The war on savers and how it damages the capital structure

Boosting 'aggregate demand'

To no-one's surprise, the Federal Reserve's open market committee (FOMC) , slashed interest rates to near zero in December, while simultaneously announcing its intention to engage in even more interventions in the credit markets, that essentially amount to what is known as 'monetization of debt', whereby the Fed buys up debt securities in exchange for newly created 'money'.

The following statement accompanied the Fed's action:

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent. 
Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.
Meanwhile, inflationary pressures have diminished appreciably.  In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.  In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. 
The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco.  The Board also established interest rates on required and excess reserve balances of 1/4 percent.

Take note of the sentence I have bolded in this statement from the money Kremlin:

„The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.“

Apparently, the Fed's central money price fixing committee holds that the way toward 'sustainable economic growth' is best fostered by making war on all of those who have refused to partake in the recently burst bubble – those that have been prudent and have accumulated savings.
It has just slashed their income by another ¾ – 1% to virtually zero, in the hope that this low rate of interest will induce them to spend their savings – in short, it intends to spur consumption by waging war on savers.

It is also hoped, judging from the statement, that consumption will be boosted by inducing the banking system to lend more money at favorable rates. The banks are large holders of the types of securities the Fed intends to 'monetize', and the Fed obviously wants to stuff them to the gills with 'new bank reserve assets' , to give them incentive to lend and get that darn money multiplier pointing up again.


A picture of monetary erectile dysfunction:
The famed 'money multiplier' – measured by dividing the money measure M1 through the monetary base. Since M1 measures inter alia the creation of new deposits (an indirect measure of the proliferation of fractionally reserved credit), the recent plunge in the multiplier indicates that the Fed's pumping up of base money has not had the desired effect. Click on chart for larger image.

The erroneous beliefs these actions are based on represent a sort of economic superstition. The idea that we have a 'deficiency of consumption' flies in the face of common sense, since common sense alone tells us that prior to the recent bust we had too much consumption – much of it financed with the same credit out of thin air that the Fed so desperately wants to get flowing again - and that this surfeit of credit based overconsumption is what has actually caused the bust in the first place.

So how come the money Kremlin believes more of the same will be a good thing?
Their error is in believing that the state of affairs prior to the bust was 'good', and thus should be recreated at all costs.
Was not the period now fondly remembered as the 'good times' – the boom – marked by lots of consumption? Yes, it was. Therefore, so they apparently hold, one should strive to once again put in place the set of conditions that seems to be the proper backdrop to 'good times'.

As I have mentioned previously, the people responsible for these decisions base them on a very simple circular flow model of the economy consisting of 'aggregates' that can be neatly pressed into equations. Drop some new fiat money into someone's lap, and presto, consumption will be revived, and with it 'sustainable growth', so their economic models tell them.
What they fail to consider is the economy's capital structure. To them, investment and capital are just another 'aggregate' , that sits somewhere in their circular flow model. 'Boost demand', so their thinking goes, 'and the rest will take care of itself'.

Unfortunately, it is a whole lot more complicated than that. If all it took to create 'sustainable economic growth' were the throwing of a few levers by a bunch of monetary bureaucrats, Zimbabwe under Dr. Gono's wise monetary leadership would be a utopia of riches. Surely no-one can possibly doubt his credentials as an accomplished inflationist. He has done a lot more to 'boost aggregate demand' than the FOMC has gotten around to so far, so it is only proper that we ask how his country ended up with an 80% unemployment rate. There has to be a fly in the ointment somewhere.

The structure of production, savings and interest rates

To the average mainstream economist, capital is merely an aggregate ; if that were actually the case, then the conclusion that lower consumption will necessarily lead to recession and unemployment would be correct.

However, there is in reality a trade-off between consumption and investment. Let us consider a world without interfering central planners.
In such a world, savings are simply that part of production that has not been consumed. Since investment is constrained by the amount of available savings, it follows that less consumption is the prerequisite for more investment.
Every year, a certain amount of capital needs to be replaced. The amount of savings in excess of this replacement need is what is available for additional, net new capital investment. Keep in mind that we are talking about real resources and capital, not 'money'.

Capital is however not an amorphous aggregate. It has a structure – what we will refer to as the 'structure of production'. This structure has a complex inter-temporal ordering; before a consumer good hits the shelves at Wal-Mart, it goes through number of processes , the stages of production.

Consider a relatively simple good like a toaster. It has metal and plastics parts, put together in such a way as to make the toasting of bread possible. In the early stages of production, the metal needs to be mined and smelted; the oil needs to be pumped and transformed into plastic. In the next stages the metal and plastic must be shaped into the various parts that will make up the toaster. In a still later stage, the parts need to be assembled. In the final stage, wholesalers and retailers hold an inventory of toasters and organize their distribution to consumers (this is a very simplified version of the whole process for the purpose of discussion – consider e.g. that the shaping of parts requires dies and molds, the production of which is quite a complex process as well).
If we consider the various stages of production involved in making this toaster, we can see that some of them must take place earlier in time than others, and that the earlier stages in which the higher order raw and intermediate goods are produced are likely to involve very long range planning and large capital investment.

So how will entrepreneurs know how much and in which stages of the production process to invest? Obviously this will depend on the amount of funds available for investment – i.e. the amount of available savings. The market signal that indicates whether a relatively large or small amount of savings is available is the prevailing interest rate.
We are all producers, consumers and savers in personal union; our propensity to collectively either consume more in the present, or consume less in the present in order to save for future consumption, is referred to as 'time preference'.

If our time preference is low, we will tend to save more of our production, which will increase the amount of savings available for investment – the interest rate in this case will fall. This allows the long range planning of consumers (saving for future consumption) to mesh with a corresponding long range planning of producers – as the larger amount of available savings as indicated by low interest rates makes very complex long range investment projects possible. Investment will then increasingly gravitate toward the earlier stages of the production structure, and these stages will then be able to outbid the later stages for labor and resources.
In addition, the production structure will tend to lengthen – a more complex and roundabout production process will evolve, adding new stages of production to the structure , improving overall productivity via increased specialization.

At the end of this process, over time, more consumption will be possible than would otherwise have been the case, i.e. if fewer savings had been available earlier. In short, by people deciding to consume less in the present and save more for future consumption, more investment is made possible, which in turn will enable more production and consequently make possible more consumption in the future.

This is what 'sustainable' growth actually is. There is no need to interfere with this process – it will spontaneously order itself in an optimal manner if left alone – by what Adam Smith called the 'invisible hand'. The sum of all individual decisions in the market economy – individual decisions that are all aiming for one's material betterment – will spontaneously create the order that makes such betterment actually possible.

By means of rising and falling interest rates, the market informs investors and entrepreneurs about the size of the subsistence fund available to finance capital investment projects, the preference for consumption relative to saving, and will thus guide the decision-making process regarding in which stages of the production structure to predominantly invest.

This also illuminates why Keynes' so-called 'paradox of thrift', which holds that a collective propensity to save more and consume less is a negative development for the economy, is wrong.
It fails to consider that only by saving can one invest – and that a propensity to save more will only affect investment in the later stages of production.
If the cycle of inventory build-up and liquidation and bidding for labor resources at retailers were the only measure of the economy's health, then we might agree with the 'paradox' – but not otherwise.

How the central bank distorts the market process

Consider now the populist policy of artificially holding interest rates as low as possible that is employed by the central bank. As noted in the introductory paragraph, low central bank interest rates are designed to artificially inflate credit and thereby stimulate consumption.

This has two simultaneous effects that conspire to create an artificial boom that must perforce give way to a bust at a later stage.
For one thing, it creates an incentive to consume rather than save – i.e. it raises time preferences. This raising of time preferences is not only due to the rising availability of credit and the lowering of returns on savings, but also due to the devaluation of money that the central bank's policies engender over time.

Normally, rising time preferences would tend to drive up the rate of interest, as fewer savings, and thus fewer funds for lending, are available. However, the rate of interest has been artificially fixed by the central bank, which then supplies as much money to the marketplace as is demanded at its prevailing administered rate. Contrary to real savings, this is however 'money out of thin air' – no production preceded its introduction to the marketplace.

At the same time, it won't fail to transmit the information to investors and entrepreneurs that there are plenty of savings available to invest.
In other words, the artificially low interest rate misleads investors into assuming that the pool of available savings (the pool of real funding) is much larger than it actually is. Large long lead investment projects in the earlier stages of production will be undertaken, just as consumers are actually saving less and consuming more due to the same artificial incentive.

For a time, the central bank can 'paper over' the fact that real resources are consumed instead of saved, but this process of 'papering over' actually accelerates the decline in the pool of real funding via overconsumption, while capital is concurrently misdirected and malinvested. This process of malinvestment can also be described as an intertemporal discoordination of the production structure, as too much capital flows toward the production of early stage higher order goods production.

This combination of overconsumption and malinvestment takes place until the point in time when the actual state of the pool of real funding is suddenly revealed.
Malinvestment implies that numerous investment projects were started that could not possibly be finished, respectively also that numerous economic activities were underway that would not be viable at all absent a credit boom.

Sometimes the artificial boom ends because the central bank belatedly decides to abort its artificial low interest rate due to the secondary lagged effect – rising prices – becoming 'visible in the data'. As an artificial boom-bust sequence progresses, it takes more and more credit inflation to engender the 'desired' economic effect of 'creating growth', which is really synonymous to creating economic activities that squander wealth. At the same time, it takes an ever smaller rise in the administered interest rate to actually starve the boom of the exponential credit creation it needs to survive.

The duration and amplitude of the boom-bust sequence meanwhile increases over time, as more and more of the pool of real funding is consumed. How can there be a 'boom' at all, when it consists mostly of overconsumption and malinvestment? Simply put, the artificial boom that credit and money out of thin air create draws upon the previously accumulated capital and consumes it, or part of it.

Note that there comes a point in time when no amount of additional credit out of thin air can restore the boom – this final stage is reached once the credit expansions of the past have consumed so much of the subsistence fund of real savings that it has stopped growing, respectively has actually begun to decline. The current 'credit crunch' episode is a strong sign that we may have reached that point.

How can we measure the increasing amplitude of the boom-bust sequence over time? This can be done by observing the ratio of the stock market to real money, i.e. gold.
Stephen Fairfax has written a brief article on the topic , entitled 'Out of Control: Recognizing Instability', which is a highly recommended take on the subject.

Although the pool of real funding is not directly measurable, a good indicator of its state is likely how the stock market reacts to monetary pumping. Normally the stock market is very sensitive to decreases in the Fed's rate of interest. When it fails to react to numerous rate cuts, we have a strong indication that something must have gone wrong on a very fundamental level – this fundamental level is the economy's production/capital structure and the pool of real funding.

Considering the fact that the the Dow Industrials Average has declined by almost 80% vs. gold and that the stock market has rarely – no, never – reacted so negatively to a major rate cut campaign (the stock market has never before experienced a one year decline as steep as in the one from its October 2007 high), we can conclude that a major failure of the 'money and credit out of thin air' experiment is in train.


The Dow-Gold ratio. Since the Federal Reserve was established, the oscillations in this ratio have become bigger and bigger. This is a good proxy for the boom-bust cycles engendered by fractionally reserved fiat money expansion. An additional note: should the stock market reach its putative target in real terms, there will have been no progress in real stock market value at all since the turn of the century; this contrasts with the time period prior to the establishment of the central bank, when the Dow-Gold ratio consistently rose in a relatively tight channel. This is to say, the stock market rose in real terms from 1790 to 1920 in said channel, until it broke out of it in the first artificial boom-bust sequence of the 1920's and 1930's. Ever since it has gyrated wildly. Click on chart for larger image.
chart via Fred's Intelligent Bear site.

The Bust – its function and why it should not be fought.

There is great incentive for the political class and the monetary authorities to be seen to 'do something' in the face of the developing bust. So they go forth and 'do something' – with nothing even remotely resembling a plan (although they are central planners, they do not even possess a plan – as evidenced by the ad hoc changes to various interventions to date and the continual piling on of new ones).
The public expects them to do something, in a mistaken assumption that they are actually able to avert or alleviate the bust. As I have said before, we should judge them by their results, which so far are sobering indeed.
As Bob Hoye has mentioned in this context, if it is true, as the interventionists contend, that their actions 'will only be felt with a one to two year lag', then one might well ask what they were planning for one or two years ago. A crash?

Let us consider for a moment in the light of the above excursion into capital theory what the root cause of the bust is – it is the preceding artificial boom. It felt like 'good times', but in reality it was an illusion. We certainly did not create a better economic production structure that will enable us to consume more in the future.
On the contrary, capital was malinvested on a truly momentous scale (as a look at current housing inventory easily demonstrates) , and quite apparently, this happened worldwide.

We did not save enough, as countless 'nay-sayers' warned - here, and here and here - while being ridiculed by the gaggle of courtier 'experts' and pundits, who to a man turned out to be wrong .
The bust is naturally painful – in fact, it's a good bet that the bust now underway will be very severe in terms of rising unemployment , falling industrial production, and other statistics describing the level of economic activity.

Think for a moment what a herculean task the economy now has to perform – the production structure must be considered to be severely out of whack, now that it has turned out that the pool of real savings is much smaller than previously thought.
Thus malinvested capital needs to be liquidated, and where possible redirected. Many investment projects in earlier, higher order goods production stages have been, or will still have to be, abandoned.
Savings need to be rebuilt, so the later stages of production are and will be exposed to a sharp decline in consumer demand.
The amount of labor needed to repair the capital structure will perforce be much lower than that likely to be employed when everything is running smoothly.

So there simply is no way this can be done painlessly. The mistakes of the boom can not be 'unmade' – the houses no-one needs, the shopping malls no-one needs, the factories producing cars that no-one wants, and the capacity in earlier production stages supplying them – it all has been built already. Creditors have lent money they will never get back.
The boom created both economic activities that were entirely artificial and consumed wealth (such as the surfeit of real estate agents in California, for instance) as well as misdirecting capital to the 'wrong' portions of the production structure , so we can also conclude that other, more worthy economic activities were deprived of capital – after all, the pool of real funding is finite. It will take time to redirect capital toward these activities, so one must allow for a period of sub-par economic performance until this process is completed.

The best we can hope for is that we get it over with as quickly as possible – but that is precisely what the interventions are unwittingly designed to prevent. We need more savings and less consumption for a time – which the Fed discourages by pushing rates to zero.
We need the private economy to have full access to the available resources at the right price. Instead we have the government 'crowding out' private borrowers by engaging in huge deficit spending. This spending must be financed from existing resources, but it can not possibly be a 'better' use of scarce capital - on the contrary, it will lead to more misdirection of resources.

In this context, note that the much higher interest rates that now e.g. prevail in the market for corporate bonds are a step in the right direction. Given that the risks of lending have risen and savings are scarce, the best way to draw new savings into the marketplace is by offering interest rates that compensate for these higher risks.

Meanwhile, the government and the central bank are trying to keep the 'something-for-nothing' scheme going that has led us to this juncture – the bust – in the first place. It will unnecessarily delay the economy's healing process, and this is no small matter, as one can easily ascertain when looking at Japan's two 'lost decades' or Hoover's and FDR's Great Depression.

In the whole world I have found precisely one mainstream politician in a position of political power (although he will find out that his position is a lonely one indeed, even in his own government's cabinet) who publicly speaks out against the folly – German minister of finance, Peer Steinbrück.
In reference to Gordon Brown's most recent economic insanities, Mr. Steinbrück remarked in a Newsweek interview:

“All this will do is raise Britain's debt to a level that will take a whole generation to work off.”...”The same people who would never touch deficit spending are now tossing around billions. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn't this the same mistake everyone is suddenly making again, under all the public pressure?”
“It's the yearning for the Great Rescue Plan. It doesn't exist. It doesn't exist!”

Even if it is only a small consolation, there is at least one major political figure in a Western industrialized nation who does not seem to subscribe to interventionist voodoo economics. Funny enough, he's a member of the German Social Democratic Party. Paul Krugman doesn't like him, which counts as indirect confirmation that Steinbrück must be 100% correct.

Before anyone gets too excited, here is what Brown had to say by way of riposte:

“Mr Brown, who will head to Brussels later today, reiterated that "every country around the world" agreed with him.
He told LBC Radio in London: "Actually, the German Government is investing more. They have just announced a fiscal expansion so that they can invest in public works and helping their banks and doing these sorts of things. "I do not really want to get involved in what is clearly internal German politics here, because they have a coalition in Germany with different political parties. "The important thing is that almost every country around the world is doing what we have been doing." Not taking such actions would mean "failing in the role of Government", he said. (my emphasis).

Clearly there is little reason for hope, because what Brown says is true – virtually every government in the world has adopted the deficit spending and rate cutting malfeasance that has demonstrably failed every time it has been tried.

Ergo, get ready for a long, hard slog.


Interventionist Brown, crisis-stricken


Doubting Thomas: Peer Steinbrück


Interventionist Bernanke, pre-crisis


Interventionist Bernanke, crisis stricken