from Silver Doctors:
The dollar is at its lowest level in years in terms of gold. Keith explains…
Let’s start with Frederic Bastiat’s 170-year old parable of the broken window. A shopkeeper has a broken window. The shopkeeper is, of course, upset at the loss of six francs (0.06oz gold, or about $75). Bastiat discusses a then-popular facile argument: the glass guy is making money (to which all we can say is, “plus ça change, plus c’est la même chose”). Bastiat says it is true, and this is the seen. The glazier does make money.
Then he introduces the concept of the unseen. The shoemaker does not earn the 6 francs he would have earned, had the shopkeeper not had to replace his window. The shopkeeper himself has the same window as before, but he is poorer by 6 francs. The unseen are the consumer, and the other producer. The consumer must consume less, and thus is impoverished. The other producer’s business shrinks in proportion to the gain in the glassmaker’s business.
Bastiat does not stop there. He adds that a government-imposed restriction can be thought of as a partial destruction.
Does anyone else feel as we do—that there should be a day to commemorate Bastiat?
Anyways, let’s take Bastiat’s parable into the modern era of central banks and monetary policy. We will tackle one of the leading proposals of the otherwise-free-marketers: nominal GDP (nGDP) targeting. In nGDP targeting, monetary policy attempts to cause GDP to grow at the right rate, as opposed to inflation targeting where consumer prices rise at the right rate, unemployment targeting where people can’t find work at the right rate, interest rate targeting where interest rates are set at the right rate, or even gold price targeting where the price of gold is fixed right.
What is the right number for each of these statistics? We don’t know—and neither do the dirigistes! But it makes for great opportunities to publish papers, not to mention the political power one could have, to be put in charge of administering the economy…
And even if there were a right price, it would be right for one moment only. And then on to the next price. That’s how markets work in reality (as opposed to nominally—sorry, we couldn’t resist).
And even if they always knew the right price, their mechanism for setting it is not equivalent in any way to how a market sets the right price. This was the topic of topic of our essay a few months back, What They Don’t Want You to Know about Prices. It is one of our more important essays.
Anyways, in nGDP targeting, the central bank is supposed to enact policies to grow GDP. And this leads us to the key question: how is a central bank to make GDP go up?
To answer, one must understand what is included in GDP and what is not. To make an analogy to financial statements, GDP is a cash-basis measure. In the cash basis, you book revenues when you deposit a check. And you book expenses when you write a check. Cash basis may work for a small business with no capital and no long-term contracts, such as a pizza restaurant that rents its premises. Every day it buys ingredients. And every day it sells pizzas. If the gozzinta is greater than the gozzouta, it is making money. Any child with a cash basis ledger can see it.
However, more substantial businesses must use the accrual basis. This is because cash basis does not paint an accurate picture where there is financing, capital, long-term contracts, etc. For example, suppose an insurance company wrote a one-year policy that paid $1,000 when the year ends in “0”, and receives a premium of $100 today. Can it book a $100 profit in 2019?
No, it cannot.
Accrual basis accounting requires the company to book that $1,000 payment that will be due in six months. You cannot just book a cash deposit and ignore the corresponding liability.
It is obvious that writing such a policy is a recipe to lose money. And the books should reflect this fact.
GDP is a cash basis measure. That is, it looks at only current activity and ignores changes to the balance sheet. It ignores capital.
That leads to an essential question. What if it were possible to induce a conversion of capital to income? What if the people could be incentivized or deceived or otherwise nudged or manipulated into eating their seed corn?
That would make GDP go up.
Back to Bastiat for a moment, breaking a window adds to GDP. At least in our modern era, with ubiquitous credit, one can borrow to repair the window with no impact to one’s consumption. This is not a recommendation to break windows. Bastiat’s point remains valid. It is a damning indictment of GDP as a measure of the economy.
And more germane to this discussion, there is no need to break windows to stimulate GDP. That is not what central banks do. They push down interest rates. And asset prices are inverse to rates.
An endlessly-rising asset market is a process of conversion of one party’s capital into another’s income, to be spent. Every seller has a profit, which he can spend. That profit comes from the capital of the buyers. And the buyers are increasingly borrowing that capital, which they fork over so eagerly to the sellers. And endless bull market is a process of liquidation of capital.