Is monetary theory dead?

When the world economy plunged from ‘unprecedented prosperity’ into unfathomable crisis in 2008, most economists had conceded that it was not just an economic crisis, but one of economics itself.

Great economists, whose theories the world followed blindly, could not explain why they could not detect or prevent the crisis, nor suggest how to get out of it. They shied away from their (almost superstitious) faith that the market knew everything, and urged the State to intervene and to book trillions of dollars of losses to public account to save the spoilt brat — the financial market.

The result, the financial market, already flooded with semi-phony monies self-generated by banks and shadow banks, was invaded by a tsunami of real phony monies digitised by the central banks. The phony $5 trillion already pumped in, with $1.5 trillion in the pipeline, keeps the show going. And yet the economic thought leaders have declared real economic recovery.

As a consequence, the philosophy and discipline of monetary economics are being turned upside down. And, what was admitted in 2008 as the cause of the crisis is now touted as the way to prosperity. Here is an illustration of how phony money is perceived as the future driver of global economy.

Global Capital Pyramid

Some six months ago, Bain & Company, the leading global business consulting firm, came out with a report titled A World Awash In Money (November 14, 2012), which studied the relation between financial economy and real economy in the last two decades. As for its credentials, Bain, ranked first among global consulting firms, claims that its clients have outperformed the market by four times.

Bain’s report ‘discovers’ that the rate of growth of world output of goods and services has seen an extended slowdown over recent decades, and yet the volume of global financial assets has expanded rapidly. Bain adds that the relationship between financial economy and underlying real economy has reached “a decisive turning point”.

The report said that by 2010, global capital had swollen to some $600 trillion, tripling over the past two decades, against which the real economy stood at $210 trillion — almost one-third of the financial economy. And today, the total financial assets of $600 trillion (with largely matching financial debts) are nearly 10 times the value of the global output of all goods and services (the global GDP) of $63 trillion. Bain concludes that for the balance of the decade 2010-20, markets will be awash with monies — read phony monies.

It says that the fundamental forces that inflated the global financial balance sheet since the 1980s, that is, financial innovation, high-speed computing and reliance on leverage, are still active. The total global capital, Bain report says, will expand from $600 trillion, by half again, to $900 trillion by 2020 (at 2010 prices and exchange rates).

More than any other factor on the horizon, Bain says, the self-generating momentum for capital (read ‘phony capital’) to expand — and the sheer size the financial sector has attained — will influence the shape and tempo of global economic growth going forward.

The Bain study builds the Global Capital Pyramid pictorially, where the financial sector stands on top with the real economy at the bottom. The pyramid shows that “total financial assets”, which stood at $600 trillion in 2010, will expand by $300 trillion in ten years to $900 trillion in 2020. In the same period “financial holdings” will increase by $165 trillion, from $335 trillion to $500 trillion. What Bain calls as “financial assets” is gross financial assets. The debts on the other side which is out of the radar is in itself a huge topic.

upside down

Now, back to the main story. What, according to Bain, is total financial assets and financial holdings? Total “financial assets” ($900 trillion) which is the sum total of ‘financial assets of the financial sector and non-financial sector’ includes direct “financial holdings” ($500 trillion) of the non-financial sector, namely, households, corporations and governments and other direct owners. As against the rise of financial economy by $165 trillion by 2020, the real economy (or the underlying ‘Asset Base’) will rise by $90 trillion, from $210 trillion to $300 trillion.

The Asset Base (or real economy) represents the “accumulated tangible and intangible assets of all sectors”, namely, the sum of all factories, farms, infrastructure, intellectual property and the like — and everything that might appear as non-financial asset on a balance sheet”.

Thus, against the total underlying Asset Base of $300 trillion (in 2020) at the lower end of the Pyramid, the financial economy at the top will swell to $900 trillion by 2020. The two sub-sets of the asset base of the economy are Total GDP, at the middle of the real economy in the Pyramid, and Annual Economic Savings last at the bottom. The Total world GDP will grow from $63 trillion to $90 trillion, that is by $27 trillion and the Annual Economic Savings will grow from $15 trillion to $23 trillion, that is by $8 trillion.

Total GDP is the annual total real output of good and services. The annual economic savings is “the annual economic output not immediately consumed”, which is “derived from gross world savings (the sum of gross national savings at the country level) that “represents the underlying free GDP available for investments” and “does not include depreciation as some of these amounts needs to be reinvested to maintain a constant asset base”.

See how the ratio works. The real assets of the economy grow by $90 trillion against the financial savings of $8 trillion — showing a leverage of more than 10 times. Against the additional equity of $8 trillion generated during 2010-20, the additional monies/debts self-generated by the financial system will be $82 trillion. The apparent prosperity ($900 trillion) is three times the real asset base ($300 trillion) and ten times the real growth ($90 trillion).

The disproportionate growth of the financial economy over the underlying real economy is what led to the 2008 crisis. And Bain’s report makes it clear this will not only not abate, but continue and intensify. The report says that it has turned the world of capital upside down. Not just that. This has turned monetary economics upside down.

Milton effect evaded

The first principle of monetary economics is that variation in money supply has a major influence on national output in the short run and on the price level over long periods. Milton Friedman, Nobel Prize winner for monetary economics in 1976, theorised that “inflation is always and everywhere a monetary phenomenon” and advocated that the central bank must pursue a policy to keep the supply and demand for money at equilibrium and limited to the growth in productivity (GDP) and demand.

Along with economist Edmund Phelps, who was a Nobel Prize winner later, Friedman found that policy makers could not maintain low unemployment by permitting higher inflation. Milton’s prescriptions were followed by Paul Volcker who, as Chairman of the US Federal Reserve System (1979-1986) adopted money demand and supply targets that first drove the interest rates high and the economy into recession but ultimately brought down inflation and also unemployment.

This proved Friedman and Phelps right on the need to correlate the demand for money and the growth in the real economy.

Milton Friedman suggested that governments must statutorily limit the rate of money expansion to the rate of growth of the real economy. That is, there must be direct correlation between money and growth. But now, post 1990, the financial economy has grown 10 times the real economy.

The Friedman norm has been violated ten times over, but still there is no correspondingly high inflation in the Euro West.

His view has been frontally challenged today. Japan is doubling its monetary base in 18 months, yet, assumes that inflation rate will not be 100 per cent but just 2 per cent. How could, with money expanding at 200 per cent, inflation be just 2 per cent?

To make it worse the outstanding derivatives, which represent underlying assets, have gone up from $100 trillion in 2000 to over $632 trillion in December 2012 against the underlying asset value of just $24.7 trillion — less than 4 per cent of the derivatives in the market. Is Friedman’s celebrated monetary economic theory then dead?

No. The Friedman effect has been evaded by the developed nations by two financial innovations. One, large-scale de-territorialisation of convertible currencies by cross-border currency circulation, foreign investment and forex-holdings forced by currency internationalism.

This has virtually limited the application of Friedman’s monetary theory only to nations with currencies which are not convertible. And two, unlike commodity prices, re-defining inflation to exclude asset price rise caused by money supply. Each of them an independent topic by itself.

(The author is a commentator on political and economic affairs, and a corporate advisor)