, while the others cannot. Therefore the Ruritanians withdraw more goods from the world market than they did before. The non-Ruritanians are forced to restrict their consumption because they cannot compete with the higher prices paid by the Ruritanians. While the process of adjusting prices to the altered money relation is still in progress, the Ruritanians are in an advantageous position against the non-Ruritanians. When the process finally comes to an end, the Ruritanians have been enriched at the expense of the non-Ruritanians.4
It seems that the production of goods from the rest of the world has played an important role in keeping the U.S. pool of funding going. It is envisaged, however, that the emerging economic slump in the rest of the world is likely to weaken the support for the U.S. pool of funding in the months ahead.
Implications for Stock Markets
As a result of the Fed's aggressive loose monetary policy, the yearly rate of growth of money AMS adjusted for nominal economic activity stood at 13.2 percent in December against -4.1 percent in January.
This strong increase in liquidity should provide support to stock prices (see chart).
However, this strong liquidity build-up without the backup from company profits will not be able to generate a sustainable stock market recovery. Moreover, the present record-high P-E ratio (see chart) doesn't bode well for stocks. Unless the real pool of funding is still in good shape, the prospects for a healthy turnaround in corporate profits do not appear to be very promising.
Obviously, if the pool of funding is sound, we should witness a strong economic rebound and a strong rebound in stocks. However, a possible negative that might mitigate the rebound in stocks in this scenario is the likely acceleration in price inflation as a result of present the Fed's loose monetary policy.
The large overinvestment in capital goods versus consumer goods production means that on a relative basis, greater profit opportunities will be in companies that to a large extent are engaged in the production of final consumer goods. The stocks of companies that are associated with activities that are directly, or indirectly, linked to capital goods production are expected to underperform. Furthermore, within the framework of a stagnant pool of funding, on account of rising bad debts, bank stocks are likely to come under pressure.
Implications for Interest Rates
Within the framework of a "shaky" pool of funding and invisible cyclical upturn, we envisage that the Fed will continue to lower interest rates further. As a result, the differential between the yield on the ten-year T-bond and the federal funds rate, which stood at 3.3 percent at the end of December, is likely to widen further.
The strong build-up in liquidity coupled with subdued economic activity is likely to benefit the Treasury bond market (see chart). If, however, the pool of funding is "doing OK," then a possible rebound in price inflation might mitigate the effect of the build-up in liquidity.
According to the popular view, the revival of some important economic indicators has raised the likelihood that the aggressive lowering of interest rates by the Fed will invigorate the economy. The irony is that the very same loose monetary policies that are expected to energize the economy in fact undermine its main source of strength. As long as the real pool of funding is growing, the lower-interest policy of the Fed will appear to be "working." The collapse in personal savings coupled with the massive overinvestment in capital goods in relation to consumer goods production raises the likelihood that the U.S. real pool of funding may be in trouble.
Furthermore, in the past, the American pool of funding was helped by the rest of the world; but with a weakening in world economic growth, this support is likely to diminish. Consequently, it will not be a surprise if the U.S. economy follows the Japanese path some time in the future. Having said all this, we do not deny the possibility of a cyclical recovery in the months ahead. However, we suspect that this recovery is likely to be of a shallow nature.
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- 1. Milton & Rose Friedman, Free to Choose, p. 85.
- 2. Murray N.Rothbard, America's Great Depression (Kansas City: Universal Press), p. 153.
- 3. AMS money supply stands for the Austrian School of Economics money supply definition. See Frank Shostak, "The Mystery of the Money Supply Definition," Quarterly Journal of Austrian Economics,3(4), winter 2000, pp. 69-76.
- 4. Ludwig von Mises, Human Action, 3rd revised edition (Chicago: Contemporary Books) p. 477.