Central banks' unprecedented monetary expansion over recent years has created damage they cannot simply undo by switching directions now - as Frank Shostak explains in this guest post, their tight interest stance now will struggle to undo the damage caused by their previously ultra-profligate position.
Note that commentators commonly identify the growth rate measured by the CPI, i.e. rising prices, as "inflation." We hold, however, that what inflation is all about is increases in money supply.
The price of a good is the amount of money paid for it, but whenever there is an increase in the money injected into a particular goods market, this means that the price of the goods in money terms will tend to rise. All things being equal, however, this increase in money in one market will be offset by a decrease elsewhere. It is only an increase in the money supply itself that allows all prices to raise across all markets. This general increase in prices is itself not inflation, however, but rather the manifestation of inflation as a result of the increase in money supply, all other things being equal.
Bad as this is, what is even more important than the increases it causes in the prices of retail goods is the damage that monetary inflation inflicts to the process of wealth generation. This is because increases in money supply set in motion an exchange of nothing for something, which generates a similar outcome to what counterfeit money does. This counterfeit capital progressively weakens wealth generators, thereby weakening their ability to generate wealth. This, in turn, undermines living standards even as real capital is consumed.
Also, note that when this new money is injected, it initially enters a particular goods market. Once the price of those goods rises to a level at which they are perceived as fully valued, the money begins spilling over into other markets that are now considered under-valued. This gradual shift from one market to other markets gives rise to a time lag between these increases in new money, and their effect on the wealth generation process.
Note that contrary to popular thinking, interest rates are determined not by central bank monetary policy. Instead, they are driven by the time preferences of individuals. According to the founder of the Austrian school of economics, Carl Menger, the phenomenon of interest is the outcome of the fact that individuals assign a greater importance to goods and services now than they do to identical goods and services in the future. I is this that we call "time preference."
Because of this breach between the time-preference interest rate and the market interest rate, businesses responding to the declining market interest rate have essentially malinvested in capital goods relative to the production of present consumer goods. At some stage, by incurring losses, businesses are likely to discover that pass decisions with regard to the capital-goods expansion were in error.
According to Ludwig von Mises, a tight monetary stance cannot undo the negatives of the previous loose stance. (In other words, the central bank cannot generate a “soft landing” for the economy.) The misallocation of resources due to a loose monetary policy has already happened, and cannot simply be reversed by a tighter stance. (Mises likens the attempted correction to attempting to cure a road-accident victim by reversing over him.) According to Percy L. Greaves Jr. in the introduction to Mises's The Causes of the Economic Crisis, and Other Essays before and after the Great Depression:
As long as sustaining our lives remains individuals' ultimate goal of individuals (that is, as long as our species continues to breathe), they will go on assigning a higher valuation to present goods than they will to future goods -- to $100 now rather than to $103 a year from now -- and no amount of central-bank interest-rate manipulation is going to change this reality.
Dr Frank Shostak is a leading Austrian economist and director of Applied Austrian School Economics Ltd, which aims to assess the direction of various markets using the Austrian School methodology. AASE aims to make Austrian economics accessible to businessmen.
Central Banks Cannot Undo the Damage They Have Already Caused
by Frank Shostak
On March 16 this year, the US central bank (aka the Federal Reserve) raised the target for their federal funds rate by 0.25 percent, to 0.50 percent. According to officials of "The Fed," their increase was in response to the strong increases in the yearly growth rate of the Consumer Price Index (CPI), which in February stood at 7.9 percent (risen from 7.5 percent in January, and from 1.7 percent in February of the year before).
Most commentators believe that by raising the interest rate target, the central bank can slow the increase of prices of goods and services. Supporters of this strategy often refer to May 1981, when then Fed chairman Paul Volcker raised the Fed's funds-rate target from 11.25 percent to 19 percent. The change was dramatic. By December 1986, the yearly growth rate in the CPI, which in April 1980 had stood at 14.8 percent, had fallen to 1.1 percent (see Fig. 1 below).
On March 16 this year, the US central bank (aka the Federal Reserve) raised the target for their federal funds rate by 0.25 percent, to 0.50 percent. According to officials of "The Fed," their increase was in response to the strong increases in the yearly growth rate of the Consumer Price Index (CPI), which in February stood at 7.9 percent (risen from 7.5 percent in January, and from 1.7 percent in February of the year before).
Most commentators believe that by raising the interest rate target, the central bank can slow the increase of prices of goods and services. Supporters of this strategy often refer to May 1981, when then Fed chairman Paul Volcker raised the Fed's funds-rate target from 11.25 percent to 19 percent. The change was dramatic. By December 1986, the yearly growth rate in the CPI, which in April 1980 had stood at 14.8 percent, had fallen to 1.1 percent (see Fig. 1 below).
Fig. 1: CPI vs Federal Funds Rate, 1980 to 1986
As such, we do not say that inflation is caused by increases in money supply, as some commentators are suggesting. Instead, we hold that increases in money supply are what inflation is all about.
The price of a good is the amount of money paid for it, but whenever there is an increase in the money injected into a particular goods market, this means that the price of the goods in money terms will tend to rise. All things being equal, however, this increase in money in one market will be offset by a decrease elsewhere. It is only an increase in the money supply itself that allows all prices to raise across all markets. This general increase in prices is itself not inflation, however, but rather the manifestation of inflation as a result of the increase in money supply, all other things being equal.
Bad as this is, what is even more important than the increases it causes in the prices of retail goods is the damage that monetary inflation inflicts to the process of wealth generation. This is because increases in money supply set in motion an exchange of nothing for something, which generates a similar outcome to what counterfeit money does. This counterfeit capital progressively weakens wealth generators, thereby weakening their ability to generate wealth. This, in turn, undermines living standards even as real capital is consumed.
Also, note that when this new money is injected, it initially enters a particular goods market. Once the price of those goods rises to a level at which they are perceived as fully valued, the money begins spilling over into other markets that are now considered under-valued. This gradual shift from one market to other markets gives rise to a time lag between these increases in new money, and their effect on the wealth generation process.
Central Banks do not set interest rates. Individuals do.
Note that contrary to popular thinking, interest rates are determined not by central bank monetary policy. Instead, they are driven by the time preferences of individuals. According to the founder of the Austrian school of economics, Carl Menger, the phenomenon of interest is the outcome of the fact that individuals assign a greater importance to goods and services now than they do to identical goods and services in the future. I is this that we call "time preference."
For example, most people will generally prefer being given $100 now rather than, say, $103 a year from now. It is this evaluation by multiple individuals that is the driving force of interest rates across all markets.
Observe that the higher valuation of present goods is not the result of capricious behaviour, but rather the identification that life in the future is impossible without sustaining it in the present. According to Menger:
Naturally, each individual's time preference is different. Those with paltry means often have shorter time horizons -- they can contemplate only short-term goals, such as making a basic tool. As his means increase, however, he can consider undertaking the making of better tools. With the expansion in the pool of means, individuals are able to allocate more means towards the accomplishment of ever-more remote goals in order to improve their quality of life over time.
Again, while prior to the expansion of means, the need to sustain life and wellbeing in the present made it impossible to undertake various long-term projects, with more resources now this has become possible.
Not that few, if any, individuals will embark on a business venture promises a zero rate-of-return. The maintenance of the process of life, over and above hand-to-mouth existence, requires an expansion in wealth. Wealth expansion implies positive returns.
Contrary to the popular thinking, a decline in the interest rate is not the driving cause behind the increases in capital-goods investment. What permits the expansion of capital goods is not the lowering of the interest rate but rather the increase in the pool of savings.
This "pool of savings" comprises of finished consumer goods -- finished consumer goods produced, but not yet consumed. It is this pool of savings that sustains people employed in the enhancement and the expansion of capital goods such as tools and machinery. With these increased and enhanced capital goods, it is then possible to increase the production of future consumer goods.
Observe that the higher valuation of present goods is not the result of capricious behaviour, but rather the identification that life in the future is impossible without sustaining it in the present. According to Menger:
Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economising men generally endeavour to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.1Hence, various goods and services required to sustain one’s life at present must therefore be of a greater importance to that individual than the same goods and services in the future. The individual is likely to assign higher value to the same good in the present versus the same good in the future.
Naturally, each individual's time preference is different. Those with paltry means often have shorter time horizons -- they can contemplate only short-term goals, such as making a basic tool. As his means increase, however, he can consider undertaking the making of better tools. With the expansion in the pool of means, individuals are able to allocate more means towards the accomplishment of ever-more remote goals in order to improve their quality of life over time.
Again, while prior to the expansion of means, the need to sustain life and wellbeing in the present made it impossible to undertake various long-term projects, with more resources now this has become possible.
Not that few, if any, individuals will embark on a business venture promises a zero rate-of-return. The maintenance of the process of life, over and above hand-to-mouth existence, requires an expansion in wealth. Wealth expansion implies positive returns.
Is the lowering of rates the key cause behind the increase in capital-goods investment?
Contrary to the popular thinking, a decline in the interest rate is not the driving cause behind the increases in capital-goods investment. What permits the expansion of capital goods is not the lowering of the interest rate but rather the increase in the pool of savings.
This "pool of savings" comprises of finished consumer goods -- finished consumer goods produced, but not yet consumed. It is this pool of savings that sustains people employed in the enhancement and the expansion of capital goods such as tools and machinery. With these increased and enhanced capital goods, it is then possible to increase the production of future consumer goods.
Note that in an unhampered market it is not the interest rate per se that drives this pool of savings towards more (or less) future-directed production -- it is the sum of individuals' time preferences toward more (or less) future focus that compel producers to make this choice.
Individuals' decisions to allocate a greater amount of means towards the production of capital goods is signalled by the lowering of individuals' time preferences, i.e., assigning a relatively greater importance to the future goods versus the present goods.
Individuals' decisions to allocate a greater amount of means towards the production of capital goods is signalled by the lowering of individuals' time preferences, i.e., assigning a relatively greater importance to the future goods versus the present goods.
Hence, the interest rate is just an indicator as it were, which reflects individuals’ decisions regarding their present consumption versus future consumption. (Again, the decline of the interest rate is not the cause of the increase in capital investment. The decline simply mirrors the decision to invest a greater portion of savings towards capital-goods investment).
In a free unhampered market, a decline in the interest rate informs businesses that individuals have increased their preference towards future consumer goods versus present consumer goods. Businesses that want to be successful in their ventures must abide by consumers’ instructions, and organise a suitable infrastructure to accommodate this signalled demand for more consumer goods in the future (rather than now).
In a free unhampered market, a decline in the interest rate informs businesses that individuals have increased their preference towards future consumer goods versus present consumer goods. Businesses that want to be successful in their ventures must abide by consumers’ instructions, and organise a suitable infrastructure to accommodate this signalled demand for more consumer goods in the future (rather than now).
Note that through the lowering of time preferences, individuals have signalled that they have increased savings which will support the expansion of the production structure to become more future-directed. In the unhampered market, the decline in interest rate is therefore both a signal for more future-directed production, and a reward for undertaking it.
Observe that in an unhampered market, fluctuations in interest rates will tend to be in line with changes in consumers’ time preferences. Thus, a decline in the interest rate is in response to the lowering of individuals’ time preferences. Consequently, when businesses observe a decline in the market interest rate, they respond to it by increasing their investment in capital goods to accommodate the likely increase in demand for future consumer goods. (Note again that in a free-market economy, a decline in the interest rate indicates that on a relative basis individuals have lifted their preference towards future consumer goods versus present consumer goods).
What I have described here however is what happens in a free unhampered market -- in particular, one unencumbered by a government central bank. A major reason for the discrepancy between the so-called 'market interest rate' and the interest rate described here (i.e., the interest rate that fully reflects individuals' time preferences) is caused by the central bank. For instance, an aggressive loose monetary policy by the central bank leads to the lowering of the observed interest rate regardless of individuals' expressed time preference. Businesses respond to this lowering by increasing the production of capital goods, i.e., tools and machinery, in order to be able to accommodate the demand for consumer goods in the future. Note, however, that consumers have not actually indicated a change in their preferences toward present consumer goods. The time-preference interest rate did not go down. And so a gap emerges between the time-preference rate and the market rate.
It is this gap that causes the dislocations between consumption and consumption that presage economic corrections in future, and encourage over-consumption of capital now.
Observe that in an unhampered market, fluctuations in interest rates will tend to be in line with changes in consumers’ time preferences. Thus, a decline in the interest rate is in response to the lowering of individuals’ time preferences. Consequently, when businesses observe a decline in the market interest rate, they respond to it by increasing their investment in capital goods to accommodate the likely increase in demand for future consumer goods. (Note again that in a free-market economy, a decline in the interest rate indicates that on a relative basis individuals have lifted their preference towards future consumer goods versus present consumer goods).
What I have described here however is what happens in a free unhampered market -- in particular, one unencumbered by a government central bank. A major reason for the discrepancy between the so-called 'market interest rate' and the interest rate described here (i.e., the interest rate that fully reflects individuals' time preferences) is caused by the central bank. For instance, an aggressive loose monetary policy by the central bank leads to the lowering of the observed interest rate regardless of individuals' expressed time preference. Businesses respond to this lowering by increasing the production of capital goods, i.e., tools and machinery, in order to be able to accommodate the demand for consumer goods in the future. Note, however, that consumers have not actually indicated a change in their preferences toward present consumer goods. The time-preference interest rate did not go down. And so a gap emerges between the time-preference rate and the market rate.
It is this gap that causes the dislocations between consumption and consumption that presage economic corrections in future, and encourage over-consumption of capital now.
Because of this breach between the time-preference interest rate and the market interest rate, businesses responding to the declining market interest rate have essentially malinvested in capital goods relative to the production of present consumer goods. At some stage, by incurring losses, businesses are likely to discover that pass decisions with regard to the capital-goods expansion were in error.
Why tightening now cannot undo the negatives of a previous loose stance
According to Ludwig von Mises, a tight monetary stance cannot undo the negatives of the previous loose stance. (In other words, the central bank cannot generate a “soft landing” for the economy.) The misallocation of resources due to a loose monetary policy has already happened, and cannot simply be reversed by a tighter stance. (Mises likens the attempted correction to attempting to cure a road-accident victim by reversing over him.) According to Percy L. Greaves Jr. in the introduction to Mises's The Causes of the Economic Crisis, and Other Essays before and after the Great Depression:
Mises also refers to the fact that deflation can never repair the damage of a prior inflation.... Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.A tighter interest-rate stance, while likely to undermine current bubble activities, is also however still likely to generate various distortions, thereby inflicting damage to wealth generators. Note that a tighter stance is still intervention by the central bank, and in this sense it still falsifies the interest-rate signal set by consumers. A tighter interest-rate stance still doesn't result in the allocation of resources in line with consumers’ top priorities. Hence, it does not follow that a tighter interest rate stance can reverse the damage caused by inflationary policy.
Now, if we were to accept that inflation is about increases in money supply, then all that is required to erase inflation is to seal off the loopholes for the generation of money out of “thin air” by the central bank. A careful scrutiny of this is going to reveal that the culprit behind the increases in money supply is the monetary policies of the central bank.
Policies aimed at stabilising price increases are in fact producing economic upheavals. Observe that by February 2021, the yearly growth rate of our monetary measure for the USA jumped to almost 80 percent! This is truly astonishing. Against the background of this massive increase, one should not be at all surprised that the yearly growth-rate of the CPI has accelerated. And against the background of this article, one might begin to understand why policies that aim only at slowing the growth rate of the CPI rather than arresting the growth rate of money supply are likely to undermine economic conditions rather than improve them.
Policies aimed at stabilising price increases are in fact producing economic upheavals. Observe that by February 2021, the yearly growth rate of our monetary measure for the USA jumped to almost 80 percent! This is truly astonishing. Against the background of this massive increase, one should not be at all surprised that the yearly growth-rate of the CPI has accelerated. And against the background of this article, one might begin to understand why policies that aim only at slowing the growth rate of the CPI rather than arresting the growth rate of money supply are likely to undermine economic conditions rather than improve them.
Conclusion
As long as sustaining our lives remains individuals' ultimate goal of individuals (that is, as long as our species continues to breathe), they will go on assigning a higher valuation to present goods than they will to future goods -- to $100 now rather than to $103 a year from now -- and no amount of central-bank interest-rate manipulation is going to change this reality.
But this will not stop them trying. Any attempt by central bank policy makers to overrule this fact however will undermine the process of wealth formation, and will lower individual living standards.
On the one hand, if individuals have not allocated adequate savings to support the expansion of capital goods investments, then it is not going to help economic growth if the central bank artificially lowers interest rates. It is not going to help, because it it not possible to replace real savings with more money and an artificial lowering of the interest rate. It is not possible, because it it not possible to generate something from nothing.
Likewise, by raising interest rates the central bank cannot undo the damage from its previously easy interest-rate stance. A tighter stance will likely generate various other distortions. Hence, what is required is that policy makers should leave the economy alone -- and let the market be completely free from central-bank tampering.
* * * *
Dr Frank Shostak is a leading Austrian economist and director of Applied Austrian School Economics Ltd, which aims to assess the direction of various markets using the Austrian School methodology. AASE aims to make Austrian economics accessible to businessmen.
Versions of this post previously appeared at the Mises Wire and Cobden Centre.
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