Bernanke Gets It Wrong

By: Gerard Jackson | Mon, May 5, 2008
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Since the 2000 election America's leftwing mainstream media has tried to pump out a stream of bad economic news. According to this mob of political bigots recessions only happen under Republican presidents, completely ignoring the easily researched fact that the 2000 recession began under President Clinton. Now that so many indicators have turned negative the media are having a collective orgasm.

Unfortunately the economic commentariat -- including Bernanke -- have not grasped the fact that every credit fuelled boom inevitably ends in recession, even though no one can really predict the actual timing of a recession one can look out for certain danger signals. In 1998 recession signals were flashing red for the US economy, even though consumer spending was telling a very different story. In fact, despite what orthodox economics preaches, consumer spending increased during the last recession. Let us therefore begin with the vital role that consumer spending is supposed to play in fuelling booms.

Consumer spending as an engine of economic growth is probably the greatest and most dangerous economic fallacy of the age. It ought to be patently obvious that one cannot consume what has not been produced. In other words, consumption follows production and is its raison dêtre. In turn, it is the existence of capital goods, i.e., machinery, factories, power stations, etc, that makes the vast production of consumer goods possible. The more capital goods we accumulate the greater the quantity, quality and range of consumer goods and services that can be produced at lower real prices.

It is axiomatic in economics that opportunity cost is the true cost of anything; meaning that what we sacrifice to obtain any object or goal is its true cost. If I choose a world trip to a car than the real cost of the trip is the car and its foregone services. It follows that whatever is consumed cannot be invested. Hence economic growth is foregone consumption, which is commonly called savings.

It was recently reported that for the first time since the depths of the Great Depression America's personal savings rate appeared to be in negative territory while real consumption increased. This leaves us with three possibilities:

1. Savings were understated.

2. Nothing was being put away for capital accumulation.

3. Personal debt levels must have been rising.

It has been argued that personal savings are understated because they exclude equity in housing and other liquid assets. Such assets, however, are not savings. To save is to expand future purchasing power by investing in capital goods. This is why much of what is invested in pension funds can be regards as genuine savings. Even taking pension funds into consideration, it was clear that personal savings had declined. This is countered with the so-called wealth effect, which holds that as Americans became wealthier they would spend more and more and this would keep recession at bay.

Whether people cease saving because they feel wealthier is neither here nor there. What matters in this respect is the source of the spending. There ought to be no doubt that the Fed's easy money policy considerably expanded credit, as it has also done throughout the Bush Presidency. It was this credit expansion that fuelled the boom and thus consumer spending by raising nominal incomes and funding the disturbing rise in household debt. Therefore, when the party comes to an end the US will sink into recession irrespective of consumer spending.

But why does the party always have to stop? Because nothing is for nothing. The last recession was created by the Fed's credit expansion that set loose economic forces that it does not even acknowledge, let alone control. By using credit to stimulate output it misdirected production by distorting interest rates -- and it is doing so again.

A lot of companies embarked on projects that market conditions did not justify because easy credit misled entrepreneurs into thinking that demand would underpin the investment. Unfortunately for them, the credit they were granted was not the same as actual savings. Why? When people save they indirectly shifts resources from the production of consumption goods to capital goods and it is this process that increases future output and not consumer spending.

On the other hand, reducing savings means directing more resources to current consumption, a process that lowers investment and future living standards. The logic of this reasoning leads to the conclusion that what the US economy needed was an increase in savings and not consumption. Instead, the country tried to invest more than it saved while simultaneously increasing consumption. This process aggravated the recession, despite the fallacious claims of Keynesians.

Companies used the credit to hire labour and buy goods and services. These expenditures translated into incomes which are spent on consumption. But as we have seen, the effect of raising the demand for consumer goods is to direct resources away from investment. This is why firms found their costs rising as they competed for resources against a rising demand for consumer goods. The result was a fall in profits, output and an increase in unemployment. (Even if the savings ratio had not fallen this phenomenon would still have arisen).

The above process explains why employment started to fall in manufacturing while still expanding in consumer or consumer related industries. This sectional employment fall, I believe, was one of the danger signals that nearly all economic commentators ignored. This Austrian explanation was given additional weight by the so-called 'mystery' of the country's capital utilisation. According to the current orthodoxy when the NAICU (non-accelerating inflation rate of capacity utilisation) exceeds 82 per cent inflation begins to rise. (NAICU is obviously a version of the discredited Phillips curve).

Observers were bothered because utilised capacity was only at 80 per cent even though unemployment had fallen to 4.3 per cent and expansion had continued unabated. One explanation is that a global downturn had subdued American capacity despite rising employment. But this cannot explain the general 'softness' that was beginning to afflict a number of American manufacturing industries in the 1998. Austrians, however, explained that the country was experiencing the consequences of misdirected production.

Another danger signal, and one greatly commented on at length, was the stock market boom. Excess credit is much like excess water, it must find an outlet. Every credit boom I know of eventually triggered a stock market boom that inevitably resulted in a speculative frenzy, sometimes causing stock prices to reach stratospheric levels, much like Wall Street in the late nineties.

Shares are titles to capital goods. It follows, according to economic theory, that the discounted anticipated earnings of those shares determine the value of the companies that issued them. Now does anyone still believe that the massive gains in stock prices were justified by future earnings? Or that price earning ratios of 32 were justified? Take, for example, Amazon whose shares traded at $US9 in May 1997; they reached $US320 in January 1999, a 3,455.6 per cent rise. Last month they were trading at about $US77.

It has to be emphasised that all economic activity is speculative. It cannot be otherwise in an uncertain world. But there is speculation and speculation. The latter is what we witnessed on Wall Street. This speculation was fuelled by the Fed's easy credit policies that generated a "quick-buck" mentality that knew it was playing musical chairs with very few chairs but lots of players. Large daily share turnovers in certain companies strongly suggested that speculators were aiming at short-term profits before the boom bust. That the Fed realised monetary expansion was responsible for the situation was admitted by Greenspan when he pointed to the effects of the "flood of liquidity" into the US economy.

When the necessary economic adjustments were finally made many people once again blamed a stock market crash for the recession. And once again they were wrong. In July 1929, about five months before the October crash, the US economy was already going into a depression: manufacturing was slowing down, output was falling, layoffs rising and capital utilisation was declining.

Bernanke is said to be an expert on the Great Depression and that it has shaped his thinking about the role of the Fed. Be that as it may, Bernanke's actions suggest that far from absorbing the lessons of the 1930s he has in fact hammered them into a Keynesian mould. And this is why we just got another rates cut.



Author: Gerard Jackson

Gerard Jackson

Gerard Jackson is Brookes economics editor.

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