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<font face="Verdana" size="1" color="#002864">http://www.mises.org/fullstory.asp?control=882</font>
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<font size="2"><font face="Verdana" color="#002864" size="5"><strong>Recovery
or Illusion?</strong></font>
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<font size="4">by Frank Shostak</font>




[Posted January 31, 2002]




<em>[Presented at Boom, Bust, and the Future: A Private Retreat with
Austrian Economists,</em> <em>January 20, 2002.]</em>


<div>
<img align="right" border="0" src="http://www.mises.org/images/shostak.jpg" width="156" height="203">Does
the recent revival in various economic data raise the possibility that the
Fed’s aggressive loose monetary stance is starting to yield results? The
purchasing management index rose to 48.2 in December from 44.5 in the
previous month. New home sales increased by 6.4 percent in November after
growing by 1.7 percent in October. Also, indices of manufacturing activity
in the New York and Chicago areas increased in December from November.
Furthermore, the consumer confidence index jumped to 93.7 in December from
84.9 in November.
</div>


Notwithstanding all this, what determines whether the U.S. will experience
a meaningful economic recovery is not the Fed’s aggressive lowering of
interest rates but whether the real pool of funding is growing.


<h1>The Heart of Economic Activity</h1>
<p align="left">According to mainstream economics, consumer demand is the most
important factor in an economy. If consumers are active, it is regarded as a
good sign of economic health; if consumers do not spend enough, it is seen as
a bad omen. Whenever a deficiency in overall demand emerges, it is argued that
the government and its central bank must step in to prevent the economy >from
falling into a slump.


<p align="left">The theory goes like this: If demand is increased, an
increased production of goods and services will follow suit and, consequently,
prosperity will be restored. In other words, what enables economic growth is
demand for goods and services. Within this way of thinking nothing is ever
said about how the demand for goods and services is funded. Moreover, is it
enough that by means of demand for goods and services the economy can be kept
going?


<p align="left">The distinguishing characteristic of human activities is that
they are purposeful--people employ means to promote their life and well-being.
In the real world one has to become a producer first before one can demand
goods and services. That is, it is necessary to produce some useful goods (means)
that can be exchanged for other goods (goals). Means fulfill the role of
funding--they make it possible to secure individuals goals.


<p align="left">For instance, with given resources at his disposal, a baker
can produce a given amount of bread. The bread that the baker has produced is
his means in securing ends--the bread is his pool of funding. Thus the
baker might use a portion of the bread for his own consumption. Another
portion might be exchanged for other consumer goods, i.e., they might fund his
consumption of other goods and services. The rest of the bread might be used
to buy a new oven and to hire workers to install this oven.




The portion of bread that the baker has exchanged to acquire and install
the oven is what saving is all about. Instead of consuming the bread directly,
or exchanging it for other final consumer goods, the baker has exchanged the
bread to acquire a better oven. The new oven, in turn, will permit a greater
production of bread. This in turn permits a further expansion and enhancement
of the baker’s production structure, which subsequently enables the baker to
lift the production of bread further.




Note that as long as the baker's pool of funding, i.e., the amount of bread
at his disposal, continues to expand, he is in a position to raise both
consumption and savings; his living standard will rise. 


<p align="left">Saving is required not only for the expansion of a given
production structure but also for its maintenance. If the baker fails to
maintain the oven and replace its worn-out parts, the production of bread will
suffer. This in turn will undermine the baker's pool of funding and lower his
living standard. (In other words, to keep the production of bread going, some
of the bread must be exchanged for the new parts.)




Note that when the baker exchanges his bread for the oven and other
consumer goods, he is supplying individuals that have been engaged in the
production of these goods with the means that promote their life and
well-being. Likewise, final consumer goods that the baker has secured for his
bread promote his life and well-being.


<h1>Money and the Pool of Funding</h1>


The introduction of money into our discussion does not alter the essence of
what saving and the pool of funding is all about. Money fulfills the role of
the medium of exchange. It enables the produce of one producer to be exchanged
for the produce of another producer. Observe that while money serves as the
medium of exchange, it doesn’t produce goods and services; it only enables
these goods and services to be exchanged.




Another important role of money is to serve as a medium of saving. Instead
of saving goods, which requires storing them, people can now save money. In
the world of barter, perishable goods are difficult to save for very long.
These difficulties are resolved in the money economy. Once a producer has
exchanged his goods for money, he has begun saving. When a baker sells his
bread for money to a shoemaker, he has supplied the shoemaker with his saved,
i.e. unconsumed, bread. The supplied bread, in turn, which sustains the
shoemaker, allows him to continue making shoes. Being the medium of exchange,
money enables the baker to secure goods and services some time in the future
whenever he may require them.


<p align="left">Through money, people channel real savings, which permit
economic activity to take place. Thus the saving of money by one individual
supports the production of another individual, who in turn, by exchanging his
produce for money, supports a third individual. In this way money enables real
savings to permeate across the economy and lift the pace of production of
goods and services.




However, it does not follow that one can lift economic growth through
printing presses. When money is printed--i.e., created"out of thin
air"--it sets in motion an exchange of nothing for money and then money
for something, i.e., an exchange of nothing for something. An exchange of
nothing for something amounts to consumption that is not supported by
production. Since every activity has to be funded, it follows that an increase
in consumption that is not supported by production must divert funding from
wealth-generating activities. In short, consumption that is not preceded by
production amounts to unearned consumption; i.e., it takes from the pool of
funding without making any contribution to this pool.




Consequently, when a central bank expands the money stock, it does not
enlarge the pool of funding, but, on the contrary, dilutes the pool, thereby
weakening the rate of economic growth. Thus when money"out of thin
air" gives rise to consumption that is not supported by prior production,
it diverts the funding that supports production of goods and services of the
first wealth producer.




This in turn undermines his production of goods and thereby weakens his
effective demand for the goods of another wealth producer. The other producer
in turn is forced to curtail his production of goods, thereby weakening his
effective demand for goods of a third wealth producer. In this way, money
"out of thin air," which destroys savings, sets in motion the
dynamics of the consequent decline of the growth of real wealth production.


<p align="left">In the money economy, the pool of funding is comprised of all
the final consumer goods produced by various producers. In contrast with gross
domestic product (GDP) that only pays attention to the final stage of
production, the pool of funding deals with the funding for all the stages of
production, i.e., final and intermediate. By ignoring funding to the
intermediate stages of production, the GDP framework lapses into a world of
illusion where final goods and services emerge"out of the blue."
However, in the real world, no final product can ever emerge without
intermediate stages.


<h1>Recession versus Depression</h1>


Contrary to popular thinking, recessions are not about two quarters of a
negative growth in real GDP, or declines in various economic indicators; they
are about the liquidation of business errors brought about by previous loose
monetary policies. In short, they are about the liquidation of activities that
sprang up on the back of previous loose monetary policy. The ensuing
adjustment of production may or may not manifest itself through a negative GDP
rate of growth.




As a rule, symptoms of a recession emerge once the central bank tightens
its monetary stance. But what determines whether an economy falls into a
depression or just suffers an ordinary recession is the state of the pool of
funding. As long as this pool is still growing, a tighter central bank
monetary policy will culminate in a recession. In other words, notwithstanding
that various false activities (i.e., business errors that sprang up on the
back of a loose monetary policy) will now suffer, overall economic growth will
be positive.


<p align="left">As long as the pool of funding is expanding, the central bank
and government officials can give the impression that they have the power to
reverse a recession by means of monetary pumping and the artificial lowering
of interest rates. In reality, however, these actions only slow or arrest the
liquidation of false activities, thereby continuing to divert funding >from
wealth generators to wealth consumers. What in fact gives rise to a positive
rate of growth in economic activity is not monetary pumping but the fact that
the real pool of funding is actually growing.




The illusion that through monetary pumping it is possible to keep the
economy going is shattered once the pool of funding begins to decline. Once
this happens, the economy begins its downward plunge, i.e., the economy falls
into depression. The most aggressive loosening of money will not reverse the
plunge (for money cannot replace bread). In fact, rather than reversing the
plunge, loose monetary policy will further undermine the flow of savings and
thereby further weaken the structure of production and thus the production of
goods and services.




The size of the pool of funding imposes a limit on the type of projects
that can be accomplished. In a situation where the accomplishment of a
particular project requires funding for one year of work while the pool of
funding is only adequate to support six months of work, the project cannot be
made feasible and no amount of monetary pumping can make the project possible.
If money could have replaced real funding, then poverty would have been
eliminated a long time ago.




In his writings, Milton Friedman blamed central bank policies for causing
the Great Depression. According to Friedman, the Federal Reserve failed to
pump enough reserves into the banking system to prevent the collapse in the
money stock[1]
and thus in economic activity. For Friedman, the failure of the U.S. central
bank is not that it caused the monetary bubble during the 1920s but that it
allowed the deflation of the bubble.




An economic depression, however, is not caused by the collapse of the money
stock as suggested by Professor Friedman, but rather by the collapse of the
real pool of funding. The shrinkage of this pool is set in motion by the
previous monetary pumping of the central bank and fractional reserve banking[2].
Moreover, a fall in the pool of funding triggers declines in bank lending and
thus in the money stock. This in turn implies that previous loose monetary
policies cause the fall in the pool of funding and trigger collapses in
economic activity and in the money stock.




Declines in stock prices and the prices of goods and services follow
declines in money supply. Most economists erroneously regard this as"bad
news" that must be countered by central bank policies. However, any
attempt to counter price declines by means of loose monetary policies further
undermines the pool of funding. Furthermore, even if loose monetary policies
were to succeed in lifting prices and inflationary expectations (as suggested
by Professor Paul Krugman), this cannot revive the economy while the pool of
funding is declining.


<p align="left">Lastly, it is erroneous to regard falls in stock prices as
causing recessions. The popular theory argues that a fall in stock prices
lowers individuals’ wealth and this in turn weakens consumers' outlays.
Since it is held that consumer spending accounts for 66 percent of GDP, this
means that a fall in the stock market plunges the economy into a recession.


<p align="left">However, we have already shown that it is the pool of funding
and not consumer demand that permits economic growth to take place.
Furthermore, prices of stocks mirror individuals’ assessments regarding the
facts of reality. As a result of monetary pumping, these assessments tend to
be erroneous. But, once the central bank alters its stance, individuals can
see much more clearly what the facts of reality are and scale down previous
erroneous evaluations. Observe that while individuals can change their
evaluations of the facts, they cannot alter the existing facts which influence
the future course of events.


<h1>The Current State of the U.S. Economy</h1>


Whenever the central bank changes interest rates, the effect of this change
on producers is not instantaneous. It takes time before the effect of a change
starts to assert itself. Historically, the average time lag between changes in
the federal funds rate and changes in the yearly rate of growth of industrial
production has been twelve months.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart1-shostak-2.gif" width="384" height="300">




Using this historical time lag, we can suggest that in response to the
tighter interest rate stance between June 1999 and May 2000, the current
recession, or the current cyclical downturn, began in June 2000 (see chart).
In other words, by raising the federal funds rate from 5 percent in
June 1999 to 6.5 percent in May 2000, the Fed had set in motion in June
2000 the process of liquidation of businesses that sprang up on the back of
previous loose monetary policy.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart2-shostak-2.gif" width="384" height="335">




In January 2001, the Fed embarked on a new stage of lowering interest rates.
The central bank lowered the federal funds rate from 6 percent to 1.75 percent,
i.e., by 425 basis points. This artificial lowering has set in motion a
renewed misallocation of resources. Using the lagged-by-twelve-months federal
funds rate, we can suggest that there is a growing likelihood that a cyclical
upturn in the manufacturing sector has already begun.




As such, a cyclical upturn doesn’t cause real economic growth. It only
misdirects the given pool of real funding, thereby weakening potential
economic growth. As long as the real pool of funding is growing, an
aggressive loose monetary policy can"stage a strong cyclical
upturn"--i.e., strong positive year-on-year percentage rises in economic
activity. If, however, the real pool of funding is stagnating, the cyclical
rebound will be associated with a stagnant rate of growth in real economic
activity. 




As has been shown, a major negative for the real pool of funding is
increases in money supply. These rises set in motion an exchange of nothing
for something, which weakens the flow of real savings and thereby undermines
the real pool of funding. Since 1980, the U.S. has experienced large monetary
injections. A major cause of this is the"liberalization" of
financial markets, which, for all its merits in permitting financial
entrepreneurship, also removed various restrictions on banks' lending
"out of thin air." The magnitude of money creation since 1980 is
presented in the chart below.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart3-shostak-2.gif" width="384" height="330">




Observe that in December 2001, money AMS[3] was
80 percent above the trend, which is based on the history between 59 and 79.
This massive increase in the money stock has been associated with a
corresponding collapse in personal savings (see chart). In short, every dollar
that was created"out of thin air" amounts to a corresponding
dissaving by that amount.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart4-shostak-2.gif" width="384" height="330">




This large money creation has also been accompanied by the relentless
lowering of federal funds rates, which stood at 19.1 percent in June 1981.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart5-shostak-2.gif" width="384" height="330">




While it is true that businessmen react to interest rates, what permits the
expansion of tools and machinery, i.e., the infrastructure, is not interest
rates but the growing pool of funding. As long as interest rates are not
tampered with, they serve as an important medium in facilitating the flow of
real savings toward the build-up of a wealth-generating infrastructure. In
this sense interest rates can be regarded as an indicator.




Whenever the central bank tampers with interest rates through an artificial
lowering, it falsifies this indicator, thereby breaking the harmony between
the production of present consumer goods and the production of capital goods,
i.e., tools and machinery. In short, an overinvestment in capital goods and an
underinvestment in consumer goods emerge. While an overinvestment in capital
goods results in a boom, the liquidation of this overinvestment produces a
bust. Hence the boom-bust cycle.




The prolonged artificial lowering of interest rates must have contributed
to a large overinvestment in capital goods versus consumer goods production (a
severe misallocation of resources), thereby severely hurting the pool of
funding (see chart). 


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart6-shostak-2.gif" width="384" height="315">


<h1>The Rest of the World </h1>


From what has been said so far, it will come as no surprise that the real
pool of funding might be in bad shape. This in turn raises the likelihood that
the U.S. may follow the path of the Japanese economy. 




The question that needs to be addressed is how, despite prolonged monetary
pumping, the U.S. managed to perform so exceptionally well, at least in
terms of real GDP, while Japan, which has been also pursuing aggressive loose
monetary policies, has fallen into a severe economic slump. Thus both the U.S.
and Japan have been aggressively pushing money supply (see chart) and
aggressively lowering interest rates.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart7-shostak-2.gif" width="270" height="232"> 
<img align="middle" border="0" src="http://www.mises.org/images/chart8-shostak-2.gif" width="270" height="225">


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart9-shostak-2.gif" width="384" height="313">




It is quite likely that the mighty U.S. production structure has managed so
far to offset by a big margin the negatives of a prolonged monetary pumping.
In short, despite loose monetary policies, the U.S. pool of funding has been
growing. The U.S. pool has further benefited from the imports of goods and
services from the rest of the world. The balance on goods and services stood
at -$340 billion in 2001 against -$376 billion in 2000.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart10-shostak-2.gif" width="384" height="308">




Contrast this with Japan’s massive exports of goods (see chart) in return
for U.S. government bonds, which has likely undermined Japan’s production
structure and thus its pool of funding. (Bear in mind that the Japanese
government has been pursuing for decades policies that promote exports at the
expense of other sectors of the economy.) In other words, Japan has diverted a
large portion of its pool of funding in exchange for U.S. government promises.
Imagine that instead of investing his saved bread in a new oven, the baker
exchanges his bread for government bonds. Obviously this will impoverish the
baker, for his savings are not employed to keep his production structure going.
His savings are wasted on various government non-wealth-generating activities. 


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart11-shostak-2.gif" width="384" height="315">




In Q3 2001, Japan held $311.6 billion in U.S. Treasury securities--26.6
percent of total foreign holdings and 11.2 percent of total private holdings.
Moreover, foreign holdings of Treasury securities as a percent of total
privately held debt stood at 42.2 percent in Q3 2001 against 15.8 percent in
Q1 1986.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart12-shostak-2.gif" width="384" height="322">




It seems that Japan is currently paying a very high price for policies that
were aimed at promoting exports. In this respect it must be reiterated that
policies that aim at boosting any economic activity at the expense of other
economic activities are likely to undermine the harmony between consumption
and production and thereby cause economic impoverishment. What we are saying
here applies to policies that aim at boosting either aggregate demand or
aggregate supply. Only the environment of a free unhampered market will
guarantee the harmonious interplay between supply and demand. 




An important factor that helps the diversion of real funding >from the
rest of the world to the U.S. is the increase in the American money supply.
The fact that the U.S. dollar is the main international medium of exchange
makes it possible for it to divert real funding from other countries to itself.
In short, when new dollars are created, the first recipients of these dollars
are Americans who can exchange them for foreign goods and services. Americans
are in a position to practice the exchange of nothing for something because
only the U.S. can produce American dollars. On this Mises wrote:


<blockquote style="MARGIN-RIGHT: 0px">


Let us assume that the international authority increases the amount of
its issuance by a definite sum, all of which goes to one country, Ruritania.
The final result of this inflationary action will be a rise in prices of
commodities and services all over the world. But while this process is going
on, the conditions of the citizens of various countries are affected in a
different way. The Ruritanians are the first group blessed by the additional
manna. They have more money in their pockets while the rest of the world’s
inhabitants have not yet got a share of the new money. They can bid higher
prices, while the others cannot. Therefore the Ruritanians withdraw more
goods from the world market than they did before. The non-Ruritanians are
forced to restrict their consumption because they cannot compete with the
higher prices paid by the Ruritanians. While the process of adjusting prices
to the altered money relation is still in progress, the Ruritanians are in
an advantageous position against the non-Ruritanians. When the process
finally comes to an end, the Ruritanians have been enriched at the expense
of the non-Ruritanians.[4]


[/i]


It seems that the production of goods from the rest of the world has played
an important role in keeping the U.S. pool of funding going. It is envisaged,
however, that the emerging economic slump in the rest of the world is likely
to weaken the support for the U.S. pool of funding in the months ahead. 


<h1>Implications for Stock Markets</h1>


As a result of the Fed’s aggressive loose monetary policy, the yearly
rate of growth of money AMS adjusted for nominal economic activity stood at
13.2 percent in December against -4.1 percent in January.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart13-shostak-2.gif" width="384" height="330">




This strong increase in liquidity should provide support to stock prices (see
chart).


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart14-shostak-2.gif" width="384" height="358">




However, this strong liquidity build-up without the backup from company
profits will not be able to generate a sustainable stock market recovery.
Moreover, the present record-high P-E ratio (see chart) doesn’t bode well
for stocks. Unless the real pool of funding is still in good shape, the
prospects for a healthy turnaround in corporate profits do not appear to be
very promising. 


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart15-shostak-2.gif" width="384" height="330">




Obviously, if the pool of funding is sound, we should witness a strong
economic rebound and a strong rebound in stocks. However, a possible negative
that might mitigate the rebound in stocks in this scenario is the likely
acceleration in price inflation as a result of present the Fed’s loose
monetary policy.


<p align="left">The large overinvestment in capital goods versus consumer
goods production means that on a relative basis, greater profit opportunities
will be in companies that to a large extent are engaged in the production of
final consumer goods. The stocks of companies that are associated with
activities that are directly, or indirectly, linked to capital goods
production are expected to underperform. Furthermore, within the framework of
a stagnant pool of funding, on account of rising bad debts, bank stocks are
likely to come under pressure.


<h1>Implications for Interest Rates</h1>


Within the framework of a"shaky" pool of funding and invisible
cyclical upturn, we envisage that the Fed will continue to lower interest
rates further. As a result, the differential between the yield on the ten-year
T-bond and the federal funds rate, which stood at 3.3 percent at the end of
December, is likely to widen further.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart16-shostak-2.gif" width="384" height="337">




The strong build-up in liquidity coupled with subdued economic activity is
likely to benefit the Treasury bond market (see chart). If, however, the pool
of funding is"doing OK," then a possible rebound in price inflation
might mitigate the effect of the build-up in liquidity.


<p align="center"><img align="middle" border="0" src="http://www.mises.org/images/chart17-shostak-2.gif" width="384" height="303">




<strong>Conclusions</strong>


<p align="left">According to the popular view, the revival of some important
economic indicators has raised the likelihood that the aggressive lowering of
interest rates by the Fed will invigorate the economy. The irony is that the
very same loose monetary policies that are expected to energize the economy in
fact undermine its main source of strength. As long as the real pool of
funding is growing, the lower-interest policy of the Fed will appear to be
"working."  The collapse in personal savings coupled with
the massive overinvestment in capital goods in relation to consumer goods
production raises the likelihood that the U.S. real pool of funding may be in
trouble.


<p align="left">Furthermore, in the past, the American pool of funding was
helped by the rest of the world; but with a weakening in world economic
growth, this support is likely to diminish. Consequently, it will not be a
surprise if the U.S. economy follows the Japanese path some time in the future.
Having said all this, we do not deny the possibility of a cyclical recovery in
the months ahead. However, we suspect that this recovery is likely to be of a
shallow nature.


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<hr align="left" SIZE="1" width="33%">
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Frank Shostak, Ph.D., is an adjunct scholar of the Mises Institute and a frequent
contributor to Mises.org. Send him <font color="#000080" size="2">MAIL</font>
and see his outstanding Mises.org <font color="#3571ca" size="2">Articles
Archive</font>. Listen to Dr. Shostak's lecture entitled <em>Where
We Are, Where We Are Headed </em>found on the Mises.org
Audio page. See also Richard von Strigl's <em>Capital
and Production</em>


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[1]
Milton & Rose Friedman, <em>Free to Choose, </em>p. 85.


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<div id="ftn2">


[2]
Murray N.Rothbard, <em>America’s Great Depression</em> (Kansas City:
Universal Press), p. 153.


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<div id="ftn3">


[3]
AMS money supply stands for the Austrian School of Economics money supply
definition. See Frank Shostak,"The Mystery of the Money Supply
Definition," <em>Quarterly Journal of Austrian Economics,</em>3(4),
winter 2000, pp. 69-76.


</div>
<div id="ftn4">


[4]
Ludwig von Mises, <em>Human Action, </em>3^rd revised edition
(Chicago: Contemporary Books) p. 477.


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