Why the US Economy is Facing a Very Unhappy New Year?
Since US business investment peaked in 2008 it has dropped by 20 per cent. Not to worry though. According to Professor Blinder -- an eminent Princeton economist -- the situation will reverse itself because "plants and equipment wear out". This is an incredible statement for professor of economics to make. It assumes an automatic process that replaces capital once it is consumed. But capital replacement requires a human decision based on the availability of savings and favourable expectations about the future.
If there are no savings then net investment is not only impossible but a process of capital consumption must clearly prevail. If savings are available but the prospect of future profits are considered zero then additional investment will not be undertaken. This too results in a process of capital consumption. And this is exactly what happened during the 1930s, as evidenced by the fact that the amount of metal working machinery more than 10 years old rose from 48 per cent in 1930 to 70 per cent in 1940, a 45.8 per cent increase. Why? Because Roosevelt's economic policies favoured consumption and government spending and regulations over economic growth with the result that the production structure actually shrank even though GDP rose.
Professor Higgs calculated that from 1930 to 1940 net private investment was minus $3.1 billion. (Robert Higgs, Depression, War, and Cold War, The Independent Institute, 2006, p. 7). W. Arthur Lewis calculated that from 1929 to 38 net capital formation plunged by minus 15.2 per cent (W. Arthur Lewis, Economic Survey 1919-1939, Unwin University Books, 1970, p. 205). Benjamin M. Anderson estimated that in 1939 there was more than 50 per cent slack in the economy. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, pp. 479-48). This is what some contemporaries had to say about Roosevelt's economic policies:
...the present Administration has shown but scant inclination to profit in any way from the errors of its predecessors. By consuming more than we have produced we have succeeded only in digging our way deeper into depression; we have tried to recover from depression by spending our way out of it rather than adopting the alternative procedure, -- the one which has effected recovery from every past depression, -- of saving our way out of it. By the policy of maintaining consumer purchasing power we have had to draw upon our store of past savings, and by so doing we have not only failed to keep up our accustomed rate of capital formation but have actually destroyed past accumulations by neglecting to provide for maintenance, depreciation, and obsolescence. C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, pp. 165-166).
Any suggestion that capital depreciation automatically brings forth additional investment is easily refuted by history and sound economic theory. Investment is usually defined as fixed capital, inventory stocking and residential building. The problem with the last component is that houses are consumption goods* and by definition add noting to the productivity of labour because they are at the lowest stage of production.
This leaves us with inventory and plant and equipment. Because inventory has dived it is argued that firms must start restocking to meet increased sales and that this will raise the demand for labour. Apart from the fact that a significant increase in sales appears to be a tad optimistic at this stage, it is very poor economics to assume that a restocking of inventory must lead to an increase in fixed investment, particularly when we consider the amount of idle capacity.
The rapid increase in productivity is the economic Pollyannas' next line of defence, according to which labour slack has been eliminated which means that any increase in output can only come from increased employment. Not necessarily: It can come from increased overtime plus a reduction is short-term working and the conversion of part-time workers to full-time employees. Moreover, increased productivity can be used to keep rising labour costs at bay without having to hire more labour, a strategy that Obama's proposed health reforms and taxes would encourage.
In any case, where is the increased demand supposed to come from? Keynesianism preaches that recessions are caused by demand deficiency. Basically, all the central bank needs to do is lower interest rates. This will inflate the money supply and raise the demand for labour by reducing real wages relative to the value of the workers' marginal product. In other words, the problem of unemployment is to be overcome by using inflation to cut real wages. As Keynes candidly put it:
Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods [consumption goods] (The General Theory, Macmillan-St. Martin's Press, 1973, p. 9.)
Right now there are no signs that this process is taking place. On the contrary, despite the massive increase in the monetary base bank loans to business are still falling along with consumer loans while manufacturing is still in a highly anaemic state. On top of this the government's relentless and unprecedented peace-time spending and borrowing binge threatens long term investment. Observers like Hans Blommestein, head of public debt management at the Organization for Economic Cooperation and Development, are warning that government debt threaten to raise interest rates. Of course, it's possible that this reckless financial behaviour might not raise interest rates at all. But that situation could only eventuate if the demand for business loans was crushed. Something similar happened in the 1930s.
The recent surge in the Fed's balance sheet suggests that Bernanke and his crew might be trying to give the economy another monetary shot in the arm, even though wholesale prices jumped 1.8 per cent in November, an annual rate of 6.3 per cent over the previous three months. This would appear to support the pessimists' prediction that Bernanke's monetary policy would trigger inflation. This would certainly be so if we focussed on the monetary base alone.
However, using the Austrian approach -- a somewhat narrow one according to many critics -- we find that the money supply peaked last June. If this is so, we should therefore expect the trade deficit to narrow significantly, which is exactly what happened. It was reported earlier this month that the "US trade deficit with the rest of the world dropped unexpectedly in October, by 7.6 percent". (Italics added.) Now if this definition of the money supply holds and monetary expansion slows considerably or contracts -- as indicated by the figures -- then the economy could be paradoxically heading for a monetary crunch.
All in all, future prospects are pretty grim at the moment, which brings me to the share market. It seems to me that given the present state of the US economy a sustained increase in share prices could only be driven by a monetary expansion.
*Capital goods are future goods. This means they are intermediate that goods that are eventually transformed into consumer goods. Put another way, the services of consumer goods are directly consumed while the services of capital goods serve consumers indirectly. According to this definition durability does not define capital goods but the position in the capital structure does.
What is more, the good must be reproducible, i.e., land is not capital. Oddly enough Hayek considers houses to be capital goods "so far as they are non-permanent". Additionally, "we have to replace them by something if we want to keep our income stream at a given level..." (The Pure Theory of Capital, The University of Chicago Press, 1975, pp. 77-78).
But the same thing can be said of cars, televisions, books, furniture. In fact, just about any household appliance. Huerta De Soto adapts the same approach as Hayek with respect to durability as a definition of a capital good:
Fourth, durable consumer goods satisfy human needs over a very prolonged period of time. Therefore they simultaneously form a part of several stages at once: the final stage of consumption and various preceding stages, according to their duration. (Money, Banking and Credit Cycles, Ludwig von Mises Institute 2002, p. 300)