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Update 24-12-2007

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Inflation and the ineffectiveness of Monetary Policy


The dogmatic belief that easy money policy with low interest rates could boost economic growth is increasingly being questioned. Ever more empirical evidence in deed point at total ineffectiveness of monetary policy. Two decades of close to zero interest rates in Japan and Switserland for instance have been totally inadequate to give any stimulus to their sluggish growth.
Nobel-prize winners  Friedman (1976), Lucas (1995),  and Phelps (2006) all expressed their doubts about the effectiveness of loose money policy as means of boosting the economy. The severest critique on central banking effectiveness, and also the most systematic research into the matter has come from Robert E. LUCAS. In his comprehensive study which yielded him the  1995 Nobel Prize he could find no significant relation between growth of the money supply and growth of the real economy. For Lucas, the only significant effect of increasing the money supply is increasing inflation, which obviously slows down growth in the long run. So any attempt to boost growth through reducing interest rates is therefore counterproductive.

Lucas: More Money means higher Inflation, not more Growth
JP_chevallierVery remarkable also are most recent (2006) empirical findings by ' Prof. J-P. Chevallier of the university of Nice (France). Chevallier found that "Excess Money Supply"  (EMS: Growth of the Money Supply M3 in excess of the growth rate of the real economy)  has a remarkable inverse relation to the real economy's growth rate. High EMS coincides with low growth. Chevallier's study is based on over 550 data pairs covering 47 years of US monetary history from 1960 till 2006. The inverse course of both variables in the figure below is indeed too remarkable to be coincidental.

Do we really need central Bankers?
Other studies go as far as questioning the very reasons for the existence of Central Banks altogether. Prof. Hanke for instance found that the average economic growth rate in countries without central banks is 2.1 times higher than in those with central banks. Countries without entral banks also have lower inflation. So the main result of all the Central Banks actions is increased inflation. ( Source: Charles Oliver, "IMF Again Comes Under Fire: Does it Really Need to Exist?" )

INFLATION: Diluting workers' and savers' Buying Power

European Monetary System
Excessive Money Suppliers ?

Inflation is a stealthy robbery, diverting resources from productive investment and therefor slowing down the economy. Money can indeed only maintain its buying power when an increase in the money supply is matched by an equivalent increase of the supply of real goods and services. Central Banks often set interest rates at artificially low levels supposedly to stimulate growth. These low interest rates cause demand for loans to increase excessively and the money supply to expand at a faster rate than the real economy. This results in fast growing amounts of money chasing slowly growing quantities of goods causing the price levels to rise.
Robbery:  Inflationary money such as bankers create from thin air obviously does not increase wealth of a nation nor its real buying power, as their increase of the money supply is not accompanied by an increase of real goods or services. The nominal buying power such money provides to borrowers is merely diluted buying power, diluted from the real buying power of someone else. It is indeed buying power stealthy robbed from people having earned theirs through hard labour or in exchange for real goods and services. Obviously the stealthy devaluation of peoples' labour and savings progressively discourages the producers of real wealth. Eventually they tend to reduce their productive contribution, resulting in slowdown of growth; just the opposite easy money was set up to do.

excessive_money_supplySo contrary popular belief and to bankers' claims, easy-money policy can never cause real growth, but merely creates a nominal illusion of progress. In the end real wealth can only be increased through increasing the availability of real goods and services, and the only way to increase production of tangible services and commodities is by working more or by producing more effeciently. And productivity can only be improved to a substantial extend through investment in better machines, superior techniques or improved infrastructure. So a policy aiming real growth must therefor promote saving and investment, and certainly should not stimulate consumption. Easy money does the opposite: it promotes consumption, discourages saving, penalises investment and productive contribution, in the long run all slowing down real growth; exactly the opposite it was set up to do.

INFLATION : diverting productive Resources to Consumption

ECB president Jean-Claude Trichet can't hide a Mona-Lisa smile while he is stealthly diluting the worker's and saver's buying power.
Artificially low interest rates merely enlarge borrowing margins. They do not increase earnings or possession. This easy access to loans therefor merely creates an illusion of wealth tempting borrowers into unsustainable debt. It is this illusion which temporarily causes an artificial excess of demand over supply, temporarily making everything saleable. Easy loans make expensive consumer goods suddenly appear affordable. Outdated real estate turn into desirable investment projects, and so do business concepts with low retrurns whose life-cycle has since long gone by. Low interest rates and excessive money supply consequently cause asset prices tot rise. As a consequence ever more buying power gets immobilised for far too long in outdated and low-return projects or in shares of outdated businesses.

Postponing Renovation and creative Destruction
By doing so, easy money policy diverts resources from productive investment, ultimately slowing down technological evolution, productivity gains and progress. Real estate in the end gets so expensive that house rent absorbs much of people's earnings, and acquiring a family house engages lifetime savings. The most devastating effect of easy-money however is that by penalising saving, easy money stimulates over-consumption, and slows down capital formation; ultimately the indispensable resource of all technological progress.

Free institure for economic research

(*) Read the whole story in: the book below

The Path To Sustainable Growth
Lessons From 20 Years Growth Differentials In Europe
Martin De Vlieghere and Paul Vreymans
Abstract:    While the rest of the world is booming, Europe lags behind. Europe's performance is weak in spite of high productivity and knowledge, high level of development and good labour ethics. Growth is also remarkably dissimular among regions. France, Germany and Italy are stagnating, and so do Denmark, Sweden and Finland. All gained less than 44% prosperity over the last 20 years. The Irish economy grew 4 times faster, gaining 169% wealth over the same period. In half a generation Ireland so metamorphosed into Europe's second richest country creating jobs for all.
" Big government " is the main cause of Europe's weak performance. The oversized Public-Sector
lacks productivity and undoes the entire productivity gains of the Private Sector, eradicating all of its outstanding performance and productiveness. Europe can improve its overall performance by copying the Irish success formulas: Scaling down Public Spending, downsizing bureaucracy, and shifting the tax burden from income on consumption. This book demonstrates why the Lisbon Agenda and decades of Keynesian inflationist demand stimulation have failed. It devellops alternative and workable supply-side strategies as well as effective cures for humane growth and a financially sustainable social security.
This book reads as a   step-by-step manual for economic recovery.   It is a data-reference for students and politicians interested in growth, wellfare and in social modelling.   It is a  classic  for  economists concerned about Big Government,  poor public sector productivity  and for parents worrying about  their declining standard of living and
their children's future.



Dr. Martin De Vlieghere is economist and doctor of philosophy since 1993.  His PhD was written on the conditions of modernity in the works of Habermas and Hayek. He has been assistant professor at the Department of Philosophy of the University of Ghent. He is president of the "Free Association for Civilization Studies" and member of the board of directors of Nova Civitas.
Paul Vreymans is econometrist and advisor at the Free Institute for Economic Research. As an international businessman he is a close witness of Europe's industrial collapse and the rise of the parasitical bureaucratic complex. He is a founding member of the Brussels' think tank WorkForAll.

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