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US economy: is another recession on the way?
Gerard Jackson
Much has been made of the fact that if the last GDP figure was adjusted for imports then it would show that the US economy had expanded by 4.6 per cent instead of 3.1 per cent (later adjusted to 3.8 per cent).
Some have defended the adjustment on the grounds that higher imports are a sign of growing economic strength. Therefore failure to correctly account for them inadvertently leads commentators to underestimate the true rate of economic expansion.
Although I agree with making the adjustment to GDP I think that the accompanying opinion that America’s tide of imports signifies a strengthening economy is ridiculous, even though I can see where the confusion has its roots.
The argument goes that “all the trade-deficit talk is Alice-in-Wonderland stuff” because it denies the fact that consumer and business spending is rising because incomes are up. Let us ignore the economic reality that consumer spending does nothing to raise real incomes (this should be remembered next time some commentator brags about consumer spending and housing being strong) and direct our attention to the fact that rising incomes are not always a sign of a healthy economy. This is an important truth that today’s commentariat has lost sight of.
Back in 1957 Mr. J. J. Polak, a Keynesian economist employed by the International Monetary Fund, attempted to integrate money and credit factors into the Keynesian model. He assumed velocity was stable and that nominal incomes would rise if money supply doubled. (In reality, of course, there is no proportional relationship between changes in the money supply and changes in general prices).
His inquiry revealed that if a country engaged in credit expansion nominal incomes would rise, imports would grow and a balance of payments deficit would emerge. He concluded that money supply changes will induce changes in demands for domestic and foreign goods, services and securities before any significant change in prices occurs.
Actually there was absolutely nothing new in Polak’s findings. Professor von Mises described this process precisely in his article the Balance of Payments and Foreign Exchange Rates<, Mitteilungen des Verbandes Oesterreichischer Banken und Bankiers, 1919.
Hence credit expansion raises nominal incomes which suck in imports causing a current account deficit. It followed from his reasoning that where a current account deficit is the result of monetary expansion there remains only three ways to deal with it:
1. The deficit country must cease credit expansion. 2. Other countries must inflate their economies. 3. The deficit country must devalue its currency until the deficit is eliminated.
According to the Fed’s latest monetary figures M1 grew by 26 per cent from December 2000 to March 2005. This is what is really driving the current account deficit. Additionally, the monetary expansion is not only misdirecting production at home it is also having the same effect on America’s trading partners.
Eventually inflation — in the form of credit expansion — invariably makes itself felt in the manufacturing sector first, a phenomenon I am forever drawing attention to. From March 2004 to March 2005 intermediate goods prices advanced 8.7 per cent, and the crude goods index rose 10.8 per cent. Now this has happened at what the Fed would call “the earlier stages of processing” and what the Austrians call the higher stages of production. It is also what Austrian analysis predicts.
The Institute for Supply Management found that “manufacturers continue to pay higher prices in March. This is the 37th consecutive month the index has registered higher prices. March’s index is at 73 percent, 7.5 percentage points higher than February’s reading of 65.5 percent. In March, 51 percent of supply executives reported paying higher prices and 5 percent reported paying lower prices, while 44 percent reported that prices were unchanged from the preceding month”.
In other words, inflationary pressures are building up. Nevertheless, supply-siders still argue that inflation is not a problem.
Defenders of the current state of the US economy have added the effects of the Bush tax cuts as a second string to their bow. In this they are quite right. I would go even further and suggest that this is the only string they really have.
It is supposed to be self-evident in economics that the way to increase the supply of a product is to reduce its costs of production. Naturally, the reverse also holds. The ‘product’ I have in mind is savings.
By cutting taxes on capital gains and dividends President Bush increased the amount of savings, cut the cost investing and reduced the burden of allocating capital. This “supply-side” impact would be better stated as a product of Say’s Law of markets. (Unfortunately, it is impossible to completely separate the investment effects of the tax cuts from the effects of monetary expansion).
What the above boils down to is that the Fed has once again laid down the foundations for a recession by generating another unsustainable monetary boom. As I said years before the last recession: “It’s not if but when”.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 9 May 2005