Best of the Week
Most Popular
1.BrExit House Prices Crash, Flat or Rally? UK Housing Market Affordability Crisis - Nadeem_Walayat
2.Stocks Bull Market Climbs Wall of Worry, Bubble? When Will it End? - Nadeem_Walayat
3.Gold Price Is Now On Its Way To All-Time Highs - Hubert_Moolman
4.Deutche Bank Stock Price Crash - The EU Has Problems Far Beyond the Brexit - Harry_Dent
5.UK interest Rate PANIC CUT! As Banks Prepare to Steal Customer Deposits - Nadeem_Walayat
6.Gold and Silver Bull Phase 1 : Final Impulse Dead Ahead - Plunger
7.Central Bankers Fighting An Unprecedented Global Economic Slowdown - Gordon_T_Long
8.Putin Hacking Hillary for Trump, Russia's Manchurian Candidate? - Nadeem_Walayat
9.Stock Market Insiders Are Secretly Selling, Cycle Top Next Month - Chris_Vermeulen
10.Gold Sector - Is it time to Back up the Truck? – Mortgage the Farm? - Peter_Degraaf
Free Silver
Last 7 days
Ignore Yellen and Buy the Dip in Precious Metals - 27th Aug 16
SPX Downtrend Should be Underway - 27th Aug 16
Unraveling the Secular Economic Stagnation Story - 27th Aug 16
The Precious Metals Sector and the Fed. . . - 27th Aug 16
Stock Market - All Is Calm, All Is Not Right - 27th Aug 16
Gold Junior Stocks Q2 2016 Fundamentals - 26th Aug 16
Buy Gold’s August Dip? Gold’s Monthly Sweet Spot In September - 26th Aug 16
The IMF’s Internal Audit Reveals Its Incompetence and Massive Rule Breaking - 26th Aug 16
Commodities Are the Best Bargain Now—Here’s What to Buy - 26th Aug 16
Why I Left Canada and Became A Citizen of the Dominican Republic - 26th Aug 16
The GLD vs GOLD - 26th Aug 16
Can Stocks Survive Without Stimulus? - 25th Aug 16
Why Putin Might Be on His Way Out - 25th Aug 16
Bond Guru Gary Shilling - The Bond Market Rally of a Lifetime - 25th Aug 16
A Zombie Financial System, Black Swans and a Gold Share Correction - 25th Aug 16
OPEC’s Output Freeze: What Has Changed Since Doha? - 25th Aug 16
Merkel Prepares For a Deliberate Crisis While White House Plans For a Disastrous Succession - 24th Aug 16
Suspicious Reversal in Gold Price - 23rd Aug 16
If Trump Can’t Pull Off a Victory, Expect a Civil War - 23rd Aug 16
Ceding ICANN and Internet Control to Globalists - 23rd Aug 16
How to Spot an Oversold Stock Market - 23rd Aug 16
Gerald Celente Sees Worst Market Crash, New Military Conflict, Gold Spike to $2,000/oz - 23rd Aug 16
EU Olympics Medals Table Propaganda Includes BrExit Britain - 22nd Aug 16
BrExit Win's Britain Olympics Success Freedom Dividend, Economy Next - 22nd Aug 16
Stock Market Top Forming, but Slowly - 22nd Aug 16
(Really) Alternative Banking Systems - 22nd Aug 16
Vauxhall Zafira Fires - Second Recall Issued - Inspection Before Bursting into Flames? - 21st Aug 16
Will the Stock Market Bubble Pop Regardless if the FED Never Raises Rates? - 21st Aug 16
US Government Spending - 3 Big Stories Not Being Covered – Part III - 21st Aug 16
Silver Analysis - 20th Aug 16
SPX New Highs, Correction Next? - 20th Aug 16
Housing Bubble - The Marginal Buyer Holds The Pin That Pops Every Asset Bubble - 20th Aug 16
Gold Miners Q2 2016 Fundamentals - 19th Aug 16
Which Price Ratio Matters Most in a Fiat Ponzi? - 19th Aug 16
Big Policies, Bigger Failures - 19th Aug 16
Higher Crude Oil’s Prices and USD/CAD - 19th Aug 16
Here’s Why You Should Look for Dividend Stocks and How - 19th Aug 16
Deglobalization Already Underway — 4 Technologies That Will Speed It Up - 19th Aug 16
These 6 Charts Show Why the Average American Is Fed Up - 18th Aug 16
SPX Easing Lower - 18th Aug 16
Low / Negative Interst Rate’s Legacy - 18th Aug 16
The 45th Anniversary of The Most Destructive Event In Modern Monetary History - 18th Aug 16
USDU - An Important Perspective on the US Dollar - 17th Aug 16
SPX Completes Wave 1 Decline - 17th Aug 16
How to Quickly Spot Common Fibonacci Ratios on a Chart - 17th Aug 16
When Does a Forecast Become a Trade? - 17th Aug 16
Kondratiev Wave - The Financial Winter Is Nearing! - 17th Aug 16
Learn "The 4 Best Elliott Waves to Trade -- and How to Trade Them" - 16th Aug 16
Stock Market Bears Turning Bullish At New All Time Highs - Time to Get Worried? - 15th Aug 16
Job Seekers Sacrificed to the Inflation Gods - 15th Aug 16
A Look At Commodities and Financial Markets Trading Week Ahead - 15th Aug 16
Stock Market New Top Forming? - 15th Aug 16

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

How to Trade Elliott Waves

Fed’s Destructive Monetary Policies Expose Mainstream Economic Fallacies

Economics / Economic Theory Feb 10, 2013 - 12:12 PM GMT

By: Frank_Shostak

Economics

At the annual meeting of the American Economic Association in San Diego (January 4–6, 2013), Harvard professor of economics Benjamin Friedman said,

The standard models we teach … simply have no room in them for what most of the world’s central banks have done in response to the crisis.

Friedman also advises sweeping aside the importance of the role of monetary aggregates. On this he said,


If the model you are teaching has an “M” in it, it is a waste of students’ time. Delete it.

According to most economic experts, the Fed has re-written the central banking playbook, cutting interest rates to near zero and tripling its balance sheet by buying bonds. The federal funds rate target is currently at 0.25%. The Fed’s balance sheet jumped from $0.86 trillion in January 2007 to $2.9 trillion in January 2013.

Professors who say they agree with the Fed’s approach to the 2008–2009 economic crisis are nonetheless challenged to explain this new world of central banking to their students. They argue that the dramatic action by the central banks to counter a global financial crisis cannot be explained by traditional models of how monetary policy works.

So what seems to be the problem here?

According to traditional thinking, a lowering of interest rates stimulates the overall demand for goods and services, and this in turn, via the famous Keynesian multiplier, stimulates general economic activity. Furthermore, according to traditional thinking, massive monetary pumping should also lead to a higher rate of inflation.

Yet despite the massive monetary pumping, both economic activity and the rate of inflation remain subdued. After closing at 8.1% in June 2010, the yearly rate of growth of industrial production fell to 2.2% in December 2012. The yearly rate of growth of the consumer price index (CPI) fell to 1.7% in December 2012 from 3.9% in September 2009. Additionally, the unemployment rate stood at a lofty 7.8% in December 2012 with 12.2 million people out of work.


So why has the massive monetary pumping by the Fed, and the near zero federal funds rate, failed to strongly revive economic activity and exert visible upward pressure on the prices of goods and services?

Is the comment by Benjamin Friedman, that money is not relevant, now valid?

No. The fact that the massive Fed pumping has failed to produce the expected results—along the lines of mainstream models—does not mean that the money supply is no longer important to understanding what is going on.

The fact that economic activity is currently not responding to massive monetary pumping, as in the past, indicates that prolonged reckless monetary policies have severely damaged the economy’s ability to generate real wealth. So contrary to Friedman, we maintain that money matters very much. However, contrary to mainstream thinking, an increase in money supply does not grow, but rather destroys the economy.

The ongoing monetary pumping, coupled with an ongoing falsification of the interest rate structure, has caused a severe misallocation of scarce real capital. As a result of reckless monetary policies, a non-wealth-generating structure of production was created. Obviously, with the diminishing ability to generate real wealth, it is not possible to support, i.e., fund, strong economic activity.

Monetary pumping is always bad news for the economy because it diverts real funding from wealth generating activities to wealth consuming activities. It sets in motion an exchange of something for nothing.

As long as the economy’s ability to generate wealth is functioning, the reckless monetary policies of the central bank can be absorbed. Under such conditions, market watchers get the false impression that "loose" monetary policies are the key drivers of economic growth.

When wealth-generating activity, as a percentage of the total economic activity, drops below a certain point, reality takes over and general economic activity has to fall. This decline in wealth-generating activity undermines the ability to lend. Real funds for lending have also declined and lending "out of thin air" results. Following suit is the growth of the money supply and price inflation.

As a result of the weakened wealth generating process, formerly subsidized non-wealth-generating activities come under pressure. Since they don't produce enough to sustain their own viability, they are forced to lower their prices of goods and services to stave off bankruptcy. According to Mises,

As soon as the afflux of additional fiduciary media comes to an end, the airy castle of the boom collapses. The entrepreneurs must restrict their activities because they lack the funds for their continuation on the exaggerated scale. Prices drop suddenly because these distressed firms try to obtain cash by throwing inventories on the market dirt cheap.[1]

It is not clear whether we have already reached this stage in the US. But despite massive pumping by the Fed, economic activity remains subdued and this raises the likelihood that the US economy is not far from sinking into a black hole.

The Fed's aggressive pumping policies highlight the destructive nature of loose money. Popular mainstream theories aside, the actions of the Fed have proven that monetary pumping cannot grow an economy. It can only set in motion a process of destruction.

Many mainstream policy thinkers are of the opinion that the Fed’s policies can be made more effective by making the central bank’s policies transparent and consistent. The following remarks, by the prominent economist Michael Woodford and reported by Reuters, are but an example:

"The recent events ... have given us a lot of reason to change what we teach when we talk about monetary policy," said Michael Woodford, a professor at Columbia University and one of the most influential current thinkers about monetary policy.

In future, Woodford said he would incorporate a lot more discussion about the importance of stability in the financial sector on the macro economy, and tell students why future expectations for central bank interest rates can be vital.

"Explain why expectations are important for aggregate demand," he told the panel. . . .

"Make it credible that the central bank will actually follow through with the policy it is indicating," Woodford said, referring to the importance of convincing businesses and households to invest and spend.

The belief that greater transparency and consistency in the Fed’s policies would lead to stable economic growth is fallacious. We have seen that it is the Fed’s actual policies that are the key factor behind the destruction of the wealth generating process. Hence, the damage inflicted by these policies cannot be avoided even if the Fed is consistent and transparent.

The key problem with the mainstream perspective is its notion that all that is needed for economic growth is to boost the demand for goods and services, i.e., demand creates supply. It is for this reason that mainstream thinkers held the view that increases in the money supply, and the subsequent increase in the overall demand for goods and services, is a catalyst for economic growth.

But we have seen that once money is pumped, it sets in motion an exchange of something for nothing, i.e., the diversion of real wealth from wealth generators to non-wealth generators, and subsequently to economic impoverishment.

Summary and conclusion

At the recent American Economic Association meeting, academic economists said that the latest monetary policies of the Fed made it difficult to employ accepted theories regarding the effect of central bank policies on the economy. Experts are of the opinion that in the “new world,” because of Fed policies, there is little room left for the money supply to explain why economic activity and the rate of inflation are subdued despite, the Fed’s aggressive policies since 2008. Contrary to mainstream thinking, the aggressive policies of the Fed have highlighted the destructive nature of loose monetary policy. Money supply matters more now than ever.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global. Send him mail. See Frank Shostak's article archives. Comment on the blog.

© 2013 Copyright Frank Shostak - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2016 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife