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Gold Standard and Boom Bust Cycles

According to the Austrian Business Cycle Theory (ABCT), the boom-bust cycle emerges in response to a deviation in the market interest rate from the natural interest rate, or the equilibrium interest rate. It is held that the major cause for this deviation is increases in the money supply. Based on this it would appear that on a gold standard without the central bank an increase in the supply of gold is also going to set in motion boom-bust cycle.

An increase in the supply of gold is likely to result in the lowering of market interest rates. This in turn is likely to cause the market interest rates to deviate from the equilibrium interest rate. Consequently, following the ABCT an increase in the supply of gold is going to set in motion the boom-bust cycle.

According to Robert P. Murphy “More Than Quibbles: Problems with the Theory and History of Fractional Reserve Free Banking” in the QJAE Volume 22 Spring 2019, Ludwig von Mises held that an increase in the supply of gold could trigger boom-bust cycle.

Whilst suggesting that the gold standard could generate business cycles whenever an increase in the supply of gold causes the market interest rate to deviate from the natural interest rate, or the equilibrium rate, Mises however, viewed this possibility as remote.

Mises regarded the gold standard as the best monetary system as far as keeping the expansion in credit under tight control. Murphy quotes Mises on this,

Even a rapid increase in the production of the precious metals can never have the range which credit expansion can attain. The gold standard was an efficacious check upon credit expansion, as it forced the banks not to exceed certain limits in their expansionist ventures…

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Relation Between Inflation and Deflation

For most commentators inflation is about persistent increases in the prices of goods and services. However, is this the case?  For example, the definition of human action is not that people are engaged in all sorts of activities as such, but that they are engaged in purposeful activities–purpose gives rise to an action.

Similarly, the essence of inflation is not a general rise in prices as such but an increase in the supply of money, which in turn sets in motion a general increase in the prices of goods and services in terms of money.

Consider the case of a fixed stock of money. Whenever people increase their demand for some goods and services, money is going to be allocated towards these goods and services. In response, the prices of these goods and services are likely to increase– more money will be spent on them.

Since we have here an unchanged stock of money, less of it can be now allocated towards other goods and services. Given that the price of a good is the amount of money spent on the good this means that the prices of other goods will decline i.e., less money will be spent on them.

In order for there to be a general rise in prices, there must be an increase in the money stock. With more money and no change in the money demand, people can now allocate a greater amount of money for all goods and services.

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…

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Monetary Pumping and Resources

As a result of the recent strong stimulatory policies employed by the US government and the Fed, most commentators are of the view that the risk of a deepening slump in the US economy on account of the COVID-19 pandemic has now receded.

Some other commentators are not so certain that the risk has declined, arguing that the economy is still heading towards difficult times ahead. These commentators are of the view that to prevent the possible economic difficulties ahead authorities should continue with easy fiscal and monetary policies until the economy safely placed on the trajectory of stable economic growth.

Most commentators are of the view that by failing to act swiftly authorities are running the risk of raising the cost of an economic slump in terms of idle or unutilized resources such as labor and capital.

This way of thinking is succinctly summarized by Ludwig von Mises,

Here, they say, are plants and farms whose capacity to produce is either not used at all or not to its full extent. Here are piles of unsalable commodities and hosts of unemployed workers. But here are also masses of people who would be lucky if they only could satisfy their wants more amply. All that is lacking is credit. Additional credit would enable the entrepreneurs to resume or to expand production. The unemployed would find jobs again and could buy the products. This reasoning seems plausible. Nonetheless it is utterly wrong.

Conventional thinking argues that boosting the overall demand for goods and services is going to strengthen the supply of these goods and services – demand creates supply.

However, why should an increase in the overall demand be followed by the increase in the production of goods and services? This requires a suitable production structure that is going to permit the increase in the production.

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The IMF Chief Economist Sees a Threat to World Economies From a Liquidity Trap

In the Financial Times from November 2 2020, the IMF chief economist Gita Gopinath suggested that world economies at present are likely to be in a global liquidity trap. Gopinath has reached this conclusion because the yearly growth rate of the price indexes has been trending down despite very low interest rates policies. According to the IMF chief economist, central banks have lowered interest rates to below 1 percent and in some countries interest rates are at present negative. In the framework of a liquidity trap, it is held that the ability of central banks to stage an effective defense against various economic shocks weakens significantly. So how then can one resolve the problem of the central banks inability to produce the necessary defense of the economy?

A possible way out of the liquidity trap suggests Gopinath, is to employ aggressive loose fiscal policy. This means an aggressive government spending in order to boost the aggregate demand.

According to Gopinath,

Fiscal authorities can actively support demand through cash transfers to support consumption and large-scale investment in medical facilities, digital infrastructure and environment protection. These expenditures create jobs, stimulate private investment and lay the foundation for a stronger and greener recovery. Governments should look for high-quality projects, while strengthening public investment management to ensure that projects are competitively selected and resources are not lost to inefficiencies.

Furthermore, according to Gopinath,

The importance of fiscal stimulus has probably never been greater because the spending multiplier — the pay-off in economic growth from an increase in public investment — is much larger in a prolonged liquidity trap. For the many countries that find themselves at the effective lower bound of interest rates, fiscal stimulus is not just economically sound policy but also the fiscally responsible thing to do.

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Can Constant Money Growth Rule Prevent Boom-Bust Cycles?

According to the Nobel Laureate in Economics, Milton Friedman, the key cause of the business cycles is the fluctuations in the growth rate of money supply. Friedman held that what is required for the elimination of these cycles is for central bank policy makers to aim at a fixed growth rate of money supply:

My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System should see to it that the total stock of money so defined rises month by month, and indeed, so far as possible, day by day, at an annual rate of X per cent, where X is some number between 3 and 5. The precise definition of money adopted and the precise rate of growth chosen make far less difference than the definite choice of a particular definition and a particular rate of growth.[1]

Could however, the implementation of the constant money supply growth rule eliminate economic fluctuations?

Honest money versus money out of “thin air”

Originally, paper money was not regarded as money but merely as a representation of gold. Various paper money receipts represented claims on gold stored with the banks. The holders of paper receipts could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper receipts to exchange for goods and services, these receipts came to be regarded as money.

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Can An Increase In the Demand For Money Neutralize the Effect of a Corresponding Increase in Money Supply?

CAN AN INCREASE IN THE DEMAND FOR MONEY NEUTRALIZE THE EFFECT OF A CORRESPONDING INCREASE IN MONEY SUPPLY?

According to popular thinking, not every increase in the supply of money will have an effect on the production of goods. For instance, if an increase in the supply is matched by a corresponding increase in the demand for money then there will be no effect on the economy. The increase in the supply of money is neutralized so to speak by an increase in the demand for money or the willingness to hold a greater amount of money than before.

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

Demand for money versus demand for good

The demand for a good is not essentially the demand for a particular good as such but the demand for the services that the good offers. For instance, an individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and wellbeing.

Demand here means that people want to consume the food in order to secure the necessary elements that sustain life and wellbeing.

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

With the help of money, various goods become more marketable – they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.

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How the GDP Framework Creates the Illusion That By Means of Money Pumping the Central Bank Can Grow an Economy

HOW THE GDP FRAMEWORK CREATES THE ILLUSION THAT BY MEANS OF MONEY PUMPING THE CENTRAL BANK CAN GROW AN ECONOMY

In response to a weakening in the yearly growth rate of key economic indicators such as industrial production and real gross domestic product (GDP) some commentators have raised the alarm of the possibility of a recession emerging.

Some other commentators are dismissive of this arguing that the likelihood of a recession ahead is not very high given that other important indicators such as consumer outlays as depicted by the annual growth rate of retail sales and the state of employment appear to be in good shape (see charts).

Most experts tend to assess the strength of an economy in terms of real gross domestic product (GDP), which supposedly mirrors the total amount of final goods and services produced.

To calculate a total, several things must be added together. In order to add things together, they must have some unit in common. It is not possible however to add refrigerators to cars and shirts to obtain the total amount of final goods.

Since total real output cannot be defined in a meaningful way, obviously it cannot be quantified. To overcome this problem economists employ total monetary expenditure on goods, which they divide by an average price of goods. However, is the calculation of an average price possible?

Suppose two transactions are conducted. In the first transaction, one TV set is exchanged for $1,000. In the second transaction, one shirt is exchanged for $40. The price or the rate of exchange in the first transaction is $1000/1TV set. The price in the second transaction is $40/1shirt. In order to calculate the average price, we must add these two ratios and divide them by 2. However, $1000/1TV set cannot be added to $40/1shirt, implying that it is not possible to establish an average price.

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How Fractional Reserve Banking Contributes to Increases in Money Supply

HOW FRACTIONAL RESERVE BANKING CONTRIBUTES TO INCREASES IN MONEY SUPPLY

Some commentators consider fractional reserve banking as a major vehicle for the expansion in the money supply growth rate. What is the nature of this vehicle?

We suggest that fractional reserve banking arises because banks legally are permitted to use money placed with them in demand deposits. Banks treat this type of money as if it was loaned to them.  However, is this really the case?

When John places $100 in a safe deposit box with Bank One he does not relinquish his claim over the $100. He has an unlimited claim against his money. Likewise, when he places $100 in a demand deposit at Bank One he also does not relinquish his claim over the deposited $100. Also in this case John has an unlimited claim against his $100.

Now let’s assume that Bank One takes $50 out of John’s demand deposit without getting any consent from John in this regard and lends this to Mike. By lending Mike $50, the bank creates a deposit for $50 that Mike can now use.

Remember that John still has an unlimited claim against the $100 while Mike has now a claim against $50. What we have here that the Bank One has generated an extra spendable power to the tune of $50. We can also say that Bank One has $150 deposits that are Bank’s One liabilities, which are supported by $100 cash, which are Bank’s One reserves. Note that the reserves comprise 66.7% of Bank’s One deposit liabilities. This example indicates that Bank One is practicing fractional reserve banking.

Although the law allows for this type of practice, from an economic point of view, this results in money out of “thin air” which leads to consumption that is not supported by production, i.e., to the dilution of the pool of real wealth.

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Can Expectations Undo the Validity of the Mises’s Business Cycle Theory?

CAN EXPECTATIONS UNDO THE VALIDITY OF THE MISES’S BUSINESS CYCLE THEORY?

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

Once the central bank reverses its stance this sets in motion an economic bust. It follows then that the artificial lowering of interest rates sets a trap for businessmen by luring them into unsustainable business activities that are revealed as such once the central bank tightens its interest rate stance.

Critics of the ABCT maintain that there is no justification that businessmen should fall prey repeatedly 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. Consequently, correct expectations will undo or neutralize the whole process of the boom-bust cycle that is set in motion by the artificial lowering of interest rates.[1]  Hence critics are questioning the validity of the ABCT.

Even Mises himself had conceded that it is possible that some time in the future businessmen will stop responding to loose monetary policy thereby preventing the setting in motion of the boom-bust cycle. In his reply to Lachmann he wrote,

It may be that businessmen will in the future react to credit expansion in another manner than they did in the past. It may be that they will avoid using for an expansion of their operations the easy money available, because they will keep in mind the inevitable end of the boom. Some signs forebode such a change. But it is too early to make a positive statement.[2]

Do Expectations Matter?

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Should the Fed Tamper With the Quantity of Money?

SHOULD THE FED TAMPER WITH THE QUANTITY OF MONEY?

Most economists are of the view that a growing economy requires a growing money stock, because economic growth gives rise to a greater demand for money, which must be accommodated.

Failing to do so, it is maintained, will lead to a decline in the prices of goods and services, which in turn will destabilize the economy and lead to an economic recession or, even worse, depression.

For most economists and commentators the main role of the Fed is to keep the supply and the 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 a necessary action to keep the economy on a path of economic and price stability.

As long as the growth rate of money supply does not exceed the growth rate of the demand for money, then the accommodation of the increase in the demand for money is not considered as money printing and therefore harmful to the economy.

Note that on this way of thinking the growth rate in the demand for money absorbs the growth rate of the supply of money hence no effective increase in the supply of money occurs. So from this perspective, no harm is inflicted on the economy.

Historically, many different goods have been used as money. On this, Mises observed that, over time,

. . . there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money[1].

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The Problem With Modern Monetary Theory

THE PROBLEM WITH MODERN MONETARY THEORY

According to the Modern Money Theory (MMT), money is a thing that the State decides upon. Following the ideas of the German economist, Georg Knapp, the MMT simply regards money as a token. For instance, when an individual places a coat in the cloakroom of a theatre, he receives a tin disc or a paper receipt. This receipt or a disc is a proof that the individual is entitled to demand the return of his coat. The token was labelled by Knapp as chartal or a pay token.

On this way of thinking money is seen as a chartal means of payments. According to the MMT, the material used to manufacture the tokens is irrelevant – it can be gold, silver, or any other metal or it can even be paper. Hence, the definition of money according to the MMT is what the State decides it is going to be[1].

According to this theory, the value of money is established because the State forces people to pay taxes with the money that the State has decided upon. The State taxes have to be paid with the money tokens issued by the State. The State also has the ability to control the value of money through its declaration of how much it is willing to pay for a certain commodity produced by the private sector. What we have here is a situation wherein the State exchanges empty tokens for goods and services produced by individuals. It then requires them to pay taxes with part of the tokens.

If one dissects the whole process one would discover that it is about an exchange of worthless tokens for real goods and services i.e. nothing for something.

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Changes in Government Deposits and Money Supply

CHANGES IN GOVERNMENT DEPOSITS AND MONEY SUPPLY

The US debt ceiling suspension, signed in February 2018, expires at the beginning of March this year. Some commentators are of the view that the US Treasury must carry out special measures if it expects a delay in raising the debt ceiling in March.

The Treasury would have to draw down its deposits at the Fed and deposit the cash in various government department accounts at commercial banks, for future use to pay government salaries and contractors’ fees.

These commentators are of the view that the Treasury deposit withdrawals act like QE (quantitative easing) and the Treasury deposit build-ups like QT (quantitative tightening). However, is it the case?

If in an economy people hold $10,000 in cash, we would say that the money supply in this economy is $10,000. If some individuals then decided to place $2,000 of their money in demand deposits, the total money supply will still remain $10,000, comprising of $8,000 cash and $2,000 in demand deposits.

Now, if government taxes people by $1,000, this amount of money is then transferred from individual’s demand deposits to the government’s deposits. Conventional thinking would view this as if the money supply fell by $1,000. In reality, however, the $1,000 is now available for government expenditure meaning that money supply is still $10,000, comprising of $8,000 in cash, $1000 in individuals demand deposits and $1,000 in government deposits.

If the government were to withdraw $1000 from its deposit with the Fed and buy goods from individuals then the amount of money will be still $10,000 comprising of $8,000 in cash and $2,000 in individuals demand deposits.

From this we can conclude that a large withdrawal of money from the government deposit account with the Fed is not going to strengthen the money supply as suggested by popular thinking. 

What are the sources for money expansion?

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Importance of Model Building in Economics

IMPORTANCE OF MODEL BUILDING IN ECONOMICS

In the natural sciences, a laboratory experiment can isolate various elements and their movements. There is no equivalent in the discipline of economics. The employment of model building is an attempt to produce a laboratory where controlled experiments can be conducted.

The idea of having such a laboratory is very appealing to economists and politicians. Once the model is built and endorsed as a good replica of the economy, politicians can evaluate the outcomes of various policies.

This, it is argued, enhances the efficiency of government policies and thus leads to a better and more prosperous economy.

It is also suggested that the model can serve as a referee in assessing the validity of various economic ideas. The other purpose of a model is to provide an indication regarding the future.

By means of mathematical and statistical methods, a model builder establishes relationships between various economic variables.

For example, personal consumer outlays are related to personal disposable income and interest rates, while fixed capital spending is explained by the past stock of capital, interest rates, and economic activity. A collection of such various estimated relations—i.e., equations—constitutes an econometric model.

A comparison of the goodness of fit of the dynamic simulation versus the actual data is an important criterion in assessing the reliability of a model. (In a static simulation, the equations of the model are solved using actual lagged variables. In a dynamic simulation, the equations are solved by employing calculated from the model-lagged variables).

The final test of the model is its response to a policy variable change, such as an increase in taxes or a rise in government outlays. By means of a qualitative assessment, a model builder decides whether the response is reasonable or not. Once the model is successfully constructed, it is ready to be used.

Is the mathematical method valid in economics?

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Tax Cuts Without Reducing Government Outlays Is Not Possible

TAX CUTS WITHOUT REDUCING GOVERNMENT OUTLAYS IS NOT POSSIBLE

According to many economic experts and commentators, an effective way to generate economic growth is through the lowering of taxes. The lowering of taxes, it is held, is going to place more money in consumer’s pockets thereby setting in motion an economic growth. This way of thinking is based on the popular view that a given dollar increase in consumer spending will lift the economy’s gross domestic product (GDP) by a multiple of the increase in consumer expenditure. An example will illustrate the magic of this multiplier.

Let us assume that on average individuals spend 90 cents and save 10 cents of each additional dollar they receive. If consumers raise their spending by $100 million this will boost retailers’ revenues by this amount. Retailers in turn will spend 90% of their new income, i.e. $90 million on various goods and services. The recipients of the $90 million will in turn spend 90% of $90 million i.e. $81 million and so on. At each stage in the spending chain, people spend 90% of the additional income they receive. This process eventually ends with the GDP rising by $1 billion i.e. (10*100million).

In short, all that is required is to give every individual more money to spend, and this in turn should set in motion increases in consumer expenditure, which in turn will trigger increases in the production of goods and services. Observe that within the framework of ‘the multiplier’ savings are actually bad news – since the more people save the smaller is the multiplier.

The magic of ‘the multiplier’ however, is just wishful thinking – a myth. Every activity in an economy has to be funded and therefore it is always in competition with other activities for scarce real savings.  Hence, within all other things being equal if more is spent on consumption goods, then less is left for capital goods. An increase in retailers activity will be offset by the decline in the activity of capital goods producers.

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The Difference Between Money Supply & Liquidity

THE DIFFERENCE BETWEEN MONEY SUPPLY & LIQUIDITY

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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Olduvai IV: Courage
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Olduvai II: Exodus
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