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The Fed Desperately Tries to Maintain the Status Quo – Article by Ronald-Peter Stöferle

The Fed Desperately Tries to Maintain the Status Quo – Article by Ronald-Peter Stöferle

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The New Renaissance HatRonald-Peter Stöferle
November 5, 2015
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During the press conferences of recent FOMC meetings, millions of well-educated investment professionals have been sitting in front of their screens, chewing their fingernails, listening as if spellbound to what Janet Yellen has to tell them. Will she finally raise the federal funds rate that has been zero bound for over six years?

Obviously, each decision is accompanied by nervousness on the markets. Investors are fixated by a fidgety curiosity ahead of each Fed decision and never fail to meticulously observe Janet Yellen and the FOMC, and engage in monetary ornithology on doves (growth- and employment-oriented FOMC members) and hawks (inflation-oriented FOMC members).

Fed watchers also hope for some enlightening information from Ben Bernanke. According to Reuters, some market participants paid some $250,000 just to join one of several dinners, where the ex-chairman spilled the beans. Apparently, he does not expect the federal funds rate to return to its long-term average of about 4 percent during his lifetime.

In a conversation with Jim Rickards, Bernanke stated that a rate hike would only be possible in an environment in which “the U.S. economy is growing strongly enough to bear the costs of higher rates.” Moreover, a rate increase would have to be clearly communicated and anticipated by the markets — not to protect individual investors from losses, Bernanke assures us, but rather to prevent jeopardizing the stability of the “system as a whole.”

It is axiomatic that zero-interest-rate-policy (ZIRP) cannot be a permanent fixture. Indeed, Janet Yellen has been going on about increasing rates for almost two years now. But, how much more lead time will it require to “prepare” the markets? In both September and October the FOMC chickened out, even though we are not talking about hiking the rate back to “monetary normalcy” in one blow. The decision on the table is whether or not to increase the rate by a trifling quarter point!

The Fed’s quandary can be understood a little better by examining what “monetary normalcy,” or a “normal interest rate,” is supposed to be. Or, even more fundamentally: what is an interest rate?

We “Austrians” understand an interest rate as an expression of market participants’ time preference. The underlying assumption is that people are inclined to consume a certain product sooner rather than later. Hence, if savers restrict their current consumption and provide the resources for investment instead, they do so only on condition that they will be compensated by increased opportunities for consumption in the future. In free markets, the interest rate can be regarded as a measure of the compensation payment, where people are willing to trade present goods for future goods. Such an interest rate is commonly referred to as the “natural interest rate.” Consequently, the FOMC bureaucrats would ideally set as a goal a “normal interest rate” that equals the “natural” one.This, however, remains unlikely.

Six Years of “Unconventional” Monetary Policy
ZIRP was introduced six years ago in response to the financial crisis, and three QE programs have been conducted. This so-called “unconventional monetary policy” is supposed to be abandoned as soon as the economy has gathered pace. Despite the tremendous magnitude of these market interventions, the momentum in the US economy is rather lame. Weak Q1 data, which probably resulted from a weak trade balance due to a 15 percent rise of the US dollar, shocked even the most pessimistic of analysts; the OECD and the IMF have revised down their 2015 growth estimates. A long-lasting, self-sustaining growth is out of the question. This confirms the assumption that ZIRP fuels everything under the sun — see “The Unseen Consequences of Zero-Interest-Rate Policy” — except long-term productive investment.And what about unemployment and inflation that are key elements of the Fed’s mandate? The conventional unemployment rate (U3) has returned to its long-run normal level, so the view prevails that things are developing well. However, those figures conceal a workforce participation rate that has fallen by more than 3 percent since 2008, indicating that some 2.5 million Americans are currently no longer actively looking for a new job. However, should the economic situation improve, they would likely rejoin the labor force. Furthermore, the proportion of those only working part-time due to a lack of full-time positions is much higher now than before the crisis. “True” unemployment currently stands rather at about 7.25 percent.

A Weak Economy and Weak Inflation
With regard to inflation, the Fed’s target is 2 percent, as measured by growth of the PCE-index. This aims to buffer the fiat money system against the threat of price deflation. In a deflationary environment, it is believed, the debt-servicing capacity of market participants (e.g., governments, private enterprises, financial institutions, and private households) would come under intense pressure and likely trigger a chain reaction in which loans collapse and the monetary system implodes.

In many countries, and among them the US, inflation is remarkably low — partly due to transitory effects of lower energy and import prices — while low interest rates have merely weaved their way to asset price inflation so far. But, as price reactions to monetary policy maneuvers may occur with a lag of a few years, we should expect that sooner or later inflation will also spill over to normal markets.

As a response to anything short of massive improvement of economic and employment data, a rate hike is scarcely likely, and inflation in the short-term is also unlikely. Moreover, the current composition of the FOMC — which is extremely dovish — implies inflation-sensitive voices are relatively underrepresented. This gives rise to the suspicion that rate hikes are not very likely at all in the scenario in the short-term.

What Will the Fed Do If There’s Real Economic Trouble?
One is concerned about economic development, which has a shaky foundation and headwinds from other parts of the world; it appears that growth has cooled down substantially in the BRICS countries. Meanwhile, China might be on the brink of a severe recession. (Indeed, China was possibly the most decisive factor to nudge the Fed away from raising rates in September and October.) This implies that world-wide interest rates will remain at very low levels and a significant rate hike in the US would represent a sharp deviation in this environment, bringing with it massive competitive disadvantages.

The markets are noticeably pricing out a significant rate hike. The production structure has long since adapted to ZIRP and “short-term gambling, punting on momentum-driven moves, on levered buybacks” are further lifting the opportunity costs of abandoning it. In order to try to rescue its credibility, the Fed may decide to try some timid, quarter-point increases.

But what will they do if markets really crash? Indeed, they are terrified of the avalanche that they might trigger. If there are any symptoms that portend calamity, the Fed will inevitably return to ZIRP, launch a QE4, or might even introduce negative interest rates. Hence, there does not seem to be a considerable degree of latitude such that a return to conventional monetary policy could seriously be expected.

“The Fed is raising rates!” — This has become a running gag.

Ronald-Peter Stöferle is a Chartered Market Technician (CMT) and a Certified Financial Technician (CFTe). During his studies in business administration and finance at the Vienna University of Economics and the University of Illinois at Urbana-Champaign, he worked for Raiffeisen Zentralbank (RZB) in the field of Fixed Income/Credit Investments. In 2006 he began writing reports on gold. His six benchmark reports called “In GOLD we TRUST” drew international coverage on CNBC, Bloomberg, the Wall Street Journal, The Economist and the Financial Times. He was awarded “2nd most accurate gold analyst” by Bloomberg in 2011.

This article was originally published by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Today’s War Against Deflation Will Make Us Poorer – Article by Frank Shostak

Today’s War Against Deflation Will Make Us Poorer – Article by Frank Shostak

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The New Renaissance HatFrank Shostak
October 29, 2015
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The yearly growth rate of the US consumer price index (CPI) fell to 0 percent in September 2015, from 0.2 percent in August and, 1.7 percent in September last year.

The yearly growth rate of the European Monetary Union CPI fell to minus 0.1 percent in September from 0.1 percent in the previous month and 0.3 percent in September last year.
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Also, the growth momentum of the UK CPI fell into the negative in September with the yearly growth rate closing at minus 0.1 percent from 0 percent in August and 1.2 percent in September last year.

The growth momentum of China’s CPI eased in September with the yearly growth rate falling to 1.6 percent from 2 percent in August.

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Deflation Fears Gain Steam
Consequently, many experts are expressing concern regarding the declining growth momentum of the CPI and are of the view that rather than tightening the monetary stance, central banks should loosen their stance further in order to counter the emergence of deflation, which is regarded as a major threat to economic well-being of individuals. For most experts, deflation is bad news since it generates expectations of a decline in prices. As a result, they believe, consumers are likely to postpone their buying of goods at present since they expect to buy these goods at lower prices in the future. This weakens the overall flow of spending and in turn weakens the economy. Hence, such commentators believe that policies that counter deflation will also counter the slump.
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Will Reversing Deflation Prevent a Slump?

If deflation leads to an economic slump, then policies that reverse deflation should be good for the economy, so it is held.

Reversing deflation will simply involve introducing policies that support general increases in the prices of goods, i.e., price inflation. With this way of thinking inflation could actually be an agent of economic growth.

According to most experts, a little bit of inflation can actually be a good thing. Mainstream economists believe that inflation of 2 percent is not harmful to economic growth, but that inflation of 10 percent could be bad for the economy.

There’s good reason to believe, however, that at a rate of inflation of 10 percent, it is likely that consumers are going to form rising inflation expectations.

According to popular thinking, in response to a high rate of inflation, consumers will speed up their expenditures on goods at present, which should boost economic growth. So why then is a rate of inflation of 10 percent or higher regarded by experts as a bad thing?

Clearly there is a problem with the popular way of thinking.

Price Inflation vs. Money-Supply Inflation
Inflation is not about general increases in prices as such, but about the increase in the money supply. As a rule the increase in the money supply sets in motion general increases in prices. This, however, need not always be the case.

The price of a good is the amount of money asked per unit of it. For a constant amount of money and an expanding quantity of goods, prices will actually fall.

Prices will also fall when the rate of increase in the supply of goods exceeds the rate of increase in the money supply.

For instance, if the money supply increases by 5 percent and the quantity of goods increases by 10 percent, prices will fall by 5 percent.

A fall in prices cannot conceal the fact that we have inflation of 5 percent here on account of the increase in the money supply.

The Problem Is Really Wealth Formation, not Rising Prices
The reason why inflation is bad news is not because of increases in prices as such, but because of the damage inflation inflicts to the wealth-formation process. Here is why:

The chief role of money is the medium of exchange. Money enables us to exchange something we have for something we want.

Before an exchange can take place, an individual must have something useful that he can exchange for money. Once he secures the money, he can then exchange it for the good he wants.

But now consider a situation in which the money is created “out of thin air,” increasing the money supply.

This new money is no different from counterfeit money. The counterfeiter exchanges the printed money for goods without producing anything useful.

He in fact exchanges nothing for something. He takes from the pool of real goods without making any contribution to the pool.

The economic effect of money that was created out of thin air is exactly the same as that of counterfeit money — it impoverishes wealth generators.

The money created out of thin air diverts real wealth toward the holders of new money. This weakens the wealth generators’ ability to generate wealth and this in turn leads to a weakening in economic growth.

Note that as a result of the increase in the money supply what we have here is more money per unit of goods, and thus, higher prices.

What matters however is not that price rises, but the increase in the money supply that sets in motion the exchange of nothing for something, or “the counterfeit effect.”

The exchange of nothing for something, as we have seen, weakens the process of real wealth formation. Therefore, anything that promotes increases in the money supply can only make things much worse.

Why Falling Prices Are Good
Since changes in prices are just a symptom, as it were — and not the primary causative factor — obviously countering a falling growth momentum of the CPI by means of loose a monetary policy (i.e., by creating inflation) is bad news for the process of wealth generation, and hence for the economy.

In order to maintain their lives and well-being, individuals must buy goods and services in the present. So from this perspective a fall in prices cannot be bad for the economy.

Furthermore, if a fall in the growth momentum of prices emerges on the back of the collapse of bubble activities in response to a softer monetary growth then this should be seen as good news. The less non-productive bubble activities that are around the better it is for the wealth generators and hence for the overall pool of real wealth.

Likewise, if a fall in the growth momentum of the CPI emerges on account of the expansion in real wealth for a given stock of money, this is obviously great news since many more people could now benefit from the expanding pool of real wealth.

We can thus conclude that contrary to the popular view, a fall in the growth momentum of prices is always good news for the wealth generating process and hence for the economy.

Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, master’s degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.

This article was originally published by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Blame the Federal Reserve, Not China, for Stock-Market Crash – Article by Ron Paul

Blame the Federal Reserve, Not China, for Stock-Market Crash – Article by Ron Paul

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The New Renaissance HatRon Paul
September 6, 2015
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Following the historic stock-market downturn two weeks ago, many politicians and so-called economic experts rushed to the microphones to explain why the market crashed and to propose “solutions” to our economic woes. Not surprisingly, most of those commenting not only failed to give the right answers, they failed to ask the right questions.

Many blamed the crash on China’s recent currency devaluation. It is true that the crash was caused by a flawed monetary policy. However, the fault lies not with China’s central bank but with the US Federal Reserve. The Federal Reserve’s inflationary policies distort the economy, creating bubbles, which in turn create a booming stock market and the illusion of widespread prosperity. Inevitably, the bubble bursts, the market crashes, and the economy sinks into a recession.

An increasing number of politicians have acknowledged the flaws in our monetary system. Unfortunately, some members of Congress think the solution is to force the Fed to follow a “rules-based” monetary policy. Forcing the Fed to “follow a rule” does not change the fact that giving a secretive central bank the power to set interest rates is a recipe for economic chaos. Interest rates are the price of money, and, like all prices, they should be set by the market, not by a central bank and certainly not by Congress.

Instead of trying to “fix” the Federal Reserve, Congress should start restoring a free-market monetary system. The first step is to pass the Audit the Fed legislation so the people can finally learn the full truth about the Fed. Congress should also pass legislation ensuring individuals can use alternative currencies free of federal-government harassment.

When bubbles burst and recessions hit, Congress and the Federal Reserve should refrain from trying to “stimulate” the economy via increased spending, corporate bailouts, and inflation. The only way the economy will ever fully recover is if Congress and the Fed allow the recession to run its course.

Of course, Congress and the Fed are unlikely to “just stand there” if the economy further deteriorates. There have already been reports that the Fed will use last week’s crash as an excuse to once again delay raising interest rates. Increased spending and money creation may temporally boost the economy, but eventually they will lead to a collapse in the dollar’s value and an economic crisis more severe than the Great Depression.

Ironically, considering how popular China-bashing has become, China’s large purchase of US Treasury notes has helped the US postpone the day of reckoning. The main reason countries like China are eager to help finance our debt is the dollar’s world reserve currency status. However, there are signs that concerns over the US government’s fiscal irresponsibility and resentment of our foreign policy will cause another currency (or currencies) to replace the dollar as the world reserve currency. If this occurs, the US will face a major dollar crisis.

Congress will not adopt sensible economic policies until the people demand it. Unfortunately, while an ever-increasing number of Americans are embracing Austrian economics, too many Americans still believe they must sacrifice their liberties in order to obtain economic and personal security. This is why many are embracing a charismatic crony capitalist who is peddling a snake oil composed of protectionism, nationalism, and authoritarianism.

Eventually the United States will have to abandon the warfare state, the welfare state, and the fiat money system that fuels leviathan’s growth. Hopefully the change will happen because the ideas of liberty have triumphed, not because a major economic crisis leaves the US government with no other choice.

Ron Paul, MD, is a former three-time Republican candidate for U. S. President and Congressman from Texas.

This article is reprinted with permission from the Ron Paul Institute for Peace and Prosperity.

Asset-Price Inflation Enters Its Dangerous Late Phase – Article by Brendan Brown

Asset-Price Inflation Enters Its Dangerous Late Phase – Article by Brendan Brown

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The New Renaissance HatBrendan Brown
August 12, 2015
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Asset price inflation, a disease whose source always lies in monetary disorder, is not a new affliction. It was virtually inevitable that the present wild experimentation by the Federal Reserve — joined by the Bank of Japan and ECB — would produce a severe outbreak. And indications from the markets are that the disease is in a late phase, though still short of the final deadly stage characterized by pervasive falls in asset markets, sometimes financial panic, and the onset of recession.

Global Signs of Danger

A key sign of danger, recognizable from historical patterns of how the disease progresses, is the combination of steep speculative temperature falls in some markets, with still-high — and in some cases, soaring — temperatures in other markets. Another sign is some pull-back in the carry trade, featuring, in particular, the uncovered arbitrage between a low (or zero) interest rate, and higher rate currencies. For now, however, this is still booming in some areas of the global market-place. Specifically, we now observe steep falls in commodity markets (also in commodity currencies and mining equities) which were the original area of the global market-place where the QE-asset price inflation disease attacked (back in 2009–11). Previously hot real estate markets in emerging market economies (especially China and Brazil) have cooled at least to a moderate extent. Most emerging market currencies — with the key exception of the Chinese yuan — once the darling of the carry traders, are in ugly bear markets. The Shanghai equity market bubble has burst.Yet in large areas of the high-yield credit markets (including in particular the so-called covenant-lite paper issued by highly leveraged corporations) speculative temperatures remain at scorching levels. Meanwhile, Silicon Valley equities (both in the public and private markets), and private equity funds enjoy fantasy valuations. Ten-year Spanish and Italian government bond yields are hovering below 2 percent, and hot spots in global advanced-economy real estate — whether San Francisco, Sydney, or Vancouver — just seem to get hotter, even though we should qualify these last two observations by noting the slump in the Canadian and Australian dollars. Also, there is tentative evidence that London high-end real estate is weakening somewhat.

How to Identify Late Stages of Asset Inflation

We can identify similar late phases of asset price inflation characterized by highly divergent speculative temperatures across markets in past episodes of the disease. In 1927–28, steep drops of speculative temperature in Florida real estate, the Berlin stock market, and then more generally in US real estate, occurred at the same time as speculative temperatures continued to soar in the US equity market. In the late 1980s, a crash in Wall Street equities (October 1987) did not mark the end-stage of asset price inflation but a late phase of the disease which featured still-rising speculation in real estate and high-yield credits.In the next episode of asset price inflation (the mid-late 1990s), the Asian currency and debt crisis in 1997, and the bursting of the Russian debt bubble the following year, accompanied still rising speculation in equities culminating in the Nasdaq bubble. In the episode of the mid-2000s, the first quakes in the credit markets during summer 2007 did not prevent a further build-up of speculation in equity markets and a soaring of speculative temperatures in winter 2007–08 and spring 2008 in commodity markets, especially oil.What insights can we gain from the identification of the QE-asset price inflation disease as being in a late phase?The skeptics would say not much. Each episode is highly distinct and the disease can “progress” in very different ways. Any prediction as to the next stage and its severity has much more to do with intuition than scientific observation. Indeed some critics go as far as to suggest that diagnosis and prognosis of this disease is so difficult that we should not even list it as such. Historically, such critics have ranged from Milton Friedman and Anna Schwartz (who do not even mention the disease in their epic monetary history of the US), to Alan Greenspan and Ben Bernanke who claimed throughout their years in power — and these included three virulent attacks of asset price inflation originating in the Federal Reserve — that it was futile to try to diagnose bubbles.

We Can’t Ignore the Problem Just Because It’s Hard to Measure

Difficulties in diagnosis though do not mean that the disease is phantom or safely ignored as just a minor nuisance. That observation holds as much in the field of economics as medicine. And indeed there may be a reliable way in which to prevent the disease from emerging in the first place. The critics do not engage with those who argue that the free society’s best defense against the asset price inflation disease is to follow John Stuart Mill’s prescription of making sure that “the monkey wrench does not get into the machinery of money.”Instead, the practitioners of “positive economics” demonstrate an aversion to analyzing a disease which cannot be readily identified by scientific measurement. Yes, the disease corrupts market signals, but by how much, where, and in what time sequence? Some empiricists might acknowledge the defining characteristic of the disease as “where monetary disequilibrium empowers forces of irrationality in global markets.” They might agree that flawed mental processes as described by the behavioral finance theorists become apparent at such times. But they despair at the lack of testable propositions.

Mis-Measuring Increases in Asset Prices

The critics who reject the usefulness of studying asset price inflation have no such qualms with respect to its twin disease — goods and services inflation. After all, we can depend on the official statisticians! In the present monetary inflation, a cumulative large decline in equilibrium real wages across much of the labor market, together with state of the art “hedonic accounting” (adjusting prices downward to take account of quality improvements) has meant that the official CPI has climbed by “only” 11 percent since the peak of the last business cycle (December 2007). The severity of the asset price inflation disease makes it implausible that the official statisticians are measuring correctly the force of monetary inflation in goods and services markets.

What Is the Final Stage?

A progression of the asset price inflation disease into its final stage (general speculative bust and recession) would mean the end of monetary inflation and also inflation in goods and services markets. What could bring about this transition? Most plausibly it will be a splintering of rose-colored spectacles worn by investors in the still hot speculative markets rather than Janet Yellen’s much heralded “lift-off” (raising official short-term rates from zero). What could cause the splinter? Perhaps it will be a sudden rush for the exit in the high-yield credit markets, provoked by alarm at losses on energy-related and emerging market paper. Or financial system stress could jump in consequence of the steep falls of speculative temperature already occurring (including China and commodities). Perhaps there will be a run from those European banks and credit funds which are up to their neck in Spanish and Italian government bonds. Or the Chinese currency could tumble as Beijing pulls back its support and the one trillion US dollar carry trade into the People’s Republic implodes. Perhaps scandal and shock, accompanied by economic disappointment will break the fantasy spell regarding US corporate earnings, especially in Silicon Valley. As the late French President Mitterrand used to say, “give time to Time!”

Brendan Brown is an associated scholar of the Mises Institute and is author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution. See Brendan Brown’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

The Fed’s Confusion Over the “Natural Rate” of Unemployment and Inflation – Article by Frank Shostak

The Fed’s Confusion Over the “Natural Rate” of Unemployment and Inflation – Article by Frank Shostak

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The New Renaissance Hat
Frank Shostak
July 20, 2015
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In May, the US unemployment rate stood at 5.5 percent against the rate of 5.3 percent for the “natural unemployment,” also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU).

According to the popular view, once the actual unemployment rate falls to below the NAIRU, or the natural unemployment rate, the rate of inflation tends to accelerate and economic activity becomes overheated. (This acceleration in the rate of inflation takes place through increases in the demand for goods and services. It also lifts the demand for workers and puts pressure on wages, reinforcing the growth in inflation).

By this way of thinking, the central bank must step in and lift interest rates to prevent the rate of inflation from getting out of control.

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Recently, however, some experts have raised the possibility that the natural unemployment rate is likely to be much lower than the government official estimate of 5.3 percent. In fact, earlier this year, economists at the Chicago Fed argued that the natural unemployment rate since October last year has fallen to 4.3 percent.

The reasons for this decline are demographic changes and an increase in the level of education. (The natural unemployment rate tends to fall, so it is held, with the rising age of the labor force and with its education.)

Experts are of the view that these factors should continue to lower the natural unemployment rate for at least the remainder of the decade.

It is held that a lower natural rate may help explain why wage inflation and price inflation remain low, despite the actual unemployment rate recently reaching 5.5 percent.

Advocates for a lower natural rate also claim a lower rate would mean the Fed can keep interest rates lower for longer without worrying about lifting the rate of inflation.

Why NAIRU Is an Arbitrary Measure

The NAIRU however, is an arbitrary measure; it is derived from a statistical correlation between changes in the consumer price index and the unemployment rate. What matters here for Fed economists and others is whether the theory “works” (i.e., whether it can predict the future rate of increases in the consumer price index).

This way of thinking doesn’t consider whether a theory corresponds to reality. Here we have a framework, which implies that “anything goes” as long as one can make accurate predictions.

The purpose of a theory however is to present the facts of reality in a simplified form. A theory has to originate from reality and not from some arbitrary idea that is based on a statistical correlation.

If “anything goes,” then we could find by means of statistical methods all sorts of formulas that could serve as forecasting devices.

For example, let us assume that high correlation has been established between the income of Mr. Jones and the rate of growth in the consumer price index — the higher the rate of increase of Mr. Jones’s income, the higher the rate of increase in the consumer price index.

Therefore we could easily conclude that in order to exercise control over the rate of inflation the central bank must carefully watch and control the rate of increases in Mr. Jones’s income. The absurdity of this example matches that of the NAIRU framework.

Inflation Is Not Caused by Increased Economic Activity

Contrary to mainstream thinking, strong economic activity as such doesn’t cause a general rise in the prices of goods and services and economic overheating labeled as inflation.

Regardless of the rate of unemployment, as long as every increase in expenditure is supported by production, no overheating can occur.

The overheating emerges once expenditure is rising without the backup of production — for instance, when the money stock is increasing. Once money increases, it generates an exchange of nothing for something, or consumption without preceding production, which leads to the erosion of real wealth.

As a rule, rises in the money stock are followed by rises in the prices of goods and services.

Prices are another name for the amount of money that people spend on goods they buy.

If the amount of money in an economy increases while the number of goods remains unchanged more money will be spent on the given number of goods i.e., prices will increase.

Conversely, if the stock of money remains unchanged it is not possible to spend more on all the goods and services; hence no general rise in prices is possible. By the same logic, in a growing economy with a growing number of goods and an unchanged money stock, prices will fall.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies.

This article was originally published by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Fact-Checking Paul Krugman’s Claim To Be “Right About Everything” – Article by Andrew Syrios

Fact-Checking Paul Krugman’s Claim To Be “Right About Everything” – Article by Andrew Syrios

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The New Renaissance Hat
Andrew Syrios
June 10, 2015
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But can the debate really be as one-sided as I portray it? Well, look at the results: again and again, people on the opposite side prove to have used bad logic, bad data, the wrong historical analogies, or all of the above. I’m Krugtron the Invincible!

Thus wrote the great Paul Krugman. A man so modest as to proclaim that “I think I can say without false modesty, a huge win; I (and those of like mind) have been right about everything.”

Quite a claim. Indeed, predictions are extraordinarily difficult. Even to an expert in a subject who has dedicated his life to a field of study, predicting the future proves elusive. Daniel Kahneman referenced a study of 284 political and economic “experts” and their predictions and found that “The results were devastating. The experts performed worse than they would have if they had simply assigned equal probabilities to each of three potential outcomes.”

A whole book of such wildly inaccurate predictions by experts was compiled into the very humorous The Experts Speak with such prescient predictions as Dr. Alfred Velpeau’s “The abolishment of pain in surgery is a chimera. It is absurd to go on seeking it” and Arthur Reynolds belief that “This crash [of 1929] is not going to have much effect on business.” Indeed, a foundational block of Austrian economics (that some Austrians unfortunately forgot regarding premature predictions of hyperinflation) is that the sheer number of variables in the world at large makes accurate forecasting extraordinarily difficult.

So it must be a rare man indeed that can be right about everything. And this man, Paul Krugman is not.

Predicting a Bubble He Recommended

Paul Krugman likes to reference the fact that he predicted the housing bubble. Of course, he also sort of recommended it. From a 2002 column of his,

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

In 2009, when this came out, he denied its obvious implication and wrote, “It wasn’t a piece of policy advocacy, it was just economic analysis. What I said was that the only way the Fed could get traction would be if it could inflate a housing bubble. And that’s just what happened.” So that doesn’t count as a recommendation? It certainly sounded like he was agreeing with Paul McCulley on inflating a housing bubble. And he verified that that’s exactly what he meant in a 2006 interview where he said,

As Paul McCulley of PIMCO remarked when the tech boom crashed, Greenspan needed to create a housing bubble to replace the technology bubble. So within limits he may have done the right thing. But by late 2004 he should have seen the danger signs and warned against what was happening; such a warning could have taken the place of rising interest rates. He didn’t, and he left a terrible mess for Ben Bernanke.

The best Krugman can possibly say is that he thought Greenspan went too far with the housing bubble he recommended.

Deflation is Around the Corner

While running victory laps because the United States hasn’t seen massive price inflation, Krugman seems to have forgotten what his prediction actually was. In 2010 he wrote, “And what these measures show is an ongoing process of disinflation that could, in not too long, turn into outright deflation … Japan, here we come.”

Robert Murphy called him on this and noted Krugman’s response,

… Krugman himself … said of his 2010 analysis: “(In that post, I worried about deflation, which hasn’t happened; I’ve written a lot since about why).”

Note the parenthetical aside, and the timing: Krugman in April 2013 is mentioning in parentheses to his reader that oh yes, as of February 2010 he was “worried about deflation, which hasn’t happened.” In other words, Krugman entered this crisis with a model that predicted how prices would move in response to the economic situation, and chose his policies of government stimulus accordingly. He was wrong, and yet maintains the same policy recommendations.

But of course to Krugman, anyone who predicted price inflation can’t explain why that hasn’t happened. Such people are just those “… who take a position and refuse to alter that position no matter how strongly the evidence refutes it.” Krugman is different.

Europe Will Do Better Than the United States

In 2008, Krugman wrote:

… tales of a moribund Europe are greatly exaggerated. … The fact is that Europe’s economy looks a lot better now — both in absolute terms and compared with our economy.”

Later he noted that “Americans will face increasingly strong incentives to start living like Europeans” and that “he has seen the future and it works.” (I should probably note that that is a quote he borrowed from Lincoln Steffens about the Soviet Union.)

Then Greece went bankrupt and the international consensus is unquestionably that the crisis hit Europe harder.

The Euro Will Collapse

Niall Ferguson counted eleven different times between April of 2010 and July 2012 that Krugman wrote about the imminent breakup of the euro. For example, on May 17th, 2012, Krugman wrote,

Apocalypse Fairly Soon. … Suddenly, it has become easy to see how the euro — that grand, flawed experiment in monetary union without political union — could come apart at the seams. We’re not talking about a distant prospect, either. Things could fall apart with stunning speed, in a matter of months, not years. And the costs — both economic and, arguably even more important, political — could be huge.

Most of these predictions are laced with weasel words such as “might,” “probably,” and “could” (more on that shortly). Still, while I’m no fan of the euro, and it might still collapse, as of today, three years later, it has not. If the word “imminent” means anything at all, Krugman was wrong.

The Sequester Will Doom Us All

Paul Krugman at least admitted the sequester was “relatively small potatoes.” But for “relatively small potatoes” he makes a big deal about it, referring to it as “one of the worst policy ideas in our nation’s history.” And it “will probably cost ‘only’ around 700,000 jobs.” (Note the word “probably” again.)

Then later, he decided that these were actually quite large potatoes, stating,

And, somehow, both sides decided that the way to buy time was to create a fiscal doomsday machine that would inflict gratuitous damage on the nation through spending cuts unless a grand bargain was reached. Sure enough, there is no bargain, and the doomsday machine will go off at the end of next week.

The economy has done quite well since then actually. Indeed, how $85.4 billion dollars in “cuts” (from the next year’s budget not the previous year’s spending) could affect anything in a $17 trillion dollar economy is simply beyond me. And of course, it didn’t.

Interest Rates Can’t Go Below Zero

In March of this year, Krugman wrote in regard to some European bonds with negative nominal yields,

We now know that interest rates can, in fact, go negative; those of us who dismissed the possibility by saying that people could simply hold currency were clearly too casual about it.”

But as Robert Murphy points out, “The foundation for the Keynesian case for fiscal stimulus rests on an assumption that interest rates can’t go negative.” Murphy also points out that Krugman should admit he was wrong again because back in 2009, Krugman wrote,

And the reason we’re all turning to fiscal policy is that the standard rule, which is that monetary policy plus automatic stabilizers should do the work of smoothing the business cycle, can’t be applied when we’re hard up against the zero lower bound. [i.e. zero percent interest]

“Inflation Will be Back”

In 1998, Paul Krugman predicted “Inflation will be back.”

Nope.

“The Rate of Technological Change in Computing Slows”

Same article as the last one, “… the number of jobs for IT specialists will decelerate, then actually turn down.”

Aside from a short dip after the 2001 recession, the answer would be nope again.

Weasel Words and “Accurate Predictions”

Let’s take a look at Paul Krugman’s “accurate prediction” of the financial crisis. On March 2nd, 2007, he predicted the following explanation would be given a year from then for the financial crisis he was sort of predicting,

The great market meltdown of 2007 began exactly a year ago, with a 9 percent fall in the Shanghai market, followed by a 416-point slide in the Dow. But as in the previous global financial crisis, which began with the devaluation of Thailand’s currency in the summer of 1997, it took many months before people realized how far the damage would spread.

So the crisis would begin in China? Almost.

He concluded that column by saying, “I’m not saying that things will actually play out this way. But if we’re going to have a crisis, here’s how.”

That’s a good hedge, just like with the euro. He can say he got the financial crisis right (albeit happening in a different way than he expected), but then say he didn’t get the euro wrong because he added “probably” before any prediction about it.

Normally, there would be nothing wrong with these weasel words. Given the nature of predictions, any prediction that is made should have a qualifier in front of it. It’s simply an admission that you aren’t omniscient. But you can’t eat your cake and have it too. Either Krugman was right about the crisis (sort of) and wrong about the euro (and many other things) or neither should count at all.

Or course, this doesn’t refute Krugman’s theories. But then again, Krugman may want to slow down on his victory laps.

Andrew Syrios is a partner in the real estate investment firm Stewardship Properties. He graduated from the University of Oregon with a degree in Business Administration and a Minor in History.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

The Bait-and-Switch Behind Economic Populism – Article by Nicolás Cachanosky

The Bait-and-Switch Behind Economic Populism – Article by Nicolás Cachanosky

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Nicolás Cachanosky
May 26, 2015
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Argentina will hold elections this year, and a number of provinces will be electing governors. Buenos Aires, the capital city, is holding elections for mayor, and Mauricio Macri, who is stepping down as mayor, is a favorite to become the next president. Toward the end of the year, a presidential election will be held and Cristina Kirchner, after two consecutive mandates, will have to step down because she cannot be re-elected.

Like Chávez and Maduro in Venezuela, Argentina can be described as a country that fell victim to extreme populism during the Nestor and Cristina Kirchner administrations, which began in 2003. Twelve years later, this populist political project is about to end.

The economic policy of populism is characterized by massive intervention, high consumption (and low investment), and government deficits. This is unsustainable and we can identify several stages as it moves toward its inevitable economic failure. The last decade of extreme populism in Argentina can be described as following just such a pattern.

After observing the populist experience in several Latin American countries, Rudiger Dornbusch and Sebastián Edwards identified four universal stages inherent in populism in their article “Macroeconomic Populism” (1990). Even though populism can present a wide array of policies, certain characteristics seem to be present in most of the cases.

Populism usually fosters social mobilization, political propaganda, and the use of symbols and marketing practices designed to appeal to voter’s sentiments. Populism is especially aimed at those with low income, even if the ruling party cannot explain the source of its leaders’ high income. Populist rulers find it easy to use scapegoats and conspiracy theories to explain why the country is going through a hard time, while at the same time present themselves as the saviors of the nation. It is not surprising that for some, populism is associated with the left and socialist movements, and by others with the right and fascist policies.

The four stages of populism identified by Dornbusch and Edwards are:

Stage I

The populist diagnosis of what is wrong with an economy is confirmed during the first years of the new government. Macroeconomic policy shows good results like growing GDP, a reduction in unemployment, increase in real wages, etc. Because of output gaps, imports paid with central bank reserves, and regulations (maximum prices coupled with subsidies to the firms), inflation is mostly under control.

Stage II

Bottleneck effects start to appear because the populist policies have emphasized consumption over investment, the use of reserves to pay for imports, and the consumption of capital stock. Changes in sensitive relative prices start to become necessary, and this often leads to a devaluation of the exchange rate, price changes in utilities (usually through regulation), and the imposition of capital controls. Government tries, but fails, to control government spending and budget deficits.

The underground economy starts to increase as the fiscal deficit worsens because the cost of the promised subsidies need to keep up with a now-rising inflation. Fiscal reforms are necessary, but avoided by the populist government because they go against the government’s own rhetoric and core base of support.

Stage III

Shortage problems become significant, inflation accelerates, and because the nominal exchange rate did not keep pace with inflation, there is an outflow of capital (reserves). High inflation pushes the economy to a de-monetization. The local currency is used only for domestic transactions, but people save in US dollars.

The fall in economic activity negatively affects tax receipts increasing the deficit even more. The government needs to cut subsidies and increases the rate of the exchange rate, depreciation. Real income starts to fall and signs of political and social instability start to appear. At this point the failure of the populist project becomes apparent.

Stage IV

A new government is swept into office and is forced to engage in “orthodox” adjustments, possibly under the supervision of the IMF or an international organization that provides the funds required to go through policy reforms. Because capital has been consumed and destroyed, real wages fall to levels even lower than those that existed at the beginning of the populist government’s election. The “orthodox” government is then responsible for picking up the pieces and covering the costs of failed policies left from the previous populist regime. The populists are gone, but the ravages of their policies continue to manifest themselves. In Argentina the expression “economic bomb” is used to describe the economic imbalances that government leaves for the next one.

Economic Populism is Alive and Well

Even though Dornbusch and Edwards wrote their article in 1990, the similarities to the situation in countries like Venezuela, Bolivia, and Argentina is notable. In recent years, to keep populist ideas going in the minds of voters, Venezuela created the Ministry of Happiness, and Argentina created a new Secretary of National Thought.

These four stages are actually cyclical. The populist movement uses the fourth stage to criticize the orthodox party, and argues that during the populists’ tenure, things were better. The public opinion discontent with stage IV allows the populist movement to win new elections, receive an economy in a crisis or recession and the cycle starts over again from stage I. It is not surprising that populist governments usually appear following the hard times caused by economic crisis. A more bold populist government could avoid stage IV by finding a way to remain in office, calling off elections, or creating fake election results (as was the case in Venezuela). At such a point, the populist government succeeds in turning the country into a fully authoritarian nation.

Nicolás Cachanosky, a native of Argentina, is assistant professor of economics at Metropolitan State University of Denver.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Why Do We Celebrate Rising Home Prices? – Article by Ryan McMaken

Why Do We Celebrate Rising Home Prices? – Article by Ryan McMaken

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Ryan McMaken
May 26, 2015
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In recent years, home price indices have seemed to proliferate. Case-Shiller, of course, has been around for a long time, but over the past decade, additional measures have been marketed aggressively by Trulia, CoreLogic, and Zillow, just to name a few.

Measuring home prices has taken on an urgency beyond the real estate industry because for many, home price growth has become something of an indicator of the economy as a whole. If home prices are going up, it is assumed, “the economy” must be doing well. Indeed, we are encouraged to relax when home prices are increasing or holding steady, and we’re supposed to become concerned if home prices are going down.

This is a rather odd way of looking at the price of a basic necessity. If the price of food were going upward at the rate of 7 or 8 percent each year (as has been the case with houses in many markets in recent years) would we all be patting ourselves on the back and telling ourselves how wonderful economic conditions are? Or would we be rightly concerned if incomes were not also going up at a similar rate? Would we do the same with shoes and clothing? How about with education?

With housing, though, increases in prices are to be lauded, we are told, even if they outpace wage growth.

We’re Told to Want High Home Prices

But in today’s economy, if home prices are outpacing wage growth, then housing is becoming less affordable. This is grudgingly admitted even by the supporters of ginning up home prices, but the affordability of housing takes a back seat to the insistence that home prices be preserved at all costs.

Behind all of this is the philosophy that even if the home-price/household-income relationship gets out of whack, most problems will nevertheless be solved if we can just get people into a house. Once someone becomes a homeowner, the theory goes, he’ll be sitting on a huge asset that (almost) always goes up in price, meaning that any homeowner will increase in net worth as the equity in his home increases.

Then, the homeowner can use that equity to buy furniture, appliances, and a host of other consumer goods. With all that consumer spending, the economy takes off and we all win. Rising home prices are just a bump in the road, we are told, because if we can just get everyone into a home, the overall benefit to the economy will be immense.

Making Homes Affordable with More Cheap Debt

Not surprisingly, we find a sort of crude Keynesianism behind this philosophy. In this way of thinking, the point of homeownership is not to have shelter, but to acquire something that will encourage more consumer spending. In other words, the purpose of homeownership is to increase aggregate demand. The fact that you can live in the house is just a fringe benefit. This macro-obsession is part of the reason why the government has pushed homeownership so aggressively in recent decades.

The fly in the ointment, of course, is if home prices keep going up faster than wages — ceteris paribus — fewer people will be able to save enough money to come up with either the full amount or even a sizable down payment on a loan.

Not to worry, the experts tell us. We’ll just make it easier, with the help of inflationary fiat money, to get an enormous loan that will allow you to buy a house. Thus, rock-bottom interest rates and low down payments have been the name of the game since the late 1980s.

We started to see the end game at work during the last housing bubble when Fannie Mae introduced the 40-year mortgage in 2005, which just emphasized that when it comes to being a homeowner, the idea is not to pay off the mortgage, but to “buy” a house and just pay the monthly payment until one moves to another house and gets a new thirty- or forty-year loan.

It Pays To Be in Debt

On the surface of it, it’s hard to see how this scenario is fundamentally different from just paying rent every month. If the homeowner stops paying the monthly payment, he’s out on the street, and the bank keeps the house, which is very similar to the scenario in which a renter stops paying a landlord. There’s (at least) one big difference here, however. It makes sense for the homeowner to get a home loan rather than rent an apartment because — if it’s a fixed-rate loan — price inflation ensures the real monthly payment will go down every month. Residential rents, on the other hand, tend to keep up with inflation.

But why would any lending institution make these sorts of long-term loans if the payment in real terms keeps getting smaller? After all, thirty years is a long time for something to go wrong.

Lenders are willing and able to do this because the loans are subsidized and underwritten through government creations like Fannie Mae (which buys up these loans on the secondary market), through bailouts, and through a myriad of other federal programs such as FHA. Naturally, in an unhampered market, a loan of such a long term would require high interest rates to cover the risk. But, Congress and the Fed have come to the rescue with promises of bailouts and easy money, meaning cheap thirty-year loans continue to live on.

So, what we end up with is a complex system of subsidies and favoritism on the part of lenders, homeowners, government agencies, and the Fed. The price of homes keeps going up, increasing the net worth of homeowners, and banks can make long-term loans on fairly risky terms because they know bailouts of various sorts will come if things go wrong.

But problems begin to arise when increases in home prices begin to outpace access to easy money and cheap loans. Indeed, we’re now seeing that homeownership rates are going down in spite of low interest rates, and vacancy rates in rental housing are at a twenty-year low. Meanwhile, new production in housing units is at 1992 levels, offering little relief from rising prices and rents. Obviously, something isn’t going according to plan.

Who Loses?

The old debt-based tricks that once kept homeownership climbing and accessible in the face of rising home prices are no longer working.

From a free market’s perspective, renting a home is neither good nor bad, but American policymakers long ago decided to favor homeowners over renters. Consequently, we’re faced with an economic system that pushes renters toward homeownership — price inflation and the tax code punishes renters more than owners — while simultaneously pushing home prices higher and higher.

During the last housing bubble, however, as homeownership levels climbed, few noticed or cared about this. So many renters became homeowners that rental vacancies climbed to record highs from 2004 to 2009. But in our current economy, one cannot avoid rising rents or hedge against inflation by easily leaving rental housing behind.

This time around, the cost of purchasing housing is going up by 6 to 10 percent per year, but few renters can join the ranks of the homeowners to enjoy the windfall. Instead, they just face record-high rent increases and a record-low inventory in for-sale houses.

There once was a time when rising home prices and rising homeownership rates could happen at the same time; it was possible for the government to stick to its unofficial policy of propping up home prices while also claiming to be pushing homeownership. We no longer live in such a time.

Ryan W. McMaken is the editor of Mises Daily and The Free Market. He has degrees in economics and political science from the University of Colorado, and was the economist for the Colorado Division of Housing from 2009 to 2014. He is the author of Commie Cowboys: The Bourgeoisie and the Nation-State in the Western Genre. 

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Janet Yellen is Right: She Can’t Predict the Future – Article by Ron Paul

Janet Yellen is Right: She Can’t Predict the Future – Article by Ron Paul

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Ron Paul
May 25, 2015
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This week I found myself in rare agreement with Janet Yellen when she admitted that her economic predictions are likely to be wrong. Sadly, Yellen did not follow up her admission by handing in her resignation and joining efforts to end the Fed. An honest examination of the Federal Reserve’s record over the past seven years clearly shows that the American people would be better off without it.

Following the bursting of the Federal Reserve-created housing bubble, the Fed embarked on an unprecedented program of bailouts and money creation via quantitative easing (QE) 1, 2, 3, etc. Not only has QE failed to revive the economy, it has further damaged the average American’s standard of living while benefiting the financial elites. None other than Donald Trump has called QE “a great deal for guys like me.”

The failure of quantitative easing to improve the economy has left the Fed reluctant to raise interest rates. Yet the Fed does not want to appear oblivious to the dangers posed by keeping rates artificially low. This is why the Fed regularly announces that the economy will soon be strong enough to handle a rate increase.

There are signs that investors are beginning to realize that the Fed’s constant talk of raising rates is just talk, so they are looking for investments that will protect them from a Fed-caused collapse in the dollar’s value. For example, the price of gold recently increased following reports of stagnant retail sales. An increased gold price in response to economic sluggishness may appear counterintuitive, but it is a sign that investors are realizing quantitative easing is not ending anytime soon.

The increase in the gold price is not the only sign that investors are interested in hard assets to protect themselves from inflation. Recently a Picasso painting sold for a record 180 million dollars. This record may not last long, as an additional two billion dollars worth of art is expected to go on the market in the next few weeks.

Another sign of the increasing concerns about the dollar’s stability is the growing interest in alternative currencies. Investing and using alternative currencies can help average Americans, who do not have millions to spend on Picasso paintings, protect themselves from a currency crisis.

Congress should ensure that all Americans can protect themselves from a dollar crisis by repealing the legal tender laws.

Congress should also take the first step toward monetary reform by passing the Audit the Fed bill. Unfortunately, Audit the Fed is not a part of the Federal Reserve “reform” bill that was passed by the Senate Banking Committee. Instead, the bill makes some minor changes in the Fed’s governance structure. These “reforms” are the equivalent of rearranging deck chairs as the Titanic crashes into the iceberg. Hopefully, the Senate will vote on, and pass, Audit the Fed this year.

The skyrocketing federal debt is also a major factor in the coming economic collapse. The Federal Reserve facilitates deficit spending by monetizing debt. Congress should make real cuts, not just reductions in the “rate of growth,” in all areas. But it should prioritize cutting the billions spent on the military-industrial complex.

Some say that eliminating the welfare-warfare state and the fiat currency system that props it up will cause the people pain. The truth is the only people who will feel any long-term pain from returning to limited, constitutional government are the special interests that profit from the current system. A return to a true free-market economy will greatly improve the lives of the vast majority of Americans.

Ron Paul, MD, is a former three-time Republican candidate for U. S. President and Congressman from Texas.

This article is reprinted with permission from the Ron Paul Institute for Peace and Prosperity.

The Other Half of the Inflation Story: Credit Expansion Adds Noise to Price Signals – Article by Sanford Ikeda

The Other Half of the Inflation Story: Credit Expansion Adds Noise to Price Signals – Article by Sanford Ikeda

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Sanford Ikeda
May 7, 2015
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More money means higher prices. It’s too bad not everyone understands that connection. Even some economists don’t get it. Readers of the Freeman do, I’m sure. And they also understand why that’s a bad thing.

Increasing the supply of money and credit, other things equal, will cause a general rise in wages and prices across an economy. When the Federal Reserve, the central bank of the United States, excessively “prints money,” the result is “inflation” as it’s now commonly called. For those who get the new money after everyone else has spent theirs, inflation means incomes will now buy fewer goods, and every dollar lent before prices rose will be worth less when it’s returned.

If inflation continues, people will eventually learn to demand more for what they sell and lend in order to compensate for the purchasing power that inflation keeps eating away. That, in turn, will cause prices to rise faster, which makes planning for households and businesses even more difficult. In the past, that difficulty has led to hyperinflation and a breakdown of the entire economic system.

But as awful as all this may be, it’s really only half the story, and perhaps not even the worse half. What follows is a highly simplified story of what happens.

The structure of production

If you’d like to build a sturdy house, you’ll need to have some kind of blueprint or plan that will tell you two things:

  1. how the frame, floor, walls, roof, plumbing, and electrical system will all fit together; and
  2. the order in which to put these components together.

Even if the house was made entirely of identical stones, you would need to know how to fit them together to form the floor, walls, chimney, and other structural components. No two stones would serve exactly the same function in the overall plan.

The economy is like a house in the sense that each of its parts, which we might call “capital,” needs to mesh in a certain way if the eventual result will be order and not chaos. But there are two big differences between a house and an economy. The first is that the economy is not only much bigger, but it consists of a multitude of “houses” or private enterprises that have to fit together or coordinate, and so it’s an unimaginably more complex phenomenon than even the most elaborate house.

The second major difference is that a house is consciously constructed for a purpose, typically for someone to live in it. But an economic system is neither consciously designed by anyone nor intended to fulfill any particular purpose, other than perhaps to enable countless people with plans to do the best they can to achieve success. It’s a spontaneous order.

The way all the pieces of capital, from all the diverse people in the economy who own them, fit together is called the capital structure of production.

Credit expansion distorts the structure of production

When people decide to spend a certain portion of their incomes on consumption today, they are at the same time deciding to save some portion for consumption for the future. The amount that they save then gets lent out to borrowers and investors in the market for loanable funds. The rate of interest is the price of making those transactions across time. That is, when you decide to increase your saving, other things equal, the rate of interest (what some economists call the “natural rate of interest”) will fall. The falling interest rate makes borrowing more attractive to producers who invest today to produce more goods in the future.

That’s great, because when the market for loanable funds is operating freely without distortions, that means when people who saved today try to consume more in the future, there actually is more in the future for them to consume . Businesses today invested more at the lower rates precisely in order to have more to sell in the future when consumers want to buy more.

Now, if the Federal Reserve prints more money and that money goes into the loanable funds market, that will also increase the supply of loans and lower the interest rate and induce more borrowing and investment for future output. The difference here is that the supply of loans increases not because people are saving more now in order to consume more in the future, but only because of the credit expansion. That means that in the future, when businesses have more goods to sell, consumers won’t be able to buy them (because they didn’t save enough to do so) at prices that will cover all of the businesses’ costs. Prices will have to drop in order for markets to clear. Sellers suffer losses and workers lose their jobs.

And, oh yes, all that credit expansion also causes inflation.

While this process sounds rather involved, it’s still a highly simplified version of what has come to be known as the Austrian business cycle theory. (For a more advanced version, see here.) Of course, each instance in reality is significantly different from any other, but the narrative is essentially the same: credit expansion distorts the structure of production, and resources eventually become unemployed.

The explanation is more involved than the typical inflation-is-bad story that we’re more familiar with. Indeed, that probably explains why it’s the less-well-known half of the story. Even Milton Friedman and the monetarists pay little attention to the capital structure, choosing instead to focus on the problems of inflationary expectations.

Again, for Austrians, the problem arises when credit expansion artificially lowers interest rates and sets off an unsustainable “boom”; the solution is when the structure of production comes back into alignment with people’s actual preferences for consumption and saving, which is the “bust.” Most modern macroeconomists see it exactly the opposite way: the bust is the problem, and the boom is the solution.

An intricate, dynamic jigsaw puzzle

To close, I’d like to use an analogy I learned from Steve Horwitz (whom I heartily welcome back as a fellow columnist here at the Freeman).

The market economy is like a giant jigsaw puzzle in which each piece represents a unique unit of capital. When the system is allowed to operate without government intervention, the profit-and-loss motive tends to bring the pieces together in a complementary way to form a harmonious mosaic (although in a dynamic world, it couldn’t achieve perfection).

Credit expansion, then, is like someone coming along and making too many of some pieces and too few of others — and then, during the boom, trying to force them together, severely distorting the overall picture. During the bust, people realize they have to get rid of some pieces and try to discover where the others actually fit. That requires challenging adjustments and may take some time to accomplish. But if the government tries to “help” by stimulating the creation of more superfluous pieces, it will only confuse matters and make the process of adjustment take that much longer.

Inflation is bad enough. Unfortunately, it’s only half the story.

Sanford Ikeda is a professor of economics at Purchase College, SUNY, and the author of The Dynamics of the Mixed Economy: Toward a Theory of Interventionism.

This article was originally published by The Foundation for Economic Education.