Adrian Orr irresponsible to the last

"What of yesterday[, when Reserve bank governor Adrian Orr up and abruptly left]?

"... We had brief press releases from the Bank and from the Minister but no real answers. We are told there were no active conduct concerns – although there probably should have been, when deliberately misleading Parliament has happened time and again, and just recently – and yet the Governor just disappeared with no notice on the eve of the big research conference, to mark 35 years of inflation targeting that he was talking up only a week or two ago, (I also know that one major media outlet had an in-depth interview with Orr scheduled for Friday – they’d asked for some suggestions for questions). And with not a word of explanation. 

    "If you simply think your job is done and it is time to move on, the typical—and responsible – way is to give several months of notice, enabling a smooth search for a replacement. 

    "He could easily have announced something next week, after the conference, and left after the next Monetary Policy Statement in May.

"Instead, it is pretty clear that there has been some sort of 'throw your toys out of the cot and storm off' sort of event, which (further) diminishes his standing and that of the Bank (but particularly the Board and its chair). 

    "It all must have happened so quickly that we now have this fiction that Orr is on leave for the rest of the month ... After several hours of uncertainty, the Board chair finally decided to hold a press conference, which he didn’t seem to handle particularly well and (I’m told—I only have a transcript—in the end he too stormed off) we still aren’t much the wiser. ...

"I guess it is probably true that Orr can’t be forced to explain himself, although since he is still a public employee until 31 March I’m not sure why considerable pressure could not be applied. But even if he won’t talk the answers so far from either Willis or Quigley really aren’t adequate. You don’t just storm off from an $800000 a year job you’ve held for seven years, having made many evident policy mistakes and misjudgments, as well as operating with a style that lacked gravitas or decorum etc, with not a word. 

   "Or: decent and honourable people, fit to hold high public office don’t.

"... I had heard a story—apparently well-sourced—that the Bank had actually been bidding for a material increase in its funding, on top of the extraordinary increases of the last five years ... and Orr has long been known more for his empire-building capabilities than for his focus on lean and efficient use of public money, But ... [it] surely it can’t be the whole story.

"Comments by Quigley suggests that perhaps Orr was getting to the end of his tether, and some one or more recent things made him snap, reacting perhaps more than a normal person would do faced with the ups and downs of public sector life. It seems highly likely the budget stuff, and the desire to keep pursuing whims, was part of it, but it can hardly have been all. 

    "I don’t suppose he felt any great compunction about misleading Parliament so egregiously again…..but he should. And all this time – having stormed off with no adequate explanation—Quigley declares that he still had confidence in Orr.

    "Surely yesterday confirms again that both of them, in their different ways, were unfit for office.

"[Not to mention] the latest estimate of the losses to the taxpayer from the Bank’s rash punting in the government bond market in 2020 and 2021. $11 billion dollar in losses. Three and a bit Dunedin hospitals or several frigates or…..all options lost to us from this recklessness, undertaken to no useful end, and a loss which Orr endlessly tried to play down (suggesting it was all to our benefit after all), and about which not one of his Monetary Policy Committee members—one now temporarily acting as Governor—either dissented or gave straight and honest contrite answers. 

    "It has been 43 years since a Reserve Bank Governor was appointed from within. That is an indictment on the way the place has been run."

~ Michael Reddell from his post '$11 billion and out'

Reserve Bank's 'stabilisation': still chaos

In honour of the Reserve Bank's admission this morning of their own blithering incompetence, I wore my favourite anti-monetarist shirt to work. Its point is that the so-called stabilisers of prices create instead more chaos from their incessant boom and bust programme — first overheating, then withdrawing the heat, then resiling and trying to re-heat again.

No to mention that they don't even know what they don't know.

From May to August, the Reserve Bank undertook what Michael Reddell calls "a huge shift" — "from a “hawkish hold” (best guess, no easing until this time next year, and possibly some tightening late this year) to not only an OCR cut now, but a really large (at peak 130 basis points) change in the projected forward track for the OCR."

Do you think they know what they are doing?

"There has been no nasty external shock in that time (global financial crisis, pandemic, collapse in commodity prices etc) ... . I can’t recall another change that large that quickly, in the absence of a major external shock, in the 27 years since the Bank started publishing these forward tracks."

So why did they cut now, when price inflation is still out there, when three months ago they insisted they wouldn't, and couldn't?

"It was simply because Orr and the Monetary Policy Committee [at the Bank] badly misread how the economy was unfolding now ... Other commentators have used the label 'U-turn.' I prefer flip-flop myself."

I'd suggest it's the simple incompetence of the monetary stabilisers, tilting at the same old windmills with the hope of a different result. The programme of the stabilisers ("we know how to put inflation back into the bottle" they crow, then prove they can produce only the destruction of boom and bust) has always and everywhere been destructive. Hayek nailed the stabilisers decades ago, placing the blame for “the exceptional severity and duration of the Great Depression” squarely on central banks’ “experiment” in “forced credit expansion” first to stabilise prices and then to combat the resulting depression.

Hayek defiantly declared: “We must not forget that ... monetary policy all over the world has followed the advice of the stabilisers. It is high time that their influence, which has already done harm enough, should be overthrown.”

It's the kind of thing you need nailed up above the Reserve Bank's door. At least some of us have it on the back of a shirt.

"Don't ignore the reputational harm Willis is inflicting on our financial system by proposing untested, populist policy measures driven by short-term political motives."

"The Minister of Finance [Nicola Willis] has, over the last couple of weeks, been trailing various possible changes in the financial system. ... trying to beef up Kiwibank ... overriding various bits of policy that are now squarely the legal responsibility of the Reserve Bank ... chang[ing] the law to force the Reserve Bank to lower bank capital requirements, and provide carveouts for some or other favoured groups. ...
    "But if you really want to make a change like that you do it after wide and serious consultation, or perhaps even as part of a well-trailed campaign promise, not simply (as it seems) to play distraction because another government agency might be about to release a briefly awkward report. ... if you want to be taken seriously as a Minister of Finance, you don’t just drop such a view into an interview – with, it appears, nothing in support – you outline carefully your case, or commission some reviewers to look into the matter carefully. ...
    "I don’t suppose it is very likely that Willis and the government will end up doing any of the things she trailed in last week’s 'Herald' interview. ... [But don't ignore] the reputational harm Willis is inflicting on our financial system by proposing untested, populist policy measures — arguably driven by short-term political motives. ... it hardly enhances any reputation Willis aspires to to be (and be seen as) a more serious Minister of Finance (focused on things that might make a real difference) than her predecessor. ...
    "Willis could readily have changed the chair of the Reserve Bank board when his term expired ... She could have filled the vacancies on the board with people better qualified than those Robertson appointed. But [she] hasn’t done anything about that either. ... suggest[ing] she isn’t really serious about any of this.

    "In the same vein, each year the Minister of Finance writes a Letter of Expectation to the Board... [Her] 2024 letter ... has not a hint of any of the sorts of issues/concerns Willis was raising in the 'Herald' interview. She also hasn’t revised the Financial Policy Remit(a new tool) issued by Robertson a couple of years ago. ... [S]he has shown no sign of doing any of the things she could (e.g. Board chair and vacancies, unwinding new indemnities the Bank has been given) or of using any moral suasion (e.g. through the letter of expectation) around financial policy issues or the Bank’s budgetary excesses.
    "So it all just looks a lot like a search for a good headline ... rather than a Minister with any sort of serious interest in ... a much better central bank ... Perhaps in that sense she and the Governor ... deserve each other. It is just that New Zealanders deserve much better from both ..."

~ Michael Reddell, from his post 'Still a bad idea'

So maybe, just maybe, we shouldn't give central bankers the keys to the whole monetary system.

"To repeat one of my consistent lines, human beings are fallible, they make mistakes. Central banks – here and abroad – are made up of humans, so they make mistakes. Really serious ones, of the sort seen in the last few years, shouldn’t happen but they do. One might even offer perspectives in mitigation: the pandemic was something quite extraordinary, and many people (here and abroad) misread the macroeconomics of it for too long. But those responsible need to take responsibility for the mistakes that were made."

~ Michael Reddell from his post 'Still avoiding responsibility'

Don't worry, the central banks will control inflation.

 

[Hat tip Rudy Havenstein]

"To repeat, inflation is a purely monetary phenomenon."

"Unfortunately, the entire edifice of the government’s theories [on the causes of inflation] — the assumption of discretionary power, the administered-price theory, the wage-price spiral, the exogenous shocks, the self-sustaining expectations, the idea of 'cost-push' — all of it is the rankest nonsense as an explanation of inflation....

"Inflation occurs, by definition, when the economy’s aggregate volume of money expenditure grows faster than its aggregate real output. The excessive growth of money expenditures can have, again by definition, only two sources: either the velocity of monetary circulation grows excessively or the money stock itself grows excessively (or both). Our current inflation is attributable almost entirely to excessive growth of the money stock.
    "Because the excessive growth of the money stock and the inflation it causes do not happen simultaneously, some people always fail to perceive the relationship. Increases in the money stock take some time before their effect on the volume of expenditure becomes significant. But once the actual lag is recognised, the relationship is seen to be very close....
    "In short, inflation is not caused by cost-pushes, wage-price spirals, depreciation of the dollar on foreign exchange markets, regulatory constraints, minimum wage laws, or lagging productivity growth. Inflation is a purely monetary phenomenon: when the purchasing power of the dollar falls steadily and persistently over many years, it is because dollars have steadily and persistently become more abundant in relation to the total quantity of real goods and services for which they exchange. Inflation, in sum, is caused by excessive growth of the money stock. Period.

"As the [central bank] authorities can control the rate of growth of the money stock, they clearly are to blame for its excessive expansion....
    "[Government] deficits, in the absence of excessive monetary expansion, can not cause inflation. Clearly, the deficits, working through the political process as it influences the [central bank], encourage a loose monetary policy. But it is essential to recognise that it is the excessive growth of the money supply, whether to finance deficits or for some other reason, that causes inflation. Conversely, with a sufficiently slow growth of the money stock, there can be no inflation, no matter what is happening to the [government] budget, labour costs, regulatory standards, minimum wages, and so forth. To repeat, inflation is a purely monetary phenomenon.

"It hardly needs to be added that once excessive monetary expansion has been halted, inflation cannot be kept alive merely by expectations of inflation. People will find that, in the absence of continuing monetary stimulation of aggregate expenditures, the inflation they expected just doesn’t happen. If they are obstinate and continue to act as if inflation is not abating, they will simply price themselves out of their markets in the same manner as the conspiring firm in the example above. It is far more likely, however, that they will adjust their expectations as the rate of inflation falls.
"Expectations cannot sustain an inflationary process unless they are validated by the actual course of inflation; and that validation can occur only so long as the growth of the money stock remains excessive."

~ Robert Higgs, from his article 'Blaming the Victims: The Government’s Theory of Inflation'

Few people truly understand the destructive present relationship between interest rates and central banks. Daniel Lacalle points out the toxicity in this guest post, and suggests a way out ...

Central Banks Are Wrong about Rate Cuts

by Daniel Lacalle

When we talk about monetary policy, people do not understand the importance of interest rates reflecting the reality of inflation and risk. Interest rates are the price of risk and manipulating them down leads to bubbles that end in financial crises, while imposing too high rates can penalize the economy. Ideally, interest rates would flow freely and there would be no central bank to fix them.

A price signal as important as interest rates reflecting the true amount of money would prevent the creation of bubbles and, above all, the disproportionate accumulation of risk. The risk of fixing rates too high does not exist when central banks impose "reference rates," as they will always make it easier for state borrowing—artificial currency creation—in the most convenient—what they call “no distortions”—and cheap way.

Many analysts say that central banks do not impose interest rates; they only reflect what the market demands. Surprisingly, if that were the case, we wouldn’t have financial traders stuck to screens [before every central bank announcement] waiting to decipher what the rate decision is going to be. Moreover, if the central bank only responds to market demand, it is a good reason to let interest rates float freely.

Citizens perceive that raising interest rates with high inflation is harmful; however, they do not seem to understand that what was really destructive was having negative real and nominal interest rates in the business cycle's earlier phase. That’s what encourages economic agents to take far more risks than we can take, and to disguise excess debt with a false sense of security. At the same time, it is surprising that citizens praise low rates but then complain that home prices and risky assets rise too fast!

Shifting the Blame

Inflation is a huge advantage for the currency issuer. It blames everyone and everybody for the rise in prices, except for the only thing that makes aggregate prices go up, consolidate that increase, and continue to rise, even at a more moderate rate: printing much more currency than the private economy demands and setting rates well below the real risk levels.

The benefit of statism is that it puts the blame for high interest rates on banks, just as it blames supermarkets for high and rising consumer prices.

Who prints currency and disguises risk? Of course, we look at the European Central Bank (ECB) and the Fed and the local Reserve Bank, who all dictate the increase in money supply through repurchases and fixed interest rates. However, central banks do not buy back state assets, print money, or impose negative real interest rates because they are evil alchemists. They do so because the state’s deficit—which is artificial monetary creation—remains unsustainable, public debt is atrophied, and state solvency is worsened by imbalanced public accounts. The central bank is not responsible for implementing fiscal policy. Thus, the state is the one that prints money out of nowhere and passes the imbalance to the citizens through inflation and taxes.

No wonder politicians are always so eager to shift the blame.

In a genuinely open unhampered economy, banks do not create money out of nowhere; they lend to real projects that are expected to be repaid with interest, and those loans have collateral. If commercial banks created money out of nowhere, none of them would go bankrupt. They only create money out of nowhere when regulation imposes risk-disconnected rates and eliminates the need for capital to sustain the government by accumulating its bonds and loans under the false construction that they are “no-risk assets.” Thus, the castle of cards built under the disguise of public-sector risk always creates inflation, financial crises, secular stagnation, and liquidity traps. The amount of money created goes to unproductive expenditure, destroys the purchasing power of the currency, impoverishes citizens, and at the same time decapitalises the most fragile companies, SMEs (small and medium enterprises). 

That’s what they call the social use of money. Seriously.

Hikes or cuts?

The ECB has announced a possible interest rate cut in June that is in danger of being premature and wrong. First, because money supply, credit demand, and supply are rebounding, and inflation remains persistent and above the 2% target. Furthermore, the underlying trend is a much higher inflation level than the ECB’s target, even after two changes in the CPI calculation. After a 20% accumulated consumer price level since 2019, calling victory on inflation after two changes in the calculation of CPI and still elevated core inflation is insane. If we see the rise in non-replaceable goods prices, we can understand why citizens are angry. Real non-replaceable goods’ CPI is probably closer to 4-5% per year.

The ECB rate hikes are signalled by many market participants as the cause of the euro zone’s stagnation, but curiously, no one mentions that the euro area was already experiencing massive stagnation due to negative interest rates earlier in the phase. Besides, if you need to have real negative rates to “grow,” you’re not growing but accumulating toxic risk. 

The ECB knows that the base effect, which played in favour of year-on-year inflation in 2023, will not be supportive in 2024. They also know that monetary aggregates were down a few months ago but are rebounding, and that the supply of credit has not collapsed. The ECB, like every other non-deluded central bank in the known world, knows that inflation is a monetary phenomenon and that there is no such thing as so-called cost-push inflation, “greedflation,” or similar statist excuses. None of those factors can cause aggregate prices to soar, consolidate, or continue to rise; it is only the destruction of the currency’s purchasing power that causes inflation.

Of course, no central bank will acknowledge that inflation is its fault, among other things, because no central bank increases the money supply at will but to finance an unsustainable public deficit. However, no central bank will challenge a financial structure that is based on the myth that public debt is risk-free. Central banks know that inflation is a monetary phenomenon, which is why they attack rising consumer prices with rate hikes and money supply reductions. They just do it mildly because governments benefit from inflation.

Eurozone cuts?

The problem of lowering interest rates now, when there is no evidence of having controlled inflation and achieved a target that already erodes the purchasing power of the currency by 2% annually, is to fall into the narrative that the eurozone is in a poor economic situation because of monetary policy when it is due to the wrong fiscal policy, the disaster of the Next Generation EU Funds, whose failure is already only comparable to the forgotten "think big" Juncker Plan, a shortsighted and destructive energy, agricultural, and industrial policy, and a taxation system that shifts innovation and technology to other countries.

The ECB is aware that interest rates are not high and that the system’s money supply has not decreased as expected. In fact, it continues to repurchase outstanding bonds and will not carry out a significant reduction in its balance sheet in real terms until the end of the year. Lowering interest rates now includes the risk of depreciating the euro against the dollar and thus increasing the euro area’s import bill in real terms, reducing the inflow of reserves into the eurozone, and further encouraging public spending and government debt that has not been contained in countries like Italy and Spain, which boast of “growing” by massively increasing debt and where inflation, moreover, is not under control. 

All this reminds us of the mistakes of the past when Greece boasted to be the EU’s growth engine, and many said that Germany was Europe’s “sick member.” The ECB cannot pretend to be the Bank of Japan for two reasons: the eurozone lacks the luxury of Japanese society’s dollar savings structure or its iron citizen discipline, and, above all, because the failure of Japan’s ultra-Keynesianism has brought the yen to a 35-year low against the dollar.

(To those who say that the euro and the ECB are Europe's main problem however, I recommend that you exercise your imagination of what Spain, Portugal, or Italy would be with their own currency and populist governments printing as if Argentina were Switzerland. You don’t have to imagine it; remember when these countries had an inflation rate of 14–15% and they destroyed savings and real wages with the falsehood of “competitive” devaluations? It wasn't that long ago.)

* * * * 

Daniel Lacalle, PhD, economist and fund manager, is the author of the bestselling books Freedom or Equality (2020), Escape from the Central Bank Trap (2017), The Energy World Is Flat​ (2015), and Life in the Financial Markets (2014). He is a professor of global economy at IE Business School in Madrid.
Ranked as one of the top twenty most influential economists in the world in 2016 and 2017 by Richtopia, he holds the CIIA financial analyst title, with a postgraduate degree in higher business studies and a master’s degree in economic investigation. He is a member of the advisory board of the Rafael del Pino Foundation and Commissioner of the Community of Madrid in London.
Lacalle is a regular collaborator with CNBC, Bloomberg TV, BBC, Hedgeye, Seeking Alpha, Business Insider, Mises Institute, and the Epoch Times as well as an occasional consultant for the World Economic Forum, Focus Economics, the Financial Times, the Wall Street Journal, and other major news publications around the world.

His article first appeared at the Mises Wire.

The Governor who printed $50 billion of inflation ...

"Yesterday the Reserve Bank ... released a statement saying, 'The NZ economy continues to evolve as anticipated by the Monetary Policy Committee.' What a line coming from a Governor who told 'Bloomberg News' in the US in 2021, whilst he was busy printing $50 billion in cash, which is the primary cause of our current high inflation, that "The fear of the 70s, the 80s, stagflation, it is such a different world [now]." How amusing, given that stagnation, recession & inflation is exactly what we are now experiencing. How amusing that the RBNZ says our economy continues to evolve as anticipated when its forecasts could not have been proved more wrong.
    "It gets worse. ..."

~ Robert MacCulloch, from his post 'When will the Reserve Bank of NZ Stop Spinning and Stop Misleading Parliament and the Nation?'

 

How often do we hear that government "austerity" is destructive —that it is the job of government, or their central bank, to "stimulate demand"? Or that growth can be gussied up by gobs of government cash? In this guest post, Frank Shostak is here to dismantle those ideas, and to explain that monetary pumping does not create new wealth, it destroys it ...

Does Government Spending and Money Expansion Create New Wealth or Destroy It?

by Frank Shostak

Many economists claim that economic growth is driven by increases in the total demand for goods and services, additionally claiming that overall output increases by some multiple of the increase in expenditures by government, consumers, and businesses. Thus, it is not surprising that most economic commentators believe that a fiscal and monetary stimulus will strengthen total demand, preventing an economy from falling into a recession. [And conversely, that a withdrawal of govt spending will send it there. - Ed.]

These economists believe that increasing government spending and central bank monetary pumping will increase production of goods and services and strengthen total demand. This means that demand creates supply. However, is this the case?

Why Supply Precedes Demand

In the market economy, producers do not produce solely for their own consumption. Some of their production is used to exchange for what others produce. Hence, in the market economy, production precedes consumption. Something is exchanged for something else. This also means that an increase in the production of goods and services leads to an increase in the demand for goods and services.

According to David Ricardo,

No man produces, but with a view to consume or sell, and he never sells, but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

An individual’s demand is constrained by his ability to produce goods. The more goods an individual can produce, the more goods he can demand. For example, if five people produce ten potatoes and five tomatoes, this is all that they can demand and consume. The only way to consume more is to produce more.

James Mill wrote,

When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation that constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation’s power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation. . . . Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.

The Expanding Pool of Real Savings Key to Economic Growth

Without the expansion and enhancement of the structure of production, it is impossible to increase the supply of goods and services in accordance with the increase in total demand. Expanding and enhancing the infrastructure depends upon expanding the pool of real savings, which is composed of consumer goods and supports those employed producing those necessary goods and services.

Consequently, it does not follow that increasing government spending and employing loose monetary policy will increase the economy’s output. It is impossible to lift overall production without the necessary support from the real savings pool.

For example, a baker produces twelve loaves of bread and saves ten loaves. He then exchanges them for a pair of shoes with a shoemaker. In this example, the baker funds the purchase of shoes by means of the ten saved loaves of bread, which maintains the shoemaker’s life and well-being. Likewise, the shoemaker has funded the purchase of bread by means of shoes that he had produced.

Assume that the baker has decided to build another oven to increase production of bread. To implement his plan, the baker hires the services of the oven maker, paying the oven maker with some of the bread he is producing. If the flow of bread production is disrupted, however, the baker cannot pay the oven maker, so the making of the oven would have to be abandoned. Therefore, what matters for economic growth is not just tools, machinery, and the pool of labour but also an adequate flow of consumer goods that meet the producer’s needs.

Government Does Not Generate Wealth

Government does not produce wealth, so how can an increase in government outlays revive the economy? People employed by the government expect compensation for their work. One way the government can pay these employees is by taxing others who are generating wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic growth.

According to Murray Rothbard, 

Since genuine demand only comes from the supply of products, and since the government is not productive, it follows that government spending cannot truly increase demand.

If the pool of real savings is large enough to fund government spending, then a fiscal and monetary stimulus will seem to be successful. However, should the pool of real savings decline, then regardless of any increase in government outlays and monetary pumping by the central bank, overall real economic activity cannot be revived. In this case, the more government spends and the more the central bank pumps, the worse off wealth generators will be, eliminating prospects for a recovery.

When loose monetary and fiscal policies divert bread from the baker, he will have less bread at his disposal. Consequently, the baker cannot secure the services of the oven maker, making it impossible to increase the production of bread.

As the pace of loose government policies intensifies, the baker may not have enough bread left even to sustain the workability of the existing oven since he no longer can afford the services of a technician to maintain the existing oven. Consequently, the production of bread will actually decline.

Because of the increase in government outlays and monetary pumping, other wealth generators will have fewer real savings at their disposal. This in turn will hamper the production of their goods and will weaken overall real economic growth. The increase in loose fiscal and monetary policies not only fails to raise overall output, but on the contrary, it leads to a general weakening in the wealth-generation process.

According to J.B. Say, 

The only real consumers are those who produce on their part, because they alone can buy the produce of others, [while] . . . barren consumers can buy nothing except by the means of value created by producers.

Conclusion

Most economists and economic commentators claim that increases in government spending and central bank monetary pumping strengthen the economy’s overall demand. This, in turn, sets in motion increases in the production of goods and services. Thus, demand supposedly creates supply.

However, to be able to exchange something for goods and services, individuals must first have something by which to exchange. To demand goods and services individuals first must produce something useful. Hence, supply drives demand, not the other way around.

Increases in government spending divert savings from the wealth-generating private sector to the government, thereby undermining the wealth-generating process. Likewise, monetary pumping results in wealth diversion from wealth generators toward the holders of pumped money. Far from stimulating economic growth, government actions hinder it.

* * * * 

Frank Shostak has over 40 years experience as a market economist and central bank analyst. He is an adjunct scholar of the Ludwig von Mises Institute and a member of the board of editors of the Quarterly Journal of Austrian Economics. He is highly regarded for his skills to convert complex economic issues into plain English. He has written articles that have appeared in The Wall Street Journal and in academic journals in Europe and the US. A follower of common -sense economics and damage inflicted from reckless money creation, his Sydney-based consulting firm, Applied Austrian Economics, provides in-depth assessments of financial markets and global economies.

His post first appeared at the Mises blog.

"Forget the cost-of-living-crisis. That's not something experienced in Wellington by public sector executives."

 

No wonder they're smiling: These ten people you see above above are given $5.2 million between them every year. Isn't that nice. Averaged out, that's a pretty tidy sum. What do they do for that money? They're on the Executive Leadership Team at NZ's Reserve Bank, aka Te Putea Matua (which my dictionary translates as "important basket.") Which doesn't really answer the question. (But might describe some of these people.)

The Reserve Bank, as I'm sure you know, has a coercive monopoly on the central price in the economic system. Only two of the Reserve Bank's "leadership team" however (Orr and Hawkesby) have any training in economics at all beyond high school. If that. "So," says economics professor Robert MacCulloch, "so I'm not clear what it is they do that's associated with NZ having better economic (monetary & banking) policies." 

They're posssibly not too clear about that themselves either -- although one does admit that "Sustainability has been a key focus," and another is a "recognised thought leader on digital and data innovation." Which clearly doesn't come cheap.

Overseeing this "team" is the Reserve Bank's Board of Directors (below)-- about whom, observes McCulloch, "it's even less clear what they do - again most have little to no expertise in central banking. [Quigley at least is an exception.] Nevertheless that 7 member Board took $662,000 for what-ever-it-is-they-do."

As McCulloch wryly notes, "Forget the cost-of-living-crisis. That's not something experienced in Wellington by public sector executives." No. But it should be.

What's ESG? What's ZIRP? -- and why should you care?

ZIRP (zero-interest rate policies) characterises the cheap credit that has flooded out of central banks in the last decade or more. 

ESG (environmental, social, and governance) is the dripping wet "stakeholder" theory that demands that so-called "ethical investors" should direct companies to undertake more politically-correct projects. It is the stakeholder theory route to collectivism.

Fortunately, as Peter Earle explains in this guest post, shareholders and consumers are starting to flex their muscles, and the credit contraction is making a lot of what was formerly cheap very expensive.

ESG as an Artifact of ZIRP

Guest post by Peter C. Earle

Founding myths tend to be mired in obscurity, and like many other investment trends, the roots of environmental, social, and governance (ESG) philosophies are unclear.

The founding of the World Economic Forum is one origin. Stakeholder theory is another of ESG’s clear antecedents, especially as formalised in R. Edward Freeman’s 1984 book Strategic Management: A Stakeholder Approach. The 2004 World Bank report “Who Cares Wins: Connecting Financial Markets to a Changing World” is another contender, providing as it did guidelines for firms to integrate ESG practices into their daily operations. And the publication of the reporting framework United Nations Principles for Responsible Investing in April 2006 (the most recent version of which can be found here) was another.

Its origins however are less important than the destruction it has caused.

Wherever it began, ESG clearly hit its stride within the last five to ten years. Those were heady times for bankers and financiers, first characterised by zero interest rate policies (ZIRP) and then, during the pandemic, by massively expansionary monetary and fiscal programs. Yet in the last two years or so, the prevailing economic circumstances have changed considerably. Inflation at four-decade highs is battering firms by raising the cost of doing business. It is also negatively impacting corporate revenues, as consumers retrench by cutting back on expenditures.

Nowhere are these effects more evident than in shareholder land, where the fourth-quarter 2022 S&P 500 earnings season is just about over. “Earnings quality” is an evaluation of the soundness of current corporate earnings and, consequently, how well they are likely to predict future earnings. For the past year, and certainly for the last quarter, the quality of earnings has been abysmal. One particular element – “accruals,” or cashless earnings – are their highest reported level ever, according to UBS. In that same report, we find the somewhat shocking revelation that nearly one in three Russell 3000 index constituents is unprofitable.

For those and other reasons, a theme in many of the fourth-quarter corporate earnings reports has been cost-cutting: Disney, Newscorp, eBay, Boeing, Alphabet, Dell, General Motors, and a handful of investment banks are all eliminating jobs and slashing unnecessary expenses. And although firms regularly write off the value of certain assets and goodwill, that process accelerates during recessions. 

Firms are additionally contending with the highest interest rates they’ve faced since 2007, and in some cases back to 2001. A substantial amount of corporate debt assumed at lower interest rates is now more costly to service, as a generation of managers grapple with a world of interest rates (and its effects) that they've never seen before.

Dividend payments for example, typically considered sacrosanct during all but the most severe financial straits, are being targeted for savings. February 24th in Fortune:

Intel, the world’s largest maker of computer processors, this week slashed its dividend payment to the lowest level in 16 years in an effort to preserve cash and help turn around its business. Hanesbrands Inc., a century-old apparel maker, earlier this month eliminated the quarterly dividend it started paying nearly a decade ago. VF Corp., which owns Vans, The North Face, and other brands, also cut its dividend in recent weeks as it works to reduce its debt burden … Retailers in particular face declining profits, as persistent inflation also erodes consumers’ willingness to spend. So far this year, as many as 17 companies in the Dow Jones US Total Stock Index cut their dividends, according to data compiled by Bloomberg.

All of this suggests two things.

First, if large firms are doing everything they can to reduce unnecessary overhead, then feel-good initiatives and other corporate baubles are likely to face the chopping block – even if quietly. ESG observance is one of those very costly trinkets, bringing as it does compliance costs, legal costs, measurement costs, and opportunity costs. The reporting requirements alone associated with upholding ESG standards are high, and rising. In 2022, two studies attempted to estimate those costs:

Corporate Issuers are currently spending an average of more than $675,000 per year on climate-related disclosures, and institutional investors are spending nearly $1.4 million on average to collect, analyze and report climate data, according to a new survey released by the SustainAbility Institute by ERM … The survey gathered data from 39 corporate issuers from across multiple U.S. sectors, with a market cap range of under $1 billion to over $200 billion, and 35 institutional investors representing a total of $7.2 trillion of AUM … The SEC has released its own estimates for complying with its proposed rules, predicting first year costs at $640,000, and annual ongoing costs for issuers at $530,000. The study explored the specific elements covered by the SEC requirements, and found that issuers on average spend $533,000 on these, in line with the SEC estimates. Elements not included in the SEC requirements included costs related to proxy responses to climate-related shareholder proposals, and costs for activities including developing and reporting on low-carbon transition plans, and for stakeholder engagement and government relations.

Difficulty measuring costs means difficulty budgeting for them. Another recent report commented:

Although it is inherently difficult to assess the costs [of ESG], it is fair to anticipate significant costs for ambitious ESG goals. In an article in The Economist, a specific cost estimate was made in relation to offset a company’s entire carbon footprint. This was estimated to cost about 0.4 percent of annual revenues. This could already be a huge component for many companies, but it is only one aspect of merely one ESG factor.

Yet that comment concludes with the kind of assurance that flows effortlessly from consultants well-positioned to, frankly, make a lot of money off of ESG compliance: “However, there is no real choice. The climate certainly cannot wait.” Given the recent backlash against ESG, whether driven by ideology or accounting, it’s clear that there is a real choice, and that choice is being invoked with increasing frequency throughout the commercial world.

Second, the recent explosion of ESG adoption may have been in the spirit, if not embodying a strictly theoretical manifestation, of malinvestment as predicted by Austrian Business Cycle Theory (ABCT). 

Without engaging in a lengthy discussion of ABCT, artificially-low interest rates (interest rates set by policymakers instead of markets) undercut the natural rate of interest, misleading entrepreneurs and business managers. Many years of negligible interest rates, indeed negative real rates, have given rise to bubble-like firms, projects, and I would argue, by extension, business concepts. The latter, which include but are not limited to ESG, seem feasible and arguably essential when the money spigots are open. When interest rates normalise and sobriety re-obtains, cost structures reassert themselves. It’s back to the business of business. 

Interest rates are now beginning to normalise. And, perhaps, business practices with them.

Gone are the salad days of easy money, and with it the schmaltzy wishlists of niceties which a decade of monetary expansion permitted activists to blithely force upon corporate executives. In the face of rising interest rates, an uncertain path for inflation, budget-constrained consumers, and rapidly deteriorating corporate earnings, shareholders are likely to take a closer look at how and where their money is being spent than they have in some time. 

Although it is unlikely to disappear completely, the ESG fad is probably past the crest of its popularity. It’s time again for firms to focus, singularly and completely, on the inestimable task of making money.

* * * * 

Peter C. Earle is an economist who joined the American Institute for Economic Research (AIER) in 2018. Prior to that he spent over 20 years as a trader and analyst at a number of securities firms and hedge funds in the New York metropolitan area. His research focuses on financial markets, monetary policy, and problems in economic measurement. He has been quoted by the Wall Street Journal, Bloomberg, Reuters, CNBC, Grant’s Interest Rate Observer, NPR, and in numerous other media outlets and publications. Pete holds an MA in Applied Economics from American University, an MBA (Finance), and a BS in Engineering from the United States Military Academy at West Point.

His post first appeared at the AIER blog.

INFLATION: Orr lies

"[T]he Reserve Bank Governor [Adrian Orr]... likes to make up stuff suggesting that high inflation isn’t really the Reserve Bank’s fault, or responsibility, at all....
    "Late last year there was the line ... that for inflation to have been in the target range then (Nov 2022) the Bank would have to have been able to have forecast the Russian invasion of Ukraine in 2020. It took about five minutes to dig out the data ... to illustrate that core inflation was already at about 6 per cent BEFORE the invasion ... It was just made up, but of course there were no real consequences for the Governor....
    "And then there was last week’s effort in which Orr ... attempted to brush off the inflation as just one supply shock after the other, things the Bank couldn’t do much about, culminating in the outrageous attempt to mislead the Committee to believe that this year’s cyclone explained the big recent inflation forecasting error (only to have one of his staff pipe up and clarify that actually that effect was really rather small)....
    "It is, of course, all nonsense....

See for example:

• INFLATION: A critique of the “crisis-push” doctrine
• INFLATION: The Elimination of "Less Supply" as the Cause of an Inflationary Rise in Prices
• INFLATION: "Under such a system, the increase in the quantity of money is limited only by the self-restraint of government officials."

"Bottom line: all those stories trying to distract people ... with tales of the evil Russian or the foul weather or whatever other supply shock he prefers to mention, really are just distractions (and intentionally misleading ones ...). The Bank almost certainly knows they aren’t true, but they have served as convenient cover ... We are now still living with the 6 per cent core inflation consequence. It is common – including in the rare Bank charts – in New Zealand to want to compare New Zealand with the other Anglo countries. But what the Bank has never acknowledged – and just possibly may not have recognised – is much larger the boost to domestic demand happened in New Zealand than in the US, UK, Canada or Australia. And domestic demand doesn’t just happen: it is facilitated by settings of monetary policy that were very badly wrong, perhaps more so here than in many of those countries."

~ Michael Reddell, from his post 'Excess Demand'

Says Law explains why we don't need a recession to kill price inflation

Image Source: Unsplash

We need to engineer a good recession, say central bankers, to kill the inflation engineered by those same central bankers. But as Alasdair Macleod explains in this guest post, policy makers who believe a recession will kill price inflation, and therefore allow central banks to reduce interest rates, are simply wrong. This is simply mad macroeconomic dogma.

Updating Say’s Law For Modern Times

by Alasdair Macleod

It was Keynes’ offhand dismissal of Say’s law, or the Law of the Markets, in 1936 which is leading us into an economic and monetary crisis.

It was dismissed by him to invent a role for the state.

That is why Keynes is so popular in the mainstream establishment. By dismissing market reality, he invented a whole new branch of economics. Macroeconomics exchanged statistics and mathematics for human action, the prospect of centralised management substituted for ambiguity.

In this article I look at the flaws in macroeconomics, the state theory of money (an old recurring theme from John Law onwards), misleading statistics measured in unhinged fiat currencies, and why Keynesian fears of a general glut are misplaced — all of which stem from the error of dismissing Say’s law.

Importantly, Say’s law ties the volume of production to demand, so policy makers who believe a recession will kill price inflation, and therefore allow central banks to reduce interest rates, are simply wrong.

The state-educated mainstream is so sold on macroeconomic theories and the state management of economic outcomes that reasoned debate gets no traction. The only solution is for a final economic and monetary crisis to bring an end to all macroeconomic dogmas.

The origin of macroeconomics

Jean-Baptiste Say wrote his ground-breaking book on economics in 1803, revising subsequent editions. His Traité D’économie Politique, as it is known in French in short form, described the division of labour and the role of money as the agent for turning specialised production into general consumption. It became known as Say’s law or the law of the markets, and was the first commandment of classical economics, until Keynes persuaded us otherwise in his General Theory published in 1936.

Keynes denial of Say’s law was in the spirit of Humpty Dumpty — ″’When I use a word, it means just what I choose it to mean – neither more nor less.” He rewrote economic definitions to suit his thesis. Humpty Keynes redefined economics to exclude the inconvenient reality of Say’s law, along with many others that logically followed from it. It was necessary for Keynes to deny it in order to ease in a role for the state, allowing governments to intervene in the relationship between production and consumption. 

The invention of macroeconomics, which played down the unpredictable human element expressed in markets, in favour of statistics and mathematical analysis, can be traced to Chapter 3 in his General Theory, where he wrote:

“If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.”

Say’s law was summarily dismissed, hardly mentioned again in his seminal work. The whole basis of Keynes’s new macroeconomics, that vitally important chapter of economic theory which remains to be written, boils down to that one little word, “If” heading the quote above. “If” is a supposition and certainly not evidence leading to the discovery of an entirely new branch of economic science. It was a simple trick, dismissing the inconvenient truth early in his thesis so that he could proceed to construct a fantasy. 

Keynes should have been dismissed as a quack, like John Law who propounded similar theories and ruined France in 1720. And like Georg Knapp, a German economist of the Historical school, who published his state theory of money in 1905, arguably encouraging the Kaiser’s government to build up armaments before the First World War at no visible cost to the people, and to continue to finance itself by inflationary means after Germany’s defeat.

Yet with Keynes’s little “if”, here we are nearly ninety years later still travelling along his intellectual rails full tilt into the buffers of economic destruction. The reasons why Law, Knapp, and now Keynes and their theories rose from obscurity to fame are that their theories appeal to governments, seemingly conferring on them an economic role, enhancing their control over their citizens, and therefore the justification for increased power and revenues. The last thing they will consider is that these theories are flawed, until the evidence of a final crisis forces them to face up to their fallacies.

Despite Keynes’s intellectual fraud, the division of labour and the role of money cannot be denied. But the world has moved on from the simpler world of J.B. Say. At the time of the French Revolution when he was observing the economic activities of people, tradesmen probably refused to take credit for payment, accepting only gold and silver coin because paper assignats followed by mandats territoriaux were successively descending into worthlessness.

The more things change...

Plus ça change, plus c’est le même chose! Today, under neo-Keynesian policies directed by the state, it is only forms of credit that intermediate between our production and consumption, and coins are only tokens. Over two centuries ago in rural France, consumption for most was more a question of survival than access to the luxuries we are familiar with today and reckon to be our right. Production was basically local, whereas today it is global. And we now have factories, when few existed in the predominantly agricultural economies of Say’s time because the industrial revolution in France had barely started.

Yet, despite all these differences Say’s central proposition still holds -- Say's Law, the Law of Markets, still links production to consumption; and it still rules out a general glut of goods due to a collapse in consumption. It still holds -- and as long as reality is what it is, it always will. No employment: no demand. No demand: no employment.

However, rehabilitating Say’s Law into modern economics must take account of today’s economic and monetary conditions. Neo-Keynesians ignore the consequences of credit’s loss of purchasing power in their static models. This may confuse the issue for them, but Say’s law still holds whether transactions are in money or credit. (Here, we are defining legal money as a medium of exchange without counterparty risk — gold and gold coin.) Now that we have only fiat currencies whose values in terms of goods are continually deteriorating, statistical evidence is worthless — despite macroeconomists treating long runs of price and related data as if the purchasing power of a fiat currency is constant over time. I have more to say on this below.

In the days of sound money and the credit which took its value from it, we could see the consequences of economic progress and regression on both individual prices and also their general level. Today, we labour under the delusion that what we knew to be true under sound money still applies to unsound fiat currencies and their dependent credit. In all our statistical comparisons we therefore believe that all price changes still come from the values of goods and services. And by dismissing Say’s law, we dismiss the certainty that the purchasing power of unanchored credit will continue to decline even in a recession. So, what are the true consequences of a deteriorating economic condition for prices in a modern economy?

It is far from a simple matter, but as a starting point we can sensibly argue three points. 

• First, just as Keynes dismissed Say’s Law in order to create an economic role for the state, its rehabilitation must reject his supposition entirely and everything that flowed from this error. 
• Second, that with the dismissal of the state from economic functions, macroeconomic statistics-gathering can only have restricted validity, and economic modelling must be dismissed entirely. 
• And third, in economic conditions leading to unemployment not only does consumption decline but production will as well because the unemployed are no longer producing. In other words, there is no such thing as a Malthusian glut, and the hope in some quarters that price inflation will diminish in a recession as demand contracts will be disappointed.

The rest of this article looks at the major issues arising from the Keynesian dismissal of Say’s Law — the law of the markets.

The errors in modern socialism

Perhaps the starkest example of the difference today between a state-controlled economy and a relatively free capitalist one is found in the contrast between the two Koreas. In the North, they are starving. In the south, people of the same ethnicity are prospering. This is not just a fluke. In the late 1940s, China was descending into communism and abject poverty while Hong Kong rose from the ashes of Japanese occupation and the collapse of the military yen into capitalist prosperity with no natural resources of its own. Concurrently with China and Hong Kong, East and West Germany exhibited the same phenomenon until freedom of movement between the two returned.

The empirical evidence of these failures and success are put down to communist extremism by historians and today’s politicians in the western alliance, and they say are different from democratic socialism. But apologists for state intervention and control can argue as much as they like that communism is different from democratic socialism, but they cannot explain away the fact that communism is simply socialism in extremis sharing the same basic flaws as socialising democracy.

Understanding why this is the case is hampered by the superficial attraction of organisational planning applied to spontaneous markets. The former appeals to a surface form of logic, while the latter lacks a ready explanation. This riddle was laid bare by the great economist of the Austrian school, Ludwig von Mises in his 1922 book Socialism: An economic and sociological analysis. The essence of the argument was contained in a further essay, Economic Calculation in the Socialist Commonwealth, written in 1920 and a hot topic for decades thereafter. 

In that essay, Mises laid down the reasons why economic management and intervention by the state would always fail. As the Russian economist, Yuri Maltsev put it, “Mises exposed socialism as a utopian scheme that is illogical, uneconomic, and unworkable at its core.” Maltsev confirmed this from his personal experience as an economist in the Soviet Union.

The difference between communism and democratic socialism can be likened to the fate of a lobster plunged into boiling water compared with that of a frog, who in the modern cliché is cooked from cold. The relative level of authoritarianism is different from the outset but ends up being similar in its final outcome. The demonstrable failures of democratic socialism have led to ever-increasing restrictions on markets, inching it ever closer to communism. The common denial of capitalism and the profit motive as being somehow immoral is part of the pro-state and anti-market propaganda.

The reason the state always fails in its attempt to manage the economy is partly due to its objectives being political in nature rather than economic, and partly due to the impossibility of it entering into economic calculation. It was the latter point which Mises explained so well in his 1920 essay. Irrespective of the politics, it is impossible for a state which owns the means of production in its central planning to know in advance whether its output will be demanded by consumers. Some of it might well be, but assessing the level of demand in the planning of production is impossible. And the state cannot assess the evolution in a product to ensure it will be freely demanded in future. The state therefore resorts to monopolistic behaviour to enforce consumption.

By way of contrast, the capitalist in a free market will use his specialist knowledge to assess demand and seek to respond by supplying his product to consumers profitably. For him, the customer is king. If he fails, he either cuts his losses, or adapts the product to satisfy consumer demands. Production methods and output evolve to satisfy demand, which together define progress. While the state is unable to evolve its production satisfactorily and therefore lacks the fundamental ability to foster economic progress, capitalists seeking profits in free markets improve economic conditions and standards of living wholly in accordance with Say’s Law. In other words, through specialisation the entire cohort of independent manufacturers and service providers together satisfy the general and evolving demands of the markets.

As a matter of reluctant practicality, social democracy permits capitalism to exist. In common with the early fascist policies of Mussolini, capitalism is tolerated so long as it can be controlled by the state. This control is achieved through extensive product regulation, by partial nationalisation of the economy, and by virtue of the fact that state spending is the largest single element in a social democratic economy. This spending is not funded out of production, but by taxes imposed on producers and consumers. A socialising state is promoted as a benefit for society as a whole, but the reality is that is an economic burden in proportion to its size.

Under the aegis of social democracy, the economy becomes increasingly directed away from market freedoms, and it performs progressively less than its potential to improve the living conditions of the population. The economy’s underperformance is invariably blamed upon the private sector by the state when it is the consequence of the state’s own interventionalist policies.

How statistics mislead us all

The social division of labour means that it is always the individual who deploys his or her skills in order to consume — consumption which is personal to the needs and desires of the individual. While there are needs common to each individual, the consumption of which goods and services an individual actually desires cannot be forecast by any observer. Much of tomorrow’s demand is spontaneous and is not even known in advance to individual consumers. 

Even if they are accurate, the gathering of statistics measuring this demand can only be of its past history. It is a gross error to think that demand statistics valid in the past can be projected into the future and retain any true relevance. We see this in the continual failure of economic modelling and econometric forecasts. It is one thing for an economist to further his understanding of a branch of human science, as a branch of psychology, and another to assume it is a natural science, such as physics or biology. The former cannot be averaged and predicted, while the latter can be statistically quantified. No wonder Keynes, whose primary discipline was mathematics, preferred to dismiss Say’s law in favour of mathematical and statistical analysis.

Mention has already been made above of the mistake in comparing prices of goods and services over time valued in fiat currencies. The chart below of WTI oil, a basic unit of energy upon which almost the entire global population depends, illustrates the enormity of this mistake.

The two prices are in legal money, which is gold, and in fiat dollars, which is currency. Since 1950, when the price of WTI oil was $2.57 per barrel and in gold grammes it was 2.28, in dollar terms the price has soared to around $70 today, a multiple of over 27 times. Yet in gold, it is 1.14 grammes, having exactly halved. In legal money the price has been considerably less volatile than in dollars. The riddle posed to us by this chart is which price should be used for valuing oil — a depreciating and volatile dollar, or a relatively stable legal and sound money?

Clearly, it is long-term dollar price comparisons which are badly flawed. Yet market traders, proud to call themselves macroeconomists without understanding the implications of the term, maintain their long-term charts of oil and other commodities in dollars wholly unaware of their falsity. Furthermore, everything which can be traded is valued in fiat dollars and other currencies, from financial assets to housing. The next chart is of residential property in London, priced in pounds and gold.

Anyone who observes the residential property market in the UK will tell you what an excellent 'investment' it has been, nowhere more so than in London. But this statement only holds for a fiat pound, which since 1968 has lost over 99% of its purchasing power measured in real legal money, which is still the gold sovereign coin. Today, the value of London residential property in gold has risen by a paltry 14% since 1968, compared with 116 times in depreciating pounds. Yet, the plain facts are met with widespread disbelief.

Under the fiat currency regime, values of everything are a flawed concept, reflecting not changes in subjective values so much as that of declining fiat currencies. But this statistical legerdemain which fools everyone extends to other areas of the statistical universe. Labour productivity analysis is a nonsense because of the underlying assumptions, and the lack of consideration of the costs to an employer of employment and other labour taxes. The approach is always from the statist viewpoint, whereby politicians wish to see higher output per worker promoting higher tax returns. It is never that of an employing businessman who is the only true assessor of the costs and benefits of employing the various forms of labour in his enterprise profitably.

GDP and government spending

To confuse gross domestic product with economic growth, itself a meaningless term when economic progress is implied, is a further error. Governments are fixated on GDP, which must always grow. GDP is not economic growth, but growth in the total currency value of transactions, usually over the course of a year or annualised.

If the currency is debased by its inflationary issuance, nominal GDP increases to the extent that debasement feeds into the GDP statistic. Inflation of the currency is particularly associated with increased government spending, so virtually all the increase in it fuels GDP. In the past, governments have regularly outperformed market expectations of GDP growth by the simple expedient of increasing government spending. Investors failing to understand this trick see it as positive, and stock markets rise on the news. GDP is only good for allowing a government to estimate prospective tax income. Otherwise, it is a useless and misleading statistic.

As stated above, GDP is routinely and unconsciously confused with economic progress. But a moment’s reflection will show that progress cannot be statistically measured. Progress is a concept which at its fundamental level is an improvement in a person’s living standard. There is no doubt that entertainment technology, in the form of televisions, gaming computers, and other electronic equipment all of which have fallen in price have improved many people’s enjoyment immensely. GDP incorporating declining prices for these products is bound to undervalue these benefits, and by classifying their prices as deflationary might even claim they detract from economic growth. Yet, government spending which is funded by removing purchasing power from producers and consumers and is therefore a brake on progress is classified as positive due to its inclusion in GDP.

During the covid crisis, when much of the productive economy shut down UK government spending rose to about 50% of GDP, though since then it has declined to an estimated 43% in the last fiscal year (to April 5th, 2023). Similar increases occurred in other nations. In Europe, French government spending peaked at 61.3% of its economy in 2020, declining to 58.1% last year. In Italy it was 57% and 56.7% respectively, and in Spain, 52% and 47.8%. With these levels of state spending, when analysing GDP it is extremely important to decide how to treat it.

Government economists are bound to argue that government spending is important in economic terms, and that GDP growth must include it. Furthermore, on a consumption basis it is argued that spending by government employees must be included, as well as government demand for goods and services. While this might appear to be a valid point, it misses the bigger picture.

While it is true that state employees’ and departmental spending are part of the total economy, the state’s taxes which fund them reduces income available for consumption for those not employed by the state. Government spending as a whole replaces it with the provision of services not freely demanded, which is fundamental to the benefits which flow from Say’s law — the law of the markets.

You don’t have to look far for examples of how state spending is a burden on overall economic activity, and that the successful economic approach is to free up the private sector, eliminating government and its intervention as much as possible. It is this approach which led to the remarkable success of Hong Kong in the post-war decades, compared with the poverty inflicted on the same ethnic people on the mainland under Mao Zedong where government was 100% of the economy.

Convincing the establishment that inflating GDP ends up suppressing economic progress is an uphill struggle. Instead of accepting the empirical evidence, governments routinely use their tax-raising powers to increase economic intervention, spending as a proportion of the whole, and debasing the currency by deliberately running budget deficits.

This leads to a conflict between politicians seeking to represent the electorate’s interests and the state itself. Politicians on the right vying for office are usually free marketeers with ambitions to reduce the state’s presence as a proportion of the total economy. They are appointed with a zeal to take an axe on spending and bureaucracy, but there are good reasons why they never achieve it. When they gain ministerial responsibility, their priority changes to protecting their budgets from being reduced, because cuts in departmental spending amount to a loss of power. Therefore, to the extent that any savings on spending are achieved, ministers always want to come up with other plans to maintain or increase funding levels. The negative economic consequences simply rack up, and the government’s share of GDP inexorably tends to increase.

This is the true legacy of confusing GDP with economic progress. While the transactions that together make up a GDP total can be measured, their true value in terms of the satisfaction and the progress in the quality of life they provide cannot. The only way in which they can be measured is by each individual in a community and nation, and not by those who claim to represent them.
Why there cannot be a general glut

The Keynesian error of believing that a recession leads to a general glut, and therefore a fall in the general level of prices, has its origin in the 1930s depression. But it is obvious that under the conditions of the division of labour, whereby people are employed to produce so that they can consume, this cannot be true in a general sense, because production must decline as well as consumption when unemployment rises. In other words, a general glut of unsold produce cannot arise, because the unemployed are no longer producing.

Nevertheless, Keynesian fears of a glut when a recession occurs and unemployment rises leads modern governments to create demand in a recession by increasing welfare benefits. According to the Keynesian playbook, this funding is stimulative by means of inflationary deficits, intended to help stabilise prices as demand weakens. But without a general glut and a stable currency the overall level of prices is unlikely to change significantly in real terms when there is no government intervention because of Say’s law.

Modern governments intervene by deficit spending without contributing to production. Instead of a recession leading to surplus production, government spending leads to surplus demand. This explains how the inflationary effects of Keynesian stimulation can lead to significantly higher prices, even in a slump, as was seen in Britain’s inflationary crisis in the mid-1970s. It is also entirely consistent with the factors driving an economy into a slump during a currency’s collapse, such as witnessed in the European inflations in the early 1920s.

So, what happened in the 1930s, disproving Say’s law in the minds of the neo-Keynesians?

The first error in their analysis was not understanding the consequences of the inflationary 1920s. They were fuelled by the Fed’s expansionary monetary policies under the leadership of Benjamin Strong, and President Hoover’s anti-capitalist, interventionist policies at the peak of the credit cycle. The inevitable consequences were a speculative bubble followed by a financial crisis between late-1929 and 1932 which wiped out thousands of banks and their credit, which were the backbone to maintaining economic activity. And this was followed by Hoover’s heavy handed interventionism.

Hoover also raised income taxes significantly to fund his interventions. Despite these increases, during Hoover’s tenure the Federal Government’s deficit to GDP soared from a 0.7% surplus to a 6.4% deficit and these deficits continued under Roosevelt, though they lessened as the banking crisis passed.

Not only did banks go bust in their thousands, but there were other factors. The Smoot-Hawley Tariff Act, which built in higher tariffs on top of those of the Ford McCumber tariffs of 1922, was signed into law by President Hoover in 1930. So, not only was bank credit in the economy imploding, but including tariffs the prices of imported goods and therefore the production costs of most American manufactured products were raised to uneconomic levels. It was a fatal combination, because little could be produced profitably at a time when there was little or no bank credit available. Consequently, US GDP contracted from $103.6bn in 1929 to $56.3bn in 1933. This was not the same thing as a general glut, because demonstrably both production and consumption contracted. Primarily, it reflected a collapse in bank credit.

While credit had become freely available in the previous decade, the introduction of tractors and other farm machinery had led to a massive expansion of agricultural output. Prices of agricultural produce, which were already declining due to oversupply, were bound to fall even more when credit was withdrawn by failing local banks in America. The farming community was forced to sell its output at anything they could get for it, because of the lack of credit.

This was a specific market adjustment at a time when worldwide cereal and other agricultural output prices were falling due to overproduction. The slump in prices attributable to the banking crisis hit farmers particularly hard, not just in America but worldwide through values reflected on the commodity exchanges.

Because American farmers were forced sellers of their agricultural output, it was later assumed by Keynes and other economists that there was a glut and that Say’s law was therefore flawed. But the mistake was to miss the links between the collapse in bank credit from bank failures, the pressure on farmers to dump their product at any price, and the coincidence of global overproduction due to the rapid advances made in mechanisation in the previous decade.

The causes of the 1930s depression and its longevity were clear — you need look no further than empirical evidence. Long before Keynes traduced Say’s law, both Hoover and Roosevelt with his New Deal made the depression considerably worse than it would otherwise have been, acting as proto-Keynesians. It was the first time that the Federal Government had intervened in what would otherwise have been two or three years of economic and credit hiatus, which had been the experience of previous episodes. The previous depression in 1920—1921 lasted only eighteen months without statist intervention. Before President Hoover’s tenure, it was generally acknowledged that intervention only made things worse, and that left alone, a slump in business activity would correct itself.

Economists subsequently formulating statist policies badly misread the causes of a slump. They still fail to appreciate that there is a cycle of bank credit, identified by economists of the Austrian school as a business cycle. It is caused by bankers acting as a cohort increasing the quantity of credit to a point when their balance sheet exposure becomes excessive relative to the bankers’ own capital, and they then try to reign in their balance sheets. This is not a conspiracy between bankers, but reflects their human behaviour, and is cyclical in nature. It can be traced for so far as reasonable records exist, in the UK as far back as the end of the Napoleonic wars. And it is a cycle of credit expansion and contraction averaging roughly ten years.

Even for economists, it is always easier to observe the evidence of an economic downturn than its underlying cause. In all the voluminous analysis of the great depression, the cycle of bank credit is hardly mentioned. Only economists of the Austrian school have pointed out that the depression was the natural consequence of excessive credit expansion in the previous decade. And Keynes’s followers with their mathematical and statistical macroeconomics are still blind to the role of bank credit underlying booms and slumps. They think they can model the economy, steering it from one objective to another by supressing free markets. But they cannot model human bankers’ balance of greed for profit and fear of losses.

Economic and monetary policies ignore Say’s law — the law of the markets — persisting in their failed interventions. The response to failure is usually to claim that the error was to not intervene enough. A feature of these failures is for policy makers to seek solace with their international counterparts, doubling down in a group-thinking effort to achieve statist objectives.
The errors in currency management

This week, the persistence of consumer price inflation in the UK has even led a member of the Monetary Policy Committee to say that interest rates will have to be raised to the extent that the UK economy enters a recession. But with broad money supply, no longer expanding, we can see that there’s something wrong with his analysis. At the same time, all commentary on stubborn price inflation is about too much demand for too few goods. Changes in the purchasing power of the currency are never mentioned. While individual prices fluctuate, when the general level of prices increases it can only be because of changes in a currency’s purchasing power.

There is only one reason why the purchasing power of a fiat currency changes, and that is in the behaviour of its users. By adjusting the relationship of their immediate liquidity to their spending, collectively they can have a profound impact on its purchasing power. This is why the state theory of money fails, and the monetary authorities always fail to control the purchasing power of their fiat currency. A currency must be anchored to real money, which is gold coin.

When banknotes were fully exchangeable for gold coin, their purchasing power remained constant irrespective of the quantity in circulation. But banknotes are typically less than a tenth of the circulating medium, the balance being bank credit. The relationship between bank credit and banknotes is almost parity. Therefore, so long as counterparty risk between a bank’s depositors and the bank is not an issue, bank credit will always take its value from the currency. It is the currency which must be credible.

In the first of the two charts above of WTI oil priced in dollars and gold, we can see that the price of oil in dollars was stable between 1950 and 1970, when the dollar price increased from $2.57 per barrel to an average of $3.35. At that time, the dollar was loosely tied to gold through the Bretton Woods agreement, with only national central banks and organisations such as the IMF able to exchange dollars for gold. During that time, M3 money supply increased from $172bn to $750bn, an increase of 336%.

This was not the only example. Between 1844 (the time of the Bank Charter Act) and 1900, the wholesale price index was unchanged, and it was also remarkably stable over that time fluctuating little. But between 1844 and 1900, the sum of Bank of England banknotes in circulation and commercial bank deposit obligations increased eleven times —almost entirely bank credit with the Bank of England’s note issue being little changed — and there was a material increase in the quantity of short-term, commercial bills funding foreign trade as well. Monetarist theory would suggest that the expansion of credit on such a scale would undermine the purchasing power of the currency, but plainly it did not.

The reason the expansion of bank credit need not undermine a currency’s purchasing power is that so long as the level of credit is genuinely demanded by economic activity instead of financing excess consumption, its expansion does not drive up prices. The source of excess consumption is to be found in government deficit spending because individuals always have to settle their debts while a government does not. As mentioned above, governments can always resort to deficit spending.

From this we know that government fiscal and monetary policies coupled with its fiat currency are the sole reasons behind a deteriorating purchasing power for its currency. Indeed, the Keynesians deliberately target a continual rate of debasement reflected in a CPI inflation rate of 2% by using monetary policy in an attempt to regulate credit demand.

The solution: leave markets alone and bring back sound money

If monetary stability is to return, all attempts by governments to manage private sector outcomes which have always failed and will continue to do so must be abandoned. And sound money, that is to say a gold coin standard freely available to ordinary people at their choice must be re-established. Interest rates would then stabilise at risk-free annual rates of just a few per cent set by markets in the context of demand for investment capital and the availability of savings. Market stability will automatically follow. The diversion of human activity into speculation will diminish, benefiting the economy from its redeployment into more productive pursuits. No longer would we have governments attempting to chase monetary objectives which bankrupt homeowners with mortgages as a result of misguided Keynesian policies.

A return to sound money clips the wings of high spending politicians, but other specific changes must also be introduced, reversing Keynesian macroeconomic policies entirely:

• Government spending must be reduced substantially, with an initial target for it to be no more than 20% of the economy. This will reduce the tax burden on productive businesses and workers for the benefit of non-inflationary progress. It will require extensive legislation to be passed eliminating mandated spending commitments.
• The policy of regulating goods and services must be abandoned, and responsibility for judging product suitability handed back to individuals.
• All taxation must be removed from savings, interest earned, and capital gained: savings will have already been taxed when earned. Savings are the necessary source of investment funding for economic progress. And citizens must be encouraged to save for their future, because the state must withdraw from providing widespread welfare, restricting it to a bare minimum for genuine need.
• Inheritance taxes and death duties must be rescinded. Families should be allowed to accumulate and pass on wealth which is otherwise destroyed the moment it is acquired by government. 
• Protectionist trade policies must be abandoned in favour of free trade. The benefit to an economy from the comparative advantage of buying the best suited products from anywhere are enormous, as the evidence from entrepôt economies, such as Hong Kong, confirms.
• Government ministers must not be permitted to accept lobbying by pressure groups and businesses, because their democratic responsibility is to the entire electorate.
• All central bank activities must cease and replaced by a note issuing authority regulating the relationship between gold coin held in reserve and the face value of notes in circulation. The relationship should be laid down by law, funded by government, and for the gold coin to note relationship to be maintained at a 40% minimum at all times. It must be coin and not bullion in order to be available to the entire population. A bullion standard risks foreign arbitrage in potentially destabilising quantities.
• Foreign policy must be amended to not interfere in other nation’s politics, except where national interests are demonstrably affected.
• Government spending must be fully accountable. All revenue received by the Treasury must be hypothecated — no more robbing Peter to pay Paul.

Clearly, these reforms will not happen before an existential crisis serious enough to force a complete policy overhaul. Even then, it depends on government ministers and bureaucrats correctly diagnosing the reasons for the crisis, which with all of them in thrall to neo-Keynesian macroeconomics and the realisation and admission of their own roles in creating a final crisis is extremely unlikely to happen in a Damascene fashion. Instead, a period of policy vacillation is likely, leading to a danger of political instability and a retreat into yet more socialism.

The final crisis brought upon us by Keynesian policies will almost certainly not mark the end of all our troubles.

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Alasdair Macleod is Head of Research for Goldmoney. He has been a celebrated stockbroker and member of the London Stock Exchange for over four decades. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy.

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His article previously appeared at the Cobden Centre, UK.