Gary North Misses the Boat on Economic Theory

by: Karl Denninger

Gary North flies off the rails with the following nonsense:

Oddly enough, Keynes' arguments have persuaded a group of non-economists in the hard-money camp. These men are known as deflationists. They predict inevitable deflation. They use Keynes' arguments. Yet they are so poorly informed on economic theory that they are unaware that they are Keynesians. I call them Keynesians in drag.

Keynesians in drag?

Among other things I'm not a "hard money" guy; I have never advocated such. Mis-characterizing someone (on purpose) is the first resort of those who have no argument to make and therefore try to stake their claim through outright misrepresentation. But enough of that; this is supposed to be a "scholarly debate", not a name-calling flamefest.

North seems to be unaware that Keynes called for governments (and central bankers) to inexorably rebuild their Treasuries (that is, stuff 'em full of actual savings) during times of economic prosperity, thereby allowing them to spend that excess to level out recessions.

Nobody bothers with that part of Keynes theories - but that doesn't negate them. Quite to the contrary; they are the essence of Keynes' economic principles: the application of counter-cyclical forces to the markets by governments (and by extension central bankers); a beautiful principle in theory but one never practiced in the history of the markets.

Keynes economic theories are mathematically able to be proved correct. That's irrelevant since there is no government, now or ever, that will implement them as-written. As a consequence arguing over the validity of Keynes theories is akin to arguing over whether Christianity is a valid religious path while taking a big fat Sharpie Marker to the 10 Commandments!

The deflationists have taken Keynes' argument one step beyond. They say that we are about to enter an economy in which lenders will not lend at any price. Friedmanite inflation will not save the capital markets this time. Borrowing from the FED will not help. Nothing can prevent a deflationary collapse, because bankers will not lend, and borrowers will not borrow, at any price.

In short, price -- the interest rate -- does not allocate capital. This is Keynes' argument, re-packaged for hard-money investors. Sadly, a lot of them are buying it. They don't understand where it came from.

It is here that North completely flies off the rails into the realm of pure fancy.

The issue is not whether interest rates allocate capital (they do), it is what happens when the marginal productivity of debt disappears.

To review, there are three uses of borrowed funds:

  • Productive: The use of borrowed funds to purchase something such as a CNC machine that then produces more in output than it's acquisition cost (including interest) over the lending term. The net GDP contribution to such lending is positive.
  • Consumptive: The use of borrowed funds to purchase something that is consumed (housing, food, etc.) While there may be productive components to consumption this use of borrowing is differentiated from the first by the primary character of the consumed good or service.
  • Ponzi: The use of borrowed funds to purchase an item that has as the essence of ownership the intent to sell to someone else at a higher price. The purchase of stock in the open market (but not in an IPO) is in this category; the company gets no tangible benefit from this transaction, and the intent of the purchase is simply to sell to a "bigger sucker." The same is true for a home purchased with the intent to flip it, not live in it, or where the intent is to extract equity to spend on consumer goods (the essence of the transaction is that it is able to be completed as agreed only if the "price" of the house rises.)

As interest rates fall it becomes more and more profitable to employ the second and especially the third uses of lending.

But while the second use of lending provides "par" in GDP contribution the third subtracts from GDP over time, because (1) there is no contribution to GDP from the activity itself and yet (2) the funds carry an interest cost up and down the line.

That is, only the first use of lending is productive for society as a whole.

The issue is not whether interest rates allocate capital, it is whether and how the balance of activity with lent funds changes - and whether those activities are of net benefit to the economy.

North, having failed to make his primary case, then turns to the ridiculous to try to buttress a lost argument:

He begins with a crucial error. It is the same error that misleads Keynesians and Chicago School economists. He defines inflation incorrectly.

(Me) - Now remember: The definition of "inflation" in the monetary sense is the growth of money beyond the growth in goods and services. Deflation is the opposite.

The correct definition was offered by Ludwig von Mises and his Austrian School followers: inflation is an increase in the supply of money. We can debate how best to define and measure money, but to discard this definition is to discard the foundations of economic analysis.

What part of reading comprehension did North fail?

Inflation is the increase in "money" beyond output.

The Austrian School (and Mises) look at a statis system in terms of output and then define inflation in terms of that. This is a perfectly legitimate exercise for academic purposes but of course output is never static.

The error that North (and most of the rest of the crooners make) is to define "money" for the purpose of inflation (or deflation) in terms of Mx, where "x" is whatever you choose - M1, M0, M', M2, M3, whatever.

That's wrong and it takes an extreme level of willful blindness to continue to tout that which every person in the United States and indeed the Western World knows for a fact from their personal experience is wrong.

I'll prove it right here and now for you.

Go get your wallet and value every item in it for its maximum purchasing power - that is, what you could spend right now should you choose to do so.

If you're like most people there is a small amount of paper currency. Perhaps $100 or so?

You probably have an ATM card in there that is also a debit card. That is, you can spend the entire contents of your checking and/or savings accounts using that electronic piece of plastic.

But you also probably have in there one or more credit cards which provide you access to many times the amount of money you have in your checking and savings accounts. Right now, right here, on (your) demand.

So what is the supply of money?

It is in fact that which you both can and will borrow plus the total of your actual stored funds.

As I have repeatedly stated: When you put forward a false premise as the foundation of your argument everything you do from that point forward is wrong.

Now let's examine the rest of North's premise:

On the contrary, there was no price deflation occurring. That is why the CPI rose. Yes, rose. The deflationists have kept predicting a fall in prices (NYSEARCA:CPI), and they have been wrong.

Oh really? So now we turn to an intentionally-cooked number that excludes the largest single component of every person's spending - housing - from influencing its reading - and then claim that "CPI rose"?

That's ridiculous.

Housing expense is typically 30 to as high as 50% of one's after-tax income. It is the single largest line item on virtually everyone's personal balance sheet. The price of houses has fallen by double-digit percentages in the last two years; in some parts of the country, like SW Florida, you can now buy a house for $50,000 that in 2005 sold for $500,000!

CPI-U (or any of the other CPIs) willfully and intentionally ignored this on the way up in the housing bubble. They now ignore it on the way down.

This is outrageously dishonest and so is basing an argument on anything reported via CPI.

If we went back to how CPI was computed before the government tampered with it (post-Carter) we would have seen double-digit inflation rates for the period from 2000-2007. Why? Because housing was rising at double-digit rates and that, plus the rest of prices, would have resulted in a CPI print in the teens.

But in 2008 and 2009 we would have seen massive negative CPI prints - that is, price deflation - for the same reason.

Why did the government change the reporting rules?

Simple: they are complicit in the bubble game but more importantly entitlement payments are linked to CPI; with an honest CPI Social Security would have instantaneously exploded in the 1990s and 2000s. They therefore changed the rules to exclude where the inflation was showing up - which not coincidentally now excludes where the DEFLATION is showing up!

The rest of North's sophomoric attack is unworthy of digital ink.

I can forgive the mistake made in the definition of "money" (North prefers M1 and M1MULT as his indicators, which many others do as well) even though that requires willful blindness.

But to claim that government-reported CPI measures "inflation" when it (intentionally) failed to capture the entire housing price rise, given that housing expenses are anywhere from 30-50% of the average person's after-tax expense, is beyond willful blindness. That crosses into the realm of intentional deception and those who choose to go there have voided the entirety of their argument.

For that reason I will stop here, and strongly suggest that anyone relying on someone's "analysis" that includes in their claims changes in "CPI" change horses now - you're going to be bankrupted following the so-called path put forward, and that's a certainty.

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