There's a great analogy in Thursday's Mises Daily by Llewellyn H. Rockwell Jr demonstrating how low interest rates alone will do little to "fix" the global economic crisis.

To understand the implications, imagine if a fine restaurant advertised a five-course meal and French wine for all comers — at $1 each. Would the customers be exuberant? You bet. They would be wild with anticipation, choosing to stand in a line and hang out at the restaurant rather than do other things with their time.

The restaurant would be packed and happy, though of course it couldn't sustain this in the long run, but the fun is great while it lasts. At some point, reality kicks in. The manager notes that there are no more tables and maybe no more food. The employees are exhausted. Moreover, the balance sheets don't line up: they are losing money on every meal they serve. At some point, the manager is going to have to announce the bad news and everyone is going to have to go home.

This is roughly what happened with the current boom and bust. Policy makers, however, seem to be under the assumption that they can keep the boom going on forever simply by dropping the interest rate ever lower. This is something like a restaurant owner thinking that he can continue to have people wait in line even though he has no tables or food or servers remaining. It is a physical and economic impossibility for him to make good on his promises.

At some point in this process, people begin to drift away and go on to other things. The manager can continue to advertise $1 meals in the hope of stimulating his business but this is simply illusion. No one is buying it; even if they did, the restaurant can't make the balance sheets work out. We can venture a prediction here that this restaurant will not be stimulated. It will enter into a prolonged period of inactivity until nothing is left.

Policy makers can lower interest rates as much as they like but at the end of the day, the only way they can maintain a rate below that of the market (the rate based on the pool of real savings plus risk, time and so on) is through increases in the quantity of money. They have to produce additional quantities of money and offer it on the money market (to banks) to maintain any downward pressure on rates at all - with the consequence being price inflation. This whole process is nothing more than wealth redistribution as each unit of the money supply is diluted and the new money is not distributed evenly; it inevitably reaches certain people first - the bankers, government, etc. These people can then buy more out of an unchanged supply of real goods which in turn increases money prices - the prices the rest of the population now pays with their depreciated dollar savings.

Increasing the quantity of money does nothing to benefit the economy as a whole but does benefit some; namely governmental officials, policy makers and bankers at the expense of everyone else, especially the poor and people on fixed incomes. Not only that but it deceives firms by distorting a very important price signal, encouraging malinvestment and sowing the seeds of the next crisis. Steve Horwitz provides an excellent summary, noting that by lowering the interest rate, it gives firms "...the impression that the public is now more patient and more willing to wait for consumption goods. Had the expansion of loanable funds been financed by genuine savings, the lower interest rate would be sending an accurate signal about the public’s wishes. However, when the expansion is caused by an excess supply of money rather than a shift in the public’s time preferences, the tight relationship between market rates of interest and underlying time preferences is broken."

If these Mercantilist policies of monetary inflation are maintained the question is not if we're going to have another recession after this one, but when.

An excellent question. though most would say ‘who cares’?  Let us examine the end result of each scenario:

INFLATION       The value of your money progressively decreases as central banks print enough money to prevent deflation (a contraction in the money and credit supply).  Anyone who has a debt will have no problems paying off the nominal value of the debt, as the nominal value of your wage increases over the nominal value of your debt.  Example: this year the price of bread is $1… next year the price of bread is $3.  I have covered this phenomena in some detail in previous posts, I encourage you to ask me questions if you still want some help understanding the concept of inflation.

DEFLATION      The value of your money progressively increases as central banks are unable to print enough money to prevent the contraction in the money and credit supply.  If you have a debt, it is almost impossible to pay off the debt as it’s real value increases (nominal value is unchanged) while the nominal value of your wage decreases.  Example: the price of bread decreases from $1 to 50 cents in one year.  The collapse of lending, increased number of loan defaults, all contribute to a contraction of the supply of money, which makes the individual value of money greater (think the polar opposite of inflation).

In short… INFLATION = good for people with debts.  DEFLATION = bad for people with debts.

Now “deflationists” will not contend with the assumption that INFLATION can occur, even hyperinflation like Zimbabwe, but they see it as highly unlikely as the level of money printing would be astronomically high.  Furthermore, any attempts to neutralize the effects of deflation with money print would hopelessly collapse as seen with the central bank of Japan in the Asian Financial Crisis.  Also, any money that is printed goes directly to creditors and doesn’t touch the local economy to raise the price of everything.  Post-Keynesian economists like Steven Keen, a man whom I deeply respect, also contend that there is evidence to suggests that the money print by the central bank precedes the increase in the money supply (M2 to be exact)…. which means that the central banks are printing money in response to bank insolvency.  Thus, the increase of $1-2 trillion in the Federal Reserve’s balance sheet was in response to the ‘bank runs’ which took place at the end of last year, rather than an effort to create new money to pump into the local economy.

Inflationists on the other hand say that the government is perfectly willing to go as far as to print our way to hyperinflation.  More importantly, that the government is currently pursuing a course that will inevitable lead to hyperinflation.  They contend that the government has a course of trading private debt with public debt, these are also known as bailouts and they continue to this day as the government is pursuing a relentless nationalization agenda.  This isn’t perceived to be so much of a problem as the price of the debt (i.e. the interest rate) is quite low, thanks to the majority of the debt financed by short terms T-bills (1-3 years bonds).  When these bonds are required to be paid off, the government rolls the debt over into new bonds… or simply put, it borrows money to pay off borrowed money.  This is somewhat manageable when the economy is in a boom phase, where there is predictable growth that can theoretically outpace the increase in debt.  The failure of neoclassical economics for both monetarists and Keynesians was that their models assumed the the economy would be in perpetual growth, which was found to be the case as gravity exists in the economics in the form of finite resources.  As the government increasingly swaps more private debt with public debt and simply rolls over the debt repayments, exponential functions take over and the debt servicing on the debt starts to become impossible.

Pretty soon, people who buy the debt (like China and Japan) start to realize that the US is not going to pay back that money with any real value and stop purchasing this debt (they already have btw).  This forces the US to start doing something called ‘quantitative easing’, which means that the central bank prints money and buys it’s own bonds.  As the money print continues, the government starts to pay creditors the freshly printed money.  These creditors want to dispose of this currency either through exchange into their own currency (as most of the creditors are foreigners) or they will spend it on raw materials or even US financial assets.  As more US money abounds, the value of this money begins to decrease, even outside the local US economy.  As the value of the dollar decreases, the US central bank will be in a trap: the only way to defend the value of the dollar is to raise interest rates, but this will increase the amount of debt the government as to go into to service the existing debt.  And, if the interest rates rise, all of a sudden the credit based economy grinds to a halt as no one can pay back their debts.  If the central bank chooses to ignore that the value of the money is decreasing and the prices of everything are increasing, entering into hyperinflation will occur more rapidly than anyone predicts as they will eventual ‘turn the corner’ on the exponential curve of the depreciation of the US dollar.

The Japanese example isn’t applicable, the inflationists say, as the nature and origin of Japan’s productive capacity and creditors are completely different to the US.  Also there is the tiny little fact that Japan is the largest creditor nation in the world, while the US is the largest debtor nation.  This is a striking point between the two schools… the PKs say that the scale of the debt black hole is too enormous for pure money printing to overcome.  The Austrians are saying that the money printing is being used to swap the private debt with the public debt, and if this process continues then the value of the currency will collapse.

So… which one is right?  The answer is, no one really knows.  Some people will say ‘I’m 100% sure this way or that way’, but in reality, we’re all just economic geeks watching the carnage unfold.  This is exciting to watch, but painful in reality to the people at the bottom of this gigantic pyramid scheme that we call money and banking.

Personally I’m not interested in the little esoteric arguments between the economic schools… and there are many.  I think there’s value in the analysis of the financial system from both schools and both possible scenarios make sense and are plausible.  We’ll just have to see what happens.  In any case, my advice is to horde faith in God and put your money in assets that will protect you from either scenario, which are precious metals (i.e. gold, silver, platinum).

God bless,

Dr Washo

PS   And if you’re a US citizen, support bills like H.R. 1207 ‘The Federal Reserve Transparency Act’ aka ‘Audit the Fed’

The Reserve Bank of Australia (RBA), a group of government-sponsored bankers given the task of keeping the banking, finance and currency cartel going on behalf of various interest groups, decided to leave rates on hold at 3.25pc during their last meeting. Their decision was received with mixed results: the politicians were slapping themselves on the back, citing their 'stimulus packages' as having cushioned the economy while the homeowners and other debtors were moderately critical.

The minutes of that meeting which were released today have revealed that they believe "...the domestic financial system remained strong and the monetary policy transmission process was working to deliver large reductions in interest rates to end borrowers, particularly households."

Well that's true enough. The artificial reduction of interest rates below what the market rate would be will distort the capital structure of the economy and encourage malinvestment in areas such as housing. Why shouldn't people be able to buy houses that they can't afford, right?

"Early indications were that the monetary and fiscal stimulus that had been applied to the economy was having an expansionary effect, but the size of this remained unclear and it would take some time for the full impact to come through."

"The question for policy was whether further stimulus should be added at this meeting, or whether, having reduced rates at each meeting since September, the Board should pause for a further evaluation of the situation. Members could see reasonable cases for both courses of action. On balance, they judged that, having made a major change to monetary policy over the preceding several meetings in anticipation of weak economic conditions, the best course for this meeting was to leave the cash rate unchanged. Members believed this would leave adequate flexibility for policy at future meetings."

The real reason behind the RBA's decision to leave rates unchanged is the dreaded "liquidity trap" that they all fear. The theory behind this stems back to Keynes, where he said that if the rate of interest falls to a level where people prefer to hold cash rather than debt (due to the low level of interest), then central banks have lost "...effective control over the interest rate". This view is supported by central bankers around the world, including the RBA. Here's a good argument outlining the flaws in this theory.

Interest rates need to rise, not fall. Monetary and Fiscal policy will only cause long-term misery. Eventually -- I don't know when -- the stop-go inflationary policy of the central banks will have to end. Each time we have a recession (a necessary restructuring process) and it's 'cured' by said policy, the capital structure of the economy is further distorted. The Austrian's tried to let their government sort out their woes in the 20s and 30s with spectacular results,

“Austria was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures, she increased wages, she increased social benefits, she increased bank credits, she increased consumption. After all those achievements she was on the verge of ruin.” -- Fritz Machlup, The Consumption of Capital in Austria, Review of Economic Statistics, II, 1935, p. 19.

We can't turn stones into bread as Keynes suggested. Printing money doesn't create any wealth. If we continue down this path, unrestrained government spending will result in the "eating of the seed corn", or capital consumption, as Mises noted after witnessing the Austrian demise. There's a point at which the interventionist welfare state will have exhausted "the reserve fund" of accumulated wealth, after which the consumption of capital becomes the only basis upon which to continue to feed the fiscal demands of the state.

A bit of good news out of the Reserve Bank today, with the board deciding to leave rates unchanged at 3.25%. Despite the heretics screaming that this will cause us to head into a deeper recession from the rooftops of the highest building they can find, this is relatively good news. I say relatively because the best news would have been a rate hike, but that's just not going to happen with the current incumbents.

You see, when there's a credit crisis people suddenly realise that they didn't save enough over the boom period -- many investments were undertaken, malinvestments, that never should have been started. Many businesses that were in fact not profitable, appeared profitable throughout the boom. The capital structure of the economy has been distorted. People start to realise they need more liquid funds and seek to borrow money to keep their businesses afloat. The logical response by the lenders of this liquid capital, as simple supply and demand dictates, would be to raise prices (interest) -- supply hasn't increased but demand has (this would also deter the marginal -- high risk -- borrowers from taking out loans). Only the most profitable enterprises would be able to afford these higher rates, allowing the most prudent and successful to acquire the much needed liquidity while leaving the unprofitable ones (where all of the malinvestment was) to die. This would no doubt be painful in the short run, but it's not nearly as bad as the current inflationary policy response will be.

...today credit expansion is exclusively a government practice. As far as private banks and bankers are instrumental in issuing fiduciary media, their role is merely ancillary and concerns only technicalities. The governments alone direct the course of affairs. They have attained full supremacy in all matters concerning the size of circulation credit. While the size of the credit expansion that private banks and bankers are able to engineer on an unhampered market is strictly limited, the governments aim at the greatest possible amount of credit expansion. -- Ludwig von Mises, Human Action

The response I speak of is of course a rate cut - lowering the rate of interest below the natural rate lenders would charge in a free market. Rather than let the rate of interest rise, the central bank begins watering down the potency of the currency, enabling them to supply everyone with much needed liquid funds. This fallacy arises from the belief that lower borrowing costs will revive the economy by stimulating investment and consumption, thereby adding to output and employment. The rate is lowered to whatever is deemed appropriate by the government, pressure groups, unions and so on -- people with a vested interest in seeing this rate fall. This is only a superficial solution as these new funds aren't backed by any commodity or anything of value. The areas of malinvestment will still exist; this will just prolong their survival at the expense of the entire economy, transferring wealth from creditors to debtors. This just the obvious issue though, there is something much more sinister about inflationary policy which I'll touch on below.

"In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils inflation and credit expansion have brought about." -- Ludwig von Mises, Human Action

Hayek noted that inflation is much more than just a transfer of wealth from creditors to debtors, as inevitably some people receive the new money first. This causes a distortion in the price structure: some goods and services increase in price first (the first to get the 'new' money) with the rest to follow in succession. Investment will pour into these sectors as they appear to be more profitable thanks to the increase in price, creating further malinvestments, all of which are dependent on an ever-increasing rate of inflation. This distortion in the price system will only cease some time after the end of the inflationary policy. When that time comes, the jobs created in these industries -- the ones which had an inappropriate amount of resources allocated to them due to this new money hitting them first -- will be destroyed. The only way to keep this going is to keep inflation going at an ever increasing rate, one which eventually has to bust -- and the fall will be far more painful the longer this policy is continued.

There are two outcomes from continued monetary expansion: Firstly, if these policies are continued indefinitely, we'll get hyperinflation. That one is straightforward. The other option is what we've had over the past few decades -- a stop-start inflationary policy; a continuation of the boom-bust cycle, or as Hayek said, one "in which from time to time the authorities get alarmed and try to brake, but only with the result that even before the rise of prices has been brought to a stop, unemployment begins to assume threatening proportions and the authorities feel forced to resume expansion."

It's unlikely the central banks will allow the onset of hyperinflation. The latter, on the other hand, is subject to diminishing returns (each stop-start becomes less effective and the recessions will last longer) and unless there are fundamental changes to the way in which we operate -- changes to the way unions, fiat money, central banking and so on exist -- we're doomed to either hyperinflation (with inevitable bust) or larger, more frequent boom-bust cycles.