Monday, January 10, 2011

Hussman Weekly Market Comment: "Illusory Prosperity" - Ludwig von Mises on Monetary Policy

Illusory Prosperity - Ludwig von Mises on Monetary Policy

"Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not a real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth [i.e. the accumulation of savings made available for productive investment]. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent that this economic situation is built on sand."

Ludwig von Mises, The Causes of Economic Crisis (1931)

Historical note - The U.S. stock market lost more than two-thirds of its value over the following year

If one looks back to the recent housing crisis, it is clear that the policy emphasis on easy money was one of the primary elements that created the illusory prosperity of the housing bubble and eventually led to crisis. The same is true of the various other crises that we have observed over the past decade. At present, I am convinced that the misguided policies that have been pursued in response to the recent downturn will again be reflected as significant new strains within a few years, if not sooner. While we will exercise as much latitude as possible to accept moderate investment exposures when the evidence is supportive, we have to be aware of the longer-term outcomes that are being set in motion by the present course of monetary and fiscal recklessness.

Perhaps more than any other economist, Ludwig von Mises got the theory of money and credit right, because he made distinctions between various forms of money and credit that are often conflated by other theorists. The amount of real physical investment in the economy is, and must be, precisely equal to the amount of output not allocated to consumption but instead to savings. Unlike many other economists, Von Mises not only recognized this identity, but carried it through to what it implied for monetary policy. Specifically, he observed that all real investment in the economy must be financed by real savings, while the creation of financial claims (which he called "circulation credit" or "fiduciary credit") in the absence of those savings tends to distort prices rather than output.

What follows are writings that I have selected from Von Mises work. The warnings that he gave prior to the Great Depression were particularly acute. Though Von Mises concerns unfortunately went mostly unheeded, they speak volumes about the origins of the recent crisis, and the risks that we are likely to face in the years ahead. As you read these, keep the recent housing crisis and the recent actions of the Federal Reserve in mind.