Archive for March, 2010

What Causes Financial Imbalances?

March 17, 2010

Never has so much copy been printed on economic policy in the Western hemisphere, which for decades had fallen below the public radar. Suddenly, controversy is mounting regarding the use of fiscal and monetary policy in the West to counter the effects of the financial crisis, with a particular focus on how quickly to reverse the attendant growth in public indebtedness and base money. In order to make headway on these questions, it is necessary first to set out the purpose of economic policy, and restore its connection with welfare.

Economics has a natural interest in welfare. Correspondingly, it must take account of people’s preferences regarding leisure and consumption, since these are the fonts from which welfare  is drawn. Both activities, which compete over people’s allocation of precious time, are only made possible by an output of goods and services. If production falls, consumption will also fall unless otherwise permitted by an erstwhile savings rate; conversely, restoring consumption depends on boosting production, for which people must allocate less time to leisure (or produce more in a given period). In the classical model, agents apportion their time between labour and leisure so as to maximise welfare.

The only constraint on the enjoyment of leisure -assuming basic subsistence needs are met- is time. Although experienced subjectively, time is fully describable in its own terms: the difference between one hour and three hours is always two hours. Owing to this tautology, time is an objective axis along which other variables can be compared. The same is not true for the key constraint placed on consumption, wealth, even though it is a by-product of time. Even if labour productivity (the amount of wealth produced in a given time period) is held constant, wealth is not fully describable in its own terms. That is because wealth comes in limitless forms, comprising goods. No two goods can be objectively compared along a single scale in a way that fully accounts for their difference, and although the invention of money provided a scale, it is far from being objective in any meaningful sense. Demand for one good does not imply demand for any other good.

What does this mean? While more free time for leisure permits greater welfare to be drawn, producing more goods may fail to produce a similar outcome – everything hinges on what exactly is being produced. There is a modern tendency among economists and policymakers to treat production as all of a piece and thus to ignore differences in the form that wealth takes. Nowhere is this more striking than in the corruption of the classical term ‘capital’, which once denoted a special kind of producers’ good, but now seems to refer abstractly to savings.

One term which features prominently in economic parlance is ‘aggregate demand’, ostensibly the sum of all demand for goods (and services). This may have some application, but it is yet another example  of the general tendency to blend what is variegated: output. One effect is that whenever consumption falls, instead of considering whether welfare preferences may have changed, there is an urge to tailor policy so as to boost aggregate demand. While it may be theoretically tempting to hold preferences constant, demand for different goods and services is always in flux. Moreover, as production evolves, consumption may evolve too, as the existence of a new good spawns demand for something complementary or makes something else obsolete.

All this gives rise to natural ‘imbalances’ between supply and demand, the cause of most economic crises. One pertinent question for policymakers ought to be whether their policies are resolving or exacerbating imbalances. A deep faultline in economics divides those on the one hand who believe government intervention is required to ‘correct’ various market failures -some resulting from a flawed social contract, others from human psychology- from those on the other hand who claim that government intervention is largely responsible for such failures, whether by disturbing prices, undermining ‘monetary neutrality‘, suppressing the ‘natural rate of interest‘, unleashing inflation, crowding out investment, etc.

Whichever camp has it, imbalances most certainly arise. They can originate in production or finance, and manifest themselves across space and time. They always signal some surplus product is going to waste.

  1. Goods may fail to circulate as a result of people simply hoarding them, a very basic spatial imbalance that is entirely uneconomic. Involuntary hoarding (resulting from barter trade) was eased greatly by the introduction of a circulating medium (money). The urge to hoard remains, however, under the mask of ‘liquidity preference‘, the desire to hold money. As discussed in previous posts, the modern banking system not only indulges it, but functions as it does on account of liquidity preference. While elasticity in the money supply means that liquidity preference cannot amount to outright hoarding, it can nevertheless create economic weakness, by freezing exchange and thus delivering a shock to production; and by masking the growth of enormous financial imbalances, whilst neutering monetary policy. Eradicating liquidity preference depends on an alternative to money emerging as a savings instrument, a problem addressed in previous posts that is discussed below.
  2. Producing goods that are in low demand is equally uneconomic. Imbalances could be confined to low-order goods (i.e. ones that do not take long to produce) e.g. apples could be overproduced while oranges are in short supply. Such imbalances would not tend to sustain themselves for very long, assuming hoarding does not interfere with correcting price signals. Imbalances that are not confined to low orders of production are more complex, and will tend to be more persistent, owing to longer production cycles and relative slowness of repricing in response to changing demand.

Problem (2) was the cause of much pontification by Hayek, the Austrian School economist. In his theoretical writings, he worked on the basis of speedy repricing by assuming that high-order production was decomposed into successive stages, each one interfaced by merchants-cum-producers purchasing intermediate products before manipulating them into slightly higher-order goods to be sold on. Since in his model changes in the price of goods of one order relative to another were wholly responsible for transmitting variations in the interest rate, it was sufficient for him to argue that any interference in the demand for goods of a given order would disturb the rate of interest from its ‘natural’ level.

Foremost among the sources of such interference, for Hayek, was elasticity in the money supply as administered by bank lending. As new money went into the hands of consumers, say, their ‘forced savings’ would increase the price of consumer goods above their equilibrium level, attracting a higher share of productive forces from higher stages in production, thus compressing the term structure of production. By the same token, lending to producer-consumers would artificially raise the price of higher-order’ goods, although the effects of this would be similar, he asserted. Without elaborating on Prices and Production further, any increase in the money supply would (by establishing ‘forced savings’) eventually lead to an oversupply of consumer goods and a corresponding undersupply of producers’ goods, in either case relative to actual demand for them.

For Hayek, allowing the term structure of production to extend to its supposedly natural level was a precondition for economic advancement, or as he put it, for a more ‘capitalistic’ form of production. Anything that opposed this would lead to retardation i.e. depression. So for Hayek it was imperative to establish a ‘neutral’ money and allow the rate of interest to converge on its ‘natural’ level – which meant holding the money supply constant and avoiding outside intervention.

What could Hayek’s recommendations mean today, in the context of our recent financial crisis followed by government intervention on a scale he had feared in his own time would be counterproductive? What do the old-fashioned concepts of ‘neutral’ money and a ‘natural’ rate of interest hold for policymakers today, confronted as they are with such enormous challenges and weighed under a barrage of criticism?

The engine of economic growth and recovery is always deferral of gratification. This is normally associated with saving, but it is important to distinguish savings of consumer goods (hoarding) from investment in producers’ goods. Since for investment to take place, consumption continues apace, it is correct for policymakers to read into falling consumption signs of economic stagnation. However, to respond to this by seeking to boost consumption is to conflate cause and effect.

Rather, policymakers should focus on any structural reasons why consumption would be held below its desired level. In a financial structure that indulges liquidity preference, the risk of falling prices can become a self-fulfilling prophecy as consumers defer purchases in anticipation of improved terms in the future. Indeed any uncertainty can elicit a similar course of self-insurance. Rather than tackling the origins of this in the banking system, authorities have embarked on quantitative easing (QE), a programme of expansion in the monetary base (largely to mitigate contraction in broad money caused as banks reduced lending). While doses of QE may have allayed fears of deflation, they have also had the effect of reducing monetary velocity, with growing money balances sitting idle. Liquidity preference has soared to new highs; should sentiment change, unless these balances are drained with deft timing they will be free to circulate once again, changing hands and bidding up prices with increased rapidity, thus posing the age-old risk of inflation.

However QE is not too dissimilar to banking, since it describes a reversible change in the supply of money. This raises the question of whether an elastic money supply is reconcilable with ‘neutral’ money, which at heart has the sense that money should be no more than a medium of exchange. As long as its role is restricted to that of a token -no longer used as a savings vehicle- money would cease to be used as a store of value, and would therefore be unable to influence real variables, irrespective of its supply. Hayek’s concerns about an elastic money might be valid with a banking system, but if liquidity preference was successfully rooted out, money would circulate at high velocity regardless of its supply. It is this, not an inelastic currency, that is the condition for ‘neutral’ money.

In earlier posts I made some of my own proposals known, including the abolition of banking in favour of a public clearing house bridging savers with investors. In summary, investors would be able to sell their holdings of risk-free rental assets to savers, thus procuring money (and short-term assets). Rental assets would be guaranteed under a new rehabilitated social contract under which rent accruing on all scarce resources would be confiscated from users and redistributed to all. In this way, this universal contract would secure wealth as private property for its producers.

By making these asset purchases, savers simultaneously satisfy their own desire to defer consumption (until some future remittance of rent) as well as investors’ desire to produce capital goods (by financing the ongoing costs of production). Indeed, savers and investors alike could individually target specific durations: savers would balance the benefit of higher returns offered by longer-term instruments against their greater illiquidity, whereas investors would balance the higher cost of obtaining committed term funding against its added certainty. Such myriad individual calculi would determine the nature of financial transactions which, when writ large, would construct the term structure of finance for society as a whole. Rates of interest over time could thereby settle on a yield curve that harmonises the demand to save and invest over different terms. Such a mechanism would furnish the productive economy with a money cost of funding able to commit productive resources over a duration that helps ensure supply and demand remain in kilter. When allied with neutral money, this natural rate of interest would favour sustainable economic expansion.