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March 16, 2008

A Monetary Storm Hits US Economy
by Gerard Jackson

The current monetary crisis has brought forth an avalanche of opinions on what President Bush and the Fed need to do to arrest the dollar's decline and prevent a recession. But what really needs to be done? The quarterly Anderson Forecast by the University of California at Los Angeles is betting that there will not be a recession, though there will be a significant downturn in the rate of growth. Of course, there is the usual caveat that if consumers reduce their purchases of big-ticket items this could bring on a recession.

It has yet to sink in that consumption does not drive an economy but business spending does. (Standing Keynesian GDP on its head: Saving not consumption as the main source of spending). What one needs to do is examine aggregate business spending. And this means spending on intermediate goods, i.e., inter-firm expenditures. This type of spending is a key economic indicator that very few forecasters use. We've got the same problem with mortgages. Bernanke is urging the banking system to write down millions on housing loans in the hope that this would raise equity for borrowers and avoid foreclosures. Behind this 'policy' there lurks our old friend the consumption fallacy.

Legions of economic commentators are giving dire warnings that a combination of jump in foreclosures and drop in inequity will depress consumer spending and hence drive the country into recession. If we apply the Austrian approach, however, we find that aggregate spending is actually about $28-$30 trillion, against which expenditure on housing is a tiny per centage. Once again our economic pundits -- along with media commentators -- have gotten hold of the wrong end of the economy.

Bernanke's Keynesian response to the monetary crisis he helped create is to make it worse. By slashing the funds rate he fuelled inflation and put even more downward pressure on the dollar. Just to show that he means business the Fed is making $200 billion in Treasury securities available to the banks and Wall Street investment houses. I take this as an assurance by Bernanke that he will pump as many dollars into the economy as is necessary -- in his opinion -- to avert a credit collapse and a recession, proving once and for all that he never learnt a thing from studying the great depression.

Having taken the 'necessary' monetary measures the Fed still makes the risible claim that it's targeting price stability. The lesson that Bernanke should have learnt from the great depression is that trying to stabilize prices is not only futile it destabilizes the economy and generates the boom-bust cycle.

I have warned on and off for sometime that loose monetary policies eventually bring on a credit crisis if left to run their course. They also have the effect of driving down the currency. What is being called "the dollar crisis" is really a monetary crisis that few people understand. The effect of cutting the funds rate has been to accelerate the dollar's decline. This signals that the markets are anticipating that Bernanke's monetary policy will aggravate inflation.

Whenever a currency crisis strikes the cry for a "strong currency" from some quarter or other always arises, usually accompanied by the assertion that a "strong currency is in the national interest" and that it should "reflect economic fundamentals". What is really in the national interest is a sound monetary policy. Get that right and you will get your so-called fundamentals right. These people have not grasped that if a central bank sets an inflationary course "economic fundamentals" cannot stop it. Rather than face that fact some commentators would sooner blame the regime of floating exchange rates. That monetary policy is the reason why rates are dramatically changing against each other is one thought that always eludes them.

It's an odd thing but even those commentators who are supposed to be economically literate invariably write as if economic laws have nothing whatever to say about exchange rates. Yet one economic theory states that rates are supposed to ultimately reflect purchasing power and not the so-called wealth of a country. Professor Ludwig von Mises once recalled how in 1919 a banker had told him that the Polish mark should never have dropped to 5 francs

Poland is a rich country. It has a profitable agricultural economy, forests, coal, petroleum. So the rate of exchange should be considerably higher. (On the Manipulation of Money and Credit, Free Market Books, 1978, p. 20. The article was first published in 1923).

Mises stressed that the value of a country's currency is determined by the supply of and the demand for money so that "even the richest country can have a bad currency and the poorest country a good one". (Ibid. p. 21). In other words, monetary expansion is the fundamental cause of a falling exchange rate and not speculation or some mysterious link with another currency. From this we conclude that the basis of a "strong currency" is a sound understanding of the nature and power of money.

A reader emailed me to say that a country with a weak-currency cannot have a healthy economy. The point is that a weak currency is a symptom and not a cause. And even some of those who recognise this fact still do not grasp just how dangerous loose monetary policies are. Capital accumulation is economic growth. And savings are the source of capital. But inflation can severely damage capital accumulation, not just by creating distortions in the production structure but by also eating away at savings.

Capital gains are profits. It is these profits that entrepreneurs plough back into their businesses. Capital gains taxes are not indexed for inflation. This means that the current rate of inflation has greatly increased the effective tax rate on capital gains and hence capital accumulation. And what is the response of the Democrats? A proposal that would inflict on Americans the biggest tax hike in their history.

Bismarck is reported to have said: "God looks after fools, drunkards and the United States of America". The world had better hope that he got it right.

*Heilperin disputed the theory that exchange rates are ultimately determined by relative purchasing power. (Michael A. Heilperin, International Monetary Economics, Longmans, Green and Company, 1939, ch. VII). However, I believe that Wu successfully dealt with the problem of relative purchasing power and the price level. (Chi-Yuen Wu, An Outline of International Price Theories, George Routledge & Sons LTD, 1939, pp. 250-254).

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2008 Gerard Jackson

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