In his Outside the Box e-letter, February 13, 2012,
respected economic commentator John Mauldin presents an interview with Dr. Lacy
Hunt, a highly regarded US financial economist. According to Hunt the key
factor behind the current world economic crisis — in Europe and the United
States in particular — is a very high level of debt relative to gross domestic
product (GDP). For instance in the United States, as a percentage of GDP, both
public- and private-sector debt is currently at around 400 percent, while in
the eurozone it is 450 percent.
This way of thinking follows in the footsteps of the famous American economist Irving Fisher who held that a very high level of debt relative to GDP runs the risk of setting in motion deflation and in turn a severe economic slump.[1] According to Fisher the high level of debt sets in motion the following sequence of events that culminate in a severe economic slump:
1. The debt liquidation process is set in motion because of some random shock, for instance, a sudden large fall in the stock market. The act of debt liquidation forces individuals into distressed selling of assets.
2. As a result of the debt liquidation the money stock starts shrinking, and this in turn slows down the velocity of money.
3. A fall in money leads to a decline in the price level.
4. The value of people's assets falls while the value of their liabilities remains intact. This results in a fall in the net worth, which precipitates bankruptcies.
5. Profits start to decline, and losses emerge.
6. Production, trade, and employment are curtailed.
7. All this leads to growing pessimism and a loss of confidence.
8. This in turn leads to the hoarding of money and a further slowing in the velocity of money.
9. Nominal interest rates fall, however; but because of a fall in prices, real interest rates rise.
Note that the
critical stage in this story is the stage 2, that is, debt liquidation results in
a decline in the money stock. But why should debt liquidation cause a decline
in the money stock?
Take a producer
of consumer goods who consumes part of his produce and saves the rest. In the
market economy our producer can exchange the saved goods for money. The money
that he receives can be seen as a receipt as it were for the goods he produced
and saved. The money is his claim on these goods.
He can then make
a decision to lend his money to another producer through the mediation of a
bank. By lending his money, the original saver — i.e., lender — transfers his
claims on real savings to the borrower. The borrower can now exercise the money
— i.e., the claims — and secure consumer goods that will support him while he
is engaged in the production of other goods, let us say the production of tools
and machinery.
Observe that
once a lender lends his money he relinquishes his claims on real goods for the
duration of the loan. Can the liquidation of credit, which is fully backed by
savings, cause a decline in the money stock? Once the contract expires on the
date of maturity the borrower returns the money to the original lender. As one
can see, the repayment of the debt, or debt liquidation, doesn't have any
effect on the stock of money.
Things are,
however, different when a bank uses some of the deposited money and lends it
out. Remember that the owner of deposited money continues to exercise demand
for money — he didn't relinquish his claims on real savings in favor of a
borrower. Therefore, when a bank uses some of the deposited money, the bank
effectively creates another claim on real savings. This claim is just empty
stuff. While in the case of fully backed credit the borrower, so to speak,
secures goods that were produced and saved for him.
This is however,
not so with respect to unbacked credit. No goods were produced and saved here.
Consequently, once the borrower exercises the unbacked claims, this must be at
the expense of the holders of fully backed claims. The bank here creates money
"out of thin air." On the date of maturity of the loan, once the
money is repaid to the bank, this type of money must disappear, because it
never existed as such and never had a proper owner.
The Money Supply and the Pool of Funding
The point that
must be emphasized here is that the fall in the money stock that precedes price
deflation and an economic slump is actually triggered by the previous loose
monetary policies of the central bank and not the liquidation of debt. It is
loose monetary policy that provides support for the creation of unbacked
credit. (Without this support, banks would have difficulty practicing
fractional-reserve lending.) The unbacked credit in turn leads to the
reshuffling of real funding from wealth generators to non–wealth generators.
This in turn weakens the ability to grow the pool of real funding and in turn
weakens the economic growth. Note that the heart of the economic growth is the
pool of real funding, or the pool of real savings, or the "subsistence fund."
According to
Böhm-Bawerk,
"The entire wealth of the economical community serves as a subsistence fund, or advances fund, from this, society draws its subsistence during the period of production customary in the community.[2]"
Similarly von
Strigl wrote,
"Let us assume that in some country production must be completely rebuilt. The only factors of production available to the population besides labourers are those factors of production provided by nature. Now, if production is to be carried out by a roundabout method, let us assume of one year's duration, then it is self-evident that production can only begin if, in addition to these originary factors of production, a subsistence fund is available to the population which will secure their nourishment and any other needs for a period of one year.… The greater this fund, the longer is the roundabout factor of production that can be undertaken, and the greater the output will be. It is clear that under these conditions the "correct" length of the roundabout method of production is determined by the size of the subsistence fund or the period of time for which this fund suffices.[3]"
Because of
prolonged and aggressive loose monetary and fiscal policies, a situation can
emerge in which the pool of real funding starts shrinking. In short, there are
now more activities that consume real wealth than activities that produce real
wealth. Once the pool of funding starts falling then anything can trigger the
so-called economic collapse.
Obviously, when
things are starting to fall apart, banks try to get their money back. Once
banks get their money (credit that was created out of thin air) and don't renew
loans, the stock of money must fall. Note however that the consequent price
deflation and the fall in the economy is not caused by the liquidation of debt
as such, nor by the fall of the money supply, but by the fall in the pool of
real funding on account of previous loose monetary and fiscal policies.
The Size of the Debt and the Severity of the Economic Slump
In his writings,
Fisher argued that the size of the debt determines the severity of an economic
slump. He observed that the deflation following the stock market crash of
October 1929 had a greater effect on real spending than the deflation of 1921
had because nominal debt was much greater in 1929.
We, however,
maintain that it is not the size of the debt as such that determines the
severity of a recession but rather the state of the pool of real funding.
Again, it is not the debt but loose monetary and fiscal policies that cause the
misallocation of real funding. (The level of debt is just a symptom, as it
were; it doesn't cause damage as such.)
By putting the
blame on debt as the cause of economic recessions, one in fact absolves the Fed
and the banking system it maintains from any responsibility for setting the
whole thing in motion. Additionally, once it is accepted that debt can set in
motion a monetary implosion and in turn an economic depression, it appears to
justify the idea that the Fed must step in and lift monetary pumping in order
to offset the disappearing money supply.
However, rather
than countering the emerging depression, what monetary pumping in fact does
here is to further weaken the pool of real funding and thereby deepen the
economic crisis. (Note that many commentators are of the view that, because of
price deflation, the debt burden intensifies. Consequently, it is held that, by
means of monetary printing, this burden can be eased, thereby arresting the
economic plunge. Again we suggest that pumping more money only dilutes the pool
of real funding and makes things much worse.) Additionally, the emergence of
monetary deflation is a positive development for wealth generators, because it
slows down the diversion of real funding toward nonproductive activities.
The Fallacy of Insufficient Aggregate Demand
Now, both Keynes
and Friedman felt that the Great Depression was due to an insufficiency of
aggregate demand, and so the way to fix the problem was to boost the aggregate
demand. For Keynes, this was to be done by having the federal government borrow
more money and spend it when the private sector wouldn't. Friedman
advocated that the Federal Reserve pump more money to revive the demand.
Fisher, while agreeing that the problem was with insufficient demand, held that
insufficiency of aggregate demand was a symptom of excessive indebtedness. Therefore,
what was needed to contain a major debt depression was to prevent it ahead of
time. You have to prevent the buildup of debt.
Again we suggest
that Fisher deals here with symptoms and not the true cause, which is the
declining pool of real funding that results from loose fiscal and monetary
policies. Additionally, there is never such a thing as insufficient aggregate
demand, as such.
We suggest that
an individual's effective demand is constrained by his ability to produce
goods. Demand cannot stand by itself and be independent — it is limited by
production. Hence what drives the economy is not demand as such but the
production of goods and services. The more goods an individual produces, the
more of other goods he can secure for himself.
In short, an
individual's effective demand is constrained by his production of goods.
Demand, therefore, cannot stand by itself and be an independent driving force.
According to
James Mill,
"When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation's power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation.… Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.[4]"
If a population
of five individuals produces ten potatoes and five tomatoes — this is all that
they can demand and consume. No government or central-bank tricks can make it
possible to increase effective demand. The only way to raise the ability to
consume more is to raise the ability to produce more.
The dependence
of demand on the production of goods cannot be removed by means of
loose-interest-rate policy, monetary pumping, or government spending.
On the contrary,
loose fiscal and monetary policies will only impoverish real wealth generators
and weaken their ability to produce goods and services. It will weaken
effective demand.
What is required
to revive the economy is not boosting aggregate demand but sealing off all the
loopholes for the creation of money out of thin air and curbing government
spending. This will enable true wealth generators to revive the economy by
allowing them to move ahead with the business of wealth generation.
Conclusions
Contrary to the
popular way of thinking, the threat to the US economy is not the high level of
debt as such but loose fiscal and monetary policies that undermine the pool of
real funding. Also, the fall in the money stock that precedes price deflation
and an economic slump is actually triggered by the previous loose monetary and
fiscal policies and not the liquidation of debt as such. Also, once the pool of
funding becomes stagnant or begins to shrink, economic growth follows suit and
the myth that government and central-bank policies can grow the economy is
shattered.
According to
Mises,
An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.[5]
[2] Eugen
von Böhm-Bawerk, The Positive Theory of Capital, book 6, chapter 5, Macmillan and Co., 1891.
[4] James
Mill, "On the Overproduction and Underconsumption Fallacies." Edited
by George Reisman, a publication of the Jefferson School of Philosophy,
Economics, and Psychology, 2000.
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