Sunday, October 19, 2008

War, Crisis, and Economics (amv)

The market has failed. Policy failed by leaving the market on its own. Policy ought to step in and re-regulate. This is the common interpretation of the recent crisis. It comes as no surprise, since anti-capitalistic presumptions were widespread before. What is surprising, however, is how easily government distortions are blanked out, even those who are otherwise on top of the agenda. I mean the War in Iraq and in Afghanistan.

Warfare distorts economic activity. The government spends money to reshape the capital and production structure. By forced saving, government hypes investments in very special kinds of capital goods, those which do never mature in consumption goods but are rather used to destroy (human) capital elsewhere. Beyond a level sufficient to ensure protection against external enemies, spending on war is unproductive. War often proved to be the long-run alternative for trade. To reshape the economy and to defend the warranted structure of production, government needs funds to compete with the consumer on resources. The Bush-Administration piled up a huge stock of national debt. No president before has such a bad record. And here is the link to the financial crisis:

If an increase in money does not supply an increase in the demand for credit, funds are limited by savings at home and abroad. If government borrows, it has to crowd out private investments, that is, it has to attract funds planned for private investments by offering higher interest rates. The adjustment of the capital structure in favour of a war-economy would express itself in lower capital values of peace-production. There is no reason for expectations to take off. There is no bubble, but gains here and losses there. But what happens if the central bank targets interest rates? In this case the central bank has to purchase government bonds (or in fact use much more subtle measures) and thereby increase the money supply. Thus, even inflation-targeters with a strong commitment to stability produce savings in disguise. There you find the myth that US-debt has is financed by foreign savings as such. The increase in nominal incomes of those who benefit from the reshaped structure of the economy, if they do not save themselves, are made available to foreign investors by imports of goods and services. International savers purchase US-government bonds with new money, motivated by the increase in purchasing power of foreign currencies relative to the US-Dollar (if the detoriation of the Dollar is expected to be overcompensated by the Dollar-return of the investments). The inflationary impact of lower productivity growth due the expenditures on war is multiplied by the central bank which ironically attempts to ensure neutrality of money in a world with price and wage rigidities. If foreign savers take up the additional money, asset price inflation is especially high due to the higher money circulation on financial markets. Asset price inflation boosts distortions in credit standards and opens all gates for unfounded price speculations.

The financial crisis is therefore also a crisis of Big Government, of reckless government spending in conjunction with central bankers, who manipulate the interest rate. Note that central bankers do so for others reasons than in the past. We are lucky that very good economists head our central banks. Our problem is their pretty bad models of the economy. The major mistake is the Keynesian presumption that the interest rate is a purely monetary phenomenon, that central banks should target the interest rate to ensure a full-employment level of effective aggregate demand.