Some Light Reading

I’ve recently been reading “The Accidental Theorist” by Paul Krugman, a collection of essays penned during the Clinton Years. After reading two particular ones last night, a series of thoughts and ideas that I’ve been encountering during the past year suddenly made sense.

In the first essay of interest (by no means the first in the book, it is buried about 2/3s of the way through), Krugman relays a story about a Babysitting combine: Several couples agree to exchange babysitting services for one another. To keep it fair, they issue each couple several pieces of scrip, which they can exchange with another couple for an evening of babysitting. Notice how this forces each couple to exactly reciprocate the number of times they desire babysitting, they must provide it. All works well.

As time goes on, more couples are admitted to the combine, but interestingly, the amount of babysitting goes down! The amount of scrip in circulation per couple has been reduced, and couples tend to hoard their scrip for very special occasions – with reduced opportunity to gain new scrip, very little exchanges hands. The combine has placed itself in a recession.

Eventually, the answer is found, more scrip is created, and the instances of babysitting returns to a more normal pattern. Since scrip is no longer in short supply, couples are willing to exchange it more frequently for a night out, knowing that they will have many opportunities to earn it back before the big occasion.

The second essay that I read last night concerned Japan in the 1990’s, and discussed their economic problems. Low demand, excess capacity, economic stagnation….and click!

America doesn’t have enough money!

Go back a few years. The economy is doing fine, in fact, housing is booming. New construction has soared to levels not before seen. As people purchase their houses, many people previously out of the market are coming in. Not only that, with the rising values, people are able to tap into their equity to purchase things: Furniture, upgraded interiors, exterior landscaping, electronics, even cars.

Making loans for houses increases the money supply. Consider: A bank doesn’t have to actually have on deposit amounts equal to the loans they make, they only need 10-30% in deposits to back the loans. The excess of the loan over the actual deposit is essentially an increase in money – it is pretty much just the same as if the US Mint had printed an amount equal to the difference. (I’m hedging a little here because there are some trivial differences – real, but not germane to the story or the issues at hand.)

As the US money supply increased, so did the capacity of the economy. New production facilities where opened, car lines were expanded, more restaurants and other services where built; in short, everything necessary to prevent inflation occurred. Imports went up to fill the gaps, and everyone exclaimed over the wonderful increases in the standard of living, and that perhaps inflation had been conquered.

But then, some of the loans went bad. Not surprising, it happens all the time. But then this whole intertwining of CDS and CDO’s changed the dynamics, large banks and insurance companies found themselves insolvent, the DOW plummeted 40% - we know the history.

What really happened, though, is that the real and perceived money supply of America also plummeted – how much I’m not sure, but it certainly is large enough: 10, 20, 30%? (I’ve seen estimates of $10 to $15 Trillion Dollars.) The very real outcome is that there is no longer enough money in circulation to purchase all of the output of our economy – and so output must (and does) fall. As output falls, workers are laid off, money is no longer circulated through payroll, a further contraction in the money supply occurs, more production and services are canceled…

America needs more money. There are two basic ways that money can be created. The US Mint can print money, and banks can make loans. The Federal Reserve, to a degree, has control over both. It can control loan making through interest rate setting: The lower the Federal Interest Rate, the more attractive borrowing is, and, essentially, the more money will be created through that avenue. Raise interest rates if the money supply appears to be getting too great (rising inflation) to slow the money supply, and theoretically, at least, it all works. The Federal Reserve uses the insights of interest rates and inflation rates to gauge the amount of money for the Mint to print.

Using this tried method, the Federal Reserve has lowered interest rates in the hopes that loans will be made, money created, demand raised, and the economy restored. But, we’ve seen that they are actually up against a wall, the banks still don’t have enough reserves to make many loans, and, due to the failing economy, the desire of rational people to borrow has been curtailed. Interest rates are near zero (Fed to banks) – they are against the stops.

So, this leaves the other avenue: The US Mint simply prints more money, and attempts to get that into circulation. Now, many will worry about inflation – “Increasing money will lead to inflation!” But, remember: Currently, the economy’s capacity exceeds the money supply. As long as the increase in money doesn’t exceed current capacity, there is very little reason to expect that inflation will occur. Just like in the babysitting combine: As more money enters circulation, more economic exchanges take place – the increase in activity restores the demand for the goods and services America produces, people are called back to their jobs, further increasing activity, and so on.

The original TARP was a direct attempt to move more money into circulation. TARP II and the ARRRA (! Or stimulus package to the rest of us!) are attempts to do the same. Now, there has been a lot of talk about pork, but we have to keep our sights on the ultimate goal: Getting more money into circulation to restore the demand for the goods and services our economy can provide. Now, I’m not advocating that we turn a blind eye: Certainly, projects with long term benefits are superior to short term benefits or no benefits, and we should punish our lawmakers who advocated overall low return spending at the polls (if we can determine who!)

From all of this discussion it should be obvious that tax cuts provide no stimulus. Taxation is a transfer payment from individuals and groups to the government: By itself, taxation creates no money. During good economic times, a reduced tax load frees money for individuals and groups to invest, which can be borrowed against to increase the productive capacity to meet the increased demand. However, we are not in such a situation: We have excess capacity, so placing more money in the hands of individuals and groups that already are hoarding money (not investing or borrowing) changes nothing. Transferring the money to the government (perhaps even in greater quantities) gives the government the ability to move that money (through unemployment payments, transfers to state governments) to places where it will be used to increase demand. To that end, we can see that any spending in the stimulus package is good – it creates to a degree the desired result of entering more money into circulation. We can disagree about the value of the end product itself, but the money entered will go somewhere and have some positive effect on demand.

Please notice what I am not saying in all of this. For one, I have avoided all references to the Free Market, with good reason. Those who pull out the mantra of “Let the Market Decide!” as an opposition to government intervention are purposefully (if they actually understand) obfuscating the issues. It should be clear that the available money supply is not an artifact of the Market; it is instead a necessary (and influencing) condition. Money is created and managed by governments, not the Market. The Market uses the available money to set wages, invest for production, and transfer wealth. The Market cannot decide.

Second, I’m not advocating for specific winners and losers – surely there will be some of each. Although we might conceptually like it if everyone shared equally in the money outlays, or if each shared according to their personal culpability (some maintaining their relative increases, others losing a portion of theirs), such an outcome is beyond the coarse tools of money supply the Fed has. Although we might prefer if everyone shared in the reduction of the economy, what really happens is that 80% maintain, 10% lose some wages, and 10% lose 100% - their jobs, their houses, everything. It falls disproportionally on the already poor and the elderly. Certainly that is not fair. And, there are strong forces, highly controlled by those most culpable, to prevent them from seeing the large reductions in personal and business wealth they amassed during the recent run-up.

Those are the basics. They are important to understand, because they are the backdrop against which the current actions are being taken. It is also important because we hear and read debate about the relative effects of various proposed solutions, but without an understanding of the basics, we cannot independently evaluate the discussion. Without the context, we can easily be swayed by false arguments, taken in by specious reasoning, diverted into advocating counter-productive outcomes that benefit Wall Street lobbyists rather than America as a whole. Worse, we can be pulled into a blame-game that benefits those most culpable, instead of working post-stimulus to re-write the non-Market Government created rules that govern borrowing, lending, investing, and money supply.

Hope my insight has helped – it is your Light Reading for the day. If you are still interested, don’t take my word for it: This is properly a synthesis of my understanding of the economic writings of Milton Friedman, J. K. Galbraith, Robert Heilbroner, J. M. Keynes, Dean Baker, Paul Krugman, and others. Have Fun!