Dr. Paul Kengor, FrontPage Magazine contributor and the executive director of The Center for Vision and Values, recently discussed the economic bust with Dr. Jeffrey M. Herbener, the chair of the department of economics at Grove City College and fellow for economic theory & policy with The Center.
Kengor: Dr. Herbener, please tell us how
credit expansion by the Fed distorts what things are really worth in an
The economy is a vast structure of the production of inter-related
capital and consumer goods. The viability of these different production
processes is determined by the pattern of spending or demands that
people have. If consumers demand, say, the Toyota Prius more heavily,
the increased sales will generate more revenue for Toyota. The
additional revenue provides the funds Toyota needs to buy more inputs
to increase production to satisfy the greater demand. Toyota’s
additional demand for, say, the batteries used in the Prius’ hybrid
engine, provide more revenue to Panasonic EV Energy Company. Then
Panasonic EV can use its greater revenue to buy more of its inputs, and
When the Fed stimulates monetary
inflation and credit expansion, the patterns of demand are shifted
toward capital and consumer goods that people borrow money to buy.
Consumers borrow more money to spend on houses and automobiles.
Entrepreneurs borrow more money to buy factories and equipment. This
additional spending makes not only housing, automobile, factory, and
equipment production more profitable, but the production of the inputs
used to produce these goods, like steel, lumber, cement, and the inputs
to produce them, and so on. The result of the new patterns of demands
is a lengthening of the entire structure of production.
Kengor: Applying this to the Prius example, what happens next, during the boom?
The expansion of credit not only increases consumer demand for the
Prius, but makes it feasible for Toyota to finance a new Prius factory.
There is now more demand for steel not only to build more cars but to
build more auto factories. Because demands are not falling in other
steel-using production, the steel producers will find it profitable not
to merely divert steel from other uses into autos and auto factories,
but to increase steel production overall. To do so, they must buy more
iron. For similar reasons, iron producers will increase iron
production. Resources are diverted into opening more iron mines,
building more mining equipment, and producing more steel mills and
equipment to produce steel. This buildup of the capital structure in
the economy lengthens out production processes. Before the capital
buildup, the time and resources used to produce more Priuses followed
this path: iron was mined, steel was produced, fenders were made, and
the Priuses were assembled in existing factories. During the capital
buildup, the time and resources used to produce additional Priuses
followed this path: iron was mined, steel was produced, steel girders
were made, a Prius factory was assembled, more iron was mined, more
steel was produced, steel fenders were made, and additional Priuses
were assembled in the new factory. The latter process takes longer and
employs more resources in building up capital capacity to produce
capital goods like iron and steel.
Kengor: This eventually leads to a bust, right? Because the boom can't be sustained?
The reason that these lengthened-out production processes cannot be
profitability sustained is that they are inconsistent with the
preferences people have to save and invest. To illustrate, suppose
people desire to save and invest 10 percent of their incomes. If they
produce $15 trillion in income a year, then they will save and invest
$1.5 trillion. This saving and investing funds the process of capital
accumulation. Now suppose the Fed increases bank reserves to the extent
that banks create an additional $1 trillion in loans and un-backed
checkable deposits. Instead of $1.5 trillion in funding capital
accumulation, which is the amount people prefer at 10 percent of their
incomes, there is $2.5 trillion, or almost 17 percent of income. But
people do not want such a large portion of resources to go to opening
more mines, building more factories, and so on. They want a smaller
portion going into longer processes of capital accumulation and a
larger portion going into shorter production process to make consumer
Kengor: How do people react to this distortion done by the Fed?
People adjust to the Fed induced distortion in the following way: The
additional lending made possible by bank-credit creation is the source
of more spending later on, and thus, more production in lengthening the
capital structure. The new money is earned as income by the producers
of goods in expanding lines of production: steel workers, shareholders
of mining companies, and so on. These producers, then, save and invest
their new income in the preferred ratio of 10 percent. Each time the
new money is spent to buy another input in the production process, the
producers of that input earn more income and save and invest as they
prefer. At the end of the process, income increases to, say, $17.5
trillion, of which $1.75 trillion, or 10 percent, is saved and
invested. Although the Fed can produce additional money through the
credit markets (and, thereby, artificially increase the supply of
credit), people disburse the additional income it generates according
to their preferences. As a result, entrepreneurs find it profitable to
restore the capital structure people prefer.
Kengor: How do we get out of the current mess?
The market economy, unhampered by government intervention, efficiently
arranges production to satisfy people’s preferences. Entrepreneurs can
make efficient production decisions because they are guided and
constrained by profit and loss. They can estimate the effect each
production decision has on their profit and they earn profit if their
decisions are successful and suffer loss if they are unsuccessful. If
Toyota and Honda correctly anticipate that consumer demand will be
shifting away from gas-guzzling SUVs and toward gas-sipping hybrids,
then their decisions to produce more Priuses and Insights will earn
profit. If instead consumers buy more crossovers, then Toyota and Honda
will suffer losses from producing more hybrids. Since entrepreneurs’
income rises and falls as they earn profits and suffer losses, they
seek the former and avoid the latter. There is no other method to make
production conform to people’s preferences. The abject failure of
socialism in the 20th century amply demonstrated that government
officials have neither the framework nor the incentive to make
efficient production decisions.
Kengor: The key is to let entrepreneurs make the decisions, not government?
Because entrepreneurial decision-making is the only way to efficiently
arrange production, it is all the more important to give it free reign
when government policy has, as currently, created dire circumstances.
It is unfortunate that Fed monetary inflation and credit expansion of
the last several years distorted prices and resulted in malinvested
capital, but the problem now is to decide what to do with the existing
capital capacity in the economy to best satisfy people’s demands.
Entrepreneurs need to be free to buy and sell assets and recombine and
reallocate them in efficient ways. The government needs to eliminate
regulations that impede the adjustment process and impose financial
burdens on producers.
It would also aid the recovery
if the government slashed taxes and spending. Permanently eliminating
the capital gains tax, for example, would immediately restore some of
the equity lost during the stock market crash that began in the fall of
2007. Permanently slashing the income tax would permit people to
increase both their consumption spending and their saving and
investing, providing more profitable opportunities for entrepreneurial
Since monetary inflation and
credit expansion distort prices and profitability, the Fed should
immediately cease all attempts to re-inflate. Halting monetary
inflation would also pave the way for the elimination of the Fed and
the establishment of a genuine gold standard or some other market
monetary system. Doing so is necessary to purge the economy of the
boom-bust cycle altogether.
Is the bailout good policy? I suppose we should specify which bailout!
Let's go with the bank bailout, setting aside the Big Three for now.
Any policy that blocks or inhibits entrepreneurs from reallocating
resources is counterproductive to recovery. Bailouts serve to freeze in
place or inhibit the liquidation of the malinvestments made during the
boom. They either leave decision-making in the hands of entrepreneurs
who malinvested capital during the boom or turn it over to government
officials. Neither is conducive to recovery.
Kengor: Tell us about re-inflation.
Another favorite policy of the state during a financial crisis is
re-inflation. The Fed attempts to force asset prices back up to restore
the profitability of boom activities with another round of monetary
inflation. This policy fails because conditions for banks have
radically changed. During the boom, banks are eager to create new
credit by issuing more un-backed checkable deposits. Any increase in
reserves from Fed monetary inflation expands credit and the resulting
additional spending on assets pushes their prices up. But when the
crisis hits, borrowers realize that they have taken on too much debt
during the boom. Homeowners are upside down on their mortgages. Equity
in businesses evaporates and even turns negative. Borrowers,
understandably, pull in their horns and their demand to borrow dries
up. Having lent more and more money on assets during the boom when
their prices were soaring, banks, too, find their equity drying up and
turning negative when asset prices collapse during the financial
crisis. Their willingness to lend into these ventures, understandably,
diminishes. Instead, they seek to rebuild their asset portfolios by
acquiring safe and liquid assets. Although the Fed has generated around
$600 billion of additional reserves for banks in the last few months,
it has not regenerated credit expansion. Instead, banks are,
understandably, holding them as “excess” reserves.
Kengor: Dr. Herbener, as always thank you for your time.