the plan for the future
24 December 2019 (latest update: 29 February 2020)
In the 19th century the state of the economy was believed to be more ore less the result of market forces in which governments had little reason to interfere. It was the era of classical economics. According to classical economists the natural state of the economy is to run at full capacity where jobs are plentiful because the desires of consumers always exceed the capacity of businesses to satisfy them.1
Classical economists believe in the law of supply and demand. If there is a surplus of goods or services, they drop in price until they are consumed. Lower prices make it more attractive to buy those goods and services while it is less attractive to produce them. And so a new equilibrium is achieved. At lower wages, working is less attractive so fewer people are willing to work. At the same time it is more attractive to hire people so employment rises.1
During World War I the governments of the warring countries took up the task of organising the economy in order to to support the war effort. From then on more and more people came to believe that governments can manage the economy. Poor economic performance became blamed on politicians rather than market forces. The argument could be that the government did too little or that the government interfered too much.
The Great Depression hit the United States more than Europe. In the United States the depression lasted until World War II when the war effort brought the economy back to life. But most of the fighting took place in Europe and the United States remained largely unaffected. And so the Great Depression still has a significant influence on the collective memory in the United States. In Europe World War II plays a similar role. It was a reason to establish the European Union.
The depression challenged economic thinking. Existing economic theories and policies had not prevented it from happening. Three economists came up with three different recipes. From their ideas three economic schools emerged that came to play a greater role after World War II. Adherents of these economic schools differ on how to manage the economy but they all aim at strengthening liberal democracy and capitalism. There was a fourth economist who has been neglected until now.
The first economist was John Maynard Keynes. He became the founder of the Keynesian School of Economics. Keynes believed that a lack of demand for products and services was the main cause of the Great Depression. If there is a lack of demand businesses close and unemployment rises. Unemployed people have little income so demand could fall further. In this way matters could spiral out of control.2
Keynes advised governments to spend more or to lower taxes and go into debt so that people had more money to spend. Keynes advised fiscal policies to stabilise the economy. When consumption goes down production will be lowered as will subsequent investments, resulting in a lower national income and more unemployment. More spending would generate more tax income that could be used to pay down the debt the spending would generate.2
Keynesian economists believe that prices aren't flexible. Wages of existing employees are not likely to go down if unemployment rises. Employees will resist lower wages even when prices go down. And Keynesian economists believe that cutting wages is a bad idea as it will reduce demand further while insufficient demand is the cause of recessions in the first place. Lower prices and wages can deepen a depression as falling prices and wages make debts more difficult to repay.2
After World War II Western governments took up Keynesian economic policies. In the 1950s and 1960s welfare states were built and recessions were short-lived. Over time the cost of the welfare states began to mount and governments were running large deficits, often financed by money printing by the central bank. Inflation began to rise and it turned into stagflation during the 1970s. At the same time competition from foreign countries with lower wages began to hurt industry.
The mounting troubles suggested that there is a limit to what governments can do for the economy and society. Monetarism became the recipe to deal with the mounting inflation. Central banks increased interest rates and limited the money supply. Inflation dropped but at the expense of a steep recession in the early 1980s. Neoliberalism became the recipe for dealing with the rising cost of welfare states and competition from low wage countries.
The second economist was Irving Fisher. He is famous for his quantity theory of money which made him the founder of Monetarism. He had a different view on the cause of the Great Depression. During the economic boom that preceded it, prices rose because of spending with borrowed money. These debts had to be repaid so spending went down. That turned the boom into a bust but the debt made it worse. During the depression prices fell and the incomes of corporations went down.
This made their debts more difficult to repay leading to bankruptcies and unemployment. If wages were to be lowered to deal with the new circumstances, labourers would also find it harder to repay their debts. In this way matters can spiral out of control. Fisher advised central banks to pump more money into the economy so that prices would not drop. The central bank of the United States did the opposite by raising interest rates and limiting the money supply.
According to Fisher this made the Great Depression worse as it allowed the economy to crash and prices to drop so that debts became the proverbial millstone around the neck of the economy. Fisher believed that the central bank should aim for price stability by lowering interest rates and increasing money supply when prices go down and raising interest rates and limiting money supply when prices go up. His work was the basis for Monetarism. Monetarism aims at price stability.
Monetarists believe that changes in the money supply usually cause a similar change in prices. The more money there is, the higher prices go, at least after some time. Monetarists think that if you give people more money, they will spend it like the money they already have. In the short run, this increases demand as prices aren't flexible in the short run. In the long run the law of supply and demand makes prices rise so that not much changes in the end.
Keynesian economists believe there is a trade-off between employment and inflation as higher inflation goes together with lower unemployment. Monetarists think this effect only exists in the short run.3 At first workers and businesses confuse a change in price level with a change in real prices and wages and produce more. When business owners see their costs rise and and workers see their costs of living increase and demand higher wages, unemployment rises again.3
The Monetarists proposed monetary policies aimed at stabilising the price level. They proposed a fixed monetary rule in which the money supply is aiming for would be calculated based on macro economic factors and targeting a specific level or range of inflation. The Taylor rule, which a central bank could use to set the nominal interest rate, is such a rule. It is based on changes in inflation, GDP, or other economic conditions.
The third economist was Friedrich Hayek. He believed that governments and central banks caused the Great Depression. Central banks cause interest rates to be lower than they would be in a free market as they reduce the risk of systemic failure. That makes banks feel more free to lend and at lower interest rates. This can promote economic booms on borrowed money and that can increase systemic risk.
Most notably Hayek feared over-investment. Low interest rates could make investors prefer capital intensive long-term investments. Hayek also didn't favour mathematical economic modelling. He believed that the economy is incalculable because it is made up of the countless decisions of individuals. The only thing a government or a central bank can do is nothing as their interference makes problems worse.
Hayek's ideas stood at the basis of neoliberalism. Neoliberalism consists of policies of economic liberalisation, including privatisation, deregulation, globalisation, free trade and reductions in government spending in order to increase the role of the private sector in the economy and society.
Supply-side economics emerged in the age of neoliberalism. It favours low taxes on wealthy people and corporations to stimulate business investment. Supply side economists believe that as a consequence consumers benefit from a greater supply of goods and services at lower prices and employment will increase. High taxes may deter businesses and wealthy individuals from investing and enterprise as taxes would eat away their profits.4
It turned out that monetarism wasn't such a great success after all, at least not everywhere and certainly not in Great Britain. The reason may be that people can anticipate policy actions, rendering these actions ineffective. This phenomenon is called Goodhart's law named after economist Charles Goodhart, which has also been phrased as "When a measure becomes a target, it ceases to be a good measure."
The rational expectations theory states that people make rational economic decisions based the available information and past experiences. When making economic decisions most people try to be rational. People are sometimes wrong but on average they are right. And people learn from their past mistakes. Their decisions are based on their expectations and these expectations are based on the available information and past experiences.5
Rational expectations can make economic policies ineffective. For instance, if the central bank plans to stimulate the economy by printing money, businesses and people may expect inflation to rise, so that they increase prices and wage demands. In this way the desired effect of the policy would be undermined.5 This fits within the neoliberal framework as it can be used to argue that governments should not interfere with the economy.
Related to the rational expectations theory is the efficient market hypothesis. It states that share prices reflect all available information. As a consequence it is impossible to outperform the overall market through stock selection or market timing. The only way an investor can obtain higher returns is by taking more risk.6
The fourth economist was Silvio Gesell, even though he was not an economist but a businessman. He was ahead of his time, perhaps even by more than a century as it may turn out. He figured out a solution for economic depressions as early as 1916. He drew his conclusions from his experience as a businessman in Argentina during the late 19th century. In 1890 Argentina was hit by a depression. Gesell came to believe that the nature of money was to blame.
When interest rates are low lending would stop and the economy could crash. Money would go on strike as Gesell put it.7 There is always risk attached to lending out money. You could put your money in a safe deposit box so why lend out money when interest rates are low? In this way money would be withdrawn from circulation. It was not used for consumption nor was it available for investment. Gesell figured that this could cause economic depressions.
The solution Gesell proposed was a holding fee on money. If holding money is costly, you would be more willing to lend it or spend it, even when interest rates are low. During the Great Depression his idea was put into practise. It produced a remarkable success in a small Austrian town named Wörgl but Gesell and his proposel were soon forgotten after World War II. In recent years his solution gets more attention as negative interest rates are spreading.
In 1972 the Club of Rome published its report The Limits to Growth. It seemed that humanity would soon run out of natural resources. Living within the limits of the planet will be greatest challenge humanity is currently facing. Dealing with this challenge might require low or even negative economic growth combined with immense long-term capital investments. This may require low or negative interest rates. Only Gesell's solution may make that work.
Markets aren't always rational. The efficient market hypothesis states that it is not possible to achieve higher returns in financial markets except by taking more risk. That doesn't explain why certain investors like Warren Buffet make consistently higher returns. It can also not explain stock market crashes. In 1987 the Dow Jones Industrial Average fell by 22 percent in a single day. This proves that stock values can significantly deviate from their fair value.
Human behaviour isn't always rational. Behavioural economics tries to explain irrational behaviour in financial markets and the economy by a combination of psychology and economics that explores why people make irrational decisions from time to time. Humans are emotional and easily distracted beings so their decisions aren't always in their self-interest.8 Emotion may play a role in the valuations of individual stocks and the stock market as a whole.
Changing perceptions contribute to the contradiction between efficient market hypothesis and behavioural finance. Perceptions make changes in equity prices appear rational. There is uncertainty in the market about future economic growth and consumer preferences as well as government and central bank decisions. New information can change perceptions and produce a stock market crashes. Buying stocks just before a crash may appear irrational with the benefit of hindsight.
For instance, in 1929 business profits in the United States seemed to justify the stock prices. By 1933 the stock market in the United States had lost 90% of its 1929 value. Based on price to earnings stock market valuations in 1929 and 1933 were nearly the same. It was impossible to foresee in 1929 that the stock market would drop 90% and that earnings would justify such a drop. People who bought stocks in 1929 may therefore only be irrational in hindsight.
An important finding of behavioural economics is that most humans are risk-averse and value gains lower than equal losses.9 From that it is possible to infer that stable financial and economic conditions can make investors prefer equity over debt. Potential losses in diversified portfolios could be smaller under those conditions. The same may be true for potential gains but the smaller potential for losses might outweigh that.
Because of changing perceptions the economy can suddenly experience a Minsky Moment, which is a market collapse caused by reckless speculation after a long bull market.10 It can mark the start of a recession or even a depression. The stock market crash of 1929 as well the financial crisis of 2008 might fall into this category. Minsky believed that the capitalist economy is unstable because of credit cycles.
If prices are flexible then the economy will do fine classical economists claim. But even when all prices are flexible, the equilibrium interest rate where the supply and demand for money and capital equal could be negative, which is something classical economists didn't realise. If all other prices are flexible, and classical economics is correct, the price of money not being flexible enough might be the only obstacle to a flourishing economy.
Keynes didn't believe that prices are flexible. And like Gesell Keynes realised that investments would stop when interest rates are low. It is called the liquidity trap or the zero lower bound. Keynesian economists fear interest rates near zero. Investors do not invest when investments do not yield enough. Investments must at least make the interest rate in the market. This may mean that the interest rate can be too high for the economy to recover.
Interest rates do not go lower because lenders aren't willing to lend at rates close to zero. Keeping the money at hand yields zero without the risks attached to lending. As a consequence savings exceed investments and money is withdrawn from the economy. This could cause an economic depression. Keynes advised governments to lower taxes or to spend more to revive the economy so that demand for money and capital increases and interest rates go up.
Monetarists believe that changing the money supply is the way to deal with booms and recessions. That is why interest rates are raised when the central bank believes that the economy is overheating and interest rates are lowered when the central bank believes the economy is in a slump. At least this was more or less the case until the financial crisis of 2008. As interest rates neared zero central banks opted for excessive money printing in order to prop up inflation.
After the financial crisis of 2008 inflation figures remained low but the economy did not collapse like in the 1930s. The reason for the low inflation could be that investors exchange the bonds the central bank is buying for currency because of the liquidity trap. This newly printed money then remains on the sideline and is not used for consumption or investment. Ending the liquidity trap might require implementing Gesell's solution of a holding fee on currency.
Financial and economic instability are amplified by leverage and interest on debts. Incomes vary while interest payments are fixed. A fee on holding money and not allowing positive nominal interest rates can help to make capitalist economy stable. As fiscal and monetary policies do not address thus underlying cause of financial and economic instability, the issue has not yet been fully resolved.
Ending usury might make the financial system and the economy stable and make fiscal and monetary policies obsolete. Taking away one price control, the minimum interest rate of zero, and replacing it by another, a maximum interest rates of zero, may do the magic. That was not possible until recently because the equilibrium interest rates were above zero, but it may be possible once they are not. The economy can be stabilised as follows:
With Natural Money nominal interest rates are negative but positive real interest rates are possible as the currency unit will most likely rise in value. Natural Money is deflationary. Debts are replaced with equity so the money supply is expected to shrink at first in order to stabilise later on. Economic growth can translate into lower prices which is the same as a higher value of the currency unit.
Like lower interest rates negative interest rates can cause a flight into assets likes stocks, real estate and gold but over time the price of everything is likely to go down. This means that when the price of an asset is inflated, for instance when houses are priced above building cost or when gold is valued much higher than the mining cost, there is considerable risk to the downside, which will limit the upside.
1. Natural Money After Five Years - Classical Economics. Bart klein Ikink (11 September 2013). Naturalmoney.org. https://www.naturalmoney.org/blog/130911.html#clas
2. Natural Money After Five Years - Keynesianism. Bart klein Ikink (11 September 2013). Naturalmoney.org. https://www.naturalmoney.org/blog/130911.html#keyn
3. Natural Money After Five Years - Monetarism. Bart klein Ikink (11 September 2013). Naturalmoney.org. https://www.naturalmoney.org/blog/130911.html#mone
4. Natural Money After Five Years - Supply-side economics. Bart klein Ikink (11 September 2013). Naturalmoney.org. https://www.naturalmoney.org/blog/130911.html#ssec
5. Natural Money After Five Years - Rational expectations. Bart klein Ikink (11 September 2013). Naturalmoney.org. https://www.naturalmoney.org/blog/130911.html#raex
6. Efficient Market Hypothesis. Lucas Downey (updated 5 February 2020). Investopedia. https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
7. Silvio Gesell (1916). The Natural Economic Order. Translated by Philip Pye, Peter Owen Ltd (1958): http://www.naturalmoney.org/ NaturalEconomicOrder.pdf
8. Behavioral Economics. Will Kenton (updated 6 May 2019). Investopedia. https://www.investopedia.com/terms/b/behavioraleconomics.asp
9. Financial Markets - Value function of the Prospect Theory. Professor Robert Shiller (2014). Coursera.org. Notes: https://www.naturalmoney.org/financialmarkets.html#020304
10. Minsky Moment Defined. Akhilesh Ganti (updated 20 June 2019). Investopedia. https://www.investopedia.com/terms/m/minskymoment.asp