The stock market and other financial markets do not rise and fall based on a strong or weak economy. The stock market and the economy are unrelated—ignoring superficial and loosely-related links—except to the extent that it is money supply that inflates both stocks and GDP.

But if financial markets move up and down primarily based on the quantity of money in circulation (i.e., “inflation”), then what good are the “fundamentals” in telling us how to value stocks? The fact is that they are very helpful in telling us the prospects of one company versus another, but they do little to tell us the prospects of the market as a whole. After all 95% of all stocks go up during bull markets and 95% fall during bear markets, since it is mostly the surge and shrinkage of credit and the volume of spending that inflates and deflates the market (most of the velocity of circulation of an economy takes place in asset markets). Similarly, the economic and earnings prospects of most companies increases during the credit expansion phase and contracts during the credit contraction phase.

Most tools used to analyze the fundamentals give only a vague idea of the value of a company and whether it is under or overvalued. Whether it is under or overvalued first depends on subjective assessments of value. But a particular value might be considered reasonable at one point in time, given the state of the economy, and unreasonable at another time. For example, in 1928, Public Service Electric and Gas Company earned $3.93 per share, and paid a $3.40 dividend and was valued as high as $137.5 per share. In 1932, it earned $3.46 per share, paid a $3.30 dividend, but sold for $28 per share.[1] It could be the case that the perception of value related to this company changed by those in the marketplace during the intervening years. A more likely reason for its dramatic fall is that as the money supply shrank dramatically between 1928 and 1932, there were fewer and fewer dollars to hold the stock price high, and it fell along with the quantity of money in circulation, as did most other stocks.

On the flip side, it was a substantial enough quantity of money, not the expectation of companies making even more money, that held stock prices at levels representing P/E ratios of $60 before the crash. To the extent that these perceptions could have been correct, they would have been justified only in the sense that the expectations would be for yet more money to be printed by the central bank, increasing company earnings still more. Stock prices and valuations can stay high for years, when it seems they should be falling, with no (seemingly) real explanation. They can also stay low for years, when it seems they should be rising. These facts are more indications that prices do not move based on fundamentals.

Market values are based on expected future earnings. The primary problem with trying to determine a market value based on future earnings is that aggregate earnings are mostly based (or at the very least partly based, as it is usually assumed), on particular economic conditions. Therefore, what is perceived as the expected future earningsunder certain economic conditions becomecompletely incorrect under other economic conditions. For example, at the end of a bull market when the money spigot is flowing and the volume of spending is high, a given market valuation might be appropriate. But within months, the flow of money might have slowed dramatically, accompanied by a reduction in the volume of spending in the economy and a reduction in profits; such changes would warrant lower valuations. At the least, all the assumptions that went into the previous valuation assessment, and more importantly, the actual forecasts and expectations, in the previous months were wrong. More to the point, the assumptions were wrong because they were based on a lack of understanding about finance, namely that the financials are largely determined by economics.

That’s right: it is primarily economics, not finance, which drives the financial fundamentals. Keep in mind that this is true in relation to the overall market, not in relation to how a single company performs relative to its industry or how one industry performs relative to another (though, as we have seen, economic changes can certainly affect one industry relative to another).

To reveal how it is the case that the economics drives the financial fundamentals, let’s look at the most basic financial element that determines the “fundamentals:” profits. Profits rise and fall with the ebb and flow of money and spending that arises from central bank credit creation. In order to understand how, it’s important to comprehend in detail what determines profit margins.

Nominal aggregate profits are usually seen as being generated by increasing productivity of the capital employed, and different versions of this theory incorporate the factors of time preference and opportunity cost. The most common understanding of profits is along the line of the following: if tools and machines can be used to create an additional quantity of goods, the difference between the value of the additional goods and the cost of the tools and machines that produced them is the rate of profit. But this theory usually boils down to having the production of physical goods explain the gap between monetary costs and monetary incomes. The reality is that productivity has nothing at all to do with economy-wide profits. Increased productivity can help a particular firm increase its profits relative to competing firms, but it cannot help all firms increase their profits together.

If the quantity of money in the economy were static, there would necessarily be the same dollar amount of total economy-wide revenues and the same dollar amount of economy-wide costs each year across all companies. For example, imagine that $10 Trillion was spent to produce goods and pay workers’ wages (business outlays) while $11 Trillion was spent on purchasing those goods (sales revenues). Imagine also that in the next year, output increased by 5%. No matter that the amount of goods produced increased in number, there could still be only $11 Trillion worth of sales revenues in terms of dollars,[2] and approximately $10 Trillion worth of costs—the number of dollars existing in the economy did not change. The additional volume of goods would serve to reduceprices; they could not increase the amount of dollars spent on purchasing goods or reduce the amount of dollars spent on producing goods.

Therefore, we must ask how it is that in any given year, total economy-wide business sales revenues exceed total business costs, when all the money business spend must necessarily show up as revenues to other businesses. Since all business spending comes back to businesses in the form of revenues, why isn’t there the same amount of revenues as there are costs (i.e., the amount spent)? Shouldn’t sales revenues equal business spending? The answer to this puzzle is that while business spending and revenues do in fact equalize, there is additional consumer spending in excess of the wages that are paid by businesses to its workers (keep in mind, businesses spend money in two primary categories: capital goods and wages). The amount of consumption—the amount of spending to purchase consumer goods—in excess of what is received in wages is termed Net Consumption by Reisman.

The additional consumer spending comes mainly from dividends, draw payments, stock buybacks and other forms of payments made by business to its owners (a smaller part of it comes from people consuming savings they already had). In other words, profits are mostly payments to capitalists to compensate them for going without the use of their money and instead allowing the business to use it in the form of factories, offices, and research and development, as well as to pay workers. Businesses that do not pay out dividends or other payments to their owners provide the return on the use of capital in the form of larger income statement profits, by way of ensuring a wider spread between revenues and costs. Net Consumption is essentially money that flows from companies to owners of capital and back to companies without hitting the income statement as costs; dividends and the like are not costs that show up alongside expenditures on capital goods and labor, they are a flow-through item.

More important to us as investors is how the derivation of profits changes in a world where the money supply is not static—in other words, in our current world of investing. In this latter case, the increase in the quantity of money, as noted briefly above, increases the rate of profit. The Net Consumption component just discussed is still present when an increasing quantity of money enters the picture, but added to the Net Consumption component is the component of Net Investment.

Net Investment is the monetary amount of investment created by the difference in purchasing power between the current time period and a previous time period when things cost less. It is the current amount of monetary spending by business which is recognized on income statements as sales revenues to other firms (every dollar of business spending by one firm is revenues to another firm) but is matched with income statement costs that were incurred previously in time when the price level was lower. The result is that, as long as there is an increasing money supply and corresponding price inflation, current business revenues exceed current costs; and the more the quantity of money expands, the greater the gap between revenues and costs. A more specific way of looking at it is that a company’s current productive expenditures exceed the amount of current costs because to incur the same physical expenditure of capital goods and to pay the same number of wages payments (productive expenditures)costs more today  than it did in previous years (costs). The difference between current productive expenditures and current costs is Net Investment.

With a constant amount of savings in the economy, there is not necessarily an additional amount of net real, physical investment added each year. Most of the increase—if there is any at all—is in monetary terms only. In other words, the same amount of physical investment that takes place each year has a higher price tag. Why? Because there is a greater quantity of money and, therefore price inflation, each year.

In a world of an unchanging quantity of money, for a given amount of revenues, a company’s general and administrative expenses, costs of goods sold, and depreciation expenses would be roughly the same each and every year. But with a growing money supply, these expenditures become more costly each year, and thus, a larger monetary amount is spent. The large portion of business costs which relate to inventories and capital equipment (large-scale investments) are typically recognized at a much later date than they are incurred, due to standard accounting procedures.

For example, steel sheet purchased to go into an automobile—a cost of goods sold item—might be purchased in June of year 1, but it is sold—in the form of a finished automobile—in June of year 2, when prices are 5% higher. Similarly, a factory—a capital good that is depreciated—which has a useful life of 20 years will have the first 1/20th of costs recognized the first year but the last 1/20th will be recognized 20 years later. Imagine the increased cost of a factory over twenty years. In the intervening years, inflation makes the cost of past purchases cheap relative to current purchases. Thus, with current spending showing up as revenues in the current year, but previous, lower-priced, expenditures showing up as costs, revenues are greater than costs. This creates a positive amount of monetary net investment in the economy. When the money supply is expanding, economy-wide business revenues rise while costs lag behind, widening the profit margin. When the money supply stops growing, revenues stop rising due to a fall-off in demand and a reduction in the volume of spending, and even fall, as discussed above, lowering the profit margin.

To summarize, profits equal Net Consumption plus Net Investment. Real profits equal Net Consumption plus Net Investment plus the increase in production and supply (the latter lowers prices in real terms, which constitute an increased rate of profit).

Earnings

The Net Investment component of profit is the main factor in determining changes in earnings during economic cycles. As the money supply increases during a bull market, revenues rise while costs fall behind, thus increasing profits and earnings. If still more money is pumped in at an even higher rate, revenues rise that much more above costs. Once the money supply slows or stops, revenues fall while the historical component of costs continue to climb. Profits and earnings therefore fall. During deflationary periods, revenues can fall below costs, but only temporarily. Obviously, then, aggregate “top line growth” can occur only with credit expansion (of course individual firms can gain revenue growth at the expense of other firms).

At the end of a bull market and the start of a recession, the common analysis is that “spending has fallen off.” Unbeknownst to those who talk in this fashion, what this really means is that the Fed’s slower rate of money pumping as slowed, resulting in business losses, which then results in bank losses and therefore the money supply and or the volume of spending (i.e., velocity) falling off. With a reduction in business and consumer spending, sales revenues fall while costs fall more slowly (since many of them are fixed, historical costs). The lack of net money creation causes revenues to fall and profits to shrink.

During a recession, the central bank tries to flood the economy with money because it believes that 1) simply enticing companies to invest will somehow bring prosperity, and 2) for its (justified) fear that a falling money supply will result in deflation and a collapse of much of the financial system.  When it begins pumping money into the economy, the new money is taken by business and spent, and therefore shows up as new and additional sales revenues. Greater sales revenues relative to costs raises the rate of profit. With business spending, hiring, and margins widening, official indicators point to a “recovery,” even if there is no real, sustainable economic growth (or employment); there might likely even be economic retrogression during this period.

Stock analysts usually try to determine what overall economy-wide profit margins (i.e., earnings) will be by looking at indicators such as retail sales, consumer sentiment, the consumer price index, manufacturing orders, new construction, government spending, and the like. But these indicators don’t tell much about future profits because they are all coinciding indicators to increasing or decreasing profits; they, like profits, are all derived from changes in the money supply. For a more specific example, consider the leading indicator industrial production. Economists will often tell us that there are signs of economic recovery due to the fact that industrial production is picking up. This does not tell us anything about the real state of the economy—the amount of goods and services being produced, and whether they are the goods that are truly demanded, or whether they are the goods artificially demanded based on credit expansion[3] —it simply tells us that new money from the Fed is flowing into the economy and causing spending and the prices of capital goods to increase. Specifically, it tells us that companies which produce capital goods are taking the new money the Fed has provided at low interest rates and making investments with it, and that they are seeing (monetary) “demand” from their customers who are spending their new money from the Fed.

The bottom line is that not only does the central bank create bull and bear markets and the improving and worsening economic conditions, but it also creates and reduces the very profits that are usually believed to be the basis for these first two factors.

Relative Valuation Ratios

It is because money has flowed disproportionately into asset prices in the last 25 or so years that relative valuation measures in recent years have averaged—over a 20-year period or so—the highest they ever have; market prices have remained at a new, elevated valuation level. Figure 8.1 shows that P/E ratios now average about 20 whereas they used to average 10-15, with the same and lower level of interest rates that existed in past decades (especially prior to the late 1970s and 1980s). The market used to bottom out in bear markets with P/Es at 5. Now they bottom out at 12 and 16, as is the case at the 2009 market bottom below. Stocks are now permanently more expensive because more money, proportionately, is chasing them than before. Plus, money is now more easily contained in asset markets without leaking out into the real economy than in prior decades.

Previously, an interest rate reduction of 100 basis points might have meant that P/E ratios should rise from, say, 10 to 12, based on fundamental analysis. Now, a 100 basis point reduction could mean that P/E ratios rise from 20 to 24.

Figure 8.1: Historical P/E Ratios

Source: Robert Shiller, Yale University

                Similarly, as Figure 8.2reveals, Tobin’s Q Ratio, a measure of the market value of a company’s stock relative to a company’s equity book value of the book equity, shows an elevated state in recent years, even if its level has fallen during the most recent crisis.

Figure 8.2: Tobin’s Q Ratio

In comparable fashion, relative indicators such as the price to sales, price to dividend, price to cash flow, price to book, and market capitalization as a % of GDP have reached new highs and elevated low-high ranges in the last quarter century. As money is created by banks, then borrowed and spent by companies to purchase goods and supplies from other companies, and to pay wages to workers who then purchase goods from other companies, aggregate company revenues, earnings, and cash flow increase. As the newly-created money flows into the stock exchanges, company market prices rise. Since more money flows into share prices disproportionately more than it flows into the companies themselves, prices—the the numerators of the relative ratios rise to a greater extent than the denominators.

The Discounting of Expected Cash Flows and Expected Valuations

                It is often said that all else being equal, lower interest rates lead to and enable higher stock market prices. This “common knowledge” is not necessarily correct. Prices are prices. Overall prices of stocks are determined by how much money flows into the stock market. If all the money that is available to flow into the market is already in the market, prices cannot rise higher just because a rate of interest is reduced per-se (except, of course, to the extent that money that was going towards paying extra basis points of interest instead go directly into the financial markets); they can rise only with more money available with which to bid up prices. When interest rates are lowered by the central bank, money is added to the system in order to lower the rates, and the new money subsequently flows into the financial markets. But the mere existence of a lower rate, without the accompaniment of an additional quantity of money, will not and cannot make the market go higher. Though admittedly, it might justify a higher price.

                The theory behind lower interest rates leading to higher prices is based on solid logic and math, but it is extrapolated incorrectly to mean more than it actually does. The basic idea starts with the notion of compounded interest, and then proceeds into the notion of the present value of money. As Brealy, Myers, and Marcus state in their textbook The Fundamentals of Corporate Finance:

We have seen that $100 invested for 1 year at 6% will grow to a future value of 100 x 1.06 = $106. Let’s turn this around: How much do we need to invest now in order to produce $106 at the end of the year? Financial managers refer to this as the present value (PV) of the $106 payoff…to calculate present value, we simply reverse the process and divide the future value by 1.06.

The explanation presented here is correct: $100 grown at 6% for X number of years will give us the future value. Similarly, discounting the expected future value by the appropriate interest rate—the required rate of return—will tell us how much we should pay now for a future investment worth a certain amount. If we pay more than the present value of the future amount, we are paying too much. If we pay less than the present value, we will have a gain. The incorrect assumptions and methodology, however, come along when one starts thinking that discounting future values with a lowered rate of return than before somehow creates a higher future value. It does not. A lower rate means that one can buy today at a higher price and still have a profit (based on their lowered required return). But just because one’s required rate of return falls does not mean that stocks should perform better. Discounting is simply a formula; it is not something that assigns a value.

The Time Preference Fallacy

                Part of the confusion with discounting present values stems from the required return component of the formula, which begins with what is called the risk-free interest rate that is obtained by investing in government bonds, which themselves are seen as revealing the time preference of savers who make funds available for lending.

I’ll explain starting from the latter first. Time preference is seen as revealing the preferences of individuals to consume today versus consuming in the future. A common explanation of the theory states that, naturally, people prefer to have money and to consume with it today instead of waiting to do so in the future. Therefore, a dollar is worth less in the future than in the present.

Now, time preference definitely exists, and it does dictate how much people consume today versus tomorrow. But it is not true that just because time preference exists, a present dollar is worth more than a future dollar. It therefore also does not mean we should discount future values based on a time preference of individuals. It simply means that some, or all, people chose to save some of their money in the future rather than the present. In fact, the very existence of time preference shows that some goods in the future are valued more highly than goods in the present.

People often prefer to save their money in the present once immediate needs are satisfied, and to instead use that money in the future. Thus a future dollar means more to them than a current dollar. For example, it is true that people would rather have an ice cream today rather than in the future, but once they’ve had an ice cream or two, they would rather wait till later to have the third, fourth, and especially the twentieth ice cream. Most people would rather consume less of a multitude of goods today so that they have something available to live off during retirement. Even in the absence of earning a rate of return on their money, people would still save for the future.

Additionally, in an economy in which the money supply is fixed—the assumption that must underlie basic finance and economic theories—there is a reason why some future goods might be worth more than present goods: they are more valuable to buyers in the sense that it costs less to buy them tomorrow than today. Why buy a car today for $30,000 when if you wait till next year it will cost only $29,000? Effectively—but not intentionally—the price is discounted to compensate one for waiting.

(As a sub-component of the current argument, it is often stated that interest is important in determining profitability. While this logic is true from a certain perspective and given the right context, it is important to remember that interest could not exist without profit, as interest is paid out of profit. Without profit, there would be no gain in paying interest, and therefore no means with which to do so.)

Second, even if no one ever wanted to save anything for the future, the risk-free interest rate does not reveal what the time preference is. One reason is that the interest rate earned on government bonds is not wholly determined by individuals in the marketplace: it is highly influenced by the Fed’s manipulation of short term rates and by the artificial supply and demand stemming from central bank money creation. Another reason is that government bonds are not the only place savings goes; it also goes into corporate bonds, stocks, commodities, real estate, precious stones, art, and antique cars, and even under the mattress. Thus, the full supply and demand for loanable funds is not present in the government bond market alone.

The “Risk Premium” and “Required Return” Fallacy

But the more important problems with the required return component arise once the so-called “risk premium” comes into play. Ben McClure, a former Wall Street equity analyst and director of his own research and consulting firm, explains the risk-premium component of the required return function in his Investopia.com tutorial, which explains how to discount future values for the purposes of investing. He begins by stating that:

According to financial theory, a stock’s value proposition starts there: stocks are risky assets, even riskier than bonds…Therefore, investors ‘require’ a higher return for taking on extra risk by investing in stocks instead of Treasury notes, which are guaranteed to pay a certain return[4].

                It is true that if riskier stocks did not yield higher returns, investors would not take on the additional risk investing in them. However, similar to the concept of “demand” that we learned about, the idea that investors “require” a higher return is unrealistic. Their “requirement” is meaningless. Just because they require, demand, or even hold their breath until they get what they want does not mean that they will get it. And it is the market participants themselves which must create the return by the very act of buying the assets which will give the return. The stock market does not deliver higher average returns because investors insist upon it. If it did, why shouldn’t investors insist on 100% returns per year? Or, why didn’t the stock market listen to their demands during the bear market of the 1970s? Yet, McClure (as well as most investment textbooks) states that:

If the required return rises, the stock price will fall, and vice versa. This makes sense: if nothing else changes, the price needs to be lower for the investor to have the required return. There is an inverse relationship between required return and the stock price investors assign to a stock.

                This statement seems to contradict the notion that the stock market has superior returns just because investors require it. But working within this vacuum, investors will certainly have more room to buy profitably today if the required return falls. Yet a change in the rate of interest—all else being equal—does not mean the stock market will, or should, go higher. Indeed, investors might invest more money because they think they have more of a margin to work with in making money. But thinking that lower rates mean a market must go up leads one down the path of thinking that overall, long-term market movements are based upon interest rate movements instead of money flow from the central bank.

Discounting in a World of Constant Prices

                Most of the confusion dealing with discounting present values stems from the idea that prices must always go higher. We must ask ourselves what purpose discounting would serve in an environment where the quantity of money never increased and stock prices, as a whole, never went higher over the long term (a very realistic scenario). Suppose we have an economy in “equilibrium,” where no new products or services are invented, and where no new money is created. In this case, since the volume of money and spending is constant, total company revenues would remain about the same, while selling prices fell. Each individual company would earn the same amount of money by selling a higher volume at lower unit prices; each company would have total costs that remain about the same by buying a greater volume of inputs at lower unit prices (as was the case during the 1800s). Since company revenues would be the same each and every year and entrepreneurial profits would not exist, each company would earn the same total amount of sales revenues each year. In this case, each company’s accounting profit would disappear after paying out dividends/interest to its owners or other providers of capital. Yet each year as owners spent their dividends on consumption (on average—some would, some wouldn’t), accounting profits would return.

                In this scenario, the future value of monetary company earnings would be equal to present value of monetary company earnings. What, then, would there be to discount? The value of the future company earnings would not (or should not) be discounted since their future value is the same in nominal terms as they are today. The same applies to future dividends; they would have the same nominal value in ten years as they do today—with the same quantity of money in the economy then as now, dividends would not increase. Even if we still accepted the time preference theory, future company earnings should not be discounted for time preference because the real future revenues are already compensating for time preference since their value is higher than today’s value. They are higher is because with the additional production and supply of goods, consumer prices would fall each year, raising the real purchasing power each year of both the dividends and the value of the capital.

                Thus, suppose we have a 10-year investment horizon. Suppose also that we have an investment in a company whose value in 10 years is expected to be $100—the same as the current value (remember: the future earnings and future value will be the same as the present since the quantity of money will be the same). At a discount rate of 10%, the current value of our expected $100 in revenues would be $38.55. What exactly does that mean? According to the finance text books it means that we should pay no more than $38.55 for our investment in the company to acquire those revenues. But why shouldn’t we pay as much as $100 for an investment whose future value is $100 (and worth more, not less than $100 in real terms)? We should! It would mean that we are “loaning” (with a long-term equity purchase) the company our $100 so that it can produce $100 in revenues (revenues-profit= cost).

Importantly, the company will also pay us a dividend each year for the use of our funds (which, for simplicity, we have not calculated); this is how we are compensated for going without our funds. Lower future prices take care of our time preference and dividend payments takes care of our opportunity cost.

Besides, we would never be able to purchase the company’s shares for $16.35 because it would never be priced that low in the market since its intrinsic value would always be $100. This example shows how the entire notion of discounting future values breaks down in a world where credit creation is non-existent.

It All Comes Down to Inflation

                So why, one might ask, does the current system of discounting future cash flows seem to work out (as far as the math, not the predictability) reasonably well in the real world every year? The answer is that what analysts, unknowingly, are calculating with their present value formulas are a compensation for inflation.

Indeed, analysts use earnings net of inflation or an inflation premium to compensate for the expected CPI, but the CPI reveals consumer price inflation, not asset or salesrevenue ordividend orearnings inflation. Inflation pushes up the value of assets, revenues, costs, earnings, dividends and the like much more than it pushes up prices, because the quantity of the former does not increase as quickly as the quantity of the latter. Each year, these companies whose assets and incomes are rising, are increasing the supply of goods in the economy with their production, and thus lowering consumer prices (inflation raises prices while at the same time goods production lowers prices; in the end, inflation wins out by a small margin).[5]Using a CPI number still leaves many basis points of inflation uncompensated for.

It is this uncompensated inflation which most of the interest/discount rate not associated with an inflation-premium addresses. In other words, I have stated that future values should not be discounted with an interest rate; this leaves an interest rate being used that should not be. I have also stated that there is inflation which is not addressed (earnings inflation) but should be. These two components largely cross each other out. While analysts think they are discounting future values (which they shouldn’t), they are actually discounting asset inflation (which they implicitly think they shouldn’t but they should). On a net basis, these two components often roughly approximate each other. But they are also often far apart from each other; there are many reasons for this and the results are incorrect forecasting and valuations.

Similarly, though inflation raises revenues, earnings, dividends, etc., it also raises securities prices, providing the purchasing power to market participants to be able to bid up prices to be in line with the present value of the inflated earnings. Sometimes money flows more into the companies’ actual revenues and costs (and at different rates for each of these, as we have seen), and sometimes it flows more into the securities prices themselves. The earnings and the securities prices act like a see saw balancing while still oscillating as each side of the see saw, or the see saw as a whole, is pushed higher and higher with inflation.

Commodities Fundamentals

                Many assumptions are made about commodities prices that, as happens with other asset classes, confuse the effect of money with the fundamentals. One effect of this confusion is the belief that commodities act in a certain way based on some natural economic phenomena. For example it is often stated that commodities take off at the end of economic growth cycles once the rest of the economy is overheated. Famed investor Jim Rogers points to research in his book Hot Commodities showing that stocks and commodities have been inversely related since 1880, with commodities having on average an 18-year cycle. This would indeed support the notion that commodities would tend to start rising at the end of equity bull markets. But if commodities take off once the economy is overheated, what would explain why commodities continue to run for many years after the economy “cools down”? And though there might have been a negative correlation for more than a hundred years, what would explain the positive correlation in the 2000s, where commodities and stocks rose simultaneously, and collapsed simultaneously in 2008? A common link—money—would explain it.

                There was not, in fact, a negative correlation between stocks and commodities during the 100 years prior to 1880. As Figure 8.3 shows, commodities prices were lower in 1880 than in 1780.

Figure 8.3: Historical Commodity Prices

Source: http://www.gannglobal.com/invest/commodity_history.gif

Throughout the mid 1700s and 1800s, commodities prices remained near the same index level, experiencing multiple “spikes” within that time frame. In other words, the overall price level of commodities stayed rather constant, as did consumer price levels during the same period. The spikes were due to the periods of time referenced earlier where banks created paper bills at rapid rates, causing prices to rise, until they reigned in credit for fear of losses, which resulted in a collapse of the money supply, and deflation. Figure 8.3 also reveals that commodities, which are usually priced in dollars, did not have “bull markets” that were more than spikes, until the international gold standard eroded and dollars began being created at exponential rates.Figure 8.4 shows that while the prices of commodities and most other goods were staying level or falling during the 1800s, stock prices were rising (though they were static during the 1700s), presumably because the supply of commodities and other goods increased faster than did the production of gold, but the number of equity shares did not.

Figure 8.4: Historical Commodity Prices

Source: MetaStock

                The point of the previous discussion is to show that 1) commodities price movements are mainly a function of the money supply (mainly the U.S. dollar money supply) and 2) that there are no reliable long-term trends or relationships regarding commodities.

                The first of the two points above leads us into the main part of our commodities discussion, which is the fact that most of the demand for commodities is not really demand for commodities. In other words, commodities prices do not really rise mostly because there is a need for them—they rise because the demand consists mostly of money, not a desire to consume an increased rate of commodities. As with all topics in this book, am not saying that real supply and demand make no difference. People and companies do in fact consume modestly more each year, putting upward pressure on prices. But the supply of commodities also increases moderately, putting downward pressure on prices. Absent the printing of money, these two effects would largely cancel each other out, leaving a commodities chart looking like the first half of the chart in Figure 8.3, but without the spikes. In other words, commodities prices would fluctuate moderately around a rather constant mean. But with increasing quantities of money, the monetary demand for commodities far outpaces any real demand, causing prices to rise and to fluctuate wildly due to the constantly changing rate of increase of money creation.[6] As an analogy, consider a fish swimming north in shallow water at a beach, with the beach to the east. The fish, moving on its own (representing true supply and demand), might swim east then west then east again as it is travelling north. But when a wave of water (representing inflation) pushes the fish towards the beach, the fish still maintains his back and forth east-west motion, but while, overall, being pushed further east towards the beach by the water.

To better grasp the idea that it is money, not true supply and demand mostly affecting commodities prices consider that during our recent commodities boom, it was alleged that food prices were rising due to, among other things, a reduced supply of food and increased demand for food from China.

Make no mistake: for various fundamental reasons related to production, supply, and demand, there was a lack of supply of some commodities available relative to the growing real demand for them. Still, this lack of supply was not the root cause either of the occurrence of shortages or of the extreme increase in world food prices (by over 80% in three years). Additionally, though many commodities such as wheat had been stagnant or in reduced production over the previous several years, other commodities had seen continued increases in production; other food groups such as cereals, fruits, livestock, and fish/seafood products had seen mostly increased supply. Data[7] from The Food and Agriculture Organization of the United Nations show that both agriculture production and food production per capita had risen since 1990, and stayed steady since 2000. In comparison, commodities prices had been rising since 1999.

Any “new demand” for food from China would necessarily have resulted not only in the Chinese themselves producing more food to meet this demand, but in the rest of the world doing so as well. (In fact, China increased agricultural production per capita by 22% between 2000 and 2007.) Can we really imagine that world food producers would not have spotted this demand and tried to make profits by satisfying it? They did, and had therefore been producing more food. The Chinese population is increasing by just over one-half of one percent per year. How, then, could the Chinese suddenly have a desire and need for 30% or so more food per year in recent years? Further: how could they pay for it, even if they had the want of more food? The Chinese did not have real demand to consume that much more food per year, they had 30% more paper bills in their wallets.[8]

If there were as much of a new demand for food in China as economists claimed—given a constant amount of money in the economy—there would necessarily be a corresponding reduction in the demand and prices of other goods. Therefore, the Chinese may well have been consuming more food, but this increased consumption would not responsible for (absolute) higher prices or shortages.

The ultimate proof of this argument arrived in summer 2008, when world commodities prices and thus world food prices collapsed due to a lack of monetary demand stemming from the “credit crunch”—the collapse in money and spending.

The same applies to oil prices, which is a commodity. We consumers do not go through periods were we suddenly want to consume double or triple the amount of gas that we did a year or two before—even during a “growing economy”—thus pushing gas prices higher. There is simply double or triple the amount of money flowing into oil markets.

A conventional explanation is that speculators are driving up prices. But speculators (and investors in general) cannot just run a price up for no reason. They cannot control the entire world market for oil. For every trading position they open, they must close. Therefore, their speculation must be correct or they will suffer losses. The slice of truth in the speculation argument is that investors and speculators (along with other individuals) are indeed making prices go higher, but not on their own by manipulating prices, but by simply investing more with the increased amounts of money available from banks. The speculators—at least those speculating price rises—can then be right, for a while, in their bets because prices will indeed keep going higher until the money valve is turned off.

Gold

                Gold is even less predictable than other commodities, because it has more diverse uses in an economy, including as an alternative money. As far as its use of money is concerned, it has traditionally been said that gold is a safe haven when there is uncertainty in financial markets and the economy. Yet this has notstrongly proven to be the case in the most recent crisis, as gold did not increase during the crisis. In fact, gold actually fell when other commodities collapsed in summer 2008, as the safe haven was then treasury bills. But it soon returned to new highs—the only asset class to do so.

For the last year it has been said that the Federal Reserve’s unprecedented amount of money creation in order to save the banks will result in not only massive price inflation, but in skyrocketing gold prices.  This might or might not be true. First, if it was a certainty, gold prices would have already risen—more than they have—as investors put their both existing and newly borrowed money in gold. But in fact, their money has been put back in all asset classes, as they have all rallied significantly since winter 2009. As that fact likely portends, new inflation created by the fed might likely flow into other asset prices as much or more than into gold in 2009, leaving gold an average performer, if not an underperformer. It is also because most new money might flow into asset prices that consumer prices might remain tame, leaving a normal CPI rate of growth. These arguments assume that the Fed’s reflation will work. It is still possible that the government’s manipulations cannot save the financial system from a Japanese style stuck-in-the-mud lending system where banks hold on to new excess reserve, or, from a financial collapse, if consumers withdraw their money for some reason or another, in which case there will be a massive collapse of the money supply, and all asset prices will fall.

                In the mean time, most observers seem to point to gold’s rise as a bubble. A few years ago, people constantly denied that bubbles existed, that markets could fail to continue going higher and higher. Now, since bubbles are virtually undeniable, it seems that people see bubbles everywhere, including in such things as gun sales, incandescent light bulbs, and ETFs. Clearly, people who don’t understand what bubbles are and how they are caused are confusing fads with bubbles.

                The act of pundits citing gold in 2009 and 2010 as being in a bubble is certainly more sensible than these other types of bubble identifications. But the odds are almost certain that this thinking too is flawed. Bubbles occur from expanding credit flowing into prices of assets, or even goods.

To better understand gold in 2009 and 2010, let’s start with gold in 2008. It is highly unlikely that when the reduced growth rate of money and velocity caused a credit implosion in all asset classes—global stocks, bonds, art, jewelry, and especially that of commodities—in 2008that a single commodity, gold, could stay as it did near its highs, while all other assets and commodities fell dramatically, due its being in a single, isolated, monetary bubble. Why would gold not fall when other assets fell? Gold remained near its highs due for two reasons. The first is its becoming more valuable as an inflation hedge and a store of value (as opposed to a commodity), and even as a medium of exchange, because more dollars were attempting to be created by the Federal Reserve—the Fed increased bank excess reserves by an unprecedented $1 trillion, an amount capable of increasing the money supply by $10 trillion, almost the size of the entire economy currently. The second reason is its becoming somewhat more valuable as a safe haven, since other asset classes were deteriorating. In 2009, with dramatic credit expansion, a dramatic rebound in capital markets occurred. Gold stayed at its highs even as money flowed out of it and into other assets. But in late 2009, as other asset classes begin to level off, gold struck out to new highs. Gold’s making new highs, after never really correcting as other asset classes corrected, points to its being relatively fairly and realistically valued all along.

                Still, there is more evidence of an absence of a bubble in gold. Asset price bubbles tend to appear as increasingly steeper price trends, which eventually begin growing exponentially. As the trend progresses, corrections, or pullbacks, are rarer and briefer, even if sharper. Gold, in contrast to having been on a run for decades as bonds and equities had, were in a twenty year bear market until the late 1990s. During its bull run in the 2000s, gold moved at a reasonable pace, maintaining a reasonable slope. Just when it really started to run, it would have a long, sustained correction period. Never did it take off exponentially at breathtaking speeds. This is the sign of a calm, methodical bull market, not a crazed, credit-induced, fast-paced bubble where people are falling over themselves to buy at the new high week after week, at an increasing pace.

                When gold is adjusted not only for inflation, but especially for real inflation in the form of money supply growth, it is still far below its highs of the early 1980s. The odds are much higher that gold will eventually catch up in real inflation-adjusted terms—putting it at a price of more than $3,000 an ounce—than continue to lag behind in price even as the fundamentals of gold—the supply and availability of gold versus that of dollar paper bills and checking account balances—becomes increasingly out of line (in favor of gold rising).

The Pretense of Risk

                The main problem with investing is that it is possible to lose, and not gain, money. This risk of losing some, all, or even a multiple (in the case of leveraging) of one’s money is a primary focus among individual investors and professional money managers alike. But just as changes in the quantity of money mask the real cause of the movements of financial markets, they also mask the real risk involved in investing in the assets.

                Asset price inflation actually changes the context of what risk is. For example one could argue that there were a multitude of risks to economic growth and the financial system in the late 1990s. While the Asian currency crisis, the Russian debt crisis and the implosion of Long-Term Capital Management, the near-collapse of the Brazilian economy, the Y2K scare, actual and threatening terrorist attacks in the Middle east and North Africa, a threatening economic crisis in Argentina, and rising oil prices made headlines weekly, the western stock markets, the NASDAQ in particular, continued their climb into nosebleed territory. They did the same in early 2010 while the markets were “threatened” daily with the fallout from the Greek debt crisis. But the market “ignored” those “risks. Why? Because even if they were risks to western equity markets, the brute force of newly-created money flowing into equity shares forced prices higher no matter what the risks. Besides, how significant are thereal risks when a force close to that of physics—newly printed money creating thrust and acceleration of asset prices and virtually preventing them from falling as long as it flows—is on ones side? In reality, the risks were not risks. A risk is something that could cause a market to fall; a market cannot fall if the force of money flooding into it is so great that it outweighs any selling pressure from scared investors wanting to exit.

                This explanation allows us to understand current accusations that during the recent financial crisis the stock market did not act rationally and efficiently, and most importantly, that it did not function smoothly and fluidly. One of the strongest advocates of this view, George Soros, states that “market moods have a way of affecting the fundamentals that markets are supposed to reflect[9]” In other words, Soros says that it is psychology and emotions which drive markets out of line with their fundamentals.

Yet, in support of this argument, he states “banks give you credit based on the value of the houses, but they don’t seem to somehow understand that the value of the houses can be affected by the amount of credit they are willing to give…and [being] willing to give more and more credit…has pushed up the value of the houses” In this last statement Soros reveals the real reason house prices rose and then fell, but he still states—as did John Maynard Keynes—that it was a detachment between the fundamentals and investor psychology that caused the crisis.

What Soros won’t admit, and what many don’t understand, is that the market did act rationally and it did adjust to the fundamentals—money and credit are fundamental! When money was flowing strongly, investors invested the money. When the flow of money was reduced, there was not enough of it to keep asset prices high and interest rates low (it is the sheer volume of money creation which forces interest rates below market prices). When interest rate rose, so did variable rate mortgages, which suddenly made home ownership more costly than people could afford. Because of this, mortgages were not paid off, which caused the value of asset-backed securities to fall, which caused losses in the financial system, which caused more losses. With the lack of credit due to the lack of creation of it, due to previous credit creation, and with mounting losses on bank balance sheets, more losses ensued and asset prices plummeted. Falling prices caused other investors to get scared and sell much of their holdings—that, is when the psychological effects come in and cause markets to overshoot, on the down side, their “fair value.” This psychological aspect what causes markets to be less than “efficient.”

Estimating Risk

                The disconnect between what the real fundamentals are and how people expect the market to act according to perceived fundamentals, is, in my opinion, the primary reason why those calculating risks cannot accurately anticipate events such as the 2008 crisis. Because risk analysts use the wrong assumptions—the wrong input variables in their models—their models do not predict accurately. Risk calculations are too often primarily based on means, deviances from means, and reversions to means. They do not anticipate complete “regime changes.” They focus on how often and how far and for how long assets might have a precipitous fall. These things are very important but are far from the whole picture. Or, models use faulty economic indicators and incorrect assumptions with respect to those indicators. The models don’t model the economy and the financials accurately, and they don’t focus on the things that will cause the entire trend, including its semi-periodic deviations and corrections, to experience a fall two or three times more dramatic (as in a large wave pushing the swimming fish up on the beach) and or longer-lasting than the typical, or even more extreme, traditional correction. In other words, they don’t incorporate the variables related to the true economic fundamentals which make prices go up and down—and up and down more or less “permanently.” Models should always incorporate things such as money supply growth and duration, total loans and leases of commercial banks, interest rate levels and duration, bank asset/capital ratios, the extent of leverage, and ratios for levels of debt burden, and the extent and duration (including the slope) of asset prices themselves. These are the kinds of factors which will reveal the amount of risk present in asset prices, not historical statistics focusing on mean deviations or on an earnings growth trend.

Michael Lewis’s recent Vanity Fair magazine article on the collapse of AIG tends to confirm this when discussing how professional forecasters didn’t expect a mortgage debt implosion. He states:

                Because there were many different sorts of loans, to different sorts of people, the logic applied to corporate credit seemed to apply to this new pile of debt: it was sufficiently diverse that it was unlikely to all go bad at once… for the bonds to default, U.S. house prices had to fall, and [AIG’s Joseph] Cassano didn’t believe house prices could ever fall everywhere in the country at once…Cassano set out on a series of meetings with Morgan Stanley, Goldman Sachs, and the rest—all of whom argued how unlikely it was for housing prices to fall all at once. “They all said the same thing,” says one of the traders present. “They’d go back to historical real-estate prices over 60 years and say they had never fallen all at once.”

The quote reveals that Morgan Stanley, Goldman Sachs and the rest relied on historical trends and deviations; they did not consider what was causing housing prices to rise now and why it might not last. (For proof that these assertions are not mere hindsight-is-20/20 analyses, reference this collection of research by those who understand this brand of economics far prior to the housing bust: http://mises.org/daily/3128.)

No matter what housing prices have historically done, it was clear at least by 2002 that something was different this time. For how could it be that from at least 2000, home prices in virtually all developed countries in the world, were moving higher, at faster than historical rates of growth, while recessions were taking place in these countries and after all of these countries’ stock markets had risen together and then fallen together? These facts and this overall profile should have caused any halfway knowledgeable trader or investor to know that things were a little strange. By 2004, it should have been clearly seen by almost anyone that housing prices were in a bubble—even if one does not really fully understand the parameters of a bubble.

For real estate prices to rise at double digit rates for seven-plus years around the world, for the “fundamentals” such as house price-to-income ratios, etc., to be so out of historical alignment (where the median income individual could not afford the median-priced home), for there to be such an excitement by everyone you know about their appreciating home price and their plans to buy a new house or investment house because of the money they could make (and ¼ of all sales were pure speculation—the highest level ever), little else should be needed to reveal the classic symptoms of a quintessential asset bubble.

Wall Street should have known that what goes up so quickly not only comes to an end, but falls quickly (in terms of securities prices; I fully admit that I had no idea that housing prices themselves would fall so fast, and that the financial collapse would be so sudden and widespread[10]). More importantly, the street should have understood that prices were not rising because of population growth or increased demand or because of a good economy. The reason was that a flood of money had been created and inserted into the market. The phenomenon occurred—and ended—in tens of countries simultaneously because the monetary system of all of these countries are linked and coordinated by via official government policies. Had Wall Street understood the economics behind the fundamentals, it would have been watching money supply and interest rate figures most of all, and would have anticipated prices to begin falling sometime within two yearslater than the Fed began raising interest rates in July 2004. In fact, prices peaked about two years later, depending on the city (though the real trouble didn’t come until another year after that in summer 2007.

Interest Rate Risk

                A different category of risk is the risk relayed by interest rate spreads in the financial markets. It is usually assumed that high rates or high rate spreads entail high built in risk premiums. But just as the basic Fed Funds rate is artificially low, so are longer term bond yields    .In fact, it is the fact that the Fed Funds rate is lowered that long-term bond yields are lowered as well. Short term rates are reduced by having the Fed buy bonds from banks or the customers of banks, and paying for them with newly-created money. With banks gaining new reserves—and excess reserves—from this process, the demand for Fed Funds is reduced, and the interest rate is lowered.

                But the new reserves constitute the basis of new credit and new loans in the real economy, including the source of new and additional funds for stock and bond purchases (and just the fact that there is a continual demand for bonds from the central bank creates a demand in the marketplace to hold bonds). As more new money is created and more bonds purchased, the more bond prices rise and bond rates fall.

                As more and more bonds are bought, the sheer flow of money into bonds keeps rates low. To add fuel to the fire, Fed officials all but actually promise that the money will keep flowing, and give far ahead notice to bond participants as to when they might be reducing the pace of money creation (i.e., when they might raise rates). Therefore, bond buyers face little risk of falling bond prices; this is even more of an incentive to keep buying bonds.

This constant demand driving bond prices higher reduces the risk of even riskier bonds, as long as the money is assured to flow. Therefore yield curve arbitrage takes place, leveling out rates across the curve. Not only are both the perception and reality of risk diminished, but the surge of money flowing into bond (and equity) markets keeps volatility low, reinforcing the illusion that there is little risk (and in fact there is, until the credit expansion slows). For these reasons, real risk is not reflected in bond yields.

Correlations and Diversification

                The primary way to reduce risk in a portfolio is to diversify an investment across uncorrelated assets. If one asset falls in price another will likely rise.  If an asset consisting of 10% of the portfolio falls, the other 90% will likely not, and most of one’s money will remain relatively safe. This is the traditional view—and rightly so.

But today, this logic is less realistic and the strategy is less effective. Why? Because more money is now chasing each asset class, causing the boom and bust of each asset class to be in synch with other asset classes. As world central banks have become more interconnected and as foreign central banks have been recycling increased amounts of newly created money in a piggy-back fashion based on dollars they receive from trade with the U.S., more money is invested at the same time in the same assets in every country. Also, as more institutional investors access and leverage more new money, they transmit the new money throughout the world in similar fashion. If one asset class is not performing well, investors, with their newly borrowed and levered money, “attack” the slumping asset class and pump it higher. The result is that money flows more and more into each asset class at the same time.       

                This is why, for example, both stocks and commodities moved together in the 2000s, instead of alternating cycles. Similarly, it’s why emerging markets equities are no longer inversely correlated with developed market equities. Even art and antique cars generally move up and down with stocks. Is real estate the new comer to this correlation effect? Perhaps.

One of the tools Keynesians are most proud of is their so-called “multiplier,” which they seem to think is equivalent to magic. The idea is that new additional spending of money creates new incomes. Keynesians believe that the formation of any additional spending in the economy, that is in turn spent by its receivers and re-spent in successive rounds, will create additional incomes at a multiple of the original amount of spending. They consequently propose that government should engage in deficit spending during recessionary periods when businesses will supposedly not spend, so as to pump up the economy. They are so convinced of this magic multiplier that they even claim that if government invests in building such things as Egyptian pyramids, the spending on the pyramids would create subsequent additional incomes and create prosperity. Paul Samuelson, a leading Keynesian theorist, wrote in his textbooks that if the government printed money to pay for a million dollars worth of goods to be thrown in the ocean, the spending and re-spending of the million dollars which created those goods would create additional employment and production. Under that logic, if we threw everynew thing, or merely many things, we created into the ocean we would somehow become really wealthy.

 
Indeed, the mathematics of the multiplier theory is sound, but the assumptions are not.  Since it is only productive expenditure, not consumption expenditure, which pays wages, the multiplier could only result in additional profit income, not wage income (the Keynesians specifically state that the multiplier works if incomes are spent, not saved and invested). To understand this concept better, suppose you spent $100 at the book store. Then the bookstore owner, instead of re-investing in his business, spent the money at the grocery store. The grocery store owner then takes the $100 out of the cash register and spends it on a new appliance. The appliance store owner spends it on movies, carnival rides, or whatever. The spending goes on and on in this fashion. In this case, the money was never not spent. If it were not spent, it would instead be saved.

 
If people spent all their incomes, there would be no funds available with which to invest and to pay wages. It is saving, i.e., not spending, that pays for additional capital goods and labor. Had any of the above businesses saved the $100 and invested it in their business, they could buy new machines or hire more workers. Had they saved the $100 in a bank, other businessmen, in borrowing these funds, could have expanded their operations or started new ones.

 
If all monies were spent and not saved, we would soon consume all existing goods. Since we would not have produced any new goods to replace those consumed, we would soon have literally no goods of any kind, including food or housing (after our food was eaten and our houses deteriorated).
In sum, the only effect from any additional spending is to raise the rate of profit: Business costs remain the same, but the additional spending increases sales revenues. But nothing new is created, no investments are made, and no wages are paid.

 
Keynes stated that if people were careful not to save too much, there could be full employment with interest rates of zero. But this is illogical thinking. For if people saved nothing, there would be no productive expenditure, thus there would be no employment (only self-producing for profit). In this scenario of not saving at all, profits would be equal to the entire amount of sales revenues, and the rate of profit would thus be infinite.

 
But the Keynesian multiplier has even deeper problems than assumed thus far. Any additional spending cannot create real additional wage income even if the spending was in fact saved. This is because increased real incomes can only come about from new and additional production; workers can’t consume more goods if there have not been any additional goods created for them to consume.

 
The multiplier’s math (Figure 9.1) shows us that a single $5 million of “investment” expenditures by the government can create $20 million of new national income, if people spent 75% of their incomes and saved 25%. With a portion saved each round, the amount of money being spent eventually completely diminishes to zero. But, according to the Keynesian’s own model, if people spent everything they earned, saving nothing, the amount spent each round would never diminish. In this case, each time the $5 million is spent it would create another $5 million in national income. This means that as long as the same money is spent and re-spent it will perpetually create an infinite amount of national income, forever. Obviously, this cannot, and does not, happen.

 
Now, a less important fact is that companies and businesses only receive so much income each year, and can only spend it once. And we know from studying how many times the same dollar is spent in the economy each year (velocity) that the same dollar is spent only several times in an economy on average —people don’t just take the same dollar and pass it around faster and faster.

 
The more important insight to consider is that it is not just passing around dollar bills that create new wealth. If it did, why would we need to pass around bills in order to encourage us to begin making things? It is not for lack of thought or incentive that we don’t make more things; it’s for lack of savings and real capital goods. If you think back to the desert island example in chapter 1 where a barter economy existed, you will recall that money is a “receipt” or “claim” that represents ownership of real goods already produced. It’s the real goods that are being exchanged, and once they are consumed they’re gone. Adding more paper bills to the economy for people to pass around simply changes the money price of the goods, but does not create new goods. Can we imagine five people on a desert island creating goods faster by passing around paper bills than they would by not doing so? With or without the bills they need to find resources, to build things, and to have real, unconsumed and stored previously-created food and materials (i.e., savings) to sustain themselves while they produce more wealth. If we look at the Keynesian multiplier in the context of a barter economy the assumptions behind its mathematics break down and its façade disappears.

 
Lastly, if new spending comes from newly printed money, it does in fact result in increased monetary incomes, but as incomes are spent, consumer prices rise in proportion (or even in disproportion, as consumer goods are used up), and no new wealth is created. Printing money is therefore not a realistic way to increase real incomes. Also, spending taken on by government necessarily reduces the ability to spend by others, because it either depletes savings via taxes or reduces purchasing power via inflation.

 
Still, since most of the government’s economic advisors believe in the multiplier effect, the government continues to spend and spend, on any and everything, believing it will somehow bring prosperity. This is the basis behind our “stimulus” programs. Japan too has tried unsuccessfully to spend its way out of economic recession for the last 19 years; the Keynesian economist’s only explanation is that Japan did not spend enough. The only thing the spending in Japan has created is the greatest amount of debt a country has ever had in history. But politicians don’t have to worry about profits and losses, as it’s not their money.

So much for freedom. So much for stating opinions. It is now illegal in South Korea to forecast the negative results of the government’s policies. Korean officials could have at least blamed the free market and a lack of regulation as other countries have—blaming a single blogger for disrupting the economy will not as easily fool even the ignorant public. Still, people are convinced that we need more of this regulation and government control.

 
GDP is held to reflect the value of national income and output simultaneously, or, more generally, the value of what a country produces. My intention is to show, in contrast, that it reflects primarily the amount of money, and therefore the amount of inflation, in the economy. As more money is created by the central bank and inserted into the economy, prices rise. Higher prices necessarily mean that the value of goods and services, corporate revenues, profits, wages, investments, and expenditures included in the calculation of GDP rise as well (as demonstrated in chapter 2). Thus, GDP largely reflects inflation.

 
By way of illustration, if the quantity of money in the economy did not increase, neither could nominal nor real GDP. We have seen that there are only two ways that prices can rise: the supply of goods and services must fall or the supply of money must increase. Clearly, our volume of goods is not declining—at least not rapidly enough to cause price increases of 3%-6% per year—but the quantity of money is increasing.
Prices in the GDP calculation are “deflated” with a price index in order to adjust for inflation, but they are only partially deflated because price indices, as we have learned, significantly understate the actual inflation rate.

 
As evidence that creating money lifts GDP, consider the following scenario. If the money supply of the economy were static, i.e., if the central bank neither added to nor subtracted from the amount of paper bills and bank credit in the economy, GDP would be the same each and every year, because the fixed quantity of money would have to be distributed across an increasing amount of goods (and velocity, or the number of times we spent those same dollars, would also necessarily remain essentially unchanged each year ). In other words, no matter how many goods exist in the economy, the value of the amount of total spending and incomes in the economy would be the same every year because the quantity of money would be the same—an increased number of goods each selling at lower prices would leave the total sales value (price x quantity) constant.With a fixed money supply, our real economic prosperity would be measured by the extent to which prices of goods and services fell relative to our static incomes, since with the same amount of dollars chasing more goods, the price of each good would necessarily fall. This analysis demonstrates that prices and wages cannot rise without an increasing supply of money, and that an increased production of goods would actually reduce prices. Thus, GDP measures inflation, not production.

 
What GDP is ideally trying to measure is the physical volume of goods and services at our disposal. But, as Keynes himself signified, since we can’t add up oranges, trucks, movies and airplane tickets, and since there is not a stable and reliable monetary benchmark with which to measure all such items, we must accept that we can’t fully count our domestic product in monetary terms (but we can calculate the rate of increase of units produced of individual products and services).

 
The second major problem with using GDP as an economic indicator is that it counts mostly consumer spending and consumption, not the production of goods and services. Indeed, consumer spending is generally held to account for approximately 70% of GDP. However, since the production of goods, and not the consumption of goods, is what constitutes real wealth, an increase in GDP signifies mostly an increase in spending and consumption, not an increase in real economic prosperity.

 
As economist George Reisman has shown, an increase in GDP in fact correlates with a decrease in economic progress because most business spending—productive spending—is subtracted from the calculation of GDP in order to avoid so-called double-counting (which will be explained below). The greater the amount of productive spending in the economy, the greater is the corresponding number that is subtracted from the GDP calculation.

 
To understand this more clearly, consider the following:

1. GDP ≈ National Income
2. National Income ≈ profits + wages + interest
3. Profits + wages + interest ≈ total business sales revenues-(total business costs-wages)
4. GDP ≈ Sales revenues minus all costs except (most) capital goods expenditures

 
Total business sales revenues minus only capital goods costs leaves profits, wages, and interest. Thus, GDP approximately equals total sales revenues minus only capital goods costs. This means GDP has capital goods costs subtracted out, leaving only (mostly) expenditures for consumer goods (derived largely from wages). Therefore, the greater the amount of capital goods expenditures, the more that is subtracted from GDP and the lower is GDP. As a result, the stated GDP is lower than would otherwise be the case. This is significant because productive spending, as I have shown, is virtually the sole means of wealth production. Saving, not consumption, is the primary source of spending.

 
Most business costs are subtracted from GDP in order to prevent “double counting,” because it is thought that the value of most goods associated with business spending is reflected in the value of the final product, and should be counted as such. Therefore, GDP counts the final product as representing both the final product and all the products that went into it. It says that if we produced bolts, screws, and automobiles, in sum, we produced only automobiles. This is wrong because the screws and bolts were in fact produced, in addition to automobiles, and they have their own separate values, even if they are eventually used to create the composite automobile.

 
Since, then, most business spending is excluded from GDP, the resulting calculation over-represents the contribution of consumer spending to total expenditures, and under represents total productive spending, which far exceeds consumer spending and pays most wages—business spending is what is likely 70% of the economy. GDP, therefore, leads people to believe that prosperity comes about by means of spending and consuming our wealth. Government officials and pundits, in turn, tell us to go and spend in order to “help” the economy. But it is savings, i.e., abstaining from consumption, which pays for the production of goods—real wealth—and increases our ultimate amount of consumption. Contrary to popular belief, savings do not usually sit under a mattress being hoarded, but are actively invested and financing production. All the assets companies possess are owned by capitalists (individuals), via their invested savings.

 
After all, if we spent all our savings on consumer goods, what money would finance factories, tools, and machines (and home mortgages and credit cards)? What money would pay the wages of workers producing products that have yet to be sold? As a reminder, machines and workers are paid for the products they make before consumers buy them. When we purchase a house, the hammer and the construction worker have already been paid and have moved on to building the next house. Food, groceries, and CDs, as well as the tools and people that make them, have all been paid for before the consumer compensates (by purchasing these goods) the companies/employers who have paid to have the products created. Similarly, an automobile factory is paid for many decades prior to the complete reimbursement of the investors (when the last cars are produced). Almost all workers and machines are paid in advance with savings, not with sales revenues from consumers.

 
In sum, economic progress consists of increased productive capabilities, not production-sacrificing consumption. Therefore, GDP does not measure our wealth-producing capabilities. It can give us an idea of the relative wealth between countries (assuming exchange rates can freely adjust to the relative quantity of money, production, and capital flows across countries). And it shows us an approximate rate of inflation and how much we are consuming. But it should not be understood as an indicator of economic progress or standards of living.
 

Additionally, GDP merely counts the monetary value of things produced; but what’s produced may not be what really adds value to a society. For example, leftwing government economists such as John Kenneth Galbraith used to cite the Soviet Union’s strong GDP growth as an example of successful socialist policies (Similarly, Latin America had GDP growth rates as high as developed countries for many decades in the 20th century, but it’s real standard of living did not grow comparably). The truth is that the Soviets created little of value. They had tons of screws, but not enough screwdrivers; they had scores of bricks, but not enough mortar with which to assemble the bricks into a building. According to the mathematics of calculating GDP, the Soviets could have produced nothing but screws, and seen their GDP rise. If they produced more screws each year, or even the same amount of screws while the quantity of money increased, they could have shown a rising GDP. To Galbraith this would represent wealth; but to the soviet citizens, having tons of screws, but no new clothes, food, or houses, would mean death and poverty. Given the assumptions and methodology of GDP calculations, a nation could really increase its GDP by having each citizen simply pay their friends and neighbors to scratch their backs while the government simultaneously printed a lot of money. The more backs that were scratched, and the faster the government printed money, the faster GDP would rise. It should be clear from this that simply having an increase (or decrease) in GDP, like simply having jobs, does not necessarily mean anything. For real wealth to be created, both jobs and GDP must entail the creation of goods and services society needs.

 
Broken economies suffer from a misallocation of resources consequent upon prior government interventions and can be healed only by allowing the economy’s natural balance to be restored. Falling prices and lack of government and consumer spending are part of this process. What is spent or printed is consumed; what is not spent or printed is saved and invested in new machines and labor.

What Created the Onset of the Depression?

As is the case today, it was in fact the government’s central bank that started the economic problems of the 1930s. As we shall see in more detail later, when the central bank expands the money supply, not only does it cause inflation, but it distorts the nation’s production structure in a way that causes a large-scale misallocation of capital. The result of this misallocation is financial losses among companies in the capital goods and construction industries, which in turn results in bank losses and a contraction of the money supply. The central bank lowers interest rates by pumping money into the economy which did not previously exist. This money serves not only as new demand for products, but as funding for business projects which would otherwise not receive funding. When the central bank, for fear that the new money it is printing will cause prices to rise, raises interest rates near the end of the business cycle, the flow of new money is reduced, economy-wide demand falls off, and the availability of credit to businesses - credit which keeps unprofitable projects afloat - is no longer available. Reduced production, bankruptcies, layoffs, and increased unemployment ensue.

It is precisely this turn of events that caused not the depression itself, but only the initial economic downturn. The U. S. central bank, the Federal Reserve, expanded the money supply by about 60% between 1921 and 1929.[2] Official inflation rates were low, primarily due to extraordinary technology-based productivity increases. But the fact that price increases rose at all, instead of falling, during this time of high productivity, reveals that real inflation (i.e., increases in the money supply) was high. The large amounts of money being poured into the economy, along with, to a lesser degree, gold (real money at the time) flowing in from WWI debtor countries, caused a large economic boom that caused this period to be called the “roaring 20s.” But when the money valve was shut off (interest rates rose from 3.5% to 6% between 1938 and 1939), the boom came to a crashing halt.

The reduction in money supply, which fell by 30% over the next three years, and which was exacerbated by the Federal Reserve’s selling of government bonds, caused the economy to collapse and the stock market to fall. Up until that point in our nation’s history, recessions were largely left alone (some more than others) by government, and most lasted less than two years and never more than four. This too would have been an ordinary recession had it been left alone by government. The natural market forces would have corrected the economic imbalances: the price system would have moved labor and capital back to where they were most effective. But the market was not allowed to “clear” - as they are doing today, our politicians prevented the free market from working.

The Economy Under Hoover

Hoover engaged in unprecedented interference in the economy in order to try and help it. He was rightly accused by his 1932 presidential opponent Franklin Roosevelt of taxing and spending too much, boosting the national debt, choking off trade, putting millions on the dole, and for trying to centralize economic turmoil in Washington. John Nance Garner, Roosevelt’s running mate, stated that Hoover was “leading the country down the path of socialism.[3]” Hoover’s administration created 30 new government departments and hired 3,000 new bureaucrats.[4]

In 1930, Hoover, ignoring the pleas of many economists, signed the Smoot-Hawley Tariff, virtually preventing foreign goods from entering the country. The act increased rates on various goods of between 20% and 60%, on average. Production processes that used inputs imported from abroad were hit with higher costs, resulting in unemployment. For example, Most of the 60,000 employees of plants making cheap clothing from imported wool rags were unemployed after the tariff on wool rags rose by 14%.[5] Hoover and Congress thought that by raising trade barriers they would cause more citizens to buy American goods, thereby reducing unemployment. But they didn’t consider that besides raising costs to consumers, tariffs would cause unemployment in those sectors making goods to be exported to other countries.

With the ability of foreigners to sell in the American market drastically reduced, they could not afford to buy as many U.S. products. American agriculture was hit the hardest. Thanks to their politicians, farmers immediately lost a third of their market, causing (along with a declining money supply) agricultural prices to plummet, and tens of thousands of farmers went bankrupt (keep in mind that during this time, almost 30% of the population was involved in farming).

Losses from farming and other industries caused losses for banks, since they were not repaid loans. Over 9,000 banks went out of business between 1930 and 1933. The stock market, as measured by the Dow Jones, fell by almost 90% by summer 1932. It would take 25 years for the market to once again reach its 1929 peak (and 35-40 years when adjusting for inflation).

Since falling prices were hurting farmers the government attempted to raise farm prices by reducing agricultural production. Thus, the government, with public tax money, paid farmers not to work, not to grow food, and not to grow livestock, which also implicitly means it paid them not to hire farm workers. Not only were they directed not to produce, they were directed to destroy crops and animals. Federal agents sanctioned the plowing under of fields of cotton, wheat and corn (mules had to be retrained to walk on the crops, since they had previously been trained not to). Healthy sheep, pigs (including six million baby pigs), and cattle were slaughtered and buried in mass graves. While much of the rest of the country was desperate for food, the government was destroying it in order to attempt to benefit a single political group. Roosevelt, in his administration, not only continued these policies, but accelerated them.

The farmers also took matters into their own hand. One farm union, led by a preacher, tried to force all farmers, against their will, not to produce food. To ensure that independent farmers did not increase supply, the farm unions in multiple mid-west states created an embargo that prevented food from being exported from the states. The farm union threatened fellow farmers and the public with guns in order to enforce their blockade. The governor of Minnesota went so far as to assist the union by offering to use the state militia to prevent innocent citizens from engaging in trade of agriculture.

Farmers were also aided by the senate, which directed the FTC to investigate the too-low export prices being paid to grain farmers.[6] Congress, doing its part, helped farmers to threaten the meatpacking industry. Farmers had always complained that the meatpackers paid them too little for livestock (while consumers complained that the meatpackers charged too much at retail. Since meatpackers were not a big voting block, under the guise of a war emergency, congress threatened to authorize the president to take over and manage their operations. The meatpackers were eventually forced to curtail much of their harmless operations, and to be regulated by the Secretary of Agriculture. This allowed farmers to benefit at the expense of the meatpackers and the public.

With economy-wide consumer prices falling, wages rates needed to fall as well. But Hoover single-handedly came up with the idea to keep wages high. His notion was that high prices bring wealth, when in fact it’s the other way around. He though that by restoring wages to what they were, wealth would be restored (in reality low prices were brought about by previous government policies of inflation). He thus “encouraged” (government encouragement means that if you don’t do if voluntarily, you will eventually be forced to) to keep wages high. Shockingly, many business leaders were at first on board with this idea, because they too thought it would help the economy. Eventually, the plan became broader and mandatory. But as company revenues were falling, in order for businesses to be profitable, costs, including wages, needed to fall as well. During the period in which consumer prices (business selling prices) fell by 25% from 1929 through 1933, wages decreased by only 15%. This represented a relative increase in wage rates and thus business costs. The result was widespread unemployment. (Had wage rates been allowed to fall to the market price, production would have still been profitable for businesses, and they would have still needed the workers. There would still have been a demand for business products by either other businesses or by consumers (who would still have had jobs, and would have kept spending). The only difference in terms of business production, employment, and wages, would have been the change in prices of goods and labor (except that many people would have needed to switch jobs, since the change in the flow of money from the central bank had caused a change in the demand for consumer goods relative to capital goods industries)).

As often is the case, businesses were all too happy to cozy up to government in cases where they could benefit. Gerard Swope, the head of General Electric, called for the cartelization of American business. This regulation, where the Federal Government would “coordinate production and consumption” was welcomed by much of the business world, including the U.S. Chamber of Commerce.[7] Why? Because such socialist planning would result in restricting production in order to increase selling prices. Such a feat could not be accomplished without government regulation because, in free markets, companies that attempt to maintain a cartel inevitably cheat by not limiting production to the cartel-mandated levels. Thus, supply is not artificially restricted.

Because of widespread unemployment, Hoover dramatically increased government spending on subsidies and relief schemes. The government’s share of GNP increased from 16.4% to 21.5% over a single one-year period between 1930 and 1931. Since farmers were hurt by Hoover’s previous policies, he handed out to them hundreds of millions of dollars. Billions more were given out to other businesses and individuals suffering from prior government actions.

Similar to the politicians of our crisis today, Hoover blamed the crisis on a lack of credit, without identifying what caused that lack of credit.[8] Also, Hoover wanted to loosen bankruptcy laws so as to make lender’s, instead of consumers, suffer from the lack of being able to pay debts (just as our politicians today want the same with consumer mortgages).

As though the previous policies of high tariffs, large subsidies, and a deflationary monetary policy were not enough, congress then passed and Hoover signed the Revenue Act of 1932, which resulted in the largest tax increase in peacetime history. This act doubled the income tax, raising the normal rate from a range of 1.5%-5%, to a range of 4%-8%. The top tax bracket increased to a marginal rate of 63%! Additionally, exemptions were lowered, corporate and estate taxes were raised, new gift, gasoline, and automobile taxes were imposed, and even the writing of checks became taxed (just as some in congress today want to tax each and every stock trade). Not only were people made poorer by these tax increases, but their savings, particularly those of the rich, were desperately needed in the private sector in order to produce goods and to pay wages. By 1933, the results of these policies resulted in one quarter of the population being unemployed. Some states saw as much as 40% unemployment and some cities reached 80%.

The Economy Under Roosevelt

Contrary to Hoover’s view, Roosevelt blamed the depression on “unscrupulous money changers” (just as our politicians today blame shifty lenders for the housing bust and speculators for high oil prices). And like Hoover, he placed no blame on the central bank or the previous government policies which brought about the problems at hand.

FDR won the 1932 election on the promise of a 25% reduction in federal spending, a balanced budget, a sound currency based on gold, to end the “extravagance” of Hoover’s farm programs, and to remove government from areas that “belonged more appropriately to private enterprise.”

But Roosevelt delivered on none of these promises. He used the very same economic manipulation tactics as Hoover, and magnified the intensity. As Murray Rothbard stated, Hoover and Roosevelt were ideological twins. Rexford Guy Tugwell, a great admirer of Stalin and socialist central planning, stated that “We didn’t admit it at the time, but practically the whole New Deal was extrapolated from programs Hoover started”[9]

During the first year of the New Deal, Roosevelt proposed spending $10 billion, though government revenues were only $3 billion. Federal expenditures would rise 83% in the three years between 1933 and 1936.

As is usually the case with government spending and government “help,” the actions taken were based more on politics than on truly helping those in need. Economists Couch and Shughart, upon statistically analyzing New Deal government spending, concluded that: “The Weight of this evidence thus points to a political explanation for New Deal spending patterns: other things being the same, more federal aid was allocated to states which had supported FDR most solidly in 1932 and which were crucial to the president’s 1936 Electoral College strategy”[10] They also assert that the more economically devastated south, which was already mostly democratic, received disproportionately little new deal spending since it did not need to be encouraged to vote for Roosevelt.

New Deal money intended for economic aid was misused in many areas in order to win votes. Republican government workers in Kentucky were told that they would have to change their party affiliation if they wanted to keep their jobs. Pennsylvania WPA workers were told the same, and many that refused were fired. Tennessee WPA workers were instructed to contribute 2% of their salaries to the Democratic Party as a condition of receiving their wages. In Cook county Illinois, 450 men were directed by the WPA to canvass for democratic votes in 1938. The men were all laid off the day after the election.[11]

As is the case with our crisis today, banking regulation in the 1920s not only caused the great depression, but made it worse. Almost all of the banks that went under during the great depression were those in states with unit banking laws - laws prohibiting branch banking that allows banks to diversify their assets and reduce their risks.[12] Canada, which allowed unit banking, had not one bank failure, while 9,000 banks failed in the U.S.[13] Further, Canada did not have a central bank “saving the economy” during the worst part of the great depression.[14]

Roosevelt, who promised during his elections to take care of the nation’s money, instead, stole it. Upon being given the power by congress, he seized citizen’s private gold holdings. Government took away the only REAL money citizens had, and instead forced them to hold only paper bills. After doing this, the government devalued the dollar by 40%, simultaneously causing the citizens to lose 40% of their wealth while allowing the government to gain by the same degree; it might as well have just gone door to door with a gun to take 40% of their property. It was one morning over breakfast that Roosevelt decided to change the ratio between gold and paper bills, arbitrarily settling on a 21-cent price hike, because it was a lucky number.

The largest of the many New Deal government agencies was the Works Progress Administration (WPA), which employed millions of Americans to build highways, bridges, public buildings, canals, dams, and sidewalks, as well as to engage in artistic projects such as the production of paintings, theatre performances, and musical performances (about 4,000 a month). It could be argued that the infrastructure projects that truly contributed to economic growth do have economic value. But most of the construction did not consist of work that directly benefitted the production of goods and services. The myriad projects such as bridges, canals, and roads that were seldom or never used were a complete waste not only of funds that paid worker’s wages, but also of physical resources that could have been used elsewhere to produce goods consumers needed more urgently.

Similarly, even those projects that were condusive to economic growth still mostly resulted in a decreased standard of living. This is because the labor, materials, and machines employed to, for example, pave a road, could have instead been used to produce, household goods or other capital goods which would have produced more household goods. The importance and the need of one type of investment (such as highways) relative to another type (such as bread and sugar) can only be determined by consumers and businesses through the price system. It is highly likely that had government allowed a free market, suffering consumers would have first chosen to have more food and clothing during the decade of the 1930s, and settled for having new sidewalks and public buildings long after more immediate needs were satisfied.

Perhaps the most dramatic regulation enacted under Roosevelt was the totalitarian-style National Industrial Recovery Act (NRA). Passed in 1933, the NRA suddenly forced most manufacturing industries into government-mandated cartels - and forced businesses to finance it with newly assessed taxes (throwing yet more workers on the street). The mammoth bureaucracy created under the act was given unprecedented powers that would have made Italian dictator Benito Mussolini proud. In fact, it was run by General Hugh “Iron Pants” Johnson, an admirer of Mussolini. Johnson proclaimed: “May Almighty God have mercy on anyone who attempts to interfere” with his agency. He personally threatened to publicly boycott or “punch in the nose” those who refused to comply with the NRA.

The NRA developed more than 500 codes that regulated prices and terms of sale of individual products, which transformed American industry into a fascist operation. The codes, which spanned a slew of manufacturing goods categories, covered more than 2 million employers and 22 million workers. As Lawrence W. Reed States:

“there were codes for the production of hair tonic, dog leashes, and even musical comedies. A New Jersey tailor named Jack Magid was arrested and sent to jail for the “crime of pressing a suit of clothes for 35 cents rather than the NRA-inspired “Tailor’s Code” of 40 cents.”

The NRA had its own enforcement police who would enter factories, send out the owner, line up the employees to interrogate them, and confiscate the owner’s books. These enforcers would storm through the clothing district at night knocking down doors with axes to look for those who were committing the terrible crime of sewing clothes. For NRA accomplishments such as these, Time Magazine named Hugh Johnson the New Dealer Man of the Year in 1933.[15]

In the five months prior to the act’s passage, the economy was showing some signs of recovery, with factory payrolls having increased by 35% and employment by 23%. But six months after the implementation of NRA rules that raised business costs, taxed production, limited the hours worked, and raised wage rates, industrial production fell by 25%. The Supreme Court outlawed the NRA in 1935.

Not only did Roosevelt raise minimum wage laws that threw an estimated 500,000 blacks out of work, but he further increased taxes, insuring that fewer jobs would be created, and likely more destroyed. Naturally, like today, he increased taxes on the evil rich, and introduced a five-percent withholding tax on corporate dividends. After several rounds o f tax hikes, he eventually achieved a top marginal tax rate of 90%. He was accused by Senator Arthur Vandenberg of Michigan of doing what virtually every politician does today, namely following the socialist notion that America could “lift the lower one-third up” by pulling “the upper two-thirds down.”[16] (today, however, we try to lift the bottom nine-tenths up by pulling the top one-tenth down). In 1941, he even attempted to have a 99.5% marginal tax rate imposed on incomes over $100,000. When an advisor asked why, Roosevelt replied “Why Not?” He also issued an executive order to tax all income over $25,000 at 100% - to take every bit of income anyone earned that was in excess of $25,000! Soon after, congress rescinded the order.

Dramatic legislation supposedly intended to directly aid workers was also initiated during the depths of the depression. With the passing of the Wagner Act in 1935, not only were labor disputes taken out of courts and placed under the National Labor Relations Board, which was full of union sympathizers who distorted the law and shunned equality under the law, but most employer resistance to labor unions were crushed. Anything business did to defend themselves against unions that were destroying them were deemed to be an “unfair labor practice” punishable by the board. Board decisions ultimately made it illegal to resist the demands of labor union leaders, instead of “negotiating” with them. Naturally, with these kinds of laws, union membership more than doubled, and boycotts, strikes, seizures of plants, and violence increased strongly, causing sharp reductions in productivity and sharp increases in unemployment. Due to union coercion, wages increased by 14% in 1937 alone, meaning that fewer people could be employed.

Roosevelt was anti-business, which means he was anti economy, and therefore anti-prosperity. He claimed that it was businesses that were blocking the recovery. He blamed them for not hiring and not producing, even though it was he and congress that were preventing it. Instead of freeing the economy and allowing business to be more profitable, Roosevelt punished businesses further, therefore also punishing workers and consumers. He imposed new restrictions on the stock market and by assessed a new tax on corporate retained earnings (profits not paid out as dividends). He increased the capital gains tax from 12.5% in 1933 to 39% in 1937[17]. He tried is best to extract all possible wealth from investors responsible for providing capital for companies to operate with. The result was a depletion of capital, and investors who were too scared, for fear of confiscation, to fund business operations.

While very modest economic improvement had been occurring in the mid 1930s, these additional anti-business policies caused a second round of economic suffering. From spring 1937 to spring 1938, the stock market fell by almost 50%. Unemployment, at 17% in 1936, rose to almost 20% in 1938. Bad economic policies generated a recession within a recession.

Overall, the economy did not improve until World War II came along. For on the eve of the war in 1939, GNP per capita was lower than in 1929. Similarly, unemployment, which was 3.2% in 1929, was still over 17% in 1939.

But contrary to popular opinion, it was not the economic stimulus of the war which improved it, as production of bombs and tanks - instead of bread and houses - make an economy weaker, not stronger. As Figure 1 reveals, unemployment declined because the value of what workers could produce was no longer below the cost of employing those workers (there was increasingly less payment of wage rates above and beyond the value of what businesses were getting in return for those wage rates). This was primarily because of the wage and price controls government instituted at the start of the war. The wage controls prevented wage rates from increasing, while high inflation rates raised business selling prices (the value of what workers produced). This, however, is not a productive way to have full employment, as citizens were still relatively impoverished during WWII. They earned wages, but had few goods available to purchase. The unemployment rate received help from the fact that we sent 16 million of our youngest and least skilled workers off to war, thus reducing the number out of work.

Figure 1:

Just as the Hoover and F.D.R. caused the nation to suffer a great depression, so will Obama cause us to suffer tomorrow if he tries to replicate the types of “policies” that “saved” us in the 1930s. What America, and the world, needs are free markets, not government help. It is government help (government intervention in the markets) that caused the very problems we currently face. The markets will right themselves if we let them, and it would not take very long.

.

[2] Murray Rothbard, America’s Great Depression

[3] “FDR’s Disputed Legacy,” Time, February 1,1982, p. 23.

[4] Thomas J. DiLorenzo: http://mises.org/media.aspx?action=search&q=great%20depression

[5] Reed

[6] Murray Rothbard, America’s Great Depression

[7] Murray Rothbard, America’s Great Depression

[8] Today, our politicians blame the lack of credit on the housing market bust, without identifying what caused the housing bust (the central bank’s printing of money)

[9] Paul Johnson, A History of the American People (New York: HarperCollins Publishers, 1997), p.740.

[10] The Political Economy of the New Deal, Jim F. Couch and William F. Shughart II, Cheltenham, Eng., and Northampton, Mass.: Edward Elgar for the Locke Institute, 1998, (p. 190).

[11] These examples are based on a lecture given by Thomas J. DiLorenzo: http://mises.org/media.aspx?action=search&q=great%20depression

[12] Jim Powell, FDR’s Folly: How Roosevelt and His New Deal Prolonged the Great Depression (New York: Crown Forum, 2003), p. 32.

[13] Jim Powell, FDR’s Folly: How Roosevelt and His New Deal Prolonged the Great Depression (New York: Crown Forum, 2003), p. 32.

[14]http://macromarketmusings.blogspot.com/2008/03/what-many-of-great-depression.html

[15] http://en.wikipedia.org/wiki/Hugh_S._Johnson

[16] C. David Tompkins, Senator Arthur H.Vandenberg: The Evolution of a Modern Republican, 1884-1945 (East Lansing, MI: Michigan State University Press, 1970), p. 157.

[17] http://www.huppi.com/kangaroo/TaxTimeline.htm

Imagine that I start a business, and it fails. I lose $50,000 that I risked in the venture. But then imagine that I don’t have to worry, because you and each of our other three million citizens will be forced to chip in less than a penny to compensate me. That’s no skin off of your back, you might think.

But then suppose that I’m not the only one to be compensated. What if each person who lost various amounts of money from failed businesses each year were compensated for their losses?  According to the Small Business Administration (SBA), a record 672,000 businesses were started in 2005.  Also according to the SBA, 50% of these will fail within five years. The dollars start adding up.

This week, our government told us that we will all be forced to pay $700 billion to compensate various investment banks for their business losses. This is in addition to the $29 billion Bear Sterns Rescue, $300 billion for the Fannie Mae and Freddie Mac nationalization, and $85 billion for the AIG nationalization. All of these total over $1.1 trillion we each have to pay. That averages out to $3,666 per person, or almost $15,000 for a family of four.

Additionally, a good rule of thumb is to multiply by 5 or 7 times any dollar value estimate the government gives us for its spending. The per person expenditure then comes to over $18,000. This number is in addition to the $9.6 trillion of current government debt. And don’t forget the more than $10 trillion in “off-balance sheet” debt which is not counted in the official government debt number. Adding these together reveals that each citizen owes approximately $2 million.

The problem is that most of us citizens don’t think this affects our own lives very much. But it does! We just can’t see the harm because it’s hidden.

How Socializing Losses Harms You

By having to compensate financial institutions every decade for their losses, we lose our ability to produce wealth. When government, through taxes, forcibly takes part of our incomes in order to compensate those who carelessly made bad investments, or to pay interest on the debt (previous bailouts), we have less money. Thus, in addition to spending less, we save less than we would otherwise be able to.

But here’s the kicker: most of the total taxes paid are not paid by each of us citizens, most are paid by a minority of citizens – the “evil” rich. To quote Bruce Bartlett of Creators.com:

“in 2006, 53.7 percent of all federal income taxes were paid by those with incomes over $200,000. Those with incomes between $100,000 and $200,000 paid 28.3 percent of all individual income taxes. Thus those with incomes over $100,000 paid 82 percent of the total….Those with incomes below $40,000 paid no federal income taxes at all in the aggregate. The positive liability for those who paid anything was more than offset by tax rebates [paid for by the rich] from the Earned Income Tax Credit for many more who paid nothing”

The rich pay the most because they have the most. They save an overwhelming majority of their income. That which they save, is invested – it’s made available as capital to businesses. These businesses, with this capital, purchase factories, machinery, tools, technology, trucks and other capital goods. These capital goods make other capital goods, and they make all of our consumer goods. They also pay our salaries. Since these capital goods are used by workers to make things, the more capital each worker has, the more each worker can produce. Because of economic competition, workers are paid according to the amount they are capable of producing. It should be clear that the more wealth that is left with the rich, the more goods we can have in our lives at lower prices (the more goods produced, the less each one costs), and the more we will be paid for producing them.

But by having the rich’s wealth confiscated by taxes in order to pay for other capital destroyed by banks and investment banks, the fewer business the smaller amount of savings/capital can support. Alternatively, the bailouts might be financed by having the government print more money, or by going into more debt, as mentioned above. The outcome is the same regardless of the means of payment – our capital is being destroyed.

The result is fewer goods and services, fewer jobs, and lower salaries. But this happens slowly through time. Had we not already spent millions on bailing out financial institutions, you would instead see that you had a larger home, a higher salary, more luxury goods, more vacations, lower prices for everything you buy, or some combination of these. You don’t notice what you’re missing if you never had it. By accepting to bail out companies, we reduce our own standard of living. It is possible that our standard of living as a nation is already in decline, or might soon start to decline. We are well on the road to full socialism, and to economic retrogression.

Why Financial Bailouts Are “Needed”

Our government officials – the very same people who got us into this mess – tell us that the bailout is needed for the sake of saving the entire financial system. It is true that the system could collapse, but it’s only true because of the fact that these same “leaders” engage in creating money from thin air. They literally bring into existence money which did not previously exist.

Were it not for the fact that new credit is extended, and were all of our money actually backed by something of value, such as gold, all of our bank accounts would actually consist of real money instead of an IOU. Since the banking system takes money we deposit, adds to it almost 10 times that amount of fake money and lends it out to others, our bank could collapse if the loaned money is invested for a loss, because the bank does not have the money with which to repay us. It is because of the fractional reserve system – keeping only a portion of deposits in the bank and loaning the rest out – which creates the possibility that our bank could go bankrupt, and that it could also cause many others to go bankrupt as well.

Otherwise, if one group of people or businesses lost money, they would suffer losses and it would not affect the rest of us. Only a financial system based on debt is one that can cause a chain reaction of bank implosions. Not only is our debt-based financial system supported and encouraged by our government, it exists primarily so that government can take our money through inflation.

There is no economic benefit whatever to adding additional money to the economy. It’s not needed. Instead of being beneficial, credit creation is the sole cause of asset bubbles, financial crises, recessions, and widespread destruction of capital. Our current crisis has been building for many years, under both Republican and Democratic leadership. Virtually every single member of congress supports our current system. All of our politicians, regardless of party, are destroying our country and our lives. We MUST demand change. We must NOT vote for them if they do not support destroying our central bank. If you do not act now to demand change, they will destroy our country.

]]> http://www.theproletariatsnews.com/2008/09/socializing-financial-losses-what-does-it-mean-for-you/feed/ http://www.theproletariatsnews.com/2008/09/how-holding-the-olympics-harms-countries/ http://www.theproletariatsnews.com/2008/09/how-holding-the-olympics-harms-countries/#comments Wed, 24 Sep 2008 22:38:13 +0000 Kel Kelly http://www.theproletariatsnews.com/?p=54 We all marveled at the glamour and prestige of the Chinese Olympics. It was the most impressive, grandiose Olympics yet. That’s exactly the impression the Chinese government wanted us to have. The Chinese people themselves were proud to show the world what their nation could fund, assemble, and display.

But besides national pride, what did those citizens get out of it? What was the true benefit to them? Nothing. The Olympic Games, for any country which holds it, is a losing proposition economically.

Even if governments don’t expect to have their Olympic expenditures recouped in additional taxes, they expect that economic spending will stimulate the economy. The popular notions regarding how Olympic spending will bring economic growth is three-fold. First, foreign visitors who come to see the Chinese games will spend money in hotels, restaurants, historical sites, shops, etc. It is expected that this will be additional income to Chinese citizens, and improve their economic state. This is not true.

This notion is similar to the old Mercantilist fallacy that if a country exports more than it imports it will be better off. This incorrect belief is based on the idea that money per-se is wealth. In reality, goods and services are wealth. If a country exports all of its goods, and obtains cash or gold in return, what is there left to buy? There are no goods remaining in the country because they’ve all been exported. What we need money for is to buy goods.

The same case applies to the Olympics: the goods and services that Chinese consumers sell to foreign Olympic visitors means a net reduction in the amount of these goods and services available in the country. The foreigners did not trade goods in return, they traded cash. One could argue that Chinese vendors will take their new cash and purchase new foreign goods. But the cost of obtaining the cash they collect from Olympic tourists consists of the expenditures made by their government to get the foreigners to come over. Without those expenditures, the additional tourist spending would not exist. The nation as whole spent money so that it could obtain foreign cash. The amount of government spending needed to generate those additional receipts from tourists was greater than the value of the receipts! It was a losing proposition.

This brings us to the second popular notion regarding the notion that Olympic spending will bring economic growth. It is the idea that spending on the infrastructure for the Olympic venue sites will constitute income to local providers of materials, construction, and capital goods. Indeed it is, but that income constitutes a loss to other citizens who paid for it with tax money (or inflation). The money taxpayers spent (yes, the Chinese pay taxes) for the Olympics goes mostly into building things that will be used rarely and often never again.

For example, as Martin Rogers of Yahoo! Sports noted, 21 of the 22 Olympic venues from the 2004 Athens Olympics now lie abandoned in various states of ruin. He states:

Gypsy camps have sprung up in the shadow of stadiums where the world’s finest athletes once battled for gold. Graffiti is scrawled over the outer walls of many sites, and it has been reported in Greece that upward of $1 billion has been spent simply to maintain these ugly wrecks.

This one-time spending constitutes a waste of a country’s resources. Even for those few buildings which will be used again, they operate at a huge loss – the total revenues they will create will never equal the total cost put into them. The billions of dollars spent for pride and prestige could have instead been used to build factories, machines, tools, trucks, etc., by individual businesses. In this case, these investments would usually earn a profit; the investments would more than pay for themselves. Additionally, these additional factories and tools would be used to generate more and more truly-needed economic goods and services, year after year.

The third popular notion regarding Olympic spending is one based on Keynesian economics. It is the notion that if a government spends money on anything, that additional spending will constitute additional income to businesses, who will then spend the money causing yet more income and more spending. All of this additional spending will bring additional wealth and additional economic growth. All that’s needed is the original additional spending . It has been argued in Keynesian government textbooks that governments, using the multiplier, could even build pyramids, or build anything, and then dump it in the ocean, and still create wealth. This theory is called the Keynesian multiplier. This theory is not only 100% incorrect, it is absurd.

There are many reasons why the multiplier theory is fallacious, but the main reason is that wealth is not generated by spending, but by saving and investing. Suppose you spent $100 at the book store. Then the bookstore owner, instead of re-investing in his business, also spent the money at the grocery store. The grocery store owner then takes the $100 out of the cash register and spends it on a new appliance. The appliance store owner spends it on movies, gasoline, or whatever. The spending goes on and on in this fashion. In this case, the money was never NOT spent. If it were NOT spent, it would be saved.

It is saving, i.e., not spending, that pays for additional capital goods and labor. Had any of the above businesses saved the $100 and invested it in their business, they could buy new machines or hire more workers. Had they saved the $100 in a bank, other businessmen could have expanded their operations or started new ones. For things company’s produce are paid for (with savings) before customers buy them. When you go to buy a car, or even a bagel, the product is already made. Savings pays for goods to be produced, consumer spending does not.

The only effect from additional spending is to raise the rate of profit of businesses. Business costs remain the same, but the corresponding sales revenues have increased from the new spending. No new wealth is created. No investments are made.

Still, since most government’s economic advisors believe in the multiplier effect, they continue to spend and spend, on any and everything, believing it will somehow bring prosperity. Japan has tried to spend its way out of economic recession for the last 18 years. The only thing the spending has created is the greatest amount of debt a country has ever had in history. But politicians don’t have to worry about profits and losses, as it’s not their money.

The Olympics are just another case of governments wasting their citizens’ taxes on unprofitable “investments.” It destroys wealth and makes people poorer - all in the name of national pride.

The “patriotism card” is pulled more and more these days. It’s used as a tool to make people feel guilty for doing the right thing. A child might say to her mother: “If you don’t buy me this toy, it means you don’t love me!” Most mothers will not fall for that. But many Americans fall for it when other children, our politicians, say that it is un-American or unpatriotic to do things that are in fact…patriotic.

This week in an interview, one child, Joe Biden, said that “it’s time [for the rich] to be patriotic….time to jump in…time to be part of the deal…time to get America out of the rut.” Many people in fact do believe that the rich need to pitch in and help us innocent workers who are in this rut – a rut which was created by Biden and other government officials by their policies of printing money, spending more than they can steal from citizens, and by many other ways that they destroy our wealth and bring on economic crises. It is a rut which was created because we voted yet again for the same bad policies of the last 100 years.

The “rich” are in fact the ones who pay most of the total taxes paid.  And most of our taxes do not go towards roads, bridges, and schools – most taxes go directly into the pockets of other people, the poor and middle class.  The rich are the ones Biden wants to steal more from in order to “return” the funds to the middle class.  The rich provide most of our capital – our farms, factories, tools, equipment, trucks, etc. – everything that enable us to create goods and services.  They also pay our salaries.  They also finance our homes, cars, and all the other things we buy but can’t afford.  Just because they own their own wealth (for now) doesn’t mean we don’t use it and benefit from it.  We do!

But Biden says the wealthy are using too much of their money to provide us with goods and jobs.  They should instead turn their assets into cash and give it to us to consume.  Thus, according to Biden, it’s unpatriotic to provide the things which improve our lives.  Conversely, it’s patriotic to squander all our wealth.

Keep in mind, when the rich pony up even more of their wealth to hand out to us, it’s done by government force.  If the rich refuse to let us steal their money, the government will come to their homes with guns and handcuffs (on our behalf).  This, according to Biden, is patriotism.  If we do not steal our fellow citizens’ wealth, we are unpatriotic.  Naturally, one who is at risk of having more and more of their property taken simply because other’s want it, is not a free person.  They are at risk of having their wealth confiscated at will by the government (thanks to your vote), or else have their freedom of movement taken from them once they arrive in prison for not paying up.  Yet we always speak of having freedom in this country, and we call that patriotism.  Plus, socialists, primarily Democrats, but also many Republicans, who espouse wealth redistribution daily in the name of “equality,” are ones who claim to be ones with morals who care about their fellow citizens.

But life goes on in America whereby we claim to be a free country full of patriots.  And it is not only theft which occurs in the name of patriotism, but also death, destruction, and general impoverishment arising from wars, dictatorships, and outright communism.  Lenin, Stalin, Hitler, Mussolini, and Zedong, all justified their terror, crimes, and repression in the name of one or another form of nationalism (patriotism + 1 more step forward).  Clearly, there were other incentives, such as attempted equality, attempts to gain back lost territories, etc., but all the policies carried out by these monsters were said to be in the name of national pride.  Today Bush and our other politicians wage wars in the Middle East (as usual) in the name of keeping America free (as usual).  Propaganda promoting their military aggression is always presented with the American flag waving (remember “Mission Accomplished?”).  Now, anyone who makes any type of television appearance, including NCAA referees, must wear a pin or patch with an American flag, to show that they are patriotic and that they support our little boys killing people abroad for no reason (and of course all our “enemies” wave their flags equally to reveal that they are the ones who are patriotic and moral).

If this is all what we call patriotism, I want no part of it.  I’m not sure I comprehend what patriotism actually is, but I know what it should not be. It should not be a system where we support theft, economic decline, and killing of others because they want to kill us because we want to kill them because they want to kill us because we knocked over their government or stole their land.

Let’s ditch the patriotism and freedom charades and start to think in terms of real freedom and truly doing the right thing.  Let’s let people live as they choose unless they do real physical harm to us or our property.  Let’s free the rich and free the “enemies.”  We will be better off economically and will live more safely.