Sunday, December 21, 2008
The Fallacy of Neutral Money
Probably the single most important concept that Austrian monetary theory grasps is recognizing that its rivals, Keynesianism and especially the Chicago school, whether knowingly or not, embrace a false notion which the Austrians call "Neutral Money." In fact, if you are not explicitly an Austrian at this point, you probably believe it, too, though you may not yet know it. This doesn't make you stupid; pretty much everyone who ever thought about it probably arrives at the same false notion, including me. It sounds very simple and straightforward, kind of like the idea that keeping prices stable fights inflation. But both are wrong, and both lead to disastrous economic consequences if embraced. Neutral Money is the idea that an incremental increase in the quantity of money in the economy for a given quantity of goods and services results in an evenly distributed, incremental increase in the prices of all goods and services across the board. This is incorrect. It actually results in very concentrated price increases in certain areas of the economy at certain times, and spreads out in a predictable fashion to different areas. This results in the warped price structures that lead to improper investment patterns and economic development, which we know as economic bubbles and the boom and bust of the business cycle, including the present crisis. Because the other theories don't understand this, the entire process looks disjointed and irrational to them. The Keynesians in particular never seem to be able to wrap their minds around why the business cycle persists despite the best efforts of their beloved central banks. They perpetually find ever more complex and convoluted ways to explain the process, suggesting the creation of ever more Byzantine regulatory and monetary schemes to fight off the imagined ghosts and gremlins that ruin their plans. There are really two good ways that I know of to think about this and understand what is going on. The first, and most strictly Austrian, is to consider interest rates. The money supply of the United States and of other countries which practice central banking is regulated through credit markets. When the central bank begins an "intervention," which is to say, a suppression of the interest rate to "stimulate growth," it lowers targeted interest rates by systematically buying debt instruments, usually loans to banks and US Treasury Debt, with new money. The flurry of buying activity lowers interest rates by artificially increasing demand for those bonds, as I talked about before, which spreads throughout the credit market. As banks are able to borrow at lower rates of interest from the Fed, they bid down interest rates as they compete to lend into the market. Businesses, perpetually in search of opportunities for profit, suddenly find that the interest costs of financing have fallen. This makes many projects, which previously would have not been deemed profitable, begin to look like worthy targets for investment. So they begin to undertake new investment and development activities. To understand this, lets look at a simple, concrete example of a profitable investment: a rental house. Suppose that without intervention by the Fed, an open-market loan is available at 8%. Estimating that the average worker in a neighborhood of $100,000 houses can spend about $1000 per month on rent for such a house, revenue from a rental property will be $12,000/year. So a property with a price tag of $100,000 will cost $8000/year to finance (.08 X $100,000, interest on the debt used to buy the property), and generate $4000 in income, assuming no other expenses. A business typically trades at 8-10 times earnings, so this "business" would be worth about $32,000 to $40,000. Since $100,000 in liabilities would be assumed in such a venture (the cost of the house) this is only a marginal investment at best. However, suppose that through intervention, the interest rate is reduced to 5%. Now the property costs $5000 per year to finance, and revenues are now $7000 per year. The "business" looks to be worth $56,000 to $70,000, a full 30% higher than in the previous scenario and not too far below the asking price of the house. A buyer might think about making the investment. (As an aside, I should also note that a wide range of government interventions make the above scenarios look even more enticing, especially mortgage interest, business expense, and depreciation deductions. Once those are taken into account, the second scenario looks very good indeed, but that gets very complicated and is beyond the scope of this essay. Few people realize just how inflated home prices are as a result of these policies. Housing would be a lot more affordable if the government would stop trying to make it so.) Such increased buying by businesses, then, begins the first cycle of price increases, at least in a form we would commonly recognized. Only those properties and goods which businesses are interested in as investment vehicles appreciate; consumer goods are largely left out of the buying spree. Austrians distinguish between two classes of goods as "consumer goods," goods whose value is derived purely from their consumption value and are therefore destroyed upon the "realization" of this value, and "capital goods," whose value is derived from their capacity to produce consumer goods and other capital goods. A "higher-order" capital good is one that is very far up the production process and is used to produce other capital goods. An example of each might be: a steel mill (high-order capital good), a butter knife (a lower-order capital good), and a sandwich (a consumer good). Businesses, investors, and entrepreneurs predominantly use credit to buy capital goods. One interesting example of a capital good is that well known paper security called a "share" or a "stock," which represents a partial ownership share in a company. Since a share in a company represents a claim to productive capital (ignoring the various and prolific financial shenanigans, of course), e.g. a specific set of "capital goods," stock prices typically increase in response to a reduction in interest rates. In particular, early in the business cycle, those stocks which represent companies producing the capital goods that other business will buy as investments will tend to increase first, as they benefit from interest rate reductions and their products are increasing in demand early in the cycle, making their higher-order capital goods look particularly valuable. IBM shares, claims to higher-order capital goods, will tend to rise more quickly early on in the business cycle in response to interest rate suppression than shares of Coca-cola, which are claims to lower-order capital goods. The Nasdaq will tend to lead the S&P early in a boom. As the prices of capital goods increase, businesses that serve other businesses tend to realize higher profits than businesses that serve consumers directly. The production structure also tends to lengthen, as more convoluted and resource economizing production methods appear reasonable due to increasing sales volumes of these capital goods. In other words, engaging in economies of scale looks more profitable as the necessary investment capital appears cheaper to obtain due to lower interest rates. The division of labor tends to increase and work becomes more specialized as increasing levels of capital are employed. Eventually, in the later stages of the boom, businesses begin to compete for lower-order resources, including workers, and eventually, commodities. Employment of both labor and resources will have reached saturation. When this happens, wages and commodity prices rise. This is where the boom reaches a turning point. If wages continue to rise, eventually the prices of consumer goods will rise as consumers compete with one another for the available consumer goods. The public will recognize the inflation and begin to take countermeasures, driving up interest rates and prices further. But at the same time, business plans are going sour as their costs increase in a way they had not anticipated. Profit projections fall. Companies producing consumer goods, so-called "consumer staples" companies, and their profit projections start to look a lot better, as their products finally increase in price and they did not experience the wild run up in projections early on in the cycle. Coca-cola stock starts to look like a better, safer investment than IBM. At this point, the central bank has a choice: it can either stop suppressing the interest rate, stabilizing the money supply, or it can continue the suppression and increase the money supply even further. If it does the former, it will slow the increasing price of consumer goods, but cause wages to fall and reduce businesses profits further and therefore cause a stock market crash, and potentially a rash of bankruptcies as well. If it does the latter, continuing and exacerbating the inflation, it can keep the boom alive but only at the expense of the legitimacy of the currency. Eventually, the market enters a hyperinflationary boom, and the currency becomes worthless. At any rate, the effect of interest rates on the business cycle was not the purpose of this essay. The point is, with the onset of an inflation, the price increases do not occur across the board, they occur in specific markets in a specific pattern, distorting investment and causing a boom. The pattern is typically capital goods first, then moving on to labor, commodities, and finally consumer prices. New money entering a market is not neutral. The other way to understand the situation, which is the one I have used in the past, is to "follow the money" through the economy. Let's look at it. Monetary expansion begins, once again, at the central bank. The bank buys debt from member banks and from the US Treasury. The money is spent by the Treasury, on things like salaries, road construction, military spending, welfare programs, etc. In any case, the money once initially spent winds up in the bank accounts of the recipients. So by either pathway, it ends up in the banking system in short order. Once in the banking system, a small portion of the money is held as reserve while the remainder is re-lent back into the market through fractional reserve banking. The lent money is spent on whatever it is the borrower desires, at which point, once again, it winds up in a bank account somewhere, ready for the next lending cycle. And on, and on, multiplying itself along the way. Increasing the inflationary effect, I might add. This is old hat to people who know how fractional reserve banking works. The point is, only a select few institutions and markets see the money first. Nobody takes out a loan at a bank to buy groceries, and wages do not rise at first as a result of these activities. The government gets first dibs, then usually businesses close to the government and the banking system. And of course, the banking system sees the money several times. These groups get to spend the money into the market before others, outbidding them in the marketplace for resources. What do they buy? Here, the analysis is the same as before: capital goods, higher-order at first, then later labor and commodities. These entities are typically businesses, not private consumers, so they have the spending priorities of businesses. And once again, those close to where the money enters the market get the gold mine, the wage earner at the bottom of the totem pole wind up with the shaft. By the time consumers see any of the "new money," it is old, and consumer good prices are already being bid up and the Federal Reserve is likely thinking of inducing recession. Both analyses lead to several conclusions. The first is that by the time consumer goods are actually increasing in prices, inflation is already rampant. It has been "baked in" for some time and has been inevitable for years. This is why it is important to identify the increase in the money supply as inflation, not an increase in prices. Austrians understand this, Keynesians and the Chicago school do not. Second, and a bit more subtly, inflation is redistributive. Property is transferred from those last in line to those first in line as the new money moves through markets. The late receivers are outbid in the marketplace by those closest to the entry points. This has the effect of centralizing wealth and power in those institutions closest to the government, especially the banking system, and especially those directly linked to the business activities of the Federal Reserve. This is a list of the "primary dealers" with the Federal Reserve. Perhaps you've heard of a few: BNP Paribas Securities Corp. Banc of America Securities LLC Barclays Capital Inc. Cantor Fitzgerald & Co. Citigroup Global Markets Inc. Credit Suisse Securities (USA) LLC Daiwa Securities America Inc. Deutsche Bank Securities Inc. Dresdner Kleinwort Securities LLC Goldman, Sachs & Co. Greenwich Capital Markets, Inc. HSBC Securities (USA) Inc. J. P. Morgan Securities Inc. Merrill Lynch Government Securities Inc. Mizuho Securities USA Inc. Morgan Stanley & Co. Incorporated UBS Securities LLC. It appears from recent events that the relationships between them are being, "solidified," shall we say. Not for the good of the nation. Expect the trend to continue. Understanding the fallacy of neutral money is one of the key concepts to keeping the forest and the trees in focus. The Keynesians are too shortsighted, focusing on the numbers of the day and suggesting the money supply can be expanded to "stimulate" the economy with no fear of inflation so long as unemployment doesn't get too low, the CPI stays tame, wages do not rise, etc. They are up-to-the-minute statistics mongers and cannot see the bigger picture of the various interrelationships, especially over time. The Chicago school, on the other hand, is actually farsighted, claiming that the best policy is to consistently increase the money supply by a small amount continuously, so that prices rise predictably over time, and everybody can know what will happen and plan for it, thinking that all prices will rise and fall together in response to the general level of money and goods in the marketplace. "Money chasing goods," as it were. While it is true in the very long run that an increase in the money supply results in inflation, they cannot see the intermediate consequences between the increase and the final price increase. They fail to see that new money entering the system distorts the price structure, and therefore leads to the malinvestment, waste, and tragedy of the boom-bust cycle. Both are wrong. Only the Austrians understand the mid-term consequences of an increase in the money supply. Only they have a rational, comprehensive theory of the business cycle with testable, confirmable hypotheses. Only they can keep the whole picture in focus. But they do not run the country. The inflationists do.