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March 29, 2009

Dark Clouds Hover Over US Economy
by Gerard Jackson

Any criticism of Obama's economic illiteracy -- no matter how accurate -- is in danger of being met with a storm of abuse from his cultist followers. Even Bill Clinton supporters weren't this bad: and I do speak from experience. But facts are facts and economic laws are what they are. Pointing to the Dow as evidence of Obama's success only reveals a complete ignorance of economics and economic history.

It is true that I said that I would not be surprised to see the Dow drop to 3000 -- and I still wouldn't. But my point was not that the Dow will collapse -- I never said it would -- or that a 1930s-type depression is on the way -- I have stated emphatically that this is not the case -- but that conditions are so erratic today that at this stage of the game it is not possible to really know whether we are seeing extreme fluctuations around an upward trend or a bear rally

Those who follow my articles on Brookesnews well know that my main focus has always been on the real economy and how it is influenced by monetary factors. Using stock market indexes as a guide to what is really happening in the economy is like trying to study marine life by observing the surface of the sea. This is why time and time again fortunes are lost and capital laid waste by recurring economic crises.

There were those in the 1920s who declared that there was now a "New Era" that had banished the business cycle fore ever more. The very same thing was more or less repeated in the 1990s. In each case the stock market was cited as evidence that the dreaded boom-bust-cycle was behind us. In each case the prophets of the "New Era" were confounded by economic reality otherwise called economic laws. We must focus on money because as Fritz Machlup wrote:

. . . monetary factors cause the [business] cycle but real phenomena constitute it, Essays on Hayek, Routledge, Kegan Paul 1977, p. 23).

When Bush implemented the capital gains tax I predicted that it would trigger a recovery. However, I also warned at the beginning of his first term that Greenspan's monetary policy was laying down the foundations for another recession. In 2004 I wrote that the US could expect "another recession in or around 2008". The Fed's policy was one of credit expansion by forcing interest rates down below their market clearing rates. The effect was to discoordinate the capital structure and create massive financial imbalances.

This always happens because money is not neutral with the result that the structure of relative prices is distorted in away that brings about unsustainable changes in the pattern of production that sooner or later must be terminated1. (The role that time plays in this process is of crucial importance). Now if this is correct then the crisis, as Machlup pointed out, should first emerge in the area of real factors (manufacturing). Well, this is exactly what we find. The Institute for Supply Management's latest release reported a contraction in "new orders, production, employment and inventories. Moreover, manufacturing has been contracting for 13 months and the rate of dismissals has accelerated. From January to February the ISM employment index fell from 29.9 to 26.1, a 12.7 per cent drop.

Now one must wonder about a rising stock market when manufacturing is still contracting and unemployment rising. The table below has production at 100 for 1929. Note that the Dow moved in tandem with changes in production. Also note that both of these moved in tandem with changes in M1. (Industrial production had bottomed out by late 1932 and began to recover in the February-March period 1933).

It was well known among pre-WWII students of the business cycle that when the production of raw materials and capital goods finally bottomed out an upswing would begin in these industries that would work its way down the production structure to the consumption stages. This movement (which was described by von Hayek in 1925) would be picked up by the stock market which would begin to rise. (F. A. Hayek, Money, Capital and Fluctuations: Early Essays, Routledge & Kegan Paul, 1984, p. 8). These firms would have found themselves with excess cash balances for which they then sought outlets. (Fritz Machlup, The Stock Market, Credit and Capital Formation, William Hodge and Company Limited, 1940, p. 246). Wesley C. Mitchell provided a vivid description of this process:

Among the ultimate effects of a period of hard times, then, are: a reduction in the prime and supplementary costs of manufacturing commodities and in the stocks of goods held by wholesale and retail merchants, a liquidation of business debts, low rates of interest, a banking position that favors an increase in loans, and an increasing demand among investors for corporate securities. Now all these conditions are conducive to a resumption of business activity, either because (like the settling of old accounts) they remove obstacles, or because (like the reduction of mercantile stocks) they promise a larger demand for wares, or because (like low interest and low manufacturing costs) they widen the margin of profit, or because (like the position of the banks and the attitude of investors) they facilitate the borrowing of capital. Fundamentally, the revivals of business must be ascribed to the processes that initiate these favorable conditions. (Wesley C. Mitchell, Business Cycles and Their Causes, Business Cycles: Part III, University of California Press, 1941, pp. 1-2. Chapter 4 contains a more detailed description of the recovery process).

Of course, back in the 1930s the Dow really did represent an industrial average. Today it is excessively skewed to financials with the result that the 'real economy' seems to be largely ignored, a situation made worse by the fallacy that consumption drives the economy even though it is in reality only about 33 per cent of total spending. This results in the ludicrous situation where "increased consumer spending for a second straight month in February" leads to the media -- and those who should know better -- asserting that this must be good for the economy, even as unemployment rises and manufacturing continues to decline.

That stimulating consumption in the current circumstances could cause manufacturing to contract further and shed more labour is a real possibility that is clearly not understood by the economic commentariat, including those who see themselves as free marketeers. (See F. A. Hayek, The Paradox of Savings in Profits, Interest and Investment, Augustus M. Kelley Publishers, 1975, pp. 255-263).

Since last August AMS2 has expanded by 20 per cent and the monetary base by 100 per cent. Therefore the Fed has spent about eight months expanding the money supply. It used to be the general rule that a significant turning point in the money supply would affect stock prices in the same quarter. This is certainly not the case today. Something is not right here. If the Geithner plan -- backed by the Fed -- of throwing buckets of money at that banks ignited the rally I cannot see how it as a harbinger of recovery and prosperity. (I'll deal with this issue next week).

While manufacturing remains depressed there can be no general recovery though it is true that a consumer boom could be triggered. Should this be the case the economic consequences will be most unpleasant. Now let us assume that the Fed's monetary policy is sufficient to jump start manufacturing, then the US is going to have surging inflation further down the road as the money supply drives up prices, not to mention driving down the dollar. In addition, we have Bernanke monetising the debt and buying masses of paper. This is one process that can only end in tears.

Let us be clear, the Dow rally is not squaring Obama's economic circle. His policy of big government is -- at best -- guaranteed to retard economic growth. The bigger the government the more resources it commands and the more resources it commands the fewer resources there are for capital accumulation. Even without the suffocating effects of increased regulation the increased demand for resources will in itself reduce the amount of entrepreneurial activities. And it is entrepreneurship that drives economic growth while savings fuel it. Obama's policy -- deliberate or not -- is one of severely curtailing both.

Obama and his fellow historical illiterates are making the same mistakes that Hoover and Roosevelt made. Thanks to their grotesque economic incompetence the US remained depressed throughout the 1930s, all because that arrogance pair paralysed the recovery process.

1. Leftist economists always refer to this phenomenon as market failure despite the fact that the real failure lies with central banks and their lousy economics

2. Austrian money supply definition:

Cash + demand deposits with commercial banks and thrift institutions + government deposits with banks and the central bank + demand deposit at foreign commercial banks and foreign official institutions + sweeps.

Monetary base: currency and coins held by individuals, firms, depository institutions and at the central bank.

Sweeps: Demand deposits that have been reclassified as savings deposits.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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