Peter Costello’s economic fallacies and the credit crunch, part II
Gerard Jackson
Treasurer Peter Costello has claimed that the trade deficit is the country’s biggest economic challenge and that it is being affected by “capacity constraints” and the exchange rate. (In part I I dealt with the trade deficit and the Treasurer’s exchange rate fallacies).
To adhere to the idea that our export industries “are being held back by bottlenecks” and “capacity constraints” is to completely fail to comprehend what is happening to the economy. It’s not hard, however, to determine the source of the Treasurer’s error.
Recently Glen Stevens, Ian MacFarlane’s deputy at the Reserve Bank of Australia, warned that the economy was approaching capacity constraints and so growth would slow as output failed to keep up with demand, meaning monetary expansion.
This is truly bad stuff. Unfortunately this is the kind of advice that Costello is getting from the Treasury, his pals in the private sector and the media. And he’s buying it.
Bottlenecks are not a problem but a symptom of a capital structure that has been discoordinated by a very loose monetary policy. Costello’s advisors treat capital as homogenous and money as neutral, except with respect to the general price level.
But once it is understood that not only is capital heterogeneous but that money is an extremely potent agent the dreadful ramifications of loose monetary policies should become readily apparent. Unfortunately primitive views on capital and money are heavily entrenched among the economic commentariat.
There is a certain amount of confusion in the economics profession, at least among the Keynesians, monetarists and supply-siders, about the nature of capital and power of money.
By treating money as neutral and capital as homogeneous mainstream economists conclude that so long as there is idle labour and capital an expansionary monetary policy won’t raise general prices until full capacity has been reached. (That is when so-called “capacity constraints” emerge).
Some mainstream economists simply assume that idle capacity is uniform throughout the economy. However, experience always shows that these assumptions are without foundation. If it were otherwise bottlenecks and capacity constraints would never emerge.
As current assumptions about capital and money are fallacious what causes the bottlenecks? To put it somewhat crudely, the central bank forces the interest rate down below the market rate causing bank credit to expand.
This monetary expansion discoordinates the production structure by generating overinvestment in the capital goods industries relative to the consumer goods industries
Because investment expenditure is being undertaken where there are insufficient complementary factors of production, particularly of a specific or part-specific nature, to either finish the project or provide the necessary circulating capital a bottleneck emerges. (I think I must still stress at this point that this is a theory of relative overinvestment and not general overinvestment).
Because production takes place in stages each firm that expands production does so on the assumption that the complementary factors at the higher and lower stages will be available. But because monetary expansion has distorted the pattern of production by sending out false price signals this is no longer the case.
What this means that there will be insufficient complementary factors to finish the firm’s project unless those factors can be bid away from other firms, which will only creates shortages elsewhere, i.e., bottlenecks. Before this situation fully develops I would expect producer prices to have already started an upward trend.
(See Ludwig von Mises, Human Action, Henry Regnery Company 1966 and Prices and Production, Pub. Augustus M. Kelley 1967).
As so-called capacity constraints develop there also emerges an increase in demand for various types of labour, which of course raises wage rates. This always happens as a boom reaches its peak. Even Marx pointed out “that crises are precisely always preceded by a period in which wages rise generally (italics added) …”
What the classical economists recognised, though hardly understood, our commentators have forgotten, as Terry McCrann made clear when he said “The possibility of a wages break-out for the first time since the 1980s is a pointer to overall economic strength and, more specifically, to skills shortages.” Nothing is certain, but seems we're on a roll (Terry McCrann, Herald Sun, 13 February 2005).
In the nineteenth century, particularly during the bullion debate, the idea of forced savings was discussed. Would an expansion of the note issue in excess of gold reserves increase the quantity of capital goods? There was a qualified yes, with the exception of Ricardo, but only under certain circumstances. Nevertheless, it was generally recognised at the time that the situation would be unsustainable and could only occur at the expense of the poorer members of society.
The other alternative would be to use the newly created credit to purchase capital goods from abroad. This too would be an unsustainable policy. Eventually the central bank would have to restrict the money supply and send the economy into recession in response to a deteriorating trade balance.
It would then be found that many of these new investments are in fact malinvestments that need to be liquidated.
None of the above will register with anyone at the Reserve as made evident by it summary statement of monetary policy in which it is suggested that “capacity constraints may be becoming more important.” It then goes on to talk about “bottlenecks” “producer prices” and “inflation”, as if they were discrete economic phenomena.
So how does the Reserve stand with respect to its monetary policy? From January 1996 to September this year currency grew by 72.7 per cent, bank deposits by 108.3 per cent and M1 by 100.3 per cent. The word for this is criminal.
Yet Henry Thornton, another economic commentator felt free to call the bank’s
summary an “excellent economic survey”, thereby demonstrating how far our economic commentariat has yet to travel.
Peter Costello’s trade deficit fallacies and the credit crunch, part I
Australian Reserve Bank blames others for its own folly
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 14 February 2005