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Is the economy heading for an inflation-driven recovery?
Gerard Jackson
By and large economic commentary is a right dog's dinner, and I am not just referring to Australia. What brought this fact to mind — again — was the failure of our economic pundits to grasp what is happening with the money supply and output. The Australian Industry Group's Performance Manufacturing Index has been climbing, giving rise to the hope that the economy is beginning to recover. On the other hand, the unemployment picture is far from pretty, with the unemployment rate being held down by a fall in working hours and the participation rate.
Access Economics expressed the view that it is highly unlikely that consumers will add much to economic growth in the near future. How many times does one have to state that consumer spending can never add anything to growth. It is saving that expands the capital structure (or, as a neo-classical economists would put it: the capital stock) and not consumption. In simple English, growth is forgone consumption.
It follows that to increase consumption at the expense of savings would reduce the rate of capital accumulation. Eliminating savings altogether would set in train a process of capital consumption. The nexus between consumer spending, savings and business spending used to be fully understood by competent economists before Keynesian fallacies swept through the universities. As was pointed out more than 70 years ago:
The larger number of payments is not from consumers to producers, but is made between producers and producers, and tends to cancel out in any computation of net incomer of net product value. "In fact, income produced or net product is roughly only about one-third of gross income." [Italics added]. What is cost for one producer is in part income for some other producer, but part of that income the latter has to pay out in costs to other producers in another stage of the productive process (for intermediate products, raw materials, supplies, etc.), and so on. All that is necessary in order that equilibrium be maintained is that consumers' incomes equal the cost of producing consumers' goods; the total of producers' payments necessarily exceeds that of consumers' incomes. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 71).
These economists understood that by implementing policies that focus on consumption instead of production a government would actually retard recovery and create a situation where the consumer industries expanded while the producer goods industries stagnated with idle capacity and high levels of unemployment becoming a permanent feature of the economic landscape, which is what happened under Roosevelt during the 1930s, even though GDP is rising. Nevertheless, despite the lessons of history and the teachings of sound economics our commentariat stubbornly insist on adhering to the Keynesian mantra.
And then there is inflation, which apparently the Treasury and the Reserve Bank of Australia expect to be a non-issue for the next eight years or so. Why? Because of the magnitude of the country's excess capacity. What we have here is the Keynesian error that inflation cannot emerge while widespread excess capacity exists. Underpinning this error are two dangerous fallacies: The first error treats inflation as a case of rising prices. In fact, rising prices are a symptom of inflation and one that is not always present if we think of prices in absolute terms. The second error treats capital as homogeneous. What this means is that Treasury and Reserve officials are arguing that stagflation is impossible. Mainstream economists have never grasped the fact that it is the heterogeneous nature of capital that makes stagflation possible.
Not everyone agrees with these officials. There are those who think a much faster rate of recovery is on the cards and that the economy could be operating at full capacity in early 2011. The rise in the AIG's production index and PMI is considered supportive of this view. Yet the underlying rate of inflation is considered dangerously high. Curiously enough, no mention of the money supply is ever made. In a June article I stated that a recovery before the end of the year was highly unlikely given that M1 and bank deposits continued to remain flat.
At the time of writing the available monetary aggregates only went up to March. The latest figures extend to June and reveal a rapid monetary expansion. One can see from the chart below that though currency has remained flat the growth in both bank deposits and M1 started to accelerate in April, climbing from 194 and 239.1 respectively to 210.5 and 255.6 in June, an increase of 8.5 per cent and 7.8 per cent and an annualised rate of 31.2 per cent for M1. Although I don't expect this rate of monetary growth to continue it does suggest that Australia can look forward to some serious inflation-created problems next year.
Source: RBA
Sufficient monetary growth reduces excess capacity by raising the value of the product relative to production costs. (It should be noted that this does not always mean a general increase in prices). However, where inflation is already a force and there is a great deal misallocated capital then a loose monetary policy can bring about accelerating inflation before full operating capacity has been reached and full employment restored. In which case expect the Reserve to slap on the monetary brakes.
Gerard Jackson is Brookesnews' economics editor
BrookesNews.Com
Monday 14 September 2009
