On March 9th 1776, Adam Smith officially published his Inquiry into the Wealth of Nations, or The Wealth of Nations for short. In this work, he examined how a nation’s wealth increased, decreased and behaved according to various social and political events and decisions. It is then that he first defined the term invisible hand from an economic point of view. Along with it he introduced the notion of a free market and supported the idea of having a free market. Almost 250 years on, does this notion of free market apply in today’s world?
The short answer to this question would be a definite yes, however if we closely examine today’s economy not only from a purely economic perspective, but from a social and political (sadly) point of view, we will see that today’s world market has become a vicious debt cycle that reflects heavily on today’s society and that is influenced just as much by a country’s government as it is by the fundamental rule of supply & demand.
Ever since the financial collapse of the Housing bubble and Wall Street in 2008, the U.S (and with it most of the world) entered an economic debt cycle never before seen. Countries were experiencing larger and larger balance of payments deficits as each year passed by. Babies were literally born with debts, and with that debts they may never be able to realistically pay off. The worst part was, and still is, that the U.S. is incapable of paying off their foreign debt (which the country’s economy has been built on). This means that if the U.S. were to pay off what they owe, the U.S. market of goods, services and employment would go into bankruptcy and drag down the world economy with it. Sadly this applies not only to America, but to other major countries in the world today such as China, Brazil, India and a great (sadly) number of Third World Countries and LEDCs (Less Economically Developed Countries for short). This is just one example of economic paradox that makes us ask the question “How did this happen and why did the free market system that most countries know today let that happen?”
There are two main terms we need to remember here: quantitative easing and open market operations, both of which are piloted by the Central Bank of a given country and will be explained in the following lines.
Say a country is currently experiencing a stagnating economy, i.e. the growth rate of that country is minimal or non-existent. In order for this country to increase its economic growth, it needs to increase the amount of money that circulates in the market, meaning it needs to get more people to spend more and subsequently to produce more. The government or the Central bank may intervene here in two ways through either monetary policies (policies that revolve around the Central bank’s power over the money supply in a market, i.e. raising/lowering interest rates, the above mentioned quantitative easing and open market operations etc.) or fiscal policies (policies that revolve around governmental intervention, e.g. subsidizing, public spending etc.). We will mainly focus here on the monetary policies used by Central banks in today’s world, how they influence the economy, as well as how they interact with the law of the free market and economic freedom.
If the given country is in a period of stagnation, that country’s Central bank may decide to lower interest rates in banks in order to stimulate loan taking and thus increase the money supply in a country. However, this method isn’t always effective since it relies on citizens taking loans, which they may not want to do (even if they can do it at lower interest rates) for personal reasons or for fear of being incapable of paying the money back to the bank. However, if a Central bank decides to print money (this is what quantitative easing essentially is) and that money enters the monetary flow of the country’s market (i.e. the amount of money that circulates in the country’s market), then this would surely increase the economic growth of the country since more people would be spending and thus producing, right?
Wrong. By simply printing more money, the central bank increases the amount of circulating money in a very artificial way which defies the principle economic law of Supply & Demand (To quote Jean-Baptiste Say, a 19th century French classical economist, “Supply creates its own demand.”, meaning there needs to be a higher supply of goods & services in order for the demand for those goods & services to increase, and with it the money supply of a country). This so-called easing causes inflation rates to rise and increases poverty rates, causing the value of money in a country’s market to greatly decrease, sometimes even overnight in a few extreme cases. Quantitative easing is a highly ineffective method of increasing the money supply in a market because it is artificial and opposes Smith’s theory of the Invisible Hand, which should be the one regulating the amount of money in an economy.
Another way for Central banks to manipulate the monetary flow of a country’s economy is through open market operations. In simple words, the Central Bank would buy and sell bonds from and to banks and resell them at exponentially higher prices. The banks would then use the money they made from selling bonds to the Central bank to create more loans and thus increase the money supply in an economy, or, alternatively, decrease the money supply in case they bought bonds from the Central bank. Just like quantitative easing, this method of money supply increase creates artificial inflation and may cause a bubble similar to the one of the 2008 financial crisis (which was caused by the above-explained method of money supply increase through the buying and selling of bonds by banks).
But how does this relate to the topic of economic liberty and market freedom? Many economists today, including names such as Nobel Prize winner Thomas Piketty, have said that we need to free today’s market from the influence of the major international private banks. In an interview he did on the topic of free markets with website bigthink.com, Piketty says “{…} we need strong public institutions in order to regulate these market forces.” The key term we need remember here is public, whereby it is the government that, through subsidizing and increased public spending, needs to make sure that the market is self-regulatory instead of it becoming internationally controlled by a small group of multi-billion privatized banks who can, if big enough, control the Central bank’s open market operations policies.
“Why am I reading an article on Macroeconomics and how does this relate to freedom?” I hear you ask. The main goal of this article is to demonstrate that economic freedom, i.e. not being financially tied to anything/anyone (an example of such freedom would be Smith’s theory of the Invisible Hand and free markets) is highly subjective. Even in a system dominated by a so-called free market, the reality of things is that this free market is in fact regulated by governments as well as Central banks (and multi-billion private banks) alike. Such freedom like the one classical economists such as Adam Smith, Jean-Baptiste Say and Thomas Malthus promoted and supported exists only in confined spaces today and is
determined not by natural forces such as the law of Supply & Demand, but by artificial processes that have proven to cause economic catastrophes not once, but twice, first in the 1930s and not more than 7 years ago in 2008.
Sources:
1. Chris Gallant, “How do central banks inject money into the economy?”, Investopedia Inc., Web. 28th Oct 2015, http://www.investopedia.com/ask/answers/07/central-banks.asp
2. Unknown, “Open Market Operations Explained”, Investopedia Inc., Web. 30th Oct 2015, http://www.investopedia.com/video/play/open-market-operations-explained/
3. Unknown, “Even Adam Smith Didn’t Trust the Invisible Hand, with Thomas Piketty”, The Big Think Inc., Web 30th Oct 2015, http://bigthink.com/videos/why-markets-need-regulations
by George Vutov
Nicely written, but theres some comments to be made.
ReplyDelete1. All money, by definition, is debt. Debt isnt inherently bad, on the opposite, without debt our monetary system would cease to function.
2. Inflation is essential in promoting economic growth. Inflation is only bad if its excessive which is what happens in a hyperinflation scenario like in germany 1923. As to create economic growth, central banks aim to create an inflation rate of 2% to keep the economy going. What happened in the economic crisis was that the rate of inflation was too low and that banks and businesses were reluctant to spend money as a consequence as it retained to much value over time. The ecb tried to solve this by devaluating the euro, inflation basically, by injecting loads of money into the economy (q.e.)
3. You say that quantitative easing is bad since it artificially interferes with the market. Besides thw fact that a free market is a neoliberal myth (which you imply in the last paragraph) and that capitalism has always strongly depended on very strong regulating states, a few lines further you propose that the government should intervene with subsidies and increased public spending which, from a neoliberal perpective, would again be a gross artificial intervention by the state into the free market and from a rational perspective logically not a step towards a freeer market.
4.The law of gravity is a natural law, the thermodynamic principles are natural laws, economic principles are not natural laws. Economics is still a social science and markets are social constructs. They seem to obey to certain laws, but those are more social than natural.
5.Saying that government and central bank intervention in the market are articficial and dangerous to the economy, all while citing an article whose title is "Why Markets Need Regulation" is.......Interesting? (at best)
Nicely readable though
Hi, thanks for your feedback, in reply to the comments you made:
Delete1. The point I was trying to make about debt is that, in the case of the U.S for example, it has become an essential part of the economy since the country was built on debt, literally.
2. I did not (or at least did not intend to) say inflation is bad. Central banks should excise their power to maintain inflation low and stable. The argument I tried to pass through is that artificial inflation, i.e. trying to drastically change inflation rates by dumping a huge amount of money in the economy, is highly ineffective as you explained (Yes I am aware that most if not all economic processes are artificial, i.e. man-made since economics is a study of human behavior, I am referring to extreme cases of human interference, so point taken regarding terminology)
3. When talking about artificial intervention regarding the free market, and in relation to the second point you made, I was referring to monetary policy intervention, and in particular the way it can be exploited, like for example through open market operations, which although should be dictated by the will of the Central bank, are sometimes operated by private banks (like the lead-up to the Housing bubble collapse of 2008 for instance). A few lines further, I proposed government intervention through increased public spending in support of Piketty's (left) views, i.e. utilizing fiscal policies that should not be interfered with by private entities.
4. Again, point taken regarding terminology.
5. As said in response to your third point, I am mainly criticizing the role of the Central bank in today's economy, as well as (some of) the monetary policies it puts in use. I am, however, in support of the idea that governments should fiscally impose SOME regulations on the market, as explained in the stated interview. Suggesting that monetary and fiscal regulations are the same is... interesting?
In relation to the last point, I would also like to say that Smith, although innovative and for the most part right in his theories, failed to acknowledge the true nature of people. The one major flaw in his work is that he assumes people do what is in everyone's interest and fails/misses to take into consideration the fact that individuals pursue personal gain (this can be explained through a variety of examples and theories, namely the Tragedy of the Commons). This is where governments should intervene in order to insure that no individual is capable of exploiting others/the market by chasing their own interest. The main point of the article is that it fails not in what it seeks to achieve, but in how it seeks to achieve it.
Thanks again :)
An interesting read & strong conclusion!
ReplyDelete