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June 07, 2004

Let's Go Fly a Kite
by Sean Corrigan

'In my view, there still is an output gap and I think that it will continue to create some downward inflation pressure, which may be offset by other things, such as rising inflation expectations for example or by the fall of the dollar, or other factors.' ~ Governor 'Gutenberg' Bernanke, Q&A before the Investment Analysts' Society of Chicago.

'Plunkett used to say there was this difference between boys' kites and men's kites: that, with boys, the wind raised the kites; but, with men, the kites raised the wind' ~ Riddles and Jokes, 1859

In the fabled land of Aeranova, there was a palpable sense of anticipation in the air, an unwonted feeling of urgency as the citizens rushed to and fro in the cobbled streets of the capital.

The little port, nestling in its sheltered bay, also bustled with a throng of excited newcomers, as the curious, the credulous, and the cynical disembarked there, attracted - as men unfailingly are - to the hubbub of a Boom.

For, on Aeranova, you see, there had arisen a New Thing, a shift in men's thinking, a collective enthusiasm - even a mania - for the new endeavour of Otium production.

Tired of working long hours in the wheat fields, weary of sweating over forges and hammers in the factories, the Aeranovans had come to believe that ease and prosperity could be more directly had, by setting up an Otium industry.

True, you couldn't actually eat Otium, or clothe yourself in it, or use it to protect yourself from the elements and, No, it was hard to say just when the multitude of newly formed Otium enterprises themselves would begin to repay the efforts of those involved in their creation, but that was hardly to point.

Besides, if men only paid heed to the naysayers, the curmudgeons who cast a sceptical eye over all things new, in what primitive state would humanity have been left to languish, with all progress so derided?

No, the Aeranovans were a far more optimistic people than that. Whose forefathers were they who had moved to this land of Milk And Honey and whose had fought to throw off the garb of tradition and the robes of inherited privilege in which the Metropolis had sought to wrap them?

But, such self-regarding Jingoism aside, the key fact was that local bank of issue had become a fervent supporter of such risk-taking and had graciously accommodated the entrepreneurs involved by providing them with the means with which to carry on their undertakings in that industry of tomorrow, the Otium business.

Also, the stock jobbers and promoters had already moved in to help the common people buy and sell (but mostly buy) their own stakes in the business, so helping spread the participation in its expected bounty far beyond the circles of the favoured few.

As the rush intensified, more and more people quit their fields and closed their tool shops; more boarded up their mines and more abandoned their medical studies to join in the great leap forward, to be a part of building Aeranova's shining new Tomorrow.

All of this, it was noted in some quarters, had already had some obvious, indeed, some slightly worrying, consequences, in that Aeranova - once a land fabled for the fecundity of its soil and for the prolificacy of its citizens - had begun to make up the growing shortfall in items for everyday consumption by issuing notes to the foreigners, whose merchants and their agents were filling its quayside inns, as they came to sell the grain and fuel, the clothing and the machinery, formerly made in Aeranova itself.

For their part, the foreigners were happy, at first, to trade their hard-laboured goods for a share in the virtual goldmine which Otium production was bound to entail. And, if a sea captain or owner of a manufactory did want a little more immediate reward for his exchange, he only had to take the Aeranovans paper along to his own bank of issue back home, where he would be given the means to buy goods on his local market, forthwith!

However, there came a time when, some way through the construction of the vast, interlocking network of shops, factories and offices all devoted to the production, storage, marketing, sale and financing of - not to mention, to the speculation in - Otium, a sudden and unheralded collapse of confidence set in.

This shattering epiphany, came about when, having built all bar the top few courses of this pyramid of faith, the increasingly obviously disconnect between the seemingly endless resources being poured into Otium production and the scanty remuneration - present or prospective - accruing from it, set off a counter-reaction; a revulsion.

In truth, of course, this was all much more than a sudden gestalt, but it resulted when the bank of issue - which had been fostering a world of insupportable illusions - at last suffered its own failure of will and faltered in its provision of ever more credit.

Instantly, the higher costs pertaining thereto could no longer be borne by the large numbers of intrinsically unprofitable undertakings and the wave of easy money broke violently on the unyielding foreshore of hard physical scarcity.

Now, almost overnight, the same men who had eagerly fought to join in the game, quitting their jobs to work in it and mortgaging their property to buy shares in it, scrambled even more violently to be out.

In the ensuing panic, stock prices plunged, collateral values were slashed, net indebtedness rose alarmingly, and people were thrown out of work wholesale, as Otium companies everywhere either shrivelled alarmingly or folded completely.

All would have been calamity - though all also might have been salutary - if the bank of issue had not stepped in and diverted men's attention by offering more and more credit against the tangible goods they had, especially against their dwelling places.

Indeed, before long, where men had once left their fields fallow to join the Otium mania, they now returned to them, but only to level the ground and to lay foundations upon them so that ever more houses could be built there.

For, it was obvious, wasn't it, that the rapid rise in the price of houses which soon materialized proved they were in acute undersupply (though a few did stop to ponder if they were only in such a state of seemingly urgent scarcity when compared to the flood of new credit being made available specifically for their purchase)?

Of course, with fewer fields than ever before under the plough and with industrial plant being bulldozed to make way for suburban shantytowns of plaster and ply, the Aeranovans found they had even more need of foreign comestibles than ever before and so, for a while, their external debts mounted as sharply as ever.

This time, however, their foreign partners were much less willing creditors and though they still came to offer their wares on Aeranova's markets, they were keen to rid themselves of its currency as soon as possible thereafter, either swapping it for their own paper - in a similar manner, but to a much greater degree, than they did previously - or, a more novel development, spending it for tangible goods of their own, whether for use in production or for their own personal satisfaction.

As this went on, it became increasingly apparent that the only things being turned out globally in ever greater numbers were paper money and unbacked credit and that the overwhelming proportion of this was for destined for use in unproductive (and certainly for unreproductive) purposes.

In contradistinction to this universal outpouring, the Aeranovans were offering just as little of tangible value to their trading partners as before.

Moreover, whereas their taste for unearned consumption had not been diminished by this, or by the inconvenience that numbers of them were idle, now that the Otium business was in decline, the consumptive appetites of their commercial counterparts abroad had been similarly increased by the relative surfeit of monetary assets - whether Aeranovan or home-grown - they now possessed.

Prices everywhere of goods and services, not just financial assts and property, inevitably began to rise and with them came a growing murmur, a groundswell of discontent that the Aeranovan bank should continue no longer as it had, issuing essentially 'kited' cheques against its borrowers' homes and so driving this spiral of imbalance into a vortex of exhaustion.

But, no, replied the good bank governors - pausing for a moment from their Sisyphean task of printing off enough money to ensure a sufficiency of 'purchasing power' for all - there could be no worries if a few, scattered prices rose here and there.

Who worried if these were prices of those quintessentially volatile categories of food and fuel; or if they were to be 'hedonically' adjusted to make a new $500 suit with three buttons seem like the old $250 one with two; or if the typical shopping basket was 'chain-weighted' (stoically-adjusted, perhaps?) to reflect the fact that the new $500 suit was unavoidably left on the rack in favour of the more affordable (if also now dearer) $100 dungarees?

After all, the bankers pleaded, was there not an 'output gap', was there not evidence of slack in the economy?

Look at all the people still in need of work, they cried. Lo! Behold all the empty offices and half-idled factories. Were these not evidence of an excess of capacity whose gradual re-employment would prevent the higher prices from becoming a self-sustaining dynamic, even if the printing presses did continue to hum?

But, alas, it was already too late for such blandishments to indifference.

The ordinary Aeranovans had finally woken up to the fact that the same goods now took more money to buy and, worse, that they might soon cost even more in the near future, so their purchase had better not be deferred any longer than was necessary.

The Aeranovans also began to notice that they could not get goods on such easy terms from abroad as formerly, whether by dint of the fact their currency was not so readily accepted, or because their creditworthiness was deemed to have fallen, so increasing the discount rate applied to their assets.

Never fear, the government assured them. If you can't buy it abroad, look at all those people eager for work here at home. Look at all the factories ready to put on an extra shift, or to bring some plant out of mothballs.

Just keep asking for goods at the stores, came the exhortation, and the orders will soon go out to our domestic businessmen and, before you know it, we'll soon be back to full employment - a goal surely worth the minor irritation of modestly higher prices, wouldn't you say?

Sadly, however, when the orders did pass up the chain, what the Aeranovans found was that many of the idle workers only knew how to make unwanted Otium and so could neither guide a plough, nor operate a lathe.

What looked like a spare 'pool of labour' was, it transpired, now unskilled - perhaps, 'de-skilled' would be more apposite - in the tasks required of its members; members who were thus reluctant to re-enter the workforce at the lower wages and reduced seniority to which their lack of experience (and lesser marginal value) condemned them.

Even more of a hindrance, was the discovery that much of the 'idle capacity' upon which the authorities had predicated their 'patient' attitude to monetary 'accommodation' was underutilized for one reason and one reason alone - it was capacity mistakenly put in place during the Otium boom, very little of which could be redeployed to mine the ores and cast the steel, to drill the wells and refine the oils, which a clamouring populace needed to more closely meet its own needs.

Thus, a series of rude awakenings were to end the pleasant reveries back into which Aeranovans had been lulled after the earlier dreams of Otium had ended in their own, sudorific nightmare.

Firstly, they had realized that ever higher prices - and its corollary, an ever lower value of their money - was a very real prospect and, acting to counter this, they could only intensified its progression.

Secondly, their foreign suppliers, too, had sought to protect their interests by charging more for their goods, or by selling the Aeranovan dollar more readily on the exchanges.

In addition, many of these suppliers were waking up to the fact that even their own domestic money was no longer commanding as many real resources as it did, so they were beginning to mimic the Aeranovans' response to the fall in its value.

Thirdly, when the Aeranovans sought to meet their needs internally, they found that the rusting legacy of the previous Boom was an overhang of plant, equipment and personnel which was predominantly, if not wholly, incompatible with the aim of meeting this challenge.

They learned that pyramids do not make petrochemicals; that residential real estate cannot be brought to produce rubber or rice; that fibre-optics are poor substitutes for either food crops or fuel cells: in summary, they saw that much of what was deemed to be 'slack' - where not simply wilfully being withheld from the market because its selling price was too low for its previously miscalculating and now self-spiting owners' taste - was in fact capital frozen uselessly into wholly redundant and largely unsalvageable forms.

What the Aeranovans were confronted with was the reality that check-kiting - extending credit against promises of future payment unrelated to the prior existence of saleable products or of income-generating property - is the route to ruin, not riches.

What the Aeranovan central bank was forcibly taught was that the only 'output gaps' which matter are the ones between its governors' specious pronouncements and their genuine intellectual content and between the pernicious effects of the bank's output of unbacked monetary substitutes and the beneficent credit which arises from its citizens' suspension of the right of use and the temporary transfer of property to one another through means of voluntary saving.

Sadly, for us all, this is not a fable - merely a retelling of what we have all been living through these past few years.

As prices continue to rise and as new anxieties replace the phantasms of deflation with which the Fed has for long sought to frighten us children into a cowering quiescence, think about the Aeranovans and realize the following essential Austrian truths.

Only Keynes and his fellow travellers have ever believed that they could make bread from stones simply by printing more money; that by running the printing presses there would be jobs for all, chickens in every pot and Hummers in every drive.

No. Entrepreneurialism, rooted in genuine savings, is what builds economies - foolish economics and even more foolish politics are what contracts them.

For all that it would be comforting to think it, we cannot 'will' ourselves to riches for, 'If wishes were horses, then beggars might ride'. Neither is mere technological ability, nor scientific advancement, a sufficient - perhaps, not even at first a necessary - condition. Instead, there must be foundations of thrift, sound money, personal liberty and inviolate property rights to give us the soil to till and also the plough with which to turn it, not to mention the incentive to try.

The Fed's failing is that it can only influence economic outcomes in the short run by fraudulently subverting all four of these and thereby it is damned to a series of overlapping failures.

But all is not gloom and doom, for Mankind's salvation from this Collectivist evil lies in the fact that every one of the six billion-odd of us who does not work for the State is a potential entrepreneur and neither he, nor those of us who work for him, can long provide a livelihood for our own families without making the material aspect of the lives of our fellows marginally better as we do.

Sean Corrigan
Capital Insight

Sean Corrigan is a principal of www.capital-insight.com, and a co-manager of  the Bermuda-based Edelweiss Fund.

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CAPITAL INSIGHT performs top-down analysis, wedded to an understanding of market action founded during long experience on the trading floor.

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