Friday, 27 April 2018

The Economic Stimulus Fable

Economic stimulus generally refers to the use of monetary and fiscal policies implemented centrally by a government or government agencies to "spur" or “kick-start” economic growth in a struggling economy. Stimulus is usually called for following a period of inflationary growth that necessarily must come to an end. The central bank, whose policies are partly founded on the doctrine that interest rates should be raised during good times and lowered during bad, controls the monetary element of the “stimulus.” Furthermore, the thinking goes, money supply growth therefore needs to be slowed during good times and managed up during bad times. Why? Because lowering interest rates and increasing the money supply growth rate fuel demand and with it economic activity while rising interest rates and decreasing money supply growth achieve the opposite according to this line of thinking.

Through manipulating the money supply and interest rates, a central bank is able to steer the economy and smooth out booms and busts. At least this is the claim made by central banks and the institutions and scholars that support such politics and interventions.

The view that lower interest rates will support economic activity is held by, to my knowledge, all central banks around the world in their quest to “combat” the lack of growth. In recent years, central banks have held a zero interest rate policy (ZIRP) including the Fed, ECB, Bank of England, and Bank of Japan, and the Bank of Canada. This line of thinking makes it sound like the artificially lowering of interest rates, i.e. implementing policies that push interest rates lower than what the market would establish with no intervention, unleashes some sort of untapped economic potential.

The economy is no horse however and should not be handled like one. While lower interest rates brought about by increased voluntary saving certainly bodes well for future economic growth, artificial lowering of interest rates by central banks and commercial banks do not achieve the same feat. In this regard, it should be observed that it is not the lower interest rates per se resulting from increased saving that generate brighter economic prospects. Rather, it is everything that made the interest rate decrease in the first place that is the deciding factor, i.e. the increased accumulation of saving and the factors that made it possible in the first place. It therefore does not help one iota to artificially decrease interest rates when it is not fueled by increased saving.

Unwittingly, rather than planting the seeds of economic progression, an artificial lowering of interest rates is a fertilizer for economic regression. Lower interest rates of course do lower the borrowing costs for entrepreneurs seeking to expand production or invest in new facilities and lines of business. Likewise, people with floating interest debt payments and owners of a wide range of interest-sensitive securities gain with lower interest rates.

But these gains need to be paid for by someone as they did not appear out of nothing and without consequences elsewhere. If there were no costs attached to an artificial lowering of interest rates, we could just abandon interest rates altogether and implement a permanent zero-interest rate policy and make everybody better off in economic terms as a result. Common sense tells us that interest rates would have been abandoned long ago if creating economic prosperity was that simple. Well, it is not that simple. Someone needs to pay for these gains as no economic wealth whatsoever is created by the act of artificially lowering interest rates.

And these gains for some are certainly not paid for by central- or commercial banks. They are instead paid for by the people not benefiting from lower interest rates. First and foremost, it is those with most of their savings deposited with the local bank and people on fixed wages and salaries that foot the bill, i.e. the great majority of people in any economy. Secondly, as an artificial lowering of the interest rate is accomplished mainly through increasing the quantity of money, it is especially the late receivers of these new monies that lose out as the purchasing power of their existing money have become diluted by the time they get their hands on the new ones. Thirdly, monetary expansion creates economic distortions that create the business cycle and which tends to reduce, not increase, economic growth over the longer term. In this sense, the great majority lose out in the long run.

The stimulus button is little more than the grandest of schemes (referred to as "tools" in central bank speak) to make consumers spend more and facilitate ever-growing government spending and to lure businesses into investing above and beyond what they can possible make an adequate return on during the life of the asset. Business owners might have figured that out during the last couple of cycles which might in part explain why investment levels have ran at relatively low levels after 2008.

“Economic stimulus” through monetary inflation and an artificial lowering of interest rates never was, nor will it ever be, a source of untapped economic growth that can be turned on and off by the whims of central planners. It is a button however that does squander scarce resources by facilitating overconsumption and capital misallocations. In essence, economic stimulus is little else than spurring current economic activity and hoping the market will make up for the costs attached to this stimulus in time to make it appear as though it was achieved by the stimulus. In reality, the increased economic activity over the shorter term comes at the expense of future economic growth. Hence the expression kicking the can down the road, leaving the problems to be solved by those elected at a later stage.

Additionally, and of the greatest importance for the central bank and the banking system, monetary stimulus is highly effective in inflating asset prices and the market values of the very collateral bank credit is secured by. Specifically, fractional reserve banks depend on ongoing inflation not only for growth, but for their very existence. Deflation on the other hand is a death sentence for commercial banks as the market values of collateral shrink while their liabilities (mostly deposits) remain largely unchanged at face value.

But for the real economy, it is increased savings and production that is really required, not increased spending financed by newly created money which had already been artificially boosted and then saturated during the previous boom (the reason for the bust!). Consequently, economic growth likely slumps even lower when stimulus is once again added. Which so happens to be the case for the U.S. economy for especially the past decade.

But the central planners' fable is now again nearing its end as the Fed has been turning the stimulus button off and the tightening button on. But as there is no real growth to turn off, the result is an inevitable one; the revelation that the economy has in fact been doing poorly all along. And when confidence vanishes as it must since it cannot forever be disconnected to reality, everyone that desire so can now see that the people at the FOMC had been walking nude this whole time. The dumb audience, spanning well know mainstream economists to financial news statists stuck comfortably in their ivory towers now should look silly to all except for the permanently incompetent. Until it is all forgotten and the whole parade starts all over again.

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