A different kind of political blog.

Via the Financial Times:

The US Federal Reserve on Tuesday took a first step toward extending its crisis-era monetary policy regime, as it downgraded its view of the economic outlook amid rising fears of a “double-dip” recession.

I expect the Bank of England to do similarly at 10:30 this morning.

On 2 September 2009, I took the risk of explaining why a senior economist writing in The Times was bound to be disappointed when he wrote, Now it’s looking like V for victory over recession. I explained that he was wrong because the contemporary mainstream lacks a robust capital theory, so most economists are misled by distorted data. I wrote

No one is arguing that the present interventions by government are not giving the impression of prosperity; we agree that injecting new money creates economic activity. However, these measures create only an illusion which cannot last and which succeeds only in postponing and worsening the unavoidable crash. Society can ill-afford that outcome.

O’Neill is right: things look better. Unfortunately, this is another artificial boom which will not last.

You can find the article here.  In due course, the Times reported, Economists revolt over surprise recession data. I repeated that “most economists allow themselves to be misled by a superficial reading of numbers distorted by central bank action.”

Injecting more new money, whether through QE or credit expansion in excess of real savings, will not “fight recession”. It will merely delay and worsen the eventual downturn, because injecting new money is bound to shift activity from sustainable economic action to action supported only by that new money.

Sooner or later, the economic paradigm must shift to accept the importance of time and hence a robust capital theory. That moment cannot come too soon.

See also

• “The Pretence of Knowledge”: how economists come to make astrologers look good. 
• How an Economy Grows and Why It Crashes: Two Tales of the Economy
• Academic economic literature may be found here.

I have discovered that the IEA have relaunched “The Austrian School” by Jesús Huerta de Soto:

It has become increasingly clear that interventionism played a significant role in precipitating the 2008 financial crisis. The Austrian School is more than capable of providing the free market theoretical framework needed to understand why governments and central banks helped bring about the bust.

Jesus Huerta de Soto’s book offers a comprehensive yet concise overview of the Austrian school, an increasingly influential branch of economics. It succeeds in contrasting the most important elements of Austrianism with the Monetarist and Keynesian paradigm and draws from seminal Austrian texts to stress the importance of subjectivist methodology.

I met Jesús in Salamanca when we attended the Ludwig von Mises Institute’s conference celebrating the birthplace of economic theory. He is a man of inspiring intellect, passion and values. His book Money, Bank Credit and Economic Cycles is one of the seminal books for this crisis, and we were delighted when Jésus agreed to become a Senior Fellow of The Cobden Centre.

I have downloaded the PDF and I’m looking forward to what I expect will be an excellent read…

This article originally appeared at cobdencentre.org.

Via Thrifty families accused of prolonging the recession – Times Online, yet more crass Keynesianism:

Anxious families are repaying debts instead of spending in the shops, amid concern over the uncertain economic outlook. The share of income saved in banks and building societies has risen to its highest level in more than a decade, heightening fears that faltering consumer demand could prolong the recession.

But see also Correction, Mr. Bernanke:

It is real savings that fund economic activity. The increase in the pool of real savings is the key behind sustained real economic growth.

These two authors make fundamentally different diagnoses and policy prescriptions because economics is not a positive applied science comparable to, say, physics. There are at least four schools of economic thinking, as Jeffey Tucker explains, but only one school predicted the bust.

This conflict over whether saving promotes recovery really matters: if the wrong side win and policy makers take heed, the recession will be deeper and longer than necessary.

Further reading

• Now it’s looking like V for victory over recession – Times Online — including links to technical explanations of the differences between Keynesian and Austrian macroeconomics.
• Material Evidence – Recovery or crisis?
• Bastiat’s Iceberg: A Sean Corrigan Masterpiece for Christmas
• The Errors of Posen, New MPC Recruit
• The economic paradigm and its shift
• America’s Great Depression, by Murray N. Rothbard

From the article which took the Cobden Centre through 1000 views per day, My Journey to Austrianism via the City, by James Tyler:

I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Freidman, Fisher Black, Myron Scholes and the modern international financial system.

My analysis was steeped in the neo-classical, efficient markets paradigm.

Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.

Credit flowed, people got wealthier, economies developed and all was well.

And then the crisis struck.

Markets dried up and ceased to make sense. Price moves became highly irrational.

Then the whole market edifice began to crumble. Bear Stearns going bust tore a hole in the system and Lehmans almost collapsed the entire financial world.

What had gone so badly wrong I asked myself? How could this have happened?

At about this time I was listening to the US presidential debates. A load of guff and hot air really – all except this fella called Ron Paul. He banged on about liberty, the constitution and the evil of the Federal Reserve. His ideas were fresh to my ears.

In particular he talked about what seemed like a loopy idea. He wanted Gold as money, and the free market to handle it.

Without central banks.

My curiosity had been piqued.

Via Tangible Ideas – Goodbye to All That » The Cobden Centre, Sean Corrigan explains the end of an economic era:

The sheer violence of this reversal of fortune — something akin to the sudden, mortal swoop of a melted-wax Icarus after long hours of patiently spiralling heavenward on the thermals rising off the Cretan coast — has perplexed everyone from Her Britannic Majesty and her hapless First Minister to the fallen idols of investment practice, like Bill Miller and Bruce Bent – yet while its pattern may be a complex tangle of circumstances, there are, in truth, only a few basic threads in the weave, all of them very familiar to those with an Austrian perspective on the case: fiat money, gross government interference with markets, and the avid, rent-grubbing irresponsibility it fosters in everyone involved …

Via FTSE 100: stock market has best month in more than six years – Telegraph:

The stock market has enjoyed its best month in more than six years, boosting the savings of millions of investors and bringing hope that the worst of the recession may be over.

The FTSE 100 index of leading shares climbed 8.5 per cent in July, adding £134 billion to the value of the stock market, its best monthly performance since the fall of Baghdad during the second Gulf war in April, 2003.

The rise in share prices followed a series of strong profit figures from Britain’s biggest companies, with many proving to investors that they are coping well in the recession by cutting costs.

However, according to Austrian-School Theorists¹:

[U]ninterrupted stock market growth never indicates favorable economic conditions. Quite the contrary: all such growth provides the most unmistakable sign of credit expansion unbacked by real savings, expansion which feeds an artificial boom that will invariably culminate in a severe stock market crisis.

In other words, and most unfortunately, the present stock market conditions are an illusion produced by quantitative easing that will not last. And:

The crash will take place as soon as economic agents begin to doubt the continuance of the expansionary process, observe a slowdown or halt in credit expansion and in short, become convinced that a crisis and recession will appear in the near future. At that point the fate of the stock market is sealed.

1. De Soto, “Money Bank Credit and Economic Cycles”, p462 [↩]

This post has been brought forward for those people who asked me today about money, bank credit and economic cycles while I was telling for the EU and local elections.

As the Austrian Theory of the Trade Cycle gains interest for its coherent explanation of our present predicatment, it also gains opponents. Here, Robert Murphy answers Australian economist John Quiggin:

The Mises-Hayek theory of the business cycle — and of our recent housing bubble in particular — is gaining more and more adherents in the “real world.” To give anecdotal evidence: Five years ago, when I’d write a Mises Daily article, the fan mail would pour in from college students. But now, I get questions from hedge-fund managers and others working in the financial sector. Austrian economics is no longer a hobby; this is serious stuff.

…

I am not here to tell you the Mises-Hayek theory of the business cycle is a work of art that has no flaws. If I said that, then I would be living up to Quiggin’s caricature. What I will say is that the Austrian explanation of the boom-bust cycle makes more sense than any other explanation I’ve seen. In particular, most rival schools of thought say that the way to fix an economy plagued by overconsumption and reckless lending is to have the government borrow obscene amounts of money and to have politicians take over financial accounting. And it’s the Austrians who allegedly cling to dogma in the face of overwhelming counterevidence?

via Correcting Quiggin on Austrian Business-Cycle Theory – Robert P. Murphy – Mises Institute .

Why should we care? Because we are all in this economic mess together: understanding how we came to be here is the beginning of our route out.

See also The Importance of Capital Theory:

Once we understand how our present problems are due to a Fed-induced distortion in the capital structure, it becomes clear that the worst recommendation is for the Fed to cut interest rates and pump in ever more “liquidity.” It was artificially cheap credit that fueled the housing boom in the first place. Greenspan brought the federal funds target rate down to a ridiculous 1 percent — meaning the interest rate was actually negative, once we adjust for price inflation — and held it there for a year. He did this in order to (apparently) obviate the need for a harsh recession in the “real economy” after the dot-com crash. But in fact he sowed the seeds for our present crisis. If Bernanke continues shoveling in hundreds of billions to needy bankers, five years from now Americans (and the rest of the world) may look back fondly on the present the way the 2001 downturn now seems like a minor inconvenience.

It is worth remembering that Alan Greenspan once blamed the Great Depression on the actions of the Federal Reserve in that it pumped excess credit, “triggering a fantastic speculative boom”.

There are issues here that we should all strive to understand. That understanding is not out of reach: Rethinking economics — primer.

It seems everyone is talking about swine flu and the financial crisis, but they seem to be most persistently interested in what has gone wrong with the economy. After I explained the key points of this Nobel Prize Lecture by F A Hayek to my hairdresser this morning, she had confirmed in her mind what she always knew: that economists cannot discover all they need to make accurate predictions.

This is something we all need to understand.

What follows is a precis of that 1974 lecture (sometimes quoted verbatim). It explains why and how the economic policies of the time contributed to inflation and unemployment and it points the way out of our present and coming difficulties.

This is its message:

• Physical scientists can observe and measure the things that drive the sytems they are studying.
• Society, and therefore the economy, is not like a physical system: many of the most important factors cannot be seen or measured. Consider the thoughts and intended actions of millions of people at different times, for example.
• Economists and other social scientists, in their attempt to be scientific, ignore what they cannot measure.
• Therefore, many of the most important factors affecting the economy are not considered, while some of those factors which can be measured are deliberately controlled.
• The results are incorrect predictions and actions which positively harm society.

In a sentence: society is not a machine to be controlled, but a garden to be cultivated.

By the way, the remark about making astrologers look good is attributable to the Keynesian economist J K Galbraith:

The only function of economic forecasting is to make astrology look respectable.

The precis:

A Precis of “The Pretence of Knowledge”

The topic of this lecture is the chief practical problem of economists, who must now explain how to stop the accelerating inflation they have caused. In imitating the techniques of the physical sciences, economists have made grave errors of economic policy.

The assertion guided policy that there exists a positive correlation between total employment and the aggregate demand for goods and services. It implies we can permanently ensure full employment by maintaining total expenditure. This is fundamentally false and very harmful.
Read more

An explanation of the financial crisis for everyone:

Linda is the proprietor of a bar in Cork. In order to increase sales, she decides to allow her loyal customers – most of whom are unemployed alcoholics – to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around and as a result increasing numbers of customers (still mostly unemployed alcoholics) flood into Linda’s bar. Taking advantage of her customers’ freedom from immediate payment constraints, Linda increases her prices for wine and beer, the most popular drinks. Her sales volumes and profits increase massively.

… read on: You’re having a laugh ….. seriously?: The Credit Crunch Explained.

Three themes appear often in explanations of the crisis:

1. That bankers were greedy and irresponsible; that they made bad business decisions and sold bad products.
2. That regulation was insufficient or inadequate.
3. That too much money was loaned.

Read more

From an interview with ex-IMF economist Gunnar Tómasson:

Does this mean that generations of students have been brought up on nonsense ideology? For this is ideology, of course.

Gunnar:

Yes, nonsensical ideology. The root of the problem goes back to a point made in the mid-19th century by John Stuart Mill, one of the sharpest minds of all time, in an overview article on unresolved methodological aspects of economics. Mill viewed economics as a branch of logic and noted that the least error in the premises of any logical argument would infect with like error the whole superstructure built thereon. A seemingly small error is embedded in the premises of modern monetary economics. Paul Samuelson noted it very briefly in his Ph.D. thesis in 1942 and said it didn’t matter. Today, this small error is destroying the world’s monetary system.

via The End of Mainstream Economics: An Interview with Gunnar Tómasson – Gunnar Tomasson – Mises Institute . The small error infecting today’s mainstream system of economic thinking from its foundations — the error which has caused this crisis — is an inadequate understanding of the source of interest.