Post-Covid-19, time to apply policies based on the Production Accessibility & Consumption Model (PACM)
Part 2
Hector McNeill1
SEEL
In Part 1 of this article a table was presented showing the layout of the Production Accessibility and Consumption Model (PACM). It was used to show how the Covid-19 crisis has served to expose the false narrative that gives rise to the Aggregate Demand Model (ADM) which provides the "logic" of Keynesianism, monetarism and so-called supply side economics.
In this Part 2 the crises that occurred in 1929, the 70s and 80s, 2008 and 2020 are analysed in more detail using the PACM analysis.
The specific events starting each crisis were different. However, the weaknesses that intensified the crises were the result of failure of policies, leading up to each crisis event, to provide appropriate incentives for the supply side determinants of real economic growth. As a result, the common feature of every crisis was the erosion in real incomes and consumer purchasing power. The common attribute of every crisis was a decline in real incomes caused in the main by policy-induced ruptures in the supply chains of goods, services and/or money.
The ADM fails as a policy solution since all "recoveries" sunk the economy further into debt and have sustained a baseline inflation that undermines the purchasing power of the currency. Whereas the PACM explains the cause of inflation, the ADM and the Quantity Theory of Money (QTM) provide no logical or evidence-based explanation. The PACM is more transparent and establishes that there is an alternative to the ADM-based policies in the form of a real incomes policy.
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The PACM analysis of four economic crises
A short analysis of each of the main economic crises of 1929, 1970s through 1980s, 2008 and 2020 is provided below with additional comments where considered to be appropriate. Part of this analysis is to identify the operational factors affected in the supply side determinants.
1929The New York Stock Exchange suffered from excessive speculation in stocks and shares. The purchase of shares was not at that time funded by the Federal Reserve financing share buy backs by corporations, but rather by millions of people investing their savings and increasing amounts of borrowed money to buy stocks. In other words there was an excessive
supply of funds to the stock market increasingly funded by bank loans and rising debt. This caused prices to rise as a result of
rising expectation of further stock price rises to levels that bore no relationship to corporate profitability or prospects. As a result the underlying productive return on these investments declined drastically.
One reason for such speculation was that at the time the combined value of inflation (16%) and interest rates (10%) maintained a currency deflator treadmill of some 26% each year. In other words to maintain purchasing power and standard of living people had to increase nominal incomes at least by 10% by that amount each year and any bank loans really had to perform because the income to repay loans was deflating. As a result of these circumstances and declining real incomes most investors sole interest was to gain asset value without much thought being given to the fact this could not be sustainable.
The Crash
The trip wire was an increase in interest rates and a mild recessions in the summer of 1929. The rise in interest rates meant those relying on ever-increasing share values were caught out needing to sell their shares to prevent further losses and to meet the loan commitments. Then on September 20th, the London Stock Exchange crashed amid a scandal related to top investors in England related to fraud. The London crash weakened the optimism of the stock market in the United States leading to a high degree of volatility in the market which set the stage for the events of late October. As a result most stock prices began to decline in September and October, eventually leading investors to panic and so-called Black Thursday (October 24), which is generally treated as the beginning of the crash. By Black Tuesday (October 29) stock prices declined by 25 percent, as measured by the Dow Jones Industrial Average, which dropped from 305.85 points to 230.07 points.
As increasing numbers lost their assets being unable to pay back loans and losing houses and other assets put up as collateral to guarantee loans. Money holdings were lost by increasing numbers of people resulting in a
loss of purchasing power and ability to consume at previous levels. This led to corporate closures and increasing unemployment and declining number of economic units paying wages. As a result real incomes declined.
AnalysisExcessive debt was raised and driven into
assets as a result of people speculating on the stock market. These funds were withdrawn from circulation at the time of the purchases depressing the cash flow within the transactional supply side production (real economy) of goods and services. This was caused by an
increasing supply of bank loans being raised, that is,
increasing debt not for investment and increased productivity and wages but to be
withdrawn from the supply side by
diverting these funds into assets in the stock market. This led to some smaller companies closing or laying people off. So the productive supply sectors initiated a process of a fall in wage payments because of an inability to pay. This only intensified a depression in overall purchasing power amongst an increasing proportion of people and a decline in consumption levels. The funds tied up in the shares over the next three years were lost so bank loans to these investors failed. Therefore the diversion of transactional funds into assets from
the production sector markets resulted in
declines in supply and falls in the
ability to consume on the part of increasing numbers of people. The lack of purchasing power led to the "Great Depression".
As a result is it evident that the lack of production and supply and payment of wages was not a deficit in "Demand" but was the result of too much money being diverted into shares (assets) on the basis of debt. At that time banking was based on fractional reserve banking so a small percentage of loans were based on savings from the supply side. However, when banks become over-exposed by exceeding their fractional reserve limits they begin to introduce phantom funds that have no underlying monetary reserve. This exogenous money is no more than a ledger entry by the bank crediting a lender with an agreed sum. On the other side of the equation, in spite of the failure in due diligence on the part of the banks in these cases, they normally had lien over collateral put up by the lender, such as a house.
John Maynard Keynes considered the excessive
supply of funds to stock speculation to be something to be avoided suggesting the application of some form of taxation on gains specifically to discourage speculation and lower income groups from becoming involved in this process ( see:
Keynes on Stock Markets ).
The ADM solutionWhen the over-supply of credit or debt had caused a hollowing out of an economy by transferring this to assets which ended up with no value, the low supply side productive capacity and its inability to pay wages became a norm. There was therefore a need for funds to prime the circulation of money and without a normally functioning economy with excessive numbers unemployed. The only way to have the supply side begin to generate income again was to carry out public works paid for by the government, using money raised from banks, to provide work contracts to firms and begin to regenerate supply chain linkages and functioning of the economy. In a crude shorthand way this was the contribution of Keynes in his General Theory on how to secure an economic recovery.
What was paradoxical in this solution is that such an "investment" to prime the supply side was in reality designed to reconstitute a supply side payment chain which fed through, finally, to income of workers and thence to rising consumption. However, this was named "Aggregate Demand". The aggregate demand model or ADM came into shape but what is quite often overlooked is that it is was originally based on massive government loans from private banks. Such loans would have to be paid back in the future by constituents through taxation to service the government debt. What is notable is that these loans were to generate income and were not linked to any strategy of investment related to increasing the productivity of existing enterprises to create resilience in the future operations of the economy. Indeed, Keynes General Theory makes no reference to the importance of technology or productivity to increasing economic growth or to enabling the supply side pay higher wages, there were no notions of growth or innovation. It is true that Robert Solow (1957) and Kenneth Arrow (1962) came up with their models explaining the contribution of technology and learning to economic growth in the 1960s but the economic sectors in the 1920s were already running mass production lines and understood this well at the time. Ford, of course, understanding the significance of the supply side role in enabling work forces to save and consume by making sure his workforce were paid enough to permit them to save and purchase automobiles. Here, there were no notions of "Demand" just circulation of adequate amounts of money generated by and within the supply side. It is notable that those running enterprises appeared to understand these notions that macroeconomic theory and policy practice still has not grasped because of a lack of a microeconomic foundation for macroeconomics that persists to this day.
The lessons learned
- Excessive debt is a risk to the supply side of the economy
- Interest rates were high fluctuating at around 12-16% and inflation was high at around 16% a currency value deflator of 28%; this is destabilizing leading to irrational decisions relates to raising incomes
- With this level of depreciation in the currency caused by inappropriate monetary policy, real wages and purchasing power were eroding
- These circumstances gave rise to a desire by many to compensate by attempting to raise real incomes through speculation
- Applying borrowed funds to assets diverts funds from the transactional supply side of the economy reducing real incomes
- A rise in interest rates and stock price declines created circumstances that converted most loans into sub prime loans leading to financial collapse
- The broader speculative behaviour of banks using savers funds (fractional reserves) led to an important move in the form of the Glass Steagall Act of 1933 separating commercial and investment banking from domestic retail banking
Leading up to the next crisis
The US New Deal based largely on a range of government led initiatives under Roosevelt was followed by the Second World War.
The Golden Age of KeynesianismThe unprecedented growth of the British economy after 1945 was anointed as the
"Golden Age of Keynesianism". However, the economist Robin Matthews published a 1968 paper in the Economic Journal on why Britain had full employment since the war. In this he noted that the governments during this period had not deployed Keynesian Aggregate Demand Management by injecting demand into the system, but rather, this so-called "Golden Age of Keynesianism" had been characterized by government persistently running large current account surpluses, instead of the budget deficits which would have been the confirmation that they had run Keynesian stimuli. From this he inferred that fiscal policy had been not only deflationary, but strongly so in the post-war period, therefore something other than Keynesian policy must have been responsible for the steady growth and general rise in the standard of living. The answer, he felt, lay in works required to undertake reconstruction of the wartime destruction and an unusually prolonged private sector supply side investment boom. It should be added that much of this was also supported by rising levels of personal savings, a reflection of rising incomes, accumulated and invested on the supply side as well as advances in technology and production methods.
The separation of commercial and retail banking appeared to have calmed any excesses in speculation. Mutual building societies were doing a good job providing the population with reasonably priced houses based on savings of building society members. The prices of houses were accessible to a large proportion of the population in terms of their ability to place a deposit and pay the expected premiums on the loan (mortgage). As a result the ravages of
financialization had not been allowed to continue.
However, in the very early 1970s financial intermediaries had become enamoured by the Black & Scholes' options pricing model developed in the 1970s which greatly expanded confidence in financialization based on a false notion of lower risk transactions and option holdings as hedges. This technique was already taking hold in New York, Chicago and London but it was less evident as a factor in economic performance at that time. This only became a serious issue as a result of changes in financial regulation that took place following the next crisis.
In other words, the economy was doing well while there was not much interference through the impositions of top-down ADM type policies.
The mid-1970s to mid-1980s
In the 1970s-1980s, the petroleum price crisis, created by conflicts between Israel and several Middle East countries, and stagflation constituted a classic supply side problem, somewhat like the beginning of the current Covid-19 crisis, but it was not accessibility to the product, petroleum, that was the problem. There was plenty of petroleum. The issue was the high price. The price rises reduced consumption because of low price accessibility by corporate cash flows and households purchasing Petroleum Based Products(PBPs) such as oil, plastics and fertiliser.
What caused this inflation?Inflation was definitely not caused by excessive demand. Early work on the Real Incomes approach had established, by 1976, that the petroleum price hike was transmitted through the economy by high
price performance ratios of companies. It was the inability of companies to reduce their price performance ratios below unity by technological means, PBP substitution or price setting that drove inflation through the supply chains, affecting just about everything. This was because, at that time, petroleum was a major imported commodity to the UK economy. Unemployment therefore rose as companies closed and inflation persisted as a result purchasing power and real incomes declined as did consumption levels. All classic supply side phenomena.
The ADM solution however, was to apply demand control "to drive inflation out of the economy" by raising interest rates to in excess of 15%.
Some economists' leap of faith - Letter to the Times
"We, who are all present or retired members of the economics staffs of British universities, are convinced that:
(a) there is no basis in economic theory or supporting evidence for the Government's belief that by deflating demand they will bring inflation permanently under control and thereby induce an automatic recovery in output and employment;
(b) present politics will deepen the depression, erode the industrial base of our economy and threaten its social and political stability;
(c) there are alternative policies; and
(d) the time has come to reject monetarist policies and consider urgently which alternative offers the best hope of sustained recovery." |
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An excessive number of families lost their homes because this policy imposed a conversion of sound mortgage agreements into sub-prime mortgages because families could no longer afford to pay the premiums.
When it came to the 1981 budget, if the electorate had been left out of communications loop so, it would seem, had British economists, or at least, some of them. This became very clear when some 364 economists, almost one for each day in the year, largely from British academia, signed a letter sent to the The Times Newspaper in 1981 (content shown on the right). This was in response to the Conservative government's 1981 Budget which was not based on any known Keynesian notion of policy but essentially raised taxation and lowered interest rates.
The letter to the Times asserted that the Budget was not based on any known economic theory, that the outcome would deepen the depression, erode the industrial base of our economy and threaten its social and political stability, and that there were alternatives. What was remarkable in this note was that the economists did not in fact state what aspect of the Budget was wrong but simply referred to the fact that it contravened unspecified theories.
Although, at the time, I could sense and understand the feelings expressed in that letter it did not pass for more than a political statement. It was very much along the lines of exchanges within the Britain's political party adversarial system where one states that the other party is wrong but fails to suggest a better option.
One peculiar presumption on the part of the signatories was their apparent claim that as a body they were cognizant of all economic theory and indeed aware of all viable options. Any reader accepting this unlikely state of affairs could at least have expected one or two alternative policy options to have been attached to the letter. In the event they failed to come up with any. This paradox is easy to explain. The reality was and is that the "leading " economic theorists are essentially factions between clerics of the same ADM church so nothing of practical utility was going to emerge from their largely sterile debates. It was as if they had momentarily forgotten that it was the prolonged failure of any convincing options being presented, on my count during a period of some five years, that had stimulated supply side analysis on the one hand and the increasing rivalry between contending schools to gain the ear of a government who seemed keen to supplant Keynesianism by some variant of Monetarism. Unfortunately the supply side work ended up as a fiscal marginal taxation policy and therefore a variant of ADM economics. In reality the only approach to have stepped outside the ADM bubble and emerge as an more transparent analysis and basis for policy based on true supply side principles was the Real Incomes Approach ( see
What are the elements of a supply side policy? and
Why Real Incomes? ).
Supply side economics is not supply side
The British government responded to the letter by pointing out their faith in Monetarism and adding " [as far] as output and employment are concerned, the Government's supply side policies have been designed with the objective of raising both output and employment specifically in mind.... directed .. to fostering the more effective working of market forces and the restoration of incentive." and that [without mentioning the USA] "...Countries pursuing policies broadly of the kind being implemented here are those with the strongest industrial base."
This budget had many aspects that paralleled the then current fascination with the recent emergence of so-called "supply side economics" which in reality is an ADM fiscal stimulus based on taxation being aired as the basis for the new macroeconomic policy to be tested in the USA by the Reagan administration. Although, for some reason discussions on supply side economics invariably refer to the so-called Laffer Curve that pointed to an optimal tax rate in terms of tax take. Paul Craig Roberts has made it plain that this never made up part of the Reagan government's policy. This is why this policy created the biggest deficit in US history for the very reason of a lack of optimization of government revenue-seeking behaviour. This was intentional. Reagan and Margaret Thatcher in train, wanted to impose reduction in the size of government and public services
In the UK, as things turned out, the letter writers were correct in that in the short to medium term (0-3 years) the approach adopted deepened the depression, did erode the industrial base of our economy and for a short while seemed to threaten social and political stability. It initiated a rising disparity in wealth and incomes which has continued over the last 40 years to the present. When analysed during the early foundation work leading to the Real Incomes Approach, it was clear that Keynesianism with its limited range of policy instruments offered no practical options. In assessing the US experience it is worth reading a summary of the lecture given by Bill Clinton at Georgetown University where the income disparity outcome of the Reagan administration can be shown to have been particularly evident (See:
Some evidence on the failure of supply side economics ). It is widely accepted that this failure in supply side economics provided Bill Clinton with a lot of support in his election as President of the USA.
Some would argue that many current social ills in Britain stem from that period. This is more true in relation to the dismantling of the barriers between commercial and retail banking and liberalization of financial regulations which set the scene for the lead up to the next crisis. On balance the position and action of the UK government of the day, following a difficult but relatively short period, turned out to reduce inflation but as a result of declining value of currency and therefore purchasing power and therefore consumption while hundreds of thousands of houses were repossessed because of the policy of an imposed massive rise in interest rates converted many sound mortgages into sub prime mortgages. This affected around 2 million people of the families who were essentially evicted.
The fixation with a strange mix on monetarism and supply side economics results in a similar policy being pursued after 1990 leading to another large swathe of households losing their homes.
In all of these exchanges between these members of the factions within the ADM church there appeared to be no concern for the prejudice inflicted on the population by the policy implementations creating winners, losers and some in a neutral policy impact state. The exchanges were largely about inflation, unemployment, economic growth, exchange rates, interest rates, money volumes and how centrally imposed policy instruments could be used to manage these indicators. What was always missing from such a command and control logic was the heterogeneity of the social and economic constituencies all with different conditions, objectives, capabilities, cash flow and sizes of order books; it is self-evident that the "one size fits all" ADM centralized impositions could have highly differential impacts including considerable prejudice for many. Needless to say, this reckless policy resulted in an intensification of unemployment and the ensuing depression. The continued cause of inflation was the very slow capacity to absorb the petroleum and PBP input costs through medium term rises in productivity. However, the high interest rates resulted in it being too expensive to raise loans to invest for this purpose.
The cause of inflationBy 1976 the first results on work on the Real Incomes approach had established that inflation has very little to do with "demand". Real Incomes analysis had demonstrated that price rises are the result of constraints on the ability of companies to compete by managing their
price performance ratios and set unit prices to accessible levels against the rising costs of inputs; a supply side issue. A more detailed analysis of the causes of inflation in this period can be found here:
"What are the elements of a supply side policy? - Part1" ).
Demand, the magic wordIt is not altogether evident why ADM economists confuse consumption that is determined by unit prices and real disposable incomes, with a magical word "demand". People's incomes come from their places or modes of work not from financial intermediaries as indicated under the Real Incomes column in the table above. This is shown as the looped white arrow between production and income in the green Real Incomes column on the left. Therefore inadequate incomes, corporate pricing policies and inflation determine real incomes or purchasing power. These mechanisms all lie on the "supply side" and determine consumption levels. The ADM asserts low consumption is caused by "lack of demand" and can only be resolved by manipulating money supply through variations in centrally-imposed interest rates and "money volume" where such money comes from financial intermediaries in the form of debt. This process erodes real incomes and results in many having to resort to credit card debt to maintain their standard of living. The monetarist target of 2% inflation representing "price stability" represents an underlying erosion of the value of money by around 18% each decade which has resulted in the value of the pound being reduced to less than 1% of its value in 1945. Accordingly these ADM justified solutions have placed the economy and the constituents of this country, each time, in an increasingly precarious state of affairs.
The alien character of exogenous moneyThe funds that are based on debt are only marginally related to the supply side through the relationship of fractional reserves based banking. Any difference between loans and liquid reserves backing involves the release of alien or exogenous money into the supply side economy almost always with destructive outcomes. The destabilizing impact of this form of money was illustrated during the 1929 crisis and the outcome of the excessive loans driving the speculative stock market bubble.
Leading up to the next crisisThe confusion that dominated the exchanges between the economists of the factions within the ADM church did not come to any conclusions on how to handle such an obvious supply side issue as the petroleum price crisis and the ensuing slumpflation other than by policy actions that severely prejudiced constituents.
QTM-The Quantity Theory of Money on thin iceOn balance, however, monetarists gained ground in terms of influencing policy and between 1975 and 2008 largely based on assertion as opposed the analytical logic. The reason for this logical void and lack of transparency was caused by the fact that the monetarists were applying an incomplete equation for the monetary equivalent of the ADM, in the form of the then prevalent Quantity Theory of Money (QTM). Milton Friedman of the Chicago School was never able to explain the mechanism of the relationship between money volumes, interest rates and inflation which the Real Incomes Approach had established in 1976. Milton Friedman and the 364 letter writers did not seem to be aware of these facts.
The subtle evaporation of the QTM mythAs early as the 1980s and as a result of the experience with the mixture of supply side economics and attempts to apply the QTM in practice ravaged the economy and social stability in ways that threatened the survival of political parties. There was a subtle change in central bank positions in that they changed applying monetary volume as an indicator or instrument to emphasizing interest rates and establishing a target interest rate of around 2% as the conditions of price stability. There was never an admission that the QTM was pretty useless in its extant form as a guide to policy. I explain the missing parts to the QTM later in this article.
The rise of financialization However, in spite of the shaky foundations of the QTM the monetarists sought to imposed monetarism as an increasingly dominant component of macroeconomic policies with increasing references to increased "efficiency" and "financial engineering", convincing political parties and government to introduce a range of pro-financialization changes in this period that included:
- The development of the 1973 Black-Scholes hedging model for derivatives
- The Reagan administration’s generation of one of the largest government debts in history under a monetarist ADM agenda aiming to “reduce the size of government”
- The rupture of the Glass-Steagall Act (1933) in 1991 when the Commodity Futures Trading Commission provided Goldman Sachs with a “Bona Fide Hedging” exemption to be followed by similar exemptions for other banks this allowed banks to combine retail and commercial business
- Under President Bill Clinton bank deregulation was formalized through the repeal of the Glass-Steagall Act (1933) in 1999 by the Gramm-Leach-Bailey Act. This effectively removed the barrier between retail and commercial investment/trading activities in banks, placing retail segments at risk
- In the UK the Thatcher government de-regulated deposit takers, such as mutuals, to become banks on the plc model; many banks intruded into the building society markets and several building societies abandoned their mutual models
- The dominance of macroeconomic policy by monetarism modeled on ADM since the 1980s
- Monetary policy has maintained a tolerance of low but positive inflation rates that have now devalued the pound by over 99% since 1945
- A refusal of policy-makers to target zero or negative inflation but maintenance of low positive interest rates creating a real income depreciation treadmill
- The organization of the Euro Zone in 1999 precipitating and crystallizing economic regional differentials and in some cases national marginalization
- A rate of enlargement of the European Union since 2004 exceeded the economic resources to bring all countries into a comparable economic status on the basis of the monetarist model applied within the Euro Zone as well as in member states not members of the Euro Zone leading eventually to a Eurozone crisis (case o Greece)
- The increasing participation of banks in derivative and commodity futures trading
- Bank and company regulation came under extra-constitutional regimes that effectively were managed by the main players in the financial and corporate sector
- With deregulation and the advance in shaping of many new financial derivative products private banking activities shifted from their prime policy role as mainstream lenders in support of the social and economic constituency to trading activities carried out largely for the benefit of bank shareholders, executives and larger corporate clients
- Monetary policy control over national finance has become increasingly ineffective as a result of unrecorded derivatives trading being variously reported to be 4-6 times the size of the national income
- The growth in use of performance “ratings” sector based almost exclusively on financial measures and issued by agencies close to the parties who derive a direct benefit from the sale of rated products
2008
In between 2004 and 2007 the Federal Reserve in the USA increased interest rates from 1% to over 6% causing many low income mortgage payers to be unable to meet payments causing many mortgage based derivatives to lose their value. This effect mushroomed leading eventually to bank failures. This was because banks in the USA had rolled up portfolios of risky mortgages into derivatives that generated an aggregate output of the sum of premiums paid by the mortgagees. However the banks knew these derivatives were at risk if interest rates rose since the many so-called sub prime mortgage contracts would be beyond their ability pay the premiums. These derivatives were purposely graded as AAA as opposed to their true rating in order to sell them quickly, largely to UK and European Banks.
DerivativesThe business of financial intermediaries and banks involves using an
input of a supply of money to supply financial services for a fee. Therefore the purchase of derivatives provides a
constant source of supply of money from this form of asset. However, with the sub prime crisis
this supply of funds and their associated asset value (their price) collapsed. So this crisis, in financial terms was
a supply side issue.
The situation was that many banks were not only exposed by
lack of supply of funds but they were at risk of governments permitting them to fail.
It is notable that the ADM model does not have much to say about this circumstance but it is self-evident that this gap in flow in the supply of money or income to banks had been cause by a combination of unethical and high risk decision making. This spread beyond sub prime mortgages to manipulations by banks of the interbank rate Libor affecting contracts, worldwide, prejudicing millions of people subject to their terms to aggregates totalling $trillions some of which was transferred to banks. However to generalize, wrong decisions were made breaking the essential trust between financial intermediaries and clients starting with banks refusing to lend to other banks facing liquidity issues.
Ethical decision analysis During the period of growth between 1945 and 1970 the financial regulations were more stringent but, as outlined above, various steps towards financialization occurred. Their main impact was to remove previous regulatory constraints on banks through various changes in legislation and
regulations. As the regulatory constraints were relaxed this also meant that sanctions for irregular behaviour also were reduced. Whether a decision is ethical and "doing the right thing" can be determined by the result of a decision analysis that weighs up the tradeoffs associated with leaning towards prudence, the law or ethics. Prudence represents the least risk to the interests to the bank so to decide what is the prudent decision is, depends upon the sanctions under the law, such as a fine, and the publicly stated mission of the bank which, under normal circumstances, refers to fair and just treatment of customers and the application of stringent due diligence procedures to deliver on this promise. Under a more strict regulatory regime, sanctions can result in a decision that transgresses the regulations becoming more costly than the benefit from not following the rules. As long as the regulations encompass issues of ethics and approved and required due diligence procedures, the prudent decision for the bank tends to be to comply with the legally correct and ethical decision. The more relaxed the regulations, in terms of specification of rules and lower due diligence requirements combined with nominal sanctions, then the prudent decision for the bank becomes not complying with the regulations because the benefit of a decision can be far outweigh, in financial terms, the costs of prevailing sanctions. Thus the prudent decision is less ethical and the sanction becomes simply a cost of doing business.
Criminal activityThe very close associations between the financial industry, political parties and government officials resulted in some decisions venturing into crimes of stealing funds, the purposeful misrepresentation of the quality of products offered, such as derivatives containing sub prime mortgages, the fraudulent rating of products by rating agencies and manipulation of several commodity markets while maintaining the image of a free and competitive market and insider trading.
In spite of much of this unraveling and becoming public knowledge, very few of the people directly involved in these damaging decisions and criminal activity were punished because they hid behind the corporate veils.
Unreliable decision makersThe main outcome was the exposure of sharp practice on the part of an industry that no longer merited the trust of the people of the country.
Leading up to the next crisis In spite of this, governments, except for Iceland, succumbed to bailing the banks out through Quantitative Easing (QE) to provide very low interest base rates against which banks could make loans to expand debt. This had two stated objectives:
- To help the banks sort out their balance sheets
- To generate demand through low interest lending
and implicitly to increase economic growth.
The ADM theory, demand management in this specific case was justified on the basis of the a resuscitation of the Quantity Theory of Money. However, financial intermediaries simply channeled much of this very cheap money (at close to 0% interest) to benefit their own shareholders and some large corporate clients. This money was directed to the purchase of assets including land, real estate, share buy backs and selected high value commodities where secret consortia control the prices while the markets masquerade as being open and free markets providing bone fide price discovery. As a result much of the money destined for funding real production and transactions in manufacturing and services ended up in assets owned by the a very small number of people. This was an intensification of this process which had been in train since around 2000.
When is long run, long run?In 2008 quantitative easing was introduced and interest rates lowered and after almost a decade the increased money supply has not resulted in either increased investment in production and service activities and prices have not risen appreciably. Therefore the QTM and Milton Friedman's claim of long term price rises has not been born out in practice.
The missing factors in the QTM-Quantity Theory of MoneyWith the development of national accounts the QTM applied during the period of this review was the following:
M.V = P.Q ..... (i)
Where:
M is the total amount of money in circulation;
V is the velocity of circulation or the average frequency across all transactions in final expenditures.
P is the price level associated with transactions in the period under consideration;
Q is an index of the real value of final expenditures.
The Cambridge equationThe economists Marshall, Pigou & Keynes, all associated with Cambridge University, reasoned that the application of money was more significant than the supply, in that a certain proportion of nominal income (designated as k in the short run) is not be used for transactions but it will be saved or held as cash. So the equation is modified as follows:
M = k . P. Y ..... (ii) Where:
P is the price level
Y real income.
or:
M/k = P . Y ..... (iii)
I carried out some cross-checks on this equation by testing it as a computer simulation. However, it generated impossible outputs. This is because "k" is set as a multiplier when it should be an added item; "k" is removed from circulation.
M = k + (P. Y) ..... (iv) and
M - k = (P. Y) ..... (v) In applying this change, the equation simulates correctly.
These economists also considered wealth to have some influence, which is correct. Unfortunately and for simplicity's sake, this element was omitted from the equation.
The last decade has shown that these economists were correct qith respect to the impact of wealth (held assets). But their summary equation did not include this and in any case the savings assignment was not correct. But at that time, based on experience, the wealth or asset class would not have been considered to be a significant determinant. Demand management focused almost exclusively on goods and services consumption markets. As a result neither the Cambridge equation and the QTM were full representations of all relevant factors in the determination of real incomes "Y".
Adding wealth in the form of assetsIn the shadow of the evidence of a decade of quantitative easing (QE) it is therefore very relevant to add to the modified equation assets in order to reflect the effect of the diversion of the flow of monetary expansion into assets. This is not a theoretical notion, it is what has happened. Thus designating "a" as asset holdings, that is, money not circulating but invested in assets such as land, shares and stocks, the Cambridge equation can be made more realistic by writing it out as follows:
M = (a + k) + (P. Y) ..... (vi) Where:
P is the price level and Y real income.
or:
| M - (a+k) = P . Y ..... (vii) |
Conclusion: As "k" (savings and cash) has been driven down by QE to close to zero, real incomes and prices (P and Y) fall to the degree that "a" (asset holdings) increase. This is exactly what QE has accomplished. I have dubbed this new equation a
Real Money Theory as a proposed substitute for the close-to-useless, QTM which, as applied, has little relationship to reality, it is flawed.
The destruction of competing fundsThe close to zero interest rates associated with QE caused millions of people to lose their fixed incomes based on personal savings and pension funds lost an important source of stable income. The banks and financial intermediaries did not oppose this since this might help them impose their services on a larger section of the community as the only source of funds. The economy switched from one where endogenous supply side money used for expansion and investment was replaced by exogenous non-supply side sourced funding based on debt. If the governments had carried out a similar move destroying the incomes of companies there would have been a lot more resistance to this sort of irresponsibility, including legal challenges and claims for compensation. In those cases where the government have, for instance, changed retirement ages downwards destroying the ability of some groups to aggregate adequate funds, the government has refused to entertain compensation.
The death of the QTMThe massive assets effect of the quantities of money or "money volume" issued under QE which has had only a deleterious impact on the economy and awareness of the increasing debt has become generally evident. It was therefore fitting that the Bank of England finally stopped using the gobbledygook references to Money Volume and released a low profile note in 2014, explaining that this money is exogenous funding created by private banks out of thin air by simply entering the amount of the loan in a ledger against the name of the person or company receiving the loan ( see
BoE-Money creation in the modern economy ). This has had the subtle, no doubt intentional, effect of focusing attention on the behaviour of the private banks as opposed to that of the Bank of England who has authorized QE. The outcome has been an intensification of the slow decline in real incomes, investment and productivity that started in the mid 1970s but then accelerated under the removal of the most important regulations resulting an increasing level of income and wealth disparity in the United Kingdom. In spite of these obvious trends the UK government over the last decade has continued QE and even applied so-called austerity of imposing budgetary reductions on local councils and vital public services including police, social services and health services. Compared with 1970s, the majority of families have faced real incomes declines and are unable to save money.
Leading up to the next crisisSince the 1980s there was an acceleration in offshore engineering or what is now referred to as globalization. Rather than work to organize the supply side to become more efficient, financialization had developed its own set of principles and objectives largely confined to the maximization of financial return and the linking of financial return to executive pay, bonuses and shareholder "value" while domestic UK workforces, being an accounting cost, became increasingly dispensable and substituted by lower paid work forces in low income countries largely located in South East Asia. Much of this expansion into a globalized system was driven by private bank loans. The margins involved were high and without equivalent "worker protection" to those in the United Kingdom. In the host countries the bargaining position of the companies was strong resulting in a perceived reduction in risk associated with these ventures. With this trend in the undermining of manufacturing and industry in the United Kingdom the concept of the "Stages of Economic Growth", as identified by Walt Rostow in 1960 and the dominance of agriculture, manufacturing and services at different stages was taken literally by many economists and government policy makers in terms of an evolutionary fatalistic inevitability. But as Marshall McKluhan observed,"..there is absolutely no inevitability as long as there is a willingness to contemplate what is happening."
There has been, in the public discourse and government actions, a fatalistic adherence to out of date concepts. There has developed a general willingness not to contemplate too deeply what has been happening to society, social conditions, human wellbeing, wealth and income disparity. The running down of vital public and social services in exchange for an enthusiasm for values that appear to be increasingly prepared to tolerate unethical decisions which prejudice segments of society has become a "norm". No consideration is given to providing compensation and just settlements mediated by the social conscience. So a weakened Britain, constantly undermined by QE and austerity, with run down public and health services entered the year 2020 unprepared for a disaster such as Covid-19.
2020
The initial recent slide in the performance of the global economy was not a lack of demand but rather a lack of supply. Since many economic units survive and earn their income from servicing supplies from China such companies have had significant problems and some have already failed. As a result some people have been laid off and no longer receive their income from the service supply activities of these companies. So the governor of economic activity in this case was not a gap in Aggregate demand but it is a gap in Aggregate production. This gap transmitted an impact in the form of essential products from China not being accessible locally in the market where they are normally consumed, that is, the effective supply was not there. Therefore, even although in the short run consumers were able to afford to purchase the products, if accessible, so consumption (what ADM refers to as "demand") would not have been affected, the lack of supply resulted in low or no consumption but this does not signify a "lack of demand". The other aspect of accessibility, besides unit prices and local availability, is access to information concerning products and services. As Covid-19 bites further, self-isolation and the lack of income resulting from lack of gainful employment, the cash flow of consumers could be compromised leading to a fall in their purchasing power and as a result what were accepted as normal affordable prices can move beyond the state of accessible unit prices leading to a fall in consumption. The essential point to note here is that all of the main input factors (Goods, Services and Money) and the controlling influences over this whole affair are the main PACM model determinants.
With Covid-19 impacts now affecting Western economies, the purchasing power of many people who are self-isolating and out of work has fallen because the normal prices of rent, mortgages, food and utilities are beyond their ability to pay on a sustained basis over even a few weeks. This is because of lack of nominal income and savings. The generalize low income levels and inability to save, creating a lack of resilience within the population to tide them over difficult periods, is related to a prolonged adherence of policy makers to the Aggregate Demand Model. For example profits and asset holding have risen while real wages have fallen over the last 30 years. During the last decade under Quantitative Easing interest rates have been so low as to destroy personal savings and fixed incomes of the elderly, all in the name of the misguided notion of "aggregate demand". The combination of low real incomes, and effectively no savings, has placed most in a precarious state of affairs as is evident from the current situation. This has affected a large proportion of constituents in "developed" and "high income" countries, most of which follow ADM-led policies.
The Bank of England and the Chancellor's recent actionsThe Bank of England's reduction of interest rates and the undertakings of the Chancellor to provide income support for those losing employment are essential compensatory actions in the light of the specific nature and impacts of Covid-19.
They are needed, however, in large part because of a prolonged period of inappropriate ADM-based macroeconomic policies that promote expansion based on debt provided by financial intermediaries. Quantitative Easing (QE) killed off the alternative source of investment funds in the form of accumulated personal savings of constituents. This destroyed the incomes of many relying on fixed incomes placing millions of elderly constituents in a precarious financial situation.
Current extreme difficulties are also caused by generally very low nominal incomes of employees which have followed a trajectory of declining purchasing power and falling real incomes. An increasingly significant cause of this situation is the behaviour of financial intermediaries and larger corporations allocating funds, needed for productivity and employee income-enhancing investments, to their own asset holdings or used to provide executives with enhanced wealth and bonuses. These funds are also used to arrange share buy-backs leading to stock market booms that have no relationship to corporate prospects or efficiency. This stock situation is knowingly unstable because the "demand" is manufactured, confidence only remains as long as the flow of funds is guaranteed to raise prices. When market circumstances threaten the constant flow of Central Bank funds to financial intermediaries, these markets usually crash.
All of the policy "solutions" to all crises have always been based on debt and more business for financial intermediaries in the name of "raising aggregate demand" when each time the problem has been a lack of real incomes policies based on investment in supply side determinants.
ADM justified solutions have placed the economy and the constituents of this country, each time, in an increasingly precarious state of affairs.
Real Incomes policies can enable the country to escape this real incomes depreciation treadmill maintained by the interests of financial intermediation and ably assisted by the Central Banks worldwide.
With the Covid-19 experience providing us with a case study as to why ADM is and always has been a weak basis for determining economic policy, it is to be hoped that as more people understand this to be this case that the constituents of this country will reject the tired mantra that, "There is no alternative" and begin to demand a better alternative.
1 Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.
