Trade Deficits and Fiat Currencies
Although Austro-libertarians have always been staunch supporters of free trade, many are worried over the unusually large current account deficits of recent decades. Even though they concede that a truly free market trade deficit would be perfectly benign, they believe that the current "global imbalances" in trade patterns largely reflect the behavior of central bankers, rather than voluntary exchanges between private individuals across the planet. Are they right? FULL ARTICLE
Comments (113)
"On the one hand, we are supposed to be terrified of the massive liabilities that are mounting with foreign central banks. Yet at the same time, we are supposed to be horrified that our money is tied to nothing, that the dollar is just a worthless piece of paper. Well that's true (in a sense), but doesn't this cancel out the first objection? Why should we worry about owing foreigners trillions of pieces of "worthless" paper"
I think the point of concern here is that the dollar is obviously not yet worthless, but the vast accumulation of dollar debt creates a compelling incentive to continue and indeed to accelerate dollar inflation, hastening the day it truly becomes worthless. The collapse of the dollar will likely have devastating consequences on economic activity. This is not something to look forward to. The best we can hope for is an orderly transition to trade based on a market-preferred form of money (i.e. precious metals), but this is very unlikely. We can be assured that governments will resist any such transition vigorously. Say's law also suggests that fiat currency will be the preferred medium of transaction so long as anyone will accept it.
Published: February 15, 2007 9:18 AM
Non-Merc as in NON-MERCANTILIST. The US should be GLAD that these bozo nations adopt mercantilist economic policies trying to race the US to the bottom of currency value.
Look at China and Japan, they are locked in a grudge match over getting their currencies lower in relative value to the US currency. The result of which is:
The US government can accumulate massive deficits and pay for these with dollars of decreasing value that are purchased knowingly by the Japanese and Chinese to keep their currency lower than it would be otherwise.
The result is:
The US economy keeps a boom going despite government deficits and increased regulation.
The Japanese and Chinese people GET SCREWED as their currencies are of less value to the dollar and they get hosed on buying imports.
The beauty of this is that it will not end. There are always nations with large populations of poor people itching to play the same game. These include but are not limited to:
Vietnam
Pakistan
Cuba
Haiti
Domincan Republic
Bangledesh
etc.
Published: February 15, 2007 9:31 AM
Thanks for another excellent article! For those who are still confused by trade economics, I highly recommend this piece from the IMF: Do Current Account Deficits Matter" at
http://www.imf.org/external/pubs/ft/fandd/2006/12/basics.htm
The short answer is that the part of the trade deficit caused by the gov deficit is definately harmful, but it's the smaller part. The rest is extremely beneficial to the US economy and the wealth of Americans.
Published: February 15, 2007 9:31 AM
Correction to my post, I meant Gresham's law, not Say's law in noting that fiat money will remain the preferred medium for transactions as long as it is worth anything.
Published: February 15, 2007 10:00 AM
As Murphy intimates in his second recent article on trade deficits, not all market transactions in the real world (with governments and central banks) are benign. And, I think , therefore, that now everyone agrees that part of the the U.S. liability to foreigners is future income reducing. The only question remaining is an empirical one: How much of the recent trade deficits have been future income reducing, and for those that have been, how many have been for "worthwhile" consumption? Of course, this brings up debates about the value of expenditures in Iraq, etc.
Published: February 15, 2007 10:04 AM
I am only a student of human actions. I believe this article misses the point in the trade deficit and fiat currencies. Mr. Ben Bernanke, an economist and chairman of the Fed, flatly stated that he would inflate money supply. Monetary inflation assists a nation in meeting debt obligations. Currently the estimate is that U.S. M3 is inflating at an 11% annual rate. Aside from the malinvestments, a larger money supply means the dollar is not going to purchase as many real goods or services. I have no idea of what value the US dollar will be with respect to other fiat currencies tomorrow or a year from now, just like any other human, but if Mr. Bernanke inflates the currency, it will loose purchasing power in our real world and thus will be worth less.
Published: February 15, 2007 10:25 AM
I find this Blog an interesting contrast to the article "Do Current Deficits Matter?" which is posted on this web-site under "Working Papers" on the "The list" page.
That paper conveys the impression that the Chinese funding of any deficit is not safe, because at some point it will end and this could lead to credit contraction - which leads to a fall in asset prices.
So there seem to be two "petard" to be hoisted upon. One would be a credit contraction driven by foreclosures beginning in the sub-prime market (anyone else worried about all the lay-offs announced and the recent increase in jobless claims) that would lead to a possible credit contraction. (i.e. supply fatigue)
The other would be a situation where loans from foreigners would no longer be financing the purchase of their goods and services, but would be necessary to pay the interest. I would suggest that this situation would lead to a drying up of foreign credit - another credit contraction possibility.
I am having difficulty, though, in understanding how the FED could deal with the latter case. I suspect that it would happen due to a fatigued consumer who is unable to take on more debt (i.e. demand fatigue).
Any thoughts or comments? In the end I would like to be able to assess the likelihood of either raging inflation or credit contraction.
Thanks.
Published: February 15, 2007 10:42 AM
Graham: "That paper conveys the impression that the Chinese funding of any deficit is not safe, because at some point it will end and this could lead to credit contraction - which leads to a fall in asset prices."
Since the Chinese fund a small part of our trade deficit, we should include the rest of the world in this discussion. At some point, foreign investment in the US has to reach a saturation point. That just seems like common sense. Whether that will be next year, or in 30 years, no one knows. But when it happens, it probably won't be dramatic like the 3rd world crises of the last decade for the reasons mentioned in the IMF article: the US system is too flexible.
All other things being equal, which they won't be, a cooling of the interest in investing in the US will raise interest rates. Helicopter Ben will probably try to counter that with inflation.
"The other would be a situation where loans from foreigners would no longer be financing the purchase of their goods and services, but would be necessary to pay the interest."
That scenario could happen only if our foreign borrowing for consumption exceeded our borrowing for investment, and/or if the US economy failed to grow. The gov deficit causes borrowing for consumption, we know. But it's a small part of the total deficit. How much of the remainder is investment I don't think anyone knows. But that portion of the borrowing that is for investment will pay for itself and earn a profit to help pay for the consumption part. That will be easier if the US economy grows faster than the trade deficit.
Published: February 15, 2007 11:32 AM
"(anyone else worried about all the lay-offs announced and the recent increase in jobless claims)?
Yes, I am. Anyone else notice that every time layoff is announced the stock price jumps?
It should be obvious that there are two economies, the economy of the working class wage owner and the economy of the stock owner. The stock owner can be doing fine while the wage owner is slipping into poverty. The rising tide does not raise all boats. It raises the stock owner's boats. The worker's boats are sitting on the bottom.
Published: February 15, 2007 1:17 PM
Cliff: Currently the estimate is that U.S. M3 is inflating at an 11% annual rate.
Is that really the case? Do you really think prices are "really" increasing 11%, and the effect is hidden? If so, what financial instrument's value tracks the size of M3? I'd like to invest in it.
Published: February 15, 2007 1:18 PM
"Cliff: Currently the estimate is that U.S. M3 is inflating at an 11% annual rate.
Is that really the case? Do you really think prices are "really" increasing 11%, and the effect is hidden? If so, what financial instrument's value tracks the size of M3? I'd like to invest in it."
Cliff and Person:
If money supply is increasing at x% (11 or 13, pick your poison) then there would be inflation if ALL prices were increasing. What appears to be happening is that some prices are increasing (services, some domestic products). With the quantity of imports coming from countries who have tied their currency to the USD, this is effectively acting as a bit of a brake on inflation.
So some prices are increasing (the "needs" and services, some are staying the same or falling (the "wants") - what is happening to the extra money? It has to find a home, and that home is in assets - stocks, bonds, real estate, commodities etc... non-consumables, non-tradeables.
If those countries who are pegged to the USD - especially China because it is the (or one of) the largest source of products for consumption in the US - decide to, or are forced to let their currencies strengthen, then this would increase the price on a number of goods that are imported.
If the level of money continues to rise, then the value of the USD continues to fall against the importers to the US, prices keep rising - and at some point the amount of money going into assets drops - unless the money creation outpaces the decline in the USD. In the latter case, asset prices would climb, but the underlying value (i.e. what you could buy outside the US) would remain the same or fall somewhat.
Or, at least that is how I interpret it.
"To reiterate, this type of extreme position is simply false. If an American entrepreneur starts up a new company and issues equity or debt to raise capital from foreigners, then that contribution to the "capital account surplus" is at the same time an addition to the current account deficit. To put it differently, if you prefer that foreigners invest more capital here than Americans invest in other countries, then the rules of accounting force you to favor a trade deficit.[2]"
Mr. Murphy:
I'm not sure I agree with the interpretation that money entering the capital account creates a deficit in the current account.
The end effect may be that, but the actual steps would be something like:
Yen come into the Yen reserve account, dollars are issued and the money is invested in the company.
At some point the Yen would need to be spent on Japanese products or services (by anyone in the US). Dollars would be exchanged for Yen, which would be used to purchase the goods or services.
Because of accounting, the first transaction would increase the capital account. The second transaction would "decrease" the current account.
So one transaction does not affect both accounts, apparently.
Also, money enters the capital account through the issuance of debt to foreigners. But the interest paid on that debt, later, is part of the current account.
As you have mentioned or implied in your comments after the blog: In effect the debt is being used to fund consumption. As consumption increases, debt increases by a greater nominal amount because of the interest being paid, and interest continues to grow. So even if consumption drops, but less than the growth in interest, increasing amounts of foreign funding (this could be investment - but look what happened when the chinese tried to buy an American oil company) are required - so either assets are being sold, or more debt is being taken on.
An intersting question is: How long will increasing amounts of foreign savings be lent to the USA if it is not going towards consumption of products from those same countries, but rather to pay interest?
Even foreign aid seems to be tied to purchases from the country providing the money.
It seems you're saying that this will be inflated away (how else to get rid of an onerous debt burden). Assuming that US consumers and businesses still have capacity to borrow, this may work. Otherwise, the USD may become the next carry trade for continuing to prime the global pump, and another region will take over as the consumer of choice.
I wonder how this will all fall out, and if the middle class will be crucified as all their assets and promised pensions disappear into nothing. (In the Weimark republic circa 1923, inflation was so rapid, that the printing presses apparently couldn't keep up with the demand for money. At the end of inflation, all the marks in circulation were only enough to buy a single newspaper.)
To avoid this, it seems that there has to be a credit crunch. What US political party wants to face the wrath of an entire boomer generation scorned and broke!
Regards,
Graham.
Published: February 15, 2007 2:00 PM
I recently wrote an essay about the trade deficit and the Chinese:
"I don’t know if the Chinese government has a long term plan to dominate the world like some James Bond villain, but their mercantilist impulses have consequences for the US economy and sovereignty. The number of grandstanding, populist politicians demanding that the Chinese revalue their currency up against the dollar grows by the day. These economic ewoks believe our trade deficit with China will magically disappear if only the Chinese will allow the Yuan to appreciate. And everyone knows that the trade balance is the vital sign that signals economic health…right? Well, not exactly."
You can read the rest at http://alhambrablog.blogspot.com/2007/02/theyve-got-us-by-theassets.html
Published: February 15, 2007 2:23 PM
Mr. Murphy,
As I'm sure you expected to hear from "one of the more vocal critics," let me not disappoint by saying, first of all, that I'm not an economist, nor do I play one on TV. Rather, I am but a lowly entrepreneur who daily laments the vast amounts of "money" spiraling out of sight and into an alternate universe of carry trades and derivatives markets, producing not wealth but the illusion thereof.
Beyond that, I have nothing to add to my earlier remarks other than to point you to a couple of recent articles and to thank "Bill, Non-Merc" for his post, that you might reflect on the "beauty" of billions of poor people "GET[ING] SCREWED" on a daily basis. For however true this is -- not just for the poor and not just in Japan and China -- if it does "not immediately inform us as to the strength or weakness of our economy" (though I for one believe it speaks volumes), it surely informs us as to the strength or weakness of our country.
http://www.atimes.com/atimes/China_Business/IB15Cb03.html
http://www.financialsense.com/editorials/navarro/2007/0204.html
Published: February 15, 2007 2:25 PM
Being one of those Austro-libertarians who argue for the view that RPM , I feel obliged to comment. While it is great that he finally acknowledges the role of currency interventions from China (and many other countries too) while also pointing out that the Chinese people are the big losers (that is why I have always argued for a stronger yuan from the perspective that it would benefit China) from this, the article also contains numerous flaws:
1)The article fails to adress the way that ABCT-type inflating increases the trade deficit.
2)He attacks the argument that trade deficits are only sustainable for a shorter period, an argument that may have been raised by Paul Craig Roberts or other protectionists, but as far as Austro-libertarians are concerned, this a straw man theory. Of course trade deficits driven by sound factors are sustainable. And indeed, even unsound trade deficits may be sustainable as long as they're not too large (In the same sense that government intervention in general is sustainable as long as it is not too extreme). But that does not alter the fact that trade deficit could be a symptom of government intervention, which is what RPM:s Austro-libertarian critics argue.
3)The article's argument against the effect of the budget deficit on the trade deficit is only valid against the "identical twin deficit"-theory, a straw man theory held by few, if any, people. Of course, there are a lot of other factors involved. Indeed, there is one factor -the business cycle- which will have opposite effects on the trade deficit and the budget deficit. A boom will increase the trade deficit and reduce the budget deficit, while a bust will have the opposite effect.
But that a third factor have the effect of driving the budget deficit and the trade deficit in opposite directions and so seemingly create a empirical pattern of no or negative correlation between the two, does not take a way the fact that an increase in the budget deficit will, ceteris paribus, increase the trade deficit.
Published: February 15, 2007 2:36 PM
Problem with those trade and SNA statistics is that they deal only with the aggregates; very meaningfull information is hidden inside of those statistics.
We know that government has its statistics which say how much it has made investments during the year , but are these investments any value for ordinary people? Government purchases battleships, fighters, tanks etc and all these are stuff which has limited value outside of military.
Of course considering world order where one nation can get free meals just by issuing green papers seem to be very funny idea except that it contains some truth.
I dont have illusions that I could explain why and when US economy will sink since theories which we have now are very incomplete and often clearly wrong too..
Published: February 15, 2007 2:39 PM
Murphy:
Mr. Murphy, you're apparently minimizing an important fact. Economics is a function of jurisprudence, not vice versa. The more reliable laws are, the more free and productive an economic system can be. The more laws are unjust, the more destitute the economy, on the whole. Of course there are always some who prosper even in a bad system, usually those who help to prop it up. True, the "market can ... overcome the obstacles put in place by the politicians", as long as people are willing to allow themselves to be screwed yet another time. But at some point, people will get fed up, regardless of "the efforts of ... entrepreneurs to make ... lives better".
"Unjust laws are not laws." - Augustine (De Lib Arb, i, 5)
Basic Jurisdictional Principles
Published: February 15, 2007 3:42 PM
Graham: I still don't know what asset I'm supposed to invest in whose total return tracks M3. A basket of commodities? A real estate index?
Published: February 15, 2007 3:46 PM
Stefan wrote:
2)He attacks the argument that trade deficits are only sustainable for a shorter period, an argument that may have been raised by Paul Craig Roberts or other protectionists, but as far as Austro-libertarians are concerned, this a straw man theory.
Peter Schiff himself emailed me after my previous article (on him) and said exactly this. David White was quite beside himself that Mises.org ran my hatchet job on a real Austrian like Schiff.
So either I'm not attacking a strawman, or David White was wrong to consider Schiff an Austrian. I'll let you two decide.
Published: February 15, 2007 4:14 PM
Person: "I still don't know what asset I'm supposed to invest in whose total return tracks M3. A basket of commodities? A real estate index?"
While it's correct that the Fed's monetary inflation will cause asset price inflation, I haven't found any asset that's a consistantly good buy. It seems that people with money rotate between stocks, bonds, real estate and commodities. For example, when the stock market got expensive in 2000, many wealthy investors got out before the crash and invested in real estate and commodities. Now that those have crashed, they may go back to the stock market. The ideas is that the excess money the Fed creates sloshes around between asset types. Probably the best idea is to put your money in the asset class that is doing th worst at the moment, a type a value investing.
Published: February 15, 2007 4:37 PM
Excuse me, Mr. Murphy, but I was indeed "quite beside [myself] that Mises.org ran [your] hatchet job on a real Austrian like Schiff," and I very much appreciate his acknowledgement of this fact.
What is it that you don't get here?
Published: February 15, 2007 5:05 PM
And while you're absorbing the real meaning of Schiff's reply, let's look at what he had to say today regarding two Austrian mining firms' potential purchase of Alcoa:
"By running huge trade deficits, Americans are literally selling cows to buy milk. Alcoa is just the latest heifer headed for the auction block. In other words, because we do not trade enough domestically manufactured consumer goods for those we import, we are making up the difference with our assets instead. To the extent that foreigners are tiring of buying more Treasuries and mortgage-backed securities, they are casting their eyes on industrial assets. Last year’s trade deficit alone provided foreigners with enough dollars to buy twenty Alcoas. ... It is astounding that so many fail to see the sale as further proof of America’s economic decline. In his testimony yesterday before the Senate Banking Committee, Fed Chairman Ben Bernanke showed little concern for the trade deficit and its implications for the American economy. If our economy really was as strong as Mr. Bernanke believes, Alcoa would be buying foreign companies, not the reverse. Nations with strong economies use their trade surpluses to acquire choice foreign assets. Nations with weak economies are forced by their trade deficits to surrender those assets." -- http://www.financialsense.com/fsu/editorials/schiff/2007/0215.html
Published: February 15, 2007 5:30 PM
"Without the influx of their savings, US interest rates would be higher than they are now."
If that were the case then the BOJ and the PBOC would not need to intervene in the forex market, it is precisely because there is no private demand for these assets that foreign central banks are holding the bid on U.S. debt.
"And contrary to the claims of some Austrians, it is not a Misesian boom-bust cycle if a foreigner (even a foreign central bank) lowers interest rates by providing real savings."
You cannot seriously be this confused as to the nature of savings. Printing pieces of paper does not constitute savings, thus a central bank cannot ever supply real savings.
Your article is all over the map RPM, first you say that trade deficits are not apriori a product of fiat money/FRB malinvestment, but acknowledge that they could be, and that each particular case must be established empirically. The you give us the empirical evidence: i.e. that central banks ARE actively intervening in the forex and government debt markets and by your admission this does cause distortions in trade. Yet you somehow manage to avoid drawing the obvious conclusions from economic theory, namely abct. Instead you dance around the issue by claiming it's "good" for americans and that while the financial system may be unsound it's not on the edge of a precipice. In the end your article is pointless, you sidestep all the real issues, you admit to all the same truths that the "doomsayers" claim and yet provide no explanation why these global FCB driven malinvestment booms and distortions are not going to end in a bust. If the point of your article was to say that Peter Schiff was not rigorous enough in his economic analysis of the trade deficit then you've succeeded. However, I can tell you that I have spoken to him personally and he does not believe trade deficits to be a problem apriori.
Published: February 15, 2007 5:41 PM
David White said,
It is true that many American assets have been sold to foreigners in recent years. From the tone of your post, I gather that you find this to be a bad thing. I disagree. Let's analyze the situation.
I believe we can accept these premises without controversy:
Your claim, if I understand it, is that the United States is in fact engaging in these activities. Thus, you quoted the article that gives an example of certain Americans selling assets.
I too accept the three premises above; I disagree, however, with your conclusion because I believe I can empirically falsify your other premise that Americans are engaging in these activities.
The net worth in 2005 dollars of all American households in 1990 was ~$30 trillion (~$35 trillion assets and ~$5 trillion liabilities). By 2005, liabilities had grown by ~$7 trillion, but assets had grown by ~$29 trillion giving a new net worth of ~$52 trillion.
The tangible result of the current account deficit/capital account surplus is that as of 2005, foreigners had ~$2.5 trillion more claims on Americans (e.g. corporate bonds, T-Bills, etc.) and ownership of American assets than Americans had claims on foreigners and ownership of assets abroad. Even with this, however, Americans increased their wealth by ~$29 trillion. This is hardly comparable to selling all one’s cows to purchase milk. If you must use an illustration containing cows, you might imagine a farmer who doubles the size of his farm and then sells 5% of his cows. Selling 5% of your cows to raise money while having such a magnificent business season is completely understandable. It is in no way unsustainable nor can it be construed as even being a remotely bad thing.
Your conclusion is incorrect because your premise has been falsified. Americans as a whole are not selling assets/acquiring liabilities and decreasing their net worth just to finance consumption. Assets have increased faster that liabilities have i.e. net worth has gone up.
What do you think? Have I made any errors here?
Published: February 15, 2007 8:03 PM
I have to say Mr. Murphy, that I think you time getting a PHD in Econ has blurred the clear mind I remember reading in articles published in the late 90's.
Firstly, the trade deficit is a sale of our seed corn. Alcoa is on the auction block, and Australia is bidding. Daimler-Chrystler is planning on killing 10's of thousands more manufacturing jobs in the United Hates. How are they going to sustain their debt saying "You want fries with that?" at their new job (provided they speak Spanish as most of those jobs go to illegals).
Second, you seem to be unaware that the UH dollar has value as an international means of exchange, because oil is traded in it, and other nations need it to buy oil. If the oil producers accept Yuan for oil, the Chinese do NOT need dollars. What will happen if they dump their dollars? Hyperinflation as the fed monetizes the debt? I think so.
Thirdly, an historical analogy is available. Between the first war to end all wars and the second, the British Empire collude with the UH to return the pound to pre-war valuations. This lead to, at first an investment the speculative bubble in the UH, and in Britain. However, the British lost much industrial capacity, while the UH gained. The same is occuring now, only the UH is the loser and Asia is the winner. The big problem with this analogy is that much of Asia is neutral/hostile to the UH.
Fourthly, consolodation and alliances between some semi-hostile to hostile nations is a brewing. The Shrub-boy Maladministration is doing it's damndest to start a third war. This does not portend well with the precarious position UH gov and UH finances are in.
Finally, UH savings has been negative for nigh unto two years. You can't consume more than you make unless you burn through your savings. UH capital IS being consumed. You can't consume capital and grow...only decline.
I'm sorry in advance for typos and spelling mistakes. This is off the head and I don't feel like proofing. It's late and I'm tired.
Published: February 15, 2007 9:38 PM
Gabriel:
"The net worth in 2005 dollars of all American households in 1990 was ~$30 trillion (~$35 trillion assets and ~$5 trillion liabilities). By 2005, liabilities had grown by ~$7 trillion, but assets had grown by ~$29 trillion giving a new net worth of ~$52 trillion."
I also agree with your 3 statements about what is bad.
Unfortunately, the increase in household worth is not due to an increase in value, but an increase in price.
Think of it this way. If the total assets are 100 widgets, then they remain 100 widgets whether their cost is $1 each or $10 each.
In other words, the net household worth that has increased is due to too much liquidity chasing the same or fewer assets.
The fact remains that the current account deficit reflects greater consumption than sales (including interest being paid). I would feel better if a lot of that "consumption" were for equipment and technology being used by business. Unfortunately, it is for goods and services that are being consumed.
The only way to pay for that extra consumption over sales is to borrow, or sell assets. This condition is exacerbated when the borrowing or asset sales start being used to pay interest and not just a difference in consumption.
Instead of measuring household worth in dollars, measure it in a non-southeast Asia (since they are pegged to the dollar) trade-weighted currency index, or even gold. You may find that the assets have not increased in value as much as thought.
China (and possibly other countries) are facing a dilemna brought about by their pegged currencies. Too much money growth from the exchange of local currency for dollars being earned from sales to the USA. So long as domestic-destined production of goods and services grows, this moderates inflation. But if they don't grow, then this creates inflation as all prices rise. China (and others) have 2 choices to resist the tidal wave of money: 1. Issue debt in the local market and soak up cash - but this has the effect of increasing interest rates; and 2. Increase the bank reserves required: this is cheaper than issuing debt and also takes money out of circulation - by reducing the velocity of money.
Without the adjustment to the currency that China (and others) may need, there will be those local inflationary pressures - especially as most growth in production seems destined for export.
Where am I going with this? good question!
Bottom line is that according to the balance of payments, the USA is financing its consumer binge with debt and asset sales. Most of this debt is not self-liquidating. (Borrowing money for equipment that makes widgets is self-liquidating because the sales of the widgets made from the equipment can pay down the debt. Borrowing money for a house is self liquidating because the owner is effectively "renting" from themselves. i.e. buying a second unit that is rented is self-liquidating. Borrowing money for a vacation, or for a car is not self-liquidating. It is using money from the future to pay for goods and services now. And, these activities will not by themselves generate any income to pay off the debt.)
So, the end can come in two ways.
1. Supply or Demand driven credit contraction. (Consumers can't borrow any more or banks can't lend anymore in tangent with debt defaults.
2. An end to easy money as foreigners realize that the USA is borrowing money to pay interest while purchases of goods decline.
3. Inflation spiral in China which pushes the USA into its own inflation - followed by the usual blunt hammer cures.
4. Pick any other scenario which means the world's lungs have run out of air and can't keep the balloon going.
In a case of credit contraction, asset prices fall. THe underlying "Value" may remain the same, but in currency denominations they cost less. And this continues until some form of equilibrium is established (i.e. Japan where the royal palace was worth more than Canada (don't know if this is annual GDP or value of assets and the resulting deflation over the last 15+ years).
In the case of inflation, it depends how rapidly us regular people figure out what is going on. In the beginning it can push up asset prices without impacting tradeable goods and services. But in the end, only debtors win. If inflation is coming and looks big - borrow long to the hilt and buy real assets like houses, gold ect.... Inflation will push incomes up in nominal terms to where the debt is a small percent of income.
If deflation is coming. Avoid debt, sell assets, put them in a store of value and wait for the bottom to start buying again. I have seen it written that gold actually does quite well in a credit contraction. I don't pretend to undersand why and I will have to think about it a bit.
Graham.
Published: February 16, 2007 7:54 AM
Person: "I still don't know what asset I'm supposed to invest in whose total return tracks M3. A basket of commodities? A real estate index?"
As Mr. Murphy says, buy what is out of favour, because if the growth in money translates into inflation it will raise all boats. In fact as I said in an earlier post, if inflation expectations are increasing (meaning your wages will start to rise as a result) then load up on fixed interest rate debt that has a longer term maturity, and buy an asset that is good value.
M3 increasing now cannot be played directly. Part of it is causing some price pressures on goods and services from non-pegged currency countries, and the rest is sloshing around in various assets (as alluded to by Mr. Murphy). Typically the cycle is business, real estate, stock market, bust! We've had an internet bubble, a real estate bubble, and now stock markets going up no matter what. Remember Asia.
Things tend to keep going as they are for a long time. Usually some external event forces a change long before the end has been naturally reached.
I am leaning more toward a credit crunch - but you know that every vested interest around the world will try to prevent this. So I remain torn between coming hyperinflation and coming credit crunch.
You might want just to pick a foreign currency where its money supply is not growing as rapidly as the USA and it has real and growing productive capacity and not just paper assets.
Sorry I can't be more help, but it's still just a crapshoot.
Graham.
Published: February 16, 2007 8:04 AM
Doesn't the malinvestment happening here worry anyone? If capitalism is a need discovery and fulfillment mechanism in its broadest sense, then what is happening here is grossly wrong signs being sent everywhere.
Instead of concentrating on fulfilling the needs of hardworking chinese the market mechanism due to these government distortions is turning to fulfil the needs of americans who are buying houses. How many man-years of misdirected effort is going on here? If this malinvestment is causing savers to be discouraged and spenders and speculators to be encouraged, how much has this impeded future research and development?
Published: February 16, 2007 8:41 AM
Gabriel: "Have I made any errors here?"
No! You did an excellent job. It's true we're selling cows to buy milk, but as you wrote, we're also raising a whole lot of new cows while purchasing many cows at other farms at the same time.
If the entrepreneurs and businessmen in the US see opportunities to invest, but Americans don't save enough to finance those investments, what's wrong with borrowing from foreigners or selling assets to them to finance the growth? Fear of foreign ownership smells a lot lack fascism to me.
Published: February 16, 2007 9:06 AM
Gabriel: "Have I made any errors here?"
RogerM: "No! You did an excellent job. It's true we're selling cows to buy milk, but as you wrote, we're also raising a whole lot of new cows while purchasing many cows at other farms at the same time."
Guys, read the excerpt from Bernankes recent testimony below. One key phrase is "...what causes inflation is monetary conditions or financial conditions that stimulate spending which grows more quickly that the underlying capacity of the economy to produce. Anything that increases the economy to produce, be it greater productivity, greater workforce, other factors that are productive, is only positive. It reduces inflation."
This appears to agree with what you are saying. The only catch would be: Is the money flowing in being used to increase productive factors, or is it simply being used to consume with the productive factors being increased overseas?
Graham.
MR. PAUL: The other question I have deals with a comment made by one of the members of the Federal Reserve Board just recently. He made a statement which was a rather common statement made. He expressed a relief that the economy was weakening, mainly – inferring that the weakening economy would help contain inflation. And I hear these comments a lot of times, the economy is too strong, and therefore we need a weaker economy. If this assumption is correct – would you agree that this assumption – that a weaker economy is helpful when you are worried about inflation?
MR. BERNANKE: Congressman, as I talked about in my testimony, we need to go to a sustainable pace. We need to have a pace which matches the underlying productive capacity; that will probably be a bit less robust than the last few years, because over the last few years we were also reemploying underutilized resources, and going forward we don’t have that slack to put to work.
MR. PAUL: But if you accept the principle, as it seemed to be in this quote, that if you are worried about inflation, you slow up the economy, and then inflation is brought down, it is lessened, it infers that inflation is caused by economic growth, and I don’t happen to accept that, because most people accept the fact that inflation is really a monetary phenomenon. And it also introduces the notion that growth is bad, and yet I see growth as good. Whether it is 3 or 4 or 5 or 6, if you don’t have monetary inflation, we don’t need to worry, because if you have good growth in the marketplace rather than artificial growth, that it is this growth that causes your productivity to increase. You have an increase in productivity, and it does help bring prices down, but it doesn’t deal with inflation.
And I think what I am talking about here could relate to the concerns of the gentleman from Massachusetts about real wages. There is a lot of concern about real wages versus nominal wages, but I think it is a characteristic of an economy that is based on fiat currency that is just losing its value that it is inevitable that the real labor goes down. As a matter of fact, Keynes advocated it. He realized that in a slump, that real wages had to go down; and he believed that you could get real wages down by inflation, that the nominal wage doesn’t come on and keep the nominal wage up, have the real wage come down and sort of deceive the working man. But it really doesn’t work because ultimately the working man knows he is losing, and he demands cost of living increases.
So could you help me out in trying to understand why we should ever attack economic growth? Why can’t we just say economic growth is good and it helps lower prices because it increases productivity?
MR. BERNANKE: Congressman, I agree with you. Growth doesn’t cause inflation; what causes inflation is monetary conditions or financial conditions that stimulate spending which grows more quickly that the underlying capacity of the economy to produce. Anything that increases the economy to produce, be it greater productivity, greater workforce, other factors that are productive, is only positive. It reduces inflation.
Published: February 16, 2007 9:23 AM
Gabriel: "Have I made any errors here?"
RogerM: "No......"
Just because U.S. real net worth increases does not imply that all transactions that might affect the balance of trade are good (or benign). I thought everyone agreed on that point, but apparently not.
Published: February 16, 2007 10:36 AM
Alex: "Just because U.S. real net worth increases does not imply that all transactions that might affect the balance of trade are good (or benign). I thought everyone agreed on that point, but apparently not."
Agreed!
Hey guys, take a short break and read this hilarious satire of econ: http://unicast.org/enclosures/life-econ-crop.pdf
Published: February 16, 2007 10:41 AM
Graham: "Is the money flowing in being used to increase productive factors, or is it simply being used to consume with the productive factors being increased overseas?"
That's the $64,000 question! We know for certain that the "money flowing in" to support the Fed budget deficit is for consumption only. I think that is roughly one-third of the trade deficit. The part that goes toward corporate stock/bonds or direct investment (such as buying Alcoa), is definately for productive purposes and will make us richer in the future. However, some might be going to banks for them to loan to consumers to, well, consume. I don't know of any analysis that can separate out the proportions of the latter two categories.
Published: February 16, 2007 10:50 AM
RogerM, I put that Axel Leijonhufvud's quate about the tribe of "Econ" into third page of my master thesis in economics and also funny cartoon ("How to do math econ !
Professor didnt like it at first, but it stays there as long my university keeps those theses!
Published: February 16, 2007 10:57 AM
Mr. Paul: "He expressed a relief that the economy was weakening, mainly – inferring that the weakening economy would help contain inflation."
Mr. Bernanke: "Growth doesn’t cause inflation; what causes inflation is monetary conditions or financial conditions that stimulate spending which grows more quickly that the underlying capacity of the economy to produce."
Mr. Paul is expressing the neo-classical business cycle view that shocks happen to the economy to cause it to grow too fast or too slow. Those shocks are like "acts of God" such as tornadoes. They just happen and have no explanation. Growth above the "natural rate" causes inflation because workers demand higher wages.
Helicopter Ben is expressing the monetarist view of inflation: if the money supply grows faster than production, inflation results. But he also believes that if production grows too slowly, i.e., below the natural rate, and prices fall, he can fly to the rescue with his helicopter spewing out dollars like confetti.
The Austrian Business Cycle Theory, ABCT, is the correct view and incorporates some of the insights from both the neo-classical and the monetary theories while enriching both.
On the trade issue, the money coming in from foreigners is not necessarily new money which increases the money supply; it's old money that we initially spent on imports. When we spent it on imports, that spending reduced the money supply in the US as those dollar left the country. When those same dollars return as investment, they simply replace the dollars that left to buy imports. So foreign investment doesn't raise the money supply; only the Fed can do that. That's not to say that the Fed has no impact on the trade deficit. When the Fed expands credit artificially through fractional banking, the money supply increases and the increase in nominal income causes an increase in imports.
Theoretically, if the Fed came to its senses and opted for small, regular deflation, Americans would save more, consume less and import less. Therefore, if foreigners wanted to invest in the US, they would have to lower their prices, too, in order to attract US consumers.
I think the issue becomes clearer if you think of foreign investors, such as China, as just another state of the US. Say the US is Florida, a primarily service oriented state, and China is Michigan, a primarily manufacturing oriented state. Trade enriches both states as each supplies what the other lacks. Florida has a trade deficit with Michigan, but a capital surplus. No problem. And we're all aware the problems of malinvestment that credit expansion can cause in both states. But the problem is not the trade deficit/capital surplus that Florida has with Michigan; it's the destruction of wealth caused by the Fed's credit expansion. And the Fed doesn't cause the trade deficit, but it can aggravate the situation by causing malinvestment which eventually leads to a recession.
Published: February 16, 2007 11:27 AM
It should be obvious that there are two economies, the economy of the working class wage owner and the economy of the stock owner. The stock owner can be doing fine while the wage owner is slipping into poverty. The rising tide does not raise all boats. It raises the stock owner's boats. The worker's boats are sitting on the bottom.
As long as the government keeps inflating the stock of money, this will continue to be the case. Working people do not realize just how really destructive is the monetary policy of their country, and how devious are politicians when shifting the blame towards "the rich" to justify their own criminal acts.
Published: February 16, 2007 11:33 AM
Adi, Thanks for the link to the cartoon. It's great! Keep up the resistance!
Published: February 16, 2007 12:30 PM
Graham, I believe the crux of your response to my post can be boiled down to this quote of yours:
You are claiming that the increase in net worth measured in dollars is only an illusion caused by excess in the number of dollars in circulation. I agree that there has been an excessive amount of dollars created, but I disagree with your conclusion that the increase in net worth is entirely illusory.
We can determine who is correct by measuring net worth in something other than dollars. Has the amount of “stuff” we have increased? If so, then your conclusion is false. Consider manufacturing output per hour of work. Between 1990 and 2006, output/hour increased by ~94%. Compare this to the ~96% increase in net worth over this period. The two figures match nearly perfectly.
You ask,
In 2005, our GDP was about ~$12.4 trillion. It consisted of the following:
16% of GDP was spent on investment. This is actually up slightly from 15% in 1990 (GDP total: ~$5.8 trillion):
We have not decreased the percentage of our GDP that we devote to investment. If we were using the inflowing money as a basis for more consumption, it would result in a smaller percentage of our GDP going to investment. This is not the case.
Conclusions: an expanding money supply is certainly not the sole cause of increased net worth of American households, and capital flows into the country are not being used as a basis for consumption.
What do you think?
Published: February 16, 2007 2:46 PM
Gabriel, Thanks for the data. Very interesting. Keep in mind, too, that the GDP undercounts capital spending. You might want to look up article by Dr. Reisman on how the GDP does that by attempting to avoid "double counting." Instead, the GDP counts mostly consumption, so instead of Gross Domestic Product, it should read Net Domestic Product. The BEA has recognized this problem and added a separate accounting of domestic production it calls GO, Gross Output. Investment is considerably large in GO.
Published: February 16, 2007 3:25 PM
RogerM:
"When the Fed expands credit artificially through fractional banking, the money supply increases and the increase in nominal income causes an increase in imports.
Theoretically, if the Fed came to its senses and opted for small, regular deflation, Americans would save more, consume less and import less."
Is this really part of the ABCT? A couple of problems:
Money supply effects are offset by changes in purchasing power/exchange rates, so why would imports increase with more money? Doesn't seem right to me.
Deflation would likewise have no necessary effect on trade. I'm not even buying that saving and consumption (for all but government) would be affected. Any increased costs in the domestic creditmarket would for example be met by cheaper credit abroad.
But i'm new to the ABCT, so please educate me if i'm missing something.
Published: February 16, 2007 9:44 PM
Gabriel and RogerM,
I'm late in replying to Gabriel's figures on investment, etc., so probably nobody is going to read this. Anyway, the main problem with Gabriel's figures are that they are gross, not net. There are other problems, such as excluding government investment, using GDP rather than net national income to relate investment to, etc.
However, the main problem is that gross investment does not reflect increases in the stock of capital goods available for future production. The concept that does is net investment=gross investment - wearing out of existing capital goods (depreciation). The estimates of net investment for 1990 and 2005 are as follows: 1990 net I=$861 bill-$552 bill=$309 bill; $2005=2057-1353=$704 bill. In 1990, of the $309 bill net investment, $54 bill. was financed by foreigners, meaning $255 bill was financed by domestic saving. In 2005, $704-$619=$85 bill. was financed by domestic saving. If you wish to relate these figures to GDP (though relating them to net national income makes more sense, since we usually relate saving to income) the 1990 figure represents 4.4%; the 1990 figure represents 0.7%.
RogerM, GDP represents the production value added by each producing entity. From "gross output" (for a business entity gross output would be the sales figure) the value of inputs used of other firms must be deducted (since these would be the sales of other firms). Consequently, gross output cannot be used to measure investment.
Published: February 17, 2007 10:16 AM
Push may finally be coming to shove with the December 2006 TICs report, as I expect that the net outflow of capital is not an anomaly but the beginning of a trend:
http://www.reuters.com/article/reutersEdge/idUSN1535653620070216?src=021607_1155_INVESTING_comment_n_analysis&pageNumber=1
If so, then the Fed will have no choice but to buy US Treasuries to cover the fiscal gap, sending bond yields higher and therefore interest rates, which in turn will worsen the housing collapse and drive the economy into recession. Stagflation, in other words, and possibly even a hyperinflationary one.
Let's be clear: In a sound money economy, a truly wealth-producing people would be exchanging their gold-money for foreign assets on an ongoing basis and getting wealthier in the process. And insofar as any of their exchanges were financed via debt, that debt would be production-and-savings based, not what we have today -- i.e., consumption financed via endless credit expansion made possible by the massive foreign purchases of government debt. And once China starts to shift out of debt and into equities, it will be clear (not that it isn't already to those whose eyes aren't wide shut) that the trade deficit represents nothing other than a fire sale of America, precisely as Peter Navarro said in his recent testimony before Congress -- http://www.financialsense.com/editorials/navarro/2007/0204.html -- and about which he subsequently wrote: "The hearing I testified at was before the House Ways and Means Trade Subcommittee, and my fellow witnesses were very interesting to listen to [http://waysandmeans.house.gov/hearings.asp?formmode=detail&hearing=525]. Lots of 'war stories' from the front line of Chinese mercantilism and the devastation it is causing in American industry."
Published: February 17, 2007 10:25 AM
Suffice it to say that the only libertarian member of Congress "gets it" -- http://www.lewrockwell.com/paul/paul370.html -- even if pseudo-libertarian Robert Murphy does not.
And again, shame on the Mises Institute for publishing his pernicious deficits-don't-matter nonsense.
Published: February 17, 2007 10:38 AM
David White- I have just read your last 2 posts,can you tell me if it is legal for the fed to directly purchase new govt bonds and T bills?
I was under the impression it never has been legal, except for a brief period during WW2.
Published: February 17, 2007 11:04 AM
Mikey, there is no difference between the Fed engaging in open market purchases of existing government bonds and directly purchasing newly issued government bonds. In both cases, the Fed is financing government spending.
Published: February 17, 2007 11:54 AM
zaphod wrote:
I have to say Mr. Murphy, that I think you time getting a PHD in Econ has blurred the clear mind I remember reading in articles published in the late 90's.
Hey, that's Dr. Murphy to you.
Published: February 18, 2007 1:16 PM
David White wrote:
Excuse me, Mr. Murphy, but I was indeed "quite beside [myself] that Mises.org ran [your] hatchet job on a real Austrian like Schiff," and I very much appreciate his acknowledgement of this fact.
What is it that you don't get here?
1) In my article I tackled the claim that trade deficits can't be sustained. E.g. I pointed to a 30-year period in the 1800s when there were almost uninterrupted trade deficits.
2) Stefan above claimed that this was a strawman, and that no Austro-libertarian ever said that trade deficits were unsustainable.
3) I pointed out that Peter Schiff emailed me in response to my previous article, and said that trade deficits were unsustainable.
4) I pointed out that you, David White, claimed that (unlike me) Schiff was a real Austrian.
Do you see my point now? Either I wasn't attacking a strawman, or Schiff isn't an Austrian.
Published: February 18, 2007 1:20 PM
Where are you guys getting the Ron Paul stuff? I can't find it using Google. It's great though.
Published: February 18, 2007 1:30 PM
Try this link:
http://www.lewrockwell.com/paul/paul-arch.html
Published: February 18, 2007 2:43 PM
I don't see anything about his cross-x with Bernanke there.
Published: February 18, 2007 3:02 PM
I can't find a transcript of that cross-x on the Web myself. The Fed's transcription stops at the point where the Congressional questions begin, and there's nothing on the testimony in the Clerk of the House's round-up. The only avenue I can suggest is contacting the office of Rep. Paul and asking for a copy of that cross-x.
Published: February 18, 2007 3:33 PM
Can you expand on that "etc"?
You have a point there. I did not consider that.
Can you point me to your source for the figures on how much was financed by foreigners?
I'll keep chewing on all this.
Published: February 18, 2007 9:03 PM
Ron Paul also has a weekly column called "Texas Straight Talk":
http://www.house.gov/paul/legis_tst.htm
Published: February 18, 2007 9:08 PM
Ron Paul: "Few understand that our consumption and apparent wealth is dependent on a current account deficit of $800 billion per year. This deficit shows that much of our prosperity is based on borrowing rather than a true increase in production."
This is what we've been debating, and I, along with RPM and other disagree. Some of the trade deficit is bad, i.e., that part that is caused by the budget deficit. But the rest is good because it's investment that increases production.
Paul: "Statistics show year after year that our productive manufacturing jobs continue to go overseas."
Simply not true! And easily proven wrong. Just visit the BEA web site and look at the historical output of manufacturing in the US in real dollars. We're at an all-time high right now and have rarely suffered a down-turn except during recessions.
Marcus: "Money supply effects are offset by changes in purchasing power/exchange rates, so why would imports increase with more money? Doesn't seem right to me. Deflation would likewise have no necessary effect on trade. I'm not even buying that saving and consumption (for all but government) would be affected. Any increased costs in the domestic creditmarket would for example be met by cheaper credit abroad."
Increases in the money supply cause consumption to increase proportionally, and since imports are part of consumption, they increase as well. This is standard econ agreed upon by Keynesian, Monetarists and Austrians. Also, part of the trade deficit is due to the fact that Americans don't save as much as businesses demand for investments. Increased savings would help meet that demand, reduce borrowing from overseas and therefore reduce the trade deficit to some degree.
Alex: "GDP represents the production value added by each producing entity. From "gross output" (for a business entity gross output would be the sales figure) the value of inputs used of other firms must be deducted (since these would be the sales of other firms). Consequently, gross output cannot be used to measure investment."
You should read Reisman or Huerta de Soto on the problems with GDP or GNP accounting. Essentially, GDP/GNP count consumer spending. Investment takes place upstream in the capital goods market, which GDP and GNP ignore completely.
As for the differences between net and gross investment, you're splitting hairs. If gross investment increases, so will net investment in proportion because depreciation is a constant. It doesn't matter which one you use to figure investment. And the difference between GDP and GNP in minimal. You'r just nit-picking.
David: "In a sound money economy, a truly wealth-producing people would be exchanging their gold-money for foreign assets on an ongoing basis and getting wealthier in the process."
In spite of the lack of a gold currency, Americans own about $11 trillion in businesses overseas. Foreigners own about $13 trillion in the US. Foreign investments in the US make us wealthier just as our investments in foreign countries make them wealthier. What measure of wealth do you use to claim that Americans are getting poorer?
"And insofar as any of their exchanges were financed via debt, that debt would be production-and-savings based, not what we have today -- i.e., consumption financed via endless credit expansion made possible by the massive foreign purchases of government debt."
The money loaned to us by foreigners is based on savings. They saved and invested in businesses to create export goods. We exchanged dollars for those goods, so those dollars represent the realized savings of foreign investors. Instead of consuming the dollars they get from selling their exports, they save them again by purchasing US assets. What part of that process does not involve saving?
Also, foreign purchases of government debt is not credit expansion. Only banks can cause credit expansion. Huerta de Soto explains that very well. Foregin purchases of government debt is nothing but dollars returning to the US after they left. When dollars leave the US in exchange for imports, the money supply in the US falls by exactly the cost of the imports. When those dollars return, they increase the money supply to the level it was before they left. No credit expansion takes place in international trade. You can blaim only the Fed and US banks for credit expansion, not foreigners.
Published: February 19, 2007 8:43 AM
RPM,
Straw men aside, net outflows of capital in a sound-money economy can't produce trade deficits, since, as Mises rightly said, every trade by definition balances out, and therefore so must the sum thereof. Thus, any trade "deficits" in the 1800s would simply be a reflection of the fact that Americans purchased more foreign goods with their gold-money than foreigners purchased American goods with theirs. But so what? For as long as Americans were producing enough real wealth to do so, they were simply exercising their right to buy where they saw fit, political borders be damned.
Of course domestic producers wanted Americans to buy their products, but there must have been enough of this going on, else the wealth couldn't have been generated to support the capital outflows. This doesn't change the fact, however, that in a sound-money economy, "deficits don't matter" for the simple reason that, like "surpluses," they don't exist.
Where trade deficits DO exist -- and therefore matter greatly -- is in a fiat-money regime like we have today, where Americans' massive purchases of foreign goods isn't being funded via the expenditure of production-based savings -- i.e., with real wealth -- but via credit issued "out of thin air," the dollar's status as the world's reserve currency having been exploited to the point that China's mercantilist policies, however much they give the appearance of "distorting in our favor," are in fact doing no such thing. Rather, they are rapidly turning us into a nation of debt slaves, with our government on the verge of bankruptcy -- http://research.stlouisfed.org/publications/review/06/07/Kotlikoff.pdf -- the more so as China and other countries transition out of the dollar. And if last December TIC report turns out not to be an anomaly but the beginning of a trend, then as Stephen Roach, managing director and chief economist at MorganStanley recently wrote: "With America's external financing needs remaining huge by any standard, it becomes tougher and tougher for the US to attract the requisite capital inflows under the best of conditions. It may well be that we will look back on the December 2006 TIC report as a warning shot of what was to come -- an increasingly difficult external financing climate for a saving-short US economy. The clock is tic(k)ing." -- http://www.morganstanley.com/views/gef/archive/2007/20070216-Fri.html#anchor4410
Indeed it is. So rather than perpetuate the status (as in statist) quo by publishing pernicious deficits-don't-matter nonsense, the Mises Institute should be sticking to its sound-money guns, precisely as Mises would have, the better for readers to understand the true nature of our predicament: namely, that on account of the dollar's coming collapse, precious metals are entering a "Nash equilibrium" whereby "an ideal financial strategy for everyone on Earth is to buy as much gold and silver as they can, as soon as possible." -- http://www.safehaven.com/article-5205.htm
Published: February 19, 2007 8:58 AM
David White: This doesn't change the fact, however, that in a sound-money economy, "deficits don't matter" for the simple reason that, like "surpluses," they don't exist."
This needs a lot more explanation, because it contradicts what you wrote above: "Thus, any trade "deficits" in the 1800s would simply be a reflection of the fact that Americans purchased more foreign goods with their gold-money than foreigners purchased American goods with theirs."
How is a trade deficit not a deficit just because gold is used as money? Frenchmen certainly considered it a deficit, which is why Bastiat wrote his articles explaining the economics of international trade.
White: "Where trade deficits DO exist -- and therefore matter greatly -- is in a fiat-money regime like we have today, where Americans' massive purchases of foreign goods isn't being funded via the expenditure of production-based savings -- i.e., with real wealth -- but via credit issued "out of thin air..."
You seem to be under the impression that the US creates no wealth at all because we use a fiat currency. But the money created ex nihilo through credit expansion is an addition to the wealth created via savings, investment and production. This real wealth works the same way in a fiat money regime as gold would work. RPM's example of a 30-year trade deficit in the 19th century is proof that trade deficits can exist under gold money regimes. Since the ex nihilo money created by credit expansion is a small portion of the total money supply, it's contribution to the trade deficit must be small, too.
Published: February 19, 2007 10:21 AM
David White: "...with our government on the verge of bankruptcy."
This is actually a good thing. Only the threat of bankruptcy had forced Europeans to scale back on the welfare state, and I believe that's what it will take to get Americans to do the same. But keep in mind, it's the STATE that is almost bankrupt, not the country, two very different things.
Published: February 19, 2007 10:27 AM
RogerM,
Since money, properly speaking, is a good used as a medium of exchange, it is necessarily production-based. And since fiat money didn't exist in the 1800s (with the exception of Lincoln's greenbacks), whatever foreign goods Americans purchased, they purchased with sound money (i.e., gold), meaning that real wealth had to have been created beforehand. And if Americans happened to have purchased more goods from foreigners than foreigners purchased from them, the only "deficit" involved was that American producers had fewer customers than they would have liked. But again, there still had to be enough domestic wealth production for Americans to have purchased the goods they did, no matter where they got them from. And since every trade by definition balances out, so does the sum thereof. Hence no "trade deficit," as money-goods were simply exchanged for other goods, each party in every trade deeming it beneficial to have done so, else they wouldn't have traded at all.
Not so with fiat money, since by its very nature a "deficit" is created in that no production, no real work, precedes it. For fiat money -- i.e., irredeemable paper currency -- isn't a good at all but merely credit issued, as you say, "ex nihilo." And since all credit needs debt to fulfill its function, a fiat-based monetary system is accordingly a debt-based monetary system, NO MATTER WHO THE CREDITOR IS. Why? Because the notion that domestic borrowing means that "We owe it to ourselves" is absurd, as future generations are obviously not us anymore than foreigners are.
What has really gotten us into real trouble, however, is that foreigners can do what future generations can't -- demand repayment in the here and now -- which is essentially what they're are going to do as they either dump bonds to buy equities (in which case we'll be "selling cows to buy milk," precisely as Schiff said) or get out of the US economy entirely. Either way, the US government won't be able to fund its operations, which will require the Fed to step in and buy Treasuries to make up the difference. The resulting inflation will drive up interest rates, hastening the housing collapse, which will in turn hasten the economy's collapse, since the borrowing-based consumption that keeps the economy afloat will have lost it line of credit.
Lastly, I never said that the US creates no wealth. Rather, the US creates wealth that, because of the massive indebtedness involved in its creation, it is not going to be able to hold on to. For when foreigners finally pull the plug, down we will go. And we will go down precisely because "the ex nihilo money created by credit expansion" is in fact "the total money supply," the hyperinflation of which will remonetize the precious metals that precious few Americans will have known enough to stock up on.
Which is to say that they'll be just as bankrupt as the government will.
Published: February 19, 2007 12:56 PM
David White: "And if Americans happened to have purchased more goods from foreigners than foreigners purchased from them, the only "deficit" involved was that American producers had fewer customers than they would have liked. But again, there still had to be enough domestic wealth production for Americans to have purchased the goods they did, no matter where they got them from."
You're playing semantic games. In the 19th century, people complained about trade deficits just as your a doing now, even though they paid in gold. You can't make trade deficits in the 19th century go away justy by changing the definition of trade deficits. The same line of reasoning that Bastiat used against those who opposed trade deficits, and championed trade surpluses, when money was gold, applies to your arguments. And those arguments are the same ones that I, RPM and others are using.
You're arguing that production was required in order to obtain the gold with which to purchase imports. And that's true. But a whole lot of the US growth in the 19th century was financed by debt, borrowed from England, or the selling of assets such as stock in businesses.
The only difference between the trade deficits of the 19th century and those today is that we use fiat money today. But fiat money is not the evil; credit expansion is. Fiat money can be just as sound as gold if the government acts with restraint. Credit expansion creates money ex nihilo, and credit expansion has happened for the past 800 years, all but the last century under a gold money standard, according Huerta de Soto.
Published: February 19, 2007 1:24 PM
Graham,
Can you please tell us where you got that Paul/Bernanke exchange? I want to pass it along to some people but I'd rather get it from a more official source than a blog post. (I don't see it on the Ron Paul site either, that Gabriel suggested.)
Thanks,
Bob
Published: February 19, 2007 4:43 PM
Gabriel,
Sorry, I've been away from computer all day. The "etc." I was thinking of was that we should talk in real (inflation adjusted terms) rather than nominal terms, but since you related nominal investment to nominal GDP, I didn't elaborate. Plus, I wanted to emphasize the important point: that we must look at net investment (investment after wearing out (dep'n) has been subtracted). Net investment, as opposed to gross investment, increases net real wealth (the ability to produce future consumer goods). If all of this increase in net real wealth is financed domestically, then domestic residents will enjoy all the future benefits from the wealth. To the extent that foreigners finance real investment, only part of the future benefits are enjoyed by domestic residents. So, as far as future benefits are concerned, the greater the amount of real investment financed domestically, the better.
In 2005, the amount of net investment was about $700 billion, as I stated. Unfortunately, I underestimated the amount of this investment financed by foreigners. I pulled the wrong figure out of The Economic Report of the President, 2007 statistical tables. The figure was not $619 billion, as I stated, but about $700 billion, as you stated. Therefore, in 2005 the amount of net investment financed domestically was $704 bill -$700 bill= Zilch. The same thing may be seen directly by examining "Total net saving" in Table 32B of the Economic Report. This figure was estimated at $7.2 billion. in other words, zip.
Published: February 19, 2007 6:30 PM
RogerM:
With regard to GDP measuring only consumper spending. As the Geico caveman said, "What?" Could you give me a specific reference or explain what you mean.
With regard to your neglect of the difference between gross and net investment, please see my last reply to Gabriel.
With regard to your dismissal of the conceptual and measured difference between GDP and GNP, this fits perfectly with your attitude that current account deficits and foreign liabilities don't matter, and is equally in error.
GDP measures a country's total production of goods and services in a given year, whereas GNP measures the total income of a country's residents. The greater the net foreign liabilities, the smaller is the income of residents in comparison to the production they must generate. Unfortunately, if the U.S. current account deficits combined with zero or negative national savings continue, everyone will come to fully understand this distinction.
Published: February 19, 2007 6:43 PM
Alex: "GDP measures a country's total production of goods and services in a given year, whereas GNP measures the total income of a country's residents."
Not true. Unfortunately, I'm old enough to remember when only GNP existed. Both GDP and GNP are calculated the same. The only difference between the two is that GDP excludes income earned overseas. The differences are very slight.
Both Reisman and Huerta de Soto have chapters that deal with the calculations for GDP/GNP, and both show that the two count primarily consumer spending. This was done on purpose, because the guy who came up with the method was Keynesian and drew up the measure to match Keynes's view that consumer spending drives the economy.
Here's another reference on the subject: http://www.mises.org/journals/scholar/Johnsson2.pdf and http://www.mises.org/story/770
Published: February 20, 2007 8:28 AM
Bob:
I don't remember exactly where I saw it. I read so much.
I will retrace my steps and try to find the link. In future, I will post the link as well. Sorry about that.
Graham.
Published: February 20, 2007 9:12 AM
RogerM,
Read the Shostak and Johnsson references. Frank makes some good points everyone recognizes in regard to measurement of GDP and Johnsson article was difficult for me to understand, since his definition of certain variables were vague to say the least.
Reminding you of what you said, "Essentially GDP/GNP count consumer spending. Investment spending takes place upstream [whatever that means] in the capital goods market, which GDP and GNP ignore completely."
As you know, GDP is the sum of consumption, investment, government spending and exports less imports. Now, "investment" is "investment", and even some of the government spending is made up of investment goods, so please explain (in your own words) how GDP ignores investment.
Published: February 20, 2007 9:13 AM
Dear all and Drs.:
Related to my earlier rhetorical question:
Is the money flowing in being used to increase productive factors, or is it simply being used to consume with the productive factors being increased overseas?
The following link was a discussion between Morgan Stanley heavy hitters on capital spending.
http://www.morganstanley.com/views/gef/archive/2007/20070216-Fri.html#anchor4410
From that online article:
Eric Chaney: Gerard's point about capex is important: The global capex cycle, which is still in an early stage in my view, was so far mostly driven by China. But two changes are underway. First, oil producers are now funneling excess cash into the real economy rather than into Treasury bills, as Serhan Cevik has documented in his piece ‘Tracking Petrodollars’ (February 14). Second, capital spending seems finally to be picking up in mature economies — that is at least something we see in Europe where rising capacity utilization rates have led companies to upgrade capex plans. This is particularly impressive in Germany where, on my estimates, manufacturing capacity increased by 2.3% (YOY) in the second half of 2006. In France, industrial companies have just raised their capex forecast from 4% to 7%. There’s an important lesson here: The global saving glut — the ex-ante imbalance between saving and investment — may be bridged by a rise of investment, which would not be a bad thing for the global economy!
Minack: Eric, to follow on that point, perhaps what's good for the economy won't be so flash for markets. First, if the capex revival soaks up the ex-ante saving excess, it points to higher real rates. Second, the extraordinarily high returns on equity partly reflect what Dick calls ‘capital discipline:’ a combination of strong top-line growth and an unusually tepid capex response. But as capital (real capital, not financial flows to existing assets) heads to high-ROIC sectors, those returns will shrink. So, what’s good for the capex-producers — among them Germany and Japan — is not so good for asset-shufflers.
Regards,
Graham.
P.S. I'm still looking for that link to the exchange. Sorry about that. I know it's out there.
Published: February 20, 2007 9:29 AM
RogerM,
If I do my laundry and you do yours, nothing it added to GDP. But if I pay you to do my laundry and you pay me to do yours, then GDP goes up. Nothing of value is added, however, which is why GDP is essentially useless as a measure of a nation's economic output, all the more so for counting spending on natural disasters (e.g., Katrina), wars (e.g., Iraq), environmental accidents (e.g., the Exxon Valdez), crime (e.g., the war on drugs), avoidable medical costs (e.g., obesity) as "product." Furthermore, it treats the depletion of natural capital as income, while totally ignoring the non-market economy of household and community.
While not perfect, something like the Genuine Progress Indicator -- http://en.wikipedia.org/wiki/Genuine_Progress_Indicator -- is much to be preferred. Why? Because "The GDP vs the GPI is analogous to the difference between the Gross Profit of a company and the Net Profit; the Net Profit is what determines the long term health of the company. Accordingly, the GPI will be zero if the increases in dollar costs of crime and pollution equal the total dollar rise in production of goods and services, all other factors being constant."
Thus would it show that "While per capita GDP has more than doubled from 1950 to present, the GPI shows a very different picture. It increased during the 1950s and 1960s, but has declined by roughly 45% since 1970. Further, the rate of decline in per capita GPI has increased from an average of 1% in the 1970s to 2% in the 1980s to 6% so far in the 1990s. This wide and growing divergence between the GDP and GPI is a warning that the economy is stuck on a path that imposes large -- and as yet unreckoned -- costs onto the present and the future." -- http://www.flora.org/sustain/Question/GPI.html
Published: February 20, 2007 9:48 AM
Alex: "Now, "investment" is "investment", and even some of the government spending is made up of investment goods, so please explain (in your own words) how GDP ignores investment."
I can't do the subject justice here. Reisman, Huerta de Soto, Garrison, Skousen all have chapters on the subject in their books. The essential idea is this: The creators of the GNP/GDP wanted to avoid what the called "double-counting." So they subtracted the cost of materials for a product at each stage of its production, leaving the "value added" at that stage. However, in standard accounting, when you subtract the cost of goods from the sales revenue, you have net sales, not gross sales. What the method actually does is count the total value of final goods sold to consumers, instead of the "value added" at each stage. This leaves out all of the expenditures on capital goods upstream (of a higher order) from the consumer goods.
The example Reisman uses is a loaf of bread. When GDP counts the "value added" of the wheat crop from the farmer, the flower from the mill, the bread from the baker, the bread from the distributor, then the bread sold at the retail store, it ends up with nothing more than the price of bread at the retail store, in spite of their complex accounting gymnastics. As a result, it ignores all of the work and investment in the stages upstream from the sale of bread, that is, the capital investment at each stage. That's why all of those authors I mentioned above have come up with alternatives to GDP. Even the BEA has an alternative called the GO, Gross Output, because it recognizes the limitations of the GDP. The BEA's GO is very much like the alternatives created by the authors above.
The last recession, in 1991, provides a good example. GDP fell only slightly, just enough to call it a recession. But GO shows a much deeper fall in output, all in the capital industries.
Published: February 20, 2007 10:11 AM
Graham: "Is the money flowing in being used to increase productive factors, or is it simply being used to consume with the productive factors being increased overseas?"
The Morgan Stanley article is very interesting, thanks.
I think econ speak needs a little translation. When economists say we're borrowing to finance our consumption, that doesn't necessarily mean that we're borrowing from foreigners and spending that on consumption. Some economists mean that, but the good ones mean that we're consuming most of our income and saving very little, at least not enough to finance expanding businesses. So those businesses have to borrow from overseas in order to expand. So in a round-about way, foreign borrowing allows us to continue consuming most of our income.
The money coming into the US goes to government bonds, corporate bonds, stocks and/or direct investment. It has no where else to go. That part going to government bonds to finance the Fed deficit, about $300 billion, can be counted as consumption and is about a third of the trade deficit/capital inflow. The rest has to be for investment in productive enterprises.
As for stepped up capex being bad for the markets, Huerta de Soto has an interesting chapter on that. He says that low profits are a sign of stepped up capex. Low profits scare investors and cause the stock market to fall. But the capex sets the stage for even greater profits in the future, so that's the time to invest. It's sort of a value investor mentality.
Published: February 20, 2007 10:35 AM
David: "While not perfect, something like the Genuine Progress Indicator ... is much to be preferred."
Well, the GPI was developed by socialist environmentalists who can manipulate it to show enormous damage and costs to the environment. Roger Garrison has a good alternative, and the BEA's GO is good, too.
But you do point out another flaw of the GDP--government spending. Keynes believed that government spending was extremely important to maintaining the economy. In fact, some believe he wanted the government to take over everything (see Garrison's "Time and Money") So, during WWII, you get very, very high GDP levels due to government spending on the war, but private production nearly died. I think that to be consistent with Austrian econ, all government spending should be excluded from output, because it's essentially consumption. Also, government doesn't create value; it takes value from one sector and gives it to another. What we should care about is the health of the private sector.
Another oddity of the GDP is that it excludes sales of used items--used home sales, used car sales, used equipment sales. The sale of used products seems to me to be much more valuable to the health of the private sector than is government spending. I can't understand their justification for leaving that out.
All things considered, the GDP is a very bad measure of the health of the economy.
Published: February 20, 2007 10:46 AM
RogerM,
Sales less cost of sales = gross profit, and not "net sales". Net sales = gross sales less discounts and returns. Please do not redefine standard accounting terminology as that only leads to confusion. Gross profit is a red herring in regard to estimating the total value of consumption-type and investment-type goods produced in a given year. And this is what GDP measures: the total value of consumption-type and investment-type goods produced in a given year.
There are a number of ways to get to the GDP figure: 1. add up the market value of final goods and services produced (where final implies that intermediate products are subtracted to avoid obvious double counting); 2. add up the incomes of everyone (allowing for incomes earned by foreigners); and 3. add up the value added at each stage of the production process.
The loaf of bread example you gave is how you could use both the value added and market value approach to calculate the value of a consumer good produced. The value of an investment good would also be calculated in a similar manner. What's the conceptual problem here? Once more, GDP measures the market value of both consumption and investment goods produced by an economy in a given year.
Published: February 20, 2007 10:47 AM
RogerM,
I just saw your reference to the sale of used items and that these things should be added into GDP as well. You seem to want to redefine terms. One last time: GDP measures the market value of currently produced (let me repeat, currently produced meaning produced this year) goods and services within the borders of a given country.
Published: February 20, 2007 10:51 AM
Dr. Murphy: "The money coming into the US goes to government bonds, corporate bonds, stocks and/or direct investment. It has no where else to go. That part going to government bonds to finance the Fed deficit, about $300 billion, can be counted as consumption and is about a third of the trade deficit/capital inflow. The rest has to be for investment in productive enterprises. "
Unfortunately, just because an enterprise borrows money, it does not mean that it is being spent in a fashion that is self-liquidating i.e. productive capacity. It can be used for stock repurchases, dividends, LBO's. True that money goes into circulation and may wind up back in the stock market - but I would argue that buying stocks does nothing for productive capacity unless its a new offering by a company,
So, how can I tell if the corporate borrowing that is going on is actually being used to create productive capacity (or increase productivity which I guess would be the back door way)?
Graham.
P.S. I have had no luck tracking down the link. I have been to Mish's blog, Market Traders, and every link from those and I can't find it. I'm beginning to suspect that it may be in Market Traders in a link within one of the threads - and not a bernanke-related thread since I've scanned through those. This is frustrating!
Published: February 20, 2007 11:08 AM
FOUND IT!!!
http://www.lewrockwell.com/paul/paul340.html
It is actually from July 2006, not the recent testimony, and it was inside of a post on Money Traders
Whew!
Published: February 20, 2007 11:19 AM
Sorry. That should have been:
RogerM:
"The money coming into the US goes to government bonds, corporate bonds, stocks and/or direct investment. It has no where else to go. That part going to government bonds to finance the Fed deficit, about $300 billion, can be counted as consumption and is about a third of the trade deficit/capital inflow. The rest has to be for investment in productive enterprises. "
Published: February 20, 2007 11:25 AM
Graham: "Unfortunately, just because an enterprise borrows money, it does not mean that it is being spent in a fashion that is self-liquidating i.e. productive capacity."
That's a good question. Even if the money goes to productive purposes, the company may fail. I don't think you can guarantee that a single investment will be productive, only that the majority will be.
As for investments in the stock market being productive, if you look at it as a whole I think it can be, because foreign investment adds to the total pool of investments in the US. For example, if foreing investment merely replaces domestic ownership of stocks, then the money that the domestic sellers get will go somewhere. Some of it may be consumed, some may go to bonds, some to IPO's, etc. I can't say that any particular purchase will be productive, but as a whole, foreign investment increases the total pool of investment available to businesses for productive purposes.
Published: February 20, 2007 12:26 PM
Alex: "One last time: GDP measures the market value of currently produced (let me repeat, currently produced meaning produced this year) goods and services within the borders of a given country."
One last time: No it doesn't! As for wanting to add the sales of used items, I just think it would be more honest. I'm not trying to redefine anything. I also don't think it should include government spending.
GDP measures sales net of the cost of goods at each stage of production, in order to avoid "double counting". Yes, it's generally called gross profit, but it's not gross output with is the same as gross sales. It's more like a "net output" figure. The end result of their accounting gymnastics is a figure that equals gross sales of consumers goods and the elimination of most expenditures on capital goods. Consumer and government spending appears to be much more important to the economy than they really are. With something like GO, capital spending takes up about half of total spending.
Published: February 20, 2007 12:36 PM
Alex: "One last time: GDP measures the market value of currently produced (let me repeat, currently produced meaning produced this year) goods and services within the borders of a given country."
RogerM: "One last time: No it doesn't! "
RogerM, you must remember that GDP is calculated just as Alex said. SNA93 and ESA state it quite strongly that it's this net value added method which is mainly used. So GDP is an aggregate of all final goods and services sold or sum of net value added of all intermediate stages.
It's another thing to say that some other accounting method would be better. In this case Alex is right.
Do you think that I am right if I quess that you prefer to have an accounting system which shows how much expenditures are made at each stage of production and where these expenditures are coming?
Published: February 20, 2007 1:16 PM
Adi,
Alex wrote "GDP measures the market value of currently produced (let me repeat, currently produced meaning produced this year) goods and services within the borders of a given country."
If you read Reisman, Huerta de Soto, Garrison or Skousen on this subject, they all say that Alex is wrong. I didn't make this up. I can understand Alex's reluctance to accept this; it took me awhile to come around to their way of thinking about GDP, too.
As you write, the GDP calculates the net value, which is not the same thing as the "market value of currently produced." Net value is much smaller than "the market value of currently produced." It has to be because net value is always smaller than gross value. GDP should be called NDP, net domestic product.
Both Reisman's and Huerta de Soto's books are available online at this web site. I encourage you to search for GDP in both and read what they have to say.
"Do you think that I am right if I quess that you prefer to have an accounting system which shows how much expenditures are made at each stage of production and where these expenditures are coming?"
I like the BEA's Gross Output, GO, figures. It basically calculates the sales of all companies in a given year. Garrison has his own index for calculating gross output that's also good.
Published: February 20, 2007 1:47 PM
The GDP is a poor measure of the economy and I believe it is the main reason that people have trouble modeling and forecasting the economy. If Austrian econ is correct that capital investment drives wages and consumer spending, then GDP fails to capture the most important part of the economy.
That said, GDP is at least fairly consistantly estimated and widely used. It's a poor tool for understanding the structure of a single economy, but it's good for comparing the same economy from one time period to the next, or for comparing one economy against another. It's not totally worthless.
Published: February 20, 2007 2:03 PM
Just to try to referee the GDP argument, there have been at least two occasions where you guys are saying equivalent things. E.g. GNP measures the income of a country's citizens (even if they produce in France), and it also measures the net value added at each stage. It is still a gross figure (in a sense) because it is the net value over things that aren't finished products.
Anyway I realize this blog post per se is useless but I'm just saying RogerM and others (Alex?) are doing things like saying, "No, that's not what GDP is, rather it's..." and giving correct definitions. But the other guy's definition is correct too.
Published: February 20, 2007 3:21 PM
RPM, Do you have any comments on the views of Reisman, Huerta de Soto and others on the fallacy of GDP accounting?
Published: February 20, 2007 4:11 PM
RPM and RogerM,
Annual GDP means the total market value of final goods and services produced within the borders of a given country within a given year. Such goods include investment goods, of course. The investment goods produced in 2005, for example, were estimated to be $1866 billion (private investment in bldgs, mach. & equip and inventory change); government investment in similar goods was estimated to be $397 billion. And each of these figures were added as part of the process to estimate GDP.
Now, you can define another measure for production undertaken in a given year if you wish but you cannot deny that the current measurement of GDP includes investment goods.
Many people criticize GDP for all sorts of reasons: it is measured inaccurately, it doesn't measure happiness, and so on. But how can you deny that it does measure investment goods? Perhaps you mean that investment goods are not measured properly. If so, how should they be measured? And please don't give me a reference. If you have read the referred material simply explain its logic. If its logic is too convoluted to be remembered then it probably is poor logic.
Published: February 20, 2007 7:02 PM
RogerM,
I forgot to explain that "cost of sales" for any company producing a good (as opposed to service) is not subtracted out in measuring GDP, as you seem to believe. Only the material input part of cost of sales is subtracted, since that would show up as sales of other firms. Consequently, as I said, gross profits are not what are added together to arrive at GDP.
Published: February 20, 2007 8:04 PM
Concerning GNP/GDP accounting (Money, Bank Credit, and Economic Cycles, Huerta de Soto, p.
418)
The statistics of gross national product (GNP), and in general, the definitions and methodology of national income accounting do not provide a reliable indication of economic fluctuations. Indeed gross national product figures stematically
conceal both the artificial expansionary effects of banks’creation of loans and the tightening effects the crisis exerts on the stages furthest from consumption. This phenomenon can be explained in the following manner: contrary to the very implications of the term gross, which is added to the expression “National Product,” GNP is actually a net figure that excludes the value of all intermediate capital goods which at the end of the measurement period become available as inputs for the next financial year. Hence gross national product figures exaggerate the importance of consumption20 over national income, relegate to third place, after government expenditure, the production of final capital goods completed throughout the period (the only capital goods reflected in the GNP by
definition) and absurdly exclude approximately half of all of society’s entrepreneurial, labor and productive effort, that devoted to the manufacture of intermediate products.
The gross domestic output (GDO) of a financial year would be a much more precise indicator of the influence business cycles exert on the market and society. This measure would be calculated as described in tables from chapter 5, i.e.,
in truly gross terms, including all monetary spending, not merely that related to final goods and services, but all intermediate products manufactured in all stages in the production
process. A measure of this sort would reveal the true effects exerted on the productive structure by credit expansion and by the economic recession it inevitably causes.21
19See pp. 274–78. As Mark Skousen has pointed out:
Gross Domestic Product systematically underestimates the expansionary phase as well as the contraction phase of the business cycle. For example, in the most recent recession, real
GDP declined 1–2 percent in the United States, even though the recession was quite severe according to other measures (earnings, industrial production, employment). . . . A better
indicator of total economic activity is Gross Domestic Output (GDO), a statistic I have developed to measure spending in all stages of production, including intermediate stages. According to my estimates, GDO declined at least 10–15 percent during most of the 1990–92 recession. (See “I Like Hayek: How I Use His Model as a Forecasting Tool,” presented at The Mont Pèlerin Society General Meeting, which took place in Cannes, France, September 25–30, 1994, manuscript awaiting publication, p. 12.)
20Most conventional economists, along with political authorities and commentators on economic issues, tend to magnify the importance of
the sector of consumer goods and services. This is primarily due to the fact that national income accounting measures tend to exaggerate the
importance of consumption over total income, since they exclude most products manufactured in the intermediate stages of the production
process, thus representing consumption as the most important sector of the economy. In modern economies this sector usually accounts for
60 to 70 percent of the entire national income, while it does not normally reach a third of the gross domestic output, if calculated in relation to the total spent in all stages of the productive structure. Moreover it is evident
that Keynesian doctrines continue to strongly influence the methodology of the national income accounts as well as the statistical
procedures used to collect the information necessary to prepare them. From a Keynesian standpoint, it is advantageous to magnify the role of consumption as an integral part of aggregate demand, thus centering national income accounting on this phenomenon, excluding from its calculations the portion of the gross domestic output which fails to fit well into Keynesian models and making no attempt to reflect the development of the different stages devoted to the production of intermediate capital goods, which is much more volatile and difficult to predict than consumption. On these interesting topics see Skousen, The Structure of Production, p. 306. According to a study carried out by the U.S. Department of Commerce, entitled, “The Interindustry Structure of the United
States,” and published in 1986, 43.8 percent of the American gross domestic output (3,297,977 million dollars) comprised intermediate
products which were not reflected by GDP figures (merely equal to 56.2 percent of the gross domestic output, i.e., 4,235,116 million dollars). See Arthur Middleton Hughes, “The Recession of 1990: An Austrian Explanation,”
Review of Austrian Economics 10, no. 1 (1997): 108, note 4. Compare this data with that provided for 1982 in footnote 38 of chapter 5.
Published: February 20, 2007 10:30 PM
RogerM,
Thanks for your reply outlining Heurta de Soto's criticism of GDP and explanation of GDO.
First of all de Soto seems to misunderstand how GDP is estimated. Let me explain.
There are two firms in the economy. Their income statement info is as follows:
Retail Co. A has sales of $100, cost of material inputs of $40, wages of $35, interest expenses of
$10, profit of $15.
Manufacturing Co. B had sales to Co A of $40. They had raw material on hand at the beginning of the year of $9 that they used up in producing the goods they sold to Co. A, together with wages expenses of $23. They made a profit of $8.
GDP is the market value of goods produced this year. It would be measured by adding up the sales of each of firm A and B less material inputs used up or purchased from other firms (the value added approach). The figure for GDP would be estimated, therefore, as the market value added by Co. A ($100-$40)=$60 plus the market value added by Co. B ($40-$9)=$31. This makes a GDP figure of $91. Notice that this is $9 less than the market value of 'final goods' sold by Co. A (this $9 rightly representing production of a previous period).
Using the income approach, GDP would be estimated as wages plus investment income=$35+$23=$58 wages plus $10+$15+$8=$33. Total =$58+$33=$91. And the product sold by company A might be a consumption good or an investment good. GDP adds them all up.
Now, I invite you to prove in the above example that the year's production in the above economy was anything o