Money Is Neutral – The Great Keynesian Fallacy

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In this week´s edition of Mountain Vision, I will dig deeper into a subject I have only indirectly touched upon in some of my previous postings. Basically it is one of the greatest fallacies in both the Keynesian and Monetarist theoretical framework that will ultimately help decide your optimal portfolio allocation!
Both Keynesians and Monetarists build their models on the assumption that money is neutral with regard to the economic outcome. In other words, the mainstream economists believe that monetary policy should be used to increase aggregate demand in the short run and by so doing will not in any way affect the economic structure over the long run.
Closely related to this grave fallacy is the belief that all economic activity is 100 per cent substitutable. A Keynesian does not discriminate between various forms of economic activities, as they are all considered equally good. This absurd claim derives from yet another fallacy, the conviction that aggregate demand causes aggregate output.

“A dictum of Lord Keynes: In the long run we are all dead. I do not question the truth of this. I do not question the truth of this statement; I even consider it as the only correct declaration of the neo-British Cambridge school.”

~ Ludwig von Mises

Money neutrality is a lie!
In Keynes own words “[p]yramid building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.”

This sort of nonsensical logic has caused and continues to cause untold misery in the world, and is directly responsible for the fact that more than 50 per cent of Spain´s youth is now unemployed, angry and understandably extremely frustrated. The plague that currently wreaks havoc in the global economy is nothing but the natural outcome of economic policies that have been implemented over the last 40 years!

It should be obvious to all Mountain Vision readers that value added economic activity is not substitutable by any state-orchestrated farce of growth. It should be understandable why the destructive conduct of a war cannot be equal to the value of building a successful company and creating jobs through innovation, capital accumulation and consumer satisfaction. I am convinced that you need at least a Ph.D., or maybe a Nobel Prize in economics, to believe otherwise!

Nevertheless, the concept of “non-neutral money” may be less obvious. I will therefore explain what is meant by it, what it means to disregard money´s said non-neutrality and lastly try to put it into the context of portfolio allocations.

A review of history, and its manifold periods of hyperinflation in various countries, should be sufficient to realize that money is NOT neutral. In other words, the abundance of money will not remain without impact on the real and fundamental economic structure of a nation. For instance, the massive destruction brought upon Germany in the early 1920s was possibly worse in economic measurement than WWI itself. This single episode in German history is still an important part of Germany´s identity and, according to historians, helps explain the Bundesbank´s relative hawkishness and hence reluctance to go along with Draghi´s “Outright Monetary Transaction” program today.

But such episodes are not enough to convince ardent Keynesians in control over the world´s economy! Money´s neutrality is very much part of their economic framework. Only by repetitive, mantra-like reference to the neutrality of money have they been able to brainwash the majority of the world´s intelligentsia. Thus, they are able to justify the scope of current quantitative easing programs, security market programs, interest rate dictates, and the range of other market manipulations they orchestrate in the name of increasing aggregate demand.

In order to properly understand why money is non-neutral, it is necessary to understand capital theory. The Keynesian obsession with aggregates makes them completely miss out on the importance of capital and time in the economic system. The Austrian School of Economics, on the contrary, takes human action as their starting point and thus does not get befuddled with the use of aggregates in their economic analysis. By doing so, the Austrian School has a good grasp of capital theory, and thus recognizes clearly that changes in money supply do in fact impact the real economy with all the long term implications that come with it.

The essence of capital funding – and the impact of money on daily lives
Inflation, over time, becomes destructive. It is the result of money supply that is not in step with real economic growth. A hyper-inflation, therefore, is essentially a “normal” inflation in fast-forward mode. All the underlying factors that undermine the social and economic fabric of a society are also at play in a normal inflation. And the most important of all those factors, and simultaneously the one that is the most disrupted with monetary inflation, is real funding of economic activities.

We need to understand that it is not only the stock of tools and factories together with the pool of labor that determine productive outcome. Equally important is the funding of both capital goods and labor. While the stock of labor and capital goods will be unaffected during and after inflation, capital funding, which is the source of real savings, will not. Leaving funding out of all the fancy mathematical equations that are supposed to describe our society leads the Ph.D. to conclude that monetary policy is neutral.

Let´s look at the arguably simple example of an iron ore mine and try to track one month´s worth of production through the value chain in order to understand why funding is so important:

Over one month, mine workers need to eat, drink, sleep, and enjoy some social activities and a range of other things that people do and consume in their spare time. As you now realize, in a Keynesian world, funding is assumed to be irrelevant. Therefore, let´s assume that there is no capital funding. In other words, the workers would have to be paid with the same month‘s worth of production of iron ore instead of money. However, iron ore does not help fund the worker and his family, so it needs to be processed further. It will have to be shipped to a steel mill. At the steel mill, iron ore is turned into steel. But steel will not be useful for the worker either; it needs to be turned into, say, a bridge. The bridge will have an economic life up to 100 years and its contribution to society will be paid out in increments of 1/1200 months. But even the service of a bridge cannot sustain the worker. The bridge must connect two productive assets or a productive asset with a consumer market in order to create value. Assume the bridge connects a farm with a food factory. Farm products can then be transported to the factory to be processed…you get the picture.

To make a long story short, the next month worth of iron ore production will be paid back to the worker over the next 100 years! This is of course an untenable situation for the worker and his family, which would literally starve to death before they could accumulate a “cash-flow” large enough to sustain themselves. A society without funding is a crude barter society where the level of specialization is minimal and most people produce what they themselves consume.

The reason why we can have iron ore mines today is simply because we have gone through generations where people have produced more than they consumed and allocated the remaining surplus into funding of, among other things, the workers at the iron ore mine. A worker is able to consume today what a capitalist saved yesterday. He can of course not expect to get the full value of his product today, as the socialists seem to think. No, the worker must be satisfied with the discounted value of his production in order to create a surplus value to pay the capitalist saver for his own deferment of gratification, i.e. savings and consumption.

The enlightened reader will now ask where the discount value is expressed in the market place. It is simply the interest rate, or more correctly stated, it is the price difference between the output prices and the input prices paid to make the product in a specific part of the productive chain.

At this stage we start to understand why monetary policy is NON-neutral.

The problem of mis-allocation, when the price is not right
The price of money is interest. The manifold price manipulations we witness today – in other words the fact that interest rates, due to monetary policy shenanigans, are not in line with the value and risk of funding – leads to dis-coordination between the various stages of production.

If one part of the economic structure enjoys a healthy profit while the other does not, and this discrepancy is solely due to the fact that real interest rates do not correspond to the real free market rate of interest, then too many resources will be mis-allocated to the artificially favored sector – think housing, tech companies or financial institutions.

Equally important, but less obvious, is the change of relative prices through the process of money injection. Note that monetary policy must inject money into the economy at specific points, often through big banks and government, which must necessarily lead to a new demand pattern. This will obviously change the relative pricing structure and thus allocate resources into economic activities that can only be sustained by a continuation of money injection. Think military contractors, European farmers and the welfare state.

According to von Mises; “[t]he notion of neutral money is no less contradictory than that of a money of stable purchasing power. Money without a driving force of its own… …would not be money at all” and he goes on to say “people misunderstood the cause and effect of these [economic depressions] [as] [t]ey tacitly assumed that changes in purchasing power occur with regard to all goods and services at the same time, and to the same extent. This is, of course, the fable of money´s neutrality implies.”

What are the implications for portfolio allocations?
We now know that the world´s Keynesian “leaders” believe they can “use money” to erect pyramids or go to war in order to revive the global economy. They will resort to either monetary or fiscal measures to achieve their goals. In either instance, the pool of real savings is depleted as it goes into unproductive governmental activities and consequently away from productive usage.

Obviously, the more the global economy depends on such artificial government spending and money creation, the more mis-allocation is created and the more contorted the real economy becomes. Furthermore, if and when the non-market intervention disappears, the economic activity in question must naturally shut down as it cannot bid away resources from the productive bidders.

But herein lays the crux of today´s problem. With monetary inflation accelerating unabated since the early 1970s, there has been a shrinking connection between production and consumption; even at the household level, consumption has tended to be higher than production. The discrepancy between what one produces and what one would like to consume is expressed through debt accumulation.

In this model, at some point, the pool of real savings will no longer be able to maintain the overall productive structure. An economic depression will ensue. We are probably at this end-station today. The weakest buckle first: Greece, Ireland, Portugal and now Spain and soon Italy and France. These are countries with the most debt and the least production to cover it.

At this stage, painful choices must be made. Living standards accustomed to, either through public debt accumulation and redistribution or through private debt accumulation, comes to its natural end with grave disturbances to the affected societies. As you now see, it all comes down to mis-allocation of capital through the belief that money is neutral on the productive structure and the policies that naturally follow from such wrong-headed beliefs.

This is all well and good, but what does it mean for prudent portfolio allocation? To keep clarity and simplicity in our thinking, I divide the next five to ten years up into three distinct scenarios:

1) Rapid real growth. In this case, you would like to own stocks.

2) Deflation. The massive load of credit that comes to default will overwhelm central banks efforts to reflate the system. In this scenario you would own bonds, and if you have no moral scruples, preferably government bonds.

3) Inflation. The drain on real saving becomes so large that the productive structure cannot sustain itself, production goes into a tailspin (goods induced change of purchasing power) and the money creation used to revive aggregate demand (money induced change of purchasing power) help aggravate the price inflation. In this scenario the obvious choice is to own physical assets, of which the two precious metals are the most likely to maintain your purchasing power.

In my August 20th Mountain Vision article on shadow banking, I explained why deflation might be with us for the short term, but that it is unlikely to last. With the new open-ended QE program from the Fed we are bound to see a situation in which shadow banking becomes insignificant and almost completely replaced by high-powered banking reserves.

However, the reader should note that the very action of QE can be deflationary in the short term, as shadow banks do not only re-hypothecate sub-prime mortgage backed securities, but increasingly high quality “risk-free” assets such as US treasuries. By removing these from the market, shadow-banking chains may be deprived of reserves and logically deflate. In the longer term on the other hand monetization of outstanding liabilities will end up in massive inflation.

That excludes scenario two, but what about scenario one and three?

Rapid real growth must be based upon a sound and expanding pool of real savings allocated efficiently. Nowadays we have the exact opposite and all policies enacted so far are making things worse as they are designed to push the system back into the unsustainable configuration we had prior to 2008. But could the government get out of the way? Could they stop funding unsustainable economic activities? Of course they could, but it seems highly unlikely. If they were to do so it would cause a massive depression in the short term.

By cutting funding to these activities, re-allocation of capital into sustainable uses must take place, and this process is time consuming. And the more restrictions that are put in place, like minimum wage laws, zoning regulations, environmental considerations and the like, the longer the re-allocation will take. The very act of trying to do the right thing would create unfeasible short-term political pain for elected politicians. It would expose for all to see the unsustainable welfare state with dire consequences as already witnessed in southern Europe. Scenario one is thus implausible and will create too much short-term pain if ever tried.

This leaves us with scenario three as the most plausible scenario. Governments around the world will revert increasingly to the printing press in order to secure for itself an increasing share of a dwindling pool of real savings. This can only lead to one thing: continued debasement of currencies with prices of gold and silver expressed in said currencies rising to ever-new highs.

Today markets cannot decide which scenario to believe in, so investors bid up the price of stocks, bonds and commodities all alike. However, the winner at the other end of this economic- and hopefully political reset will be the one who identifies the correct scenario and has the courage to allocate accordingly.

If any of Mountain Vision readers detect a flaw in my reasoning I would surely appreciate it if you contact Mountain Vision and let me know. Getting this right is much more important than being right!

Author: Hans Fredrik Boe-Hanssen. He is a talented young economist and analyst and a regular Mountain Vision contributor with a deep appreciation and understanding of Austrian economics. He holds a MA from the Norwegian School of Economics (NHH, Bergen) and Warsaw School of Economics (SGH, Warsaw). He is currently working out of the US for a globally diversified oil company as an oil market analyst and economist.

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