Effects of Monetary Pumping on the Real World

As long time readers know, we are looking at the economy through the lens of Austrian capital and monetary theory (see here for a backgrounder on capital theory and the production structure). In a nutshell: Monetary pumping falsifies interest rate signals by pushing gross market rates below the rate that reflects society-wide time preferences; this distorts relative prices in the economy and sets a boom into motion – which is characterized by widespread malinvestment of scarce capital and over-consumption; eventually, the distorted capital structure proves unsustainable – interest rates begin to rise, and boom turns to bust. Many businessmen belatedly realize that the accounting profits of the boom were an illusion – in reality, capital was consumed. Many as yet unfinished investment projects have to be abandoned, as they either turn out to be unprofitable at higher rates and/or the resources needed to complete them are lacking.

 

When capital runs short: several of countless housing developments in Spain which had to be abandoned when the bust of 2007-2009 started. The image on the right hand side shows a Spanish construction machinery graveyard in 2010. Money supply growth in the US and the euro area exploded after the turn of the millennium, as central banks pumped heavily to combat the demise of the tech boom. In the process they egged on an even more dangerous bubble in real estate. In their great wisdom they have now replaced the expired real estate boom with an even larger, more comprehensive bubble in everything.

 

Below we show updates of a chart that depicts the effect of money supply and interest rate manipulation on the capital structure. The caveat to this is that such statistical data have to be viewed with a critical eye: one must always to ask to what extent the economy is actually amenable to “measurement” – often such aggregated data obscure more than they reveal. Having said that, many data series at least convey information about general trends.

The chart shows the ratio between the production indexes for capital and consumer goods in the US. The trends in the ratio certainly seem consistent with theory: in booms driven by credit expansion, investment is increasingly drawn toward the higher stages of the production structure – capital goods production therefore increases relative to consumer goods production.

Busts are heralded by a reversal of this trend. Eventually downtrends will be arrested, as monetary pumping is resumed at full blast and a new cycle starts. There is a catch though: this only “works” as long as there is enough real wealth that can be diverted by an inflow of new money. Obviously, printing additional fiat money is not equivalent to creating new capital (an aside: obviously the production structure is a complex latticework of processes and plans and does not just comprise two broadly defined sectors – but this simplification makes sense for the particular purpose of this illustration).

Here is a medium term chart of the ratio since 1990:

 

Credit expansion-driven bubble eras, interrupted by busts. The ratio is currently well below its 2014 peak, but it remains close to the level it reached at the height of the previous boom. It seems fair to conclude that the fat lady is still in the process of clearing her throat.

 

The current GBEB (Great Bernanke Echo Bubble) is still underway, although it almost keeled over when the Fed discontinued “QE 3” in 2014. This led to a downturn in the oil sector (and the wider commodities space). At the time capital spending related to energy production seemed quite important to the US economy, so it could not be ruled out that the sector’s woes would lead to a wider bust. Readers may recall that Fed district surveys of the manufacturing sector were weakening rather noticeably at the time and credit spreads started blowing out.

Moreover, a number of emerging market economies did suffer outright busts. In some ways the situation was reminiscent of the 1997/1998 Asian/ Russian crisis, which caused a growth scare in developed markets, but didn’t trigger a recession.  Instead of the Fed intervening and reigniting the bubble, the ECB and the BoJ stepped into the breach this time. Their debt monetization exercises propagated across the globe, suppressing yields and credit spreads far and wide through arbitrage effects.

 

The Long Term View

The next chart shows the pattern in the capital vs. consumer goods production ratio since 1947, i.e., over the entire post WW 2 era. Under the Bretton Woods gold exchange standard, it was confined to a sideways channel far below recent  levels. Recessions were more frequent at the time, but they tended to be shorter and less severe than the busts we have experienced since then. Not to forget, economic growth was on average much stronger as well.

This is not surprising; the gold exchange standard was far from an ideal system, but it did impose some limits on central banks and governments – theoretically, anyway. It failed because they eventually decided to simply ignore these limits. By the time Nixon decided to default on the US government’s obligation to exchange its confetti for gold at a fixed ratio in line with the Bretton Woods agreement, the only open question was the degree of embarrassment the default would involve.

He probably went for a “flight forward” because it created the illusion that he was still in control of events. His solemn declaration that he would “temporarily” suspend gold convertibility (a qualification that was never officially rescinded as far as we know), while blaming shadowy “speculators” for the dollar’s woes and announcing the imposition of tariffs and price controls was both funny and sad.

It also serves as a useful reminder that government officials will routinely lie and misrepresent reality, particularly when they are about to reach deep into the wallets of the citizenry.

 

“Hi there dear fellow hoi-polloi, allow me to temporarily relieve you of the ghastly burden of prosperity and give you an unprecedented opportunity to pay a lot more for everything. We’ll show them money-shufflers!” Famous guns and butter merchant, wagging a finger at nameless international speculators.

Photo credit: AP

 

In any case, it certainly made for a very interesting decade – and the global debt-berg has expanded exponentially ever since. Here is the long term chart of our ratio:

 

Capital vs. consumer goods production since the end of WW 2: a tale of two eras.

 

There is probably more than just one reason for the uptrend in the ratio since the adoption of the fiat money system. Nevertheless, the ups and downs in the ratio clearly continue to correspond to boom-bust cycles.

Over time much more wealth was created under the capitalist system than was consumed in credit expansion-induced booms – at least so far. Note that even a severely hampered market economy has enormous wealth creation potential.

Ludwig von Mises states in this context that the ultimate outcome of credit expansion is “general impoverishment” (Human Action, p.562). While some people will escape this fate, or may even end up profiting due to a good sense of timing or due to sheer luck, the majority of the population will pay a price for the capital malinvestment and over-consumption of the boom period. However, he adds the following important point by way of clarification:

 

One must guard oneself against a misinterpretation of this term impoverishment. It does not mean impoverishment when compared with the conditions that prevailed on the eve of the credit expansion. Whether or not an impoverishment in this sense takes place depends on the particular data of each case; it cannot be predicated apodictically by catallactics.

What catallactics has in mind when asserting that impoverishment is an unavoidable outgrowth of credit expansion is impoverishment as compared with the state of affairs which would have developed in the absence of credit expansion and the boom.

The characteristic mark of economic history under capitalism is unceasing economic progress, a steady increase in the quantity of capital goods available, and a continuous trend toward an improvement in the general standard of living.

The pace of this progress is so rapid that, in the course of a boom period, it may well outstrip the synchronous losses caused by malinvestment and over-consumption. Then the economic system as a whole is more prosperous at the end of the boom than it was at its very beginning; it appears impoverished only when compared with the potentialities which existed for a still better state of satisfaction.

 

(emphasis added)

 

A thumbs-up from Ludwig von Mises

 

This certainly rings true – it can hardly be denied that a “continuous improvement in the general standard of living” has occurred.  On the other hand, the pure fiat money system is still young and the vast debt expansion it has enabled has no precedent.

The more often cyclical boom-bust sequences are repeated, the more difficult real wealth generation is likely to become, as more and more capital will be consumed. Eventually a tipping point could be reached, after which “impoverishment” could well become a problem in absolute rather than merely in relative terms.

Up next: recent developments on the money supply and credit front.

 

Charts by www.acting-man.com (data source: St. Louis Fed)

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

One Response to “The Capital Structure as a Mirror of the Bubble Era”

  • vfor:

    To this discussion I think it can be added that nothing is linear in human behavior. People in stress take all kinds of stupid decisions that can wreak havoc with their own economy and others. One only has to look as far as the Deep State in Washington to imagine what might happen in a worst case. With this I want to say that the risk that we are standing in front of a major cliff is far higher than Black and Scholes would suggest.

    Looking forward to part two.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • The Federal Reserve is a Barbarous Relic
      The Sky is Falling   “We believe monetary policy is in a good place.” – Federal Reserve Chairman Jerome Powell, October 30, 2019.   The man from the good place. "As I was going up the stair, I met a man who wasn't there. He wasn't there again today, Oh how I wish he'd go away!" [PT]   Ptolemy I Soter, in his history of the wars of Alexander the Great, related an episode from Alexander’s 334 BC compact with the Celts ‘who dwelt by the Ionian...
  • Incrementum 2019 Gold Chart Book
      The Most Comprehensive Collection of Gold Charts Our friends at Incrementum have just published their newest Gold Chart Book, a complement to the annual “In Gold We Trust” report. A download link to the chart book is provided below.   As of late 2019 an ounce of gold will get you 115 liters of beer at the Munich October Fest – a 7-year high. Cheers!   The Incrementum Gold Chart Book is easily the most comprehensive collection of charts related to or relevant...
  • The Golden Autumn Season – One of the Most Reliable Seasonal Patterns Begins
      The Strongest Seasonal Stock Market Trend Readers may already have guessed: when the vibrant colors of the autumn leaves are revealed in all their splendor, the strongest seasonal period of the year begins in the stock market – namely the year-end rally.   Will Santa wake up this year? Last year he was clearly missing in action – but that is actually the exception, not the rule [PT]   Stocks typically rise in this time period. However, there are questions, such...
  • Maybe the West Should Adopt Iran’s Nuclear Weapons Policy
      The Rise of Total War Prior to the modern age, when war was engaged in, combatants, for the most part, acted by a code of conduct which attempted to minimize civilian deaths and the destruction of non-participants’ property. With the onset of the democratic age and the idea of “total war” such modes of conduct have tragically fallen by the wayside, the consequence of which has made warfare far more bloody and destructive.   Iranian Seiji-2 missile. Of course, we...
  • Riding the Type 3 Mega Market Melt Up Train
      Beta-driven Fantasy The decade long bull market run, aside from making everyone ridiculously rich, has opened up a new array of competencies. The proliferation of ETFs, for instance, has precipitated a heyday for the ETF Analyst. So, too, blind faith in data has prompted the rise of Psychic Quants... who see the future by modeling the past.   Gandalf, quant of Middle-Earth, dispensing sage advice. [PT]   For the big financial outfits, optimizing systematic –...
  • Bitcoin Moonshot - Precious Metals Supply and Demand
      Bitcoin Gets Juiced The prices of gold and silver were up $19 and $0.48 respectively last week. But that’s not where the massive inpouring of groceries went.   When Friday began (Arizona time), Bitcoin’s purchasing power was under 75 grocery units (assuming a grocery unit is $100). By evening, speculators added 25 more grocery units to the same unit of bitcoin.   Bitcoin, daily – shortly after breaking below an obvious lateral support level, Bitcoin did an...
  • Maurice Jackson Interviews Brien Lundin and Jayant Bhandari
      Two Interesting Recent P&P Interviews Our friend Maurice Jackson of Proven and Probable has recently conducted two interviews which we believe will be of interest to our readers. The first interview  is with Brien Lundin, the president of Jefferson Financial, host of the famed New Orleans Investment Conference and publisher & editor of the Gold Newsletter – an investment newsletter that has been around for almost five decades, which actually makes it the longest-running...
  • Targeting nGDP Targeting – Precious Metals Supply and Demand
      Everybody Has a Plan Not too long ago, we wrote about the so called Modern Monetary so called Theory (MMT). It is not modern, and it is not a theory. We called it a cargo cult. You’d think that everyone would know that donning fake headphones made of coconut shells, and waving tiki torches will not summon airplanes loaded with cargo. At least the people who believe in this have the excuse of being illiterate.   A few images documenting cargo cults on the island of...
  • Volatility Galore - Precious Metals Supply and Demand
      Fun and Regret Ex Nihilo The price of gold dropped last week, but not calamitously. From $1514 to $1459, or -$55. The price of silver dropped. Calamitously. From $18.08 to $16.75, or -$1.33. -3.6% vs -7.4%. Once again, silver proves to be volatile relative to gold.   Silver jumped off a cliff again last week – the chart formation nevertheless continues to look corrective. [PT]   In standard vernacular, the metals lost purchasing power this week. Purchasing power can...
  • Is the Fed Secretly Bailing Out a Major Bank?
      Prettifying Toxic Waste The promise of something for nothing is always an enticing proposition. Who doesn’t want roses without thorns, rainbows without rain, and salvation without repentance?  So, too, who doesn’t want a few extra basis points of yield above the 10-year Treasury note at no added risk?   The yield-chasing hamster wheel... [PT]   Thus, smart fellows go after it; pursuing financial innovation with unyielding devotion.  The underlying...

Support Acting Man

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!