Friday, August 27, 2010

KA-POW! #42 - Shostak

This week's “Kick-Ass Post O’th’ Week” (KA-POW) goes to Frank Shostak for “Is Deflation Really Bad for the Economy?” :

A general fall in prices can also emerge as a result of a fall in the money stock. An important cause for such a fall is a decline in fractional-reserve lending. The existence of a central bank and of fractional-reserve banking permits commercial banks to generate credit not backed up by real savings, i.e., credit created out of thin air. Once the unbacked credit is generated, it creates activities that the free market would never support — activities that consume, and do not produce, real wealth. As long as the pool of real savings is expanding and banks are eager to expand credit, various false activities continue to prosper.

Whenever the extensive creation of credit out of thin air lifts the pace of real-wealth consumption above the pace of real-wealth production, this undermines the pool of real saving. Consequently, the performance of various activities starts to deteriorate, and bank's bad loans start to rise. In response to this, banks curtail their loans by not renewing maturing loans and this in turn sets in motion a decline in the money stock.

The point that must be emphasized here is that the fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary policies of the central bank and not by the liquidation of debt.

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The unbacked credit in turn leads to the reshuffling of real savings from wealth generators to non–wealth generators. This in turn weakens the ability to grow the pool of real savings, which in turn weakens economic growth.

It must also be emphasized here that government outlays are another important factor undermining the pool of real savings. The larger the outlays are, the more real savings are diverted from wealth generators.

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As we have seen, deflation comes in response to previous inflation. Note that as a rule a general increase in prices, which is labeled inflation, requires increases in the money supply. Hence a fall in the money supply leads to a fall in general prices — labeled as deflation. This amounts to the disappearance of money that was previously generated out of thin air. This type of money gives rise to various nonproductive activities by diverting real savings from productive real wealth generating activities.

Obviously, then, a fall in the money stock on account of the disappearance of money out "of thin air" is great news for all wealth-generating activities; the disappearance of this type of money arrests their bleeding. A fall in the money stock undermines various nonproductive activities. It slows down the decline of the pool of real savings and thereby lays the foundation for an economic revival.

But what about the fact that a general decline in prices is accompanied by a fall in general economic activity? Surely this means that deflation may be bad news for productive and nonproductive activities? The fall in economic activity, as we have already shown, comes not on account of falling prices, but on account of a fall in the pool of real savings.

The emergence of deflation is the beginning of the process of economic healing. Deflation arrests the process of impoverishment inflicted by prior monetary inflation. Deflation of the money stock, which as a rule is followed by a general fall in prices, strengthens the producers of wealth, thereby revitalizing the economy.

Obviously, the side effects that accompany deflation are never pleasant. However, these bad side effects are not caused by deflation but rather by the previous inflation. All that deflation does is shatter the illusion of prosperity created by monetary pumping.

Again, it is not the fall in the money supply and the consequent fall in prices that burdens borrowers but the fact that there is less real wealth. The fall in the money supply, a money supply created out of "thin air," puts things in proper perspective. As a result of the fall in money, various activities that sprang up on the back of the previously expanding money supply now find it hard going.

It is those non–wealth generating activities that end up having the most difficulties in serving their debt, because these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators.

Contrary to the popular view then, a fall in the money supply is precisely what is needed to set in motion the buildup of real wealth and a revitalizing of the economy. Printing money only inflicts more damage and therefore should never be considered as a means to help the economy.

Honorable mention goes to Grant M. Nülle for “Cutting Is So Hard to Do” :

Every dime of government spending pleases some in-built constituency. Once legislators give money away (that is, spend tax monies), it is much harder subsequently to take the spending back.

Whether it is public employees, government agencies, trade unions (teachers, fire, police, etc.), pensioners, or particular businesses and industries benefitting from government largesse, each constituency or special interest has its sacred cows of government spending. In times of plenty — such as cheap-money-induced economic booms — when the government's tax take is bountiful, each constituency fights for additional appropriations to be directed to their favored cause, whether it is new spending programs, special tax credits for social-welfare causes, or pseudo-economic purposes. In times of dire fiscal conditions, each constituency fights vehemently to oppose a loss of their share of seized private property.

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This problem is compounded by the fact that government has grown so large that it is involved in every aspect of life. It is sometimes unfathomable to realize modern governments possess a claim on one's wages (Social Security, Medicare, and payroll and withholding taxes, income (progressive income taxes), property (property taxes), spending (sales taxes and VATs) — and this is not to mention the destruction of savings and distortion of prices through inflation. With no prospect of relieving any of these profound burdens, it is little wonder the average citizen is largely apathetic and alienated by modern government.

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At the heart of the capitalist system is the reality that all business planning and decision making must be based on market prices. Prices are used to determine whether various configurations of the factors of production are available at prices low enough to yield a profit based on the expected prices customers are willing and able to pay for businesses' products.

It follows then that valuation of business performance can be made through the method of accounting. By accounting for the market prices paid for the business inputs (factors of production employed) and the market prices received for business outputs (products sold to customers), business managers may ascertain whether a profit or loss is being made. In particular, business managers can use this accounting information to identify which aspects of the business are yielding profits and which ones are not.

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Conversely, government does not operate by the rules of the marketplace. As the only organization in society — save criminal gangs — that parasitically thrives on plundering the fruits of others, its existence, purpose, and method of evaluation are distinctly different from business.

Government agencies do not operate on the basis of profit and loss; this method of calculation is inapplicable because government does not incur costs and receive revenues the same way a business does. Government operations are not funded through the sale of goods and services to customers; rather, monies are acquired through coercion — principally taxation — and then allocated to each agency through the Byzantine legislative process described earlier.

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Because there is no link between the "revenue" acquired by government agencies and the costs these entities incur to perform public functions, there is no way of utilizing the yardstick of profitability to evaluate whether agencies are performing a useful function.

As Ludwig von Mises succinctly puts it, "bureaucratic management is management of affairs which cannot be checked by economic calculation."

Unlike the business manager of a private enterprise, bureaucrats and elected representatives have no means of rationally evaluating the value of any public service. This means that any cuts to that spending are intrinsically irrational — one simply lacks a reliable means of making a decision. Given this vacuum of objective assessment criteria, legislators, voters, SIGs — and really, anyone — may manufacture their own methods of justifying an increase or decrease to any dime of government spending, whether through persuasion, political pressure, or any other means available. Constituencies necessarily drive the appropriations process.

Economic calculation does not apply to government services; that is fundamentally why cutting spending is so hard to do.

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