Guest Author: derryl is the nom de plume of Derryl Hermanutz, who is a frequent commenter of note on economic topics on such sites as Seeking Alpha and RagingDebate. The editors of Global Economic Intersection have long admired his insightful philosophical essays and have selected a recent one to present here as a guest feature.
Recently John Lounsbury published Depression: The Forgotten Part of the Business Cycle to refine definitions of terms like “recession”, “recovery” and “depression”. In a comment in a discussion of the article at RagingDebate.com therooster wrote, “The business cycle is primarily driven by the inflation and deflation of the debt currency supply.” This is a monetarist perspective along the lines of Milton Friedman, but I think economic history supports a more classical understanding. The business cycle has been a much analyzed phenomenon since long before our current experiment with a fractional reserve fiat money system. If we consider gold a fixed supply system, and fiat an adjustable supply system, and if the same business cycles occur in both kinds of systems, then quantity of money supply is probably not the factor that drives business cycles, but merely a symptom.
In Principles of Political Economy, published 1848, John Stuart Mill describes the business cycle (“capitalist cycle”) in the gold-money economy of his era. He attributes the onset of a recession (a “commercial revulsion”) to the accumulation of profits, where too much of the economy’s money is held by people who want to reinvest it and earn returns rather than spend it on consumption. Mill wrote:
“Such are the effects of a commercial revulsion: and that such revulsions are almost periodical, is a consequence of the very tendency of profits which we are considering. By the time a few years have passed over without a crisis, so much additional capital has been accumulated, that it is no longer possible to invest it at the accustomed profit: all public securities rise to a high price, the rate of interest on the best mercantile security falls very low, and the complaint is general among persons in business that no money is to be made. …But the diminished scale of all safe gains, inclines persons to give a ready ear to any projects that hold out, though at the risk of loss, the hope of a higher rate of profit; and speculations ensue, which, with the subsequent revulsions, destroy, or transfer to foreigners, a considerable amount of capital, produce a temporary rise of interest and profit, make room for fresh accumulations, and the same round is recommenced.”
The Distribution of Money
Mill could be describing 2010, with high prices for bonds, low interest rates, and low profits in the domestic economy. Mill had previously noted that the capital, the money, was not actually “destroyed” but was simply transferred into other hands. The classical term “capital” simply means money in the hands of people (i.e. “capitalists”) who plan to save and invest it for profit rather than spend it on consumption. This passage of money from the hands of “capitalists” to the hands of “spenders” is the event that initiates the recovery phase of the business cycle. It is not the “quantity” of the money supply that drives these cycles but the “distribution” of it.
In the classical era the gold money supply was not inflated and deflated like our modern fiat “debt-currency” (as therooster correctly describes it), but nevertheless the business cycle was so common as to be “almost periodical” as Mill observes. I would suggest that it is the same phenomenon, whether in a fixed supply money system like gold or a variable supply system like fiat debt-money, that causes these cycles, and I believe Mill has correctly identified the root cause as the over-accumulation of the money in the hands of “capitalists” and other “savers” who want to invest and increase their money rather than spend it back into the economy where it can be earned as incomes by other participants.
The Paradox of Thrift
For an individual it is good and prudent to save for your future and try to increase your money by investing it profitably. But when everybody is trying to save their incomes rather than spend them the economy is starved of final demand and unless you can export your productive output (as all the mercantilist European nations of the classical era tried to do) the lack of demand will render further investment in new production a losing proposition, and in fact you will find yourself with unemployed plant and labor, and the reduction of profits and employment incomes will further reduce spending.
This scenario is called a “paradox of thrift” or a “fallacy of composition”, where behavior that is beneficial for individuals is detrimental to the system as a whole. In Mill’s scenario it is only after capitalists who have all the money take big losses on risky and speculative ventures during the low-profit depression phase of the business cycle that sufficient money is freed up, “spent”, to get the upturn started again.
Note: The paradox of thrift is widely associated with John Maynard Keynes but actually has a much longer conceptual history. See Wikopedia.
Distribution of Savings
Money that is “invested” in soon-to-be-bankrupt and shut down money-losing ventures generates the same macro effect as money that is “spent” on “consumption”. The capitalist, desperate for some yield during the depression, hoped he was “investing” the money in a profit-making enterprise, but in fact his money was “consumed”. His money was “wasted” (from his perspective, but not from the perspective of the people who earned it from him) by pursuing what would prove to be illusory profits.
The “malinvestor” paid out incomes to people who contributed to building his new factory (for e.g.). He converted his money, his “liquid” capital, into “fixed” capital: the factory. So he reliquified the economy by wasting his money building fixed capital for which there was no profitable need. He will never get his money back. It now belongs to other people, the 100 (let’s say) workers and suppliers who built his factory, and who are now busy running around in the economy spending their incomes.
Those spent incomes become the revenues and earned incomes of people who sell goods and services to the factory builders, and now money velocity is running up again, so the same unit of money being spent multiple times has a multiplier effect on economic activity that is activated by the money. Velocity multiplies demand in the economy. The malinvestor’s wasted spending now becomes the “profits” of other businesses who sell stuff to the people who contributed to building the malinvestment and, in Mill’s words, “the same round is recommenced”. Profits are to be made so investment and employment incomes increase and the economy goes into recovery phase. If the “malinvestment” was in fact made with sufficient foresight, it may eventually produce a positive revenue stream and the investor rewarded. Otherwise, the investment is lost to consumption and some other producer profits.
Demand Side Depression
If there is no “money squandering” in a fixed supply money system, the money will all coagulate in the hands of the capitalists who earned it as their profits, and the working class will have no employment and incomes, and the economy stops churning. If the factory was not a waste of money but was in fact profitable in the short term, then all the money the capitalist spent into the economy building the factory, he will quickly collect back from the economy by selling the factory’s outputs. His own investment spending now becomes his operations earnings and now he has all the money again and we’re back in a demand side depression.
In our monetary system ongoing injections of new debt-money (i.e. borrowing and spending newly created ‘fractional reserve’ bank-deposit money) keep the economy liquified, except at times like now when the private sector is overextended and wants to reduce its debt so rather than borrow and spend and liquify the economy, they are earning and saving and paying down debt, deliquifying the economy. Our capitalists and savers today have trillions of dollars of investable money, and our consumers have trillions of dollars of debts. That’s our problem. We have trillions of liquidity seeking returns on investment, but no demand to make that investment profitable. So the money sits there doing nothing for the economy.
Keynes was right to focus on aggregate demand, because without somebody buying your output you cannot make any money producing stuff. And Henry Ford was right to pay his workers enough to afford to buy the cars they were making, because unless you have a “mass market” of people with sufficient incomes to buy your output, there is no point in “mass producing” that output. It will sit in your lot unsold because the masses of people who work for you and live in your economy lack sufficient incomes to buy your product.
Demand Side Recovery
I am not prepared, as my quote of Mill might suggest, to advocate large scale capitalist malinvestment to inject earned incomes into the economy by building unprofitable fixed capital (though China has been doing this on a large scale and so far so good for them, but this only works if the government owns the money system and can take unlimited losses). But these mechanics might explain why war spending is able to drive an economy out of depression. Government becomes the malinvestor, hiring the economy to produce for the war effort. When your output is never sold to anybody and literally blows itself to smithereens, you can add a lot of earned incomes into the economy without adding any goods for sale that will reabsorb that money back to you.
The money becomes available for other capitalists to earn by selling stuff to people who earned incomes contributing to war production. The government, the malinvestor in war production, loses all their investment money and everybody else can grab their piece of it. This gets the private sector economy going again by adding incomes, which become “effective demand”, demand backed by having the money to buy stuff.
The Fixed Currency Trap
Anyway, it seems that in a fixed supply money system the only way to start a recovery from a depression is for the winners of the last round of economy to blow their winnings on hopeless loser investments, to distribute earned incomes back into the economy and get money flowing again. Ownership of the money has to pass from the hands of capitalists into the hands of spenders to revive aggregate demand which makes business investment profitable again.
A fixed supply money system is by definition zero-sum, so for spenders to have more money to spend, capitalists have to have less of the money. If this all sounds like a game of blindfold and let’s pretend profits are permanent well, yes, that appears to be the case. Either somebody wastes their capital and gets money flowing again, or the economy stalls and stays stalled for want of demand. This is the fixed supply monetary trap.
The Variable Currency Trap
In a variable supply money system like we have you can always add new money into the system to make it positive-sum but if, as is the case, all that new money must be “borrowed” as “debt”, then in the depression where there is little prospect for earning additional income in order to pay principal and interest on your new debt, it is not credible to believe an economy will start itself out of depression via this borrow-and-spend route.
Today the only households and small businesses who want to add more borrowing are those who are on their way down and need new debt to make payments on their old debt, the last gasps of their personal Ponzi finance. Lending to these people is a malinvestment, if the lender is lending as a profit-making proposition because these people cannot pay you back. A private sector debt-financed demand rebound does not seem to be in the cards. This is the variable supply monetary trap.
The Path to Recovery
Economy mobilizing war production seems a pretty extreme fiscal policy solution to depression, but it would provide the income-injection function that drives the economy toward the recovery phase of the business cycle. Obama is talking about wasting hundreds of billions by ‘investing’ in uneconomic, unprofitable green energy. Maybe that’s an improvement over building stuff that’s designed to blow up, but I’m not sure. Look at what Dalton McGuinty and George Smitherman’s green dreams are doing to Ontario’s energy economy. Blown to smithereens might be an improvement over that.
Ultimately, the driver of recovery is increased demand side incomes and spending, without which business investment, sales, and the profits that justify further investments and hiring, are not feasible. This should not be reduced to a chicken or egg debate: The best way out will have both chickens and eggs.