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US economy, trade deficit, money supply and growth
Gerard Jackson
When it comes to the US economy, or any other economy for that matter, it is not just the quality of the statistics that matter but more importantly the quality of the economic analysis that is applied. In short, no matter how accurate and abundant the statistics, poor economic analysis will still produce miserable results. We got this with the US economy in the 1990s. I think we are getting it again.
To the surprise of many the first-quarter figure on salaries and wages had to be revised upwards by a massive $163 billion. At the same time corporate profits in the US economy have risen to nearly 11 per cent of GDP, the highest level in 37 years. Giving even more cheer to supply-siders statistics show that profits rose by about 37 per cent during the last year. Moreover, on an after-tax basis the profit share of GDP is at its highest since the end of WW II.
The first though that would spring to the mind of just about every supply-sider who came across this information is that the Laffer-curve works. The argument here is that lower tax rates expand net incomes the expenditure of which generates more tax revenue. It is this process that explains the unexpected double-digit tax returns.
There is, however, an alternative explanation. It’s called money supply. From January to December 2003 M1 grew by 6 per cent, and for 2004 it was 7.6 per cent. Nearly all of this growth was in the form of credit expansion. The effect of this has been to raise nominal incomes and expenditures which have produced most of the additional tax revenues.
However, one of the baleful consequences of this expansion has been to badly distort the pattern of international trade. As Mr. J. J. Polak, a Keynesian economist, discovered in his 1957 study that tried to integrate money and credit factors into a Keynesian model.
He found that credit expansion raised nominal incomes which in turn raised the demand for imports and aggravated the current account deficit. His findings supported Taussig’s conclusion that an expanding money supply will bring about changes in the demand for imports before having a significant effect on domestic prices.
It obviously follows from the above that a sustained monetary induced increase in the demand for foreign goods and services by the US economy will, on account of the economy’s huge size, cause exporting countries to become excessively export oriented to meet the US’s inflated demand for their products.
When the Fed eventually applies the monetary breaks a correction also takes place in the exporting countries who now find that they have excess capacity. Not only that, but the US economy is likely to find that a number of firms have been misled into shifting operations abroad.
This explanation is in direct opposition to those supply-siders who argue that the growing trade deficit is a sign of a healthy economy. In support of their argument they make the point that growing economies always increase their demand for imports. True or not, the fact still remains that what matter is what drives the demand for imports: genuine economic growth or monetary expansion.
When it is the latter the result is always recession, mild or otherwise. Irrespective of what the Pollyanna’s think, the US economy’s current insatiable demand for imports has nothing to do with a “demographic gap between the US and other developed countries”.
Many supply-siders ignore the money supply because they reason that it is not well correlated with GDP growth. But this view misses the vitally important point that definitions are not determined by correlations. To define money we must determine what it is. In other words: what does money do?
Fortunately this question was answered for us by Walter Boyd who wrote 204 years ago:
By the words ‘Medium of Exchange’, ‘Circulating Medium’, and ‘Currency’, which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exchange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation.
It follows from Boyd’s definition that travellers’ cheques, certificates of deposits and other credit transactions are not part of the money supply. From this we conclude that money supply consists of cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.
Moreover, the supply-siders are badly hampered by their assumption that money is neutral. This egregious error is compounded by their habit of dealing in aggregates and treating capital as homogeneous.
Note: Readers may have noticed that though I stressed Boyd’s definition of the money supply as being the only sensible one, I nevertheless used M1 even though it includes travellers cheques. I did this because I believe that M1 is close enough to Boyd’s definition to serve my purposes.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 30 May 2005