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A Brief Economics Primer

There's no such thing as free money

By John P. Hussman, Ph.D.

Table of Contents

  Where do profits come from?
  Does economic growth cause inflation?
  What are the best indicators of an oncoming recession?
  How does monetary policy work?
  Are monetary policy and fiscal policy independent?
  Is there a tradeoff between inflation and unemployment?

Where Do Profits Come From?

The fundamental law of economics is that profits always go to those resources which are both scarce and useful. The value of those things which are scarce and in demand will tend to rise, relative to the value of those things which are abundant and less desired. Whenever we say "the price of X is high", or "the expected return on X is high", it is another way of saying that X is currently both scarce and useful. A profit opportunity is essentially a signal to bring those goods into production. These profit opportunities contain the seeds of their own destruction. As more of the desired good is brought into production, the profit opportunities vanish, along with the underlying scarcity. In this way, the systematic emergence and elimination of profit opportunities is what drives long run growth in living standards. So the best response to profits is generally to reduce "barriers to entry" and allow individuals to compete in exploiting these opportunities. If government instead attempts to eliminate profits by taxing them away, it does nothing to eliminate the underlying scarcity. In every country where profits are hated, you will see people standing in line for a loaf of bread.

Profits are always earned by providing those things which are scarce and useful to others. In financial markets, this means making trades which provide others in the market with scarce, useful services such as risk bearing, information and liquidity. One way to read what is "scarce" in the market is by looking at the level of yield on a security (adjusted for risk and growth). This is what we call "Conditional Excess Yield". An excess yield is a signal that the willingness to bear risk in a given security is scarce, useful, and likely to be compensated. In this sense, profits in the stock market, like anywhere else, reflect service to others.

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Does economic growth cause inflation?

The popular view of inflation is "too much money chasing too few goods." That is, inflation is fundamentally viewed as a problem of either too much money, or too few goods. A greater supply of goods tends to reduce inflation. A greater demand for goods, when supply is not forthcoming, tends to raise inflation. In other words, inflation tends to occur when the economy is not growing fast enough to meet demand.

A more precise way to say this is that we get inflation when the demand for the existing supply of money is too low, or the demand for the existing supply of goods is too high. But this is not strictly a problem of money per se. My own view is that inflation is primarily the result of growth in unproductive forms of government spending (basically entitlements, defense, and other expenditures that fail to stimulate the supply of goods and services). The evidence from both the U.S. and other countries clearly demonstrates this relationship. As Milton Friedman has noted, the burden of government is not measured by how much it taxes, but by how much it spends.

The impact is particularly severe when growth in entitlements and defense spending is high and growth in productivity is low. This is why inflation exploded after the late 1960's, and why it came down after the early 1980's. This is why the Germans suffered hyperinflation after World War I when its government decided to keep paying workers who had gone on strike.

Always and everywhere, rapid inflation is produced by excessive creation of government liabilities without a corresponding increase in the amount of goods produced by the economy. Congress determines this much more than the Federal Reserve does. The form of government liabilities does not matter as much as the quantity. If the Germans had decided to issue bonds to striking workers instead of money, bond prices would have been driven to ridiculously low levels, driving interest rates to extremely high levels, creating an unwillingness to hold currency (which does not bear interest), resulting in a rapid deterioration in the value of money, and hyperinflation just the same.

Economists use the term "marginal utility" to describe the additional happiness that an individual obtains from one extra unit of a given item. Here's the standard example: if you're very hungry, the marginal utility for one ice cream cone is very high. But once you've eaten ten ice cream cones, the marginal utility of another cone is fairly low. Marginal utility increases when a) individuals begin to prefer more of a given item, or b) a preferred item becomes more scarce.  If an extra ice cream cone has a marginal utility of 6, and an extra pencil has a marginal utility of 3, you'll be willing to trade 2 pencils for one ice cream cone. How much X will you pay to get one unit of Y? Simple. The marginal utility of Y divided by the marginal utility of X. If we choose X to be money and Y to be goods, we therefore have a simple economic statement: The Consumer Price Index basically measures the marginal utility of consumer goods divided by the marginal utility of money: P = MUgoods / MUmoney.  Given this, there are exactly four causes for inflation:

1) Supply of money increases without a matching increase in money demand (money growth: MUmoney falls)

2) Demand for money decreases without a matching decline in money supply (rising "velocity": MUmoney falls)

3) Demand for goods increases without a matching increase in goods supply (constrained demand: MUgoods rises)

4) Supply of goods decreases without a matching reduction in goods demand (restricted supply: MUgoods rises)

In short, we get inflation when:

  1. The supply of government liabilities rises faster than the demand. This typically occurs when the growth of government spending rises more rapidly than the growth of the economy - particularly when government spending is in the form of entitlements or defense outlays. These types of spending, though often justifiable on social or military grounds, do not generally stimulate the supply side of the economy to make goods and services more available to the public. In general, growth in entitlements and military spending are accompanied by rapid growth in government liabilities, particularly government debt or currency.
  2. The demand for goods grows faster than the supply. This typically occurs during the late stages of an economic cycle, when the ability of the economy to produce more output becomes constrained, but demand continues to grow. It is generally this situation which prompts a Federal Reserve tightening.

Historically, periods of rapid economic growth are related to lower, not higher rates of inflation. Rapid inflation is typically the result of money growth (and government spending more generally) which is faster than output growth. In contrast, we have typically observed deflation when the supply of money has grown slower than output, or when banking panics have increased the demand for currency and bank reserves. The claim that rapid growth causes inflation is simply false. A correct statement would be that inflation occurs when demand grows more rapidly than the economy can satisfy that demand with new supply. In other words, if the economy is already operating at full steam and demand keeps growing, there is no way for the new demand to be satisfied, so prices tend to rise instead. But what this really means is that inflation accelerates when the economy is not growing fast enough (relative to growth in the supply of government liabilities).

Clearly, the risk of inflation increases when the economy is close to its capacity constraints, particularly if demand is growing rapidly. As a result, the Federal Reserve keeps a close eye on the rate of unemployment, wage pressures, factory use and inventories, as well as indicators of demand growth such as the Purchasing Managers Index and new orders for durable goods. The Federal Reserve tends to tighten monetary policy when demand growth threatens to outstrip the ability of the economy to produce new supply. The purpose of a Federal Reserve tightening is therefore not to cause slower economic growth, but rather to anticipate slower economic growth (by bringing demand growth to a similar rate). Inflation is best kept in check when the growth rate of money is kept in line with growth in the economy's ability to produce output.

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What are the best indicators of an oncoming recession?

The most reliable indicators of an oncoming recession are not the widely followed data on retail sales, factory output, and employment. Rather, the best early warning signals come from "forward-looking" indicators given by financial markets and key surveys of business and consumer confidence. The financial markets and confidence surveys offer an enormous amount of early information that only becomes apparent months later in the more widely followed economic reports.

Surprisingly, the consensus among economists has been consistently optimistic at the beginning of every major U.S recession in the past. The problem is that most of the widely followed data lag the beginning of a recession, with the unemployment rate being the last to turn unfavorable. In addition, the best information is found in the "spread" or difference between financial indicators and confidence surveys, rather than in the individual economic reports. Unless one carefully analyzes these spreads, the signs of an oncoming recession are rarely obvious.

Financial markets are not perfect in their ability to convey information, but are an extremely useful way of summarizing the information available to market participants. In terms of statistical accuracy, no other approach comes close. When several key indicators turn unfavorable at once, the resulting signal is particularly important.Historically, the following combination has occurred immediately before or during each of the past 5 recessions in the U.S. economy:

1) The "credit spread" between corporate securities and default-free Treasury securities becomes wider than it was 6 months earlier. This spread is measured by the difference between 10-year corporate bond yields and 10-year U.S. Treasury bond yields (or alternatively, by 6-month commercial paper minus 6- month U.S. Treasury bill yields). This spread is primarily an indication of market perceptions regarding earnings risk and default risk, which generally rises during recessions.

2) The "maturity spread" between long-term and short-term interest rates falls to less than 2.5%, as measured by the difference between the 10-year Treasury bond yield and the 3-month Treasury bill yield. A narrow difference between these interest rates indicates that the financial markets expect slower economic growth ahead. If the other indicators are unfavorable, anything less than a very wide maturity spread indicates serious trouble, regardless of unemployment, inflation, or other data.

3) The stock market falls below where it was 6 months earlier, as measured by the S&P 500 Index. Stock prices are another important indicator of market perceptions toward credit risk and earnings expectations. While the economy does not always slow after a market decline, major economic downturns have tended to follow on the heels of a market drop. Stock markets tend to reach their highs when the economy "cannot get any better" -- unemployment is low and factories are operating at full capacity. The problem is that when things cannot get any better, they may be about to get worse.

4) The National Association of Purchasing Managers Index declines below 50, indicating a contraction in manufacturing activity. This index is strongly related to GDP growth, and when combined with the previous three indicators, has signalled every recession in the past 40 years.

[Note: See the November 12, 2007 Market Comment Expecting A Recession for slightly modified criteria that improve the timeliness of the signal]

The following are some additional early warning indicators of an oncoming recession.
  A flat or "inverted" yield curve in which long term interest rates are not significantly higher than short term rates. An inverted yield curve is a particularly negative signal, in which long term interest rates are actually below short term rates. This situation is generally the result of either high inflation or very tight monetary policy.

  A sudden widening in the "consumer confidence spread". Deterioration in consumer confidence often signals an oncoming economic downturn. A drop in consumer confidence by more than 20 points below its 12-month average has generally accompanied the beginning of recessions. A useful leading indicator is the "consumer confidence spread", measured as the difference between the "Future Expectations" index and the "Present Situation" index released by the Conference Board. A plunge in this spread, with "Future Expectations" falling more sharply than "Present Situation", is a classic signal that has usually foreshadowed recessions by less than 6 months.

  A sharp slowing in the annual growth in consumer installment debt. In the late stage of an economic expansion, demand growth often rises faster than the ability of the economy to produce new output. Frequently, this demand growth is fueled by credit card borrowing and other installment debt. A sharp slowing in the growth of consumer debt is an important indicator that demand growth is beginning to turn down.

  Low or negative real interest rates measured by the difference between the 3 month Treasury bill rate and the rate of inflation. Just as a nominal interest rate measures the number of dollars which will be paid tomorrow in return for lending one dollar today, the real interest rate measures the number of goods which will be paid tomorrow in return for lending one good today. A high real interest rate is a signal that goods are scarce today, and are expected to be plentiful tomorrow. This suggests market expectations for future growth. A low or negative real interest rate is a essentially a signal that the market believes that goods are more plentiful today than they will be tomorrow, which is another way of saying the market expects a recession.

  Falling factory capacity utilization. A decline in capacity utilization from above 80 to below that level has generally accompanied the beginning of recessions.

  Slowing growth in employment and hours worked. The unemployment rate itself rarely turns sharply higher until well into recessions (and rarely turns down until well into economic recoveries). So while the unemployment rate is an indicator of economic health, it is not useful to wait for major increases in unemployment as the primary indicator of oncoming economic changes. As for employment-related data, slowing growth in employment and hours worked tend to accompany the beginning of recessions. Specifically, when non-farm payrolls have grown by less than 1% over a 12 month period, or less than 0.5% over a 6 month period, the economy has always been at the start of a recession. Similarly, the beginning of a recession is generally marked by a quarterly decline in aggregate hours worked.

While many economists believe that the best response to a recession is to pursue interest rate cuts, tax cuts or new government spending, this approach is too simplistic. It treats the economy as if it produces a single good, on demand, and the only problem is to stimulate that demand. I suggest that recessions are essentially periods when the mix of goods supplied by producers has become too different from the mix of goods demanded by consumers. Except during the deepest recessions, blindly stimulating demand is not a useful way to remedy these imbalances.

Recession is a natural, even useful process. The economy requires a whole range of adjustments in prices, production and worker skills. Those adjustments can be costly, time consuming, and painful, but the lesson from other countries is that if you try to avoid the adjustments, you end up avoiding long term growth. The best policy response for the Federal Reserve is to ease only enough to keep the banks liquid, and to reassure the markets during any short term panics. The goal is to make sure that even in a recession, there is never a panic that prevents good, potentially successful business ventures from obtaining the capital they need to operate. As for Congress, quite frankly, the best policy response to a recession is to get out of the way.

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How does monetary policy work?

In the United States, money is created when the U.S. government issues debt (Treasury securities) to finance its spending, and the Federal Reserve buys this government debt rather than the public having to hold the debt. The Federal Reserve "pays" for these bonds literally by creating money, in the form of currency and bank reserves. The decision of how much government debt the Fed should buy is decided by the Federal Reserve Open Market Committee or FOMC.

Easy Money: When the Federal Reserve decides to buy Treasury securities, it executes an open market purchase, generally buying these securities from U.S. banks. The Fed pays for these securities by crediting the reserve accounts of these banks. The banks, now having more reserves, can make new loans to the public. In short, an open market purchase makes bank reserves more abundant. The short run effect is to reduce the "price" of bank reserves (the Federal Funds rate, which is the interest rate at which banks borrow and lend reserves between themselves). This is really what it means when the Federal Reserve "lowers interest rates".

Tight Money: When the Federal Reserve decides not to accumulate Treasury bonds as quickly, the result is a slowing of the growth in bank reserves, and generally an increase in the Federal Funds rate and short term lending rates. This is what it means when the Fed "raises interest rates".

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Are monetary policy and fiscal policy independent?

There is a simple way to think about the relationship between fiscal policy (government spending, taxes) and monetary policy (money supply, interest rates). It is what economists call the Government Budget Constraint

Government Spending = Tax Revenues + Change in Bonds held by Public + Change in Bonds held by Federal Reserve

What this says is that there are literally only 3 ways to finance government spending.

  1. Increase tax revenues. Note that this is not necessarily accomplished best by raising tax rates. Regardless of how high the government has set top tax rates, government revenues have consistently hovered between 19% and 19.5% of GDP. The high deficits of the recent past are due to growth in the government share of GDP from about 19% in the 1960's to nearly 23% currently. This growth has been due primarily to an increase in Social Services expenditures such as Medicaid and Social Security. The share of GDP allocated to infrastructure (highways, telecommunications) as well as basic research has actually declined.

  2. Sell bonds to the public. This borrowing from the public is the primary means of financing the government deficit. Other things being equal, if the government issues more bonds, the price of those bonds tends to decline, meaning that interest rates tend to rise. This does not mean that a government deficit raises interest rates (there is no statistical evidence to support this notion). The true burden of government is not how much it borrows, but how much it spends. If the government decides to raise taxes rather than borrow from the bond market, it is true that investors will need to buy fewer bonds, but only because they also will have less to invest (due to the higher taxes, which almost always fall on those individuals with the highest savings rate). Raising taxes to cut the deficit therefore does nothing to increase the supply of funds available to other borrowers, and therefore nothing to reduce the level of interest rates. A cut in government spending does increase the supply of funds available to private borrowers. This is particularly true if the tax and regulatory environment is friendly to investment, which can then offset the cut in government spending without a decline in GDP.

  3. Sell bonds to the Federal Reserve. This is another way of saying print money.

In short, the Federal Reserve is not nearly as independent as it may appear. The Fed has the choice of whether government liabilities take the form of bonds held by the public, or money held by the public. The Federal Reserve can alter the mix of government liabilities (bonds held by the public vs. money held by the public), but the total amount of these liabilities is determined by fiscal policy, not monetary policy. The Fed can affect whether excessive government spending results in tight bank credit or high inflation, but it cannot prevent both unless Congress controls the growth of government spending itself.

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Is there a tradeoff between inflation and unemployment?

The belief in a tradeoff between inflation and unemployment is both widely held and completely false. On a statistical basis, the relationship between inflation and unemployment is actually slightly positive; higher inflation is weakly correlated with higher unemployment. The relationship is highly significant if we lag unemployment by two years. High inflation today is strongly related to high unemployment two years later. In contrast, there is no statistically significant evidence that low unemployment today is followed by high subsequent inflation. There is also no evidence that excessive, inflationary credit creation can be used to create jobs.

The widespread view to the contrary is based on a 1958 Economica paper by A.W. Phillips, which presented what has come to be known as the "Phillips Curve". Phillips studied the relationship between unemployment and wage inflation in Britain using a century of data through the 1950's. What he found has a very straightforward interpretation: when labor is scarce, the price of labor tends to rise. This is a basic fact of economics, and was indeed supported by the data presented by Phillips. Moreover, the data Phillips used was largely during a period when Britain was under the gold standard, and overall price inflation was subdued.

I've long asserted that the only accurate interpretation of the Phillips Curve (which still holds true in the data) is that low unemployment is associated with inflation in real wages. Quite simply, when workers become scarce, the price of labor tends to rise faster than the overall price level.

Unfortunately, over the past several decades, the idea of the Phillips Curve has been twisted beyond recognition. Some economists and the public have quite incorrectly come to believe that the Phillips Curve is a relationship between unemployment and overall prices. Moreover, it is often argued that higher inflation can be pursued as a way to create jobs. This is a fascinating distortion of the facts. The true Phillips Curve says that low unemployment tends to lead to inflation in real wages. The notion that higher overall inflation can buy jobs not only drops the words "real wages", but reverses the direction of cause and effect.

In short, when workers become scarce, the price of labor tends to rise, relative to the price of other things. There is nothing controversial in this. However, the belief that overall inflation can buy jobs is simply false. The belief that low unemployment causes general prices to rise is also false. Even if wages rise, there need not be general price inflation. As long as labor productivity (output per worker) is growing, workers can be paid higher wages without having to raise output prices. In addition, wage increases can be accommodated by reducing profit margins, rather than by raising prices, particularly when profit margins are high.The only way for wages (measured in dollars) and overall prices (also measured in dollars) to "spiral" higher together is for the government to create too many dollars.

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Copyright 2001 John P. Hussman, Ph.D.


The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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