Currently Mistaken Ideas in Western Economics and Their Suggested Corrections (preferably soon) Part 2
Mon 9th Sep 2013
3.5 The Major Determinant of Private Investment Demand is the Repayment Cost or the Affordability of Borrowing
The assumption is 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. This issue is so vital that John Carrington and I devoted a book to the subject (“Financing Industrial Investment”) in which we demonstrated that the demand for industrial and commercial loans is entirely dependent on their repayment costs. During the 1970s, Japanese industry had borrowed over 90% of GDP, but the annual repayment rate was about 6% pa, so their annual repayment was about 5.4% of GDP a year. German industry had borrowed about 40% of GDP, and their annual repayment rate was about 20%, so they were repaying about 8% of GDP a year.
The Public Affairs Unit of The CLCB and their successors, the British Banking Association, have always acted as if their profit-maximising interests were all that mattered and public relations propaganda in support of that objective has been their recurrent activity for decades. But you cannot ignore the indisputable reality that some financial-industrial arrangements are better at producing the goods than others. See
The misguided Public Relations propaganda of the British Clearing Banks has always argued in favour of their profit-maximising activities. This led, within the last few years, to the merchant bank branches within the UK banks becoming the dominant force within these banks, which then gambled with as much of the national savings as they could in a speculative credit-creation bubble. That speculation failed on a massive scale and the banks have had to be supported by no-debt credit creation at the Central Bank, in the UK, the USA and the EU. It is high time that credit creation is used to help the real economy by being targeted at the most productive sections of the economy. Preferably soon.
As Feynman said with respect to the Shuttle disaster:
“For a successful technology, reality must take precedence over public relations, for nature cannot be fooled.”
Perhaps the British Banking Association (the renamed successor to the Public Affairs Committee of London and Scottish Clearing Banks) need to realise that Feynman’s observation applies with equal force to the financial-industrial technology of nations as well as it does to the operations of the Space Shuttle.
3.6 The Mistaken “Trade-Off” Theory of Optimal Capital Financing
There is an optimal theory of capital financing which is taught in universities and which implies that the optimal mix of debt and equity is 30% debt, 70% equity.
This theory must be intellectually impressive because the Bank of England has accepted that the UK banks can insert a clause into loan agreements saying (I paraphrase) that if the debt-equity ratio rises above 30%, then all the bank loans of the company must be immediately repaid. This clause in loan agreements has been responsible for a significant amount of industrial collapse, because bankers have bankrupted companies by requiring the immediate repayment of debt because of a technical infringement of this clause. Stone-Platt, for example, was not (as Wikipedia records) shut down because it could not repay the debt repayment schedule required by its bank loans, it was shut down because of a technical infringement of the debt-equity ratio which required the immediate repayment of all its bank loans.
There is only one thing wrong with the theory of optimal financing - it bears no relationship to the real world. Japanese companies are funded by over 90% debt, French and German companies often have over 60% debt funding. There is no real-world relevance of the theory of optimal financing. It is a destructive bit of intellectual nonsense. (Robin B Fox, in his article “Leverage in UK Companies 1967-73, An Empirical Investigation”, Management Decision, Vol 1, 1977, tried to find evidence for this theory and for the idea that high-debt firms would be in low-risk industries but he could not find any supporting evidence for the theory).
As Feynman has commented, theories are only useful if they relate to the real world. The theory of optimal finance doesn’t. High levels of debt have helped European and Japanese firms to invest much more without these companies running into this destructive and inapplicable theory, which is limiting the growth potentials of British industry. This theory should be completely disregarded in all loan agreements, preferably soon.
3.7 Dealing with inflation and deflation
Furthermore, inflation can be better managed when economic growth is high, as the Kurihara equations illustrate (See Pages 77 to 79 of Kurihara’s 1971 book where the equations for economic growth without secular inflation are set out). What Professor Kurihara has done in these equations is to calculate the investment-produced increase in the production function for the Japanese economy and to compare that with the extra financial demand for these outputs.
Western economists need to learn and teach about this possibility. Preferably soon.
4.1 Adequate Wealth Creation in Modern Nations depends on the Understanding and Practice of Investment Credit Creation
Western economists who do not understand investment credit economics do not understand the fundamental processes of wealth creation. All Western economists – nearly every one of these highly-trained university economic graduates and doctorates, perhaps some hundreds of thousands of people - are all taught, as fundamental articles of faith, a few things that are entirely wrong. The results would be hilarious except for the fact that these mistaken ideas are now, and have for decades, produced increasing misery and poverty for millions of people, not only in the richer countries but also in the developing world. These mistaken ideas prevent some economists from understanding what they are looking at, and from giving correct advice based upon that better understanding.
Universities should stop teaching the logic of the excluded middle and that the only source of external debt is foreign or domestic saving, because central bank created investment credit can play a major part in providing the funds for economic development.
4.2 The lack of understanding of wealth creation
Misunderstanding private investment funding and the inadequate economic advice given to governments leads governments to behave in a moribund or growth-decreasing manner. Governments and their advisors need to know what they can do.
4.3 The idea that governments cannot act, in concert with banks and industry, to create much greater wealth.
Governments can be useful in increasing the rate of economic development if they understand the fundamental economic forces better. As Henry Ford has commented, “Whether you think you can, or think you can’t - you’re right.”
All the high-growth governments showed abundant courage and great self-confidence in implementing investment credit economics in the desperate situations in which they found themselves. Roosevelt was one of the most confident and competent presidents the USA has ever had, hence the American economic miracle of 1938-44. The Japanese Government in 1945-6, and in subsequent decades, showed great courage in implementing the investment-credit-creating advice of Shimomura. The 1972 Chinese Government showed great foresight and determination not only in sending many economic teams to Tokyo to discover how Japan had produced rapid economic growth, but they also followed through on the largest possible scale to deliver the Chinese economic miracle.
The idea that governments cannot act, in concert with banks and industry, to create much greater wealth is entirely wrong. They can and they should. Preferably soon.
4.4 The disregard of Shimomuran Economics
Shimomura was an Asian Keynes. The absence of adequate Western academic intellectual consideration of his 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) is a major omission from Western economic teaching. That omission needs to be corrected, preferably soon.
4.5 The assumption that the interest rate is the major determinant of the demand for private investment funds
The demand for investment funds is actually determined by the affordability of the loans offered, or the cash-flow cost of capital. How could it be otherwise?
4.6 The mistaken theory of optimal capital financing
As Feynman has accurately remarked, the usefulness of any theory depends upon its relevance to the real world. The theory of optimal finance has no relationship to the real world. Its destructive use in bank-industry agreements (when there is no evidence whatsoever that the theory has any practical value - quite the converse) is quite inappropriate.
This theory belongs in the dustbin. Now.
4.7 The management of inflation
Western economics teaching has generally ignored the developments which illustrate that it is possible in a higher-growth economy approximately to equalise the growth of output with the growth in domestic demand and to arrive at the outcome of stable wholesale prices – minimal inflation with high growth.
4.8 General Comments
In the final analysis, Western governments (for want of a better collective expression) can no more ignore the new phenomenon of investment credit economics producing explosive economic growth than other countries could ignore Britain’s innovation of industrialisation. Investment credit economics – the economics of Franklin Delano Roosevelt in the USA, of Shimomura in Japan as explained by Kurihara, and the highly significant Chinese copying of these financial industrial systems - have already given us the postwar economic and political dominance of the USA, the rapid recovery and development of the industrial giant of Japan, and the rise of China to world power (with more to come).
The lack of competent western academic focus on the successful Asian understanding of macro-economic principles has produced a vacuum at the heart of western consideration of economic development. In the 1990s, the politicians and economists of Japan politely but firmly showed their IMF visitors the door with the mild comment that perhaps the IMF remedies were inappropriate in the Japanese context. What they perhaps meant, of course, was that IMF economists who do not understand the Shimomura model cannot knowledgeably comment on how to run the Japanese economy. The comments some of the IMF team - that the Japanese people should save less and thus increase the effective level of demand - were unfortunately badly mistaken because the Japanese people do not have any access to the mountain of debt, written down as “public savings” (to which the public have no access) as a counterpart entry to the value of the asset mountain created by the Bank of Japan.
The rapid industrial development of China is hollowing out US industries in the same way that Japanese development in the last century hollowed out UK industry. That need not continue in the presence of an adequate economic understanding.
An understanding of the additional principles set out above can enable an improvement in the government operation of macro-economics and improve prosperity for decades. Economists who accept and understand these principles could provide much better advice to the governments they serve. The wealth of nations could leap forward once again through the faster adoption of innovations and a better response to the recurrent annual disasters arising from the climate change.
4.9 One Potential Downside of Investment Credit Creation
But – as the outstanding mathematician Godel has pointed out - no intellectual system can ever be both consistent and complete. Intellectual systems can be complete but inconsistent, or consistent but incomplete. That result is not merely applicable in the realm of mathematical models but has a general applicability to all intellectual systems of understanding.
The practice of investment credit creation in Japan has illustrated difficulties which were not obvious in the 1970s, when, along with John C Carrington, I first began to research this area. These problems would never have been revealed if the theory of investment credit creation had remained only a theory.
The practice of investment credit in Japan has shown how easily investment credit creation can be subverted into non-productive speculative credit creation (SCC), financing the intense Japanese asset and property bubble and destroying the prospects of a generation through the debt overhang and through the temporary destruction of trust between the three key players of the government, the bankers and private businesses.
Shinzo Abe is now acting to re-create the bond of trust that lies at the root of the successful practice of Shimomuran investment credit economics and there is every likelihood that he will succeed.
One of Kurihara's conclusions is a devastating rebuke to the current behaviour of many Western governments. Kurihara said:
"If, therefore, greater investment can be financed partly by credits, there is no need for that 'abstinence' which the classical economists considered necessary for economic progress, any more than there is for that 'austerity' which some present day underdeveloped countries impose on an already under-consuming populations at the constant peril of social unrest. Nor is it difficult, in such credit-creating circumstances, to agree with Keynes' observation that investment and consumption should be regarded as complementary rather than competitive."
Kenneth K. Kurihara “The Growth Potential of the Japanese Economy” (John Hopkins Press Maryland 1971) pp137-8.
This observation could hardly be more relevant at a time when the British Coalition Government has introduced deep cuts in public services and government expenditure, when the EU is destroying part of the productivity of some EU nations through savage cuts in government expenditure, and when the US government is floundering with no industrial policy in the aftermath of the credit crunch, unnecessarily borrowing from China the funds that investment credit creation could have provided if economics were slightly better understood by American economists and politicians.
The abstinence and the austerity are both completely unnecessary. The waste of people’s lives due to mass unemployment brought about by inadequate political and economic understanding, the loss of the outputs of the unemployed, that could have added enormously to the capital base of the economy, the terrible loss of family living standards and the destruction of the prosperity of whole industries, some cities and many communities - all completely unnecessary.
A much better solution to the credit crunch crisis is the creation of investment credit at the central bank provided that credit can be canalised via secondary banks to commercial and industrial investment. It is not true to say that investments have to be paid for in advance, because they can be paid for out of the increased output of the economy, out of the economic growth these investments engender.
The implications of all these observations are completely revolutionary. Many less developed, under-equipped countries could follow Japan’s lead, as China, South Korea and Taiwan already have, more rapidly to develop their domestic economies, without depending on external finance. Poverty could rapidly (and really) be made history in virtually all countries with an educated workforce and a competent government. And in the Anglo-Saxon and EU group of countries, much higher economic growth based upon investments to reduce import dependence on finished goods could produce considerably higher prosperity, the much faster adoption of the already available innovations based upon existing technology, and in the future faster development of new innovations in energy generation and use through new technologies and the faster adoption of the machinery of a greener economy.
© George Tait Edwards 2013