Monetary policy, the pattern of
consumption and boom-bust cycles
For the time being the Fed’s decision-makers have decided
to keep the federal funds rate target unchanged at 1.75% however, they
hinted that if the economy were to slow further they would lower the fed
funds target rate. Most critics of a possible further lowering in the
federal funds rate target regard this as a bad idea. It is held that
another lowering will bring the federal funds rate to a very low level and
thereby dilute the strength of this tool in “fighting” economic slumps
whenever it may be required in the future. However, the main problem is
not that the Fed may lose a tool to "fight" recessions, but that another
lowering of the federal funds rate target will further intensify the
already unsustainable pattern of consumer consumption and thereby make the
current economic slump much more severe.
How loose money and credit affects the pattern of
consumption
In order to stay alive an individual with meagre
resources at his disposal is forced to allocate his wealth towards the
bare essentials such as food, basic clothing and a roof over his head. As
his real wealth begins to expand the individual can expand the variety of
goods and services consumed and thereby raise his living standard. Instead
of being confined to basic essentials he can now afford a bit of luxury,
or less essential goods, so to speak. It follows then that one would
expect an increase in personal wealth to be associated with a tendency to
expand the variety of goods and services consumed.
The key to the expansion in real wealth is saving - which
is an unconsumed production of goods. Thus if a baker produces ten loaves
of bread and consumes one loaf his savings is nine loaves of bread. He can
now exchange his saving for a pair of shoes with a shoemaker. Observe that
his savings are his real means of payments-he pays for the shoes with the
saved bread. Likewise, the shoemaker pays with the shoes that are his real
savings for the nine loaves of bread.
What gives rise to real demand for goods is the
production and saving of goods - the demand for goods is always fully
backed up by a corresponding production of goods. As the production of
goods expands obviously it gives rise to greater demand for them. For
instance, the baker may decide to exchange his saved bread to enhance his
production facilities, which in turn will enable him to lift the
production of bread. This in turn will give him greater purchasing power
since he can acquire a greater variety of goods with more bread at his
disposal.
The introduction of money does not alter the basic fact
that the driving force of real wealth expansion is real saving. All that
money does through its role as the medium of exchange is to facilitate the
flow of real wealth among various wealth producers.
When a baker sells his bread for $1 to a shoemaker, he
has supplied the shoemaker with his saved ( i.e., unconsumed) bread. The
supplied bread will sustain the shoemaker and allow him to continue making
shoes. Note that money received by the baker is fully supported by his
unconsumed production. Being the medium of exchange, money will enable the
baker to secure goods and services some time in the future whenever he
requires them. In other words, money is bakers’ claim on real
savings — they are however, not savings.
Through money, people channel real savings, which permits
economic activity to take place. Thus the goods that are exchanged for
money by one individual supports the production of another individual, who
in turn, by exchanging his produce for money, supports a third individual.
In this way money enables real savings to permeate across the economy and
lift the pace of production of goods and services.
It must be appreciated that once real savings are
exchanged for money it is of no consequence what the holder of money does
with the money. Whether he uses it immediately in exchange for other goods
or puts it under the mattress it will not alter the fact that his real
savings are already employed towards the expansion of real wealth.
Furthermore, if the holder of money decides to buy another financial claim
like a stock, by doing this he simply transfers his claim on real savings
to the seller of the stock.
In a free unhampered market economy there will be a
harmonious and sustained change in the pattern of consumption with a rise
in consumers’ real wealth. This harmony however, gets disrupted whenever
the central bank pumps money. The monetary pumping disrupts the production
of consumer goods as a result of the fact that when money is injected not
everybody gets it first. The injection of new money to the economy
benefits individuals that receive the newly created money first at the
expense of those individuals who don’t receive the new money at all, or
receive it late. The early recipients can now purchase a greater amount of
goods while the prices of these goods are still unaffected. In other
words, the early recipients' real wealth has increased. According to
Rothbard,
The individuals who receive the new money first are the greatest gainers from the increased money; those who receive it last are the greatest losers. (Man Economy and State, Nash Publishing p 711)
As prices of various goods and services start to rise
this hurts those individuals who don’t receive the newly printed money at
all - or receive it last. Note that while in an unhampered market economy
demand for goods is exercised through the production of goods, now the
central bank money out of thin air permits consumption without production.
What we now have is pure consumption of real wealth. The newly created
money gives rise to the diversion of real wealth towards the early
recipients of money at the expense of other individuals. Since the early
recipients of money are much wealthier now than before the monetary
injections took place, they are likely to alter their pattern of
consumption. With greater wealth at their disposal their demand for less
essential goods and services expands. The increase in real wealth of the
first recipients of money gives rise to the demand for goods that prior to
monetary expansion would not have been considered.
In contrast to this, the late recipients of money, or
those who don’t receive the newly printed money at all, have less real
funding at their disposal. This in turn undermines their demand for the
various essential goods required to sustain their life and well being.
How changes in the pattern of consumption alters the
pattern of production
A change in the pattern of consumption draws the
attention of entrepreneurs who, in order to secure profits, adjust their
structure of production in accordance with this new development. According
to Mises,
In the capitalist system of society's economic organization the entrepreneurs determine the course of production. In the performance of this function they are unconditionally and totally subject to the sovereignty of the buying public, the consumers. (Planning for Freedom, Libertarian Press p 108.)
In the process of mobilizing funding to accommodate the
consumers’ altered pattern of consumption businessmen also rely on bank
loans. As a result of the loose monetary policy of the central bank
commercial banks lower their lending interest rates thereby making
borrowing by businessmen more attractive. The expansion in bank credit in
turn lifts further the money supply rate of growth and boosts further the
relative demand for non-essential consumer goods. As the monetary pumping
continues this eats into real savings and starts to hurt various wealth
generating activities. This in turn sets in motion the dynamics of an
economic recession.
When money "out of thin air" gives rise to consumption
that is not supported by production, it lowers the amount of funding that
supports the production of goods and services of the first wealth
producer. This, in turn, undermines his production of goods, thereby
weakening his effective demand for the goods of another wealth producer.
The other producer is then forced to curtail his production of goods,
thereby weakening his effective demand for the goods of a third wealth
producer. In this way, money "out of thin air" destroys savings and sets
up the dynamics of the consequent shrinkage of the production flow. (The
money out of thin air destroys the real purchasing power by destroying
savings. Remember, means of payments are real savings).
In response to the emerging decline in economic activity
banks curtail their loans to businesses thus putting pressure on the money
supply rate of growth. This in turn weakens further the demand for various
non-essential consumer goods and in turn weakens the viability of various
businesses engaged in the production of these goods.
As a rule a recession emerges once the central bank
reverses its loose monetary stance. However, as was shown above, the
inflationary boom always plants the seeds of a recession - implying that
even if the central bank were to decide not to alter its easy stance the
depletion of the pool of real savings would put an end to the artificial
boom.
Explaining historical data
| 1959.11 to 1961.9 |
| 1966.11 to 1967.7 |
| 1969.8 to 1972.2 |
| 1974.7 to 1977.1 |
| 1981.6 to 1983.2 |
| 1984.8 to 1986.10 |
| 1989.3 to 1993.12 |
| 2000.7 to now |
Since 1959 we have
identified eight phases of low interest rate policy. The low interest rate
phases that were identified are the following: The following chart
provides the confirmation of these low interest rate phases (see chart).
(Shaded area represents the low interest rate phases) produce
instantaneous effects – it takes some time. The time lag is on account of
the fact that it takes time for the money to move from one receiver of
money to another. However, once a low interest rate policy begins to
dominate the scene i.e. outweighs the effect of the previous tight stance,
there is the tendency for the relative growth momentum of durable goods
production versus non-durable goods production to increase (see chart).
Likewise, the dominance of the low interest rate phase
doesn’t disappear instantaneously with the introduction of a tighter
interest rate stance. Obviously, there are some other factors that exert
their influence on the data and thereby cause the effect of loose monetary
policy on the pattern of consumption to be less pronounced in some phases
versus other phases.
The relative increase in consumer durable goods
production versus non-durable goods sets in motion - after a time lag - an
expansion in capital goods production. Inspection of the chart below
indicates that the increase in the growth momentum of business equipment
production relative to non-durable consumer goods production tends to
occur at the latest phases of loose monetary policy.
We have estimated that the relative growth momentum of
durable consumer goods production tends to lead the relative growth
momentum of business equipment production by about 8 months. Given the
fact that the current loose monetary policy has significantly lifted the
relative growth momentum of durable goods versus non-durable goods raises
the likelihood of a strong increase in the relative growth momentum of
business equipment in the months ahead, all other things remaining equal.
In short, loose monetary policy prevents the necessary adjustment thereby
raising the likelihood of a much more severe economic slump ahead.
Conclusion
Most critics of a possible further lowering in the
federal funds rate target regard this as bad idea. It is held that another
lowering will bring the federal funds rate to a very low level and thereby
dilute the strength of this tool to “fight” economic slumps whenever it
may be required. The main problem is not that the Fed may lose a tool to
fight a recession if it were to ease its monetary stance further, but that
the lowering of interest rates will further make things much worse. Low
interest rate policy intensifies the relative overproduction of durable
goods against non-durable goods, which in turn slows down the adjustment
in the capital goods sectors. All this inturn is likely to set in motion a
much more painful economic adjustment in the months ahead.
Frank Shostak, Ph.D.
FShostak@MANFINANCIAL.COM.AU
9 September 2002
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