John Hearn takes the opportunity to muse about China

China is only the trigger

Time to bring together things that have been written on my blog so that you can see how the ideas fit together in understanding and searching for a solution to our global economic problem.

When I was thinking of a title for this piece the following crossed my mind:

"Sleepwalking into economic disaster"

"Wake up the nightmare is real"

I am glad that I date stamped all my blogs so that I cannot be accused of being wise after the event.

The world economy is in a bad way because governments have been overspending ineffectively and interest rates have been held artificially low for too long. The cause of the problem is Keynesian and interventionist economics which assumes that our macroeconomic problems can be solved by the wisdom of government. The scenario created by these interventionist economists is very attractive to politicians because it tells them how they can be active in saving the country from economic disaster.

There are fundamental errors which compound the mistakes made by Keynesians. Firstly their theories assume that when the economy has an output gap it can be closed by demand management policies, which are fiscal and monetary policies. There is no evidence that demand management policies can close output gaps and so it remains an unproven theory. Secondly it must assume the possibility that inflation can be caused by a rise in the costs of production: cost push inflation. This is a fallacy as all inflations require more money to be used in the same number of transactions and rising costs do not increase the money supply. The Bank of England has monetary demand under control, although it does not always admit it and sometimes even blames cost push inflation for its mistakes.

There are two periods in history that can be used to illustrate the damage caused by demand management policies. The first one centred on the UK and US in the 1970s and is dealt with in "What really happened in the seventies"The second was a G20 decision in April 2009 that caused a worldwide problem and is explained in"A fiscal stimulus". In response to the Financial Crisis the G20 countries collectively agreed to stimulate their economies with yearly fiscal deficits that, ex-post, solved no problems, but created a situation that governments found difficult to control as illustrated by the UK national debt which grew from £750 billion in 2009 to £1.6 trillion at the time of writing.

Economic growth is synonymous with efficiency and there is absolutely no evidence that governments ever spend money efficiently. The only time that government must spend money is in the provision of the public good (a non-rival non- excludable product that we collectively require e.g. internal and external defence, but are not prepared to buy individually). However when government take on the role of managing demand they take spending power from the private sector through taxes, borrowed money or printed money. It is therefore taken from where it would have been spent more efficiently. This problem is dealt with in "Are demand management policies the solution or a mass delusion?"

Fiscal policies are as distorting and damaging as misused monetary policies founded on fallacious assumptions. Of course they may not be misused as it is possible to manage monetary demand using a policy that controls the quantity of money not the price of debt and therefore leaves interest rates to be determined by market forces. This was explained in "Understanding monetary policy" and "Understanding and misunderstanding QE".

Is there a solution to our economic problems that does not involve government overspending and the Bank keeping interest rates too low. The answer is to promote private enterprise and support capitalism with governments forced to balance their budgets as explained in "A balanced budget goodbye fiscal policy" and a monetary policy that accepts it is only possible to influence the rate of inflation by managing monetary demand so it grows at a slightly faster rate than the growth in output as explained in "Understanding monetarism".

Unfortunately there are too many vested interests to accept an argument that is counter intuitive and explains how the economy can only have sustained high levels of economic growth if the government spends less, raises interest rates and lets capitalism produce more equality in society as explained in "Equality or inequality...". If we do not radically rethink our approach to managing an economy then we are faced with years of damagingly low interest rates with bubbles bursting and new bubbles being created as well as governments searching for the Holy Grail of faster economic growth by spending more of our tax pound/dollar/euro.

And finally a brief mention of the euro which is destined to collapse into domestic currencies as was explained in "Unwinding the euro" or it will commit a generation of eurozoners to lower standards of living and continuous political wrangling.

John Hearn August 2015