Alan Greenspan: what does his rate rise mean for the US economy?
Gerard Jackson
By raising rates by 0.25 per cent Alan Greenspan seems to have given markets second thoughts about the direction of the US economy, despite the Federal Open Market Committee (FOMC) playing down the threat.
Some economic commentators think that by taking this action Alan Greenspan is signalling that more rises are on the way. These commentators think that these hikes would dampen US economic growth rates and corporate earnings. In short, markets are factoring in reduced future profits for which they hold Greenspan responsible.
Other commentators believe that Greenspan and the US economy have nothing to worry about at this stage of the recovery: gold and other commodity prices turned down suggesting to them that inflationary fears are exaggerated. In the meantime, US manufacturing, fuelled by tax cuts, is continuing to rapidly expand.
The problem is not Alan Greenspan or the US economy but the belief that interest rates can be successfully manipulated by central banks to bring about increased economic growth. So long as this belief persist most commentators and economic advisers, including central bankers, will always be guaranteed a cold bath, along with the economy.
As the Spanish economist Faustino Balvé succinctly put it, when one borrows one "hires time" (The Essentials of Economics 1963). Put another way: interest is how we discount time. It is not and never has been the "price of money." In his Theory of Money and Credit, 1912, Mises called this monetary theory of interest one "of unsurpassable naiveté."
Nor is interest determined by the productivity of capital. In a truly monumental three volume work (Capital and Interest) Böhm-Bawerk demolished the old interest theories and established the time preference theory as the correct theory of interest. Nevertheless, the eclectic theory, to which I believe Greenspan subscribes, that combines time preference with productivity has come to dominate economic theory.
This theory makes the fundamental mistake of looking at the phenomenon of interest as would a layman. After all, a businessman judges how much he will borrow according to his expected profit. Now most economists assume the existence of a range of investment possibilities, each with a different rate of return, say from 20 per cent to 5 per cent.
It follows from this that if the rate of interest is 10 per cent the businessman will only borrow to finance projects that yield more than 10 per cent. Thus the most productive investments will be made first.
These investments will become less and less value productive as they absorb more savings. Eventually the range of investment possibilities become exhausted and the rate of return settles at 10 per cent. It is this range of investment returns that it is claimed gives us the shape of the demand curve.
It seems that what is being assumed here is that each dose of new investment yields a marginal value productivity of 5 to 20 per cent. Knowingly or otherwise, the theory is making the grave error of attributing value productivity to monetary investment. Now the theory rightly connects increases in physical productivity to investment. This, however, has nothing to do with the return on investment.
For example, a firm produces 20 units per period for $X; investment in new processes increases its output to 100 units per period while increasing gross revenue by $2X. But this does not mean that value productivity increased by 100 per cent, because what benefits producers is the price margin between their selling prices and the sum of their factor prices and not gross revenue.
The long-run tendency in the market is towards the equalisation of returns (price spreads) as entrepreneurs move to compete away profits. What the productivity theory calls a range of investments with different marginal productivity values is nothing more than a shelf of expected levels of profits.
And profits are maladjustments between supply and demand. This means that in a truly profitable firm factors of production are actually paid less than the value of their marginal products. The difference is economic profit, not rent.
The theory also contains another grave fallacy that we have already touched on. Keynesians insist that the rate of interest is determined in the producers' loan market. But the 'normal rate of profit' (price spreads) is the rate of interest. Contract loans are only a reflection of that fact. Therefore the productivity of production processes has no bearing on the rate of interest.
In the long-run, the rate of return (what some economists call normal profit) is not merely equal to the rate of interest it is the rate of interest, which in turn is determined by the social rate of time preference, that is, the sum of the time preference schedules of everyone in the economy.
All of this is not idle theorising. If we accept that interest is determined by time preference the ramifications for monetary policy become immense. It has to be immediate recognised that because interest is the 'price of time' it not only equates the supply of capital with the demand for capital but also allocates capital goods through time.
By artificially lowering the rate of interest inflation is generated and businesses are told that there are more savings, capital goods, available than actually exist. This means that they will start projects that cannot succeed because the necessary capital for their completion does not exist. Eventually recession sets in.
(This has been misinterpreted by some critics as meaning that in time of depression the economic landscape would be dotted with half-built factories. It means nothing of the kind).
This happened to the US economy in '80s and the '90s and now it is happening again.
Right now the price of gold is telling us nothing about inflation or the future state of the US economy. If we think of inflation as monetary expansion then the price of gold can remain comparatively stable even as the money supply grows, so long as there is no general rise in price. Nineteenth century Britain is a good example of this phenomenon.
During the first part of the nineteenth century Britain experience a downward trend in prices that the California and Australian gold discoveries reversed. Prices fell somewhat after 1857 and then remained comparatively stable until about 1874 when they resumed their downward trend as output once again started to exceed the supply of gold. The situation was reversed again, this time the mid-90s.
The economist J. E. Cairnes stressed at the time that stable prices had concealed a serious inflation in the absence of which there would have been a significant fall in prices. This brings us back to the fallacy of the stable price level, to wit: if prices are stable there is no inflation, even if the money supply is quickly growing.
Therefore I suggest that the money and not the price of gold is what one should look at with respect to future inflation.
The remarkable flexibility of the US economy means that the current increase in the money supply has been bringing into use 'idle' capacity by raising the price of products relative to the costs, especially labor costs, of producing them.
It is true that part of the recovery is due to President Bush's tax cuts, particularly on capital. If you want more of something then reduce the cost of producing it. The same goes for capital (the material means of production): if you want more capital accumulation, reduce the cost of producing capital goods. This means cutting taxes on capital gains and savings.
To cut to the chase: artificially lowering interest rates and creating phoney bank deposits distorts production (money is not neutral) and generates a boom-bust cycle. So welcome to another monetary roller-coaster, courtesy of Mr Alan Greenspan.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 5 July 2004