As lackluster results from rather experimental central bank policies continue to emerge, it’s time to readdress the seemingly endless nature of the perpetual-motion machine known as central bank stimulus — to stop and be still for moment and question whether the endlessly spinning wheels should be spinning at all, to question whether the maze is leading us back to the beginning. It’s often difficult to do — to question a lifetime’s worth of custom — but it’s so very important, as even the most advanced civilizations have drifted off course at some point in history.
A brief look at the charts below can give us a sense of the misalignment that is occurring:
- The experimental monetary policies (Large Scale Asset Purchases / Quantitative Easing) that have been used to expand the monetary base have not met the goal of dramatically affecting the money supply.
- A misallocation of capital has occurred shifting assets away from the broader economy, and toward a portion of the economy — tradable securities. Since the 1980s, the prices of many tradable securities, including stocks, have seen a significant rise, yet the economy as a whole has been unable to reach previously-attainable levels of growth.
And although the results can be damaging (to be addressed in this multi-part series), the outcome should not be surprising:
When faced with near-zero interest rates, it’s not surprising if banks decide against pursing their low-return commercial banking side, and instead favor leveraged asset speculation via their proprietary trading desks. If the trade-off from low-risk/guaranteed-low-return to high-risk/potential-for-return takes place, it may actually deprive the economy of funds while banks temporarily improve earnings through risk-taking — a point that would be consistent with Robert Hall’s comment at the Jackson Hole Monetary Conference in 2013: “An expansion of reserves contracts the economy”. And in a similar fashion, when savings rates are near-zero, there may be an irresistible temptation for companies and investors to take on unsustainable, speculative, investment risk (in an attempt to try to meet performance and savings goals).
Questions then arise: Why is this form of economics being pursued? Are there other options available? Is economics and central bank policy worthless?
A Starting Point
Although economics is typically addressed without a qualifier to distinguish one version from another, it may be worthwhile to begin the custom as there are many schools of economics — each with strongly opposing views of the world. And if there are many schools of economics (see the video Economics is for Everyone), why should we assume that the choice made by many of the world’s economies — which is to eschew all but one version — is the proper decision? Given that the world is constantly changing, and that each version of economics has its own built in assumptions, it may be naïve to assume that economics in its existing state has reached peak perfection; and based on the charts above, the current form of economics may not even be desirable.
The Questionable State — and Abusive Use — of Economics
A necessary and constant desire to explore alternative viewpoints — as a way to broaden the scope of understanding — has brought me to Henry Hazlitt’s Economics in One Lesson. It aligns with the important recognition that an idea, profession, concept, axiom, or story, should not be seen as a static topic to be memorized and repeated, but as one to be challenged in a constantly evolving process of reeducation, to merge established ideas with novel ones; it should constantly be influenced, adjusted, and questioned. Only then, is the fallibility of any one particular idea realized — its transitory nature recognized.
And this brings us to our current economic environment, where one predominant ethos has been perpetuated, saturating the economic landscape — arguably because its benefits are lucid and ramifications clandestine. That idea is a bizarre version of keynesian economics — not even in its originally intended form — a version that pursues debt-based spending to temporarily boost growth, a version that disregards the quality of debt being taken on and the long-term affects on all other parties; this is the version of economics used by central banks and governments throughout the world. It’s a stagnant policy that has favored the short term over the long term, while creating an illusory environment based on inflation, the results of which are a misallocation of wealth, and social disruptions.
In moving away from the study of classical economics — which also suffers its own drawbacks, showing a certain callousness toward the groups immediately hurt by its attempt to focus on the long term — modern economic policies have reversed course so drastically that they have merely unbalanced the ship to the other side.
“There are men regarded today as brilliant economists, who deprecate saving and recommend squandering on a national scale as the way of economic salvation; and when anyone points to what the consequences of these policies will be in the long run, they reply flippantly, as might the prodigal son of a warning father: ‘In the long run we are all dead.’ And such shallow wisecracks pass as devastating epigrams and the ripest wisdom.
But the tragedy is that, on the contrary, we are already suffering the long-run consequences of the policies of the remote or recent past. Today is already the tomorrow which the bad economist yesterday urged us to ignore. The long-run consequences of some economic policies may become evident in a few months. Others may not become evident for several years. Still others may not become evident for decades. But in every case those long-run consequences are contained in the policy as surely as the hen was in the egg, the flower in the seed.
From this aspect, therefore, the whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence. The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”
– Henry Hazlitt (H.H.)
And the oversight suggested in the last line is the reason that economics and central bank policy are becoming questionable endeavors — not because they are worthless but because they have been abused. The immediate effects of a policy are visible, the affects on one (or a few) particular groups are seen, yet the implications for all remaining groups are overlooked; the chain of events that is set into motion — each causing its own further effects — is forgotten.
“Economics is haunted by more fallacies than any other study known to man. This is no accident. The inherent difficulties of the subject would be great enough in any case, but they are multiplied a thousandfold by a factor that is insignificant in, say, physics, mathematics or medicine — the special pleading of selfish interests. While every group has certain economic interests identical with those of all groups, every group has also, as we shall see, interests antagonistic to those of all other groups. While certain public policies would in the long run benefit everybody, other policies would benefit one group only at the expense of all other groups. The group that would benefit by such policies, having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case. And it will finally either convince the general public that its case is sound, or so befuddle it that clear thinking on the subject becomes next to impossible.” – H.H.
One may stop to ponder on why the immediate is preferred to the future (An innate survival instinct? Merely due to a lack-of-awareness of consequence?), but one point is clear and immovable in our current environment: it is easier to choose the “here and now”.
The Fallacy of Deficit Spending
The fallacy in the concept that a country can borrow money to boost growth (i.e. deficit spending) in an economic downturn is that it assumes that politicians will counter the process in the recovery period to actually slow growth down.
When an individual takes a loan they are able to boost their current spending, yet at the same time they’re also reducing their future spending (future payments toward the loan are reducing their income and ability to spend at that time). Just as an individual can only spend from income, a country can only spend from taxes, so a country that uses deficit spending to boost the economy during a downturn will be forced to slow the economy while the loan is being paid back through increased taxes.
Deficit spending is easy to agree to, but its other side is so very difficult to complete — especially when it’s likely that a different politician will be the one that will need to complete the process. Although it’s possible, what politician would campaign to slow the growth of the country? — yet that’s what is necessitated by deficit spending.
Although deficit spending can be used to boost growth in a deflationary / recessionary / depression-type environment, by doing so the country is pulling growth forward — borrowing from future taxes — and if it occurs over a long enough period of time, the taxes will be placed on a different generation; this is the concept of “generational warfare” — the consequences of a spendthrift generation are passed to another.
The Continuous and Immediate Democracy of the Price System
So often the devastating social and economic events of our past have occurred due to a misplaced desire to “fix” a problem. For an illustration of the mechanism just look to the disastrous implications of forest fire suppression (also addressed by author and hedge fund manager Mark Spitznagel) — an attempt to prevent damage to ecosystems by only allowing small fires to occur has allowed more kindling to be built up to stoke even larger more disastrous fires.
In a similar fashion, current economic policies have — in an attempt to “fix” a problem — moved the economy away from the continuous and immediate democracy of the price system; a system that can be thought of as a constantly adjusting balance. Every minute, of every hour, of every day individuals are voting on whether more or less of a product should be produced. Every time they purchase an item they encourage its continued production at the expense of another item, and every time they decide not to buy they discourage its production, to the encouragement of another. If more individuals want a particular item, it is difficult to keep it in stock, and the retailer is pushed to move the price up (if they don’t then they will underperform the competition who will move the price up). But the price moves up because the majority of individuals agree that it should be higher; they desire the product more, which draws individuals into the industry (seeking profits) and increases production to meet demand. By voting the price higher they are signaling desirability; when the price moves up, the profits of the company selling the product move up, more individuals enter the industry to follow profit potential, and the price then moves down when more have entered the industry than are necessary to meet demand. It’s a cycle of adjustment based on the continuous and immediate voting of the individual — the voter decides whether the price is reasonable.
The shrinking or expansion of an industry depends on the desires of the majority. If more people think that industry’s product or service is reasonable, the price transitions up, encouraging individuals to leave less desirable industries behind to pursue the industry with more profits — accommodating the desire of the majority. If more people think the price is unreasonable, they refuse to buy, the price transitions down, and the industry shrinks as individuals move to pursue other industries that the majority does desire.
So, in this fashion, the decisions of individuals — on a moment-to-moment basis — cause the change in prices and production. If more people desire computers rather than typewriters, the price of typewriters falls until it reaches the point where they are desirable again, and the typewriter industry is forced to lower prices based on the desire of the majority — the industry shrinks based on the majority’s preference for other items and services.
The continuous and immediate democracy of the price system is what calls into question the results of artificial adjustment schemes — those results being that any adjustment to this voting system would, in effect, benefit a small group of individuals at the expense of the larger group; yet this is the nature of the adjustment schemes championed by all sorts of different groups and governments. The adjustments pursued include “parity” pricing, tariffs, “stabilizing” commodities, and price “fixing”, among many others; their commonality is that they disrupt the democratic price system, allow a smaller group to inhibit the desires of the larger group, and are still being used.
Leaving a much lengthier discussion to other sources, a few examples may be of use here. Of the many examples of adjustment (or manipulation) previously listed, one would be the attempt to keep a price level artificially high. In an attempt to save a dying industry the price for the product is held above the price voted on by the majority. In this case the industry benefits (a minority of the population) at the expense of the majority who now have to pay more than they would otherwise deem reasonable. The money above what they were willing to pay will now flow toward the “adjusted” industry and away from a different, more desirable one. The effect of this attempt to manipulate the democratic price system is a temporary (short-term) benefit to the supported industry (the small group) at the expense of the larger group; yet since the majority is negatively affected, and the smaller group is not isolated (they are also dependent on others), the smaller group will eventually be negatively affected as well as the cycle continues. This is, in essence, the wildfire suppression scenario — prevent fires (prevent the death of an undesirable industry) only to have to deal with larger fires (the majority is negatively affected and in turn negatively affects the smaller group). The significance is that the manipulation of the equilibrium moves the majority to a lesser-desired state, encouraging a waste of raw materials and a squandering of time, both of which are used up on industries that are not as desirable as others — a misallocation of capital and an aggregate hindrance to the economy.
Technological Progress: Cessation of Industries = Progress for Others
Unfortunately, due to the custom of “specialization” (a person typically works in one industry), the individual effects of technological progress and invention can often be disastrous for some (those working in the industry with reduced demand), even though the change provides an aggregate benefit to the majority. By its very nature that reduced demand for the failing industry is due to a demand for other more-desirable items. This is not a new process. It has occurred throughout history. The mechanical revolution displaced so many that people that some thought work would become obsolete. The same progress has continued to occur: the dwindling of the typewriter industry due to the boom of the computer industry and the loss of cashiers to automation, among many, many others. But there are other jobs created that are not so easily recognized; the machines created to replace cashiers have also created jobs — designers, manufacturers, etc. Labor moves to the desirable industries and creates new ones. Technological advancement can even create demand in an industry if it reduces the price of the item to the point where individuals want more.
The cessation of undesirable industries results in progress for desirable ones; the outcome is a social benefit to the majority and an unfortunate, temporary, expense for a smaller group. The best solution isn’t to prevent progress, but to allow for mobility between industries — to ease the transition, to encourage movement to existing in-demand industries and to those new industries yet to be created.
Unless everyone’s desires are completely satisfied there is still progress to be made. It’s when individuals are freed from undesirable industries that their faculties are applied to the desires of the majority. The worse outcome is for groups and governments to manipulate and encourage undesirable industries to use up finite raw materials and time when the actual demand of the majority lies elsewhere.
“If it were indeed true that the introduction of labor-saving machinery is a cause of constantly mounting unemployment and misery, the logical conclusions to be drawn would be revolutionary, not only in the technical field but for our whole concept of civilization. Not only should we have to regard all further technical progress as a calamity; we should have to regard all past technical progress with equal horror…
…It follows that it is just as essential for the health of a dynamic economy that dying industries should be allowed to die as that growing industries should be allowed to grow. For the dying industries absorb labor and capital that should be released for the growing industries.” – H.H.
Returning to the topic of economic policy, one can see the wildfire suppression scenario occurring once again. The attempt to pull growth forward by reducing interest rates (and using experimental policies, i.e. large-scale asset purchases) is effectively encouraging short-term benefits (fire suppression) at the expense of long-term benefits (a worse outcome, larger fires). One could argue that the market crises and stock manias of the 21st century have been more severe because risk (kindling) has been allowed to build.
Since the 1980s the Fed has been encouraging debt-based spending to attempt to counter slowing economic growth — they influence interest rates lower (you get paid less interest in your bank account), and by doing so they’re attempting to make debt more attractive due to it being more “affordable” (individuals pay less in interest when they take on debt); individuals may then borrow more and spend more to boost economic growth.
However there is a “catch”: although more debt and more economic growth may occur temporarily due to the reduction of the interest rate target, the productiveness-of-the-debt determines the long-run outcome. If the debt is productive — i.e. creates an income stream to repay the principal (original amount borrowed) and the interest on the debt — then long-run growth may not flag due to the debt; yet if the debt is unproductive and/or counter-productive then economic growth is constrained in the long run. One of the most important measures of the productiveness-of-debt is the velocity of money.
The more serious implications of economic policy, however, are for the broad economy and country (the stock market is only a portion of the economy). A misallocation of capital and investment, due to economic policy, slows growth and results in zombie industries kept alive by the continued attempt to manipulate the democratic price system; it creates an undesirable imbalance — a temporary benefit to a small group at the expense of a larger group, which in turn inhibits growth.
After addressing the dire condition of economics and monetary policy in Part 1, and highlighting some of their more-damaging effects in Part 2, it’s now time to address one of the fundamental pillars of current policy — a hazard so deeply rooted yet one so easily accepted due to its illusory nature: namely, the process of currency devaluation and inflation targeting.
Yet another adjustment/manipulation scheme used to temporarily boost growth, currency devaluation (via currency creation) is not a new policy — it’s one that has been used throughout history by many countries and empires, including the Roman Empire. And while the process of currency devaluation can evolve so slowly (potentially over a lifetime or more in a major economy/empire) that an unawareness develops and the instinct to question it subsides, its temporary benefits are often merely offset by a reduction in economic prosperity in the future; depending on the extent to which the policy is used, the economic strains may even lead to social disruption.
For an extreme example one need only look to the social disruptions and anger that developed in 1920s Weimar Germany; currency devaluations were so extreme that they yielded bizarre cases of zero stroke, and created an environment where it was cheaper to burn currency than use firewood.
This example is not highlighted to imply that inflation or deflation should be the desired target, but merely to point out that economic policy can often be over-influenced by recent history — the economic and social strain of hyperinflation in the 1920s led to a German tendency to fear inflation, while the U.S. Great Depression of the 1930s has led to an American tendency to fear deflation.
The important point to make here is that deflationary and inflationary economic forces can often be occurring at the same time in different areas of the economy — they may simply be indicating a transition (cost and/or popularity of one time falls as the cost and/or popularity of another item rises). The more-dangerous situation is when extremes in deflation or inflation develop throughout the economy indicating an imbalance, or when that imbalance is specifically targeted.
As discussed, following the Great Depression, modern economic policies have reversed course so drastically that they have merely unbalanced the ship to the other side. The fear of inflation has given rise to a tendency for central banks to “lean on inflation” (i.e. actively target inflation) via a process of currency-creation/currency-devaluation.
However, actively targeting positive inflation to avoid its counterpoint, deflation, may simply result in a storing of deflationary energy to be released later, as a misallocation of wealth builds. Here again the wildfire suppression scenario highlighted in “Part 2” is at play: just as fires are restricted (the kindling builds, the ecosystem changes storing potential energy for larger fires), so too does inflation-targeting work in the same way; it inhibits deflationary forces, allowing the potential energy of deflation to be stored and released later. A further visualization of this concept — the storage-and-release of energy — can be seen in introductory physics…
A roller coaster that momentarily stops on the top of its very last large ramp has a high potential energy (energy that is not currently being used, as the coaster is motionless and high above the ground), but a low kinetic energy (energy of movement). Then as the coaster begins to descend, the potential energy transitions to kinetic energy (motion).
“So inflation turns out to be merely one more example of our central lesson. It may indeed bring benefits for a short time to favored groups, but only at the expense of others. And in the long run it brings ruinous consequences to the whole community. Even a relatively mild inflation distorts the structure of production. It leads to the overexpansion of some industries at the expense of others. This involves a misapplication and waste of capital. When the inflation collapses, or is brought to a halt, the misdirected capital investment — whether in the form of machines, factories or office buildings — cannot yield an adequate return and loses the greater part of its value…
…Yet the ardor for inflation never dies. It would almost seem as if no country is capable of profiting from the experience of another and no generation of learning from the sufferings of its forebears. Each generation and country follows the same mirage. Each grasps for the same Dead Sea fruit that turns to dust and ashes in its mouth. For it is the nature of inflation to give birth to a thousand illusions.” – H.H.
The difficulty in “leaning on inflation” (i.e. creating currency above the natural state) is that creating more currency to distribute does not increase real purchasing power — the country has more currency, but that currency buys less items than it could before (a currency is only a tool used to exchange real wealth items, it is not fundamental wealth).
Yet, regardless, inflation continues to be targeted — arguably due to ease, and its illusory nature — to “paper over” the restrictive reality of deflation; and in that respect, inflation can be considered a clandestine redistribution of wealth — one that is similar to an unpredictable, unbalanced, and spontaneous tax. The redistribution of wealth occurs as the created currency disproportionately benefits those who receive it first; they have the first bid (vote) on assets, goods, and services. As the newly created currency reaches other individuals, the more desirable assets, goods, and services will have already been bid up (higher prices) by those that received the currency first. In effect, those that receive the currency last are punished at the expense of those that receive it first; and knowing who will be affected — and to what extent — will be difficult (What will the desirable assets be when the currency makes its way through the economy?). By its very nature inflation indicates that some individuals benefited before others, yet it typically rests heavier on those least able to pay.
“…inflation does not and cannot affect everyone evenly. Some suffer more than others. The poor are usually more heavily taxed by inflation, in percentage terms, than the rich, for they do not have the same means of protecting themselves by speculative purchases of real equities. Inflation is a kind of tax that is out of control of the tax authorities. It strikes wantonly in all directions.” – H.H.
So although it’s possible that inflation targeting can be used to temporarily offset deflation, its risk is that it’s illusory and more easily abused. In our current environment the tendency to question deflation is more commonplace than the inclination to challenge inflation (maybe merely due to a lack of education and awareness). In deflation, the imbalance is visible; in inflation, the problems are for another day.
A more direct illustration, case 1: If your income rises but inflation is greater than the change in your income, you’re actually poorer than you were before even though you have more money. How can this be? It’s because the total currency in circulation has increased, thus your currency — simply a medium of exchange — buys less real items; you’re poorer even though you have more dollars because each dollar now buys fewer real items.
In a countering example, case 2: If your income goes down but deflation is more significant than the change in your income, you’re actually wealthier than you were before even though you have less money — each dollar can now buy more real items.
This is the illusory and deceptive nature of inflation: if the amount of currency has increased, your wealth is less — and although it is openly targeted, inflation is infrequently questioned, because, in our current environment, there is less of an inclination to question the state of things when you have more currency (even though your real wealth has gone down). The inclination to question the state of things — even though it’s misplaced — seems more natural in case 2 because you have less money. The education and awareness are not present to raise the flag of warning. For these reasons, inflation is politically favorable, leading us to the questionable state — and abusive use — of economics.
“And this is precisely its political function. It is because inflation confuses everything that it is so consistently resorted to by our modern ‘planned economy’ governments.” – H.H.