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US economy, commodities and China
Gerard Jackson
Rising commodity prices have been explained largely in terms of rapid growth in the US and China. However, some observers are implicitly arguing that “excess money” is the real driving force behind commodity prices rather than growth.
This has led certain quarters to call on Allan Greenspan to enforce the commodity price rule, according to which rising commodities are signalling excess liquidity, and so the Fed should raise interest rates to pre-empt inflation. On the other hand, if commodity prices are going into slump then the Fed should avert deflation by loosening the monetary spigot to reduce interest rates.
If some readers detect a similarity between this rule and the price rule then they are spot on. (See
How the Fed’s price rule caused the recession. One of the usual symptoms of a classic boom-bust situation is a rise in commodity prices. The central bank forces interest rates down below their market clearing rates. This triggers a domestic boom which raises the demand for commodities.
The implication of the commodity price rule that it is natural for commodity prices to remain relatively stable. But this view ignores the fact that commodity prices have been trending down in real terms for 200 years. If we had managed to keep commodity prices stable in real terms we would all now be very much more the poorer for it.
Economics predicts that as technology improves and new reserves and substitutes are found commodity prices will decline, which is precisely what economic history shows. (I guess economics is not so dismal after all). Advocates of the commodity-price-rule do not understand that using monetary policy to try and stabilise commodities prices only starts booms and busts, just as the price rule does. Therefore the commodity rule is not only self-defeating it is also destructive.
According to the Fed M1 expanded by about 23 per cent from January 2001 to July 2005. Most of this expansion was in the form of bank deposits. Monetary expansion in China has been vastly worse. From January 2004 to December 2005 M1 grew by about 14 per cent, but the credit component actually grew by 17.5 per cent. (However, I have been told that these figures greatly underestimate monetary growth).
It is this monetary expansion that has been fuelling the rapid demand for commodities. As expected, the vast majority of our economic commentariat completely misinterpreted the data. Instead of looking at monetary growth they assumed that the world’s “excess global” liquidity was due to “excess savings”.
Ben Bernanke, Princeton economist and former Federal Reserve Governor, stated that there’s a “global saving glut”. Ricardo Hausmann, a Harvard professor of economics, argued in the Financial Times (16 June 2005) that “excessive savings are at the root of the imbalance in China”. On the same day the Wall Street Journal warned of a global housing boom driven by a “saving glut”.
The idea of surplus savings seeking a foreign outlet goes back to at least Jeremy Bentham, who was persuaded by James Stuart Mill that it was fallacy. It was resurrected in 1829 by Wakefield’s Letter from Sydney. Despite being refuted by the classical economists (unfortunately, John Stuart Mill was pretty wishy-washy about it) it was resurrected by J. A. Hobson at the end of the century, and Lenin made it part of his theory of imperialism. (Engels had also alluded to it). And of course, when Keynesianism turned the fallacy of excess savings into mainstream economic dogma it gave the Wakefield-Hobson thesis a degree of respectability.
But as Ricardo pointed out to Malthus, to save is to spend. To save is to transfer purchasing power from one person to another. The Austrian school goes further and explains that genuine saving means the restriction of current consumption in favour of greater future consumption. This is what the Austrians mean when they say that to save is to transform present goods into future goods. In other words, to save is to accumulate capital.
The confusion centres on the fact that the central bank creates bank deposits when it engages in credit expansion. There really should not be any confusion at all. These deposits are not genuine savings. Nevertheless, they have led some economists to draw the ridiculous conclusion that it is growth that drives savings and not the reverse. (See High taxes cripple economic growth).
This brings us to China’s savings rate and level of investment. Numerous commentators have argued that China “is certainly investing too much”. But no country can have too much capital — and China is no exception. In any case, how much is too much? And how can any thinking person maintain this argument when it is painfully obvious that China is a very capital poor country?
According to The Economist:
In the year to the first quarter of 2004, spending on fixed assets — plant, property and infrastructure — grew by 43%. Investment accounted for 42% of GDP in 2003, and perhaps a still greater share last year. No economy can sustain such a colossal rate of capital accumulation… At some point, China’s investment must run into rapidly diminishing returns. Are two cement factories twice as good as one? (A reheated economy, 25 January2005).
It never occurred to the author that the problem was not actual savings but phony savings created by the People’s Bank of China. Forcing the interest rates down below the market levels encourages businesses to invest in lines of production for which there are insufficient savings. Nevertheless, these phony deposits can be used for a time to generate forced savings (Friedrich von Hayek’s Prices and Production, Pub. Augustus M. Kelley 1967).
The process of forced savings was discussed by classical economists who were opposed to it because they believed it was not only unsustainable but that it could only occur at the expense of the poorer members of society. Malthus had this to say on the subject:
Whenever, in the actual state of things, a fresh issue of notes comes into the hands of those who mean to employ them in the prosecution and extension of profitable business, a difference in the distribution of the circulating medium takes place, similar in kind to that which has been last supposed; and produces similar, though of course, comparatively inconsiderable effects, in altering the proportion between capital and revenue in favour of the former.
The new notes go into the market as so much additional capital, to purchase what is necessary for the conduct of the concern. But, before the produce of the country has been increased, it is impossible for one person to have more of it, without diminishing the shares of others.
This diminution is affected by the rise of prices, occasioned by the competition of the new note, which puts it out of the power of those who are only buyers, and not sellers, to purchase as much of the annual produce as before: While all the industrial classes, — all those who sell as well as buy, — are, during the progressive rise of prices, making unusual profits; and, even when this progression stops, are left with the command of a greater proportion of the annual produce than they possessed previous to the new issues.
Jeremy Bentham called the process “forced frugality”. The same process by which consumption is forcefully restricted was discussed at length by Professor Robertson in Banking Policy and the Price Level, 1932, in a section headed Automatic Stinting. Arthur Pigou simply described it as a process by which the banking system transfers purchasing power to business which then uses it to command resources that would have otherwise gone into consumption.
The statement about diminishing returns to capital is an egregious error. Capital has never undergone diminishing returns. The reason is that capital is a heterogeneous structure and not a homogeneous lump. This means that as the economy progresses capital becomes more specialised which in itself wards of the possibility of diminishing returns. (Ludwig M. Lachman, Capital and its Structure, Sheed Andrews and McMeet Inc, 1978).
Despite what has been said and written during the last 200 years about monetary expansion, forced savings and the nature of capital our economic commentariat — including certain professors of economics — are still regurgitating the long-refuted fallacy of surplus savings. The economics profession seems to be taking two steps forward and three steps back, at least on these issues.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 29 August 2005