The debt binge since 1975, fueled by an easy-money policy from the Fed, has landed the US economy in serious difficulties. Wall Street no doubt lobbied hard for debt expansion, because of the boost to interest margins, with little thought as to their own vulnerability. There can be no justification for debt to expand at a faster rate than GDP — a rising Debt to GDP ratio — as this feeds through into the money supply, causing asset (real estate and stocks) and/or consumer prices to balloon. What we see here is clear evidence of financial mismanagement of the US economy over several decades: the graph of debt to GDP should be a flat line.
The difference between domestic and private (non-financial) debt is public debt, comprising federal, state and municipal borrowings. When we look at aggregate debt below, domestic (non-financial) debt is still rising, albeit at a slower pace than the 8.2 percent average of the previous 5 years (2004 to 2008). Public debt is ballooning in an attempt to mitigate the deflationary effect of a private debt contraction. Clearly this is an unsustainable path.
The economy has grown addicted to debt and any attempt to go “cold turkey” — cutting off further debt expansion — will cause pain. But there are steps that can be taken to alleviate this.
If private debt contracts, you need to expand public debt — by running a deficit — in order to counteract the deflationary effect of the contraction. The present path expands public debt rapidly in an attempt to not only offset the shrinkage in private debt levels but also to continue the expansion of overall (domestic non-financial) debt levels. This is short-sighted. You can’t borrow your way out of trouble. And encouraging the private sector to take on more debt would be asking for a repeat of the GFC. The private sector needs to deleverage but how can this be done without causing a total economic collapse? The answer lies in government spending.
Treasury cannot afford to borrow more money if this is used to meet normal government expenditure. Public debt as a percentage of GDP would sky-rocket, further destabilizing the economy. If the proceeds are invested in infrastructure projects, however, that earn a market-related return on investment — whether they be high-speed rail, toll roads or bridges, automated port facilities, airport upgrades, national broadband networks or oil pipelines — there are at least four benefits. First is the boost to employment during the construction phase, not only on the project itself but in related industries that supply equipment and materials. Second is the saving in unemployment benefits as employment is lifted. Third, the fiscal balance sheet is strengthened by addition of saleable, income-producing assets, reducing the net public debt. Lastly, and most importantly, GDP is boosted by revenues from the completed project — lowering the public debt to GDP ratio.
Public debt would still rise, and bond market funding in the current climate may not be reliable. But this is the one time that Treasury purchases (QE) by the Fed would not cause inflation. Simply because the inflationary effect of asset purchases are offset by the deflationary effect of private debt contraction. Overall (domestic non-financial) debt levels do not rise, so there is no upward pressure on prices.
Infrastructure investment should not be seen as the silver bullet, that will solve all our problems. Over-investment in infrastructure can produce diminishing marginal returns — as in bridges to nowhere — and government projects are prone to political interference, cost overruns, and mismanagement. But these negatives can be minimized through partnership with the private sector.
Projects should also not be viewed as a short-term, band-aid solution. The private sector has to increase hiring and make substantial capital investment in order to support them. All the good work would be undone if the spigot is shut off prematurely. What is needed is a 10 to 20 year program to revamp the national infrastructure, restore competitiveness and lay the foundation for future growth.
There are no quick fixes. But what the public needs is a clear path to recovery, rather than the current climate of indecision.
Colin,i think you are stuck in the Keynesian framework.
1 Government spending on infrastructure bids away resources from the private sector, which means that other projects either don’t get done or become unprofitable.
2 There is no way to determine whether government spending creates a market-related return, and in any case all government spending is done to meet political goals.
3.Debt and money are different things, so a debt contraction cannot possibly offset a money-supply expansion.
4.The economy may get a short term boost but significant additional infrastructure spending will continue to cause malinvestment and only bring forward what would have been done at some future time.
5.Such government spending transfers resources from one part of the economy to others.Roosevelt tried to do the same thing and it did no good in the longer term.
6. I agree infrastructure spending is better that welfare spending but it will still cause additional debt which have to be paid by taxpayers. The taxpayer would have to bear less tax had such spending not happened.
7.If the private sector wants such such infrastructure in a free market economy it will get done at no cost the the taxpayer. Indeed the privater sector will benefit because investment has risen which leads to greater economic wealth
Robert, I appreciate your viewpoint. I am definitely not a Keynesian (though he did get some things right — like you need to run a deficit in order to offset a shortfall in private spending — he just did not give enough attention to how the deficit should be spent) and started out from a similar position to your own. But months of reflection have led me to re-examine my assumptions:
1 There is a dearth of capital investment by the private sector — and more than $1T of excess bank reserves waiting to fund it — plus more than 16% of the male workforce (25 to 55) without jobs.
2 Spending under direct political control is wasteful. But there are many examples of successful projects completed by infrastructure banks or public/private development corporations. The #1 criterion must be market related risk/return.
3.Debt and money are different things — but two sides of the same coin: assets and liabilities on bank balance sheets. A (private) debt contraction can offset a (public) debt expansion.
4.Private sector investment does not have a 100% success rate. There are bound to be failures, but as long as the successes outweigh the failures we are on the right road.
5.See point #1. Hoover practically invented it (infrastructure programs during an economic down-turn), before Roosevelt expanded on the idea. Boulder dam (Hoover dam) and the Tennessee Valley project are still in use today — as is Sydney Harbor Bridge and the Snowy River project in Australia.
6.No additional debt is created with QE. The government is effectively lending to itself. While at the same time we are creating real, saleable assets.
7.The taxpayer will pay for the infrastructure service (e.g. tolls on a toll road) whether funded by public or private sector investment. If the private sector will undertake the project, there is no role for the government. They should only act as investor of last resort: when the scale of the project prevents the private sector from acting alone.
I agree that the debt should not have been incurred in the first place. But now that the patient has developed a terminal illness, drastic treatment is justified which I would never advocate under normal conditions. If we don’t act quickly and decisively, the patient will die. Once health is restored we can build adequate safeguards to ensure that we are never confronted with the same situation again.
There are several considerations that need to be addressed, none the least is what happens if we fall into a deflated and devalued economy?
1. Why does no one discuss wages for infrastructure jobs? Do we pay $40 an hour for digging ditches? And in a deflation situation, $10 an hour jobs could be overpayment.
2. The cost of infrastructure spending would outweigh the low value of the projects as well as reduced ability for repayment in a devalued economy. Lack of adequate ROI could expand the public debt in real dollars and leave us with many “projects to nowhere”.
3. “Nothing is as permanent as a temporary government program.”
In addition, the risk of setting off inflationary price spirals is not even being addressed. You assume asset value for sale of government work projects but in a deflated economy they soon become white elephants.
The oversimplification of the convoluted problem in our economy will not be solved by government interference in any fashion. And the patient will not die, as you so say.
What is needed is a muddling along as it is while banks, credit, mortgages, and all manners of assets de-leverage. It is called bed rest, to follow your medical metaphor. And it what we are seeing if you stop and think about it critically.
Hi Steve, Thank you for contributing to the discussion. This is an important topic and deserves a wider audience.
I thought I had addressed inflation. QE will not cause inflation as long as there is an equivalent contraction in private debt: the one offsets the other.
What we have at present is muddling along and it is not working. Even worse in the euro-zone. If bold action is not taken we will face another deflationary spiral as soon as government spending is cut back from its current profligate levels. The reality is that debt contraction is vicious and could cause a 20/25 percent fall in GDP if left unattended. I am a great believer in “hands off” management of the economy, but these are exceptional times — and call for exceptional measures.
Colin, what precisely ” bold action” are you suggesting?
Europe, US, UK and others are continuing to increase government spending albeit at a slower pace in some countries as the PIIGS. Germany, France, Italy, Japan, China, Brazil, amongst others are increasing their government debt – ion 2012 the maturing debt is targeted to be rolled over and new debt is sought. There is n evidence of government debt slowing on any great degree except in a small number of cases.
There is no evidence of deflation as money supply growth is still quite high in USA, China and Japan is growing its money stock starting earlier this year ( refer Michael Pollaro for details of money supply growth in various countries) The Euro money stock has fallen this year to low levels but it is still positive . Recent policy decisions by the ECB (LTRO’s) and the acceptance of lower grade securities from the Euro banks( similar to TARP in the USA) is expected to reverse this trend in coming months. We are going through a deflation scare period which the government and central banks will use to provide even more juice to the economies.
Kind regards
Governments have been running deficits to maintain positive debt growth and prevent a deflationary spiral. Are you suggesting that this is evidence that no intervention is/was necessary?
Thanks for your comments, Colin. On the run response follows:
1.Japan did the same thing- spent billions on infrastructure spending after the 1989 stock market crash. Did not do them much good – their economy has not suffered as badly as it might have done because the rest of the world did not follow them into a prolonged recession. Unfortunately the worst is yet to come for Japan mainly due ti their mercantilist/ Keynesian policies- their government debt is reported to be about 220% of GDP. Incidentally regardless of the huge fiscal deficits racked up under Roosevelt’s presidency the unemployment rate of around 20% or more lingered for several years- all through his presidency. Had the US Government stayed out of the way of the unwinding of the malinvestments (1929-1932) caused by the large monetary expansion in the 1920’s there would almost certainly have been no economic depression ( refer Murray Rothbard’s writings on economic history).
If the excess reserves held at the US Fed ever get released into the real economy then additional malinvestments and a guaranteed depreciation of the USD will ensue. Such a release would have a huge effect due to fractional reserve banking which i am confident you are well aware of.
2. Agree but refer comment in 1.
3. An increase in the general price level ( for simplicity say the CPI) is the effect of monetary inflation – it is a loss of of purchasing power caused by the addition to the money stock by the central or commercial banks. An increase in credit is not an increase in the money stock. In a fiat currency system paper money is created out of nothing – it is not backed by anything other than the confidence of the public- if the public lose confidence in the currency it quickly and severely loses its value as a medium of exchange and a store of value. QE is pure counterfeiting – if i did it i would go to jail. Counterfeiting does nothing to improve the economic wealth of a country ( Zimwabe, Argentina etc.) If it were otherwise would it already not have been put into effect?
Credit is generated by the banks by the stroke of a computer button and the fractional reserve banking system is essentially and primarily responsible for the huge level of private sector and government sector debt.Most people don’t realise that almost all of the loans for personal use e.g. buying a house or for business reasons does NOT come from money deposited by the likes of you and me- it literally comes out of thin air and is not backed by real money. For example
we” should not underestimate the willingness of banks to play the Ponzi with free money. A fractionally reserved system is after all at all times on the very edge of insolvency. The euro area’s especially so – of € 3.92 trillion in sight deposits, only € 211 billion were actually covered with standard money before the most recent halving of reserve requirements. In theory, if more than 4.6% of depositors were to exercise their legal claims to standard money, the banking system would become instantly unable to pay. We say ‘in theory’ because it is of course backstopped by the central bank – as we can in fact once again see in the recent balance sheet explosion.” Quoted from recent article written by Pater Tenebrarum – Acting Man Website. The same situation apples worldwide – in Australia i understand about 40% of the major banks funding for lending comes from the overseas wholesale credit markets.
4. Agree- but that is the way of free market system which is not what we have today (government intervention is exceptionally large and regular).Incidentally the government accounts for some 40% plus of the economy ( worldwide). Governments take from the private sector (taxes) to pay its employees and to distribute to its constituents as it sees fit. Governments do not add to economic wealth – they distribute it. When they trumpet the creation of jobs because of a particular program all they have done is employ resources from elsewhere in the economy such as the pink batts program,cash for clunkers program, solar energy program and school infrastructure program.
5.Just because infrastructure projects are used does not necessarily mean they are economically viable. For example,in NSW certain rail projects and toll road projects make the point i think. If the NSW government wishes to sell such projects (if they could find a buyer) it would result in a huge financial loss borne by the taxpayer. The North West Rail link ( top be built) is another good example ( i understand the cost of train trip per passenger is about $80K)
Infrastructure projects which are economically viable should proceed and if attractive enough could be funded by the private sector or funded by the Government and sold to the private sector at a profit at a later date. Infrastructure projects which are not financially viable add little, if anything to the economic wealth of the country. Whilst the latter provide temporary relief they are a burden on the economy in the longer term.
One needs to ask that if infrastructure projects funded by government is such a good thing then why was it not done to any great degree during the 2001/2003 recession and the recession 2007/???
6.If QE was such a wonderful vehicle as you seem to suggest than why is not done openly and with great fervour? The EU n has embarked in the last few days back on a behind the scenes QE program giving unlimited loans from the ECB to EURO banks for 36 months. Do you really think such loans will be repaid bearing in mind the insolvent and undercapitalised state of the Euro commercial banks? Indeed they have publicly stated that such monies will find its way as loans to citizens and businesses( which is highly unlikely as the private sector is trying its hardest to de-leverage.With money printing or QE i agree that the main beneficiaries are those which have first access the new money viz. the government and the commercial banks – the least who will benefit is the general population – like you and i. With QE no one really knows where the new money will end up – ]with QE 1 and QE 2 it was the commercial banks, Hedge funds and those people who had the means to leverage up and buy financial securities (stocks, bonds). These 2 exercises as well as similar QE exercises worldwide Europe, UK, China, Brazil,Russia, Australia and so on have not increased the real economic wealth of economies but have weakened them. The currencies of such countries have been weakened and i do not know of a case where currency debasement has actually benefited the economic wealth of any country in real terms. Do you?
its getting late so i will exit stage left.
Wishing you a joyous Christmas and a prosperous 2012
Robert de Beer
Thank you Robert,
And best wishes to you and your family for the Christmas season.
Here are further comments:
“why was it not done to any great degree during the 2001/2003 recession and the recession 2007?” ~ We are undergoing a financial crisis (sometimes referred to as a banking panic) not a recession.
I will be taking a break for a few days but hope we can continue this discussion in the new year. Regards, Colin
Hello Colin and all, the following may be of interest
Regards
Robert de Beer
http://mises.org/daily/5781/Is-Debt-Necessary-for-Recovery
http://mises.org/daily/5464/The-Critical-Flaw-in-Keyness-System
http://mises.org/daily/4993/My-Reply-to-Krugman-on-Austrian-BusinessCycle-Theory
http://tpmcafe.talkingpointsmemo.com/2008/12/16/depression_economics_normal_ru/
http://mises.org/daily/3290
http://www.acting-man.com/?p=12580
ECB Study: Big Government Is Bad for the Economy
BY CRIS SHERIDAN12/14/2011
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The European Central Bank may have just disproved the entire European big-government model in their recent release of an exhaustive study analyzing the relationship between government size and economic growth. After reviewing a massive 108 countries over a 38 year time period, they came to a shocking and definitive conclusion:
Big government is bad for economic growth!
“Our results show a significant negative effect of the size of government on growth.”
“Interestingly, government consumption is consistently detrimental to output growth irrespective of the country sample considered (OECD, emerging and developing countries).”
Now, for most people who operate based on common sense and formulating their opinions from the natural world they experience every day, this is not a shocking result; but, unfortunately, many economists and others need 44 page research studies and sophisticated differential equation models (see pages 31-33) to conclude what most people have known and said for quite some time.
As a wise man once said, “The great achievements of civilization have not come from government bureaus.” (see video below)
http://www.financialsense.com/contributors/cris-sheridan/2011/12/14/ecb-study-big-government-is-bad-for-the-economy
Is Debt Necessary For Recovery?
Using Murphy’s basic example:
During a financial crisis:
During a financial crisis, Willy is likely to pay off debt, Larry is likely to decrease — not increase — the land he cultivates, and Cathy will hoard her capital — spending as little as possible as she has no income.
Big Government Is Bad for the Economy
I couldn’t agree more. Its role should be as facilitator rather than employer.
Let’s extend the financial crisis example:
Income in Year 2: Willy $1000 ($500+500), Cathy $100, Larry $1000 ($1000 from food sold to Willy and Cathy). Willy saves $100 of his income.
Income in Year 3: Willy $1000 (from Larry), Cathy $140 (70% of $200), Larry’s crop yields $1300 out of which he pays $200 for water and sells $1100 to Willy and Cathy. Willy saves $60 of his income. And Government receives $60 (30% of $200) which it invests to cover future shortfalls in terms of its revenue guarantee.
Now if bond markets are badly shaken by the financial crisis, government may only be able to raise say $150 for a 20% private shareholding. It goes to the central bank and borrows the remaining $450 to build the dam. That is quantitative easing. Under normal conditions QE would cause inflationary pressure: Willy’s income would increase to $1000 + $500 while food production is unchanged, driving up food prices. But, because of the debt contraction, Willy’s income is unchanged at $500 + $500.
Government debt has increased by $450 but so has its income — by $100 a year (50% of $200) — which it can use to repay the debt.
“All we need is one country to try deleveraging without intervention to alleviate the deflationary spiral. If they succeed, they will have proved you right. I can only recall two leaders that have tried it: Herbert Hoover/Andrew Mellon (US) and Chancellor Heinrich Bruning (Germany) in the 1930s.”
one case comes to mind quickly – President Grant did it quite successfully. A few other examples i understand from memory occurred in the latter part of the !9th Century in the USA.
regards
We could continue on and on the issues raised. i think it best to have an open mind and to ascertain the facts and most importantly the root causes of the problems (now and in the future). To this end i have provided information in my post on 22/12 . HELLO!!!! The ECB itself has stated big government is detrimental to economic wealth creation.
I will provide responses to a few comments .
1. In an economic slowdown the private sector will of course de leverage which is what is happening now albeit that private sector debt is still extraordinarily high in many countries. In Australia’s case personal debt remain at very elevated levels. The reduction in private sector debt is offset( and growing) by increased government debt everywhere. Overall debt levels are still rising and this unsustainable.
2. ..During a financial crisis Willie is more likely to default on his debt?
Murphy article takes on the flawed thinking of Keynesians such as Krugman … “However, prompted by a recent scolding given by Paul Krugman, it’s important to revisit the topic in a more elementary fashion. When Krugman, et al., casually claim that debt reduction would by sheer accounting cause total spending to fall, they are simply wrong. Thus their mistake is twofold: their faulty Keynesian economics leads them to worry needlessly about nominal spending, while their sloppy accounting leads them to champion debt as necessary for investment.”
Robert Murphy’s article contains a number of different scenarios and we can add our own as Colin has done. the key point is that Murphy contends that private sector de leveraging is a good thing and concludes his article as follows:
“Conclusion
The old-school, commonsense solution to an economy plagued by excessive debt is for people to work hard and save more. Keynesian economists have been saying throughout our current crisis that this folk wisdom overlooks basic accounting tautologies, but these pundits are smuggling in a Keynesian theory without realizing it.
Contrary to the assertions of these pundits, an economy does not need mountains of debt — whether government or private — in order to grow. Corporations can still raise needed financing through issuing equity. There are pros and cons to debt financing, but it isn’t necessary for a strong economy.”
The policies of governments and central banks target less saving (negative real interest rates) and loose lending standards encouraging more debt for more consumption spending. the public have got it right and the government has got wrong.
3.Japan – if the Japanese government had left the market to sort out the malinvestments caused by their flawed policies the country would be in better shape today. The Japanese had domestic savings by is citizens in excess of 3 trillion US dollars in 1990. Such savings were used up to fund government deficits – govt. debt is now 220% of GDP and rising. The Japanese have just kicked the can down the road and their impending b economic malaise will now be much greater. Koo and his ilk fail to address the root causes of the Japanese situation. Not knowing or failing to acknowledge the root cause will prevent the cure. Had the Japanese Government stayed out of the way the Japanese stockholders and their bondholders would have lost most of their money but the depositors money would be intact. their economy would have quickly recovered in about 1-2 years considering the growth in emerging markets and the loose monetary policies of the US Fed. The point is that a a severe recession or depression is unavoidable (globally) because of flawed economic, fiscal and monetary policies. the debt levels are so high they will never be repaid. Increasing the debt to pay for maturing debt, interest payments and new debt to fund ever growing government spending is plain stupidity.
3.Debt and money are different things, so a debt contraction cannot possibly offset a money-supply expansion.
When i stated the ” an increase in credit is not an increase in the money stock.” what i meant was that the money is not standard money but is fiduciary media. The money i deposit from earning my income is very different from any money i get by means of a loan from a bank. De Soto says it well and i quote from his book “Money, Credit and Economic Cycles”
Monetary Irregular Deposit
Economic differences
1. Present goods are not exchanged for future goods.
2. There is complete, contin- uous availability in favor of the depositor.
3. There is no interest, since present goods are not exchanged for future goods.
Legal Differences
1. The essential element (and the depositor’s main motivation) is the custody or safekeeping of the tan- tundem.
2. There is no term for returning the money, but rather the contract is “on demand.”
3. The depositary’s obliga- tion is to keep the tantun- dem available to the depositor at all times (100-percent cash reserve).
Monetary Loan
Economic differences
1. Present goods are exchanged for future goods.
2. Full availability is transferred from lender to borrower.
3. There is interest, since present goods are exchanged for future goods.
Legal Differences
1. The essential element is the transfer of avail- ability of the present goods to the borrower.
2. The contract requires the establishment of a term for the return of the loan and calcula- tion and payment of interest.
3. The borrower’s obliga- tion is to return the tantundem at the end of the term and to pay the agreed-upon interest.
Finally , i provide some additional links about money and credit.
i trust that the information i have provided especially via the links in my posts will encourage thinking/ debate about the the issues contained in this and other of Colin’s posts. h Her are some more.
http://mises.org/daily/3556/Credit-Expansion-Crisis-and-the-Myth-of-the-Saving-Glut
http://mises.org/daily/3810/Does-a-Fall-in-Credit-Lead-to-Deflation
http://mises.org/daily/4480/Is-Deflation-in-the-United-States-Possible
http://mises.org/daily/3810/Does-a-Fall-in-Credit-Lead-to-Deflation
http://mises.org/journals/qjae/pdf/qjae3_4_3.pdf. (THE MYSTERY OF THE MONEY SUPPLY DEFINITION FRANK SHOSTAK)
http://mises.org/daily/5802/A-Priori-Theory-and-Sound-Money
http://mises.org/daily/5621/Central-Banks-Can-Increase-the-Money-Supply-Even-If-Banks-Do-Not-Lend
http://mises.org/resources/2745/Money-Bank-Credit-and-Economic-Cycles (Must read)
Hi Robert,
Best wishes to you and your family for the Christmas season.
Some quick comments:
Regards, Colin
Colin, as i have stated earlier de leveraging by the private sector is common sense and is exactly the right thing to do,Governments and central banks do not agree and have put in place policies designed to the opposite -ultra loose monetary policy ( extraordinarily low interest rates), relaxing lending standards ( a la UK in recent weeks)). These policies punish savers Savings equal investment so the greater the level of savings the greater the level of investment in the economy. Increased investment leads to higher levels of production which on turn increases real economic wealth and eventually greater levels of consumption. This scenario has historical example such as much of the !9th century in the UK USA and Australia. No debt personal or public was m][needed to experience these wonderful economic periods. real incomes grew and real prices fell such that ordinary folk could buy more consumption goods than ever before.
There are 2 ways to de leverage – pay the loan back or default. i suspect governments will choose monetary inflation to permit the repayment of loans in lieu of outright default …wont be a pretty outcome if this is correct
I have commented on the aim behind Murphy’s article. He produced 3 different examples i seem to recall. Assumptions are just that – i could suggest a number of different variables which may be relevant in todays world.
I repeat what Murphy’ article set out to do and i believe he has done so:
“However, prompted by a recent scolding given by Paul Krugman, it’s important to revisit the topic in a more elementary fashion. When Krugman, et al., casually claim that debt reduction would by sheer accounting cause total spending to fall, they are simply wrong. Thus their mistake is twofold: their faulty Keynesian economics leads them to worry needlessly about nominal spending, while their sloppy accounting leads them to champion debt as necessary for investment.”
“Conclusion
The old-school, commonsense solution to an economy plagued by excessive debt is for people to work hard and save more. Keynesian economists have been saying throughout our current crisis that this folk wisdom overlooks basic accounting tautologies, but these pundits are smuggling in a Keynesian theory without realizing it.
Contrary to the assertions of these pundits, an economy does not need mountains of debt — whether government or private — in order to grow. Corporations can still raise needed financing through issuing equity. There are pros and cons to debt financing, but it isn’t necessary for a strong economy.”
As i have posited and backed up by the historical evidence the economy does not “need mountains of deb”t as suggested by Murphy. Colin, did you read the other articles i provided which support the view that excessive government interference in the economy is bad for the economy?
The claim that the Japanese economy would have collapsed is not backed up by any reasoned analysis to my knowledge It a hypothesis or opinion at best. I recall at the time that several financial commentators and the US economists were suggesting that the Japanese government should not bail out their commercial banks. in any event even had there been a significant economic downturn in Japan had the government there stayed out of the way the economy would very likely have recovered quickly. Japanese savings was high ( in excess of 3 trillion dollars) and were guaranteed by the Japanese. Lenders to the he commercial banks ( bondholders would have suffered a major loss as would the stockholders of the banks. Depositors would have come out unscathed. the malinvestments (inefficient enterprises ) supported by the flawed government policies would have been liquidated quickly ( they were eventually liquidated anyway down the track). Japans high level of savings could have been use to fund new investment( plants, machinery and so on ), The Japanese holders of savings would only be too pleased to invest in the remaining enterprises. look what has happened to Japan over the last 2 decades and what is still to come with a sovereign debt level of 220% of GDP ( the highest in the world i believe) and with the personal savings all but gone to fund the increase in government debt/ Not pretty sight , is it with he knowledge that the worst is yet to come. Japan will now suffer longer and more severely than it would have done had the Japanese government not had a policy of significant government interference over the last 2 decades.
i dont understand your comment that “money loses its identity when it is deposited.” Can you please explain? Money deposits do not lose their identity as money is available to the depositor at call. It exists and is the same as it was when the money was deposited.
Kind regards
All we need is one country to try deleveraging without intervention to alleviate the deflationary spiral. If they succeed, they will have proved you right. I can only recall two leaders that have tried it: Herbert Hoover/Andrew Mellon (US) and Chancellor Heinrich Bruning (Germany) in the 1930s.
Regards, Colin
Colin, fot your information,
“Black Swan” Fund Creator Explains Why Central Planning Has Doomed Us All
Submitted by Tyler Durden on 12/23/2011 09:42 -0500
Black Swan Central Banks Fail Federal Reserve Illinois Mark Spitznagel Market Crash Mean Reversion Monetary Policy Moral Hazard Nassim Taleb Real estate Too Big To Fail Unemployment Universa Investments
In a must read Op-Ed in the WSJ, Mark Spitznagel, founder of “fat tail” focused hedge fund Universa, where Nassim Taleb has been known to dabble on occasion, explains the fundamental flaw with central planning, and specifically why “moral hazard” or the attempt to avoid the destructive part of natural cycles, is the greatest unnatural abomination ever conceived by man. His visual explanation should be sufficient for even such grizzled academics who have no clue how the real world works, as the Chairsatan, to comprehend why what he is doing is an epic abomination of every law of nature: “Suppressing fire, creating the illusion of fire protection, leads to the wrong kind of growth, which then invites greater destruction. About 100 years ago, the U.S. Forest Service took a zero-tolerance approach to forest fires, stamping them out at the first blaze. Fast forward to 1988 when a massive wildfire at Yellowstone National Park wiped out more than 30 times the acreage of any previously recorded fire.” Another way of calling this, is what we have been warning about for years: delaying mean reversion does nothing but that. And when the Fed finally fails to offset the inevitable, and it will – it is a 100% certainty – the collapse and destruction will be unprecedented. Ironically, the only way the system could have been saved would be by letting it fail in 2008. Now, we are sorry to say, it is too late.
Spitznagel’s Op-Ed from The Wall Street Journal
Christmas Trees and the Logic of Growth
The ubiquitous greenery of the season has me thinking conifers and stock market crashes. There is much to be learned from the coned evergreen trees that form vast forests across the Northern Hemisphere. As the oldest trees on the planet, the mighty conifers have survived threats of catastrophic extinction since the time of the hungry herbivorous dinosaurs.
The conifer’s secret to longevity lies in a paradox: Their conquest has been largely the result of episodes of massive forest destruction. When virtually all else is gone, conifers show their strength and prowess as nature’s opportunists. How? They have adapted to evade competitors by out-surviving them and then occupying their real estate after catastrophic fires.
First, the conifer takes root where no one else will go (think cold, short growing seasons and rocky, nutrient-poor soil). Here, they find the time, space and much-needed sunlight to thrive early on and build their defenses (such as height, canopy and thick bark). When fire hits, those hardy few conifers that survive can throw their seeds onto newly cleared, sunlit and nutrient-released space. For them, fire is not foe but friend. In fact, the seed-loaded cones of many conifers open only in extreme heat.
This is nature’s model: overgrowth, followed by destruction of the overgrowth, and then the subsequent new growth of the healthiest and most robust, which ultimately leaves the forest and the entire ecosystem better off than they were before.
Pondering these trees, it is not too much of a stretch to consider the financial forests of our own making, where excess credit and malinvestment thrive for a time, only to be destroyed—and then the releasing of capital into markets where competition has been wiped out. The Austrian school economists understood this well, basing a whole theory around this investment cycle.
After the purge, great investment opportunities are created, from which prolific periods of growth emanate—provided that sufficient capital remains to reinvest into the fertile and now-open landscape.
Suppressing fire, creating the illusion of fire protection, leads to the wrong kind of growth, which then invites greater destruction. About 100 years ago, the U.S. Forest Service took a zero-tolerance approach to forest fires, stamping them out at the first blaze. Fast forward to 1988 when a massive wildfire at Yellowstone National Park wiped out more than 30 times the acreage of any previously recorded fire.
What obviously occurred was that the most fire-susceptible plants had been given repeated reprieves (bailouts, in a sense), and they naturally accumulated, along with the old, deadwood of the forests. This made for a highly flammable fuel load because when fires are suppressed the density of foliage is raised, particularly the most fire-prone foliage. The way this foliage connects the grid of the forest, as it were, has come to be known as the “Yellowstone Effect.”
A far better way to prevent massively destructive fires is by letting the fires burn. Human intervention in nature’s cycles by suppressing fires destroys the system’s natural homeostatic forces.
Strangely parallel to the Yellowstone catastrophe was the start of the federal government’s other fire-suppression policy with the 1984 Continental Illinois “too big to fail” bank bailout. This was followed by Alan Greenspan’s pronouncement immediately after the 1987 stock market crash that the Federal Reserve stood by with “readiness to serve as a source of liquidity to support the economy and financial system,” which heralded the birth of the “Greenspan put.” The Fed would no longer tolerate fires of any size.
From a forestry point of view, the lessons were learned. In 1995, the Federal Wildland Fire Management Policy stated, “Science has changed the way we think about wildland fire and the way we manage it. Wildland fire, as a critical natural process, must be reintroduced into the ecosystem.”
Herein are pearls of great wisdom for central bankers today. Central banks are creating a tinderbox by keeping alive many very bad investments, fertilizing them with everything from artificially low interest rates to preferential liquidity to outright securities purchases. As these institutions and instruments overrun the financial landscape, they hamper the economic ecosystem and perpetuate the environment of low growth and high unemployment in which we currently find ourselves.
Seeing periodic, naturally occurring catastrophes as part of the growth cycle requires thinking more than one step ahead, not only longer term but, more specifically, intertemporally. This is perhaps an insurmountable cognitive challenge, both to investors and central bankers in today’s news-flash world. When contemplating the forest, we may intuitively understand nature’s logic of growth. Yet when we look at the seeds of destruction we have sown through current monetary policy, it is clear we are lost in the trees.
Mr. Spitznagel is the founder and chief investment officer of the hedge fund Universa Investments L.P., based in Santa Monica, Calif.
Robert,
We seem to agree on most issues. I certainly agree that the capitalist system is a process of “creative destruction” and that attempts to suppress this cycle can lead to catastrophic outcomes (see Black Swan of Cairo).
Using the forest fire analogy, forests need regular burn-offs to remove underbrush. Attempts to suppress these regular events can lead to fires of catastrophic proportions. That is the situation that we are confronted with: attempts to suppress the regular boom-bust cycle led to an unnatural build up of market forces that threaten to engulf the entire economy. I think we agree that was a mistake. Where we differ is in how to deal with the resulting “forest fire” of catastrophic proportions. If I understand you correctly, your solution is to turn off the hoses and let it burn out. My concern is that we may not have any forest left to regrow. We first need to save what we can and then address restoring the natural balance to prevent a recurrence.
If we cannot agree on which path to take, at least we know our end goal is the same.
Regards, Colin
Colin, There have been many financial crisis even worse than the one we we are presently in. One can go back to Ancient Greece and the Roman Empire after 4th Century and after, France, UK, Holland, Germany, USA and there was sufficient forest to regrow the economy to good health. Booms and Busts come and go. The bast thing that could happen is the reintroduction of sound money. There have several historical examples of fiat currency systems and they ALWAYs fail sooner or later. Get rid of central banking which are there solely for enriching the commercial banks and the financing of government spending. finally do away with fractional reserve banking which does irreparable harm to the economy and to ordinary folk. did you know that Holland had a banking system in the 17th century i understand that banks were required by law to have a !00% reserve. That means that the banks had to have available at call 100% on demand for money deposited with them by all of the depositors. The Dutch currency was widely acclaimed throughout Europe and moneys were withdrawn from the banks in other countries to be deposited with the Dutch banks. It was a time of great prosperity for Holland. After several decades the 100% reserve requirement was gradually reduced and fractional reserve banking once again became dominant,The effect was a deterioration in the currency ( relative to other currencies and gold) and a weakening of the Dutch economy.
Let natural economic laws prevail – they will do so so sooner or later anyway. The longer the government/ central banks interfere the greater the level of interference and the greater the bust. We need to accept that we need to swallow our medicine and get on with it and with minimal interference by Governments.
Kind regards
Regards, Colin
Colin, what is your definition of the capitalist system?
Ever since the early part of the 20th century we have not had a free market system (which is the more accurate definition of a capitalist system).
it is precisely that we do not have a free market economic system that we have had the booms and busts of the 20th Century and extending into the current century.
Do the research and get the facts.
Regards
Colin, the following may be of help. It is provided to clarify the difference between money creation and credit.
recently it has been reported that the ECB will issue credit (loans) of 489 billion Euros to European Banks. Questions:
1.Where did the ECB get the funds to effect such loans?
2.Why was it necessary to issue such loans?
3.What collateral was provided by the banks to the ECB?
4.What will the banks do with the funds?
5.What is the risk that the loans will not be repaid within the 3 year term of the loans?
It has been reported that the vast majority of the funds will be used by the banks to purchase sovereign debt (bonds)of the periphery countries of the Euro zone(PIIGS) and others such as Belgium, France, Hungary and others. If correct is that not an indirect way of monetizing (money printing) sovereign debt? What will the banks do with their newly acquired bonds? Sell them and/or use them as further collateral for more loans from the ECB?
http://www.investopedia.com/articles/basics/03/061303.asp#axzz1hbYUHx00
http://www.investopedia.com/articles/basics/03/061303.asp#axzz1hbYUHx00
http://www.qfinance.com/dictionary/credit-creation
Definition of
credit creation
ability of banks to lend more money
the collective ability of finance companies, banks, and other lenders of money to make money available to borrowers. While a central bank can create money, it cannot create credit.
What Is Credit Creation?
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One of the important functions of commercial bank is the creation of credit. Credit creation is the multiple expansions of banks demand deposits. It is an open secret now that banks advance a major portion of their deposits to the borrowers and keep smaller parts of deposits to the customers on demand. Even then the customers of the banks have full confidence that the depositor’s lying in the banks are quite safe and can be withdrawn on demand. The banks exploit this trust of their clients and expand loans by much more time than the amount of demand deposits possessed by them. This tendency on the part of the commercial banks to expand their demand deposits as a multiple of their excess cash reserve is called creation of credit.
The single bank cannot create credit. It is the banking system as a whole which can expand loans by many times of its excess cash reserves. Further, when a loan is advanced to an individuals or a business concern, it is not given in cash. The bank opens a deposit account in the name of the borrower and allows him to draw upon the bank as and when required. The loan advanced becomes the gain of deposit by some other bank.Loans thus make deposits and deposits make loans. Anonymous
Colin, counterfeit money printed by central banks stay permanently in the economy. Credit created will eventually be extinguished by either repayment of the loan or by default.
incidentally i have some knowledge of infrastructure projects because of my professional career in the engineering and construction industries.
An infrastructure project(“IP”) normally takes a long time from conception to completion. Here is a guide to a typical engineering IP
The Client (owner of the IP) employs its own staff or selects a private sector designer for preparing conceptual deigns. Conceptual designs are then prepared and various approvals need to be given by various stakeholders including but not necessarily limited to regulatory authorities. During this process designs are often changed. Once the conceptual designs have been approved any preliminary design drawings are prepared and/ or a Request To Tender (“RFT”) document is issued to potential Tenderers. The various RFT’s are evaluated and a short list of Tenderers – usually ranging from 3- 6 -is selected. The Tender documents including the Contract terms and conditions and Specifications are finalised and issued to the selected Tenderers for submission of a Tender (Offer). Tender periods vary but usually range from 3- 6 months ( sometimes longer) depending on their complexity and number and type of stakeholders. Tenders are submitted on the due date for tender submission stated in the Tender documents. The various Tenders are then assessed by the Client and this assessment will usually include meeting(s) with each of the Tenderers. Eventually the successful Tenderer is elected or the IP is cancelled because of price and/or difficulties arising from the Tender assessment process. Contract documents are prepared and usually after some negotiations the Main Contract is executed. This period of the IP lasts about 12 – 24 months or longer. ( 12 months would be extraordinarily short)
Upon selection of the successful Tenderer (Main Contractor – “MC”) the MC will commence main design work and submit the drawings to the Client for approval. Once such approvals have been given detailed designs are then prepared by the MC and various Specification documents together with subcontract terms and conditions are prepared and issued as Tender documents to a selected number of potential subcontractors. Tenders are received and assessed. after discussions /negotiations the various successful subcontractors are then selected and subcontracts are exchanged. Subcontractors will then be required to issues any designs for approval before any manufacturing or construction work can commence. Large/key manufactured items take about 12 – 18 months from start to finish.
Construction (site) design will not commence until well into the manufacturing phase. The MC after any necessary input from manufacturers will prepare Tender documents for site installation/ construction. The Tender documents are issued to potential subcontractors. Tenders are submitted to the MC and assessed.Subcontract documents are drawn up by the MC and negotiated with the successful tender. Detailed Installation/constriction drawings are prepared by the subcontractor for approval by the MC. Once approved onsite work can then commence. After installation of manufactured items and power is available on site testing and commissioning of the main equipment items can commence. Once this is successfully completed the whole interconnected IP goes through a testing commissioning phase.
The onsite construction period ranges from 6-18 months depending on the type of IP, number of stakeholders and complexity.
The key points are IMO as follows:
1. IP take a long time
2. Except for HUGE IP you are not going to see a political leader at a typical construction site proclaiming that “if it were not for my policies these people would not have a job” .Whenever i see major roadworks in my travels i find it hard to see more than 40 people all up.
3 . IP often incorporate goods manufactured overseas – energy sector,roadworks( earthmoving equipment). Many custom made goods ( cable,nails, screws, portable machines, hand tools etc.) are manufactured overseas such as China, Germany, South Korea, Japan
4. It will be virtually impossible to employ the majority of staff required for the IP from the ranks of the unemployed. Private sector firms will use their existing staff and only add staff if they don’t have existing staff coming available from other projects. In a recession staff are laid off as new work increasingly declines. In a worsening private sector part of the economy only IP in the government sector could offset such declines PROVIDED the Government guaranteed work ( placing orders for several IP’s) for several years. This would mean an incumbent government making decisions which would commit future governments. How likely is that? Firms manage their work forces only using existing orders and immediate short term expectations. Firms will only increase staff numbers if they receive orders to pay for the cost of hiring additional staff. Period!! Once work on a government funded IP finishes and new orders have not been received the employer will lay off the surplus workers quick smart and especially in a recession. So the Government has to continuously place with the SAME firm and this would be anti- competitive and illegal. But i can hear someone say the Government should give long term commitments to ALL firms. Really? If not all which firms are selected?
5 Notwithstanding high unemployment (say 20%) eighty percent of the ‘available ‘ workforce is employed. Obviously
the private sector is using its resources to supply private sector and government sector needs in the absence of Colin’s mooted IP’s. Now along comes one or more of Colin’s IP’s. New orders will be placed with firms which would not have been placed if it were not for Colin’s IP’s. Let us the take the role of a manufacturing firm (“MF”). On receipt of the new order the work will be incorporated in the firm’s production schedule. It is likely in a recession that the firm has some idle capacity which can now be taken up so as to meet the delivery requirements of the newly placed order. Capital equipment constraints is unlikely to be an issue. If this is not possible than Increased overtime for a short period by existing workers will likely cover any labour shortfalls. Even after both these avenues were insufficient the firm is more than likely to extend delivery promises before hiring any additional staff. Albeit (unlikely) if such 3 remedies were still insufficient casual labour might be employed and would cease once the temporary production hump ceased.
Now what has also occurred is the fact that the new order ( via government funded IP) is incorporated in the production schedule and any other orders subsequently received in the normal course of business have to slotted in the production schedule. Very likely this will cause a later delivery for all or some of such other new orders than what would have been the case had the new government funded IP order not been placed.
6. Unemployed people are scattered throughout the country. Some regions have a higher level of unemployed persons than others, The unemployed have various skills/ skill levels in many different occupations. How do you get unemployed auto workers in Detroit to work in a Government funded IP transmission line project 200 miles from their homes? What about the many thousands of retrenched Wall St. workers – what use are such persons on IP’s? My point is its is impossible (IMO) to staff an IP with mostly unemployed people. The geographic and logistical problems are extreme restricting factors.
My own experience is that IP require good competent and experienced staff and this will be even more so in a recession. I put it to you that a competent unemployed tradesperson will more likely got selected in a job vacancy for a labourer provided the former accepted a labourer’s wage ( provided both came from the same field of work).
7. Greece, Ireland, Spain, Portugal, USA, Japan amongst many others are in very sever financial problems – don’t see any of them proposing long term government infrastructure programs – why not ?
Colin, i am of the view that infrastructure spending suggested by you in this post is not practical nor desirable. It would cause further weakening of the economy an add to the severity of the eventual global economic and financial bust to come ( if it has not already started. My posts add (IMO) the evidence to support such view.
In the event of any response from you which seriously differs from my own from i would think 2 things are necessary:
1. The debunking of my views including those in the links i have provided, and
2. the basis of your views.
In both1 and 2 i think it fair that you provide supporting evidence and facts.
Incidentally i do not intend to provide any more posts on this issue. If we cant agree we will agree to disagree.
Kind regards,
Robert de Beer
My main point is that you need to focus on creating value — not jobs. If you create value, jobs will follow. If there are skills shortages, people will re-skill (and/or travel across the country) to earn the extra money. Otherwise engineers are great at finding ways of working around the bottlenecks.
I disagree.
You seem to totally ignore the fact that IP programs purely instigated to offset deteriorating economic activity is essentially a redistribution of resources and add very little, if any to the overall economic wealth of the nation. I have provided a detailed response to your claim that it would add economic value in my post above sent earlier today.
Colin, what do you mean by “adding value “? How do you realistically determine “value”in real terms throughout the whole economy? The only means for increasing the economic wealth of the nation in the longer term is to increase production (more capital ( plants, machinery etc.) and/or by increasing productivity ( efficiency). Increasing already excessive debt levels which debt has to be repaid by the private sector does not increase economic wealth. Governments do NOT create jobs – they distribute resources and take from one sector the the benefit of another.. pink batts, Cash for clunkers, solar panels , school building are good examples .. once finished the resources had to be incorporated elsewhere.
Incidentally the huge levels of sovereign debt cannot and will be not be repaid except by means of high monetary inflation or otherwise there will be defaults.
To my knowledge there is no hard evidence to support the assertion that ” people will re-skill (and/or travel across the country) to earn the extra money.” indeed there is evidence to the contrary. Generally and for the most part people will not or cannot re- skill and travel across the country leaving home and family behind. There has been severe skills shortages in WA and QLD due to the mining boom and skilled people had to be imported to fill the vacancies. Wages were /are 2- 3 times in the mining areas than in Sydney and Melbourne and yet there was no significant transfer of tradespersons to the boom mining centres. Do you think that most unemployed Wall St people will learn a trade and work on an IP. In any event would an employer hire such people on lieu of skilled tradespersons with several years of experience? Colin, this assertion of yours is an example of well intentioned bur flawed thinking throughout your article and not backed by historical evidence nor rational and practical thinking.
Colin, as I have said before i would be pleased to change my views to your way of thinking provided you presented historical evidence ( not just a few isolated cases without considering the overall impact) of the real economic benefits to the over all economy and you give a reasoned response to the many points i have made which do not lend support to your views. One the common responses of the supporters of Keynesian economic theory is that they point to isolated cases where they trumpet ” if it were not for my program you would not have jobs today” Yet they never comment on the worsening economic situation, high unemployment, growing already excessive debt, low savings,falling real estate prices, rising home foreclosures,increased cost of living expenses, the severe drop in personal net worth band so on.
If you have not already done so i would ask that you read the content in the links i have provided and when you have done so you might then wish to respond to my detailed personal analyses/ reasoning in posts. Only by exchanging analysis based on facts and historical evidence can this debate proceed with clarity and reflection. I for one am quite happy to change my views if there is good reason to do so ( which means my thinking needs to be proved to be wrong). I have provided evidence to which support my reasoning to be right but i acknowledge that that does not make it right. Only because of my respect for you and a way of thanking you for all i have learned from IC i have gone into the length and depth of my posts. So again i say “Thank You.”
Kind regards
“You seem to totally ignore the fact that IP programs purely instigated to offset deteriorating economic activity is essentially a redistribution of resources and add very little, if any to the overall economic wealth of the nation.”
Let’s go back to my earlier posts on this issue.
You cite the mining boom as an example, but how many people working on the mines did not move there from somewhere else, either in Australia or internationally? And re-skilling is part of the creative destruction that you were earlier advocating as a strength of the capitalist system. When an industry collapses and new ones spring up, people have to adapt and re-skill. That is why the system works.
Regards, Colin
“QE will not cause inflation if there is a deflationary contractio
n happening at the same time. The two will offset each other. If there is no deflationary contraction, QE will cause inflation.”
Colin, i wish to only make a single point to your comment quoted above in that if it were not for the QE prices would have fallen faster and deeper. Your comment is not new and politicians over the centuries have made it before you – and at no time have they ever admitted that in practising QE policies prices would have fallen to greater extent during the recession were it not for QE or printing money out of thin air. consumers and businesses would have benefited greatly from lower prices as their real incomes were falling.
regards
“consumers and businesses would have benefited greatly from lower prices as their real incomes were falling”
I am not averse to falling prices but how do you prevent an implosion of the banking system if stocks and property prices fall?
“QE will not cause inflation if there is a deflationary contraction happening at the same time. The two will offset each other. If there is no deflationary contraction, QE will cause inflation”
1.” deflationary contraction” i take to mean a credit contraction in the private sector. A credit contraction in the private sector is occurring in most countries. This means that the private sector new credit growth is less than the retirement of existing debt. the important thing here is – Why are corporations and consumers not taking on more debt? This cannot be answered properly in a few lines bit over indebtedness , too much of everything and deteriorating economic conditions/ outlook are a starting point.
2. If “deflationary contraction” is meant to be a contraction in the country’s money stock then deflation has occurred regardless of any QE. In this case QE may slow the rate of the contraction in the money stock and lessen its extent.
3.Inflation is solely an increase in the money stock; deflation is a contraction in the money stock. This has not happened and is highly unlikely to happen if current policies are maintained (which is very likely).
4.There is no evidence of any contraction in the money stock. The money stock in USA and UK is robust, Japan’s money stock is starting to increase, the Eurozone’s money stock has fallen most of this year but it is still positive. Recent ECB policies will very likely increase the Eurozone’s money stock at a faster pace.
5. An increase in the general price level ( commonly but wrongly referred to as the CPI) is the effect of inflation. A rise in the CPI is NOT inflation but the effect of inflation.
6. Substantial and prolonged QE will ALWAYS cause an increase in the general price level. Since the establishment of the FED in 1913 the purchasing power of the USD has fallen by 97%. – this is called currency debasement and has been practiced by the ruling powers since ancient Roman days.
7. QE is counterfeiting – new money is produced from nowhere – it does not come from the hard work and productive efforts of the economy- if you and i did it we would go to prison.
8.QE adds more new money to the existing money stock and so prices are bid up for goods and services as there is more money sloshing around.
9. QE during a recession will probably slow the natural rate of decline of prices whist real incomes usually fall at a faster rate – not good for the private sector- so QE will cause an increase in nominal prices regardless of a fall in credit. In the USA and UK in the 19th century real net incomes rose significantly.Even during the Great Depression of !873- !895 in the USA real prices of goods and services fell at a faster rate than the fall in wages meaning net real income rose. There was little, if any, QE in the 19th century in he USA and UK.
10. the last 2 sentences are nonsensical. A ‘deflationary’ contraction or weakening of the economy will not be made better by the printing of new money. the US, UK, EU have pumped trillions of dollars into their economies esp. since the GFC of 2007/9. Their economies have weakened considerably since then and will weaken much more in the years ahead. I don t see any evidence that “the two will offset each other” .
11. QE or printing money out of thin air debases the currency of the country( i am not aware of any instance in history when currency debasement improved the economic wealth of the country – indeed the evidence is to the contrary). But money printing or currency debasement has another serious adverse effect on the economy. Our current monetary system where central banks have power to print unlimited amounts of money ( as so aptly put by ben Bernanke) together with fractional reserve banking cause severe malinvestments. Inefficient enterprises are propped up caused by the extraordinary loose monetary policies of central banks, New projects are commenced which would never have seen the light of day but for such loose monetary policies. Remember the dot.com. bubble when a great number of IPO’s burned to the ground after the bubble burst?
12.”If there is no deflationary contraction, QE will cause inflation”- As posited earlier QE will cause an increase in prices ( or a slowdown in natural falling prices which still means an increase in prices) regardless of the economic status of the economy.
Colin,i have given a 12 point reply to just a few lines of your post. I think this post demonstrates the difficulty in responding to just a small portion of pour original post in a few lines I could go on and say some more such as that central banks have no control over where the new money ends up in the economy or elaborate on these 12 points but i refrain from doing so. If people are interested in my points or with to dispute any of them i would suggest that they research the issue at their leisure first ( and reading all that i have provided at no cost to them) and acquire a sound knowledge of the subject matter. I am by no means an expert in these matters but have found time over the years to acquire what i think is a basic understanding of most of the aspects of the economy and the causes of booms and busts in a fiat currency world with fractional reserve banking. In short i do not intend nor wish to to be teacher in matters such as these. If any one wants to find out more then do the research.
Regards
“Treasury cannot afford to borrow more money if this is used to meet normal government expenditure. Public debt as a percentage of GDP would sky-rocket, further destabilizing the economy. If the proceeds are invested in infrastructure projects, …” and” Public debt would still rise, and bond market funding in the current climate may not be reliable. But this is the one time that Treasury purchases (QE) by the Fed would not cause inflation’ Quotes from your original post.
On the 26/12 you state “I have also emphasized that government act as facilitator, in partnership with the private sector, and not alone in order to minimize the common failures of government projects.”
To me your statements are confusing. Is the government the owner or not of the types IP you state in your post?( at least for potentially long period until the IP’s are supposedly sold to the private sector when the economy returns to good health)
In the first place you imply that “proceeds” come from an increase in public debt which i can only assume means funding (ownership) of IP by governments which apparently are destined to sold to the private sector when good economic health returns. As most governments own the nation’s infrastructure why would they facilitate IP’s? If an IP was NEEDED it will get built at the appropriate time by the private sector anyway. government IP’s usually fail because the Government goes ahead without the proper research and they are often politically motivated. You can facilitate all you want but if the government is determined to develop an IP it will be done regardless of the cost and lack of a reasonable return (or any return for that matter). Bringing forward IP is impractical and only harms he economy in the longer term – it would simply be another example of malinvestments caused by governments. Government spending would increase – more resources would be employed to handle the increase in spending. Government debt would increase during the first half of the expected life period of the IP because the revenue earned from the IP is in most if not all cases insufficient to pay for the Funding costs (interest) and repayment of Principal. Attractive IP returns only come in the later stages of the IP life period. In addition there is no realistically good and sound way to forecast interest rates in future years. Banks will only fund IP ‘s at variable rate of interest. who knows what interest rates may be in 1, 3,5, 10 or 15 years from no. We can be reasonably confident they will not be at the historical lows experienced today. Such interest rate rises will have a major impact on IP and on any sale by the Government OF IP to the private sector.
Incidentally you seem to have totally ignored the ECB report that big government is bad for the economy. Quote “Big government is bad for economic growth!
“Our results show a SIGNIFICANT negative effect of the size of government on growth.”
“Interestingly, government consumption is consistently detrimental to output growth irrespective of the country sample considered (OECD, emerging and developing countries).”
Under your plan Governments will only get bigger for say 10 – 20 years – how significant is that for economic growth?
Regards
My offer to publish a 800- to 1000-word rebuttal remains open.
Regards, Colin
The problem is that many people have done the research and arrived at different conclusions. I think it is important that we not “drink the Kool-Aid” and attach ourselves to a particular school — whether it be Keynesian, Monetarist, Post-Keynesian or Austrian — but remain open to ideas from all quarters.
Regards, Colin
http://www.investopedia.com/articles/basics/03/061303.asp#axzz1hbYUHx00
http://www.investopedia.com/articles/basics/03/061303.asp#axzz1hbYUHx00
http://www.qfinance.com/dictionary/credit-creation
Definition of
credit creation
ability of banks to lend more money
the collective ability of finance companies, banks, and other lenders of money to make money available to borrowers. While a central bank can create money, it cannot create credit.
What Is Credit Creation?
Ads by Google
Purchase Order Finance
Take on larger orders today new finance option no property security
http://www.arcashflow.com.au/purchaseorder
One of the important functions of commercial bank is the creation of credit. Credit creation is the multiple expansions of banks demand deposits. It is an open secret now that banks advance a major portion of their deposits to the borrowers and keep smaller parts of deposits to the customers on demand. Even then the customers of the banks have full confidence that the depositor’s lying in the banks are quite safe and can be withdrawn on demand. The banks exploit this trust of their clients and expand loans by much more time than the amount of demand deposits possessed by them. This tendency on the part of the commercial banks to expand their demand deposits as a multiple of their excess cash reserve is called creation of credit.
The single bank cannot create credit. It is the banking system as a whole which can expand loans by many times of its excess cash reserves. Further, when a loan is advanced to an individuals or a business concern, it is not given in cash. The bank opens a deposit account in the name of the borrower and allows him to draw upon the bank as and when required. The loan advanced becomes the gain of deposit by some other bank.Loans thus make deposits and deposits make loans. Anonymous
There seems to be some confusion about money and debt. Take a look at a dollar bill in your wallet. It is a promissory note. You are a creditor of the US/Canadian/Australian government. The dollar bill is effectively a Treasury bill that bears no interest and has no date of redemption.
We talk of “printing money” — when the Fed (as the governments agent) purchases Treasury bonds/notes and credits dollars to the sellers bank account, it simply exchanges one form of government debt for another more liquid form.
I am confused with your reply as follows…”There seems to be some confusion about money and debt. Take a look at a dollar bill in your wallet. It is a promissory note. You are a creditor of the US/Canadian/Australian government. The dollar bill is effectively a Treasury bill that bears no interest and has no date of redemption.
We talk of “printing money” — when the Fed (as the governments agent) purchases Treasury bonds/notes and credits dollars to the sellers bank account, it simply exchanges one form of government debt for another more liquid form.”
I agree with the first paragraph in that all fiat money is loaned into existence.
Where does a central bank get the money to purchase government bonds? it is new money created out of thin air and backed by nothing. The currency is literally being debased as i have evidenced in my posts. Such money creation is pure counterfeiting which i would be illegal if you or i would have done it. Because the Government has passed a law it is legal for the government to print money out of thin air.The process gives the greatest benefits to the first receivers of the new money( banks and government) and punishes savers. I have pointed out the differences between credit and money. The Fed has not got banks notes in its vaults which which derived from economic activity. it literally prints the notes electronically. The process causes an increase in the money stock and an increase in government debt as the government uses the new money from the Fed to fund its programs. Are suggesting that money printing or QE is of no consequence? I would be very surprised if you thought so. Indeed if it were so why do not Governments everywhere adopt the practice and we could all have free money and enjoy life to the full. Do you recall the consequences of money printing by the Weimar ( German) Republic on the 1920’s and Zimbabwe and Argentina in more recent times?
Quote from your article…..”Treasury cannot afford to borrow more money if this is used to meet normal government expenditure. Public debt as a percentage of GDP would sky-rocket, further destabilizing the economy. If the proceeds are invested in infrastructure projects, however, that earn a market-related return on investment — whether they be high-speed rail, toll roads or bridges, automated port facilities, airport upgrades, national broadband networks or oil pipelines — there are at least four benefits. First is the boost to employment during the construction phase, not only on the project itself but in related industries that supply equipment and materials. Second is the saving in unemployment benefits as employment is lifted. Third, the fiscal balance sheet is strengthened by addition of saleable, income-producing assets, reducing the net public debt. Lastly, and most importantly, GDP is boosted by revenues from the completed project — lowering the public debt to GDP ratio.”
Colin, your reply is hard to understand ..your article specifically mentions jobs and savings in unemployment benefits as benefits .. so 2 of your so called 4 benefits are clearly about jobs which you now say is not the case. i have addressed that point in detail whilst you continue with general assumptions. Japan in recessions since 1990 and USA during the depression years 1932 – 1946 through money at infrastructure projects .. their economies continued to weaken. Your 3rd benefit is illusionary. in the USA rail and energy assets are privately owned- are you suggesting that the government fund IP in these sectors? this is completely unrealistic and would be detrimental to the economy. With perhaps a few exceptions high speed rail is not profitable any where in the world as i understand it – do airports need upgrades? Airports are generally owned by the private sector – if there is a need for an upgrade and it will provide a reasonable economic return it will be done by the private sector. Broadband- there is a lot of controversy about the economic benefits of NBN in Australia- not a clear cut issue. Probably best if improvement in computer speed were left to the private sector . In the US the private sector owns and operates such assets. Are not oil pipeline in the US privately owned? Infrastructure owned by the private sector will be upgraded or replaced as needed by the private sector- the government needs to stay out. I can imagine the Government saying to a power generator or pipeline operator – we want you to build a new power station or pipeline. We the Government will fund it and sell it to you on completion of the IP. First of all the Company does not need the IP.. if it did it would have been done or the IP would be committed by the Company- it is forced on the Company. Secondly i can see the private sector companies rubbing their hands with glee at the opportunity to get work paid for by the Government. They would charge like a wounded bull. If cost overruns occurred the Government would continue funding- it cant afford have a half completed IP on its hands. Anyone thinking the Company would buy a completed IP which it did not want in the first place at the actual cost or at a premium in a recession has got to be dreaming. In such cases the IP must be sold immediately on completion. the Government has no resources/ expertise to own and operate some infrastructure ( say a single power station or pipeline) where the over all responsibility lies the private sector.
We now turn to IP where the infrastructure is owned and operated by the Government. Unlike the USA power generation and rail in most if not all in Europe, UK, China, India, South America, Australia, and elsewhere is owned by the Government. IP where the infrastructure is owned by the Government cannot be sold to the private sector. I is just impractical to suggest otherwise.
Finally it should be noted that as in all recessions the capital good sector of the economy suffers the greatest. For example energy demand falls because of deteriorating economic conditions. Simply put the NEED for new IP reduces dramatically during the hard times. It would be unreasonable to build a new power station when electricity demand is weakening. the financial return on investment falls during economic weakness. Even you have acknowledged that IP is not the total answer – in short there is no real hope that any amount of IP would bring the economy back to good health.
Finally my posts totally refute the assertion that significant IP over a long period will add economic value – indeed i am of the view they are counterproductive.It is easy to point to a few historical IP which added to the economic wealth of the country. Such IP would have been done at some regardless of the economic conditions because there was an acceptable financial return on investment. One has to accept reality and that we need to recognise it is time for the piper to be paid. Let Mr Market do its thing with no interference from Government and central banks and whilst there will be pain it will not last any where as long and be much less severe than if Governments continue with their flawed policies and keep on kicking the can down the road.
Colin, your replies to my posts are general in nature and content and fail to address the detailed reasoned points i have made personally and in links to articles which lend support to my position on the issues. You are just not coming up with the evidence and reasoned thinking to back up the claims made in tour article. This is somewhat surprising and disappointing.
Kind regards
I am confused with your reply as follows…”There seems to be some confusion about money and debt. Take a look at a dollar bill in your wallet. It is a promissory note. You are a creditor of the US/Canadian/Australian government. The dollar bill is effectively a Treasury bill that bears no interest and has no date of redemption.
We talk of “printing money” — when the Fed (as the governments agent) purchases Treasury bonds/notes and credits dollars to the sellers bank account, it simply exchanges one form of government debt for another more liquid form.”
I agree with the first paragraph in that all fiat money is loaned into existence.
Where does a central bank get the money to purchase government bonds? it is new money created out of thin air and backed by nothing. The currency is literally being debased as i have evidenced in my posts. Such money creation is pure counterfeiting which i would be illegal if you or i would have done it. Because the Government has passed a law it is legal for the government to print money out of thin air.The process gives the greatest benefits to the first receivers of the new money( banks and government) and punishes savers. I have pointed out the differences between credit and money. The Fed has not got banks notes in its vaults which which derived from economic activity. it literally prints the notes electronically. The process causes an increase in the money stock and an increase in government debt as the government uses the new money from the Fed to fund its programs. Are suggesting that money printing or QE is of no consequence? I would be very surprised if you thought so. Indeed if it were so why do not Governments everywhere adopt the practice and we could all have free money and enjoy life to the full. do you recall the consequences of money printing by the Weimar ( German) Republic on the 1920’s and Zimbabwe and Argentina in more recent times?
.
If you would like me to respond to each question you raise, you will need to keep your posts short and to the point.
Regards, Colin
Colin , the issues you have raised in your posts are very important. One cannot discuss them in a few lines.
I have given detailed reasoned response to such issues and you have failed to address them My posts clearly spell out why your statements on major infrastructure funding over a very long period, government intervention in the economy, debt, inflation are either impractical, flawed,or just plain wrong. you have stated that there are 4 benefits to significant IP paid for by the Govt which i refute and have stated the basis for doing so. If you consider my responses are wrong you should point out the errors and provide a reasoned basis with historical evidence to support your opinions. This you have failed to do. I acknowledge most of posts are long but they are (IMO) incorporate substance and often facts.
incidentally you should note that the points i make for the most part are brief but are baked by supporting analysis and facts such as the fact that IP projects tend to take a very long time
My take is that you think things are so bad and would get much worse unless governments “take bold action” whatever that means and significantly add their already HUGE debt levels to spend on infrastructure spending which will be sold(profitably to the private sector notwithstanding that most infrastructure is owned by governments ( with some notable exceptions esp. in USA such as energy and rail. You fail to recognise that in all recessions esp. those caused by financial extravagance ALWAYS throughout history cause a severe downturn in the capital goods sector of the economy,There is less energy usage , a reduction in transport ( air travel, freight – air, shipping, road and rail). Corporations will simply not invest in IP during a recession and whilst the demand for more IP is not there. Governments would be crucified if they were to spend HUGE sums ( via DEBT) on IP that are not necessary at the time or foreseeable future.This is just a brief summary and you really need to read mu posts to fully grasp my points.
Any way, Colin i seem to have wasted my time writing these posts. There is a possibility that Governments will do as you suggest but i the odds are against it. It is much more probable they will not do much in the way of IP other than as a token gesture to the electorate to help them retain power. Remember George Bush Jnr implemented a national road works program ( did not do much did it). colin , i fear your suggestion of IP’s are clutching at straws. Somehow i suspect you know it and that is why you refuse to address my points because, unlike myself, you cannot supply facts, logic and reasoned analysis together with historical evidence which lend weight to your case and which rebuffs mine. ( Please do not refer to an isolated case like the Hoover Dam- which i have dealt with in my posts).
All the best for 2012 and i hope everything works out for you and your family that you wish for.
Colin, where do you get the notion that a long term IP program is necessary?
Does Europe need more infrastructure? Does Australia? What about Japan? China infrastructure is in dire straits – much of it unused ( whole cities are lying idle), their high speed rail program has been suspended ( for how long?) due to technical problems. In the USA there are reports which suggest their infrastructure is decaying and will need to be fixed. This will be done as and when appropriate. You glibly mention the types of IP that governments should implement over a 10 -20 year period. Are their published reports based on thorough technical research which suggest the NEED for such IP in the countries comprising the EU, Japan, China, Australia, USA and others and that such IP should be initiated now or in the foreseeable future?
As i have stated and explained in my posts it is not only impractical but logistically virtually impossible to staff the labour required for an IP with unskilled and inexperienced people scatted all over the place _ Sure you may get some such people but not the majority. My posts clearly spell out why your views on hiring the majority of unemployed persons on IP just cannot work – if you still think otherwise please be good enough to specifically spell out why each of the factors lending support to my case is wrong.
Incidentally most IP are capital intensive and have you though the implications of that together with the staffing needs of each unique IP?
regards
Long but useful,Colin.. topics:
Japan – Land of the Rising Debt,Dreadful Dreams and Japan’s Peculiar Situation,Full Speed Ahead – A Powder Keg Waiting For A Spark
http://www.acting-man.com/?p=12710#more-12710
Regards
“In reality, every cent the government spends must be taken from the private sector and therefore can no longer be spent or invested by it.”
Is that true when US banks are holding more than $1 Trillion in excess reserves?
Using a simple test: can the IP deliver market-related returns on investment? Let the markets decide.
Robert, You have not wasted your time. Every time we question an idea/proposal it is either weakened by exposing flaws or strengthened by building a firmer base. That is the creative-destructive process at work. The Comments column is not the place for a detailed rebuttal. You need to keep it short and pithy to hold readers’ interest. But if you write an 800 to 1000 word summary of your arguments I would be happy to publish it on the site. This is not about me/you being right or wrong — it is about a search for solutions to the complex problems we face.
Regards, Colin
Colin,you posited that infrastructure would provide 4 benefits and that would do much to offset the credit contraction in the private sector. I have responded to each of your claims and put the case that they are either impractical, flawed or just plain wrong and would further weaken the economy.
I am not all that interested in summarising my posts to few lines on each issue. One problem with that it is that readers who are either economically illiterate or who have a predetermined view are very unlikely to shift their position because of a few lines stating a different view. IMO people need reasoned arguments clearly explained and often supported with historical evidence. IMO this is what i have provided.
I am of the view that posts such as yours should be based on sound reasoning, common sense and supported by historical precedence. Your original post failed on all fronts. Like people of the Keynesian school of economic theory IMO that you believe governments need to do something, anything to (“take bold action”) and avoid a severe deflationary recession. Keynes’s position was that governments need to step in when private sector activity declines. Roosevelt and Hoover before him did just that with disastrous results. If you and your readers are not interested in reading my posts because points and explanations are not limited to few lines then i put it it to you that interest in the issues are shallow at best. it is a shame that many financial commentators provide opinions and suggestions whist not having the knowledge to do so authoritatively. In addition most people including but not limited to politicians ,central bankers and corporate leaders see a problem and then proclaim so called solutions without factual knowledge of the root cause(s) and the wider implications of their policies designed to ‘fix’ the problem. This is Keynesian economic thinking. In almost all cases the ‘fix’ makes the problem(s) worse.That is reality, unfortunately.
There have been very little interest from your readers on the issues ( only a few replies)so it would seem best that i leave it as it is.
Regards
“Using a simple test: can the IP deliver market-related returns on investment? Let the markets decide”
What an odd comment!. As i understand it you are of the view all such new IP’s should be owned by the Government and then sold to the private sector at a profit when economic good health returns.
Why do you think most infrastructure is owned by the Government and not the private sector? Notable exceptions are Rail and energy in the USA and Power Generation and distribution in Victoria- Australia. IP in infrastructure sectors already owned by the government are likely to remain in the public sector and not be sold to the public sector. Are you suggesting that IP be owned by the government in infrastructure areas owned by the private sectorI cant imagine the government owning a power generator(power station) where the power generator system is owned by the private sector corporation. IP should only be commenced if there is need now or in the foreseeable future – these would be done regardless of any new government intervention. I am just repeating myself . You just don’t seem to understand how infrastructure actually works esp when it comes to IP which has a benefit to the economy i.e. increases the economic wealth of the nation. It is far better to commence IP when it is needed and not for the purpose of trying to hold back the necessary downturn caused by decades of bad policy and bad management. It would be far better to let the private sector economy heal itself without interference by governments which have already stuffed op ]badly and we don’t need more of the same thank you very much.
Colin, you obviously have not read or understood my posts or you would not have made such a remark. The economic viability and expected return is normally (and should) be modelled before commitment of the new IP and based on the current and expected conditions during the life of the IP. The market will decide at the point of sale the price it will pay for an IP owned by the government. this may well cause a loss to the government for reasons i have already posited.
regards
“As i understand it you are of the view all such new IP’s should be owned by the Government and then sold to the private sector at a profit when economic good health returns.”
That is not what I said:
“Infrastructure investment should not be seen as the silver bullet, that will solve all our problems. Over-investment in infrastructure can produce diminishing marginal returns — as in bridges to nowhere — and government projects are prone to political interference, cost overruns, and mismanagement. But these negatives can be minimized through partnership with the private sector.”
Later comment:
“Big Government Is Bad for the Economy
I couldn’t agree more. Its role should be as facilitator rather than employer.
Let’s extend the financial crisis example:
Government builds a dam.
Willy is paid $500 to perform the labor.
Larry agrees to buy water for $200/year as it will improve his crop yield.
Cathy agrees to invest $500 for a 70% share in the project, provided govt. makes good 50% of any revenue shortfall — and receives 50% of any surplus (the figure does not have to be 50% — it could be higher or lower). Cost overruns are borne 70/30 in line with shareholding.
Cathy receives $100 for managing the project.”
“In reality, every cent the government spends must be taken from the private sector and therefore can no longer be spent or invested by it.”
Is that true when US banks are holding more than $1 Trillion in excess reserves?”
The Reserves came from the FED – not from the private sector. Governments do not add economic wealth- they distribute wealth taken( stolen?) from the private sector. The private sector pays taxes on the income it has generated from using its capital stock. If there were no taxes there would be no government. In the USA and UK prior to the first world war there were no taxes on income earned by citizens. A small tax (5% i believe ) was introduced to help pay for the war effort and was supposed to have been terminated at the end of the war. This , of course , never happened.
If and when such reserves are released by the commercial banks into the economy it will be highly inflationary due to the application of fractional reserve banking. Trillions of new money dollars created out of thin air will be released by new lending using this process. There would likely be short term gains but cause much greater pain and for longer down the road. Incidentally it is now widely acknowledged that QE2 did little if anything to help the economy get back to good health.
If such reserves were released it would e good for the PM’s, gold and silver mining stocks and to a lesser extent commodities. Also the stock market will rise for a time but be still in a secular bear market in real terms- would not like to be an investor in bonds though – interest rates will almost certainly rise.
Regards
Our currency is bogus, illegal, immoral. Federal Reserve Notes have been irredeemable since 1965. They are unConstitutional in all 50 states. Hence, their use in lending is illegal. Hence, there has been no large national debt created over the last 46 years. The U.S. has no money. The Federal Reserve was never given authority to do what they are doing.
Many thanks Colin for this great analysis and paths (long term usefull investment in infrastructure) to cure the debt fundemental crisis. Could be implemented in “old Europe” too. Should be. Let’s hope the message goes to our polititians…
Best postings I have ever seen. Very educational and will require re-reading. One aspect which has been left out of the discussion, however.
Whwn you have government intervention and decision making in the re-distribution of wealth, you create situations which deteriorate the economy.
1. The buying of votes by the politicians causes improper programs to be created or continued.
2. The citizens of the “Republic” feel that they are entitled to whatever they can get from the government instead of being entitled to a freedom which allows them to “earn” what they wish to require.
3. The hard working people of the country, such as myself, feel that the government has left the country and that the only possible positive outcome will be the destruction of the government so that the country can survive.
I could go on, but my point is that LONG TERM Robert is correct and Colin HAS to be wrong because when an AUTOCRAT (the government) makes a decision it can be right many times but sooner or later it will be drastically wrong and we all suffer instead of those that made the decisions suffering.
Again, a great series of postings and very enjoyable reading.
Holy cow. I’ve read through all of these posts and I have been able to ascertain a few things. First, the Federal Reserve and Central Banking system prints money out of thin air. As it does so the value of each dollar shrinks, which should trigger inflation for products, goods and services. More money=more demand and without a corresponding increase in goods/services the cost goes up. A system of money based on precious metals, as was the case prior to the Fed, is naturally limited by it’s availability. In theory, when the Fed was first established the amount of money printed was equal to the total amount of gold that was deposited in the banking system making a dollar whole. As more and more dollars are printed out of thin air the value of the dollar vs what is deposited in terms of gold declines and inflation is a natural result since people who own property, goods, and services are not going to take less value in exchange for it. Therefore the ONLY natural response is for either the demand to go down (prices fall), or for the availability of the commodity to increase (making it more available). This is why a natural solution to the economic problem is “economic growth”. Colin is trying to make a point, I guess, that the government should be in the business of borrowing and spending on infrastructure to create growth. However, unless the government is going to expand the availability of a good or service to drive economic expansion it won’t work. A perfect example is the Housing Reinvestment Act. The government forced banks to make money more available for people to borrow for real estate (Fannie/Freddie). Initially, this effort was overwhelmingly successful. Banks, construction firms, workers, and just about every trade involved in home building and maintenance was enjoying the fruits of this wonderful government program. There was just one problem. The very foundation on which this entire adventure was built was “thin ice”. The government forced banks to loan to people who simply didn’t have the ability to pay it back! At the end of this crazy adventure in government involvement in the private sector the entire house of cards folded and people and banks fell through that thin ice. Only those who were behind this adventure and some very wise individuals profited. Many smaller banks and people were severely damaged by it. The thought process was that “trickle down” economics won’t work so let’s force the system to move along faster than it can in order for politicians to pat themselves on the back, lobbyists to get rich quick, and in the end most of us suffer. During the government’s involvement in the real estate market prices soared due to the availability of cash and a low volume of available homes. In the end it all came crashing down as people and banks defaulted. All that toxic debt is still out there waiting on someone to take care of it. There are some who say that we should just “wish it all away” and just forgive it. Wow. Is this what our generation has come to? Shame. Trickle down economics works because it is based on sound money, investment and expansion of real estate, goods, and services. You cannot make the economy grow faster than what the market can demand or the workers can produce. The sad fact, Colin, is that there is no easy way out of the mess we are in other than stretching out the pain over generations!
“there is no easy way out of the mess we are in”
This is the easy road! Though it could be improved through more effective use of government spending. The alternative — without government intervention — is a whole lot tougher. Scroll through some photos of squatter camps, tent cities, soup kitchens and job queues from the 1930s and you will see what I mean.
I wanted to comment on your view stated above, namely “Wall Street no doubt lobbied hard for debt expansion, because of the boost to interest margins, with little thought as to their own vulnerability”.
I became aware of research, by the IMF into into rural poverty during the early 2000’s, both in developing countries and domestic. The IMF published papers stating among other reasons, that the cause for poverty was “because the rural poor’s links to the economy vary considerably, public policy should focus on issues such as their access to land and credit”. (http://www.imf.org/external/pubs/ft/issues/issues26/index.htm).
It was this research that prompted our goverments to support the credit expansion to help people get a foot on the property ladder, to increase private wealth, not Wall Street’s lobbying. Greed kicked in after that and we all have profited one way or another from the bubble, as I am sure you did too.
Sorry to spoil your conspiracy theory.
No conspiracy theory. Wall street may have not been the only beneficiaries, but they weren’t complaining about all the money they were making — and were doing everything in their power to oppose increased regulation.
I find this discussion interesting but only because the investment sector is looking at last at some of the problems. Personally, I don’t think any of what is suggested will work because all it is doing is propping up the status quo, which is corrupt beyond belief.
The fractional reserve system was invented so the elites could continue to grow their share of the pie. The system is owned by corporates who buy the politicians either directly or indirectly.
The whole monetary crisis was inevitable because of the way money is created. But meantime wealth is transferred into fewer and fewer hands. Democracy has been undermined. Where democracy has been supported, people have chosen temporary pain in order to control their own destinies. I refer to Iceland, which is an example that should be followed by the rest of the PIIGS and the sooner the better. All the bailouts have done is steal more from the 99% to prop up the 1% and that is what it is all about.
I live in New Zealand and since the sell out of the Labour Party in the 80s have watched in disgust and powerlessness as our assets were sold off (privitised) in the name of efficiencies. Our rail was run into the ground by several private companies from off shore, the policy of the Reserve Bank, which had been full employment was changed to one single goal, low inflation. A country with very little unemployment (because the assets we owned employed them–and yes we the people paid for that and better that people went to work and learned skills instead of sitting around on the dole causing trouble, which we also pay for)…. And now we have another government who will sell off our remaining hydrodams at a time when water resources the world over are being privitised and creating desertification. power Ok, I won’t rave on about this. But the cause is the Milton Friedman school of economics which created and orchestrated a global takeover (surely you have readThe Shock Doctrine?), and all of this while the world is facing the greatest crisis humankind has ever faced (peak oil and other essential resources), water, growing population, etc. (And you have seen Chris Martenson’s The Crash Course?) You guys should know all this – and probably do – so why keep trying to save a broke system? We know ever increasing growth is impossible. The whole issue needs to be about how we downsize is a fair and a painless a way as possible.
“The whole issue needs to be about how we downsize is a fair and a painless a way as possible.”
Down-sizing is not fair and painless. Take a look at photos of the squatter camps, tent cities, soup kitchens and job queues from the 1930s: the little guy gets hurt the most.
The Good Deficits
Mises Daily: Thursday, January 12, 2012 by John T. Flynn
ArticleComments Also by John T. Flynn
AA
25
[As We Go Marching (1944)]
The presence of the problem of an economic system definitely out of repair did not impress itself on the consciousness of the American public until well after Mr. Roosevelt’s administration had had its try at the situation for one term. After that the solemn truth settled only slowly upon our minds. By 1940 there were few who did not feel that there was something definitely out of joint.
However, as in Italy and Germany, our first attack upon our economic disorder, as it appeared in 1930, took the form of government spending and welfare. This was something quite new with us. Before 1914 public spending of borrowed money was a negligible feature of our economy. The expansion that astonished the world in America up to that time had been the product of private enterprise financed by private credit. In 1912, on the eve of World War I, after a century and a half of growth, the debts of our public bodies were as follows:
Most of the national debt was a remnant of the Civil War. The bulk of these debts was municipal, incurred for building city utilities such as streets, water works, schools, hospitals, and such.
The war of 1917 marked the beginning of a new era of public spending and borrowing. With the coming of war we had three years of enormous deficits as follows:
The history of the war measured in national debt may be stated as follows:
State and local debts had risen from $3,821,896,000 in 1912 to $8,689,740,000 in 1922.[3]
This was due almost wholly to war. After that, however, in the period from 1922 to the depression of 1929, the federal government, instead of borrowing, annually reduced its debt. But the state and local authorities became heavy borrowers. However, no small part of the local debts was contracted for revenue-producing improvement and practically all of this debt was created with provisions for amortization. None of it was arranged as part of any scheme to produce national income, though it had that effect. It arose chiefly out of the demand of local communities for public utilities such as schools, education, health facilities, streets, and from the great demand for roads to make way for the stream of motorcars that poured from our factories. Whatever the purpose, however, the policy did accustom the public mind to public borrowing as a fixed policy of government.
The theory of public spending as an instrument of government to regulate the economic system first appeared in the early part of 1922. The theory was advanced by the Unemployment Conference of that year. Briefly stated, it held that during periods of prosperity, when private industry is supplying all the requirements of national income, the federal and local governments should go slowly on public-works expenditures. They should accumulate a reserve of necessary public-works plans to be put into execution when business activity shows signs of tapering off. However, it was not contemplated that the governments should go into debt for these purposes but should carry them out in accordance with the principles of traditional sound finance. This theory amounted merely to a plan to carry on public building and spending operations in periods of diminished private business activity rather than in time of prosperity.
When the depression appeared in 1929, therefore, Mr. Hoover, on December 4, 1929, sent a message to Congress proposing additional appropriations for public works. He asked an increase of $500,000,000 for public buildings, $75,000,000 for public roads, $150,000,000 for rivers and harbors, and $60,000,000 to dam the Colorado River.[4] He believed this could be done within the budget. Actually the Hoover administration provided $256,000,000 in 1929 and $569,970,000 in 1930 for agriculture, public works, and farm loans while at the same time reducing the public debt by $746,000,000.[5] The central theme of these proposals was to use public spending merely as a stabilizer. There was a pretty general agreement with the theory. But as the depression advanced there was a persisting failure of tax funds so that by 1931 there was a deficit of $901,959,000 which increased the next year to nearly three billion dollars.[6] A part of this deficit resulted from the public-works expenditures but most of it was caused by a failure of tax revenues. Hoover, of course, never planned an unbalanced budget. However, so imbedded in the public consciousness was the aversion to national public debt that the Democrats in 1932 roundly denounced the Hoover administration for its extravagances and its failure to balance the budget. The platform of June 1932 contained the following as its very first plank:
We advocate:
An immediate and drastic reduction of governmental expenditures by abolishing useless commissions and offices, consolidating departments and bureaus and eliminating extravagance, to accomplish a saving of not less than 25 percent in the cost of the Federal Government; and we call upon the Democratic Party in the States to make a zealous effort to achieve a proportionate result.
Maintenance of national credit by a federal budget annually balanced on the basis of accurate executive estimates within revenues, raised by a system of taxation levied on the principle of ability to pay.
Mr. Roosevelt, the Democratic candidate, stood strongly behind these declarations. He not only opposed heavy public spending but public borrowing as well. He advised that a “government, like any family, can for a year spend a little more than it earns, but you and I know that a continuation of that means the poorhouse.” He warned that “high-sounding phrases cannot sugar-coat the pill” and begged the nation “to have the courage to stop borrowing and meet the continuing deficits.” Public works “do not relieve the distress” and are only “a stopgap.” And having asked “very simply that the task of reducing annual operating expenses” be assigned to him, he said he regarded it as a positive duty “to raise by taxes whatever sum is necessary to keep them (the unemployed) from starvation.”[7]
The party itself plastered the nation with huge posters warning that the Republican Party had brought it to the verge of bankruptcy and calling on the voters to “throw the spendthrifts out and put responsible government in.” The candidate and the party were quite sincere in these declarations and promises. They were in accordance with the most orthodox American convictions. But practical political leaders, in search of power, besieged by resolute minorities with uncompromising demands for results and bombarded by cocksure merchants of easy salvation, find themselves forced along courses of action that do not square with their public proclamations of principle. Just as Mussolini and Hitler denounced their predecessors for borrowing and spending and then yielded to the imperious political necessity of doing the thing they denounced, so the New Deal, once in power, confronted with a disintegrating economic system and with no understanding of the phenomenon that was in eruption before its eyes, turned to the very thing it denounced in Hoover. But there was a difference. Hoover’s deficits were the result of failure of revenue and were unplanned. Mr. Roosevelt’s first deficit was a deliberately planned deficit. Within a few months of his inauguration he approved a proposal for a $3,300,000,000 public-works expenditure with borrowed funds in the NRA Act of May 1933. He then turned in the following deficits: $3,255,000,000 in 1933–34; $3,782,000,000 in 1934–35; $4,782,000,000 in 1935–36; and $4,952,000,000 in 1936–37.
Nevertheless, despite this record, the administration persisted in its theory that budgets should be balanced. Its platform in 1936 said:
We are determined to reduce the expenses of the government.… Our retrenchment, tax, and recovery program thus reflect our firm determination to achieve a balanced budget and the reduction of the national debt at the earliest possible moment.
In January 1937 the president triumphantly presented what looked like a balanced budget. He said:
We shall soon be reaping the full benefits of those programs and shall have at the same time a balanced budget that will also include provisions for the reduction of the public debt.… Although we must continue to spend substantial sums to provide work for those whom industry has not yet absorbed, the 1938 budget is in balance.
The whole tone of this message was pitched on the growing importance of a balanced budget. Nevertheless, notwithstanding this amazing statement, the budget of that year was not in balance. It showed a deficit of $I,449,626,000. Immediately there was a tremendous drop in the rate of business activity. We began to have what was called a recession, while the president continued to talk about “the extreme importance of achieving a balance of actual income and outgo.” I recall all this now in order to make clear that up to this time no party in this country seriously approved the practice of borrowing as a definite policy. I think it illustrates also with complete finality that the men who were guiding national policy knew nothing about the workings of our economic system. The president made it clear that he was spending and borrowing purely as an emergency device. As late as April 1937 he said:
While I recognize many opportunities to improve social and economic conditions through federal action, I am convinced that the success of our whole program and the permanent security of our people demand that we adjust all expenditures within the limits of my budget estimate.
He then delivered himself of the following extraordinary opinion:
It is a matter of common knowledge that the principal danger to modern civilization lies in those nations which largely because of an armament race are headed directly toward bankruptcy. In proportion to national budgets the United States is spending a far smaller proportion of government income for armaments than the nations to which I refer. It behooves us, therefore, to continue our efforts to make both ends of our economy meet.
Here was a clear recognition of the fact that in Europe for many decades governments had been doing what our government was then doing, spending great sums of money and going into debt for it, but doing it on armaments instead of on peacetime activities as Mr. Roosevelt was doing. But nations which borrow money and pile on vast national debts can go into bankruptcy whether the debts be for armaments or roads, parks and public buildings. European nations were far more deeply stricken in crisis and had been for years. The armaments had become an economic necessity to them. They were not to us. Our government was delivering lectures on sound fiscal policy, deploring the deficits, yet planning new and more extravagant means of spending money, soothing the Haves with promises of balanced budgets and lower taxes, and stimulating the Have-nots with promises of security and abundance. The government was doing, in fact, what Depretis was doing in Italy between 1876 and 1887. Let the reader turn back to the first part of this volume for a description of that record:
He promised every sort of reform without regard to the contradictions among his promises. He promised to reduce taxation and increase public works. He promised greater social security and greater prosperity. When he came to power he had no program and no settled notion how he would redeem these pledges. His party was joined by recruits from every school of political thought. He found at his side the representatives of every kind of discontent and every organ of national salvation. The oppressed tenants along with the overworked and underpaid craftsmen of the towns crowded around him beside the most reactionary landowners and employers to demand the honoring of the many contradictory promissory notes he had issued on his way to office.
Depretis then, for lack of any other weapon, proceeded to do what he had denounced his conservative predecessors for doing — to spend borrowed money on an ever-larger scale. When he did “every district wanted something in the way of money grants for schools and post offices or roads or agricultural benefits. These districts soon learned that the way to get a share of the public funds was to elect men who voted for Depretis, Men who aspired to office had to assure their constituencies that they could get grants for these constituencies from the Premier,” I quote again what the Encylopaedia Britannica said of this episode:
In their anxiety to remain in office, Depretis and the Finance Minister, Magliani, never hesitated to mortgage the financial future of the country. No concession could be denied to deputies, whose support was indispensable to the life of the cabinet, nor under such conditions was it possible to place any effective check upon administrative abuses in which politicians or their electors were interested.
Miss Margot Hentz, writing of the same episode, said:
Pressure was brought to bear through the organs of local administration who were given to understand that “favorable” districts might expect new schools, public works, roads, canals, post and telegraph offices, etc.; while the “unfavorable” might find even existing institutions suppressed.
Depretis’ policy was pursued on a larger scale by his successors, including Giolitti whose administration brought Italy to the eve of World War I and the threshold of bankruptcy. Those who have read the chapter in this volume on Germany will not fail to see the resemblance first on a small scale to the performances of the old imperial government and then on a larger scale to the policies of the republican government that preceded Hitler.
All this, however old, was a new chapter in American policy. When, therefore, these vast expenditures were made, the noblest and most heroic explanations were offered. Having denounced timid deficits, the administration embarked upon a program of huge deficits, but it did it in characteristic American fashion, with proclamations of righteousness as if America had suddenly discovered something new. In fact, it was called a New Deal, Actually, it was America dropping back into the old European procession.
The recession of 1937–38 marked a turning point of the greatest importance in American public policy. Up to this point spending had been done on the pump-priming theory. That is, public funds, flowing out into business, were expected to produce a resumption of business activity. But business utterly failed to respond to this treatment. Apparently the pump itself was seriously out of order. From this point on we hear no more about balanced budgets. We find the administration committed to the same policy that marked the fiscal programs of republican Germany. It turned to the device of public spending and borrowing as a continuing and permanent means of creating national income.
There was a renewal of depression, and the president himself had to admit in his 1939 message that his expectations of recovery when he reduced expenditures were overoptimistic. It had become plain to the political elements in the government that there was something wrong, that the idea of public works during an emergency, used even on an enormous scale, had not produced recovery and was merely a stopgap. The situation of the administration was critical in the highest degree. Almost all its plans had been discarded. The AAA was declared unconstitutional; the NRA was scrapped by the Supreme Court just as it was falling into utter chaos; the devaluation of the dollar and the idea of a managed currency, as well as the gold-buying plan, had proved ineffective; social security was an aid to the unfortunate but did nothing to make the economic system work. Apparently nothing was holding back a tidal wave of deeper depression save the spending and borrowing program which everyone had either denounced or apologized for. The public debt had risen as total depression deficits amounted to 19 billion. What possible avenue of escape opened for the government in the presence of rising unemployment, rising taxes at last, farmers, workers, the aged, investors all clamoring for swift and effective aid and the land filling up again with messiahs and their easy evangels?
About this time a group of young men published a little book — An Economic Program for American Democracy (Vanguard, 1938). It got little enough attention at the time. Its authors styled themselves Seven Harvard and Tufts Economists. It proclaimed boldly that the capitalist system as we have known it was done and that, instead of balancing budgets, the government should adopt the unbalanced budget as a permanent institution; that the only salvation of the nation was in a greater and ever-expanding program of national expenditures met with revenues raised by borrowing.
Completely unknown at the time, these men were actually announcing in this small book the theories that had been worked over by John Maynard Keynes in England and Dr. Alvin H. Hansen in this country. But they were by no means the inventors of them. They had already had a vogue in Germany under the republic, which indeed had been influenced by them in its fiscal policies.
Their theory, very briefly stated, is as follows:
The present capitalist system is no longer capable of functioning effectively. The reasons for this are as follows:
The dynamic element in the capitalist system is investment. Since millions of people save billions of dollars annually, these billions must be brought back into the stream of spending. This can be done only through investment. When private investment is either curtailed or halted, these savings remain sterilized or inert and the capitalist system goes into a depression. Nothing can produce a normal revival of the capitalist system save a revival of investment.
Private investment cannot be any longer revived on a scale sufficient to absorb the savings of the people. Hence recovery through private investment is hopeless.
Private investment cannot be revived because there are no longer open to savers adequate opportunities for investment.
Opportunities for investment are not open any longer for three chief reasons: (1) because the frontier is gone, with its opportunities for territorial expansion and the discovery of new resources; (2) because population increase has slowed down to a snail’s pace; (3) because technological development has matured. That is to say, there is no longer in sight any such great inventions as the railroads, the automobile, etc., which will change all the arrangements of our social life and call for huge money expenditures.
The present capitalist system is therefore incapable of recovering its energy. This is not a mere emergency condition but is a characteristic of the system which will continue indefinitely.
For this reason we must adopt a new type of economic organization. This new type is called the Dual System or the Dual Consumptive System. Under this system the government will become the borrower of those savings funds which private business will not take. It must then spend these funds putting them again into circulation. What we must look forward to, therefore, is a “long-range program of government projects financed by borrowed funds.”
Of course such a program means borrowing perpetually by the government. It means that each year the government debt will increase. When the war ends we will owe not less than $300,000,000,000. Thoughtful men are gravely disturbed as to what course we shall pursue to mitigate the immense burden of this debt. These gentlemen say our course is clear — borrow more. Borrow endlessly. Never stop borrowing.
Of course one asks: What will be the end? How will we ever pay the debt? They reply: It is not necessary to pay public debts. As long as the bondholder gets his interest he is satisfied, and when he wants the principal he can sell his bond, which is all he asks. But how long will this ability to sell his bond last with a government that never stops borrowing and whose credit can become exhausted? This they say, despite all the lessons of history, cannot happen because the more we borrow the higher we build our national income and hence the greater is our ability to borrow. But what about the interest? we ask. Will that not rise to appalling proportions? If our debt is $300,000,000,000 when the war ends, the interest, when we refund the debt, will be at least $9,000,000,000 a year. Before the depression this government never collected more than $3,500,000,000 in taxes. The greatest amount of taxes ever collected by the federal government in peacetime, even after we began to spend on war preparations, was $7,500,000,000 in 1941. But we will have to collect that much in taxes — and an additional $1,500,000,000 — just to pay the interest on the national debt. Yet the advocates of this system say that when the war ends we must go on borrowing at the rate of 5 or 10 or even 20 billion a year. Mr. Tugwell estimated it must be around $12,000,000,000 a year in peacetime.
This theory has, in greater or less degree, been adopted by those most influential in the present government. It is not an idea that has infected a few choice spirits on the perimeter of the New Deal. It has become a part of the New Deal — indeed its most essential part. The evidence of this is that the job of planning for the postwar problems of America was taken over by the president himself, was not committed to any of the departmental bureaus, but was installed in his own executive office under his own eyes. For this purpose he organized as a department of his own office the National Resources Planning Board. The man who is the leading exponent of this theory, Dr. Alvin H. Hansen of Harvard, was brought to Washington as economic adviser of the Federal Reserve Board and installed as the chief adviser of the National Resources Planning Board. Six of the seven Harvard and Tufts economists who prepared the published plan were brought to Washington and made economic counsel of various important agencies. Mr. Richard V. Gilbert, one of them, and one of the most vocal apostles of this theory, is at the moment I write guiding the economic destinies of the OPA, which is supposed to be leading the battle against inflation. Most of the others have been given posts of importance in the government. Dr. Hansen has been described by such journals as the New Republic and Fortune as the man “whose fiscal thinking permeates the New Deal.” The board has put out a series of pamphlets designed to outline its guiding ideas. The most important of these was written by Dr. Hansen. Everywhere in Washington, in the most important key positions, are men who have been indoctrinated with this theory.
It is interesting to note that as early as 1936 a little book appeared called Uncommon Sense, by David Cushman Coyle. The book, however, was circulated by the Democratic National Committee and one wonders if the hard-headed men who paid the bills realized what they were doing. It contained this amazing passage:
There are two ways to get out of depression. One is for business to borrow ten or twenty billion dollars from investors and build a lot of new factories, loading itself with debts that the investor will be expected to pay. The other is for the Government to borrow money and build public works, loading itself with debts that the investors will have to pay out of their surplus incomes. Some kind of taxpayer has to carry the debts either way. But business debts have to be paid mostly by the poorest taxpayers, whenever they go to the store to buy a cake of soap. Federal debts have to be paid by the people with better incomes who would not spend all their income anyway. That is why it is better for business and consumers if we get out of the depression by having the Government borrow than by having business do all the borrowing.
It is this incredible yet dangerous piece of nonsense which is at the bottom of the postwar plans that are being made in Washington. Recently Congress, to its amazement, became aware of these plans. It had provided funds for the National Resources Planning Board to work out a program for the postwar period. Of course everyone is in favor of that. It had been hearing about the “projects” which that board was blueprinting. It learned, finally, that the great project upon which the board was working was a project for recasting the whole economic and social system of America along the lines outlined here and based primarily upon a settled conviction that the capitalist system is dead. And it was doing this in the office of the president of the United States. It was the discovery of this fact which led to one of the first congressional revolts in 1943 and compelled the abolition of the National Resources Planning Board by Congress. The liquidation of this Board, however, does not in any particular alter the theories upon which the present government is proceeding. It is merely forced to transfer its revolutionary planning activities to other bureaus and departments.
All this is nothing more than a conscious imitation of the German experiment. Some of the political leaders, including the president, may not realize this, since they are not students. But the men who have been publicizing and promoting the program do. Thus, for instance, we find an article in Harper’s[8] describing with a good deal of gusto the financial operations of the Hitler regime. We are told that we must not let the brutality of German political policy “divert our attention from the German financial program. It is revolutionary and it is successful.” The author then tells us that if we will look behind the dictatorship we may possibly find “clues to the nature of our own recent financial ills, indicating what has been wrong and what can be done to strengthen economic democracy now and in the future.” The men who built this German system are called men of unquestioned genius. It is becoming clear that “Germany’s internal financial program is removing the limitations of her financial environment on rates of productive activity. For years prior to the present war German industry operated at capacity. To do these things she is changing capitalism but she is not destroying it.”
Of course there is nothing new about Hitler’s financial operation, as anyone who has read the German chapter of this volume will remember. It is merely the adoption by Hitler of the spending and borrowing tactics of his predecessors, whom he so roundly denounced. Hitler was doing little more than Mussolini was doing, than the republicans and Social Democrats did before him in Germany, and what the old Italian and German Ministers did before the last war. There has been altogether too much nonsense printed about the great financial wizardry of Schacht. Schacht did no more than any banker with his knowledge of modern banking might have done, caught in the same squeeze. Being an experienced financier and having seen one devastating inflation at work, Schacht introduced some clever devices to mitigate the effect of his fiscal policies. For instance, he arranged that when financial or industrial concerns of any category had accumulated large cash reserves, they were compelled to invest them in government bonds, thus relieving the government of the necessity of making inflationary bank loans. Better still, when the government decided that a new steel or munitions plant should be built, the operation would be carried on by a private corporation. It would issue its securities. In this country the government takes those securities through the Reconstruction Finance Corporation, buying them with funds raised by government borrowing on its own bonds or notes, thus plunging the government into debt. Schacht would force large financial institutions to take the securities of the private corporation directly, keeping the government completely out of the financial transaction. This was possible in Nazi Germany under a dictator. A dictator can order such things. A democratic government cannot. The author of the article from which I have quoted tops it off with the admiring observation that “the Nazis by experimentation were learning what to do while Keynes was discussing these theories in England.” This is what is being offered to America. I quote once more:
The irony of this financial revolution that has been unfolded in Germany lies in its implications for the future of economic democracy. What the Nazis have done, in essence, is to begin to chart the unknown realms of the dynamic use of government securities. Tragically for Germany and the whole world the brilliant contribution of her financial genius has been obscured by its diversion to the uses of tyranny and destruction. But can any of these financial methods be utilized so that a wise, self-governing people, determined to preserve individual freedom and anxious to make full use of individual initiative, could make private enterprise and capitalism better serve the purposes of economic democracy? If this is so — and I believe it is — we shall do well to examine the potentialities of this new arithmetic of finance as carefully and dispassionately as we should study, let us say, those of a new German development in aircraft manufacture, and seize upon whatever we can use for our own democratic ends.
This was written in 1941. The author was painfully behind the times. For already in 1938 the administration had practically seized upon this theory of finance.
It is a little astonishing how far the parallel between our fiscal theories and those of Germany go and how, once adopted, quite without design, they led off into the same weird bypaths. For instance, Italy before World War I had already learned how to increase the charges of social security in order to provide the government with money, not for social security but for its regular expenditures, and the same thing appeared in Germany. The present administration did that here until it was stopped by Congress in 1938, and now it is energetically trying to do the same thing again. Recently the New York Sun reported that when auditors got into the books of Mussolini’s treasury, after his fall, they discovered that a large part of his deficit was due to the paying out of huge sums in subsidies to conceal the rise in the cost of living — a plan industriously urged here by the Hansen group and adopted by the president but as yet resisted by Congress. It is a singular fact that at this moment the battle against inflation is in the hands of these Perpetual Debt economists who look upon government spending and borrowing — which are the cause of inflation — as things good and necessary, and who look upon the objections to huge government spending and deficits as “old-fashioned superstition.”
How the funds will be spent or “invested” by the central government is a point upon which all the advocates of this system are by no means agreed. Generally they fall into three groups:
The first group insists that the government shall not engage in any activities that either compete with private industry or impinge on its province. The government should put out its funds upon projects outside the domain of the profit system — such as public roads, schools, eleemosynary institutions, playgrounds, public parks, health projects, recreational and cultural activities of all sorts. A possible exception might be the development of power across state boundaries. Another exception would be public housing or housing for the underprivileged, which would not actually compete with private industry since private investors never put any money into housing projects of this kind. They would leave the whole subject of producing and distributing goods to private enterprises.
Another group proposes to invest these government funds in the shares and bonds of private enterprises. An eligible list of public investments would be established. The government would thus become the chief investor in private enterprise and in some cases — the railroads, for instance — the government might own all the bonds and perhaps much of the stock. Thus we would have a private corporation operating the utility in which much if not most of the funds would belong to the government. This plan, of course, would enable the general government, as the largest stockholder or holder of the mortgage, to exercise over properties a whole range of authority and power which it could not possibly exercise as a government per se.
A third plan is outlined by Mr. Mordecai Ezekiel, economic adviser of the Agricultural Department. He proposes an Industrial Adjustment Administration patterned on the lines of the Agricultural Adjustment Administration. It would work as follows: Industry, organized into local groups united by national councils, would plan each year not the amount of goods it could sell but the amount needed by the nation. This estimate, approved by the government, would be authorized as the production program of the year. Each region and each unit in the region would receive its allocation of what it might produce. Prices would be fixed and all the producing units would proceed to turn out their respective quotas. The government would guarantee the sale of everything produced, underwriting the whole program and taking off the hands of all producers their undisposable surpluses. The risks of business would be transferred almost entirely to the government.[9]
What is stewing in Washington is a potpourri of all these ideas. The National Resources Planning Board in its report to Congress did actually propose that the government should become a partner in rail-roads, shipping, busses, airlines, power, telephone, telegraph, radio, aluminum, and other basic industries. It proposed also government participation in the financing of industry without setting very much limitation on it. John Maynard Keynes — now Lord Keynes and a member of the Board of Governors of the Bank of England and the most distinguished English-speaking exponent of these theories — speaks of this as “a somewhat comprehensive socialization of investment.” By this he means to distinguish his plan from the socialization of industry. Industry would be operated by private groups but the investment in industry would be socialized. “It is not the ownership of the instruments of production which it is important for the state to assume. If the state is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who can own them it will have accomplished all that is necessary,” says Lord Keynes. The government will interpose itself between the corporate enterprise and the investor. The government will sell its securities to the investor, and as these will be guaranteed securities, the government can fix the rate of interest and therefore the rate of reward to the investor. The government will then invest these funds in industry. The industry is “owned” by a private corporation. But the government owns its bonds, perhaps much of its stock. Thus Lord Keynes thinks he avoids statism or government ownership of industry. What is perfectly obvious, however, is that in one form or another these men are attempting to fabricate a system that will not be communistic and will not involve state ownership but will put in the hands of the all-powerful state not only through institutions of public regulation but through financial investment complete control of the economic system, while at the same time running up vast debts against the government and utilizing the public credit to create employment.
Of course this is fascism. For this principle of the Dual Consumptive Economy, as Dr. Hansen calls it, or the principle of planned consumption, as the fascists call it, by whatever name it is called is in fact one of the ingredients of the fascist or national socialist system. And if we will add to it the other ingredients of fascism or national socialism, we will then have that baleful order in America.
Whether this is a sound system or not is a matter for discussion. But sound or not, as Mr. Dal Hitchcock points out, it is the Nazi system. Whether we shall adopt it or not is hardly any longer a question. We have adopted it. The question is, can we get rid of it, and how? And if we are to continue it, the next question is how can we do so while at the same time continuing to operate our society in accordance with the democratic processes? This point we shall consider later.
$3.75 $3.00
America has now stumbled through the same marshes as Italy and Germany — and most European countries. Her leaders had proclaimed their undying belief in sound finance and balanced budgets while they teetered timidly on unbalanced ones. The public clamor for benefits, the cries of insistent minorities for relief and work, the imperious demand of all for action, action in some direction against the pressure of the pitiless laws of nature — all this was far more potent in shaping the course of the administration’s fiscal policy than any fixed convictions based on principle. An unbalanced budget, after all, is a more or less impersonal evil, not easily grasped by the masses; but an army of unemployed men and the painfully conspicuous spectacle of shrinking purchasing power are things that strike down sharply on their consciousness. It is not easy, perhaps, to eat one’s words about balancing the budget. But it is easier than facing all these angry forces with no plan. It is easier to spend than not to spend. It is running with the tide, along the lines of least resistance. And hence Mr. Roosevelt did what the premiers of Europe had been doing for decades. Only he called it a New Deal.
John Thomas Flynn (1882–1964) was an outspoken critic of the Roosevelt administration’s domestic and foreign policy decisions, opposing both the New Deal and the Second World War. As Mises Institute senior fellow Ralph Raico described Flynn in his introduction to the 50th anniversary edition of The Roosevelt Myth, “There is little doubt that the best informed and most tenacious of the Old Right foes of Franklin Roosevelt was John T. Flynn.” See John T. Flynn’s article archives.
This article is excerpted from As We Go Marching (1944).
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Standing Keynesianism on Its Head
Mises Daily: Monday, April 20, 2009 by George Reisman
ArticleComments Also by George Reisman
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As Employment Increases in Response to a Fall in Wage Rates, the Rate of Profit Rises, Not Falls
This is the third in a series of articles that seeks to provide the intelligent layman with sufficient knowledge of sound economic theory to enable him to understand what must be done to overcome the present financial crisis and return to the path of economic progress and prosperity.
Introduction
Popular Keynesianism
Spending for Capital Goods Can Rise at the Same Time that Spending for Consumers’ Goods Falls
Hoarding and the Rate of Profit
100 Percent Hoarding and an Infinite Rate of Profit
More on Hoarding and the Rate of Profit
The Keynesian IS-LM Doctrine
Keynes’s Bait and Switch
Further Problems with Keynesianism
In a Recovery, Investment and Profits Move Together
In a Depression, Saving and Net Investment Are Negative
Conclusion
Beyond Keynesianism: Marxism
With his usual astuteness, Mises observed that it is common for one and the same doctrine to circulate in more than one version, typically, in its original, scholarly version and then also in a greatly simplified version designed for popular consumption. He illustrated how this applied to doctrines as diverse as Catholicism, Darwinism, and Freudianism (Money, Method, and the Market Process, pp. 301f).
Not surprisingly, his observation also applies to Keynesianism and its claim that a free economy is incapable of eliminating unemployment, because its method of doing so, namely, a fall in wage rates, is allegedly unable to increase the quantity of labor demanded.
Popular Keynesianism
The popular version of the Keynesian doctrine, which is championed above all by the labor unions, is simply that a fall in wage rates, in reducing the incomes of wage earners, causes a fall in consumer spending, which allegedly serves to worsen the problem of unemployment. This doctrine can be disposed of fairly simply, before proceeding to the scholarly version of Keynesianism, which is known as the IS-LM doctrine.
First of all, it overlooks the fact that at lower wage rates more workers will be employed. The effect of this is to enable total wage payments and consumer spending in the economic system to remain the same or even increase while the wages of the individual worker decline. For example, 10 workers each employed at 90 percent of the wages earn the same total wages and can spend just as much in buying consumers’ goods as could 9 workers each earning the original wage. (It’s as simple as the fact that 10 times .9 equals 9 times 1.) And, of course, more than 10 workers employed at 90 percent of the wage per worker would earn more collectively and spend more for consumers’ goods collectively than was possible before.
The popular version of the Keynesian doctrine also overlooks the fact that even if total wage payments and consumer spending did decline, business sales revenues would not decline insofar as reduced wage payments made possible increased expenditures for capital goods. Indeed, to the extent that additional spending for capital goods took the place of wage payments and the consumer spending supported by wage payments, not only would sales revenues in the economic system remain the same, but, what is particularly important for the process of economic recovery, the amount of profit earned on those same total sales revenues would actually increase.[1]
This result follows because wage payments as a rule show up fairly quickly — usually within a matter of weeks or months — as equivalent costs that must be deducted from sales revenues in calculating profits. In contrast, expenditures for machinery will not show up as equivalent costs deducted from sales revenues for several years or more, in accordance with the depreciable life of the machines. And expenditures for construction materials and the services of construction equipment will not show up as equivalent costs deducted from sales revenues for several decades, in accordance with the still longer depreciable lives of buildings and other highly durable assets.
Because of these considerations, if a sum such as $100 billion, say, could be shifted away from wage payments in the economic system and to the purchase of machinery and plant, profits in the economic system might well increase on the order of $90 to $95 billion dollars in the year in which this shift of spending occurred. This is because the $100 billion of spending for capital goods that would now take place would represent fully as much spending for goods, and thus fully as much business sales revenues, as the $100 billion of spending for consumers’ goods that the wage earners would otherwise have made. At the same time, while $100 billion of wage payments would have shown up in the same year as $100 billion of costs to be deducted from sales revenues, $100 billion of spending for capital goods with a depreciable life ranging from several years to several decades, may well show up perhaps as a mere $5 to $10 billion of depreciation cost in any given year. The replacement of $100 billion in wage costs with $5 to $10 billion of depreciation cost implies a rise in economy-wide profits of $90 to $95 billion.
Spending for Capital Goods Can Rise at the Same Time that Spending for Consumers’ Goods Falls
Some readers may wonder how it is possible for more to be spent for capital goods at the same time that less is spent for consumers’ goods. Less spending for consumers’ goods, it would seem, should imply less spending for the capital goods required to produce the consumers’ goods. The answer lies in the fact that while this may well be true, the spending for capital goods to produce consumers’ goods declines in a lesser degree than does the spending to buy consumers’ goods. This means that it now stands in a higher proportion to the spending for consumers’ goods. In turn, the spending to buy the capital goods to produce those capital goods comes to stand in a compounded higher proportion to the spending for consumers’ goods, and so on, with the spending for capital goods further compounded at every succeeding stage of production.
The following series of numbers will help to illustrate what is involved. Thus imagine that initially spending for consumers’ goods in the economic system was 500 units of money, the spending for the capital goods to produce those consumers’ goods was 250 units of money, the spending for the capital goods to produce those capital goods, 125 units of money, and so on, with each succeeding amount of spending for capital goods being half of the spending for the capital goods it helps to produce.
Now imagine that spending for consumers’ goods falls from 500 to 400 units of money. Here is how at the same time spending for capital goods can increase from 500 (i.e., the sum of 250 + 125 + 62.50 +…) to 600 units of money. The mechanism is that the spending for the capital goods required to produce consumers’ goods falls from .5 x 500 to .6 x 400, i.e., from 250 to 240. The spending to produce the capital goods required to produce those capital goods will now be .6 x 240 rather than .5 times 250. Inasmuch as .6 x 240 = 144, while .5 x 250 = 125, the spending for capital goods at this stage has actually risen. Its rise will be relatively greater at each succeeding stage, e.g., 86.4 versus 62.50, 51.84 versus 31.25, and so on.
Hoarding and the Rate of Profit
Finally, it should also be realized that the effect even of a decline in total wage payments that was not accompanied by any increase in spending for capital goods, would soon be very positive for profits. It would not increase profits in absolute amount, but it would increase them as a percentage of sales revenues and costs.
Here it must be kept in mind that wage payments are not only a source of funds for wage earners to spend in buying consumers goods, but they also show up equivalently as business costs, which must be deducted from sales revenues in computing profits, and do so fairly soon. Thus a decline in wage payments would quickly result in equal reductions in sales revenues and costs. To whatever extent sales revenues were greater than costs to begin with, the amount of that excess would remain unchanged, because equals subtracted from unequals do not affect the amount of the inequality. However, the same amount of inequality, i.e., of profit, would now represent a larger percentage of the reduced sales revenues and costs.
The same amount of profit in the economic system would also represent a rise in the rate of return on capital invested in the economic system. This would be the result not only of the monetary value of the capital invested shrinking in consequence of reduced spending for labor (and capital goods), but also, and far more immediately, of the write-down of the value of existing capital assets to correspond with their lower level of replacement costs made possible by widespread declines in wage rates and prices. In addition, purchases of assets at fire-sale prices following bankruptcies contribute to the same result.
What this implies is that to the extent that savings in the economic system might be unduly held in the form of cash, i.e., “hoarded,” the effect is to raise the rate of return on capital invested and thus to provide a greater incentive for savings being invested rather than being hoarded. In other words, “hoarding” is always a self-limiting phenomenon.
It follows that even if a decline in wage rates was initially accompanied not only by a fall in total wage payments but also by a fall in total business spending for labor and capital goods combined, the subsequent rise in the rate of return on capital would operate to restore total wage payments and the spending for capital goods. Consequently, once the underlying aspects of a process of financial contraction have come to an end, a fall in wage rates operates at least fairly soon to increase the quantity of labor demanded.
100 Percent Hoarding and an Infinite Rate of Profit
An implication of this discussion that may appear startling to many readers is that if it were ever the case that people kept all of their savings in the form of cash holdings and spent absolutely nothing for labor or capital goods, the rate of profit and interest in the economic system would become infinitely high. This is because while there would still be some amount of sales revenues in the economic system, resulting from consumption expenditures by those who possessed money, there would be no money costs of production to deduct from those sales revenues, since no expenditures giving rise to money costs would have been made. Thus the amount of profit in the economic system would equal 100 percent of the sales revenues generated by whatever consumer spending existed. At the same time it would equal an infinite percentage of the zero money costs of production and an infinite percentage of the zero money value of capital invested.
These conclusions are confirmed by the fact that the rate of profit and interest is far higher in countries that lack the security of property and developed financial markets and institutions and where, as a result, a far larger portion of savings takes the form of precious metals and gems rather than investments in business.
More on Hoarding and the Rate of Profit
“Hoarding,” or more precisely an increase in the demand for money for cash holding, has two effects on the rate of profit. One is its longer-run effect, which can take place within a period as short as a few months, and which is to raise the rate of profit, as I have just shown.
Its other, more immediate effect, however, is to reduce the rate of profit, even to the point of wiping it out entirely and replacing profits with losses throughout the economic system. This is the effect with which everyone is familiar and in the name of which they desire to do everything possible to avoid reductions in spending of any kind.
The reason that hoarding first reduces profits is merely the fact that reductions in spending for labor and capital goods exert their effect on business sales revenues to a more or less substantial extent before they exert their effect on the business costs deducted from sales revenues in arriving at profits. Business sales revenues decline immediately when spending for capital goods declines: for example, less spending for steel sheet by an automobile company is less sales revenue for steel companies at the very same moment. Sales revenues decline almost immediately when spending to employ labor declines, i.e., as soon as reduced wage payments show up in reduced consumer spending.
Now some costs deducted from sales revenues also decline immediately in response to reduced business spending, notably, such costs as typically come under the heading of selling, general, or administrative expenses. But other costs, namely, those which come under the headings of “cost of goods sold” and “depreciation cost” are not immediately affected by declines in current business spending. They are determined historically, that is, by business spending for inventories and plant and equipment that has taken place in the past, and which cannot retroactively be reduced.
Current spending on account of inventories and plant and equipment shows up as costs to be deducted from sales revenues only in the future, a future that ranges from days to decades. Of course, in a major recession or depression, long-term investment spending falls to a far greater extent than spending required to carry on current operations, and as a result, further declines in business spending, notably for labor and materials, almost all show up fairly quickly as declines in costs deducted from sales revenues.
Long-term investment spending falls disproportionately in large part because the wage rates of construction workers and of workers producing construction materials and the various kinds of machinery have not fallen or have not fallen to the point to which it is believed they will fall. In that case, it pays to postpone such investments and hold cash instead, because they would be at a major disadvantage in competition with investments made in the future. And when these wage rates and prices do finally fall, permitting current long-term investment to be worthwhile once again, the monetary value of existing plant and equipment can be written down commensurately, as previously indicated. The effect of the write-downs is to reduce depreciation cost on existing plant and equipment. (For example, the annual depreciation charge on plant with an asset value of $1 billion and a remaining depreciable life of 20 years is $50 million. But if the value of that plant and equipment were written down to $500 million, the annual depreciation charge incurred would also fall by half, to $25 million.)
Along with a fall in wage rates and prices, an essential condition of economic recovery from a major recession or depression is simply the end of further financial contraction, i.e., further economy-wide declines in spending. Further financial contraction stops when bank failures and their accompanying declines in the quantity of money stop (or, better still, do not start in the first place) and when the demand for money for cash holding has risen sufficiently to satisfy the need to operate without access to loans created on a foundation of credit expansion.
The additional demand for money for cash holding also includes whatever temporary further component may be necessary to allow for a failure of wage rates and prices to fall and the consequent postponement of long-term investments. At this point, the short-run negative effect of less spending on the amount and rate of profit begins to come to an end. Its final end is greatly accelerated by the write-downs of assets that accompany reductions in wage rates and prices and hence in the replacement cost of existing business assets. (As indicated, purchases of assets at fire-sale prices following bankruptcies contribute to the same result.)
These write-downs not only serve to reduce costs deducted from sales revenues earned with existing assets, thereby increasing current profits, but also serve to reduce the money value of the capital invested, thereby further increasing the rate of profit on existing assets in the economic system. In effect, they serve to increase the size of the profit numerator while reducing the size of the capital-invested denominator. More profit earned on less capital is a two-sided increase in the rate of return on capital.
In this environment, reductions in wage rates not yet accompanied by the employment of more workers or by the purchase of more capital goods quickly result in improvement in the rate of profit. They do so not only by reducing costs as much as sales revenues, but by reducing them by more than sales revenues when the effect of write-downs is taken into account. The write-downs, as just shown, also raise the rate of profit by reducing the money value of the capital invested in the economic system.
This rise in the rate of profit, and consequently also in the rate of interest, operates to reduce the demand for money for cash holding, by virtue of making the investment of money relatively more attractive in comparison with the holding of money. The reduction in the demand for money for cash holding is greatly furthered by the restoration of the profitability of long-term investment that accompanies the necessary fall in wage rates and prices and also by the rise in the rate of profit that takes place pursuant to the putting of funds into longer-term investments.
The net upshot is that the necessary fall in wage rates and prices serves to increase the quantity of labor demanded disproportionately, by virtue of calling back into the market funds that had been withheld in anticipation of the fall in wage rates and prices. At the same time, the increase in the quantity of labor demanded and the corresponding movement of the economic system toward “full employment” is accompanied by a rise in the rate of profit in the economic system.
The Keynesian IS-LM Doctrine
The doctrine of Keynes himself is far more complex than the popular variant. It is so complex that it calls to mind a popular song from years ago called “Dem Bones” that described the connection of one bone to another, from toe to head. The song went,
Toe bone connected to the foot bone,
Foot bone connected to the ankle bone,
Ankle bone connected to the shin bone,
Shin bone connected to the knee bone.…
Neck bone connected to the head bone.
My reason for associating Keynesian economics with this song is that just as one bone is connected to another in the song, so in textbooks expounding the Keynesian system, each separate but connected piece of the anatomy of that system — a bone, if you will — is presented in a series of successively connected diagrams totaling as many as eleven in all. Each one of the diagrams repeats an axis of the one before it. Thus, in the Keynesian system, the “production function” is connected to the “IS curve”; the “IS curve” is connected to the “saving function”; the “saving function” is connected to the “saving-equals-investment line”; the “saving-equals-investment line” is connected to the “marginal efficiency of capital schedule”; the “marginal efficiency of capital schedule” is connected back to the “IS curve”; the “IS curve” is connected to the “aggregate demand curve…” The diagram below, which is from the first edition of Joseph P. McKenna’s Aggregate Economic Analysis, depicts all the various relationships involved.
Anatomy of the Keynesian System
Just as in the case of the highly simplified labor-union version, the ultimate conclusion drawn from this extensive series of connections is that full employment cannot be achieved in a free market, because, once again, a fall in wage rates allegedly turns out to be incapable of increasing the quantity of labor demanded.
Even though the two versions of Keynesianism reach the same conclusion, they differ profoundly in the complexity of their explanations. And as a result, they require separate critiques.
In the textbook version, the reason that a fall in wage rates allegedly cannot reduce unemployment is not that it automatically reduces spending in the economic system. Keynes is willing to concede that initially spending might remain the same or even increase and that at the lower wage rates it would in fact employ additional workers. He writes:
Perhaps it will help to rebut the crude conclusion that a reduction in money-wages will increase employment “because it reduces the cost of production”, if we follow up the course of events on the hypothesis most favourable to this view, namely that at the outset entrepreneurs expect the reduction in money-wages to have this effect. It is indeed not unlikely that the individual entrepreneur, seeing his own costs reduced, will overlook at the outset the repercussions on the demand for his product and will act on the assumption that he will be able to sell at a profit a larger output than before. (General Theory, p. 261)
The basic problem, Keynes contends, lies in what would happen next, if the fall in wage rates did in fact manage to increase the volume of employment. Continuing in the very same paragraph, he argues that the effect of the greater employment would be a fall in the rate of profit (which he usually calls “the marginal efficiency of capital”) below the lowest rate that is sufficient to induce investment. This would serve to make the employment of additional workers no longer worthwhile and result in employment being pushed back to its previous figure. In his words (to which I’ve taken the liberty of adding explanatory comments, which appear in brackets):
If, then, entrepreneurs generally act on this expectation, will they in fact succeed in increasing their profits? Only if the community’s marginal propensity to consume is equal to unity, so that there is no gap between the increment of income and the increment of consumption [i.e., there is no additional saving]; or if there is an increase in investment, corresponding to the gap between the increment of income and the increment of consumption, which will only occur if the schedule of marginal efficiencies of capital has increased relatively to the rate of interest [i.e., either the mec schedule must somehow move to the right, which there is allegedly no reason for its doing, or the rate of interest must fall, which it can’t do, because it is allegedly already at its lowest acceptable rate, which is usually assumed to be 2 percent]. Thus the proceeds realised from the increased output will disappoint the entrepreneurs and employment will fall back again to its previous figure, unless the marginal propensity to consume is equal to unity [i.e., there is no additional saving] or the reduction in money-wages has had the effect of increasing the schedule of marginal efficiencies of capital relatively to the rate of interest and hence the amount of investment [Keynes means, of course, increase the amount of investment that is worthwhile — i.e., yields 2 percent or more]. For if entrepreneurs offer employment on a scale which, if they could sell their output at the expected price, would provide the public with incomes out of which they would save more than the amount of current investment, entrepreneurs are bound to make a loss equal to the difference; and this will be the case absolutely irrespective of the level of money wages.
I have italicized the last sentence because, if any single sentence of Keynes can express the theoretical substance of his doctrine, that is the one.
Here is the line of argument Keynes is presenting in the passage above and which is depicted in the graphical analysis. The employment of more workers results in more production, which at the same time means more real income. By a process of equivocation, which I note here, but will not make a major issue of, real income suddenly becomes interchangeable with money income, out of which saving and cash hoarding can potentially take place.
Saving, according to Keynes and his followers, is a mathematical function of income, such that more income results in more saving, e.g., 20 percent of each additional dollar of income is saved, while 80 percent of each additional dollar of income is consumed. The extra saving relative to extra income is called “the marginal propensity to save,” while the extra consumption relative to extra income is called “the marginal propensity to consume.” The names of the full mathematical functions are “the saving function” and “the consumption function.”
As the quotation indicates, the existence of saving allegedly creates a problem. If there were no additional saving as employment and income increased, there would be nothing to stop the additional employment achieved as the result of a fall in wage rates from being maintained. But saving creates the potential for cash hoarding.
Cash hoarding, in the Keynesian system need not automatically and necessarily occur every time there is saving. Potentially, additional saving might be offset by equivalent additional investment. If it were, that would put the money saved back into the spending stream. In this case too, the additional employment achieved as the result of a fall in wage rates could be maintained.
The problem that arises, according to Keynes and his followers, is that the additional investment required is the cause of a fall in the “marginal efficiency of capital,” i.e., the rate of profit or rate of return on capital. The effect of achieving full employment, believe the Keynesians, would be an increase in the volume of saving to such an extent that it would require an offsetting increase in the volume of investment of such a magnitude that the rate of return on capital would allegedly be driven to an unacceptably low level. (Below 2 percent is the figure usually assumed.)
In response to a rate of return less than the minimum acceptable rate, funds would be withdrawn from investment and hoarded. This would reduce spending throughout the economic system and cause the return of unemployment.
The fundamental problem, say the Keynesians, is that the existence of full employment would impose an unacceptably low rate of return on capital and therefore could not be maintained if it were achieved. The return of unemployment would be necessary because by reducing output/income, it would reduce the volume of saving, since less income results in less saving. With saving reduced, less investment is required to offset it in order to prevent hoarding. And with less investment, the rate of return on capital will be higher.
Keynes’s whole argument depends on the rate of profit falling as the end result of the increase in employment and output. If the rate of profit did not fall, if it stayed the same or rose as employment and output increased on the foundation of a fall in wage rates and prices, there would be absolutely nothing standing in the way of the achievement of full employment by means of a fall in wages and prices.
Clearly, it is essential to examine Keynes’s argument that the rate of profit (mec) declines as investment increases. For his whole analysis depends on it. In explaining it, he writes:
If there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased, partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase.… Thus for each type of capital we can build up a schedule, showing by how much investment in it will have to increase within the period, in order that its marginal efficiency should fall to any given figure. We can then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate of investment will establish. We shall call this the investment demand-schedule; or, alternatively, the schedule of the marginal efficiency of capital. (General Theory, p. 136)
Keynes’s reference to the prospective yield on capital falling is usually divided into two related aspects: a decline in the prospective selling prices of products as stepped up investment increases their supply, and also a decline in the physical amount of additional product produced per successive equal increment of additional investment. Thus, for example, each additional $10 billion of investment in the economic system might be imagined to result in increments of product that would sell for less and less because of increases in the supply of products and that would also bring in less and less because the physical size of the increases was smaller and smaller. Thus the first $10 billion of additional investment might be imagined to result in 1 million units of additional product that would sell at a price of $100 each. The second $10 billion, however, would supposedly result only in an additional 900 thousand units of product, which would sell at a price of, say, $95 each. By the same token, the third $10 billion of additional investment might result in only 800 thousand units of additional product that would sell for $90 per unit, and so on. Clearly, the extra revenue accompanying equal extra increments of investment would fall under these conditions. And since that extra revenue is the source of the profit on the investment, it seems to follow that the rate of profit would decline as investment increased.
In addition, of course, Keynes refers to a rising “supply price” for the various types of capital goods as their production expands in response to the additional demand constituted by additional investment. Thus, in his view, the rate of profit declines as investment increases because more investment both raises the prices of capital goods and at the same time operates to reduce their yields in terms of revenue.
Keynes’s Bait and Switch
When Keynes’s explanation of the falling “marginal efficiency of capital,” just quoted, is taken in conjunction with his previously quoted explanation of why a fall in wage rates allegedly cannot succeed in overcoming unemployment, it turns out that what is present is something similar to the technique of a dishonest salesmen who begins by appearing to offer something that is very different from what he actually ends up offering, i.e., the technique known as “bait and switch.”
When Keynes tries to explain the alleged impossibility of full employment being achieved by virtue of a fall in wage rates, he is clearly talking about the alleged impossibility of a fall in wage rates achieving full employment. But when all is said and done, what this alleged impossibility turns out to rest upon is not at all consistent with a fall in wage rates. To the contrary, in the last analysis Keynes’s argument against the ability of a fall in wage rates to achieve full employment depends on the absence of a fall in wage rates, indeed, on their rise.
The fall in the “marginal efficiency of capital”/rate of profit that supposedly results from investment having to be pushed beyond its worthwhile limit in order to offset all of the saving taking place out of the level of income resulting from full employment, and which allegedly prevents full employment from being achieved more than very temporarily — that fall turns out to depend on wage rates not falling, indeed, rising.
Consider. Why should a fall in the selling prices of products serve to reduce profitability if that fall has been preceded by a fall in wage rates and in the prices of existing capital goods, i.e., in the costs of production, which is the situation under discussion? It would be reasonable to argue that a fall in selling prices serves to reduce profits if it were not preceded by a fall in wage rates and the prices of existing capital goods, but not when it is so preceded. What Keynes has done here is to substitute the effects of a fall in selling prices on the rate of profit in the absence of a preceding fall in wage rates and the prices of existing capital goods for its alleged effect in the presence of such a preceding fall.
The same point applies even more strongly to the alleged decline in yields based on declines in physical increments of product accompanying additional increments of investment. Here Keynes and his followers take for granted the supply of labor and consider the effects on output merely of successive equal increments of investment. But this too is a total contradiction of the situation under discussion.
That situation, recall, is whether or not the re-employment of masses of previously unemployed workers can be maintained following a fall in wage rates and the prices of existing capital goods. Keynes and his followers say no, in part because of alleged diminishing physical returns to additional increments of capital investment. Here they ignore the fact that the situation under discussion implies an increase in the supply of labor employed far in excess of any secondary, derivative increase in the supply of capital goods that might come about as the result of additional saving taking place as the by-product of full employment.
Going from a state of mass unemployment to full employment implies a correspondingly large reduction in the ratio of accumulated capital to labor. The supply of existing capital goods is what it is. But going from, say, an unemployment rate of 25 percent, such as existed in the depths of the Great Depression of the 1930s, to full employment, implies in increase in the supply of labor employed in the ratio of 4:3. This, in turn, implies a fall in the ratio of capital to labor to ¾ of its previous level. Thus, if in the state of mass unemployment there were 12 units of capital in existence for every 3 workers employed, giving a ratio of capital to labor of 4:1, now, with the employment of 4 workers for every 3 previously employed, the ratio of capital to labor falls to 3:1. With capital now less abundant relative to labor, i.e., scarcer relative to labor, successive equal increments of investment should have substantially higher physical yields than they did in the state of mass unemployment. Thus, if it were the case that physical increments of output accompanying increments of investment had a connection with the rate of profit, the rate of profit would have to be expected to rise as the accompaniment of the economic system going from a state of mass unemployment to full employment.
Even if at some point, after many years of full employment and accompanying additional saving, the ratio of capital to labor ultimately came to surpass what it had been in the period of mass unemployment, it would still be far less than it would be in the face of fresh mass unemployment. Always, the employment of more labor serves to reduce the ratio of capital to labor and to have a correspondingly positive effect on physical yields to capital, all other things being equal.
The third alleged reason for the rate of profit falling as employment increases turns out to be no less bizarre and contradictory. This is Keynes’s claim that pressure on the facilities for producing capital “will cause its supply price to increase.” Since when do the prices of capital goods rise on a foundation of falling wage rates and costs of production? They would rise in a situation of rising wage rates and costs of production, but not falling wage rates and costs of production. This is just another aspect of the switch Keynes has pulled off.
Further Problems with Keynesianism
The Keynesian argument is actually absurd on its face. If one looks at its so-called IS curve, one sees a relationship purporting to show that as output and, implicitly, employment increase along the horizontal axis, the “marginal efficiency of capital”/rate of profit falls on the vertical axis. The economic system is allegedly locked into a state of permanent mass unemployment because the rate of return is already as low as it is possible for it to go consistent with investment being worthwhile, while full employment would result in an even lower rate of return. What this means is that the economic system cannot achieve full employment and recovery, because if it did, the rate of profit would be lower in the recovery than it is in the depths of the depression.
There is another problem. A leading doctrine of the Keynesians is the “investment multiplier.” According to this doctrine, every additional dollar of investment results in an induced rise in consumption spending and thus in substantially more than a dollar of additional spending overall, perhaps $2 or $3. This additional spending is held to be synonymous with additional national income. While national income is composed essentially of profits and wages, the Keynesians seem to overlook the fact that additional national income implies additional profits. If profits were just 10 percent of national income, and the multiplier were just 2, every additional dollar of investment would imply 20 cents of additional profits in the economic system. What this in turn implies is that the rate of profit in the economic system must be rising in the direction of 20 percent, i.e., that more investment has a powerful positive effect on the rate of profit.
In a Recovery, Investment and Profits Move Together
The Keynesian claim is that the additional investment that accompanies additional employment reduces the rate of profit. The strongest argument against this claim is the fact that in the context of a business cycle, investment and profits move together, virtually dollar for dollar. Profit in the economic system is the totality of business sales revenues minus the totality of the costs deducted from those sales revenues. Net investment is the totality of business productive expenditure, i.e., wage payments plus purchases of newly produced capital goods, minus the very same costs that are deducted from sales revenues in arriving at profits. Since productive expenditure is the source of the great bulk of the sales revenues of the economic system, the only difference between net investment and profits in the economic system is the extent to which sales revenues exceed productive expenditure.
The reason that net investment equals productive expenditure minus costs is that productive expenditure represents additions to the value of accumulated assets, while costs represent subtractions from the value of accumulated assets. For example, productive expenditures on account of inventory are added to the value of inventory accounts on the balance sheets of the firms making the expenditures. Productive expenditures on account of plant and equipment are added to the gross plant accounts on the balance sheets of the firms making the expenditures. In these ways, productive expenditures increase the value of accumulated assets on the books of business firms.
By the same token, when firms make sales out of inventory, the value of inventory accounts is reduced by the cost value of the goods sold, which cost value enters into the income statements of firms, under the heading “cost of goods sold.” Similarly, as time passes, plant and equipment undergo depreciation. Depreciation allowances are accumulated in depreciation reserves, which are subtracted from the gross plant accounts, leaving net plant accounts. The same amount of depreciation that is deducted from gross plant — and thereby reduces net plant — enters into the income statements of firms as depreciation cost.
If “cost of goods sold,” is subtracted from productive expenditure for inventory, the difference is the net change, i.e., the net investment, in inventory. If depreciation cost is subtracted from productive expenditure on account of plant and equipment, the difference is the net change, i.e., the net investment, in net plant and equipment.
There is a third major component of productive expenditure and costs, namely, productive expenditures that are not additions to any asset account and which are thus costs deducted from sales revenues in the very instant in which they are made; selling, general, and administrative expenses are can be taken as examples. When productive expenditures that constitute selling, general, or administrative expenses are added to the productive expenditures on account of inventory and plant, the result is total productive expenditure. When these productive expenditures are added as costs to cost of goods sold and depreciation cost, the result is the total costs deducted from sales revenues in calculating profits. Since this is a matter of equals being added to unequals, the amount of net investment equals the totality of productive expenditure minus the totality of business costs.
In the context of recovery from a depression, a rise in productive expenditure should be expected to constitute a virtually equivalent rise in business sales revenues. If costs in the economic system remained the same, profits and net investment would obviously rise to exactly the same extent. The additional productive expenditure in its capacity as the source of additional sales revenues would raise profits equivalently. In its capacity simply as additional productive expenditure, it would raise net investment equivalently. Thus the rise in profits and the rise in net investment would be equal.
Insofar as total business costs might increase at the same time that productive expenditure and sales revenue rose, the rise both in net investment and profits would be equivalently diminished. In any event profits and net investment would increase together, dollar for dollar. The implication of this is that the economy-wide average rate of profit rises in the direction of 100 percent. This is the ratio found by dividing equal additions to profits and to capital invested. Capital invested rises to the exact same extent as net investment and additional net investment.
In the same way, as was shown very early in this article, if costs in the economic system could be made to fall, say, by virtue of productive expenditure being shifted from wage payments to purchases of durable capital goods, profits and net investment would both rise equally.
The upshot is that to the extent that additional net investment accompanies the additional employment made possible by a fall in wage rates, the rate of profit increases, and increases the more, the greater is the increase in net investment. Keynes and his followers simply could not be more wrong about this subject.
In a Depression, Saving and Net Investment Are Negative
Closely related to the above, is another major error. This is the belief of Keynes and his followers that in the depths of depression and its accompanying mass unemployment, saving and investment are at their maximum tolerable limits. Allegedly, they are already as great as it is possible for them to be consistent with the rate of return on capital still being high enough to make investment worthwhile. The problem, say the Keynesians, is that full employment would result in still more saving, which would require still more investment to offset it, and which in turn would drive the already barely acceptable rate of return still lower, below the minimum acceptable rate.
Contrary to Keynes and his followers, the truth is that so far removed are saving and investment from being at their maximum tolerable limits in the conditions of depression and mass unemployment, that in reality they are both negative. For example, in the Great Depression of the 1930s, corporate saving (undistributed corporate profits) was negative in every year from 1930 to 1936 and again in 1938; personal saving was negative in 1932 and 1933 and barely more than zero in 1934; net investment was negative in the years 1931 to 1935 and again in 1938.
There should be nothing surprising in this. In a depression, business firms suffer widespread losses. What they are losing is a portion of their accumulated savings. Even many firms that manage to earn profits consume accumulated savings in a depression. This is the case to the extent that their profits are insufficient to cover the dividends they pay. Similarly, unemployed wage earners deplete their previously accumulated savings in consuming without the benefit of wages to provide the necessary funds.
Net investment becomes negative as the result of the exact same process that wipes out profits, namely, a sharp decline in productive expenditure, which results from the need to rebuild cash holdings in the aftermath of the end of the credit expansion of the preceding boom. The decline in productive expenditure wipes out profits insofar as it serves to reduce business sales revenues in the face of depreciation costs and costs of goods sold that reflect the higher levels of productive expenditure of the past. The decline in productive expenditure in the face of those same depreciation costs and costs of goods sold equivalently reduces net investment.
As explained previously, the demand for money for cash holding is also increased by a failure of wage rates to fall. And the decline in productive expenditure becomes greater still insofar as banks fail and the quantity of money is reduced. The effect is to further reduce productive expenditure, sales revenues, profits, and net investment.
In the light of such knowledge, it is difficult to imagine a theory that is more at odds with economic principles and obvious facts of reality than Keynesianism.
Conclusion
The essential conclusions to be drawn from this lengthy analysis is that once the process of financial contraction in a depression comes to an end, and existing business assets have been re-priced to reflect the deflationary aftermath of credit expansion — once this has occurred, a fall in wage rates will in fact serve to achieve the reemployment of the unemployed. Moreover, it will do so in such way that the increase in employment is more than proportionate to the fall in wage rates. At the same time, as part of the same process, the decrease in the demand for money for cash holding that occurs in response to the necessary fall in wage rates, manifests itself in a rise in productive expenditure not only for labor but also for capital goods. As the result of the rise in productive expenditure, sales revenues, profits, and net investment in the economic system all rise together.
The fall in wage rates thus serves as an essential component of a full and complete economic recovery, one that entails full employment and the achievement of a substantially increased rate of profit that will be more than sufficient to make investment worthwhile.
The economic policy that is implied by these findings of economic theory is one of a fully free labor market. That is, a labor market free of coercive labor-union interference, free of minimum-wage laws, and free of all other laws that mandate expenditures by employers on behalf of the workers they employ. All legal obstacles in the way of wage rates falling, counting as part of wages the cost of so-called fringe benefits, must be swept aside. This is the policy that will allow the cost of employing labor to fall and thus the quantity of labor demanded to increase, and will thereby achieve the employment of everyone able and willing to work, i.e., full employment.
Beyond Keynesianism: Marxism
While essential, the overthrow of Keynesianism is insufficient for being able to implement the policy of a free labor market. It is insufficient because Keynesianism constitutes merely the outer ring of the defenses of the policy of government interference in the labor market. The inner ring, which Keynesianism has served to protect up to now, is the errors and contradictions of Marxism.
Marxism holds that a free market in labor is a vehicle for the exploitation of labor. It claims that in the absence of government intervention in the form of pro-union and minimum-wage and maximum-hours legislation, employers would be free to drive wage rates to or even below the level of minimum subsistence, while lengthening the hours of work beyond the limits of human endurance, and imposing conditions of work that are nightmarish.
Because of Keynesianism, the immense majority of economists have been able to avoid having to confront Marxism. They have been able to hide behind the Keynesian doctrine that even if a free market in labor existed, it would not be able to eliminate mass unemployment. And thus they have been able to believe that there is simply no point in fighting for a free market in labor.
Being able to believe this, I’m convinced, has been a source of great comfort and relief for most economists and thus a major source of their readiness to accept Keynesianism despite the obviously absurd nature of some of its claims, such as that “Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better” (General Theory, p. 129). Keynesianism has spared them from having to do battle with practically the entire rest of the intellectual world, which has accepted Marxism as constituting a full and accurate description of what happens under laissez-faire capitalism.
In the absence of Keynesianism, economists who understood such elementary propositions as that quantity demanded rises as price falls would be obliged to argue for the repeal of pro-union and minimum-wage legislation. They would perceive such interferences as causing and perpetuating mass unemployment. But to do this, they themselves would have to understand why laissez-faire capitalism does not in fact result in any exploitation of labor and how, indeed, it is the foundation of progressively rising real wages, shortening of hours, and improvement in working conditions.
The immense majority of today’s economists — and those of the past several generations — has lacked both this essential knowledge and any will, or even mere willingness, to acquire it. They lack the will because they have no philosophical commitment to the value of individual rights and individual freedom and thus no basis for being prepared to challenge claims that these must be sacrificed for the sake of avoiding poverty. They are light years from understanding that it is precisely respect for individual rights and individual freedom that is the essential foundation of prosperity, including, as leading examples, full employment and high and progressively rising real wages.
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Keynesianism has been a refuge for masses of economists badly deficient in understanding of economics and equally lacking in essential aspects of moral character, namely, in abhorrence of the use of physical force for any purpose but that of self-defense, and in an equal abhorrence of blatant irrationalism, such as manifested in Keynes’s claims about the economic value of wars and earthquakes. Content with the unchecked growing use of physical force by government in all aspect of the life of the individual, and often taking delight in the ability to confuse the minds of students by convincing them that the absurd is true, they are completely at home in Keynesianism.
Hopefully, the overthrow of Keynesianism will set the stage for the appearance of a body of intellectuals with a far better understanding of economics than that of today’s economists, an understanding which they will join to a philosophical commitment to the values of Freedom and Reason. Thus armed, there will be a group of intellectuals able to take on the rest of the intellectual world and start to overcome the ideas that have made today’s colleges and universities more into centers of civilization-destroying intellectual disease than centers of knowledge and education.
Copyright © 2009 by George Reisman.
George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). His web site is http://www.capitalism.net. His blog is at georgereismansblog.blogspot.com. Send him mail. (A PDF replica of the complete book Capitalism: A Treatise on Economics can be downloaded to the reader’s hard drive simply by clicking on the book’s title, immediately preceding, and then saving the file when it appears on the screen.) See his article archives. Comment on the blog.
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Go here: http://www.positivemoney.org.uk/poverty-debt-inequality/
Nothing will change until the money creation system changes. And the status quo (corporate power, military and political) won’t allow that. Our best chance IS collapse of the financial system. Meanwhile the rest of us should just go on rebuilding our communities at a local level.
Spot on, Nancy
I would like to add something constructive towards how we might get ourselves out of this mess – there are lots of issues and the following is just a small contribution:
Author is George Reisman.. Ludwig Von Mises website
Inflation and Deflation: Credit Expansion and Malinvestment
The title of my talk, of course, is “A Pro-Free-Market Program for Economic Recovery.” What this entails changes as the government adds new and additional measures that create new and additional problems. If I were giving this talk a year ago, my discussion would have been weighted somewhat more heavily toward deflation and somewhat less heavily toward inflation than is the case today.
A fundamental fact is that our present monetary system is characterized both by irredeemable paper money, i.e., fiat money, and by credit expansion. There is no limit to the quantity of fiat money that can be created. This is the foundation for potentially limitless inflation and the ultimate destruction of the paper money, when the point is reached that it loses value so fast that no one will accept it any longer.
The fact that our monetary system is also characterized by credit expansion is what creates the potential for massive deflation — for deflation to the point of wiping out the far greater part of the money supply, which in the conditions of the last centuries has been brought into existence through the mechanism of credit expansion.
Credit expansion is what underlay the housing bubble, and before that, the stock market bubble, and before that a long series of other booms and busts, running through the Great Depression of 1929 that followed the stock market boom of the 1920s, through the 19th and 18th Centuries all the way back to the Mississippi Bubble of 1719, and perhaps even further back.
Credit expansion is the lending out of money created virtually out of thin air. It is money manufactured by the banking system, always with at least the implicit sanction of the government, which chooses not to outlaw the practice. Since 1913, credit expansion in this country has proceeded not only with the sanction but also with the approval, and active encouragement of the Federal Reserve System, which, as I’ve shown, is now desperately trying to reignite the process as the means of recovering from the current downturn.
The new and additional money is created by the banking system through the lending out of funds placed on deposit with it by its customers and still held by those customers in the form of checking accounts of one kind or another. The customers can continue to spend those checking deposits themselves, simply by writing checks or using other, similar methods of transferring their balances to others.
But now, at the same time, those to whom the banks have lent in this way also have money. To illustrate the process, imagine that Mr. X deposits $1,000 of currency in his checking account. He retains the ability to spend his $1,000 by means of writing checks. From his point of view, he has not reduced the money he owns any more than if he had exchanged $1,000 in hundred-dollar bills for $1,000 in fifty-dollar bills, or vice versa. He has merely changed the form in which he continues to hold the exact same quantity of money.
But now imagine that Mr. X’s bank takes, say, $900 of the currency that he has deposited and lends it to Mr. Y. Mr. Y now possess $900 of spendable money in addition to the $1,000 that Mr. X continues to possess. In other words, the quantity of money in the economic system has been increased by $900. Mr. Y’s loan has been financed by the creation of new and additional money virtually out of thin air. This is the nature and meaning of credit expansion.
Now, nothing of substance is changed, if instead of lending currency to Mr. Y, Mr. X’s bank creates a new and additional checking deposit for Mr. Y in the amount of $900. (This, in fact, is the way credit expansion usually occurs in present-day conditions.) There will once again be $900 of new and additional money. There will be altogether $1,900 of money resting on a foundation merely of the $1,000 of currency deposited by Mr. X.
The $1,000 of currency that Mr. X’s bank holds is its reserve. If Mr. Y deposits his currency or check in another bank, it is the banking system that now has $1,000 of reserves and $1,900 of checking deposits. On the foundation of these reserves, it can create still more money and use it in the further expansion of credit. Indeed, as we have seen, the process of credit expansion is capable of creating checking deposits more than 100 times as large as the reserves that support them.
Credit expansion makes it possible to understand what caused the housing bubble and its collapse. From January of 2001 to December of 2007, credit expansion took place in excess of $2 trillion. This new and additional money made available in the loan market drove down interest rates, including, very prominently, interest rates on home mortgages. Since the interest rate on a mortgage is a major factor determining the cost of homeownership, lower mortgage interest rates greatly encouraged buying houses.
This artificially increased demand for houses, made possible by credit expansion, soon began to raise the prices of houses, and as the new and additional money kept pouring into the housing market, home prices continued to rise. This went on long enough to convince many people that the mere buying and selling of houses was a way to make a good living. On this basis, the demand for houses increased yet further, and finally a point was reached where the median-priced home was no longer affordable by anyone whose income was not far in excess of the median income, i.e., only by a relatively few percent of families.
In the middle of 2004, the Federal Reserve became alarmed about the situation and its implications for rising prices in general, and over the next two years progressively increased its Federal Funds interest rate from 1 percent to 5.25 percent. This rise in the Federal Funds rate signified a reduction in the flow of new and additional excess reserves into the banking system and thus its ability to make new and additional loans. This served to prick the housing bubble.
But before its end, perhaps as much as a trillion and a half dollars or more of credit expansion and its newly created money had been channeled into the housing market. Once the basis of high and rising home prices had been removed, home prices began to fall, leaving large numbers of borrowers with homes worth less than they had paid for them and with mortgages they could not meet.
The investments in housing represented a classic case of what Mises calls “malinvestment,” i.e., the wasteful investment of capital in inherently uneconomic ventures. The malinvestment in housing was on a scale comparable to the credit expansion that had created it, i.e., about $2 trillion or more. That’s about how much was lost in the housing market. When the money capital created by credit expansion was wiped out, the lending, investment spending, employment, and consumer spending that depended on that capital were also wiped out.
And, particularly important, as vast numbers of home buyers defaulted on their mortgages, the mounting losses on mortgage loans increasingly wiped out the capital of banks and other financial institutions, setting the stage for their failure.
The current plight of the economic system is the result of credit expansion and the malinvestment it engenders. Capital in physical terms is the physical assets of business firms. It is their plant and equipment and inventories and work in progress. As Mises never tired of pointing out, capital goods cannot be created by credit expansion. All that credit expansion can do is change their employment and shift them into lines where their employment results in losses. The empty stores and idle factories around the country are very much the result of the loss of the capital squandered in malinvestment in housing.
Other Consequences of Credit Expansion
The plight of the economic system is also the result of other consequences of credit expansion, namely, the encouragement it gives to high debt and dangerous leverage. This is the result of the fact that while credit expansion drives down market interest rates, the spending of the new and additional funds it represents serves to drive up business sales revenues and what the old classical economists called the rate of profit. This combination makes borrowing appear highly profitable and greatly encourages it. Individuals and business firms take on more and more debt relative to their equity. They expect borrowing to multiply their gains.
In addition, credit expansion is responsible for many business firms operating with lower cash holdings relative to the scale of their economic activity, in many cases, dangerously low cash holdings. Many businessmen develop the attitude, why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.
“Why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.”
Thus, when credit expansion finally gives way to the recognition of vast malinvestments and the accompanying loss of huge sums of capital, the economic system is also mired in debt and deficient in cash. Thus, it is poised to fall like a house of cards, in a vast cascade of failures and bankruptcies, first and foremost, bank failures.
The Road to Recovery
The road to recovery from our economic downturn can be understood only in the light of knowledge of credit expansion and its consequences. The nature of credit expansion and its consequences imply the nature of the cure.
The prevailing — Keynesian — view on how to recover from our downturn totally ignores credit expansion and its effects. It believes that all that counts is “spending,” practically any kind of spending. Just get the spending going and economic activity will follow, the Keynesians believe.
This conception of things, which underlies the support for “stimulus packages” and anything else that will increase consumer spending, is mistaken. It rests on a fundamental misconception. It ignores the fact that the fundamental problem is not insufficient spending, but insufficient capital due to the losses caused by malinvestment. It ignores the further facts that credit expansion has brought about excessive debt and, however counterintuitive this may seem, insufficient cash. Too little capital, too much debt, and not enough cash are the problems that countless business firms are facing today as a result of the credit expansion that generated the housing bubble.
Just as a reminder: the way that credit expansion brings about a situation of too little cash while itself constituting a flood of cash is that it makes it appear profitable to invest every last dollar of cash in the expectation of being able easily and profitably to borrow whatever cash may be needed.
What this discussion implies is that an essential requirement of economic recovery is that the widespread problems in the balance sheets of business firms must be fixed. Business firms need more capital, less debt, and more cash. When they achieve that, business confidence will be restored.
Ironically what could achieve at least less debt and more cash in the hands of business, and thus actually do some significant good is if when people received government “stimulus” money, they did not spend very much of it, or, better still, any of it at all. To the extent that all people did with money coming from the government was pay down debt and hold more cash, they would be engaged in a process of undoing some of the major damage done by credit expansion. They would be reducing their burden of debt and increasing their liquidity, thereby increasing their security against the threat of insolvency. Such behavior, of course, would be regarded by Keynesians as constituting a failure of their policies, because in their eyes, all that counts is consumer spending.
The 100-Percent Reserve
The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits. Ideally, the 100-percent reserve would be in gold. And that’s ultimately what we should aim at, for all of the reasons Rothbard explained. But even a 100-percent reserve in paper would do the job of totally preventing all future credit expansion and, equally important, all declines in the money supply.
(Because the 100-percent gold reserve standard is the long-run ideal of advocates of sound money, I cannot help but feel a sense of great satisfaction in the fact that a major step toward its achievement is what turns out to be urgently needed as a matter of sound current economic policy.)
In the simplest terms, to establish a 100-percent-reserve system in terms of paper, the government would simply print up enough additional paper currency so that when added to the paper currency the banks already have, every last dollar of their checking deposits would be covered by such currency. (Strictly speaking, a significant part, and for some months now the far greater part, of the reserves of the banks are not in actual currency but in checking deposits with the Federal Reserve. For the sake of simplicity, however, we can think of the checking deposits held by the banks with the Federal Reserve as a denomination of currency, since, for the banks, they are fully as interchangeable with currency as $50 bills are with $100 bills and vice versa.)
To illustrate the process of achieving a 100-percent reserve, imagine that total checking deposits are $3 trillion. In that case, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. Through various programs, such as purchasing bad assets, the Fed has in fact already brought the total reserves of the banks up to over a trillion dollars, but almost all of those reserves, as we’ve seen, are excess reserves, a ready foundation for a massive new credit expansion, since excess reserves can be lent out.
What my example implies is adding to the $1.1 trillion of reserves the banking system now has, a further $1.9 trillion and making all $3 trillion of reserves required reserves. This would mean that the banks could not engage in any lending of these reserves and thus would be unable to finance credit expansion or any increase in the supply of checking deposits on the strength of them. The money supply in the hands of the public and spendable in the economic system would thus not be increased. That would happen only if and to the extent that the 100-percent reserve principle were breached.
Under a 100-percent reserve, checking depositors could simultaneously all demand their full balances in cash and the banks would be able to pay them all. Depositors’ demand for cash would not create a problem and no amount of losses by the banks on their loans and investments would prevent them from honoring their checking deposits immediately and in full. Thus the checking deposit component of the money supply could not fall and nor, of course could its other component, which is the paper money in the hands of the public, usually described as the currency component. Thus, there could simply be no deflation of the money supply. And, as I’ve said, because all reserves would be required reserves, there would simply be no reserves whatever available for lending out, and thus no credit expansion whatever. The expression “killing two birds with one stone” could not have a better application.
“The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits.”
In a addition, a significant byproduct of a 100-percent reserve system would be that the FDIC would no longer serve any purpose and thus could be abolished.
Now an essential prerequisite of the 100-percent reserve is knowing the size of checking deposits, so that it will be known how much the 100-percent reserve needs to cover. At present, when one allows for such things as “sweep accounts,” money-market mutual funds, and money-market deposit accounts, the magnitude to which the 100-percent reserve would apply can plausibly be argued to range from about $1.5 trillion to $8 trillion. It is very solidly $1.5 trillion, but does in fact range up to $8 trillion in that checks can be written on the additional sums involved, at least from time to time and for some large minimum amount.
To clearly establish the magnitude of checking deposits, bank depositors should be asked if their intention is to hold money in the bank, ready for their immediate use and transfer to others, or to lend money to the bank. In the first case, their funds would be in a checking account, against which the bank would have to hold a 100-percent reserve. In the second case, their funds would be in a savings account, against which the bank could hold whatever lesser reserve it considered necessary. In this case, the bank’s customers could not spend the funds they had deposited until they withdrew them from the bank.
As I’ve said, the long-run goal in connection with the 100-percent reserve would be ultimately to convert it to a 100-percent gold reserve system. At that time, following the ideas of Rothbard further, the gold reserve of the Fed would be priced high enough to equal the currency and checking deposits of the country and be physically turned over to the individual citizens and the banks in exchange for all outstanding Federal Reserve money. The Fed would then be abolished. But this is a distinct and much later step in pro-free-market reform.
The 100-Percent Reserve and New Bank Capital
It should be realized that a major consequence of the establishment of a 100-percent-reserve system could be a corresponding enlargement of the capital of the banking system and thus an ability to cover even very great losses and thereby avoid such things as government bank bailouts and takeovers.
Consider the balance sheet of an imaginary bank. It’s got checking deposit liabilities of $100. Initially, it has assets of $105, which implies that on the liabilities side of its balance sheet it has capital of $5 in addition to its checking deposit liabilities of $100.
Now unfortunately, malinvestment has resulted in a loss of $20 in the banks’ assets, in the part of its assets consisting of loans and investments. As a result, its total assets are reduced from $105 to $85 and its capital is completely wiped out and becomes negative in the amount of $15.
However, on its asset side the bank still has some cash reserve, say, $10. If $90 of new and additional reserves were added to these $10, to bring the bank’s reserves up to 100-percent equality with its checking deposits, the bank’s asset total would also be increased by $90. This $90 increase on the bank’s asset side would have to be matched by a $90 increase on its liabilities side, specifically by a $90 increase in its capital. Its capital would go from minus $15 to plus $75.
Applying this to the banking system as a whole in transitioning to a 100-percent reserve, we can see that the creation of such a vast amount of new bank capital would be entailed as easily to overcome whatever losses the banks might have suffered in their loans and investments.
As explained, if checking deposits were $3 trillion, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. If this had been done in September of 2008, bringing reserves up to $3 trillion would have required adding $2.955 trillion of new and additional reserves to the $45 billion or so of reserves the banks already had. This vast addition on the asset side of the banks’ balance sheets would have implied an equivalent addition to the banks’ capital on the liabilities side. No matter how bad the banks’ assets were, I think it’s virtually certain that an additional sum of this size would have been far more than sufficient to cover all the losses that the banks had incurred in their bad loans and investments. Their capital would have ended up being increased to the extent that the additional reserves exceeded the losses in assets under the head of loans and investments.
The government’s bailout program of stock purchases in the banks would have been avoided, along with all of its subsequent interference in matters of bank management.
Now, as we’ve seen, in fact the Fed has already supplied a vast amount of reserves, about $1.1 trillion, to the banks through various programs, such as purchasing bad assets. If the 100-percent reserve principle were adopted now, many or most of those assets could be taken back, and the programs that created them cancelled.
Thus, what I’ve shown here is how transitioning to a 100-percent reserve would guarantee the prevention both of new credit expansion and of deflation of the money supply. It could also provide additional capital to the banking system on a scale almost certainly far more than sufficient to place it on a financially sound footing. To avoid what would otherwise likely be an excessive windfall to the banks, it would be possible to match a more or less considerable part of the increase in their assets provided by the creation of additional reserves, with the creation of a liability of the banks to their depositors, perhaps in the form of some kind of mutual-fund accounts. Thus, the newly created reserves might provide a financial benefit to the banks’ depositors as well as to the banks.
Toward Gold
Of course, a 100-percent reserve system in which the reserves are fiat money does not address the problem of preventing inflation of the fiat money. It would still be possible for the government to inflate the fiat money without restraint. That is why it is necessary to have gold in the monetary system, serving as a restraint on the amount of currency and reserves.
Thus, an important ancillary measure in connection with the transition to a 100-percent paper-reserve system would be for the government to demonstrate a serious intent to move to a gold standard. Obliging the Federal Reserve to carry out a program of regular and substantial gold bullion purchases might accomplish this. In any event, it would be an essential prerequisite for someday achieving gold reserves sufficient to make possible the establishment of a 100-percent-reserve gold system. Along the way, this measure should lead to the day when purchases of gold bullion were the only source of increases in the supply of currency and reserves.
Establishing the Freedom of Wage Rates to Fall
Along with stabilizing the financial system through the adoption of a 100-pecent reserve, it’s absolutely essential to establish the freedom of wage rates and prices to fall. This is what is required to eliminate mass unemployment. Whatever the level of spending in the economic system may be, it is sufficient to buy as much additional labor and products as is required for everyone to be employed and producing as much as he can.
Nothing could be more obvious if one thinks about it. Assume, as is the case today, that there is 10 percent unemployment, with only 9 workers working for every 10 who are able and willing to work. The same total expenditure of money that today employs only 9 workers would be able to employ 10 workers, if the average wage per worker were 10 percent less. At nine-tenths the wage, the same total amount of wages is sufficient to employ ten-ninths the number of workers. It’s a question of simple arithmetic: 1 divided by 9/10 equals 10/9.
(Obviously, this is an overall, average result. In reality, some wage rates would need to fall by less than 10 percent and others by more than 10 percent.)
Of course, total wage payments are not fixed in stone. They can change. And in response to a fall in wage rates to their equilibrium level, to eliminate mass unemployment, they would increase. This is because prior to their fall, investment expenditures have been postponed, awaiting their fall. Once that fall occurs, those investment expenditures take place.
Finally, with debt levels sufficiently reduced and cash holdings sufficiently high, and thus business confidence restored, there is no reason to believe that a fall in wage rates could abort the process of recovery as the result of already employed workers earning less and thus spending less before new and additional workers were hired. The cash reserves and financial strength of business firms would enable them easily to ride out any such situation. And thus mass unemployment would simply be eliminated.
What stops wage rates from falling, what makes it actually illegal for them to fall, and which thus perpetuates mass unemployment, is the underlying pervasive influence of the Marxian exploitation theory. That doctrine is responsible for the existence of such things as minimum-wage laws and coercive labor unions and their above-market wage scales.
The most important fundamental requirement for achieving a free market in labor is the total refutation of the exploitation theory and its complete discrediting in public opinion. Such a refutation will show that it is not government and labor unions that raise real wages but businessmen and capitalists, and that essentially, all that unions do is cause unemployment and a lower productivity of labor and thus prices that are higher relative to wage rates. This knowledge is what is required to make possible the repeal of minimum-wage and pro-union legislation and thus achieve the fall in wage rates that will eliminate mass unemployment
Summary
In summation, my pro-free-market program for economic recovery is a provisional 100-percent-paper-money-reserve system applied to checking deposits, accompanied by a demonstrable commitment to ultimately achieving a 100-percent-gold reserve system. The 100-percent reserve in paper would put an end to all further credit expansion and at the same time make the money supply incapable of being deflated. Its establishment would also greatly increase the capital of the banking system. It would do so by more than enough to cover all the losses on loans and investments incurred in the aftermath of the collapse of the housing bubble and thus make possible the elimination of government ownership of common stock in banks and its interference in bank management. What it would not do is control the increase in paper currency and paper-currency reserves. That will require a 100-percent gold reserve system.
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Finally, the freedom of wage rates and prices to fall must be established through the repeal of pro-union and minimum-wage legislation, and more fundamentally, the education of the public concerning the errors of the Marxian exploitation theory and their replacement with actual knowledge of what determines wages and the general standard of living. To say the least, this will certainly not be an easy agenda to follow, inasmuch as it must begin in the midst of a Marxist occupation of our nation’s capital.
Thank you.
Copyright © 2009 by George Reisman.
George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). His web site is http://www.capitalism.net. His blog is at georgereismansblog.blogspot.com. Send him mail. (A PDF replica of the complete book Capitalism: A Treatise on Economics can be downloaded to the reader’s hard drive simply by clicking on the book’s title, immediately preceding, and then saving the file when it appears on the screen.) See George Reisman’s article archives.
This talk was given at Economic Downturn: Cause and Cure (Mises Circle, Sponsored by Louis E. Carabini) Newport Beach, California, November 14, 2009.
The US has amazing creativity in terms of communities fighting back. Go here: http://backbonecampaign.org/2011-12-13-18-50-10/local-laboratory and scroll down to The CUVashon Story, A Win-Win Organizing Strategy for Building Power by Moving Money & Debt.
Also note the success of the bank of the state of North Dakota: http://www.huffingtonpost.com/2010/02/16/bank-of-north-dakotasocia_n_463522.html. State owned assets can work but the fight to keep the predatory interests at bay is constant.