Saving the system

Aug 4, 2016·Alasdair Macleod

Monetary policy, we are told, is all about staving off recession and stimulating economic growth.

However, not only is monetary debasement in any form counterproductive and destroys the personal wealth of the masses, but the economists who devised today’s monetarism have completely lost their way.

This article addresses the confusion surrounding this subject, and concludes the real reason for today’s global monetary policies is an ultimately futile attempt to prevent a systemic and economic crisis.

Wrong tools for wrong targets

Central banks set themselves targets, such as unemployment that is deemed to be “full”, in other words the optimal low rate that will not lead to a pick-up in price inflation. CPI is the second target, typically set at 2% per annum. The hope is that these targets will lead to sustainable growth in GDP.

Unfortunately, estimates of unemployment do not tell us whether or not people are being employed productively. The term productive conjures up questions as to whether or not a government employee who is not customer-driven is economically productive, or whether or not a temporary barman should be deemed properly employed. There is also considerable tension between low rates of official unemployment, and near-record levels of the labour force not in work.

Recorded price inflation is even more flaky, with large discrepancies between official CPI and independent estimates, such as those of and the Chapwood Index in America. Their independent statistics record a far higher rate of price inflation in the US than the official CPI, and there is little doubt people are experiencing the higher rate. Assuming the GDP deflator should approximate to the actual rate of price inflation, independent estimates tell us that the US economy has been in recession every year since the dot-com bubble burst.

The statistical tools are obviously useless, and so is the principal target. GDP is a money-total, no more, no less. Imagine an economy where the total quantities of money and credit never vary, and all credit is fully backed by money instead of conjured up out of thin air. Prices for individual goods and services are free to change, but the total money deployed cannot. Credit shifts from the failures to the successes. But because credit is wholly backed by sound money, if the credit is extinguished, the money lives on. Therefore, GDP does not increase or decrease.

Alternatively, imagine you construct a balance sheet of the economy, and you introduce some more money. The balance sheet totals will increase accordingly, but it does not tell you how productively the extra money is deployed. What we seek in GDP is not found there: what we really want to know is whether or not economic conditions for the vast majority of people are improving. The only evidence of this would be increasing average wealth for all employed classes, and we are not talking about measures of wealth denominated in unsound currencies, nor are we talking about the apparent wealth that results from credit inflation. It has to be real.

Equally, it cannot be measured, but framed that way, we can begin to get a better sense of perspective as to what economic policy should attempt to achieve.

Take the example of helicopter money, which is increasingly talked about. It would undoubtedly boost nominal GDP. But if we think in terms of economic progress, we quickly realise that helicopter money is actually economically destructive as can be easily demonstrated.

Let us assume that a central bank distributes money through the banking system to the bank accounts of consumers, who will undoubtedly spend most of this windfall. The immediate effect will be to increase the GDP total, as described above. But it creates a shortage of goods, so prices can be expected to quickly rise, nullifying any perceived benefit. And because the distribution is so well telegraphed, no sensible manufacturer is going to respond by increasing his production significantly for a one-off benefit. Therefore, as the money is spent its purchasing power will decline fairly rapidly, the costs of production will rise, and a slump will ensue. Unless, that is, there are continuing helicopter drops, but that, everyone can agree, is the path to wealth destruction through hyperinflation, and therefore the end of all economic progress.

Just by rephrasing the question, from fostering GDP growth to fostering economic progress, leads to some diametrically opposed answers, as the helicopter money example illustrates. In this vein, I shall now address four of the most destructive fallacies about the relationship between money, credit, and economic progress.

Fallacy 1: Monetary debasement benefits the economy

Modern economists mistakenly ignore the intertemporal effects of changes in the quantity of money. When money or credit is expanded, the first receivers of it get to spend it on existing products before anyone else. Therefore, they benefit from the extra money before prices have risen to reflect its addition into general circulation. The second receivers have a similar advantage, but incrementally less so. Therefore, after this new money has progressed through many hands with a tendency to drive up prices every time, the last receivers of the additional money find that prices for nearly all goods have already risen and the purchasing power of their wages and savings has effectively fallen.

This is known as the Cantillon effect. It amounts to a wealth transfer from the poorest in society, the unskilled workers, pensioners and small savers, to the government and its agents. Bankers, licensed to produce credit out of thin air at no cost, thrive. The second receivers, the businesses that benefit from bank credit and unfunded government contracts, do almost as well. The result is government, banks and their close supporters enjoy a wealth benefit at the expense of ordinary people.

It is therefore hardly surprising the establishment and its lobbyists strongly favour monetary expansion, but the Cantillon effect cannot be denied, in theory or empirically. It is the single most important reason why inflating money and credit will always be counterproductive. We see this effect today, with the gap between rich and poor widening dramatically. It is monetary policy that impoverishes the masses, more surely than anything else.

Fallacy 2: Low interest rates are beneficial

The emotional appeal of low interest rates has its origin in the old religious association of interest with usury. Keynes promoted this view, not expressed so blatantly in moral terms, but by conjuring up an image of work-shy capitalists profiting from the deployment of their money for interest. His term for these capitalists, rentiers, condemned them in his followers’ minds.

Keynes’s view is consistent with the idea that it is the rentiers who set the price for money, holding the entrepreneur to ransom, when in fact it is the other way round. In a free market where interest rates are set by consenting parties, it is the entrepreneur that sets the savings rate by bidding up the interest rate. It is this phenomenon that resulted in the long-held correlation between the price level and interest rates, demonstrated in Gibson’s paradox, which Keynes, Fischer and Friedman were all unable to explain.

The fact that this correlation demonstrably existed from 1730 up to the 1970s is clear evidence that entrepreneurs were prepared to pay a rate of interest that related to the one thing they knew better than anything else, and that was the price they expected to obtain for their product in the market. There can be no other credible explanation. Equally, it shows that central bank attempts to manage price inflation by varying the interest rate are doomed to fail, because there is no natural correlation between the two. 

This was certainly the case until the late 1970s, when the Fed raised interest rates to the point where normal business activity could not be financed profitably. Since then, monetary policy has taken over control of interest rates to the point where they ignore market forces entirely. The idea that central banks can manage unemployment, price inflation and GDP by varying interest rates has also been disproved by experience, yet they still persist in this crazy quest. 

The expansion of bank credit that accompanies suppressed interest rates will increase GDP, assuming the credit expansion is not aimed at non-GDP items, such as financial assets. But that is a very different matter from fostering economic progress, which requires an interest rate that correlates with the price level, and not the rate of price inflation.

Fallacy 3: Expanding money and bank credit stimulates business

In a sound-money environment, some businesses prosper and others fail. The ones that prosper do so through success, not subsidy, and there is no subsidy for the failures. The business environment is of necessity one of constant change, as mistakes are quickly rectified. Capital resources for profitable enterprises are released from those that are less so or even unprofitable. Assuming a steady savings rate, the release of inefficiently deployed capital is vital for successful enterprises to flourish. Importantly, there can be no credit-driven business cycle to disrupt economic progress.

This is not a happy environment for legacy industries, unwilling to face the change progress imposes, or no longer relevant to the future. Often these businesses dominate communities, and are costly and inefficient compared with their modern competitors operating in lower-cost conditions. They lobby hard and successfully for subsidies. And if there is free money and credit in the offing, all businesses well-connected to political circles want their share of the largesse.

This is why today’s monetary environment is of unsound money, the expansion of money and credit designed to increase GDP. The result is good businesses no longer have to attract capital resources from the less profitable and the failures. All businesses, the successful and the failures, draw on freely available credit, either for genuine production or to avoid failure. The consequence is a growing accumulation of unproductive debt, whose default is continually deferred.

As the bad businesses compete with the good for scarce labour and raw materials, which unlike unsound money cannot be conjured out of thin air, prices begin to rise. And as higher prices work through to final products, easy money encourages consumers to alter their money-preferences in favour of goods. After all, unemployment is low and things are booming, so why go without?

At this point, central banks are forced to interrupt their expansionary policies and raise interest rates to curb unforeseen price inflation, and to only stop raising rates when widespread bankruptcies are threatened.

For anyone interested in promoting economic progress as opposed to just growing the GDP numbers, inflating money and credit is obviously not the way to go about it. Those who do not grasp the difference between real economic progress and raising GDP are likely to persist in trying to grow GDP, putting the lessons of experience behind them. Welcome to the world of central banking.

Fallacy 4: Lower exchange rates benefit the economy

This is a policy of giving preference to exporters at the expense of everyone else, and in that sense is another variation of the Cantillon effect. It is a deliberate policy of reducing the value of the wages of exporters’ employees and other domestic costs, a wealth-transfer that eventually affects everyone. It destroys personal wealth, particularly for those who can least afford it.

Economic planners appear to be blind to the true origin of trade deficits. In a sound money environment, everyone is forced to pay their bills. If you buy something, whatever its origin, you will have earned or borrowed sound money from someone else to pay for the goods purchased. Therefore, trade deficits, other than those arising from self-correcting timing differences on settlements, cannot exist. Attempts to correct trade deficits by manipulating the exchange rate, while pursuing unsound monetary policies, are in consequence futile.

It is no accident that a trade deficit is often accompanied by a government budget deficit, because the latter is bound to lead to the first, assuming the savings rate remains unchanged. The reason has already been stated above: the private sector pays its bills, so trade deficits can only arise from unsound money and unfunded government deficits. 

Empirical evidence and analysis of national accounts support this analysis, yet nearly everyone automatically subscribes to the fallacy that reducing the exchange rate is a good thing for the economy. Devaluing the currency does not correct trade deficits, and the policy amounts to an ongoing destruction of a currency’s purchasing power for no gain.

Devaluations, which go hand in glove with unsound monetary practices, can be expected to lead to an increase in the money-total of GDP, but they hinder economic progress by destroying the wealth central to the financing of market-driven industrial investment. The post-war experience of Germany with its strong mark, compared with that of Britain with its weak sterling, refers.

The real reason behind unsound money policies

The neo-classical economists that populate government and central banks are finding out the hard way that their fallacies and their dishonest use of the state’s seigniorage of money and credit have lead everyone into a dead-end debt trap. They show no understanding of how they got us all here, but are becoming acutely aware of the consequences.

Unsound monetary practices favour debt financing over financing from genuine savings, because of the wealth-transfer effect that benefits debtors. The result of decades of unsound monetary policies is that the major welfare economies have become overloaded with an accumulation of government debt, which can never be repaid, only devalued. Additionally, escalating welfare liabilities have to be financed, which means that the welfare-states’ need for low-cost financing through the expansion of bank credit and raw money has now become more or less infinite.

It is obvious that a government can only discharge its welfare liabilities by acquiring yet more of the private sector’s wealth. The wealth destruction suffered by the private sector simply detracts from its ability to fund future government spending. <b/p>

Not only are the private sectors in welfare states burdened with increasing state depredations on their wealth, they themselves have accumulated large amounts of unproductive debt as a result of decades of easy under-priced bank credit. The result is evident in very low rates of genuinely productive employment, and the impoverishment of the masses. While these problems are more evident in some nations than in others, all welfare states are affected. 

Some countries like France conceal their unemployment problem by socialising large swathes of the economy, either directly or indirectly. Unemployment is officially recorded at about 10%, the state accounts for the majority of economic activity, and there is a large agricultural sector of predominantly subsistence-farming smallholders. The whole economic structure is inherently unproductive. In other welfare nations, the unemployment problem is more obvious.

Italy is a good example, with a youth unemployment rate of 37%. The state accounts for about 52% of GDP, and non-performing loans on the banking sector’s balance sheets are recorded at 18% of GDP. Stripping out the state, NPLs are 37.5% of private sector GDP. It is therefore clear that not only is the private sector collapsing under the weight of its own debt, but there must be a growing incentive for companies which can service their debt not to do so, because their banks might not be around in the future to reward them by extending more credit. Those that see the Italian crisis as a banking problem miss the point. It is the Italian economy that’s the problem, and the banks are merely the prosciutto in the sandwich.

Italy is in the vanguard of welfare state failures. Central banks formulating monetary policy are becoming increasingly aware of this fact and the similarities with their own position. Their priority now is to avoid a global debt-induced economic crises. They see this being staved off by increasingly desperate attempts to promote GDP growth. They will pursue this policy at accelerating speed right into the buffers at the end of the line. 

The partying is over. The days of transferring wealth from the middle-classes and the poor through monetary debasement to benefit the welfare states, the banks and their preferred customers, are now numbered. The implications for future monetary policy are simple: the Fed, Bank of Japan, European Central Bank and Bank of England are working together to keep their respective GDPs from falling. The Bank of Japan is leading the way into deepening negative interest rates and more asset-supporting quantitative easing, and the others are all set to follow its example.

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