The Austrian School of Economics

Posted by PITHOCRATES - March 3rd, 2014

Economics 101

(Originally published February 27th, 2012)

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us.  The computer?  The Internet?  The cell phone?  The car?  The jumbo jet?  Television?  Air conditioning?  The automatic dishwasher?  No.  Amazingly, economists did not invent any of these brilliant inventions.  And economists didn’t predict any of these inventions.  Not a one.  Despite how brilliant they are.  Well, brilliant by their standard.  In their particular field.  For economists really aren’t that smart.  Their ‘expertise’ is in the realm of the social sciences.  The faux sciences where people try to quantify the unquantifiable.  Using mathematical equations to explain and predict human behavior.  Which is what economists do.  Especially Keynesian economists.  Who think they are smarter than people.  And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity.  The Austrian school.  Where Austrian economics began.  In Vienna.  Where the great Austrian economists gathered.  Carl Menger.  Ludwig von Mises.  And Friedrich Hayek.  To name a few.  Who understood that economics is the sum total of millions of people making individual human decisions.  Human being key.  And why we can’t reduce economics down to a set of mathematical equations.  Because you can’t quantify human behavior.  Contrary to what the Keynesians believe.  Which is why these two schools are at odds with each other.  With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school.  Because it calls for the government to interfere with market forces.  To manipulate them.  To make markets produce different results from those they would have if left alone.  Something governments love to do.  Especially if it calls for taxing and spending.  Which Keynesian economics highly encourage.  To fix market ‘failures’.  And recessions.  By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire.  They believe more in the separation of the government from things economic.  Economic exchanges are best left to the invisible hand.  What Adam Smith called the sum total of the millions of human decisions made by millions of people.  Who are maximizing their own economic well being.  And when we do we maximize the economic well being of the economy as a whole.  For the Austrian economist does not believe he or she is smarter than people.  Or markets.  Which is why an economist never gave us any brilliant invention.  Nor did their equations predict any inventor inventing a great invention.  And why economists have day jobs.  For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs.  When they’re able to do that we should start listening to them.  But not before.

Low Interest Rates cause Malinvestment and Speculation which puts Banks in Danger of Financial Collapse

Keynesian economics really took off with central banking.  And fractional reserve banking.  Monetary tools to control the money supply.  That in the Keynesian world was supposed to end business cycles and recessions as we knew them.  The Austrian school argues that using these monetary tools only distorts the business cycle.  And makes recessions worse.  Here’s how it works.  The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money).  Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc.  This new economic activity encourages businesses to hire new workers to meet the new demand.  Ergo, recession over.  Simple math, right?  Only there’s a bit of a problem.  Some of our worst recessions have come during the era of Keynesian economics.  Including the worst recession of all time.  The Great Depression.  Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse.  (Economists debate the causes of the Great Depression to this day.  Understanding the causes is not the point here.  The point is that it happened.  When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions.  They’re artificial ones.  Created by cheap credit.  Which the central bank creates by forcing interest rates below actual market interest rates.  Which causes a whole host of problems.  In particular corrupting the banking system.  Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now.  This is where savings (or investment capital) come from.  Banks pay depositors interest on their deposits.  And then loan out this money to others who need investment capital to start businesses.  To expand businesses.  To buy businesses.  Whatever.  They borrow money to invest so they can expand economic activity.  And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply.  Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later).  So they borrow to expand operations.  All because of the false signal of the artificially low interest rates.  They borrow money.  Over-invest.  And make bad investments.  Even speculate.  What Austrians call malinvestments.  But there was no shift from consumption to investment.  Savings haven’t increased.  In fact, with all those new loans on the books the banks see a shift in the other direction.  Because they have loaned out more money while the savings rate of their depositors did not change.  Which produced on their books a reduction in the net savings rate.  Leaving them more dangerously leveraged than before the credit expansion.  Also, those lower interest rates also decrease the interest rate on savings accounts.  Discouraging people from saving their money.  Which further reduces the savings rate of depositors.  Finally, those lower interest rates reduce the income stream on their loans.  Leaving them even more dangerously leveraged.  Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation.  Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.).  This alters the natural order of things.  The automatic pricing mechanism of the free market.  And reallocates resources to these higher prices.  Away from where the market would have otherwise directed them.  Creating great shortages and high prices in some areas.  And great surpluses of stuff no one wants to buy at any price in other areas.  Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap.  (But not quite that bad.)  Then comes the day when all those investments don’t produce any returns.  Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it.  They drove up prices.  Created great asset bubbles.  Overbuilt their capacity.  Bought assets at such high prices that they’ll never realize a gain from them.  They know what’s coming next.  And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning.  By keeping interest rates low.  But that only allows asset bubbles to get bigger.  Making the inevitable correction more painful.  But eventually the central bank has to step in and raise interest rates.  Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level.  And sparks off some nasty inflation.  So rates go up.  Credit becomes more expensive.  Often leaving businesses and speculators to try and refinance bad debt at higher rates.  Debt that has no income stream to pay for it.  Either forcing business to cut costs elsewhere.  Or file bankruptcy.  Which ripples through the banking system.  Causing a lot of those highly leveraged banks to fail with them.  Thus making the resulting recession far more painful and more long-lasting than necessary.  Thanks to Keynesian economics.  At least, according to the Austrian school.  And much of the last century of history.

The Austrian school believes the market should determine interest rates.  Not central bankers.  They’re not big fans of fractional reserve banking, either.  Which only empowers central bankers to cause all of their mischief.  Which is why Keynesians don’t like Austrians.  Because Keynesians, and politicians, like that power.  For they believe that they are smarter than the people making economic exchanges.  Smarter than the market.  And they just love having control over all of that money.  Which comes in pretty handy when playing politics.  Which is ultimately the goal of Keynesian economics.  Whereas the Austrian school is more about economics.

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Keynesian Economics Destroyed Good Lending Practices at our Banks and gave us the Subprime Mortgage Crisis

Posted by PITHOCRATES - August 11th, 2013

Week in Review

In the days of classical economics, before Keynesian economics, people put their money into a bank to earn interest.  The banks gathered all of these deposits together and created a pool of investment capital.  People and businesses then went to the banks to borrow this capital to invest into something.  A house to start a new family in.  Or a factory.  And the more people saved the more money there was to loan to investors.  Which kept the cost of borrowing that money reasonable.  And created booming economic activity.

It was a beautiful system.  And one that worked so well it made the United States the number one economic power in the world.  Then John Maynard Keynes came along and ruined that proven system.  By telling governments that they should intervene into their economies.  That they should manipulate the interest rates.  By printing money.  Which changed the banking system forever (see The Housing Market Is Still Missing a Backbone by GRETCHEN MORGENSON posted 8/10/2013 on The New York Times).

Yet with the government backing or financing nine out of 10 residential mortgages today, it is crucial to lure back private capital, with no government guarantees, to the home loan market. Mr. Obama contended that “private lending should be the backbone” of the market, but he provided no specifics on how to make that happen.

This is a huge, complex problem. In fact, there are many reasons for the reluctance of banks and private investors to fund residential mortgages without government backing.

For starters, banks have grown accustomed to earning fees for making mortgages that they sell to Fannie and Freddie. Generating fee income while placing the long-term credit or interest rate risk on the government’s balance sheet is a win-win for the banks.

A coming shift by the Federal Reserve in its quantitative easing program may also be curbing banks’ appetite for mortgage loans they keep on their own books. These institutions are hesitant to make 30-year, fixed-rate loans before the Fed shifts its stance and rates climb. For a bank, the value of such loans falls when rates rise. This process has already begun — rates on 30-year fixed-rate mortgages were 4.4 percent last week, up from 3.35 percent in early May. This is painful for banks that actually hold older, lower-rate mortgages.

In other words, the federal government’s intervention into the private sector economy caused the subprime mortgage crisis.  And the Great Recession.  By removing all risk from the banking industry by transferring it to the taxpayer.  This created an environment that encouraged lenders to adopt poor lending standards.  Because they made their money on loan initiation fees.  No matter how risky those loans were.  And not by managing a portfolio of performing mortgages.  Which kept the bank honest when writing a loan.  As they would feel the pain if the borrower did not make his or her loan payments.  But if they sold those loans and broomed them off of their balance sheets what would they care if these people ever serviced their loans?

This is what you get with government intervention into the free market.  Distortions of the free market.  Keynesian economics was supposed to get rid of recessions.  By cutting away half of the business cycle.  And just keeping the inflationary side of it.  Trading permanent inflation for no recessions ever.  But since the Keynesians began intervening we’ve had a Great Depression.  A subprime mortgage crisis.  And a Great Recession.  All because they tried to improve the free market.  Which also, coincidentally, enabled Big Government.  The ultimate goal of Keynesian economics.  To get smart government planners in control of our lives.  Just like they were in the former Soviet Union.  But revolutions are messy.  So the government planners bided their time.  And slow-walked their way to power.  First they took control of the banks.  And now they have health care.  Which they will destroy.  Just as they destroyed good lending practices.  Which have given us the worst economic recovery since that following the Great Depression.

Anytime you move away from capitalism things get worse.  When this nation embraced free market capitalism we became the number one economic power in the world.  And the destination for oppressed people everywhere in the world.  For the better life that was available in America.  While the nations that chose the state planning of socialism and communism became those places oppressed people wanted to flee.  And life in those nations only got better with a move towards capitalism.  China may soon become the world’s number one economic power.  But they’re not doing this by adhering strictly to their state-planning ways of Mao’s China.  No.  They are doing this by moving away from the state-planning of Mao’s China.  To something called state-capitalism.  Pseudo-capitalism.  Just hints and traces of capitalism simmering in state-planning stew.  Where communist planners still control the people’s lives.  A direction America is slow-walking itself to.  Slowly.  But surely.

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FT148: “You only know what someone taught you.” —Old Pithy

Posted by PITHOCRATES - December 14th, 2012

Fundamental Truth

If we Grew up on a Deserted Island isolated from Hate we’d Probably Grow up Better Adjusted to live with One Another

No one is born a racist.  It’s something you have to learn.  Someone has to teach it to you.  If a parent is a racist chances are the child will be bombarded with racial slurs growing up.  And become a racist.  Just like his or her parent.  But if you raised a bunch of babies of different races together on a deserted island in isolation would any of them grow up to be a racist?   No.  For they wouldn’t even know what racism is.  Because the life they knew would be normal.  It would be normal for black, white, brown, red and yellow to live together.

Catholics and Protestants have spent a few centuries killing each other.  Ever since the Protestant Reformation in 1517.  People have been persecuting Jews since forever.  The Palestinians, Hezbollah and Hamas have been killing Israelis for decades.  Shiite and Sunni have also been killing each other for a very long time.  These people have hated each other so much that they just want to see the other dead.  Yet if you took a Catholic, a Protestant, a Jew, a Palestinian, a Shiite and a Sunni baby from their parents and raised them on a deserted island in isolation they wouldn’t grow up wanting to kill each other.  They wouldn’t even know they were supposed to hate each other.

Europe was just itching to go to war.  Nationalistic fervor was just bursting at the seams.  Germans, Austrians, Hungarians, French, Russians and British were ready and waiting.  Filled with nationalist pride.  Just jonesing to open a can of whup-ass on anyone that wasn’t from their own great nation.  Having learned nothing from the Crimean War.  Or the American Civil War.  Thinking they would march their magnificent armies onto the field of battle, fight a glorious battle and watch the enemy throw down their arms and run away.  Even though tactics hadn’t changed much from the Crimean War and the American Civil War.  Though the weapons were far more lethal.  Making World War I one of the bloodiest wars of all time.  But had you taken a German, an Austrian, a Hungarian, a French, a Russian and a British baby from their parents at the turn of the century and raised them on a deserted island in isolation they wouldn’t have grown up wanting to go to war with each other.  As they wouldn’t know that they were supposed to hate each other.

Of all the Things the State did Poorly perhaps the Worst was being Husband and Father

When our parents grew up they often went to bed without locking the doors to their houses.  Even during the days of Prohibition when armed gangs shot each other in the street with automatic weapons.  Today we have deadbolts and alarm systems.  And metal detectors at our schools.  For kids today are taking guns to school.  And they’re shooting people.  This didn’t happen during the days of Prohibition when gangs were armed with Thompson 45-caliber submachine guns.  Why?  Because during Prohibition there weren’t violent video games, graphic violence in movies & television and rap & hip-hop songs glorifying gun violence.  So even though we have less lethal weapons on the streets today we have more gun violence than before.  Because kids have been so desensitized to violence that killing people just isn’t a big deal to them.  Raise these kids on a deserted island away from this violence in our pop culture, though, and they’re not going to kill indiscriminately.  Instead they’ll stay innocent kids longer.

Add to this violence in our pop culture our secular progressive culture.  The Left’s quest to remove religion and God from as much of our lives as possible.  And their attacks on Christianity.  For imposing their moral code on people.  And opposing free love and abortion.  They have gone so far as to call for the removal of the Ten Commandments from our government buildings.  And our schools.  Because teaching kids things like ‘Thou shall not kill” is a bad thing.  Or any other morality lesson.  For who’s to say what is right and wrong?  Of course when we teach our kids growing up that there are no moral absolutes it sure weakens the argument for them not to do bad things.  It detaches them from society.  And makes them lack empathy for their fellow citizens.  Making it easier to hurt them.  If you pulled these kids out of our public schools and put them and their parents on a deserted island away from this secular progressive culture and filled them with the fear of God for misbehaving they probably could sleep at night with their doors unlocked.  For hurting one another would be the last thing on their minds.

When LBJ passed his Great Society legislation it included Aid to Families with Dependent Children (AFDC).  An unmitigated disaster for poor people.  For it let men father and abandon their children.  Leaving women to turn to the state to act as husband and father.  And of all the things the state did poorly perhaps the worst was being husband and father.  It just decimated poor families.  Single mothers filled housing projects.  Their children, with no male role model, turned to the street.  Got into a lot of trouble.  And into drugs.  Even taking that behavior into their schools.  Which is part of the reason why metal detectors are needed today at our schools.  Forcing organizations like Big Brothers Big Sisters of America to pick up the parenting slack.  Had these deadbeat dads lived on a deserted island untouched by AFDC there would have been less fathering and abandoning of children.  Like there was before AFDC.

Keynesian Policies have Historically Resulted in High Unemployment and Painful Recessions

After World War II the world went Keynesian.  Classical economics (that favored savings over consumption, low taxes, the gold standard, little government intrusion into the private sector and responsible fiscal policy as in DON’T spend so much) that made America a superpower went out the window.  In came the disaster we call Keynesian economics (that favored consumption over savings, deficit spending, printing lots of money, high taxes and a lot of government intervention into the private sector.  Warren Harding and Calvin Coolidge in the Twenties were the last of the classical economists.  Their policies gave us great prosperity.  JFK adopted policies of the classical economics variety to pull America out of a recession in the Sixties.  Nixon, Ford and Carter were big Keynesians whose policies destroyed America.  Ronald Reagan rebuilt America in the Eighties by returning to policies of the classical economics variety.  As George W. Bush did to pull us out of the bad recession caused by Bill Clinton’s dot-com bubble bursting.

So the record shows the success of classical economics.  And the failure of Keynesian economics.  Yet about half the population voted for the Keynesian policies of President Obama in 2012.  Why?  Why did they vote for more of the failed policies of the past?  Because most Americans learn only of Keynesian economics in their economic courses.  While politicians, economists and the mainstream media endorse Keynesian policies as if they have a record of success.  They do this because Keynesian economics does something that classical economics doesn’t.  Empowers big government.  Sanctions class warfare.  Giving them the moral high ground when raising taxes.  And printing money.  Despite these actions causing the worst economic recovery since the Great Depression.

President Obama won reelection for one of two reasons.  Either people want more free stuff.  Or they don’t understand economics.  Or the consequences of handing out all that free stuff.  For if they understood economics they would not have voted for a Keynesian.  For Keynesian policies have historically resulted in high unemployment and painful recessions.  So even if you’re voting for the free stuff you’d vote for the classical economics candidate.  For without people working there is no income to tax to pay for all of that free stuff.  But few people understand economics.  Which is lucky for President Obama.  In fact, few people understand the disaster that has been the liberal agenda as the liberals control the public schools, our colleges, the mainstream media and the entertainment establishment.  So few are learning the long record of liberal failures.  Which helps liberals win elections.  For you only know what someone taught you.  And if the liars are in charge of teaching us the only things we will learn are their lies.  Unless, of course, we can find some deserted island to grow up on where their policies can’t reach us.  Then when we come back we can make the world a better place.  A place with sound economic policies.  With no racism, no religious intolerance, no blind nationalist fervor, no culture of gun violence and no epidemic of deadbeat dads.

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FT141: “Liberals are absolutely sure they’re right and you’re wrong even though they can’t explain why.” —Old Pithy

Posted by PITHOCRATES - October 26th, 2012

Fundamental Truth

Jobs are Everything in an Economy

In the movie Apollo 13 starring Tom Hanks it was a smart electrical engineer that saved the astronauts.  Who explained that nothing they did would save the astronauts unless they figured out how to make the limited remaining power last until reentry.  He said power was everything.  And if it ran out before reentry the astronauts wouldn’t make it back alive.  So heeding the advice of the smart electrical engineer they shut off all power to save what they had for reentry.  Which meant they had no heat.  And had to do some course corrections without the computer, requiring some complicated flying skills.  Because they listened to the smart electrical engineer they had just enough power left to make it to reentry.  And the astronauts made it back home alive.

An economy is similar in a way.  For it, too, has something that is everything.  And without it nothing else matters.  Jobs.  Jobs are everything in an economy.  For they are the only way we can afford things.  A house.  A car.  Food for our families.  The heating bill.  Fuel for our vehicles.  Electronic devices.  Our wireless/cable bills.  Coffee at Starbucks.  Clothing.  Shoes.  Pet food.  Etc.  None of these would be possible without a job.  And a paycheck.  Even our government benefits.  Paid for with taxes.  Deducted from our paychecks.  Without people working none of these things would be possible.  Because jobs are everything.

Money is not everything.  We use money to make it easier to trade our skills with others to get the things we want.  The more our skills are in demand by others the more we can trade them for other things.  Which is why doctors have more things than high school kids working an entry level job.  For there are a lot high school kids with entry-level job skills.  But not so many people with doctor skills.  So we pay doctors more.  And high school kids less.  Because doctors have more valuable skills than high school kids.  And therefore can trade those skills for a lot of other things.  So it’s not the money that matters.  It’s the skills that they can trade for money that matters.  Provided there is a job for them to fill.  Once again coming back to jobs.  Which are everything.

Birth Control and Abortion are the Pressing Social Issues that keep College Students Awake at Night with Worry

If the government printed money and paid everyone in the nation the equivalent of a doctor’s earnings it would not be the same thing.  Because if everyone was paid the same no matter their skill level no one would go through the costs and hard work to become a doctor.  Because working harder to acquire those skills wouldn’t provide them anything more than they can get for doing nothing.  Giving people money for skills they don’t have diminishes the values of those skills.  So people won’t work hard to get those skills.  With less skillful people in the workplace there will be fewer people to provide the goods and services we want to buy.  Leaving a lot of empty store shelves.  And high prices because the things you want will be very hard to find.

This is why high school kids go to college.  Take on a lot of student loan debt.  To get the skills that will let them get the kind of jobs that will let them earn a lot of money.  Granted, a lot of kids go to college for the fun.  First time away from home.  Binge drinking.  Casual sex.  Drugs.  But they’re also there for the big payday a college education is supposed to give you.  However, if the jobs aren’t there neither is that big paycheck.  But that student loan debt is.  Who’s to blame for the lack of jobs?  In part these college kids.  Who typically vote Democrat.  The party that favors social justice, access to birth control and abortion, gay marriage, the decriminalization of marijuana, and other pressing social issues that apparently keep college students awake at night with worry.  So the Democrats pursue these issues to get the youth vote.  Instead of making a favorable climate for business.  So they can grow and create the jobs these college students want and are going to college for.

The problem is that these kids don’t understand the fundamentals of economics.  They don’t understand business.  Or the affect of taxes and regulatory compliance costs on a business’ bottom line.  And they don’t seem to understand that they are not the only ones who want to make money.  So do business owners.  And if the tax burden and cost of regulatory compliance reduce the bottom line it makes it more difficult to meet payroll.  And pay their other bills.  So they will not grow their business.  They will not create jobs.  They will not offer pay raises and bonuses.  And may even lay off people.  When they do these things college kids call these business owners greedy.  While their desire for a high-paying job does not make them greedy.  Funny how subjective greed can be.

Liberals are Deep Critical Thinkers though they think about few things other than a Woman’s Reproductive Parts

In the current election cycle the Democrats don’t have a good record to run on.  The current economic recovery, if we can call it a recovery, is about the worst on record.  The biggest drag on the economy?  Jobs.  There are fewer of them today than when President Obama took office.  And his policies haven’t help.  Especially Obamacare.  Which has caused business owners to slam the brakes on hiring.  As they have no idea of the final total cost impact of Obamacare.  So having destroyed job creation, the Democrats have turned to other tactics.  Fear and loathing of Republican candidates.  Such as the so-called war on women.  Where the Democrats are warning women that if the Republicans win the upcoming 2012 election women will lose their birth control, their access to abortion, their cancer screening, their freedom.  Life for women under the Republicans, the Democrats say, will be little different than living under the Taliban.

Of course, this isn’t true.  For it didn’t happen under the 20 years of Republican rule of George W. Bush, George H. W. Bush and Ronald Reagan.  But it doesn’t stop the Democrats or their celebrity endorsers from warning about the horrible things that will happen to women should the Republicans win.  And they speak with such certain authority.  For they know everything.  At least, that’s what they think.  It would be interesting, though, to ask them a few questions.  So they can demonstrate their mastery of things economic.  By explaining the stages of production.  Why stimulus spending raises prices.  To explain the business cycle.  How recessions correct prices by wringing inflation out of them.  How keeping interest rates artificially low creates asset bubbles.  Like housing bubbles.  And how bubbles create recessions when they burst.  To explain what is Say’s Law.  To name an economic school besides the Keynesian school.  To explain the Keynesian school of economics.  The number of taxes a business must calculate and pay with every payroll.  How excessive government borrowing diverts investment capital from the job-creating private sector.  Or how the growth in government spending cannot increase greater than the population growth rate.

As they don’t teach any of this in today’s public schools and most universities they probably won’t be able to explain any of these things.  Yet liberals are absolutely sure they’re right and you’re wrong.  Even though they can’t explain why.  For they are smarter.  Brighter.  More progressive.  Enlightened.  And deep critical thinkers.  Though they think about few things other than a woman’s reproductive parts.  Even when the real unemployment rate (the U-6 number that counts everyone that can’t find a full-time job) currently stands at 14.7%.  Which is serious.  As jobs are everything.  And sometimes you can’t have everything you want.  Sometimes you must sacrifice.  And put in place policies that are business friendly.  Cutting back on the social spending.  At least until businesses start creating jobs again.  And the working tax base can once again support that social spending.

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Production vs. Consumption

Posted by PITHOCRATES - August 20th, 2012

Economics 101

To Prevent another Great Depression Keynes said the Key was Government Spending

John Maynard Keynes was a noted economist who analyzed the Great Depression.  And came to the opinion the problem was that there wasn’t enough consumption.  Consumers weren’t buying enough stuff.  That is, they weren’t spending enough money.  Which is key to consumption.  And a healthy economy.  According to Keynes.  And the people who embraced his economic theories.  What we now call Keynesian economics.

It was a whole new way to look at economics.  Consumption.  Or demand-side economics.  Which said demand created supply.  Contrary to Say’s law.  Which basically stated supply creates demand.  Tomáto.  Tomàto.  To most people.  All they understood was that it was better to have a job than to be unemployed.  Because if you had a job you could buy food for your family.  Pay for heat in the winter.  And pay a doctor if your child was sick.

To prevent another Great Depression Keynes said the key was government spending.  To make up for any decline in consumption.  The government could tax, borrow or print money as necessary to get money to spend.  Putting people to work on government projects.  Building things.  Like roads and bridges.  Or digging ditches.  So when businesses lay off people the government can put them back to work.  And pay them with the money they taxed, borrowed or printed.  These people would then take that money and spend it.  A priming of the economic pump as it were.  That, in theory, will provide consumption until the private sector begins hiring again.  Therefore eliminating recessions once and for all.

Economists attribute about 90% of GDP to Consumer Spending and Government Expenditures

There have been about 12 recessions since Keynes figured out how to end them once and for all.  The recent one being the worst since the Great Depression.  Even surpassing the misery of the Jimmy Carter economy.  A time when the impossible happened.  In the world of Keynesian economics, at least.  Government spending designed to decrease unemployment actually increased unemployment.  It turns out there was a downside to printing money.  Massive inflation.  And rational expectations that printing money will lead to massive inflation.  So while the Keynesian way worked in theory it failed in practice.  And not just once.  But a lot.  Yet it is still the model of most governments.  And it’s what colleges teach their students.  Why?  After it’s been so thoroughly debunked?  The answer to that question brings us back to consumption.  And Gross Domestic Product (GDP).

GDP is a measure of a country’s goods and services during a period of time.  That is, it is a measure of economic activity.  The bigger it is the better the economy.  And the more people that have jobs.  The formula for GDP is the sum of consumption, investments, government expenditures and net exports (exports – imports).  It’s this formula that keeps Keynesian economics alive.  Because of consumption.  And government expenditures.  This formula sanctions government spending because, according to the formula, it increases economic activity.  It is the driver of all stimulus spending.  And the welfare state.  Because government spending puts money ultimately into the pockets of consumers who spend it.  That is, government spending creates private consumption.  And consumption creates jobs (demand creates supply).  In the Keynesian world, that it.  There is only one problem.  The formula leaves out a lot of economic activity.

Using this formula economists report that consumption makes up about 70% of GDP.  And government spending about 20%.  These numbers are huge.  That’s about 90% of GDP attributed to consumer spending and government expenditures.  Which is why Keynesians love this formula.   Because it empowers them to tax, borrow and print so they can spend.  All in the name of creating jobs.  And GDP.  But what about the things people make or do that consumers don’t buy?  Like engineering and design services.  Printing presses and ink.  The extraction of raw materials?  Coal mining.  Blast furnaces making steel for use in manufacturing?  Heavy construction equipment?  Machine tools and production equipment?  Assembly lines?  Robots on the assembly line?  Locomotive engines and rolling stock?  Airplanes?  All the people and equipment in the transportation industry?  Etc.  There is a lot of economic activity that makes things or does things that consumers don’t buy.  So where is it in the GDP formula?  Don’t look for it.  Because it’s just not there.

Intermediate Business Spending accounts for about Half of all Economic Activity

Before Keynes the focus was on production.  Not consumption.  Before Keynes we looked at the stages of production.  All of that economic activity that happens before you can buy anything in a store.  Everything between the extraction of raw materials to the final finished good.  Where millions of workers are engaged in economic activity that a consumer knows nothing about when they buy a consumer good.  If you factor in this economic activity into the GDP equation it changes things.  And it changes it in a way that Keynesians and government officials don’t like.

Consumption is the last stage in the stages of production.  The final step in a flurry of economic activity that preceded it.  If you count up this intermediate business spending it comes to about half of all economic activity.  It’s about twice consumer spending.  And about four times government expenditures.  Greatly reducing the roles of consumption and government expenditures in the GDP equation.  And in the economy.  As well as providing the answer to why Keynes didn’t end recessions once and for all with his new economic theory.  Because his new economic theory was wrong.  You don’t create jobs by giving money to people to spend.  You create jobs by making it easy for businesses to hire people.

So demand does NOT create supply like Keynes said.  Supply creates demand.  Like Say said.  And what’s the conclusion we can draw?  Big activist governments do not help a country’s economy.  They just pull money out of the stages of productions.  Where it can create jobs.  And puts it into government.  Where it creates unemployment and inflation.  As demonstrated by all the big Keynesian governments of Europe.  Those social democracies struggling under the weight of their government spending.  Who borrowed money to sustain that spending.  Bringing on the European sovereign debt crisis.  Because of that GDP equation that said they could tax, borrow and print to spend to their heart’s content.  Thanks to a man named Keynes.

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Goldsmiths, Specie, Bank Notes, Bank Reserves, Spanish Dollar, Continentals, Bank of the United States and the Panic of 1819

Posted by PITHOCRATES - June 26th, 2012

History 101

When Spain came to the New World they Brought Home a lot of Gold and Silver and Turned it into Coin

Our first banks were goldsmiths’ vaults.  They locked up people’s gold or other valuable metals (i.e., specie) in their vaults and issued these ‘depositors’ receipts for their specie.  When a depositor presented their receipt to the goldsmith he redeemed it for the amount of specie noted on the receipt.  These notes were as good as specie.  And a lot easier to carry around.  So these depositors used these notes as currency.  People accepted them in payment.  Because they could take them to the goldsmith and redeem them for the amount of specie noted on the receipt.

The amount of specie these first bankers kept in their vaults equaled the value of these outstanding notes.  Meaning their bank reserves were 100%.   If every depositor redeemed their notes at the same time there was no problem.  Because all specie that was ever deposited was still in the vault.  So there was no danger of any ‘bank runs’ or liquidity crises.

When Spain came to the New World they brought home a lot of gold and silver.  And turned it into coin.  Or specie.  The Spanish dollar entered the American colonies from trade with the West Indies.  As the British didn’t allow their colonies to coin any money of their own the Spanish dollar became the dominate money in circulation in commerce and trade in the cities.  (Which is why the American currency unit is the dollar).  While being largely commodity money in the rural parts of the country.  Tobacco in Virginia, rice in the south, etc.  Paper money didn’t enter into the picture until Massachusetts funded some military expeditions to Quebec.  Normally the soldiers in this expedition took a portion of the spoils they brought back for payment.  But when the French repulsed them and they came back empty handed the government printed paper money backed by no specie.  For there was nothing more dangerous than disgruntled and unpaid soldiers.  The idea was to redeem them with future taxation.  But they never did. 

Thomas Jefferson believed that the Combination of Money and Politics was the Source of all Evil in Government 

During the American Revolutionary War the Americans were starving for specie.  They were getting some from the French but it was never enough.  So they turned to printing paper money.  Backed by no specie.  They printed so much that it became worthless.  The more they printed the more they devalued it.  And the fewer people would take it in payment.  Anyone paying in these paper Continentals just saw higher and higher prices (while people paying in specie saw lower prices).  Until some just refused to accept them.  Giving rise to the expression “not worth a Continental.”  And when they did the army had to take what they needed from the people.  Basically giving them an IOU and telling the people good luck in redeeming them.

Skip ahead to the War of 1812 and the Americans had the same problem.  They needed money.  So they turned to the printing presses.  With the aid of the Second Bank of the United States (BUS).  America’s second central bank.  Just as politically contentious as the First Bank of the United States.  America’s first central bank.  The BUS was not quite like those early bankers.  The goldsmiths.  Whose deposits were backed by a 100% specie reserve.  The BUS specie reserve was closer to 10%.  Which proved to be a problem because their bank notes were redeemable for specie.  Which people did.  And because they did and the BUS was losing so much of its specie the government legislated the suspension of the redemption of bank notes for specie.  Which just ignited inflation.  With the BUS.  And the state banks.  Who were no longer bound by the requirement to redeem bank notes for specie either.  Enter America’s first economic boom created by monetary policy.  A huge credit expansion that created a frenzy of borrowing.  And speculation.

When more dollars are put into circulation without a corresponding amount of specie backing them this only depreciated the dollar.  Making them worth less, requiring more of them to buy the same stuff they did before the massive inflation.  This is why prices rise with inflation.  And they rose a lot from 1815 to 1818.  Real estate prices went up.  Fueling that speculation.  Allowing the rich to get richer by buying land that soared in value.  While ordinary people saw the value of their currency decline making their lives more difficult.  Thanks to those higher prices.  The government spent a lot of this new money on infrastructure.  And there was a lot of fraud.  The very reason that Thomas Jefferson opposed Alexander Hamilton’s first Bank of the United States.  The combination of money and politics was the source of all evil in government.  And fraud.  According to Jefferson, at least.  Everyone was borrowing.  Everyone was spending.  Which left the banks exposed to a lot of speculative loans.  While putting so much money into circulation that they could never redeem their notes for specie.  Not that they were doing that anyway.  Bank finances were growing so bad that the banks were in danger of failing.

Most Bad Recessions are caused by Easy Credit by a Central Bank trying to Stimulate Economic Activity 

By 1818 things were worrying the government.  And the BUS.  Inflation was out of control.  The credit expansion was creating asset bubbles.  And fraud.  It was a house of cards that was close to collapsing.  So the BUS took action.  And reversed their ruinous policies.  They contracted monetary policy.  Stopped the easy credit.  And pulled a lot of those paper dollars out of circulation.  It was the responsible thing to do to save the bank.  But because they did it after so much inflation that drove prices into the stratosphere the correction was painful.  As those prices had a long way to fall.

The Panic of 1819 was the first bust of America’s first boom-bust cycle.  The first depression brought on by the easy credit of a central bank.  When the money supply contracted interest rates rose.  A lot of those speculative loans became unserviceable.  With no easy credit available anymore the loan defaults began.  And the bank failures followed.  Money and credit of the BUS contracted by about 50%.  Businesses couldn’t borrow to meet their cash needs and went bankrupt.  A lot of them.  And those inflated real estate prices fell back to earth.  As prices fell everywhere from their artificial heights.

It was America’s first depression.  But it wouldn’t be the last.  Thanks to central banking.  And boom-bust cycles.  We stopped calling these central banking train wrecks depressions after the Great Depression.  After that we just called them recessions.  And real bad recessions.  Most of them caused by the same thing.  Easy credit by a central bank to stimulate economic activity.  Causing an asset bubble.  That eventually pops causing a painful correction.  The most recent being the Great Recession.  Caused by the popping of a great real estate bubble caused by the central bank’s artificially low interest rates.  That gave us the subprime mortgage crisis.  Which gave us the greatest recession since the Great Depression.  Just another in a long line of ‘real bad’ recessions since the advent of central banking.

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The Austrian School of Economics

Posted by PITHOCRATES - February 27th, 2012

Economics 101

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us.  The computer?  The Internet?  The cell phone?  The car?  The jumbo jet?  Television?  Air conditioning?  The automatic dishwasher?  No.  Amazingly, economists did not invent any of these brilliant inventions.  And economists didn’t predict any of these inventions.  Not a one.  Despite how brilliant they are.  Well, brilliant by their standard.  In their particular field.  For economists really aren’t that smart.  Their ‘expertise’ is in the realm of the social sciences.  The faux sciences where people try to quantify the unquantifiable.  Using mathematical equations to explain and predict human behavior.  Which is what economists do.  Especially Keynesian economists.  Who think they are smarter than people.  And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity.  The Austrian school.  Where Austrian economics began.  In Vienna.  Where the great Austrian economists gathered.  Carl Menger.  Ludwig von Mises.  And Friedrich Hayek.  To name a few.  Who understood that economics is the sum total of millions of people making individual human decisions.  Human being key.  And why we can’t reduce economics down to a set of mathematical equations.  Because you can’t quantify human behavior.  Contrary to what the Keynesians believe.  Which is why these two schools are at odds with each other.  With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school.  Because it calls for the government to interfere with market forces.  To manipulate them.  To make markets produce different results from those they would have if left alone.  Something governments love to do.  Especially if it calls for taxing and spending.  Which Keynesian economics highly encourage.  To fix market ‘failures’.  And recessions.  By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire.  They believe more in the separation of the government from things economic.  Economic exchanges are best left to the invisible hand.  What Adam Smith called the sum total of the millions of human decisions made by millions of people.  Who are maximizing their own economic well being.  And when we do we maximize the economic well being of the economy as a whole.  For the Austrian economist does not believe he or she is smarter than people.  Or markets.  Which is why an economist never gave us any brilliant invention.  Nor did their equations predict any inventor inventing a great invention.  And why economists have day jobs.  For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs.  When they’re able to do that we should start listening to them.  But not before.

Low Interest Rates cause Malinvestment and Speculation which puts Banks in Danger of Financial Collapse

Keynesian economics really took off with central banking.  And fractional reserve banking.  Monetary tools to control the money supply.  That in the Keynesian world was supposed to end business cycles and recessions as we knew them.  The Austrian school argues that using these monetary tools only distorts the business cycle.  And makes recessions worse.  Here’s how it works.  The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money).  Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc.  This new economic activity encourages businesses to hire new workers to meet the new demand.  Ergo, recession over.  Simple math, right?  Only there’s a bit of a problem.  Some of our worst recessions have come during the era of Keynesian economics.  Including the worst recession of all time.  The Great Depression.  Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse.  (Economists debate the causes of the Great Depression to this day.  Understanding the causes is not the point here.  The point is that it happened.  When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions.  They’re artificial ones.  Created by cheap credit.  Which the central bank creates by forcing interest rates below actual market interest rates.  Which causes a whole host of problems.  In particular corrupting the banking system.  Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now.  This is where savings (or investment capital) come from.  Banks pay depositors interest on their deposits.  And then loan out this money to others who need investment capital to start businesses.  To expand businesses.  To buy businesses.  Whatever.  They borrow money to invest so they can expand economic activity.  And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply.  Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later).  So they borrow to expand operations.  All because of the false signal of the artificially low interest rates.  They borrow money.  Over-invest.  And make bad investments.  Even speculate.  What Austrians call malinvestments.  But there was no shift from consumption to investment.  Savings haven’t increased.  In fact, with all those new loans on the books the banks see a shift in the other direction.  Because they have loaned out more money while the savings rate of their depositors did not change.  Which produced on their books a reduction in the net savings rate.  Leaving them more dangerously leveraged than before the credit expansion.  Also, those lower interest rates also decrease the interest rate on savings accounts.  Discouraging people from saving their money.  Which further reduces the savings rate of depositors.  Finally, those lower interest rates reduce the income stream on their loans.  Leaving them even more dangerously leveraged.  Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation.  Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.).  This alters the natural order of things.  The automatic pricing mechanism of the free market.  And reallocates resources to these higher prices.  Away from where the market would have otherwise directed them.  Creating great shortages and high prices in some areas.  And great surpluses of stuff no one wants to buy at any price in other areas.  Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap.  (But not quite that bad.)  Then comes the day when all those investments don’t produce any returns.  Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it.  They drove up prices.  Created great asset bubbles.  Overbuilt their capacity.  Bought assets at such high prices that they’ll never realize a gain from them.  They know what’s coming next.  And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning.  By keeping interest rates low.  But that only allows asset bubbles to get bigger.  Making the inevitable correction more painful.  But eventually the central bank has to step in and raise interest rates.  Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level.  And sparks off some nasty inflation.  So rates go up.  Credit becomes more expensive.  Often leaving businesses and speculators to try and refinance bad debt at higher rates.  Debt that has no income stream to pay for it.  Either forcing business to cut costs elsewhere.  Or file bankruptcy.  Which ripples through the banking system.  Causing a lot of those highly leveraged banks to fail with them.  Thus making the resulting recession far more painful and more long-lasting than necessary.  Thanks to Keynesian economics.  At least, according to the Austrian school.  And much of the last century of history.

The Austrian school believes the market should determine interest rates.  Not central bankers.  They’re not big fans of fractional reserve banking, either.  Which only empowers central bankers to cause all of their mischief.  Which is why Keynesians don’t like Austrians.  Because Keynesians, and politicians, like that power.  For they believe that they are smarter than the people making economic exchanges.  Smarter than the market.  And they just love having control over all of that money.  Which comes in pretty handy when playing politics.  Which is ultimately the goal of Keynesian economics.  Whereas the Austrian school is more about economics.

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Fiscal Policy

Posted by PITHOCRATES - February 6th, 2012

Economics 101

The Constitutional Convention in Philadelphia (1787) was about Money and Unity at the National Level 

Once upon a time in America federal taxes were small.  As was federal spending.  The Constitution called for little.  The only big ticket items being an army and a navy.  To protect the new nation.  But Americans didn’t like paying taxes then any more than they do now.  There wasn’t even a federal income tax until the 16th Amendment (1913).  So even maintaining an army and a navy was difficult.  Which led to a lot of problems.  For a nation that couldn’t protect herself got pushed around in the rough and tumble world.  And the U.S. took its share of swirlies and wedgies in her infancy.  Figuratively, of course.

Just as kings needed money to maintain their kingdoms, the Americans needed money to maintain their new nation.  Which was the point of the Constitutional Convention in Philadelphia (1787).  It was about the money.  And unity.  Which the new nation (that just gained its independence from Britain) had little of.  So we got a new constitution.  And a new nation.  And the federal taxing and spending began.  Which was small at first.  Too small for Alexander Hamilton.  But far too much for Thomas Jefferson.  In fact, Jefferson thought any federal spending above zero was too much.  And when he was president he slashed government spending.  To the point that it hurt the safety of the United States.  But he also bought the Louisiana Territory.  And used the Navy and the Marine Corps to protect American interests abroad.  These two items alone required enormous amounts of federal spending.  And borrowing.  Another thing Jefferson was dead set against.  And we’re talking sums of money that not even Alexander Hamilton had proposed.  Yet here was Jefferson, the limited-government president, spending and borrowing unlimited funds. Being more Hamilton than Hamilton himself.

Of course, things change.  Even for Jefferson.  The Louisiana Purchase was a deal that no president should have passed up.  Thankfully, Jefferson took that opportunity to more than double the size of the United States.  Without a war.  Unlike Napoleon who was conquering Europe.   But he was burning through money.  And he needed money more than he needed the Louisiana Territory.  Hence the Louisiana Purchase.  Which turned out to be quite the bargain in the long run for the U.S.  And the antimilitary Jefferson flexed America’s might by teaching the Barbary pirates a lesson.  By deploying the U.S. Navy and Marines to the Shores of Tripoli.  The first U.S. victory on foreign soil.  Giving the U.S. respect.  And a cessation of those swirlies and wedgies.

Keynesian Stimulus Spending may lessen the Severity of Economic Recessions

These things cost money.  And the lion’s share of the federal budget was defense spending.  Per the Constitution.  For that was one of the main things the several states could not do well.  Maintain an army and a navy.  Because they needed unity.  One army.  And one navy.  To protect one nation.  So the states and their people could pursue happiness without foreign aggressors molesting them.  So this is how federal spending began.  But you wouldn’t know it by looking at fiscal policy today.

Fiscal policy is the collection of policies that government uses to tax and spend.  But it’s more than just defense spending these days.  Federal spending had grown to include things from business subsidies to Social Security to Medicare to food stamps to welfare to income redistribution to farm subsidies.  And everything else you can possibly imagine under the sun.  None of which was included in the Constitution.  Because neither Jefferson nor Hamilton would have agreed to these expenditures.  But it doesn’t end with this spending.

Fiscal policy also ‘manages’ the economy.  Or tries to.  By trying to maintain ‘full employment’.  Which means they adjust tax and spend policies so that anyone who wants a full time job can have one.  Based on Keynesian economics.  And the business cycle.  The business cycle is the cyclic economic transitions between economic expansions and contractions.  The inflationary and recessionary boom-bust cycles.  No one likes recessions.  Because people lose their jobs.  And have to get by on less money.  So Keynesian economists say to lessen the severity of recessions the government can take action to stimulate economic activity.  They can cut taxes.  Because when people pay less in taxes they have more disposable income to spend on economic activity.  Which they say will keep people from losing their jobs.  And create new jobs.  Or the government can spend money.  Picking up the slack from consumers who aren’t spending money.  Thus saving and/or creating jobs.  Which stimulus depends on the political party in office.  In general, Republicans favor tax cuts.  And Democrats favor spending.

All Keynesian Stimulus Spending is Deficit Spending

But it’s not as simple as that.  Because during recessions tax revenues fall.  When people earn less they pay less in taxes.  Far less.  Especially if an interruption in their income puts them into a lower tax bracket.  And if you run through all of your unemployment benefits, it will.  So there’s more to economic stimulus than meets the eye.  For to stimulate a government must borrow money.  Or print money.  Because all stimulus spending is deficit spending.

Keynesians say this deficit spending is not a problem.  Because once the stimulus turns the economy around there will be plenty of new tax revenues to pay back the money they borrowed.  But that rarely happens with a tax and spend government.  Because they like to spend.  As is evident by the ever increasing federal debt.  And when they get more tax revenue they spend that tax revenue.  On anything and everything you can possibly imagine under the sun.  Often times cutting defense spending to help pay for all that other spending.  Despite defense spending being one of the few things enumerated in the Constitution.

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Low Interest Rates in Canada are creating a Housing Bubble Similar to the one that led to the Great Recession

Posted by PITHOCRATES - February 5th, 2012

Week in Review

Easy credit created a housing bubble in the U.S.  And inflation.  When the Fed increased interest rates to stop that inflation they burst that housing bubble.  And caused the U.S. Subprime Mortgage Crisis.  Which caused the Great Recession. 

Easy credit.  The hallmark of Keynesian economics.  To maintain a small but ‘manageable’ permanent level of inflation.  To make recessions a thing of the past.  But this permanent inflation has only created bubbles.  Like housing bubbles.  Such as the one that led to the Great Recession.  Making it longer and far more painful than it would have been had they left interest rates to market forces.

Credit wasn’t as easy in Canada.  So they escaped much of the fallout from the Great Recession.  But they still practiced Keynesian economics.  Kept interest rates low these past few years to stimulate their economy.  And stimulated they did.  Perhaps a little too much (see Look out below posted 2/4/2012 on The Economist).

When the United States saw a vast housing bubble inflate and burst during the 2000s, many Canadians felt smug about the purported prudence of their financial and property markets. During the crash, Canadian house prices fell by just 8%, compared with more than 30% in America. They hit new record highs by 2010. “Canada was not a part of the problem,” Stephen Harper, the prime minister, boasted in 2010.

Today the consensus is growing on Bay Street, Toronto’s answer to Wall Street, that Mr Harper may have to eat his words. In response to America’s slow economic recovery and uncertainty in Europe, the Bank of Canada has kept interest rates at record lows. Five-year fixed-rate mortgages now charge interest of just 2.99%. In response, Canadians have sought ever-bigger loans for ever-costlier homes. The country’s house prices have doubled since 2002…

Bankers are becoming alarmed. Mark Carney, the governor of the central bank, has been warning for years that Canadians are consuming beyond their means. The bosses of banks with big mortgage businesses, including CIBC, Royal Bank of Canada and the Bank of Montreal, have all said the housing market is at or near its peak. Canada’s ratio of household debt to disposable income has risen by 40% in the past decade, recently surpassing America’s (see chart). And its ratio of house prices to income is now 30% above its historical average—less than, say, Ireland’s excesses (which reached 70%), but high enough to expect a drop. A recent report from Bank of America said Canada was “showing many of the signs of a classic bubble”…

However, the state has refused to use its most powerful tool. To protect business investment, the central bank has made clear that it plans to keep interest rates low. As long as money stays cheap, the balloon could get bigger—perhaps big enough to become a fully fledged bubble after all.

So, to further stimulate the economy (i.e., to protect business investment) they are keeping interest rates low.  When all the signs indicate that this economic growth is growing a rather large real estate bubble.  Normally a good time to start raising interest rates.  So housing prices don’t get so high that when they fall they hurt.  Like they did in the U.S.  Where they fell over 30%.  And are still falling in some areas.  And when they fall from that height it hurts.  It really hurts.  Just ask someone whose mortgage is underwater.  Where their mortgage is greater than the current price of their house.  You can ask just about any homeowner in the U.S.  Or, perhaps, any homeowner in Canada in the not so distant future.

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Monetary Policy

Posted by PITHOCRATES - January 30th, 2012

Economics 101

Monetary Policy created the Housing Bubble and the Subprime Mortgage Crisis

Those suffering in the fallout of the Subprime Mortgage Crisis can thank monetary policy.  That tool used by the federal government that kept interest rates so low for so long.  Following the old Milton Friedman idea of a permanent level of inflation (but small and manageable) to stimulate constant economic growth.  Why?  Because when people are buying houses the economy is booming.  Because it takes a lot of economic activity to build them.  And even more to furnish them.  Which means jobs.  Lots and lots of jobs.

But there is a danger in making money too cheap to borrow.  A lot of people will borrow that cheap money.  Creating an artificial demand for ever more housing.  And not for your parent’s house.  But bigger and bigger houses.  The McMansions.  Houses 2-3 times the size of your parent’s house.  This demand ran up the price of these houses.  Which didn’t deter buyers.  Because mortgage rates were so low.  People who weren’t even considering buying a new house, let alone a McMansion, jumped in, too.  When the jumping was good.  To take advantage of those low mortgage rates.  There was so much house buying that builders got into it, too.  House flippers.  Who took advantage of those cheap ‘no questions asked’ (no documentation) mortgages (i.e., subprime) and bought houses.  Fixed them up.  And put them back on the market.

Good times indeed.  But they couldn’t last.  Because those houses weren’t the only thing getting expensive.  Price inflation was creeping into the other things we bought.  And all those houses at such inflated prices were creating a dangerous housing bubble.  So the Federal Reserve, America’s central bank, tapped the brakes.  To cool the economy down.  To reduce the growing inflation.  By raising interest rates.  Making mortgages not cheap anymore.  So people stopped buying houses.  Leaving a glut of unsold houses on the market.  Bursting that housing bubble.  And it got worse.  The higher interest rate increased the monthly payment on adjustable rate mortgages.  A large amount of all those subprime mortgages.  Causing many people to default on these mortgages.  Which caused the Subprime Mortgage Crisis.  And the Great Recession.

The Federal Reserve System conducts Monetary Policy by Changing both the Money Supply and Interest Rates

Money is a commodity.  And subject to the laws of supply and demand.  When money is in high demand (during times of inflation) the ‘price’ of money goes up.  When money is in low demand (during times of recession) the ‘price’ of money goes down.  The ‘price’ of money is interest.  The cost of borrowing money.  The higher the demand for loans the higher the interest rate.  The less the demand for loans the lower the interest rate.

So there is a relationship between money and interest rates.  Adjusting one can affect the other.  If the money supply is increased the interest rates will decrease.  Because there is more money to loan to the same amount of borrowers.  When the money supply is decreased interest rates will increase.  Because there will be less money to loan to the same amount of borrowers.  And it works the other way.  If the interest rates are lowered people respond by borrowing more money.  Increasing the amount of money in the economy buying things.  If interest rates are raised people respond by borrowing less money.   Reducing the amount of money in the economy buying things.  We call these changes in the money supply and interest rates monetary policy.  Made by the monetary authority.  In most cases the central bank of a nation.  In the United States that central bank is the Federal Reserve System (the Fed).

The Fed changes the amount of money in the economy and the interest rates to minimize the length of recessions, combat inflation and to reduce unemployment.  At least in theory.  And they have a variety of tools at their disposal.  They can change the amount of money in the economy through open market operations.  Basically buying (increasing the money supply) or selling (decreasing the money supply) treasury bills, government bonds, company bonds, foreign currencies, etc., on the open market.  They can also buy and sell these financial instruments to change interest rates.  Such as the Federal funds rate.  The interest rate banks pay when borrowing from each other.  Moving money between their accounts at the central bank.  Or the Fed can change the discount rate.  The rate banks pay to borrow from the central bank itself.  Often called the lender of last resort.  Or they can change the reserve requirement in fractional reserve banking.  Lowering it allows banks to loan more of their deposits.  Raising it requires banks to hold more of their deposits in reserve.  Not used much these days.  Open market operations being the monetary tool of choice.

There is more to Economic Activity than Monetary Policy

Fractional reserve banking multiplies these transactions.  Where banks create money out of thin air.  When the Fed increases the money supply a little this creates a lot of lendable funds.  As buyers borrow money from some banks and pay sellers.  Then sellers deposit that money in other banks.  And these banks hold a little of these deposits in reserve.  And loan the rest.  Borrowers create depositors as buyers meet sellers.  And complete economic transactions.  When the Fed reduces the money supply a little this process works in reverse.  Fractional reserve banking pulls a lot of money out of the economy.  Some treat these economic transactions, and the way to increase or decrease them, as simple math.  Always obeying their mathematical formulas.  We call these people Keynesian economists.  Named for the economist John Maynard Keynes.

Big interventionist governments embrace monetary policy.  Because they think they can easily manipulate the economy as they wish.  So they can tax and spend (Keynesian fiscal policy).  And when economic activity declines they can simply use monetary policy to restore it.  But there is one problem.  It doesn’t work.  If it did there would not have been a Subprime Mortgage Crisis.  Or any of the recessions we’ve had since the advent of central banking.  Including the Great Depression.  As well as the Great Recession.

There is more to economic activity than monetary policy.  Such as punishing fiscal policy (high taxes and stifling regulations).  Technological innovation.  Contracts.  Property rights.  Etc.  Any one of these can influence risk takers.  Business owners.  Entrepreneurs.  The job creators.  The people who create economic activity.  And no amount of monetary policy will change this.

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