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The US debt ceiling suspension, signed on February 2018, expires in March this year. According to some experts, the US Treasury will have to carry out special measures because of possible delays in raising this ceiling. Treasury would need to draw down its deposits with the Fed and deposit the money in various banks for future use to pay government expenses. As a result, this would boost monetary liquidity and therefore would have beneficial effects on financial markets.

It is sometimes argued that changes in government deposits with the Federal Reserve (Fed) set in motion changes in liquidity and that this has effects on financial markets. On this logic an increase in government deposits with the Fed would lead to a decline in the supply of money and hence to a decline in monetary liquidity.

Conversely, a decline in government deposits with the central bank results in an increase in money supply and monetary liquidity. An implicit assumption in this logic is that an increase in money supply and an increase in liquidity represent the same thing.

The meaning of monetary liquidity

Whilst many people talk about money and liquidity interchangeably, the reality is these are both very different concepts. Whilst the term money simply refers to the supply of money, the term liquidity relates to the interplay between the supply of and the demand for money.

People demand money primarily in order to facilitate trade. By means of money, a product of one specialist is exchanged for the product of another specialist. The nub of what makes a particular thing money (i.e. a medium of exchange) is that it offers to its holder a greater purchasing power than any other good.

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Is an Increase in Demand Key for Economic Growth?

January 11, 2019

IS AN INCREASE IN DEMAND KEY FOR ECONOMIC GROWTH?

Whenever the so-called economy shows signs of weakness most experts are of the view that what is required to prevent the economy sliding into recession is to boost the overall demand for goods and services.

If the private sector fails to increase its demand then it is the role of the government to fill this void.

Following the ideas of Keynes and Friedman, most experts associate economic growth with increases in the demand for goods and services.

Both Keynes and Friedman felt that the great depression of the 1930’s was due to an insufficiency in aggregate demand and thus the way to fix the problem was to boost aggregate demand.

For Keynes, this could be achieved by having the federal government borrow more money and spend it when the private sector would not. Friedman on the other hand advocated that the Federal Reserve pump more money to revive demand.

There is however never such a thing as insufficient demand as such. We suggest that an individual’s demand is constrained by their ability to produce goods. The more goods that an individual can produce the more goods he can demand i.e. acquire.

Note that the production of one individual enables him to pay for the production of another individual. (The more goods an individual produces the more of other goods he can secure for himself. An individual’s demand therefore is constrained by his production of goods).

Observe that demand cannot stand by itself and be independent – it is limited by production. Hence, what drives the economy is not demand as such but the production of goods and services.

In this sense, producers and not consumers are the engine of economic growth. Obviously, if he wants to succeed then a producer must produce goods and services in line with what other producers require ie. consume.

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The Neutral Interest Rate Myth

December 13, 2018

THE NEUTRAL INTEREST RATE MYTH

In his speech to the Economic Club of New York on November 28 2018, the Federal Reserve Board Chairman Jerome Powell said that the US central bank’s policy interest rate is just below the neutral rate. This prompted many commentators to suggest that a tighter interest rate stance of the Fed is likely coming to an end. At the end of October the fed funds rate target stood at 2.25%.

It is widely held that by means of suitable monetary policies the US central bank can navigate the economy towards a growth path of economic stability and prosperity. The key ingredient in achieving this is price stability. Most experts are of the view that what prevents the attainment of price stability are the fluctuations of the federal funds rate around the neutral rate of interest.

The neutral rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required is Fed policy makers successfully targeting the federal funds rate towards the neutral interest rate.

The Swedish economist Knut Wicksell articulated this framework of thinking in late 19^th century, which has its origins in the 18^th century writings of British economist Henry Thornton.

The Neutral Interest Rate Framework

According to Wicksell, there is a certain rate of interest on loans, which is neutral in respect to commodity prices, and tend neither to raise nor to lower them.

According to this view, the main source of economic instability is the variance between the money market interest rate and the neutral rate.

If the money market rate falls below the neutral rate, investment will exceed saving implying that aggregate demand will be greater than aggregate supply.

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What is the Relation Between Supply and Demand for Money?

November 14, 2018

WHAT IS THE RELATION BETWEEN SUPPLY AND DEMAND FOR MONEY?

For most economists there is the need to keep the so-called economy along the path of a stable economic growth and a stable price inflation. One of the reasons for the possible deviation of the economy from the stable growth path is a change in the demand for money. If the authorities failing to make sure that an increase in the demand for money is accommodated by the corresponding increase in the supply of money this could result in the economy deviating from the path of stable economic growth and stable inflation. Hence, it is imperative for the central bank to make sure that the growth in the supply of money is in tandem with the growth rate of the demand for money in order to maintain economic stability.

Note that on this way of thinking, a growing economy requires a growing money stock, because economic growth gives rise to a greater demand for money. Failing to accommodate a strengthening in the demand for money could lead to a decline in the prices of goods and services, which in turn will destabilize the economy and lead to an economic recession.

Since growth in money supply is of such importance, it is not surprising that economists are continuously searching for the right, or the optimum, growth rate of the money supply.

Some economists who are the followers of Milton Friedman – also known as monetarists – want the central bank to target the money supply growth rate to a fixed percentage. They hold that if this percentage maintained over a prolonged period it will usher in an era of economic stability.

The idea that money must grow in order to sustain economic growth gives the impression that money somehow sustains economic activity.

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Can Consumer Surveys Help Ascertaining the Future Course of an Economy?

September 27, 2018

CAN CONSUMER SURVEYS HELP ASCERTAINING THE FUTURE COURSE OF AN ECONOMY?

In order to gain insight into the future state of an economy, many economists refer to a variety of consumer and business surveys. Randomly selected consumers and businessmen are asked to provide their views about where the economy is heading. Thus if a survey shows that the majority of the surveyed express optimism it is regarded as good news for the economy. Conversely, if the majority of the surveyed are pessimistic it is taken as a bad omen for future economic activity.

But, is it valid to suggest that surveys can tell us where the economy is heading? Moreover, why should we regard an opinion supported by a large percentage of people as any more credible than the view of a particular individual?

It would appear that the knowledge regarding future economic conditions is dispersed. The chances of any one particular individual obtaining an accurate picture of the economy are thus very low. In addition, it is held that a large group of people are likely to have more information than an individual.

Hence, the logic underlying consumer and business surveys is that a large group of people selected randomly has a high likelihood of securing an accurate picture of future economic conditions.

It is quite possible that a group of people will have in their possession a greater amount of information than any given individual. However, more information does not necessarily mean a more accurate knowledge of the future.

In order to ascertain the facts of reality i.e. to separate the wheat from the chaff, the information must be processed by means of a theoretical framework.

Whether a forecast “makes sense” is determined not only by the amount of information available but also whether a theory, or a thinking process, is in tune with the facts of reality.

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The Fed and Asset Bubbles

September 14, 2018

THE FED AND ASSET BUBBLES

In his speech on April 7 2010 at the Economic Club of New York the President of the New York Fed, William Dudley argued that asset bubbles pose a serious threat to real economic activity.

The New York Fed chief is of the view that the US central bank should develop effective tools to counter this menace.

According to Dudley, it should be the role of the Fed to stop the expansion of the bubble whilst it is still in the making.

By an asset bubble, I mean price increases (or declines) that become unmoored from fundamental valuations.^[1]

Dudley is of the view that the way people trade also generates bubbles. On this, he suggests that,

Bubbles may simply emerge from the way market participant’s process information and trade. In many carefully controlled experiments in which the intrinsic value of the asset could be determined with certainty, participants still bid prices up far above fundamental valuations, with the bubbles being followed by sharp declines in prices.^[2]

Furthermore, Dudley is of the view that,

A bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.^[3]

In conclusion, the New York Fed President has suggested,

Let me underscore the challenge that central bankers face in combating asset price bubbles. Doing so effectively requires us to be successful in both identifying the incipient bubble and in developing and implementing a response that will limit bubble growth and avert a destructive asset price crash. This is not easy because asset bubbles are hard to recognize in real time and each asset bubble is different. However, these challenges cannot be an excuse for inaction.^[4]

The Fed and bubbles – is there any relation?

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Fiscal Stimulus and Economic Growth–Are They Related?

September 3, 2018

FISCAL STIMULUS AND ECONOMIC GROWTH – ARE THEY RELATED?

For most experts a key factor that policy makers should be watching is the gap between the actual real output and the potential real output. The potential output is the maximum output that the economy could attain if all the resources are used efficiently.

The gap is labelled as the output gap. In June this year the output gap – expressed in percentage terms – stood at 3.8% against 3.25% in March and 2.75% in June last year.

A strong positive output gap can be of concern because according to experts it can set in motion inflationary pressures. To prevent the possible escalation of inflation, experts tend to recommend tighter monetary and fiscal policies.

Their preferential outcome would be to soften the aggregate demand, which is considered as the key driving factor behind the positive output gap.

However, of greater concern to most experts is a negative output gap, which is associated with a severe recession.

The output gap was in the negative area between November 2008 and June 2013. Note that in June 2009 it had plunged to minus 3.34% (see chart).

Most commentators are of the view that with the emergence of a negative output gap the most effective policy to erase this gap is aggressive fiscal stimulus i.e. the lowering of taxes and increasing government outlays – a policy of large government deficit.

This way of thinking follows the ideas of John Maynard Keynes.

Briefly, Keynes held that one could not have complete trust in a market economy, which is inherently unstable. If left free the market economy could lead to self-destruction.

Hence, there is the need for governments and central banks to manage the economy.

Successful management in the Keynesian framework can be achieved by influencing the overall spending in an economy.

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What Causes the Acceptance of Paper Money?

August 21, 2018

WHAT CAUSES THE ACCEPTANCE OF PAPER MONEY?

Demand for a good arises because of its perceived benefit. For instance, people demand food because of the nourishment it offers them. This is however not so, with regard to the pieces of paper we call money – why do we accept them?

Following the view of Plato and Aristotle, economists regard the acceptance of money as an historical fact introduced by the government decree^[1]. It is government decree, so it is argued, that makes a particular thing accepted as the general medium of the exchange i.e. money.

In his writings, Carl Menger raised doubts about the soundness of the view that the origin of money is a government proclamation. According to Menger,

An event of such high and universal significance and of notoriety so inevitable, as the establishment by law or convention of a universal medium of exchange, would certainly have been retained in the memory of man, the more certainly inasmuch as it would have had to be performed in a great number of places. Yet no historical monument gives us trustworthy tidings of any transactions either conferring distinct recognition on media of exchange already in use, or referring to their adoption by peoples of comparatively recent culture, much less testifying to an initiation of the earliest ages of economic civilization in the use of money^[2].

Why conventional demand – supply analysis fails explaining the price of money

So how does a thing that the government proclaims will become the medium of the exchange, acquire purchasing power or a price? We know that the price of a good is the result of the inter-action between demand and supply. From this, we could reach a conclusion that the price of money is also set by the law of demand-supply.

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The Fed and Interest Rates

August 16, 2018

THE FED AND INTEREST RATES

Most experts agree that through the manipulation of short-term interest rates, the central bank by means of expectations regarding future interest rate policy can also dictate the direction of long-term interest rates. On this way of thinking expectations regarding future short-term interest rates are instrumental in setting the long-term rates. (Note the long-term rates are an average of short-term rates on this way of thinking).

Given the supposedly almost absolute control over interest rates, the central bank by correct manipulations of short-term interest rates could navigate the economy along the growth path of economic prosperity, so it is held. (In fact, this is the mandate given to central banks).

For instance, when the economy is thought to have fallen below the path of stable economic growth it is held that by means of lowering interest rates the central bank could strengthen aggregate demand. This in turn will be supportive in bringing the economy onto a stable economic growth path.

Conversely, when the economy becomes “overheated” and moves onto a growth path above that which is deemed as stable economic growth, then by lifting interest rates the central bank could slow the economy back onto the path of economic stability.

But is it valid to suggest that the central bank is the key factor in the determination of interest?

Individuals time preferences and interest rates

According to great economic thinkers such as Carl Menger and Ludwig von Mises interest is the outcome of the fact that every individual assigns a greater importance to goods and services in the present against identical goods in the future.

The higher valuation is not the result of capricious behaviour, but because of the fact that life in the future is not possible without sustaining it first in the present. According to Carl Menger,

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Can Sophisticated Technology Prevent Severe Economic Slump?

July 19, 2018

CAN SOPHISTICATED TECHNOLOGY PREVENT SEVERE ECONOMIC SLUMP?

Most economic commentators are likely to agree that in relation to the period prior to the Great Depression, the present world is many times more sophisticated in terms of advanced technological knowledge. It is then tempted to suggest that with the present advanced technology we are in a position to generate enough real wealth to prevent a severe economic slump.

On this way of thinking, ideas are not themselves scarce unlike material inputs. Consequently, new ideas for more efficient processes and new products can make continuous growth possible.

It follows then that because of the limited amounts of capital and labour, without the technological progress the opportunities for growth will eventually run out.

We suggest that one could have argued along similar lines about the period prior to the Great Depression i.e. prior to the 1929 when comparing it with the end of the nineteenth century. During the first 30 years of the twentieth century, important technological break-throughs occurred, and individuals’ wellbeing had risen significantly in the western world. Yet despite all the sophistication, the world still experienced the Great Depression. A severe economic slump took place in spite of technological progress.

We suggest that regardless of how many ideas people have what always limits the implementation of various new ideas is the availability of real savings.

Real savings the key for economic growth

While new ideas can result in a better use of scarce resources, they can however, do very little for real economic growth without the expanding pool of real savings.

In his “Man Economy and State” 2nd edition page 542 Rothbard says, that technology, while important, must always work through the investment of capital in order to generate economic growth. On this issue Rothbard quotes Mises who says,

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Why Gold Standard is Not Conducive of Boom-Bust Cycles?

July 9, 2018

WHY GOLD STANDARD IS NOT CONDUCIVE OF BOOM-BUST CYCLES?

According to some commentators on the gold standard, an increase in the supply of gold generates similar distortions that money out of “thin air” does.

Let us start with a barter economy. John the miner produces ten ounces of gold. The reason why he mines gold because he believes there is a market for it. Gold contributes to the wellbeing of individuals.

He exchanges his ten ounces of gold for various goods such as potatoes and tomatoes.

Now people have discovered that gold apart from being useful in making jewellery is also useful for some other applications.

They now assign a much greater exchange value to gold than before. As a result, John the miner could exchange his ten ounces of gold for more potatoes and tomatoes.

Should we condemn this as bad news because John is now diverting more resources to himself? This however, is just what is happening all the time in the market.

As time goes by people, assign greater importance to some goods and diminish the importance of some other goods. Some goods now considered as more important than other goods in supporting people’s life and wellbeing.

Now people have discovered that gold is useful for another use such as to serve as the medium of the exchange. Consequently, they lift further the price of gold in terms of tomatoes and potatoes. Gold now predominantly demanded as a medium of exchange – the demand for the other services of gold such as ornaments is now much lower than before.

Let us see what is going to happen if John were to increase the production of gold. The benefit that gold now supplies people is by providing the services of the medium of the exchange. In this sense, it is a part of the pool of real wealth and promotes people’s life and wellbeing.

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Does Economic Growth Cause Inflation?

July 4, 2018

DOES ECONOMIC GROWTH CAUSE INFLATION?

Most experts are of the view that as the economy gains strength the Fed must step in at some stage and introduce a tighter stance in order to prevent the rate of inflation getting out of control.

Why however, should economic growth be positively associated with a general increase in the prices of goods and services?

Let us examine how prices in general could go up. The price of a good is the amount of dollars paid per unit of this good.

Therefore, with all things being equal an increase in the quantity of dollars in the economy must lead to a general increase in the prices of goods and services.

Now, when we talk about economic growth what we mean by that is an increase in the production of goods and services that people require to support their life and wellbeing.

Obviously then, for a given amount of money an increase in economic growth i.e. an increase in the amount of goods and services, must lead to a decline and not to an increase in the prices of goods and services in general. (We now have more goods for an unchanged amount of dollars).

Therefore, if what we are saying is correct, why are the yearly growth rate of the consumer price index adjusted for food and energy (the core CPI) and the lagged yearly growth rate in industrial production are moving in tandem (see chart below)?

Does the positive correlation between the growth momentum of the core CPI and the lagged growth momentum of industrial production make sense?

Why should more wealth, which raises people’s living standards, also generate bad things – such as a general increase in prices of goods and services?

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The Growing Pool of Real Savings Permits the Illusion That Central Bank Can Cause Economic Growth

June 28, 2018

THE GROWING POOL OF REAL SAVINGS PERMITS THE ILLUSION THAT CENTRAL BANK CAN CAUSE ECONOMIC GROWTH

Many commentators are of the view that the US central bank should pursue policies that will prevent the possible decline of the economy into a liquidity trap hole. What is this all about?

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back their outlays and hoard more money. Therefore, once an individual spends less, this will worsen the situation of some other individual, who in turn also cuts his spending.

A vicious circle sets in – the decline in people’s confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the growth rate of money supply and aggressively lower interest rates.

Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby re-establishing the circular flow of money, so it is held.

In his writings however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further. As a result, the central bank will not be able to revive the economy.

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Should the Fed Print Money to Accommodate Demand for Money?

June 8, 2018

SHOULD THE FED PRINT MONEY TO ACCOMMODATE DEMAND FOR MONEY?

For most economists and commentators the main role of the Fed is to keep the supply and demand for money in equilibrium. Whenever an increase in the demand for money occurs, to maintain the state of equilibrium the accommodation of the demand for money by the Fed is considered as a necessary action in order to keep the economy on a path of economic and price stability.

The accommodation of the increase in the demand for money is not considered as money printing and therefore not harmful to the economy i.e. setting in motion the boom-bust cycle as long as the growth rate of money supply does not exceed the growth rate in the demand for money.

Note that on this way of thinking since the growth rate in the demand for money is offset by the growth rate of the supply of money then no effective increase in the supply of money occurs. From this perspective, no harm is inflicted on the economy.

Why accommodating demand for money always harmful

What do we mean by demand for money? In addition, how does this demand differs from the demand for goods and services?

The demand for a good does not reflect the demand for a particular good as such but the demand for the services that the good offers. For instance, an individual demands food because this provides the necessary elements that sustain his life and wellbeing. Demand here means that people want to consume the food in order to secure the necessary elements that sustain their life and wellbeing.

The demand for money arises because of the services that money provides. However, instead of consuming money people demand money in order to exchange it for goods and services.

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Does Subjective Valuation Mean Arbitrary Valuation?

June 5, 2018

DOES SUBJECTIVE VALUATION MEAN ARBITRARY VALUATION?

Why do individuals pay much higher prices for some goods versus other goods? The common reply to this is the law of supply and demand.

However, what is behind this law? To provide an answer to this question economists refer to the law of diminishing marginal utility.

Mainstream economics explains the law of diminishing marginal utility in terms of the satisfaction that one derives from consuming a particular good.

For instance, an individual may derive vast satisfaction from consuming one cone of ice cream.

However, the satisfaction he will derive from consuming a second cone might also be big but not as big as the satisfaction derived from the first cone.

The satisfaction from the consumption of a third cone is likely to diminish further, and so on.^[1]

From this, mainstream economics concludes that the more of any good we consume in a given period, the less satisfaction, or utility, we derive out of each additional, or marginal, unit.

It is also established that because the marginal utility of a good declines as we consume more and more of it, the price that we are willing to pay per unit of the good also declines.

Utility in this way of thinking is presented as a certain quantity that increases at a diminishing rate as one consumes more of a particular good. Utility is regarded as a feeling of satisfaction or enjoyment derived from buying or using goods and services.

According to the mainstream way of thinking, an individual’s utility scale is wired in his head. This scale determines for the individual whether he will purchase a particular good. The valuation scale is given and there is no explanation on how it was established.

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