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The Economy, Lounge Style
Katy PMed me and asked me to start a Lounge thread on the economy, specifically addressing things like:
[ QUOTE ] . . . what's happening to our economy and what we can expect in the near future. For example, why is it bad for the feds to cut the interest rate? What is the meaning of "sub-prime" lenders and how is it that a few people defaulting on their loans could push the entire world into an economic crisis? [/ QUOTE ] While I am taking a stab at this, opinions are greatly varied and other people on the site disagree with my interpretations. They are certainly welcome to post their views as well. And I welcome all questions. Let's just please, please, please try to keep it Lounge-worthy, i.e. civil. I hate to have to ask this, but very often I've found that people with differing views on such things often cannot restrain themselves from hurling insults (myself included [img]/images/graemlins/tongue.gif[/img] ). Ok! Here's a little background, X-posted from a BFI post I just made, on how the Fed lowers interest rates by expanding the money supply, and what the negative effects of this are. It was in response to a question about some people (who generally subscribe to what's called the Austrian School of economics, like me) that claim that the Fed "prints money out of nothing": [ QUOTE ] When we say "printing money form nothing", it's a figure of speech. The money doesn't need to be physically printed to expand the money supply. An entry is simply created in an electronic account at the Fed, and then the Fed purchases government securities from special brokers during "Fed Time" in open market operations with that newly created money, via wire transfer I believe (although I'm not sure; the Fed might physically cut a check). Those brokers then deposit those funds in the commercial banks, where they become increased reserves for the banks. If commercial bank reserves are increased by $50B in this manner, the banks can then create up to a total of $500B via loans, by the magic of fractional reserve banking, if the reserve rate is 10% for example. The artificial lowering of the interest rate of course encourages people to take out these loans, which is what actually does most of the expansion of the money supply. <font color="white"> . </font> The important number is not the total of physical cash, but the total of fiduciary instruments, M3: <font color="white"> . </font> http://i27.photobucket.com/albums/c1...nited_Stat.png <font color="white"> . </font> Before the Fed stopped reporting M3 (supposedly because it "cost too much" to measure; this from the people who can create money), M3 was expanding at about 15% per year. <font color="white"> . </font> And once again I will point out that artificially lowering the interest rate, which is really the market price for investment funds and hence access to physical resources, causes a misallocation of those physical resources, just as any price cap on any good or service causes a misallocation of that good or service. If you cap the price of milk at $0.25/gallon, people would be bathing in milk and watering their lawns with it, and a shortage would develop. That's what happens to the physical capital stock when the interest rate is artificially capped; productive capacity is misallocated and a shortage develops that is eventually revealed in, and correct by, a recession. [/ QUOTE ] Now, as for why the Fed does this, the going explanation is that without careful management of the money supply, the market economy is inherently subject to periodic instability, called business cycles, which are alternating "booms" and "busts". The claim is that a central bank must manage the money supply to navigate the economy through these, cooling off the booms and heating the economy back up in the busts. The Austrians would claim that it is bank credit inflation and the associated artificial lowering of the interest rate that causes the business cycle, of artificial booms and the busts required to correct them, in the first place. Austrians don't think that those within the Fed are stupid, however. After all, Alan Greenspan was an Austrian for decades before he took the reigns of the money supply. We are very cynical about why an institution like the Fed would want a monopoly of the power to legally create money out of nothing, and very cynical about the reasons for and timing of the artificially created booms. It is much easier to be re-elected for a second term as president if the Fed has turned on the money spigot, generating an artificial boom after the recession caused by your predecessor's re-election boom, and by the time your second term is up and your recession hits, it's the next administration's problem. If you look at the one sustained period of almost zero increase in the money supply in the graph above, it is the reign of George H. W. Bush, who still bitterly complains that Alan Greenspan cost him re-election. For a more extensive overview of the Austrian Business Cycle Theory (ABCT) see this post. On to the next question, which was about "sub-prime" lending. This is part and parcel of another general problem with credit expansion: asset bubbles. Expansion of the money supply eventually drives up prices, creating price inflation (the pattern and time structure of this inflation is complex, and I won't go into it; suffice it to say that not all prices go up equally or at the same time, and in fact some prices don't go up at all; they will fall). Investment funds, seeking to stay ahead of inflation, will tend to find their way into certain asset classes, which could be anything, stocks, real estate, art, etc. and create asset bubbles, or sectors of the economy that are particularly overvalued. The entire economy is actually bubbled because the lowered interest rate tends to trick entrepreneurs into making mistakes all across the economy, but some areas are always more bubbled than others. In any event, one of the latest bubbled sectors of the economy is housing, which the Austrians and others were pointing out as early as 2002 and 2003. The last big bubble we all heard about was the "dot com" bubble, i.e. technology stocks. So what is sub-prime lending? Well, when there is a market clearing interest rate, that means that everyone that wants to borrow at the market rate and everyone that wants to invest at the market clearing rate can always find someone to do business with. By lowering the interest rate, you trick buyers into entering the market who would not have entered the market at the real rate. "Sub-prime" lending basically refers to creating loans for buyers who would not have been able to get loans before, either because of credit problems, income, or whatever. Obviously the risk of default on these loans is higher than normal. The reason that this happened (and none of the people involved was stupid) was the asset bubble in real estate values. People saw real estate values rising so fast that buyers would be gaining equity so fast that the riskier loans appeared to be justified. The problem is that all bubbles must eventually burst. When the housing bubble started to burst, and real estate values began to fall, suddenly a lot of people are revealed to be WAY upside down in their mortgages. Now, even though foreclosures are up something like 400%, that's not the real issue. That is still a tiny fraction of homeowners being foreclosed on. The real problem is what was done with all of these mortgages. They were packed up and sold as securities, so-called Mortgage Backed Securities (MBS's). Now the MBS's became a VERY popular investment vehicle when the real estate market was hot. And there was then a secondary asset bubble in MBS's. A LOT of big financial institutions, foreign and domestic, invested a lot of money (hundreds of billions of dollars) into these securities. And now that the real estate bubble has popped, the underlying market value of these securities has also popped, and the banks have had to "write down" billions and billions in losses on these instruments. Accompanying all of this is the "credit crunch". People generally think the credit crunch is being driven by the sub-prime crisis, but it is more fundamental than that. The credit crunch is not tied to one sector, its economy wide, and it is a result of the earlier credit expansion. When the interest rate is lowered, it causes entrepreneurs all over the economy to believe that all sorts of new projects are profitable. Let's say the real interest rate is 8%. A project that returns 7% would be unprofitable to take out a loan with which to undertake it. But if the interest rate is artificially lowerd to 5%, that project looks profitable, and a business might take out that loan and start that project. The problem is that as entrepreneurs all over the economy are doing this, they start bidding up the prices of the inputs, the physical factors of production like steel, energy, computers, machines, equipment, labor, office and warehouse space, etc. There aren't enough physical factors of production to complete all these projects, and they eventually bid up the prices of the inputs to the point where the project is revealed to be unprofitable. The rising input prices cause an increase in the demand for loanable funds, which tries to drive up the interest rate, the "credit crunch". The Fed can either maintain the low interest rate by injecting more "liquidity", i.e. money, which it cannot do indefinitely, or it can let the interest rate rise, revealing all of these projects throughout the economy to be unprofitable malinvestments, which kicks off the recession. It is really not that the sup-prime mortgage crisis will "spill over" into the rest of the economy. The rest of the economy is also bubbled. It's just that one sector happened to be the first to pop, real estate. That dominoed into the MBS asset bubble. That dominoed into the financial institutions. Technology stocks are showing weakness, and I even saw that the art market took a massive hit. In 2000 it was dot coms and tech stocks that were the first to go, but they didn't drag the rest of the economy down with them; the rest of the economy was already poised to go. When 9/11 crashed the stock market, it didn't really do a trillion dollars of economic damage as I've heard people claim. That trillion dollars in economic damage had already been done by monetary inflation. It was just that the recession of 2000 and the acceleration of 9/11 revealed it. We have that same scale of economic damage now driven by the last 6 years of monetary inflation; it's just that it hasn't yet been fully revealed, and it probably won't be revealed quite so quickly. Lastly, I will talk about the dollar. For many years now the Fed has been expanding the money supply at a rapid pace. We have not seen very much of this in consumer prices for a couple of reasons. One, a large fraction of those new dollars go out of the country and end up being held by foreign central banks, mostly asian and middle eastern, as their reserves, on top of which they print their own fiat currencies. China alone holds something like US$1.5T. We have basically been exporting inflated dollars and importing real goods and services. This drives our massive trade deficit, and allows us to literally exploit the world (we get goods and services, they get green pieces of paper or electronic entries representing them). Another part of the monetary expansion is hidden in increasing productivity. If the money supply expands at 5% but productivity also rises at 5%, then prices will appear to be stable, even though monetary expansion and malinvestment is still occuring (this was the case in the 1920s). Now the problem is that by expanding the money supply, you obviously increase the supply of dollars. Since all the other countries are also expanding their money supplies, if the US expanded at the same rate as everyone else, there wouldn't be any general long term weakening in the dollar vs. other currencies like the Euro. But this isn't the case. The Fed has inflated the dollar supply at a faster rate than other currencies are being inflated, which lowers its international purchasing power relative to those currencies, weakening it relative to them. As the value of dollar holdings falls, people seek to get out of dollars, either by selling them on currency markets, which further increases their supply and lowers their demand, further lowering their value, or by buying up assets for US dollars, which drives up asset prices. As the value of the dollar falls internationally, the best place to buy assets like real estate and companies for US dollars will be the US. So foreign investment will go up, our exports are going up, but all those inflated dollars coming home to roost will drive up domestic prices. So what we are set for is staglation; we are entering a recession at the same time we will see significant price inflation. The last time this happened was the 1970s, and that occured for largely the same reasons it is happening now. This turned out to be a much longer post than I thought. Keep in mind that others will greatly disagree with my interpretation, and I don't claim that my understanding of abstruse investment instruments like mortgage backed securities is perfect. I welcome thoughts, corrections, questions, and other contributions. |
Re: The Economy, Lounge Style
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When we say "printing money form nothing", it's a figure of speech. The money doesn't need to be physically printed to expand the money supply. An entry is simply created in an electronic account at the Fed, and then the Fed purchases government securities from special brokers during "Fed Time" in open market operations with that newly created money, via wire transfer I believe (although I'm not sure; the Fed might physically cut a check). Those brokers then deposit those funds in the commercial banks, where they become increased reserves for the banks. If commercial bank reserves are increased by $50B in this manner, the banks can then create up to a total of $500B via loans, by the magic of fractional reserve banking, if the reserve rate is 10% for example. The artificial lowering of the interest rate of course encourages people to take out these loans, which is what actually does most of the expansion of the money supply. [/ QUOTE ] Thanks for addressing all my questions to you Borodog. I really appreciate the time you put into your OP! Awesome. A lot of this stuff is a little over my head but I want to see if I understand some of the basic concepts. Forgive me if I screw this up but what the hell, here goes. Lowering interest rates by increasing reserves Are you saying that when the Fed lowers interest rates it first creates paperless funds (in other words expands the money supply) for commercial banks so that they can make more loans to people. So making more loans to people is the big goal right? Is this the first step in lowering the interest rate or did I misunderstand you? Sorry I'm sounding so ignorant, I just did not realize that the term "lowering the interest rate" meant creating more funds for banks to loan out. And why would banks want to make all these loans if people are in such a shaky position with high mortgages and credit card problems? I would guess they don't want to loan to private citizens as much as they do to businesses and corporations. Gah, economics and I are complete strangers [img]/images/graemlins/grin.gif[/img] |
Re: The Economy, Lounge Style
Borodog. I am very interested in this subject.
Did you know that Greenspan was a student of Ayn Rand? I am also under the impression that credit is weakening the dollar. I calculated that the dollar is only about 1/10th of it's actual value because there is way more credit than actual money. Am I correct in my assertion. How do you think this is effecting the dollar, and is this why the interest rates change? |
Re: The Economy, Lounge Style
Great post. I have several questions:
1. The newly printed dollar is actually worth less than a dollar. Please explain why. 2. A year or two ago I watched an interview on Charlie Rose with an economist who was articulating concerns about the trade deficit. Your thoughts? 3. I work in commercial construction in FL. The burst housing bubble effects have been acute and pronounced. With the weakened dollar, I am actually optimistic because of the predicted influx of foreign investment on the local level. Am I wrong? |
Re: The Economy, Lounge Style
haven't read the entire op yet, but this is a great idea. hopefully this goes better than policy talk in politics
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Re: The Economy, Lounge Style
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So what is sub-prime lending? Well, when there is a market clearing interest rate, that means that everyone that wants to borrow at the market rate and everyone that wants to invest at the market clearing rate can always find someone to do business with. By lowering the interest rate, you trick buyers into entering the market who would not have entered the market at the real rate. "Sub-prime" lending basically refers to creating loans for buyers who would not have been able to get loans before, either because of credit problems, income, or whatever. [/ QUOTE ] [ QUOTE ] Now, even though foreclosures are up something like 400%, that's not the real issue. That is still a tiny fraction of homeowners being foreclosed on. The real problem is what was done with all of these mortgages. They were packed up and sold as securities, so-called Mortgage Backed Securities (MBS's). Now the MBS's became a VERY popular investment vehicle when the real estate market was hot. And there was then a secondary asset bubble in MBS's. A LOT of big financial institutions, foreign and domestic, invested a lot of money (hundreds of billions of dollars) into these securities. [/ QUOTE ] Ok some of this is actually starting to make sense to me. I was hearing how the foreclosures had caused a world wide banking crisis and I kept wondering how in the heck a few American slackers who couldn't handle their mortgages and credit cards could be responsible for throwing world banks into crisis. It just made no sense to me. Someone on one of the forums said that the housing bust in America was messing with the European economy and I was like huh? You've got to be kidding! But now that you explain that the major banks had invested in the MSB's I can sort of see this domino effect. 1. Have there always been sub-prime lenders or is this a relatively new phenomenon? 2. You say that these risky loans looked justifiable...but to whom? The sub-prime lender, the MBS's, or the customer? Did the sub-prime companies know this would happen and is this why they turned around and sold the mortgages quickly? 3. What kind of financial institution would think this was a good idea? It seems like this kind of outcome could be predicted. Overall, what company suffered the most from the housing bubble bust? The large banks? 4. I wonder if any of my mutual funds were invested in these MSB's. |
Re: The Economy, Lounge Style
Wheee economics by borodog! Last time I participated in one of these I learned a lot about Austrian economics, I hope this one becomes just as interesting.
[ QUOTE ] 1. Have there always been sub-prime lenders or is this a relatively new phenomenon? [/ QUOTE ] Sub-prime borrowers are just a class of borrowers who have a higher credit risk. What's recent (prior to subprime meltdown) is the amount of subprime lending done without tight standards and the increasing ways in which this debt is held, in the form of structured products. The widespread investment in this risky debt and errors in risk management is what led to problems. [ QUOTE ] 2. You say that these risky loans looked justifiable...but to whom? The sub-prime lender, the MBS's, or the customer? Did the sub-prime companies know this would happen and is this why they turned around and sold the mortgages quickly? [/ QUOTE ] The loans looked justifiable to everyone, that's why there was a market for these things. Not sure what you're getting at here. Some (like Warren Buffett) predicted that this would happen with all the non transparency but there was such a strong potential for profiting off the interest from the subprime mortgages that a lot of people jumped in anyway. [ QUOTE ] 3. What kind of financial institution would think this was a good idea? It seems like this kind of outcome could be predicted. Overall, what company suffered the most from the housing bubble bust? The large banks? [/ QUOTE ] Any financial services firm or institution trying to make money would have been interested in this. The housing bubble supported the stream of payments from these babies, and there was a lot of money being made off these. One of my professors invented the method of tranching mortgages into different levels of risk and he's now ridiculously wealthy. Any type of company exposed to housing, consumer spending, or the debt instruments themselves suffered from the housing bubble bursting. [ QUOTE ] 4. I wonder if any of my mutual funds were invested in these MSB's. [/ QUOTE ] Probably not directly but they all probably had some level of exposure in the form of stock of banks, construction companies, etc. |
Re: The Economy, Lounge Style
wrt lowering of interest rates through credit expansion, you can read this katy:
http://en.wikipedia.org/wiki/Money_supply |
Re: The Economy, Lounge Style
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So what we are set for is staglation; we are entering a recession at the same time we will see significant price inflation. The last time this happened was the 1970s, and that occured for largely the same reasons it is happening now. [/ QUOTE ] Borodog can you expand on this? As far as I am aware, oil prices are leading to inflation but growth is still rather strong. I checked the latest economic data from the Fed and there was 3.9% growth in the last quarter, and very little spillover from housing into other sectors. But I'm writing a paper right now and cannot do further research [img]/images/graemlins/frown.gif[/img] |
Re: The Economy, Lounge Style
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Lowering interest rates by increasing reserves Are you saying that when the Fed lowers interest rates it first creates paperless funds (in other words expands the money supply) for commercial banks so that they can make more loans to people. So making more loans to people is the big goal right? Is this the first step in lowering the interest rate or did I misunderstand you? Sorry I'm sounding so ignorant, I just did not realize that the term "lowering the interest rate" meant creating more funds for banks to loan out. [/ QUOTE ] The real intention of the Fed when it lowers the interest rate is to "stimulate the economy." In other words, it wants more transactions taking place in the economy. It does this by lowering interest rates, which encourage businesses and individuals to take out loans with the intention of buying stuff with the money. The reason that lowering the interest rate encourages people to take out a loan is that the interest rate is essentially the price of money over a certain time horizon. If I asked you to loan me $10,000 for a year, and promised to give you exactly $10,000 after one year, you would laugh at me (unless there were special circumstances like we were good friends, etc.). I would have to pay you a price, say promise to give you $11,000 after one year for your $10,000 now. That would be a 10% interest rate. So the market interest rate is the rate set by the supply of loanable funds (i.e. money saved up and not spent by people on consumption) and the demand for loans. The higher the supply of loanable funds, the lower the price of money (the interest rate). The lower the supply, the higher the interest rate. So by creating more money to be loaned out, the Fed increases the supply of loanable funds, which lowers the interest rate, which encourages people to take out loans, because it coasts them less to do so, which encourages spending in the economy. The problem is that this whole process, while it appears great (a boom) it is actually very damaging to the structure of the economy. Make sense? [ QUOTE ] And why would banks want to make all these loans if people are in such a shaky position with high mortgages and credit card problems? I would guess they don't want to loan to private citizens as much as they do to businesses and corporations. Gah, economics and I are complete strangers [img]/images/graemlins/grin.gif[/img] [/ QUOTE ] The banks want to make loans because they make interest off of them. Now they will obviously be willing to make shakier loans if they are making interest off of money that was created from nothing than if the principle they are risking was not created from nothing. They still want to make loans to the best risks possible, but hey, when the good risks are all serviced and you still want to make loans and earn interest, you will start making shakier and shakier loans. Also, it wasn't just banks that were making sub-prime mortgages. There were a lot of mortgage brokers looking to cash in on the mortgage bonanza created by the housing boom. A lot of funding for these mortgages came from real savings, i.e. investors, rather than being printed from nothing. But since they must compete with the banks for loans, when the banks depress the interest rates, they do so market wide. Those investors turned around and sold those mortgages to be packaged as mortgage backed securities. The brokers and their investors were making money hand over fist; it was the people who bought the MBSs that were eventually left holding the bag. And remember, at the time that all of these shaky mortgages were being put together, all the participants thought that the market warranted it because of skyrocketting real estate values. It was only after the housing bubble popped that the problem was revealed, which is the nature of a recession across the entire economy. |
Re: The Economy, Lounge Style
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Borodog. I am very interested in this subject. Did you know that Greenspan was a student of Ayn Rand? [/ QUOTE ] Yes, I did. He was also a huge supporter of the gold standard, until they gave him the keys to the printing presses. [img]/images/graemlins/wink.gif[/img] [ QUOTE ] I am also under the impression that credit is weakening the dollar. I calculated that the dollar is only about 1/10th of it's actual value because there is way more credit than actual money. Am I correct in my assertion. How do you think this is effecting the dollar, and is this why the interest rates change? [/ QUOTE ] This is not quite right. The "credit" you speak of is "real money", in every sense of the word. After all, you can buy stuff with it. The actual proprtion of the money supply that is physical paper and coins doesn't really matter much; it is determined by people's preference for holding cash versus using other methods of payments like check, debit, credit card. But it definitely is "credit expansion" that weakens the dollar's purchasing power in the long run. By "credit expansion" we mean an increase in the money supply that is injected into the loan market. By increasing the number of dollars vs. the amount of goods and services in the economy, prices are bid up, and the purchasing power of the dollar falls. This is reflected in both price inflation and the weakening of the dollar internationally relative to other currencies. Of course the dollar weakens relative to those other currencies, which are also inflationary, over the long term because the dollar supply is being expanded faster than them. There are of course lots of short term things that can also affect the value of one currency relative to another that don't have much to do with expansion of the money supply per se. |
Re: The Economy, Lounge Style
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1. Have there always been sub-prime lenders or is this a relatively new phenomenon? [/ QUOTE ] I believe subprime lending first started in the 90s, but I'm not sure. Because interest rates are artificially very low, meaning there is an overabundance of funds competing for borrowers, the competitive pressures to sign borrowers are artificially enhanced, meaning lenders will take more risks trying to make a loan. Especially since they could then turn around and immediately offload that risk by selling that loan off. It got to the point where the demand for the MBSs was so high that the mortgage brokers would literaally almost do anything just to create a mortgage to sell. [ QUOTE ] 2. You say that these risky loans looked justifiable...but to whom? The sub-prime lender, the MBS's, or the customer? Did the sub-prime companies know this would happen and is this why they turned around and sold the mortgages quickly? [/ QUOTE ] Shrug. It looked justifiable to everyone, otherwise they wouldn't have done it. The sub-prime lenders turned around and sold the mortgages quickly because the market was demanding them. [ QUOTE ] 3. What kind of financial institution would think this was a good idea? It seems like this kind of outcome could be predicted. [/ QUOTE ] It was predicted, as long as 5 years ago. Banks generally think this sort of thing, creating money to lend out at interest, is a great idea, as you can imagine. It's just that this particular go round the first asset bubble to go happened to be in real estate and these mortage backed securities. In the last one it was tech stocks. In other bubbles it has been other things. The 1920s saw a huge stock and real estate bubble that led to the 1929 crash. [ QUOTE ] Overall, what company suffered the most from the housing bubble bust? The large banks? 4. I wonder if any of my mutual funds were invested in these MSB's. [/ QUOTE ] The banks never really suffer too much, in my opinion. After all, they do get to create money out of nothing and then loan it out at interest. As for who got smacked the worst, it was the people who bought the MBSs and were left holding the bag when it was revealled that they were vastly overvalued. |
Re: The Economy, Lounge Style
Oh, and what he said about the mutual funds.
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Re: The Economy, Lounge Style
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[ QUOTE ] So what we are set for is staglation; we are entering a recession at the same time we will see significant price inflation. The last time this happened was the 1970s, and that occured for largely the same reasons it is happening now. [/ QUOTE ] Borodog can you expand on this? As far as I am aware, oil prices are leading to inflation but growth is still rather strong. I checked the latest economic data from the Fed and there was 3.9% growth in the last quarter, and very little spillover from housing into other sectors. But I'm writing a paper right now and cannot do further research [img]/images/graemlins/frown.gif[/img] [/ QUOTE ] In the long run, only monetary expansion can drive inflation. And I believe that it is probably inflationary expectations that are driving up the price of oil, just as with gold. The problem with the Fed's growth data is that GDP is entirely driven by the expansion of the money supply. When more money is created, loaned out and spent, GDP goes up. People are hired and the unemployment rate goes down. People bid of the prices of inputs, so corporate profits go up in the capital goods industries. Wages are bid up. Workers spent their new money on consumer goods, driving up profits there as well. So these kinds of macroeconomic aggregate indicators can all look "good", but what is really happening is that you are weakening the economy even more, by yet more misallocations of scarce resources. You can delay the recession by papering it over with new money, but you cannot do that indefinitely. Eventually all of this malinvestment and increased consumption must be paid for. |
Re: The Economy, Lounge Style
Didn't mean to steal your thunder or anything BD, just helping out with the questions I feel qualified to answer.
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Re: The Economy, Lounge Style
Err as far as measurement of GDP goes that 3.9% is an estimate of real growth. So it shouldn't have anything to do with changes in the money supply.
Edit: so what I'm saying is that we're not in a recession now nor appear to be on the brink of one. This is independent of your expectation of a recession because of u.s. fiscal policy in general. |
Re: The Economy, Lounge Style
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Didn't mean to steal your thunder or anything BD, just helping out with the questions I feel qualified to answer. [/ QUOTE ] No problem at all. Be my guest. |
Re: The Economy, Lounge Style
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Err as far as measurement of GDP goes that 3.9% is an estimate of real growth. So it shouldn't have anything to do with changes in the money supply. [/ QUOTE ] "The GDP of a country is defined as the total market value of all final goods and services produced within a country in a given period of time." - wiki The point being, that when the money supply is expanded via credit expansion, that money is used to actually buy things, which bids up the prices of those things, which drives up GDP. GDP is not really a measure of the "size" of the economy at all. An increase of 3.9% in GDP does not necessarily measure any actual "growth" of the economy in any meaningful sense (which would be a real increase in the quantity of goods and services being produced in the economy, which cannot even be aggregated, because you cannot add apples to oranges to cars to TVs to shoes to movies tickets, and not the total price tag thereof). By the way, I know this is not the orthodoxy. [ QUOTE ] Edit: so what I'm saying is that we're not in a recession now nor appear to be on the brink of one. [/ QUOTE ] I disagree strongly. [ QUOTE ] This is independent of your expectation of a recession because of u.s. fiscal policy in general. [/ QUOTE ] |
Re: The Economy, Lounge Style
Growth of an economy can't just be measured in quantity. Quality changes also influence growth of an economy.
And if you don't believe that the value of an apple cannot be added to the value of a car I have no idea where to go! Not believing in prices would make me so confused. How do you make decisions on whether to buy things or not? If you are deciding whether to buy a vacation package that includes hotel and travel are you not adding two unlike things together? |
Re: The Economy, Lounge Style
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Growth of an economy can't just be measured in quantity. Quality changes also influence growth of an economy. [/ QUOTE ] I know that. The point is that the GDP is not a real measure of growth. Growth is folded in there, but so are a lot of other factors. [ QUOTE ] And if you don't believe that the value of an apple cannot be added to the value of a car I have no idea where to go! [/ QUOTE ] That isn't what I said. I edited and chenged the ordering of the clauses to make it more clear. I said you can't add apples to cars to TVs, not that you couldn't add the market values of apples and cars and TVs. You can. But doing that doesn't magically give you a number that represents the "size" of the economy in any real way, and in particular the first derivative of this quantity, i.e. what is labeled as "growth", can be completely dominated by effects other than growth in the real production of goods and services. |
Re: The Economy, Lounge Style
Agreed, GDP isn't perfect. But the components do not point to incipient recession. Consumer spending is very strong, indicating positive overall confidence in the economy. Employment and wages are up. Construction is down as expected. You claim that the units of measurement are wrong is but you haven't pointed to any specific "better" measurements that show current direction of growth is up, down, or otherwise. I understand that you don't subscribe to the traditional economic views but in the end someone has to measure something in order to know exactly what's going on; saying that all assets are mispriced because of U.S. monetary policy doesn't do anyone any good other than make people feel frustrated that there might be something better out there but no one can prove it's better.
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Re: The Economy, Lounge Style
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Agreed, GDP isn't perfect. But the components do not point to incipient recession. Consumer spending is very strong, indicating positive overall confidence in the economy. [/ QUOTE ] "Positive overall confidence in the economy" will not stop the recession. Unlike what Keynes would have us believe, the economy is not driven by "animal spirit". The demands of consumers and the allocation of the physical factors of production do, and the two are currently mismatched due to credit expansion driven malinvestments. There's no way around this. And "very strong consumer spending" is a bad thing, not a good thing. The economy needs more saving, not more consumption. [ QUOTE ] Employment and wages are up. [/ QUOTE ] Like I said. This is not necessarily a good thing. [ QUOTE ] Construction is down as expected. [/ QUOTE ] Why as expected? Because the housing bubble burst. Did the housing bubble arise because of "animal spirit"? No, of course not. It arose because artificially low interest rates drove a housing boom and created that bubble. The rest of the economy has been bathed in those same artificially low interest rates. Entrepreneurs throughout the economy have been making exactly the same kind of miscalculations that drove the housing boom. The housing bubble burst, and so will the rest of them. [ QUOTE ] You claim that the units of measurement are wrong is but you haven't pointed to any specific "better" measurements that show current direction of growth is up, down, or otherwise. I understand that you don't subscribe to the traditional economic views but in the end someone has to measure something in order to know exactly what's going on; saying that all assets are mispriced because of U.S. monetary policy doesn't do anyone any good other than make people feel frustrated that there might be something better out there but no one can prove it's better. [/ QUOTE ] The Fed just cut their interest rate target, twice, further expanding the money supply, lowering the interest rate, and creating further malinvestments while temporarily hiding the previous ones. This cannot be sustained. The only numbers you need to look at to know what's coming are the ones created by the Fed. All you have to do is look at the theory to understand that there is something better out there. The Austrian business cycle theory I linked too proves it's better. Contrary to what Ben Bernanke would have you believe, it is not "better to have boomed and busted than never to have boomed at all." The boom represents capital misallocation, and during the bust some of that capital is always abandoned, meaning there is always a net economic loss over the cycle, compared to what would have occurred in the absence of the cycle. Also, if you want a concrete measurement, there is the yield curve, which recently inverted. An inversion of the YC has accurately predicted recession the last 9 times, with one false positve (only one quarter of negative GDP growth, whereas the technical definition of a recession is two consecutive quarters of negative growth). People are currently poo-pooing the YC inversion, saying that somehow the economy is different now than in the past. Of course they have been saying the same thing for the last 20 years, and the YC still keeps predicting recessions. http://i27.photobucket.com/albums/c1...dog/recess.jpg |
Re: The Economy, Lounge Style
Thank you Borodog and twoplease for your explanations and taking time to answer all my questions. This is a lot for me to digest and I'm going to have to go back and re-read some of your posts. Unfortunatley I'm not very quick to pick up on these concepts even after you explain them to me [img]/images/graemlins/confused.gif[/img]
These comments have me a little puzzled: - "Very strong spending is a bad thing, not a good thing." - "Employment and wages are up....not necessarily a good thing." but I guess that you are saying that these indicators, when taken into account with other troubling factors, are not necessarily a sign of good times to come. (Also from my end of it let me just say that wages are not "up". Salary raises are in no way keeping up with the cost of living.) Like I said, I need to reread all the replies in this thread. Right now I am wondering what a recession will mean to me personally as well as to our country and its standing in the world. I'm not sure if these things have been addressed by Borodog already and I don't mean to disrespect him by not fully reading his posts as he may have already addressed this. [img]/images/graemlins/tongue.gif[/img] But here are some things specifically that are on my mind this morning as I get ready for work and worry about the state of my bank account: Given a recession may be in the near future, should I take my money and invest in bonds now? Should I be buying some real estate? Should I cancel my trip to Europe next summer as the dollar is so weak and it might be just downright foolish? How long is this recession thing going to last, a year? A decade? (Am I an idiot to be worrying about all this stuff right now and would I be better off concentrating on what's for lunch?) |
Re: The Economy, Lounge Style
While I often disagree with Boro, he is an thoughtful and knowlegeable poster.
However IMO, Lounge-esque discussions on the economy should really not center on the descriptive (ie how inflation can be measured) but on the specific (perceived) impacts of economic policy and behavior. For those who think they can learn enough econ to have an informed philosophical/econ engineering discusssion after a few courses/wiki readings, you are wrong. But anyone can talk about rent control pros and cons then come to logical conclusions. So my suggestion is to topics very specific/ centered around micro economic topics, not "the purpose of the fed". Good question: Why did milk prices in my store go up? Bad questions: Why do prices rise over time? What causes exchange rates to fluctuate? As evidenced from other forums and Boro's rediculously long post, Macro discussions don't blend with the more subjective lounge type discussions and very often don't have realistic answers. |
Re: The Economy, Lounge Style
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Thank you Borodog and twoplease for your explanations and taking time to answer all my questions. This is a lot for me to digest and I'm going to have to go back and re-read some of your posts. Unfortunatley I'm not very quick to pick up on these concepts even after you explain them to me [img]/images/graemlins/confused.gif[/img] These comments have me a little puzzled: - "Very strong spending is a bad thing, not a good thing." [/ QUOTE ] There are two classes of goods that you can put productive capacity to work producing: 1) Consumer goods. These are consumed in the short term. More consumption now implies you are living at a higher standard of living than if you were not engaged in so much consumption (i.e. you buy a new TV, a new car, go out to eat a lot, etc. versus not buying new goods or going out to eat as much). 2) Capital goods, or producer's goods. These are goods that are used in the production of other goods. Capital goods increase the productivity of labor, and allow you to produce more. Since the factors of production that exist at any one time are fixed, those factors get allocated to producing various goods in these two classes. The more factors that are devoted to producing consumers goods, the less there are that can be devoted to producing capital goods, and vice versa. Now, for the economy to grow over time, the "capital stock", the net total of capital goods in society, machines, tools, steel, oil, mines, farms, computers, etc. must increase. Since capital goods wear out, some fraction of productive capacity is used up just replacing worn out capital goods. And additional productive capacity devoted to producing capital goods can increase the capital stock, making the society more productive. In the long run, this increased productivity means that more consumers goods can be produced, raising standards of living. But for this to take place, people must forgo some consumption in the short term, and save. This lowers the demand for consumers goods and allows productive capacity to be shifted to producing capital goods. If consumption is very high now, that can only happen at the expense of savings and investment in capital goods. Hence you have a trade off. You can either have a relatively higher consumptive standard of living now, or you can have a relatively lower consumptive standard of living now, but a much higher standard of living in the future. Consumer spending being strong means that consumer saving is weak. That means little productibe capacity is being devoted to expanding the capital stock. In fact, one of the things that can happen during an inflationary boom is that the capital stock isn't even being replaced as it wears out. In other words capital is being consumed, and the absolute level of productivity of society goes *down* over time. Consumer debt is so high these days that I am fairly certain that we have actually been consuming the capital stock for some time now, although it is almost impossible to really measure this (the capital stock cannot simply be "added up"; you cannot add machines to tools to computers to vans, etc.). [ QUOTE ] - "Employment and wages are up....not necessarily a good thing." [/ QUOTE ] As I said before, when the Fed expands the money supply, and people take out loans with this newly created money, they do this so that they can buy, rent or hire things, generally the factors of production, machines, equipment, factory space, steel, oil, vans, laborers, etc. The new buyers and their new money bids up the prices of these things. This drives up GDP. They hire people and bid employees away from previous employment. So unemployment goes down, and wages and GDP go up. Corporate profits will look great for a while. This all looks great to a mainstream economist. But to an Austrian all of this is a grand deception. What is really happening is the factors of production are being misallocated, shifted from higher valued uses to lower valued uses. The recession eventually comes and reveals that projects that have been started all over the economy are unprofitable (the definition of economic waste). A tremendous amount of capital has been misallocated, and the recession corrects it. Unprofitable businesses must go bankrupt, wages must fall, jobs must be lost. Parts of the misallocated capital can then be purchased at a bargain and reincorporated into profitable lines of production, but some of it is always abandoned. Workers can be rehired at the correct wage level in profitable lines as well. This reallocates the factors of production back into a profitable capital structure. Just remember this: A booming economy is not a good thing. You too could "boom" if you wanted. You could "boom" your way through your entire life savings in a few weeks. You would live very high on the hog for a while. But after your savings were spent, would you actually be better off? Or worse? [ QUOTE ] but I guess that you are saying that these indicators, when taken into account with other troubling factors, are not necessarily a sign of good times to come. (Also from my end of it let me just say that wages are not "up". Salary raises are in no way keeping up with the cost of living.) [/ QUOTE ] Consumer inflation right now is RAGING. Don't believe the numbers they tell you for a minute. [ QUOTE ] Like I said, I need to reread all the replies in this thread. Right now I am wondering what a recession will mean to me personally as well as to our country and its standing in the world. I'm not sure if these things have been addressed by Borodog already and I don't mean to disrespect him by not fully reading his posts as he may have already addressed this. [img]/images/graemlins/tongue.gif[/img] [/ QUOTE ] I have some fairly radical thoughts on this as well. [img]/images/graemlins/wink.gif[/img] Maybe I'll post some of them when you've caught up. [ QUOTE ] But here are some things specifically that are on my mind this morning as I get ready for work and worry about the state of my bank account: Given a recession may be in the near future, should I take my money and invest in bonds now? Should I be buying some real estate? Should I cancel my trip to Europe next summer as the dollar is so weak and it might be just downright foolish? How long is this recession thing going to last, a year? A decade? (Am I an idiot to be worrying about all this stuff right now and would I be better off concentrating on what's for lunch?) [/ QUOTE ] All of this is hard to say and I don't want to give you advice that will steer you wrong. I am not an expert, nor a prognosticator. I believe there is a recession coming, but it's impossible to say exactly when, or how deep or long it will be, or what sectors will be hit hardest. I do believe that a trip to Europe next year will cost you a pantload. I don't think that real estate has bottomed. Personally, I'm buying gold. Spend less, save more. Always good advice, even though I have a hard time following it myself. [img]/images/graemlins/tongue.gif[/img] |
Re: The Economy, Lounge Style
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So my suggestion is to topics very specific/ centered around micro economic topics, not "the purpose of the fed". Good question: Why did milk prices in my store go up? Bad questions: Why do prices rise over time? What causes exchange rates to fluctuate? [/ QUOTE ] Katy asked specifically about the economy, not micro-economic concepts like rent controls, although I would be perfectly happy talking about that sort of thing, too. Fascinating stuff. But I don't think anyone can hope to have any sort of coherent understanding of "the economy" if they don't understand the purpose of the Fed, and I think, "Why do prices rise over time?" and "What causes exchange rates to fluctuate?" are perfectly good questions. [img]/images/graemlins/smile.gif[/img] |
Re: The Economy, Lounge Style
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All you have to do is look at the theory to understand that there is something better out there. The Austrian business cycle theory I linked too proves it's better. Contrary to what Ben Bernanke would have you believe, it is not "better to have boomed and busted than never to have boomed at all." The boom represents capital misallocation, and during the bust some of that capital is always abandoned, meaning there is always a net economic loss over the cycle, compared to what would have occurred in the absence of the cycle. [/ QUOTE ] I find this wanting. You assume that the boom represents capital misallocation, but I don't see proof for that. The very point of the market is experimentation, which is hugely wasteful, so why can't booms lead innovation and capital development in a way that a steady rise wouldn't? Why is a boom *necessarily* a bad thing? And how is it different to the money provided by ill informed punters on the stock market? The theory underpinning the mis allocation of capital from extra money supply also seems wanting. Businesses can react adequately to all kinds of market conditions, including those that governments helps stabilize by regulation, but suddenly when the government increases the money supply, they start misallocating capital? Doesn't sit right with me. I'd also be curious if there is any actual quantification of this waste vs the innovation and progress gained from an artificial inflation of the money supply. Without some kind of solid quantification, it seems to be just a theory that could be either unimportant in the scheme of things of overcome by other considerations - or valid. It's a bit premature to claim this as economic truth without scientific testing of these simplistic (compared to the economy) theories. |
Re: The Economy, Lounge Style
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find this wanting. You assume that the boom represents capital misallocation, but I don't see proof for that. The very point of the market is experimentation, which is hugely wasteful, so why can't booms lead innovation and capital development in a way that a steady rise wouldn't? Why is a boom *necessarily* a bad thing? And how is it different to the money provided by ill informed punters on the stock market? [/ QUOTE ] Phil, I think you hit the nail on the head. I have always had a problem with the idea that the market cannot "learn" over time. I think the more mature a market is, the better the decisions in allocation it will make. History counts. I think that a lot of the notions put forward by economists in general ignore this principle. |
Re: The Economy, Lounge Style
Borodog: great commentary, insight and analysis. I believe that there are historical differences in the current macro-economic climate which demonstrate that our domestic credit profile and the impact of our monetary policy undercuts the importance of traditionally positively viewed economic data. Specifically I am referring to misguiding and deflated inflationary numbers, GDP (a poor economic metric in its own right), employment, and consumer confidence. Hence, I am also bearish on American economic prospects over the foreseeable long-term future. Besides the raw data and analysis you’ve highlighted, several trends in a now-realized global marketplace play a role as well.
In addition to saving America from a recession in 2001, many of us benefited directly and all of us, indirectly, from loose monetary policy and the side-effects it had on the housing market. There were the financial institutions that fueled it, the labor market which had low barriers to entry into real-estate related professions that earned from it, the blue collar workforce that built into it, the middle class that spent out of unrealized equity gains caused by it, and the speculators that profited from it. However, for nearly all of the players in this game, the price of a few more years of hyper-growth has escalated the potential damage of a credit crunch even further as leverage, derivative or otherwise, has soared to gargantuan proportions. Dropping the bottom out of these extra-normal profit generators has just begun, and the fall-out goes far beyond the falling value of homes and potential needed bail-out of financial institutions that got creative with mortgage-backed securities… Zooming out a bit further, the U.S. is facing the stiffest global competition it has ever seen in nearly every sector by emerging markets and established players alike, and, as expected, profits have fallen (seen Ford lately?). Now, Phil/Exsubmariner have valid points that economic models, whether Keynesian, Austrian or otherwise, often do a poor job of incorporating the human element. Adjustments are made by the resilience of people and institutions that retool to profit from such conditions, and America has long been creative to insure that. So further technological advance or other unseen conditions may support our leveraged economy through additional cycles of unexpected growth, temporarily bolstering the beleaguered dollar and give new life to the credit markets. But, really, in the end, all of the recent creativity brought about by the over-extension of credit (and not just in real estate investment: see government, consumer, corporate, etc.) is ripe for correction. With America’s diminishing force as the dominant power within the global marketplace, rising commodity prices against a falling dollar, combined credit woes, its sense of entitlement and corresponding lack of competitiveness, and over-leveraged credit crunch, this correction suggests that we are in a larger cycle where other nations are looking to bring about a new global equilibrium in resource distribution. To get there, it is likely that a recession embodying the stagflation your analysis suggests is exactly how it comes about. The vehicles for such are already in place, and, although the timing for it is ultimately unknowable, it certainly appears it could be happening right now. For all my studies, I still don’t get gold, but it certainly looks like it will out-perform the American economy and, especially, the relative spending power of the dollar for the foreseeable future in real spending power. |
Re: The Economy, Lounge Style
Just wanted to add a few points to the discussion that borodog has written about elsewhere but that I found were critical in my own acceptance of the ABCT.
The Austrian school of economics puts great emphasis on the entrepreneur’s role in society. The successful entrepreneur is one who repeatedly, successfully navigates uncertainty and allocates resources to most aptly meet consumer demand. They are highly skilled at forecasting future market conditions since by its very nature production must occur prior to sale. Why then do so many get “tricked” by credit expansion? Why is the revered entrepreneur all of a sudden so dumb? First of all, though entrepreneurs are indeed highly skilled, normal market uncertainty doesn’t necessarily require an understanding of macroeconomics – especially Austrian theory. Indeed, for entrepreneurs to not be tricked would require that they believe that the credit expansion is not borne of real savings, not in accordance with underlying consumer time preferences, and will necessitate that a great many investments made during this period must fail for lack of real resources. Given that mainstream thought has not accepted these theories, it is understandable that otherwise talented entrepreneurs would be “tricked.” One objection I had to this line of reasoning is – why doesn’t the profit/loss mechanism select for those entrepreneurs most likely to not be fooled by a credit expansion? After all, in all other areas of uncertainty only those businessmen who continuously earn profits keep their capital – the market selects against those who waste resources. It seems this should hold even for those who waste resources due to their ignorance of the implications of credit expansion. I suspect one reason for the market’s inability here is the obligatory bailouts that always seem to follow a bust. Undoubtedly this restricts the market’s natural selection of profitable entrepreneurs. Further, as Borodog has suggested before, even if entrepreneurs completely accept the necessary consequences of artificial credit expansion they are caught in a prisoner’s dilemma. Ideally everyone would refrain from partaking in the artificial expansion, but if everyone else refrains then there is tremendous incentive to “cheat” and take the cheap credit and profit for yourself. Conversely, those who refrain from accepting the cheap credit will still bear some of the burden of the bust should others accept the artificial credit. Here is an interesting article on this idea: http://www.gmu.edu/rae/archives/VOL1...p;dempster.pdf Regardless of the reasons why entrepreneurs accept and bankers provide the artificial credit, empirically we know that they do. Given that they do, the Austrian business cycle theory is the logic of what necessarily must follow. This is what helped me grasp the importance of this theory – so long as artificial credit is successfully expanded the ABCT applies. Productive investment can only come from real savings – deferred consumption. At any one time there is only a fixed amount of real resources. If investment is expanded without the requisite deferral of consumption (indeed savings is even further reduced as artificially lower interest rates serve as a disincentive to save while stimulating investment) then the bulk of these projects must eventually be revealed as unprofitable. The real resources required for their completion simply don’t exist. |
Re: The Economy, Lounge Style
Thanks for that article, cook. I'm glad to see that other people are framing the problem in terms of the prisoner's dilemma; I hadn't actually seen anyone put it that way before it occurred to me. I feel vindicated. [img]/images/graemlins/smile.gif[/img]
Also, I feel cookbg's contribution completely addresses the concerns of Phil and Exsub, so I won't bother to comment further on them. |
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