Don’t Believe in the Stimulus of Economists

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Deloitte Access Economics is forecasting Australian economic growth below 3% for 2-3 years. That would be disappointing. An ‘investment strike‘ in the business sector is reducing expected performance everywhere except the gas sector. And business investment is what drives jobs.

David Uren started his related article in The Australian with ‘Business is investing less than ever before, apart from the resource sector…‘ He went on to explain the old mining cliff story. If mining slows, there’s not much else looking busy in the Australian economy.

And mining is looking fragile. Resource stock investment guru Rick Rule is in Australia, and he announced that most of the 800 ASX listed mining stocks are worthless. That’s a lot of investment projects which will break down.

Access Economics’ conclusion from all this is the same one that every economist always reaches: The government must do something.

It sort of makes sense though. The government does have to provide some things, after all. Economists’ favourite so called ‘public goods’ are lighthouses. Government might as well build those when the economy is running out of puff to create jobs so that the business cycle remains soft, right?

Wrong on all counts.

Economists have always used lighthouses to explain why the private sector can’t solve all problems in an economy. Nobody in the private sector would build lighthouses because there’s no profit motive. And so ships would end up torn to pieces on rocks if the government didn’t save the day by building them.

One day early last century an enterprising young economist decided to fact check that story. It turns out that a high proportion of lighthouses in Britain at the time were privately funded, built and operated. No government needed.

The free market overcame all the problems which economists pointed out it couldn’t overcome. That’s because the free market is about a lot more than the obvious incentives which economists take into account. For example, imagine a fishing village with 10 fishermen. Nine pay the lighthouse fee while the tenth ‘free rides’, which is an economic term, believe it or not.

What do you think will happen to the fisherman who isn’t paying his lighthouse fees? Keep in mind that fishermen tend to be a rough bunch.

Economists might lack the required imagination to understand the economy, but they should at least double check to see if their theories match reality. The economist who did the fact checking on the economic history of lighthouses, Ronald Coase, got a Nobel Prize for related insights decades later. His research paper on lighthouses remains a brilliant read. But the economics profession continued on with the same story regardless. It simply ignored history and went on with disproven theories and methods.

The same goes for other government projects, including those recently touted as economic stimulus like roads and bridges. Everyone agrees the government must supply these public goods, because the private sector wouldn’t. That’s despite the fact that the private sector can do a much better job, and has in the past for both of them.

The point is that the free market solves problems in much more nuanced and clever ways than economists could ever understand. And it operates in ways economists don’t understand. So don’t believe their stimulus stories.

Anyway, you can expect some infrastructure spending to come down the political pipeline here in Australia to make up for the dissipating mining boom. Not that this will sway Dan Denning’s call for a recession

We prefer the economic policies used by the Chinese government when it comes to stimulus spending. The Chinese have taken to painting windows onto their ghost cities’ endless empty high-rise buildings, according to photos that are circling the economic blogosphere.

We’re not sure why they’re doing it. Maybe this is a whole new twist on the ‘broken window fallacy’. French economist Bastiat first pointed it out. The short version is that breaking a window does not create economic growth. The glazier may get more income as a result, but you have to take into account the ‘unseen’ effects as well. The window owner would’ve spent the money elsewhere, so you don’t end up with any additional economic activity.

All that sounds obvious, but economists forget about the broken window fallacy all the time. War ending the Great Depression, natural disasters stimulating the economy and stimulus spending are all examples of the broken window fallacy at work in the mainstream economics.

You can’t break fake windows, so maybe painting them onto buildings built for economic stimulus is a symbolic gesture from China. They’ve solved the broken window fallacy. Unlike the money shuffling stimulus policies of the West, Chinese stimulated economic growth is real.

But the Chinese may also be coming up with some decent policies at their latest ‘plenum’, an event where key members of the Communist Party meet. Bloomberg reports that the Chinese Premier Li Kegiang will announce plans to cut government involvement in the economy and update financial and tax systems among other things.

Promising reforms is one thing governments do well. Implementing them not so much. The Chinese have a problem on their hands in that government involvement has directed economic growth and investment into areas it shouldn’t have been. Like empty buildings with painted on windows. An even funnier example considering Chairman Mao’s old steel policies, is an overinvestment in steel production. Mao wanted 600,000 backyard steel furnaces as part of his Great Leap Forward economic policies. Today, China suffers from chronic overcapacity in steel production after subsiding the industry. Some people never learn.

Not that government spending in China or investment in Australia matter to the price of your investments. Pfft, those days are long gone. Michael Cembalest from J.P. Morgan came up with this interesting factoid recently, published in Forbes Magazine:

More than 100% of equity market gains [in the US] since January 2009 have taken place during the weeks the Fed purchased Treasury bonds and mortgages.

And conversely, during the weeks when the Fed did NOT buy Treasuries or mortgage backed bonds, the stock market declined. 

In other words, monetary policy is the sole driver of the stock market. For now.

Instead of being grateful for this incredible achievement by the Fed, Wall Street is having a whinge. Larry Fink of Black Rock and Bill Gross of Pimco run some of the biggest funds in the world ($6.1 trillion between them). They are both urging for the Fed to reduce its stimulus.

Their reasoning is that the stimulus is supporting asset prices, but not stimulating the real economy. Monetary stimulus was supposed to be the spark that started the engine of the economy, not its ongoing fuel. That’s because money is ‘neutral’ in the long run. Instead of creating economic activity, prices just rise as more money is pumped in.

When fund managers stop caring about fund performance and start caring about the real world, it’s time to take note. Vern Gowdie reckons the moment economic reality catches up with financial markets is the moment all hell breaks loose.

Only hyper-inflation scarred central bankers are wise enough to take note of these warnings. A key decision maker at European Central Bank Europe, Austrian Ewald Nowotny, mentioned in an interview that the ECB was unlikely to lower its interest rate any time soon. Which is a surprise, because Europe is slipping towards deflation.

This chart shows how M3, a measure of money supply, and bank lending have been in a downtrend since 2012. Last month’s M3 figure came in at half the ECB’s preferred growth figure.

chart showing M3 money supply versus bank lending
click to enlarge

The return of deflation could cause another economic crisis in Europe. Cue a political scandal to distract everyone from economics: Europe is grumpy about the American intelligence agency NSA tapping their phones.

Regards,

Nick Hubble+
for The Daily Reckoning Australia

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Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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2 Comments on "Don’t Believe in the Stimulus of Economists"

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knedo
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On Malawi’s great lake many hundreds of fishermen set out each day, on surprisingly sound though somewhat primitive dug-out canoes to net & hand line their daily haul. As twilight extends the full day, and is a good time to take catches of the fish that feed at twilight, fishermen only make their way back to their villages after dark. There are no lighthouses to locate these villages, but to do so each village will sound drums, the deep & slow beat resonates many long miles across the lake, and the fishermen, each attuned to the rhythm of his own… Read more »
Jeremy
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“More than 100% of equity market gains”? This is not physically possible, you need to check the provenance and quality of your sources before you cherry pick them to support your arguments. And if an institution like J.P. Morgan comes out with this kind of thing, perhaps it is time we started to question every assumption we hold dear about the financial industry. And whilst we are at it, about those fishermen, That 10th fisherman might get his comeuppance, but what about the international shipping company based in another financial and legal jurisdiction that benefits from the lighthouse, what are… Read more »
wpDiscuz
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