Economic Distortion, Courtesy of Your Central Bank

ECONOMIC PERSPECTIVES 50

Emile Woolf, Going Postal
BIS main building in Basel, Switzerland – IIRC It Goes down as many floors and is full of Gold!

Governments rarely set out to take responsibility for every single issue, but that usually happens anyway. As a result there is a growing expectation by citizens that, whatever the problem, it is the government’s job to sort it out – and this also applies when government caused the problem in the first place.

Consequently, ministers find themselves in the impossible position of being accountable for every past error, while also having to dream up policies that will, for a time anyway, keep voters placated – whether they relate to health, housing, drugs, medicines, wages, taxes, transport, money, trade, food – and anything else that happens to be the community’s latest perceived iniquity.

It is no wonder that so many of these so-called remedies amount to little more than sticking-plaster expedients that pacify rather than cure. This century’s “big ticket” economic phantom is, of course, the unprecedented decade-long wave of “fiat” money expansion by central banks everywhere as a counter to the unwinding of the previous monster: debt that lacked any visible means of support beyond the fairy-tale world of ballooning property prices – aided, as usual, by the fact that those guardians of financial integrity, the central banks, failed to read the minutes of the previous crisis.

[Reminder: “Fiat” in this context is not a little automobile. It is the Latin subjunctive of the irregular verb “sum” (“I am”). Thus “fiat” is “let it be”, or “may it be”, or “may there be”. In the book of Genesis we have “fiat lux”, meaning “let there be light”. In economics, therefore, “fiat money” literally means, “let there be money”, or money that simply appears, like the dawn light. The image evoked is one of a magician waving his wand and tapping it on a hole in a tree trunk from which flows an endless stream of dollar notes. But the magician is a sorcerer, and with his dollars comes a terrible curse!]

So popular was the wholesale creation of fiat money by the US Federal Reserve, the Bank of England, the Bank of Japan and the European Central Bank that central banks everywhere else replicated it. After all, with such illustrious pacesetters it had to be the right thing to do. Who needs a magic wand when you can click on a computer key?

But there are consequences

Artificiality always begets artificiality: one effect of flooding the credit markets with so much artificial money was the artificial lowering of interest rates. In the world of real business this obviously distorted calculations on which commercial decisions are made, with particular reference to deployment of capital on longer-term ventures such as mining, construction, factories and transport infrastructure.

[Please remember that we are here talking about the application of private capital – I’ll come to government projects later.]

Committing private capital to long-term projects at the higher interest rates previously prevailing would have been commercially prohibitive: the longer the time taken to complete a venture, the greater the uncertainty of outcome. But at artificially suppressed interest rates it will appear that profitability is within reach, and new commitments will be entered into involving the cost of specialised equipment, vehicles, hiring of labour and related production needs.

Operation of real interest rates

The notion of artificially lowering interest rates begs the question: “Is there such a thing as a natural level of interest rates?”

Forget central banks. The natural level of interest rates is determined by participants’ respective time preferences for satisfying their needs and desires. This applies whether the participants in a transaction are individuals or businesses.

It is in the nature of long-term construction, infrastructure and mining projects that their consummation lies in the distant future, requiring capital to be tied up for years before seeing a return, implicitly involving greater uncertainty and higher risk – all indicating that the both borrowers and lenders would naturally expect a higher rate of interest to apply.

But if the central bank’s policies have had the effect of artificially suppressing rates, those policies will at the same time have distorted the distribution of resources in favour of businesses that satisfy a long-term preference, and resources will migrate in their direction – despite the fact that the underlying time preferences have not really changed at all. It is only the distortion caused by interest rate suppression that makes it appear otherwise.

Businesses set up to satisfy an immediate time preference, such as sidewalk sandwich bars and coffee counters, will have difficulty recruiting workers who have shifted into infrastructure. In due course they will be tempted back by higher pay, entailing in turn higher prices for consumers.

We see stark evidence of this ebb and flow of resources between short-term and long-term time preferences whenever marginally viable businesses, at both ends of the spectrum, are forced to close. But the losses are clearly far greater at the long-term end, where all that infrastructure spending has produced nothing at all. Capital has been irretrievably destroyed – and we can trace it all back to the original madness of fiat money credit expansion.

NOTE ON GOVERNMENT EXPENDITURE:

What I have stated above concerns the risks to private capital caused by government-induced distortions. At least the owners of that capital were able to estimate long-term outcomes. It was, after all, their money. Expenditure of private capital, unlike expenditure by governments, is susceptible to economic calculation, even while projects are in progress. An example is the recent decision of Airbus directors to cease production of its A380 “Superjumbo” in 2021 because of long-term order-book uncertainty. As custodians of shareholders’ money, they are accountable for their decision.

Bitter experience shows, by contrast, that governments should refrain from committing taxpayers’ money to projects that company shareholders would never, in their right minds, countenance. Today’s classic vanity project is, of course, HS2, intended to shorten the London-Birmingham link by 32 minutes at a cost approaching £100 billion – it is so obviously ill-conceived, given that the nation’s real transport connectivity needs lie much further North.

Other ill-starred projects are in the same category: Heathrow’s third runway now faces judicial review, as well as air and noise pollution lobbies; Crossrail, whose own boss cannot foresee any realistic delivery date, while massive unbudgeted costs escalate; Wylfa and Moorside nuclear stations, abandoned or suspended by their own contractors; and even Hinkley Point, the only nuclear plant under construction, which still has no reliable delivery date, nor any real idea of the final cost overrun.

Yet, whenever ministers are confronted by these costly white elephants, and every sane voice declares “scrap it”, they could go ahead anyway, due to the default position of ministerial inertia, the lobbying power of engineering conglomerates, property developers and special interest groups – and, above all, by the fact that spending taxpayers’ money is what ministers do!

Whenever you weigh up the so-called return on a government-sponsored venture, ask yourself whether, as a taxpayer, you would have been happy to support it with your own money – given the choice.

Keynesian poppycock

It all goes back to the Keynesian obsession with government-induced demand, as if that were an economic actor whose stimulation would magically lead to the land of plenty.  Keynes wrote: “If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to surface with town rubbish, and leave it to private enterprise to dig the notes up again, there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.”

Even if you are able to unravel this drivel it may strike you as total hokum. That’s because it is hokum. And, if you think for a moment, recognising that those buriers and diggers will have to be paid, you will see that this is the very progenitor of the central banks’ money-printing mania whose unwinding we are about to witness – big time!

Contrast Keynes’s “demand stimulation” with what happened 40 years ago: the Reagan/Thatcher reaction to this madness was what’s often labelled “supply-side economics”, which ushered in a period of stability and steady growth. Think of the supply side as production that, according to Say’s Law, MUST precede consumption. Margaret Thatcher, and her Chancellor, Nigel Lawson, recognised that the supply side does not require stimulus – other than the removal of controls, regulations and other obstacles to business such as taxes on production and employment. It works so well, unaided – what a revelation!

My final word on (dare I mention it?)…….Brexit

Most of us are so thoroughly disenchanted by the entire Brexit farce that we scarcely care any more what happens to the blasted Irish border and want only to get the whole damn thing over with. Yet a very simple question occurred to me.

Since, in essence, the whole issue is whether our membership, in some form, of the EU’s main economic institutions, the “single market” and “customs union”, should be retained, why is it that no other trading bloc in the world has erected comparable institutions, and yet survives, even thrives?

One good question deserves another: after a couple of decades of adhering to those institutions, how has the EU (and in particular the eurozone) fared economically in comparison with those other trading blocs?

The latest IMF data shows that over this 20-year period the eurozone’s GDP grew by 26 per cent, compared with the UK’s 44 per cent and the US’s 42 per cent. I’ll resist telling you the figures for Italy and Greece, other than to note that both have suffered two completely wasted decades. For proper growth we need to look at emerging, low-regulation economies like India and China, and even Israel with 98 per cent GDP growth, with no single market or customs union in sight!

As Allister Heath put it in his column this week: “If being part of the single market and customs union mattered so much more than any other policy, the eurozone would have boomed. Yet it didn’t, and the voters know they have been sold a pup.”

I’m feeling better already!
 

© Emile Woolf February 2019 (website)
 

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