Monday, June 28, 2010

The Role of Squirrels In the Economy

And why low central bank interest rates and “stimulus” programs are destructive to both savings and real economic growth.

Saving occurs when an individual or corporation does not consume a portion of the wealth they have created, but instead, sets it aside or stores it for future use. People or organizations do this for a number of reasons. First, it protects them from temporary disruptions in their future income flow, like the squirrel who saves nuts for the winter. Second, it allows them to take advantage of opportunities that may arise in the future, such as a drop in price of a certain asset they desire or the emergence of a new industry, which they can then acquire because they have wealth in reserve. But thirdly, and most importantly as it pertains to macro-economics, saving is the only means by which there can be large scale capital investment and increased productivity in the economy.

Only by saving can the amount of funds available to business be sufficient for large-scale capital investments, research, and other improvements (note: in the short term, artificial central bank credit can take the place of savings as the source of funding for growth, but this is neither sustainable nor wise as I will explain). Installation of a new “state of the art” robotic automotive assembly line, for example, cannot generally be paid for out of current income streams - especially in a competitive industry where profit margins can be quite small. The money must either come from the companies cash savings, the issue of corporate stocks or bonds (which are purchased with individual or institutional savings), or most likely in the form of a loan from a financial institution (which its lends from it’s depositor’s savings).

For an even simpler example, imagine a primitive society that is living “hand to mouth” in the forest. In order to advance to the next economic stage - an agricultural society - they must first save enough food to tide them over while they are clearing land, tilling the fields, and waiting for the first harvest. They must create excess food and forgo consuming it, so that they can then be sustained by it while they make capital improvements on the land and create capital goods like hoes, plows, etc and new structures like granaries, grain mills, etc. This is because the more advanced economy requires a greater delay between initial investment and first returns.

The same holds true for advancing from an agricultural society to an industrial society - enough savings must be created in order to finance the building of factories, the research into manufacturing technique, the opening of mines and other raw materials sources, and the hiring and training of many workers. All these steps must somehow be financed prior to the factory making a profit; there must be an existing pool of savings to use up or borrow from in order to get the factory off the ground.

The same principle applies in today’s economy. There is often a gap of many years between the initial research into a new field of technology and that technology’s mass production for general use in society. How is this paid for in the interim between conception and sale to the public? It must be paid for by loans from savings and investment from savings. The necessity of savings in order for future growth to take place is universal. Wealth must be stored instead of consumed immediately or society never advances beyond the hunter-gatherer stage. It is not just necessary in the production process, but generally to the running of any business that may require loans for capital goods, from restaurants to barbers to colleges to law firms - almost all businesses need credit in order to improve or expand. When there is no savings, there is no credit. Without savings, banks have no money to lend …. unless …

Some politicians and central bankers think they have found a way around this economic rule by printing money and simply giving it to the banks, or by loaning it to the banks at very low rates of interest. This accomplishes six things, all of them negative.

1. Artificial money creation devalues the other existing units of currency due to the principle of supply and demand - more currency is printed, but the same amount of goods still exist in the real world. Therefore, there are more currency units vying for the same number of real assets, which drives the prices higher, thus robbing everyone who is a saver of those currency units. This discourages savings because people would rather spend the money now than save it as it loses its value over time.

2. Low central bank rates distort the rate of return paid on savings accounts, certificates of deposit, corporate bonds, and other common savings instruments to the downside. This occurs because banks do not want to pay a depositor 5% interest, for example, when they can get the same amount of money lent out from the central bank at 1%. Then, this lower rate trickles into all other interest bearing instruments because the rate of return on demand deposit savings has been reduced, thus making other forms of savings more appealing, even at reduced rates. With more people and dollars bidding on anything with a decent interest rate, the rates fall. This is partly the explanation for why 10-year US Treasury rates are so low right now despite the massive increase in money supply, which, one might think, would cause investors to demand a higher rate in order to compensate for inflation. In this environment, the saver is hit with a two-pronged attack of simultaneously higher price inflation and lower interest rates on savings. Even if interest rates stay the same, the real rate of return diminishes due to inflation. This is a recipe to reduce saving to net zero or even a negative rate, which occurred in the United States.

3. A vicious cycle develops, because as fewer people save, more artificial credit must be created by the central bank in order to keep the party going. This can be clearly seen by looking at a graph of Federal Reserve interest rates in recent years. And because artificial credit creation acts as a stimulant (at least for awhile), a boom cycle often takes place and financial “bubbles” are formed. This happens because there is more business expansion (due to easy credit) and higher asset valuations (due to inflation and perceived future value based on false growth assumptions) than there is real savings to justify. 4. When interest rates are too low, it is easier to borrow. Therefore, with the combination of low rates and perceived economic boom, more long-term investments are made than are actually prudent. For example, more houses are built and sold because it costs less to borrow the money and people assume that they will go up in value as the economy “expands”. Now where have we seen that before?

5. Because of the problems #1 and #2, anyone who wants to stay ahead of inflation and find a truly high-yield investment must increase their risk in order to achieve this. People are more willing to accept higher-risk investments (such as sub-prime mortgage-backed securities) because it the only way they can stay ahead of inflation and because the perceived economic growth gives them undeserved confidence in their risk-taking. When money flows into poor investments instead of sound ones, as well as when asset values are artificially high, it causes serious economic imbalances that can only be sorted out by a recession or creative destruction in the market place.

6. Because recessions and depressions are highly unpopular, politicians and central bankers do everything they can to avoid them. Specifically, they create yet more artificial stimulus and credit, which only makes the underlying problems of inflation, low savings rates, bubbles, imprudent loans and debt loads, and high-risk malinvestment worse. They put off the pain as long as possible instead of dealing with the problem, like a wounded soldier who, instead of going through the painful task of stitching up his wound, opts to simply keep taking morphine until he bleeds to death.

On an individual basis, the only way to protect yourself from these disastrous effects is to become a silver (or golden) squirrel. While all the other animals are eating birdseed and breadcrumbs from the Fed and assuming the Fed will be scattering them out forever, you can be burying nutrition-dense walnuts and acorns for the winter. In the Spring, you will be fat and healthy, and the other animals who ate out of the Fed’s hand will have starved.

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