From http://www.safehaven.com/article-13063.htm PDF version here.

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A CRITIQUE OF THE QUANTITY THEORY OF

MONEY

Further evidences of the onset of Great Depression II

Antal E. Fekete

Professor of Money and Banking

San Francisco School of Economics

aefekete@hotmail.com

In my previous paper The Revisionist Theory and History of Depressions I

argued that persistently falling interest rates cause an erosion of capital, unseen

but nonetheless lethal. Producers are squeezed and try to survive by cutting

prices. Lower prices add to pressures lowering interest rates, and a vicious

spiral is set in motion. Thus money-creation by the Fed has a little-noticed

deflationary side-effect to it, that may ultimately overwhelm the inflationary

effect, in spite of predictions by the Quantity Theory of Money.

Money out of the thin air?

Detractors of our fiat money system (myself not included) are fond of saying

that “the Fed is creating money out of the thin air.” If that were true, then the

Quantity Theory of Money (QTM) might be valid implying that the present

runaway money-printing exercise would indeed lead to hyperinflation before

long. How could anyone suggest that the denouement will be deflationary after

all?

I maintain that the Federal Reserve banks are not creating money out of

the thin air. In fact,

they must first post collateral with the Federal Reserve

Agent (who is not under the jurisdiction of the Fed but under that of the

government). Only after the collateral has been posted can they

create a commensurate amount of

Federal Reserve notes and deposits. Typically, the

collateral is U.S. Treasury bills, notes, or bonds, purchased in the open market

on behalf of the Fed’s Open Market Committee.

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Because open market purchases of Treasury paper have consequences, we

must examine them before passing a judgment on the validity of the QTM. Such

an examination is always side-stepped by the devotees of the QTM. What are

those consequences? They are the effect of open market operations on the rate of

interest. Since open market purchases of the Fed involve bidding up the price of

government obligations which varies inversely with the rate of interest, we can

say that they will make interest rates fall. (To be sure, on occasion, the Fed may

be a seller of Treasury paper but, on a net basis, it has been a buyer every single

year.)

This means that the regime of irredeemable currency, depending as it is on

the open market operations of the Fed for its existence, imparts a definite bias to

the interest rate structure establishing a falling trend, whereas interest rates

would be stable in the absence of that regime. This in itself is a condemnation of

irredeemable currencies as they introduce an unwarranted bias into the economy

favoring debtors and spenders while punishing creditors and savers. In addition,

it favors the financial sector at the expense of the producing sector. Falling

interest rates, as opposed to low but stable ones, are detrimental to productive

capital.

Thus we have two effects to reconcile as a consequence of money creation

by the Fed: an inflationary and a deflationary one. We cannot say which

of these two forces will ultimately prevail without digging deeper.

That is to say (I think):

Risk free bond speculation

In the actual case there are other important forces at play, which are induced by

the Fed’s open market purchases. We have to take into account bond

speculation, a permanent fixture on the monetary firmament since 1971 when

the U.S. government defaulted on its gold obligations to foreign governments

and central banks. (There was no bond speculation before, for reasons having to

do with the lack of sufficient variation in the rate of interest, making such

speculation unprofitable.) Analysts and financial writers hardly ever consider

bond speculation as a factor in the money-creating process. For this reason

alone, their predictions are practically always worthless.

The fact goes virtually unrecognized that open market operations render

bond speculation risk free. All the speculators have to do is to second-guess the

Fed. They know that the Fed must be a net buyer. They know the identity of the

agents the Fed is using to execute its purchase orders, and stalk them.

Speculators study the same monetary statistics which the Fed itself is using to

determine the timing of its open market purchases. Can the Fed outsmart

speculators? Hardly. The Fed is run by bureaucrats and their trading losses are

‘on the house’. By contrast, the speculators risk their own fortune. They are

certainly smart enough to detect false-carding on the part of the Fed. Even if we

assume that they have no inside information (which is a rather naïve

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assumption), the speculators can easily front-run the Fed’s open market

purchases.

The presence of risk-free bullish bond speculation imparts a huge

additional bias to the economy, virtually guaranteeing a falling interest-rate

structure, as demonstrated by the past quarter of a century, during which interest

rates have been driven down from the high teens to close to zero. It may distort

the ultimate outcome of this latest tragic experimentation with irredeemable

currency. No longer can it be taken for granted that the denouement of unlimited

money-creation will be hyperinflation with the Federal Reserve notes rapidly

losing purchasing power. On the contrary, it could be an unprecedented

deflation with the Federal Reserve notes being hoarded by the people, firms, and

institutions as their purchasing power is actually increasing (in fact, they are

already being hoarded by foreigners in the second and third world countries in

unprecedented amounts). The dollar will not be the first among irredeemable

currencies to be annihilated in this latest hecatomb of currencies. It will be last

one.

Price wars

The QTM is a linear model that may be valid as a first approximation, but fails in

most cases as the real world is highly non-linear. My own theory predicts that it is

not hyperinflation but a vicious deflation which is in store for the dollar. Here is

the argument.

While prices of primary products such as crude oil and foodstuffs may

initially rise, there is no purchasing power in the hands of the consumers, nor can

they borrow as they used to do in order to pay the higher prices much as though

they would like to do, to support it. The newly created money is going into bailing

out banks, much of it being diverted to continue paying bloated bonuses to

bankers. Very little, if any of it has “trickled down” to the ordinary consumer who

is squeezed relentlessly on his debts contracted when interest rates were higher.

It turns out that the price rises are unsustainable as the consumer is unable to

pay them. They will have to be rescinded. Retail merchants will start a damaging

price war underbidding one another. Wholesale merchants are also squeezed.

They have to retrench. Pressure from vanishing demand is further passed on to the

producers who have to retrench as well. All of them experience ebbing cash

flows. They lay off more people. This aggravates the crisis further as cash in the

hand of the consumers diminishes even more through increased unemployment.

The vicious spiral is on.

But what is happening to the unprecedented tide of new money flooding the

economy? Well, it is used to pay off debt by people desperately scrambling to get

out of debt. Businessmen are lethargic; every cut in the rate of interest hits them

by eroding the value of their previous investments. In my other writings I have

explained how falling interest rates make the liquidation value of debt rise, which

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becomes a negative item in the profit-and-loss statement eating into capital of

businesses. Capital ought to be replenished but isn’t.

Worse still, there is no way businessmen can be induced to make new

investments as long as further reductions in the rate of interest are in the cards.

They are aware that their investments would go up in smoke as the rate of interest

fell further in the wake of “quantitative easing”.

Self-fulfilling speculation on falling interest rates

The only enterprise prospering in this deflationary environment is bond

speculation. Speculators corner every dollar made available by the Fed, and use it

to expand their activities further in bidding up bond prices. They have been told in

advance that the Fed is going to move its operations from the short to the long end

of the yield curve. It will buy $300 billion worth of longer dated Treasury issues

during the next six months. It is likely that it will have to buy much more after

that. Speculation on falling interest rates becomes self-fulfilling, thanks to the

insane idea of open market operations making, as it does, bullish bond speculation

risk-free and bearish bond speculation suicidal. Deflation is made self-sustaining.

Investors are urged by the Treasury and the Fed to invest in the toxic assets

of the failing banking system. They are offered incentives if they do, making it

appear that speculating in toxic assets has been made risk free as well. So the

choice before the investors is either investing in toxic assets for which there is no

market, or invest in Treasury paper which bond speculators and foreigners are

scrambling to get. Naturally, they will choose the latter. They don’t want to be

taken for a ride by the Treasury and the Fed. The idea to offer incentives to

investors to make them buy toxic assets is preposterous.

Marginal productivity of debt

Another way to understand the problem is through the marginal productivity of

debt. This is the ratio of additional GDP to additional debt, or the amount of

new GDP contributed by the creation of $1 in new debt. It is this ratio that

determines the quality of total debt. Indeed, the higher the ratio, the more

successful entrepreneurs are in increasing productivity, which is the only valid

justification for going into debt in the first place. The concept is due to the

Hungarian-born Chicago economist Melchior Palyi (1892-1970), although its

name has been introduced after he died.

Palyi started watching this ratio in the United States in 1945. Initially it

was 3 or higher, meaning that every dollar of new debt contracted contributed $3

to GDP. However, subsequently the ratio went into a decline and twenty years

later it was around 1. Palyi ran a weekly column in The Commercial and

Financial Chronicle entitled A Point of View. On January 2, 1969, he publicly

warned president-elect Nixon in his column that the country is adding $2 in debt

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for every $1 increase in GDP (in other words, the marginal productivity of debt

is ½).

“Does Mr. Nixon realize the kind of ‘heritage’ he is taking over? That

he is supposed to keep up a rate of economic growth or even improve on

the same, a rate that stands or falls with an utterly reckless mortgaging of

the future?... Presently, the volume of outstanding debt is rising faster

than the gross national product… True, most of the new debt — other

than that of the federal government — has a ‘counterpart’ in real assets:

homes, automobiles, plants and equipment, etc. But their value in dollars

is unpredictable, while the debts are due in a fixed number of dollars…

“Trading on the Equity was the earmark of the 1920’s. The ‘House of

Credit Cards’ broke down as the first cold wind — a serious decline in

commodity prices — hit the structure of artificially inflated values of real

estate and equities. The more debt had been piled up, the higher went the

stock market. And so it goes today, only more so. A new generation of

operators has arisen, one that has not witnessed as yet a wholesale debt liquidation.

The experience of the fathers is lost on the sons. The dream

of Eternal Prosperity is replaced by the mirage of Perpetual Inflation.

More is at stake than mere economics. A ‘new frontier’ has captured the

imagination: ‘Young man, go in debt!’ Debt has become a status-symbol

— in addition to being a prime source of riches. Automobile sales hit

new records because millions of Americans buy (on down payment) new

cars before they have finished paying for the old ones… True, to some

extent rising living standards reflect extraordinary technological progress.

But the ultimate base is, largely, the ability not to pay — to rely on the

ability to borrow ever more.”

As we know, in 1969 president Nixon did not listen to sound advice. As

president Obama forty years later, he appointed dyed-in-the-wool Keynesian and

Friedmanite advisers. The concept of marginal productivity of debt is curiously

missing from the vocabulary of mainstream economists. They are watching the

wrong ratio, that of the GDP to total debt, and take comfort in the thought that

by that indicator ‘there is lots more room’ to pile on more debt. As a

consequence, the marginal productivity of debt went into further decline. This

was a danger sign showing that additional debt had no economic justification.

The volume of debt was rising faster than national income, and capital

supporting production was eroding fast. If, as in the worst-case scenario, the

ratio fell into negative territory, the message would be that the economy was on

a collision course with the iceberg of total debt and crash was imminent. Not

only does more debt add nothing to the GDP, in fact, it necessarily causes

economic contraction, including greater unemployment. Immediate action is

absolutely necessary to avoid collision that would make the ‘unsinkable’

economy sink.

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The watershed year of 2006

As long debt was constrained by the centripetal force of gold in the system,

tenuous though this constraint may have been, deterioration in the quality of

debt was relatively slow. Quality caved in, and quantity took a flight to the

stratosphere, when the centripetal force was cut and gold, the only ultimate

extinguisher of debt there is, was exiled from the monetary system. Still, it took

about 35 years before the capital of society was eroded and consumed through a

steadily deteriorating marginal productivity of debt.

The year 2006 was the watershed. Late in that year the marginal

productivity of debt dropped below zero for the first time ever, switching on the

red alert sign to warn of an imminent economic catastrophe. Indeed, in

February, 2007, the risk of debt default as measured by the skyrocketing cost of

CDS (credit default swaps) exploded and, as the saying goes, the rest is history.

Negative marginal productivity

Why is a negative marginal productivity of debt a sign of an imminent economic

catastrophe? Because it indicates that any further increase in indebtedness would

inevitably cause further economic contraction. Capital is gone; production is no

longer supported by the prerequisite quantity and quality of tools and equipment.

The economy is literally devouring itself through debt. The earlier message, that

unbridled breeding of debt through the serial cutting of the rate of interest to zero

was destroying society’s capital, has been ignored. The budding financial crisis

was explained away through ad hoc reasoning, such as blaming it on loose credit

standards, subprime mortgages, and the like. Nothing was done to stop the real

cause of the disaster, the fast-breeder of debt. On the contrary, debt-breeding was

further accelerated through bailouts and stimulus packages.

In view of the fact that the marginal productivity of debt is now negative, we

can see that the damage-control measures of the Obama administration which are

financed through creating unprecedented amounts of new debt, are counterproductive.

Nay, they are the direct cause of further economic contraction of an

already prostrate economy, including unemployment.

The head of the European Union and Czech prime minister Mirek Topolanek

has publicly said that the plan to spend nearly $2 trillion to push the U.S.

economy out of recession is “road to hell”. There is no reason to castigate Mr.

Topolanek for his characterization of the Obama plan. True, it would have been

more polite and diplomatic if he had couched his comments in words to the effect

that “the Obama plan was made in blissful ignorance of the marginal productivity

of debt which was now negative and falling further. In consequence more

spending on stimulus packages would only stimulate deflation and economic

contraction.”

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President Obama, like president Nixon before him, missed an historic

opportunity in not ordering a complete change of guards at the Treasury and at the

Fed. Now the same gentlemen who have landed the country and the world in this

unprecedented débâcle are in charge of the rescue effort. The QTM, the corner

stone of Milton Friedman’s monetarism, is the wrong prognosticating tool. The

marginal productivity of debt is superior as it focuses on deflation rather than

inflation.

The financial and economic collapse of the past two years must be seen as

part of the progressive disintegration of Western civilization that started with the

sabotaging of the gold standard by governments exactly one hundred years ago

when in France and in Germany paper money was made legal tender. The

measure was introduced in preparation to the coming war, so that the government

could stop paying the military and the civil service in gold coins, starting in 1909.

Fed Chairman Ben Bernanke, who should have been fired by the new

president on the day after Inauguration for his part in causing the cataclysm, a

couple of years ago foolishly boasted that the government has given him a tool,

the printing press, with which he can fight off deflations and depressions, now and

forever. The reference to the GTM [QTM (Quantity Theory of Money?] is obvious.

Now Bernanke has the honor to administer the coup de grâce to our

civilization.

April 15, 2009

Reference

The Revisionist Theory and History of Depressions, see:

www.professorfekete.com

[See also his earlier (March 28) THE MARGINAL PRODUCTIVITY OF DEBT.html ]

Calendar of Events

Instituto Juan de Mariana: Madrid, Spain, June 12-14, 2009

Seminar with Prof. Fekete on Money, Credit, and the Revisionist Theory of Depressions

For information, contact: gcalzada@juandemariana.org

OroY Finanzas & Portal Oro: Madrid, Spain, June 18, 2009

Gold and Silver Meeting Madrid 2009

For information, contact: preukschat_alex@hotmail.com or

gcalzada@juandemariana.org or

http://www.portaloro.com/aemp.aspx or

info@portaloro.com

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San Francisco School of Economics: A Series of three Investment Seminars:

July 25; August 1; and August 8, 2009

The Gold and Silver Basis; Backwardation; Trading Gold in the Present Environment;

Wealth Management under the Regime of Irredeemable Currency. Given by Professor

Fekete and Mr. Sandeep Jaitly of Soditic Ltd., London, U.K. Enrolment is limited, first come

first served. For more information, see: www.sfschoolofeconomics.com

San Francisco School of Economics: July 27-August 7, 2009

Money and Banking, a 20-lecture course given by Professor Fekete. Enrolment is

limited; first come, first served. The Syllabus for this course can be seen on the website:

www.professorfekete.com, see also: www.sfschoolofeconomics.com

University House, Australian National University, Canberra: first week of November, 2009

Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com

Professor Fekete on DVD: Professionally produced DVD recording of the address before the

Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the

Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is

available from www.Amazon.com and from the Club www.economicclubsf.com at $14.95

each.

[Follow-up below.]

The Economic Statistic US Elites Keep ‘Hush-Hush’

Monday, 6 June 2011 at 12:40, By Ron Robins, Founder & Analyst - Investing for the Soul

It is a simple statistic that continues to warn of huge economic problems ahead for the US. Some economists call it the ‘marginal productivity of debt (MPD).’ It relates the change in the level of all debt (consumer, corporate, government etc.) in a country to the change in its gross domestic product (GDP). However, due to the message it is delivering, most US economists employed in financial institutions, governments and private industry, as well as financiers and politicians, want to ignore it.

And for the US economy and government finances, the MPD (and related variants of it) is continuing to indicate extremely difficult economic times ahead.

I have vague recollections of the MPD concept from my economics classes long ago. But I was re-introduced to it around 2001 by a renowned economist who, during the following few years prior to his passing, became alarmed as to the MPD path of the US. His name was Dr. Kurt Richebächer, formerly chief economist and managing director of Germany’s Dresdner Bank. Dr. Richebächer, was so respected that former US Federal Reserve Chairman, Paul Volcker once said of him that, “sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong," reported the online financial journal, The Daily Reckoning on May 15, 2004.

Investigating Dr. Richebächer’s concern further, I wrote an article on my Enlightened Economics blog on January 23, 2008, titled, Is the Amazing US Debt Productivity Decline Coming to a Bad End? I found that, “for decades, each dollar of new debt has created increasingly less and less national income and economic activity. With this ‘debt productivity decline,’ new evidence suggests we could be near the end-game... ”

Another way of viewing the debt productivity problem is to look at it in terms of how many dollars of debt it took to help create total national income, which is the wages, salaries, profits, rents and interest income of everyone. Again, from my above mentioned article, which quotes Michael Hodges in his Total America Debt Report, that, “in 1957 there was $1.86 in debt for each dollar of net national income, but [by] 2006 there was $4.60 of debt for each dollar of national income - up 147 per cent. It also means this extra $2.74 of debt per dollar of national income produced zilch extra national income. In 2006 alone it took $6.32 of new debt to produce one dollar of national income.”

Such data helps explain why US exponential debt growth—after reaching certain limits—collapsed in 2008 and contributed massively to the global financial crash.

However, whereas the US private sector debt has marginally ‘de-leveraged’ (retrenched) since that crash (which might now be reversing), the US government, as everyone knows, has run up mammoth deficits to purportedly keep the country’s economy from imploding. Thus, the US’s MPD is marching to another, perhaps even more frightening tune, suggesting government financial insolvency and/or debt default.

One fascinating way of looking at the declining MPD of US government debt has just been presented by Rob Arnott on May 9, 2011, in his post, Does Unreal GDP Drive Our Policy Choices? What Mr. Arnott does is to subtract out the change in debt growth from GDP, and refers to this statistic as ‘Structural GDP.’ He finds that, “the real per capita Structural GDP, after subtracting the growth in public debt, remains 10 per cent below the 2007 peak, and is down 5 per cent in the past decade. Net of deficit spending, our prosperity is nearly unchanged from 1998, 13 years ago.”

In its effort to counter the significant economic difficulties since 2008, the US government has added, or will have added, around $4 trillion in deficits (financed by new debt) in its three fiscal years 2009, 2010 and 2011. Yet, all this massive government deficit spending has failed to really ignite economic growth. Most likely this is because of the enormous dead weight of unproductive and onerous private sector debt, particularly that of consumer debt. Hence, real US GDP will have increased probably less than $1.5trn during these years. Including some further economic benefit in the years thereafter, a total GDP benefit of only about $2trn is probable.

So, $4trn borrowed for $2trn in GDP gains. Thus, in very rough round numbers, each new one dollar of US government debt might only produce $0.50 in new economic activity and probably only about $0.08 in new federal tax revenue. (Federal tax revenue as a percentage of GDP is around 15 per cent.) Therefore, the economic marginal return for each new dollar of US government debt is possibly around -50 per cent! If you loaned someone $10 million and they gave you back $5m, you would not be happy!

Hence, it might not be long before those holding or buying US government bonds perceive the reality that the US government, and US economy, are losing massively on government borrowings. This will result in much, much higher US government bond yields and interest costs. Most importantly, it may make the rollover of US debt and new debt issuance incredibly difficult unless either US taxes rise stratospherically to cover the deficits, and/or the US Federal Reserve money printing goes into hyper-drive to purchase the debt the markets will not buy. (Of course US banks, pension funds etc., could also be forced to buy them.)

Thus, the idea that US government debt continues to be ‘risk-free’ is absurd.

For this, and for many other reasons cited above, is why the US financial and political elites want to keep hush-hush about what the MPD and its variants reveal!

E-mail the writer: r.robins@alrroya.com