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The price rule will drive the US economy into recession
Gerard Jackson
I am forever saying that the economic commentariat never learn. Time and time again Austrians point out that loose money means boom-and-bust, and that the price rule is the economic equivalent of the Holy Grail. The only difference is that the myth of the Holy Grail never caused a recession.
Right now some commentators are complaining that Greenspan’s monetary policy is slowing down the US economy. These people ignore the fundamental economic fact that nothing is ever really for nothing. They really believe the ‘price rule’ actually works. That a policy based on the price rule always results in recession and Greenspan’s ‘mysterious imbalances’ is never given the slightest consideration is a sad reflection on current economic thinking.
To them the business cycle is a natural to a free-market economy. No it isn’t. These people do not even grasp the concept of malinvestments. Money is not neutral. This means that when the fed expands credit it creates malinvestments — imbalances as Greenspan calls them – that cannot be sustained. Eventually recession sets in and they have to be liquidated. This is what happened to the US economy during Clinton’s second term.
The simple fact is that no economy, including the US economy, can build up masses of malinvestments without having to pay a heavy price.
Part of the problem is that during the 1990s very few saw that the Fed’s loose monetary policy created a bubble, causing the private sector’s financial deficit to climbed to an unprecedented 5 per cent of GDP, the current account to reach a record 6 per cent of GDP and consumer spending to race ahead, with retail sales jumping by 9 per cent 1999, and personal savings turning negative for the first time since the depths of the Great Depression. It still beggars belief that anyone considered this situation healthy — but a great many did and some still do.
Rather late in the day some finally came to the conclusion that rapid credit expansion must have been largely to blame for the bubble. The BIS (Bank of International Settlements) was earlier than most, warning in one of its publications (published in 1994) that credit expansion had played a significant role in the “asset-price bubbles” that marked Britain, Scandinavia and Japan in the late ‘80s.
On the other hand, the Austrians had warned long before about the consequences of credit expansion, only to be ignored. Nevertheless, even this somewhat grudging and stunted recognition of the role that credit expansion plays in creating bubbles was still to be welcomed, despite the Austrians being denied credit for it.
The Austrians have been pointing out from very beginning that rising prices are an effect and not a cause of inflation. Therefore inflation can bubble below the surface without any general price rise. This is something that the BIS recognised and even the once staunchly Keynesian Economist has accepted this thinking.
In a normal situation rapidly rising productivity would generate falling prices. Unfortunately, the dangerous fallacy that this situation is deflationary and that it is necessary to maintain stable prices to keep the economy on an even keel has firmly taken hold. But some have come to realise that rising productivity and stable price policies are incompatible.
Using an expansionary monetary policy to offset the price-reducing effects of falling production costs generates economic bubbles. The Economist pointed out that America’s 1920s bubble economy developed though “inflation was modest”.
In fact, consumer prices were relatively stable during this period, but there were significant price differences between producer and consumer goods. An important fact the significance of which the Economist, like so many others, completely overlooked.
Far too many still argue that pricking bubbles causes spending to contract. Nothing of the kind. It is the rise in interest rates that restricts credit, the same thing that usually bursts the bubble and hence spending. Even if investors went completely bearish it would not effect aggregate spending in itself so long as the Fed continued to expand credit.
It was the 1929 crash that created the myth that a stock market crash would ignite a recession. The Fed froze the money supply in December 1928 and by July 1929 unemployment in manufacturing began to rise. In other words, America had already gone into depression about four months before the market crash which some believe was precipitated by the Fed raising the discount rate on August 9 from 5 per cent to 6 per cent.
This didn’t trigger the crash because the Fed actually offset the increase by reducing the buying rate for prime bankers’ acceptances from 5.25 per cent to 5.125 per cent, which was the same as the open market rate. To cut the story short, with the money supply solidly frozen and the economy sliding into recession, the outcome was as inevitable as night and day as investors realised that the party was finally over.
It’s a genuine tragedy that the economic commentariat has such a poor understanding of economic history.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 13 June 2005