The View From 1776

In the recently released estimates of 4th quarter Gross Domestic Production (GDP) numbers, the less-than-expected 3.8% drop is not evidence of business strength.  In fact it’s the opposite.

Higher inventories ordinarily result from production increases, which add to GDP.  In a contracting economy, inventories rise because production already in the pipeline can’t be sold.

In an ideal economy funded by increases in personal and business savings, demand at all levels will tend to grow at the rate of increase in savings.  To meet growing demand, businesses increase production, which initially appears as increased inventories held for sale.  Payments to workers and materials suppliers to produce that inventory add to personal and business savings, which support new growth.

In an economy with little or no personal savings (ours of the present day), increased demand depends upon expanding bank loans and credit card debt.  At some point, the game has to end.  Borrowers begin to default on their debt; banks tighten credit standards; existing loans can’t be refinanced; assets are dumped into the market to pay off debt; businesses cut costs by laying off workers, and deferring new investments and purchases of raw materials.  If inventories are increasing, it’s because businesses have not yet been able to liquidate them in the face of sharply curtailed demand.

When that happens, as in our current situation, there are no painless options.  The Fed can create more fiat money and pump it into the system, as it has been doing on an unprecedented scale.  But that’s like someone on a partying binge awakening with a terrible hangover and expecting to cure it by drinking another bottle of whiskey.

Excessive debt created with fiat money caused the problem.  Easier money and more debt won’t cure it.

Call it what you choose.  The New Deal’s “pump priming” or Keynesian stimulus programs have signally failed to revive business, but have always increased the rate of inflation. 

The flaw in Keynesian economics, the theoretical basis of stimulus programs, is concentrating upon a single aspect of economic activity: consumer spending.  It appears so simple.  Government has only to enact spending programs; consumers will resume spending; business will revive; and the politicians will have bought lifetime voter allegiance.

Unfortunately, business in the real world is more complex.  Consumer goods buying is only a small part of it, the last of many stages of production, most of which can’t respond quickly to stimulus-induced consumer purchases.  Some businesses, in favored industries and favored Congressional districts, may benefit directly, but business as a whole still must go through a painful clearing process before there can be a general economic revival that will create new jobs and induce employers to rehire laid-off workers.

The only effective, non-inflationary remedy is the painful one of cutting inventory prices until everything is sold and reducing production costs.  Business will not revive until production capacities at each level of production have been brought into line with real demand, often via bankruptcies and mergers.  One way or another, production costs have to be reduced enough to allow businesses again to produce and sell profitably at reduced prices.  As production gradually revives, workers will be rehired; wages paid to rehired workers and payments to suppliers will then lever up consumption at all levels without inflationary effects.

The housing industry is an example.  When the economic house of credit cards collapsed, the number of new homes coming onto the market and in various stages of construction was at record levels, floated by record levels of consumer debt.

Between 2000 and 2007, businesses at all levels - from mining and oil drilling, to machinery manufacturing, to manufacture of intermediate goods, to production of consumer goods - ramped up production to meet the artificial, credit-supported levels of demand.

Investment projects to increase efficiency or add to capacity often require several years of planning and construction before coming on stream.  An example is locating a new oil field, getting additional drilling equipment, completing drilling, then building the infrastructure to get oil production to market.  If the economy collapses in the midst of a producer-goods investment expansion cycle, it will be several years before increases in employment can take place in those industries. 

No matter how much temporary consumer funding a government stimulus program injects into the economy, home building will not revive until inventories of new and resale homes are cleared out, usually at fire-sale prices.  Many building contractors and materials supply companies will go broke before that process is completed, and tens of thousands of construction workers will have been laid off.  Timber cutting and lumber production will go into a nose dive.

This same process will ensue in all of the stages of production, from basic materials, to machinery production, to production of intermediate goods, and finally, to consumer goods.

Consumer spending funded by government welfare handouts and selected infrastructure projects will only touch a small part of the economy.  When government stimulus spending is on the enormous scale proposed by our Democrat-Socialist Congressional majority, the only certain result is big inflation over the next couple of years, as consumer spending outruns the supply of goods in the pipeline.

The bottom line is that a recession created by excess debt can’t be cured by creating more Federal debt.

President Reagan, in his first inaugural address, famously said:

In this present crisis, government is not the solution to our problem; government is the problem.

In 1981, when he said it, economic conditions were in many respects identical to those we face today.  And for the same fundamental reason: governments almost always arrogate to themselves the exclusive right to issue and/or to regulate the issuance of currency. The Constitution, Article I, Section 8, states: The Congress shall have Power… To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures…

This power, for any government, creates a temptation to over-expand the money supply and debase the currency.  Only the unwritten constitution of the nation can guard against it. 

During the 20th century, our original ethos, our original unwritten constitution, was eroded by the growing influence of liberal-progressivism’s secular humanism, which reoriented the nation from God-centered personal responsibility to a political-state-centered society in which individuals abandoned personal responsibility and looked to the government to bail them out of every problem.  That society, our present one, encourages government to follow the temptation to enlarge the welfare state and to finance it with inflationary expansion of the currency.

The Federal Reserve Board fecklessly swipes at maintaining economic stability while serving as Congress’s handmaiden to create ever more fiat money from thin air.

When President Reagan took office, the massive increase in Federal deficit spending set underway by President Johnson’s 1960s Great Society welfare entitlements had eventuated in the stagflation of the 1970s.  President Nixon spent Federal money like a drunken sailor on shore leave, then sought to counter the effects with price-fixing and by taking the dollar completely off its vestigial gold standard.  President Carter inherited the whirlwind.

The purchasing power of the dollar, and ipso facto the value of people’s savings, had, by 1981, dropped more than 50%.  Interest rates and the increase in the Consumer Price Index had hit modern highs. 

Manufacturing was falling into an abyss, as rapidly rising inflation pushed up producers’ costs, at the same time that high quality, less expensive imports began entering our market in large quantities.  The Midwest, our industrial heartland, became known as the Rust Bowl because of its shut-down manufacturing plants. 

In the financial markets, savings and loan associations and savings banks were being pushed toward bankruptcy, because depositors were withdrawing their funds from low-interest-paying deposit accounts.  Thrift institutions, desperately seeking to raise cash to cover the torrent of withdrawals, could not liquidate their portfolios of loans at prices high enough to avoid wiping out their equity capital. 

Money market funds came into existence, paying double-digit interest rates comparable to those in the short-term money markets, rates that savings institutions and commercial banks were not permitted to pay under existing bank regulations.  Massive flows of funds from banks into money market funds became known as disintermediation.

A major difference between then and now was that the great bulk of thrift institution mortgage loans were sound, though the results were similar.  The 1970s problem arose from the impact of interest rates: mortgage loans made at fixed interest rates of 5% could be sold only at huge discounts in an inflationary market featuring short-term interest rates in high double digits.

What brought the United States to its economic knees between 1965 and 1980 was the age-old clash between governments’ (all governments) desire to increase handouts to voters at a faster rate than the growth rate of tax revenues.  Higher taxes temporarily alleviate the governments’ problems, but can’t eliminate them.  Tax-driven higher production costs reduce the volume of business activity and, with it, the inflow of tax revenues.

Monetary history demonstrates that politicians always are inclined to buy voters’ support by enacting larger welfare benefits that cannot be funded from existing government revenues.  At least as far back as the time of the Greek city states (ca. 500 BC), governments “solved” the shortfall by creating money to fill the gap.  Then and now, the inevitable result is inflation, which robs citizens of the value of their savings and distorts investment away from productive uses and toward purely tax and inflation oriented ones.

Governments can get away with dereliction of their duty to protect citizens’ property, because they have a monopoly on issuing and regulating the currency.