At one time or another we have all heard it said that "you cannot get there from here". Much the same can be said of the current state of the US economy. Every prominent economic pundit is focusing on falling demand as the economy's nemesis. Nouriel Roubini points out that "85 percent of aggregate demand -- consumption and fixed investment -- is now in free fall". It's even worse than that because final demand as it is calculated does not include inter-business spending (spending between the stages of production). If this were taken into account the picture would change from grim to downright scary. That Treasury bills have been trading at negative rates is evidence enough of the markets fearful state.
In response to the crisis the fed forced the fed funds rate down from 1 per cent to between 0 per cent to 0.25 per cent. The real funds rate is now negative. (If the rate is 0 per cent and the inflation rate is 5 per cent then the real rate of interest is a negative 5 per cent). Some commentators feel that the present negative rate is not high enough and argue that it took a much higher rate to get the Reagan boom moving. But they overlook the obvious fact that a higher negative rate requires a higher inflation rate. It is clear that this view is based on the egregious error that money is neutral and that the successful manipulation of interest rates is one of the keys to maintaining a successful rate of capital accumulation. This is a very dangerous line of thinking and one that the fed adheres to.
To expand demand (a euphemism for an inflationary policy) the fed is engaging in what economists call "quantitative easing". In plain English, the fed is adding to its balance sheet by purchasing assets from the banks. When the fed does this it adds to the banking system's reserves and forces down the rate of interest. One can get a good idea of how much money the fed has injected into the banking system from the fact that since September the fed has accumulated more than $2 trillion in assets. This was supposed to stimulate business borrowing and hence investment. Well, it ain't working, which I think has Bernanke in something of a panic. However, as the eminent British economist D. H. Robertson observed 82 years ago:
While there is always some rate of money interest which will check an eager borrower, there may be no rate of money interest in excess of zero which will stimulate an unwilling one. (Banking and the Price Level, Augustus M. Kelley, 1989, p. 81. First edition 1926).
During the Great Depression three American economists noted:
The market rate of interest conceivably may stand at zero, but if the average return to capital is represented by positive losses and all that will result from borrowing is more losses, loanable funds will not be employed to finance new productive activity. (C. A. Phillips, T. F. McManus, R. W. Nelson, Banking and the Business Cycle: A Study of the Great Depression in the United States, The Macmillan Company, 1937 p. 233).
By now the importance of expectations should have been fully grasped by the economic pundits. Instead we get such stuff as "the velocity of money is collapsing as the recession deepens". There is no velocity of money and money does not circulate. Money always changes hands and it is always -- if only momentarily -- part of some one's cash balance. What is being misinterpreted as "falling velocity" is a perfectly rational decision by consumers to reduce their demand for credit while simultaneously raising their demand for cash balance. This behaviour is precisely what we should expect from the public once an economy slides into recession.
Despite the fact that the fed has been expanding the money supply at a frightening pace mainstream economists are still largely unfazed. Shiller argued in The New York Times that "inflation is no longer the fundamental risk" and that all Obama needs to do is to make "full employment a primary target" and "Americans' confidence in the economy would be swiftly restored". (To Build Confidence, Aim for Full Employment 14 December 2008).
But this is exactly what they are aiming at, which is why Bernanke is trying to raise the inflation rate. He adheres to the discredited Phillips curve concept, according to which there is an inverse relationship between the rate of inflation and the level of unemployment. Therefore a little more inflation will lower the unemployment rate. But unanticipated inflation -- which is what the Phillips curve is based on -- is just a devious way of pricing people into work by using inflation to cut real wage rates. This is something Keynes admitted when he stated:
Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods [consumption goods] (The General Theory, Macmillan-St. Martin's Press, 1973, p. 9).
Austrians tried to alert their fellow economists to the fact that this policy would lead to a continuous rise in prices while still fuelling the boom-bust cycle. Moreover, a situation would arise where we would find inflation and heavy unemployment coexisting. (Very few people know that from the middle of 1933 prices began to rise and continued to do so in spite of the heavy unemployment). Nevertheless, Keynesians still argue for more and more monetary expansion to keep the economy afloat, even as the economy continues to sink. What these economists have not grasped is that the recession is the adjustment process. By trying to reverse it they are in fact making things worse.
Time and time again I have stressed that fractional reserve banking is the root cause of the boom-bust cycle. I have also stressed that the market always gets the blame. It's no different today. David Nason, The Australian's New York correspondent, was echoing the prejudiced view of those who know nothing of market processes when he wrote that "the unfolding financial crisis continues to illuminate the idiocies of deregulated, anything-goes capitalism" which is the result of "30 years of free market foolishness". (US needs to stand up to hedge funds, 27 October 2008).
Like the rest of his fellow free market critics Nason is not only ignorant of economic principles he is also equally ignorant of economic history and the history of economic thought. Unfortunately, it is ignoramuses like Nason who get to shape public opinion and prejudice it against free markets.