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April 12, 2009

Can Bernanke's Loose Monetary Policy Save the US Economy?
by Gerard Jackson

As expected a great deal of attention is still being paid to the financial sector and its "toxic assets". And then we have the Dow that now seems -- at least to a great many market players -- to be signalling a recovery despite the fact that unemployment is still rising and looks like reaching the 10 per cent level. Reinforcing the Pollyanna's view of the economy is the emergence of a positive yield curve. In addition, figures from the Institute of Supply Management show that its Performance Manufacturing Index for March was up by 0.5 per cent while new orders were up by 8.1 per cent, production by 0.1 per cent and prices by 2 per cent and employment by 2 per cent.

What is missing from virtually all of the economic commentary is any recognition of the role of money in this economic drama. It is tacitly assumed that because consumption is about 70 per cent of GDP that monetary expansion will work its magic by first encouraging consumption which in turn will increase investment. Therefore it follows that consumption leads investment. It is important to grasp this thinking because it appears that Bernanke and Larry Summers subscribe to it, which would help explain their support for a reckless monetary policy.

In a nutshell, monetary expansion will trigger the "accelerator". In its simplest form the accelerator means that when demand rises for consumer goods producers will order more capital goods to satisfy it. For example, if a manufacturer employs 100 machines 10 of which have to be replaced every year then a 10 per cent increase in demand calls for an additional 10 machines. Thanks to this 10 per cent increase in demand the manufacturer now doubles his demand for machinery.

Unfortunately the accelerator is just another dangerous economic fallacy, one that is frequently wedded to the equally dangerous Keynesian multiplier. It would require a lengthy response to refute this fallacy. We are fortunate in that the late Professor William H. Hutt did just that (William H. Hutt, The Keynesian Episode, LibertyPress, 1979, chap. 17). It is sufficient at this point to stress that those who argue in favour of the accelerator ignore the role of relative prices.

Every first year student of economics learns -- or should -- two things: Firstly, when the demand for a product increases the first thing the producers do is try and expand output. There is only one way in which this can be done when full capacity has been reached and that is by expanding capacity. This requires more labour and machinery. To do this they must bid these factors away from other producers. Secondly, by bidding for these factors their prices are raised. This brings us to one of the fatal flaws in the accelerator principle.

There always exists a structure of relative prices. By concentrating spending on the consumer stages of production in the belief that this will stimulate investment more and more factors will be attracted away from the higher stages of production because relative prices have now been skewed in favour of consumption. Rather than lengthen the production structure this policy would shorten it and reduce the rate at which living standards would have grown.

Put another away, a policy directed toward consumption crowds out investment in the higher and more productive stages of production. When this happens one gets the phenomenon of a boom in consumption and the demand for labour along with the emergence of a shrinking manufacturing sector. (I should point out at this stage that the process is somewhat more complicated than this). This situation is unsustainable, rising prices, a rapidly increasing current account deficit and downward pressure on the dollar would force the Fed to act by raising interest rates until the boom had been effectively strangled. This is what happened in the UK in the 1950s, 1960s, 1970s, and again in the 1990s. (This should put to rest the canard that Austrian economic analysis does not deal with consumer booms).

So where does this leave monetary policy? In an earlier article I said that industrial production and the stock market do not appears to be responding as quickly as they did in the past to monetary expansion. I may have erred on this one. M1 was relatively flat throughout 2008. (From June to January 2009 it rose by 1.6 per cent). However, from last January to March it jumped by nearly 11 per cent, an annual average increase of 44 per cent, while the increase in the monetary base has been massive.

Manufacturing is usually responds 6-9 months after changes in the money supply and share prices within 3 months. Well it could be argued that manufacturing is now beginning to react to the growth in M1 that started to accelerate last June and that the March jump in the Dow was fuelled by the acceleration in M1 that took place in January. My point here, however, is to stress the power of money. And money is a vastly more potent and destructive force than many economists realise.

Assuming that the economy is following the usual path of recovery this cannot last. Not just because a great number of financial imbalances have not been liquidated but because it is entirely monetary driven. The Kennedy, Reagan and Bush tax cuts added real savings to the monetary mix which deepened recovery. Now this can only end with accelerating inflation, current account problems and a depreciating dollar. (Assuming, of course, that the rest of the world chooses not to follow Bernanke's inflationary policy). To make it worse, Obama's policy proposals from energy, green jobs, taxation and regulatory policies would present the economy with insurmountable barriers.

Obama is basically arguing that tax cuts are neither necessary nor fair. This flies in the face of history and sound economic principles. Unfortunately for Americans Obama is shockingly ignorant of both subjects. Regrettably America's so-called mainstream media are so corrupt that they will not allow the consequences of his primitive economics to be widely discussed. I fear Americans will have to wait until the inescapable outcome of his anti-market prejudices make it impossible to ignore the damage being done to the US economy.

Therefore the answer to the title of this article is a resounding no.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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