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The US Economy and Global Monetary Disorder

Economics / US Economy Sep 01, 2008 - 11:19 AM GMT

By: Gerard_Jackson

Economics Best Financial Markets Analysis Article"Inflation is always and everywhere a monetary phenomenon," so said Milton Friedman. After that it was down hill. The Chicago school so defined inflation and deflation that they largely severed the monetary root from which these phenomena spring. Hence a stable price level was seen as the ideal. (Even the great Knut Wicksell subscribed to the fallacy of the stable price level).

If prices rose that was inflation: if they fell then it was deflation. The thought that inflation can be wreaking havoc even though the price level appears undisturbed was an idea they refused to countenance. To make matters worse, the fact that inflation and deflation are monetary phenomena has been largely rejected by the great majority of economists.

Once the idea of a stable price level was linked to Keynes' fallacy of demand deficiency it was only a matter of time before governments would quickly ramp up their spending. As the maintenance of full employment became a government imperative the idea of maintaining a stable price was thrown overboard. We are now lumbered with the notion of acceptable rates of inflation. The result is the present world-wide monetary disorder of which the US economy is an important part.

Unfortunately, rather than reassess their theories mainstream economists still insist on pushing the same monetary nostrums much as doctors once insisted on bleeding their patients. Gary Stern, head of the Minneapolis Fed, is a dangerous example of unrepentant economic orthodoxy. He recently stated that lower oil price and tight credit have caused expectations of rising inflation to weaken.

That the massive increase in oil prices was due to a world-wide monetary explosion was not even considered. Some speculators are pointing to a fall in the prices of zinc, silver, nickel and oil as evidence that inflationary forces are on the retreat. Be that as it may, their error is the assumption that rising commodity prices are inflationary instead of being created by inflation.

As the world's largest economy by far, American monetary policy has had a detrimental effect on the world economy. The first thing to consider is the effect of monetary expansion on a country's price structure. Money is not neutral. This means that by increasing the quantity of money the pattern of spending changes in response to the emergence of new monetary streams. The necessary adjustment to the price structure that the monetary expansion causes is not sustainable. As soon as the monetary brakes are applied the price distortions reveal themselves in the form of bankruptcies, 'excess' capital and rising unemployment.

It is a known fact that loose monetary policies raise the demand for imports. This is why countries that inflate faster than their trading partners tend to accumulate current account deficits. In the case of a comparatively small economy this will have few consequences for the pattern of international trade. The case of the US economy is a very different matter.

By running current account deficits fuelled by 'cheap money' policies the US has, in my opinion, badly distorted the pattern of international trade by causing its trading partners to direct more resources into producing exports to the US. Just how bad this situation is we cannot know until the Fed puts and end to its loose monetary policy.

Free market supporters who claim that cheap imports have the effect of raising living standards and lowering inflation obviously do not realise that this situation is an inflationary one that cannot be continued indefinitely. This is why they remain serenely indifferent to American companies moving operations offshore. As far as they are concerned, this is simply the free market at work.

The underlying assumption here is the concept of neutral money. If money were indeed neutral then their conclusions would be correct. But this is not the case. It ought to be clear to anyone that for money to be neutral price rises would have to be uniform, e.g., a 10 per cent increase in the money supply would lead to a 10 per cent rise in the prices of all goods and services. The great majority of the classical economists fully understood this fact and the consequences.

What this boils down to is that the Fed's monetary policy artificially raised the prices of home-produced goods relative to foreign goods. In effect, this inflationary policy was the equivalent of taxing domestic products while subsidising foreign goods*. What to do? The sensible thing is to implement a sound monetary policy. As that is highly unlikely to happen the next best thing is for the government not to make matters worse by imposing tariffs and more taxes.

This brings us to the candidates for the presidency. Although McCain doesn't understand the situation he instinctively knows that imposing tariffs and burdening the economy with more taxes is not going to make things better. He also realises that lowering tax rates on investments, corporations and capital gains will encourage the capital formation and hence raise future living standards.

Obama, on the other hand, plans a massive tax hike and more government interventionism based on the Democrats' view that they are the smartest people on the planet. The results could make the Carter presidency look like a picnic.

*Australia is having the same problem. Unfortunately our free market club refuses to discuss this extremely important issue. Is monetary policy destroying the country's manufacturing base? provides an insight to how badly our 'free market' economists treat this topic.

By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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