How to treat a recession V

In previous recession articles, I referred to recessions as a result of "vast shifts in customer preference" that cause temporary economic inconveniences which are inevitable in a period of comparatively large transitions. While being correct in the most general terms, this is, of course, a bit misleading since it leaves out of the picture why exactly these preference shifts started occuring in the first place. It could be that people all of a sudden decided to change their preferences, but that's unlikely on such a scale. The real culprit, at least in this recent case, seems to be central banking and centrally managed interest rates.

Let's start from scratch. Our current crisis originated in the housing market. A lot of people were unable to repay their mortgages and had their homes foreclosed; house prices started dropping since an increasing number of foreclosed homes were now up for sale. This created another problem: a number of homeowners used their homes as a "source of revenue", they hoped on ever-increasing homes prices and maxed out their mortgages whenever the speculative price of their home had risen. Now that house prices started dropping, their securities started melting away and other expensive consumer goods that had been leased with the expectation of ever-increasing housing prices had to be returned, thus decreasing demand and prices in these industries as well. Ensuing layoffs in affected sectors of the economy soon started spreading and recessionary tendencies became visible.

In other words, a good amount of people had been living well above their means for quite some time. How did this happen? Why did these people get a mortgage in the first place if their solvency was that unstable?

On a free market, credit is a finite good. The availability of credit is expressed by interest rates. If little to no savings (the foundation for sound credit) exist, interest rates are high: that way, scarce credit is directed to very profitable endeavors only that are able to generate enough revenue to pay back the considerable interest. As savings become more abundant, more credit can be given out for less interest and less profitable enterprises can make use of this tool as well. The least profitable enterprise is consumption. Consumption generates no monetary profit per definition because funds are being consumed instead of being invested. Thus, credit-financed consumption by a few (basically, what the United States had been doing in the last few years) is only sustainable to some extent in a society with an enormous savings rate (in case of the United States, the thrifty lender was mainly China).

A central bank with centrally managed interest rates shuts off this market-based process of interest rate creation. Interest rates are set by fiat ("according to leading economists' market estimates"). Because central planners are unable to imitate the effectiveness of a real market, central banking also has a political objective, namely to transform the "is" condition of the market into an "ought to" condition of what politicians would like to see. Wanna "spur consumption"? Just lower interest rates! Needless to say, this creates a lot of problems down the road once political planning collides with reality. To pick up our example of United States consumption, years of low interest and low personal savings rates created a vast debt bubble that popped once one of the most debt-laden sectors of the economy, the housing market, had started to crumble - in other words, once it had become obvious that the amount of debt circulating was not backed by a sufficient amount of savings or productivity, that there simply was a lack of funds that could not be compensated by an increase in debt because there was way too much of it already.

Saving money constitutes deferred consumption. Think of money as bricks. It's your decision whether you want to use all your bricks right now to build houses for yourself or put them into a bank to gain interest and to allow others to build houses with them. If a brick bank promises to loan out more bricks than it can reasonably expect to get in due time, any constructions that have already begun based on brick loans from this particular bank will eventually come to a halt. If the brick money system itself is based on not lending out bricks according to how many bricks are there, but according to how many bricks should be there or how many bricks a wise, but economically ignorant wizard estimates to be there, then all houses that have been planned based on this system will face a lack of bricks rather soon.

And then, to finally make the point I wanted to get to, you'll see these miraculous "vast shifts in customer preference" that I'd been talking about all along. When people realize there ain't enough bricks, they'll change plans and opt for alternative solutions. This will necessarily interfere with the schemes of those who had been calculating with central bank brick numbers, but ultimately, either there are enough bricks or not. If not, there's no point in pretending anything else. It will only delay recovery.

Now, recessions are not always the fault of central banks, but these banks notably increase the likelihood of far-reaching malinvestments. They are most likely to be blamed for our most recent recession. Accordingly, I considered it worthwhile to point out that "vast shifts in customer preference" do not need to be the result of "free market animal spirits", but can also be caused by the actions of state institutions.

How to treat a recession IV

We often hear claims for tax cuts by free market advocates in times of a recession. Generally, they are right: cutting taxes allows people to control a greater share of their resources, thus making production according to public demand, not government fiat more profitable and thereby increasing the likelihood of an economy that actually satisfies people's demands.

But there's a catch: cutting taxes only works if government spending is cut by the same amount or more at the same time. Otherwise, it'll be merely make-believe: while you may have some more dollars in your wallet, your government will already be engaged in deficit spending or monetary inflation to keep up with the cost of burdensome state programs.

The current recession seems to be a prime example of this schizophrenic mentality: in order to reach a "compromise", supposed free marketeers and those who put their trust in government agree to cut taxes, but increase spending ("stimulate the economy") at the same time. That's like eating your cake and having it, too. You can only spend money once: either for private sector needs and wants or for state purposes. If both compete for a finite amount of goods and services, prices will go up and your tax cuts will essentially vanish.

Not only is this a very dishonest method of trying to buy as many political sympathies as possible, but it's more of the same "let our grandchildren pay" mentality. At some point in time, debt incurred by a state will have to be paid back: either by taxing every bit of surplus wealth out of those who are still producing, a sure-fire way to economic collapse. Or by madly inflating the currency, another quick road to economic turmoil through hyperinflation. Or by pleading with creditors to forgive debts which they will only do for a good amount of political favors - which means that the bosses you can still vote on will be subject to the decisions of another layer of creditor functionaries - so you'll be even more screwed.

In conclusion, be careful whose tax cut plan you support. Paying less is only reasonable if less is being spent as well. Otherwise, nothing fundamental changes about the unsustainable attitude of spending until the cows come home.

How to treat a recession III

When everything else fails, there's still the printing press - even though today's money creation happens mostly within the digital realm. Anyhow, politicians praise inflationary policies in recessions as a means to achieve three things:

1) Generating funds to finance stimulus packages without taxation
2) Creating incentives to spend money now due to expected future inflation
3) Preventing falling prices

As for the first part, that's pretty easily refuted. There's no such thing as a free lunch. Even though you don't have to tax at gunpoint in this case, the effects of inflation will be the same as taxing a comparable amount of money. Your dollars lose purchasing power, thus they're worth less - you're likely to need more of them to buy the same amount of goods and services. It may not be as obvious, but it still happens and there's no categorical difference between governmental inflation and taxation. It's merely semantics.

The second point rests on the fallacious view that "consumption drives the economy". If you can stimulate aggregate demand, that'll increase aggregate supply and everything's supposed to be fine again. But an economy exists to satisfy wants and needs. The fact that vast shifts in the structure of production are occuring (with the accompanying recessionary inconveniences) shows there is a vast discrepancy between what is being produced and what is being demanded. Artificially changing these demand patterns by threat of inflation does no good to the general welfare - it's like offering someone a childhood painting of yours for 50 dollars or else he will get shot. Considering his options, your counterpart will probably go for your painting - not because he demands this particular good, but because the only alternative you grant is much worse. Actual demands are not going to be satisfied. It's a charade.

Falling prices and deflation are among the biggest scare stories around. According to some, they will lead us into a downwards spiral that'll only end once we hit rock bottom. However, prices and wages need to drop if necessary adaptions to vast changes in customer demands are to be performed. If nobody wants to build a house anymore at current market rates, what's the use in upholding wages of construction crews? If jewelry is too expensive for the majority of previous customers, why should you keep prices up? It's a clinging to a previous state of affairs that may have been more beneficial to some individual market participants, but turned out to be unsustainable. Trying to freeze the economy in this boom period to prevent a supposed downwards spiral will only hinder essential corrections and prolong the recession.

In short, printing money does not increase wealth. As simple as that sounds, it's a pretty tough story to sell in Washington, D.C..

How to treat a recession II

Some more water's been going down the Mississippi since my last post. I decided it was time to get into the business again. Starting with a few minor design changes, I intend to contribute content more regularly now and offer some additional features to complement my random thoughts on supposedly important topics. Let's get back to work!

Now that a new high-priest in chief has been sworn into office, I figured it'd be a kind gesture to provide some more advice concerning the treatment of a recession. We'll examine public works programs today.

There is a widespread belief that one of the purposes of "the economy" is to provide jobs. This is false. The purpose of economic transacation is to satisfy needs and wants. The reason why the first cavemen engaged in trade with each other was precisely the effectiveness of the division of labor when it comes to satisfying diverse needs and wants. One caveman would hunt deer whereas the other one would collect berries. The two could then engage in voluntary exchange, improve their diet and increase their survivability - or just have more pleasure eating. In any case, they'd be better off than their non-trading caveman friends.

Of course, in the process of satisfying wants and needs, work opportunities are created. A few years down the road, the berry-trading cavemen may have been able to hire other neanderthals to collect more berries for him and get paid in, say, deer meat. The example isn't all too significant since it lacks a common currency and the job is not really an advance from scratch for the one performing it, but still. We now have employment. Meaningful employment. If our neanderthal would carve beautiful wooden dolls, that'd be great, but useless in the absence of demand for beautiful wooden dolls. There's no point in forcing the berry entrepreneur to give deer meat to the doll carver in order for the carver to continue his business, but that's exactly what public works programs are all about.

Instead of pursuing meaningful and profitable employment on the market, people are incentivized by the state to engage in random activity subsidized by tax money. The activity may not appear to be random since it benefits someone, but it remains a subsidy at best, for if the job was profitable, there'd be no need for the state to provide it. Thus, public works programs not only extract labor from the market to use it in unproductive endeavors, but force productive workers to finance this madness. That way, the real function of markets - the satisfaction of needs and wants - is impaired from two sides at the same time.

Public works programs do not support, but hinder economic recovery. The idea should've been discarded long ago.

How to treat a recession I

In my last article I argued that recessions are actually a good and desirable development and should be greeted whenever they occur. However, I admitted that recessions are connected with temporary hardships that ought to be overcome as quickly as possible.

Quite a number of people put their trust in government to accelerate the process. So I figured I better start a new series: a handbook for the aspiring central banker and bureaucrat to find out how to ruin an economy in transition, in other words, what NOT to do.

Today we shall start with a popular magic trick out of Mr. Keynes' cylinder: deficit spending.

The reasoning behind running up debt to become wealthy is the idea that recessions are not caused by far-reaching shifts in customer preference patterns, but by "uncertainty" and "confusion". If people can be manipulated to spend money faster than they would under true market conditions, this is seen as a success and the correction of a "market failure". Keynes doesn't want to wait until markets have adapted in the long run to what customers actually desire because "we're all dead in the long run".

Debts can be repaid in boom periods, Keynes assumes. That way, we get the best of both worlds: a stable economy and zero public debt.

However, Keynes doesn't answer the question of how to determine which public works program that we need to go into debt for will yield a sufficient profit so we can repay our obligations. Obviously, government doesn't follow the price mechanism - it would be unnecessary otherwise. That leaves political/ideological projects and socialized industries as areas to invest.

An example for an ideological project would be renewable energies. You can pump a lot of money into it without clearly defining your aim. Do you want long-lasting home generators for survivalist-minded folks in the outback, or high-performance cells with a relatively low shelf life for emergency use in factories and offices? Or do you intend to replace every non-renewable energy source in the country with wind parks and solar panels? You need to calculate your budget accordingly, and need a good reason why your specific purpose is more worthwhile than any other use (e.g., researching waterproof solar panels for diving purposes). It's a subsidy in any case, however, and yields no expected positive return. Otherwise, the market would do it.

Socialized industries include, but are not limited to, streets and police. One might wonder how building more streets or hiring more cops is going to boost profitable trade and commerce. As I explained above, there's just no way to determine and thus, no way to promise that debt incurred during a period of economic adjustment will ever be paid back.

And that's exactly what's been going on ever since. A lot more debt during recessions and a little less more debt during a boom. Interest needs to be paid for this debt in the future, this will drag down economic development since taxes need to be levied or money needs to be printed which will lead to inflation, a hidden tax, in order to repay it. Deficit spending is a vicious cycle.

In addition, government needs to borrow somewhere to finance its deficit spending. Even though credit markets have been extended ridiculously through fractional reserve banking and the Fed itself, there is still no unlimited amount of credit available. If government buys up all the credit, this drives up interest rates for private sector businesses in need. They may not get the loan they need and go bust. This is called "crowding out".

Anything more to say about it? Government deficit spending ignores your personal subjective value choices, sacrifices long-term, but stable business plans for short-term, debt-based ones and levies taxes on your children's future. In other words: hands off !

All hail the recession !

First, I'd like to apologize to my dear readers for being unproductive over such a long time span. Lack of inspiration, business in out-of-blog life and general tiredness kept me from writing.

Today, however, I feel like commenting on the craze of the day: claims that someone finally "get us out" of the coming recession.

It is a generally accepted view that recessions are bad. 'Something' ought to be done about them, we are told by all the concerned-looking pundits, otherwise we might face the full impact of the bust. And that is, supposedly, "bad" for "the economy".

That may be true in Bizarro World. On Earth, a recession indicates a reallocation of resources away from seemingly unproductive enterprises to those which actually satisfy customer demands. Various shifts in preference patterns may occur: market participants may either change their preferences for certain goods and services while remaining in the same time preference pattern, e.g. change their fondness for chewing gum to a liking for white bread, or alter their time preference altogether, e.g. stop buying video games and instead save for a house. As long as this happens in small doses, the impact of the reallocation is hardly recognizable. If, however, for some reason a large amount of market participants decide to switch from popular industry A to unpopular product B, markets need to restructure on a grand scale.

This, in turn, leads to temporary inconveniences such as unemployment, wage reductions, short-time work (or overtime) or business failures.

Think about it again: politicians, economists and pundits generally support fighting this process. How does that make any sense? It is not some bad voodoo that tends to haunt our world for an unknown reason from time to time, but simply markets reacting to future trends and expected modifications in supply and demand. So why would they want to stop it?

Of course, the argument "it's bad for the economy" holds some truth: it is bad for those entrerprises that are expected to undergo enormous changes or go bust due to production of goods or services that are not in demand (anymore). Nobody wants to leave a front row seat in the ride of life, but we have to decide at some point: Do we want an economy that produces goods and services according to market demand, or a museum economy which reflects demands and speculations of the past, but is unwilling and unable to adapt to our changing wishes and needs?

If you don't want to live in a museum, you'll be just as glad as me to see the recession unfold. Gas prices dropping, house prices dropping, commodity prices dropping in general, laggard companies like GM that have been more busy meddling with Michigan politics than producing neat cars for decades threatened to be finally gone for good, Ponzi schemers like Bernie Madoff going broke as well and, maybe of paramount importance, politicians that are too busy "fixing the economy" to think about going to war another time. I might be wrong with that one, but at least it's a reasonable hope.

Thus, as the headline said: all hail the recession !