BrookesNews.Com
Monday 8 June 2009
No matter which of the world's capitals you are in, whether it is Washington, London, Berlin, Beijing or even Canberra, when it comes to day-to-day economic policy it largely focuses on consumer spending: one of the mose dangerous economic fallacies of the age and one that the classical economists of long ago had thought they had permanently put to rest. Terry McCrann — probably Australia's leading financial reporter — was expressing the views of the Treasury, the Reserve, Academia and his colleagues when he stated that "retail sales figures are a better guide to the state of the national economy than the seemingly soggy approvals for new homes". (Terry McCrann, Consumer spending flows from a deep reservoir, Herald and Weekly Times, 31 may 2006).
Well he and the rest of the economic commentariat are wrong. Manufacturing is the best guide with housing also doing very well at times. The reason for this is time. The failure of the commentariat to understand the role that time plays in production has blinded them to the fact that the first symptoms of an impending recession are always felt in the higher stages of production. Their second failure is to grasp the fact that GDP greatly underestimates total economic activity. Once we take into account spending between firms we find that consumer spending as a proportion of total spending drops from about 60-64 per cent of GDP to about one-third. Therefore it is business spending that drives the economy and not consumer spending.
For the benefit of those who do not know how the national accounts are calculated: The first thing to note is that the procedure is a value-added approach. (This in itself means that the figure arrived at cannot be gross one). The second thing is that it ought to be self-evident that omitting expenditures on a firm's inputs from the national accounts is an absurdity. (Imagine how long a company accountant would last who tried to pull this stroke). Regardless of the current orthodoxy including this expenditure would not amount to double-counting.
When the miller buys wheat from the farmer he transforms it into a higher-valued good called flour. The baker buys the flour and transforms it into a higher-valued good called bread which is then sold to the consumer. In our simple four stage economy (farmer, miller, baker and consumer) we are in fact dealing with three goods: wheat, flour and bread. As we can see, our little model reveals that production takes place through time and that it involves transforming lower-valued goods into higher-valued goods, many of which are for direct consumption. In brief, there exists a production structure length of which is determined by the rate of interest. In other words, the structure has a time dimension.
I want to make something very clear at this point. I am not saying anything new here. In fact one can find this in John Rae's remarkable book The New Principles of Political Economy first published in 1834. (August M. Kelley, New York, 1964). Rae's contribution to economics was justly praised by John Stuart Mill. Unfortunately it tended to fall into obscurity. Nevertheless, what we should call production structure analysis was used by Jevons. (William Stanley Jevons, The Theory of Political Economy Kelley & Millman, Inc. 1957, pp. 222-265, first published in 1871). Then there was was Eugen von Bohm-Bawerk's monument three volume Capital and Interest (1884-1912, Libertarian Press, 1959).
It follows from the previous reasoning that if account were taken of inter-firm spending then the national accounts would show that the economy is contracting. Instead the fallacious GDP approach indicates that the economy is growing, leading Treasury secretary Ken Henry to declare that without the Rudd stimulus reduced consumer spending would have lobbed 0.4 percentage points off GDP. This is probably true. Unfortunately for Mr Henry GDP is no more a measure of growth (capital accumulation) anymore than it is a measure of total economic activity.
Despite the analytical power of production structure analysis and its illustrious intellectual lineage there is not a single member of our economic commentariat who is even aware of its existence, which brings us to the current state of the Australian economy. If the preceding is correct then we would have seen a contraction in manufacturing before there was any impact on consumer spending and aggregate unemployment. When we examine the data this is exactly what we find.
Readers know that I have been focusing for sometime on the consequences for manufacturing of the Reserve's monetary policy and that I have stressed numerous times just how tight monetary policy has become. Any economist worth his salt — including the better Keynesians — should know that this policy must eventually cause manufacturing to contract. The chart below shows this to be the case.
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Source for M1: RBA. |
We can see that from December 2007 to the following May M1 started to contract. The Reserve rapidly pumped it up again in June, after which it remained comparatively flat until February 2009 when another contraction set in. (The March figures are the latest ones that have been released). We can see that the PMI peaked in December 2007 at 57.6, falling to 51.2 May 2008 and then 33.4 in March 2009. So from December 2007 to March 2009 the PMI dropped by 38.54 per cent. Production followed the same trend, falling by 47.5 per cent. Note that after the monetary surge the PMI and the production index stablilised from July to September. Once the surge worked itself out the downward trend was resumed.
Given monetary conditions I have grave doubts whether there will be a genuine recovery before the end of the year, particularly when we consider the government's spending binge, the effect of which has been direct spending away from the higher stages to pure consumption. (Thank you, Mr Henry). This is guaranteed to retard recovery. Whether the Reserve will suddenly change its monetary course is something no one knows — including the Reserve
Like the rest of the economic commentariat the Reserve is clueless on real monetary theory. (In its last release on monetary policy it did not mention money supply once!) Because the Reserve is always two months behind on its monetary figures we can only hazard a guess at the current monetary situation. However, if we look at the Reserve's latest record of its monthly assets we see that they stand at $113,631 billion for April as against $163,796 billion for November 2008.
This drop of 30.6 per cent is — I believe — the result of targeting the cash rate which now stands at 3 per cent. To lower short-term rates the central bank buys assets. To raise these rates it sells assets. Therefore the drop in the Reserve's assets suggest that it is trying to prevent short-term rates from falling further. This would certainly account for the M1 contracting in March. It would also indicate that the demand for short-term credit has been falling, which is what one would expect once a recession sets in. If this is the case then this policy will be instrumental in deepening the recession.
On a final note. A reader drew my attention to a talk that Des Moore gave to the Portsea branch of the Liberal Party and which contained several important errors. He stated:
First, while this is a very serious economic crisis, history suggests that human nature has a natural tendency to swing between optimistic and pessimistic attitudes almost regardless of the type of economic organisation prevailing in a country. But such swings have occurred quite frequently in countries that increasingly adopted free market type arrangements after about 1800. Since that time one historian has identified 13 banking crises in the US and a dozen in the UK.
The crises he refers to have their origins in the fractional reserve banking system. This is why there were medieval booms. I can assure Mr Moore that historians have also documented these financial crises. I suggest he read Carlo Cipolla and Raymond de Roover? Therefore his suggestion that these crises are an unfortunate by-product of the free market and only began in the nineteenth century is patently false.
If you fall into the trap of believing that these crises are ineradicable part of the free market then one is left with nothing but regulation. And this is where Moore goes astray again. He argues "that governments and regulators share a good part of the blame". The blame, Mr Moore, rests with lousy economics and not any regulatory laxity. He came close to problem when he referred to central banks allowing too much credit at "low rates of interest". This was followed by his opinion that Prime Minister Rudd had "overlooked the fact that even our central bank allowed credit to grow at rates well above the growth in nominal GDP".
This is the monetarists' stable price level fallacy. By falling into it Moore reveals that he has no genuine grasp of the problem. If he actually knew his economic history he would know that during the Roaring Twenties the US price level remained stable. Nevertheless, this stability did not prevent an orgy of bank lending that culminated in the Great Depression. As was pointed out during the depression:
Bluntly, our present difficulties are viewed largely as the inevitable aftermath of the world's greatest experiment with a "managed currency" within the gold standard, and, incidentally, should provide interesting material for consideration by those advocates of a managed currency which lacks the saving checks of a gold standard to bring to light excesses of zeal and errors of judgment. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 56)
A stable general level of prices in itself means little; it is the disequilibria among particular paces induced by bank credit expansion (or contraction) that is of chief interest and importance for business cycle theory. (Ibid. p. 191).
It is a matter of deep regret that Australia's self-appointed defenders of the free market are as ignorant of economic history as they are of the history of economic thought. So long as these gatekeepers succeed in presenting their economic views as the genuine face of free market thinking the Australian public will continue to find itself unable to make an informed choice between free market principles or proposals for even more government control.
What this country desperately needs is a genuine economic debate.
Gerard Jackson is Brookesnews' economics editor