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Most economists concur with the view that what keeps the economy going is consumption expenditure. Furthermore, it is generally held that spending rather than individual saving is the essential condition for production and prosperity.

Savings is seen to be detrimental to economic activity as it weakens the potential demand for goods and services.

In this framework of thinking, economic activity is depicted as 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.

If however, people become less confident about the future it is held they will cut back on their outlays and hoard more money. Therefore, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

A vicious circle emerges– the decline in people’s confidence causes them to spend less and to hoard more money. This lowers economic activity further, thereby causing people to hoard more etc. The cure for this, it is argued, is for the central bank to pump money.

By putting more cash in people’s hands, consumer confidence will increase, people will then spend more and the circular flow of money will reassert itself.

All this sounds very appealing and various surveys of business activity show that during a recession businesses emphasize the lack of consumer demand as the major factor behind their poor performances.

Notwithstanding this, can demand by itself generate economic growth? Furthermore, nothing is said here about goods and services – are we to take them for granted? Are they always around and all that is required is to have demand for them?

It would appear that what impedes economic prosperity is the scarcity of demand. However, is it possible for the general demand for goods and services to be scarce?

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Does it Matter Whether Assumptions in Economics are Arbitrary?

May 21, 2018

DOES IT MATTER WHETHER ASSUMPTIONS IN ECONOMICS ARE ARBITRARY?

Various assumptions employed by mainstream economists appear to be of an arbitrary nature. The assumptions seem to be detached from the real world.

For example, in order to explain the economic crisis in Japan, the famous mainstream economist Paul Krugman employed a model that assumes that people are identical and live forever and that output is given. Whilst admitting that these assumptions are not realistic, Krugman nonetheless argued that somehow his model can be useful in offering solutions to the economic crisis in Japan.^[1]

The employment of assumptions that are detached from the facts of reality originates from the writings of Milton Friedman. According to Friedman, since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a model are. In fact anything goes, as long as the model can yield good predictions. According to Friedman,

The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.^[2]

Observe that on this way of thinking, the formation of the view regarding the real world is arbitrary – in fact, anything goes as long as the model could generate accurate forecasts.

In his Philosophical Origins of Austrian Economics (Mises Institute Daily Articles June 17 2006), David Gordon wrote that Bohm Bawerk maintained that concepts employed in economics must originate from the facts of reality – they need to be traced to their ultimate source. If one cannot trace it the concept should be rejected as meaningless.

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Expectations and the Austrian Business Cycle Theory

May 9, 2018

EXPECTATIONS AND THE AUSTRIAN BUSINESS CYCLE THEORY

According to the Austrian Business Cycle Theory (ABCT) the artificial lowering of interest rates by the central bank leads to a misallocation of resources because businesses undertake various capital projects that prior to the lowering of interest rates weren’t considered as viable. This misallocation of resources is commonly described as an economic boom.

As a rule businessmen discover their error once the central bank—that was instrumental in the artificial lowering of interest rates—reverses its stance, which in turn brings to a halt capital expansion and an ensuing economic bust. From the ABCT one can infer that the artificial lowering of interest rates sets a trap for businessmen by luring them into unsustainable business activities that are only exposed once the central bank tightens its interest rate stance.

Critics of the ABCT maintain that there is no reason why businessmen should fall prey again and again to an artificial lowering of interest rates. Businessmen are likely to learn from experience, the critics argue, and not fall into the trap produced by an artificial lowering of interest rates. Correct expectations will undo or neutralise the whole process of the boom-bust cycle that is set in motion by the artificial lowering of interest rates. Hence, it is held, the ABCT is not a serious contender in the explanation of modern business cycle phenomena.

According to a prominent critic of the ABCT, Gordon Tullock,

One would think that business people might be misled in the first couple of runs of the Rothbard cycle and not anticipate that the low interest rate will later be raised. That they would continue to be unable to figure this out, however, seems unlikely. Normally, Rothbard and other Austrians argue that entrepreneurs are well informed and make correct judgments. At the very least, one would assume that a well-informed businessperson interested in important matters concerned with the business would read Mises and Rothbard and, hence, anticipate the government action.^[1]

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Krugman Dismisses That an Increase in Money Supply Causes Inflation

April 15, 2018

KRUGMAN DISMISSES THAT AN INCREASE IN MONEY SUPPLY CAUSES INFLATION

In the New York Times article on March 27, 2018 – Immaculate inflation strikes again – Paul Krugman argues that those economists who are of the opinion that the key factor that causes inflation is increases in money supply are very wrong. According to Krugman, the key factor that sets in motion inflation is unemployment. Whilst a decline in the unemployment rate is associated with a strengthening in the rate of inflation an increase in the unemployment rate is associated with a decline in the rate of inflation.

Note that for Krugman inflation is about general increases in the prices of goods and services, which we suggest is a flawed definition. To ascertain what inflation is all about we have to establish how this phenomenon emerged. We have to trace it back to its historical origin.

The essence of inflation

The subject matter of inflation is an act of embezzlement. Historically inflation originated when a country’s ruler such as king would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens.

On this Rothbard wrote,

More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks”, but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.^[1]

On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a diluted gold coin.

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Why Mainstream Economics Consistently Fails to Explain the Occurrence of Recessions?

March 26, 2018

WHY MAINSTREAM ECONOMICS CONSISTENTLY FAILS TO EXPLAIN THE OCCURRENCE OF RECESSIONS?

In his article released on March 21 2018 – Economics failed us before the global crisis – Martin Wolf the economics editor of The Financial Times expressed some misgivings about macroeconomics.

Economics is, like medicine (and unlike, say, cosmology), a practical discipline. Its goal is to make the world a better place. This is particularly true of macroeconomics, which was invented by John Maynard Keynes in response to the Great Depression. The tests of this discipline are whether its adepts understand what might go wrong in the economy and how to put it right. When the financial crisis that hit in 2007 caught the profession almost completely unawares, it failed the first of these tests. It did better on the second. Nevertheless, it needs rebuilding.

Martin Wolf argues that a situation could emerge when the economy might end up in self-reinforcing bad states. In this possibility, it is vital to respond to crises forcefully.

It seems that regardless of our understanding of the key causes behind the crises authorities should always administer strong fiscal and monetary policies holds Martin Wolf. On this way of thinking, strong fiscal and monetary policies somehow will fix things.

A big question is not only whether we know how to respond to a crisis, but whether we did so. In his contribution, the Nobel laureate Paul Krugman argues, to my mind persuasively, that the basic Keynesian remedies — a strong fiscal and monetary response — remain right.

Whilst agreeing with Krugman, Martin Wolf holds the view that, we remain ignorant to how economy works. Having expressed this, curiously Martin Wolf still holds the view that Keynesian policies could help during an economic crisis.

For Martin Wolf as for most mainstream economists the Keynesian remedy is always viewed with positive benefits- if in doubt just push more money and boost government spending to resolve any possible economic crisis. It did not occur to our writer that without understanding the causes of a crisis, administering Keynesian remedies could make things much worse.

The proponents for strong government outlays and easy money policy when the economy falls into a crisis hold that stronger outlays by the government coupled with increases in money supply will strengthen monetary flow and this in turn will strengthen the economy. What is the reason behind this way of thinking?

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Can Money Pumping Stimulate Economic Growth?

March 21, 2018

CAN MONEY PUMPING STIMULATE ECONOMIC GROWTH?

According to most economic experts when an economy falls into a recession the central bank can pull it out of the slump by means of money pumping. This way of thinking implies that money pumping can somehow grow the economy. Indeed US historical evidence supposedly does show that easy money policy seems to work. For instance on average between 1970 and 2018.2 it took about 11 months before increases in money supply caused increases in the growth rate of industrial production (see chart).

The question is how is this possible? After all if money printing can grow the economy then why not to print plenty of it and make massive economic growth? By doing that, central banks could have created an everlasting prosperity for every individual on the planet.

For most commentators the arrival of a recession is due to unexpected events such as shocks that push the economy away from a trajectory of stable economic growth. Shocks weaken the economy i.e. cause lower economic growth so it is held.

We suggest that as a rule a recession emerges in response to a decline in the growth rate of money supply. Usually this takes place in response to a tighter stance of the central bank.

As a result various activities that sprang up on the back of the previous strong money growth rate (usually this emerges because of loose central bank monetary policy) come under pressure.

These activities cannot support themselves – they survive because of the support that the increase in money supply provides. The increase in money diverts to them real wealth from wealth generating activities. Consequently, this weakens these activities i.e. wealth-generating activities.

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What is Wrong With the Popular Definition of Inflation?

March 12, 2018

WHAT IS WRONG WITH THE POPULAR DEFINITION OF INFLATION?

According to Mises,

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation.^[1]

What is today called inflation is the general rise in prices, which is in fact only the outcome of inflation. Consequently, anything that contributes to price rises is now called inflationary and therefore must be guarded against. Thus, a fall in unemployment or a rise in economic activity are all seen as potential inflationary triggers and therefore must be restrained by central bank policies.

Some other triggers such as rises in commodity prices or workers’ wages also regarded as potential threats and therefore must be always under the watchful eye of the central bank policy makers.

If inflation is indeed just a general rise in prices, then why is it regarded as bad news? What kind of damage does it do?

Mainstream economists maintain that general price increases cause speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources.

Despite all these assertions regarding the side effects of what they define as inflation, mainstream economics does not tell us how all these bad side effects are caused.

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The Relevancy of Probability in Economics

February 13, 2018

THE RELEVANCY OF PROBABILITY IN ECONOMICS

Modern economics in addition to sophisticated mathematics also employs probability distributions. What is probability? The probability of an event is the proportion of times the event happens out of a large number of trials.

For instance, the probability of obtaining heads when a coin is tossed is 0.5. This does not mean that when a coin is tossed 10 times, five heads are always obtained.

However, if the experiment is repeated a large number of times then it is likely that 50% will be obtained. The greater the number of throws, the nearer the approximation is likely to be.

Alternatively, say it has been established that in a particular area, the probability of wooden houses catching fire is 0.01. This means that on the basis of experience, on average, 1% of wooden houses will catch fire.

This does not mean that this year or the following year the percentage of houses catching fire will be exactly 1%. The percentage might be 1% or not each year. However, over time, the average of these percentages will be 1%.

This information, in turn, can be converted into the cost of fire damage, thereby establishing the case for insuring against the risk of fire. Owners of wooden houses might decide to spread the risk by setting up a fund.

Every owner of a wooden house will contribute a certain proportion to the total amount of money that is required in order to cover the damages of those owners whose houses are going to be damaged by the fire.

Note that insurance against fire risk can only take place because we know its probability distribution and because there are enough owners of wooden houses to spread the cost of fire damage among them so that the premium is not going to be excessive.

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Can We Ascertain the Facts of Reality in Economics by Means of Mathematics?

February 5, 2018

CAN WE ASCERTAIN THE FACTS OF REALITY IN ECONOMICS BY MEANS OF MATHEMATICS?

It is generally held that by means of statistical and mathematical methods one can organize historical data into a useful body of information, which in turn can serve as the basis for the assessments of the state of the economy. It is also held that the knowledge secured from the assessment of the data is likely to be of a tentative nature since it is not possible to know the true nature of the facts of reality.

Some thinkers such as Milton Friedman held that since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory are. On this way of thinking, what matters is that the theory can yield good predictions.

According to Friedman,

The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.^[1]

For instance, an economist forms a view that consumer outlays on goods and services are determined by disposable income. Based on this view he forms a model, which is then validated by means of statistical methods. The model is then employed in the assessments of the future direction of consumer spending.

If the model fails to produce accurate forecasts, it is either replaced, or modified by adding some other explanatory variables.

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MONEY AND THE STOCK MARKET: IS THERE ANY RELATION?

January 26, 2018

MONEY AND THE STOCK MARKET: IS THERE ANY RELATION?

Is it true that changes in money supply are an important driving force behind changes in the stock price indexes?

Intuitively it makes sense to argue that an increase in the growth rate of money supply should strengthen the growth rate in stock prices.

Conversely, a fall in the growth rate of money supply should slow down the growth momentum of stock prices.

Some economists who follow the footsteps of the post-Keynesian (PK) school of economics have questioned the importance of money in driving stock prices^[1]. It is held that rises in stock prices provide an incentive to liquidate long-term saving deposits, thereby boosting the money supply.

The received money then employed in buying stocks and other financial assets. According to the PK the trend is reversed when stock prices are falling. Hence, changes in stock prices cause changes in money supply and not the other way around.

Does a shift of money from savings to demand deposits affect money supply?

Is it possible to have an increase or a decline in money supply because of a shift of money from long-term saving deposits to demand deposits and vice versa?^[2]

Can there be such thing as saving deposits? The existence of such deposits implies that money somehow can be saved. We hold that individuals do not save money. They only exercise demand for money in order to be able to employ it as a medium of exchange whenever they deemed it necessary.

For instance, out of his production of twelve loaves of bread a baker may consume two loaves of bread and save ten loaves. He then exchanges these ten loaves for ten dollars with a shoemaker.

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Is the Fall in Prices Bad News?

January 23, 2018

IS THE FALL IN PRICES BAD NEWS?

Contrary to the popular way of thinking, we suggest that there is nothing wrong with declining prices. What signifies industrial market economy under a commodity money such as gold is that prices of goods follow a declining trend.

According to Joseph Salerno,

In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.[1]

In a free market the rising purchasing power of money i.e. declining prices, is the mechanism that makes the great variety of goods produced accessible to many people. Obviously, in a free market economy it does not make much sense to be concerned about falling prices.

On this Murray Rothbard wrote,

Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.[2]

For most economic commentators a general fall in prices is always “bad news” for it generates expectations for further declines in prices and slows down people’s propensity to spend, which in turn undermines investment in plant and machinery.

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Are Inflationary Expectations the Heart of Inflation?

January 18, 2018

ARE INFLATIONARY EXPECTATIONS THE HEART OF INFLATION?

For most economic commentators the underlying driving force of inflation is inflationary expectations^[1]. For instance, if there is a sharp increase in the price of oil, individuals may form higher inflationary expectations that could set in motion spiraling price inflation, or so it is held.

If somehow expectations could be made less responsive to various price shocks, then over time this would mitigate the effect of a price shock on price inflation, it is argued.

If we were to accept that inflation expectations are the driving force of the inflationary process, is there a way to make these expectations less sensitive to various price shocks?

Most commentators are of the view that by means of suitable central bank policies it is possible to bring peoples inflationary expectations to a state of equilibrium.

At this state it is held expectations are perfectly anchored or not sensitive to changes in various economic data.

According to various economic experts once inflationary expectations become anchored, various price shocks such as sharp increases in oil or food prices are likely to be of a transitory nature. This means that over time price shocks are unlikely to have much effect on the rate of inflation.

Note that what matters in this way of thinking is the underlying price inflation. It is for this reason that Federal Reserve policy makers and many economists are of the view that to be able to track the underlying inflation one must pay attention to core inflation – percentage changes in the consumer price index less food and energy.

To make inflation expectations well-anchored individuals must be clear about the monetary policy of central bank policy makers. According to this way of thinking as long as individuals are unclear about the precise goal with respect to inflation that policy makers are aiming at it would be difficult to bring inflationary expectations to a state of equilibrium.

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Is the High Level of Debt a Major Economic Risk Factor?

January 9, 2018

IS THE HIGH LEVEL OF DEBT A MAJOR ECONOMIC RISK FACTOR?

Many economic commentators regard high level of debt relative to GDP as a major risk factor as far as economic health is concerned. This way of thinking has its origins in the writings of the famous American economist Irving Fisher. According to Irving Fisher,^[1] a high level of debt relative to GDP runs the risk of setting in motion deflation and in turn a severe economic slump. On this way of thinking, the high level of debt sets in motion the following sequence of events that culminate in a severe economic slump.

Stage 1: The debt liquidation process is set in motion because of some random shock. For instance a sudden large fall in the stock market. The act of debt liquidation forces individuals into distressed selling of assets.

Stage 2: Because of the debt liquidation, the money stock starts shrinking and this in turn slows down the velocity of money.

Stage 3: A fall in money leads to a decline in the price level.

Stage 4: The value of people’s assets falls whilst the value of their liabilities remains intact. This results in a fall in the net worth, which precipitates bankruptcies.

Stage 5: Profits start to decline and losses emerge.

Stage 6: Production, trade and employment are curtailed.

Stage7: All this leads to growing pessimism and a loss of confidence.

Stage 8: This in turn leads to the hoarding of money and a further slowing in the velocity of money.

Stage 9: Nominal interest rates fall, however, because of a fall in prices real interest rates rise.

Note that the critical stage in this story is the stage 2 i.e. debt liquidation results in a decline in the money stock. However, why should debt liquidation cause a decline in the money stock?

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Pool of Funding the Heart of Economic Growth

December 8, 2017

POOL OF FUNDING THE HEART OF ECONOMIC GROWTH

Most experts are of the view that massive monetary pumping by the US central bank, the Fed, during the 2008 financial crisis saved the US and the World from another Great Depression.

If increases in money supply is an important catalyst for economic growth then the World poverty should have been eliminated a long time ago! Most countries have central banks that know how to print money – why then the World poverty still exists?

We suggest that at no stage increases in money supply can be an important driving factor of economic growth.

Some experts do not agree with this. Following the logic that monetary spending by one individual becomes an income of another individual and the spending of another individual becomes an income of the first individual, they hold that this raises the economy’s overall income and in turn overall economic growth.

Note that in this way of thinking, money stimulates consumer outlays, which in turn strengthens overall income and overall economic activity i.e. demand creates supply.

In this way of thinking what funds i.e. provides support to economic growth is the increase in money supply.

We suggest that individuals, which are engaged in the various stages of production, in order to support their lives and wellbeing, require an access to final consumer goods and not money as such.

At any point in time, there is a finite pool of final consumer goods. Hence, the early recipients of a newly created money are going to benefit from the increase in money supply at the expense of the late recipients or no recipients at all of the newly created money.

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