Ruminations on the effects of monetary policy in the context of short term and secular cycles: Money supply growth, asset prices and capital over different time frames

Once the growth momentum of money supply wanes, asset prices – specifically stock prices – that have been buoyed by an excess of free liquidity tend to either come under pressure or see their rallies stall out. Normally an economy emerging from a cyclical recession experiences an increase in private sector credit demand. In the early stages of recovery, the Fed’s easy money policy tends to egg this credit demand and credit growth on. Investments in higher order production stages appears more profitable, as low interest rates suggest low time preferences and an abundance of available savings.

 

At the same time consumption receives an artificial boost. To the extent that the central bank rate undercuts the natural interest rate, it provokes additional credit and money growth (increased credit demand pressures short term rates higher, including the Federal Funds rate, and to keep its rate on target, the Fed must add bank reserves – with money it creates from thin air).

It becomes then for the stock market a matter of seeing whether the economy recovers, and whether vigorous private sector credit growth indeed occurs. If this happens, market participants will usually continue to bid up stock prices, until they judge monetary policy to have become restrictive once more.

In a situation of secular private sector credit deleveraging, the market can not expect this source of credit demand to surface. In all likelihood economic activity will remain sluggish, and visibly slow again whenever stimulus spending and central bank-sponsored money supply growth wane. What essentially happens is that the economy immediately resumes the necessary adjustments to the capital structure that were temporarily postponed by monetary pumping and stimulus spending, which is experienced as an economic slump.

Note here, the difference between an economy that eventually recovers relatively quickly in spite of these interventions and one that does not is that the former economy’s pool of real funding is still ample and growing. In other words, real wealth still continues to increase in spite of the distortions introduced by government policy in the former case, but not in the latter. This seems to be connected with the duration of the observed cycles as explained in more detail further below.

 

The S&P 500 Index – heavy monetary pumping has supported a strong rally lasting about 13 months. It has now stalled out, but contrary to the 2000-2002 bust, private sector deleveraging continues to this day. Absent more government debt monetization, the stock market may run out of fuel.

 

Popular false conclusions and what really limits economic activity

When such an economy – this is to say, an economy that is still sound in principle, and is growing real wealth – suffers a temporary bust, monetary pumping can very quickly restore boom conditions by promoting economic activities that would not be judged profitable absent such monetary pumping. In other words, it is very easy for people to falsely conclude that an inflationary policy is in fact beneficial.

This is in fact a highly popular – though false – notion. People can always point to a betterment in economic statistics that are describing the economy by adding up various numbers like industrial output, the growth in employment, and so forth, and comparing them with those of an earlier period. What these numbers don’t tell us however is whether the activities they portray actually permanently increase wealth, or if something else is going on under the surface.

To the extent that the economic activities thusly measured represent malinvestment of capital, they actually weaken the economy’s long term potential even as it seems to superficially do well in the short term. When thinking about bank lending, one must consider that while entrepreneurs borrow money, what they really need is capital. In the end the money must be converted into capital goods and saved real production to be useful for productive investment.

If one considers what opportunities there are for production, they are not limited by money – after all, the Federal Reserve can in theory ‘print up’ any amount of money it deems suitable. In reality these opportunities are ultimately limited by the availability of capital goods and the pool of real funding.

Money after all is merely the medium of exchange. In modern times it does not even have a secondary utility, contrary to a commodity money (the quintessential money commodity gold is useful as an industrial input and has a preexisting demand that is distinct from the monetary demand for it).

So a sudden overabundance of money can not possibly enrich the economy at large. It does not change the amount of saved capital goods and saved final goods available for production. These represent what in Richard von Strigl’s terminology may be referred to as the renewal and subsistence fund. It is on these that entrepreneurial funding ultimately depends.

Richard von Strigl wrote on this:

 

Let us assume that in some country production must be completely rebuilt. The only factors of production available to the population besides labourers are those factors of production provided by nature. Now, if production is to be carried out by a roundabout method, let us assume of one year’s duration, then it is self-evident that production can only begin if, in addition to these originary factors of production, a subsistence fund is available to the population which will secure their nourishment and any other needs for a period of one year.[…] The greater this fund, the longer is the roundabout factor of production that can be undertaken, and the greater the output will be. It is clear that under these conditions the “correct” length of the roundabout method of production is determined by the size of the subsistence fund or the period of time for which this fund suffices.

 

Nothing left to lend

Thus we can come to a number of conclusions about the economy by deducing from these principles and bringing them into context with observable phenomena. We can for instance state that if monetary pumping and deficit spending fail to bring about more than a very temporary boost to measured economic activity and are no longer accompanied by an increase in private sector credit demand, then there may in fact be nothing left to lend after spending of the government directed variety is taken into account.

Think of the entire process as a number of smaller business cycles nested in a bigger cycle, something that is reflected in the stock market’s shorter and longer term cycles. When a large-scale bust phase ends and a new expansion phase begins, the economy’s capital structure has been sufficiently modified to be in accordance with actual consumer demand and preferences.

A period of economic progress follows. Shorter term cycles then tend to play out in such a way that following periods of loose monetary policy, sectors that experience malinvestment and drive short term booms suffer corrections once monetary policy tightens sufficiently, while the broader forces of economic progress still continue in the economy at large – this is to say, the economy is still strong enough on a structural level to accommodate a renewed boom when the central bank once again loosens monetary policy.

Every policy-induced boom however consumes more capital and puts more pressure on the economy’s pool of real funding. In the course of several business cycles, the errors induced by the artificial credit expansions tend to cumulate, until the economy reaches a point at which its pool of real funding is in fact in trouble, this is to say when it either stagnates or has begun to shrink.

This is when a secular bust – a large scale bust – accompanied by what investors experience as a secular bear market in stocks occurs. The central bank’s efforts to egg on more credit demand fall short, and this is reflected by a decline in the amount of private sector credit outstanding, i.e. private sector credit demand exhibiting negative growth in spite of the loose monetary policy.

Recall here that what actually funds the boom phases is not money, as such. Only saved production is able to fund economic activities, and what the over-issuance of money and interest rates altered by central bank policy achieve is to misdirect such real resources into what will later turn out to be unsustainable enterprises. What occurs is in fact a distortion of relative prices along the capital structure – an inter-temporal misalignment of investment, that is not reflecting actual consumer preferences.

One might say the difference between sustainable economic growth and unsustainable economic growth lies precisely in whether the capital allocation along the different stages of production is induced by market-based individual time preferences or conversely induced by monetary and fiscal policy.

A series of such unsustainable booms can be strung together and reignited by loose monetary policy as long as the larger economic cycle is still advancing, i.e. as long as enough real wealth is generated to allow for a diversion of real funding into uneconomic, ultimately wealth-consuming, activities. However, this process can obviously not continue forever. We may have arrived at such a long term juncture – when the secular cycle turns down – in 2007-2008.

 

A large decline in outstanding business credit – this may be a sign that there simply is nothing left to lend at the current juncture.

 

Total Bank Credit outstanding tells the same story. Note that the spike in early 2010 is largely the result of an accounting change that forced banks to take back loan assets from SPV’s (‘Structured Investment Vehicle’) and similar off-balance sheet vehicles back onto their balance sheets – it must be discounted as a one-off distortion of the data that does not reflect an actual increase in credit (in fact, even this once-off accounting change merely brought reported credit growth back to the zero line).

 

The yardsticks guiding central bank policy create great harm

If we look at the yardsticks used by central banks to direct policy, and consider the large scale historical boom-bust phases, then what sticks out is the following: Central banks falsely define ‘inflation’ as a ‘rise in aggregate prices’.

It follows from this definition that when a given interest rate stance does not coincide with a rise in statistical (and deeply flawed) measures such as CPI, PPI or the ‘deflator’ used in ‘real GDP’ calculation, then the central bank will assume its interest rate to be the ‘correct’ one, and accommodate any increase in credit demand by inflating the supply of money. In other words, it will in effect inflate all the more the less ‘price inflation’ there is.

Consider now what happens when this policy approach coincides with a period of strong secular economic growth. Economic growth is a result of capital accumulation – the more capital per worker an economy employs, the more productive it will be. Productivity in turn means ‘producing more with the same effort’. The prices of goods and services in a growing market economy will tend to fall.

However, central banks aim to achieve an environment of ‘price stability’ (one wonders what Bernanke et al. think of the computer industry and its steadily falling prices – according to their theories this industry should be considered an ongoing economic catastrophe, due to being bedeviled by constant ‘deflation’. Both consumers of this industry’s products and producers in this industry will very likely disagree with such an assessment).

How can prices be held ‘stable’ when they are really falling due to economic growth? By more inflation – of the properly defined kind, i.e. an increase in the money supply, the effect of which on prices offsets the beneficial effects on prices of higher productivity (though not in all sectors of the economy to the same extent – the computer and related industries have had such large productivity increases that they have managed to ‘out-pace’ the price effects of monetary inflation, while large offsetting price increases have occurred in other sectors.

Adding up the prices of these disparate goods and services and calculating an ‘average’ from them is how a central bank determines if there is ‘inflation’. Sit back for a moment and consider how utterly absurd this approach is).

In short, the erroneous fixation on ‘aggregate prices’ can bring about an especially pernicious inflation problem in times of strong productivity growth, that can remain undetected for a long period of time – namely for the duration of the entire secular cycle consisting of a string of smaller scale boom-bust cycles.

What is not immediately seen is the extent to which capital has been malinvested cumulatively over the secular boom era, and to what extent the pool of real funding has been damaged by the malinvestment and overconsumption the artificial credit booms have induced.

The resulting bust can become especially devastating, and given that such busts tend to be ‘treated’ with the exact same policy prescriptions that seemingly ‘worked’ during the smaller cycle boom-bust phases within the larger cycle, they can become long-lasting secular busts, as the necessary liquidation and redirection of malinvested capital is repeatedly delayed.

Note here that we suspect that the US economy has probably experienced a secular turning point in terms of its pool of real funding with the blowing out of the Nasdaq bubble in the year 2000 already, but managed to delay the arrival of the secular bust by availing itself of real funding from foreign economies, which were happy to accumulate US financial claims in exchange for real goods.

A secular bust is the situation Japan finds itself in since early 1990. Japan continues to stand as a monument to the folly of monetary and fiscal pumping, and its stock market is a mirror image of the extensive, long lasting bust this has produced.

 

The Nikkei stock index mirrors Japan’s secular bust. In spite of the failure to revive the boom by monetary pumping and fiscal deficit spending, Japan’s government to this day persists in pursuing these policies.

 

Conclusion

Money is only the medium of exchange – the fractionally reserved banking system, backstopped by the central bank, creates money that is not ‘backed’ by preceding production – i.e. money begins to circulate by this process that is not representative of real savings in the form of saved production.

This sets in motion booms that may be considered ‘good times’ while they are occurring, but in reality impoverish the economy, a situation that becomes evident when the inevitable bust begins. A side note here: the term ‘impoverishment’ must not be taken to mean that society at large will necessarily be poorer after the boom than before it – in the modern market economy, to the extent that it is free, there is always someone engaged in the production of real wealth after all. Impoverishment means here that a certain amount of capital has been squandered, and is not available anymore to satisfy many of the wants consumers may actually have.

After a long period of malinvestment and overconsumption resulting from credit expansion, a period of ‘forced saving’ must inevitably follow – or as Roger Garrison has put it in ‘Overconsumption and Forced Saving in the Mises-Hayek Theory of the Business Cycle(1): ‘early in a credit expansion income earners consume more than they otherwise would have, while later, they are forced to consume less than they could have’. This follows from the fact that only free market based economic growth, which requires the foregoing of consumption in favor of saving and the resultant sustainable investment and capital accumulation can lead to more consumption in the future.

(1) We recommend this article for further reading. In it, Garrison attempts to reconcile and explain the various effects of a credit expansion described in Austrian literature. We found the idea that the capital consumption that occurs during the boom is concentrated the middle stages of the production structure compelling. We quote from the article:

 

“As the boom begins, consumption demand is high relative to the pre-expansion level. Incomes earned by workers and other factors in the early stages of production are being spent on consumer goods. To the extent that this high consumption demand is met with increased allocations to the late stages of production, then resources are being doubly misallocated. Considerations of derived demand and of time discount are sending resources in opposite directions.

The Hayekian triangle is being pulled at both ends against the middle. Production activities in the middle stages, which have been effectively raided because of high demands in both the early and late stages, eventually reach maturity—but with yields of consumer goods that are deficient with respect to both the boom phase and the pre-expansion economy. It is at this point that consumption falls, as it must, and saving increases. Framing the concept of forced saving in this way is not suggested by Hayek (who, as we will see, denied overconsumption) but is implicit in Mises. Interestingly, the notion of the production process being pulled at both ends against the middle is clearly set out by Richard von Strigl as understood by Fritz Machlup.

[A] prerequisite of any production using roundabout methods is, of course, the corresponding supply of consumer goods which can serve to support the originary factors of production. Here [in the case of credit expansion] we are confronted on the one hand with an expanded provision of consumer goods, and on the other, with an lengthening of the roundabout production methods. Both of these movements work together in such a way that the expansion in provisions occurs at the expense of the supply of capital….

[T]he consumption of capital only makes an expanded supply possible temporarily, but as a result of this consumption of capital, a continuous provision will not be possible to the same extent. At the same time, lengthening the roundabout methods of production requires that a perpetual supply from the previous stock of capital lasts in order to be able to bridge the time span until the end of the lengthened roundabout production process. In a simple formula: Expanding the production of consumer goods by consuming capital will further increase the difficulties which must result from lengthening the roundabout methods of production.

In a 1933 lecture at Columbia University, Machlup recast Strigl’s formulation with an explicit reference to the stages of production that make up the Hayekian triangle:

The additional credit causes an increased demand on the market for consumer goods without a substantial delay. The output of consumer goods is elastic, indeed, and simultaneous expansion of production in the construction goods industry and in the consumption goods industry takes place. We see at the same time symptoms of a lengthened and of a shortened production period, a swelling at both ends of the production structure at the expense of some middle parts of the stage system.

The subsequent maturing of those middle stages is coincident with—and virtually synonymous with—forced saving. But neither Strigl nor Sraffa nor anyone else claims that this increase in saving could be sufficient to accommodate the increased demands by the business community. Funds—and resources—needed to complete the projects initiated during the boom are simply not available. This is the essence of the internal conflict in the market process set in motion by credit expansion. Just as overconsumption eventually begets forced saving, malinvestment eventually begets liquidation. Using the two pairs of terms in this way maintains the distinction between saving and investment while emphasizing the essential nature and temporal characteristics of the boom-bust cycle.”

 

From Roger Garrison’s article: the Hayekian Triangle, a simple depiction of a production structure – the further to the left a production stage is placed on this triangle, the further removed it is from the eventual consumer good. Lower interest rates cause more capital to be invested in higher order goods production, as longer (more time-consuming) processes become profitable – the structure may be lengthened by adding additional stages. If this is supported by consumer time preferences, i.e. a commensurate amount of savings, then the economy is on a sustainable growth path. Garrison theorizes following Strigl and Machlup that a credit expansion boom also leads to misallocation of capital in the later stages (lower order or consumption goods) of the structure.

 

Further recommended reading: Time and Money, the Macroeconomics of Capital Structure, by R. Garrison.

 

Charts: Federal Reserve of St. Louis, StockCharts.com, decisionpoint.com, R. Garrison

 

 

 

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