The Way We Live Now

by Dirk Ehnts, Econoblog101

Anthony Trollope is a 19th century novelist who according to the New Yorker is “trending”. It is said that his novel “The Way We Live Now” is different from his other novels, but since it is the only book of Trollope that I’ve read I want to write a little bit about a passage that fascinated me

(p. 227, Wordsworth Classics edition, free e-book available via Gutenberg):

“You think him honest – don’t you?” asked Lady Carbury. Mr Booker smiled and hesitated. “Of course, I mean honest as men can be in such very large transactions.”

“Perhaps that is the best way of putting it,” said Mr Booker.

“If a thing can be made great and beneficent, a boon to humanity, simply by creating a belief in it, does not a man become a benefactor to his race by creating that belief?”

“At the expense of varacity?” suggested Mr Booker.

“At the expense of anything?” rejoined Lady Carbury with energy. “One cannot measure such men by ordinary rule.”

“You would do evil to produce good?” asked Mr Booker.

“I do not call it doing evil. You have to destroy a thousand living creatures every time you drink a glass of water, but you do not think of that when you are athirst. You cannot send a ship to sea without endangering lives. You do send ships to sea though men perish yearly. You tell me this man may perhaps ruin hundreds, but then again he may create a new world in which millions will be rich and happy.”

“You are an excellent casuist, Lady Carbury.”

“I am an enthusiastic lover of beneficent audacity,” said Lady Carbury […]

This discussion foreshadows the macroeconomic discussions on the credit cycle. Is it beneficial, is it harmful? What is its net effect? How can we make sure that speculation driven by greed still benefits the public? Should capitalists be allowed to rule over their fellow men? Are they rather entrepreneurs than capitalists, working for the benefit of future generations?

One year later, William Stanley Jevons published his book Money and the Mechanism of Exchange. Chapter XX on “Book Credit and the Banking System” picks up the line of thought regarding credit booms and crises:

Considerable economy of the precious metals arises, as we have seen, from passing about pieces of paper representing gold coin, instead of the coin itself. But a far more potent source of economy is what we may call the Cheque and Clearing System, whereby debts are, not so much paid, as balanced off against each other. The germ of the method is to be found in the ordinary practice ofbook credit. If two firms have frequent transactions with each other, alternately buying and selling, it would be an absurd waste of money to settle each debt immediately it arose, when, in a few days, a corresponding debt might arise in the opposite direction. Accordingly, it is the common practice for firms having reciprocal transactions, to debit and credit each other in their books with the debt arising out of each transaction, and only to make a cash payment when the balance happens to become inconveniently great. An insurance broker is one who acts as a middleman between the owners of ships and the underwriters who insure them in shares. He has therefore to make many small payments to underwriters, for the premiums on policies, and at intervals has to receive back the indemnity for any insured vessel which has been lost. It is the common practice to avoid cash payments; the broker credits the underwriters with the premiums and debits him with losses, and only pays or receives the balance when large.

To represent the highly complex system of book credit which is organized by the bankers of a large kingdom, we shall have to employ a method of diagramatic notation. I will therefore remark that the simplest case or type of book-credit is represented by the formula

P — Q.Each of the letters, P and Q, indicates a person or a firm, and the line indicates the existence of transactions between them. Only in special cases, however, will this direct balancing of accounts render the use of cash or of a more complex system unnecessary. Generally speaking, there will be a tendency for a surplus of goods to pass in one direction, so that money must pass in the opposite direction. The manufacturer sells to the wholesale dealer, the hatter sells to the retailer, and the retails retailer to the consumer. By the intervention of the banker, however, the transactions of many different individuals, or even of many branches of trade, are brought to a focus, and a large proportion of payments can be balanced off against each other.

Note the methodology of Jevons. He is interested in empirical observations and strives to explain first how credit works before any theory is brought forward. This is different today. Take Paul Krugman’s core-periphery model, for instance. It created the New Economic Geography, which is supposedly a theory that can explain (parts of ) industry location, stability of agglomerations and whatnot. However, it does not feature money. This is a most peculiar thing. The 1991 model by Krugman and later models do not feature equilibria where the current account is unbalanced because there are not financial assets that could balance the balance of payments. This is all the more surprising since Krugman also wrote extensively (and well) about financial crises. Krugman (1999, 9) writes:

“If there is a single statistic that captures the violence of the shock to Asia most dramatically, it is the reversal in the current account …”

If we assume that in good times (during the boom) there is no large demand for macroeconomists, then it would be logical that when looking at economic geography you allow for current account imbalances, isn’t it, so that when the crisis comes you can explain how current account deficits had been financed and how that finance is not forthcoming anymore (which os why the IMF comes in, usually). Think of Spain, Greece, the Baltics, etc. I think that in order to deal with crisis old models and old habits have to be discarded. We need to describe reality in detail before we make maps. This then is not a call to suspend modeling, but a call to comprehend reality first before employing models. After all, it was the failure of our maps that led us to the way we live now. And it is not so hard to spot current account imbalances in the real world. They have been ignored because of an undue focus on models and their equilibrium assumptions. This is an intellectual failure that can be repaired.