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The monetary paradox - a note

Hector McNeill1

Perverse policy incentives:- Monetary policy attempts to manage contradictory objectives including aggregate demand management to contain inflation and to sustain a state of so-called price stability. It fails on both counts and in fact proactively damages the real economy by removing needed incentives to encourage productivity and growth.

The monetary paradox

The ad hoc elements of macroeconomic policy made up of the Aggregate Demand Model (ADM) the profit motive, fiscal (government revenue-seeking) and monetary control (imposed interest rates) create a series of economic paradoxes for the management of private enterprises by making efficient resource allocation in line with the objectives and capabilities of each firm extremely difficult or almost impossible. The monetary paradox dynamics and effects are described below.

Monetary policy covers mutually contradictory elements. It makes use of money volumes and interest rates to influence aggregate demand and the value of the currency. However, this model has very weak theoretical and practical justifications (see Real Incomes & the Quantity Theory of Money). Monetary policy attempts to manage aggregate demand in order to control inflation leading to a need to deflate the economy or under conditions of deflation the objective becomes that of reflating the economy.

To reduce aggregate demand interest rates are raised and this lowers the demand for consumer credit and makes investment finance for investment more expensive. The impact is to lower demand and discourage investment in productive activities.

Natural returns & state imposed calamity

Depending upon the activity, state of the art technology and techniques the appropriate levels of interest rates for any economic unit to justify investment will depend upon the expected return on the investment. The ideal situation is one where interest rates fall into a range below the potential returns on investment to make more investment feasible.

In 1898 Johan Gustaf Knut Wicksell (1851-1926) published an important work entitled: "Interest and Prices" where he identified a natural rate of interest and the money rate of interest. The money rate of interest was that operating in capital markets and natural rate of interest was that at which supply and demand in the real market was at equilibrium with the interest rate being the "equilibrium price for money".

This raised the question as to the need for capital markets.

If the natural rate of interest was not equal to the market rate, then the demand for investment and quantity of savings would not be equal. If the market rate is lower than the natural rate, then companies are encouraged to invest and economic expansion occurs.


MSI: monopoly imposed interest rates;
PPP: under real income natural rate Price Performance Policy

The natural rate is the return on capital, that is, the real profit rate equivalent to the marginal return on new investment. The money rate is the loan rate fashioned by the bank and credit becomes "additional money". Indeed, as was finally admitted by the Bank of England recently2 (see "Money creation in the modern economy - Bank of England" Quarterly Bulletin 2014 Q1) bank credit creates deposits which can be used by borrowers and therefore the bank creates money and increases the money volume in the economy.

In reality the main policy instrument of government via the Bank of England is interest rate-setting. As described in the text on the left this policy has been somewhat calamitous because interest rates seldom fall to a reasonable level to come below the natural interest rate, and, when well below that rate, money, as in the case of quantitative easing which it totally designed to benefit the banks, funds take flight into assets starving investment activities.

In the diagram above the orange lines show the "drainage" of investment funds from productive investment in association with high or very low interest rates with the real opportunities for investment (and therefore increased productivity, exports and import substitution) being the unimpressive blue line on the graph. The Real Incomes approach, having constitutional economic foundations does no permit the state to impose arbitrary interest rates but encourages investment and investment opportunities around the natural return scales according to sectors and sub-sector practice and future potential. This more robust source of growth is indicated by the red line.

2 For the last 50-60 years leading macroeconomic textbooks did not admit that banks create money this way but insisted on a mumbo-jumbo linked into the unconvincing logic of the Quantity Theory of Money (see Real Incomes & the Quantity Theory of Money).
Higher policy-induced interest rates also attract deposits in banks in interest bearing accounts including from foreign depositors. This is usually associated with a rise in the exchange rate which reduces competitivity for exporters.

When interest rates are lowered, so as to encourage "investment" a large component of the financial investments in fixed income instruments are diverted into the purchase of assets in the FICRESS sectors (Finance, insurance, commodities, real estate, stocks and shares)as well as valuable art objects, precious metals and energy options. The general impact of this reallocation of funds combined with the methods of interactions in asset markets3 is to raise the prices of inputs to the real economy. As a result finance for investment in productive activities dries up.

The overall monetary policy cycle from high to low interest rates therefore discourages investment and future productivity.

In addition to this inflation control policy based on the Aggregate Demand Model, another declared aim of monetary policy is to secure "price stability", in the name of business predictability, by aiming to secure an inflation rate of 2% per annum. This sets the whole economy on a real incomes depreciation treadmill that lowers real income by at least 18% each decade. Combined with the monetary cycle described above that reduces productivity the outcome of "price stability policy" is a failure to generate exports and achieve import substitution. Since the 1970s the UK external balance of payments has been negative and has increased with first quarter 2015 being a record deficit. This absurd policy has reduced the purchasing power of the pound by over 99% since 1945, that is, the 2015 pound has just 1% of the purchasing power of the pound in 1945.

In spite of the handing of interest-rate setting to the Bank of England economic activity in the government sector, constitutes some 40% of the economy, continues to be dominated by fiscal accounting.

1 Hector McNeill is the director of SEEL-Systems Engineering Economics Lab.

2 Interventions in asset markets, especially those that are inputs to the real economy such as food, fibre, feedstocks and fuels often have the effect of raising prices as a result of massive speculation from within the grey market. Use of high frequency trading methods and various techniques to impose short term price variations to gain profit on assets that the speculators never use in real economic activities. The size of the grey market is several times that of national economies meaning that central banks and monetary policy can have no substantive impact on such transactions.

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