Currently Mistaken Ideas in Western Economics and Their Suggested Corrections (preferably soon) Part 1
Sun 8th Sep 2013
Most of the teaching of economics in Western universities has some value, but the hole at the heart of Western economic theory and practice is the complete lack of any practical and proven prescription for the creation of a prosperous, higher growth economy. Consequently there is a large amount of Western economic education which is less than worthless, because the wrong ideas learned at university can ramify into every corner of our minds, and every aspect of our lives, with terrible consequences for other people. Whole populations are suffering because of the inadequacy of government economic advisors and inadequate political leadership in many nations. That requires a remedy. Preferably soon.
2 An Incomplete List of the Main Mistaken Ideas
The purpose of this article is to summarise seven of the main mistakes in Western economics teaching, to point out the unfortunate consequences of these erroneous beliefs, and to indicate how these should be corrected. These seven mistaken ideas are
- the idea that high private and public investment can only be funded by domestic and/or foreign borrowing – that’s wrong because it can be and also has been funded by investment credit creation at the central bank.
- the lack of understanding of wealth creation consequent upon the misunderstanding of private investment funding and the inadequate economic advice to governments following on from that.
- the idea that governments cannot act, in concert with banks and industry, to create much greater wealth.
- the absence of adequate intellectual consideration of the key modification to the saving-investment equilibrium to allow for central bank credit creation producing much higher investment, as originated by Dr Osamu Shimomura and as set out by the master economist Kenneth K Kurihara (1910-1972) on page 79 of his seminal book “The Growth Potential of the Japanese Economy” (John Hopkins Press Maryland 1971)
- the assumption that the interest rate is the major determinant of the demand for private investment funds (when demand is actually determined by the affordability of the loans offered, or the cash-flow cost of capital)
- the mistaken theory of optimal capital financing and its destructive use in bank-industry agreements (when there is no evidence whatsoever that the theory has any practical value - quite the converse)
- the inadequate education about the economic realities of controlling inflation which illustrates that it is possible in a higher-growth economy to equalise the monetary growth of output with the monetary growth in domestic demand and thus to arrive at the outcome of stable factory-gate prices – thus producing minimal inflation with higher growth, as demonstrated in all the investment credit economies and as explained in the work of Kenneth Kurihara.
3.1 Private investment levels can be increased by credit creation at the central bank
An essay in the book Showa - The Japan of Hirohito, edited by Carol Gluck and Stephen R Gruahard, Norton and Company, New York, 1992, illustrates the problem.
One of the fifteen essay contributors (Edward J Lincoln, the Senior Fellow at the Brookings Institute, Washington) makes statements about high Japanese equipment investment (on p196) as quoted below:
"The money for investment in plant and equipment must have come from somewhere in the form of savings. To say Japan was characterized by a high share of fixed capital formation in GDP implies that either Japan generated a high share of domestic savings or borrowed extensively from the rest of the world. Japan did not borrow heavily [in fact it did not borrow at all] from international capital markets, a feature that was reinforced by government policy in the high-growth years after the war (which essentially prohibited the private sector from borrowing abroad)."
My additional text in bracketed italics. He goes on to say:
"Therefore, high investment was funded by high domestic savings."
Absolutely wrong – high investment was mainly funded by credit creation at the Bank of Japan, about which Mr Lincoln appears to know nothing. The money came from somewhere, all right, because it was created by the Japanese Government as an act of monetary policy in the form of investment credits through the re-discounting of the pre-existing loans by the Bank of Japan - but that does not appear to be a possibility that the mindset of Mr Edward J Lincoln can allow.
Mr Edward J Lincoln is not alone in his wrong, and not fully informed, thinking. I could find similar statements in almost any basic economic textbook and it is often an unstated assumption in other economic papers. That mistaken logic forms the basis for some of the incorrect statements in the economic reports about some Asian nations, produced by Western institutions such as the IMF, the World Bank, the OECD etc. It also features in the national debt tables of the CIA World "Factbook," which lists the very real Greek government debts in the same table as Chinese and Japanese government "debts" (when these are actually interest-receiving, income-generating assets). The failure to discriminate between a debt (or money you owe to a third party it has been borrowed from) and an asset (or money owed to you by a third party) makes the CIA public debt tables at best misleading and at worst useless with regard to the Asian investment credit economies of Japan, China and perhaps a few others.
The national government debt table in the CIA World “Factbook” should be reconstituted where required as two columns, one entitled “Government Domestic Assets” showing the loans created at the Central Bank for investment purposes (which are assets held by the Bank of Japan on behalf of the Japanese Government ) and a “Government Debt” column showing the borrowings of the Government from third parties. I have written to the CIA saying so, but perhaps my advice on this issue may not be entirely welcome. Still, these tables need correction, preferably soon.
The major reason for the hole in the heart of Western economics teaching - by which I mean the absence of teaching of any prescription for the acceleration of economic growth - is because Western universities don’t teach Shimomuran economics. They should.
3.2 The Lack of Understanding of Wealth Creation
Credit creation at the central bank can create wealth by increasing the investment level in a country. At every stage in the process, more wealth is created for every link in the financial-industrial chain.
The central bank, in modern banking systems such as the UK, can rediscount the pre-existing financial paper of the secondary banks by creating credit to buy commercial and industrial loans or bonds. No borrowing is necessary for the central bank to finance that monetary credit creation, so the credit creation costs nothing but provides the central bank with an increasing paper mountain of interest-bearing assets without any corresponding debt.
The extra credit can be used by the secondary banks to advance investment credit loans to the productive economy, providing the lending banks with interest-paying assets. The plant and equipment investments provide tax receipts from their installation and more employment with the tax receipts arising from that plus value added or sales taxes for the government from the additional outputs of goods and services.
In some cases (eg sometimes in China) the central bank creates credit and provides interest-bearing loans directly to the secondary banking system. The result so far as the Bank of China is concerned is almost exactly the same, the only difference being the secondary banks are paying the interests on the loans thus made.
It is of course possible for the process of credit creation by the central bank to be used in four different ways, or in any mix of these ways. Credit creation in all cases leads to increased liquidity in the secondary and subsequent banking system, and that increased liquidity could be used to meet different objectives. First, it could be targeted, like the “qualitative easing” operations as the £375bn Bank of England credit creation has been, to support the pre-existing banking system by increasing its liquidity, with no subsequent useful real investment resulting from that activity. In that case it is an act of financial credit creation (FCC) - useful for increasing the liquidity of the banks and avoiding bank collapse (surely a desirable outcome for which Mervyn King deserves our thanks) but useless and ineffective as an instrument for improving national wealth.
Second, the central bank credits could be created as a deliberate act of investment credit creation, targeted at providing cascades of long-term low-repayment cost investment credits, from loans from secondary banks mainly to industry but partly to commerce, in order to create anew, or modernise or upgrade the fixed plant and capital equipment in the factories and service industries in the country. That use of credit is investment credit creation (ICC) and is the principal mechanism which has produced the three historical economic miracles of FDR’s USA (1938-44) Japan (1946-75) and China (from 1975 to the present day).
A third possible focus of bank-created credit is possible - it could be used speculatively, to finance an enormous asset bubble. That is what happened in the Japanese asset price bubble from 1986 to 1991. If the central bank credit creation is misused for speculation, it obviously becomes speculative credit creation (SCC). From the Japanese example, the misuse of credit, intended as investment credit, for asset price and property speculation, can break the bond of trust which ICC creates between government, banks and industry and can throw an economy into the economic doldrums for a generation.
Finally the increased credit can be used to increase the spending power of consumers, in which case it is consumer credit creation (CCC). The creation of additional credit by government in order to create additional consumer demand is a good use of credit in a depression, as Keynes argued, because it increases prosperity by stimulating a greater use of already installed productive capacity.
Unfortunately, the Keynesian remedy was applied during the late 1970s in circumstances of nearly full employment and the almost full use of pre-installed factory capacity, in a situation of constrained supply. But another two of Keynes‘ major observations - that “there is no intrinsic reason for the shortage of capital” and that saving can be created prior to the investments which justify it - are entirely relevant to improving economic development and supply through investment credit creation.
Governments have a real policy choice in this area, which they should exercise in favour of investment credit creation. Universities teaching economics should teach that possibility. Preferably soon.
3.3 Government Action Can Create Much Greater Wealth
Another erroneous idea is that governments cannot act, in concert with banks and industry, to create much greater wealth. But the great growth of the USA from 1938-44, when the USA doubled the real size of its economy, the unprecedented speed of Japan's recovery from wartime devastation and the rapid growth of Japan to become a major industrial power, as well as the great growth of China, were all caused by intelligent government action to provide created investment credits for canalisation through the secondary banking system to private industry to meet an over-riding government objective.
Economists are not alone in thinking that governments can act to create wealth, although Milton Friedman (1912-2006) powerfully argued they couldn't. The British Treasury is similarly misguided, as the Treasury-drafted section of Sir Geoffrey Howe's 1982 Budget day speech illustrates, in which the British Government turned down the improvement in UK investment funding which I (and the other members of the Grylls Group) were lobbying for and advocating:
“It is the orthodox Treasury dogma, steadfastly held,” he told the House of Commons,”that whatever might be the social or political advantages, very little additional employment and no permanent additional employment can, in fact, and as a general rule, be created [from] state borrowing and state expenditure. Some state expenditure is inevitable and even wise and right for its own sake, but not as a cure for unemployment.”
But investment credit creation is neither state borrowing nor state expenditure. It is credit creation – the creation of state assets based on the lending of the central bank to the local domestic banks, increasing secondary bank liquidity by re-discounting pre-existing loans, with a direction that this fresh credit should be onward loaned to the domestic private commercial and industrial companies for investment purposes. The absence of a realistic UK Treasury economic understanding that state-created investment credit can create wealth by indirectly providing the BoE credit that ultimately funds productive investments (which subsequently produce better products and services) is one of the major factors in the economic decline of Britain.
The state does not need to borrow domestically or abroad to fund investment credit. The credit created in the banking system by Central Bank action is as real as any other money. The repayment of industrial investment credit loans is the best use of credit because the repayment of these loans is based upon real growth - increased outputs and better manpower productivity.
In a sterile monetarist-advised economy, every cycle of contraction produces rising unemployment and all the increasing welfare costs and misery associated with increased poverty. A significant part of the labour of the people runs to waste, because labour must be used when it is available or lost forever.
In a creative investment credit economy, the cyclical nature of higher investment and better machinery investments creates some unemployment, but these unemployed are taken into the continually expanding private investment sector of the economy, increasing and deepening the capital base of the economy and increasing the future dynamism of the economy and the national capabilities for growth.
Universities should stop teaching the Milton Friedman nonsense that governments cannot act to improve the wealth-creation process, and teach the contrary proposition that well advised governments can act to increase economic growth.
3.4 How Economic Theory Is Modified by the Shimomuran Saving-Investment Equation
I have already set out the amended theory of this issue in several articles in the London Progressive Journal so will keep this section brief.
The key observations have already been made in the articles about Dr Osamu Shimomura and Kenneth Kenkichi Kurihara. See “The Master Economist Dr Osamu Shimomura”
and “The Key Relevance of the Writings of Kenneth Kenkichi Kurihara”
The interesting insights of Professor Kenneth K. Kurihara in his book “The Growth Potential of the Japanese Economy” (John Hopkins Press Maryland 1971) should have been integrated into macro-economic theory by now, but are unfortunately not taught at any British universities. So, at the ever-present risk of repeating myself, here goes it.
On page 77 of that book Professor Kurihara quotes the equilibrium condition of the central investment-funding equation of the Shimomura Model of the Japanese economy as
S+D = Is+Id (Equation [3.1], p77)
Or Saving (S) plus Debt (D, equal to investment credit creation at the Bank of Japan) equals
Is (Investment financed by saving) plus Id (Investment financed by debt)
That is, the investment level of Japan is increased by credit creation at the Central Bank of Japan.
This equation replaces the classic Keynesian Savings-Investment equation with a more useful formula because (if the nation’s banks give a high priority to commercial and industrial investment) the government of a country can increase the nation’s investment level through investment credit creation at the Central Bank.
This equation sets up the conditions for an explosively expanding economy because of the structural imbalance created, with total investment exceeding saving by the investments created through the additional credit creation at the central bank.
Leading British universities teaching economics please note: if you don’t understand and teach Shimomuran economics, and you do not understand the investment credit creation well-spring of high growth economics, how can you be among the best in the world as researchers and teachers of economics? If you wish to retain your currently high status in the teaching of economics, please learn, adapt and flourish. Preferably soon. I wish you well in your endevours.
© George Tait Edwards 2013