The US economy in Wonderland
By Gerard Jackson
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posted August 23, 1999
I had intended to write a very different article on the American economy but critical questions about Austrian analysis have forced me to redirect my efforts back to the monetary activities of the Federal Reserve. I firmly believe that the vast majority of economic commentators behave as if the American economy were in some Alice-In-Wonderland state. Stocks have taken a dive, the demand for labour is still rising, savings go negative, productivity declines and the current account worsens etc.
What gives here? Fortunately (or should I say unfortunately) the situation is not unique nor is it an enigma. Last week I commented on the Fed's irresponsible monetary policy. I shall do so again in the hope of shedding further light on America's economic trends. Dr Frank Shostak's Have we learnt the lesson of the Great Depression? 1 reinforces my views. In less than 10 years M3 rose by about 200 per cent. Put another way, the Fed has pumped masses of credit into the economy.
So what? This is all too frequently the response of orthodox economists. The answer should be self-evident. I have been told that during this decade America underwent a massive investment surge. Now hang on a minute. Household savings undergo a steep fall and then become negative and from this the US gets an investment surge while simultaneously undergoing a consumption boom? How curious, as Alice would have said. But corporate profits fuelled the investment surge, is the suggestion. Corporate profits could not have been large enough to underwrite the massive investment boom that some seem to think America has enjoyed. One only has to compare them with the size of the economy to realise that fact. What about foreign investment? Still insufficient.
So where did this investment come from? No where, is the answer. If America was enjoying a record investment boom it must have had a savings boom. But personal savings are now negative, meaning that most people are borrowing. But borrowing from whom? In other words, if no one is saving how come everyone is borrowing? This is an important question because it brings us right back to investment and consumption.
Growth is forgone consumption which in turn equals investment which equals savings 2. No savings, no growth. So how can a country with very little savings undergo an 'investment' boom. Or as others might put it: how can investment exceed savings? (A question that early classical economists concerned themselves with). The answer, of course, is that it can't. But, and it is a big but, credit expansion can make it appear as if this miracle of "turning stone bread into bread", as Keynes once called it 3, can be successfully performed. The reality is very different.
When investment exceeds savings one has inflation, irrespective of how the CPI is moving. The banking system uses the fractional reserve system to inflate the number of deposits and hence artificially lower the rate of interest. Presto! New savings, or so it appears, are created at the stroke of pen. Firms are now deceived into thinking more savings have become available and so embark on investment plans that cannot be supported by the real pool of savings.
Let us say that savings and investment equal 100. The central bank then creates additional deposits that raise investment to 120, even though real savings remain unchanged. As genuine savings basically amount to redirecting resources from consumption to investment it is quite clear that the bank-inspired investments are not sustainable. Nevertheless, in monetary terms investment has leapt by 20 per cent. This is what has been happening in America. (The same thing happened in Asia on a massive scale). Eventually the true savings rate redirects resources back to consumption signalling the end of the 'investment'. All of those additional 'investments' are now revealed as malinvestments.
The longer interest rates are held below market rates more and more malinvestments will be accumulated. In the meantime, the additional spending that the central bank created through credit expansion translates into a consumer boom. This is the stage America has now reached. It should now be clear that there is no paradox of negative savings and positive investment. As the boom moves through its final stage the phenomenon of falling productivity tends to emerge. The demand for labour continues to defy economic gravity even as its output falls, caused by more marginal workers being employed at full if not raising wage rates while marginal activities expand their output 4. The inevitable result is depression.
As for credit expansion, it is the Keynsians' equivalent of smoke and mirrors. A cheap monetary trick with the most dire consequences.
Note: It has been put to me that corporate profits and the demand for
labour prove that the American economy is in a healthy state. Is that
so? In 1929 corporate profits were at an all time high in real terms,
as were dividend payments, while unemployment stood at 0.9 per cent of
the workforce. Within a few months America had sank into the longest and
deepest depression in its history. 
1 Have we learnt the lesson of the Great Depression?
2 Savings do not include cash balances.
3 Paper of the British Experts, 8 April 1943.
4 The proces is somewhat more complicated than this.
Gerard Jackson is editor and publisher of the peerless The New Australian. Reprinted with TNA's kind permission.