Every financial crisis seems to produce its own crop of economic fallacies. The Great Depression gave us the mercantilist fallacy of "demand deficiency" that Keynes dressed up in mathematical garb and convoluted language. Instead of the boom's inevitable bust being treated as a case of "disproportionalities" that needed to be liquidated if the equilibrium was to be restored it was now defined as a simple case of insufficient demand could be easily corrected by increased government spending, i.e., a monetary expansion. (Incidentally, Keynes never argued that this policy would have restored full employment in the 1930s, quite the opposite. Those who argue to the contrary should read T. W. Hutchison's Keynes v. the 'Keynesians'...?, The Institute for Economic Affairs, 1977.)

Astute economists at the time pointed out the inflationary consequences of the Keynesian solution. The great error that the vast majority of economists make with inflation is to simply treat it as a case of rising prices. Although some of them may make passing comments on the distorting affects of inflation, this is always done with respect to financial decision-making and never to real factors. This is why their references to distortions are framed in terms of financial imbalances.

Failure to understand how monetary expansion distorts a country's capital structure and pattern of foreign trade in such away as to result in plant closures and severe trade imbalances is bound to give birth to demands for greater government intervention on the grounds that the market has failed. Nevertheless, every proposed act of government meddling requires a theoretical justification if only to keep opponents at bay.

It is being put to Democrats that the emergence of China has resulted in a massive increase in the world's labour force that is now threatening US prosperity. Although this labour has always been present it never posed a serious threat because it lacked the necessary capital, technology and access to world markets. When Beijing opened up the Chinese economy it terminated this self-imposed economic embargo, allowing the free flow of capital and technology into the country. The result is that the flow of Western capital is now pushing down Western wage rates. This process is bound to continue until wages have been equalised.

This is really terrible stuff and is just another version of the long-discredited cheap labour fallacy. Those who push this line do not realise that it could only hold in a world in which labour was the sole cost of production irrespective of the supply of capital goods. Moreover, they overlook the fact that wage rates are not absolute. Therefore what matters is the wage rate relative to the marginal value of the worker's production. This is why in the 1920s European unions argued for tariffs against US goods on the grounds that American labour was more productive and hence more competitive because it had a greater quantity of capital goods to work with and that's why it was better paid.

If so-called cheap labour is threatening Western wages why export capital goods to Asia? Why not simply invest in hiring cheap labour and export its products? The contradiction should be obvious. Capital (meaning producer goods) and labour are complementary. Capital is used to raise the productivity of labour. In other words, capital lowers the price of labour relative to the value of its output. When looked at from this angle we see that though American wages are higher than Asian wages labour costs per unit are lower. At least this is how it would be in an unhampered market.

As an economy becomes more capital intensive its wage rates rise. This means that labour intensive activities in tradable goods can no longer compete against countries whose economies are labour intensive. But note: these activities contract or shut down because of the success of capital accumulation in raising real wages and not because they have been undercut by cheap foreign labour. These shifts in the pattern of international trade are usually explained by economists in terms of comparative advantage. But -- and it's and important 'but' -- comparative advantage was developed by the classical economists within the framework of a gold standard. As Joseph Schumpeter pointed out:

In the first place, the 'classical' writers, without neglecting other cases, reasoned primarily in terms of an unfettered international gold standard. There were several reasons for this but one of them merits our attention in particular. An unfettered international gold standard will keep (normally) foreign exchange rates within specie points [emphasis added] and impose and 'automatic' link between national price levels and interest rates. (Joseph Schumpeter, The History of Economic Analysis, Oxford University Press, 1994, p. 732).

Schumpeter's reference to "specie points" is extremely important because what is being said is that the classical economists assumed a sound monetary policy, which is what the gold standard supplied. Now every economist worth his salt knows that all goods have export and import points (which we shall call commodity points), the difference between them being largely determined by transport costs. An overvalued currency would have the effect of destroying the cost difference and by doing so wipe out that country's comparative advantage. (Ricardo pointed out that a tax can have the same effect).

That it is commodity points and not the price of labour that makes exports sensitive to price changes is confirmed by Asian central banks -- particularly the People's Bank of China -- buying up US dollars in an attempt to prevent a depreciation that would hammer their export industries, regardless of the fact that their labour is 'cheap'. If it were a simple question of 'cheap' labour then why worry about a sinking dollar? (By buying dollars these countries are inflating their own money stocks. So we have a situation where the US is in effect exporting inflation).

What all of this means is that if a sound money policy is abandoned in favour of permanently increasing monetary stocks (an inflationary policy) -- which is what we have now -- then we can expect the emergence of overvalued currencies with the result that the pattern of international trade will be badly distorted. A country that runs an overvalued currency for a lengthy period will find its production structure becoming more domestic oriented: its export industries will decline and imports will rise.

In such an economy one should expect to witness the emergence of a "rustbelt" accompanied by an excessive expansion of the financial and service sectors along with delirious claims that the economy has now entered a "post-industrial" phase. The irony is that this process was accurately described 77 years ago. (Friedrich von Hayek, Money, Capital and Fluctuations: Early Essays, Routledge & Kegan Paul, 1984, pp. 150-2.) More than 80 years ago Bresciano-Turroni noted how a rapid and sustained monetary expansion could expand the financial sector:

The increase in banking business was not the consequence of a more intense economic activity. The work was increased because the banks were overloaded with orders for buying and selling shares and foreign exchange, proceeding from the public which, in increasing numbers, took part in speculations on the Bourse. The banks did not help in the production of new wealth; but the same claims to wealth continually passed from hand to hand. (Bresciano-Turroni, The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany, John Dickens & Co LTD, 1968, p. 404).

Money is not merely a veil that hides the reality that ultimately goods exchange against other goods but that money itself is an extremely potent force that influences real factors. Failure to understand this fact is creating financial chaos and giving rise to dangerous fallacies.