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June 15, 2008

Our Lousy Monetary Policy and Economic Commentary
by Gerard Jackson

Some readers think I'm exaggerating the dismal state of economic debate in Australia. Alas, if that were only true. Last April The Australian referred to P. D. Johnson, aka Henry Thornton, as opining that current economic policy with respect to inflation could cause a recession. He went on to argue that we could be seeing the return of 'Goodhart's law'. (The Australian, Is he on the right track?, Graham Lloyd, 26 April 2008). Johnson defines this law as "Any statistical relationship that is relied upon will cause changes of behaviour that changes the relationship". (The Return of the Check List). This is really bad stuff.

But let us start with Charles Goodhart.Some years ago he addressed a conference at the London School of Economics at which he asserted that Japan provided evidence for the existence of the liquidity trap, a situation in which interest rates fall so low that demand does not react. If one adopts this view then one is only a short step from proposing that the solution to such a situation is the printing press. And that is exactly what Goodhart did. And right behind Goodhart there was Paul Krugman urging Japan's central bank to fuel inflationary expectations and reduce savings by flooding the economy with money.

Now this is the kind of monetary policy that got Japan into its present state in the first place. Not 'excess' savings and certainly not the mythical liquidity trap, to which I shall now turn. According to this fallacy when people come to believe that interest rates will rise and thus bond prices will fall liquidity preference (the demand for cash balances) becomes so intense the rate of interest cannot fall low enough to stimulate investment. Therefore, trying to stimulate the economy with low interest rates is like "pushing on a string." The only problem with this so-called analysis is that it is utterly and dangerously wrong.

The first thing about the Keynesian liquidity trap that should strike anyone conversant with Keynesian thinking is that it completely reverses the Keynesian explanation of what determines the interest rate. Keynes argued that it was determined by liquidity preference and the supply of money. But the liquidity trap clearly assumes that the demand to hold money is determined by the rate of interest, meaning that this demand should vary inversely with changes in the rate of interest. If this is so, what then determines the rate of interest? Sir Dennis Robertson, a far shrewder economist than either Goodhart or Krugman can ever hope to be, was keenly aware of this contradiction causing him to cleverly write:

Thus the [Keynesian] rate of interest is what it is because it is expected to become other than it is; if it is not expected to become other than it is, there is nothing left to tell us why it is what it is. The organ which secretes it has become amputated. And yet it somehow still exists a grin without a cat. (Cited in The Foundation of Modern Austrian Economics , Institute for Humane Studies, 1976, p. 189).

Moreover, the Keynesian explanation of interest should actually see interest rates peak during a depression and bottom out during a boom. Hence Japanese interest rates should have been very high and certainly not low as they are today. The truth is that the monetary explanation for interest is one of the oldest fallacies in economics. Twenty-four years before Keynes The General Theory of Employment, Interest and Money was published Professor von Mises called the monetary theory of interest one of "unsurpassable naivité." (Ludwig von Mises, The Theory of Money and Credit, The Foundation for Economic Education, Inc., 1971 p. 353).

As we have seen, the liquidity trap concept unconsciously abandons Keynes' interest theory in favour of an indeterminate and unknown force. Our conclusion, therefore, is that the liquidity trap is a Keynesian fiction. No wonder the likes of Allan Meltzer, professor of economics at Carnegie Mellon University argue that "No country has ever been in a liquidity trap'. But even from a pure monetary angle the liquidity trap does not really make sense because governments can print as much money as they like. As Charles Goodhart pointed, the central Banks can print as much money as they like. This fact was behind his proposal that the Bank of Japan should "buy everything in sight," including bonds, property, etc.

That the fictitious liquidity trap had to be conjured up as an alternative explanation because Keynesian pump priming failed is the kind of heretical thinking that this Keynesian cultist evidently cannot tolerate. This is probably why he ignores the contradiction that exists between liquidity-trap thinking and the ability of the central bank to flood the economy with money.

The claim that additional liquidity -- an expanding money supply -- money supply will lower rates and stimulate investment misses a number of vital facts, one of which is that there's no point in borrowing money if there is no prospect of an adequate return. Put another way, for the spigot to work interest rates must fall sufficiently below the anticipated rate of return. This is something that every economist should know. As Henry Thornton himself pointed out 206 years ago:

In order to ascertain how far the desire of obtaining loans at the bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances. This is to be judged of by considering two points: the amount, first of interest to be paid on the sum borrowed; and, secondly, of the mercantile or other gain to be obtained by the employment of the borrowed capital. The gain which can be acquired by the means of commerce is commonly the highest which can be had; and it also regulates, in a great measure, the rate in all other cases. We may, therefore, consider this question as turning principally on a comparison of the rate of interest taken at the bank with the current rate of mercantile profit. (Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, London: George Allen and Unwin, 1939, pp. 253-54)

Hence lending money out if you don't receive any reward demolishes the liquidity preference theory. Let us now turn to the 1930s for further illumination. Despite what Keynesians argue the 1930s are a tragic example of what happens when wage rates are maintained above their market clearing rates. Starting with July 1929=100 to June 1933 wholesale prices dropped by 38 per cent. It was no coincidence that money supply contracted by about 35 per cent. And no wonder considering the following account:

The number of bank failures in the single year 1931, on the other hand, was greater than the total for all the years from 1900 to 1929, and more banks failed in the single month of October, 1931, than in the two years 1920-1921. A very large part of the annihilation of bank credit after 1929 came about in this way. (C. A. Phillips, T. F. McManus, R. W. Nelson, Banking and the Business Cycle: A Study of the Great Depression in the United States, The Macmillan Company, 1937 pp. 168-9).

So severe was the monetary contraction that "all of the bank credit inflation of 1922 to 1929was wiped out in the short space of the three years following 1929". (Ibid. 168). However, the Hoover Administration fought against any cuts to money wages in the belief that maintaining them would restore prices and lift the economy out of depression. Statistics from the United States Bureau of Economic Analysis painted a stark picture of what this policy did to profits. In 1929 the two-way division between employees and corporations was 81.6 per cent and 18.4 per cent respectively. In 1933 employees share had rocketed to 99.4 per cent, payrolls fell from $32.3 billion to $16.7 billion and unemployment rose to a horrific 25 per cent.

I all of this might seem like a rather tedious detour, but it is meant to reveal how hollow much of what passes for economic commentary is today. This why Goodhart's law is dangerously misleading. It gives the impression that there is no port in which the monetary authorities can find a safe anchorage.

The principal reason for the lousy state of monetary management and economic commentary is due entirely to a failure of those paid to know better to comprehend the real nature of money, the true force behind inflation and the existence of a capital structure. In short, massive ignorance.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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