Thursday, November 10, 2011

Keynes & Hayek Agreement

Nicholas Wapshot has written an excellent book about the history of the disagreements between Keynes and Hayek.  The book is titled KEYNES HAYEK The Clash that defined Modern Economics.  The book points out on page 21 that both Economists believed "the amount of money in the economy was the key to understanding inflation."  Such a conclusion is inevitable from two strong adherents to Supply and Demand Theory.  "The amount" is the Supply of money and "inflation" is an indicator of the Demand for money.  According to N Theory it is this misconception that underlies the economic folly of the 20th century.  We can clearly see the folly of believing interest rates indicate the Demand for money.  During the Great Depression and the Global Financial Crisis the Demand for money was at a fever pitch, but interest rates were nearly zero.  Since interest rates are a product of Central Banks setting rates, it is absurd to consider them indicators of the free market.  They are only indicators of the government's financial strength in setting rates.  In the United States commercial banks can go to the discount window to borrow.  This opportunity and rate sets the competitive environment for purchasing T-bills.  In other words if the cost to borrow is low, then the return on lending will fall to low levels.  Why is this not working the same way for Greece and Italy?  It would if investors felt confident both countries would make their interest payments.  It is not at all about the amount of money in circulation, but whether the borrower has sufficient income to pay the interest bill.  Italy and Greece do not.  It is not  because the ECB issued too many Euros.  It is because Greece and Italy spent more money than they had capacity to repay if higher interest rates prevailed.

Countries just like subprime mortgage borrowers, look at their current financial situation to determine if they can take on more debt.  They do not consider what will happen in the future if interest rates rise.  The failure to correctly evaluate a future with higher interest rates affects home borrowers the same way it affects sovereign debt borrowers.  What home borrowers, Greece and Italy did not realize is when they went to refinance after a couple of years, the interest rate might be higher.  When this happened in all three case, the borrowers were unable to refinance and were pressed into foreclosure or default. 

Did they get into this position, because of a misrepresentation of money according to Supply and demand Theory?  Keynes and Hayek by tying the value of money to the simplistic Supply and Demand Theory made money a commodity (See Article "Money is a Concept").  This destroyed the relationship of money as payment for work.  Countries spent money that they did not earn.  Individuals home owners purchased houses that did not jive with their earning ability.  By unlinking the value of money from work and tying it to the amount in circulation both Keynes and Hayek promoted a false belief that money could increase in value without people working to earn it.  When interest rates fell home investors believed in a monetary windfall.  Oh my God, cheap money!!!  They suddenly saw their home investment increase in value.  Not realizing money is tied to work and not to interest rates, homeowners fooled themselves into thinking they were richer.  Had these homeowners not been misled by our leading Economists they could have realized it was a value bubble that would readjust to the true value of their earnings.  This illusion is most abused by national governments and Central Banks.  Greece and Italy both spent more when interest rates were low, not realizing that they would have to eventually pay for spending money their citizenry did not earn.  Likewise, China is setting her citizenry up for massive inflation by artificially under compensating her workers.

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