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How Central Banks Destabilized the World's Economies

Economics / Liquidity Bubble Oct 13, 2008 - 09:54 AM GMT

By: Gerard_Jackson

Economics Best Financial Markets Analysis ArticleThe crisis that America finds itself in is not political in origin nor can it be laid at the feet of any individual or party. The whole world, including Europe, is experiencing a massive monetary disruption. Moreover, it is not the first time that the world has been shaken by a financial crisis. It happened in 1824 and it happened again after WW I. What is depressing is that though these crises have but one single cause today' s central bankers and legions of economists find themselves utterly clueless, readily taking as a causes those data which are in fact symptoms of a very deep monetary disorder.

Monetary disorders are always the product of inflationary policies

Two economic fallacies govern the actions of central banks. The first one is that of the stable price level. According to this fallacy so long as prices remain stable the economy cannot fall into a recession. This fallacy was championed by Irving Fisher. It cost him $10 million. Those who argue that the money supply should be manipulated in away that prevents prices from either rising or falling have assumed that though individual prices are determined by supply and demand the level of prices is a function of the money supply.

This view cannot withstand even a cursory examination. Money always enters the economy at certain points from which the effects of these new spending streams ripple outwards. Even if a " helicopter" approach is assumed in which everyone simultaneously receives the same amount of money the theory still breaks down because people' s preferences are neither identical nor fixed. Not every economist at the time agreed with Fisher as the following quote shows:

...difficulties are viewed largely as the inevitable aftermath of the world' s greatest experiment with a " managed currency" within the gold standard, and, incidentally, should provide interesting material for consideration by those advocates of a managed currency which lacks the saving checks of a gold standard to bring to light excesses of zeal and errors of judgment. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle , Macmillan and Company 1937, p. 56).

If Fisher and his disciples had been correct he would not have lost his fortune and much of his reputation as an economist. During the 1920s the Fed almost doubled the money supply. So why didn' t this raise prices? It did. Commodities boomed as did the demand for capital goods. Because of the focus on consumer goods the prices of capital goods and land were ignored. What makes this observation of critical importance is that it blows away the theory that prices can be stabilised. They cannot.

Changes in money streams will always change the price structure and hence the pattern of production. (Richard Cantillon, Essay on the Nature of Commerce in General , Transaction Publishers, 2001, written about 1734 and first published in 1752). These money streams are brought into existence by the central banks forcing down the rate of interest below its market rate. Consequently businesses take on more time-consuming projects, projects that are economically justifiable because the necessary capital is not available to complete them. What central banks are in effect doing is substituting credit for capital. In the mid-'20s it was observed that the

tendency to substitute bank credit for real capital [capital goods] was looked upon as a very ominous tendency. The years 1924-29. . . abundantly justified these apprehensions. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946 , LibertyPress, 1979, p. 99).

The second fallacy is that recessions are caused by "deficient demand". This is probably the most dangerous economic fallacy around. Its adoption by the mass of economists and hence central banks is a curse for which we can thank Lord Keynes. This invites a simple question: Why is it that more and more monetary injections are needed to prevent recession?

The classical economists had the answer and it was called disproportionality. They noted two things: The first being that the "revulsion" as they called always started with manufacturing. The second thing being that these disruptions always occurred in clusters. Ricardo arrived, and rightly so, at the conclusion that the problem was caused by the banking system creating excess credit. (Excess being defined as bank deposits exceeding the banks' gold reserves). It is this excess credit is what fuels stock market booms. Fritz Machlup explained that a share market boom requires a continuous flow of bank credit. This can only happen if the central bank loosens the monetary spigot. Therefore a

... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply. (Fritz Machlup The Stock Market, Credit and Capital Formation , William Hodge and Company Limited, 1940, p. 290).

Today's economists miss what became self-evident to the early economists: Ultimately "products are always bought with other products" . (Jean-Baptiste Say A Treatise on Political Economy , 1836 edition republished by Transaction Publishers, 2001, p. 166. Also chapter XV). Say and the classical economists fully understood that goods had to be produced in their proper proportions, i.e., equilibrium had to prevail. Say's response to the charge of over production was to point out

... that the glut of a particular commodity arises from its having outrun the total demand for it in one or two ways; either because it has been produced in excessive abundance, or because the production of other commodities has fallen short. (Ibid. p. 135).

David Ricardo was at one with Say on the issue of gluts:

Productions are always bought by productions, or by services; money is only the medium by which the exchange is effected. Too much of a particular commodity may be produced, of which there may be such a glut in the market, as not to repay the capital expended on it; but this cannot be the case with respect to all commodities; the demand for corn is limited by the mouths which are to eat it, for shoes and coats by the persons who are to wear them; but though a community, or a part of a community, may have as much corn, and as many hats and shoes, as it is able or may wish to consume, the same cannot be said of every commodity produced by nature or by art. ( On The Principles of Political Economy and Taxation , Penguin Bookes, 1971, p. 292).

Concerning the problem of booms, busts and so-called general gluts, an exasperated Ricardo wrote to a friend that

Mr. Malthus never appears to remember that to save is to spend, as surely, as what he exclusively calls spending. ( The Works and Correspondence of David Ricardo Vol. II , liberty fund Indianapolis 2004, First published by Cambridge University Press in 1951 p. 449).

In 1829 or thereabouts John Stuart Mill wrote a devastating critique of the idea that aggregate demand can be deficient. Adhering to Say' s law he emphasized that so long as wants remain unsatisfied and the means to sate them are scarce then the notion of " general over-production" is absurd. The key to his argument is the insight that demand springs from production, not consumption. As he eloquently put it:

The argument against the possibility of general over-production is quite conclusive, so far as it applies to the doctrine that a country may accumulate capital too fast; that produce in general may, by increasing faster than the demand for it, reduce all producers to distress. ... It is true that if all the wants of all the inhabitants of a country were fully satisfied, no further capital could find useful employment; but, in that case, none would be accumulated. So long as there remain any persons not possessed [of goods], there is employment for capital; and if the commodities which these persons want are not produced and placed at their disposal, it can only be because capital does not exist, disposable for the purpose of employing, if not any other labourers, those very labourers themselves, in producing the articles for their own consumption. Nothing can be more chimerical than the fear that the accumulation of capital should produce poverty and not wealth, or that it will ever take place too fast for its own end. ( Essays on Economics and Society , University of Toronto Press 1967, p. 278).

William Stanley Jevons, one of the first neo-classical economists, also explained why general gluts (demand deficiency) were not possible. In his opinion

Early writers on Economics were always in fear of a supposed glut, arising from the powers of production surpassing the needs of consumers, so that industry would be stopped, employment fail, and all but the rich would be starved by the superfluity of commodities. The doctrine is evidently absurd and self-contradictory ... Over-production is not possible in all branches of industry at once, but it is possible in some as compared with others. ( The Theory of Political Economy , Kelley & Millman, Inc. 1957, p. 203, first published in 1871)

For Jevons and his contemporaries genuine purchasing power could only spring from production. It should be easy to see from this observation that as individuals increase their real purchasing power, i.e., expand individual output, total output rises, which is just a fancy way of saying that total demand has expanded. This process of exchange will tend to equate the value of the worker' s output with that of his wages. All said and done, we can now say at this point that purchasing power is another term for exchange power, which in turn is labour' s ability to create goods for exchange.

Yet something that would be glaringly obvious in a barter economy drops out of sight with the appearance of money. If the fundamental principles that the early economists discovered were resurrected and adhered these crises would not develop.

It clear that the crisis was not caused by political incompetence but by very bad economics. Unfortunately, this fact will not satisfy political bigoted journalists like Frank Thomas of the Wall Street Journal for whom lying is second nature. It is not much different in Australia, for which Rupert Murdoch much shoulder some of the blame. The idiotic Peter Jonson (aka Henry Thornton) had the audacity to blame President Bush and Chaney, pompously declaring that

Bush and Dick Chaney should resign just as soon as the votes are counted in the current election. The Speaker of the House, who would become acting President and would be expected to work closely with the President-elect on the plan to restore trust to the world' s financial system.

Other Prime Ministers and Presidents should look deeply into their souls and decide whether or not to resign -- after appointing a person of proven experience who has no interest in the coming election to run the Government until the election is settled. ( The Australian , It' s time to restore trust , 10 October 2008)

If anyone needs to do any soul searching it's the sanctimonious Jonson and his mates. Their crummy economics brought about this crisis. Now the puffed-up ass wants to put the cretinous Pelosi in charge of the US economy. I am truly sick to death of political flakes like Jonson and their imperious announcements about Bush.

By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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