ECONOMIC PERSPECTIVES – 76

Can lost production ever be recovered?

EMILE WOOLF – APRIL 2020

It’s easy to blame Covid-19 virus for the nation’s woes and, up to a point, that’s understandable. People who focus exclusively on the nation’s health tend to pay less attention to the economic damage wrought by Coronavirus, even though that damage impacts on the physical, mental, psychological and spiritual well-being of the whole nation.

For example, the virus has led to the biggest money-printing exercise undertaken by governments in living memory, and that will certainly leave plenty of misery in its wake. We can argue about whether the government’s reaction to the crisis has been excessive in terms of curbing civil liberties, and we have the Swedish option to observe – but we can agree that some action was necessary. The action selected (to give short-term relief to people and businesses currently prevented from earning a living) in fact amounts to a massive act of charitable giving by the community, paid for by the future loss of purchasing power of the nation’s money.

Sleight of hand

 

Much of the new “money” comes into being by sleight of hand: the Bank of England purchases gilts and other “secure” government debt held by major insurance companies and pension funds, and pays for these with fresh issues of – yes – more government debt, mainly in the form of bonds and short/medium/long-dated treasury bills – new money that its holders can spend or lend out to customers at commercial rates far higher than the suppressed rates attaching to the new bonds. This conjuring trick now accounts for some 30 per cent of our national debt.

New lending – where’s the collateral?

The credit-creation process doesn’t end there. When banks have been stuffed with mountains of funny-money they know they must somehow get rid of it, sharpish – and they are not too particular about such niceties as the realisable worth of collateral underpinning the loans they extend to desperate borrowers in an illiquid market.

As a consequence, a sizeable chunk of those loans will finish up in the next credit cycle’s mopping-up legacy of trashed debt. We saw the stark manifestations of such grossly irresponsible lending in the previous crisis of 2008/9, and the toll it took over the following decade. To give you a foretaste of its imminent repeat performance, consider the mounting doubtful debt provisions in the accounts of banks virtually everywhere, and ask yourself about the lending criteria they must have adopted when making all those dodgy loans.

Repayment of sovereign debt – there’s no hurry!

Governments deliberately suppress interest rates so that their own debts are tolerably cheap to service. They are not too worried about repaying them, either: credit creation, by definition, is inflationary and they can allow inflation to erode the real value of their debts over many years – until lost in the mists of time.

For example, the UK paid the final instalments of its war debt to the USA (£43 million) and Canada (£11 Million) on 31 December 2006, 61 years after WW2 ended. But when you factor in the pound’s loss of purchasing power of some 3,000% over that period, you will understand why governments don’t mind how long they take to repay their debts.

Britain pays its debts

 

Ed Balls, financial secretary to the Treasury in 2006, crowed that this demonstrated Britain always pays its debts. But if those 2006 final instalments had matched 1945 purchasing power, they would, instead of £43 million and £11 million, have cost Britain £20 billion to the USA and £5 billion to Canada!

Credit creation and the currency

The unarguable downside is that inflationary credit creation must damage the currency, especially when the government encourages banks to operate a fractional reserve system whereby they retain only a proportion of deposits entrusted to them, the rest being re-lent, further inflating the money supply.

As President Herbert Hoover put in 1936: “Blessed are the young for they shall inherit the national debt.”

As long as government instructs its statisticians at the Treasury to dissemble the real loss of our currency’s purchasing power by quoting, ad nauseam, a fictional annual inflation rate of 2 per cent, gullible citizens will continue to believe that even the latest money-creating tsunami will not lead to a rise in prices. But elementary logic tells us that the government’s story is nonsense. In relation to any given level of available goods and services (i) an increase in the money supply and (ii) a rise in the price level are two ways of expressing the same phenomenon: one is a factor of the other!

History has a different story to tell

History provides a telling illustration of what is indeed possible. Throughout most of the 100 years following the Napoleonic wars our governments reduced the ratio of debt to GDP from 200 per cent to less than 30 per cent without resorting to inflation, which roughly averaged zero. This was achieved by sustained economic growth, supported by low taxes, free trade, free movement of labour and capital, while keeping its primary budget, excluding interest payments, in substantial surplus.

19th Century Britain was on the gold standard

 

But what most economic historians fail to connect is the most telling feature of all: throughout most of the 19th century Britain operated its currency on the gold standard – the discipline of pegging its money supply to the amount of bullion held in the Bank of England’s vaults. This, strictly applied, naturally limited the government’s ability to spend what it did not have. The subsequent ending of the link to gold had the effect of removing natural barriers to government overspending – it was now able to print money out of thin air!

“I promise to pay the bearer on demand the sum of……..” still appears on every banknote, a feint relic of the bearer’s ability to exchange his token for its equivalent value in gold. Trust that the Bank would fulfil this promise guaranteed, in effect, the solvency of the realm.

The 20th century’s rampant debauchment of currencies

The terrifying levels of currency debauchment throughout the 20th century were the natural and inescapable consequence of the inflationary practices of every major central bank. But this is worth noting: the currency that best maintained its purchasing power over this period was the Swiss franc – the currency that remained pegged to gold for the longest, until 2000. No surprise!

Ministers excuse the current round of fiat money expansion as an emergency response to ease the economic fallout from anti-virus measures. But the question causing puzzlement to politicians and economists right now is whether the production lost because of the current, or any, crisis can be “made up” once industry is re-energised and normality restored. Many erudite macroeconomists now argue that our present economic affliction, namely a paralysis of every key supply-node in the delivery-chains of production will be remedied once the virus is vanquished and productive impulses re-energised.

Can enhanced productivity recover past economic loss?

But that’s a hollow assurance. Any post-virus surge in production, no matter how energetic and fruitful, will be the result of new work, new enterprise. Make no mistake, lost production stays lost. Any macroeconomic algorithms that tell you otherwise are without foundation. Remember that macroeconomics is a statistical parlour game with surmise as its underlying thesis – a brilliant guide everything that will never actually happen.

That’s not to say there will be no useful economic lessons from this period of disruption. For example, working from home involves no wasted travel time and many of us have found how much more productive we can be when left to our own devices and disciplines. This will undoubtedly have an impact on how we think about office space, and how much of it we really require – and hence rents and council taxes will require serious reappraisal.

What’s seen, and what’s unseen

 

Forgive me if I repeat this story to demonstrate the thesis that production lost can never be recovered. Frederic Bastiat, the 19th Century French economist, drew attention to the important distinction between the “seen” and the “unseen”. His story involves a shopkeeper whose son accidentally smashes a neighbour’s windowpane, and the shopkeeper must pay for its replacement. Witnesses console the shopkeeper by pointing out that if windows were never broken glaziers would soon go out of business – an observation based solely on what is seen.

The trouble with this reasoning is its suggestion that breaking windows is, ultimately, a good thing. After all, it brings profitable work in its train, creates jobs and causes money to circulate. Perhaps people should go around breaking windows? By the same reasoning, perhaps we should celebrate the arrival of Covid-19 for bringing us all those new hospitals and the new equipment that now fills them?

 

But reasoning based on what is “seen” is defective because it takes no account of all the “unseen” alternative uses to which the shopkeeper may have preferred to put his money. For the shopkeeper, spending his money on a replacement window was a complete waste of resources. Given the option, he would have had any number of preferred expenditures, possibly involving new products that would add more value. But because those options are unseen, we cannot even begin to know what any more productive outlays would have yielded.

Playing safe, or flying blind?

 

 

Similarly unseen are the myriad alternatives to producing millions of new facemasks and syringes forced upon us in the hiatus of our shut-down resources. No one really knows whether, and to what extent, our leaders, despite the existence of mutually inconsistent expert opinions now jamming the airwaves, are suspending our civil liberties in the name of “playing it safe” while actually “flying blind”.

 

But such speculations lie in the province of microeconomics, which highlights the one fact nestling amid the uncertainties: lost output stays lost!

 

Appendix – can politicians “create” jobs?

 

Some mistakenly argue that Bastiat’s story is a positive instance of “creative destruction”. But they are quite wrong. The economic phenomenon of creative destruction arises when traditional methods of production are superseded by processes that are measurably more efficient or cost-effective in their use of the factors of production, and often entail job losses. The breaking of windows in this example is not, in any sense, creative.

 

 This story is worth remembering whenever you hear politicians boasting that their policies would “create jobs” (which you will hear them doing virtually every day!) This populist drivel is a short, but logical, step from the idea of paying boys to smash windows, as if we could vandalise our way to prosperity and growth. But our powers of reason tell us that Hurricane Florence did people on the East coast of North Carolina no favours in September 2018 when it turned their homes into matchwood. It certainly didn’t provide a massive boost to the economy!

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[EMILE WOOLF – APRIL 2020 – ECONOMIC PERSPECTIVES – 76]