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August 12, 2007

Blame Central Banks for Sinking Share Markets
by Gerard Jackson

For years I have been warning readers that monetary expansion would inevitably bring recession. This, I forewarned, would probably occur when central banks decided to apply the monetary brakes. This now appears to be the case: hence falling share markets. The problem, as I have explained numerous times, is the grim fact that central bankers in particular and the economics profession in general has no genuine understanding of the nature of interest. In addition, they believe that money is neutral and that a stable price level is necessary to avoid recessions. What we have here is a very dangerous cocktail of ignorance and economic fallacies that has brought the world to the brink of recession.

For continually stressing the fact Austrian economics predicts that the world's monetary binge was going to result in a very painful hangover I have been labelled a "right-wing Austrian fanatic". (This is what passes for economic debate in Australia). Thirteen years ago the BIS (Bank of International Settlements) warned in one of its publications that credit expansion had played a significant role in the "asset-price bubbles" that marked Britain, Scandinavia and Japan in the late 1980s. (It's a little know fact that Austrian analysis does have some influence at the BIS). To top it off, last June the bank warned that the global economy might be on the verge of depression similar to that of the 1930s.

In plain language, the BIS is stating that the central banks' flooding of the global market with 'cheap' credit triggered a world-wide inflation. Any reasonable person would conclude from this opinion that if the current financial crisis is the product of inflationary monetary policies then more inflation can only worsen the situation.

So what was the response from the US Fed, the RBA (Reserve Bank of Australia), the ECB (European Central Bank) and a number of Asian central banks? More inflation, of course. Last Friday the Fed said that it was "providing liquidity to facilitate the orderly functioning of financial markets" and to stabilise the federal funds rate at 5.25 per cent. It did this by pumping an extra $US24 billion into the economy. No wonder there is talk of forcing the rate even lower. The RBA was just as by, injecting A$4.95 billion into the Australian market in an effort ward off the possibility of a decline in economic activity. ECB is no slouch either, jacking up its money supply with a massive e95 billion (A$150 billion) infection. And this is just the beginning.

What a bizarre monetary spectacle. With one hand central banks raise interest rates to curb credit expansion while using the other hand to inject liquidity (credit) into the economy to prevent a recession that they think is caused by rising interest rates. Talk about economic schizophrenia. This scene is a rerun of 1987. It was on Monday 19 October of that year when world share markets plummeted. Ever since the US market crash of 1929 central bankers and the majority of economists have clung to the erroneous belief that the market crash caused the Great Depression. It was mainly because of that belief -- bolstered by Keynesian nostrums -- that central banks let loose with the money supply in 1987. But this monetary tactic only delayed the inevitable recession that finally struck in 1990.

To understand how we got into this sorry state we need to look at what share markets do and how they do it. They are basically the means of directing savings into industry. If, for example, savers buy newly issued shares this would amount to a direct investment. If, however, they buy established shares this will have a tendency to raise their prices and so induce the firm to issue more shares. This does not mean that the receipts from the sale of every share are reinvested. Instead of reinvesting his proceeds the seller might decide to consume them, which means that net investment remains unaltered.

In buying shares investors are using the share market to buy titles to existing capital goods or to fund the production of capital goods. Once this is understood it becomes clear that the so-called distinction between finance and industry that one sometimes finds in the media and academia is a fallacy, one that conceals the fact that share markets accurately mirror business developments if not interfered with.

The effect of forcing the interest rate below the market rate (the rate that balances the supply of capital with the demand for capital) is to increase the quantity of loanable funds which in turn raises raise capital values. It should be obvious that for this process to turn into a lasting boom the banking system -- backed by the central bank -- must continue to expand credit. (It should be remembered that at one point the fed's funds rate stood at 1 per cent). In doing so it fuels profits which results in further rises in share prices as investors anticipate even higher earnings. The tendency for share prices to rise faster than other prices will quickly emerge. (In some cases the CPI might remain stable, as happened in the 1920s). If the credit expansion is allowed to continue unchecked a speculative frenzy invariably develops. It is usually at this point that the central bank decides to apply the monetary brakes.

(Benjamin M. Anderson wrote of a very experienced banker who "subscribed to the generalisation that the wilder the craze, the higher the type of intellect that succumbed to it". This particular man who "had a high IQ" borrowed $4000,000 to buy shares. He was still holding these over-valued shares when the market crashed. [Benjamin M. Anderson Economics and the Public Welfare, Liberty Press, 1979, p. 203. First published 1949]).

From the third quarter of 2001 to the fourth quarter of 2004 average annual growth rate for AMS* (Austrian money supply) was 7.5 per cent. Contrast this performance with a rate of growth of 1.44 per cent for the second quarter of 2007. The statistics reveal a clear correlation between changes in GDP and changes in AMS. (See Dr Shostak's Is the decline in housing to be blamed for US economic slowdown).

The preceding reasoning explodes the fallacious belief that the world has been facing a savings glut. Now the idea of excess savings goes back at least to Jeremy Bentham. Using Say's Law James Stuart Mill successfully explained to Bentham why the concept of surplus capital (which what excess savings amount to) was fallacious. Unfortunately, the idea was resurrected in 1829 by Edward Gibbon Wakefield who published his Letter from Sydney. (Actually it was from an English prison where he was being held for abducting a young heiress?) Part of Wakefield's thesis was that the colonies were needed to absorb England's surplus capital. The idea was picked up again by J. A. Hobson who passed it on to Lenin.

What appears to be excess savings is nothing but excess credit created by the fractional reserve banking system. Unable to see what had been discussed at length some 200 years ago led Bernanke to state that

Over the past decade, a combination of diverse forces has created a significant increase in the global supply of saving -- a global saving glut. (The Global Saving Glut and the U.S. Current Account Deficit, Homer Jones Lecture, St. Louis, Missouri, on April 14, 2005).

This statement reveals that Bernanke is clueless about the real nature of savings. It's because of economists like him that I continually refer to the wisdom of the older economists. These men would have rightly argued that to say a country can have too much savings is to argue that it is accumulating too much capital. John Stuart Mill neatly nailed this fallacy:

Nothing can be more chimerical than the fear that the accumulation of capital should produce poverty and not wealth, or that it will ever take place too fast for its own end. Nothing is more true than that it is produce which constitutes the market for produce, and that every increase of production, if distributed without miscalculation among all kinds of produce in the proportion which private interest would dictate, creates, or rather constitutes, its own demand [Say's Law]. (Essays on Economics and Society, University of Toronto Press 1967, p. 278).

Just as Mill's views on capital mirrored those of his contemporaries Bernanke's fallacious opinion on the so-called "global savings glut" reflect the fallacious views of the vast majority of economics profession, including the economic commentariat. For example, Alan Wood, economics editor of Murdoch's Australian, is just as bad. In his article With good news all around, the running of the bulls isn't over yet, 16 June 2007, he ridiculously claimed that there was an "excess of global savings". To Terry McCrann 'excess global savings' are just "multi-trillion dollar amount of cash...looking for a home". (Herald-Sun, Dollar is thin icing on cake, 27 June 2007). It seems to have never occurred to him to ask where all this "cash" is coming from.

In the US we had Lawrence Kudlow and William P. Kucewicz arguing that "[e]xcess money in the economy is the root cause of inflation". (Do No Harm: The Fed must recognize our current low-inflation, post-Katrina realities, National Review Online, 20 September 2005). What these commentators have failed to grasp is that any amount of money that has been created to stabilise prices is by definition inflationary. The problem here is the old one of defining inflation as rising prices. This leads to the dangerous fallacy that a general fall in prices must be deflationary. Kucewicz and Kudlow's views mirror those of the supply-side school.

The truth is that the world has been on a monetary roller-coaster since it abandoned the gold standard nearly 80 years ago. This roller-coaster brought the Bretton Woods agreement undone and more and more booms and busts. If left unchecked it could literally undo the international financial system. As Charles P. Kindleberger noted:

That there have been more foreign exchange crises than in any previous period of comparable length, beginning with the breakdown of the Bretton Woods system of adjustable parities for national currencies in the late 1960s and early 1970s. (Charles P. Kindleberger and Robert Aliber' Maniacs, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons Inc., 2005, p. 242).

It looks like we are heading that way again.

*Note: The Austrian definition of the US money supply is currency outside Treasury, Federal Reserve Banks and the vaults of depository institutions.

Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.

NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations.

NOW balances at thrifts, credit union share draft balances, and demand deposits at thrifts. AMS definition therefore equals cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2008 Gerard Jackson

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