In a recent article, John Mauldin dealt with the question: is economic growth driven by consumption or production? Unfortunately, he made a dog’s breakfast out of an attempt to explain why the correct answer is “production”. I’ll try to do better.

That there is even a much-debated question here is evidence of the great depths to which the science of economics has sunk. It would be like a debate between two groups of mathematicians, with one group arguing that 2 + 2 = 4 and the other group arguing that 2 + 2 = 17. Incredibly, in the world of economics the equivalent of the 2 + 2 = 17 group has gained the ascendancy. And within this leading group, the Keynesians dominate.

One of the fundamental tenets of Keynesian economics is that consumption drives economic growth, with an increase in consumption (a.k.a. aggregate demand) causing the economy to grow and a decrease in consumption causing the opposite. According to Mr. Mauldin, on the other side of the fence we have “Austrian” economist Friedrich Hayek, who “asserted that it is actually production that stimulates the economy and drives consumption.”

On a side note, “stimulates the economy” is a Keynesian phrase that an economist from the Austrian school would not normally use (economies aren’t “stimulated”), so I doubt that Hayek ever spoke/wrote in those terms. More importantly, the knowledge that production drives consumption and therefore economic growth predates Hayek by about 150 years. It is called Say’s Law and was part of the 1803 publication titled “A Treatise on Political Economy”. Say’s Law can be expressed as “production funds consumption” and “people produce in order to consume”. Because Say’s Law is demonstrably true, the “Austrians” adopted it.

The easiest and clearest way to see that an increase in production must come before an increase in consumption in order for the resulting growth to be sustainable is to consider a barter economy. An economy that uses money will tend to be more complex than one based on barter, because money facilitates specialisation (the division of labour) and intermediate stages of production, but the same basic principles apply.

When a barter economy is considered it becomes obvious that in order for someone to consume more he must first produce more, because what someone spends is what he produces. To put it another way, someone can’t spend what he or someone else hasn’t already produced. For example, a potato farmer spends potatoes, a cobbler spends shoes, and a baker spends bread. Consequently, if a baker who produces X loaves of bread per day wants to consume more on a permanent basis, he must first increase his production to X+Y loaves per day.

But how could our hypothetical baker spend more bread if there didn’t already exist demand for more bread?

The simple answer is that he couldn’t. There would have to be more demand for bread at some price. Perhaps by investing in a new oven or finding some other way to produce bread more efficiently the baker would be able to increase his production by, say, 30% and simultaneously reduce the price per loaf by 10%, enabling his customers to afford to buy more bread and increasing his own ability to consume.

Of course, if the bread market were saturated then it would not be possible for our baker to increase his production and therefore his consumption, but within the economy at any given time there will always be many things that people want more of. It’s a matter of targeting the things for which there is demand, and this is where prices come in. Prices transmit information, which is why it is so important that they not be distorted by “monetary stimulus” and other interventions. Prices tell people what to produce more of, and in cases where there is temporarily much greater demand than supply they ration the available supply. For some entrepreneurs, it can also be a matter of targeting the things for which there is currently no demand but for which there could be huge demand in the future. For example, there was no demand for the iPhone before Apple made the first one, but then, suddenly, millions of people around the world wanted an iPhone.

The bottom line is that in the real world there must be an increase in production before there can be a sustainable increase in consumption, because it’s the increase in production that funds the increase in consumption. This is as axiomatic as 2 + 2 = 4.

The market action is getting more interesting. Here are three examples:

1) Although the S&P500 Index and most other important US stock indices ended Monday’s session with gains, the Dow Transportation Average (TRAN) lost ground and has marginally breached support at 8600. It is now at its lowest level since last October — a significant bearish divergence.

Due to Monday’s marginal breach of support, the stage is set for some informative price action over the days ahead. TRAN is going to either follow through to the downside and confirm its breakout or quickly reverse upward and indicate that the downside breakout was false. Each of these possible outcomes contains clues about what the future holds in store.

2) Due to the much-worse-than-expected US employment report that was published when the financial markets were closed last Friday, it was very likely that there would be a decent bounce in the gold price when trading resumed on Monday. The gold price quickly rose to the $1220s on Monday and in doing so traded above its late-March spike high, but it subsequently gave back about half of its gains and ended the day at its 50-day MA. This price action is not bullish, but the set-up is still in place for additional near-term gains.

Critical support is at $1178.

3) I continue to think that the Dollar Index made a multi-month top in March, but the market is stubbornly refusing to either validate or invalidate this view. A daily close below 94 would remove all doubt that a multi-month top is in place, while a daily close below support near 96 would be a preliminary signal. Given the recent economic data, the Dollar Index has done remarkably well to remain above 96 until now. Even last Friday’s lousy employment report wasn’t a sufficient catalyst for a breakdown.

There’s a school of thought to the effect that if the market price of a stock you own has fallen below the price at which you bought, you haven’t really suffered a loss unless you sell. If you don’t sell, all you have is a “paper loss”. While technically correct, this is an amateurish and dangerous way to look at things. If you view a paper loss as materially different from and of lesser consequence than a realised loss, then you are essentially deluding yourself. Incredibly, some newsletter writers encourage this form of self delusion.

There will usually be a chance that a stock in your account that is currently ‘under water’ will recover and move into profit. The probability of this happening could, in fact, by very high, but it is important to acknowledge the reality that it is now showing a loss and that a recovery is not guaranteed. The simplest way to do this is to regularly — say, at the end of every week — mark your portfolio to market. In doing so, a “paper loss” is accounted for in the same way as a realised loss and a “paper gain” is accounted for in the same way as a realised gain.

By taking the simple step of regularly marking your portfolio to market you will be facing up to reality and avoiding the counter-productive behaviour, when things are going badly, of ‘sticking your head in the sand’. Accordingly, you will be putting yourself in a position where decisions can be based to a greater extent on facts and to a lesser extent on hope — a position where you will be less likely to kid yourself.

Of course, almost all good practice in the world of investing/speculating is easier said than done.

This post is a slightly-modified excerpt from a recent TSI commentary.

The monetary data published by the ECB last week showed that the rate of euro-zone TMS (True Money Supply) growth continued to accelerate in February — to a year-over-year rate of 11.8%, from 11.4% in January and ‘only’ 6.4% last October. Here’s a chart that puts the current monetary inflation rate into perspective.

The ECB didn’t begin its new QE program until March, so the above chart doesn’t include any of the effects of this new program. In fact, the effects of the new program probably won’t start becoming apparent until the April monetary data are published in late-May.

In one way, the current situation in Europe is similar to the situation in the US during the final few months of 2012. Back then, the Fed embarked on an aggressive new money-pumping program despite the year-over-year rate of US TMS growth already being in double digits and despite the prices of US stocks and bonds being near multi-year or all-time highs. Now we have the ECB embarking on an aggressive new money-pumping program despite the year-over-year rate of euro-zone TMS growth already being in double digits and despite the prices of European stocks and bonds being near multi-year or all-time highs.

The QE program introduced by the Fed in late-2012 did not help the US economy, but it did inflate a new stock market bubble. It also encouraged stock buybacks at the expense of capital investment, incentivised the continued accumulation of debt at a time when both the private and public sectors were already over-indebted, and fostered an investment boom in the shale-oil industry that’s now in the process of collapsing.

Apart from the specific example of the oil-investment boom, it’s possible that the QE program recently introduced by the ECB will end up having similar effects.