Bretton Woods System, Quasi Gold Standard, Inflation, Savings, Nixon Shock and Monetizing the Debt

Posted by PITHOCRATES - February 5th, 2013

History 101

The Bretton Woods System was a quasi Gold Standard where the U.S. Dollar replaced Gold

Government grew in the Sixties.  LBJ’s Great Society increased government spending.  Adding it on top of spending for the Vietnam War.  The Apollo Moon Program.  As well as the Cold War.  The government was spending a lot of money.  More money than it had.  So they started increasing the money supply (i.e., printing money).  But when they did they unleashed inflation.  Which devalued the dollar.  And eroded savings.  Also, because the U.S. was still on a quasi gold standard this also created a problem with their trade partners.

At the time the United States was still in the Bretton Woods System.  Along with her trade partners.  These nations adopted the U.S. dollar as the world’s reserve currency to facilitate international trade.  Which kept trade fair.  By preventing anyone from devaluing their currency to give them an unfair trade advantage.  They would adjust their monetary policy to maintain a fixed exchange rate with the U.S. dollar.  While the U.S. coupled the U.S. dollar to gold at $35/ounce.  Which created a quasi gold standard.  Where the U.S. dollar replaced gold.

So the U.S. had a problem when they started printing money.  They were devaluing the dollar.  So those nations holding it as a reserve currency decided to hold gold instead.  And exchanged their dollars for gold at $35/ounce.  Causing a great outflow of gold from the U.S.  Giving the U.S. a choice.  Either become responsible and stop printing money.  Or decouple the dollar from gold.  And no longer exchange gold for dollars.  President Nixon chose the latter.  And on August 15, 1971, he surprised the world.  Without any warning he decoupled the dollar from gold.  It was a shock.  So much so they call it the Nixon Shock.

To earn a Real 2% Return the Interest Rate would have to be 2% plus the Loss due to Inflation

Once they removed gold from the equation there was nothing stopping them from printing money.  The already growing money supply (M2) grew at a greater rate after the Nixon Shock (see M2 Money Stock).  The rate of increase (i.e., the inflation rate) declined for a brief period around 1973.  Then resumed its sharp rate of growth around 1975.  Which you can see in the following chart.  Where the increasing graph represents the rising level of M2.

M2 versus Retirement Savings

Also plotted on this graph is the effect of this growth in the money supply on retirement savings.  In 1966 the U.S. was still on a quasi gold standard.  So assume the money supply equaled the gold on deposit in 1966.  And as they increased the money supply over the years the amount of gold on deposit remained the same.  So if we divide M2 in 1966 by M2 in each year following 1966 we get a declining percentage.  M2 in 1966 was only 96% of M2 in 1967.  M2 in 1966 was only 88% of M2 in 1968.  And so on.  Now if we start off with a retirement savings of $750,000 in 1966 we can see the effect of inflation has by multiplying that declining percentage by $750,000.  When we do we get the declining graph in the above chart.  To offset this decline in the value of retirement savings due to inflation requires those savings to earn a very high interest rate.

Interest Rate - Real plus Inflation

This chart starts in 1967 as we’re looking at year-to-year growth in M2.  Inflation eroded 4.07% of savings between 1966 and 1967.   So to earn a real 2% return the interest rate would have to be 2% plus the loss due to inflation (4.07%).  Or a nominal interest rate of 6.07%.  The year-to-year loss in 1968 was 8.68%.  So the nominal interest rate for a 2% real return would be 10.68% (2% + 8.68%).  And so on as summarized in the above chart.  Because we’re discussing year-to-year changes on retirement savings we can consider these long-term nominal interest rates.

Just as Inflation can erode someone’s Retirement Savings it can erode the National Debt

To see how this drives interest rates we can overlay some average monthly interest rates for 6 Month CDs (see Historical CD Interest Rate).  Which are often a part of someone’s retirement nest egg.  The advantage of a CD is that they are short-term.  So as interest rates rise they can roll over these short-term instruments and enjoy the rising rates.  Of course that advantage is also a disadvantage.  For if rates fall they will roll over into a lower rate.  Short-term interest rates tend to be volatile.  Rising and falling in response to anything that affects the supply and demand of money.  Such as the rate of growth of the money supply.  As we can see in the following chart.

Interest Rate - Real plus Inflation and 6 Month CD

The average monthly interest rates for 6 Month CDs tracked the long-term nominal interest rates.  As the inflationary component of the nominal interest rate soared in 1968 and 1969 the short-term rate trended up.  When the long-term rate fell in 1970 the short-term rate peaked and fell in the following year.  After the Nixon Shock long-term rates increased in 1971.  And soared in 1972 and 1973.  The short-term rate trended up during these years.  And peaked when the long-term rate fell.  The short term rate trended down in 1974 and 1975 as the long-term rate fell.  It bottomed out in 1977 in the second year of soaring long-term rates.  Where it then trended up at a steeper rate all the way through 1980.  Sending short-term rates even higher than long-term rates.  As the risk on short-term savings can exceed that on long-term savings.  Due to the volatility of short-term interest rates and wild swings in the inflation rate.  Things that smooth out over longer periods of time.

Governments like inflationary monetary policies.  For it lets them spend more money.  But it also erodes savings.  Which they like, too.  Especially when those savings are invested in the sovereign debt of the government.  For just as inflation can erode someone’s retirement savings it can erode the national debt.  What we call monetizing the debt.  For as you expand the money supply you depreciate the dollar.  Making dollars worth less.  And when the national debt is made up of depreciated dollars it’s easier to pay it off.  But it’s a dangerous game to play.  For if they do monetize the debt it will be very difficult to sell new government debt.  For investors will demand interest rates with an even larger inflationary component to protect them from further irresponsible monetary policies.  Greatly increasing the interest payment on the debt.  Forcing spending cuts elsewhere in the budget as those interest payments consume an ever larger chunk of the total budget.  Which governments are incapable of doing.  Because they love spending too much.

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Keynesian Economics and Liberal Democrat Policies increase the Cost of Raising Children

Posted by PITHOCRATES - December 30th, 2012

Week in Review

A generation or two ago people got married to raise a family.  The husband typically earned the money.  And the wife raised the family.  On a single salary.  A time when most children grew up in a two-parent household.  Where boys grew up playing with toy guns.  But never took a real one to school.  Today it’s a lot harder to raise a family on a single income (see Cost of Raising a Child Up to $235K—Before College by Chris Wadsworth, special to USA TODAY, posted 12/24/2012 on CNBC).

According to the latest statistics released by the U.S. Department of Agriculture, parents will spend an average of $235,000 to raise a child born in 2011 to the age of 17. (And that’s not taking into account any savings for college).

Housing, food, clothing, health care, child care, schooling … the list of compulsory expenses goes on and on. Discretionary spending such as family vacations, birthday gifts, music lessons and the like are mostly extra…

The greatest share of these expenses is housing, which is 30 percent of the total. It’s followed closely by child care and education at 18 percent and food at 16 percent…

“Our day care expense for just our older son was over $1,000 a month,” Sutton says. “If we had put our younger son in day care as well, it would have been about $2,200 a month. That was more than our mortgage payment.”

We hear this all of the time.  But we never really hear the why.  Why is it that it takes two incomes to raise a family these days?  Forcing parents to pay so much for day care that they could buy another house with that money.  Why that house expense is so expensive.  And why education and food costs so much.  So let’s look at the why.  And here’s why.  Keynesian economics.  And liberal Democrats.

Liberal Democrats champion Keynesian economics as it sanctions what they want to do most.  Tax, borrow, print and spend.  When Nixon decoupled the dollar from gold the great devaluing of the dollar began.  In 2012 it took $8.21 to buy what $1 would by in 1955.  A $15,000 house in 1955 would cost about $127,000 today.  So that’s part of the reason why housing is so expensive.  The other reason is that Keynesian monetary policy.  Where the Federal Reserve (America’s central bank) kept interest rates artificially low to encourage people to buy houses.  Which they did.  In droves.  Driving up the price of housing.  Creating housing bubbles.  The last one bursting into the subprime mortgage crisis.  Giving us the Great Recession.

But it’s just not the Federal Reserve devaluing the dollar.  Gasoline cost about $0.23/gallon in 1955.  If you adjust that for inflation it would bring it up to $1.89 today.  At the end of summer 2012 the average gasoline price was $3.72/gallon.  Which is a $1.83 premium over the inflation-adjusted price.  A 96.8% increase in price.  What caused this near doubling in price?  Well, the American Left has shut down a lot of oil drilling due to environmental issues.  Raising the cost of crude oil.  Which increased the cost of gasoline refined from that crude oil.  Further, new environmental regulations have increased the cost of refining.  Requiring a plethora of blends depending on the time of year.  Further increasing the price of gasoline.

Higher gasoline prices make everything more expensive wherever gasoline is used.  On the farm.  The transportation from the farm to the food processor.  Transportation from the food processor to the food wholesaler.  Transportation from the food wholesaler to the food retailer.  Transportation from the family home to the grocery store and back.  High gasoline prices raise prices everywhere.  And consume more of the family budget.

Education is the one industry no one every blames those in control of the industry for being greedy.  No one every blames our universities for their high tuition fees.  They blame the taxpayers who don’t approve higher taxes to subsidize the high cost of education.  Which is high due to very generous pay and benefit packages for teachers, professors, administrators and support personnel.  Much more generous than those found in the private sector.  Why do they get away with this when liberal Democrats attack business owners for being greedy?  Because business owners don’t have as their primary mission to produce Democrat voters.

So what is increasing the cost of raising children so much?  Liberal Democrat policies.  They depreciate the currency, inflate the cost of housing (and cause Great Recessions), add huge regulatory costs that increase prices throughout the supply chain and create and protect a privileged class.  Consuming more and more of the family budget.  Making it ever more costly to raise children.

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Christmas and Keynesian Stimulus

Posted by PITHOCRATES - December 24th, 2012

Economics 101

Christians may not like the Crass Commercialization of Christmas but the Left Loves It

The Left does not have a war on Christmas per se.  For they love the consumer spending part of Christmas.  Which is pure Keynesian.  People go into debt to spend more money at retailers.  They love that part of Christmas.  What they don’t like is the religious stuff.  Especially Jesus.

They don’t like Jesus because He is the God the Christians worship.  Their Lord and Savior.  It’s these Christians that bother the Left.  Because of their opposition to birth control (mostly Catholics), abortion and having fun in general.  The kind of fun adults enjoy.  The kind of things Christians frown on.  Premarital sex.  Gay love.  Drinking and using drugs.  Coarse language and sexual situations on television shows and in the movies.  Things they champion on the Left.  Which makes the Left hate Christianity.  Which they see as nothing but a great killjoy.

It’s the moralizing the Left does not like.  But the one thing Christians don’t like about Christmas, its crass commercialization, they do like.  So the Left will try to band images of Christ from Christmas displays wherever they can.  Despite Christmas being the celebration of Christ’s birth.  But they will gather in Rockefeller Center to party when they light the Christmas tree.  Though they would prefer that we call it the holiday tree.

Retailers often become Profitable for the Year only because of this Temporary Spending Surge at Christmas

So there are two Christmases.  The one where Christians celebrate the birth of Christ.  Wish for peace on earth.  And good will towards man.  And the other Christmas.  The one marked by the orgy of consumer spending.  Much of it funded by one-time Christmas bonuses.  A celebration of demand-side Keynesian economics.  Where people spend their hard earned money instead of saving it.  And when their money runs out they spend even more using their credit cards.

Keynesians have a bunch of charts and graphs showing how great a stimulus this Christmas spending is to the economy.  And mathematical formulas.  They can tell you about the velocity of money. How fast money travels through the economy when it goes from consumer to seller.  The seller then becomes consumer.  And spends the money they just received.  Then the person who receives this money in a sales transaction goes out and spends it as a consumer.  And on and on it goes.  Flying through though the economy at breakneck speed.  Generating a whole lot of economic activity.

Retailers often become profitable for the year only because of this spending surge at Christmas.  In fact, to handle this surge in business they hire a lot of people at Christmas time.  Part-time people.  Proving again that pumping money into the economy creates jobs.  The main tenet of Keynesian monetary policy.  Pump cash into the economy and people will spend it.  Something the Keynesians have been doing since Richard Nixon decoupled the dollar from gold in 1971.  Ending any semblance of responsible monetary policy.  And recessions forever.  At least, that was the plan.

Keynesian Stimulus is nothing more than an Orgy of Temporary Consumer Spending just like at Christmas Time

When the economy slows down and people stop buying stuff businesses have to lay off workers.  So they won’t build stuff that no one will buy.  Laid off workers no longer have money to buy things.  Which causes other business to lay off workers.  So THEY won’t build stuff that no one will buy.  It’s a vicious cycle.  In fact, we call it the business cycle.  The boom-bust cycle.  From expansion to contraction.  From an economy hiring people to an economy laying off people.

Keynesian economics was supposed to remove the contraction side of the business cycle.  By picking up the spending slack.  When consumers stopped spending money the government would step in and replace their spending.  We call it stimulus spending.  Often spending money the government doesn’t have.  So they run a deficit (i.e., borrow money).  Or simply print money.  Which they did a lot of in the Seventies.  Unfortunately, as it turns out, you just can’t do that.  For when you print money you devalue it.  Which raises prices.  As it takes more of these devalued dollars to buy what they once did.

And this is why Keynesian economics doesn’t work.  Because a Keynesian stimulus is nothing more than an orgy of consumer spending.  Just like at Christmas time.  Which happens only for a limited time.  Businesses hire temporary part-time workers at Christmas because this spending does not last.  As it does not last during a Keynesian stimulus.  It doesn’t create any full-time jobs.  Because employers know it is only temporary.  And they know that higher prices will soon follow.  As they do after Christmas when the discounting ends.  Which will reduce future economic activity.  As it does after Christmas.  Once the deals end so too ends the orgy of consumer spending.  Leaving people to deal with the aftermath.  Depleted bank accounts.  A lot of credit card debt.  And a little buyer’s remorse.

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Economic Stimulus

Posted by PITHOCRATES - November 5th, 2012

Economics 101

Prices match Supply to Demand letting Suppliers know when to bring more Goods and Services to Market

There is a natural ebb and flow to the economy.  Through good times and bad.  And you can tell which way the economy is heading by prices in the market place.  When prices are rising times are typically good.  As people are gainfully employed with money to spend.  As they compete with each other for the goods and services in the market place demand rises.  Growing greater than the supply of goods and services.  So prices rise.  Because when there are fewer goods and services they are worth more money.  For those who have them to sell.  Because demand is so great people are willing to pay top dollar for them.  To get them while supplies last.  This attracts the attention of other suppliers.  Who want to cash in on those high prices.  So they bring more goods and services to market.

In time supply catches up to demand.  And passes it.  Suddenly the market has more goods and services than people are buying.  As inventories grow retailers stop buying so much from their wholesale suppliers.  Who in turn stop buying so much from their manufacturers.  Who in turn stop buying so much from their raw material suppliers.  And manufacturers and their raw material suppliers begin laying off workers.  So there are fewer people gainfully employed with money to spend.  The fewer gainfully employed buy less than the more gainfully employed.  Causing inventories to grow larger as more goods are going into them than are coming out of them.  So they start cutting prices.  To unload these inventories before people start buying even less.  Because they spent a lot of money to build those inventories.  And it costs to hold these items in warehouses and stockrooms.

And that’s the natural ebb and flow of the economy.  What economists call the business cycle.  That goes from an expanding economy to a contracting economy.  From boom to bust.  From inflation to recession.  Something normal.  And natural.  Though it could be unpleasant for those who lose their jobs.  But it’s something that must happen.  To correct prices.  You see, prices make all of this work automatically.  They match supply to demand.  Letting suppliers know when to bring more goods and services to market.  And when they’ve brought too much.  When the economy goes into recession prices fall.  Which tells suppliers that supply exceeds demand.  And that anything additional they bring to market will not sell.  As they incur costs to bring things to market this is very good information to have.  So they don’t waste money.  Leaving their businesses short of cash.  Possibly causing their businesses to fail.

Whenever we Devalue the Dollar with Inflationary Monetary Policy Prices Rise

No one likes losing their job.  Because they need income to pay their bills.  And the government doesn’t like people losing their jobs.  Because they tax those incomes to pay the government’s bills.  And unemployed people pay no income taxes.  So the government tries to tweak the economy.  At the federal level.  To extend the inflationary periods of the business cycle.  And they do that with inflationary monetary policy.  Using their monetary powers to keep interest rates below the true market interest rate.  Hoping it will encourage suppliers and consumers to keep borrowing and spending money.  Even though supply had already caught up to and passed demand.  Such that everyone that wanted to buy something could.  While every supplier that wanted to sell something couldn’t.

Some people take advantage of these lower interest rates.  Some people will remortgage their homes to lower their monthly payment.  Which will give them a little more disposable cash each month.  Which they may use to buy more stuff.  But other people will take this opportunity to buy a large house just because of the low interest rate.  As some businesses may borrow to expand their business just because of the low interest rate.  Not for unmet demand.  These actions may not help the economy.  In fact they may hurt the economy in the long-term.  When the inevitable recession comes along and they are so overextended they may not be able to pay their bills.  They may lose their house.  Or their business.  For the worst thing to have whenever you suffer a reduction in revenue or income is debt.

But there is an even worse effect of that inflationary monetary policy.  When you increase the money supply you increase the total amount of dollars in the economy.  But they’re chasing the same amount of goods and services.  Which makes each dollar worth less.  Requiring more of them to buy the same things they once did.  Which is why whenever we devalue the dollar with inflationary monetary policy prices rise.  So, yes, there may be an initial expansion of economic activity.  But some people will have inflationary expectations.  That is, they know prices will go up in the very near future.  So they won’t increase production.  Why?  While an initial burst of economic activity may draw down those bloated inventories those coming higher prices will increase business costs.  Which businesses will have to pass on in the prices of their goods.  And how do higher prices affect consumers?  They buy less.  So manufacturers are not going to expand production when price inflation is going to reduce their sales in the long run.

Cutting Taxes and Reducing Costly Regulations have Stimulated Economic Activity every time they’ve been Tried

Perhaps the worst effect of inflation is the false information those higher prices give.  When consumer demand rises so do prices.  And it’s a signal to suppliers to bring more goods and services to market.  But when prices rise because of a depreciated dollar and NOT due to higher consumer demand, some may bring more goods and services to market when there is no demand for it.  So you have rising prices.  And expanding production.  Producing more goods than the market is demanding.  Creating a bubble.  Adding a lot of stuff to the market place at very inflated prices.  That no one is buying.  Then the bubble bursts.  And recession sets in.  As businesses lay off workers to adjust supply to meet actual demand.  And those inflated prices fall back to market values.  The higher inflationary monetary policy pushed those prices up the farther they have to fall.  And the more painful the recession will be.

You see, inflationary monetary policy interferes with the natural ebb and flow of the economy.  And the automatic price mechanism that matches supply to demand.  By trying to expand the inflationary side of the business cycle, and contract the recessionary side, governments make recessions longer.  And more painful.  Which is why Keynesian stimulus policies (lowering interests rates and deficit spending) don’t stimulate long-term economic activity.  Yet it is what most governments turn to whenever the economy slows. While there is another way to stimulate economic activity.  One that is not so popular with most governments.  Across the board tax cuts on business and personal incomes.  And reducing costly regulations on businesses.  These make a more business-friendly environment.  Encouraging businesses to expand and hire people.  Because these actions will have a positive impact on a business’ long-term outlook.  And with consumers having more disposable income (thanks to the cuts in personal income tax rates) businesses know there will be a market of any increase in production.

So there you have two ways to stimulate economic activity.  One way that works (tax cuts and reducing costly business regulations).  And one that doesn’t (lowering interest rates and deficit spending).  So why is the one that doesn’t work chosen by most governments over the one that does?  Because governments like to spend money.  It’s how they build constituencies.  By giving generous benefits to voters.  But to do that they need tax revenue.  Lots of tax revenue.  Produced by increasing tax rates as often as they can.  So they cannot stand the thought of cutting taxes.  Ever.  Which is why they always choose inflationary policies over tax cuts.   Even though those policies fail to stimulate economic activity.  As proven throughout the era of Keynesian economics.  While cutting taxes and reducing costly regulations have stimulated economic activity every time they’ve been tried.

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Farming, Food Surplus, Artisans, Trade, Barter, Search Costs, Money, Precious Metals, Pound, Dollar and Gold Standard

Posted by PITHOCRATES - October 9th, 2012

History 101

Food Surpluses allowed Everything that followed in the Modern Age

Humans were hunters and gatherers first.  When the environment ruled supreme.  Then something happened.  Humans began to think more.  And started to push back against their environment.  First with tools.  Then with fire.  Bringing people closer together.  Eventually settling down in civilizations.  When the human race embarked on a new path.  A path that would eventually usher in the modern age we enjoy today.  We stopped hunting and gathering.  And began farming.

Throughout history life has been precarious.  Due to the uncertainty of the food supply.  Especially when the environment ruled our lives.  That changed with farming.  When we started taking control of our environment.  We domesticated animals.  And learned how to grow food.  Which lead to perhaps the most important human advancement.  The one thing that allowed everything that followed in the modern age.   Food surpluses.  Which made life less precarious.  And a whole lot more enjoyable.

Producing more food than we needed allowed us to store food to get us through long winters and seasons with poor harvests.  But more importantly it freed people.  Not everyone had to farm.  Some could do other things.  Think about other things.  And build other things.  Artisans arose.  They built things to make our lives easier.  More enjoyable.  And when these talented artisans and farmers met other talented artisans and farmers they traded the products of all their labors.  In markets.  That became cities.  Enriching each other’s lives.  By allowing them to trade for food.  For things that made life easier.  And for things that made life more enjoyable.

We settled on using Precious Metals (Gold and Silver) for Money for they were Everything Money Should Be

As civilizations advanced artisans made a wider variety of things.  Putting a lot of goods into the market place.  Unfortunately, it made trading more difficult.  Because while you saw what you wanted the person who had it may not want what you had to offer in trade.  So what do you do?  You look for someone else that has that same thing.  And will trade for what you have.  And when the second person doesn’t want to trade for what you have you look for a third person.  Then a fourth.  Then a fifth.  Until you find someone who wants to trade for what you have.

This is the barter system.  Trading goods for goods.  And as you can see it has high search costs to find someone to trade with.  Time that people could better spend making more things to trade.  What they needed was a temporary storage of value.  Something people could trade their things for.  And those people could then use that temporary storage they received in trade to later trade for something they wanted.   We call this ‘something’ money.

We have used many things for money.  Some things better than others.  In time we learned that the best things to use for money had to have a few characteristics.  It had to be scarce.  A rock didn’t make good money because why would anyone trade for it when you could just pick one up from the ground?  It had to be indestructible and hold its value.  A slab of bacon had value because bacon is delicious.  But if you held on to it too long it could grow rancid, losing all the value it once held.  Or you could eat it.  Which would also remove its value.  It had to be divisible.  A live pig removed the problem of bacon growing rancid.  However, it was hard making change with live pigs.  Which is why we settled on using precious metals (gold and silver) for money.  For they were everything money should be.

The Key to Economic Activity is People with Creative Talent to make Things to Trade

Money came first.  Then government monetary systems.  Traders were using gold and silver long before nations established their own money.  And when they did they based them on weights of these precious metals.  The British pound sterling represented one Saxon pound of silver.  The U.S. dollar came from the Spanish dollar.  Which traces back to 16th century Bohemia.  To the St. Joachim Valley.  Where they minted private silver coins.  The Joachimsthaler.  Where the ‘thaler’ (which translated to valley) in Joachimsthaler became dollar.  The German mark and the French franc came into being as weights of precious metals.  People either traded silver or gold coins.  Or paper notes that represented silver or gold.

We used silver first as the basis for national currencies.  Then with new gold discoveries in the United States, Australia and South Africa gold became the precious metal of choice.  Using precious metals simplified trade by providing sound money.  And it also made foreign exchange easy.  For when the British made their pound represent 1/4 of an ounce of gold and the Americans made their dollar represent 1/20 of an ounce of gold the exchange rate was easy to calculate.  The British pound had 5 times as much gold in it than the U.S. dollar.  So the exchange rate was simply 5 U.S. dollars for every British pound.  Which made international trade easy.  And fair.  Because everything was priced in weights of gold.

The pure gold standard, then, was part of the natural evolution of money.  The state did not create it.  It does not require an act of legislation.  Or political decree.  The pure gold standard existed before the state.  And states based their currencies on the monetary system that already existed.  Using weights of precious metals as money.  That is, a pure gold standard.  Central banks and fiat money are only recent inventions of the state.  And bad ones at that.  For the thousands of years that preceded the last hundred years or so there were only traders mutually agreeing to trade their goods for precious metals.  Using these precious metals as a temporary storage of wealth.  To temporarily hold the value of the things they made.  So the key to economic activity is people with creative talent to make things to trade.  And a sound money like gold and silver to facilitate that trade.  Not a central bank.  Or monetary policy.

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Ben Bernanke defends QE3 before Congress even while Admitting it won’t Create any New Jobs

Posted by PITHOCRATES - October 6th, 2012

Week in Review

Ben Bernanke, Federal Reserve Chairman, is a student of the Great Depression.  And of Milton Friedman.  Who he cited often to support his policies when speaking before Congress.  Insisting that their expansionary monetary policy will only stimulate growth.  Not inflation.  Of course, he has already tried quantitative easing one and two and they failed.  As demonstrated by the need of QE3.  Yet these Keynesians always go back to the tried and failed Keynesian policies.  Increase the money supply to lower interest rates.  To encourage people to build and sell new housing while the market is still flooded with homes left over when the housing bubble burst back in 2008.

Economics is not like trying to cure a hangover.  A little hair of the dog (drinking more alcohol to mitigate the effects of a hangover) doesn’t work in economics.  More bad monetary policy does not cure previous bad monetary policy.  At least, it hasn’t yet.  Nor does it appear that it ever will (see Bernanke presses Congress to support US economy by AFP posted 10/2/2012 on Channel News Asia).

Federal Reserve Chairman Ben Bernanke said on Monday he is confident the US economy will continue to expand, but he urged the US Congress and the White House to act to support stronger growth…

However, he said the economy is growing at a weak 1.5-2 percent rate, not fast enough to lower the employment rate, and that the Fed’s stimulus efforts need to be backed up by action from the rest of the government…

“Many other steps could be taken to strengthen our economy over time, such as putting the federal budget on a sustainable path, reforming the tax code, improving our educational system, supporting technological innovation, and expanding international trade,” Bernanke said.

“In particular, the Congress and the administration will soon have to address the so-called fiscal cliff, a combination of sharply higher taxes and reduced spending that is set to happen at the beginning of the year.

“According to the Congressional Budget Office and virtually all other experts, if that were allowed to occur, it would likely throw the economy back into recession,” he warned.

Bernanke is on to something here.  He acknowledges that the new taxes of the fiscal cliff could throw the economy back into recession.  So if more taxes will prolong or deepen the recession what can we infer from this?  Would not fewer taxes have the opposite effect?

This is the frustrating thing about all of these students of the Great Depression.  They only look at what the Fed did when they were contracting the money supply.  And nothing else.  They don’t talk about a massive increase in tariffs (the Smoot-Hawley Tariff Act of 1930) in Congressional committee during 1929.  Before the Stock Market Crash of 1929.  Nor do they discuss the progressive policies of Republican Herbert Hoover.  And his interference into market forces.  Trying to raise prices everywhere to help farmers earn more and allow employers to pay their employees more.  And the near doubling of federal income tax rates.  Talk about your economic cold shower.

This was a 180-degree turn from the pro-business polices of the Warren Harding and Calvin Coolidge administrations.  That let the Twenties roar with solid economic growth.  Yes, there were some inflationary monetary policies.  The Fed was no angel.  But the growth was strong even after the effects of inflation were factored in.  It was all those tax and tariff increases that turned a recession into a depression.  And then the bad Fed policy destroyed the banking industry on top of it.  Unfortunately, that’s the only part that any Keynesian ever sees.  What the Fed did.  Not the solid economic growth generated by low tax rates and a business-friendly environment.

The Fed’s artificially low interest rates pushed house prices into the stratosphere.  And because they were so high in 2008 they had a very long way to fall.  Which is why the Great Recession has been so painful and so prolonged.  Now they’re trying to stimulate the housing market again.  The very thing that got us into this mess in the first place.  Here’s another lesson the Keynesians need to learn.  Their expansionary policies make recessions longer and more painful.  And there is more to the economy than low interest rates.  For no matter how low they are if the environment is too business-unfriendly they won’t stimulate economic activity.  Lower tax rates and deregulation will.  But not lower interest rates.  That’s what Warren Harding/Calvin Coolidge did.  What JFK did.  What Ronald Reagan did.  What George W. Bush did.  Who all had much faster recoveries following bad recessions than President Obama is having under his Keynesian policies.

If only we could learn the objective lessons of history.  For as George Santayana (1905) said, “Those who cannot remember the past are condemned to fulfill it.”

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Unemployment

Posted by PITHOCRATES - October 1st, 2012

Economics 101

When Prices Rise Businesses Increase Output and when Prices Fall they Decrease Output

No one likes losing their job.  Even if you hate your job.  In fact, that’s why so many people stay in jobs they don’t like.  Because it’s easier than finding a new job that provides decent pay and benefits.  Sure, there are some aggressive go-getters out there who advance themselves up the earnings ladder by making career moves.  But most people prefer a steady paycheck that meets their needs.  At least, meets their needs with only a modicum of complaining.

But resigned to our places of employment as we may be change happens.  And we lose our jobs.  For a variety of reasons.  Mostly through the ebb and flow of the free market economy.  The normal business cycle.  The boom-bust cycles of the economy.  On the boom side prices rise as people are buying a lot of things.  High prices translate into business profits.  So businesses increase output to sell at those high prices.  And other businesses enter the market.  Adding jobs to the economy.  Retailers increase their orders at their wholesale suppliers.  Who increase their factory orders.  And the factories increase their orders with their suppliers.  Adding a lot of jobs to the economy.  And lowering the unemployment rate.

But eventually too many businesses flood the market with their goods and services.  Supplying more than the people can buy.  So stuff sits on shelves longer.  Retailers reduce their orders at their wholesale suppliers.  So inventories grow at the wholesalers.  So they cut their factory orders.  Leaving the factories with excess production.  So they cut back and reduce their orders with their suppliers.  As everyone cuts back on their business operations they lay off workers.  Removing jobs from the economy.  And increasing the unemployment rate.

When Capitalism destroys some Back-Breaking and Unpleasant Jobs it creates New and Better Jobs

The business cycle is normal.  And necessary.  By using prices in the market place it constantly adjusts supply to demand.  Making sure we efficiently use capital (raw materials, factories, equipment, etc.).  And human resources (labor, research, engineering, etc.).  When we under-utilize capital and human resources prices tend to rise (demand increases).  Encouraging an increase in supply.  The boom time.  When we over-utilize capital and human resources prices tend to fall (demand falls).  Encouraging a decrease in supply.  The bust time.  Or recession.  The business cycle maintains the optimum amount of economic activity automatically.  If we let this process operate automatically.  Yes, there will be recessions.  But they will typically be short in duration.  The less prices rise during the boom the shorter the duration.  The higher prices rise during a boom the longer the duration.  But one thing for certain is that prices have to fall to correct to actual demand.  And that only happens with a recession.

There are other contributors to unemployment besides the normal business cycle.  Like structural unemployment.  Such as when technology changes and makes old jobs obsolete.  A lot of ditch diggers lost their jobs when we developed mechanized excavating equipment.  People in the whale oil business lost their jobs when John D. Rockefeller brought kerosene to the market.  The Pony Express riders lost their jobs with the advent of the telegraph.  The telephone put telegraph operators out of work.  Cell phones put people in the phone booth industry out of a job.  And destroyed a lot of jobs in the pager industry.  The personal computer put a lot of secretaries and typists out of work.  The DVD destroyed jobs in the VCR industry (and those little video cassette rewinding machines).  When they found asbestos caused lung cancer it destroyed the asbestos industry.  The Internet is putting the printed newspapers out of business.  Digital cameras destroyed jobs in the instant camera business (e.g., Polaroid).  And email and texting is causing the U.S. Postal Service to go bankrupt.

There are always unemployed people.  Thanks to the normal business cycle.  Structural unemployment.  Even to changes in consumer preferences that puts some businesses out of business.  (Wearing legwarmers was a fashion trend that sold well in the Eighties but disappeared by the Nineties.)  So there are always people losing their jobs.  But that’s normal.  And necessary.  For all of those new technologies and new consumer preferences create new industries.  And new jobs.  Jobs they staff from the unemployed.  So while free market capitalism destroys some jobs it creates new ones.  Jobs that are often better than the ones destroyed.  Such as back-breaking and unpleasant manual labor jobs replaced by less back-breaking and less unpleasant jobs.  Such as the ditch diggers being replace by a machine and an operator.  And all those workers who build, transport, fuel and maintain those machines.

Some of our Worst Recessions have happened since the Keynesians set out to make Recessions a thing of the Past

Then there’s a worse kind of unemployment.  The kind government causes.  In part with their policies that are not business-friendly.  That increase the cost of business.  Which reduces the number of jobs they can create.  Such as increasing taxes and tariffs.  And mandatory employee costs.  Such as Social Security, Medicare, unemployment taxes, health insurance, etc.  As well as corporate income taxes.  Regulatory compliance costs.  And a minimum wage.  Which discourages hiring unskilled workers.  As well as increases pay levels for those earning above the minimum wage.  Who expect a much higher pay than minimum wage because of their education and/or experience.

So these policies depress the job market.  Because they increase the cost of business.  Then they compound their anti-business policies with bad monetary policy.  Keynesian economists don’t like capitalism.  Or the private sector.  Because of the business cycle.  Keynesians say they can get rid of the business cycle.  By doing what the private sector won’t do.  Hire people during times of recession.  Keynesians encourage the government to run deficits during recessions so they can spend money.  Creating government jobs.  And by creating government projects (e.g., building roads and bridges) for the private sector.  Creating jobs that the private sector won’t.  They even push interest rates below where the market would have them.  By expanding the money supply.  To encourage business to borrow money to expand their businesses for a consumer demand that isn’t there.  And they encourage consumers to buy big ticket items like houses and cars.  To further go into debt to stimulate economic activity.

The problem with these Keynesian policies is that they interfere with the automatic price mechanism to match supply to demand.  So when prices tell suppliers to reduce output these policies encourage them to increase output.  So while they may actually stimulate some economic activity it is not real economic activity.  Not driven by real demand.  Prices will continue to rise as if the boom is continuing.  The inflation created by that expansion of the money supply will even increase prices further still.  Which means when the correction happens those prices have a lot farther to fall.  Making the recession longer.  And more painful.  So the Keynesians not only failed to remove the bust-side of the business cycle.  They made the bust-side last longer than it normally would have had there been no government intervention.  Which is why some of our worst recessions have happened since the Keynesians set out to make recessions a thing of the past.

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The Federal Reserve, Roaring Twenties, Stock Market Crash, Banking Crises, Great Depression and John Maynard Keynes

Posted by PITHOCRATES - September 25th, 2012

History 101

The Federal Reserve increased the Money Supply to Lower Interest Rates during the Roaring Twenties

Benjamin Franklin said, “Industry, perseverance, & frugality, make fortune yield.”  He said that because he believed that.  And he proved the validity of his maxim with a personal example.  His life.  He worked hard.  He never gave up.  And he was what some would say cheap.  He saved his money and spent it sparingly.  Because of these personally held beliefs Franklin was a successful businessman.  So successful that he became wealthy enough to retire and start a second life.  Renowned scientist.  Who gave us things like the Franklin stove and the lightning rod.  Then he entered his third life.  Statesman.  And America’s greatest diplomat.  He was the only Founder who signed the Declaration of Independence, Treaty of Amity and Commerce with France (bringing the French in on the American side during the Revolutionary War), Treaty of Paris (ending the Revolutionary War very favorably to the U.S.) and the U.S. Constitution.  Making the United States not only a possibility but a reality.  Three extraordinary lives lived by one extraordinary man.

Franklin was such a great success because of industry, perseverance and frugality.  A philosophy the Founding Fathers all shared.  A philosophy that had guided the United States for about 150 years until the Great Depression.  When FDR changed America.  By building on the work of Woodrow Wilson.  Men who expanded the role of the federal government.  Prior to this change America was well on its way to becoming the world’s number one economy.   By following Franklin-like policies.  Such as the virtue of thrift.  Favoring long-term savings over short-term consumption.  Free trade.  Balanced budgets.  Laissez-faire capitalism.  And the gold standard.  Which provided sound money.  And an international system of trade.  Until the Federal Reserve came along.

The Federal Reserve (the Fed) is America’s central bank.  In response to some financial crises Congress passed the Federal Reserve Act (1913) to make financial crises a thing of the past.  The Fed would end bank panics, bank runs and bank failures.  By being the lender of last resort.  While also tweaking monetary policy to maintain full employment and stable prices.  By increasing and decreasing the money supply.  Which, in turn, lowers and raises interest rates.  But most of the time the Fed increased the money supply to lower interest rates to encourage people and businesses to borrow money.  To buy things.  And to expand businesses and hire people.  Maintaining that full employment.  Which they did during the Roaring Twenties.  For awhile.

The Roaring Twenties would have gone on if Herbert Hoover had continued the Harding/Mellon/Coolidge Policies

The Great Depression started with the Stock Market Crash of 1929.  And to this date people still argue over the causes of the Great Depression.  Some blame capitalism.  These people are, of course, wrong.  Others blamed the expansionary policies of the Fed.  They are partially correct.  For artificially low interest rates during the Twenties would eventually have to be corrected with a recession.  But the recession did not have to turn into a depression.  The Great Depression and the banking crises are all the fault of the government.  Bad monetary and fiscal policies followed by bad governmental actions threw an economy in recession into depression.

A lot of people talk about stock market speculation in the Twenties running up stock prices.  Normally something that happens with cheap credit as people borrow and invest in speculative ventures.  Like the dot-com companies in the Nineties.  Where people poured money into these companies that never produced a product or a dime of revenue.  And when that investment capital ran out these companies went belly up causing the severe recession in the early 2000s.  That’s speculation on a grand scale.  This is not what happened during the Twenties.  When the world was changing.  And electrifying.  The United States was modernizing.  Electric utilities, electric motors, electric appliances, telephones, airplanes, radio, movies, etc.  So, yes, there were inflationary monetary policies in place.  But their effects were mitigated by this real economic activity.  And something else.

President Warren Harding nominated Andrew Mellon to be his treasury secretary.  Probably the second smartest person to ever hold that post.  The first being our first.  Alexander Hamilton.  Harding and Mellon were laissez-faire capitalists.  They cut tax rates and regulations.  Their administration was a government-hands-off administration.  And the economy responded with some of the greatest economic growth ever.  This is why they called the 1920s the Roaring Twenties.  Yes, there were inflationary monetary policies.  But the economic growth was so great that when you subtracted the inflationary damage from it there was still great economic growth.  The Roaring Twenties could have gone on indefinitely if Herbert Hoover had continued the Harding and Mellon policies (continued by Calvin Coolidge after Harding’s death).  There was even a rural electrification program under FDR’s New Deal.  But Herbert Hoover was a progressive.  Having far more in common with the Democrat Woodrow Wilson than Harding or Coolidge.  Even though Harding, Coolidge and Hoover were all Republicans.

Activist Intervention into Market Forces turned a Recession into the Great Depression

One of the things that happened in the Twenties was a huge jump in farming mechanization.  The tractor allowed fewer people to farm more land.  Producing a boom in agriculture.  Good for the people.  Because it brought the price of food down.  But bad for the farmers.  Especially those heavily in debt from mechanizing their farms.  And it was the farmers that Hoover wanted to help.  With an especially bad policy of introducing parity between farm goods and industrial goods.  And introduced policies to raise the cost of farm goods.  Which didn’t help.  Many farmers were unable to service their loans with the fall in prices.  When farmers began to default en masse banks in farming communities failed.  And the contagion spread to the city banks.  Setting the stage for a nation-wide banking crisis.  And the Great Depression.

One of the leading economists of the time was John Maynard Keynes.  He even came to the White House during the Great Depression to advise FDR.  Keynes rejected the Franklin/Harding/Mellon/Coolidge policies.  And the policies favored by the Austrian school of economics (the only people, by the way, who actually predicted the Great Depression).  Which were similar to the Franklin/Harding/Mellon/Coolidge policies.  The Austrians also said to let prices and wages fall.  To undo all of that inflationary damage.  Which would help cause a return to full employment.  Keynes disagreed.  For he didn’t believe in the virtue of thrift.  He wanted to abandon the gold standard completely and replace it with fiat money.  That they could expand more freely.  And he believed in demand-side solutions.  Meaning to end the Great Depression you needed higher wages not lower wages so workers had more money to spend.  And to have higher wages you needed higher prices.  So the employers could pay their workers these higher wages.  And he also encouraged continued deficit spending.  No matter the long-term costs.

Well, the Keynesians got their way.  And it was they who gave us the Great Depression.  For they influenced government policy.  The stock market crashed in part due to the Smoot Hawley Tariff then in committee.  But investors saw the tariffs coming and knew what that would mean.  An end to the economic boom.  So they sold their stocks before it became law.  Causing the Stock Market Crash of 1929.  Then those tariffs hit (an increase of some 50%).  Then they doubled income tax rates.  And Hoover even demanded that business leaders NOT cut wages.  All of this activist intervention into market forces just sucked the wind out of the economy.  Turning a recession into the Great Depression.

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Macroeconomic Disequilibrium

Posted by PITHOCRATES - September 24th, 2012

Economics 101

In the Barter System we Traded our Goods and Services for the Goods and Services of Others

Money.  It’s not what most people think it is.  It’s not what most politicians think it is.  Or their Keynesian economists.  They think it’s wealth.  That it has value.  But it doesn’t.  It is a temporary storage of value.  A medium of exchange.  And that alone.  Something that we created to make economic trades easier and more efficient.  And it’s those things we trade that have value.  The things that actually make wealth.  Not the money we trade for these things.

In our first economic exchanges there was no money.  Yet there were economic exchanges.  Of goods and services.  That’s right, there was economic activity before money.  People with talent (i.e., human capital) made things, grew things or did things.  They traded this talent with the talent of other people.  Other people with human capital.  Who made things, grew things or did things.  Who sought each other out.  To trade their goods and services for the goods and services of others.  Which you could only do if you had talent yourself.

This is the barter system.  Trading goods and services for goods and services.  Without using money.  Which meant you only had what you could do for yourself.  And the things you could trade for.  If you could find people that wanted what you had.  Which was the great drawback of the barter system.  The search costs.  The time and effort it took to find the people who had what you wanted.  And who wanted what you had.  It proved to be such an inefficient way to make economic transactions that they needed to come up with a better way.  And they did.

The Larger the Wheat Crop the Greater the Inflation and the Higher the Prices paid in Wheat

They found something to temporarily hold the value of their goods and services.  Money.  Something that held value long enough for people to trade their goods and services for it.  Which they then traded for the goods and services they wanted.  Greatly decreasing search costs.  Because you didn’t have to find someone who had what you wanted while having what they wanted.  You just had to take a sack of wheat (or something else that was valuable that other people would want) to market.  When you found what you wanted you simply paid an amount of wheat for what you wanted to buy.  Saving valuable time that you could put to better use.  Producing the goods or services your particular talent provided.

Using wheat for money is an example of commodity money.  Something that has intrinsic value.  You could use it as money and trade it for other goods and services.  Or you could use it to make bread.  Which is what gives it intrinsic value.  Everyone needs to eat.  And bread being the staple of life wheat was very, very valuable.  For back then famine was a real thing.  While living through the winter was not a sure thing.  So the value of wheat was life itself.  The more you had the less likely you would starve to death.  Especially after a bad growing season.  When those with wheat could trade it for a lot of other stuff.  But if it was a year with a bumper crop, well, that was another story.

If farmers flood the market with wheat because of an exceptional growing season then the value for each sack of wheat isn’t worth as much as it used to be.  Because there is just so much of it around.  Losing some of its intrinsic value.  Meaning that it won’t trade for as much as it once did.  The price of wheat falls.  As well as the value of money.  In other words, the bumper crop of wheat depreciated the value of wheat.  That is, the inflation of the wheat supply depreciated the value of the commodity money (wheat).  If the wheat crop was twice as large it would lose half of its value.  Such that it would take two sacks of wheat to buy what one sack once bought.  So the larger the wheat crop the greater the inflation and the higher the prices (except for wheat, of course).  On the other hand if a fire wipes out a civilization’s granary it will contract the wheat supply.  Making it more valuable (because there is less of it around).  Causing prices to fall (except for wheat, of course).  The greater the contraction (or deflation) of the wheat supply the greater the appreciation of the commodity money (wheat).  And the greater prices fall.  Because a little of it can buy a lot more than it once did.

Keynesian Expansionary Monetary Policy has only Disrupted Normal Market Forces

Creating a bumper crop of wheat is not easy.  Unlike printing fiat money.  It takes a lot of work to plow the additional acreage.  It takes additional seed.  Sowing.  Weeding.  Etc.  Which is why commodity money works so well.  Whether it’s growing wheat.  Or mining a precious metal like gold.  It is not easy or cheap to inflate.  Unlike printing fiat money.  Which is why people were so willing to accept it for payment.  For it was a relative constant.  They could accept it without fear of having to spend it quickly before it lost its value.  This brought stability to the markets.  And let the automatic price system match supply to the demand of goods and services.  If things were in high demand they would command a high price.  That high price would encourage others to bring more of those things to market.  If things were not in high demand their prices would fall.  And fewer people would bring them to market.  When supply equaled demand the market was in equilibrium.

Prices provide market signals.  They tell suppliers what the market wants more of.  And what the market wants less of.  That is, if there is a stable money supply.  Because this automatic price system doesn’t work so well during times of inflation.  Why?  Because during inflation prices rise.  Providing a signal to suppliers.  Only it’s a false signal.  For it’s not demand raising prices.  It’s a depreciated currency raising prices.  Causing some suppliers to increase production even though there is no increase in demand.  So they will expand production.  Hire more people.  And put more goods into the market place.  That no one will buy.  While inflation raises prices everywhere in the market.  Increasing the cost of doing business.  Which raises prices throughout the economy.  Because consumers are paying higher prices they cannot buy as much as they once did.  So all that new production ends up sitting in wholesale inventories.  As inventories swell the wholesalers cut back their orders.  And their suppliers, faced with falling orders, have to cut back.  Laying off employees.  And shuttering facilities.  All because inflation sent false signals and disrupted market equilibrium.

This is something the Keynesians don’t understand.  Or refuse to understand.  They believe they can control the economy simply by continuously inflating the money supply.  By just printing more fiat dollars.  As if the value was in the money.  And not the things (or services) of value we create with our human capital.  Economic activity is not about buying things with money.  It’s about using money to efficiently trade the things we make or do with our talent.  Inflating the money supply doesn’t create new value.  It just raises the price (in dollars) of our talents.  Which is why Keynesian expansionary monetary policy has been such a failure.  For their macroeconomic policies only disrupt normal market forces.  Which result in a macroeconomic disequilibrium.  Such as raising production in the face of falling demand.  Because of false price signals caused by inflation.  Which will only bring on an even more severe recession to restore that market equilibrium.  And the longer they try to prevent this correction through inflationary actions the longer and more severe the recession will be.

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Microeconomics and Macroeconomics

Posted by PITHOCRATES - September 10th, 2012

Economics 101

Keynesians cannot connect their Macroeconomic Policies to the Microeconomic World

Economics can be confusing.  As there are actually two genres of economics.  There’s microeconomics.  The kind of stuff most people are familiar with.  And is more common sense.  This is more of the family budget variety.  And small business budget.  Where if costs go up (gasoline, commodities, food, insurance, etc.) families and businesses make cuts elsewhere in their budget.  When revenue falls (a decline in sales revenue or a husband/wife loses their job) people cut back on expenses.  They cancel the family vacation.  Or cancel Christmas bonuses.  Straight forward stuff of living within your means.

Then there’s macroeconomics.  The big economic picture.  This is the stuff about the national economy.  GDP, inflation, recession, taxes, etc.  Things that are more abstract.  Unfamiliar.  And often defy common sense.  Where living beyond your means is not only accepted.  But it’s national policy.  And when some policies fail repeatedly those in government keep trying those same policies expecting a different outcome eventually.  Such as using Keynesian economic policies (stimulus packages, deficit spending, printing money, etc.) to get an economy out of recession that never quite works.  And then the supporters of those policies always say the same thing.  Their policies only failed because they didn’t spend enough money to make them work.

Keynesian economics focuses on macroeconomics.  And cannot connect their macro policies to the micro world.  There is a large gap between the two.  Which is why Keynesians fail.  Because they look at the macro picture to try and effect change in the micro world.  To get businesses to create jobs.  To hire people.  And to reduce unemployment.  But the politicians executing Keynesian policy don’t understand things in the micro world.  Or anything about running a business.  All they understand, or all they care to try to understand, are the Keynesian basics.  That focus on the demand side of economics.  While ignoring everything on the supply side.

When the Economy goes into Recession the Fed Expands the Money Supply to Lower Interest Rates

Keynesians have a few fundamental beliefs.  And one of the big ones is the relationship between interest rates and GDP.  In fact, it’s the center of their world.  High interest rates discourage people from borrowing money.  When people don’t borrow money they don’t build things (like factories).  And if they don’t build things they won’t create jobs and hire people.  So the higher the interest rates the lower the economic output of the nation (GDP).

Low interest rates, on the other hand, encourage people to borrow money.  So they can build things and create jobs.  The lower the interest rates the more people will borrow.  And the greater the economic output of the nation will be.  This was the driving factor that caused the Great Recession.  The central bank (the Fed) kept interest rates so low for so long that people bought a lot of houses.  A lot of expensive houses.  The demand for housing was so great that buyers bid up prices.  Because at low interest rates there was no limit to how much house you could buy.  All this building and buying of houses, though, oversupplied the market with houses.  As home builders rushed in to fill that demand.  They built so many houses that there were just so many houses available to buy that buyers had a lot of choice.  Making it a buyers’ market.  So much so that people had to slash their asking price to sell their house.  Which popped the great housing bubble.

The Fed lowers interest rates by increasing the money supply.  They create new money and inject it into the economy.  By giving it to bankers.  Banks have more money to lend.  So more people can borrow money.  This is what lowers interest rates.  Things that are less scarce cost less.  More money to borrow means it’s less scarce.  And the price to borrow it (i.e., the interest rate) falls.  If the Fed wants to increase interest rates they pull money out of the economy.  Which makes it a little harder to borrow money.  Because more people are trying to borrow the limited amount of funds available to borrow.  And this is the basics of monetary policy.  Whenever the country enters a recession and unemployment rises the Fed expands the money supply to encourage businesses to borrow money to expand their businesses and create jobs that will lower unemployment.

Keynesian Economic Policies hurt the Higher Stages of Production where we Create Real Economic Activity

If low interest rates create greater economic activity why in the world would the Fed ever want to raise interest rates?  Because of the dark side of printing money.  Inflation.  Increasing the money supply gives people more money.  And when they have more money they try to buy what everyone else is buying.  As the money supply grows greater than the amount of economic output there is more money trying to buy fewer goods and services.  Which raises prices.  Just like those low interest rates did in the housing market.  The fear is that if this goes on too long there will be an economic crash.  Just like after the housing bubble burst.  From boom to bust.  Higher prices reduce consumer spending.  Because people can’t buy as much when prices are high.  As consumers stop spending businesses stop selling.  Faced with overcapacity in a period of falling demand they start cutting costs.  Laying off people.  People without jobs can buy even less at high prices.  And so on as the economy settles into recession.  This is why central bankers raise interest rates.  Because those good times are temporary.  And the longer they let it go on the more painful the economic correction will be.

This is why Keynesian stimulus spending fails to pull economies out of recession.  Because Keynesians focus only on the demand curve.  Consumption.  Consumer spending.  Not supply.  They ignore all that economic activity in the higher stages of productions.  That activity that precedes retail consumer sales.  The wholesale stage (the stage above retail).  The manufacturing stage (above the wholesale stage).  And the furthest out in time, the raw commodities stage (above the manufacturing stage).  As economic activity slows inventories build up.  Creating a bulge in the middle of the stages of production.  So manufacturing cuts back.  And because they do raw commodities cut back.  These are the first to suffer in an economic downturn.  And they are the last to recover.  Because of all that inventory in the pipeline.  When Keynesians get more money into consumers’ pockets they will increase their consumer spending.  For awhile.  Until that extra money is gone.  Which provided an economic boost at the retail level.  And a little at the wholesale level as they drew down those inventories.  But it did little at the higher stages of production.  Above inventories.  Manufacturing and raw material extraction.  Who don’t expand their production or hire new workers.  Because they know this economic activity is temporary.  And because they know all that new money will eventually create inflation.  Which will increase prices.  Throughout the stages of production.

The Keynesian approach focuses on the macro.  By playing with monetary policy.  Policies that ultimately hurt the higher stages of production.  At the micro level.  Where we create real economic activity.  If they’re not hiring then no amount of stimulus spending at the retail level will get them to hire.  Because giving the same amount of workers (i.e., consumers) more money to chase the same amount of goods and services only causes higher prices in the long run.  And it’s the long run that raw commodities and manufacturing look at.  They are not going to invest to expand their businesses unless they expect improving economic conditions in the long run.  All the way up the stages of production to where they are.  When new economic activity reaches them then they will expand and hire people.  And when they do they will add a lot of new consumers with real wages to go out and spend at the retail level.

One of the most efficient ways to achieve this is with tax cuts.  Because cuts in tax rates shape economic activity in the long run.  Across the board.  Unlike stimulus spending.  Which is short term.  And very selective.  Some benefit.  Typically political cronies.  But most see no benefit.  Just higher prices.  And continued unemployment.  Which is why Keynesian policies fail to pull economies out of recessions.  Because politicians use them for political purposes.  Not economic purposes.

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