How Business Happens: 27 January 2002

Folks,

Here is another review of the economy...and his points run from terrifying to
interesting. Towards the bottom he asserts the kinds of products we are
involved in are likely to be the most profitable, given the economy.

Recovery or Illusion?

by Frank Shostak

[Posted January 31, 2002]

[Presented at Boom, Bust, and the Future: A Private Retreat with

Austrian Economists, January 20, 2002.]

Does the recent revival in various economic data raise the possibility

that the Fed’s aggressive loose monetary stance is starting to yield

results? The purchasing management index rose to 48.2 in December from

44.5 in the previous month. New home sales increased by 6.4 percent in

November after growing by 1.7 percent in October. Also, indices of

manufacturing activity in the New York and Chicago areas increased in

December from November. Furthermore, the consumer confidence index

jumped to 93.7 in December from 84.9 in November.

Notwithstanding all this, what determines whether the U.S. will

experience a meaningful economic recovery is not the Fed’s aggressive

lowering of interest rates but whether the real pool of funding is

growing.

The Heart of Economic Activity

According to mainstream economics, consumer demand is the most important

factor in an economy. If consumers are active, it is regarded as a good

sign of economic health; if consumers do not spend enough, it is seen as

a bad omen. Whenever a deficiency in overall demand emerges, it is

argued that the government and its central bank must step in to prevent

the economy from falling into a slump.

The theory goes like this: If demand is increased, an increased

production of goods and services will follow suit and, consequently,

prosperity will be restored. In other words, what enables economic

growth is demand for goods and services. Within this way of thinking

nothing is ever said about how the demand for goods and services is

funded. Moreover, is it enough that by means of demand for goods and

services the economy can be kept going?

The distinguishing characteristic of human activities is that they are

purposeful--people employ means to promote their life and well-being. In

the real world one has to become a producer first before one can demand

goods and services. That is, it is necessary to produce some useful

goods (means) that can be exchanged for other goods (goals). Means

fulfill the role of funding--they make it possible to secure individuals

goals.

For instance, with given resources at his disposal, a baker can produce

a given amount of bread. The bread that the baker has produced is his

means in securing ends--the bread is his pool of funding. Thus the baker

might use a portion of the bread for his own consumption. Another

portion might be exchanged for other consumer goods, i.e., they might

fund his consumption of other goods and services. The rest of the bread

might be used to buy a new oven and to hire workers to install this

oven.

The portion of bread that the baker has exchanged to acquire and install

the oven is what saving is all about. Instead of consuming the bread

directly, or exchanging it for other final consumer goods, the baker has

exchanged the bread to acquire a better oven. The new oven, in turn,

will permit a greater production of bread. This in turn permits a

further expansion and enhancement of the baker’s production structure,

which subsequently enables the baker to lift the production of bread

further.

Note that as long as the baker's pool of funding, i.e., the amount of

bread at his disposal, continues to expand, he is in a position to raise

both consumption and savings; his living standard will rise.\xa0

Saving is required not only for the expansion of a given production

structure but also for its maintenance. If the baker fails to maintain

the oven and replace its worn-out parts, the production of bread will

suffer. This in turn will undermine the baker's pool of funding and

lower his living standard. (In other words, to keep the production of

bread going, some of the bread must be exchanged for the new parts.)

Note that when the baker exchanges his bread for the oven and other

consumer goods, he is supplying individuals that have been engaged in

the production of these goods with the means that promote their life and

well-being. Likewise, final consumer goods that the baker has secured

for his bread promote his life and well-being.

Money and the Pool of Funding

The introduction of money into our discussion does not alter the essence

of what saving and the pool of funding is all about. Money fulfills the

role of the medium of exchange. It enables the produce of one producer

to be exchanged for the produce of another producer. Observe that while

money serves as the medium of exchange, it doesn’t produce goods and

services; it only enables these goods and services to be exchanged.

Another important role of money is to serve as a medium of saving.

Instead of saving goods, which requires storing them, people can now

save money. In the world of barter, perishable goods are difficult to

save for very long. These difficulties are resolved in the money

economy. Once a producer has exchanged his goods for money, he has begun

saving. When a baker sells his bread for money to a shoemaker, he has

supplied the shoemaker with his saved, i.e. unconsumed, bread. The

supplied bread, in turn, which sustains the shoemaker, allows him to

continue making shoes. Being the medium of exchange, money enables the

baker to secure goods and services some time in the future whenever he

may require them.

Through money, people channel real savings, which permit economic

activity to take place. Thus the saving of money by one individual

supports the production of another individual, who in turn, by

exchanging his produce for money, supports a third individual. In this

way money enables real savings to permeate across the economy and lift

the pace of production of goods and services.

However, it does not follow that one can lift economic growth through

printing presses. When money is printed--i.e., created "out of thin

air"--it sets in motion an exchange of nothing for money and then money

for something, i.e., an exchange of nothing for something. An exchange

of nothing for something amounts to consumption that is not supported by

production. Since every activity has to be funded, it follows that an

increase in consumption that is not supported by production must divert

funding from wealth-generating activities. In short, consumption that is

not preceded by production amounts to unearned consumption; i.e., it

takes from the pool of funding without making any contribution to this

pool.

Consequently, when a central bank expands the money stock, it does not

enlarge the pool of funding, but, on the contrary, dilutes the pool,

thereby weakening the rate of economic growth. Thus when money "out of

thin air" gives rise to consumption that is not supported by prior

production, it diverts the funding that supports production of goods and

services of the first wealth producer.

This in turn undermines his production of goods and thereby weakens his

effective demand for the goods of another wealth producer. The other

producer in turn is forced to curtail his production of goods, thereby

weakening his effective demand for goods of a third wealth producer. In

this way, money "out of thin air," which destroys savings, sets in

motion the dynamics of the consequent decline of the growth of real

wealth production.

In the money economy, the pool of funding is comprised of all the final

consumer goods produced by various producers. In contrast with gross

domestic product (GDP) that only pays attention to the final stage of

production, the pool of funding deals with the funding for all the

stages of production, i.e., final and intermediate. By ignoring funding

to the intermediate stages of production, the GDP framework lapses into

a world of illusion where final goods and services emerge "out of the

blue." However, in the real world, no final product can ever emerge

without intermediate stages.

Recession versus Depression

Contrary to popular thinking, recessions are not about two quarters of a

negative growth in real GDP, or declines in various economic indicators;

they are about the liquidation of business errors brought about by

previous loose monetary policies. In short, they are about the

liquidation of activities that sprang up on the back of previous loose

monetary policy. The ensuing adjustment of production may or may not

manifest itself through a negative GDP rate of growth.

As a rule, symptoms of a recession emerge once the central bank tightens

its monetary stance. But what determines whether an economy falls into a

depression or just suffers an ordinary recession is the state of the

pool of funding. As long as this pool is still growing, a tighter

central bank monetary policy will culminate in a recession. In other

words, notwithstanding that various false activities (i.e., business

errors that sprang up on the back of a loose monetary policy) will now

suffer, overall economic growth will be positive.

As long as the pool of funding is expanding, the central bank and

government officials can give the impression that they have the power to

reverse a recession by means of monetary pumping and the artificial

lowering of interest rates. In reality, however, these actions only slow

or arrest the liquidation of false activities, thereby continuing to

divert funding from wealth generators to wealth consumers. What in fact

gives rise to a positive rate of growth in economic activity is not

monetary pumping but the fact that the real pool of funding is actually

growing.

The illusion that through monetary pumping it is possible to keep the

economy going is shattered once the pool of funding begins to decline.

Once this happens, the economy begins its downward plunge, i.e., the

economy falls into depression. The most aggressive loosening of money

will not reverse the plunge (for money cannot replace bread). In fact,

rather than reversing the plunge, loose monetary policy will further

undermine the flow of savings and thereby further weaken the structure

of production and thus the production of goods and services.

The size of the pool of funding imposes a limit on the type of projects

that can be accomplished. In a situation where the accomplishment of a

particular project requires funding for one year of work while the pool

of funding is only adequate to support six months of work, the project

cannot be made feasible and no amount of monetary pumping can make the

project possible. If money could have replaced real funding, then

poverty would have been eliminated a long time ago.

In his writings, Milton Friedman blamed central bank policies for

causing the Great Depression. According to Friedman, the Federal Reserve

failed to pump enough reserves into the banking system to prevent the

collapse in the money stock

< http://www.mises.org/fullstory.asp?control=882&
FS=Recovery+or+Illusion%3F#_ftn1 >[1]

and thus in economic activity. For Friedman, the failure of the U.S.

central bank is not that it caused the monetary bubble during the 1920s

but that it allowed the deflation of the bubble.

An economic depression, however, is not caused by the collapse of the

money stock as suggested by Professor Friedman, but rather by the

collapse of the real pool of funding. The shrinkage of this pool is set

in motion by the previous monetary pumping of the central bank and

fractional reserve banking

< http://www.mises.org/fullstory.asp?control=882&
FS=Recovery+or+Illusion%3F#_ftn2 >[2].

Moreover, a fall in the pool of funding triggers declines in bank

lending and thus in the money stock. This in turn implies that previous

loose monetary policies cause the fall in the pool of funding and

trigger collapses in economic activity and in the money stock.

Declines in stock prices and the prices of goods and services follow

declines in money supply. Most economists erroneously regard this as

"bad news" that must be countered by central bank policies. However, any

attempt to counter price declines by means of loose monetary policies

further undermines the pool of funding. Furthermore, even if loose

monetary policies were to succeed in lifting prices and inflationary

expectations (as suggested by Professor Paul Krugman), this cannot

revive the economy while the pool of funding is declining.

Lastly, it is erroneous to regard falls in stock prices as causing

recessions. The popular theory argues that a fall in stock prices lowers

individuals’ wealth and this in turn weakens consumers' outlays. Since

it is held that consumer spending accounts for 66 percent of GDP, this

means that a fall in the stock market plunges the economy into a

recession.

However, we have already shown that it is the pool of funding and not

consumer demand that permits economic growth to take place. Furthermore,

prices of stocks mirror individuals’ assessments regarding the facts of

reality. As a result of monetary pumping, these assessments tend to be

erroneous. But, once the central bank alters its stance, individuals can

see much more clearly what the facts of reality are and scale down

previous erroneous evaluations. Observe that while individuals can

change their evaluations of the facts, they cannot alter the existing

facts which influence the future course of events.

The Current State of the U.S. Economy

Whenever the central bank changes interest rates, the effect of this

change on producers is not instantaneous. It takes time before the

effect of a change starts to assert itself. Historically, the average

time lag between changes in the federal funds rate and changes in the

yearly rate of growth of industrial production has been twelve months.

Using this historical time lag, we can suggest that in response to the

tighter interest rate stance between June 1999 and May 2000, the current

recession, or the current cyclical downturn, began in June 2000 (see

chart). In other words, by raising the federal funds rate from 5 percent

in June 1999 to 6.5 percent in May 2000, the Fed had set in motion in

June 2000 the process of liquidation of businesses that sprang up on the

back of previous loose monetary policy.

In January 2001, the Fed embarked on a new stage of lowering interest

rates. The central bank lowered the federal funds rate from 6 percent to

1.75 percent, i.e., by 425 basis points. This artificial lowering has

set in motion a renewed misallocation of resources. Using the

lagged-by-twelve-months federal funds rate, we can suggest that there is

a growing likelihood that a cyclical upturn in the manufacturing sector

has already begun.

As such, a cyclical upturn doesn’t cause real economic growth. It only

misdirects the given pool of real funding, thereby weakening potential

economic growth. As long as the real pool of funding is growing, an

aggressive loose monetary policy can "stage a strong cyclical

upturn"--i.e., strong positive year-on-year percentage rises in economic

activity. If, however, the real pool of funding is stagnating, the

cyclical rebound will be associated with a stagnant rate of growth in

real economic activity.\xa0

As has been shown, a major negative for the real pool of funding is

increases in money supply. These rises set in motion an exchange of

nothing for something, which weakens the flow of real savings and

thereby undermines the real pool of funding. Since 1980, the U.S. has

experienced large monetary injections. A major cause of this is the

"liberalization" of financial markets, which, for all its merits in

permitting financial entrepreneurship, also removed various restrictions

on banks' lending "out of thin air." The magnitude of money creation

since 1980 is presented in the chart below.

Observe that in December 2001, money AMS

< http://www.mises.org/fullstory.asp?control=882&
FS=Recovery+or+Illusion%3F#_ftn3 >[3]\xa0was

80 percent above the trend, which is based on the history between 59 and

79. This massive increase in the money stock has been associated with a

corresponding collapse in personal savings (see chart). In short, every

dollar that was created "out of thin air" amounts to a corresponding

dissaving by that amount.

This large money creation has also been accompanied by the relentless

lowering of federal funds rates, which stood at 19.1 percent in June

1981.

While it is true that businessmen react to interest rates, what permits

the expansion of tools and machinery, i.e., the infrastructure, is not

interest rates but the growing pool of funding. As long as interest

rates are not tampered with, they serve as an important medium in

facilitating the flow of real savings toward the build-up of a

wealth-generating infrastructure. In this sense interest rates can be

regarded as an indicator.

Whenever the central bank tampers with interest rates through an

artificial lowering, it falsifies this indicator, thereby breaking the

harmony between the production of present consumer goods and the

production of capital goods, i.e., tools and machinery. In short, an

overinvestment in capital goods and an underinvestment in consumer goods

emerge. While an overinvestment in capital goods results in a boom, the

liquidation of this overinvestment produces a bust. Hence the boom-bust

cycle.

The prolonged artificial lowering of interest rates must have

contributed to a large overinvestment in capital goods versus consumer

goods production (a severe misallocation of resources), thereby severely

hurting the pool of funding (see chart).\xa0

The Rest of the World\xa0

From what has been said so far, it will come as no surprise that the

real pool of funding might be in bad shape. This in turn raises the

likelihood that the U.S. may follow the path of the Japanese

economy.\xa0

The question that needs to be addressed is how, despite prolonged

monetary pumping, the U.S. managed to perform so exceptionally

well,\xa0at least in terms of real GDP, while Japan, which has been also

pursuing aggressive loose monetary policies, has fallen into a severe

economic slump. Thus both the U.S. and Japan have been aggressively

pushing money supply (see chart) and aggressively lowering interest

rates.

\xa0

It is quite likely that the mighty U.S. production structure has managed

so far to offset by a big margin the negatives of a prolonged monetary

pumping. In short, despite loose monetary policies, the U.S. pool of

funding has been growing. The U.S. pool has further benefited from the

imports of goods and services from the rest of the world. The balance on

goods and services stood at -$340 billion in 2001 against -$376 billion

in 2000.

Contrast this with Japan’s massive exports of goods (see chart) in

return for U.S. government bonds, which has likely undermined Japan’s

production structure and thus its pool of funding. (Bear in mind that

the Japanese government has been pursuing for decades policies that

promote exports at the expense of other sectors of the economy.) In

other words, Japan has diverted a large portion of its pool of funding

in exchange for U.S. government promises. Imagine that instead of

investing his saved bread in a new oven, the baker exchanges his bread

for government bonds. Obviously this will impoverish the baker, for his

savings are not employed to keep his production structure going. His

savings are wasted on various government non-wealth-generating

activities.\xa0

In Q3 2001, Japan held $311.6 billion in U.S. Treasury securities--26.6

percent of total foreign holdings and 11.2 percent of total private

holdings. Moreover, foreign holdings of Treasury securities as a percent

of total privately held debt stood at 42.2 percent in Q3 2001 against

15.8 percent in Q1 1986.

It seems that Japan is currently paying a very high price for policies

that were aimed at promoting exports. In this respect it must be

reiterated that policies that aim at boosting any economic activity at

the expense of other economic activities are likely to undermine the

harmony between consumption and production and thereby cause economic

impoverishment. What we are saying here applies to policies that aim at

boosting either aggregate demand or aggregate supply. Only the

environment of a free unhampered market will guarantee the harmonious

interplay between supply and demand.\xa0

An important factor that helps the diversion of real funding from the

rest of the world to the U.S. is the increase in the American money

supply. The fact that the U.S. dollar is the main international medium

of exchange makes it possible for it to divert real funding from other

countries to itself. In short, when new dollars are created, the first

recipients of these dollars are Americans who can exchange them for

foreign goods and services. Americans are in a position to practice the

exchange of nothing for something because only the U.S. can produce

American dollars. On this Mises wrote:

Let us assume that the international authority increases the amount of

its issuance by a definite sum, all of which goes to one country,

Ruritania. The final result of this inflationary action will be a rise

in prices of commodities and services all over the world. But while

this process is going on, the conditions of the citizens of various

countries are affected in a different way. The Ruritanians are the

first group blessed by the additional manna. They have more money in

their pockets while the rest of the world’s inhabitants have not yet

got a share of the new money. They can bid higher prices, while the

others cannot. Therefore the Ruritanians withdraw more goods from the

world market than they did before. The non-Ruritanians are forced to

restrict their consumption because they cannot compete with the higher

prices paid by the Ruritanians. While the process of adjusting prices

to the altered money relation is still in progress, the Ruritanians

are in an advantageous position against the non-Ruritanians. When the

process finally comes to an end, the Ruritanians have been enriched at

the expense of the non-Ruritanians.

< http://www.mises.org/fullstory.asp?control=882&
FS=Recovery+or+Illusion%3F#_ftn4 >[4]

It seems that the production of goods from the rest of the world has

played an important role in keeping the U.S. pool of funding going. It

is envisaged, however, that the emerging economic slump in the rest of

the world is likely to weaken the support for the U.S. pool of funding

in the months ahead.\xa0

Implications for Stock Markets

As a result of the Fed’s aggressive loose monetary policy, the yearly

rate of growth of money AMS adjusted for nominal economic activity stood

at 13.2 percent in December against -4.1 percent in January.

This strong increase in liquidity should provide support to stock prices

(see chart).

However, this strong liquidity build-up without the backup from company

profits will not be able to generate a sustainable stock market

recovery. Moreover, the present record-high P-E ratio (see chart)

doesn’t bode well for stocks. Unless the real pool of funding is still

in good shape, the prospects for a healthy turnaround in corporate

profits do not appear to be very promising.\xa0

Obviously, if the pool of funding is sound, we should witness a strong

economic rebound and a strong rebound in stocks. However, a possible

negative that might mitigate the rebound in stocks in this scenario is

the likely acceleration in price inflation as a result of present the

Fed’s loose monetary policy.

The large overinvestment in capital goods versus consumer goods

production means that on a relative basis, greater profit opportunities

will be in companies that to a large extent are engaged in the

production of final consumer goods. The stocks of companies that are

associated with activities that are directly, or indirectly, linked to

capital goods production are expected to underperform. Furthermore,

within the framework of a stagnant pool of funding, on account of rising

bad debts, bank stocks are likely to come under pressure.

Implications for Interest Rates

Within the framework of a "shaky" pool of funding and invisible cyclical

upturn, we envisage that the Fed will continue to lower interest rates

further. As a result, the differential between the yield on the ten-year

T-bond and the federal funds rate, which stood at 3.3 percent at the end

of December, is likely to widen further.

The strong build-up in liquidity coupled with subdued economic activity

is likely to benefit the Treasury bond market (see chart). If, however,

the pool of funding is "doing OK," then a possible rebound in price

inflation might mitigate the effect of the build-up in liquidity.

Conclusions

According to the popular view, the revival of some important economic

indicators has raised the likelihood that the aggressive lowering of

interest rates by the Fed will invigorate the economy. The irony is that

the very same loose monetary policies that are expected to energize the

economy in fact undermine its main source of strength. As long as the

real pool of funding is growing, the lower-interest policy of the Fed

will appear to be "working."\xa0\xa0The collapse in personal savings

coupled with the massive overinvestment in capital goods in relation to

consumer goods production raises the likelihood that the U.S. real pool

of funding may be in trouble.

Furthermore, in the past, the American pool of funding was helped by the

rest of the world; but with a weakening in world economic growth, this

support is likely to diminish. Consequently, it will not be a surprise

if the U.S. economy follows the Japanese path some time in the future.

Having said all this, we do not deny the possibility of a cyclical

recovery in the months ahead. However, we suspect that this recovery is

likely to be of a shallow nature.

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