Recessions – and – Spending Does Not Help The Economy
I recommend reading the essays on Money and Capitalism before reading this essay
Because you have read the essays pertaining to Money, you are aware of the damage caused by the cartel’s (Bank/State) monetary inflation. This inflation also imposes great hardship on the masses through its disruption of the natural link between savings and production, thereby creating recessions and an unnaturally high rate of unemployment. At any given time, the cartel is either denying the existence of this link, or insisting they have the expertise to circumvent the link in order to provide more prosperity for all citizens.
A simple analogy allows us to easily comprehend the link between savings and production. I will use the example from Peter and Andrew Schiff’s book How an Economy Grows and Why it Crashes. The book describes a fictitious island economy as a means of explaining in layman’s terms some basic economic concepts.
The story begins with three men stuck alone on an island. Their only source of food is fish, which they used their bare hands to catch, and what they caught was only enough to feed them for that day. Each day they had to catch more fish or go hungry. In other words, they were consuming everything they produced. Then one of them, Able, came up with an idea to build a fish catching device which would make fishing faster and more efficient. Because he was occupied with the building of his fish net, Able was unable to fish for a day, which meant he had nothing to eat. He was foregoing his income (fish) for a day, hoping his sacrifice would be rewarded, while accepting the risk his invention may not work.
The other two men, Charlie and Baker, laughed at his efforts until they saw his success. Able doubled his daily fish production. Since he did not need to eat these extra fish, he kept them in reserve – his savings. Charlie and Baker were suddenly very interested, but unwilling to defer their own consumption (go hungry for a day) while attempting to build their own nets. Able agreed to loan them some of his savings so that they may eat while building their nets. Charlie and Baker agreed to repay the loan with interest – they will repay more fish than they borrowed.
The loan benefited all parties. Able earned interest on his savings, while Charlie and Baker succeeded with their nets, which expanded production in their little economy. The increased production of Charlie and Baker is traced to the savings of Able. There is a risk with every loan, but sustainable economic prosperity can only come from loans which originate from our savings.
Many good economists have used similar ‘Robinson Crusoe’ type analogies to illustrate basic economic concepts. The cartel and the bad economists it employs characterizes such analogies as quaint and amusing, but totally inapplicable to the complexities of modern society. Such criticism is understandable. The cartel hates the analogies because they reveal the insanity of the doctrines promoted by the cartel. But make no mistake, simple analogies are an indispensable tool for conveying basic principles which do not change when applied to the real world in which we live.
SAVINGS = DEFERRED CONSUMPTION
Anyone who has a job is producing, and their income is what they receive in exchange for their production. When we do not consume (spend) all of our income, we have savings. Savings represents deferred consumption, just as it did with Able.
Let’s forget the cartel for a moment and consider a civilization using honest money. An entrepreneur, let’s call her Mary, wishes to start a new business producing a particular good, and she needs money to finance her enterprise. Having no savings of her own, she knows she will have to go to a bank to borrow money, which, whether she realizes it or not, represents the savings of other individuals who have loaned their money to the bank in the form of a time deposit.
It is important to remember that a time deposit represents a loan to the bank – the lender and the bank sign a contract which specifies the interest rate and term of the loan i.e. one year, three years, five years etc. The term is fixed, without exception, because the bank is loaning this money to another person and the term of that loan matches the term of the time deposit. This is contrasted with a demand deposit which is used by depositors who desire unrestricted access to their savings and are simply using the bank’s vault as a secure depository, for which they pay a fee, and of course receive no interest on their savings.
Now back to Mary, and we should note that entrepreneurs (speculators) take great risks. Success depends on their willingness to work long hours, and their ability to forecast (or create) future demand for their products in the face of actual, or potential, competitors. They risk considerable time and money in their quest to profitably satisfy consumers. Most of them fail but some succeed. Mary develops her business plan and the bank is willing to loan her the money, but she decides to wait because the interest rate is too high. Loan interest is a significant cost for her venture and she believes she cannot be profitable while paying this high rate of interest.
SUPPLY AND DEMAND
The interest rate is the price of borrowing money, and prices are established in the marketplace through the forces of ‘supply and demand’. When the demand for something increases faster than the supply, the price rises. If supply increases faster than demand, the price falls. If demand falls faster than supply, the price falls. If supply falls faster than demand, the price rises. This is how the market allocates and conserves scarce resources, as it continually matches supply and demand through the price system, thereby bringing these two forces into a natural state of equilibrium.
High interest rates are a function of the market. A high demand for loans and a low supply of savings means that equilibrium is established at the high price of borrowing money. Prices are signals and the high interest rate sends two signals. It sends a signal to potential borrowers, prompting those who are less confident, or more cautious, to postpone their plans. It sends another signal which says: there are high rates available for time deposits, which prompts many individuals to consider postponing their consumption in order to reap the benefits of savings. As people respond to this signal by saving more money, the increased supply of savings causes interest rates to begin falling, which in turn signals many borrowers to reactivate their plans.
PRODUCTION MUST COME FROM OUR SAVINGS
When interest rates drop far enough, Mary decides to borrow the money and start her business. When she is finally ready to sell her products, she finds willing customers and she is profitable. But where do customers find the money to buy the new products? Some people will buy less of other products in order to buy the new products. Others may withdraw money from their demand deposits to buy the new products. When Mary repays her loan, time depositors regain access to their savings, which can either be spent, or kept as savings. But, as interest rates fall, the level of savings also tends to fall, and consumption tends to rise. In this way, as savings are redeployed into consumption, this added purchasing power in the market serves to support producers.
However, this does NOT mean that spending helps the economy! That is a dangerous fallacy promoted by the State/Banking Cartel. The cartel and the economic intellectuals they employ are constantly promoting this economic garbage. Many individuals say they spend in order to help the economy, but this is nothing more than an excuse to maintain their habitual extravagance. Production, not spending, is the key to a healthy economy. People will always spend. They do not need encouragement to do so. People must spend in order to survive. But one cannot spend if there is nothing available to buy. Goods must first be produced before someone can purchase them. Production must precede consumption. As long as producers make things that consumers want, spending will always follow. Thus, it is savings, not spending, which helps the economy, for without savings there can be no production, and hence no spending. The cartel encourages spending because it wants to encourage ‘borrowing and spending’ – and NOT the borrowing of savings, but rather the borrowing of new fiat money. This benefits the cartel, but you already know that because you read my essays on Money.
In a free market, as savings increase, consumption must decrease, which means some companies and industries will experience a lower level of sales and some workers may lose their jobs. Simultaneously though, borrowing is increasing, and this investment in new production provides more employment opportunities. Thus, there are no net job losses. It is simply the lines of production which are changing. One industry may shrink, but another one is expanding, and it happens because consumers are making choices. In a genuine free market, unemployment tends to be very low and transitory in nature.
This bears repeating: production comes from savings. This is what Ayn Rand, author of Atlas Shrugged, meant when she wrote:
Progress can come only out of men’s surplus, that is: from the work of those men whose ability produces more than their personal consumption requires, those who are intellectually and financially able to venture out in pursuit of the new. Capitalism is the only system where such men are free to function and where progress is accompanied, not by forced privations, but by a constant rise in the general level of prosperity, of consumption and of enjoyment of life.[1]
Rand mentions capitalism, which she clearly understood. However, it is a term which has often been ill-defined by those wishing to promote a particular political and/or ideological viewpoint. For our purposes, you may safely equate capitalism with the free market. For further elaboration, see my essays on Capitalism.
THE CARTEL CAUSES RECESSIONS
The demand for borrowing money is always limited to some degree. Not everyone wishes to borrow money, even at low interest rates, but the cartel’s power to create money means that the supply of fiat money is theoretically unlimited. Thus, banks are able to offer low-interest-loans to entice borrowers. This low price prompts various enterprises, large and small, to borrow money in order to expand their business, or to start new businesses. Borrowers take the bait, failing to comprehend the dishonest nature of the bank loan – the money which is being loaned does not represent savings from previous production. It is new fiat money, created out of thin air. Additionally, because interest rates are low, savings of fiat money will also be low, an important point to remember.
Low interest rates cause companies (and individuals) to borrow aggressively. There is an economic term: booms and busts. As borrowing increases and businesses expand, employment increases, wages rise, the economy appears prosperous, and hopes are high – this is the boom phase, which can last for years, but not forever. This apparently prosperous economy rests on a foundation of fiat money. Unstable foundations eventually crumble. The cartel knows it must not inflate the fiat money supply too much too fast because this would risk a hyperinflation of prices. Such a scenario would inflict severe economic pain on the masses, which in of itself does not concern the cartel. However, this would also reveal the fraudulent nature of fiat money, thus killing the golden goose and destroying the cartel’s monopoly, and that does concern them.
Therefore, when the cartel believes high inflation is beginning to threaten its own interests, it starts shrinking the fiat money supply. The cartel has various methods of accomplishing this objective: raise interest rates to reduce the demand for loans; some loans can be ‘called in’ i.e. immediate repayment is demanded by the bank; new loans are strictly limited; the central bank raises the reserve ratio for banks; the central bank sells securities, which takes fiat money out of the banking system.
The reduced supply of fiat money guarantees higher interest rates. The cartel makes numerous speeches warning of an “overheating economy”, and “we must take action to reign in market forces.” And indeed they take action, forcing interest rates high enough to dissuade new borrowers and instill fear in current borrowers who need to renew their loans.
The previous economic growth was fueled by fiat money. The masses saved little because (a) interest rates were low, and (b) they saw prices rising which means it is better to buy goods today because tomorrow prices will be higher – the dollar is losing value, and (c) the cartel’s intellectuals kept telling them that spending is good for the economy. The economy has now entered the bust phase and sales are dropping because (a) sufficient savings are not available for redeployment into consumption, and (b) consumers are reducing their previous level of spending because interest rates are rising and they need to pay off their own foolish loans.
Many companies realize their business plans are no longer viable. They know they made a mistake, but are unable to identify the cause. As sales plummet, companies scale back their operations and some go bankrupt – unemployment rises. Others could continue in business if they were able to renew their loans at the previously low rates – unable to do so, they are also forced out of business, and more unemployment is created. The economy is in recession. Fiat money put it there. Compounding the economic decline are the social effects. For most people, getting fired is a blow to the ego. Thus, in addition to the financial difficulty, self esteem suffers, creating tension in families.
FREE MARKET: EFFICIENT and SELF-REGULATING CARTEL: DESTRUCTIVE and WASTEFUL
Humans are not perfect, which means the free market is not perfect, but it is highly adaptive and self-regulating. The price system forces companies to satisfy consumers, or they are forced to the sidelines so that others may utilize resources in a more efficient manner. Unprofitable companies are wasteful companies, which are steadily and continuously ejected from the market, because the market is unforgiving. In this way, the market imposes efficiency and discipline, which encourages good business management and conservation of resources. However, this steady, unrelenting, non-stop, self-regulating engine of the market cannot account for these sudden bursts of economic growth, followed by multiple business failures and recessions. Booms and busts (the business cycle) are simply not a feature of the market. In his book Meltdown, Thomas Woods explains:
No one is surprised when a business has to close its doors. Businesses come and go all the time. Entrepreneurs are not infallible, and they sometimes make poor forecasts of consumer demand. They may have miscalculated their costs of production, failed to anticipate the pattern of consumer tastes, underestimated the resources necessary to comply with ever-changing government regulation, or made any number of other errors. Business failure is the inevitable consequence of our inability to know the future with certainty.
But when a great many businesses, all at once, suffer losses or have to close, that should surprise us. Losses suffered in a single business are one thing. Again, no one has perfect foresight. But why should so many businessmen make errors all at once? The market gradually weeds out business owners who do a poor job as stewards of capital and forecasters of consumer demand by punishing them with losses and, if their inefficiency persists, driving them out of business altogether. So why should businessmen, even those well established, and who have passed the market test year after year, suddenly all make the same kind of error?
One clue lies in the historical fact that busts are especially severe in capital-goods industries – e.g., raw materials, construction, capital equipment, and the like – and relatively mild in the consumer goods sector: pencils, hats, picture frames. Put another way, things consumers actually buy don’t suffer from busts as much as do things produced in the higher-order stages of production, farther removed from finished consumer goods. Why should this be?
The economist F. A. Hayek won the Nobel Prize in economics in 1974 for a theory of the business cycle that holds great explanatory power – especially in light of the 2008 financial crisis, which so many economists have been at a loss to explain. Hayek’s work, which builds on a theory developed by economist Ludwig von Mises, finds the root of the boom-bust cycle in the central bank.
Looking at the money supply makes sense when looking for the root of an economy-wide problem. . . . In particular, the culprit turns out to be the central bank’s interference with interest rates. Interest rates are like a price. Borrowed money, or loaned capital, is a good, and you pay a price to borrow it.[2]
Robert Murphy, in his book The Politically Incorrect Guide to The Great Depression and the New Deal, continues the lesson:
“Austrian business cycle theory,” says, in a nutshell, that business cycles of boom and bust are not inherent in a free market economy, but come from outside it – namely, from the actions of government through its monopoly central bank. In a truly free market economy, interest rates would be determined by the supply of savings and the demand for loans. But modern central banks, like the Federal Reserve, are always anxious to reduce interest rates below their free market levels. They do so by flooding the financial sector with new credit, which pushes down interest rates.
The motivation for this chicanery, of course, is that it provides a temporary euphoria, a period of apparent prosperity. At the artificially reduced rates, businesses undertake projects that would have been unprofitable at the higher, true interest rates set by the free market. These firms then use the new money to hire workers and bid resources away from others, so they can start their new projects. Business seems good, wages and commodity prices begin rising, and the unemployment rate drops. In short, the injection of artificial credit fuels an economic boom.
The problem, as Mises wrote in 1928, is that “every boom must one day come to an end.” Like other prices, the (undistorted) market rate of interest really means something. The market rate of interest has the important job of matching up the amount of borrowing with the amount of capital actually being saved. But because of the distortion of credit by the Federal Reserve, businesses begin buying resources and making long-term investments as if consumers have saved more than they really have. In fact, the artificially low interest rates actually lead consumers to save less (and spend more) than they normally would.
Mises and Hayek demonstrated that this situation is unsustainable. In a normal market economy, production grows over time because of a growing accumulation of capital equipment, made possible by acts of abstinence (savings). But in a Fed-induced boom, the central bank tries to rush the process; it wants businesses to produce more drill presses without consumers having to even temporarily restrict their purchases of radios and fancy dinners.
The illusion can last for some years, but it can’t last forever. As the boom persists year after year, the structure of production becomes more and more distorted and unsustainable.[3]
Robert Murphy spoke of the U.S. central bank, the Federal Reserve. The process is the same in virtually every country. Back to Thomas Woods:
The economy, in other words, can support only so many investment projects at once. The interest rate acts as the market’s restraint on how many such projects are begun, in order to prevent the initiation of more projects than the pool of savings can support in the long run. When the interest rate is artificially lowered, more loans can be extended and more projects started, but artificially low interest rates do not magically supply the additional real resources necessary to complete all the projects.[4]
Woods is correct, and the cartel is aware of this. They know that overall economic prosperity is best served by the market, but their own prosperity is maximized through subversion of the market. Woods continues:
Mises draws an analogy between an economy under the influence of artificially low interest rates and a home builder who falsely believes he has more resources – more bricks, say – than he really does. He will build a house whose size and proportions are different from the ones he would have chosen if he had known his true supply of bricks. He will not be able to complete this larger house with the number of bricks he has. The sooner he discovers his true brick supply the better, for then he can adjust his production plans before too much of the finished house is produced and too many of his labour and material resources are squandered. If he finds out only toward the very final stages of the project, he will have to destroy almost the entire house, and both he and society at large will be so much the poorer for his malinvestment of all those resources.
Investment adviser Peter Schiff draws an analogy between an artificial boom and a circus that comes to town for a few weeks. When the circus arrives, its performers and the crowds it attracts patronize local restaurants and businesses. Now suppose a restaurant owner mistakenly concludes that this boom in his business will endure permanently. He may respond by building an addition, or perhaps even opening a second location. But as soon as the circus leaves town, our businessman finds he has tragically miscalculated. [5]
This is a great analogy. Obviously, the restaurant owner would easily detect the cause of this local economic boom. He would realize it is not sustainable, and therefore would not go to the expense of expanding his business, which means he is correctly interpreting the market and will not waste resources. In contrast, the cartel’s artificially low interest rates are highly disruptive of the market’s price system. Thus, entrepreneurs misinterpret signals emanating from the (coercively manipulated) market, and undertake business activities which ultimately result in business retrenchment, bankruptcy, and significant misallocation and wasting of scarce resources. But why do businesses not detect the true cause of low interest rates, thereby avoiding the problem? Woods explains:
A reasonable objection to the Austrian explanation runs as follows: why can’t businessmen simply learn to distinguish between low interest rates that reflect an increase in genuine savings, and low interest rates that reflect nothing more than Fed manipulation? Why do they not learn Austrian business cycle theory and then avoid expanding when the Fed tries to ignite an artificial boom?
The answer is that it is not so easy. . . . even most economists are unaware of Austrian business cycle theory, and it is a rare business school in which the subject is taught.[6]
The Mises Institute is the most popular economics website in the world, and the premier website for the teaching of Austrian economics. So, why is it not taught in schools? Simply put, Austrian economics promotes free markets as the only path to the highest possible level of prosperity for the masses. As such, it is diametrically opposed to the State’s modus operandi, and the State controls the schools. More from Woods:
One more point is important to remember: all firms are affected by the artificial boom, not just those that embarked on new investment projects or that came into existence in the first place thanks to artificially cheap credit. By the peak of the dot-com boom in the year 2000, for example, Microsoft – which had been established long before the boom – found itself face to face with the shortage of factors of production that Austrian theory predicts; the company began having a difficult time finding and keeping employees, especially in Silicon Valley. Mises observed that “in order to continue production on the enlarged scale brought about by the expansion of credit, all entrepreneurs, those who did expand their activities no less than those who produce only within the limits in which they produced previously, need additional funds as the costs of production are now higher.”[7]
The costs of production are higher for everyone because the cartel’s monetary inflation begets price inflation, which affects all individuals and businesses.
WHEN WE ARE IN A RECESSION, WHAT NEEDS TO BE DONE ?
Recessions are a product of the cartel’s actions. When the damage is done, what happens next? The economy is in recession. What should the central bank do? What should the government do? The answer to both questions is……..nothing. Both entities have done far too much already. They should hibernate and let the market sort things out. Sadly, the government always likes to be seen doing something, because it creates an impression in the minds of the public that somebody is in control. The problem is that the government cannot do something without spending money, and that money has to come from somewhere. The masses often welcome government stimulus spending in a recession, because the spending creates jobs, and they can see the jobs – workers building or repairing roads and bridges for example.
However, as Frederic Bastiat said, it is easy to see what has been created, but difficult to see what has not been created. We can see a new bridge or a freshly paved road, and we assume that if the government did not create these jobs, no jobs would be created. But in order to spend, the government must first raise money by taxing or borrowing. This deprives the private sector of money which would otherwise be available to businesses for borrowing and investing in new production, thereby creating jobs – and these jobs, since they would be created through the free market process, would be in lines of production which entrepreneurs have determined are likely to satisfy the wishes of consumers.
Conversely the government, released from market forces, awards expensive jobs to its contractor friends who show their gratitude with political-campaign-contributions. Thus, resources are wasted on ‘special interests’ and denied to consumer driven productive enterprises. Furthermore, government ‘borrowing and spending’ imposes a financial burden on taxpayers for the loan repayment. In contrast, repayment of business loans imposes a burden only on the entrepreneurs.
As the State pretends to be the economic saviour, so do the banks. Having created the boom and bust, the cartel once again begins increasing the fiat money supply, thereby lowering interest rates in the hopes of stimulating new borrowing by businesses. Sound familiar? The cartel says it is trying to boost economic growth, and its intellectual underlings dutifully praise its efforts – but this is nothing more than an attempt to ignite the next boom for the benefit of the cartel.
When a recession occurs, if the cartel truly wanted to do what is best for the public, they would do nothing. No stimulus spending from the government and no more fiat money from the cartel. Stop tinkering with the economy as if it was a machine. Allow the market to operate – it will (a) finish the process of liquidating all the bad investments, and (b) reallocate resources to their most highly valued uses, minimizing waste along the way.
Booms and busts typically span a number of years, but when a recession becomes undeniable, the cartel is always anxious to shorten it, out of political and monetary self-interest. The result of their actions is a shorter recession, but an increasingly unhealthy economic foundation. Lines of production become further removed from where the free market would have set them. Living standards fall further and the wasting of resources escalates. This ‘quick fix’ creates an illusion which conceals the underlying problems, thereby ensuring future recessions. As Jesus Huerta de Soto wrote in Money, Bank Credit, and Economic Cycles:
The most serious consequence of banks’ creation of loans is the following: to the extent loans are granted without the corresponding backing of voluntary saving, the real productive structure is inevitably distorted and recurrent economic crises and recessions result.
“Manic-depressive” economic activity, with all of its heavy, painful social costs, is undoubtedly the most severe, damaging effect the current banking system (based on a fractional reserve, in violation of universal legal principles) has on society.[8]
In a recession, if the cartel resisted the temptation to act – a tall order as this goes against their nature – the market eventually repairs the damage. Then, when the economy emerges from recession, its foundation is rock solid, and will remain so if the cartel continues to sit on their interventionist hands. The government can assist the process by reducing taxes, cutting spending, and repealing thousands of market-stifling regulations. This will increase the breadth of the free market, thereby allowing the masses to raise their standard of living as they more fully enjoy the fruits of their own labour.
CONCLUSION
Sustainable and growing prosperity for the masses requires us to differentiate between good loans and bad loans.
Good loans originate from our savings.
Bad loans originate from a coercive cartel which creates money out of thin air.
Peter Schiff is an author, investment advisor, financial commentator, and CEO of Euro Pacific Capital Inc. Schiff predicted, as did many Austrian economists, the 2007 – 09 U.S. housing crash because he knows the difference between good loans and bad loans. Cheap fiat money mortgage loans were the rocket fuel which sent house prices soaring. Schiff recognized these as bad loans and repeatedly warned that the booming residential housing market was unsustainable, and a severe reversal was unavoidable. Mainstream media personalities, the so-called experts, interviewed him on television and laughed at his predictions. They stopped laughing when Schiff was proven correct.
I recommend you invest seventy minutes of your time to watch Schiff’s 2011 lecture, titled “What About Money Causes Economic Crises.”
Image source: Adobe Images
[1] Ayn Rand The Virtue of Selfishness (New American Library, 1964) p 97
[2] Thomas E. Woods Jr., Meltdown, A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Regnery Publishing, Inc., 2009) pp 64-66
[3] Robert P. Murphy, The Politically Incorrect Guide to The Great Depression and the New Deal (Regnery Publishing, Inc., 2009) pp 166-67
[4] Thomas E. Woods Jr. Meltdown, A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Regnery Publishing, Inc., 2009) p 69
[5] Ibid., pp 69, 73
[6] Ibid., pp 75-76
[7] Ibid., pp 73-74
[8] Jesus Huerta de Soto Money, Bank Credit, and Economic Cycles (Third English edition, Ludwig von Mises Institute, 2012) pp 167, 261
