Demand is not the main constraint on the US economy...

LAST WEEK, writes Dr. Frank Shostak for the Cobden Centre, The Economist raised the issue of whether the Fed can do more to support the US economy given the fact that its policy rate is effectively zero and long-term rates are close to all-time record lows.

Doesn't additional easing amount to little more than pushing on a string? The Economist is of the view "it doesn't". By lifting monetary pumping the Fed could raise inflation expectations, which in turn is going to raise inflation in the present, argues The Economist.

Consequently, this is going to lift the present demand for goods and services. (People will speed up buying at present knowing that goods will be much more expensive in the future). The increase in present demand for goods and services will speed up the pace of economic expansion – so it is suggested by The Economist.

Note that the essence of this way of thinking, which is accepted by most economists including the Fed's chairman Ben Bernanke, is that what is required to revive economic growth is to boost the demand for goods and services.

In this way of thinking the scarce factor that prevents economic growth from taking place is the demand for goods and services.

Even if one were to accept that demand is the critical factor, as far as economic growth is concerned, how is an increase in demand going to be funded?

In the real world people pay for goods and services by means of the goods and services they are producing. Hence the more is produced the more goods people can have for themselves in order to support their life and well-being.

What permits the increase in the production of goods and services is the availability of a suitable structure of production. To secure such a structure various individuals that are employed in the maintenance and the enhancement of the production structure, or the infrastructure, must be supported.

Various final consumer goods and services that are required to support people's life and well-being must be allocated towards the maintenance and the enhancement of the infrastructure.

Final consumer goods that are allocated towards the making of new tools and machinery (capital goods) are goods that were saved from the previous and the current flow of production of final goods.

If out of the production of ten loaves a baker consumes two loaves, his savings is eight loaves of bread. The baker then can invest these eight saved loaves in the making of a new oven. Whilst the oven is made the saved loaves of bread sustain the oven maker.

In this case eight loaves are allocated, i.e. channeled, towards the making of the oven, i.e. towards the enhancement of the infrastructure, which will permit him in the future to produce more bread.

Observe that failing to allocate final consumer goods towards the production of tools and machinery is going to weaken the economy's ability to produce goods and services required to maintain people's life and well-being.

So in this sense it is not demand that limits the economic growth but the amount of final consumer goods allocated towards the maintenance and the enhancement of the infrastructure, i.e. what matters is real savings.

On this score if the flow of real savings comes for whatever reason under pressure, this puts pressure on the overall pool of real savings. This in turn, all other things being equal, weakens the flow of real savings towards the production of capital goods and in turn undermines the infrastructure and hence the economic growth.

Irrespective of the state of the demand, if the pool of real savings is in trouble no economic expansion is possible. No Fed tricks regarding inflation expectations can help here.

For instance, an increase in consumption on account of an increase in inflation expectations (in response to loose monetary policy) will only weaken the pool further. This in turn will weaken further the infrastructure and weaken further the economy's ability to expand the production of final goods and services, i.e. weaken the economic growth.

If boosting demand would have been the key for economic growth then by now most countries in the world would know how to do it and world poverty would have been erased a long time ago. What is scarce is not demand but real savings or real capital.

Contrary to The Economist, the Fed's loose monetary policy can only damage the foundation of the economy. By pushing money out of "thin air" into the economy the Fed promotes an exchange of nothing for something, i.e. the consumption of capital, thus weakening the economy's ability to grow.

It must be realized that as long as the pool of real savings is still growing the Fed can create the illusion that it promotes economic growth by the artificial boosting of consumption. (Note an artificial boost in consumption results in unfunded consumption and to the diversion of funding from the production of tools and machinery). Once the pool of real savings is stagnating or declining, the Fed's ability to create illusion comes to a halt.

To add insult to injury The Economist suggests that if the Fed could pump money without raising inflation then the Fed should be allowed to monetize the government debt. The Economist writes: "If one could entirely monetize the debt with no inflationary consequences why not do it?"

To begin with inflation is not a general increases in prices as the popular thinking has it, but increases in money supply. Irrespective of what the so called price indexes are doing once money supply is expanding, this means we have inflation. If government expenditure is funded by means of printing presses this implies government expenditure is funded by means of inflation.

Once the government spends the newly printed money, this results in the consumption of capital and the weakening of the infrastructure. One only hopes that The Economist realizes that the US government debt stood at $15.8 trillion by the end of June.

The Economist on July 3, 2012 suggested that it is possible to revive the US economy by means of monetary pumping. They believe that  by means of loose monetary policy the Fed could raise inflation expectations. Consequently, people would speed up buying at present knowing that goods will be much more expensive in the future. This in turn would speed up the pace of economic expansion.

On the contrary, we hold that the Fed's loose monetary policy will lead to the consumption of capital, thereby inflicting damage to the foundation of the economy. Consequently, the ability of the US economy to stage a meaningful expansion will be diminished.

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