Sunday, 2 September 2012

Is greater money supply better for economy?

Germany, 1923: Workers were paid twice a day, and the housewife would stand at the factory gate and rush with wheelbarrows full of million mark notes to buy anything at all for money. Production fell, as people became more interested in speculating than in real production or in working wages. Germans began to use foreign currencies or to barter in commodities. The once-proud mark collapsed. Rudolf Havenstein, the head of the Reichsbank-the German Central Bank made clear that the bank would meet its responsibilities by increasing higher denominations of notes and keeping its printing presses open all night to fill the demand. In July 1914, 1$ = 4 marks and by November 1923 mark value had spiralled down to 1$ = 4.2 trillion marks.
US, 2002: In the aftermath of 9/11 and the bursting of the dot com bubble, the US was entering a recession. In response, the Federal Reserve then led by Alan Greenspan launched on what they called an “accommodative” monetary policy, a euphemism for pumping the market with money to try to stimulate the economy. Money was created basically by creating new debt. It was therefore necessary for recipients of the new money to lend it out again in order to profit from it. More money created by the Fed meant more loans that just had to be made. Property was seen as a “safe” asset to fall back on in the event of default. There was a general feeling that property prices would continue rising forever. Since money just had to be lent, many lenders relaxed lending norms and made loans easy to get. This combined with rising property prices drew borrowers like bees to honey. People with little or no income came looking for loans hoping to collect the profit from the house in the future or betting on rising price of the property to keep financing their payments. Lenders relaxed income-proof and asset ownership criteria to the point where loans were given knowing well that the borrowers had absolutely no ability to repay them. This led to Sub-prime mortgage crisis of 2008. This cycle continues. 15 Panics / Recessions / Depressions from 1796 to 2008.

So, what is the cause for this business cycle? Mainstream economists like Paul Krugman say this is an inherent feature of Capitalism. And what we can do is to predict outcomes and take preventive and corrective measures. But to according to economists following Austrian school of thought, causes are completely monetary flaws in the banking system and can be eradicated by attacking the root causes.
Structure of production: The organization of production into different stages of transformation of land and labor into (eventually) consumers’ goods. During production land and labor are paid before the actual sales take place. Where does the money to pay land and labor come from? The money has to be paid in advance, which is done by using the saved capital. Someone has to forsake consumption now and prefer consumption in the future. Money thus saved becomes available for payment to land and labor. A producer produces for future consumption and not for present consumption. But how do producers get to know that people have decided to consume in the future? For example consider the following case with 5 levels of production.
Interest income is the calculated price spread between two successive levels of production. Total savings required = 95 + 76 + 57 + 43 + 28 + 19 = 318 ounces. Suppose that consumer savings increase by 20 ounces and expenditure decrease to 80 ounces.
The interest income decreases at every level i.e. the price spread falls. This is a signal for the producer that consumers have decided to consume in the future. Eventually there is a matching of producers’ and consumers’ decision across time and leads to greater economic stability.
            Now consider the entry of the Central Bank, the Central Bank does not see the 20 ounces as savings but as credit expanded, so the total consumption spending remains at 100 ounces. And the saved capital for future consumption is zero. Hence, total gross savings required = 100*318/80 = 397.5 ounces. This increase in 79.5 ounces(397.5-318) is compensated by reducing the interest rate by 20%(79.5*100/397.5). Hence, the production seems more profitable than ever and massive investments happen in their production and a huge bubble is created. Exactly what happened to create the property bubble of 2001-07. The result of interest rate manipulation creates mismatch between investment decisions and consumption patterns. Requires non-stop credit expansion to sustain the boom, monetary expansion required to fuel credit expansion– causes consumer price inflation. Consequent massive monetary inflation makes the bust inevitable, boom-Bust cycle thus created by interest rate manipulation. Why does the Central Bank do this? This is how it earns interest for money which it does not own. This is how money is created out of thin air. Finally, what is the solution for this?

-          K. SATYA HARISH


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