Our Monetary System Favours the Rich and Hurts the Poor

 

Anybody watching their savings erode while trying to get into the rapidly-inflating housing market know the scrum is screwed against them, and that price inflation is very far from zero.  Like it or not, one of the three main culprits is the fiat monetary system. “Getting richer at the expense of others through the use of the fiat monetary system, which represents a government monopoly and banking privileges, is unjust,” says Philipp Bagus in this guest post. “This system stays in place because people do not understand its detrimental and fatal consequences such as an unfair redistribution, business cycles, poverty, bigger government, moral decay, and so on. In order to un-do this system we must convince people of all this.”

He’s so convinced of that he just wrote a book: Blind Robbery!: How the Fed, Banks, and Government Steal Our Money, co-written with Andreas Marquart. See Karl-Friedrich Israel's full review on mises.org, who recently spoke with Dr. Bagus about the new book and how certain politically-influential groups benefit from our modern monetary system.

Mises Institute: In your new book, you contend that our economic system increases wealth inequality by favouring the wealthy. Can you briefly summarise what you mean by this?

Philipp Bagus: Always when new money is produced, there is a redistribution in favour of those who receive the new money and spend it at the old, still low prices and to the detriment of those who receive the new money later and see prices rise faster than their income. In our fiat money system [in which unbacked paper is legally enforced as money] new money can and is produced at almost zero cost. Those actors who are in position to receive the new money first benefit. Among them are the government and the financial system.
    The new money is usually introduced into the market in form of loans. Those, who receive a higher percentage of these loans profit at the cost of those who do not.
    The super-rich have an advantage in this respect. They have an easier access to the new money produced by the banking system in form of loans, because they can offer collateral. They can offer real estate as a collateral for new loans using these loans to buy even more real estate or stocks pushing up prices. A poor person has more difficulties to get a loan in normal times because he does not own assets. Only in dangerous bubble times will he get easy and cheap access to loans. Thus, someone like George Soros may easily give a call to his banker and get a million dollar loan in an instant to buy more assets. A poor or even middle-class person will not get such a million dollar loan so easily, rather they will observe how asset prices are being pushed up and they keep getting relatively poorer. Thus, our fiat monetary system is one often-neglected reason for an increasing wealth inequality.

MI: As we all know, if you’re not already wealthy, it’s difficult to build wealth even if you carefully save a lot of money. What is it about our current economic system that makes this so difficult?

PB: If you save in cash today, your savings will be eroded by price inflation. Asset prices have risen relatively more than income in the past. That means that it becomes ever more difficult to buy a standard house with a standard income. The monetary system drives people to indebt themselves early in life to buy a house. The house will tend to rise in value and the debt will be eroded by price inflation. Saving in cash for 10 or 20 years in order to buy a house is not the smartest way in our monetary system that implies continual and relatively strong increases in the money supply. Things would be very different and in some sense much easier in a pure gold standard.

MI: You have suggested that without the fiat monetary system, it would be more difficult for the wealthy to stay wealthy as they do under the current system. What do you mean by this?

PB: Well, wealthy people have an easier access and a better connection to the banking system, where the new money is produced, simply because they are wealthy and have assets. Similar things apply to companies. Established and big companies that own real estate and other assets will have a relatively easier and cheaper access to new money than small newcomers. If you are wealthy and own parts of an established company with a good connection to financial markets and the banking system, you have an advantage vis-à-vis potential competitors that threaten your position due to the fiat money system. In our system in order to stay rich it has become more important to have a fast and easy access to new money, and it has become less important to be innovative and satisfy consumer wishes in better and cheaper ways. Incumbents are in a sense protected by the fiat monetary system. In a pure gold standard such an artificial protection would disappear.

MI: What would be some practical ways to start un-doing this system we have right now?

PB: This system stays in place because people do not understand its detrimental and fatal consequences such as an unfair redistribution, business cycles, poverty, bigger government, moral decay, and so on. In order to un-do this system we must convince people of all this. The problem here is that our monetary system and monetary theory is quite complex. One would have to explain it in an easy and attractive way so that everyone could understand the problem at hand. That is the reason why Andreas Marquart and I have written our new book that explains the problems of the system in a provocative and easily understandable way. So the most practical step to start un-doing the system would be to spread the message. Once we have succeeded and a critical mass shares our views on the fiat monetary system, it will fall apart on its own and will be taken over simultaneously by private alternatives.

MI: But even in a free market, won’t there be income inequality?

PB: Yes, you are right. We should distinguish between morally justified and unjustified inequality. When someone gets rich because he is productive and satisfies the wishes of people in a cheaper and better way than his competitors, we should applaud him. The resulting income inequality is justified. The problem starts if someone earns an income due to government intervention such as licenses, other regulations, or simply tax transfers. The resulting income inequality is unjustified. Getting richer at the expense of others through the use of the fiat monetary system, which represents a government monopoly and banking privileges, is unjust.

---

Philipp Bagus is an associate professor at Universidad Rey Juan Carlos. He is an associate scholar of the Mises Institute and was awarded the 2011 O.P. Alford III Prize in Libertarian Scholarship. He is the author of The Tragedy of the Euro and coauthor of Deep Freeze: Iceland's Economic Collapse. The Tragedy of the Euro has so far been translated and published in Greek, German, French, Slovak, Polish, Italian, Romanian, Finnish, Spanish, Portuguese, British English, Dutch, Brazilian Portuguese, Bulgarian, and Chinese. He is also co-author with Andreas Marquart of the German language book Warum andere auf Ihre Kosten immer reicher werden. Visit his website at PhilippBagus.com.
This post first appeared at the Mises Daily

..

How the State Worsens Economic Inequality

 

Guest post by Philipp Bagus

Thomas Piketty´s book, Capital in the Twenty-First Century, on growing inequality in capitalism, has become a bestseller. Piketty offers much data claiming that inequality is rising and draws the conclusion that the state should fix that ‘problem’ with additional taxes on the rich.

It is true that the distance between the ‘super rich’ and the rest of the population has been increasing in recent decades. It has become more difficult to reach average net wealth with an average income. But maybe the most important reason for this development has been widely neglected in the debate: our monopolistic monetary system - as Andreas Marquart and I show in our new book, Blind Robbery! How the Fed, Banks and the Government Steal our Money.

In a fiat-money system the costs of money production fall to virtually zero. Thus, the incentive to produce new money is almost irresistible. [For Keynes and his followers, this is a feature not a bug – Ed.] And all money production redistributes income and wealth, because not all economic agents receive the new money at the same time. Some people get the new money earlier, some get it later. The first receivers of the new money benefit, as they have higher cash balances and can buy at the old, still low prices. Once the first receivers spend the money, it flows to the next receivers who still profit but less than the first receivers since prices start rising. Successively the new money spreads across the economy and pushes prices upward. In the same manner as first or early receivers of the new money profit, there are late receivers that lose, because they have to watch prices increasing before their income increases, if it increases at all. The purchasing power of the later receivers of the new money is eroded.

But who are the first receivers of the new money in our fiat money system? Those who want to benefit from the new money must receive it where it is produced, namely in the banking system in form of a loan. And in order to get a loan from a bank it is helpful to be rich. Rich people owning large amounts of assets such as stocks or real estate may pledge their stocks or real estate as a guarantee for new loans. They may then use these loans to acquire even more stocks and real estate that, in consequence, keep rising in value.

Since the costs of money production are close to zero in a fiat money system, where both central banks and other banks may create money, a continuously rising money supply can be expected. Therefore, prices tend to increase steadily. In such a system, it does not make much sense to save in the form of cash, in order to buy assets such as a house later. It is rational to indebt oneself early in order to purchase a house before it is even more expensive and pay the debt back in depreciated currency.

Since assets such as property, bonds or stocks may serve as a guarantee or collateral for new loans, and as such as a means to become a first receiver of new money, in our fiat monetary system asset prices tend to rise relative to prices of goods and services, i.e. wages. This is one reason why it takes ever longer to purchase an average house by saving an average income. This is also a reason why it is easier for the rich to stay rich and more difficult for the poor to become rich in our fiat money system than it would be in a commodity money world.

While the super-rich, the financial industry and big business all profit from their fast and direct access to the newly-produced money, the working and middle classes, who tend to be late receivers, have to cope with rising housing, energy and food costs. Due to rising living costs and high taxes, it becomes ever more difficult for the working and middle classes to save and invest in financial markets.  In short, our monetary system leads to redistribution and there is a tendency for wealth and income to flow to the rich.

Our monetary system is a creation of the state. We have monopolistic state money, a central planner in monetary affairs (central banks), and banks that receive special privileges from the state. Thus, Piketty’s view that markets are responsible for growing economic inequality is mistaken. Rather it is the state itself that causes increasing inequality, which it pretends to fight.

---

Philipp Bagus is an associate professor at Universidad Rey Juan Carlos. He is an associate scholar of the Mises Institute and was awarded the 2011 O.P. Alford III Prize in Libertarian Scholarship. He is the author of The Tragedy of the Euro and coauthor of Deep Freeze: Iceland's Economic Collapse.
    The Tragedy of the Euro has so far been translated and published in Greek, German, French, Slovak, Polish, Italian, Romanian, Finnish, Spanish, Portuguese, British English, Dutch, Brazilian Portuguese, Bulgarian, and Chinese. He is also co-author with Andreas Marquart of the German language book Warum andere auf Ihre Kosten immer reicher werden.
    Visit his website at PhilippBagus.com.
    This post first appeared at the Mises Daily.

.

China’s Coming Default?

NZ’s rock star economy is relying heavily on China this year for our economic progress. In this guest post, David Howden wonders how long China’s own progress can last un-busted– and is pessimistic.

Last June I pointed to four unfortunate facts in the Chinese economy.

1. Overall credit had increased to $23 trillion dollars, up from $9 trillion as recently as 2008.
2. This amount of credit was over 200 percent of GDP, an increase of 75 percentage points in just five years. (By comparison over the same period the United States’ ratio of debt-to-GDP increased by 40 percentage points.
3. The credit rating agency Fitch had downgraded the Chinese government’s debt to AA-.

Most damning if not ominous, though, was the fourth fact:

4. The cost of short-term borrowing (seven-day) on the Shanghai repo market jumped to nearly 11 percent. This was the highest rate since March 2003. (Zerohedge reported the overnight repo rate was as high as 25 percent at the time.)

In writing Deep Freeze: Iceland’s Economic Collapse, my coauthor Philipp Bagus and I observed a similar set of events with regards to Iceland. Artificially low interest rates, and especially short-term interest rates, created an environment of heavy indebtedness. Entrepreneurs borrowed money on very-short-term loans in continual need of rolling over. By financing projects with, e.g., a one-month loan at a very low interest rate, the borrower could finance a long-term project provided the credit market remained liquid and interest rates remained low. Every month he would just borrow back the amount of money to pay off the existing loan. It is somewhat akin to taking out a new credit card to pay off your old balance, which works as long as you have decent credit and the card issuer keeps interest rates low.

At the time I reported that China was on the precipice of a looming bust, the inevitable result of a credit-fueled boom. Like most things, the bigger they are, the harder they fall.

Chinese state media recently warned that investors may not be repaid by the China Credit Trust Co. when some of its wealth management products mature on January 31, the first day of the Year of the Horse.

You say you’ve never heard of the “China Credit Trust Co.”? It was recently spun off by the world’s largest bank by assets, the Industrial and Commercial Bank of China. ICBC has recently suggested that it will not compensate investors for losses and that it will not assume any responsibility.

Indeed, writing for Forbes, Gordan Chang reports that “it should be no mystery why this investment, known as “2010 China Credit-Credit Equals Gold #1 Collective Trust Product,” is on the verge of default.” China Credit Trust loaned the proceeds from sales of a half billion dollars of product to an unlisted coal mining group. The coal company is, according to Chang, probably paying upwards of 12% for the money as it was desperate for money given that it has already been declared bankrupt.

There has never been a default in a Chinese wealth management product other than some delayed payments. Besides being the first, this one could be a sign of things to come. [Time to follow the implications of the £70bn capital hole in the HSBC, uncovered by Forensic Asia, suggesting its “stated capital ratios would appear to be nothing more than a mirage” – Ed.]

Of course, some observers are not worried. As Chang correctly notes: “”To have a market meltdown, you have to have a market” and China does not have one.  Instead, Beijing technocrats dictate outcomes.”

That is indeed correct, but there is the unfortunate fact that private money is on the line. People have invested in China thinking the party would never stop. The Chinese government acting as a surrogate for the market is also the reason why China is heading for the granddaddy financial collapses.

Chinese GDP has not contracted on a year-on-year basis since 1976, the year the great communist leader Mao Zedong died and optimists note that the Chinese government and central bank are flush with cash. This may be, but there are a lot of dodgy wealth funds out there. At the end of 2013 there was as much as 11 trillion yuan ($1.8 trillion) invested in wealth management products, just like the one expected to default at month´s end.

As I said, the bigger they are the larger they fall. After recently dethroning Japan as the world’s second largest economy, China is about as big as they come. Size is not substitute for stability, however, and China´s years of dependence predicated on short-term loans might just prove the point.

David Howden is Chair of the Department of Business and Economics and professor of economics at St. Louis University's Madrid Campus, Academic Vice President of the Ludwig von Mises Institute of Canada.
Originally posted at the Ludwig von Mises Institute of Canada.

Guest Post:The Great Nobel Heist of 2013

Add together the diametrically opposed beliefs of two of the three economics Nobel Prize winners, says guest poster David Howden, and you end up with a big fat zero.

The paradox of the awarding of the 1974 Nobel Memorial Prize in Economic Science¹ is really just par for the course. Friedrich Hayek and Gunnar Myrdal shared the prize that year – both for their work on monetary fluctuations and the business cycle. While there were some affinities between the two early in their careers: both used a Wicksellian foundation, stressed the importance of Knightian uncertainty and the role of ex ante expectations versus ex post results in investment decisions. But by the time the elder economists won their Nobels they were almost polar opposites. Hayek had moved to his work on to the social order of a free society while Myrdal had taken on a decidedly more socialistic bent.

This year’s Nobel Prize is shared between three eminent economists, Eugene Fama, Lars Peter Hansen and Robert Shiller. For the purposes of this article commemorating their achievement, I wish to compare Fama and Shiller’s accomplishments, contributions and what the Prize really represents. As we shall see, though both academics won the award for their work on asset prices, their results and conclusions couldn’t be more at odds with each other.

The Errors of Keynes

A guest post by Philip Bagus on the appearance of a new book demolishing the pseudo-economics of John Maynard Keynes—in whose name a mountain of debt and a pseudo-golden shower of paper money has been pissed out in recent years to “save the world,” to no positive effect whatsoever.

The Austrian School of economics has provided the world with devastating critics of Keynes's magnum opus The General Theory of Employment, Interest and Money for a long time. Friedrich A. von Hayek, Jacques Rueff, Henry Hazlitt, Murray Rothbard, Ludwig Lachmann, Ludwig von Mises, George Reisman and William Hutt have already provided important arguments against Keynes and Keynesianism.

Now we can add a new name to that distinguished list. In 2012, Juan Ramón Rallo has published a new Austrian critique of TGT in Spanish with the title Los Errores de la Vieja Economía (The Failure of the Old Economics) in honor of Hazlitt's work The Failure of the 'New Economics'.

In Hazlitt's time, Keynes's program was still revolutionary and described by Hazlitt as a kind of “New Economics” that broke with the insights of classical economics and especially with Say's Law. Now, Keynesianism is mainstream. Keynesianism, and especially its main idea that spending reduces unemployment, is still taught in universities, applied by grateful politicians, and prominently defended by the 2008 Nobel Prize winner Paul Krugman.

Indeed, the immediate political response to the current financial crisis in the Western World was inspired by Keynes’s General Theory. A second Great Depression was to be prevented and Keynes's insights applied. Governments engaged in loose monetary policy combined with fiscal stimulus in response to what, through Keynesian eyes, appeared to be a bubble caused by reckless speculation, which was in turn inspired by animal spirits. Thus, even if Rallo's book were just a summary of the old arguments against The General Theory, the moment for publication would be more than appropriate, since the ideas of the past are still the praxis of the present.

Yet, Los Errores de la Vieja Economía is much more than a summary and synthesis of the old arguments by the aforementioned Austrian authors. Rallo builds upon, combines, and develops these arguments in a systematic way. Most importantly, he adds his own innovative ideas to develop a devastating case against Keynes.

Rallo's critique, employing Austrian economic theory, is rigorous, systematic and exhaustive. Significantly, Keynes's ideas are not twisted or distorted. The absence of strawman arguments makes Rallo's attack against the core of Keynesian beliefs stronger than most. Rallo also does not search for terminological contradictions and inconsistencies. In this sense, Rallo's critique is more profound and devastating than for example the parts of Henry Hazlitt's brilliant critique that emphasize Keynes's inconsistencies, imprecision, and explanatory fuzziness. Rallo has a great and genuine interest in giving a clear and coherent picture of Keynes's reasoning and presents Keynes in the most favourable light.

Let's have a look of some of Rallo's arguments, beginning with Keynes's famous critique of Say's Law. Keynes's distorted version of Say's Law in his General Theory states that supply creates its own demand. Rallo vindicates Say's Law in its original version: In the long run, the supply of a good adjusts to its demand. Ultimately, goods are offered to buy other goods (money included). One produces in order to demand, which implies that a general overproduction is impossible.

Say's Laws leads us straight forward to the most innovative argument in Rallo's book that addresses the old argument against hoarding. Even harsh critics of Keynes, for example from the monetarist or neoclassical camp, admit that Keynes was at least right in that hoarding is a destabilizing and dangerous activity.

Rallo, however, proves and emphasizes the social function of hoarding. To demand money is not to demand nothing from the market. Hoarding is the natural response of savers and consumers to a structure of production that does not adjust to their needs. It is a signal of protest to entrepreneurs: “Please offer different consumer and capital goods! Change the structure of production, since the composition of offered goods is not appropriate.”

In a situation of great uncertainty, it is even prudent to hoard and not immobilize funds for the long run. Rallo provides us a visual example. Let's assume that uncertainty increases because people expect an earthquake. They start to hoard, i.e., they increase their cash balance, which gives them more flexibility. This is completely rational and beneficial from the point of view of market participants. The alternative is to immobilize funds through government spending. The public production of skyscrapers is not only against the will of the more prudent people; it will also prove disastrous if the earthquake is realized.

Hoarding is an insurance against future uncertainties. Rallo argues that, if the demand for money increases (i.e., liquidity preference increases) due to the precautionary motive, short-term market rates of interest tend to fall, while long-term rates increase. People invest more short term and less long term in order to stay liquid. This leads to an adjustment of the structure of production. More resources will be used for the production of the most liquid good (i.e., gold in a gold standard), and for the production of consumer goods. The structure of production shifts toward shorter and less risky processes reducing longer and riskier ones. Hoarding, therefore, does not cause factors of production to be idle that shouldn’t be. Factors are just shifted toward gold production and shorter-term projects. Rallo insists that it is not irrational to hoard. Indeed, when long-term projects are maintained and economic conditions change, projects might have to be liquidated suddenly. For example, the earthquake would destroy the skyscraper in progress.

It should be noted that most Austrians do not hold a hybrid liquidity preference / time preference theory of interest. For Rallo the interest rate, or the structure of interest rates, is determined both by time preference and liquidity preference. Most Austrians defend the pure time preference theory of interest. My own position on this question can be found in this article co-authored with David Howden. Due to uncertainty an actor prefers to be liquid rather than illiquid. Due to time preference an actor prefers to be liquid rather sooner than later. Therefore, the yield curve tends to be upward sloping. When uncertainty increases, the yield curve tends to get steeper. In a financial crisis, however, another effect tends to prevail over this tendency. When society is in general illiquid, the high demand for short-term loans, the scramble for liquidity, tends to cause a downward sloping yield curve.

Idle resources are another important topic in Rallo's book since Keynes recommends inflation in the case of idle resources. Rallo asks why factors are unemployed and comes to the result that their owners demand a price for their services that is higher than their discounted marginal value product. In these circumstances, inflation implies a redistribution in favour of the owners of those factors, or a frustration of attempts to restructure, i.e., the economy suffers from forced saving or capital consumption.

In contrast, when factors of production adjust their prices, i.e., wages fall back to their discounted marginal value product, aggregate demand does not fall as Keynes suggests. On the contrary aggregate demand increases, because total production increases.

Rallo goes relentlessly after other Keynesian concepts. The famous “investment multiplier” requires idle resources of all factors of production. More precisely, for Keynes to be right you need voluntary unemployment of all factors of production plus idle capacity in consumer goods' industries. If there is no voluntary unemployment of all factors, government stimulation of new projects will lead to bottlenecks as factors are bid away from profitable investment projects. If all types of factors are idle, but there is no capacity in consumer goods industries, then government stimulus will raise prices of consumer goods and lead to a shortening of the structure of production. If, however, there is a general idleness of factors and idle capacities in consumer goods industries, why is there no voluntary agreement between owners of factors of production and entrepreneurs?

Another important Keynesian idea that Rallo tackles is the famous liquidity trap. A liquidity trap exists when, in a depressed economy, interest rates are very low. In such a situation Keynes regards monetary policy as useless, because speculators will just hoard newly produced money. Speculators will not invest in bonds because they are at maximum prices and will fall when interest rates finally rise. At this point monetary policy becomes impotent. Public spending becomes necessary to stimulate aggregate demand.

Rallo shows that after an artificial boom, in a situation where there are many malinvestments and a general over-indebtedness in the economy, there is indeed almost no demand for loans even at very low interest rates. We are actually faced with an illiquidity trap, as agents struggle to improve their liquidity. They want to reduce their debts and not take on more loans. The monetary policy of low interest rates actually worsens the situation, because with low interest rates, there is no incentive to prepay and cancel debts (because their present value is raised). The solution to this situation of general uncertainty is hoarding, stable institutions, the liquidation of malinvestment and the reduction of debts.

High uncertainty does not imply high unemployment, since even under high uncertainty the reduction of prices for services of factors of production renders profitable new projects. Under high uncertainty, these projects will be gold production (in a gold standard) and the short-term production of consumer goods.

As Rallo points out in contrast to Keynes, it is not aggregate supply or aggregate demand that is important, but their composition. If, in a depression with a distorted structure of production, in a liquidity trap situation, aggregate demand is boosted by government spending, the existing structure cannot produce the goods that consumers want most urgently. The solution is not more spending and more debts, but debt reduction and the liquidation of malinvestments to make new and sustainable investments feasible.

In contrast, for Keynes, the problem is always insufficient demand. So what can we do if consumers and investors do not buy the goods of that companies offer, but instead hoard? Well, Keynes recommends lowering taxes and interest rates, to devalue the currency, or that the government buys the products for consumers. But, why, asks Rallo, should consumers and investors buy goods they don't want?

Keynes’s answer is that otherwise unemployment will increase. Rallo responds astutely: But if a person is forced to buy with his salary something that he does not want, why shall this person work at all? The alternative to forced buying is to lower wages to their discounted marginal value product, which increases production and demand. As Rallo points out, society does not get richer if the government induces or forces people to buy goods they don't want. Thus, for Rallo the essence of Keynes’s General Theory is the following: when people do not want to buy what is produced, the government should force them to act against their will.

The insights from Rallo's book presented here are only a small selection. Rallo also offers an analysis of Keynes's main definitions and the theoretical errors behind them, such as their pro-consumption bias. He provides an Austrian analysis of financial markets, discussing the interrelations between the yield curve, interest rates, the discount rate, the structure of investment, the liquidity trap and the stock market. He analyses real and nominal wages, business cycles, political implications, and intellectual predecessors of Keynes's General Theory using Austrian theory. Also very useful is Rallo's guide for readers of The General Theory that makes reading and spotting Keynes’s main mistakes, chapter by chapter, easy and efficient. As a plus, at the end of the book, Rallo also provides a critique of the IS-LM model developed by John Hicks and Franco Modigliani which formalized Keynes's theory and is still taught at universities around the world.

Rallo's book on Keynes's General Theory is full of brilliant insights and provides the most powerful and complete case against Keynes currently available. The well-written Los Errores de la Vieja Economía will be the future reference for scholars and layman alike looking for errors in Keynes's thinking and today's policies. The main downside of the book is that it is written in Spanish. Hopefully, the work will be available in other languages soon.

Philipp Bagus is an associate professor at Universidad Rey Juan Carlos. He is an associate scholar of the Ludwig von Mises Institute and was awarded the 2011 O.P. Alford III Prize in Libertarian Scholarship. He is the author of The Tragedy of the Euro and coauthor of Deep Freeze: Iceland's Economic Collapse, both of which are available in English.
See his website. Send him mail. See Philipp Bagus's article archives.
This review first appeared at the Mises Daily.

The Myth of Austerity, by Philip Bagus

Guest post by Philip Bagus

Many politicians and commentators such as Paul Krugman claim that Europe's problem is austerity, i.e., there is insufficient government spending.
    The common argument goes like this: Due to a reduction of government spending, there is insufficient demand in the economy, leading to unemployment. The unemployment makes things even worse as aggregate demand falls even more, causing a fall in government revenues and an increase in government deficits.
    European governments pressured by Germany (which did not learn from the supposedly fateful policies of Chancellor Heinrich Brüning) then reduce government spending even further, lowering demand by laying off public employees and cutting back on government transfers. This reduces demand even more in a never ending downward spiral of misery.
    What can be done to break out of the spiral? The answer given by commentators is simply to end austerity, and boost government spending and aggregate demand. Paul Krugman even argues in favor for a preparation against an alien invasion, which would induce government to spend more. So the story goes.
    But is it true?
    First of all, is there really austerity in the Eurozone? One would think that a person is austere when she saves, i.e., if she spends less than she earns. Well, there exists not one country in the Eurozone that is austere. They all spend more than they receive in revenues.
    In fact, government deficits are extremely high, at unsustainable levels, as can been seen in the following chart that portrays government deficits in percentage of GDP. Note that the figures for 2012 are what governments wish for…

Euro government deficits as a percentage of GDP

The absolute figures of government deficits in billion euros are even more impressive:

Euro government deficits in billions of euros

A good picture of "austerity" is also to compare government expenditures and revenues (relation of public expenditures and revenues in percentage):

Euro government spending above revenue, as a percentage

Imagine that a person you know spends 12 percent more in 2008 than her income, spends 31 percent more than her income the next year, spends 25 percent more than her income in 2010, and 26 percent more than her income in 2011. Would you regard this person as austere? And would you regard this behaviour as sustainable? Yet this is precisely what the Spanish government has done. It shows itself incapable of changing this course. Perversely, this "austerity" is then made responsible for a shrinking Spanish economy and high unemployment.
    Unfortunately however, austerity is the necessary condition for recovery in Spain, the Eurozone, and elsewhere. The reduction of government spending makes real resources available for the private sector that formerly had been absorbed by the state. Reducing government spending makes profitable new private investment projects and saves old ones from bankruptcy.
    Take the following example. Tom wants to open a restaurant. He makes the following calculations. He estimates the restaurant's revenues at $10,000 per month. The expected costs are the following: $4,000 for rent; $1,000 for utilities; $2,000 for food; and $4,000 for wages. With expected revenues of $10,000 and costs of $11,000 Tom will not start his business.
    Let's now assume that the government is more austere, i.e., it reduces government spending. Let's assume that the government closes a consumer-protection agency and sells the agency's building on the market. As a consequence, there is a tendency for housing prices and rents to fall. The same is true for wages. The laid-off bureaucrats search for new jobs, exerting downward pressure on wage rates. Further, the agency does not consume utilities anymore, leading toward a tendency of cheaper utilities. Tom may now rent space for his restaurant in the former agency for $3,000 as rents are coming down. His expected utility bill falls to $500, and hiring some of the former bureaucrats as dish washers and waiters reduces his wage expenditures to $3,000. Now with expected revenue at $10,000 and costs at $8,500 the expected profits amounts to $1,500 and Tom can start his business.
    As the government has reduced spending it can even reduce tax rates, which may increase Tom's after-tax profits. Thanks to austerity the government could also reduce its deficit. The money formerly used to finance the government deficit can now be lent to Tom for an initial investment to make the former agency's rooms suitable for a restaurant. Indeed, one of the main problems in countries such as Spain these days is that the real savings of the people are soaked up and channeled to the government via the banking system. Loans are practically unavailable for private companies, because banks use their funds to buy government bonds in order to finance the public deficit.
    In the end, the question amounts to the following: Who shall determine what is produced and how? The government that uses resources for its own purposes (such as a "consumer-protection" agency, welfare programs, or wars), or entrepreneurs in a competitive process and as agents of consumers, trying to satisfy consumer wants with ever better and cheaper products (like Tom, who uses part of the resources formerly used in the government agency for his restaurant).
    If you think the second option is better, austerity is the way to go. More austerity and less government spending mean fewer resources for the public sector (fewer "agencies") and more resources for the private sector, which uses them to satisfy consumer wants (more restaurants). Austerity is the solution to the problems in Europe and in the United States, as it fosters sustainable growth and reduces government deficits.

Lower GDP?
     But does austerity not at least temporarily reduce GDP and lead to a downward spiral of economic activity?
    Unfortunately, GDP is a quite misleading figure.* GDP is defined as the market value of all final goods and services produced in a country in a given period, yet this is not at all what it measures.
    There are two minor reasons why a lower GDP may not always be a bad sign.
    The first reason relates to the treatment of government expenditures. Let us imagine a government bureaucrat who licenses businesses. When he denies a license for an investment project that never comes into being, how much wealth is destroyed? Is it the expected revenues of the project or its expected profits? What if the bureaucrat has unknowingly prevented an innovation that could save the economy billions of dollars per year? It is hard to say how much wealth destruction is caused by the bureaucrat. We could just arbitrarily take his salary of $50,000 per year and subtract it from private production. GDP would be lower.
    Now hold your breath. In practice, the opposite is done. Government expenditures count positively in GDP. In our example, the wealth-destroying activity of the bureaucrat raises GDP by $50,000. This implies that if the government licensing agency is closed and the bureaucrat is laid off, then the immediate effect of this austerity is a fall in GDP by $50,000.
    Yet as we should understand, this fall in GDP is a good sign for private production and the satisfaction of consumer wants.
    Second, if the structure of production is distorted after an artificial boom, the subsequent restructuring necessarily entails a temporary fall in GDP. Indeed, one could only maintain GDP if production remained unchanged. If Spain or the United States had continued to use their boom structure of production, they would have continued to build the amount of housing they did in 2007. The restructuring requires a shrinking of the housing sector, i.e., a reduced use of factors of production in this sector. Factors of production must be transferred to those sectors where they are most urgently demanded by consumers. The restructuring is not instantaneous but organized by entrepreneurs in a competitive process that is burdensome and takes time.
    In this transition period, when jobs are destroyed in the overblown sectors, GDP tends to fall. This fall in GDP is just a sign that the necessary restructuring is underway. The alternative would be to produce the amount of housing of 2007. If GDP did not fall sharply, it would mean that the wealth-destroying boom was continuing as it did in the years 2005–2007.

Conclusion
    Public austerity is a necessary condition for private flourishing and a rapid recovery. The problem of Europe (and of the United States) [and New Zealand] is not too much but too little austerity — or rather its complete absence.
A fall of GDP can be an indicator that the necessary and healthy restructuring of the economy is underway.

Philipp Bagus is an associate professor at Universidad Rey Juan Carlos. He is an associate scholar of the Ludwig von Mises Institute and was awarded the 2011 O.P. Alford III Prize in Libertarian Scholarship. He is the author of The Tragedy of the Euro and coauthor of Deep Freeze: Iceland's Economic Collapse. The Tragedy of the Euro has so far been translated and published in German, Slovak, Polish, Italian, Romanian, Finnish, Spanish, Portuguese, British English, Dutch, and Bulgarian.
See his website.
This article first appeared at the Mises Daily.

* GDP is a completely misleading figure. The metric of GDP, so-called Gross Domestic Production, would be more accurately titled Nett Domestic Consumption—since it measures all consumption spending, including every dollar spent by the governmet, yet only a small percentage of spending undertaken on production.  “In that light, the desire to boost debt-based consumption via the creation of artificial demand seems much more questionable.” See Mark Skousen: “Consumer Spending Drives the Economy?”

It’s still all Greek to some people [update 3]

You’ll have heard it reported in recent days that Greece has been “saved.” That the Greek government has been bailed out by the European Central Bank and the EU Rescue Fund (EFSF), that things will be tough for a while, but the Greeks will now be able to dig themselves out of their hole.

Nothing could be further from the truth—and the fact Gareth Morgan subscribes to this fiction (among three other fictions) is almost certain proof the outcome won’t be all rosy.

What has just happened in this second Greek bailout (remember how the first bailout was going to save things?) is another enormous tranche of borrowing lent to the Greek government to save it from its previous enormous borrowing. And if that sounds stupid, it is—but only if you think this is a rescue of Greece.

It is not a rescue of Greece.

Because it is not so much a bailout of Greece by European central bankers, but a bailout of European bankers put together by European central bankers—with German taxpayers picking up the tab.  Greece is now officially a ward of the international community—and as a ward its only job now is to make its guardians rich, or at least to provide a conduit for whatever of its mis-loaned money its guardians can claw back through good old EuroPolitik.

Face it, there was no other way European bankers were going to get any of their money out of Greece—not with Greek 1-Year Bond Yield having just hit 682%.  So when you hear bankers whooping it up because the “rescue” plan has gone through just remember to whom the lifebelt has just been thrown. And it’s not the Greeks.

Frankly, the best thing the Greeks could do now is default, and then leave the Euro Currency Zone.  And the best thing German taxpayers could do is let them—and then leave the zone themselves.

NB: Liberty Scott has an excellent summary of how things came to this pass, and how a Greek default would help:

• “Greece for Dummies.” – L I B E R T Y   S C O T T

PS: Oh, and in case you were wondering … yes, Virginia, bailing out banks is inflationary.

UPDATE 1: Mish summarises the options:

The sooner Greece exits the euro, the more likely Greece will be able to prevent still more capital flight. The smart money has already left. (Please see Germany Draws Up Plans for Greece to Leave Euro; Athens Rehearses the Nightmare of Default; Merkel's Denial Rings Hollow.)…
    The best solution would be for Germany to exit the Eurozone first, but that is not going to happen.
The next best option would be for a simultaneous bank holiday involving all Greece, Portugal. Spain, and Ireland at the same time as noted in Why Greece Must Exit the Eurozone, How it Will Happen (and Why Portugal and Spain Will Follow); Does the Euro Act Like a Gold Standard?
That too is highly unlikely. Thus the odds of a protracted, one-by-one, and very costly breakup of the eurozone is the most likely outcome whether or not Greece survives the Ides of March.
For further discussion including an analysis of why it would be best for Germany to exit the Eurozone, please see Eurozone Breakup Logistics (Never Believe Anything Until It's Officially Denied).

Short of a real gold standard emerging, my own opinion is that best economic outcome would see the more solvent countries (solvent only in relative terms, you understand) such as Germany, Finland, Austria, The Netherlands etc. leaving the Eurozone to go back either to their original currencies or a common one, which would quickly find their/its own value; leaving the less solvent, the halt and the lame, to soldier on under the (relative) discipline of a bargain basement Euro.

It would certainly make a southern European holiday something of a bargain.

UPDATE 2: Philip Bagus on “The Future of the Euro”:

“The problems of the eurozone are ultimately malinvestments…    even before the crisis, governments had accumulated malinvestments due to their excessive welfare spending.
    Two causes had incentivized social spending in Europe’s periphery. The first cause is low interest rates… an expansionary monetary policy by the European Central Bank (ECB) and … an implicit bailout guarantee…
    The second cause is that the euro is a tragedy of the commons.”
 

UPDATE 3: An overview on what just happened in Greece from Krazy Economy, “A Note on Greek Banks Recapitalization”

As an overview, here is what we have:
The Greeks (actually you can insert any European Common Market country you want because the pattern is consistent throughout) borrowed from anywhere they could for a massive spending spree.
They required the banks to be a major lender.
They required the banks to have little or no reserves against the loans to the government.
The government can’t repay the loans.
The banks are failing.
The government, with money acquired from elsewhere because it has done stupid, insane things, is going to buy the failed [Greek] banks.
These banks are even more tied to government policies than before.
The government has ownership and control of the banks.
Does anyone think that the Greek banks will be better off?

Meanwhile, and this is perhaps the main point of the whole fiasco, the reality evasion in high places and low:

The failure of putting two and two together is a common theme in the entire European debt crisis. It is most blatant with the Greeks.
This week there have been more “strikes,” riots, and protests against the terms required by the agencies that would bail out the Greeks. Many of the chanted slogans and posters and banners declare that the foreigners are dictators and imperialists. The protestors want the politicians to “resist”!
    The Greeks appear like angry four year olds who have been told that they can’t have the toy on the shelf because mommy doesn’t have the money. How and what are the politicians suppose to resist? They are suppose to resist the requirement that they do not incur more debt. They are suppose to resist the requirement that they try to pay back their existing debt. They are suppose to resist the requirement that if they are given money they spend it wisely instead of like a drunken sailor (my apologies to sailors).
    The Greek protestors have no contact with reality. None. They have no idea that money has some connection to real things. That real things are made by someone who wants to be paid for their efforts. That borrowing actually means that the lender expects to be paid back.
    The Greek country is a testament to modern education and economic “thinking.”

Conflict of interest? Not when you’re a climate alarmist [update 4]

The hacked ClimateGate emails “don’t support claims that the science of global warming was faked” says a thorough word-by-word study by . . . Seth Borenstein, one of the very journalists whose cosy relationship with warmist “scientists” was exposed by the emails themselves.

And not only that, his dismissal of the oceans of hacked data and more than 2000 emails was based in large part on “reactions” from so-called “moderate” scientists, which those emails themselves showed not to be moderates at all but “full-fledged warmists.” As Andrew Bolt says, “Borenstein is sure the Climategate emails don’t amount to much because he asked global warming believers if they now admitted they were wrong.”

So much for journalistic integrity.

D’you think The New Deniers – who are legion – even understand the concept of conflict of interest? Or integrity. Or the first thing about confronting the real facts? Let me give them some advice. In fact, let George Monbiot, writing in the Guardian, give them some advice:

Confronted with crisis, most of the environmentalists I know have gone into denial. . . Pretending the climate email leak isn't a crisis won't make it go away. . . There is no helping it; Phil Jones [the source of most of the emails] has to go, and the longer he leaves it, the worse it will get. “

And AP’s science reporter Seth Borenstein has to go as well – if not from his job at AP, but at the very least from the pages of the Herald where his bullshit is being peddled.

Why not write and tell them so? It only takes a minute.

UPDATE 1: Andrew Bolt reports a similar theme from Aussie journos:

The ABC’s chief science reporter, Robyn ”100 metres” Williams, writes nearly 1000 words to dismiss the Climategate emails as a storm in a teacup. Of all those words, these are all you need read:

So what do the emails reveal? I hesitate to pronounce. I haven’t read them.

UPDATE 2: And Paul Walker reckons things haven’t changed much in sixty years.  Here’s peer-reviewed science circa 1945.

UPDATE 3: Maybe local journos are doing better than we think, at least at Newstalk ZB.  Petra Bagust, (yes, Petra Bagust!) put together the two scientists that Mark Sainsbury should have had on his Close UP programme recently: Jim Salinger and Bob Carter, over two hours last night.  Here’s the first hour, which was mostly Salinger, and here’s the second. (Scroll past the news at the start of each hour.)

And Kerre Woodham spent part of her Sunday programme harassing Jeanette Fitzsimplesimons. Good stuff, apparently. The interview starts around fifteen minutes into this this audio.

UPDATE 4: They faked the Siberian tree figures. They put their CO2 measuring meters next to volcanoes and exhaust systems. They warmed up the data in Wellington. They warmed up the data in Darwin.  They warmed it up in Alaska and Orland. And now they’re warming it up in Antarctica.

Crikey, it’s almost as bad as Bob Jones’ satirising The Beards in his novel Full Circle, in which a ship full of hookers parked up at the Pole for the winter to keep the Beards company raised weather temperatures to record levels by dumping hot water on the thermometers.