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May 24, 2009

Obama's Economics Brains Trust is Still Getting it Wrong on the US Economy
by Gerard Jackson

What to start with this week? The destructive Waxman-Markey "Cap-and-Trade" bill, the one guaranteed to savage American living standards? Perhaps the Obama-Axelrod proposal to regulate away the boom-bust-cycle away? Why not Obama's decision to run the car industry and dictate to the banks? See my dilemma? There is so much that is ridiculous about Obamanomics that it really is difficult to know where to start. So I thought I would begin with Alfred Marshall, one of the Greats of British economics. He warned that

the only effective remedy for unemployment is a continuous adjustment of means to ends, in such way that credit can be based on the solid foundation of fairly accurate forecasts; and that reckless inflations of credit -- the chief cause of all economic malaise -- may be kept within narrower limits. (Alfred Marshall, Principles of Economics, Macmillan and Co., Limited, 8th edition, 1920, p. 710).

And then came along another Cambridge man by the name of Keynes whose teachings gave us "that reckless inflations of credit" that has brought the world and the US to the present sorry situation. And what do central bankers, influential economists and clueless politicians offer as a solution to our economic woes? More of the bloody same. Talk about never learning from experience.

In an apparent effort to assuage the public's justifiable fear of galloping inflation it was presented with the innocuous sounding term "positive inflation" which then gave way to the scientific sounding term "quantitive easing". Either way, they both boil down to the same thing: inflating out of a recession. Back in 2002 Bernanke praised governments for their willingness to print money to "generate higher spending and hence positive inflation". Bernanke, you see, believes that adherence to the gold standard aggravated the Great Depression. It eludes him -- as it does so many other commentators on this subject -- that it was not the gold standard but deviations from it that created the boom bust cycle. A moment's thought should have told them that a pure gold standard is incompatible with fractional reserve banking. In short, the monetary system was a quasi-gold standard.

Having decided on the cause and cure for depressions Bernanke happily swallowed the Phillips curve fallacy that more inflation means less unemployment and vice versa. It was the Austrians who pointed out that this only appeared to be the case because inflation lowered the cost of labour relative to the value of its marginal product. A time would come, they predicted, when inflation-induced distortions in the time structure of production would result in more inflation and rising unemployment. We now call this phenomenon stagflation. Unfortunately, as a committed Keynesian Bernanke is no more keen on seeking out historical evidence that contradicts his cherished fallacies than is Larry Summers, another of Obama's brilliant economic advisors.

By any measure there has been a massive increase in the money supply during the last 10 months or so and still unemployment continues to climb while the stock market stalls. What makes this disturbing is that manufacturing usually responds 6 to 9 months after changes in the money supply with share prices changing within 3 months. Given Bernanke's Keynesian thinking it is no wonder the Fed has been authorised to create $1.75 trillion worth of new money in order to buy Treasury bonds. This is sheer desperation. Part of the answer -- we are told -- lies with the banks accumulating excess reserves. That it might be due to a collapse in the demand for credit by business has apparently not occurred to these commentators. A good economist knows that

while there is always some rate of money interest which will check an eager borrower, there may be no rate of money interest in excess of zero which will stimulate an unwilling one. (D. H. Robertson, Banking Policy and the Price Level, Augustus M. Kelley, 1989, p. 81, first published 1926).

One of the problems business is facing is that the Obama administration is without a doubt the most anti-business administration since FDR, who was eventually forced by circumstances to change course and get rid of most of his destructive New Dealers. None of this appears to wash with Bernanke, Geithner, Summers and the rest of Obama's unofficial economics brains trust. And where is this getting us? Well they believe that their monetary policy will at some point inflate profits and that this will increase output and hence raise the demand for labour. It will also raise prices. Not to worry, though, these masters of the universe have also got a plan for that.

Like a seasoned yachtsman finely steering his vessel to his desired destination they too will steer the SS United States to its destination, much as the Captain Smith did with the Titanic. As soon as consumer prices begin to accelerate this will signal -- at least in their minds -- success, at which point it will be time lower the anchor on the money supply. Apart from the fact that they have made the dangerous assumption that consumer prices will not rise significantly until the output gap has been closed, they also seem to believe -- in total defiance of history -- that tightening the money supply again will not send the economy into reverse and once again raise the rate of unemployment.

To soak up all this excess purchasing power that they cheerfully created out of "thin air" they will engage in open market operations. This means going from buying masses of bonds to stimulate the economy to selling masses of bonds slow the economy. (And these blokes are called brilliant. I think their admirers need to get out more). By driving down bond prices they will in effect be driving up interest rates, which by this time should be rising anyway. Whether bond holders will in the face of rising inflation start selling before the Fed acts is something else altogether.

Only the Austrians have pinpointed the fundamental flaw in the Bernanke-Summers strategy. The CPI does not measure inflation. Even today the great majority of economists and economic historians believe that the stable price level that prevailed in US during the 1920s is proof that there was no inflation.

These people are tacitly assuming that the CPI is a reflection of capital goods prices and the prices of land. It is not. When we examine the facts we discover that the 1920s also had a real estate boom, courtesy of the Fed. In keeping with Austrian analysis we also find that the prices of capital goods did in fact rise. We are left with the ridiculous conclusion -- according to the orthodox approach -- that there was serious inflation in the higher stages of production but no inflation in the lower stages. And why is a stable price level considered desirable. Because it is falsely believed that falling prices will always depress business. But as the better economists have always known:

...in the same way a manufacturer, though he has to pay for raw material and wages would not check his production onaccount of a fall in prices, if the fall affected all things equally, and were not likely to go further. If the price which he got for his goods had fallen by a quarter, and the prices which he had to pay for labour and raw material had also fallen by a quarter, the trade would be as profitable to him as before the fall. Three sovereigns would now do the work of four, he would use fewer counters in measuring off his receipts against his outgoings; but his receipts would stand in the same relation to his outgoings as before. His net profits would be the same per centage of his total business. The counters by which they are reckoned would be less by one quarter, but they would purchase as much of the necessaries,, comforts and luxuries of life as they did before. ( Alfred Marshall, Economics of Industry C. J. Clay, M. A. & Son, 2nd edition, 1881, p. 156).

In other words, falling prices are not only not a symptom of inflation when they are productivity-induced but they are to be welcomed. What matters to the producer is not the level of prices but price margins. Robertson endorsed this view when he wrote:

Thus ... a policy aiming at ultimate stability of the general price-level seems to be neither the "most natural" nor the "most effective" policy for the monetary authority to adopt. (Ibid. p. 32).

It follows that using monetary policy to prevent a productivity-induced fall in prices is in itself a inflationary by the full extent to which it prevents what would otherwise be a free market reduction in prices brought on by improved means of production. This very same fact was argued by John E. Cairnes -- sometimes called "the last of the classical economists" -- who pointed out that a stable price lavel was a misleading indicator of inflation.

He had calculated that inflation generated by the Californian and Australian gold discoveries of 1848 and 1851 had in fact reduced the purchasing power gold by something like 20 per cent to 25 per cent. Cairnes was making the extremely important observation that an absence of rising prices does not mean an absence of inflation. (John E. Cairnes, Essays in Political Economy [1873], Augustus M. Kelley, 1965, pp. 76, 106-8, 357). Those in the 1930s with a far better grasp of economics and economic history observed:

...our present difficulties are viewed largely as the inevitable aftermath of the world's greatest experiment with a "managed currency" within the gold standard, and, incidentally, should provide interesting material for consideration by those advocates of a managed currency which lacks the saving checks of a gold standard to bring to light excesses of zeal and errors of judgment. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 56).

At the end of the day, Obama's economic advisors still don't get it. The result will not be a happy one for the US and the rest of the world.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.