The AAS Economics framework
How we're different to mainstream economic analysis
Summary
In the AAS Economics (AASE) framework production precedes consumption so the focus should be on the former rather than the latter, with decisions of individuals, especially as producers, being paramount. Demand is a consequence of producers producing more than they require for subsistence and seeking the output of other.
Economic growth is a result of productivity growth, which in turn requires saving in order to finance productivity-enhancing.
Money functions as a medium of exchange – only as a medium of exchange – between goods and services which could otherwise be exchanged via barter
With central and private sector banking the core function of money as a medium of exchange is distorted through artificial changes in money supply growth above or below what a commodity-based monetary system (e.g. gold) would deliver.
Central banks and private sector banks can create money and the latter does this via fractional reserve lending i.e. by crediting client accounts with money not backed equally by amounts in other bank accounts.
Increases in bank-created money set in place severe economic distortions, whereby new businesses or activities arise or existing activities expand at a faster rate than would have occurred in the absence of this new money creation. These new or expanded activities are “bubble” activities which are reliant on the continuation of the distortionary money creation of the banking system.
The transmission of money means some people receive the newly created money earlier than others and this creates different performance and growth rates in different areas of the economy.
Bubble activities multiply as the money creation process continues and this appears as an increase in apparent general economic activity. In reality this is a process of real wealth erosion.
Costs rise faster in some sectors than others and this increases costs in some businesses without the ability to raise prices. This squeezes businesses in some sectors, with a resultant decline in activity, and can also create systemic increases in prices.
Banks reduce credit supply to struggling businesses which in turn reduces their demand for the output of supplier businesses. Faltering businesses increase in number and a negative feedback loop ensues whereby growing business weakness leads to an extension of credit rationing by banks.
Due to the increased price level central banks may also act by reducing money supply growth e.g. through open market operations.
This combination of factors turns an artificially created boom into an equally artificially created bust.
By properly measuring money supply and by using the lags between monetary growth and economic activity it is possible to predict the cycle itself and also the performance of various assets and sectors within the cycle.
The best solution to the overall problem of business cycles is a return to some form of commodity-related money such as gold.
Question (Q): What is the difference between the AAS Economics paradigm and that of mainstream economics?
A: In the AASE framework the emphasis is on individual human beings rather than on some independent macro economy. Moreover, in mainstream thinking the key driver of economic growth is an increase in consumer spending. This is based on the observation that consumption comprises almost 70% of overall expenditure in the economy, where overall expenditure consists of government outlays, investments and consumer outlays.
Q: How does the AASE approach differ?
A: Our central view is that what matters for economic growth is the ability to produce goods and services. In order to consume one must first produce something of utility that can be exchanged for some other useful thing. As a simple example a baker produces and exchanges two loaves of bread for five tomatoes. Note that the baker here secures the tomatoes by first producing bread. In the AASE approach the baker has envisaged that he can produce and exchange two loaves of bread for other products or services that he needs. Likewise the farmer has produced five tomatoes because he has anticipated a demand for his tomatoes from others such as the baker. The demand for the tomatoes produced by the farmer can, in this example, only come because the baker has baked the bread that later requires an exchange of bread for tomatoes. Hence within the AASE framework the mere fact that somebody has produced something in a quantity exceeding his own subsistence needs implies that he has set in motion a process leading to a demand for others’ goods and services. This means that demand does not stand independently of supply.
“For AAS Economics the central driver of economic activity is production. Production precedes consumption and consumption is itself a product of output exceeding subsistence. Without this surplus output there can be no demand for other entities’ output. Economic growth derives from productivity growth, which itself is a product of investment driven by savings.”
Q: How then does economic growth emerge?
A: Savings is the key to economic growth. To take the above example, if the baker wants to lift his production from two loaves to ten loaves of bread he must enhance and improve his oven (or buy a new more productive one). In order to improve his oven he would have to allocate some of his produced bread towards the payment for a technician who will improve the oven. By paying the technician some of his produced bread the baker funds the improvement of the oven. Note that the bread that is used to pay the technician is the savings of the baker - instead of eating the bread the baker puts aside some bread and uses it to pay for the technician’s services. With an enhanced oven the production of bread can be lifted. In our example, this increase in the production of bread is the essence of economic growth. The increase in the production of bread also means an increase in real wealth. Note that real wealth is comprised of goods and services that are required to maintain people’s life and well-being.
“Economic growth derives from productivity growth, which itself is a product of investment driven by savings.”
Q: Where does money enter into the production and exchange process?
A: In the AASE framework money is simply a medium of exchange. A producer produces something useful and then exchanges it for money. He then exchanges money for other useful things. This means that in the AASE framework money just facilitates the exchange of goods and services. People still have to produce things in order to acquire other things. Money just makes this entire process much easier. A professor of physics, for example, would not seek a baker who would agree to exchange bread for lessons in physics. Instead, he can exchange his lessons at the university for money and then exchange that money for bread. Note that when a producer exchanges his produce for money and then money for other produced goods he doesn’t take from the pool of produced goods, i.e. the pool of savings, without giving something useful in return - hence something is exchanged for something (with money facilitating this process).
Q: In what circumstances can an increase in money supply negatively affect the economy?
A: An increase in the money supply– i.e. an increase in paper money – sets in motion an exchange of nothing for something. This can occur via two sources: the central bank and the private sector banks. Let us say that a central bank has printed $100 and exchanged those dollars for some good or service. The central bank did not secure the $100 by producing something useful – rather it obtained the $100 out of “thin air”. Hence the central bank is exchanging nothing for something. This means that the central bank now takes from the pool of real wealth without contributing anything in return.
Q: How do private sector banks create money?
A: At any point in time an individual can hold his money either in his pocket or under his mattress or in a safe deposit box. The money kept in the safe deposit box is labeled as money kept in a demand deposit. An individual, the owner of the money, has an unlimited claim on it. Let us say that an individual Bob has placed $1,000 in demand deposits with Bank A. Let us say that Bank A was approached by Tom who wished to borrow $500. The bank then takes $500 from Bob’s demand deposit. It is like opening his safe deposit box without his consent.
By lending the $500 to Tom, Bank A places the $500 in Tom’s demand deposit. We now have here a new unlimited claim on $500. Overall we now have unlimited claims on $1,500, which are backed by only $1,000 of original money. The extra $500 is newly created money out of “thin air”. Note that both Bob and Tom can now use a total of $1,500 for spending. Also note that Bob never agreed to lend or temporarily relinquish his claim over $500.
Q: What is wrong with this credit creation by the banks?
A: As with the central bank example, the newly created money sets in motion an exchange of nothing for something, which implies the diversion of real wealth from wealth generators towards the holders of the newly created money. It also sets in motion the problem of the boom-bust economic cycle.
“Money serves the purpose of a medium of exchange. Artificial increases and reductions in the growth rate of paper money – by central and private sector banks – distort price signals and create economic bubbles and crises.”
Q: How does an increase in bank-produced money generate boom-bust cycles?
A: As a result of this newly created money there is now an increase in the demand for goods and services. The individuals who hold the new money and then exchange it are setting in motion an exchange of nothing for something. In a barter economy (i.e. when exchange is of goods and services for goods and services) an exchange of nothing for something is highly unlikely if not impossible. In the money economy, when the exchange is indirect (i.e. goods are exchanged for money and money exchanged for goods) this is quite possible. Note that if the pool of real wealth is expanding the increase in the money supply will appear to be associated with the increase in the overall demand for goods and services. This gives the misleading impression that the increase in money supply causes the increase in the overall demand for goods.
Q: So this means that an increase in bank-produced money cannot grow an economy?
A: On the contrary it will divert real wealth from wealth generators and undermine its production. As mentioned, if the pool of real wealth is expanding (via increases in savings-induced productive investment) then the increase in the demand for goods and services is misleadingly attributed to the increase in money supply, whereas in fact it is on account of the increase in the pool of real wealth. The increase in the money supply here alters the composition of demand. Demand emanating from true wealth generators comes under pressure whilst demand from the holders of newly printed money expands. As long as the pool of real wealth is expanding the money printing can generate the illusion that it generates economic prosperity, also called an economic boom.
Q: What is actually happening when bank-produced money supply is increasing?
A: In reality what is emerging is the consumption of real wealth. The ongoing money printing ultimately starts to manifest through an increase in the prices of goods and services and pressure on the profit margins of companies.
“Newly created money by central and private sector banks reaches different individuals and businesses at different times. This creates artificial advantages for some sectors and artificial disadvantages (especially through cost pressures) for other sectors.”
Q: Why is that so?
A: When new money enters a particular market it means that there is now more money per good in that market. Since the price of a good in a market is the amount of money per good in that market the overall prices of goods in this market now increases. As money enters other markets the prices of goods in these markets follow suit. The increase in money doesn’t spread instantly to every individual in an economy. There are early recipients of money, later recipients and then those who don’t receive it at all. When money is injected into the economy it starts with a particular individual or business who uses it to buy goods and services in a particular market. The money then moves from recipient to recipient and other markets, etc. There are time lags as new money moves from market to market and some businesses are confronted with rising costs while the prices of their products are still unchanged. This leads to pressure on profit margins in some industries.
Q: What undermines the boom?
A: As a result of a decline in profit margins in some companies the banks, who have been aggressively expanding their lending out of “thin air”, begin to reduce their credit expansion. Those activities that sprang up on the back of the higher money supply growth must now reduce their demand for goods, services and labour. Remember that these activities, which we label as bubble activities or artificial forms of life, rely on the maintenance of rapid money printing which diverts real wealth to them from genuine wealth generators. These bubble activities must now slow down or be curtailed. This leads to their decline, which extends and forms the phenomenon popularly known as an economic downturn or bust. If the pool of real wealth is stagnating or declining then the overall demand for goods will follow suit.
Q: Could central bank policies also set in motion an economic bust?
A: By slowing down the rate of money supply injection the central bank can also trigger an economic downturn.
“As some sectors boom banks lend them more money out of thin air. As others are disadvantaged bank credit to them is rationed. The entire industrial structure is distorted and the combination of price pressures in some industries and declining profitability in others becomes widespread and destructive.”
Q: What is the relationship between the pool of real wealth and the economic cycle?
A: As the pace of money creation increases this strengthens the exchange of nothing for something i.e. increasingly weakens the ability to generate real wealth. As a result the pace of real wealth generation declines and this reduces the pace of expansion in the overall demand for goods and services. All this tends to be associated with a slowdown in bank credit expansion and in turn with the slowdown in the money supply growth rate. The decline in the money supply growth rate undermines bubble activities further and extends the economic downturn. Note that a decline in the money growth rate is, ultimately, good news for wealth generators since the pace of wealth diversion also now declines. This enables wealth-generators to rebuild themselves and regenerate, so to speak, the process of real wealth production, thereby ultimately strengthening the pace of economic growth.
Q: So fluctuations in the growth rate of money supply can be indicative of the pace of wealth destruction?
A: Yes. An increase in the money growth rate is indicative of an increase in the pace of real wealth destruction. Conversely, a decline in the money supply growth rate is indicative of a slower pace of wealth destruction.
Q: Increases in bank-created money supply, whether at a faster or a slower pace, undermine the pace of wealth formation. You said that the key for economic growth is increases in the pool of real wealth. How then does a strong increase in the money supply result in a strengthening in economic activity?
A: This can be achieved by a more intense use of existing infrastructure and labor. However this cannot be sustainable. To achieve an ever rising pace of economic growth would require that the pool of real wealth to expand at a faster pace. But the increase in the growth rate of the money supply sets the dynamics for a decline in the rate of expansion in the pool of real wealth. This in turn slows the growth rate in money supply and sets in motion an economic bust. Hence the boom sows the seeds for a bust.
Q: So it seems that the key drivers of boom-bust cycles are the fluctuations in the money supply growth rate engineered by the central and commercial banks. What about interest rates – what role do they play?
A: Whenever the central bank lowers interest rates it distorts price signals. As a result, businesses are channeling real wealth to fund various activities that normally they wouldn’t do in a market economy. Note that a lowering of interest rates goes hand in hand with an increase in bank lending and hence an increase in the money supply growth rate. In most cases the central banks will engineer the change in interest rates via open market operations that impact the money supply.
“A lowering of central bank interest rates – often through enforced changes in the money supply via open market operations – simply adds to the distortion of market signals. If real wealth is not rising, or is declining, then this can be ineffective in stimulating the bubble activities popularly deemed to be the drivers of economic growth.”
Q: Could a situation emerge whereby a lowering of interest rates will not significantly boost bank lending and the money supply growth rate?
A: Yes, this could occur if the growth rate of the pool of real wealth is declining. Under these conditions banks will not extend credit at a faster pace. Also, as a result, the money supply growth rate will not expand at a faster pace either, all other things being equal. An economic upturn will not emerge in this situation.
Q: What is AASE’s stand on the argument that the Great Depression of the 1930’s occurred because the US central bank failed to pump enough money to prevent the emerging forces of depression?
A: AASE holds that due to the prior loose monetary stance of the central bank the pool of real wealth was badly damaged. It is this that caused the collapse in bank lending and the collapse in the money supply growth rate. Note again that, as outlined above, money as such cannot grow an economy, but it can destroy it. So once the central bank’s policies weaken the pool of real wealth obviously more of the same policies cannot make things better – on the contrary it only makes things much worse. If the central banks could indeed produce genuine economic growth through monetary pumping then by now most countries in the world would not have experienced economic recessions and economic hardship. In any event it is true that during the Great Depression the US Federal Reserve increased its balance sheet but this did not stop the decline in economic activity. From October 1929 to December 1932 the Fed increased its balance sheet from $165 million to $2,432 million, a rise of 1,374%.
Q: Given the importance of changes in the money supply growth rate in creating boom-bust cycles, how can one apply this knowledge in investment decision-making?
A: We at AASE hold that by using the growth rate of money supply as a leading indicator one can ascertain likely fluctuations in economic activity in the months following. Changes in money supply today will have an effect on various markets, and economic activity in general, at some time in the future. Hence, from a money supply perspective, already-known information about the money growth rate provides us with leading information about the future economic climate.
This in turn can be used in the asset allocation process and in the timing of various investment decisions. For instance, if, the past money supply growth indicates that economic activity will fall at a rapid pace, then more investment funds should be allocated towards defensive stocks and government bonds and cash and less to commodities and non-cyclical stocks.
“Given the differential rate of diffusion of changes in money growth through the economy, different assets and sectors will perform differently in different stages of the cycle. If one can predict the cycle then one can in principle predict the performance of various assets and sectors.”
Q: In the AASE framework money supply plays an important role. Does it matter what money supply definition one uses?
A: It is important to identify as accurately as possible the correct amount of money in the economy in order to use it as a gauge for future economic growth. We at AASE view money as cash held by individuals outside the banks and cash held in demand deposits.
Q: What about “savings deposits”? Shouldn’t they also be part of the definition of money?
A: Savings deposits are not deposits as such but lending by individuals to banks. If Bob opens a saving account for $1,000 he has in fact made a loan to the bank for this amount. If the deposit is for three months Bob has relinquished his claim on the $1,000 for three months. If the bank lends Tom $1,000 then this will be placed in Tom’s demand deposit account. Note that the $1,000 was transferred from Bob’s demand deposit. What we have here is an unchanged amount of money. Counting savings deposits as part of money will lead to a double counting. The key is then to focus only on claim transactions to ascertain the amount of money at any point in time. At AASE, in the calculation of our money supply gauge we also incorporate Government deposits with the central bank and in the US case also incorporated so-called sweep transactions.
“A central tenet of AAS Economics’ approach to economic analysis is the correct definition of money, based as it is on cash plus immediate claims on the banking system. Many conventional definitions of money involve double-counting and are misleading as predictors of the cycle.”
Q: So what is the best monetary system according to AASE?
A: We hold that money fully backed by gold is the proper system. It will eliminate the wild boom bust cycles associated with the present paper money system. Note that in essence we subscribe to any commodity-based money. Over time people have chosen gold as their preferred commodity to be used as money.
Q: On a gold standard could we still have fluctuations in the money supply growth rate due to fluctuations in the amount of gold? Could this consequently result in boom-bust cycles and could it be the case that there might be insufficient gold to match the demand for money expanding on account of economic growth, which itself could choke off that growth altogether?
A: Gold as such cannot be created out of “thin air”. It must be mined and it is part of real wealth. So when a gold miner exchanges gold for other goods he exchanges something for something. As long as this is the case no boom bust cycles will emerge. We have seen that it is not fluctuations in the money supply growth rate as such that set in motion boom-bust cycles but rather fluctuations in the growth rate of the supply of money created by central and commercial banks out of “thin air”. Again, on the gold standard no one creates gold out of “thin air” and hence no boom-bust cycles in this sense are going to occur.
We at AASE are of the view that any given amount of money is sufficient to fulfill the role of the medium of the exchange. (Observe that people want more purchasing power of money not more money as such. With an increase in wealth for a given money supply its purchasing power will increase).
In the present paper system an increase in the money supply growth in response to an increase in the demand for money will not prevent economic cycles. Rather it will set in motion an exchange of nothing for something and thereby the menace of the boom-bust cycle.
“For AAS Economics the most rational monetary system is a commodity-backed system such as one based on or backed by gold. Such a system is unlikely to be manipulated in the manner of paper money as its supply will be determined by its own productive dynamics rather than by the destructive machinations of central and commercial banks.”
Q: What is the view of AASE on statistical correlations?
A: We regard correlations as a useful means to form a preliminary view regarding the relationships among various variables. For example, if we observe a change in the money supply growth rate based on our framework we can deduce a corresponding change in economic activity in the months following, or if we observe that over time the growth rate in money supply in country A exceeds that in country B then we can determine that from this perspective the currency rate of exchange of A versus B must come under pressure. Now, if we observe a fall in correlation between two variables we do not change our framework but rather try to find out the reason for the decline in the correlation. It is quite possible that the effect of the fundamental core variable is now obscured by a large irregular non-core variable.