19 November 2015
Your country faces a stagnating economy. Let us assume your Prime Minister (or President if that is who holds the executive power) seeks advice from two imaginary economists.
PM: You two economists have different views on what our economic policy should be. What is your advice?
FIRST ECONOMIST (Austrian school): Prime Minister, the reason we face a stagnant economy is your central bank perpetuated the credit cycle by suppressing interest rates when the economy turned down after the banking crisis and lending risk escalated. That has left us with a legacy of under-performing businesses, which should have been left to go bankrupt. Instead they are struggling under a burden of unrepayable debt. Capital is not being reallocated to the new enterprises of the future. The dynamism of free markets has been throttled.
The extra money and credit created by the banking system has not been applied to the real economy. Instead they are fuelling a financial boom in asset prices, which have become dangerously separated from production values.
Eventually, current monetary policy will lead to a fall in the purchasing power of the currency, and the central bank will be forced to raise interest rates to a level that will precipitate the next financial crisis, if the crisis has not already occurred by then. Overvalued assets become exposed to debt liquidation. It happens every time, and if you think the last crisis, which led to the Lehman collapse was bad, on current monetary policies the next one will be much worse, just as Lehman was much worse than the aftermath of the dot-com boom.
A monetary policy that relies on the transfer of wealth from savers to debtors always fails in the end, as certainly as death and taxes exist. It is also the real reason the bankers are getting wealthy while ordinary people become poorer. The time has come to recognise that your central bank, by licencing and encouraging the banks to create credit out of thin air, is the source of the problem.
Sadly, your central bank seems blissfully unaware of the debilitating effect of monetary inflation on your voters’ wages and savings, and if I may say so Prime Minister, your administration pays little regard to the natural injustice of rewarding profligate borrowing and penalising thrift.
I advise you to stop your central bank from manipulating interest rates and to let the markets sort themselves out. Furthermore your central bank must stop debasing the currency as a cure-all. So this is what I suggest.
First, encourage savers to rebuild their wealth directly through tax policy. When someone has paid tax on his income he should be entitled to keep his savings. The evidence from Germany and Japan in the post-war years is that a stable source of low-taxed savings is a prerequisite for a strong, yet stable, economy. And as savers rebuild their personal wealth, the state can scale back its future welfare commitments, which as you must be aware, are in danger of escalating out of control.
Second, I would reform the financial system. Banks should manage their affairs on the basis of reputation, and not hide behind regulation. Instead of looking after their customers, they use their regulated status to game the system. Regulating the banks has led to crony capitalism of the most pernicious sort. In future banks must set their own standards and be answerable to their customers first and foremost, not to a government regulator.
Third, the state must always run a budget surplus, to pay down its high level of debt. In balancing the books it is important to bear in mind that money taken in taxes destroys wealth. For a truly prosperous economy, you should plan in the longer term to reduce the state’s tax take to below 30% of GDP, and lower still in the fullness of time.
You will only put a stop to successively worsening cycles of boom-and-bust in the future if you return to sound money, free markets and small government. Your ministers must stop pretending they can run the economy. They have no basis for making commercial judgements. Government interventions are always politically-driven. Nor should your ministers listen to big business, which always seeks to influence policy in its favour.
I realise all this will take time to implement and must be done in steps so that the private sector can adjust. For this reason I recommend you structure these changes over a ten year period, announcing the legislative schedule in advance. You will find that businesses will reposition themselves to your new policies ahead of their implementation. The benefits to your economy and your voters are more likely to flow smoothly without disruption, and deliver economic benefits much sooner than you think.
SECOND ECONOMIST (Neo-Keynesian): Prime Minister, I cannot believe what we have heard from my esteemed colleague. He lives in a world that no longer exists. I really don’t see the relevance of nineteenth century values to the economic conditions of today. The disciplines of macroeconomics and econometrics have made great advances, allowing us to plan the course for the economy in greater detail than before.
I am confident that I have the solution to your problem. I firmly believe that your government’s monetary and economic policies are going in the right direction, but you are not bold enough. People are too reluctant to spend, so you must do everything to encourage them to do so, perhaps forcing the banks to cut the cost of consumer credit. Alternatively, you should explore means of distributing extra money to consumers through government spending, along with negative interest rates perhaps, to jump-start economic growth.
I am convinced your government can safely increase its budget deficit, injecting money into the economy by creating more jobs in the public sector. You should bring forward spending on infrastructure, which will boost the construction industries. Creating employment by expansionary measures will reduce the cost of unemployment, offsetting some of the budget deficit.
Prime Minister, it would be a huge mistake to cut back now, because the result will certainly be a deepening recession, widespread bankruptcies and increasing unemployment. I am convinced that with government support, the welfare state and vital industries can be safe-guarded, and if your central bank increases the money supply further and encourages the banks to lend we shall get through this temporary problem. It’s vital we get consumer confidence going again, and I firmly believe progressive economic and monetary policies can save the day.
The time to cut back is not now. When the economy resumes its long-term sustainable growth trend, increasing tax revenues will then close the deficit, bringing government finances back into balance. There really is no need for any cuts in public spending, which will only lead to disaster.
I have presented both arguments unadorned with any compromises, but they capture the essence of the chasm between the laissez-faire Austrians and the anti-market neo-Keynesians. The difference between the two is the Austrian argues from a sound theoretical basis, while the Keynesian approach is founded on beliefs and a reluctance to consider second-order effects.
It should be apparent that a politician driven by short-term considerations, which describes just about every leader in Western democracies, will have great difficulty in dealing with the destructive credit cycle. For a start, they all claim that their central banks are independent, which is code for “we don’t understand monetary policy, so we don’t want to be responsible for it.”
This is why the order of events is crisis first, solution second. The solution is always to address the symptoms and not the underlying problem. It is not for nothing that everyone refers to the Lehman crisis as if it was the crisis. No, the crisis was the over-inflation of asset prices relative to their productive capacity, and the speculative greed that drove it. Lehman, AIG, Bear Stearns and all the rest were merely the subsequent casualties.
Very few people understand the fundamental truth that in properly functioning markets, assets are valued by their productive capacity: property yields a rent, or the equivalent use-value for an owner-occupier. Machinery produces manufactured goods, and the value of the goods produced determines the value of the machinery. Even art produces a return in aesthetic value, hard though that is to value. But when speculation drives values for values’ sake, as was the case with the dot-coms and the liar-loan property boom seven years later, a financial crisis always follows. Yet again, this description fits the conditions of today.
The only time asset values can continue to rise on a non-speculative basis is when the public as a whole changes its preference against money and in favour of goods. In this instance it is the purchasing power of money falling, and not the value of goods rising. This does not apply today, as the price of gold attests. However, it is likely to apply when the central banks react to the coming crisis.
The truth is it is too late for our politicians to act, because the speculative peak that precedes the crisis is already upon us. Last time round, the Federal Reserve Board wrote open-ended cheques to save the banking system, estimated at the time to be as much as $13 trillion or thereabouts, though not all this facility was drawn down. It followed this with zero interest rates and three rounds of quantitative easing. What will it take this time?
Whatever it takes, as Mario Draghi famously said in 2012. This time it will almost certainly be currencies that end up taking the hit.