By Dr Frank Shostak
Most economic commentators consider a softening in economic statistics such as gross domestic product (GDP) as indicative of a likely economic recession ahead.
According to most experts this weakening, as a rule arises because of a decline in the overall demand for goods and services.
On this way of thinking, the key driver of the economy is the increase in demand that gives rise to the increase in the supply of goods and services i.e. demand creates supply.
A recession is seen as emerging predominantly because of a weakening in the private sector’s demand. Consequently, it is recommended that the central bank should step in and fortify the private sector’s ability to strengthen demand. This it is held, is going to prevent the economy falling into a recession.
It is recommended by experts that the central bank should embark on expansionary monetary policies such as the lowering of the interest rates.
Is it however, valid that recessions are about the weakening in the overall demand as depicted by the weakening in the GDP?
Definition of recession
We suggest that the subject matter of a recession is not the decline in the GDP and various other economic indicators but the liquidation of various nonproductive activities that have emerged on the back of the expansionary monetary policies of the central bank. These activities are also labelled bubble activities.
Expansionary monetary policies set in motion the exchanges of nothing for something, which amounts to a diversion of real savings from wealth generating activities to non-wealth generating activities.
Within all other things being equal, this weakens wealth generation and in turn weakens the process of real savings formation – the heart of economic growth.
Note that once the central bank strengthens its expansionary monetary policy, this strengthens the diversion of real savings. Conversely, once the central bank tightens its monetary stance, this slows down the diversion of real savings from wealth producers to non-wealth producers.
Activities that sprang-up on the back of the previous easy monetary policies are getting now less support as a result of a tighter monetary stance. These activities fall into trouble – an economic bust, or a recession emerges.
Regardless of how large an economy is, a tighter monetary stance is going to undermine various bubble activities that sprang-up on the back of the previous easy monetary policies.
It follows then that recessions are not about a decline of an economic indicator such as GDP. It is about the liquidation of activities that emerged on the back of the previous expansionary monetary policies of the central bank. As a rule, the recessionary process is set in motion once the central bank reverses its expansionary stance.
Now, recessions as a result of a tight monetary stance by the central bank are good news for wealth generators. A tighter monetary stance slows the diversion of real savings from them towards bubble activities. This in turn strengthens the wealth generation process.
By most commentators as long as the growth rate of consumer expenditure displays strengthening there is no risk of a recession ahead.
This means that as long as there is a strengthening in consumer’s demand, good times are going to continue. Demand however, cannot stand by itself and be independent, it is limited by production. This means that it is supply that causes demand and not the other way around.
According to David Ricardo,
No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.
What limits the production of goods is the availability of tools and machinery i.e., capital goods, which makes workers more productive.
Capital goods are not readily available; in order to make these goods it is necessary to allocate consumer goods to sustain individuals that are employed in the production of tools and machinery. The allocation of consumer goods is what real savings is all about.
Note that real savings emerge once some individuals have agreed to transfer a portion of their consumer goods to individuals that are employed in the production of capital goods.
Obviously, they do not transfer these goods for free, but in return for a greater quantity of consumer goods in the future.
Since real savings enable the production of capital goods, obviously real savings are the heart of economic growth.
How money out of “thin air” undermines economic growth
Now, when money is generated “out of thin air”, all other things being equal, this reduces the flow of real savings to the producers of wealth, which weakens the production flow i.e., sets in motion an economic recession.
For example, an increase in the money supply “out of thin air”, all other things being equal, gives rise to consumption that is not supported by a preceding production. This weakens the flow of real savings that is necessary to support the production of the first wealth producer.
This in turn undermines the production flow of the first wealth producer, all other things being equal, thereby weakening his demand for the goods of the second wealth producer.
The second wealth producer, all other things being equal, in turn is forced to curtail his production of goods thereby weakening his demand for the goods of the third wealth producer etc.
In this way money, “out of thin air”, which depletes real savings, sets up the dynamics of the consequent shrinkage of the production flow. This in turn weakens the demand. Observe that what has weakened the demand for goods is the increase in the money supply “out of thin air”.
GDP and money supply
The economic statistic that most commentators are paying attention to is the gross domestic product (GDP).
Given that this indicator is the monetary turnover obviously, changes in the money supply after a time lag are followed by changes in the GDP. Hence, it is not surprising that the monetary policies of the central bank appear to be able to navigate the economy in terms of GDP.
We suggest that policies that are aiming at preventing the emergence of a recession make things much worse. These policies not only provide support to existing bubble activities but allow the emergence of new bubbles thereby undermining the wealth generating process further.
Note that by means of expansionary monetary policies the central bank does not help the economy. It only sets in motion a further diversion of real savings from wealth generators to various nonproductive activities thereby weakening the wealth generation process.
As long as wealth producers can generate an adequate amount of real savings to support all the activities i.e., productive and bubble activities, the expansionary monetary policies of the central bank, which strengthens the GDP, are regarded by most experts as a success.
Once the ability of wealth generators to support overall economic activity weakens, the central bank’s expansionary monetary stance is going to have difficulties in lifting the economy. Note again, that the easy monetary stance undermines the real savings formation process thereby weakening the wealth generator’s ability to support the production of goods.
We hold that a better way to revive the economy is to allow wealth generators to take charge whilst the central bank should leave the business arena.
Those commentators that demand the interference of the central bank in order to revive the economy must realise that the central bank is not a wealth generator. All that the central bank can do is to transfer goods from one individual to another individual. In the process this weakens the overall pool of real savings.
Conclusion
We suggest that the subject matter of recessions is not the decline in the GDP and various other economic indicators but the liquidation of various nonproductive activities that have emerged on the back of expansionary monetary policies of the central bank. These activities are also labelled bubble activities.
What matters for the economic health is not strong economic data but the freedom from central bank policies of tampering with markets. Whenever various commentators argue in favour of central bank policies to provide support to the economy, what they imply is a support for inefficient bubble activities.
