Unraveling puzzles in the US economy

By Gerard Jackson
web posted November 8, 1999

To many observers America's current economic situation has the appearance of an enigma filled with paradoxes. But this view is no more than a symptom of inadequate analysis. For example, as savings have fallen this decade, finally turning negative, business investment has risen by 13 per cent to 18 per cent of GDP. Some will argue that foreign savings fueled this splurge. However, it is no accident that this period also saw the money supply rise steeply, with M3 growing at about 9 per cent per annum during the last two years. In fact, broad money has not grown this fast since the 1970s. (No wonder there's a consumption boom). This growth is entirely due to the Fed forcing interest rates down below their true market rates.

Even the Keynesian-leaning Economist has now realized that artificially lowering interest rates will tempt firms "to overinvest in risky projects", completely overlooking the fact that these firms still require credit to invest. It also noted, while missing its true significance, that "As the quantity of investment surges during a bubble, its quality decreases." But this is just a clumsy way of saying that credit expansion generates malinvestments which at a later date have to be liquidated.

Now the effect of forcing interest rates down is to expand credit. This creates the apparent puzzle of investment exceeding savings. More appears to be invested than is being saved 1. The word for this is inflation, even though it doesn't show up in the CPI. Eventually, if left unchecked, increased consumer spending will force these companies' production costs up as they compete for labour and capital. At this point another puzzle emerges: even though interest rates are being held down in general they begin to rise for some of these companies as they compete for credit. As crumbs are preferable to starvation, they'll even be prepared to borrow up to the point where any profits disappear. This explains why interest rates rise at the end of a boom even though monetary policy is still loose. (This phenomenon made its appearance in Australia during the later stages of the '80s).

All I know at the moment is that some companies are paying higher rates for credit. Whether this is becoming widespread I cannot say at this stage. However, another aspect of this phenomenon is the emergence of 'excess capacity', a tricky term at the best of times. Now there is always unused 'excess capacity' in the sense that a nation's capital is never fully utilized 24 hours a day, seven days a week. Nevertheless, despite the putty-like nature of the concept there is a preferred utilization rate. It is argued that exceeding this rate is an inflationary signal while falling below it could signal falling demand.

What has been put to me is that the American economy is operating below the 'preferred capacity' and this represents a paradox. How can an economy experience a consumer boom with 'full employment' while operating below 'full' capacity? Flexible labour markets, is the answer. More and more labour can be employed at the lower stages of production even as idle capacity emerges in the higher stages. This doesn't mean that all the unemployment in those stages are absorbed elsewhere, only that some of the increased unemployment is statistically offset by rising employment elsewhere.

What all of this tells us is that there are no puzzles or new 'paradigms' in the American economy. We are only witnessing the workings of economics immutable laws — nothing else. And this means, given the Fed's monetary policy, that a shakeout is inevitable.

1 I do include foreign savings. I should also make clear that I am using the Austrian definition of savings and investment, which defines saving as the process by which present goods are transformed into future (capital) goods.

Gerard Jackson is the founder and editor of Australia's only free-market magazine online, published weekly at http://www.newaus.com.au/.

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