Some reflections to read over the Easter holidays
With Japanese and Eurozone interest rates becoming increasingly negative, and the Fed backing off from at least some of the planned increases in the Fed funds rate this year, economists are reassessing the interest rate outlook.
Economists lack consensus, with some expecting yet more easing, based on the apparent collapse in cross-border trade last year. The fact that the Bank of Japan and the European Central Bank see fit to pursue increasingly aggressive monetary reflation is taken as evidence of underlying difficulties faced in these key economies. And lingering doubts about the sustainability of China’s credit bubble point to a high risk of a credit-induced slump in the world’s growth engine.
Other economists, citing official US data and relying on the Fed’s statements, point out that unemployment levels have more than satisfied the Fed’s target, and that core inflation has picked up to the point where the Fed would be fully justified to increase interest rates over the course of this year, or risk overheating in 2017.
These two opposite camps conflict in their forecasts, but where they fundamentally differ is in expectations of future economic growth. Far from displaying the highest levels of macroeconomic discipline, their diversity of opinion should alert us that their forecasts may lack sound theoretical foundation. The purpose of reasoned theory is to reduce uncertainty, not promote it. And the explanation for most of the failures behind modern macroeconomic thinking is the substitution of market-based economics by economic planning.
The fact that today’s macroeconomics dismisses the laws of the markets, commonly referred to by economists as Say’s law, explains all. Subsequent errors confirm. The many errors are a vast subject, but they boil down to that one fateful step, and that is denying the universal truth of Say’s law.
Say’s law is about the division of labour. People earn money and make profits from deploying their individual skills in the production of goods and services for the benefit of others. Despite the best attempts of Marxism and Keynesianism along with all the other isms, attempts to override this reality have always failed. The failure is not adequately reflected in government statistics, which have evolved to the point where they actually conceal it. So when an economist talks of economic growth being above or below trend, he is talking about a measure that has no place in sound economic reasoning, and that is gross domestic product.
Gross domestic product in its current form is a relatively recent invention, dating from the 1930s. It was a gift to state-sponsored economists, needing a statistical justification for perfecting their theories of management of the economy. At last, here was a means of measuring the effects of economic policy, and therefore to adjust its future implementation based on evidence. The inconvenience of having to pander to markets had been dealt its final blow. Or so it was thought.
GDP comes in various guises, but for our purposes, we can define it as the total monetary value of recorded and eligible transactions between two points in time. It tells you nothing more. It does not tell you anything about the reasons for those transactions. It tells you nothing about the future. Economists, politicians and laymen who talk of economic growth miss this point entirely. What GDP does tell you, and only tells you, is how much money has been spent on new products included in the statistics. And, assuming there is no change in the allocation of total spending between qualifying and non-qualifying items, the limitation is simply the total earnings and profits of individuals and businesses applied to the purchase of those products. This is not to be confused with economic progress, which is an entirely different thing.
So ingrained is the belief that growth in GDP is a desirable objective, that it is akin to heresy to point out its utter meaninglessness. Assume for a moment that the GDP statistic captures all economic activity in a community, conventionally a nation state. Let us also assume that the quantity of money and credit is fixed, neither expanding nor contracting. And let us also assume that the trade balance is always zero. Therefore, all money earned, or made through profits, is spent or saved. Savings are deferred consumption, and through financial intermediaries, invested by businesses in capital goods and working capital. Logically therefore, the following must all be true:
- All consumption is funded by income, whether it comes from salaries, entrepreneurial profits, income and profits on savings, or government benefits and subsidies.
- All government spending must be financed by taxes or domestic savings. In other words, if the government increases its spending it must be at the expense of the non-government sectors. Therefore, an increase in government spending does not increase GDP.
- Imports are paid for by exports.
- Prices are free to reflect changes in demand for money, and changes in demand between different goods and services.
It is now be obvious that GDP cannot change from one period to the next. An economy under these conditions is free to evolve, respond to consumer and investment demands, to progress, all with zero “growth”. Therefore, growth in GDP can only be an increase in the quantity of money deployed, and it cannot be anything else.
This was broadly the situation when gold was money. Broadly, because there was also the cyclical effect of bank credit, which was formalised by the UK’s Bank Charter Act of 1844. At least it evened out over the cycle, and despite the ups and downs of bank credit, the British, European and American economies progressed, as consumers were offered and acquired improved goods throughout the industrial revolution, at least until the disruption of the First World War. This empirical example, which is fully explained by sound economic theory, confirms that the substantial leaps in economic progress at that time could not be quantified by GDP.
This is not to say that disruption in the rate of economic progress does not cause changes in GDP in a fiat currency environment. But the relationship between changes in GDP and true progress is not predictable and is wholly unsuited as an economic indicator.
Having established that GDP is simply a measure of the quantity of money spent on goods and services specified in the statistic, and nothing more, the basic goal of modern economists in a world of unlimited fiat currency is exposed as meaningless. This mistake is a source of considerable error, not only among policy-makers, but commentators as well.
The Fed has accepted this by default, because it does not target GDP. Instead, it operates a dual mandate of price inflation and unemployment, as proxy indications for advance warning of when monetary stimulus should be moderated. And here again, the use of these statistics is no substitute for a proper understanding of price formation and the forces that drive employment. So we shall look at these in turn.
This term is abused to the point where it is commonly assumed to mean a rise in prices. Rising prices may or may not be a symptom of inflation, which was originally defined by economists as a monetary phenomenon. To point out this confusion is important, because an expansion in the quantity of money and credit in fiat currencies is only one of three main factors that affect the overall price level:
- When the quantity of money and credit is increased and that increase is applied to the components of GDP or the consumer price index, it represents the application of new money, which in time devalues the previously existing money employed for the purposes of these statistics. It generates extra demand, which fades and reverses as the purchasing power of the currency falls to accommodate the increased quantity of money introduced. Further increases in the quantity of money are required to negate the tendency for demand to return to the previous level after the effect of the initial increase in the quantity of money wears off.
- When money and credit is withdrawn from activities not included in the GDP or CPI statistics, and then applied to goods and services which are included, the effect is to create a temporary increase in recorded demand as in the first case above. This time, the effect of expansion and subsequent contraction of demand can be detected in GDP and CPI statistics, while the effect of the withdrawal of money applied to non-GDP items is ignored.
- By far the most important factor driving prices is changes in the overall preference individuals have for holding a reserve of money. It is this factor which can either enhance a fiat money’s purchasing power, or lead to its total collapse, and is independent from changes in the quantity of money and credit in circulation. Changes in preference override the first two cases in a fiat money economy, and should be regarded as the most risk to currency stability.
In all three cases, the change in prices comes from the money side of transactions and not that of goods. This is the exact opposite of the common belief that money is an unchanging constant behind all transactions, having a valid objective-exchange value, and that inflation is rising prices of goods. We have collectively taken the past attributes of gold as money, and applied them without modification to modern fiat currencies. It is illogical to regard the declining purchasing power of a fiat currency as only a long-term effect.
The Fed’s open market committee is targeting an inflation rate of 2%, by which the members mean that they will attempt to achieve an outcome, through monetary policy, whereby prices expressed in dollars will rise by that amount. The correct description of their objective is they seek to reduce the dollar’s purchasing power in a controlled fashion. In pursuing this objective, they rely on the quantity theory of money, which was devised when gold was money, and is applied without modification for current fiat monies. In other words, ignoring inter-temporal factors, they assume there is sufficient correlation between changes in the quantity of money and credit, and the overall price level for the purposes of monetary policy. The relationship was broadly true in the days when gold was money, because its common role as money extended beyond national boundaries. Any tendency for changes in preference for or against it, varying its purchasing power in any one location, were therefore restricted by arbitrage.
This cannot be true of a fiat currency, whose value as money is contained by national boundaries. In this case, changes in the relative preference expressed by consumers between money and goods are potentially the most important variable affecting the purchasing power of money, as described above.
Attempts to manage the decline in a currency’s purchasing power are sure to fail, if only because it is not consumer preferences that are being targeted. If central bankers have missed this point, so have all the economists and commentators employed by the investment banks and by the media.
Central bankers and economists fail to appreciate how changes in the general price level arise from the money side. The use of a statistic, such as the consumer price index, for inflation targeting is deceiving, misleading policy makers into believing that they can override Say’s law.
So far, we have addressed fallacies behind the concept of GDP, the real objective of monetary policy, and also inflation statistics, which are one of the two proxies for GDP targeting the Fed uses. That leaves unemployment. Unemployment is an unnatural condition, because in accordance with the indisputable theory of the division of labour, people work to acquire from others their needs and wants. This is why without government intervention the unemployment problem tends to resolve itself.
In the US, even a cursory analysis of the composition of unemployment statistics and the application of seasonal adjustments show them to be wholly unfit for purpose. But to complain about the veracity of unemployment statistics is to miss the more important point, that it is the contribution of the labour force to economic progress that really matters. When intelligent, skilled individuals are working as waiters and barmen, we can say the economy is in transition, because an increase in employment of this nature is probably temporary. When it has a sense of permanency about it and people are not retraining for newly-demanded skills, the economy is not evolving as it should, and progress is being blocked.
Unemployment, being an unnatural condition, is fundamentally a problem created by the state. The state sets employment legislation, favouring the employee, with the consequence that employers are deterred from taking on staff they would otherwise freely employ. Many states tax employment, raising the cost of it above its use-value. France’s experience is a good example, where high employment taxes and restrictive regulation has resulted in permanently high unemployment rates. Central banks seek to counter these disadvantages by reducing the purchasing power of the currency, in an effort to encourage employers to employ, which has become the basic justification for monetary intervention. It amounts to beating everyone with a stick, then offering a monetary carrot while continuing to weald the stick.
If the state stopped interfering with the labour market, unemployment would not be anything other than a short-term problem. Even if the state only desisted from further intervention, unemployment would tend to fall, because of the need and desire for people to work. It is natural for the unemployment rate to drift lower over time, so the fact that unemployment statistics, imperfect though they are, have reached the Fed’s target after eight years of zero interest rates, should not be a surprise.
The likelihood that some economists will be right about the future course of interest rates should not be taken as evidence of their grasp of economic theory. However, we can conclude that the recent fall in the dollar’s purchasing power, expressed in energy and commodity prices, has reduced the likelihood of negative interest rates. If the dollar’s purchasing power falls much further, the market will expect higher interest rates, so this then becomes the likely outcome.
The question will then arise as to whether or not the Fed will dare to raise interest rates sufficiently to stabilise the dollar's purchasing power. If the Fed delays, it could find itself facing a difficult choice. The level of interest rates required to stabilise the dollar’s purchasing power would not be consistent with maintaining the record levels of debt in both government and private sectors. Thirty-six years on it could be another Volker moment. It would surely be a mistake to think that Fed officials are unaware of this danger, and would recommend early action to avoid this outcome.
Alternatively, if the dollar’s purchasing power begins to rise over the rest of this year, the Fed can defer interest rate rises, and perhaps introduce negative rates. It would be the most desired outcome for the Fed, being a continuation of indefinite economic suppression with a lower likelihood of financial crisis.
It is changes in the dollar’s purchasing power that really matter, and forecasting interest rates based on GDP, consumer prices, or employment levels not only relies on bad, incomplete and misleading statistics, it has no basis in sound economic theory. It’s the course of markets, encapsulated in Say’s law, that should guide economists and commentators alike.