The Age of Economic Ignorance

Frank Shostak is a former professor of economics who is now M. F. Global's chief economist.

In this article published at Brookesnews he outlines the danger the world faces due to the belief that printing money will somehow lift the world out of recession or even avoid what appears to be an inevitable depression.

There is now no excuse for the layperson to not have spent some time studying up on the reason for the dire economic straits that the world finds itself in.

People should by now understand that consumption does not drive the economy and that the current problem has been created by the expansion of the money supply, exacerbated by ridiculous government intervention in the markets such as the immoral Community Reinvestment Act in the United States.

What's it going to take for people to realise the folly of their ways?

Food lines?

Civil strife?

Worse?

We live in an age of grave economic ignorance, if central-bank policy is an indication of prevailing economic theory. It is apparent that we've learned nothing from several millennia of monetary destruction. The persistent demonstration that capital, not paper, is the basis for prosperity has fallen on deaf ears. Daily, we face the sad spectacle of government officials, pundits, and even Nobel laureates telling us that printing money is the answer to an economic downturn. Consider that since the eruption of the financial credit crisis in the second half of 2007, all major central banks have embraced an irresponsibly loose interest-rate stance. For instance, the policy rate of the Bank of England (BOE) was lowered from 5.75 per cent in November 2007 to the current level of 1 per cent.

The sharp decline in the BOE policy interest rate is in line with policies of other central banks. The US central bank (the Fed) has lowered its policy rate (the federal-funds rate target) from 5.25 per cent in August 2007 to around zero at present. Also, the relatively "conservative" European Central Bank (ECB) has been aggressively lowering its policy interest rate. The rate was lowered from 4.25 per cent in September last year to the present target of 2 per cent. Similarly, the Bank of Japan (BOJ) has visibly eased its interest rate stance. The policy rate was reduced from 0.5 per cent in September 2008 to the current level of 0.1 per cent.

Given that, so far, already extremely low interest rates have failed to revive economic activity, central bankers are now considering another approach. Last Wednesday, February 11, the governor of the Bank of England said that the UK central bank is going to embrace a quantitative easing policy to revive the economy. The idea here is to flood the economy with money by buying government bonds. US central-bank policy makers are currently contemplating a simliar idea. We shouldn't overlook the fact that, since embracing the aggressive lowering of rates, central banks have been aggressively pushing money into the banking system without succeeding in reviving economic activity. So why should aggressive money pumping work now?

The yearly rate of growth of the US central-bank balance sheet (money pumping) jumped from 3.9 per cent in August last year to 152.8 per cent in December 2008 before falling to 127.5 per cent in January. The yearly rate of growth of the balance sheet of the Bank of England jumped from negative 7.2 per cent in May 2007 to positive 179.4 per cent by October 2008 before easing to 157.6 per cent in November last year and 129 per cent in January.

The growth momentum of the European Central Bank balance sheet has accelerated in January. Year on year, the rate of growth jumped from 7 per cent in July 2007 to 45.5 per cent in December and to 56.5 per cent in January. Also, the yearly rate of growth of the BOJ balance sheet follows a visible uptrend. The rate of growth climbed from negative 0.8 per cent in August last year to 10.3 per cent in December before easing to 5.7 per cent in January.

What permits real economic growth is an improvement in the investment infrastructure of the production process. What makes the improvement possible is real savings. It is real savings that fund the enhancement of infrastructure through various tools and machinery, i.e., capital goods. With better tools and machinery, a better quality and a greater quantity of goods and services can be produced.

In a free, unhampered market economy the established infrastructure is in accordance with the tendency toward harmony between various activities. This means that the flow of real savings is sufficient to fund various lines of production without any disruption. On this Murray Rothbard, paraphrasing Ludwig Lachmann, wrote,

Capital is an intricate, delicate, interweaving structure of capital goods. All of the delicate strands of this structure have to fit, and fit precisely, or else malinvestment occurs. The free market is almost an automatic mechanism for such fitting; … with its price system and profit-and-loss criteria, [it] adjusts the output and variety of the different strands of production, preventing any one from getting long out of alignment. (Murray N. Rothbard, Man, Economy, and State with Power and Market, Mises Institute, 2004, p. 967).

As a result of the artificial lowering of interest rates and massive money pumping, an additional demand for various goods and services emerges. This leads to an attempt to expand the infrastructure. This attempt is bound to fail since the flow of real savings is not large enough to support the expansion of the capital structure. Consequently, the attempt to expand the infrastructure leads to the diversion of real funding from various activities that make the present flow of real savings possible. Thus, the flow of real savings comes under pressure and the rate of real economic growth follows suit.

Neither an artificial lowering of interest rates nor monetary pumping by central banks has direct input in the production of capital goods and the production of goods and services that are required to promote and maintain human life and well-being. The artificial lowering of interest rates and monetary pumping only give rise to various false activities by diverting a portion of the flow of real savings to these activities. The more false activities that emerge on the back of the artificial lowering of interest rates and monetary pumping, the less real savings will be available for wealth-generating activities.

The fact that economic conditions have continued to deteriorate despite the aggressive lowering of interest rates and massive money pumping by central banks raises the likelihood that the flow of real savings is in trouble. Note again that monetary pumping and the artificial lowering of interest rates can't replace nonexistent real savings. Without additional real savings, it is not possible to undertake various new projects without weakening the existent structure of production.

Remember that the interest rate is just an indicator of the state of demand and supply for real savings. The falsification of this indicator cannot expand the flow of real savings. Likewise money is just a medium of exchange. Its function is to permit the exchange of the products of one specialist for the products of another specialist. More money cannot generate more real savings or real economic growth.

On the contrary, a further planned expansion in monetary pumping by central banks can only weaken the flow of real savings and undermine prospects for a sustained economic revival.

I can't see how any - any - of the so called stimulus packages around the world can have any other effect than to make the situation worse.

(Nothing Follows)